Quiz on Government Finance

The significance of the government deficit, and the balanced reciprocal flow of government spending versus its receipts from taxes and bond sales is not widely understood.  This TRUE-FALSE quiz of 20 questions will test your understanding.

1. The Treasury deposits its receipts from taxes and bond sales in commercial bank accounts where they count as reserves of the banking system.  [True*]

Since government spending cannot be synchronized with receipts from taxes and bond sales, the so-called Treasury Tax and Loan accounts in commercial banks provide a buffer stock needed in managing the Treasury's general fund.

2. Except for petty cash, all Treasury spending is paid out of its account at the Fed.  [True*]

The Treasury targets a constant balance of 5 billion dollars in its account at the Fed by transfers from its TT&L accounts.  The purpose is to minimize variations in banking system reserves and thereby facilitate the Fed's control of the Fed funds rate.

3. The amount of money in the Treasury's commercial bank accounts increases when the government runs a budget surplus.  [False]

The Treasury has no use for and does not accumulate funds in excess of its near term payment obligations.  A budget surplus is normally used to reduce the national debt held by the public.

4. As the economy grows, Treasury revenues from taxes and bond sales must exceed spending in order to build up the balance in its accounts.  [False]

On average, the Treasury must spend at least as much as it receives in taxes and bond sales in order to avoid a drain on the monetary base, which would eventually create a liquidity crisis in the banking system.

5. Interest paid on the debt by the Treasury reduces the funds it has available for other spending.  [False]

The Treasury has unlimited spending power in its own currency.  All of its spending, including interest payments, is normally covered by tax revenues and the sale of bonds to the public.  It can also borrow directly from the Fed, although that is rarely done.

6. Most of the funds from the sale of new Treasury securities are used to pay for the redemption of maturing securities.  [True*]

The principal reason for new security sales by the Treasury is to roll over existing debt.  Acquiring funds for deficit spending normally accounts for a small fraction of those sales.

7. The government will eventually go bankrupt if it continues to deficit spend indefinitely.  [False]

Only if the government borrowed heavily in a foreign currency, which it has no need to do, would it potentially have any difficulty in repaying the loan.

8. The sale of Treasury securities by the government crowds out borrowing within the private sector. [False]

Funds the Treasury borrows are promptly returned to the private sector through government spending, and thus become available for further lending.  There is no net drain on the private sector, only a redistribution of financial assets.

9. All government spending redistributes financial assets within the private sector.  [True*]

There is no correlation between those who receive government checks, directly or indirectly, and those who pay taxes and/or buy Treasury bonds.  All government spending necessarily redistributes financial assets within the private sector.

10. The Treasury sells its securities in an auction process and pays a market rate of interest.  [True*]

Most of the Treasury securities are sold at auction to a group of securities dealers who are required to create a market in those securities, in effect acting as underwriters.  The public can purchase Treasury securities at the price determined in the auction.

11. The net financial wealth of the private sector increases when the government deficit spends. [True*]

Deficit spending adds to the supply of Treasury securities which, together with money issued by the Fed, increases the net financial wealth of the private sector.  By contrast, every dollar of bank credit is matched by a dollar of debt, and thus nets to zero.

12. Paying down the national debt would create additional money for the private sector.  [False]

Paying down the national debt means the net redemption of Treasury securities.  It has no direct effect on the money supply.  It simply transfers funds from tax payers to holders of the debt, who to some extent are the same people.

13. The national debt must some day be retired.  [False]

The Treasury must redeem individual securities as they mature, but the debt can be rolled over indefinitely.  Treasury securities are now an important savings vehicle for the public.

14. Government deficits typically increase during economic recessions.  [True*]

During recessions, the national income decreases due to higher unemployment and reduced spending in the private sector, which results in lower tax revenues and larger budget deficits.

15. Government deficits usually cause interest rates to rise.  [False]

Short-term interest rates are controlled by the Fed.  Long-term rates are mainly a function of short-term rates and inflationary expectations.  There is no significant correlation between government deficits and interest rates.

16. Unlike the federal government, most state and local governments must balance their budgets annually.  [False]

Their operational budgets must be balanced annually, but capital projects such as building roads and schools are normally funded through long-term borrowing whose costs remain on the books as continuing debt.

17. Funds from Social Security taxes, not needed for benefit payments, are invested in non-negotiable Treasury bonds owned by the Trust Fund.  [True*]

Excess FICA tax revenues are used by the Social Security Trust Fund to buy special purpose Treasury bonds.  The proceeds automatically become a part of the general fund of the Treasury.

18. The bonds owned by the Trust Fund represent a debt of the government to those who paid FICA taxes.   [False]

The government owns the assets and earnings of the Trust Fund, and can raise or lower future Trust Fund collections and payments, or change the purpose for which the collections are used, by changing existing law.  The bonds are IOUs of the government to itself, basically a meaningless bookkeeping exercise.

19. If the Trust Fund were privatized and invested in the stock market, the government budget deficit would automatically be reduced.  [False]

The end of FICA tax revenues to the Treasury due to privatization of the Trust Fund would have to be offset one way or another.  The government would have to spend less, tax more, or borrow more.

20. Measured in terms of present value, borrowing or taxing are equivalent in cost to the public as a whole.  [True*]

The present value of the future tax required to retire money borrowed today is, to first order, the same as if the money were acquired today through taxes.