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. The Fed can get away from using bonds as reserve drain by paying interest on reserves equal to their target rate. That’s what the Bank of England now does on reserves – paying the Bank Rate.

    That then highlights the current problem with the system. At the moment both financial corporations and non-financial corporations are piling up huge quantities of cash in Japan, the US and the UK. That money is going straight into bonds at a risk free rate well above the current target rate.

    What I find amusing is how the politicians complain about the ‘feckless unemployed’ living off state welfare, when the corporations of the country are doing just that.

    We should stop issuing bonds to get rid of the interest which is nothing more than unemployment benefit for feckless corporations. Then they might start investing their cash pile in productive assets.

    • Neil, can you please elaborate on “That money is going straight into bonds at a risk free rate well above the current target rate”?

      What is the risk free rate and current target rate that you refer to?

      • Ithink he refers to Fed rates at zero, where e.g. banks can borrow at and park the cash at 3.7% in the US Treasury 10yr bond. There is no credit risk involved and, if held to maturity, no price risk in Treasuries. So the only risk in this carry trade is if Fed rates rise above the current Treasury rate.

        • yeah but isn’t the fed funds generally always under the 10 yr? is it not essentially the interest rate floor and one of the primary channels through which the fed tries to control interest rates?

          • Currently you have the steepest curve ever. And the Fed rate can be > UST rate, e.g. before the 2007-2008 crisis started.

    • “The Fed can get away from using bonds as reserve drain by paying interest on reserves equal to their target rate. That’s what the Bank of England now does on reserves – paying the Bank Rate.”

      In the last few years the Fed has been paying interest on “excess reserves”. If you view the central bank as part of the government (an MMT view I totally agree with) then the Fed paying interest on money is not really different than the Treasury paying interest on money. They both reduce aggregate demand, as long as the money is tied up. However, bonds are more stable as they can lock money up for many years. Interest on excess reserves does not lock the money down, people could take it out and spend it at any time. If people decide we are headed for hyperinflation that money could come out and contribute to the sudden demand.

  2. Hello,

    I have a question regarding eurozone functionning. As there is no government, how does money supply can increase then?

    As for the US, I still would like to know how the difference between what as been spent and the liability recorded in the book. Let say the government is at 0, start their computer, day 1: transfer $1 million to a tank manufacturer to buy 1 big tank. Day 3, (cause it Sunday was between) They will need to issue a $1 million bond to “cover” the spending, right? So my question is, in which account are those $1 million during Sunday?

    It would help me undesrtanding MMT I think.

    Thank you!

    • …in Europe, a national CB due to the ECB rule and article 123 of the European Constitution as amended by the Lisbon Treaty prevents a national CB from financing a government deficit.

      As a result, EU members need to raise taxes to pay for loans from the ECB

      Kind Regards

      • Klaus, do you know how the ECB disburses new funds? Surely they must over time, right? I am not familiar with the process. Any info would be greatly appreciated.

        • Cullen Roche:

          In U.S. style central banking, liquidity is furnished to the economy primarily through the purchase of Treasury bonds by the Federal Reserve Bank. Because the European Community does not have system-wide bonds backed by a system-wide taxation authority, it uses a different method.

          Member banks, of which there are several thousand, bid for short term repo contracts of two weeks’ to three months’ duration. The member banks in effect borrow cash and must pay it back; the short durations allow interest rates to be adjusted continually. When the repo notes come due the participating banks bid again. An increase in the quantity of notes offered at auction allows an increase in liquidity in the economy. A decrease has the contrary effect. The contracts are carried on the asset side of the European Central Bank’s balance sheet and the resulting deposits in member banks are carried as a liability. In lay terms, the liability of the central bank is money, and an increase in deposits in member banks, carried as a liability by the central bank, means that more money has been put into the economy

          …the problem in the EU at present is the provision of collateral of member banks of weaker countries like Greece, Portugal, Spain

          Kind Regards

          • The way I understand vertical money in the eurozone is this:
            The ECB creates it when it loans (and these loans expand and are not repaid in aggregate) and when it purchases (which it does very little of). Unlike the US system the treasury liabilities of euro governments, like state governments are not risk free.

            I take some issue with the notion that the government is the monopoly issuer of the currency mantra. Since loans create deposits, the vast majority of broad money aggregates is created by banks. A euro bank could make a loan which is used to purchase something, the receiver of that purchase can use that income to buy a Greek bond. Banks are also large purchasers of eurobonds.

