Monday, December 6, 2010

Government Debt and Money Printing

That governments issue bonds to finance their activities is news to no one. That bonds represent a claim to future cash flows should also not be news, since that is the nature of a bond. A lends money today to B in exchange for periodic interest payments and eventual principal repayment. B's burden is to generate the cash flow necessary to make the payments. If B experiences a short fall at any time, then technically B is in default and A usually has some special privileges - like taking B's stuff. Or A and B can work together and restructure the bond such that B has a better chance of making interest payments.

In the case of governments, the future cash flows come from at least two sources: taxes or new borrowing. Taxes can be used to discharge the debt fully, but new borrowing would only change the structure of the debt, not discharge the debt. A may be paid back, but now B would be indebted to C. There's nothing inherently wrong with rolling over the debt in such a manner, provided C is willing to lend B money.

Now, if the government is the sole money producer for a nation, a third method of paying back debt is available: seignorage. Seignorage is the process of printing (physically or electronically) new money (which is zero-maturity debt in this case) for revenue purposes. Note that printing money for circulation purposes is not the same as seignorage.

Let us suppose we are at the point that B needs to pay back A, and B is not the money monopolist. If B has the free cash flow from taxes, no problem: B pays back A and the debt is discharged. If B hasn't the cash flow from taxes, but can roll over the debt (either with A or with a new creditor C) still no problem. However, if B is distressed and can't roll over the debt then B is in default and needs to restructure the debt. This typically has long-term consequences for B's growth, and so is rightly feared.

But, what if B is the money monopolist? Well then B can simply print up all the zero-maturity debt needed to discharge the debt owed to A. No need to worry about taxes or finding another creditor. What are the consequences of this action? At the time of debt maturity, B is swapping zero-maturity debt with zero-maturity debt. So it might look like the net effect is nothing. However, A was expecting to be paid dollars of a certain value - dollars from the current stock of money that has a certain purchasing power. But B has not done so - B has increased the stock of money by the amount of the debt owed to A and thus has reduced the purchasing power of money. A has been made worse off than expected because of this. We see also that the debt itself has not been discharged. Rather, the debt has been restructured in just the same way as issuing new bonds. The only difference is that the maturity structure of debt has been shortened, rather than maintained. That moves claims to real assets closer to the present and this is the source of price inflation.

If B does this once or twice, for relatively small amounts, the negative consequences are likely to be minimal. However if B does this frequently, present claims will come to dominate the maturity structure of the debt and one will observe quite a decline in the purchasing power of money. Furthermore, this will hamper B's ability to borrow since the As of the world do not want to lose money on their investments in real terms. Thus the political consequences of, say, the Weimar republic.


  1. As I'm sure this post was mostly directed at me, let me be the first to respond (although I'm such a fat fingered typist someone may actually beat me to posting).

    What should a "lender to the govt" expect? All they should expect is for them to get the nominal amount of the agreed bond back plus the interest stated. There are NO guarantees that anything will be available to buy with it. Yes this is assumed and in the history of most govts in the last 100 years that is a reasonable assumption, that something will be available to buy with your returned money but no govt can 100% iron clad guarantee as can NO private party. If you switch from government and insert GM or GE or Microsoft in to your story its clear A and B would have ZERO guarantees, not only would they have no guarantee that the nominal amount would be returned in full they have no guarantee that GE GM or Microsoft would be left to produce anything. Would you prefer that the govt have a TRUE default risk? Would you prefer that they actually say to a bond holder sorry we have no money? How is this better?

    Now you may be arguing that the govt should pay more for the "borrowing" That the lenders to the govt should get a higher return than they're currently receiving but this will NOT shrink govt budgets, it will make the interest portion HIGHER and if you include the possibility of true default how does that improve todays outcomes.

    You seem to be arguing that it is wrong for the govt to make the payment that it truly is capable of making (with inflated dollars to use your term) . On another level it seems you're really saying we should have never borrowed the money in the first place and simply spent less, which I agree with in part because I've never thought we have had the proper discussion in this country of where we should be spending, so now we need to spend less on X so we can pay the debt back to the debt holders and give them the proper value for their loan.

    To word it another way, it seems you and many others are arguing that forcing an austere lifestyle on some people now (not everyone mind you) so we can give the bondholders their due is necessary to avoid having an austere lifestyle forced on us later by rampant inflation/hyperinflation.
    So the "some" now are of course that guy and not me and the later we are trying to avoid would be on everyone.

