Can you explain this (from a notable economist):

• A. The sum of all financial assets and liabilities is zero (your financial asset is someone else's liability)
• B. Banks must be in positive equity or they're bankrupt
• C. So in the absence of fiat money, the non-bank private sector must be in negative equity
• D. Government deficits puts the government into negative financial equity--which it can sustain because (a) it's the government & (b) it has enormous non-financial assets.
• E. Therefore Government deficits enable the non-bank private sector to be in positive financial equity.

Me: So other than the value of property rising/more things being made, a population can only become wealthier with increased government debt?

Them: No. True wealth comes from creating non financial assets: factories etc. that enable goods and services to be produced. But net financial assets are needed to facilitate the creation of factories etc., and obsessing about government debt destroys private sector financial assets.

Me: But buying government issued debt gives the buyer an asset, yet takes that money off the table. Only by buying back the debt (QE) do they free that up... Which begs the question; why issue the debt in the first place and not just "QE" gvmt spending?

ChatGPT said:

This discussion touches on several key concepts in macroeconomics, particularly the relationship between financial assets, liabilities, and the role of government debt in the economy. Let me break down each part to clarify the underlying principles.

A. The sum of all financial assets and liabilities is zero.

This is a fundamental accounting identity. In the economy, every financial asset has a corresponding liability. For example, if you hold a bond, that bond is your asset, but it's a liability for the entity that issued it. When you aggregate all financial assets and liabilities across the entire economy, they cancel each other out, resulting in a net sum of zero.

B. Banks must be in positive equity or they're bankrupt.

Banks operate by holding assets (loans, investments, etc.) and liabilities (deposits, borrowings, etc.). Their equity is the difference between their assets and liabilities. For a bank to remain solvent, its assets must exceed its liabilities, meaning it has positive equity. If a bank's liabilities exceed its assets, it becomes insolvent and, effectively, bankrupt.

C. In the absence of fiat money, the non-bank private sector must be in negative equity.

If we remove the government and the creation of fiat money from the equation, the non-bank private sector would generally end up in negative equity. This is because banks, which need to maintain positive equity, would have to hold enough assets (i.e., loans or investments) to exceed their liabilities (i.e., deposits). Since every loan a bank makes is a liability to the borrower, the non-bank sector would collectively hold more liabilities than assets, leading to negative equity.

D. Government deficits put the government into negative financial equity.

When the government runs a deficit, it spends more than it collects in taxes, leading to the accumulation of government debt (liabilities). This means the government's financial equity becomes negative. However, the government can sustain this because it has unique powers: it can tax, issue currency (fiat money), and has substantial non-financial assets like infrastructure, natural resources, etc.

E. Therefore, government deficits enable the non-bank private sector to be in positive financial equity.

When the government runs a deficit, it effectively injects financial assets into the non-government sector. For example, when the government borrows by issuing bonds, it creates a financial asset for the bondholders in the private sector. This injection of financial assets allows the non-bank private sector to hold more assets than liabilities, enabling it to maintain positive financial equity.

The Wealth of a Population and Government Debt

In this framework, government deficits are essential for allowing the non-bank private sector to maintain positive financial equity. However, this does not mean that government debt is the only way for an economy to become wealthier. True wealth, as your conversation partner pointed out, comes from creating non-financial assets like factories, infrastructure, and technology, which increase the economy's capacity to produce goods and services.

Financial assets, including those created by government debt, play a crucial role in facilitating investment in these non-financial assets. They provide the liquidity and stability needed for businesses and individuals to invest in productive activities.

The Role of QE and Government Debt Issuance

Quantitative Easing (QE) is a policy where the central bank buys government bonds or other financial assets, increasing the money supply and lowering interest rates. QE can effectively "free up" money that was tied up in government debt by replacing it with central bank reserves, which banks can then lend or invest.

However, the reason governments issue debt instead of just using QE from the outset is that debt issuance is a conventional method of financing deficits that maintains the separation between monetary and fiscal policy. QE is often used in extraordinary circumstances, such as during a recession or financial crisis, to stimulate the economy when traditional monetary policy tools (like adjusting interest rates) have become ineffective.

In Summary Government deficits create financial assets for the private sector, enabling positive financial equity. True wealth comes from creating non-financial assets, which are facilitated by the existence of financial assets, including those created through government deficits. QE can be seen as a tool to manage the money supply and stimulate the economy, but it is not a substitute for the traditional process of issuing government debt. The balance between government debt, QE, and the creation of true wealth through non-financial assets is complex and involves careful management of fiscal and monetary policy.

You said: I suppose what I do not understand is point E - how can buying a bond give private holders more assets, when they need money to buy it?

ChatGPT said: Great question! Let's dig deeper into how buying government bonds can result in the private sector holding more assets, even though they use money to purchase these bonds.

The Process of Buying Government Bonds

Initial Wealth: Let's assume you, as part of the private sector, have cash (a financial asset).

Buying the Bond: When you buy a government bond, you're exchanging your cash (which is an asset) for the bond. After the transaction, you hold a government bond instead of cash.

Nature of Bonds: The government bond is a financial asset that has a promise of future payments (interest and principal repayment). The bond is essentially a loan you have made to the government. While you’ve exchanged cash for the bond, you now hold an asset that typically has a value equal to or greater than the cash you gave up, depending on interest rates and the bond's terms.

Net Financial Assets and Equity in the Private Sector

Before the Purchase: Your net financial position is the cash you initially held.

After the Purchase: Your net financial position remains positive because the bond is still an asset, potentially even more valuable than cash because of the interest it earns.

Here's the key idea in point E:

Government Deficit Spending Increases Private Sector Wealth

When the government runs a deficit, it spends more than it collects in taxes. To finance this deficit, it issues bonds. The deficit spending itself injects financial assets into the economy (such as through government contracts, social security payments, infrastructure spending, etc.). When the private sector receives these payments, it gains financial assets (money) without a corresponding liability.

Now, the private sector has both the newly acquired cash and the option to purchase government bonds.

If they buy bonds with that cash, they simply exchange one type of financial asset (cash) for another (the bond), which also earns interest.

The crucial point is that the private sector now holds an asset that is a claim on the government (the bond). The government, in turn, has a liability (the debt), but the private sector's overall financial position has improved because it received the initial cash from government spending without giving up an equivalent amount of financial assets.

The Creation of Net Financial Assets

Government Debt as a Private Asset: The government's liability (debt) is the private sector's asset. When the government issues debt to finance a deficit, it creates net financial assets for the private sector because the private sector ends up holding assets (bonds) without a corresponding increase in its own liabilities.

Equity in the Private Sector: The private sector's financial equity improves because it now holds these bonds, which are valuable assets. This would not have happened without the government deficit.

Why Does This Matter?

The key point is that government deficit spending injects financial assets into the private sector. Even though the private sector uses money to buy bonds, the process of deficit spending means that the private sector ends up with more net financial assets than it started with. These assets can then be used for investment, saving, or other purposes, which supports economic activity.

In summary, government deficits allow the private sector to hold more assets by creating government debt, which is an asset to the bondholders (the private sector). This process increases the private sector's financial equity, even though it involves purchasing bonds with money they initially received from the government’s spending.