3.1 How Governments Actually Finance Themselves
A government that spends more than it collects must cover the gap in one of three ways: by borrowing, by running down its cash, or by creating money through the central bank. In ordinary times borrowing is the main way. In fiscal 2025 the US deficit was $1,775.4 billion, and it was financed almost entirely by selling Treasury securities.
Why it matters: A deficit isn’t paid by magic: someone has to lend the money.
Summary: A government covers spending above its revenue by borrowing, by running down its cash, or by central-bank money creation; in ordinary times borrowing dominates. In fiscal 2025 the US deficit was $1,775.4 billion, financed almost entirely by selling Treasury securities.
- The government budget constraint is an identity: the deficit equals new borrowing plus any cash drawdown or money creation.
- Borrowing spreads the cost of temporary needs over many years and lets investors, not the government, set the price.
- Fiscal dominance is the danger case: the central bank is pushed to finance the government whatever inflation is doing.
- A currency issuer can always pay in nominal terms, but paying through money creation turns default risk into inflation risk.
- At 6% inflation a $10,000 ten-year bond loses about 44% of its real value; at 2%, about 18%.
A government has three fundamental ways to fund spending that exceeds its tax revenue in any given year: borrowing (issuing bonds, covered throughout this Part), running down its cash balance, and, for a country that controls its own currency, having the central bank create new money — a tool of last resort given its direct inflationary risk (Volume I’s Part 0 on the history of money and Part 2: Real Estate & Infrastructure Finance on the Fed’s dual mandate). Raising taxes closes the gap instead of funding it, and it is politically constrained and slow to implement. In ordinary times, in almost every developed and large developing economy, borrowing via bond issuance is overwhelmingly the dominant tool, precisely because it allows a government to fund a temporary spending need without either the political cost of tax increases or the inflationary risk of money creation.
The arithmetic every finance ministry lives by is the government budget constraint: whatever spending exceeds revenue in a year must be covered by new borrowing from the public, by running down the government’s cash balance, or by money the central bank creates. In US fiscal year 2025 (October 2024 to September 2025), federal receipts were $5,234.6 billion and outlays $7,010.0 billion, so the deficit was $7,010.0B − $5,234.6B = $1,775.4 billion, covered almost entirely by selling Treasury securities. Those yearly deficits accumulate into the debt: debt held by the public stood at $30.28 trillion on September 30, 2025 and $32.43 trillion on October 1, 2026.
Borrowing dominates for a reason beyond politics. It spreads the cost of a temporary need, such as a recession or a war, over many years of future taxpayers instead of loading it onto one year’s tax bill, and its price is set by investors rather than by the government itself. The US Treasury describes its goal as financing the government “at the lowest cost over time,” pursued by issuing debt “in a regular and predictable manner”; Section 3.2: The Sovereign Debt Issuance Process shows how that works at an auction.
Money creation and borrowing are less separate than a three-way list suggests. When a central bank buys government bonds it pays with newly created bank reserves, so debt the public would otherwise hold ends up financed by central-bank money (Volume I, Part 2: Real Estate & Infrastructure Finance covers quantitative easing). The danger case is fiscal dominance: the government’s debt path is fixed first and the central bank is pushed to accommodate it, holding rates down or buying bonds whatever inflation is doing, because the alternative looks like a fiscal crisis.
Thomas Sargent and Neil Wallace set out the logic in “Some Unpleasant Monetarist Arithmetic” (Federal Reserve Bank of Minneapolis Quarterly Review, Fall 1981). If deficits are fixed and the public will hold only so much government debt, a central bank that resists inflation today by holding back money growth simply lets debt build up faster, and that debt must eventually be paid for with money creation. Tight money now can then mean higher inflation later. The practical warning sign is a central bank cutting rates or buying bonds while inflation is above its target, with the government’s funding costs as the stated or obvious reason. Central-bank independence and a credible fiscal anchor are the two defenses, and the debt arithmetic in Section 3.7: Debt Sustainability Analysis — r versus g is why markets watch both.
To judge how a government is really financing itself, read three numbers together: the deficit as a share of GDP, the change in the central bank’s holdings of government debt, and inflation against its target. If the deficit is large (as a rule of thumb, above about 5% of GDP), the central bank is a net buyer of government bonds, and inflation is above target, treat money creation, not borrowing, as the real financing source and price inflation risk into anything you hold in that currency. If the central bank is holding its bond portfolio flat or shrinking it, private savers are funding the deficit at market prices, and the right test becomes the debt dynamics of Section 3.7: Debt Sustainability Analysis — r versus g. Ignore the rule during a financial panic, when central-bank bond buying is a market-stabilizing operation; the test then is whether the buying stops once markets function again.