    In your story B is the govt and you say "If B does this once or twice, for relatively small amounts, the negative consequences are likely to be minimal. However if B does this frequently, present claims will come to dominate the maturity structure of the debt and one will observe quite a decline in the purchasing power of money."

    So when has B done this before? To you? I would suggest that we here in America have enjoyed the highest living standard on earth for decades and certainly a very high living standard for most of our countries existence. Has our govt been excessively punishing to savers? I'd say no. Most savers that have gotten killed have been investing in stocks when they lost their ass, not govt bonds.

  2. What I find confounding is the bond markets are still not placing any measurable risk premium on gov't bonds, despite the current and expected future deficits. Why? We just experienced the two largest deficits in history (2009 & 2010) - in excess of $1.3 trillion each. The outstanding debt is nearly $13.5 T, and is approaching 100% of GDP. The Fed is monetizing the debt and printing money out of thin air (QE2).

    Yet the yield on bonds is historically low. I'm not understanding how the markets brush aside the risks we (as a nation) face.

  3. Because there is no default risk. Look at Japan with debt to GDP over 200%

    Why does the level of govt debt to GDP even matter?

    Govt debt level is a "stock". It is a fixed amount that has accumulated over time. GDP is a "flow", an ongoing event measuring current spending activity. Govt debt actually adds to the flow of GDP via interest payments.

    While irrelevant, the debt to GDP ratio worsened because GDP plummeted not because debt skyrocketed. The fall in GDP came first then debt levels went up. The solution is to restore GDP, not drop debt.

    This is like taking the ratio of "Miles of roads constructed in the US"/ "Miles driven by US drivers" and thinking that a drop in miles driven needs to be fixed by tearing up more of our roads.

  4. There may be little default risk, but currency debasement is a reality. I suppose we'll never "default" as long as the printing presses don't die and we don't run out of ink. But this isn't sustainable. A country cannot run $1 trillion deficits in perpetuity. Deficits are simply deferred taxes.

    By 2020, the interest payments will be around $700-800 billion annually, double (or triple) today's payments.

    There are real consequences to large sustained budget deficits.

  5. Real consequences of budget deficits;

    More income in the hands of non govt which they can save or spend

    Real consequences of decreased budget deficits;

    Less income in hands of non govt

    Why do you wish for less income for the non govt sector? Are we overpaid?

    And if you are going to call inflation a form of default risk must you not also call deflation a form of usury?

    Let me ask you this. Would you "lend" 10,000$ of your money to govt if it was paying 10% on T Bills? If yes, what you are really hoping for is not less cost of govt but more govt payment TO YOU!

  6. Prof J,

    About printing money, The Ben Bernanke offered a few comments on QE2 and priting money in a recent 60 Minutes interview. And I quote:

    “One myth that’s out there is that what we’re doing is printing money.” He added, “The money supply is not changing in any significant way.”

    Is he being truthful?

  7. Brad,

    I'm not sure. It depends on what he means. If The Ben Bernank means "printing" in a literal way, then I think that this is the case. They are not literally printing green pieces of cotton and linen.

    Any measure of money is going up, though. These can be obtained from the St. Louis Fed's website (FRED).

  8. Surely The Ben Bernanke isn't a lawyer, parsing words. Technically, the US Mint would carry out any orders to print money, but the Fed is having the same effect. And why would he be deceitful about this?

    The Fed has this surreal, cloak of secrecy surrounding it. I think that's why folks view them skeptically.

  9. Yes - the secrecy is definitely not helping peoples' view of the Fed.

    Now, I'm no conspiracy theorist - even thought the Fed was created by a small consortium of politicians and bankers - but I don't see much social value in hiding their lending/borrowing partners for so long.

    I am against central banking generally also. I think competitive currency is the only way to have stable economic growth.

  10. Does a competitive currency necessarily demand a backing, i.e. gold? Or do you mean that the money supply is governed by market forces, free from the manipulative actions of the government? I don't fully understand the consequences/benefits of a competitive currency. Can you recommend some literature (laymans's terms) on this issue?

  11. Well sir, in the modern history of free banking, there are really only two examples: Scotland in the 18th century, and Hong Kong until technically the 1960s, but really only until the 1930s. Scottish banks had gold-backed currency, but reserves were very low (around 2%). Hong Kong had 100% reserves, but the reserves were foreign currency (mostly pounds sterling). Ultimately the strength of the currency is governed by the bank's choices in lending. Better lending = more secure banks.

