THE FED IS NOT MONETIZING THE DEBT

The Fed’s purchases of treasuries continue to attract a huge amount of attention.  Despite solid evidence that the program is failing to have any real fundamental economic impact there are other worries about the program.  None has been more apparent in recent weeks than the Fed’s supposed monetization of the US government’s debt.  These fears of monetization are unfounded due to the various myths that are perpetually touted by the mainstream media, supposed experts on the US monetary system and even Fed officials.

In an article Monday, Bloomberg reported that the Fed has been buying an exorbitant proportion of the recently issued treasury debt:

“More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.”

Why does this matter?  Because it gives the appearance that the US government is directly funding itself via the Fed’s purchases.  This would be nefarious if it were true and would give credence to the endless complaints about the high rate of inflation in the USA (which is currently running at a staggering 1.5%-2.25% depending on the source).  Fortunately, the concerns are unfounded.

When the US government was working under the gold standard the US Treasury would literally print up certificates to purchase gold from the gold mines.  These gold bars would be delivered to the government and the Treasury would issue a check to the miner.  This new money would end up at the Federal Reserve Bank in the form of deposits.  This would naturally increase the money supply.   An increase in the money supply is scary for obvious reasons.   So, the term debt monetization has its origins in the days of the gold standard, but persists to this day despite the fact that we are no longer on a gold standard.  Not surprisingly, the term is still used today despite the fact that the US government can’t monetize its debt via Fed purchases (I elaborate below).

This issue was magnified yesterday when Richard Fisher of the Dallas Fed invoked the evil “debt monetization” term in his speech:

“the FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we will be purchasing the equivalent of all newly issued Treasury debt through June.  By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: “Monetary policy responsibility cannot substitute for government irresponsibility.”

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”

Fisher’s implication is that the Fed is directly helping to fund the US government’s spending.  After all, if they’re buying the debt then they’re obviously funding the spending, right?  Wrong.  As regular readers know, the US government is never constrained in its ability to spend.  Our monetary system underwent a dramatic change when Richard Nixon closed the gold window. It removed any constraint on the US government’s ability to spend.  Nonetheless, the operating structure of the gold standard (issuing bonds, etc) still largely remained intact.

It’s important to understand the Fed and Treasury’s symbiotic relationship.  When the US government wants to spend money they do not call China and ask for a line of credit.  They do not count tax receipts.  And they most certainly do not call the Fed to ensure that we have any money left.  The Treasury is actually able to harness banks as funding agents at all times due to the unique relationship between the banking system, central bank and US government.  So the entire implication that the Fed is helping to fund US government expenditures is entirely inaccurate and anyone who implies as much is still working under the now defunct gold standard model and clearly doesn’t understand the workings of the modern monetary system.  Auctions in the USA don’t fail because they’re designed not to fail.

For a brief instant, Mr. Fisher appears as though he is on the verge of understanding the system he now heavily influences as a new voting member of the FOMC.  Mr. Fisher says that the spending effectively comes first:

“But here is the essential fact I want to emphasize and have you think about today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place….The Fed does not create government debt; Congress does.”

Lights should be going off in Mr. Fisher’s head at this point as he says this. Congress can’t “run out of money” unless it decides to.  That is, the US government is always able to raise the necessary funding through bond issuance if it must (see here for more).  The idea that the US government can’t “run out of money” is so foreign to most people that their minds repel it.

By now you might be thinking that this is all semantics.  Who cares if the Fed isn’t helping to fund the spending?  They’re still buying the bonds and the spending is occurring regardless of the Fed’s actions.  Well, it’s important for several reasons:

1) Someone who understands the modern monetary system understands that a sovereign government with endless supply of currency in a floating exchange rate system has no solvency issue.  Therefore, it should not be treated as if it is a household, business or state.

2) If solvency is not a concern then clearly the concern is inflation or potential hyperinflation.  But as we’ve seen over the last few years the Fed has not succeeded at creating inflation anywhere close to the historical average and certainly not dangerously high levels of inflation.  To someone who understands how the modern monetary system functions it not surprising then, that the Fed has been unable to generate inflation during a balance sheet recession.

3) We have to be very precise about monetary operations and the relationship between the Fed and Treasury.  Although I acknowledge that the US Congress is never constrained in its ability to spend this by no means implies that the US Congress should spend beyond its means.  To do so can possibly result in malinvestment or very high inflation.

4) The idea that the Fed is buying government debt might imply that there are is a shortage of buyers of US debt.  This is impossible due to the government’s symbiotic relationship with the Fed.  Auctions are designed around calculated reserves and are carefully designed so as not to fail.

