L. Randall Wray, Professor, University of Missouri—Kansas City


In this chapter, we will explore the nature of “government finance”. The approach presented here is properly called a “functional finance” approach to government finance—an antidote to conventional principles of “sound finance”. Readers will recognize the debt owed to Abba Lerner; indeed, some functional finance principles were incorporated into Keynesian economics—bastard and otherwise—but I believe the full import of Lerner’s principles of functional finance has not been recognized even by followers of  Keynes. An understanding of the nature of government finance not only sheds light on “fiscal policy”, but also on the true nature of what is normally called “monetary policy”. We will then move on to analysis of US government budget surpluses at the beginning of the new millenium, and of projections that these will continue into the twenty-first century as the government retires its outstanding debt stock.



According to the conventional view, tax revenue provides the income needed by the government to finance its spending. A government might be able to spend in excess of its revenue, at least temporarily, if it is able to issue debt that the public will hold. That is, the government might be able to borrow from the public to finance deficit spending. One method that is almost universally scorned is for the government to issue non-interest-bearing debt – currency – to finance deficits. This can either be done directly by the Treasury, or indirectly through the central bank. Because government deficits financed in this manner would directly cause the money supply to expand, many economists claim this would directly cause inflation.

            If, instead, the government sold interest-earning bonds to finance (or ‘fund’[i]) its deficit, the money supply would increase – according to most economists – only if the central bank ‘accommodated’ by increasing bank reserves. So long as the central bank did not accommodate, there should be no direct impact on inflation.[ii] However, government borrowing is likely, according to a common view, to ‘crowd out’ private borrowing because government borrowing adds to the demand for loanable funds, driving up interest rates, and displacing interest-sensitive private spending (presumably, investment, housing, and consumer durables). Crowding out can be partial, complete, or even more than complete, depending on assumptions.[iii] Over the longer run, if crowding out does occur, this will depress aggregate supply and could thereby induce cost-push inflation.

            Finally, while most economists recognize that at least under some situations government deficits are desirable (and that at times, benefits outweigh costs), most would argue that persistent deficits must be avoided. Even Keynesian[iv] economists generally argue that structural deficits should be avoided; that is, while a government should run deficits in recessions, these should be offset by surpluses during expansions. It is believed that permanent deficits must be avoided because no government can operate in such a manner as to generate the expectation that it will never be able to retire its debt, that is, the expectation that debt can only be ‘rolled over’. While there may not be a specific debt-to-GDP or deficit-to-GDP ratio at which markets lose trust in the government, it is not doubted that such thresholds exist.[v] Governments are thus believed to be subject to market forces that determine the quantity of debt the government can issue as well as the price (interest rate) of the debt. If the domestic population will not take up all the debt, the government is forced to sell bonds in international markets. International markets might even force the government to borrow in a foreign currency (issue foreign-currency-denominated debt) if the country’s finances are questionable. Indeed, the government may be forced to impose austerity on its population in order to placate international markets before it will be able to sell bonds internationally.

            The principles of “sound finance” can also be applied to portions of the government’s budget, representing individual programs such as the Social Security program. Since 1983, “sound finance” has meant running large and rising OASDI (Old-Age and Survivors Insurance) surpluses in order to “advance fund” baby-boomer retirements. The reasoning behind this will be familiar to all readers: the number of retirees per worker will rise rapidly early this century, making it impossible to cover (rising) OASDI benefit payments from payroll taxes (without raising them to exorbitant levels). (Papadimitriou and Wray 1999) Thus, surpluses are necessary today in order to “save” and thereby reduce the burden on future workers. Many analysts have (belatedly) recognized some of the peculiarities of trying to keep separate accounts for a portion of the government’s budget.  For example, some controversies have centered around the practice of “accumulating” Social Security surpluses in the form of Treasury debt. Those holding up the troglodyte end of the debate argue that when it comes time for babyboomer retirements, the Treasury might just default on the debt, thus, favor “investing” Social Security surpluses in a broader range of—presumably more credit-worthy—private assets. The more astute argue that when the time comes, the Treasury will either have to raise other (non-payroll) taxes, borrow, or “print money” to retire the IOUs held by the Social Security Trust Fund. Thus, some (including Friedman 1999) have argued that the Trust Fund is nothing more than an “accounting gimmick” that allows the government to “owe itself”.

“Keynesians” (Blinder 1999, Summers and Yellin 1999) have defended current practice, arguing that to the extent that Social Security can run large surpluses, this can offset deficits in the rest of the government’s budget. Indeed, because of the extraordinary turn-around achieved during the Clinton boom, the overall budget has moved to surplus allowing retirement of some publicly held debt. So far, the surplus is entirely attributable to the Social Security program, but on current projections the rest of the budget will move to surplus soon. Indeed, surpluses are now projected as far as the eye can see, which leads “Keynesians” to argue that the government’s budget is contributing to national saving and thereby lowering interest rates and stimulating private investment. (Blinder 1999) This will then generate faster economic growth and thereby lessen the “real burden” on future workers of providing for the elderly. Thus, running Social Security surpluses is “sound finance” that adds to expected surpluses on the rest of the budget. While the normal “Keynesian” position would be that there is nothing necessarily wrong with running cyclical budget deficits so long as budgets are structurally balanced, the “excesses” of the Reagan-Bush deficits justifies structural surpluses over the intermediate term. This is butressed by the new-found faith in the ability of Saint Greenspan’s Fed to offset the depressionary impact of budget surpluses (in spite of the oft-repeated warning that one cannot “push on a string”, as well as the glaring example of the Japanese quagmire), which has led  Blinder and Summers to support structural budget surpluses—at least through the first two decades of the new millennium. 



