Wartime Fiscal Policy
Soft currencies, combustion engines, and financial sovereigns
While the wisdom of “living beyond your means for too long eventually comes home to roost” is very much true, remarks regarding “bankruptcy” “insolvency”, and the like are wrong as they pertain to the United States government. Technically wrong. Instrumentally wrong. Insolvency is a balance‑sheet concept. A financial sovereign writes the balance sheet.
For those of you who have read my Fed series (essays linked at the end), you know I take a weirdly keen interest in the raw mechanics of how monetary operations and bank balance sheets work as a means of verifying Federal Reserve claims about what it can, and cannot, do. I am a firm believer that technical, falsifiable claims should be examined in a deeply literal way, independent of what the “official” answer is.
In this essay we will strip down every way the federal government will always get what it wants when it comes to cashing checks. Regardless of what the rules or economics textbooks say. The following isn’t an endorsement of the system, but a systematic, apolitical description of how it works so you can navigate it.
It’s right to criticize unsustainable practices and recognize the fundamental nature of scarcity and resource claims. It’s misleading to present it as a debt issue.
Here Balaji gives a detailed breakdown how the US government is broke and needs to steal your things to pay off its debt, assuming it’s like a lemonade stand. If the US were a lemonade stand, it’d be spot-on analysis.
The “they need to steal your things to pay off the bonds” sentiment is so disconnected from the substance of how the monetary system works that you can tell within 5 seconds he doesn’t understand what he’s assessing (or more likely he’s intentionally hyperbolizing for the engagement). If you look at that thread and can’t immediately see it’s not describing concrete reality, this essay will help you cultivate that ability.
Financial Sovereigns
When discussing US debt, almost everyone analyzes the government as if it’s a lemonade stand, subject to bankruptcy if it doesn’t sell enough tasty drinks. The US government is not a household, it is not a business. The US is a financial sovereign.
A financial sovereign does the following:
Issues its own soft currency (no fixed exchange rate)
Collects taxes in that currency, under violent threat
Issues debt payable in its own currency
A financial sovereign cannot default on interest and principal payments unless it chooses to. It is a political decision, not a monetary one.
This isn’t some persnickety finance nerd snipe, insolvency and bankruptcy are flat out not-applicable concepts for financial sovereigns.
When someone deploys the terms “bankruptcy” and “insolvent” for financial sovereigns, you can readily infer they do not understand the raw capabilities of the system they’re opining on. Since these priors are false, it’s likely their conclusions are too. One bad apple, or assumption, spoils the bunch.
A financial sovereign does not hard default unless it wants to. Think Japan during WWII… “we’re at war, no I’m not paying you” kinda stuff.
Because its liabilities are denominated in a coin it can create at will, a hard default is never a funding necessity, but a policy choice. Japan’s 1946 repudiation, the Soviet write‑off in 1918, and the US gold‑clause override of 1933 were political calls, not funding shortfalls. The instances of deposit seizures (Argentina 1989‑90, Brazil 1990) likewise stemmed from political trade‑offs, not a missing checkbook.
Hard and Soft Currencies
There are certain constraints that apply to hard currencies, which is fiat money that has a fixed exchange rate to another asset. Historically, that asset is usually gold or silver (metallism).
However, there are different rules that apply to soft currencies: fiat money that has no fixed exchange rate to another asset (chartalism). Also known as a floating-exchange-rate currency.
Both hard and soft currencies are fundamentally “backed” by the resources of the issuing nation and its ability to impose coercive taxation in said currency. A fiat currency’s value comes from the claim it exerts on a country’s resources.
Metal-based fixed exchange rates do not imbue value, rather they impose limitations on the issuance of the currency. You can print money, but you can’t print silver or gold; if the currency is fixed to an amount of metal, it’s a means of enforcing spending discipline.
The vast majority of financial analysis implicitly rests upon hard-currency assumptions. Relying on hard-currency frameworks for soft-currency financial sovereigns is like having a combustion-engine mechanic diagnose why your electric car isn’t working.