  3. Cullen,

    I think this analysis is correct, but it has a flaw. It considers only the vertical level QE effect, but QE has also an effect on the horizontal level, which can be extremely powerful – it alters the mix of assets in the private sector by i) increasing the portion of more liquid assets (cash being more liquid than treasuries) and ii) by reducing the level of income in the portfolio it forces a shift toward other income / capital appreciation generating assets (e.g. speculation psychology and later “feel good” economy psychology).

    So it not only misleads people to speculative (which is often inflationary as now in food and energy) activity by pandering to their misconceptions, but also forces them to speculate by having an income reducing effect on their portfolios while also providing the necessary means (more liquid cash).

    So your analysis may be correct (appears to be) regarding the fundamental economic effect on the economy / asset markets, but the psychological indirect effect (portfolio mix effect) may be so much powerful as to create a self-fulfilling “feel good” economy and thus real economic rebound.

    Thus, my issue with your analysis is that it does not predict the correct economic / market effects in the end (at least not with the current market “pavlovian bulls” / “I want an iPad” psychology)

    InvestorX

    • The issue is that the psychological effect leads to a real fundamnetal effect. As per Soros reflexivity theory or my attempt to explain the links above. And the second issue is, that the forecast of your theory is not useful / actionable.

      InvestorX

      • Perhaps short-term positive impacts. But it does little to resolve the structural problems that got us into this mess. Sure, QE might cause some speculation, make markets run higher, and make us all feel better for a few years. But what happens when we all wake up in 5 years and notice that the consumer balance sheet is still upside down? Then what? We crash and crank up the Bernanke fix it machina again?

        • On that I agree. But who trades with a 5 year horizon nowadays? The market is up / economy is all “green shoots” for almost 2 yrs now and I cannot argue that I should not be in, because – see – in 3 years the market will crash again…

  4. Point #1 is the crux. We might be the monopoly supplier of $ but we aren’t so for commodities. They are the ‘gold’ standard. Thus QE = “money printing” = monetizing the debt = inflation. End of story. The dead time has passed and now we are starting the lag. Prices (inflation) going up, up, up.

  5. “The idea that the Fed is buying government debt might imply that there is a shortage of buyers of US debt. This is impossible as government debt issuance serves only as a reserve drain.”

    Reserve Drain?
    Oh, drainning all all those FREE excess reserves from Wachovia, Citicorp, Wells Fargo, Etc.?

    Shortage of Buyers?
    Move over China & Japan, here comes the lender of last resort the US Treas (now the largest holders of US Debt then any FCB in less than 1 year but please let’s not use the “M” word (and it was only an accounting procedure))

    “Monetization is achieved by act of Congress via deficit spending and is independent of the Fed’s monetary policy”

    The FederalReserve was created by an Act of Congress and derives its power from same but has limited accountablity and can & does act under clowd of secrecy.

    “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.”

    Tell this to the Commodity Pits around the world (Food prices up +30% since Sept ’10)and food riots in the Meditranian states (tUNESIA, eGYPT, jORDAN, ETC.)
    Suggest you talk to your Wife about food prices here at home.

    IMHO
    BB.

  6. Since 2008 the Fed has been paying interest on reserves, so it’s no longer true that government debt is needed to implement monetary policy. The only function of government debt today is to manage inflation risk (i.e. to transfer inflation risk from taxpayers to bondholders).

  7. There you go again Cullen.
    Hubris, whether The Feds, The Congress, or yours, always leads to destruction.

  8. I know I’ve said this many times before, but it’s a point worth repeating ad nauseam.

    The trouble with QE2 is that it indirectly, massively, increases systemic risk by artificially suppressing yields (downwards), thereby forcing fixed income into higher risk (primarily equities).

    The mutual fund elephant alone currently has global liabilities around 26 trillion (http://www.guardian.co.uk/business/2011/feb/07/pension-funds-assets-liabilities). Comparably, US muni debt (that is on the radar again) is about 10% of that size, falling short of 3 trillion. (http://static.businessinsider.com/image/4d5014744bd7c8d752120000/bubble.jpg)

    When $26 trillion wants to flow into hugely overvalued stocks, that’s a problem, A BIG problem.

