jungle

September 29, 2005 The Economist
What is Debt Monetization? When is it Automatic? Is it a Risk?
What is debt monetization and how does it work? How can constant interest rate rules make debt monetization automatic? Why is this a worry and how does it relate to the choice of a new Fed chair?

What it is and how it works

1. Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.

2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.

3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).

4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.

5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that).

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.

2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).

3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed.

This is one reason why the Fed has made so much noise lately about letting interest rates rise in the face of budget deficits. The Fed is sending a signal to fiscal authorities that it would rather let interest rates rise than monetize the debt and suffer the inflation that debt monetization brings about. So far we have been lucky in this regard. Long-term interest rates have remained low while budget deficits have increased. But if your read what Janet Yellen said yesterday, echoing remarks by other Fed officials, she is clearly concerned that this may not persist and that interest rates could rise quickly. The Fed is signaling that if the increase in interest rates is caused by budget deficits, the Fed is unlikely to intervene due to the inflationary consequences of monetization. It will allow interest rates to rise.

Is this a risk?

For me, this is one of the important considerations for the new Fed chair. I will be interested to hear the commitment of the new chair to fighting inflation even if it’s not a direct commitment to an explicit inflation target. There is every incentive for both parties to choose someone who will allow the debt to be at least partially monetized by allowing inflation to increase because this relieves congress of the responsibility for raising taxes or cutting programs. With debt monetization, government debt disappears and inflation takes its place.
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In simple terms, it isn't so much the last 1.3 trillion that is causing all the worry, it is the many trillions which have come before and will come after.
Spending has been out of control for decades and is now nearing a level that is clearly unsustainable.

Look for a future unwinding of many "promises to pay" in entitlement programs as the effort to bail out the sinking ship is suddenly recognized, as if it were fresh news.

As more and more debt is created and held by government, there is an equal amount of reduction in private debt available-in other words, growing government stunts private sector growth.

Deflation of real assets such as housing, commodities, stocks, is obvious in the great reductions of price in the assets recently. Some of the recent government activity, such as holding interest rates as low as possible and monetizing the debt may be seen as a way to reinflate the bubble. Inflation favors the lender(gov) and deflation favors the borrower(taxpayer).




"Blood running in the streets. Mobs of rioters and demonstrators threatening banks and legislatures. Looting of shop and home. Strikes and unemployment. Trade and distribution paralyzed. Shortages of food. Bankruptcies everywhere. Court dockets overloaded. Kidnappings for heavy ransom. Sexual perversion, drunkenness, lawlessness rampant. The wheels of government are clogged, and we are descending into the vale of confusion and darkness. No day was ever more clouded than the present. We are fast verging on anarchy and confusion. (George Washington in a 1786 letter to James Madison, describing the effects of fiat paper money inflation then ravaging America in the pre Constitutional period.)