On the surface they’re both cars and seem close enough, however under the hood…. they’re radically different. The rules of how one operates do not apply to the other. You will chronically come to errant conclusions if you insist on using an incorrect frame of analysis like this.
The following will explain how the US will always service its debts, no matter how much it owes.
Treasury Rituals
Note: I will use the US and its system as the example here, but this analysis effectively applies to all financial sovereigns.
Sovereign debt for soft-currency issuers (e.g. Treasurys for the US) is an anachronism of the gold standard. The system changed dramatically in 1971, yet the ritual of bonds remained. The US government converted to an electric car fleet, and everyone continued with the combustion engine blueprint.
However even in the pre-1971 times of the gold standard, the government did not need to “raise” money in the traditional sense. Rather, it used bonds as a way to maintain a gold peg it pinky-promised it would keep.
When the US government issues debt, it takes dollars out of the financial system (by selling bonds) and then puts those dollars back into it when it spends them, thus the raw amount of dollars in the onshore system stays the same.
(Emphasis on “onshore”, eurodollars send their regards)
If it spent dollars without first taking them out of the financial system, it would violate the gold peg by introducing excess currency that exceeds its gold convertibility. That’s all government bonds do, they’re timelocks on dollars to maintain a gold peg.
This is why fixed exchange rates to metals only act as a limiter on a nation’s ability to print; it forces financial discipline so a gold peg can be upheld. No one holds the currency because they actually want the gold! The gold isn’t “backing” the currency in any practical way, rather the gold peg simply keeps profligate spending in line.
Treasurys are a gold-standard relic that no longer applies. When you analyze a country’s debt and spending using this vestigial framework, it’s tantamount to applying “combustion engine economic theory” to assess your Tesla.
There is no more peg. There is no more fixed exchange rate. There is no more need for this, yet the ritual persists.
Treasury Games and Primary Dealers
Despite financial sovereigns not needing to issue debt, they still do and have many eager buyers! Banks in particular love US Treasurys (USTs) because they’re some of the best collateral for repo activity and credit creation (i.e. they’re useful in the plumbing of banking). Banks actively seek USTs as balance sheet tools.
Sidenote: those confused why anyone would own a negative-interest-rate bond (lots of sovereign debt has had negative rates) would quickly have their confusion dissipate once they understand banks see these bonds primarily as repo instruments, not investments.
Bank demand for USTs is in part a product of regulations such as Basel III and Liquidity Coverage Ratios (holding USTs is viewed favorably by regulators); however attributing it entirely to this is inaccurate. USTs are the most-sought-after collateral in financial plumbing, banks are often clamoring to own these things.
The bid-to-cover ratio for UST auctions is roughly 2.5-3x; this means there is about triple the demand for Treasurys at each auction than there is supply (!). Each US debt sale is about 3x oversubscribed. The demand for this stuff is voracious.
SCENARIO ANALYSIS
Let’s create some Zero Hedge-style Armageddon situations. Say the organic demand for USTs vanished, the doomers are having their moment in the sun, the US government can’t sell debt to “fund” the Treasury General Account (aka the TGA, this is the government’s checking account).
Here are the games that will be played so checks don’t bounce:
Treasury Games 1.0
There are brokers/financial institutions called primary dealers (PDs). Being designated a PD is rather prestigious. You earn that title in part by being a mandatory bidder at government auctions.
PDs have to buy US debt sales; it’s a regulatory requirement the government imposes on them. If there’s insufficient demand for USTs, PDs step in and fill that gap.
Treasury Games 2.0
If banks and PDs were ever so strapped for cash they lacked the raw funds to buy new USTs and the broader market stopped bidding (we’re talking a cataclysm here), there’s a pretty simple fix: Congress will have its accountant play some swap games.
The Fed can do what’s called Open Market Operations (de facto QE): in this instance, it would buy existing Treasurys from banks and PDs, providing reserves in exchange for bonds. These institutions would then purchase newly auctioned Treasurys, completing the circular flow of funds.
