I’ve been reading a lot of Leonardo Da Vinci lately and what I love about his approach to solving puzzles was his desire to understand what made things work. Da Vinci wasn’t always so interested in solving the world’s problems. Rather, he was interested in answering the questions about the way things worked. I’ve adopted some of this in my approach to understanding the monetary system and I think it’s useful here in expanding on a concept that is very important.
In the “Ask Cullen” section, Chuck asked a question about debt monetization and why it’s different when the Fed buys debt on the secondary market as opposed to the Fed buying directly from the US Treasury. This can be a bit confusing so it’s helpful to perform a brief scenario analysis to highlight some key points. Often, the most extreme environments teach us the most about the way a system works. In this case I will use a hyperinflation. I think this is crucial in understanding why we haven’t been in a hyperinflationary environment and more generally regarding a basic understanding of money demand and operational realities of the monetary system.
The US government finances itself in one of two ways – taxing or selling bonds. It sells bonds when it cannot procure enough funds from tax payments. This is what we refer to as the “budget deficit”. US government bond auctions are well orchestrated events that are designed not to fail. The US government essentially harnesses banks as funding conduits by requiring them to bid at government bond auctions in exchange for being a Primary Dealer. The Fed works in a symbiotic fashion with the Treasury to ensure that banks can settle the auctions while essentially serving as an implicit backstop. That is, even in a worst case scenario the banks can always sell to the Fed or the Fed can buy directly (although this is illegal now). In this regard, the US government can’t “run out of money” or face a solvency constraint like Greece (the US government always faces an inflation constraint), who operates in a monetary system with what is essentially a foreign central bank.
So what would happen in a hyperinflation? First, we must understand that money is ultimately only stable because its demand is based not only on the government’s ability to procure funds ( legal enforcement, taxation, selling bonds, etc) but also because the public is willing to utilize that money (MR calls this quantity value and acceptance value – see here for more). In the case of a hyperinflation what happens is that the demand for money becomes very tight. But its utility collapses. So people stop paying taxes as profits collapse and the utility of money declines. So people actually end up hoarding more money. When the government has to cover its tax receipt short-fall they sell more bonds. But the Primary Dealers can’t be expected to take on all these bonds in a hyperinflation, can they? Why would they collect endless amounts of bonds whose prices are collapsing? They most likely won’t because they’ll weigh the benefit of being a Primary Dealer versus the benefit of staying in business. So the Fed has to step in and buy the bonds. The Fed is like any bank. It can credit accounts at will. So they gobble up all the bonds directly from Treasury. But who cares? The money is already hyperinflated and worthless. That’s REAL monetization. It means the utility of money has collapsed and as a result the demand for bonds by the currency users has cratered.
The difference between this alternate environment and the one we currently face is that demand for government debt is extremely high. Treasury prices are at record highs, yields have collapsed, bond markets remain deep and highly liquid, bond auctions are seeing very strong demand, etc. In other words, there’s no need for the Fed to be buying bonds to fund the Treasury’s account. This form of QE is just good old fashioned monetary operations in an attempt to alter interest rates and other facets of the economy (it obviously hasn’t worked out all that well).
To me, this is a crucial scenario analysis to understand because it highlights the difference between a hyperinflationary collapse and the QE we’ve been seeing, which to me, is just boring old monetary ops and nothing remotely similar to real monetization because the private demand for debt (and US dollars more generally) is still very strong.
Some of the key insights from a little scenario analysis like this:
- Understanding quantity value and acceptance value matters enormously to your understanding of the monetary system.
- QE, as we’ve seen it, is not “debt monetization” since that implies a lack of demand for government debt (or an inability for the government to procure funds from anyone but its own central bank).
- Getting the precise operational realities of the monetary system will help you avoid colossal investment mistakes.
Recommended reading in addition to this: