Power of Story: Monetizing the Federal Debt

So, just how does the U.S government magically turn the federal debt into an asset of spendable money?

As we discussed earlier, the U.S. Treasury Department keeps most of its money in the Federal Reserve Bank. Checks are written for every government expenditure from this account. Upon occasion, however, those in the government have a very interesting problem: they spend more than they have in their account.

If your personal bank account were overdrawn, you basically would have two ways of covering the deficit. Either you would hurry around and earn enough to cover the amount, or you would find someone who would make you a quick loan. The federal government does not earn money, so it is left with the choice of either quickly levying a new tax to raise the money, or going to the marketplace to get a loan. Taxing is part of the government’s fiscal policy, while adjusting the money supply is part of the Federal Reserve’s Monetary Policy.

But, think about it for a minute: who could lend the government several trillion dollars just to cover the extravagant spending desires of the administration and Congress? Lots of people . . . together, that is! The government does not go to just one source and borrow the money; they make thousands and thousands of little loans in the form of U.S. Treasury bills (T-bills), notes, and security bonds. They are essentially government I.O.U.s given in return for the borrowed money.

In order to assimilate the debt into our system we use a function called monetizing. Many less sophisticated countries simply print the money to pay for the cost of overspending by their governments, finding that form of taxation to be a simpler method. But, as you will recall, increasing the supply of money in the system causes inflation.

We sell the security bonds and treasury notes to our citizens, and also to foreign countries. But that transaction does not inject new money into the system. It would be as if there were 10 dollars and 10 cherry pies in the system. The government wanted one of the cherry pies, but did not have 10 dollars to pay for it. So, it would offer a bond, presuming that there would be one person in the system who would rather have an interest-bearing bond than a cherry pie. So now you have 10 dollars, 10 cherry pies, and 1 bond in the system.

When it comes time to pay back the borrowed money plus the agreed interest on the secured bond or T-bill, the Federal Open Market Committee of the Federal Reserve Bank calls in the note and pays it off. How do they do that? You guessed it . . . with newly created money!

The monetizing process is accomplished by the Federal Reserve Bank issuing a check to the bond dealer, who in turn deposits that check into his bank account. The check, when it is deposited, is credited by the Federal Reserve Bank to that bank’s reserves, and that bank is then entitled to make loans against that new reserve or exchange it for cash.

Why did the Federal Reserve Bank have the right to issue the check? Because it was backed up by the U.S. Treasury I.O.U. that it had just purchased! In essence, what happens in the transaction is that the federal debt—a liability—is transformed into an asset of spendable cash by the U.S. Treasury’s signing of a note! The note is an asset of the Federal Reserve Bank. In other words, the debt of the government has been miraculously turned into spendable money. That’s called Monetizing the Federal Debt!

Monetizing the national debt, by using the intermediate step of issuing bonds, stalls the impact on the economy for at least a year . . . perhaps much longer. But it has exactly the same ultimate effect as if the government did not issue the bonds in the first place, but simply paid its debt with printing-press money or entering strange numbers into a computer. Instead of having 10 dollars and 10 cherry pies and 1 bond in the system, there would now be 11 dollars, 10 cherry pies, and no bond. The outcome is the same as the irresponsible actions of Germany in paying off the war reparations. There is new money injected into the monetary supply that lowers the value of the rest of the money and causes a sustained increase in the general level of all prices . . . Inflation!

When a government overspends, goes into debt, sells bonds and T-bills, it is not a slick process of smoke and mirrors whereby that government creates free money. That government has just set into motion the devaluing of their money and economic system through inflation. The people do not vote on having the value of their money taken away from them, their earnings and equities stripped from them, and their savings stolen from them. The Congress doesn’t even have to vote to raise a tax to accomplish such results. But the silent consequences of extreme and rapid inflation (hyperinflation) are set into motion, as sure as the sunset.

So, just what gave rise to the notion that the federal government could manufacture debt and new money to satisfy the lust of over spending? Next week we will take a look at the interesting paper trail. 

(Research ideas from Dr. Jackson’s new writing project on Cultural Economics)

© Dr. James W. Jackson

Permission granted by Winston-Crown Publishing House