It is worth noting in this instance the net amount of financial collateral in the banking system is *exactly* the same. QE does not create more assets, it only changes the composition of bank balance sheets.
The Fed can only swap assets around, it cannot expand the amount of assets in the system by the nature of how its operations work (rare technical exceptions to this). I cover this process and its raw nuts and bolts in The Fed Part 1: QE, A Mechanical Deconstruction of an Impotent Illusion.
The Treasury Games 2.0 approach is what some refer to as "monetizing the debt". Meaning monetary policy (the Fed) and fiscal policy (Congress) are basically washing each other’s hands and the government is selling its own bonds to itself, with extra steps. It’s kind of true, however it’s also unnecessary, you don’t have to sell those bonds…
It doesn’t matter if you like or dislike the system, it is what it is. Recognizing the nature of a thing doesn’t mean you have to support it. No matter the option, the TGA will spend, and none of those US checks will bounce. No hard default will happen. Thus is the way of the soft currency.
"So per this technically pristine breakdown of how the financial system works I take it you support money printing then! You think we can just print our way out of problems??"
No.
What I'm telling you is SOLVENCY IS NOT AN ISSUE FOR THE UNITED STATES GOVERNMENT. IT HAS 99 PROBLEMS BUT SOLVENCY AIN’T ONE.
Inflation is the only issue, it's all that matters. When gold pegs stop limiting spending, inflation is the mistress that’s always lurking. Bankruptcy is not an applicable concept for a financial sovereign, but inflation always is.
You can’t print your way out of systemic economic fractures for the same reason you can't get blood from a stone. A financial sovereign's true constraint isn't one of accounting ledgers, but resource capacity: when too many dollars chase too few goods.
A sovereign’s restrictions are never one of solvency, but of scarcity.
The difference between bankruptcy and inflation is substantial, it’s the difference between hard defaults, and soft defaults, which brings us to our next section.
Hard vs Soft Defaults
There are substantial differences between a hard and soft default. They're sometimes conflated as equally bad or treated as sorta the same. This is misguided.
Hard default: you flat out can’t (or won’t) service your debts and fail to make interest and principal payments. When people say “default”, this is what they mean.
Soft default: you print money and cover your debt obligations. However this degrades the purchasing power of the currency.
That’s why it’s a “soft” default: the nominal terms of the loan are fulfilled, you got your dollars back, however the value of those dollars is diminished. You have the same amount of money, but you don’t have the same purchasing power.
Comparatively, the soft version is vastly preferable. Neither are good though.
What would happen in a hard default: Government transfer payments are halted (devastates the poor), and you probably get a depression as spending plummets, growth goes severely negative, markets scream, asset prices are decimated, the banking system has a crisis that cascades into others defaulting, and the unemployment rate skyrockets. Extremely bad. In financial terms, this is the worst-case scenario.
What happens in a soft default: Moderate to high levels of inflation. Hurts purchasing power, things get more expensive. The degree its destructive depends on the degree of inflation; not all soft defaults are Weimar Republics. There are negative distribution effects with inflation that disproportionately harm the poor and those with no assets (asset prices typically rise in inflationary environments, those without assets don’t benefit from this).
This doesn’t necessarily mean economic ruin. For example, Turkey has had some intense, chaotic bouts of inflation, but the economy still expanded.
Growth can co‑exist with high inflation. Even with CPI between ~54‑72 % in 2022‑23, Turkey’s real output (adjusted for inflation) still grew ~4‑6 % per year.
To be clear: this is absolutely not something you want and it’s quite volatile. But is it as destructive as a hard default? No.
A soft default is not a hard default, and unless the sovereign wants otherwise, the default will be soft.
Wartime Fiscal Policy
Did you know the Federal Reserve Act doesn’t allow the Fed to buy corporate bonds? However, the Fed bought corporate bonds in 2020. How? Did someone misplace the rulebook???
