What is Debt Monetization? When is it Automatic? Is it a Risk?
What is debt monetization and how does it work? How can constant interest rate rules make debt monetization automatic? Why is this a worry and how does it relate to the choice of a new Fed chair?
What it is and how it works
1. Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.
2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.
3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).
4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.
5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.
6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that).
Thursday, June 18, 2009
Thursday, June 11, 2009
Comments from friend in China
THE BELOW COMMENTS ARE FROM A FRIEND IN CHINA WHO WAS RESPONDING TO ONE OF MY EMAILS. I THOUGHT YOU'D FIND IT INTERESTING. THINGS ARE NOT SO GREAT IN CHINA. READ ON....
Spot On Holmes!
I keep hearing the same garbage about Buffett too. The fact of the matter is, the current rally is going to prove very painful for the bulls. On another matter, I am currently studying for my FSA and CFA exams, while living with my Girlfriend's family in Shanghai. Immediately we arrived in Shanghai from London (last week), the economic troubles were obvious, the worry is on everyone's face over here. The Japs are divesting and moving back, the Western firms are cutting jobs (McKinsey, PWC, KPMG, you name it). Local markets have been flooded with goods previously destined for export at 50% discount. If there is a recovery underway here, I certainly cannnot see it. The shopping malls are basically deserted, apart from a few stray Americans. The people here are very smart and cautious, be it on official television or one of the many housewives I have spoken with: they know a crash is coming. As for the talk of reserve currency, I find it very interesting when people begin to check even small bills as the market has been flooded with counterfeits. Makes me pause to think very hard. This is my Third visit to China and it is indeed a wonderful place (as is India), but be sure of one thing: Most people here do not believe a recovery is likely, not in the near future. And if you talk about a V-Shaped recovery you will be laughed out of the tea shops by the housewives.
Best,
Vinay
Spot On Holmes!
I keep hearing the same garbage about Buffett too. The fact of the matter is, the current rally is going to prove very painful for the bulls. On another matter, I am currently studying for my FSA and CFA exams, while living with my Girlfriend's family in Shanghai. Immediately we arrived in Shanghai from London (last week), the economic troubles were obvious, the worry is on everyone's face over here. The Japs are divesting and moving back, the Western firms are cutting jobs (McKinsey, PWC, KPMG, you name it). Local markets have been flooded with goods previously destined for export at 50% discount. If there is a recovery underway here, I certainly cannnot see it. The shopping malls are basically deserted, apart from a few stray Americans. The people here are very smart and cautious, be it on official television or one of the many housewives I have spoken with: they know a crash is coming. As for the talk of reserve currency, I find it very interesting when people begin to check even small bills as the market has been flooded with counterfeits. Makes me pause to think very hard. This is my Third visit to China and it is indeed a wonderful place (as is India), but be sure of one thing: Most people here do not believe a recovery is likely, not in the near future. And if you talk about a V-Shaped recovery you will be laughed out of the tea shops by the housewives.
Best,
Vinay
Tuesday, June 9, 2009
More about Inflation
Jeremy Siegel, Ph.D. The Future for Investors
Inflation, Not Default, Is Risk for Treasury Bonds
by Jeremy Siegel, Ph.D.
The headlines are scary. Standard and Poor's warns that UK gilts (British Treasury bonds) may lose their AAA rating and indicates that U.S. government bonds may also be downgraded. Bill Gross, PIMCO's "bond king," says emphatically that the U.S. will eventually lose its AAA rating.
What does all this mean? Is it possible for the U.S. government to default on its own debt?
Technically, the answer is "no." The government can always print the money to pay its obligations. But from an economic standpoint, the answer is "yes," since printing money causes inflation and pays off bondholders with depreciated dollars.
The Debt Mechanism
All U.S. treasury debt is denominated in dollars, and except for the less than 10 percent that are "inflation-protected bonds," all bonds are promises to pay a specified number of dollars on given dates. Dollars are created when our central bank, the Federal Reserve, either buys securities in the open market or lends to banks against their loans and other assets. Although Congress imposes a ceiling on the debt issued by the federal government, the Federal Reserve has no effective constraints on the amount of money it can create.