Assuming that because a currency-issuing government “can always pay,” its bonds cannot lose you money. It can always pay its own-currency bills in nominal terms, but paying through money creation moves the loss from a missed coupon to inflation. Take a $10,000 ten-year bond held to maturity. The real value of the principal at maturity is $10,000 ÷ 1.0210 = $8,203 if inflation averages 2%, but $10,000 ÷ 1.0610 = $5,584 if it averages 6%: $8,203 − $5,584 = $2,619 more purchasing power, about 26% of face value, lost without any default ever being recorded. Avoid it by comparing a bond’s yield with expected inflation, not just with default risk, and by using inflation-protected securities where the fiscal-dominance signs in this section are present.
Can the US government just print money to pay its debt?
Mechanically it could come close, because the debt is in dollars and the Federal Reserve creates dollars, but doing so to cover deficits would swap a default for inflation. In practice the Fed buys and sells Treasuries to steer interest rates and market conditions, not to pay the government’s bills, and the Treasury funds itself by selling securities to investors at auction. The cost of abandoning that separation is the fiscal-dominance spiral described above.
What is the difference between the deficit and the debt?
The deficit is a one-year flow and the debt is the accumulated stock. The US ran a deficit of $1,775.4 billion in fiscal year 2025; that borrowing was added to debt held by the public, which passed $32 trillion in 2026. A government can cut its deficit sharply and still see its debt rise, because any deficit above zero adds to the stock.
Why don’t governments raise taxes instead of borrowing?
Because the spending gaps borrowing covers are often temporary, and raising taxes in a downturn deepens it. Borrowing lets a government smooth tax rates over time and pay for long-lived investment over the years it is used. The limit is the cost: once interest consumes a rising share of revenue (Section 3.3: The Debt-to-GDP Ratio — What It Actually Measures (and Doesn’t)), higher taxes or lower spending stop being optional.
How does a government budget constraint work?
It says that every dollar of spending must come from taxes, new borrowing, the government’s existing cash, or central-bank money. Rearranged, this year’s deficit equals the change in debt held by the public plus any drawdown of cash and any money creation. It is an accounting identity, so it always holds; what it cannot tell you is which financing source a government will be forced to lean on next.
Governments finance deficits by borrowing, by drawing down cash or through central-bank money creation, and in ordinary times borrowing dominates: the US covered a $1,775.4 billion deficit in fiscal 2025 almost entirely by selling Treasuries. A currency issuer can always pay in nominal terms, but when the central bank is pushed to finance the government (fiscal dominance) the cost of the debt shows up as inflation rather than default.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A government collects $4.2 trillion in revenue and spends $5.9 trillion in a fiscal year. What deficit must it finance?
- $1.7 trillion
- $2.1 trillion
- $0.7 trillion
- $1.3 trillion
Reveal Answer
Answer: A. Deficit = outlays − revenue = $5.9T − $4.2T = $1.7 trillion, which must come from borrowing, cash or money creation.
2. Which pattern is the clearest warning sign of fiscal dominance?
- The central bank sells bonds with inflation below target, citing its own balance sheet size
- Tax revenue rises faster than government spending during a strong economic expansion
- The central bank buys bonds with inflation above target, citing state funding costs
- The treasury lengthens the maturity of its debt through regular, predictable auctions each quarter
Reveal Answer
Answer: C. Fiscal dominance means monetary policy is bent to the government’s financing needs, so bond buying with inflation above target is the tell.
3. You hold a $10,000 ten-year government bond to maturity while inflation averages 5% a year. Roughly what is the principal worth at maturity in today’s purchasing power?
- About $5,000
- About $7,441
- About $9,524
- About $6,139
Reveal Answer
Answer: D. Real value = $10,000 ÷ 1.05^10 = $6,139; the nominal $10,000 is repaid in full, but inflation erodes it.
4. What is the core argument of Sargent and Wallace’s “Some Unpleasant Monetarist Arithmetic” (1981)?
- With deficits fixed, the central bank can safely ignore government debt in setting policy
- With deficits fixed, tight money now can mean higher inflation later
- With deficits fixed, creating money reduces government debt without raising inflation
- With deficits fixed, tight money now guarantees permanently lower inflation later
Reveal Answer
Answer: B. If the public will hold only so much debt and deficits do not change, debt built up under tight money must eventually be financed with money creation.
3.2 The Sovereign Debt Issuance Process
Governments sell their debt at scheduled auctions run by a debt management office. Banks called primary dealers are expected to bid at every auction. The key point is that the auction, not the government, sets the yield: investors bid, and the price that clears the whole sale decides the interest rate. So a government’s funding cost is discovered afresh each time.
Why it matters: A government can choose how much to borrow, but not the price.
