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Sunday, May 1, 2011

What is Monetizing the Debt?

On Friday DIY Investor looked at how the Federal Reserve puts money into the economy. Interestingly, just yesterday he saw a commenter somewhere ask the age old question of where does the Fed get the money to buy securities. The answer is - out of thin air. And this is the problem.

In many areas of life when a screwup occurs there is a choice. People have to pay for their screwup or they are bailed out. Many times it depends on where the screwup happens to be on the economic spectrum. At the lower income part of the spectrum, for example, a job loss can be a catastrophe. Towards the upper end not so much.

One function the Federal Reserve has taken on is bailing out the financial system when it screws up. This of course is the whole "moral hazard" /too big to fail issue.Our biggest financial institutions including investment banks, rating agencies, and even auditors thumb their noses and take excessive risks. They know they'll be bailed out.

The Federal Reserve's  "lender of last resort" function has morphed over time (thanks mostly to former Fed Chairman Greenspan) into a " lender whenever there is a small bump" function.

On Saturday DIY Investor described how the Fed and the Treasury are different. In basic terms Treasury borrows for the Federal government to fund its chronic deficit. Just like any corporation, it issues bonds. To see the actual issuance check out the Bloomberg Calendar where the weekly auctions of bills, notes, and bonds are listed. Treasury borrowing is only a problem in that it "crowds out" private sector borrowing and, in turn, this bcomes an issue as the economy moves towards full employment. It will push up interest rates and thereby worsen the deficit problem.

The real issue is when Treasury borrows and the Fed buys the issues it is selling. This is called "monetizing the debt". The two ballyhooed "Quantitative Easing" programs were basically just old fashioned "monetizing the debt" programs but they couldn't be called that. Certain phrases like "bailout" and "monetizing the debt" are not typically used in polite company.

What does monetizing the debt do? Simply it creates high powered money or what is officially called the monetary base. This is the stuff that bankers hold and use for their part to create money out of thin air. When they create money out of thin air it lowers the value of money. Just like anything, when supply increases, price drops. In terms of the monetary unit this is inflation. When your grandmother said the dollar doesn't buy what it used to it was just her way of saying there has been a lot of inflation.

Now you're probably wondering what the monetary base looks like today. Wonder no more:

The bottom line is this: banks have the potential for explosive growth in the nation's money supply. They have an incentive as well - banks earn profits (and they are profit maximizers like every other business all though that might not be obvious from recent experience) by making loans, i.e.creating money out of thin air.

Chairman Bernanke's press conference was basically to keep markets from freaking out over signs that inflation is picking up. He is attempting to inject confidence in the market as commodity prices skyrocket. He is trying to send a message that the Fed is in control.

All of this is reminiscent of 2006 when he was a leader in the ongoing refrain that the housing crisis was a localized event and wouldn't have a major impact on the broader economy.


  1. A number of countries peg their currencies against gold... to avoid this exact scenario - creating money out of thin air! A form of self discipline.

    Maybe the Feds should too.

  2. Thank you for sharing your insightful article. I have a few questions for you.

    1) When US debt is monetized in the fashion employed under QE1 and QE2, to what entity is the newly created debt owed?

    2) Presuming the answer to my first question is The Fed and that the money is created out of thin air, as you profess, is it conceivable that The Fed will eventually just forgive the monetized debt of the US? You know...wipe the slate clean?

    3) If The Fed can do this, why don't they just move straight to monetizing all of the US debt? Why do they seem to be dancing around the edges, and not tackling the entirety of the problem?

    4) What do you suspect would happen if other countries acted together to remove the US Dollar as the world's reserve currency, before the debt became fully monetized?

    From my perspective, I'm not saying that it is right that the US engages in any of the actions outlined above...but I also can't see how the current debt can ever be repaid, other than in the fashion I've outlined above, or via a direct and willful default.

    Funny thing is, printing the debt away is--to my way of thinking--just another form of default.

    I'd love to see what you think...

  3. Well, I've been checking back periodically, and I'd still love to see what you think.

    I'm not trying to trap you, or be funny. I really would like to get a better handle on what trained folk think about these things.

  4. re: Jay
    Thanks for the questions.

    1. The debt is owed to the U.S. Treasury. They are (in the case of QE) Treasury notes and bonds (not bills). When the debt is bought by the Fed and the seller deposits the proceeds in the banking system it becomes required reserves and excess reserves. The excess reserves can then be lent out in which case the banker is creating money with the stroke of a pen out of thin air. That debt is owned by the banks- it is an asset of the bank. Note that when the public buys the Treasury debt there is no potential expansion of the money supply - it just like corporations issuing bonds!
    2. The Fed could tell the Treasury it doesn't have to pay back the borrowing it made to the extent that the Treasuries are held by the Fed. This of course would take away the Fed's ability to fight inflation when it comes (and it will come!) and leads to all kinds of questions on future fiscal management. A lot of the national debt is held by other countries!
    3. Monetizing the debt would cause inflation and long term interest rates to go through the roof. There are a couple of ways to think of this: first think of the non Fed part of the economy as holding a giant portfolio comprised of money, stocks and bonds. Part of the bonds are Treasuries. To induce the public out of their bonds and to hold much more money would require increasing the bond prices sharply etc. Secondly, think of the international situation. We buy much more goods and services than the rest of the world buys from us. A goodly part of the shortfall is made up by the rest of the world buying our financial assets - presumably the safest if the Fed hasn't reneged. How would this be financed if the Fed held all the Treasury securities?
    4. I can't envision the Fed monetizing the debt so it is hard to speculate on the dollar losing its reserve currency status.
    To me the objective is to not seek to totally eliminate the debt but get it under control. Getting it to 60% of GDP is feasible if we got our energy problems under control and the economy growing at a decent clip. It of course is necessary to get our fiscal affairs in order - and I think the messy process we are going through now is moving us towards that direction.
    I know this rambles but hopefully there is something in here you find useful.