On Debt Monetization

This is a pretty wonkish post but I hope you appreciate the concepts presented.

I made some allusions to modern monetary theory in a recent post when I asked, “If the U.S. stopped issuing treasuries, would it go broke?” The short answer is no. But that still leaves questions about the inflationary impact of all of this debt. The fact is a lot of base money is being added to the system. Normally, one would expect this to be inflationary. However, it has not been because the money multiplier (the relationship between base money, more inclusive monetary aggregates and credit) has dropped precipitously. Still, if and when the economy picks up – and with it the demand for credit, inflation could be a serious problem.

Scott Fullwiler had a post out Monday at the UMKC Economics Blog which answers whether ‘monetizing the deficit’ is even more inflationary. I will present some of his ideas, highlighting and interjecting with a few comments to simplify the argument and end with a link to the rest of his post.

Here’s the issue:

While most economists typically assume a supply and demand relationship, as in the hypothesized loanable funds market, and then build models accordingly, such an approach can miss important relationships in the real world. In particular, any transaction in a capitalist economy results in changes in the agents’ financial statements; if the hypothesized supply and demand relations are not consistent with the actual changes occurring within the financial statements of the relevant agents, then the hypothesized model is irrelevant. In a modern money regime such as ours in which there is a sovereign currency issuer operating under flexible exchange rates, “monetization” versus “financing” as characterized both in the GBC and in the hypothesized loanable funds market fall into this category.

Translation: the loanable funds model that everyone is using to describe why America will go bust or slip into a double dip is bogus. It gets basic real world accounting wrong.

Consider first the case in which the federal government runs a deficit but neither the Treasury nor the Fed sells bonds. This is “monetization” as usually suggested by the GBC [government budget constraint]. As always, and as noted by Wray, the Treasury spends by crediting bank reserve accounts at the Fed, while simultaneously instructing the banks to credit the deposit accounts of the recipients of the spending. (The process is simply delayed a bit where the Treasury sends the recipient a check, triggered when the recipient deposits the check at his/her bank.) Taxes have the reverse effects. For a government deficit, the Treasury’s credits to accounts are greater than what has been debited via taxation. Figure 1 shows the balance sheet effects of a government deficit for the private sector, with the effects on banks and non-banks shown separately.

As the quantity of reserve balances banks desire to hold to settle payments and meet reserve requirements is already accommodated by the Fed, the deficit in Figure 1 creates excess balances. Prior to fall 2008, Fed operating procedures set the federal funds rate target above the rate paid on reserve balances; in that case, the federal funds target would be bid down—theoretically, to the rate paid on reserve balances. Figure 1—or, “monetization”—thus was not an operational possibility under previous Fed procedures that set the target rate above the rate paid on reserve balances. In other words, prior to fall 2008, even if the federal government wanted to “monetize” the deficit, either the Treasury or the Fed would still have been required to sell bonds to hit the Fed’s target rate. However, since the Fed now sets the target rate equal to the rate paid on reserve balances, no such bond sales by the Fed or the Treasury are necessary. Instead, as the Treasury spends and excess balances increase, the Fed’s target can still be achieved and the Fed can raise or lower its target as desired by simply announcing an equivalent change to both the target rate and the rate paid on reserve balances.

What Fullwiler is saying here is this: Normally, the U.S. Treasury must sell bonds when there is a budget deficit. The principal reason that the Treasury could not just print money out of thin air (what Murray Rothbard calls counterfeiting) is because the Federal Reserve needs them to control supply and demand of Fed Funds in order to maintain its target interest rate above the interest rate on reserve balances.

However, when interest rates are zero percent, the Federal Reserve doesn’t have this problem. There is no difference between the Fed Funds rate and the rate on reserve balances. Ostensibly, this is why the Federal Reserve has a band of interest rates between 0.00% and 0.25% instead of a fixed zero percent rate.