Let us turn to a more fundamental question: why is it important to balance budgets? If an economic unit cannot “spend” by issuing its own IOUs, its spending is limited by its stock of readily accepted medium of exchange and flow of income received in the form of the medium of exchange. We might call this a liquidity constraint. Clearly, most economic units are not strictly limited by liquidity constraints because they are able to incur liabilities as they spend. Sometimes this takes the simple form of postponed payment—for example, allowing “payment” thirty days after delivery of a good or service—which is the implicit acceptance by the seller of a short-term liability. Other times, a financial intermediary is involved, allowing a seller to receive immediate payment in the form of the medium of exchange while a buyer is committed to deferred payment of principal and interest to the intermediary. Of course, variations on these themes lead to complex financial instruments and financial commitments. Minsky (1986) created a tripartite division to describe financial positions: hedge to denote an economic unit whose income flows meet committed outflows in every period; speculative to identify a unit that could meet only interest payments out of income flows over at least some of the contract period; and Ponzi to indicate a unit that would have to “capitalize” interest—that is, increase liabilities just to make interest payments.

Note that there is no “deep” economic constraint on ability to spend by incurring liabilities—if one can “borrow” to pay interest (Ponzi finance), there is no strict limit to the amount of debt that one can service—even if one had no income at all. Recognition of this simple point has long bothered economists, leading to Smith’s admonition that banks must require repayment of loans by delivery of banknotes rather than “fictitious” bills of exchange[vi], as well as to the “real bills doctrine” (which would limit expansion of bank lending to “self-liquidating” debts).

Modern economists have tended to resolve this issue by looking at long-run sustainability, often defined as a situation in which the debt-to-income ratio is not permitted to rise beyond some limit. However, it should be clear that such a constraint is of necessity arbitrary—rules of thumb, accounting rules, or regulatory limits that establish constraints on the ability of an economic unit to issue debt—and because these limits are a human invention, they can be finessed and changed. This is not to argue that such rules are not reasonable. For example, one might reasonably argue that an economic unit with a finite life span should be expected to retire liabilities before, or at, the time of death, unless liabilities can be forced onto heirs. However, there is no “deep” reason why even the dead could not continue to service debt through Ponzi finance. In any case, economic units with potentially unlimited lifetimes, such as governments or corporations, do not face this problem, but one could pick from among a number of reasonable constraints that might be imposed—such as a limit to the portion of income flows that ought to be devoted to debt service. Let us emphasize that such a constraint, while reasonable, would be chosen arbitrarily.

When we turn to the case of a sovereign nation, which has the right to issue currency, it is not so easy to determine what is an income flow. Most would identify tax revenues as the appropriate accounting equivalent to a nongovernmental income flow. However, it has long been recognized that governments obtain seigniorage income if they can issue currency whose nominal value exceeds its cost of production. Even in the case of a gold standard, it is supposed that government typically obtained seigniorage either by charging for minting precious metals brought to the mint or by debasing coin. Clearly, in the modern economy with a “fiat” money, the cost of issuing currency falls close to zero. This means that “printing money” is an alternative to “tax revenue” as an income source, and because the direct costs to government are nearly zero “seigniorage” generates an unlimited income so long as the fiat money is accepted.

Orthodoxy posits a limit to the public’s acceptance of government currency—“money demand” is not infinite except under special circumstances (the liquidity trap). Beyond some point, it is argued, the government might have to issue interest-paying bonds, “borrowing” money rather than issuing it. This commits government to paying interest, thus, bond issue could lead to a Ponzi finance situation if tax revenues plus money emission become insufficient to pay interest on the outstanding debt stock (requiring government to issue bonds just to raise the “money” required to pay interest). As discussed above, this does not in itself lead to a necessary constraint on government spending. Rather, most analysts would argue that it is the economic effect on the economy that places a limit on the prudent level of deficits or growth of deficits or level of debt or debt ratio.[vii] Such impacts could include effects on prices or interest rates.

In the next section, we turn to an alternative view of “government accounting”, before returning to current debates about the government surplus.



Abba Lerner presented a functional finance approach as an alternative to the doctrine of sound finance. He argued

             Functional Finance rejects completely the traditional doctrines of ‘sound finance’ and the principle of trying to balance the budget over a solar year or any other arbitrary period. In their place it prescribes: first, the adjustment of total spending (by everybody in the economy, including the government) in order to eliminate both unemployment and inflation, using government spending when total spending is too low and taxation when total spending is too high; second, the adjustment of public holdings of money and of government bonds, by government borrowing or debt repayment, in order to achieve the rate of interest which results in the most desirable level of investment; and third, the printing, hoarding or destruction of money as needed for carrying out the first two parts of the program. (Ibid. p. 41)

 We will argue that his approach can be applied to all modern economies in which the government provides the domestic currency. Our discussion that follows cannot, however, be applied to any country that adopts an external currency—for example, one that operates a currency board. Governments of such economies are not able to issue a fiat money.