It was able to because Congress said “do it, we give you permission”. A Special Purpose Vehicle was set up that allowed the Fed, acting in conjunction with the Treasury, to do something it officially could not. There's a clause in the Fed Act (approved by Congress) called Section 13(3) Unusual and Exigent Circumstances that basically says: "We will break the rules as emergencies require. We judge what an emergency is”. Nice set of super-serious rules you have there… “here’s the law, except if we don’t feel like it.”
For a national sovereign, both rules of war and finance are both matters of convenience. If breaking your laws creates a worse outcome, you adhere to them; if breaking your laws creates a better outcome, you violate them. Whether or not the government obeys government-imposed directives is a strategic consideration, not a moral or legal one. It’s one of game theory, not legal theory.
There are no statutes in true war, only actions that advantage and disadvantage you. The same is true for a financial sovereign and its checking account.
For example: even if a hard currency is “hard” and “pegged” to gold…. is it really? Or is it just there when convenient? Wartime financial decisions adhere to what’s expedient.
In addition to those Treasury Games scenarios, I’d like to provide you a third wartime scenario.
In this instance the TGA will *still* spend and there will be:
No monetizing the debt
No Federal Reserve or QE
No primary dealers
In this scenario, the Ron Paul guys have “ended the Fed”, the boogeyman has been excised, the financial problems are solved! We did it, we got rid of the central bank and the government’s ability to print and spend!
Wrong.
This misunderstands the fundamental nature of a government’s authority over its own financial system. Congress ultimately retains the capacity to authorize spending regardless of institutional constraints. Fiscal policy, not monetary policy, is what spends and is what determines how much money gets thrust into the world that consumes resources. Fiscal policy. Congress. Not the Fed. The Fed is a false God, your anger is misplaced by believing it’s the culprit for a nation’s financial woes. It’s a scapegoat, your hate is best directed at Congress and/or Parliament.
Here’s what Congress can do: the TGA… the thing that prints and spends money, will… *pregnant pause*…. spend as it pleases, and to account for this they will simply put a negative number in the account.
A negative number?!?! You can’t do that! Money must go in before money go out!
The US breaks its own rules as necessary right? Indeed. Because they're the ones who make up the rules, right? Certainly. The TGA is the checking account of Congress and the weapon where the government actually spends money, right? Indubitably.
I assure you if no bonds could be sold and there was no Fed, the TGA can and will.... just have a negative number in front of it. It will still spend from its infinity printer. You know how that will be facilitated without a central bank?? With the unthinkable: a negative symbol in a checking account. Crazy!
Congress can always spend, without Treasurys or without the Fed. Because the parameters of the TGA are completely made up. As are all the other “rules” we covered, which are either discarded or subverted when the going gets tough. Wartime fiscal policy does not allow itself to be preoccupied with notions of decorum.
If you’ve found this blog you’re probably at least lightly aware of all the deceitful, malignant nonsense governments do. Well, I hate to say, it’s not beyond the pale for a government and politicians to let a number in an account have a negative digit in front of it. The “thin red line” of government honesty is not drawn at the TGA being “overdrafted”.
Debt Ceiling Pageantry
I’ll conclude with one more “rule” that gives macro bros and pundits something to reliably freak out about: the debt ceiling.
What it is: A statutory cap, set by Congress, on the total amount of debt that can be outstanding at any one time. The debt ceiling is about the legal authority to issue more Treasurys, because if you can’t sell more bonds then the TGA “runs out of money”.
When the ceiling is reached, the TGA can juggle cash with short‑term “extraordinary measures,” but once those are exhausted it cannot sell new debt, putting payments (including interest on existing bonds) at risk of delay or default.
The debt ceiling is Washington’s arbitrary limit on the Treasury that Congress heroically lifts at the eleventh hour so the government doesn’t default on its obligations. The ceiling is changed by either:
Raising it by a fixed dollar amount
Suspend the limit until a given date. Since 2013, Congress has preferred suspensions
Debt-ceiling adjustments are not a new phenomenon, they’ve happened 78 times since 1960. However, the routine brinksmanship and using it as a negotiating cudgel is a post‑2011 development. The House majority routinely predicates debt-ceiling increases on policy concessions (spending cuts, pork, etc.), turning ceilings into bargaining chips. Quick lore:
From 1939 through the 1990s, increases were treated as administrative housekeeping, not political theater. The ceiling was frequently adjusted without real threat of default.
