To Monetize or Not to Monetize: Who Cares?

Suppose the Treasury issues $100 billion worth of 3-month T-bills yielding approximately zero (as 3-month T-bills do today and likely will continue to do until some time in the unforeseeable future when the Fed raises its target rate). Does it make any material difference to anyone whether those T-bills are bought up by the Fed (i.e. monetized) or remain with the public?

First of all, does it make any difference to the public? To put that a little differently, does anyone care whether they personally are holding T-bills or cash? More precisely, not really anyone. After the Treasury sells $100 billion worth of T-bills (assuming that the Fed doesn’t buy them), there will still be millions of people who didn’t choose to buy those bills. Those people don’t matter: they obviously don’t care if the Treasury sells the bills to the public, because they won’t buy them either way. They might care about the possible economic and financial effects of monetization, but, as I will argue, there aren’t any effects to care about.

So let’s look at those people (let’s call them people, even though IRL they’re mostly institutions) who are currently holding money and who will buy up the $100 billion worth of T-bills if the Fed doesn’t do so. Does the Fed’s action or lack of action make any difference to those people? Obviously it must make at least a tiny bit of difference, or they wouldn’t have bothered to buy the T-bills.

But it makes only a tiny bit of difference. Money yields zero; T-bills yield zero. Money is slightly more liquid than T-bills. But only ever-so-slightly: the market for T-bills is extremely efficient, and the price variation is minimal (especially given the Fed’s policy of only changing its target in quarter-point increments). There is only the tiniest risk of being unable to sell a 3-month T-bill almost immediately at any time at a price close to the price you paid for it. Aside from liquidity, T-bills are slightly safer then money. But only ever-so-slightly: if you’re an individual, you can distribute your money across banks and have it 100% FDIC insured; if you’re a bank, you can hold deposits at the Fed, which are possibly even safer than T-bills. It makes no material difference in which form you hold your assets.

But if the monetization doesn’t make any difference to the public, does it make a difference to the Fed or the Treasury? Let’s take the Fed first. The Fed can create and destroy money at will. The Fed will be able choose, with no constraint or cost either way, whether to roll over the T-bills when they mature. Moreover, like the public, the Fed can sell the T-bills, very quickly and with little price risk, before they mature, if it should decide to do so. So the only way it would make a difference to the Fed is if the purchase of T-bills has some economic effect that the Fed cares about. But, again, as I will argue – as I am arguing – there are no economic effects.

What about the Treasury, the government? Surely the government cares whether it really owes money to someone out there in the world vs. merely nominally owing it to the Fed. Actually, no. As noted above, the Fed can create and destroy money at will. If the Fed does buy the T-bills initially, it will still be able to choose whether or not to roll over the T-bills when they mature, and it will be able to choose whether to sell the T-bills before they mature (in which case the Treasury would subsequently owe money to the public again). Unless (as I again deny) the monetization has some economic effect, the Fed will continue to be indifferent, as long as the conditions of my initial assumption hold (i.e. until the T-bill yield rises above zero, which would have to be the result of a choice by the Fed to raise its interest rate target). And since the yield is zero, the Treasury pays no interest on the T-bills either way.

Suppose we do get to the point where the Fed raises its target rate. First take the case where the Fed had not monetized the debt initially. Suppose, for example, that, to get the target rate up, the Fed has to sell $200 billion worth of T-bills. Fine. Now take the case where the Fed had monetized the debt. In that case, the Fed will now have to sell $300 billion worth of T-bills. After the transaction takes place, the Fed’s balance sheet, and everyone else’s balance sheet, will look exactly the same in one case as it did in the other. The only difference is in what those balance sheets looked like before the Fed decided to raise the interest rate. And that difference, as I have argued, is inconsequential to all the parties involved.

Except of course if it has some economic effect. But the only way it could have an economic effect is if it changes someone’s behavior. And, since it has no material consequence for anyone, it won’t change anyone’s behavior.