            Virtually all modern capitalist economies operate on the basis of a high powered money (HPM) system[viii]. The HPM is issued directly by the Treasury (as in the US, where the Treasury issues coins or checks) or through the central bank (as in the US, where the Fed issues paper notes and issues reserves whenever banks present Treasury liabilities for payment) as a non-convertible government (Treasury) or quasi-government (central bank) liability. This HPM generally functions as legal tender, that is, it is sanctioned by the courts as the money which fulfils ‘all debts, public and private’. It is the only money that is ultimately accepted in payment of taxes.[ix] It is also the money into which bank liabilities are convertible (either on demand or after some specified waiting period), and which is used for ultimate (or net) clearing among banks and between private banks and the central bank. It is the money used as the link between the public and private pay communities.[x] It is the money that sits at the top of the debt pyramid (or hierarchy), or the ‘definitive’ and ‘valuta’ money.[xi] It is the most liquid liability used domestically – except in rare circumstances where a foreign currency is used domestically (as is the case in some of the formerly socialist countries today). The most important thing to understand is that in a normally functioning modern economy, the domestic HPM is always accepted in exchange for domestic production; anything that is for sale with a dollar price can be had by delivering US currency (coins or notes).[xii]

            When a modern government spends, it issues a check drawn on the Treasury; its liabilities increase by the amount of the expenditure and its assets increase (in the case of a purchase) or some other liabilities are reduced (in the case of a social transfer, for example, Social Security benefit liabilities are reduced by the amount of Social Security checks issued). The recipient of the Treasury check will almost certainly ‘cash’ the check at a bank; either the recipient will withdraw currency, or, more commonly, the recipient’s bank account will be credited. In the latter case, bank reserves are credited by the Fed in the amount of the increase of the deposit account. For our purposes, it is not important to distinguish between the Fed’s and the Treasury’s balance sheet. The bank reserves carried on books as the bank’s asset and as the Fed’s liability are nothing less than a claim on HPM – at any time, the bank can convert these to coins or paper notes, or use them in payments to the government. When the recipient ‘cashes’ a Treasury check, a bank will convert reserves to currency – which is always supplied on demand by the Fed, which acts as the Treasury’s ‘bank’, converting one kind of Treasury liability (a check written to the public) to another kind (coins or an IOU to the Fed, offset by Fed issuance of paper notes).

            The important thing to notice is that the Treasury spends before and without regard to either previous receipt of taxes or prior bond sales. In the US, taxes are received throughout the year (although not uniformly as receipts are concentrated around certain quarterly dates, as well as the 15 April deadline) mainly into special tax accounts held at private commercial banks. It is true that the Treasury transfers funds from the private banks to its account at the Fed when it wishes to ‘spend’, but this is really a reserve maintenance operation. When the Treasury spends, bank reserves increase by the same amount (unless cash is withdrawn from banks) so that the transfer from tax accounts is used to stabilize bank reserves. If the Treasury did not make this transfer, its spending would lead to an increase of bank excess reserves, which would have to be drained by the Fed. Thus, if the Treasury attempts to transfer funds more-or-less in step with its spending, this reduces the size of interventions required of the Fed. These additions to/subtractions from reserves need to be carefully monitored, with a central bank injection of reserves used to make up any shortfall (for example, if transfers from tax accounts exceed deposits of Treasury checks) or a reserve drain used to remove excess reserves.

            These central bank actions are taken to offset the daily fluctuations that destabilize the overnight interest rate (called operating factors). By consolidating the Fed and Treasury balance sheets, one sees that in reality, the Treasury cannot withdraw taxes from the economy before spending – any transfer of tax accounts from the private economy to the government’s balance sheet would have to be exactly offset by government provision of an equivalent amount of HPM through use of the Fed’s balance sheet. In practice, a tax payment to the Treasury leads to debit of a commercial bank reserve account. If that bank has insufficient reserve balances at the Fed, it incurs an overdraft that is booked as a loan of reserves from the Fed to the bank. Thus, HPM is restored automatically whenever the Treasury accepts tax payments that lead to insufficient reserve positions. Indeed, this is necessitated by “par clearing”—if bank checks always clear at par in payments made to the Treasury, then HPM must be provided as needed to the banking system to ensure there is HPM available for clearing purposes.

            In any case, as government is the only supplier of HPM, it cannot receive in taxes HPM that it has not provided to private markets. The original source of all HPM must be the (consolidated, Fed plus Treasury) government, and the coordination between the Treasury and central bank is required to maintain reserves. If it were not for the effect of government spending on bank reserves, there would be no need to tie spending to transfers from tax accounts. The coincident timing of tax ‘receipts’ and government spending (or central bank open market operations) is not an indication of a ‘financing’ operation but rather is required to maintain stability in the market for reserves. The implication is that tax payments do not ‘finance’ government spending but that they must serve another purpose. (See Bell 1998, Mosler 1997-8,  and Wray 1998, Chapter 5 for further exposition.)

