Redefining monetizing government debt

Daniel Thornton of St Louis Fed has an excellent note on the topic.

Monetizing debt implies central bank buys bonds of the government by printing currency. This was a common practice a few years ago leading to hyper inflation etc. Central Banks were not independent entities and seen as agents of government. Then  came central bank independence and we had a focus on price stability. Then came this crisis and questioned everything under the sun. Central banks were again buying government bonds leading to questions over monetisation of debt.

Thorton says we need to re-define debt monetization concept. What matters is the purpose for which central banks are buying debt.

 The idea that the Fed monetizes government debt by the simple act of exchanging money for government debt is too narrow and uninteresting because the Fed conducts monetary policy primarily through open market operations— buying and selling securities—most often government high-powered money (also known as the monetary base) increases.

 When it sells securities the monetary base decreases. If “monetizing the debt” is defined as the act of converting government debt to money, there would be no reason to ask, “Has the Fed monetized the debt?” The answer would be simple: “Yes, every time it purchases government securities.”

Now, we cannot call this monetisation of debt. This is how Fed (and other central banks) conduct monetary policy.

He suggests that an economically meaningful definition of “monetizing the debt” must be based on the Fed’s motive for increasing the money supply. If Fed buys bonds for its normal monetary policy operations, it is not monetization of debt. However, there is a problem trying to differentiate between motivation aspect versus actions taken by the Fed.

First, it is difficult to determine whether debt purchases are solely driven by the Fed’s policy. Second, the Fed increases the monetary base whenever it purchases any asset—not only when it purchases government debt. This increase in monetary base could be used by private sector to purchase govt debt. So a central bank does not really need to buy govt debt to monetize it. It can do it via indirect ways as well.

So what can be done?

The only effective way to determine whether the Fed (or any central bank) has monetized debt is to compare its performance relative to its stated objectives. Many central banks have adopted a numerical inflation target. If inflation is running above the target when the government is faced with a debt-financing issue, one might suspect that the central bank is monetizing the debt. The Fed has not adopted a specific numerical inflation target, which makes it more difficult to determine whether its actions are purely motivated by its policy objective. In general, the more explicated a central bank is about its policy objectives, the easier it is to determine whether it is monetizing the debt.

A great thought to work on. The crisis has create a lot of damage but it is helping redefine and rethink economics in a big way.