5) Voting members of the FOMC do not understand the actual workings of the Federal Reserve System and the US monetary system and have played a direct role in the misguided policy response in recent years.  Of course, this is nothing new.  This problem has persisted throughout the entirety of the last 40 years and is largely to blame for the structural flaws in the US economy currently.

6) The overwhelming majority of US citizens have no idea how the US monetary system actually functions and therefore are reluctant or unable to force any sort of real change.  Those with political or monetary motivations tend to invoke fearful language that incites anger and in truth only adds to the problems in the US economy by driving the voter base to react to their emotions and not their knowledge of the system in which they reside.

7) Quantitative easing does not increase the money supply and is therefore not inflationary.  Although this operation can have significant psychological impacts (such as inducing undue speculation) QE can only work in the same manner that traditional monetary policy is implemented at the short-end of the curve.  This occurs by setting a target rate and by being a willing buyer of any size at that rate.  This is NOT how the current policy is designed.  The current structure of QE leaves interest rates entirely controlled by the marketplace and not the Fed.  Therefore, the mixed results should come as no surprise to anyone as the policy was poorly designed to begin with and is likely doing little more than contributing to excessive speculation and promoting the continued financialization of the US economy.  The Fed’s implementation of such policies (such as QE) and complete misunderstanding of such policies does nothing but help create disequilibrium in the marketplace and increase the odds of future instability.


See the QE primer for more details such as the proper discussion of “monetization” with respects to the various QE transactions.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. “Well yeah, that’s 99% of why your thesis is wrong. The whole world would sink into an economic black hole in your USA hyperinflation scenario. And that’s exactly why no one will ever let it happen.”

    Most places would stop using dollars before it was very bad hyperinflation. Hyperinflation is not an economic black hole, it is just the death of a currency. Commerce goes on, though if the government tries hard to force people to keep using the dieing currency life can be very hard for awhile.

    But this idea that “no one will ever let it happen” makes it sound like they get to vote “all in favor of hyperinflation” but it is not like that. If China, Brazil, Japan, UK, Russia, etc stop buying US bonds the US dollar will get hyperinflation. Not like Obama, or anyone else, has to “let it happen”, he will not be able to prevent it no matter how much he wants to. Hyperinflation is where things are out of control.

    Now it has happened around 100 times before, twice in America. You think all these other places just “let it happen” without wanting to stop it?

    • “Now, that doesn’t mean it couldn’t happen, but the odds are extremely low because the human race knows there is too much at stake….”

      I think only a tiny percentage of the people in congress really understand how hyperinflation starts and the feedback loops that makes it so hard to get out of. I think there will not be enough votes to change anything till after hyperinflation hits, and by then it is too late. You really think I am wrong on this point? Before you answer please watch this video where Obama says he has been to 57 states:
      http://www.youtube.com/watch?v=EpGH02DtIws

      • “I get your position. You think the world’s largest economy is going to sink into some sort of uncontrollable spiral. I also think the world will get sucked into a black hole one day, but I am not egocentric enough to try to convince myself that it will happen during my lifetime. ”

        I think the US dollar is going into hyperinflation. This need not be an economic black hole. Many countries have had hyperinflation. Some have had it several times. It probably means the death of the dollar; however, we can expect them to make a new currency and a new system designed so that it won’t have hyperinflation for awhile.

          • “And if you understood things you would know that it is impossible to have a growing economy and population without an expanding money supply. But that simple reality seems to escape you.”

            Wrong. The US stopped making silver coins in 1873. The economy kept growing fast but the supply of gold was not growing as fast, so prices went down by 1.7% per year from 1875 to 1896. The increasing value of money is hard on debtors, and may not be ideal, but the economy was growing far faster back then than it has over the last 10 years when the government has been making money like crazy. Reality is you are wrong.

    • “See Vincent – this is what you can’t comprehend. The USA is 25% of world GDP. That’s because a huge portion of what the world makes and consumes is due to the USA.”

      After the dollar crashes it might only be 5% of the world GDP. I highly recommend this 3 minute video for understanding how American consumers do not drive the world:

      http://www.youtube.com/watch?v=IlWpGm9POwQ

  2. Is this the longest thread in PragCap history :-)

    Lots of good discussion and information.

  3. “So, is this check mate yet?”

    You said: “it is impossible to have a growing economy and population without an expanding money supply.”

    I provide a counterexample showing how foolish your claim is and you think that because there was a financial crisis during that time, even though it totally contradicts what you said, that you are now right?

