Monetizing the Debt: Explanation For Non-Economists, Bankers and Other Laymen

As I see uncountable search engine inquiries with the phrase "monetizing the debt" landing at my blog (The Prudent Investor) I begin to realize there is a huge void of knowledge not only amongst interested economic laymen but also among employees from what were highly prestigious financial institutions only 2 years ago. Let me fill you in with the executive briefing version. In order to monetize the debt you need the following:

1. An economy in shatters that cannot produce enough taxes for the state
2. A parliament/congress/senate full of incompetent politicians eager to continue showering their constituencies with pork regardless of a nation's declining tax income
3. A people that has never received any macroeconomic education in their schools (otherwise they'd be shouldering the pitchforks by now)
4. A central bank with a transaction computer running under Unix (Windows would probably crash before any real economic damage could be done)
5. Commercial banks with executives searching the web for an easily understood explanation of the said term and no idea about monetary inflation either, but a perfect understanding of their contracts sweetened with lavish bonuses, no matter whether they remain prudent or crash the cart against the wall.

Now that we got our most important players together (starving retirees, widows and kids will only appear on the scene after the monetizing-the-debt-party has sunk the world into a depression), we take a punch bowl (literal), fill it with cheap credit and pass it around to everybody except the central bank computer (it will have to work hard very soon).

In contrast to all commodities, unbacked fiat money is created at virtually no cost. This is most comfortable as it means the central bank computer can keep the party going.

All that needs to be done are a few keystrokes (maybe they already have macros for the task) and a screen wide enough to accommodate the ever growing number of zeroes after the $/€ sign.

So they enter a number, e.g. €60 billion as the ECB will do somewhen in the coming weeks, and wire this digitally created money to the commercial banks, who in return hand over other serious looking papers that are called "securities" as collateral. In our fractional reserve banking system banks can use this central bank money to hand out ten times as much in loans. For 10 money units lent they have to hold one money unit as "reserve," just in case some investors want their deposits back.

It truly is a thrilling business: Put one money unit in the cash register (for which they currently pay 0.25% (Federal Reserve Notes) to 1% (Euros), let the borrowers come in and lend them 9 money units at anything between 5% (mortgages) to 12% (business loans.) You do the math yourself. It is virtually impossible not to turn a profit, weren't it for the rocket scientists with their Excel spreadsheets who think about new ways (derivatives!) on how to produce still more income that will be paid to them in form of a bonus. This is why the bankers drive Ferraris, but rarely their customers.

If you now wonder, what this has to do with "monetizing the debt," you are right. It doesn't. But it explains that banking would be such a surefire business, had they not hired mathematical whiz kids who came up with those derivatives Warren Buffett calls "weapons of financial mass destruction."

Ok, I will try to continue explaining the original subject in comprehensible words (which is a tough issue, I say after having spent already six hours on this post and far from over).

So here we go again: As it didn't cost the central bank more than a few cents to create this money/credit but the unknowing hard working public will accept it as compensation for their labour, we are already a step further in the Ponzi scheme called fiat money creation.

Now the politicians have to act plainly ignorant (which should not pose a problem for most of them) and develop still more ambitious spending projects. As their Keynesian advisers had told them that a slowing economy is best countered with stimulating spending they scratch their heads, wondering where the money will come from. Their advisers had missed out on telling them that John Maynard Keynes had also recommended to build reserves during the good economic times.

Diabolic help arrives in the form of a delegation from the central bank that will offer a solution so easy that the politicians immediately jump on their bandwagon.
"If you issue a bond we will buy them for the amount you write on your piece of paper," whispers the pin-striped central banker into the finance minister's (treasury secretary) ear. The politician is jubilant now as this appears to be such an easy game with winners only.

So the Treasury prints a government bond and writes, let's say 100 billion on it.
As the economy has slowed for reasons that fill the long evening discussions of economists, without reaching a decisive answer, potential investors have no more money left to buy this bond.

US Treasuries: The Longest Running Ponzi Scheme In the World

So the central bank creates this wonderful stuff called MZM (Money Zero Maturity) or unbacked central bank fiat money and "buys" (hahaha) the bonds for itself. The state turns around, starts new "growth projects" and is comfortable as it watches the mere mortals without any macroeconomic education working hard in order to get a part of this funnily coloured money.

This game usually lasts for a few years before the broad public starts scratching its heads. They begin to see (or gut-feel) a recurring scheme: Public projects fill almost everybody's wallets but prices are ratcheting up too. That's called monetary inflation as the quickly rising amount of fiat money is spread over a slower growing amount of produced goods and services.

Politicians, eager to keep up economic growth in order to get reelected, will want to keep the game going and issue the next bond, confident that their central bank will - hahaha - "buy" the next issue again with the next round of freshly created fiat money.

This game could go on and on if there were no rational and prudent private bond buyers around. As in every Ponzi scheme the only disturbance arises once these prudent investors want their money back. As the state has no money it will beg the central bankers for the next shot in the arm. This usually works as the central bankers know they are in the end at the mercy of the politicians.

The end of the monetizing the debt game is always the same. This time it will be the Chinese who have amassed so many FRNs (look at a greenback: it nowhere says US dollar!) that they will cozy up to the idea of throwing all their FRN holdings on the market in exchange for some real assets like commodities because the FRNs are only backed by future tax income. But in a recession this tax income shrinks too and therefore this backing is worth less and less.

A truly diabolical circle and we haven't yet touched the next due issue, called hyper-inflation...

Note: Nothing is more difficult than explaining high finance in simple terms. Please let me know in your comments whether this attempt (after busying myself with the subject since 2001) was useful to you. I will strive to improve as this is the single most important issue in the process of ruining a country.

