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:

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.)

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

  1. Scott Fullwiler says

    Thanks, Ed!

    Very well explained. I would just add that if the target rate is set equal to the rate paid on reserve balances (as now), then the Fed can still raise/lower the target rate as desired whether bonds are sold or not.


  2. dansecrest says

    I’ve been following this line of argument for a couple of months now and haven’t yet seen anyone make a good counterargument. These MMT guys may be onto something fundamentally wrong with conventional economic wisdom. Thanks to Edward Harrison for spreading the word. I wonder when others will notice…

    1. jzw says

      “Unlimited power is apt to corrupt the minds of those who possess it”

      If its such are great idea why don’t you print some money give every member of congress 1BN to spend as they choose fit.

      If you are lucky you might get employment as a gardener or maid for someone in congress.

  3. Vangel says

    Why do smart people make such dumb mistakes? Which county has ever been able to keep interest rates at zero while it was printing money to pay for deficit spending and keep the purchasing power of its currency stable?

    1. Scott Fullwiler says

      Japan for the last 10 years? US during WWII? Wasn’t at all the point of the article, but do you want more examples?

      1. Vangel says

        Japan does not fit because it ran trade surpluses and had huge amounts of domestic savings. The US has neither and must run hat in hand to foreigners to finance its deficit.

        The deflation argument simply does not hold water and monetization will mean the destruction of the purchasing power of the USD. As the Fed prints money to purchase debts foreign holders of treasuries will refuse to roll them over and will look to a way to hedge their reserves. No matter how it is done, the long term play is to dump fiat money and move to the real stuff.

        1. Tschäff Reisberg says

          Vangel, if you had read this whole article and understood it you wouldn’t be saying this.

  4. Brick says

    Yes there is no difference monetary base wise between printing and issuing debt except as one commenter pointed out you can have imported inflation due to currency fluctuation. The significant difference between Japan and the US was the savings rate which remained high whilst last month there was a shock decline in the savings rate in the US. The other difference was that Japan printed money at a time when there was no global recession.
    Putting that aside and accepting your argument that these are not issues I think you are right about the supply and demand relationship and the actual changes occurring within the financial statements. I think you might be right about the the non-government being logically be more likely to spend as well. However assuming that spending will flow towards the economy is risky and it might well flow towards asset appreciation and risk being inflationary, especially if central bank actions outside the US are not in line.

  5. Anonymous says

    “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.”

    Spot on. The loanable funds theory ignores the reality of credit creation by credit intermediaries. Money created as interest-bearing debt/credit is instantaneously the subject of a matching deposit somewhere in the system as an accounting identity.

    The ‘loanable fund’ theory is consistent with the belief of 99.999% of the population that banks take in deposits and lend them out again. If that were the case then there could not BE any new money other than (interest-free) cash created ex nihilo by Central Banks or (possibly) Treasuries.

    The belief is also consistent (and equally misconceived) with the ’savings glut’ canard. US etc credit = money created as debt and used for consumption came first – Chinese deposits/savings and purchases of T Bills followed – and was a consequence, not a cause.

    Dirk Bezemer and Steve Keen, among others, are getting to grips with the disconnections between economic assumptions based on debt/equity finance capital as distinct from the real world.

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