            In principle, then, the government first spends HPM (to purchase goods, services, and assets or to provide ‘transfer payments’, which retires a government liability). Once the government has spent, then that HPM is available to be transferred to the government to meet tax liabilities. As a matter of logic, the public cannot pay HPM to the government to meet tax liabilities until the government has paid out HPM to the public. In a modern capitalist economy, it may appear more complex than this because most taxes are paid using checks drawn on bank deposits, rather than currency. However, this amounts to the same thing since every payment of taxes generates a reserve clearing drain, or, a loss of reserves.[xiii] Thus taxes cannot be paid until actual coins or notes are injected into the economy, or bank reserves have been created. Government expenditure will generate coins, notes or bank reserves that are needed to ‘pay taxes’. It is also true that central bank “lending” (purchases of bank IOUs, or discounts against bank assets), as well as central bank purchases of gold or foreign currencies, injects HPM and can thus substitute for government spending, more narrowly defined. In practice, in most nations this is done only on a temporary basis (properly categorized as passive interventions).

            Given these considerations, a balanced budget is the theoretical minimum that a government can run continuously—again, with the caveat that if a central bank were willing to continually intervene to lend to banks or to buy gold and foreign currencies, the treasury could run a persistently balanced budget, or even a surplus. Normally, if the government were to attempt to run a surplus, the public would find that its ‘net money’ receipts of HPM would be less than its tax liability, requiring households to dip into hoards of HPM (accumulated from past government deficit spending and purchases of assets) to pay taxes. (Again, an exception must be noted for the case in which the central bank continually lends to banks or buys gold and foreign currencies.) Eventually, of course, the hoards would be depleted. Finally, the public could present maturing government bonds for payment to obtain HPM with which to pay taxes, but, again, this is limited to the portion of the outstanding debt stock that is maturing (itself a function of previous government deficits and the maturity structure of the debt). (It should also be noted that much of the outstanding debt stock is “locked away” in tax advantaged accounts, unavailable to a public trying to liquidate claims on government in order to make tax payments.) After the public has run down its holding, the only sources of HPM to pay taxes are new government (deficit) spending or government purchases of assets (including purchases by the central bank). However, for reasons discussed below, it is highly unlikely that an economy can withstand the deflationary impacts of government surpluses for long—thus, we would expect surpluses to be short-lived so that the normal case is a deficit position and rising government debt over time.

            We have hinted that taxes do not finance government spending. Then what is their purpose? If the government spent HPM but did not impose an HPM tax, it is difficult to see why anyone would trade goods and services to the government in exchange for HPM. Certainly one could not explain the “origins” of government purchases on the basis of emission of HPM unless there were already in place a demand for the HPM. This original demand must have come from imposition of an HPM tax. Of course, once the public has become accustomed to use of HPM in market exchanges, it might be possible to conceive of an inertial demand for HPM that could persist for some time even after abolition of HPM taxes. However, without the tax system to underlie demand, it is difficult to imagine that the public would continue to use HPM in private exchanges, and even more difficult to imagine that the public would sell things to the government in exchange for HPM, if HPM were not needed to make payments to the government. The tax burden must be sufficiently great to create a general demand for HPM in order to pay taxes. Beyond that, taxes are used—as Lerner said—to remove excess HPM income that might generate spending so great as to generate inflationary pressures. Thus, taxes can be thought of as one of the spokes of the steering wheel, used to adjust aggregate demand by reducing disposable income when it becomes too high.


If government spending is ‘financed’ through emission of HPM, and if tax revenues are adjusted only to ensure aggregate disposable income is at the correct level – rather than to ‘finance’ government spending – then why does the government sell bonds? Of course, governments believe that they must sell bonds to borrow the funds necessary to financing spending. However, this is an illusion, as the spending must come first. As we will argue, bond sales (whether by the treasury or by the central bank) function to drain excess reserves; they cannot finance or fund deficit spending. This view builds upon Lerner’s second law of functional finance: ‘the government should borrow money only if it is desirable that the public should have less money and more government bonds’ (Lerner, 1943, p. 40). More specifically, bond sales are designed to substitute an interest-earning government liability for non-interest-earning government HPM, and is properly thought of as a monetary policy operation rather than a fiscal policy operation.

            As discussed above, all government spending is initially financed through issuance of HPM; this normally takes the form of a Treasury check, deposited at a private bank, increasing bank reserves by the amount of the government spending. To avoid a situation of excess reserves, a simultaneous transfer is made from bank tax and loan accounts to the central bank. However, in the case of a government deficit, the amount of HPM created exceeds the amount of bank reserves removed through tax payments. In a fractional reserve system, this normally creates an excess reserve position of the banking system. Some reserves will be withdrawn by the non-bank public, which holds some HPM in the form of currency. However, most will remain as excess reserves.

            Individual banks will offer excess reserves in wholesale markets – namely, the fed funds market at the fed funds rate – which can shift reserves around but cannot eliminate the excess. The excess reserves will force a “market break”, with fed funds offered finding no takers. While it is true that in the longer run banks can adjust to a position of excess reserves through normal growth of their loan and deposit portfolio (which, all else equal, increases required reserves), in the short run the only adjustment can be to the fed funds rate. Since all modern central banks operate with an overnight interest rate target, excess reserves automatically trigger bond sales (typically, reverse repos or matched sale-purchase transactions) by the central bank to drain excess reserves. Note that prevention of a market break requires that this operation is nearly simultaneous with the creation of excess reserve positions. 