    In that crisis the government had issued more paper money than it had gold to back it and people lost confidence in the government paper money. It was only when JP Morgan was able to get $65 million worth of gold that the Treasury was saved.

    http://pair.offshore.ai/38yearcycle/#1895

    Losing confidence in government paper money is what I think is coming next now.

    The reason growth rates are lower today is that the government is an overhead on the economy and the overhead is far larger now. You can see this in this graph that shows places where governments are a larger fraction of the economy grow slower.

    http://pair.offshore.ai/38yearcycle/#governments

    So is this checkmate?

    • You provided a historical example during which the US suffered one of the worst depressions of its history. Of course there can be growth during monetary contraction. I should have said “sustained growth”. You read my work. You know that I discuss how the private sector gets driven into debt when the sovereign collapses the money supply. And a debt bubble was exactly what happened in the 1890′s. You got a few great years of growth because of debt binging and then it all collapsed.

      How does that prove that the economy can be great without a flexible money supply? It doesn’t at all. In fact, it proves my entire point…You just make things up to satisfy false claims. Your example is like saying that you eat McDonalds every day and have no side effects! For a full decade you lived prosperously and ate nothing but MCDs. But you leave out the part where you died of a heart attack at the end of the decade. How convenient….

      The govt reduced its debts by 50% during the period in which you cite. Yet, it still collapsed the economy. That totally contradicts all the nonsense you’ve been discussing.

      We fundamentally disagree. That’s fine. But I hope you’ll be man enough to come back every few months and remind us why you are wrong because you will be. THEN, it will be check mate.

    • “The reason growth rates are lower today is that the government is an overhead on the economy and the overhead is far larger now. You can see this in this graph that shows places where governments are a larger fraction of the economy grow slower.”

      that graph is embarrassing, lazy. it says nothing of value, any introductory econometrics student creates more meaningful scatterplots as a homework assignment. there is worthwhile research showing how government interventions can stifle economic growth, this particular piece is not among them

      • >that graph is embarrassing, lazy. it says nothing of value,

        Do you have a better source showing how government spending as a fraction of GNP impacts 10 year growth rate?

  4. A) Russia is an oil producer.
    B) China will sell as long as it gets paid and can use the dollar to buy oil and other goods. If the dollar goes down they will ask for more dollars thats is the same as refusing the dollar as it stand now.

  5. “Do you have a better source showing how government spending as a fraction of GNP impacts 10 year growth rate?”

    this doesn’t show this…i’m really not sure how to respond here, where does one have to start with you? correlation is not causation? have you read any growth theory at all?

    • “this doesn’t show this…i’m really not sure how to respond here, where does one have to start with you? correlation is not causation? have you read any growth theory at all?”

      My mistake. Correlation does not prove causation.

      I understand that if a government borrows or prints lots of money people can feel better for a couple years. But this is similar to if I spend lots of money on my credit card I can live better for awhile. But long run I am worse off.

      This 10 year growth rate data seems to fit my theory (Austrian) and contradict your theory (MMT). Shall we toss out your theory or do you have other data that would contest the accuracy of my data?

      • “Had a chat with Warren about your bond market concerns last night. What he proposes is simply changing the term structure of the market. Eliminate the long end. Reduce tsy’s holdings to short duration only. ”

        The shorter the duration on the bonds the faster people can convert them to cash. Part of why the US it at risk, in my view, is that 1/2 their debt comes due in the next 12 months. If it were spread out over 30 years there would be much less risk as only 1/30th could come due on any given year.

        The problem with interest rates lower than inflation rates is people are losing value. Eventually they get pissed and leave. They may go to commodities or gold.

        So what he is proposing will make the risk of people suddenly getting out of bonds higher. If all the debt came due in the next 6 months they might have to print for the whole deficit in 6 months. This is not a fix at all.

        • “People don’t “get out of bonds”. Investors exchange existing securities. They don’t just get rid of them. The govt never has a problem rolling over these securities because the desire to net save is always high.”

          You are not looking at the history of the real world. Sometimes people stop buying and as bonds come due they just get their cash. This means they are getting out.

          Many governments have had problems rolling over debt. Ever hear of Greece? Anyway, many governments that can print their own money just start printing when they can not roll over debt. If Greece could print they would.

          The more the Fed buys US debt the worse an investment it will be, so less people will want to buy, so the Fed will have to buy more. Feedback loop is already starting really.