    It was for that reason that I called, repeatedly, for the Fed to stay the hell away from the long end of the yield curve. Just stay left and keep rolling that position indefinitely. There is absolutely NO good reason for the Fed to be on the long end.

    Their justification for engaging the long end is to take heat off the housing market, propping the market by reducing the rates of defaults as a consequence of lower long yields flowing into lower mortgage rates. FORGET IT! The problem with US housing is NOT high rates, it’s INFLATED PRINCIPAL as a consequence of systemic and pervasive fraud. It is the FRAUD that must be addressed.

    QE1 was (and is) the solution here. Just swap the toxic assets onto the Fed’s books then write it down during the fraud exposure process. Let the Fed absorb the loss (because it can), refactor the principal on all those loans out there, backtrace to find corrupt parties in the mortgage origination pipeline and send them to prison, and regulate appropriately to ensure moral hazards are removed. This would restore confidence in the financial system and return the housing market to a healthy state.

    QE2 is a mistake. Either the Fed is making a big blunder or, as I stated earlier, there is a secondary motive in play. I believe this motive exists, and, as I said eariler, I suspect that QE2 is *really* a lead-in to a bailout of the states.

    Of course, the Fed being the Fed, like any low resolution central planner utterly fails to distribute money effectively (at high resolution) leading to certain investment banks ending up far more cashed up than they should be while the underlying real economy sinks into deflation.

    This encourages commodity speculation (which further kills the real economy). However, it is unfair to point the blame only at the Fed here. As Cullen correctly pointed out, Chinese maintenance of the USD-RMB currency peg is the primary problem (Chinese inflation).

    None of this ends well. QE1 was necessary, QE2 was poorly thought out. All will continue to fail while fiscal and judicial activities fail to keep pace with the Fed’s actions.

    • In this line of thinking how would QE2 in theory be intended to bailout the states? By lowering the rate at which they are forced to borrow?

      Thx

  9. The thing is, if “our bond market funds nothing and serves only as a reserve drain”, then it only follows that what they are doing now is “undraining reserves”.

    When congress runs a trillion dollar deficit, and it is not soaked up by the bond market, then the money is being printed and available and i don’t see why we should get all hot and bothered by the names they give it or who is being blamed for printing it.

    • It’s actually quite important to look at who does what, because in the US system it isn’t unusual to have two opposing political parties share power but work in completely opposite directions at the same time using different government institutions. And arguably the interests of the banking system effectively form yet a third party…

      If congress is trying to do one thing and the fed is trying to do another, then we need to know which one will have which impact, or we won’t be able to predict what will happen. With the current political and banking climate it seems quite likely that we’re entering exactly that place right now.

  10. It would seem that the fed, with these open market purchases, alters the interest rate feedback mechanism – effectively enabling more debt being issued than the market forces would allow (regardless of being able to pay back in inflated dollars or not).

    The other issue, which has been documented over at zerohedge.com buy tracking individual bonds, is that the primary dealers in QE have been effectively been given handouts by the FED as it typically buys the most expensive bonds. They estimated the value of this subsidy to be about $5B/month.

  11. There are several points here where you are not being completely candid. First of all while it is true that Congress is the source of deficit spending it is the FED by way of keeping Treasury interest at its artificially low rate which is enabling the Congress to do what would be politically much more difficult to do if rates were higher.

    TPC – The point is that the govt controls the rate it pays. It is not paying investors to take some risk. It is not funding. Therefore, it’s absurd to even pay a premium for duration. The govt should control the entire curve just like they control the short end. But they let the market control. It makes no sense.

    If you are going to use a range of inflation figures you should also include those of Shadowstats who are more realistic given they have no political agenda. That would put inflation at a much more realistic level in the 5% to 6% range.

    TPC – No one in the world knows where SS gets their numbers from and I don’t know of any other reliable independent gauge that has inflation being even close to 6%. Until they disclose their methodology or some portion of it I find it difficult to believe.

    To say that the government is never constrained in its spending is not true. It is constrained by the public opinion of the voters. By misinforming the voters as to the seriousness of deficit spending, you are helping to enable the government in its crimes.

    TPC – That is only a technical constraint. Not an operational constraint.