Figures 1 (above), 2 (below), and 3 (below) demonstrate that government deficits create increased net saving in the non-government sector. By definition, additional net saving flows to a given sector are shown on a balance sheet as additional net financial assets and net worth for that sector. The creation of any financial asset generates both an asset and a liability given the two-sided nature of financial assets; in the case of a government deficit, the liability remains on the government’s balance sheet while there is a simultaneous increase in net equity or wealth in the non-government sector.

In Figure 1, the new net financial assets for the non-government sector are the additional deposits—the M1 measure of money—on the non-bank sector’s balance sheet unaccompanied by an offsetting increase in its liabilities.

Figure 2 shows the same deficit accompanied by a bond sale that is purchased by banks. The Treasury security purchase by the banking sector is settled by a debit to reserve accounts. As already explained above, the operational effect of the reserve balance drain is to support the interest rate target under traditional operating procedures. There is still an increase in net financial assets or wealth of the non-government sector, as the deposits (M1) remain on the non-bank private sector’s balance sheet. Figure 3 shows the same deficit accompanied by a bond sale to the non-bank private sector, as in sales to non-bank Treasury dealers. As in Figure 2, the reserve drain enables the Fed to sustain the federal funds rate target under traditional operating procedures, and there are again net financial assets created for the private sector in the form of Treasuries on the non-bank private sector’s balance sheet. (While some may object to the placement of the deficit as the first event and the bond sale as the second event in Figures 2 and 3, note that the ultimate effect on net financial assets is identical regardless of how one orders the transactions.)

There is no difference between the monetization scenario and the government bond sale scenario except in regards to the Fed Funds rate. So, in a situation in which the Fed Funds rate is essentially zero, the Federal Government does not have to issue any bonds at all. Moreover, there is no difference in terms of the inflationary impact as the two scenarios have identical impacts on base money. This example makes the accounting very clear. You can read more of Fullwiler’s post at the link at the bottom.

Source

What If the Government Just Prints Money? – Scott Fullwiler

Comments

[Moon Kil Woong]

This is a valid point and one of the reasons I insist that if rates are to rise and there be a delinking of rates then the Federal Reserve must reverse it's monetization and QE endevours first. Thus, any gossip about the Fed getting tough is pure garbage unless they reverse their QE.

Raising rates withouyt first doing so will cause accounting headaches. So will a Congressional audit. And so will any recognition of losses on all their trillion of backstopped bonds which are like AIG derivatives. The Federal Reserve has their head stuck in the honeypot and can't seem to find their way around or out of it.

2009 Nov 24 06:25 AM

[Scott Fullwiler]

Thanks to Edward for the excellent explanation!

Note that with interest payment on reserve balances equal to the target rate, the Fed can raise its target rate without draining the reserve balances, so no need to "wind down QE," actually, and they know this. What will happen is the Fed's profits will fall as it pays more interest, and as it must turn almost all of these profits over the Tsy, Tsy revenues fall and the deficit increases. The net effect is basically the same as if the Tsy had issued, say, Tbills to replace the existing reserve balances that pay interest at roughly the Fed funds target. So, while there may be political reasons why the Fed may "wind down QE" before raising rates, there is no operational necessity that they do so.

As for Chris's question . . . the point is there's no difference for the effect on net financial assets and there's no difference for the effect on interest rates if the fed funds target and rate paid on reserve balances are the same (which they currently are). There is a difference in terms of interest payment on the debt and the Fed's ability to achieve a positive target rate if reserve balances don't earn interest.

2009 Nov 24 11:27 AM

[Carlos Lam]

There is another way to inflation: devaluation of the currency (de facto or de jure). Simply put, when the central bank prints its currency to death, foreign sellers of goods will demand more units of currency for any given product because the central bank is issuing more units of currency without backing. This is not the "typical" inflation created by price increases as a result of [base money] x [money multiplier]. It is a loss of faith in the currency.

