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.  While the public moans at the Fed over high inflation, fiscal authorities, because the debt is monetized, are absolved of responsibility.  The Fed is signaling it does not intend to monetize the deficit and I hope the choice for a new chair will maintain that commitment.

Comments

[anne]

Excellent comments. Though I did not read Janet Yellen's comments as indicating the Federal Reserve might not respond to a rise in inflation, I understand the concern and we need a sense that the coming Fed Chair will respond vigorously to a prospect for inflation to increase for any fiscal reason.

[Bruce Wilder]

It would be interesting to know the maturity structure of the national debt.

If the Treasury had taken the opportunity presented by low, long-term interest rates, and sold boatloads of 30-year bonds, I would tend to think that the future temptation to inflation would be greater for Democrats and less for Republicans. On the other hand, if the debt is "young", then I might suspect the motives of "starve-the-beast" Republicans are pro-inflationary in a particularly perverse sense.

[Mark Thoma]

anne - sorry for not being clear. I meant they may not respond to an increase in the interest rate if it is believed to be deficit induced. I too believe she sent a clear message of vigilance against inflation.

[anne]

No; you were entirely clear but surprising nonetheless. There is however no sign yet that our deficits internally or externally are adversely effecting prices or long term interest rates.

[anne]

http://flagship5.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/04 to 9/28/05

S&P Index is 1.7
Large Cap Growth Index is 0.7
Large Cap Value Index is 4.6

Mid Cap Index is 8.7

Small Cap Index is 4.3
Small Cap Value Index is 3.8

Europe Index is 6.7
Pacific Index is 11.9

Energy is 50.1
Health Care is 11.3
Precious Metals 31.9
REIT Index is 7.0

High Yield Corporate Bond Fund is 1.6
Long Term Corporate Bond Fund is 5.1

[Mark Thoma]

Glad I'm not completely predictable these days! To run with that thought, Gov. Macfarlane of the Australian Reserve Bank does not believe the deficit is a problem for the U.S.

My reading of Yellen (and others) is that they agree - for now interest rates do not appear to be affected and inflation remains in check. But she is worried that the situation could change quickly causing a rapid rise in interest rates and it is at that point the Fed will have to decide how to react. I thought the message was that if it is due to irresponsible fiscal policy, they would let interest rates rise rather than respond by loosening policy, monetizing the debt, and risking inflation.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsVIPERByName

Sector Stock Indexes
12/31/04 - 9/28/05

Energy 48.5
Financials -2.4
Health Care 6.0
Info Tech -1.8
Materials -6.0
REITs 7.1
Telecoms -0.4
Utilities 21.0

[Movie Guy]

Gov. Macfarlane of the Australian Reserve Bank appears to have a better handle on the deficit/surplus issues than many U.S. commenters.

Granted, I didn't focus on his finer points in the comment post that I provided under the thread that you posted, but his remarks are noteworthy.

I was surprised that no one else posted any comments.

Significant post, Mark. Thanks.

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Dollars]
12/31/04 - 9/28/05

Australia 16.5
Canada 24.2
Denmark 16.6
France 9.3
Germany 5.5
Hong Kong 10.6
Japan 11.2
Netherlands 5.7
Norway 30.9
Sweden 6.7
Switzerland 8.6
UK 7.0

[anne]

http://www.msci.com/equity/index2.html

National Index Returns [Domestic Currency]
12/31/04 - 9/28/05

Australia 20.7
Canada 22.5
Denmark 32.4
France 23.7
Germany 19.4
Hong Kong 10.4
Japan 23.0
Netherlands 19.6
Norway 40.8
Sweden 25.5
Switzerland 23.8
UK 16.6

[johnchx]

Bruce: "It would be interesting to know the maturity structure of the national debt."

I looked at this early this year. At that time, the marketable portion of the national debt looked remarkably short-dated. As of 12/31/2004, $1.5 trillion (about 40%) was scheduled for repayment in calendar 2005, with an additional $0.6 trillion (about 15%) due in 2006.

Non-marketable series (held primarily by federal trust funds) are longer dated.

I may be off-base about this, but I have a hard time seeing any sound treasury-management reason for having $1.5 trillion in short-term financing for debts which we have no plan to repay at any time in the forseeable future. Borrowing short-term and desperately hoping that our creditors will continue to roll over the principal every three to six months...hmmmm...where have I heard this strategy before?