            In the US, primary sales of bonds to drain reserves are undertaken by the Treasury, while the Fed uses repos and reverse repos to ‘fine-tune’ as it adds/drains reserves to offset daily operating factors. Primary bond sales permanently ‘mop up’ excess reserves created by government deficits, providing interest-earning alternatives to non-interest-earning excess reserves held by banks and cash held by the public.   If a government were to decide to avoid sales of bonds in primary markets, the central bank would eventually drain all the reserves it could through sales of bonds and foreign currency, as it would eventually run out of bonds and foreign currency to sell. At that point, it would be up to the Treasury to sell bonds to drain any remaining excess reserves. This reinforces the view that bond sales are part of monetary policy and not a financing operation to allow the government to run deficits. It also points out that rather than deficit spending raising interest rates, it actually places downward pressure on interest rates. If the government did not drain the excess reserves, the overnight (fed funds) interest rate would tend to fall toward zero.

            Government spending is never constrained by the quantity of bonds that markets are willing to purchase; rather, bond sales are undertaken to provide an interest-earning alternative to cash and excess reserves. Government spending is constrained only by private sector willingness to provide goods, services or assets to government in exchange for HPM. Anything that is for purchase in terms of the domestic currency can be had through government creation of HPM. If excess reserves result, the government will have to drain them if it wishes to hit a positive interest rate target.

             Governments sometimes believe that they must sell bonds in international markets because domestic markets are already saturated with bonds and any further domestic sales would require higher interest rates. While this can be true, it has reversed the causation: the government does not ‘need’ to sell bonds at all; bond sales are by design an ‘interest rate maintenance’ operation. Thus, while it might be true that at a higher interest rate government might induce the public and banks to give up some HPM (although this effect is probably quite small because the demand for HPM is highly interest-inelastic), this is not an indication that the government is ‘forced’ to pay higher rates to ‘finance’ its deficit. It can always incur more deficits and then drain resulting excess reserves at any interest rate above zero that it desires.

            Since bond sales are really nothing more than an interest rate maintenance operation, the government can decide the interest rate it will pay – or, alternatively, the price of government bonds – in its monetary policy. Thus government deficit spending is never subject to ‘market discipline’ regarding either the quantity of bonds sold or the price at which they will be sold, so long as the bonds are issued in the domestic currency. When there are excess reserves, the market will ‘demand’ bonds at any interest rate above zero, for the alternative is non-earning excess reserves. There may be very good reasons for maintaining a significantly positive interest rate on government bonds, but it is never necessary to do so merely because the market would like a high interest rate. A high government borrowing rate is evidence that the government (treasury plus central bank) has chosen a high interest rate – it tells us nothing about ‘market forces’ of supply and demand. The government can always have a lower interest rate merely by reducing the interest rate target. Interest rates are determined by monetary policy and cannot be affected by fiscal policy.

            Note that both bond sales and payment of taxes drain HPM from the economy. However, they serve different purposes. Taxes are used to drain excessive disposable income and to reduce private sector net (or “outside”) wealth to prevent aggregate demand from becoming too high. This is a legitimate function of fiscal policy. However, bond sales—whether conducted by the Treasury or the Fed—are a function of monetary policy. Furthermore, bond sales merely change the form of outside wealth—from holdings of HPM to holdings of interest-bearing debt—but leave wealth intact. Thus, while orthodoxy frequently sees bond sales and taxes as “alternative” means of “financing” government spending, they actually serve quite different functions and have quite different impacts on the economy.



According to President Clinton's 1999 and 2000 State of the Union addresses, we are on a course to run federal government budget surpluses for the next 15 to 25 years. On current projections, these surpluses are so large that all the publicly held debt of the US government would be completely eliminated by 2015. The President actually proposed that some portion of the surplus be “set aside” to be held in Social Security trust funds. For example, if a budget surplus of $100 billion were to accrue in one particular year, $100 billion worth of government bonds held by the public would be retired, while perhaps $60 billion worth of new government debt would be created to be held in the trust fund. This would be described as “saving” 60% of the budget surplus to be used later when babyboomers retire.

            The President’s analyses have been well received. A number of prominent economists, including at least six Nobel winners circulated an open letter after the 1999 State of the Union address dubbing the president's plan "good economics" and stating that "Although no one can predict how large the budget surpluses will turn out to be, we can be sure that saving them by reducing outstanding government debt is an excellent way to ease the burden on future workers of supporting an aging population." Lawrence Summers, now Secretary of the Treasury, and Janet Yellen, chair of the President's Council of Economic Advisers, assured us that the president's proposal to "lock away" most of the projected budget surpluses in the Social Security Trust Fund is based on "sound accounting" and that it will extend Social Security's solvency through 2055. David Broder's Washington Post article (February 7, 1999) proclaimed the plan to be "the greatest gift to our children" because it will "help grow the economy" by "raising national savings." Unfortunately, the accounting is not sound, and a policy that would preserve surpluses in an attempt to retire Treasury debt held by the public is anything but a gift to our children.

