A government faced with financing its deficits in quantities some multiple of private saving must resort to monetary schemes in order to keep its promises to spend. Monetary schemes are essentially costless ways to pay the government’s bills today while ignoring long-term consequences. Understanding the schemes reveals them to be disarmingly simple, but effective.
Some varieties of these schemes include monetization of Treasury debt, monetization of Treasury coin and Treasury currency.
Monetization requires the Treasury to issue something (debt or coin) that the central bank purchases from the Treasury with dollars, which in turn provides the dollars to the government to deliver on its spending promises. In both monetization schemes, consolidating the balance sheet of the government and its financing arm, the Federal Reserve, reveals dollars outstanding as a liability and government investment items purchased (such as infrastructure) as an asset after the financing is accomplished and the money is spent.
The rest is spent for consumption items with no remaining asset to put on the consolidated balance sheet. In both cases, with each occurrence of monetization, the government becomes more upside-down (insolvent) as long-term asset accumulation is but a fraction of its additional liability issuance.
To make the debt not just saleable but also costless, the interest consequence of the sale of the debt held by the Fed is negated. This occurs when the Fed, as the owner of the debt, is paid interest by the Treasury (ostensibly from tax proceeds) which it in turn remits to the Treasury, less their costs of operation. How convenient.
This renders the net interest carry paid by taxpayers inconsequential. With the Treasury issuance of coin, interest is not paid and hence there is no need to tax in order to make an interest payment — and hence, there is no need to remit interest. Thus the Treasury coin sold to the central bank is almost the ultimate in costless government finance.
But yet there is another way to accomplish costless government finance and make it even slicker with less fanfare. This would be Treasury currency issuance that doesn’t involve the Fed at all — nor does it involve selling anything or collecting interest payments. In this scenario, Treasury (not the central bank) prints currency to make good on the government’s promises.
This was done during the Civil War and continued up until 1971. The legislation is still in place, but it would require some fine–tuning, such as eliminating ceilings on issuance of Treasury currency. However, that strategy could become a political nightmare if it is exposed as an end run around the debt ceiling because, by law, Treasury currency is considered to be infinite-maturity, zero-coupon debt. What could produce less friction than Treasury printing cash and making good on the promises to spend, without the need to involve or embarrass the Fed, struggle to sell its debt, or pay interest?
In another dimension of Fed support of Treasuries and the housing market there are ongoing QEs in which the Fed is also purchasing market debt from investors in the public capital markets. Investors who sell securities to the Fed receive cash, which puts them in a difficult position: They would have an investment mandate to earn positive returns in a Fed-induced zero interest rate (ZIRP) financial market environment.
This drives some investors into purchasing foreign assets, which turns the Fed QEs into a global Currency War in the following way: Converting dollars to another currency in order to participate in foreign financial market investments sends the foreign currency price upward relative to the dollar. While these countries might be momentarily pleased by the interest shown in their securities and currency, the capital inflow stiffens their currency values, making exports a more uphill proposition.
The central bank, not wanting to lose what they consider to be their fair share of net exports and trade surpluses, responds by selling its currency into foreign exchange markets. That is to say, the Fed’s QE goes global when foreign central banks seek to offset their currency appreciation, which is fought off with more money issued by foreign central banks and sold in the foreign exchange markets. Japan is the latest recruit in reacting to the Fed, and from all indications, it plans to do so in a big way.
This is the Currency War that is now gripping many countries across the globe. And the recent developments with the Fed’s QE are not the first cases of this happening. Bergsten and Gagnon of the Peterson Institute indicate that 20 countries have been in the currency manipulation business to their advantage for some decades, but that has increased recently due to Fed QEs.
Now monetization is ramping up again with QE3, giving more reason for foreign currency offsets to the Fed’s QE. The recent G-20 meeting to discuss Currency Wars resulted in a conclusion to continue with currency intervention but not talk about it in public and keep it out of the press.
However, despite stonewalling and denials by governments and central banks, we know foreign currency appreciation is being offset simply by observing the balance sheets of the foreign central banks that accumulate foreign exchange reserves.
These assets held by foreign governments or central banks are the byproduct of currency intervention, which can’t be brought back home as it would offset their currency offset. In many instances, their purchase of U.S. dollars in the foreign exchange market gives them the dollar purchasing power to in turn purchase U.S. Treasuries — and they did so to the tune of $555 billion in 2012.
Thus the Fed’s direct Treasury purchases — targeted to be close to $500 billion this year — are more than matched by foreign official purchases, so the promises to spend continue to be met. Certainly a half-trillion dollars in U.S. Treasuries purchased by foreign officials is not the byproduct of taxing their own nationals to purchase U.S. Treasuries. While they might love America, it’s not likely to that extent.
So Currency War deniability is necessary in order to contain inflation expectation pricing in financial markets, but it isn’t something that is likely to occur without U.S. acquiescence. Moreover, the U.S. must be in silent support as long as the foreign officials keep purchasing U.S. Treasuries at ridiculously low interest rates that the private market would not tolerate.
So we are off to a Brave New World of money expansion and money supply multipliers that go global. The inflation is likely to first hit in the emerging market countries that are most participating in defending the cheapness of their currency and with more limited excess supply capability of producing goods. Brazil, for example, has an inflation rate above 6% and rising. Their inflation becomes imported inflation to the otherwise deflating developed countries stuck in economic and financial distress.
Certainly an investor needs to be Brave in this New World of interactive monetary policies that struggle to make good on the government’s promises.
For a video version of this discussion go here.
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