Should we Balance the Budget?

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    Just finished lesson 1.

    Looks good. I love this stuff. In the meantime I have a question.

    There is a movement in the US called The Compact for America >
    The basic idea is to pass a balanced budget amendment. I am confused about balancing the budget.

    It is my understanding that a fiat money system that is based on debt must have an ever expanding money supply. The US dollar is a fiat money system based on debt. So the US (through the FED and the Treasury) must constantly increase the amount of money in the system just to maintain the system. One way to do this is by borrowing more money.

    If the US passes an amendment to balance the budget the FED and the Treasury will not be able to increase the money supply by borrowing money. If the US can’t borrow money it will not be able to increase the money supply and the entire money system will collapse.

    I have two questions; first, do I have this right? I know that this is an oversimplified example. There seems to be a disconnect between borrowing money and creating money. Is there a simple example that describes the relationship between our fiat dollar and our ever expanding debt?

    Second, will the USD collapse if we pass a Balanced Budget Amendment?

    I would like to support the Compact for America but I am afraid that they don’t really understand the consequents of their actions. I know it sounds great to balance the budget but I’m not sure they know what would happen if we did.

    I don’t mean to take up too much of your time. If there is a link or something please show me the way.

    – Joe


    Fiat money is not itself a debt instrument. Debt comes into existence when one party, the lender, loans money to another party, the borrower. The debt instrument is the borrower’s I.O.U. to pay back the principle borrowed plus interest. U.S. Treasury securities are debt instruments. Corporate bonds are debt instruments. Certificates of deposit are debt instruments.

    Fiat money is money itself. It is not itself a loan to a borrower that the government must pay back principle plus interest in the future. Just like a counterfeit bills are not an I.O.U. of the counterfeiter to pay back principle plus interest in the future to someone.

    Governments of some countries can, and have in the past, simply printed fiat money and spent it to buy goods and services. Technically, this process need not involve debt at all.

    In practice the Federal Reserve’s policy of issuing of fiat money expands the supply of credit and thereby makes the sale of federal debt by the Treasury more feasible. Without monetary inflation and credit expansion interest rates would be much higher and government borrowing less feasible.

    Instead of a balanced budget amendment, a more binding constraint on the issue of debt by the federal government would be to supplant the Federal Reserve with a commodity money like gold coins or silver coins.

    In the first chart at the link below is the history of Gross Public Debt. You can see how it exploded after the U.S. repudiated dollar redemption into gold in 1971.

    You can read about the issues involved in Murray Rothbard’s book, What Has Government Done to Our Money?


    The question is, I guess, how do we transition to real money that isn’t lent or spent into existence–what will happen to debt and debtors/creditors? I believe Rothbard introduced a way of transitioning that had to do with finding the current dollar/gold ratio of which the government is in possession, supplying the banks with the corresponding gold amounts for 100% reserves…so that the government doesn’t own the money anymore–of course, FDIC and fiat legal tender would be eliminated. Perhaps it is in one of the links but I understand Joe’s concern–all the solutions seem paradoxical. Why do so many people believe that we have to have credit that is issued out of nothing? Why do people believe it is the only way to grow or sustain life? Living beneath your means worked for centuries, did it not–for growth and wealth accumulation? Now borrowing above the economy’s means seems to be the only way…and paying off debt by borrowing more through a fiat system…


    Austrian economists have proposed two types of plans to restore commodity money. One is to make the dollar redeemable into gold and then leave gold production up to the market.

    Rothbard lays out one version of this type at the end of The Case Against the Fed:

    Mises has a version of this type in part four of The Theory of Money and Credit:

    The second type is to remove all legal barriers to private money and all legal privileges for government money and let the market take over.

    Advocates of this view include Hans Sennholz, Guido Huelsmann, Joe Salerno, and Peter Klein. For example, Huelsmann mentions this at the end of The Ethics of Money Production:

    These different proposals have different effects on debtors. For example, One of Rothbard’s plans calls for redeeming all currency into the Fed’s gold stock dollar for dollar and making banks keep a 100 percent reserve of money against their customers’s checking accounts. This plan would destroy the created credit that was based on the issue of fiduciary media. In other words, banks would have to call in loans or not renew loans in order to build up their reserves to 100 percent. Rothbard has a second plan, which like Mises’s, prevents any further fiduciary media issue and credit creation. These plans, along with the second type of reform measures would leave existing dollar debts intact to be paid off, but not renewed and as that happened the credit supply would gradually shrink.


    Dear Dr. Herbener;

    I’m working my way through your videos on Samuelson and Nordhaus. I just finished episode 10 on regulation. I have three questions about regulations. First, do you think there needs to be a regulation prohibiting the naked short selling of securities or commodities? Second, what do you think of algorithmic trading or high frequency trading? Should this be regulated? Finally, we hear a lot about the evils of derivatives. Are derivatives a threat to the financial system? Should there be some regulation on derivatives?

    I am enjoying your class and thank you for your time.

    – Joe


    Government regulation of entrepreneurs is both unnecessary and harmful. In a market economy, entrepreneurs strive to gain customers by offering different goods and services. As long as their offerings are consistent with private property, e.g., there is no fraud involved, then the goods and services will be subject to the test of profit and loss. Those that satisfy customers earn profit and survive, those that fail to satisfy customers suffer losses and die out. Customers can appeal to other entrepreneurs to provide expert advise about products too complicated for the non-expert. And this advise can also be tested by success and failure in the market. Government regulation impairs this efficient process of the market and is, therefore, harmful.

    The entrepreneurs operating stock exchanges can set their own rules about which trades they allow and which they ban. We would expect that if naked short selling or algorithmic trading were allowed on some exchanges and not others, then customers’ preferences would determine which configuration of allowing and banning was most profitable.

    Financial innovations, like derivatives, would also have to pass the market test of profit and loss. As long as no fraud is involved, its efficient for entrepreneurs to offer new financial products and find out if customers prefer them or not. The problems with derivatives in the latest boom-bust have been the result of government regulation. For example, Fannie Mae and Freddie Mac provided support for mortgage-backed securities which then generated a moral hazard for investors.

    Here’s a piece by Bob Murphy on the financial crisis. He points out that credit default swaps were a financial innovation to get around government regulation on insurance:

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