Keith Hennessey was a senior White House economic advisor to President Bush. He recently started a very interesting and informative blog. On Wednesday, he discussed (and disagreed with) Budget Director Peter Orszag's claim that the effective government debt is smaller than the reported number because the government owns a sizable amount of assets that should be netted against that debt.
I've enjoyed Hennessey's blog, but he appears to be confused about the way a fiat currency system works. I don't think he's alone among top government economists. For starters, Hennessey refers to Treasury bonds as IOUs which need to be redeemed in cash, which he seems to imply is something tangible.
It is not only Treasury bonds that are IOUs, of course, but money itself. A little green piece of paper with Benjamin Franklin's picture on it is nothing more and nothing less than a government IOU. When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.
In the UK they are somewhat more explicit about the credit-based, fiat monetary system there. The 5 pound notes read "I promise to pay the bearer on demand the sum of 5 pounds." The "I" refers to the Bank of England, and if you take the note to the Bank, they will indeed exchange it for 5 pounds -- either another 5 pound note or a handful of smaller notes and coins which add up to 5 pounds.
The point is that a dollar, whether it is green or electronic, is an IOU of the United States government, where the government is somewhat vague about what it in fact owes the holder. The IOU is imbued with value by two things: 1) the willingness of the government to provide some real goods and services in exchange for those IOUs ; and more importantly, 2) the government's demand that certain people pay IOUs back to the government in exchange for staying out of jail (i.e. taxation). These two things create demand for government IOUs and make them valuable.
The government, of course, can create as many IOUs as it wants. Sometimes it does it in the form of interest-bearing Treasury bills, notes, or bonds, and sometimes it does it in the form of non-interest bearing numbers in a reserve account at the Fed (i.e. cash). Actually, sometimes it does it in the form of a promise to pay pension and medical benefits in the future (e.g. Social Security and Medicare), but that is a discussion for another time.
Of course, there is a practical limitation on how many IOUs the government can create before inflation becomes a problem. Inflation can be mitigated by tempting people to exchange some of their non-interest bearing IOUs for interest-bearing ones (whether Treasury bonds or deposits at the Fed) which can't be spent easily. The Fed does this by offering a higher interest rate on overnight repurchase agreements, thus reducing aggregate demand for real goods and services by incentivizing people to save rather than spend. But if the government continues to create IOUs much faster than nominal GDP is growing, it is inevitable that the IOUs will depreciate against the value of real goods and services, and we will have destabilizing inflation.
With all of that said, I'll address two points that Hennessey made with which I strongly disagree. First, he disparages Orszag's idea of netting out assets of the government with the outstanding stock of IOUs. Looking at the assets of the government as being available to pay claims, i.e. to pay off and extinguish IOUs, netting is certainly appropriate to some degree because the assets help to maintain the value (real and perceived) of the IOUs backed by the government. In the case of financial assets, particularly relatively liquid, relatively short-term assets which actually spin off cash flows, the fungibility with IOUs is apparent. Financial assets should clearly be netted, although the financial assets do need to be valued appropriately (i.e. not anywhere near face value).
Second, Hennessey claims that when the government borrows to buy financial assets there is a "crowding out" effect. This is pure rubbish. There is no such thing as "crowding out" due to the issuance of Treasury bonds, whether it was done to offset government spending, investing, or tax cuts. For every dollar the Treasury receives from the issuance of Treasury bonds, a dollar is sent back to the private sector, by definition. Net IOUs remains the same.
The fallacy embedded in Hennessey's Alan I. Gorp example is that Alan would have the $100. Alan either spends that $100, pays down his own bank debt with it, or deposits it in a savings account at another bank. As long as Alan doesn't put the money under his mattress, it ends up at a bank. If the money did end up under a mattress, then the Fed could inject (i.e. create) an extra $100 into the banking system without spurring inflation.
Expanding the example back to the government level, we see that if the government issues $1T of bonds to pay for $1T of so-called toxic assets, the next effect is that the private sector in aggregate has received $1T of low-interest government IOUs in exchange for $1T of toxic assets. No doubt this would make the private sector a lot more confident about the creditworthiness of financial intermediaries and counterparties. It would also provide $1T of good assets that could be used to collateralize lending. I'm not saying such a swap is the right thing to do, but it certainly would spur investment and aggregate demand, rather than "crowd" it out.
The only way for the government to starve the private sector of investment funds is to run a budget surplus. This removes IOUs from the system, thus reducing aggregate net financial wealth. The reduction in aggregate net financial wealth would tend to reduce aggregate demand and be disinflationary/deflationary.