It was not always this way this way. Before 1933, the Federal Reserve could only print dollars in proportion to how much gold the government held -- the so-called gold standard. During the Great Depression, one country after another, including the U.S., left the gold standard and moved to a fiat money standard. Under this monetary arrangement, the government decrees by law (fiat) that its money (Federal Reserve notes in the U.S.) is legal tender for all transactions. There is no gold, silver, or other commodity backing the money.
In a fiat money standard, money only retains its worth because the government limits its supply. The government can limit its supply if it has other sources of revenue, such as taxes or borrowings, to cover its expenditures. But if those other sources dry up, the government may effectively borrow from the Fed, and this would result in large increases in money and rapid inflation.
There is much debate among conservatives about whether the government's decision to leave the gold standard was correct. I, like the majority of economists, believe that it was a good move. If we were still on a gold standard, it would not have been possible for the Federal Reserve to back up money market funds and other bank deposits last September when the credit crisis hit. The resulting run on banks and flight to liquidity would have likely sparked a far worse financial crisis than we experienced. But the flexibility of a fiat money standard must be weighted against its bias towards inflation.
Default Under a Fiat Standard
Although under a fiat money standard government money must be accepted as a means of payment, there is no law that says what that money is worth when it is paid. If too many dollars are issued relative to demand, inflation must result. In that case the bondholder gets shortchanged not because of a government default on its bonds but because of the loss of purchasing power of the dollars paid. (Some countries impose price controls in a futile attempt to assure their own currency won't depreciate in value. Except for limited periods during wartime, such controls have always failed.)
There is one type of Treasury bond that could theoretically default, and that is Treasury-Inflation Protected Securities, or TIPS. Since TIPS compensate bondholders for inflation by increasing the coupon payments and final principal payment by the cumulative rise in prices, the bondholder suffers no decline in purchasing power during inflation. In contrast to standard nominal bonds, TIPS cannot be inflated away, and this leaves open the theoretical possibility that the government could not marshal enough resources to pay interest and principal on these bonds. TIPs for the U.S. government are similar to issuing foreign currency bonds. Any attempt to pay them off by increasing the money supply will cause inflation, depreciate the dollar, and increase the government's dollar indebtedness.
Of course, just because the government can always technically fulfill its debt obligations does not mean that it always will. Since a large proportion of U.S. government bonds are owned by foreign investors, the government could decide that it will only default on those bonds owned by foreigners. The Russian government defaulted on its foreign-owned bonds in 1998, while still honoring domestic bonds. But such selective default would be met by wholesale dumping of dollar assets, sending the dollar crashing on international markets. Given the huge volume of goods the U.S. imports, a plunging dollar means inflation would skyrocket and render such a policy counterproductive.
Our Current Situation
Since the credit crisis began, the Federal Reserve has more than doubled the supply of its own money, and government deficits are running into the trillions of dollars. Many believe this will inevitably lead to rapid inflation.
But such a conclusion is premature. The Fed has increased the supply of money in response to the tremendous increase in the demand for such money caused by the liquidity crisis. And government borrowing is just offsetting the sharp increase in consumer saving caused by the declining value of assets and tighter credit.
I believe that the government's current economic response is right. But the government must be on guard. Once confidence returns, the Fed must pull back the money it loaned and the government must bring deficits under control. This will inevitably mean raising interest rates, and the latest increase in long-term treasury rates is a clear signal that the bond market sees this happening soon. If, by the second half of this year, the economy turns around, the Fed will have to start raising the Fed Funds rate and restrict liquidity. Otherwise the government will effectively default on its obligations -- not by missing its payments but by making those payments in a depreciating currency.
Inflation, Not Default, Is Risk for Treasury Bonds
by Jeremy Siegel, Ph.D.
The headlines are scary. Standard and Poor's warns that UK gilts (British Treasury bonds) may lose their AAA rating and indicates that U.S. government bonds may also be downgraded. Bill Gross, PIMCO's "bond king," says emphatically that the U.S. will eventually lose its AAA rating.
What does all this mean? Is it possible for the U.S. government to default on its own debt?