            With one brief exception, the federal government has been in debt every year since 1776. In January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called "a fund to meet future deficits." (See Wray 1998, p. 63, and Stabile and Cantor 1991.) In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since. Since 1776 there have been six periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson's efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. (Thayer 1996) The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction. Further, every budget surplus has been followed, usually sooner rather than later, by renewed deficits. However, correlation—even where perfect—never proves causation. Is there any reason to suspect that government surpluses are harmful?

            At the macroeconomic level, government expenditures generate private sector income; taxes reduce disposable income. When government spending exceeds tax revenue (a budget deficit), there is a net addition to private sector disposable income. This addition may well have secondary and tertiary and even further effects (for example, households may spend on goods produced domestically or abroad, thereby raising consumption or imports as measured in national GDP accounts). Some of that extra disposable income is devoted to saving, first accumulated in the form of HPM which is then exchanged for interest-earning government debt when the Treasury sells bonds. Even if the Treasury did not sell the bonds, however, the private sector would be (nominally) wealthier by an amount equal to the government's deficit, but this would be held in the form of non-interest-earning cash (and bank reserves) for the simple reason that the total value of checks issued by the Treasury to finance expenditures would exceed the total value of checks written by the private sector to pay taxes.

            On the other hand, when tax revenues exceed government spending (a budget surplus), private sector disposable income is reduced. Again, there may be further effects (consumers may cut back spending, for example). Because checks received by the Treasury exceed the value of checks issued by the Treasury whenever there is a surplus, outstanding cash and bank reserves will be reduced. To restore cash and reserves, the private sector sells Treasury bonds. The bonds are purchased by the Fed and the Treasury; the purchase restores reserves and cash. (Sales of bonds between private sector entities cannot add reserves or cash; they simply shift reserves and cash from one "pocket" to another.) Note that if the Treasury refused to buy the bonds (that is, refused to retire outstanding debt), then only the Fed would be left to buy them. This is why any sustained surpluses must be met by Treasury retirement of the debt, for otherwise the Fed would accumulate vast holdings of Treasury debt (on which the Treasury pays interest) while the Treasury would hold huge deposits in its checking account at the Fed. (In practice, the Treasury tries to end each day with a deposit of $5 billion.) For this reason, it is quite silly to argue about “what to do with the surplus” and to debate about whether some of the surplus ought to be used to retire outstanding debt. In truth, simple accounting ensures that if the government taxes more than it spends, it has reduced the private sector’s holdings of claims on government.

            Movements of the budget position are largely automatic. Rapid economic growth, such as that experienced in the United States since 1992 or in Japan previous to 1988, tends to cause tax revenues to rise faster than government spending, resulting in surpluses. Recessions and depressions tend to cause tax revenues to fall as spending rises, resulting in deficits. Many economists focus on the secondary or tertiary effects of government deficits and surpluses. While they might agree that deficits increase disposable income and private sector wealth, they argue that deficits also increase interest rates and thus depress investment or that households reduce consumption on the expectation that tax rates will be increased in the future. They argue that while surpluses might reduce disposable income and private sector wealth, they also lower interest rates and thus spur private capital formation. While I believe these arguments are based on faulty reasoning (the belief that deficits push up interest rates, for example, is based on the flawed notion that interest rates on government bonds are competitively set, and the “Ricardian Equivalents” argument is based on the flawed view that bond sales and taxes “finance” government spending), it is possible that under some conditions the secondary effects might outweigh the primary effects so that, at least for a while, deficits might depress the private sector and surpluses might stimulate it. However, history and theory suggest that over the longer run, deficits can allow the economy to grow while surpluses can inhibit growth.

            If, as projected, the federal government continues to run surpluses (resulting in Treasury debt retirement), this must as a matter of course remove $4.5 trillion of private sector income and wealth over the next 15 years. Can an economy withstand such a bloodletting? Our own history suggests not, and we can also look to the recent experience of Japan.

            Since WWII we have had the longest depression-free period in the nation’s history. However, we have had nine recessions, each of which was preceded by a reduction of deficits relative to GDP. The deficit fell rapidly toward the end of the Carter presidency, preceding the deepest recession since the Great Depression. In spite of President Reagan's pledge to balance the budget, he presided over the largest deficits we had seen since World War II. To some extent, the deficits grew because of the economic slowdown; however, tax cuts and spending increases (primarily for defense) caused a discretionary increase of the deficit. The "Reagan boom" lasted from November 1982 to July 1990, the longest expansion in the postwar period (until it was surpassed by the Clinton expansion). Predictably, this reduced the deficit relative to GDP and preceded the Bush recession. In the early years of the Clinton presidency, the deficit grew again and was projected to continue. However, as a result of the long expansion and budget agreements, the deficit was entirely eliminated, and we experienced our first budget surplus in a generation.

