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.