          • “Can you give me an example of a country in a floating exchange rate system with monetary sovereignty that suffered hyperinflation? ”

            All 100 of them had monetary sovereignty. How else were they print the money for the hyperinflation? You think someone can have 100% inflation per month and really be pegged to some other currency? I don’t know of any case like that with a real peg. Perhaps the official exchange rate was pegged to something but probably nobody could really exchange money at that rate. I think all of the cases of hyperinflation had floating exchange rates, at least on the black market. In hyperinflation it is the black market winning over government control and the currency failing. Check out the stages of how things evolve:

            http://pair.offshore.ai/38yearcycle/#hyperinflationstages

            • “No, most of them were not really sovereign even though you think they were. For instance, Weimar had foreign denominated debts. Argentina had a peg. Zimbabwe had foreign debt, Etc. Give me real examples.”

              Sovereign means nobody tells them what to do. Sovereign countries can drop a currency peg and/or defaults on foreign debt if they want. That is so easy (voters don’t really care about defaulting to foreigners). Hyperinflation is very destructive to an economy but defaulting on foreign debt or relaxing a currency peg is no big deal. In your world view why doesn’t any country at risk of hyperinflation from these 2 problems just get rid of the problems with a rule change?

              As for examples of hyperinflation, this URL has a nice list. How about staring with Bolivia.

              http://www.sjsu.edu/faculty/watkins/hyper.htm

          • “Greece is in a single currency system. They are a currency user. Not a currency supplier. It’s not an apples to apples example. They have no monetary sovereignty. Wanna try again?”

            If Greece could print their currency people would be fleeing their bonds even faster. It would mean that they would be printing lots of money and making each unit have less value. Not a good time to hold bonds.

            Again, I think in every case of hyperinflation people drastically slowed or stopped buying government bonds (at least in real terms). It is a key part of the feedback loop of hyperinflation. The worse things get the less people want to buy bonds and the more the government prints, so the worse it gets… Why would anyone want to lock their wealth into a currency that might not be worth anything a year from now? Once people see things going south they stop buying bonds.

      • agh. even if the data were relevant, how do they contradict mmt?

        i don’t know what to tell you. it’s really, really bad econometrics, amateurish. people need to read their ed leamer. why pick gov’t spending at the start of each decade? what possible economic theory supports just picking those years?

        was nothing else happening during those four decades? such as rising inequality, rising oil prices?

        • “even if the data were relevant, how do they contradict mmt? ”

          Most MMT people seem to think the more the government spends the better things will be. While there is a bit of truth to that in the short turn, this data contradicts that idea for the long term. The Austrian’s think a smaller government is better for long term growth rates. Leaves more of everything in the hands of the productive parts of society. This data supports the Austrians. Do you have any data that long term (like 10 years or more) it is good to have governments that spend lots?

          • inequality was rising in most oecd countries during that time period. why is this not an explanation for the falling growth rates. you have to account for confounding variables if you want to do econometrics. this paper is embarrasing

          • that may contradict the political desires of ‘most mmt people’ but it says nothing about mmt in and of itself. think harder

  6. I will concede that Weimar had questionable sovereignty so lets just ignore that one. But how in what other cases of hyperinflation was a government not fully in control of what it was doing? I am not aware of others under threat of invasion if they defaulted.

  7. Help me here. Allow me to paraphrase, please – “The Fed is not printing money, the congress is….”

    A hypothetical. Congress has approved a budget and authorized a fictional $24 deficit. So now it is up to treasury to fund the cash shortfall. Again, assuming cash flows are smooth, this occurs each month…

    US Treasury
    Cr Cash $2
    Dr USTBond or USTBill liability $2

    When the Fed buys on the open market what is now a public security the transaction looks like:

    US FRB
    Cr Bond asset $2
    Dr Cash $2

    Security Holder
    Cr Cash $2
    Dr Bond or Bill Asset $2

    Where does the Fed get its cash (or digital equivalent) to settle the transaction? I understand that the FRB balance sheet has grown with assets and liabilities to match, but as a seller of an open market security want to see the Credit of $2 in my account. Where does it come from? Is treasury the one who settles the account in lieu of the FRB? If so then it gets worse..

    Treasury
    Cr ???? $2
    Dr Cash $2
    where ???? = ????

    MPP

  8. On one hand we have created aggregate debt levels equalling 3.5 times GDP. Recently a lot of these loans
    As assets have been transferred onto the Fed’s balance sheet at nominal book value in exchange for cash and cash equivalents issued by the Fed. Simultaneously we are running deficits which axiomatically enter the economy as cash and equivalents like bonds.
    The two are not unrelated. In fact one cannot happen without the other because the fair market value of the assets the Fed is buying is lower than the price paid. This is where the complaint that banks privatize profit but socialize losses comes from. Fundamentally we’ve all been caught in a Ponzi scheme. The answer to that is: Don’t do that. Time will tell how much damage we have done to the private economy. Unwinding the debt will cause further dislocations and misapplication of resources. Understanding MMT can help but we still have big trouble coming.