Well, OK, it might. The only way it might change someone’s behavior is if they expect it to have an economic effect. Then the existence of such an effect would become a self-fulfilling prophecy. That’s what economists call a “sunspot” (by the analogy that literal sunspots will have economic effects if and only if people expect such effects). I would suggest that, even in that case, the effect is likely to be quite small. If there is no fundamental reason to expect an economic effect, there should be plenty of people speculating against those who do expect an effect. Moreover, if there is no fundamental reason to expect an effect, while one can still imagine that someone might expect some effect, it’s hard to see how anyone could expect a large effect, unless their reasoning process is seriously screwed up (in which case they aren’t likely to have much wealth left to allocate). With some people expecting not-too-large effects and other people speculating against them, it’s hard to see how the net impact on markets could be significantly large.

Now you might say, so much for your example of short-term T-bills, but the subject of this essay was whether or not to monetize, and the Fed has been talking about the possibility of monetizing long-term Treasury debt as well. Won’t that have an effect?

But again the answer is no – as long as the Treasury is flexible enough to choose its preferred financing option in either case. How much of Treasury borrowing will be long-term and how much will be short-term? That is entirely the Treasury’s decision. Suppose the Fed decides to monetize long-term debt instead of short-term debt. If the Treasury’s preferences are unchanged, it will simply issue more long-term debt and less short-term debt, and there will be no difference in the quantity of each type of debt held by the public. The only difference will be what is held by the Fed. But that is no difference at all, since the Fed’s profits go directly into the Treasury. It is as if the Treasury owed the money to itself. Why should the Treasury care whether the money it owes to itself is booked as a long-term debt or a short-term debt? Moreover, since the Fed can buy and sell any amount at will at any time in the future, the Fed, counting on the Treasury’s indifference, should also be indifferent.

But, since the price of long-term debt is quite variable, what if, for example, the Fed’s future policy requires it to liquidate the debt at a loss? Won’t that have an effect? Again no, because, when the Fed liquidates the debt at a loss, the Treasury can buy back the debt and retire it at a profit. What if the Fed ends up liquidating at a profit? Yet again, no effect. If the Fed can liquidate at a profit, that means the Treasury’s borrowing costs have gone up, so, in present value terms, the Treasury has a loss to offset the Fed’s profit.

So there you have it: under present circumstances, except for possible technical and psychological effects (and the tiny effect they may have on those who are on the margin between holding T-bills and cash), the Fed’s decisions about monetizing government debt are entirely inconsequential. No doubt there will come a time in the future when such decisions will once again be consequential (as they have been during most of the past), but for all we know, that time may be a long way off.

So my advice is, ignore all the information you get about the Fed’s actions (and contemplated actions for the immediate future) with respect to the monetization of government debt. That does mean that you should ignore (or at least reinterpret) most of what I said in my earlier post on the subject. (I plan to expand on it in a future post, because I still think it has some potential substance.) Pay attention, perhaps, to what the Fed does (and it has been doing quite a lot) with private sector debt, since there we are no longer dealing with mere book-entries between the Treasury and the Fed, and real gains and losses are possible, with real effects on both public finance and private sector wealth.

But bear one thing in mind when you do pay attention to the Fed’s monetization of private sector debt – and the Treasury’s bailouts or speculative actions with respect to private sector entities. Consider the implications of the argument I have made here. The Fed’s decisions about monetizing Treasury debt make no difference. Therefore, when the Treasury does a so-called bailout, it would make no difference whether that bailout were financed by the public or by the Fed. Therefore it might as well be financed by the Fed. Therefore Treasury bailouts are no different than the Fed’s monetization of private sector assets directly. I plan, in a future post, to argue that those bailouts/monetizations are not as dangerous as some economists think (and certainly not as costly in “expected value” terms as much of “Main Street” seems to think). But bear in mind the equivalence. If you must worry about something, don’t worry about the $400 billion or so that the Treasury has used; worry about the trillions that the Fed is using.