Summary: Governments sell debt at scheduled auctions run by a debt management office, with primary dealers expected to bid in every one. The auction, not the government, sets the yield, so funding costs are discovered afresh each time.
- US Treasury auctions are single-price: every winner gets the highest accepted yield, the stop-out yield.
- Noncompetitive bids (up to $10 million) are filled first; no competitive bidder may win more than 35% of an offering.
- Bid-to-cover and the tail against the when-issued yield are the two standard readings of auction demand.
- Short debt is usually cheaper but reprices fast: bills were 22.8% of marketable Treasury debt in August 2026.
- A 1.5 basis point tail on a $40 billion 10-year note costs about $6 million a year.
Governments issue debt through regular, scheduled auctions run by a debt management office (DMO), the unit that decides how much to borrow, at which maturities and on what calendar. In the United States that job sits in the Treasury, which announces its plans at a quarterly refunding and then auctions bills, notes and bonds; in other countries it sits in a separate agency or, as the India Lens at the end of this Part shows, inside the central bank. A select group of large financial institutions, the primary dealers, underpin demand: the Federal Reserve Bank of New York lists 26 of them, and each is expected to “bid on a pro-rata basis in all Treasury auctions at reasonably competitive prices” and to act as a trading counterparty when the Fed conducts monetary policy. The auction itself sets the yield the market demands (The Practitioner’s Codex Part 3’s bond pricing mechanics apply directly), which is why a government cannot simply set its own funding cost: it is discovered afresh at every auction, from the bids investors are willing to make on that day.
Treasury auction rules are simple. Noncompetitive bidders (up to $10 million each) agree to take whatever yield the auction sets and are filled first. Competitive bidders name a yield, and no single bidder may be awarded more than 35% of the offering. Competitive bids are accepted from the lowest yield upward until the offering is sold, and in a single-price auction every winner, including the noncompetitive bidders, receives the same yield: the highest one accepted, called the stop-out yield.
Suppose Treasury offers $40 billion of 10-year notes and receives $2 billion of noncompetitive bids, leaving $40B − $2B = $38 billion for competitive bidders, who submit the stack below.
| Bid yield | Amount bid | Cumulative competitive | Result |
|---|---|---|---|
| 4.10% | $8B | $8B | Filled in full |
| 4.12% | $12B | $20B | Filled in full |
| 4.13% | $10B | $30B | Filled in full |
| 4.14% | $9B | $39B | Stop-out: $8B of $9B filled (88.9%) |
| 4.15% | $15B | $54B | Rejected |
| 4.17% | $20B | $74B | Rejected |
The first three tiers absorb $30 billion, so the last $38B − $30B = $8 billion comes from the 4.14% tier, which is filled pro rata at $8B ÷ $9B = 88.9%. Every winner, including the bidder who asked for only 4.10%, receives 4.14%. Total bids were $2B + $74B = $76 billion, so the bid-to-cover ratio is $76B ÷ $40B = 1.90. If the note was trading at 4.125% in the “when-issued” market just before the deadline, the auction cleared 4.14% − 4.125% = 1.5 basis points higher: an auction tail. On $40 billion that costs taxpayers $40B × 0.015% = $6 million a year, or $60 million over the note’s ten years before discounting.
Why one price for everyone? In an auction where each winner pays its own bid, bidders shade their bids to avoid being the one who overpaid. Paying everyone the clearing yield removes most of that reason to shade, so bids sit closer to what investors really think the debt is worth.
The DMO’s second big decision is maturity. Treasury bills (one year or less) usually cost less when the yield curve slopes upward, but they must be refinanced constantly, so a government heavy in bills carries high rollover risk: its average interest cost follows market rates within months. Long bonds lock in a rate for decades but usually cost more up front. At the end of August 2026, bills were $7.25 trillion of $31.83 trillion in marketable Treasury debt, $7.25T ÷ $31.83T = 22.8%. That share is a policy choice, and it decides how fast a change in interest rates reaches the budget (Section 3.7: Debt Sustainability Analysis — r versus g).
A poorly received auction — where demand is weak and yields rise sharply above expectations — is one of the most closely watched, real-time signals of market confidence in a government’s fiscal trajectory, functioning as a continuous, live referendum on sovereign creditworthiness that happens far more frequently than any formal credit rating review.
To read a government bond auction, compare the stop-out yield with the when-issued yield just before the deadline and the bid-to-cover ratio with its recent average for the same maturity. If a coupon auction tails by more than about one basis point and bid-to-cover is below its recent average, treat it as weak demand at that maturity on that day (both thresholds are market rules of thumb, not official benchmarks). If tails repeat across several maturities over weeks while longer-term yields rise faster than expected policy rates, treat it as a fiscal signal. Ignore a single tail on its own: month-end positioning, holiday-thin markets and a large supply week all produce tails with no fiscal meaning.