The first modern brinkmanship was the 1995‑96 Clinton–Gingrich standoff; markets were rattled but a deal came before the Treasury ran out of room.
The 2011 “crisis” was a turning point: it resulted in the Budget Control Act and S&P’s rating downgrade of the US.
Since then, every expiration has required some kind of “extraordinary measure” last‑minute legislation. Is a chronic “emergency” really an emergency? If you're a naive pundit who doesn't understand your self-imposed rules are ENTIRELY SELF-IMPOSED, it is!
Now let’s create another wartime situation: what if the brinksmanship one day goes too far? The US turns delinquent because the ceiling isn’t raised, interest payments are missed on bonds, we have a politically induced, transient, hard default on our hands.
The politicians can be obstinate children, meanwhile their henchman accountant will make sure the financial trains still run on time. Quasi-leaked documents have exposed how this would be rectified. They don’t want to broadcast it, but it’s out there.
In this case, the Fed can do some sneaky bond swaps and paper right over this clerical pageantry highly serious fiscal matter. In fact, it has detailed exactly how it would do so in a release from an FOIA request, I will summarize the primary methods for you here:
Securities‑lending: Institutions can swap their tainted notes for pristine collateral at the usual lending haircuts. The Fed would work with defaulted Treasurys as if nothing happened.
Repurchase agreements: The Fed has repo windows it uses to influence overnight bank lending rates (the Fed Funds Rate), and defaulted securities would be accepted on identical terms as non-defaulted ones.
Discount window lending: If banks are struggling with repo market conditions, defaulted Treasurys would be accepted as standard collateral at the Fed’s discount window (a faculty banks are loathe to use but is there for emergencies).
Purchase program for defaulted CUSIPs: The Fed would swap reserves for bad bonds.
Sidenote: Treasurys the Fed holds already effectively do not pay interest on them anyways, default or otherwise, as the Fed must remit interest it’s paid back to the Treasury.
One‑for‑one CUSIP swaps: exchanging defaulted securities for non-defaulted ones that the Fed already owns on its balance sheet. The Fed would swap good bonds for bad ones.
NOTE: every single action here is a swap of some kind. The Fed only shuffles assets around; the net amount of assets in the banking system is nearly identical as a result of any of these techniques.
The most remarkable thing about this memo is how little it’s been remarked on. An official document that shows how debt ceiling theatrics are neutralized gets no focus from MSM. I guess it’s better for clicks if you ignore boring, material stuff like this and play Chicken Little for the engagement farming.
Concluding
On matters of government spending and the printing of money, fiscal policy of a financial sovereign runs the show, makes the rules, breaks them, and gets what it wants when it’s determined to spend. Monetary policy (central banks) does what it’s told and occasionally enables fiscal to keep up a veneer of Treasury-based compliance while it continues to spend.
When it comes to government spending, central banks should be thought of as lackeys, accountants, who help the mob boss cover up his crimes (crimes he’ll do with or without them); the perpetrator is the mob boss, not the accountant.
What keeps a financial sovereign in check is not a law of man, but a natural law of finance. Inflation is always the true governor of a sovereign’s abilities. The financial physics of too many dollars chasing too few resources will be what brings extravagant spending to heel, nothing else. It is never a matter of solvency, but of scarcity.
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Please help me understand what is wrong with this understanding. If the financial sovereign prints limitlessly to pay its debts... 'cos it can't run out of money as you explain. Will not the currency devalue relative to foreign assets? I suppose that if I lived entirely in US dollars then I might not notice 'cos I still have the same number of dollars. But if I want to sell my house and move to Paraguay, I will be able to buy less house in Paraguay. So the govt's profligacy has impoverished me... essentially, taken my wealth... re all actions outside my country.