Comments

[Long Silver...:]

I sense intuitively that when the Fed buys up all the newly issued Treasuries that need to be purchased, this will result in an increase in the money supply in circulation and therefore price inflation. Yet I am having trouble understanding how this scenario actually gets money in circulation (i.e., beyond offsetting book entries within the government). How does that happen, or are you saying it doesn't happen and this scenario offers a cost-free solution to massive government deficit spending? Please clarify...

Jan 09 10:05 AM

[AlexR:]

I believe the point missed here is a sort of "displacement" that occurs. When the Fed buys $100B worth of treasuries from the "public", that forces the public to find other places to invest $100B. Most of these displaced funds will go into bank balance sheets (FDIC insured deposits) and money market holdings, both of which do have a real economic effect: bank deposits increase the money supply; while money market influxes cause corporate short-term borrowing rates to go down.

Jan 09 10:59 AM

[Bankerbob:]

LJS, lets say,

Treasury sells $100 in newly created tbills, government recieves $100 in cash which it uses to fund programs...

Buyer purchases $100 in newly created tbills, buyer pays government $100 and holds tbills on balance sheet...

In this case no new money is created.

Now, if the Federal Reserve decides to get involved it "creates" $100 in new money and buys the tbills, either direct from Treasury or from the buyer.

In this case $100 in new money has been added to the financial system.

doesnt matter whether its book entry or not....... question is, does the Fed buy it or not.

Jan 09 11:06 AM

[secmaven:]

Japan monetized trillions of yen government debt in the last five years and its currency is the strongest in the world. Why? Because Japan's economy is productive and operates under a rule of law. its currency, borrowed at zero interest rate, has become an engine of finance, providing the liquidity needed to facilitate much economic activity. If the world perceives our economy as strong and operating under a rule of law, ie. no Patriot Act arrests in the night and tax the wealthy out of existence schemes, etc. there is no reason monetization of our debt cannot work the same way it has in Japan.

Jan 09 11:11 AM

[Jan VanDenB...:]

Our monetization will not work the same as Japan's because Japan has a huge trade surplus, is a creditor nation and is exporting capital to the world.

We have a huge trade deficit and must borrow massively every day just to pay our bills.

Also, Japan started the era with a grossly undervalued currency which had suddenly appreciated, quite against the wishes of the Japanese government (remember Plaza?). The monetization was largely an attempt to slow that appreciation.

Our situation is almost exactly the opposite.

Jan VanDenBerg

Jan 09 11:29 AM

[OldNavySailor:]

Why does the government have to issue debt (bills, notes, bonds)?

It has a printing press (U.S. Treasury). Why do the American people have to pay income taxes to pay the interest on self-inflicted debt when the government can loan the money directly to the lending industry?

The government receives the interest payed by the banks and uses it to pay for its operating expenses.

Banks loan the money for commercial/personal loans and charge interest. When the loans are repaid the money is taken out of circulation until new loans are made by the banks again. This free market expansion and contraction of the money supply establishes equilibrium in the money supply thereby keeping inflation under control.

So tell me, why do we need the Federal Reserve to "buy" the government's debt if the government doesn't have to issue debt?

In fact, why do we "need" a Federal Reserve private corporation to manage the countries monetary base?

Oh, and why do we have to have an income tax if the government can pay for itself with the interest earned from loaning "our" money to the banking system?

Does this make sense to anyone?

Jan 09 01:12 PM

[Andy Harless:]

Long John Silver, the reason it doesn't result in inflation is that nobody spends the money. The money goes into "circulation" in the sense that, whoever had the T-bills before now has the newly created money (or if you want to think of it as the Fed buying directly from the Treasury, then whoever the Treasury pays or buys from now has newly created money, which otherwise would have had to be withdrawn from elsewhere in the economy via borrowing). But I put "circulation" in quotes for a reason: the money doesn't literally circulate; it just gets held as an asset by some person or institution. We can surmise that they are not going to spend it, based on the fact that they were already holding T-bills with zero yield. They could easily have converted those to cash and spent the cash, but they chose not to. Since cash is more or less the same as T-bills now (both yielding zero, both safe, both highly liquid), if they were holding the T-bills without spending, we can surmise that they will hold the cash without spending.

