Where Does the Money Come From?

Readers Question: I read today that US owes an overall debt of 16 trillion, similarly India is also too worried about its fiscal deficit, I think that every country owes some debt. so if everyone owes some money, then where is that money coming from???, or in other words, if everyone’s account balance is in negative then where is that money come from and to whom do they have to pay it back to???

These fiscal deficits refer to government debt (also referred to as public sector debt). It is the amount governments need to borrow from the private sector (and sometimes their Central Bank) to meet the shortfall in government spending.

The majority of this government borrowing is from domestic investors (e.g. the US and UK borrow approximately  25% of its government debt from overseas)

In a way countries are borrowing from the themselves.

If you take Japan with a public sector debt of over 225%, this is primarily financed by the high level of domestic savings. In other words Japanese savers are willing to keep buying government bonds. This gives the Japanese government funds to finance its large debt.

The concern is when domestic or foreign investors no longer want to lend to the government. In the case of Greece, investors are concerned that the Greek government is unable to meet its debt requirements and therefore will default. This caused investors to stop buying Greek government bonds (causing bond yields to rise). See more on EU debt crisis

When a government like the UK borrows, primarily it is investment trusts and pension funds who are buying UK bonds.

  • Instead of borrowing from pension funds, the government could in theory, place a one off tax on financial institutions to raise the money that way.
  • Another way of thinking about borrowing is to see it as deferred taxation. Rather than increase taxes now, the government borrow enabling taxes to be lower than if they were unable to borrow.

Mortgage Analogy

This is another way of thinking about where the money comes for government borrowing. Where do people get money to borrow for a mortgage and buy a house? They borrow from other people in the economy (e.g. a bank) and then spend the next 30 years paying back the bank. Government borrowing is just a different kind of borrowing. The government borrows from different people in the economy, and then pays them back.

Crowding out of Private Sector

Another way of thinking about government borrowing is to see what happens to private sector investment.

If the private sector lend the government £100bn, then this might be £100bn that the private sector can’t invest in private investment projects. When the economy is growing, some economists see government borrowing as a tool for reducing the size of (the more efficient private sector). Therefore, borrowing is simply another way to increase the size of public sector at the expense of the private sector.

Making use of savings

However, other economists say that often when the government borrows, they are not reducing the private sector investment. For example, in a recession, investors don’t want to invest in risky private sector investment. They prefer to buy ‘safe’ government bonds. Therefore, the government borrowing is merely making use of unused ‘savings’ which would just lie dormant in bank accounts.

Since 2007, the UK saving rate increased from 1% to over 6%. Part of this increase in UK savings has been used to finance government borrowing.

Balance of Payments

The balance of payments measures financial flows between one country and the rest of the world. This is completely separate from government borrowing.

These do balance out. E.g. if one country has a large current account surplus (e.g. China) this will be matched by a large current account deficit in another country (e.g. US)

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2 thoughts on “Where Does the Money Come From?”

  1. ‘Where does money come from ?’ is also the title of a very good book published in the UK by the New Economics Founadation (www.neweconomics.org).

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