    I'm not sure about layman's literature on this issue, since it is mostly of interest to academics. But you could have a go at George Selgin's "Theory of Free Banking." It is available for free here:

    I also like Vera Smith's "Rationale of Central Banking and the Free Banking Alternative" although you have to pay for that one.

    And there's probably lots of stuff on the Mises website. Rothbard wrote about it certainly.

  12. QE is an asset swap. Switching long maturity rates for shorter ones. Bonds for reserves. M0 is rising but since there is no such thing as a money multiplier, there will be no direct effect on the other money metrics. There is no channel from M0 to M1,2 or 3. This is all a failed supply side monetary experiment that gives lie (if you are paying attention) to the whole monetarist ideology.

    The fallacy is that reserves get lent out out. They dont. Reserves are acquired AFTER loans are made, in order to meet reserve level rules. IF the money multiplier was remotely true we'd see all credit levels shooting up.

    QE is largely a non event in terms of affect on the economy. There has been some increase in stock prices but they have been steadily rising since early '09 any way, hard to attribute any increase to QE, although many are trying.

    Credit issuance will not rise until incomes start rising. Wake me up when that starts happening.

  13. Greg,

    So you are correct that it is an asset swap. I believe I intimated this in my original post, in fact, without specifically mentioning QE2. Federal reserve notes and treasury bonds are claims against the federal government separated only by time. But the real treatment in the economy of the two assets differs. Zero-maturity notes (i.e. money) is used to fully discharge debts. Positive maturity notes (e.g. bonds) cannot fully discharge debt. They must first be exchanged for zero-maturity notes. So this friction matters for in this case because it is a swap of future claims for present claims. I covered this in my post above, and won't rehash it here.

    I don't understand why you think the money multiplier exists. It is a feature of a fractional reserve system. Please elaborate on this point.

    A reserve is gained when a deposit is made. Prior to lending any of the deposit, reserve is 100%. Once it is lent, the reserve is reduced, typically to its minimum. Again, you are claiming something here that is counter to what appears to be the reality, so you must explain this position much more clearly.

    Quantitative easing is making its effects known through a variety of asset markets, but we can see the effects most clearly in currency markets, where the U.S. dollar has been declining.

    Which incomes are you referring to? According to the BEA, personal income was down only slightly in 2009 from 2008, and 2008 was the peak year.

    I chanced to speak with some local bankers the other night. We were having our secret meetings regarding how to shift the economy in our favor. Anyhow, anecdotal evidence is that businesses do not want loans, not that banks aren't unwilling to loan. So I would say credit demand won't pick up until uncertainty regarding the business climate goes down.

  14. Above should read: "why you think the money multiplier doesn't exist."

  15. The money multiplier assumes that a loan is made against a level of reserves or money "in the bank". It looks at 10% reserve levels and says one loans 10x the amount of reserves. In fact it is 180 degrees, the loans are issued, the deposit is created THEN the reserves are sought according to the rules. If the bank already has the reserves fine, if they dont they purchase them in the overnight loan market.

    My point is this; A bank does not say to a credit worthy customer "Wait, let me check my reserve levels to see if I have the money to loan you".
    A credit check is done, collateral is agreed upon, the loan is granted, a deposit is created (out of thin air) and THEN the reserve level is adjusted to meet requirements. This process is well documented by those who have studied modern banking.

    The money multiplier is a no longer applicable concept, heldover from our gold standard days.

    Are you not aware that there has been serious discussion about having a ZERO reserve requirement here(like they do in Canada)? Bernanke talked about this earlier this year. How could a bank make loans in your model if that were the case.? 10 x 0 = 0

    Now why is this fact important to the QE discussion? Because raising reserve levels through asset swaps or anything else does NOTHING to increase the amount of credit created. We could raise the reserve levels to 600 trillion and there would be no more or less money to lend. A loan is created when and only when a credit worthy customer comes through the door. Raising reserves is NOT inflationary.

    Here is a source;

    The "uncertainty" that is spoken of will disappear as soon as more customers start coming through the doors. But more customers wont start coming through the doors til people have a job that pays them an income.

    It is the levels of PRIVATE debt that is holding our economy back NOT govt debt. People must service their private debt out of their income leaving them less to spend on stuff other than essentials. Too many people are trying to get by on UI payments, their stock of prior savings or just defaulting. Those of us fortunate enough to still have our jobs at the same income level as two years ago are living life the same but way too many have dropped out of the economy... hence our current start of our lost decade.

  16. Hey Prof

    Come and add your comments to this post when you get the time.

    This has the potential to be one hell of a discussion section.