Tuesday, March 24, 2009

US Makes Plans to Monetize Debt

In the nations with the worst inflation rates (historical examples include Brazil, Bolivia, and now, Zimbabwe), there is often little independence between the central bank the the nation's treasury. In such a circumstance, it becomes easy--too easy--for the country's government to pay its own bills by simply printing money. And in such a case, the money printing is real, literal, waiting-for-the-ink-to-dry money printing. Need to purchase some new rocket launchers? Print some currency. Or pave a few roads heading into a general election to help your party's popularity? Start the money-printing presses.

A fairly obvious implication of such a strategy is that the nations with the highest rates of inflation rarely have annual budget deficits of any significance. After all, why would a nation need to borrow anything to meet current budget shortfalls, when it has no budget shortfalls? A country with lots of money printing rarely borrows much, if at all.

Now, most nations are far too principled to resort to plain old money printing to finance some of their current spending. And to guard against such temptations, countries arrange their governmental financial institutions to limit the likelihood of such activity. The simplest way--and the arrangement we have here in the United States--to forestall such misdeeds is to make the nation's fiscal authorities (the ones in charge of taxing, spending, and borrowing) independent from the monetary authority (the central bank). So we have an independent Fed: a central bank that calls its own shots in the conduct of monetary policy.

Nevertheless, there is a way for a nation to do the equivalent of "money printing" even if the nation has constructed its institutional arrangement to make literal money printing either difficult or illegal. That is, even with a Fed and Treasury that operate independently, it is possible for virtual money printing to take place.

That practice is called debt monetization (or "monetizing the debt"). And here's how it would work.

As a matter of a central bank's daily ordinary functions, bond traders that work at a central bank's trading desk routinely purchase and sell government securities. In fact, its is through buying and selling securities in this manner that central banks like the Fed increase or decrease the nation's money supply. Want more money out there? Buy securities and pay for them. Want a little less out there? Sell securities, then collect the payment afterward and keep it.

So how could a country take advantage of this arrangement? Well, suppose a national treasury knows it does not have sufficient funds in the coffers to pay its bills. And either because of recession or politics, higher taxes are not viewed as a viable option. Then if the treasury printed some new bonds (the instrument governments use to borrow money), and those brand new bonds ultimately were purchased by the central bank using an increase in the money supply to make its payment, then the central bank and the treasury would have achieved monetary alchemy: they would have created new money where there had been none before--new money the treasury will use for bill paying. Voila.

Despite our best intentions, debt monetization happens most of the time, even right here in these United States. But in most years, the money supply grows by considerably less than the size of the deficit. So some of the debt is monetized, but not much.

But now we are in new territory. The US has major budget shortfalls, and right now our normal go-to lenders (such as China) are not as keen to lend to us as in the past.

Faced with such conditions, the Fed and US Treasury are orchestrating multiple deliberate debt monetizations. Despite the Fed's independence, Bloomberg reports today that
The Federal Reserve is likely to target the newest, most-traded Treasury securities for purchase . . . . The central bank may announce as early as today which maturities it will buy as part of its plan to acquire $300 billion of Treasuries during the next six months.
So why does this matter? After all, if the Fed monetizes some debt in most years anyway, without necessarily even trying, is there any legitimate cause for concern?

The potential--though perhaps latent--challenge is inflation. Despite concerns today of a deflation, money printing is ultimately inflationary. Moreover, money printing is inflationary whether it is the literal variety or the "monetizing the debt" variety. For this reason, debt monetization is also referred to in the literature of monetary economics as "seigniorage," and in the literature of public economics as "inflationary finance." The public economists--especially the public choice economists--like to call it an "inflation tax."

And inflation is what makes monetizing the debt begin to hit you in the pocketbook. Every time that the monetary authority adds one more dollar by purchasing a new bond, the value of any dollars you are holding in your bank account, or that you receive in your paycheck, falls a little. More dollars => dollars are less valuable. And the more this happens, the more your purchasing power is eroded.

A more important, yet less immediately obvious implication is that over time, our nation's productive resources and activities will be used less to make the goods you and I as consumers want, and more of the goods that government wants. If the government can always "print" more money, it will always be able to buy what it wants (tanks, missiles, roads, etc). And the more that it does this, the less purchasing power you and I will have to buy the things we want. More business plane trips for government officials means fewer pleasure plane trips for the rest of us.

So are the Treasury and the Fed out to get us? Probably not. But right now, in the current climate, their focus is upon more short-term concerns, and also on taking big actions designed to improve immediate circumstances for bigger economic players than you and me.


  1. When the Fed acquires their 300 billion in treasuries, how long do you think it will take before interest rates start to climb?

  2. The Fed is trying to stimulate the economy due to the recession. I suspect that the Fed policymakers think they can help stimulate the economy in this way, and then reverse themselves when the time is right to prevent future inflationary pressure. Of course, the key concern is whether they can identify the correct time and whether the combination of loose monetary policy and the expansionary fiscal policy will combine months down the road and lead to substantial inflationary pressure. I don't see this happening in the near future--but six to nine months down the road is a real possibility.

  3. Monetization is currently advertised as an operation to get interest rates lower. But in fact, monetization now is to cover the funding gap that exists between Treasury supply and Treasury demand. This gap could be as large as 900B or even 1T for FY 2009.

    When the Recognition phase kicks in on this monetization, look out.

  4. Dr. Claar, your explanation make complete sense, but never the practice of "debt monetization." Incidentally, let us not forgot that, thanks to the Fed, the dollar has already lost more than 90% of its value. Too many "dollars" chasing too too few good will never be a good thing despite what establishment economists and lying government statistics report.