A New Peek at the Secrets of the Fed?
In December, the Levy Institute issued a working paper that asked how the economy might be affected by the seemingly unusual fiscal and monetary policies implemented by the Fed and other central banks since 2008. The authors, Dimitri Papadimitriou and I, used a phrase that is not often spoken in this era by governments and central banks around the world: “monetizing the deficit.” This phrase traditionally describes the practice of financing a government deficit with money that is “printed” rather than borrowed or raised by taxation. We feel perhaps a little more comfortable with our use of these words in light of a recent blog entry on the Financial Times website Alphaville. The blog reports that the Fed has come close to running out of securities to buy in the markets for certain types of government bonds, having bought so many of them already. Hence, it is increasingly resorting to the purchase of recently issued bonds and notes, which it had apparently sought to avoid. This development makes the link between deficit spending and monetary policy initiatives such as the current round of “quantitative easing” in a monetary system like ours easier to grasp. If the Fed buys a Treasury security almost immediately after it is issued, there is less reason than ever to think of the financing process as anything other than the use of the Federal Reserve’s “printing press” to pay for government operations–an essential use of “monetization” to stimulate the economy and avoid drastic fiscal measures during a time of weak tax revenues. Some worry still, but this practice has been used many times by numerous governments around the world and seems unusual only in light of common but unrealistic beliefs about monetary systems and how they normally work. Hence, those in Congress should not give credence to arguments that it is necessary to eliminate entire government programs or freeze major parts of the federal budget in order to restore some fanciful state of budgetary normalcy.
February 10 addendum on recent news: A short and interesting article on the implementation of quantitative easing policies was posted very recently on the New York Fed’s website. The article mentions changes in the composition of the Fed’s asset purchases, including the recent increase in purchases of newer issues that was reported in the Alphaville blog entry linked to above. On the other hand, the new piece, based on a speech by a Fed official, finds no evidence that the Fed’s purchases have caused “significant market strains.” The article covers some other important issues associated with the recent policy actions involving long-maturity securities and might be interesting to people wanting detailed information about these topics.
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I do not understand why you would aid and abet the deficit hawks and inflationistas by adopting the obsolete terminology of the gold standard. “Printing money” suggests an increase in nongovernment net financial assets. None occurs.
The Fed does not “print money” under the current noncovertible floating rate system, in which government funds itself directly with issuance and not taxation or borrowing, in spite of fictions erected voluntarily to make it seem so. The Fed issues reserves and the Treasury issues securities in this arrangement, and the reality is that the Treasuries issued as an offset to deficit expenditure simply drain excess reserves so that the Fed can hit its target rate. This is unnecessary operationally and could be accomplished by the Fed paying interest on excess reserves equal to the target rate, or just setting the rate to zero.
What is actually happening when Treasuries are issued in offset of deficits is that reserve accounts at the Fed get shifted to Treasury securities, similar to the way deposit accounts are shifted to time accounts to earn interest. There is no change in nongovernment net financial assets, only their form and maturity. Similarly, when the Fed purchases Treasuries, the net financial assets are switched in form and maturity, with no change in amount. The only change in amount is the shift of interest payment to government when the Fed purchases securities from nongovernment, which is arguably a deflationary influence.
Please lose the confusing term “printing money.” It is unhelpful to understanding the present (post-1971) monetary system.
This is an important issue of terminology, and it has much to do with the definition of money. Of course, many noneconomists immediately think of currency, which in the United States is mostly made up of Federal Reserve notes. You mention reserves, which include among other things the deposits that banks have at the Fed, cash in the vaults and ATMs of retail banks, and any similar items that provide very quick and certain access to liquidity. By most definitions, money includes both reserves and currency held outside of financial institutions. Of course, much of the time money is created immediately after individuals cash or deposit federal government checks at financial institutions: the Fed quickly makes good on such checks by crediting the accounts that banks have at the Fed in the total amount of checks that are cleared with them. Banks’ deposits in these Fed accounts count as part of their reserves, along with some other assets, as explained before. Obviously, this process involves much more than “printing money,” which is why we often use that term within quotation marks. Also, in our writings, we try to explain as often as possible that this term is not entirely appropriate, without belaboring a point that may seem obscure to noneconomists and indeed obscure a lot of other important issues. In fact, we qualify the use of a similar phrase in footnote 3 of the paper mentioned in our original blog entry (WP no. 640). We know you wish to clear up an important and common confusion, namely the notion that the Fed’s open market operations involve merely giving away money of one sort or another; I think you are right to point out that the Fed normally exchanges one asset for another in these operations. However, it was my belief that this point was not crucial in the context of my recent blog post, and I hope I have not confused anyone by the somewhat casual use of a well-worn phrase common in the popular discouse. In fact the intent of the working paper itself was to challenge many unhelpful ideas common in such economic rhetoric and argument.