Why Money Printing Works (And When It Doesn’t)

This past year, in response to the economic devastation caused by COVID, the Federal Government authorized at least $4 trillion of stimulus spending (nearly 20% of annual GDP), successfully sparing much of the country from the worst economic impacts of the crisis.

This amount of spending is unprecedented, and it has raised concerns about the sustainability of the national debt and inflation expectations. Many argue that this spending means that we are borrowing from our children’s future, falling under Chinese control, ensuring future Social Security cuts, or otherwise overwhelming the country with debt.

The goal of this essay is to demonstrate that these concerns are unfounded. Coming up with the dollars necessary to pay for things is not the constraint; inflation is. In order to understand why, we need to understand exactly how the government raises the money it wishes to spend.

How does the government raise money for spending?

With a keyboard.

You and I are users of the U.S. dollar. If we want to buy a house, we first must find someone willing to lend us dollars, and then we can make the purchase. We cannot buy the house until someone has given us the money first. The same is true for business, state/local governments, and foreign countries that borrow in U.S. dollars. If the debt bill comes due for any of these entities, and the entity doesn’t have enough U.S. dollars to pay the bill, it defaults, which obviously is very bad.

The Federal Government is not a currency user; it is a currency issuer. It does not need to get dollars from anyone in order to pay its bills; it can simply print/issue dollars into existence. Note that “printing” usually does not mean physically printing dollars. This is how it typically works:

1. Congress votes to authorize some spending. For example, let’s say they want to spend $1 billion on a defense contract with a specific company.
2. Congress tells the Federal Reserve to credit the account of this company with $1 billion
3. Every American bank has its own bank account at the Federal Reserve, so the Federal Reserve simply goes on their computer and changes the balance of the appropriate bank account by $1 billion.

That’s it.

This is extremely important to understand, because it illustrates that we do not depend on tax revenues, China, investors, or any other group to fund government spending. The Federal Government can always spend money if it chooses to do so. The dollars are generated on a keyboard at the Federal Reserve, not from outside funders.

Side note: assuming the Federal Government is in a deficit, it sells Treasury Bills equal to the amount of the deficit. However, it does not have to do this. It chooses to do this after it spends the money, just to allow holders of U.S. dollars to earn interest. Both dollars and Treasury Bills represent debt of the Federal Government, so you can think of Treasury Bill sales as switching out non-interest bearing dollars for interest-bearing dollars. If it chose to, the government could simply not issue Treasury Bills.

But doesn’t this lead to inflation, or even hyperinflation?

It depends. Government spending only causes inflation if the spending exceeds the capacity of the economy to produce goods and services.

Let’s say you have a hypothetical economy capable of producing 10 cars per year, and nothing else. Let’s assume that there is demand for exactly 10 of your cars, and you sell exactly 10 in a normal year. This hypothetical economy is running at 100% capacity.

In a normal year, if the government spends a large percentage of GDP to buy cars, the price of cars will rise because the demand for cars has now exceeded the capacity to produce them. If you do not raise prices, the economy will probably end up with a black market for cars selling at a higher price. So in this case, yes, government spending results in inflation, and no amount of money printing will get you more cars.

However, let’s say that your economy goes through some crisis, like a pandemic or another disaster. In this case, the demand for your cars will fall, so you may only sell 5 or 6 cars at their normal price, even though you still have capacity to produce 10. Here, the government can spend money (or send cash to its citizens) to purchase the 4 cars you would have otherwise produced in a normal year. As long as the spending doesn’t exceed the overall economic capacity, inflation will not occur.

This is why the Federal Government can spend $4 trillion (~20% of GDP) during COVID without triggering inflation; the increase in demand from the government spending offsets the collapse in demand due to COVID, but the spending does not exceed the capacity of the U.S. economy.

In summary, the Federal Government will never be forced to default on its debt because it always has the authority to issue more dollars, and inflation will not appear as long as government spending doesn’t exceed capacity.

So how do we know when the economy is operating at less than capacity?

The most obvious signs of slack in the economy are unemployment and underemployment, along with idle factories and price deflation.

If there are people, factories, and businesses sitting idle in the economy, it suggests that the economy is running below its capacity. Considering that we are currently around 6.7% unemployment, compared to ~3.5% pre-COVID (not to mention the large decline in labor force participation due to COVID), it is clear that our economy is running below capacity, and there is room to absorb more government spending.

You can still get localized inflation without getting overall inflation.

One important caveat to all of this is that “inflation” is an imperfect measure — it is a single number which attempts to capture millions of price movements across a complex economy.

Even if your overall economy is running below capacity, and inflation is low in the aggregate, government spending can still cause inflation on certain goods and services. An example of this can be seen in my hometown, South Bend, Indiana.

The payments from the initial stimulus package, combined with lower household spending due to COVID, resulted in the highest household savings rate in American history:

With these new savings, many Americans bought boats and RVs — large-ticket items which they could still use freely during the pandemic. The area around South Bend is a major producer of boats and RVs, and many companies in the region have done very well this year. Both the owners and employees of these companies have seen their incomes rise, and have been buying homes in the area. As a result, home prices have spiked around South Bend. This could be considered an example of localized inflation that indirectly resulted from government spending.

It’s important to keep an eye on these localized cases of inflation to make sure they are indeed localized and not indicative of overall inflation. We must always weigh any potential harms of inflation against the harms of not providing financial help to people struggling to pay for food and rent during the pandemic. At the moment, overall inflation appears to be under control and is the much smaller harm.