    Your piece also completely ignores QE as being the source of funding for the carry trade in which banks are borrowing at practically O% interest and loaning in emerging countries like Brazil at 10+% driving commodity prices which is inflationary worldwide.
    Lastly you do not address the fact that all funds created by the FED are inflationary as soon as they are created due to the fact they are created with interest. As soon as a dollar is created it is worth less than 100 cents because of interest via the FED. The more monetary creation, the more inflation.

    TPC – This “carry trade” is a horizontal transaction which results in an asset and liability. There is no net change in financial assets. Money is not pouring into anything. These speculators are buying an asset from someone else. Can it influence market price? Only if the buyer is more eager than the seller or vice versa. Does it have any fundamental impact? I have never rejected the speculative notion surrounding Fed ops.

    • Generally if something is to complicated there is a reason.
      There was more information coming out of the State bank of the USSR.

      Its a transfer of wealth. When inflation will hit the fan they will deal with that later as long as they save the Banking system first. For now BB still benefits from exporting inflation. The world is flooded with Dollars. The US is the largest economy in the world and the Federal Open Market comity does not understand the actual workings of the Federal Reserve System. ????
      With all due respect that sounds a bit naive.

      • Do you have any evidence (money supply data) to support your claim that the world is awash in dollars?

        • Yes, in addition to when I buy Gasoline or go to Walmart look at the estimated dollar carry trade its $1,500bn – which is much bigger by the way than the Japan carry trade was. This is money that as left ultra-low interest rates in the US to purchase higher-yielding assets around the world.

          Its done all day long. Take a very simple example like a high quality Australian paper (4% nice return) plus 28% capital gain in the last 24 months. Net cost close to 0 and yes they can leverage it.

          When rate turn around and bank reserve start to come down we will see if BB can really swims.

  12. If your post is true, then do we even have a deficit? we use our dollar which is limitless to buy anything around globe. why cares about the deficit? Bail out anyone in this country by just giving them dollar! states, family, housing….. To a degree this sounds crazy.

    • You have to read Cullen’s posts more carefully. He never says this and in fact often makes sure to preempt these sort of comments.

      “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.”

      More specifically, if spending leads net financial assets > than the productive capacity of the economy, then inflation becomes a threat. He would consider your extreme hypothetical to be extreme malinvestment and would likely lead to crippling inflation.

      • to more directly answer your question, the “deficit,” or in other words net govt spending, can be used to promote economic growth and societal well-being. however, if the deficit is mismanaged through inefficient or corrupt spending, then the outcome will certainly not be optimal and potentially severely damaging.

    • No, not “bailout anyone”. Malfeasance should never be rewarded. We can spend up to our productive capacity and it should be efficient and promote productive pvt sector behavior.

  13. Cullen,

    This is a great post summarizing a lot of what’s been happening over the past several months.

    Question with regards to money creation and fiscal vs monetary policy. If the Fed issues a bond, it must pay interest, above and beyond the principal it initially “swapped” out of the system. Do you not consider that interest to be net new money infused into the economy and thus a form of net govt spending?

    Thanks.

  14. Cullen, quick question. MMT is right in stating that government credits account when it spends (beyond tax receipts) and hence creates money.

    However, the government cannot spend (beyond tax receipts) without issuing debt. It can sell that debt either on the open market or to the CB. Selling to the open market will retire the money created by the government spending (hence it’s money neutral, or ‘funded’). Selling to the CB credits the government accounts of what they already have spend.

    So expanding the money supply is NOT possible without CB debt purchases. The order of things can indeed be different than traditional monetary theory has it (that is, spending and money creation can precede CB funding), but money creation by overspending has to involve the CB so the issue seems moot to me.

    Unless you’re telling me the government can spend beyond tax receipts WITHOUT issuing any debt at all, I can’t see what MMT brings to the table, but perhaps it’s just my traditional monetary training speaking here..

    • The US govt certainly could spend without issuing bonds. Bond issuance is just a reserve drain. And that reserve drain is now done effectively by IOER. So, the existence of the govt bond market is more a political tool than anything else.

      • ["The US govt certainly could spend without issuing bonds"]

        Spending over and above tax receipts and WITHOUT issuing bonds? How does that show up in the national accounts. As far as I’m aware:

        government spending = tax receipts + debt issuance.

        By accounting definition.

        • So are you saying that by paying IOER ties up the reserves, effectively draining them from the system ?

          But this is just an overnight lock, the next day the bank can decide to use the reserve to loan out or buy some other asset. If the later path is taken then don’t those funds flow into the economy exerting inflationary pressure.

