What is monetizing debt and how it works? How can the rules of the constant interest rate of debt monetization automatically? Why is a concern and how it relates to the election of a new Fed chairman?
1. Suppose the government runs a deficit. As an example, public spending on goods and services is $ 10,000. For simplicity, all transactions are in cash. Let the net taxes from all sources is $ 9000 so there is a deficit of $ 1,000.
2. The government has $ 9,000 in actual taxes, but has to spend $ 10,000. In some ways (money, borrow money, raise taxes or lower spending) should get $ 1000 more.
3. Suppose we decide to borrow – the issuance of new debt. Then the Treasury sells bonds to someone in the private sector for $ 1,000. The person who gives $ 1,000 in cash and in return the government receives an IOU (perhaps for, say, $ 1,100 in a year).
4. The government now has $ 9000 cash $ 1000 in taxes and it has taken to the public so that you can now buy $ 10,000 in goods and services.
5. Now let’s do the monetization step. This can occur automatically, as explained below, but for now we will conduct a $ 1000 Federal Reserve open market operation to increase the money supply. To this end, the handles of the press, some loads of paper and green ink, and print a new invoice for $ 1000. Take the $ 1000 and buying a bond bill for the public, for simplicity makes it the same Treasury bond just published. Then, the money supply increases by $ 1,000 (and can go through multiple deposit expansion), and debt held by the public is going for $ 1,000 from the Fed now has the bond. The increase in money supply is inflationary.
6. What happened? When all paper has been changing hands, the $ 10,000 in goods and services paid for the collection of $ 9000 in taxes and the printing of new currency in 1000 U.S. dollars. Public debt simply moves to the Treasury of the Federal Reserve (the U.S., the Fed pays for its operations from its earnings on these bonds and refers the rest to the Treasury, I think that the remittance weekly, but I am not positive).
How can constant interest rate rules potentially cause debt monetization to occur automatically?
Suppose the Fed follows a rule of interest rates. Moreover suppose that an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman published on the site today NBER). That is, when the government issues new debt, the supply of bonds increases by reducing prices and increasing interest rates. Under these premises, what will happen when there is deficit spending?
1. Deficit spending financed by loans from the private sector makes the interest rate to rise. Thus, initially two things happen, the bonds held by the public (debt) and increase the interest rate increases.
2. However, the Fed is following a rule of constant interest rate. See the increase in interest rates, what should I do? It should increase the money supply and what the money is printed, as above, and uses it to buy bonds from the public. To repay the interest rate that began when all of the debt issued in step one must be purchased with newly printed money (you can smell the fresh ink?).
3. In the end, what happens? It is only in the previous case, the entire deficit is financed by printing money and debt issued by the Treasury ends up in the hands of the Federal Reserve.
This is one reason why the Fed has made so much noise lately about leaving interest rates rise in the face of budget deficits. The Fed is sending a signal to the tax authorities do not permit interest rates rise monetize the debt and inflation suffered monetization of debt brings. So far we have been fortunate in this regard. Long-term interest rates have remained low, while budget deficits have increased. Echoing comments by other officials of the Federal Reserve is clearly concerned that this cannot persist and that interest rates could rise rapidly. Signaling the Fed is that if the increase in interest rates is due to budget deficits, it is unlikely that the Federal Reserve to intervene because of the inflationary consequences of the monetization. It will allow raising interest rates.
Is this a risk?
For me, this is one of the important considerations for the new Federal Reserve chairman. I would be interested to know the new president’s commitment to fighting inflation, even if not a direct commitment to explicit inflation target. There is every incentive for both parties to elect someone who will allow debt to be at least partially, by allowing money to increase inflation, because this Congress relieves the responsibility of raising taxes or reducing programs. With debt monetization, government debt disappears and inflation takes its place. While lamenting that the public at the Federal Reserve about high inflation, tax authorities, as the debt in cash, are absolved of responsibility. Signaling that the Fed has no intention to monetize the deficit, and I hope that the election of a new president will maintain that commitment.