[anne]

The problem is the divergence between core inflation and inflation counting energy and food. Core inflation shows no signs of increase, and is remarkably subdued while inflation as a whole is being driven by energy costs. Contain energy costs and there is simply no problem, though there may be too little inflation absent rising energy costs.

[claus vistesen]

... " this is an undergraduate student applying the theory of debt monetization into his economic vocabulary ..."

...:)

[Stormy]

Am puzzled here. Let us take steps 1-4, resulting in the government now owing $100 in one year.

Let us suppose also that in that one year tax revenues + inflation do not cover the $100 payment.

How can the government cover the debt other than through monetization, cranking up the presses to print a new $100 bill?

It seems to be—considering the reductions in revenues and low inflation—that the government is already monetizing its debt.

Have I missed something?

[Mark Thoma]

Stormy: All of the same choices are available - cover the $100 by raising taxes, lowering spending, printing money, etc. The constraint is:

G + int. payments - Taxes = (change in M) + (change in debt)

The lefthand side is the deficit.

When interest payments go up, it has to come out of some other part of the constraint, G, taxes, etc., and one choice is a change in M.

If this is still confusing, don't hesitiate to follow up.

[Jeffrey Miller]

"in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury"

Mark,

1. Does the above mean that the Fed is limited to buying
only as many bonds as it can pay for from the income on
the portfolio of bonds that it currently owns? Or can
it just create an unlimited amount of money?

2. What is the value of the Feds current portfolio?

3. What is the income it gets from this portfolio?

Thanks for clarifying these points for me.

[Stormy]

Mark,

The example I gave assumed that taxation+inflation could not cover the $100 the government owed.

If this is the case, then does not the government have to print the money that is now owed? i.e., monetize that debt?

Thanks for the response.

[Mark Thoma]

Jeff:

1. The Fed can print as much money as it wants. However, its powers aren't constitutional, they are granted by congress and can be changed legislatively. So, if the Fed abuses its independence, it would be taken away.

2. 721,922/7,860,234. The bottom number is total federal securities outstanding, the top number is the amount held by Federal Reserve banks. See here and click on "ownership of federal securities."

3. It can take what it needs from the interest income on its bond holdingsto fund its operations, then turns the rest over to the Treasury as it is far more than it needs. Details on how that works is here, but it's a bit long and you have to dig out that section. The Fed can refuse audits from the GAO so it's financially independent as well which is important. The purse strings can be powerful instruments of control.

[Mark Thoma]

Stormy - If it cannot cut government spending by $100, and it if does not issue new debt to pay the interest, it would have to monetize min your example

Issuing new debt to pay the $100 interest is kind of like getting a new credit card to pay the interest on the old, but it is a possible strategy.

If you lower spending by $100, you can use the taxes that would have paid for the spending to pay the interest instead.

says...

as for that $100...

If the debt is monetized, for simplicity sake, let's say it is repurchased from the same party which origianally bought it. That party is no longer entitled to the coupon, thus taking the $100 out of play. Of course they'd accrue some small portion depending on how long it was held, but this is trivial and would be included in the initial monetization.

[JKU]

Mark,

You said 'The Fed can print as much money as it wants. However, its powers aren't constitutional,
they are granted by congress and can be changed legislatively.'

How does the 'money printing' chain of the commands carried out? Who initiates the order? How does the FED balance it's book when the new money bills (Federal Reserve Notes) were printed before it buoght the bonds?

[Micki]

Fed fighting inflation???
Let me quote the great Mogambo; HAHAHA
The funny thing is that following the lemmings on Bloomberg, they still think something will be done to magically turn around inflation.
Got gold?

[hari]

Whereas the mandate of ECB is *price stability* (inflation control) within Euro zone, Feds mandate includes price and employment stability...and more(I don't know it).

In context of current global monetary stance, I see policy convergence (more likely) between Fed/ECB than before. Debt monitization may be one (political) issue which will not wash easily across the Atlantic Basin.

So, Mark, you've to take this important policy issue a step further with a view to developing synergy globally - primarily because the buyers of your *debt* are now SWF. And SWF are owned by their sovereign and their outlook seems (to me) long term (not a bad strategic proposition for Feds *debt monetization* in current situation).

[J]

kool,thanks- shud help with my econ exam tomor....