Funding a debt at the cheapest point of the yield curve while ignoring how fast it reprices. Take $1 trillion of debt and a 2-percentage-point rise in market rates. Financed entirely in bills, the whole stock reprices within a year: $1,000B × 2% = $20 billion of extra interest in year one. Financed as an even ladder of 10-year notes, one tenth matures each year, so year-one extra interest is $100B × 2% = $2 billion, rising to $4 billion in year two. The saving from short debt in calm years is usually a small fraction of that exposure. Avoid it by setting the maturity profile against a stress test of rate rises, not against today’s curve, which is what the “regular and predictable” principle in Section 3.1: How Governments Actually Finance Themselves protects.
What is a primary dealer?
A primary dealer is a bank or securities firm that the Federal Reserve Bank of New York uses as a trading counterparty and that is expected to bid, pro rata and at reasonably competitive prices, in every Treasury auction. There were 26 on the New York Fed’s list in October 2026. Their standing commitment to bid is what keeps an auction from failing outright even on a weak day.
What does the bid-to-cover ratio mean?
It is the total amount bid divided by the amount sold. A $40 billion auction that draws $76 billion of bids has a bid-to-cover of 1.90. Higher means more demand per dollar sold, but the ratio is best compared with recent auctions of the same maturity, since bills and long bonds have very different normal levels.
What is a tail in a Treasury auction?
A tail is the gap by which the auction’s stop-out yield exceeds the when-issued yield trading just before the bidding deadline. A 1.5 basis point tail means the Treasury had to pay 0.015% a year more than the market expected, which on a $40 billion 10-year note is about $6 million a year. Repeated tails across maturities matter far more than any single one.
Can individuals buy Treasuries at auction?
Yes. Individuals can place noncompetitive bids of up to $10 million per auction, either through TreasuryDirect or through a bank or broker, and receive the same yield the auction sets for everyone. Competitive bids, where you name the yield, must go through a bank, broker or dealer.
A debt management office sells government debt at scheduled auctions, and primary dealers are expected to bid in every one, so the market, not the government, sets the yield. In the US single-price auction every winner receives the stop-out yield; bid-to-cover and the tail against the when-issued yield measure demand, and the share of short-term bills decides how quickly a rate rise reaches the budget.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. Treasury offers $30 billion, receives $3 billion of noncompetitive bids, and competitive bids of $10B at 4.20%, $9B at 4.22%, $12B at 4.23% and $15B at 4.25%. What is the stop-out yield?
- 4.23%
- 4.22%
- 4.20%
- 4.25%
Reveal Answer
Answer: A. Competitive bidders get $30B − $3B = $27B; the first two tiers fill $19B, so the last $8B comes from the 4.23% tier, which sets the yield for everyone.
2. In that same auction, total bids were $3 billion noncompetitive plus $46 billion competitive. What is the bid-to-cover ratio?
- 1.53
- 1.63
- 0.61
- 1.90
Reveal Answer
Answer: B. Bid-to-cover = total bids ÷ amount sold = $49B ÷ $30B = 1.63.
3. In a US single-price auction, an investor whose competitive bid of 4.10% was accepted receives which yield?
- The when-issued yield quoted just before the bid deadline
- The average of all the accepted yields in the auction
- The highest accepted yield, paid to every winning bidder
- The 4.10% yield named in its own winning competitive bid
Reveal Answer
Answer: C. All successful bidders receive the same yield as the highest accepted bid, the stop-out yield.
4. A government has $500 billion of debt, all in Treasury bills, when market rates rise by 1 percentage point. About how much extra interest does it pay in the first year?
- $0.5 billion
- $50 billion
- $1 billion
- $5 billion
Reveal Answer
Answer: D. Bills reprice within a year, so the whole stock pays the higher rate: $500B × 1% = $5 billion. An even 10-year ladder would reprice only $50B, or $0.5 billion.
- US Treasury, Debt to the Penny — Debt held by the public, 2025–2026
- US Treasury, Monthly Treasury Statement — FY2021 and FY2025 receipts, outlays, deficit and net interest
- US Treasury, Financing the Government
- Sargent and Wallace, “Some Unpleasant Monetarist Arithmetic,” FRB Minneapolis Quarterly Review 5, no. 3 (Fall 1981): 1–17
- Federal Reserve Bank of New York, Primary Dealers — 26 primary dealers and their bidding expectation
- TreasuryDirect, How Auctions Work — Single-price auctions, $10 million noncompetitive limit, 35% competitive limit
- US Treasury, Monthly Statement of the Public Debt — Bills share and savings bonds outstanding, August 2026
- US Treasury, Quarterly Refunding