2009 Nov 24 11:46 AM

[bob adamson]

Usually in discussions of this sort the implicit assumption is that the choice is between doing the thing in question or not (i.e. an all or nothing choice ‘Will the US stop issuing Treasuries?” Will the US monetize its debt?). This is a necessary first stage in exploring what the consequences of the adoption of some policy might be. Too often, however, we don’t move on to the real life fact that most policies are adapted to a limited extent in special circumstances for a limited space of time.

For example, no one seriously advocates that the US simply monetize all its outstanding debt or routinely monetize its annual deficit. It is recognized, however, that at some point the Federal Reserve must raise interest rates above their currently near zero level and that this will have major implications for the way the accumulated US debt burden is handled thereafter. The hope is that a combination of improving government revenues and reductions in government expenditures will allow this debt to be managed and ultimately reduced but there is great doubt that this hope will be fully achievable at the point in time when interest rates must be raised in order to prevent unacceptable distortions in the US domestic economy and international relationships. The UK, Japan and certain other western European countries are in an analogous position and most other countries are also accumulation government debt currently to a significant extent. It follows that a viable strategy to stabilize debt accumulation and accommodate rising interest rates needs to be negotiated internationally and implemented domestically when the time comes to end the current near zero interest rate policy.

Since 2008 the great need has been to prevent a world wide deflationary collapse from occurring even though it was recognized by all concerned that the short term remedy, massive fiscal and monetary stimulus, would create its own problems at some future time. It follows that, by necessity, the US and the international community must work their way from one difficult stage to another (each new set of difficulties compounded by the measures necessarily taken in addressing the previous situations). Informed opinion should therefore be debating how the transition from one stage to another should best be handled so that chaos is avoided and a viable economy is eventually restored without undue distress.

Some will argue that it is only through a deflationary depression that the route to economic recovery can be efficiently and effectively achieved and that government interference only delays this happening and compounds the cost. The burden fall on the rest of us to envisage how a more active government policy can work.

In short, the real question that follows on the questions that Edward Harrison has explored so well here and in other recent articles is whether a partial monetization of the national debt (and State debts) of the US in concert with similar actions by other nations can play a constructive role as the role of stimulus reduces and ends.

2009 Nov 24 01:28 PM

[flow5]

Fullwiler's sterilization (financing & monetizing, or the reserve dance hokey pokey), is true enough, but the standpoint of the whole economy, the salient accounting flows are still obfuscated.

Fullwiler et. al, don't know the accounting differences between financial intermediaries and member commercial banks. IOR's @.25% have induced disintermediation (an outflow of funds or savings from the non-banks) and have decreased the supply of loan-funds in the economy (because of competing instruments & yields). I.e., the intermediaries have shrunk in size & the size of the member banks has remained essentially the same.

A minimum of a trillion dollar's worth of savings in the form of IORs has been diverted from investment, or was forced out of the shadow banks, to meet redemptions and ongoing deleveraging.

Monetary savings are impounded (bottled up), within the banking and monetary system. I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings (member banks create new money in the lending process, they do not loan out savings).

Money that would have flowed to the non-banks (if the member bank's returns were lower), never would leave the monetary system (making the member banks more profitable), as anyone who has applied double-entry bookkeeping on a national scale would know. I.e., redirect savings to the non-banks, and velocity (consumption & investment), will rebound, without unnecessarily forcing prices (stagflation), higher (as evidenced by the reduction in REG Q ceilings in 1966 did).

IOR's have also increased the taxpayers's costs, because of both the interest rate "floor" that is created by the remuneration rate, and the new interest rebate (free, or your money, given to the bankers). Both increase interest expenses and consequently the Federal Budget Deficit. Keynes is dead. Leave him that way.

2009 Nov 24 04:16 PM

[flow5]

"Bill Gross (PIMCO Bond King), That 0% yield is not a joke. Almost all money market accounts – totaling over $4 trillion dollars, shown in Chart 1 – yield close to nothing, so close to nothing that I mistakenly did a double take when reviewing my monthly portfolio statement. “Yield on cash,” read the buried line on page 15 of the report, “.01%.”

