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 has a post out today 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:

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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.

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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.)

In terms of the effect on net financial assets for the non-government sector, the figures show that there is no difference between “monetization” or bond sales besides potential effects on the federal funds rate that depend on the Fed’s chosen method of achieving its target. But from the widely-held view that “monetization” is more inflationary than bond sales, Figure 1 is assumed to be more inflationary than Figures 2 and 3. Regarding Figure 1, though, recall that banks do not use reserve balances or deposits to make loans, as loans CREATE deposits; bank lending or money creation instead occurs when banks are presented with opportunities to lend at an expected profit (and have sufficient capital). Banks instead hold reserve balances ONLY for settling payments and meeting reserve requirements (see, for example, my previous post on bank lending and reserve balances here), and their desired holdings for these purposes are always accommodated by the Fed at its target rate. What this means is that the reserve balance drain shown in Figures 2 or 3 can in no way restrict potential money creation by banks.

There is no difference  between the monetization scenario and the government bond sale scenario exceptregarding 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.


What If the Government Just Prints Money? – Scott Fullwiler

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