Yesterday the Federal Reserve announced that it was going to purchase $1 trillion in long-term Treasury bonds and government-guaranteed mortgage-backed securities (source). The money used to purchase these obligations will be created electronically. How can we understand this?
Consider Zimbabwe. The government there can’t raise enough tax revenue to pay its expenses. The government there can’t borrow from foreigners at attractive rates and certainly can’t borrow in its own currency. How does the government pays its bills, then? Zimbabwe’s government goes to Germany and contracts with a printing company to create some local currency, which it then hands out to government workers and contractors. The result was that the Zimbabwe local currency became worthless (source).
Let’s return to the U.S. Our government can’t raise enough tax revenue to pay its expenses. Despite skepticism from Chinese investors, we can still borrow money in our currency. We take money today from investors and issue them a long-term Treasury bond, a promise to pay them back sometime between 2019 and 2039. Our government uses the money from the bond sale to pay employees, pensions, and contractors. Until yesterday, we were spending our grandchildren’s tax dollars.
The Fed steps in and buys long-term Treasury bonds from whoever is currently holding them. The government has thus effectively purchased its own obligation using newly (electronically) printed money. This new money competes with money that people (a.k.a. “the chumps”) had been saving. The government is indirectly spending money that people were saving in bank accounts, money markets, and other cash equivalents.
How is this different from Zimbabwe? They did their printing in Germany. We do ours inside a computer at the Fed. Zimbabwe paid printing charges. The U.S. government pays Wall Street commissions: an investment bank collects fees when the Treasury bond is sold to a customer and then probably collects some more fees when the same bond is sold back to the Fed.
Not that I’m excited about any of this, but isn’t there is another crucial difference? The Fed is buying debt with that printed money. Presumably, they can reverse that infusion of liquidity in the future by selling it back. I think that makes it much different than what Zimbabwe did. I hope so, at least…
Whether the Fed is buying debt or doughnuts, it is doing so by *creating* out of thin air the money to buy it with. All the remaining money is worth that much less, especially as the market eventually, as always, begins factoring in the devaluation.
Jonathan,
That would be true if the debt that the Fed is buying is real and has value. Something that you can touch and know won’t depreciate to zero over 10-20 years.
— George
What’s the difference between a firecracker and a nuclear bomb? The difference is a matter of scale. The US government has been slowly devaluing the dollar for decades by a few percent per year, but Zimbabwe did it on a massive scale, 50%/day or something absurd like that.
I’m all for picking up the pace. The government will never be reined in as long as foreigners are willing to lend it money, so worse is better. I’d rather see Chinese bondholders get screwed than our children. And, as a typical American, I have no savings, so it’s no skin off my nose.
(I accidently submitted the previous post prematurely.)
This technique for printing money is euphemistically called “quantitative easing”.
It’s worth noting that as long as the interest rate of our government debt is zero, the Treasury can essentially print money on it’s own. Treasury bills with a zero interest rate are interchangeable with cash. Regardless of whether they are long term or short term, when they come due the Treasury can always pay for them by issuing more T-bills. If the interest rate is still zero when they come due, then it doesn’t cost the Treasury anything to roll over the debt.
Debt obligations are worth exactly what borrower can provide in goods and services down the road. Zimbabwe’s debt is meaningless, despite once being the breadbasket of Africa. The USA obligations are just worth, for the moment, what those obligations can purchase in what is left of America’s industrial capacity.
Hey Phil,
How do you think the fed controls interest rates? It’s by printing money and buying bonds with the printed money. This is why the money supply goes up every year, because the fed creates artificial demand for bonds by buying them with printed money. It’s also why we have price inflation, even though labor productivity keeps going up, and so otherwise we would have consistent deflation. We see this consistent deflation in electronics for example, where the pace of productivity improvement is even faster than the fed is printing money, but not in agriculture, where productivity goes up, but not as fast.
The only difference here is that the fed normally buys short term bonds rather than long term ones. They’ve effectively run out of short term bonds to buy, as the rate is virtually zero, and exchanging t-notes, yielding zero percent with federal reserve notes, yielding zero percent doesn’t make much economic difference.
What’s the incentive to save and invest now if the specter of hyperinflation is going to destroy it anyway? Or, is that the point?
Hi, I’m a curious layman. I’m wondering what the relationship is between purchasing treasury bonds and inflation. Here’s an example of what kind of answer I’m looking for. It’s my almost certainly oversimplified and wrong, pulled-out-of-nowhere guess:
inflation% = (money supply + new money)/(money supply)
I’m asking because I’m wondering /how much money/ we’d have to print in order to make serious inflation happen. The total amount of cash in circulation is around $1bn, but the total M1+M2+M3+cash supply is around $10bn. If the Fed purchases $1 trillion in treasuries, my naïve estimate says that’ll result in every existing dollar being deflated by a factor of … 100? I’m not sure how much I’ll like paying $300 for my next latte, but on the other hand I guess that’s still 2,310,000x better than Zimbabwe’s situation.
JimmyZ, the way I see it the incentive right now is to purchase as much as we possibly can with fixed interest rates, and then put any savings into something that’s relatively inflation indexed. We don’t have to get a loan for the new car we’re buying, and ordinarily we’d never set up for a 5 year loan for a new car (let alone buy a new car), but with fixed interest rates this low it seems like a good idea…
Tongodeon, thanks, the way you asked that made me realize that the various bubbles bursting has probably shrunk our money supply fairly dramatically, so maybe inflation won’t be quite as huge as I expect.
Hi Tongodeon,
Do you have your data correct? According to the wikipedia (which is based off of data from the Federal Reserve), the money supply is 10 trillion. A back-of-the-envelope estimation is that the Federal Reserve will increase the money supply by a staggering 10 trillion (assuming that the reserve multiplier is 10) which is about a 100% rate of inflation. Of course, my back-of-the-envelope estimation is probably an overestimate since the fed will effectively be buying M1…M3 money and the speed at which money changes hands has slowed down so the multiplier from M0 will take time to fruition. This just confirms that we will be directly inflating our way our of this mess. Yay! a tax on everybody through increased inflation.
http://en.wikipedia.org/wiki/Money_supply#United_States
http://en.wikipedia.org/wiki/File:Components_of_the_United_States_money_supply2.svg
Well here’s some new comment about it:
http://finance.yahoo.com/tech-ticker/article/216311/Part-I-Geithner%27s-Plan-%22Extremely-Dangerous%22-Economist-Galbraith-Says?tickers=^gspc,^dji,c,bac,jpm%20,WFC
I’m astonished that Wall Street has jumped yesterday…..
George:
Regardless of whether or not US debt is worthless, your comment is beside the point. As explained by Krugman, in one of his rare moments of clear thinking when he’s not spouting leftist ideology and dressing it up as economics, the real risk here is that the long bonds purchased by the fed will lose value, and thus they will lose money on the transaction and be unable to mop up all the liquidity injected by the purchases. Still a long way away from Zimbabwe. Degrees matter. Superficial comparisons are pointless.
http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/