The public debate regarding the debt and debt monetization is as old as the Republic. James Madison called debt a curse on the public, First Treasury Secretary Alexander Hamilton called it a blessing provided the debt wasn’t large. The modern day debt monetization term emanated from the Treasury’s cost of financing World War 2’s war debt because the Federal Reserve’s holdings of government debt tripled from 1943-1946.
The public was fearful of buying any debt during this period. Historically the Treasury Department then and now determines the amount of debt and maturities issued. In this capacity, they have full control over monetary policy, defined as the supply of money and credit. The Federal Reserve was the distributor of all debt to the public and supported debt prices through sales of bonds, notes and bills. A collision would occur between the two agencies as to their roles due to the failure to timely finance the war debt. The 1951 Treasury -Fed Accord settled the question who controls the fed’s balance sheet by reversing roles. The Fed would control monetary policy by supporting debt prices without control over any debt it holds and buy what the public doesn’t want while the Treasury would focus on amount of issuance and categorical maturities. .
Monetary policy since 1951 would be controlled through the Fed’s Open Market Operations with a Treasuries only policy. This would separate the Fed from fiscal policy and credit allocation and allow for true independence. This freed the Fed from monetizing debt for fiscal policy purposes and prevented collusion such as agreements to peg interest rates directly to treasury issues. Credit policy was also separated and limited to Treasury, defined as bailing out institutions, sterilizing foreign exchange operations and transfer Fed assets to Treasury for deficit reduction. The Treasury Secretary and the Comptroller of the Currency were removed from the Federal Reserve Board so policy decisions were separate from fiscal policy. Today 12 Federal Reserve Bank Governors and the Chairman of the Fed make up the Federal Open Market Committee that sets interest rate and money supply policies.
Monetizing the debt can be defined as money growth in relation to interest rates but not money growth in relation to government purchases or open market operations. Monetizing the debt occurs when changes in debt produce changes in interest rates. Yet money growth alone is not a monetizing of the debt since money growth ebbs and flows through contraction and expansion cycles over the years without a change in interest rates. Suppose a wash sale occurred where all debt issued was sold, no monetization. This is fiscal policy objectives completed. Fiscal policy is tax and spending policy by current Presidential Administrations. What if money growth was equal to debt, no monetization? Money growth is found in M1, M2 and M3. M1 is money in circulation, M2 is M1 plus savings and time deposits under $100,000 and M3 is M2 plus large time deposits over $100,000. So Open Market Operations is the issuance of debt replaced with money.
Monetizing the debt can also be characterized as money growth in excess of the federal debt or no money growth in relation to debt. This last example is called the liquidity effect where low money growth leads to low interest rates. Either will change the velocity of money defined as how fast money circulates. Usually the target is a debt growth equal to velocity. This allows the system to be in sync.
A better way to understand this relationship is to ask exactly what are the feds targets. Do they target growth to velocity, money growth to employment as was once the case, money growth equaled to the present supply of money, interest rate targets or even inflation. Targets to inflation has proven to not only be disastrous but studies show negative statistical relationships forcing an out of sync growth to debt relationship. Many avenues have been tried since the 1913 Federal Reserve Act was passed that created the Federal Reserve System.
The question of monetization and growth to debt must be understood in terms of the multiplier effect, how much the money supply increases in response to changes in the monetary base. This is a better method to understand fed holdings. Suppose the fed changed the banks reserve requirements, the cash ratio banks must hold against customer deposits. This would change the rate of money growth in the multiplier, the monetary base and possibly cause an interest rate change. As long as debt is in sync with this money growth, no monetization occurs because all that was increased was the monetary base or the supply of money and credit. Previous studies over the years shows without question a statistical impact between money growth and changes in debt.
Monetization occurs in other ways such as when money growth targets higher interest rates. This is money growth with desired growth targets. The only way this can occur is to reduce maturity levels to increase liquidity. An increase in liquidity with corresponding reductions in debt issuance would cause a higher money supply and disequilibrium in growth to debt. Interest rates would have to rise to bring equilibrium back to the system. The problem occurs when interest rates rise, the value of outstanding debt falls. Longer term debt falls more than short term debt so deficits ensue due to a slowdown in economic activity and an increase in the debt to income ratios. This method would boost GDP growth in the short term but slow down an economy in the longer term.
During contractionary cycles and low interest rate environments, money growth and debt usually decrease simultaneously. This means governments must payout the yields bonds, notes and bills command in the marketplace. New debt and taxes are needed to retire old debt and service the new debt. If bond prices are not rising and governments are only paying yields, this ensures further contractions and a lengthening of the cycle. Why the debt tripled between 1943-1946 was investors didn’t want to buy bonds whose prices were decreasing. Investors can’t earn money on yields alone. Yet as long as money growth equals debt, no monetization occurs.
Its important to watch the amount of debt and length of maturities offered by the Treasury. For the most part, equal maturities were traditionally offered in the 2, 10, and 30 year bonds and 13 week T-Bills. Watch for any changes to this dynamic as money growth to debt will change. Also watch prices of these various instruments. You don’t want short term debt to pay more than long term debt. This presages a wholesale change in the growth to debt ratio. Be especially careful of big demand for shorter term debt because this may crowd out longer term capital. This is called debt neutrality or the Ricardian Equivalence named after David Ricardo the famous 18th century economist. Debt neutrality can be viewed as Treasury issuing more shorter term debt than longer term maturities. The purpose is twofold. To hide deficits or, as in years past, to keep inflation and employment low. While net debt issued may have been equal, the long term effects can be devastating to an economy.
Lastly, be aware of fed statements as monetary policy can only target money supply or interest rates. Understanding money growth to debt issues will help those understand their direction.
November 2009 Brian Twomey
Brian Twomey is a currency trader and Adjunct Professor of Political Science at Gardner-Webb University