In part two of this series, we explore how households, businesses, and banks can opt out of the national debt scheme. We also examine how central banks and governments monetize debt with quantitative easing.
Show Notes
Different types of central bank insolvency and the central role of seignorage by Ricardo Reis
Can the Central Bank Alleviate Fiscal Burdens? by Ricardo Reis
Ricardo Reis Tweets on Monetizing the National Debt
M2—Federal Reserve Economic Data
Assets: Total Assets: Total Assets: Wednesday Level—Federal Reserve Economic Data
A Complete Guide to Understanding and Protecting Against Inflation—Money For the Rest of Us
A Complete Guide to Investing in TIPS and I Bonds—Money For the Rest of Us
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Related Episodes
National Debt Master Class Part One
Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 478. It’s part two of our national debt master class.
Four Debt Principles
Last week, in episode 477, we reviewed four principles when it comes to the national debt. First, the debt will never be paid off. Second, governments can control the terms of its debt issuance, including the interest rate.
Three, government debt doesn’t crowd out the private sector’s ability to borrow and invest. There isn’t any crowding out. And four, that doesn’t mean governments get a free pass. There are consequences to government borrowing and government money creation. Too much of it can overwhelm the private sector, leading to inflation.
In that episode, I shared portions of Money for the Rest of Us episodes that were released in 2014 and 2017, and I would characterize those episodes as I wasn’t overly concerned about the national debt.
This week though, I’m sharing portion of episode 295. It was released in April 2020, during the pandemic lockdown. We watched as the Federal Reserve and other central banks took unprecedented action to monetize the national debt, but also purchase other assets such as corporate bonds and ETFs.
The Impact of QE
In that episode, we shared how governments and central banks can get into trouble if households and businesses don’t want to hold the currency, or are worried about currency devaluation or debasement, or inflation, and how that could potentially lead to central bank insolvency. That hadn’t really occurred to me, at least specifically how it could happen, until I released episode 295 in April 2020. And I pulled from work by Ricardo Reis, who was an economist and professor at the London School of Economics.
I said some things though in that episode that weren’t entirely correct. I shared a tweet, which was correct, by Reis, where he said, “Is the explosion in the central bank’s balance sheet a sure sign of monetization of the debt, and future inflation?” Again, this was in 2020. Reis continued, “No, it might or might not. It depends on the monetary and fiscal policy that will follow.”
Well, there was massive fiscal stimulus and continued massive quantitative easing that led to inflation, as we’ve seen. But back then, in April 2020, I said it depends on how much money is flowing into the economy. Right now, all that quantitative easing is just ending up on the Federal Reserve’s balance sheet as assets. It ends up as reserves, as the liability. In other words, the Treasury bonds are the asset, and the reserves on the Federal Reserve Bank’s balance sheet is the liability, which is also an asset of the commercial banks.
I continued, “The person that sold the Treasury bond or other assets gets cash, which they may spend”, but it was an asset swap. I imply there was no inflation impact of quantitative easing. And that was incorrect because if a country is running a budget deficit at the same time the central bank is purchasing bonds as part of quantitative easing, that increases the money supply, and private sector net worth. And we saw it happen before our very eyes, as the money supply increased by 40%.
I just hadn’t made that connection before, in April 2020. But by May 2022, in episode 388, I had, and I share an example, that I’ll replay this episode, of how that works. Go back to the basics, step by step, so we can truly understand that principle.
There are potential negative ramifications to quantitative easing and an ever-growing national debt. So this is part two. At the conclusion, I’ll give a preview for what we’ll be covering in part three.
National Debt Concerns
We’ve had a lot of discussions on the Money for the Rest of Us Plus forums recently regarding actions the Federal Reserve is taking and the federal government, most of which are necessary in order to combat the economic shutdown related to the pandemic.
But there’s also some concerns. Here’s a few quotes from members. “When you hear about debt in the trillions anymore, it’s beyond mind-numbing. How can this be sustainable? But the debt is generally measured in dollars, trillions of dollars, and it is got awfully high. But a dollar is a unit that is not fixed. A milliliter never changes. A cup never changes. But today’s dollar is not 10 years ago dollar, or 50 years ago dollar. Maybe it would be better to hear we are 170 billion Benjamins in debt, maybe.
I think a better unit is percent of GDP. That is really the only way you can compare debt over time. How about debt versus GDP after World War II versus now? The federal debt, publicly-held debt as a percent of the economic output in the US, gross domestic product or GDP is 106%. Back in 1948, it was 119%. So we are below that level. Japan’s debt to GDP is over 200%.”
Another member wrote “Rumors and stories about the Federal Reserve possibly buying equities to stabilize the prices should the need arise causes me to recoil. It seems to me that price discovery and evaluating the true value of assets would be difficult. As an investor, that gives me pause about equity investments. But it’s really no different than the Fed buying bonds at the end of the day. And for some reason I don’t recoil as much at that action.”
And finally, another member wrote, “We don’t have free markets anymore if the Fed buys everything at some arbitrary price and eliminates price discovery. At some point, the government owns so much of the market that we no longer have a market economy.”
So are there limits, and what are those limits? Can the Federal Reserve go insolvent? Can the Federal Reserve monetize the national debt? Is there really a free lunch available that somehow this can be done?
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