Jan 09 02:24 PM

[Alan von Al...:]

Andy, you were on solid ground until this leap of screwball logic:

"The Fed’s decisions about monetizing Treasury debt make no difference. Therefore, when the Treasury does a so-called bailout, it would make no difference whether that bailout were financed by the public or by the Fed."

When the government seizes a private asset (taxation, fines, forfeiture) there's no confusion about what happened. Bailouts and subsidies do the same work of destruction, not to the firms who were granted a boon, but to their disfavored competitors and would-be competitors. Bailouts sustain incompetents and 'grace-and-favor' power elites, negating the competitive market for private enterprise.

Jan 09 06:39 PM

[austrian63:]

At the end of the day monetization does matter. It takes a long article with many loops to enable a writer and a reader to convince themselves that it does not matter.

The Treasury sells $100 bn of 3 month T-bills to the Fed. The Fed does not give the Treasury (existing) paper currency from a vault. The Fed prints it or creates it electronically and gives it to the Treasury to spend. Magic, there is now $100 bn of new currency in existence. Another point: since the Fed and Treasury are related parties, do you really think the T-bills will be retired in 90 days? I don't think so.

What everyone must understand is that creating money out of thin air does damage the economy and the currency. Beware of long, acedemic sounding explanations that seek to convince you that you are a simpleton if you are worried about monetization of the debt. Hayek called this the pretense of knowledge.

Money is only a medium of exchange and not a store of value. If more can created with little effort, its value declines.

Jan 09 10:30 PM

[devassocx:]

It seems to me that TBills are at zero rate because the FED doesn't want
money from the public to be there.

Our government is encouraging private money to go into more risky aspects of the economy to get a better return...might be good for the country by reversing asset price decline but it might also be very bad for those who are traditionally fiscally conservative or live on fixed incomes(retirees). It also seems to me that a lot of our current problems
stem from way too much of that activity.

Jan 10 12:26 AM

[Alexander M...:]

Fed lends money to banks throught the discount window at the discount rate (fed funds rate + 50 bp)

Banks right now instead of lending it out to businesses, individuals etc are afraid. Instead they are hoarding it. They don't really lock the Ben Franklins in vaults. What they do is Buy Treasuries at ridiculously low rates (10-year is now trading at 2.40%). The Fed is basically forcing them to borrow at the window due to the so called "target rate" and they do that by buying the treasuries themselves in competition with the banks. I guess some people here argued that they do that to make them so unattractive so that the banks start lending to real causes again. That's Monetization and it does hurt the currency. Simple laws of supply and demand. Someone also called it very accurately displacement.

So, as of right now the excess monetary supply has not yet hit the real goods market (main street) and that's why we are not seeing any signs of inflation. But at some point the banks will realize that it's stupid to buy T-bills at these stupid levels and find "better" return scenarios in other investments. The spreads between the G-bonds and the C-bonds will close and the corporate market will get flooded with money. That will be the bottom and possibly (if the fed doens't start raising rates quick and drain the market off the excess supply) the start of runaway inflation like some pundits accurately claim. Obama seems to be on top of that (thank god Bush is out) as I heard him talking about it in an interview the other day.

So, watch out for the corporate bond market and watch those spreads. Once the banks flood that market with money, it's like a show of confidence that there will be no bankruptcies, defaults etc and a sign that they are tired of the 2.5% unheard-of yield in the 10 year.

Next step: The companies basically take all this cheaply borrowed money and start spending it in investments, goods, you name it. Then you have too much money chasing too little goods (i.e. inflation), unless of course you have the political muster to stop the bubble, which I haven't seen anyone so far do...

And as far as Gold: I doubt the world is coming to an end. You'll know of WWIII when you see trade barriers going up but we are not even close to that... I would rather much go with Yen or Euro or Commodities...

Jan 10 02:11 AM