Technically, the answer is "no." The government can always print the money to pay its obligations. But from an economic standpoint, the answer is "yes," since printing money causes inflation and pays off bondholders with depreciated dollars.
The Debt Mechanism
All U.S. treasury debt is denominated in dollars, and except for the less than 10 percent that are "inflation-protected bonds," all bonds are promises to pay a specified number of dollars on given dates. Dollars are created when our central bank, the Federal Reserve, either buys securities in the open market or lends to banks against their loans and other assets. Although Congress imposes a ceiling on the debt issued by the federal government, the Federal Reserve has no effective constraints on the amount of money it can create.
It was not always this way this way. Before 1933, the Federal Reserve could only print dollars in proportion to how much gold the government held -- the so-called gold standard. During the Great Depression, one country after another, including the U.S., left the gold standard and moved to a fiat money standard. Under this monetary arrangement, the government decrees by law (fiat) that its money (Federal Reserve notes in the U.S.) is legal tender for all transactions. There is no gold, silver, or other commodity backing the money.
In a fiat money standard, money only retains its worth because the government limits its supply. The government can limit its supply if it has other sources of revenue, such as taxes or borrowings, to cover its expenditures. But if those other sources dry up, the government may effectively borrow from the Fed, and this would result in large increases in money and rapid inflation.
There is much debate among conservatives about whether the government's decision to leave the gold standard was correct. I, like the majority of economists, believe that it was a good move. If we were still on a gold standard, it would not have been possible for the Federal Reserve to back up money market funds and other bank deposits last September when the credit crisis hit. The resulting run on banks and flight to liquidity would have likely sparked a far worse financial crisis than we experienced. But the flexibility of a fiat money standard must be weighted against its bias towards inflation.
Default Under a Fiat Standard
Although under a fiat money standard government money must be accepted as a means of payment, there is no law that says what that money is worth when it is paid. If too many dollars are issued relative to demand, inflation must result. In that case the bondholder gets shortchanged not because of a government default on its bonds but because of the loss of purchasing power of the dollars paid. (Some countries impose price controls in a futile attempt to assure their own currency won't depreciate in value. Except for limited periods during wartime, such controls have always failed.)
There is one type of Treasury bond that could theoretically default, and that is Treasury-Inflation Protected Securities, or TIPS. Since TIPS compensate bondholders for inflation by increasing the coupon payments and final principal payment by the cumulative rise in prices, the bondholder suffers no decline in purchasing power during inflation. In contrast to standard nominal bonds, TIPS cannot be inflated away, and this leaves open the theoretical possibility that the government could not marshal enough resources to pay interest and principal on these bonds. TIPs for the U.S. government are similar to issuing foreign currency bonds. Any attempt to pay them off by increasing the money supply will cause inflation, depreciate the dollar, and increase the government's dollar indebtedness.
Of course, just because the government can always technically fulfill its debt obligations does not mean that it always will. Since a large proportion of U.S. government bonds are owned by foreign investors, the government could decide that it will only default on those bonds owned by foreigners. The Russian government defaulted on its foreign-owned bonds in 1998, while still honoring domestic bonds. But such selective default would be met by wholesale dumping of dollar assets, sending the dollar crashing on international markets. Given the huge volume of goods the U.S. imports, a plunging dollar means inflation would skyrocket and render such a policy counterproductive.
Our Current Situation
Since the credit crisis began, the Federal Reserve has more than doubled the supply of its own money, and government deficits are running into the trillions of dollars. Many believe this will inevitably lead to rapid inflation.
But such a conclusion is premature. The Fed has increased the supply of money in response to the tremendous increase in the demand for such money caused by the liquidity crisis. And government borrowing is just offsetting the sharp increase in consumer saving caused by the declining value of assets and tighter credit.
I believe that the government's current economic response is right. But the government must be on guard. Once confidence returns, the Fed must pull back the money it loaned and the government must bring deficits under control. This will inevitably mean raising interest rates, and the latest increase in long-term treasury rates is a clear signal that the bond market sees this happening soon. If, by the second half of this year, the economy turns around, the Fed will have to start raising the Fed Funds rate and restrict liquidity. Otherwise the government will effectively default on its obligations -- not by missing its payments but by making those payments in a depreciating currency.
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