  15. Chairman Ryan jumps straight into a QE2 question, and not a bad one: Does the Fed creating money amount to debt monetization? (By definition, some Fed policy makers acknowledge that’s what the Fed is doing.) Bernanke makes an important distinction: Monetization “would involve a permanent increase in the money supply” to pay the government’s bills through money creation. The Fed is planning to reverse it.

    Let’s see about that….my take is that QE3 is coming (because housing is in the doldrums). At some point, this becomes irreversible! And Cullen, you and your MMT’ers are likely going to be wrong – this is going to be inflationary (core and other such nonsense notwithstanding).

    • I have NEVER denied that fact that we would see inflation during an economic recovery. In fact, I wrote several stories saying that we definitely would see inflation during recovery. And look what’s happening. I have maintained that none of this would be hyperinflationary. I have about a 2.5% inflation target this year. Will be higher if we get an oil shock. But that will likely just push as back into recession anyhow….

    • Your problem is you, Ryan, and most others do not understand that holding a govt liability with overnight maturity is not inherently more inflationary than holding a govt liability with longer maturity.

  16. So Inflation is not a function of M2, Mx or whatever, but a function of supply and demand of goods (production capacity and money in the hands of people) and can be adjusted down by the tax structure: (more taxes on people – less on corporations so they can expand production) And since we have so many people unemployed NAIRU says no inflation and baby boomer demographics says people with an average of 89k in their 401ks will be saving more for retirement. And corporations have large reserves of cash right now and fear abounds and spending is less. So I don’t believe we will see inflation either. BUT why or how does inflation come after wars? And will that be the spoiler?

  17. While you are technically correct, what you don’t see is the invisible account called “global confidence in the US dollar.” Every time we expand the supply of dollars relative to the underlying productive capacity of the US economy we deduct some amount from the “confidence” account. When the “confidence” account hits zero inflation accelerates and is very, very difficult to contain. This is a rare, but recurring event in the global economy. The problem is we can’t see the value of the “confidence” account. However, for you to simply assume it does not exist is flat out wrong. There is no free lunch…simply an externality you are not accounting for.

  18. I noticed that my chocolate bar did not increase in price but its 20% smaller is that suppose to be reverse hedonics?

  19. Under mmt framework usa should buy every asset of canada and germany. Than wait a few months …if not inflationary it can buy brazil. After all its just an accounting identity and we hav e the biggest balance sheet on earth. Our natural resource problem would forever be over and suddenly china would be cowering. Politically unfeasible but in theory the us could run 3 to 4T deficits and buy every vale rio tinro bhp potash and heck the housing stock of other countries since we can deficit spend to the moon until some magical point inflation appears.

    Or the fed can create make work jobs in the millions. Everyone would be employed doing unproductive things but if we pay them$ 20 an hour our economy would boom as a virtuous cycle was born. 15M more incomes all ready to shop and buy homes. When they shop and buy homes it creates more jobs and it feeds on itself. If inflation jumps just lay off 1M until inflation subsides. The fed and treasury can take us to prosperity through mmt.

  20. Excellent explanation. What is happening when the Fed purchases tsys is that risk-free assets are taken off the table by exchanging one form of nongovernment net financial assets for another, that is, non-zero maturity government liabilities (tsys) for zero maturity government liabilities (bank reserves). Non-government NFA does not change. No “money” (purchasing power) is created or destroyed. Only the liquidity of the assets involved is shifted. (However, the interest that would be paid on the tsys is shifted to government through POMO, which is a deflationary influence since it reduces future nongovernment NFA.)

    The net result of POMO is zero with respect to nongovernment NFA, but it does reduce the amount of tsys available in the market. That means some of those wishing to save must seek other instruments. The Fed’s expectation is that this increased liquidity and higher bond prices will induce some of those savers into higher risk financial assets like equities, driving stocks “higher than they would be otherwise,” thereby increasing the “wealth effect,” which the Fed hopes will inspire wider confidence to undertake greater spending. (Quotes indicate Fed officials own words.) In other words, this is another exercise in bubble blowing and the Greenspan/Bernanke put. I don’t know why anyone would have any confidence in that.

    • Great explanation.