            Indeed, as Godley (1999) has demonstrated, the turn-around of the budget from deficit to surplus was the sharpest in the postwar period. The budget now seems to be so biased toward restraint that economic growth will generate continued surpluses. Given a US trade account deficit and a government budget surplus, economic growth is made possible only by a domestic private sector deficit—that is, by private expenditures exceeding private income.[xiv] Godley has demonstrated that the gap between private income and spending had reached entirely unprecedented levels by 1998—and that gap continues to increase each year in which GDP grows. Continued private sector deficits also mean growing private sector indebtedness—which by 1999 had also reached record levels. While it is impossible to say with certainty when the private sector will finally decide to retrench, it is simply not conceivable that private sector deficits and debts will grow without limit. Returning to our discussion above, there is no “deep” accounting necessity that sets a strict limit to the private sector’s ability to spend more than its income. By the same token, neither theory nor evidence would suggest that households and firms would deficit spend at an increasing rate forever. It is curious that those who would deny that the government can deficit spend in perpetuity would argue that the private sector will deficit spend for the next two decades in order to allow the government to retire all its debt.

            Americans know that Japan's growth rate in the 1980s was the envy of the world, but they are generally unaware that the government deficits as a percent of GDP rivaled those in the United States. The enormous growth of the 1980s caused government tax revenue to rise faster than spending so that by the late 1980s the budget moved to surplus. The Japanese economy moved into a recession-cum-depression from which it has not been able to recover. Government deficits have been restored, but as a result of the sluggish economy, not as a result of discretionary, expansive, fiscal policy. While there have been some small initiatives to cut taxes and increase government spending, Japan has primarily relied on monetary policy to get it out of recession. Indeed, Japan held interest rates essentially at zero in an attempt to stimulate the economy. To this point, the most expansive monetary policy the world has seen since World War II still has not succeeded in jump-starting Japan's economy. This might serve as a cautionary tale for those who believe that Chairman Greenspan can keep the U.S. expansion going in spite of budget surpluses that are expected to rise well above 2 percent of GDP early this millenium.

            It is difficult to take seriously any analysis that begins with the projection that our government will run surpluses for the next 15 or 25 years. Part of our skepticism comes from the inherent difficulty in making projections. Even more important, our economy cannot continue to grow robustly as the government sucks disposable income and wealth from the private sector by running surpluses. When the economy slows, the surpluses will disappear automatically—and because the private sector will eventually demand that the government stop draining income from the economy. Tax cuts will be rushed through Congress and the president will put forward spending initiatives.

            Finally, surpluses, even if realized, cannot be "locked away" for future use—for example, to be used by retiring baby boomers. In every period that government spending falls short of tax revenues, outstanding government debt is retired. Equivalently, the private sector's stock of wealth is reduced (since a budget surplus reduces disposable income, and this shows up as a reduction of government debt in private portfolios). There is simply no "surplus" that can be "spent" or even "saved." Should the government decide to spend more, that simply increases spending relative to taxes and results in a smaller budget surplus. When total federal government tax revenue falls short of expenditures (including those associated with Social Security), this first takes the form of net injections of HPM. In order to allow the central bank to hit its overnight interest rate targets, the Treasury will issue new debt to the public to drain excess HPM. But it must do this whether or not there is a Trust Fund. Neither budget surpluses over the next 15 years nor accounting fictions can change that simple fact. There may be good (noneconomic) reasons for keeping Social Security accounts separately from the rest of the budget, but this should never lead one to believe that a projected “revenue shortfall” can be cured by having the government issue IOUs to itself.


All modern governments spend by emitting HPM, normally by having the Treasury issue a check. Taxes are never necessary to “finance” spending, nor, indeed, is it possible for them to do so. The government must first provide the HPM before it can receive HPM in tax payment. Thus, taxes serve a different purpose. The primary function of taxes is to create a demand for HPM—for why would the private sector provide goods and services to government in return for HPM unless it needed HPM for taxes? Of course, we recognize that HPM can be used for many things other than tax payment, but these other uses must be derivative. Taxes also serve another useful purpose, as Lerner emphasized: they remove disposable income and destroy private sector net wealth.

            Far from recommending perpetual deficits come what may, the functional finance approach recognizes that the private sector can become overheated, which is remedied through rising taxes to drain HPM and disposable income. Deficits can be too large, but also too small. We normally expect that a deficit will be required, however, for the simple reason that the private sector prefers to accumulate some net wealth in the form of HPM and Treasury bonds. For this reason, the government will usually be required to run a deficit, which means that its outstanding debt stock will grow over time. This is nothing to be feared. The government never faces a “financial constraint”, so long as its offers of HPM for goods and services are taken. Bond sales come after government spending, so, like taxes, cannot possibly be required to “finance” spending. Rather, bond sales are used to drain excess HPM to maintain a positive overnight interest rate. Whether that interest rate target is high or low, it must be set discretionarily by the central bank and then maintained by ensuring banks have the desired level of reserves. While taxes and bond sales both remove HPM from the economy, taxes drain income and wealth while bond sales merely offer an interest-earning alternative to non-interest-earning HPM.

            The functional finance approach concludes that there is no magic deficit-to-GDP ratio or debt-to-GDP ratio that ought to be maintained or avoided. It also demonstrates that there is no sense in which budget surpluses in one year can be “locked away and saved” for spending in future years. And it leaves one perplexed when faced with the argument advanced by Nobel winners that running surpluses today—hence, destroying private sector income and wealth—is the best way to encourage investment in order to enhance living standards into the future. 




Aschauer, David A. “How should the surpluses be spent?”, Policy Note 1998/2, Jerome Levy Economics Institute.

