Arnold Kling  

The Macro Implications of Monetized Debt

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PIMCO's Bill Gross writes,


most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys - the Chinese, Japanese and other reserve surplus sovereigns.

Pointer from Tyler Cowen. The way I see it,

1. The government is issuing a huge amount of debt.
2. The central bank is monetizing it.

The implications from various macroeconomic perspectives.

Traditional monetarist: Yikes! Hyperinflation coming in 1, 2, ...

1960's Keynesian: No worries. Inflation is all about the Phillips Curve. This policy is just what the doctor ordered. He might even have ordered more of it.

Modern macro theorist: look at market expectations of inflation (Scott Sumner would say to look at expectations for nominal GDP). The Fed is managing those about right. Presumably, it can continue to do so.

Me: Think of inflation as a fiscal phenomenon. The issuance of a lot of debt is inflationary.

Everybody talks about a monetary "exit strategy" once a strong recovery takes hold. But what about a fiscal exit strategy? Other than Ron Paul, does anyone have several hundred billion in spending cuts ready to go?

Tyler Cowen's NYT column is on what he calls "fiscal illusion." Maybe it should be the "fiscal allusion," because he alludes to so many things, or the "fiscal elusion," because the implications of his writing may be elusive. But one interpretation is that we need fiscal rules, because discretionary fiscal policy is biased toward deficit. That is, the Keynesian prescription is for surpluses when times are good and deficits when times are bad, but the Keynesian prescription is only taken when times are bad.


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COMMENTS (10 to date)
David R. Henderson writes:

Good post, Arnold.
You ask, "Other than Ron Paul, does anyone have several hundred billion in spending cuts ready to go?"
Yes. Rand Paul. :-)

Ted writes:

I think it's pretty clear now that inflation has nothing to do with the monetary base and is entirely about expectations. If the public expects the Federal Reserve to not allow inflation to go above 2%, it won't.

It's hard to create a model where debt issuance creates inflation, at least in the United States. The only way I could rationalize such a phenomena is if the public's expected future path of debt was so outside reasonable limitations that the public believed active monetary policy became an unfeasible policy and so the central bank would lose total control of both current and expected inflation and inflation would be solely determined by the path of expected future primary surpluses.

The Sheep Nazi writes:

If the public expects the Federal Reserve to not allow inflation to go above 2%, it won't.

I'm not sure the public has any idea who the Federal Reserve even is. The public keeps its eye on the price of gas, though, so if you've got a theory of inflation based on what the public expects, then it seems to me that you ought to be expecting inflation right about now.

Mike Sproul writes:

Arnold:

I'm a landlord. Sometimes I go to the local grocer and buy a loaf of bread by handing him four "Mike dollars", each of which is good for $1 of rent on my properties. I'm told that those Mike dollars often pass through several hands before returning to me. My net worth is $500,000, so I could, in principle, issue up to $500,000 in Mike dollars before they would start to lose value (assuming I spent them wastefully, without getting any new assets).

Instead of issuing Mike dollars, I could issue a bond and spend the proceeds wastefully. Here again, as long as I keep my bond issuance below $500,000, my bonds won't lose value.

Or, having issued my bonds, I could buy them all back with Mike dollars, thus replacing one liability with another, but otherwise having no effect on the value of my bonds or my money.

When I look at my issuance of bonds and dollars, and compare it to the Federal government's issuance of bonds and dollars, I see no important difference. Do you?

effem writes:

The current value of your "Mike dollars" is 0.25 USD. Any further issuance (assuming flat net worth) will cause the value to fall. Markets are all about equilibrium.

Mike Sproul writes:

effem:

Each Mike dollar is redeemable by me for rent of 1.00 USD, so they are worth $1 US each. If my net worth is $500,000, then I could easily buy $100 of groceries by issuing $100 Mike dollars. If I then issued another $200 in Mike dollars to buy $200 more in groceries, then even though I've tripled the number of Mike dollars, each is still worth $1 US.

Matt C writes:

All the talk of a monetary exit strategy assumes that we will first have a strong recovery and then start seeing more inflation than we like. To have 8% unemployment and also 8% inflation is apparently supposed to be unthinkable. But of course it has happened before.

Arnold, you didn't talk about the monetary exit strategy. It sounds like it is basically two things:

1) Pay banks to lend less money.
2) The Fed starts selling bonds instead of the Treasury.

Will the Fed have the guts to apply negative incentives to lending if unemployment is above 8%? This is not my mental model of Ben Bernanke or anyone else in any recent administration. I think it is much more likely that we'll be told that 4, 5, 6% inflation is really not that bad, and in fact some of our strongest periods of growth took place during moderate inflation, yadda yadda yadda. Of course, the longer we wait to address rising inflation, the harder it will be to fix.

The idea that the Fed will be allowed to sell their bonds to reduce the money supply . . . this is basically throwing QE into reverse, right? The Treasury will issue less debt, and the Fed will sell their bonds to make up the difference. Isn't this the same thing as the several hundred billion in spending cuts that Arnold is talking about, and which we all know won't happen?

I admit I don't understand all this stuff very well. Maybe there's something I'm missing here. But we don't have a fiscal exit strategy, and I think we only have a monetary exit strategy in the scenario where we get an unequivocally strong recovery first.

I'd like to believe that because the market hasn't panicked about inflation yet, this means that it won't happen. But I would think the last fifteen years give some hint that the market doesn't always move in a nice gradual way when it changes its mind about something.

Charles R. Williams writes:

Money has slipped out of the control of central banks. The process of intermediation creates money. Banks can finance any liquid asset having certain characteristics with short-term "deposits." This process occurs inside and outside the regulated banking system, inside and outside the boundaries of the US and across currencies. Some money - like T-bills - does not even require financial intermediation to come into existence, just very efficient and liquid markets.

Money is created as needed by the economy, baring some kind of financial panic such as August 2007. This means that while the Fed can screw up and drive the economy over a cliff, they have little capacity to fine tune the economy. Money, interest rates and the price level are endogenous with respect to the fed.

Fiscal policy is another matter. If the Treasury borrows $2T a year to hand out to retirees, they will spend it in certain ways that shift relative prices in the global economy. Investment and consumer spending will rise in the US driving up prices for domestic inputs like labor. This occurs whether the fed buys the bonds and creates excess reserves in the regulated banking system or whether shadow banks buy the bonds and finance the purchase with repos. It gets interesting when the US runs huge deficits that cannot be sustained but no one knows how that imbalance will be resolved. There is the potential for a financial crisis that swamps anything the world has ever experienced.

bingo writes:

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fundamentalist writes:

Yes, expectations have a lot to do with future price increases, however, no one is asking how people form expectations about price inflation.

They certainly don't follow the Fed, as Sheep Nazi wrote. People look to past inflation and then do linear forecasting. That's why you see so much serial correlation with inflation data.

So if people project the future by reading the past, how does price inflation ever happen in the first place?

It surprises. Price inflation always surprises. Today, the Fed is hoping that the recent spike in prices won't become part of expectations, but if they persist, they will. Then the Fed is in trouble. It takes a few quarters of rising prices for people to decide that prices will continue to rise.

So how do prices surprise if expectations are all that matter? As Kling writes, federal debt being monetized by the fed starts the process of price inflation. If it persists, then people begin to expect it.

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