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What does it mean to “finance government spending by purchasing bonds”?

Summary:
Here’s the Financial Times: Torsten Sløk, a Deutsche Bank economist, pointed out the US central bank is not only under pressure from the White House, but also from progressive economists and lawmakers, where there is a growing belief that central banks can help finance extra public spending by purchasing government bonds, without triggering dangerous levels of inflation. I see this sort of thing quite often.  It’s not exactly wrong, but it’s so misleading as to be the moral equivalent of wrong. Debt can be monetized in two ways, by using newly printed currency to purchase T-bonds and by creating zero interest reserve accounts at the Fed and exchanging them for Treasury bonds in an environment where market interest rates are positive.  In contrast, creating positive interest

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Here’s the Financial Times:

Torsten Sløk, a Deutsche Bank economist, pointed out the US central bank is not only under pressure from the White House, but also from progressive economists and lawmakers, where there is a growing belief that central banks can help finance extra public spending by purchasing government bonds, without triggering dangerous levels of inflation.

I see this sort of thing quite often.  It’s not exactly wrong, but it’s so misleading as to be the moral equivalent of wrong.

Debt can be monetized in two ways, by using newly printed currency to purchase T-bonds and by creating zero interest reserve accounts at the Fed and exchanging them for Treasury bonds in an environment where market interest rates are positive.  In contrast, creating positive interest bearing reserve accounts does not provide revenue for the government, it merely swaps one debt for another.

As a practical matter, in a world of positive interest rates about 98% of debt monetization is cash for bonds, and 2% is the creation of non-interest bearing reserve accounts at the Fed.  So as a first approximation, when people talk about financing spending by monetizing debt they are talking about buying Treasury debt with currency.

If you are willing to tolerate hyperinflation, then you can use money printing to finance spending up to roughly 3% or 4% of GDP, at most.  If you are not willing to tolerate hyperinflation (and we are not willing to), then the amount of spending that can be financed by printing currency is trivial.

If bonds pay positive interest rates, then banks don’t want to hold large quantities of zero interest reserves.  If the yield on T-bonds is zero then banks are willing to hold large reserve balances, but in that case swapping zero interest base money for zero interest bonds doesn’t finance anything.

So yes, you can finance spending by printing boatloads of currency when interest rates are positive and create high inflation.  That’s a tax on money holders, which is every bit as unpopular as any other tax.

I wish people would stop talking about this option; it’s simply not important in the modern world.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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