Money Market Accounts = non-banks, shadow banks, or financial intermediaries (intermediaries between saver & borrower). I.e., the FED's technical staff is inducing disintermediation and forcing the economy to contract.

I.e., disintermediation is an outflow of funds, deposits, or a negative cash flow out of the non-banks (financial intermediaries).

Disintermediation for the member commercial banks can only exist in a situation in which there is both a massive loss of faith in the credit of the banks, and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of its depositor’s withdrawals.

The last period of disintermediation for the member CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

2009 Nov 24 05:03 PM

[Curious Bystander]

The US government, along with the Fed, is a dog chasing its own tail at the moment. This is a game that has no end other than ruination for all of us and a continuation for all of "them". This is nothing more than an economic "Cheyenne Mountain" for their friends, the chosen few. The rest of us? We're getting nuked...

2009 Nov 24 05:07 PM

[flow5]

The FED’s policy tool, interest on reserves (IOR’s), has induced widespread dis-intermediation among the non-banks (the most important economic sector in this recession/depression — or 82% of the lending market,e.g., MMMFs, GSEs, etc., Z.1 release). Some instruments: 4 Week Treasury Bills (.05%), Financial Commercial Paper (.10%), Effective Fed Funds (.12%), etc. (today's quotes = 11/19/2009)

A trillion dollars + in monetary savings (if you count just the verifiable portion in excess reserves), was siphoned out (via redemptions, etc.), of the non-banks (e.g., hedge funds, investment banks, finance companies, insurance companies, mortgage companies, pension funds, etc.).

I.e., interest-bearing deposits at the financial intermediaries were siphoned out of the economy (in the form of loans and investments at the non-banks (mortgages, etc.). I.e., net debt (or velocity), has contracted (but not net new money).

Non-banks (contrary to Lord Keynes), are not in competition with member commercial banks. Savers never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries.

Shifts from time/savings deposits to other deposit types within the CBs (and the transfer of the ownership of these deposits to the thrifts/non-banks), involves a shift in the form of bank liabilities (and a shift in the ownership of (existing) deposits (from savers to thrifts, et al).

The utilization of these savings by the thrifts has no effect on the volume of deposits held by the CBs, or the volume of their earnings assets. I.e., the non-banks are customers of the member, money creating, depository banks.

The financial press has attributed this to deleveraging. However, the member banks (18% of the lending market, Z.1 release), has suffered no dis-intermediation (just portfolio readjustments).
.
Such a “cessation of circuit income” has adverse effects on production and employment, and requires large dosages of money to counter-act.

Thus under one view, the quantitative easing performed by the FED (an increase in legal reserves), has been substantially erased. But we are not done. If the FOMC raised the average reserve ratios on member bank deposits, the volume of required reserves would increase (which if large enough, could induce bank credit contraction), ceteris paribus.

This process is the same as if the FOMC raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields. It would also increase the volume of legal reserves, ceteris paribus (which also acts to reduce the monetary system’s lending capacity).

I.e., the BOG increased reserve-deposit ratios by increasing the volume of inter-bank deposits held in the District Reserve Banks, owned by the member banks (in the form of IORs).

I.e., the FED has followed a downward spiraling contractionary policy in the midst of a recession/depression. Quantitative easing was tried, but there were opposing forces that rendered it immeasurable.

2009 Nov 24 05:07 PM

[flow5]

"Murray Rothbard calls counterfeiting" or maybe it should be called concealed greenbacking.

IORs won't prevent the US from debt repudiation.

It was once called a "tax" because the member banks didn't earn any interest on their required reserves. This is so awfully wrong (even where the member banks are unencumbered in their lending operations - just like the Prudential Reserve Euro-dollar Maket).