Comments

[Prudent Inv...:]

Prudent Man,
I am impressed and would like to give you a TRILLION thumbs ups. Pls check out my latest post
prudentinvestor.blogsp...
and add to it.

May 10 11:59 AM

[Norm Garnett:]

Terrific article. The only problem is that, so far, no time-line is estimated, but maybe that's not possible. As with Ponzi schemes, no-one can be quite sure when the game will be up!
Neville Green

May 10 03:54 PM

[Living4Divi...:]

TPI wrote " Their advisers had missed out on telling them that John Maynard Keynes had also recommended to build reserves during the good economic times."

And indeed, that is the fatal flaw in the U.S. current use of Keynesiasm.

I recently wrote an article in SA on this very subject titled "The Dollar Is Doomed" The current level of monetization is nothing to worry about .. it is what may come next.

May 10 07:05 PM

[Steve Hughes:]

Thank you, both "prudents" for the straight facts, dissection of what is taking place in the financial towers of government, and for the scathing appraisal of those charlatans pulling the strings.

May 10 09:59 PM

[DONE_SONZ:]

This game usually lasts for a few years before the broad public starts scratching its heads. They begin to see (or gut-feel) a recurring scheme You would think the vast majority would be getting it by now!?Great post by the way.

May 11 07:59 AM

[Dave Raithel:]

A non-polemical account would have been much appreciated, but I usually expect too much from people. About all this "essay" does is demonstrate, once again, that "economics" is not a science. Economics is a babble of competing claims about reality reflecting the interests of the babblers...

May 11 09:04 AM

[Prudent Inv...:]

IMO Blogging is about expressing an opinion.


On May 11 09:04 AM Dave Raithel wrote:

> A non-polemical account would have been much appreciated, but I usually
> expect too much from people. About all this "essay" does is demonstrate,
> once again, that "economics" is not a science. Economics is a babble
> of competing claims about reality reflecting the interests of the
> babblers...

May 11 11:14 AM

[Gregman2:]

Excellent article. See: www.debtdeflation.com/.../

May 11 12:00 PM

[PJZ:]

Nice piece. But I think that you have to include "velocity" in your explanation. The money that the Fed creates by buying up bonds until now by and large sits in the reserve accounts of the financial institutions with the Fed and is so far not lent into the economy. The banks so far do not want and/or cannot lend the money because the economy is so sluggish. As soon as the eonomy picks up and the banks start to lend, if nothing else happens, a tsunami of liquidity would flood the economy creating inflation. Now comes Helicopter Ben and says: at the right moment, I'll undo what I have done before, sell the bonds and suck up the additional liquidity within the central bank. Theoretically, he can do that. But unfortunately, there are three problems with Ben's strategy whose helicopter flies over uncharted territory: 1: If the resale of the bonds and the undoing of the liquidity creation works on time, he might kill the recovery of the economy, if he comes too late, massive inflation will result. 2: Long term interest rates will likely surge and the owner of the helicopter, Barack Obama, can't finance all his other stuff. 3: And who is going to be the buyer of all these bonds in the first place? The Chinese won't, and everybody else in the world by then will know that America since long has been and still is living beyond its means.

PJZ

May 11 01:01 PM

[EUARTE:]

The trouble is most Americans are super ignorant in both finance and economics. They prove it by the slime they vote for in Congress. They have not caught on to Obama yet. I suspect Obama has not caught on to Obama yet.


On May 11 07:59 AM DONE_SONZ wrote:

> This game usually lasts for a few years before the broad public starts
> scratching its heads. They begin to see (or gut-feel) a recurring
> scheme You would think the vast majority would be getting it by now!?Great
> post by the way.

May 11 03:04 PM

[snakyjake:]

Most people are super ignorant, not just Americans. I don't see the Chinese, Japanese, Europe, and individual foreign investors being any less ignorant by continuing to loan and finance US debt and consumerism.


On May 11 03:04 PM EUARTE wrote:

> The trouble is most Americans are super ignorant in both finance
> and economics. They prove it by the slime they vote for in Congress.
> They have not caught on to Obama yet. I suspect Obama has not caught
> on to Obama yet.

May 11 04:55 PM

[snakyjake:]

Thanks for the article. Very simple to follow and easy to understand. What I don't like today in my personal finances is that I'm financing inflated prices via credit. I as a consumer am now saying "No" to financed inflated prices. Going back to cash is good financial discipline.

May 11 05:00 PM

[pftittl:]

Blaming Obama is foolishness. First of all, an alleged "compassionate conservative" George W. Bush ran up FIVE TRILLION in debt and helped create the housing crisis by trying to drive up the percentage of homeowners in this country with unregulated subprime loans! Secondly, it seems now that Obama has two choices: REPUDIATE the debt (we've never done that) or MONETIZE it!

I think he chose the more prudent path. To reduce Social Security payments for current and future retirees would be madness and political suicide. Doing it his way--reducing the buying power of those "pensions" by inflation--is a more face-saving way to dig out of the mess that Bush created.

May 11 05:11 PM

[Ad Orientem:]

OUTSTANDING article! Bumped on my blog.

May 11 05:19 PM

[Jubilee Year:]

And thus, the Baby Boomers destroy that last remaining legacy of the great country they inherited: the strength of the dollar. Flooding it with third world laborers and outsourcing its industrial capacity apparently weren't enough.

They also seem more than happy to enslave their offspring to support their old age, though debt and social security.

Truly, they are the most wicked generation in history.

May 14 05:47 PM