      The question is, even though the “wealth effect” is spurious, if it does indeed spur spending, would the fundamentals catch up to reality? In theory this is what you would hope for, and then all is well. However, would you say this would be very difficult to successfully implement in today’s economic environment since balance sheets by and large are still over-leveraged? And thus, govt deficits are preferred, so as not to risk further private sector debt trouble? Because, govt deficits are in their own way “bubbles” until they generate further productivity. I guess the difference is deficits would at least buffer balance sheets.

    • It’s also called market manipulations, Its also criminal.

      “Manipulating transactions – trading, or placing orders to trade, that gives a false or misleading impression of the supply of, or demand for, one or more investments, raising the price of the investment to an abnormal or artificial level”.

      • Yeah but what you fail to realize is that equities are valued based upon the discounted value of current and future cash flows. Thus theoretically, if people start spending again, spending should lead to an improved economy, and should valuations will go up.

        Whether the govt spends to stimulate the economy from a slump or whether private sector does it should in theory lead to the same outcome. The point is just to ignite spending in order to get out of the recession. The only difference (it seems to me) is that with private sector spending again there might be increased risk of a credit crisis again, considering we’re all still highly leveraged. Perhaps by the govt spending, this risk is ameliorated.

        • The core issue is that any solution via monetary policy requires releveraging, whereas fiscal policy deleverages the non-govt sector. So, even if monetary policy “works” as you hypothesize, the fundamentals are actually worsened if you haven’t dealt sufficiently with the balance sheet recession.

            • As you might have seen in my last presentation, I think the appropriate way to look at monetary policy is that it “works” only if it affects desired leveraging against existing income. Because we talk about monetary policy with terms like “money,” “cash,” and “money creation,” which are generally poorly understood (e.g., most use the term “money” to be equivalent to “income”) even by economists (or especially), we fail to understand that monetary policy is fundamentally about leverage.

              • good point. and that’s why you need an understanding of monetary operations and the sector balances, so you can understand the difference b/n releveraging via monetary policy vs. deleveraging vs. fiscal policy (not that other things like financial regulation, etc. aren’t important, too).

                  • The way I imagine it is the fed sets the reserve/treasury ratio held by the non-govt sectors. Is this more or less accurate? When you say monetary policy is about leverage, can you please elaborate?

              • I think that comes from the FED seeing and treating everything as a liquidity crisis as opposed to a solvency one.

          • Which is exactly what I was suggesting re: the benefit of deficit spending over monetary induced spending.

            However, for the sake of debate, couldn’t one argue that there is the potential for govt spending to reinforce the indebtedness? You say “if you haven’t dealt sufficiently with the balance sheet recession,” but that can apply to both the fiscal and monetary routes at the end of the day. In other words, fiscal policy could introduce moral hazard. I could use the govt’s spending to further leverage my balance sheet, rather than paying it down (that seems to be what is sort of occurring right now). Alternatively, if the government doesn’t spend, then I might think I have no choice but to pay down my debt.

            Would you say, at the end of the day, you would rather take that chance than end up like Japan?

            • Yes, I would agree. For MMT, that’s about financial regulation. If you don’t change the financial system, then even fixing balance sheets will just lead to a repeat crisis in due time. It takes longer if balance sheets are fixed, but you still get there.

              • I’m on board.

                You guys need get to through to Washington somehow.

                Has the MMT community made concerted efforts to speak with influential figures in DC? Has that been unsuccessful, and that is why the effort is mostly concentrated through online blogs (and seemingly self-contained journals)? I suppose it is a starting point.

                It just must be so painful to dedicate your life to uncovering these truths as society remains oblivious and, to certain degrees, self-destructive.

          • Interestingly, the run up in equities has been accompanied by a run up in margin debt fueled by low rates.

            • Really? How do you discover that?

              Shouldn’t the government limit (or eliminate) the use of government subsidies to gamble in the stock market?

    • Net financial assets in the system may not change but do not system participant balance sheets increase on a gross basis?

      Fed purchases the Treasury from one of its primary dealers by crediting the PD’s bank with a reserve which the bank uses to back a demand deposit payable to the PD.

      At the beginning of this Fed transaction, the financial system had a PD with a Treas asset on its balance sheet. At the end, the system has a PD with a demand deposit (swapped for the Treas); a Fed with the Treas asset and reserve liability; and bank with a reserve asset and demand deposit liability.

      The system appears significantly more liquid to me.

