Banking Example #8: Treasury Deficit Spending

This example illustrates what happens when the Treasury department deficit spends (this includes auctioning bonds and then spending the proceeds). The core of this process is illustrated on balance sheet sets 2, 3, and 4 (debt auction depicted on the transition from 2 to 3, and spending the proceeds on the transition from 3 to 4).

Setup: the Treasury Dept. (Tsy), the central bank (CB), a commercial bank (A), and two people, x (Peter), and y (Paul). There are no reserve or capital requirements, and all balance sheets start off clear except that person y owns a house*.

1. Initial balance sheets for all players:

Tsy, CB, A, x

Assets	Liabilities
$0	$0

Person y

Assets	Liabilities
$100k house	$0
Negative Equity	Equity
------------------	$100k

 2. Balance sheets after person x takes a loan from Bank A and buys person y's house with it (this step, with a bank deposit in the private sector's hand, can be considered the initial setup for the deficit spending process):

Tsy, CB

Assets	Liabilities
$0	$0

Bank A

Assets	Liabilities
$100k mortgage to x	$100k deposit for y

Person x

Assets	Liabilities
$100k house	$100k mortgage at A

Person y

Assets	Liabilities
$100k deposit at A	$0
Negative Equity	Equity
------------------	$100k

3. Now person y decides to use the proceeds from the house sale to invest in Treasury bonds (T-bonds) from Tsy (say through Treasury Direct):

Tsy

Assets	Liabilities
$100k CB deposit	$100k T-bonds

CB

Assets	Liabilities
$100k loan of reserves to A	$100k deposit for Tsy

Bank A

Assets	Liabilities
$100k mortgage to x	$100k reserve borrowing from CB (mortgage used for collateral)

Person x

Assets	Liabilities
$100k house	$100k mortgage at A

Person y

Assets	Liabilities
$100k T-bonds	$0
Negative Equity	Equity
------------------	$100k

4. Tsy spends all the proceeds from the bond sale on services provided by person x to the government. The resulting balance sheets are:

Tsy

Assets	Liabilities
$0	$100k T-bonds
Negative Equity	Equity
$100k	----------------

CB

Assets	Liabilities
$100k loan of reserves to A	$100k reserve deposit for A

Bank A

Assets	Liabilities
$100k mortgage to x	$100k reserve borrowing from CB (mortgage used for collateral)
$100k reserves	$100k deposit for x

Person x

Assets	Liabilities
$100k house	$100k mortgage at A
$100k deposit at A	----------------------
Negative Equity	Equity
--------------------	$100k

Person y

Assets	Liabilities
$100k T-bonds	$0
Negative Equity	Equity
------------------	$100k

5. Finally Bank A pays back its reserve borrowing from the CB. The resulting balance sheets are:

Tsy

Assets	Liabilities
$0	$100k T-bonds
Negative Equity	Equity
$100k	----------------

CB

Assets	Liabilities
$0	$0

Bank A

Assets	Liabilities
$100k mortgage for x	$100k deposit for x

Person x

Assets	Liabilities
$100k house	$100k mortgage at A
$100k deposit at A	----------------------
Negative Equity	Equity
--------------------	$100k

Person y

Assets	Liabilities
$100k T-bonds	$0
Negative Equity	Equity
------------------	$100k

One way to interpret what happened during this Tsy deficit spending sequence (covered by the balance sheets illustrated in steps 2 through 5) is that Tsy deficit spending resulted in person y's bank deposit being redistributed to person x, and in the process person y was issued a net financial asset (NFA) (in this case the T-bonds). This is the usual pattern for Tsy deficit spending when the Tsy spends all of its proceeds and it must fund its CB deposit prior to spending (as in the USA) and it must turn to the private sector for this funding (also the case in the USA). Keep in mind that the only players here that can and do have CB deposit accounts are the Tsy and Bank A. That is why Bank A (person y's bank) must facilitate the funding of Tsy even though person y purchased the T-bonds through the Treasury Direct program: behind the scenes, and invisible to person y, Bank A borrows reserves from the CB (using its assets, in this case x's mortgage, as collateral) and transfers this CB deposit (reserves) to Tsy. What's the upside for Bank A in doing this? It get's to erase y's deposit from the liabilities side of its balance sheet. Also note that Tsy can only spend from its CB deposit, and to do this it transfers its CB deposit to the payee's bank (Bank A in this case), and the bank in turn credits the payee's bank deposit (person x's deposit in this case). Note that CB deposits held at commercial banks are called "reserves" while those at Tsy are not.

6. Now we examine one additional step: person x repays his loan (this step is not part of the deficit spending process, but it's useful in clarifying how equity, in the form of NFAs, are moved from Tsy to the private sector):

Tsy

Assets	Liabilities
$0	$100k T-bonds
Negative Equity	Equity
$100k	----------------

CB & Bank A

Assets	Liabilities
$0	$0

Person x

Assets	Liabilities
$100k house	$0
Negative Equity	Equity
------------------	$100k

Person y

Assets	Liabilities
$100k T-bonds	$0
Negative Equity	Equity
------------------	$100k

Notice how the non-bank private sector (persons x & y aggregated together) have obtained an NFA (the $100k T-bonds) as a result of Tsy deficit spending and the Tsy now has negative equity in this same amount (the government's debt). The overall result is as if Tsy just "printed" the T-bonds and handed them to the non-bank private sector in exchange for services the private sector performs for it. Meanwhile, bank A's and the CB's balances sheets are unchanged from the initial step 1. Also note, that like in step 1, no bank deposits exist after this step (making it a little easier to compare with step 1.).

*Why have person y start off owning a house? No particular reason. I was going to have person y simply perform some service for person x (like I usually do) but thought I'd change it up a bit. Plus that gives the bank a nice "mortgage backed security" (i.e. the mortgage itself) as collateral for borrowing reserves from the CB... perhaps moving the needle an incremental bit towards a more realistic example. Ha!