  9. I think you’re a little off on your belief in money creation and your assumption that insolvency issues are moot because of our fiat currency. Here’s why.

    When the federal government spends more than their general revenues from taxes, they borrow to cover the rest of it. You seem to think this is analagous to creating money to cover the deficit. I don’t think so.

    First, though the Federal Treasury owns the printing press, they can only print federal reserve notes. Correct me if I’m wrong (and I’d like to see proof. Not to be a prick, but I’d like to have a source for my own works), but the indenture of the Fed has the explicit control over the US government’s permission to print cash – because it’s supposed to be backed by the collateral of the Fed’s Reserves.

    That, I believe is why they borrow the money instead. Short of getting the Fed to ‘monetize’ the debt, they can’t just print money. And though the federal government can borrow past the point of what would be total insolvency in the private sector, as the amount they borrow increases the more interest payments erode their general revenues.

    At a certain point, there is a real risk that the federal government can’t make payments, and as we continue deficit spending that threat grows. Of course I agree that even though the national debt is right around our total GDP we can still take on a much greater debt load and come out the other side ok. But as deficit spending grows, it shows the economy is out of balance and inefficient. At some point, the government will have to pay more for its debts unless by the fed decided to buy them all and forgive the interest payments.

    I think before that would occur though the US would remove the FED. It’s the only way to enable themselves the right to print money and inflate their way out.

    But here’s a very unorthodox solution – and I think it could be done without spurring excessive inflation. Allow the Federal Government to pay all of it’s deficit spending, and potentially that of the budget shortfalls of the heavily indebted states, with freshly printed money to the extent that new money equals the lost value of the housing market from a 2004-2005 level (there’s a few trillion dollars there). Overlooking the fact the FED wouldn’t allow it here’s what I think would happen.

    First, I need to backtrack. QE is only an increase in the monetization of assets, increasing the monetary base. Unlike yourself, I do believe that ‘new money’ has been introduced to the system. But I think it’s negligible when, without a reserve requirement, banks themselves can actually create the money themselves if there were worthy investments to put it in. But here’s what makes it really ineffective. Because QE is, in its most basic form, the exchange of equivalent promissory iou’s from the Fed to the Government, all money introduced in this way is actually credit.

    This is the problem with how banks, including the fed, make ‘money’. If all money is credit, the money supply can only grow with a proportional increase in debt. When excessive leverage is the issue there’s no way out but default or the introduction of real money to be used towards deleveraging.

    Ideally, it would inject cash into the areas hurting the most – Main Street. The cash wouldn’t be caught up fueling commodity and junk bond bubbles betting on inflation for some time – it would take a while for Wall Street to get it’s hands on it. Further, it would stop your everyday employee’s like teachers and labor union members from taking a hair cut that’s killed spending. All the while, it would subsequently allow the federal government and states to use general revenues to deleverage themselves for a short time.

    Of course, it would shock the markets and by fear alone, ‘devalue the dollar’. But with a negative savings rate and spending declines, that money would be absorbed pretty quickly and it would probably only be enough to counter the growing deflationary pressures. If it did devalue the dollar it would boost exports and production, lower the real interest rates, save jobs and wages before they’re gone, and potentially put people back to work.

    In a very odd way, it may even out the disproportional growth Wall Street is enjoying during a trying time for the American people because of it’s disproportional influence and safety net derived from the Federal Reserve. Instead of stimulus being injected into the financiers (yes, I can sip my wall street hatorade… I’ve accepted a job at an ibank on wall street. And really I don’t blame the street, but I don’t like our current solutions either) it would go to the average joe’s and states who need it the most.

    In theory, it would be a stimulus to rival Greenspan’s removal of the Fractional Reserve Requirement in 94, freeing up 10% of banks deposits, switching money creation from endogenous limitations to exogenous growth determined by the market. It ushered in the greatest boom of all time.

    But then again, delaying the bursting of the largest credit bubble in history that’s developed around the financial deregulation of the last 40 years may only hurt us. I don’t think a world where banks are leveraged up on average 30:1, they record 1.30 or so in assets for every dollar of deposits, and unregulated derivatives carry a notional value around 25x the world’s GDP (and climbing by the day) is sustainable. The system may simply need to reset. I just hope we can do it quick, smart, and with a calm head on our shoulders.

    Hope I’m entertaining ya.

    Best,
    E.B. Mill