By adding one dollar of "tax" (legal reserves), the banking system was given the opportunity to acquire $200 plus in earning assets. Then, because of open market operations, the Treasury recaptured 97% plus of the earnings on the FED's system open market account. Just who was losing money??? The answer is no one. Economists have pertetrated a fraud and deceit upon the American people.

It is also mathematically impossible to miss economic forecasts using bank debits. And nearly so using legal reserves. The combination is unmatched. I'm not buying any of it.

2009 Nov 24 07:02 PM

[flow5]

The banks aren't totally unencumbered:

(1) Some people think Feb 27, 2007 started across the ocean.

"On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market's pullback a day earlier".

In fact, it was home grown (Bernanke was directly responsible).

Feb 27 coincided with the sharpest decline in 1) the absolute level of “free” legal reserves, & 2) & an historically large peak-to-trough reversal of roc’s for proxies on real GDP & the deflator. Bank squaring day also factored in. It was an unprecedented move in terms of volume and duration.

(2) Also, “Black Monday" Oct. 19, 1987, coincided with the sharpest and fastest peak-to-trough decline in the roc for real GDP since 1917. It was the trigger (bank squaring day again) but there were many other factors as well.

Listen to the experts?

2009 Nov 24 07:13 PM

[flow5]

Bernanke didn't know???

My testimony:

flow5 (2/26/07; 14:34:35MT - usagold.com msg#: 152672)
Suckers Rally
If gold doesn't fall, then there's a new paradigm. The drop in member commercial bank adjusted "free" legal reserves is unprecedented

2009 Nov 24 07:16 PM

[flow5]

The FED doesn't even follow legal reserves (per the world's foremost expert). And then Anderson & Rasche wiped out (overlayed the data in their reconstruction). Now 1980 shows no change in legal reserves on the St. Louis FED's databases. History has been re-written.

Actually Volcker increased total reserves at an 18% annualized rate of change after the DIDMCA of March 31st 1980 went into effect (control act it wasn't). Volcker increased the fed funds bracket racket ranges, he did not abolish them. Monetarism has never been tried.

2009 Nov 24 07:29 PM

[MacroStrategy Edge]

"no one seriously advocates that the US simply monetize all its outstanding debt or routinely monetize its annual deficit."

Bob - That is precisely what they do, and what they must do. Households cannot create money. Nonbank businesses cannot create money. Both of those acts are legally deemed to be counterfeiting under current arrangements.

For the private sector to pay taxes or buy bonds, the government must first create the money by deficit spending or by central bank purchases of privately held assets. The Fed credits private bank accounts when the Treasury deficit spends or when the Fed buys privately held assets. The Treasury bond issuance is simply to soak up the resulting excess reserves and thereby allow the Fed to maintain a target policy rate in the face of deficit spending.

Think about, and you will see the problem with the conventional view that taxes and bond issuance finance fiscal budget deficits.

2009 Nov 25 12:31 AM

[bob adamson]

MacroStrategy Edge –

I think you and I are interpreting “monetize” differently. Correct me if I’m wrong but you appear to be saying that whenever the Federal government runs a deficit by not meeting all its annual expenditures out of annual revenues the amount of that deficit has been monetized. I would say that in that situation any amount of that deficit that is covered by a US government bond promising future payment of the principle covered by the bond is not monetized; this is so because no increase in legal tender has been created to cover that principle (only a promise to make future payments as specified in the bond. In short, if you want to say that amounts covered by US Treasuries and other US bonds represent ‘latent monetization’ because, if not paid down, defaulted on or borrowed afresh when the principle comes due, it must at this later date be monetized, I’ll agree with you. It just isn’t monetization now.

You might respond that the distinction I draw between 'latent monetization' and monetization is a distinction without a difference that matters. If so, I would respond that while domestic and foreign markets may not welcome increasing US government borrowing beyond certain levels, they would be much more worried if the US government, instead of such borrowing simply increased the supply of US legal tender.

2009 Nov 25 03:35 PM