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Apart from what the other user has said, let’s walk through this in a manner that I hope is as simple as possible.

First, bear in mind that “debt” simply means promise. I owe you something. I am indebted to you. It means I promise to pay/give something back to you at some point in the future.

If you take some money from your checking account and buy a Certificate of Deposit of 2 years to earn, say, 3% interest, you are effectively transferring the money from your checking account to a new savings account. The bank “borrows” from you by safekeeping the money for the next 2 years in the new savings account, then return that same amount of money + interests when it matures. Note that nothing actually changes, except that you cannot use that money for 2 years.

The government debt functions the same way by “borrowing” from private investors. This used to serve a function in the old days when national currencies were tied to gold, or another currency. This is known as the “fixed exchange” currency regime, as opposed to the “floating exchange” system we have today in the modern financial system where for many countries, their currencies are not tied to anything.

To understand why government debt matters in the past but not today, we need to learn about the difference between fixed and floating exchange regimes.

In the gold standard era (or the Bretton Woods era when currencies were pegged to US dollar, and the US dollar itself was pegged to gold), you need to accumulate reserves (e.g. gold) before you can issue the currency of an equivalent amount. That’s because in a fixed exchange system, you are promising that, say, 1 oz of gold can be exchanged for $35. If you do not have enough gold reserves to back your exchange rate of $35 to 1 oz gold, then you have to devalue your currency if you want to print more money.

This becomes a problem when it comes to government spending. Let’s take a simple example of a small economy with $100M worth of gold reserve. In principle, you can issue $100M of currency into the economy. You have enough gold to support the exchange rate you have set.

Now, let’s say you want to build a hospital that costs $10M - you can simply print the $10M into the economy, but you would end up with $110M of currency in the system, but only $100M worth of gold reserve.

To defend that exchange rate, you have to take $10M out of the circulation. There are two ways you can do this: first, by taxation (this is where the myth of “taxing billionaires to fund healthcare” comes from - the government doesn’t need the money itself creates, it simply wants to take the money out so it can defend its own exchange rate).

Second, by issuing government bonds. Unlike taxation, which collects money from the people and then destroys the money, government bonds act exactly like a savings account - you let the government safekeep the money for you over, say, 10 years while you get to earn interests. This way, you still get to keep your money, you simply can’t use them for 10 years, and you get interest payment every year as a bonus. This is another way to take $10M out of the system - but note that the government “borrows” not because it needs your money, it simply wants to take the money out of the system to defend the exchange rate.

Of course, there are other ways, like increasing your gold supply. You can dig for more gold within your national boundary, you can export goods to other countries and use those revenues to purchase gold, you can colonize another country and steal their gold. Many ways to do that. The government can even choose to devalue its own currency, or simply default when it can no longer keep its “promise” (paying its “debt”).

The upshot here is that when your currency is pegged to something else (fixed exchange rate), you have limited fiscal space to grow your economy. This is why the Bretton Woods system didn’t last long and, when the US overspent its dollars during the Vietnam War, culminated in the French asking the US to pay them in gold instead of dollars. Nixon ended the Bretton Woods and we have since entered a new phase of fiat monetary system.

So, what is the role of the government bond in a “floating exchange” system, then?

First, we need to learn a bit about central banking operations. It’s pure accounting but you will need to understand this to make sense about why the US government still continues to issue treasury bonds.

The Central Bank (Federal Reserve in the US) has special accounts known as Reserve accounts. These reserves are only accessible to other banks, and not the general public. Commercial banks have Reserve accounts with the Central Bank. The Treasury also has an account (Treasury General Account, or TGA) with the Central Bank.

When the Federal Government wants to spend $10M to contract a company to build a hospital, the TGA goes into negative $10M at the Central Bank. The Central Bank then creates an equivalent positive $10M at the Reserve account of the Commercial Bank, where the Private Contractor’s deposit account is linked to. The Commercial Bank then creates $10M deposits at the Private Contractor’s deposit account, which it can then spend to hire labor, purchase raw materials etc. to build the hospital.

Note that the Commercial Bank now still has +$10M in its Reserve account. Because these are dead money, the Commercial Bank will want to lend it out to earn some interests. These reserves are only accessible in the Central Bank (not available to the public), so it will try to lend them out in the interbank market at the Central Bank, where other banks have their reserve accounts linked to.

What are reserves then? They are what banks use to clear everyday payments! When you take a $1000 check (payer has a different bank to yours) to a bank to deposit the money, Bank A doesn’t have to “send” any money to Bank B. Instead, Bank A (payer bank) subtracts $1000 from its Reserve account and Bank B (recipient bank) adds $1000 in its Reserve account, then creates an equivalent $1000 in your Deposit account. Therefore, the reserves allow banks to clear payments very rapidly (we’re talking about billions of transactions every single day!) and this is an essential component to support a highly efficient modern economy.

As you can see, by the end of every business day, some banks will have less reserves (because more money is withdrawn from their banks) and some banks will have more reserves. There is a legal requirement to keep a minimum amount reserves relative to the bank’s assets (Reserve Requirement Ratio). To meet this legal requirement, the banks will have to make sure they have this minimum amount of reserves by the end of every day (of course, in reality this is audited over an average of period).

There are two ways a bank can increase its reserves: it can directly borrow from the Central Bank (Discount Window lending), but because the government doesn’t want to encourage banks to keep borrowing to fill their reserves, they will usually set some penalty. So, the second way to increase reserve is to borrow reserves from another bank via the interbank market within the Central Bank.

Now we’re back to the above scenario where the Commercial Bank has racked up an extra $10M reserves it wants to lend out via the interbank market. However, many other Commercial Banks also want to lend out their excess reserves, and will compete with one another by lending at a lower rate. Without any intervention, this competition will quickly drive the interest rate down to 0%.

Usually, this is not a problem if the government wants to run a 0% interest rate policy. However, if the government is targeting, say, 2% interest rate, then it will have to intervene at the interbank market.

Remember that the Treasury General Account (TGA) went into negative $10M after government spending? This account also needs to be balanced out so it runs a surplus or at zero balance.

Usually there are laws where the Central Bank is not allowed to purchase bonds directly from the Treasury, so to fix this, the government simply issues Treasury bonds at the target rate it wants (2%) to “borrow” from the secondary market (the Commercial Banks).

This solves two problems at the same time: first, by setting an interest of 2%, the government has guaranteed that the interest rate will not be driven down to 0%, because every bank with excess reserve will rather lend to the government’s 2% interest. (This is how the Fed rate determines interest rate in commercial banks); and second, the negative TGA account can be filled up.

Thus, government debt simply soaks up the excess reserve created by the Treasury to finance a $10M hospital in the first place! Government debt = deficit = spending - tax!

To re-iterate:

1. Congress passes spending bill, which includes building a $10M hospital
2. Treasury spends by having the TGA going into negative $10M
3. Federal Reserve adds $10M matching reserves in the Commercial Bank from the TGA deficit
4. Commercial Bank adds $10M deposits in the Private Contractor account, which it can then use to build hospital
5. Commercial Bank still left with $10M reserves, and wanting to lend out these excess reserves
6. Treasury issues bond to soak up the $10M reserves that itself created in the first place

Steve Keen has a nice double entry bookkeeping illustration to keep track of how the spending works, if you’re interested in the details:

The final point to make is that this only applies if the government wants to run a >0% interest rate. If it doesn’t want to target any interest rate, it can simply let the reserves build up in the system. This whole system is inherited from an already defunct financial structure during the gold standard/Bretton Woods era.