Bell, Stephanie. “Can Taxes and Bonds Finance Government Spending: Reserve Accounting and Government Finance”, The Third Annual Post Graduate Economics Conference: Conference Papers, Leeds University Business School, Novermber 1988.

Blinder, Alan S. “Strange but True Economics”, New York Times, 1999.

Friedman, Milton. “Social Security Chimeras”, New York Times, 11 January 1999, p. A-17.

Godley, Wynne. “Seven Unsustainable Processes: Medium-Term Prospects and Policies for the United States and the World”, Special Report, Jerome Levy Economics Institute, 1999.

Knapp, George Friedrich (1924/1973), The State Theory of Money, Clifton, NY: Augustus M. Kelley.

Lerner, Abba, “Functional Finance and the Federal Debt”, Social Research, vol. 10, pp. 38-51, 1943.

Minsky, Hyman P. Stabilizing an Unstable Economy, New Haven Ct: Yale University Press, 1986.

Mosler, Warren. “Full Employment and Price Stability”, Journal of Post Keynesian Economics, 20(2) Winter pp. 167-182, 1997-8.

Papadimitriou, Dimitri and L. Randall Wray, “Does Social Security Need Saving?: providing for retirees throughout the twenty-first century”, Public Policy Brief No. 55, 1999, the Jerome Levy Economics Institute.

Stabile, Donald R. and Jeffrey A. Cantor, The Public Debt of the United States: An historical perspective 1775-1990, New York: Praeger, 1991.

Summers, Lawrence and Janet Yellen, “Saving the Surplus will Protect Retirees”, Wall Street Journal, Thursday February 18, 1999.

Thayer, Frederick C. “Balanced Budgets and Depressions”, American Journal of Economics and Sociology, 55, April 1996.

Wray, L. Randall. Understanding Modern Money: the key to full employment and price stability, Aldershot: Edward Elgar, 1998.

 -----. “Surplus Mania: A Reality Check”, Policy Notes, Jerome Levy Economics Institute, No. 3, 1999.


8000 words excluding endnotes

L. Randall Wray
Professor, Economics Dept
Senior Research Associate, Center for Full Employment and Price Stability
211 Haag Hall
100 Rockhill Road
University of Missouri--KC
Kansas City, Mo 64110-2499
phone 816-235-5687, fax 5263
email [email protected]




[i].Economists often use the term ‘finance’ to indicate use of money to purchase a good, service or asset. It usually means the money was borrowed short term. The term ‘fund’ is used to indicate long-term borrowing. Thus one might borrow short term temporarily to ‘finance’ a purchase, then use long-term borrowing to retire the short-term debt and ‘fund’ the purchase long term.

[ii].The deficits still might be inflationary either due to ‘bottle-necks’ that lead to supply constraints and cost-push inflation, or due to excessive aggregate demand (causing demand-pull inflation) if the economy operates beyond full capacity.

[iii].It is even conceivable that ‘crowding in’ might occur – the government’s borrowing actually increases the demand for private bonds – although most economists do not pay much attention to this theoretical possibility. Some economists recognize that some government spending (for example, that on public infrastructure investment) is likely to increase private sector productivity and reduce private sector costs, which might encourage private investment.  See Aschauer (1998).

[iv] Both Post Keynesians and Bastard Keynesians have adopted such positions. For example, Hyman Minsky (1986) argued that Reagan’s deficits were too large and in danger of generating the belief that the government would never be able to repay them—which, he thought, might lead to a situation in which the government would not be able to issue new debt.

 [v] It is common to assert that the debt-to-GDP ratio must eventually converge to some value, for a perpetually rising ratio would be “unsustainable”. An important determinant of “sustainability” would be the relation between the economy’s growth rate and the interest rate paid on government debt; if the interest rate exceeds the growth rate, then debt would explode even if the “primary budget” (excluding interest spending) were in balance.

 [vi] See Wray 1998, p. 21.

 [vii] Although some simply assert that Ponzi finance is unsustainable because it implies debt ratios that increase without limit. In this case, the constraint is simply a mathematical constraint.

 [viii] We prefer to describe government-issued money as HPM rather than fiat money. We include bank reserves as HPM, while many would not include bank reserves in the definition of fiat money.

[ix].We sometimes say that HPM is a government liability. For what is the government liable? To accept its money in payment of taxes.

[x]. These terms were used by Knapp to describe transactions in the “private” economy (private pay community) and transactions between the private sector and the government (public pay community). See Knapp (1924) and Wray (1998).

[xi]. These terms were used by Knapp to describe the “ultimate” money created and accepted by government. See Knapp (1924) and Wray (1998).

[xii]. In the case of some extremely large transactions, it is conceivable that due to obvious problems arising from dealing with large sums of currency, intermediaries must be used so that no actual currency changes hands. The sale thus leads to credits and debits on computerized balance sheets of intermediaries – which leads to reserve-clearing transfers on the balance sheet of the central bank – but this changes nothing of principle, and these credits could be exchanged for fiat money both in theory and in practice.

[xiii].Unless the tax payment is offset by the Fed’s injection of reserves as it purchases assets.

[xiv] As Godley (1999) shows, the private sector’s deficit is identically equal to the government’s surplus plus the trade deficit.