      • jbvo, the point is that liquidity increases through POMO but not NFA. Then, the question is where that increased liquidity going to go. No one is going to sell a tsy bond and hold cash absent deflationary expectations. The Fed’s presumption that the funds will flow into higher risk financial assets with, viz., equities.

  21. “We most certainly can see it. We see it in the value of the trade weighted dollar and in our rates of inflation. There are no worrisome signs in either.”

    This is wrong and entirely inconsistent with how markets actually work. For years people talked about the fiscal deterioriation in the PIGS. The bulls argued simply that there was no evidence of any issue – spreads were narrow and markets were calm. Then one day you crossed that invisible line and spreads went vertical. Financial market events often go from improbable to inevitable without ever arriving at some in-between state. This is critically important for people to understand..there may simply be no major warning.

    • You’re comparing Euro nations to the USA. It’s apples and oranges. They have a solvency issue. There is no such thing in the USA. If your scenario were indeed true we would be seeing very high rates of inflation in the USA. It’s not happening.

  22. Cullen if they have a solvency issue why is the Central Bank of Ireland financing €51bn of an emergency loan program by “printing its own money” ?

  23. Cullen, stpioc hits a point i wanted to ask as well………..Is the treasury constrained by law to issue bonds/bills to equal the gov’t spending not accounted for by tax and other revenues? I’m not saying that the tsys FUND the spending, but by law, do the two sides have to match?? if so, then it seems like trsy issuance to soak up targeted reserves is not the entire picture.

    thanks for clarifying.

    rhp

    • I have to say this is the single most important distinction I had to grasp first in order to understand Mr. Roche’s commentary throughout the site. The federal government acts as though spending is revenue-constrained, but that is only through current law and is not an axiomatic economic reality. The law can change relatively easily while the monetary system can not, and the economic indicators we see here are often far more useful when you look past the current laws into the reality of the system they govern.

      It might be worth at some point having a more thorough discussion of the specific laws that define those artificial constraints. It would be very interesting and probably would help address a lot of the common confusion on that point.

    • What is confusing is that there are Bonds at the FED against which the counterfeit money is issued or credited.

  24. Any comments on how Lag Time confuses the issues? (1.5-3.0 yrs lag time after printing till inflation effects) And when else in the cycle does the FED print money? (so that we can see the effects under different circumstances) If the economic tools are ham handed and are ONLY used a specific times such as printing money now. Then are there ANY OTHER cause and effect examples at OTHER times? So how is theory proven when there are so many variables like fear and demographics and politics and varying tax structures? (not that I am a disbeliever)
    Bernanke seems a little sensitive or maybe fearful of the debt ceiling issue these days. So he says he is looking for other tools. (testing the limits of the law perhaps) looking for a silver bullet maybe. And where are the silver bullets? People look for powerful solutions. If a little does a little good … Print more. It seems like blood letting to me. A vector virus is small, but delivers just the right DNA to the right spot and fixes all. Any silver bullet ideas??

  25. Cullen – I have read carefully and understand all you have written about this subject.

    And I thoroughly understand that the Fed is not monetizing the Treasury’s debt.

    But Perception is Reality in the securities market. At what point does this information begin to influence perception?

  26. So, after reading all of these comments, I conclude that no one knows what they are talking about. I mean this sincerely, as if they did this topic would not come up over and over and the fed would not be reinventing ways to screw everyone out of their money. First, money cannot be printing by anyone, last I checked. Congress can spend currency, which is just a marker based on future production of money, that being cars, houses, mined materials and commodities, anything produced, etc. So what we are talking about is merely the manipulation of the currency supply, which is already far greater than the supply of money, thus a constant circle jerk to try and keep living above our means. As a citizen of this country with children, I am rooting for the loss of our reserve currency so that we can all live based on our ability to create. This would usher in the end of the financial sector above it’s basic necessary function and eliminate the jobs of millions of “money changers” that supply no value to the world. The sooner we can finish pissing all over the Constitution, the sooner we can get back to living by it.

  27. I understand that there is no OPERATIONAL constraint, but as long as there is a mandate that says inflows (including those coming in from trsy issuance) must equal outflows (gov’t expenditure), it seems like the Fed/Treasury cannot specifically control how many bonds they can issue to soak up excess in the system. They can only vary the term structure issued. Am I missing something??