The mechanics of debt monetisation
- Why debt monetisation may not be feasible for the US

Robert Wutscher
The Shadow Economist
Jun 15, 2010

In this article I attempt to delineate the consequences of monetising a) existing and b) future public debt. More importantly I will show why such a controlled measure proves politically unpalatable for the US. I also deal with what many would consider as monetising bank debt and show how it falters on the double-edged sword of bank intermediation.

In previous articles I tried to show how increased money printing (defined in the literal sense and not the metaphoric sense loosely employed by many pundits) can lead to monetary deflation once the level of private debt has become unsustainable. This was seen to hinge on the fact that money withdrawn from the banking system as paper would merely prove to be a substitution for digital or IOU backed deposit currency. An excess of private debt was also shown to be one of the primary preconditions for a reversal of the money multiplier process. Up to about 2008, the money multiplier has been working in ever higher forward gear. This has been so since the end of the last Great Depression and especially since the severance of the link between money and gold.

It should be conceded that recent central bank policies are different to policies of credit creation that preceded 2008. Many pundits, however, assume that these policies are merely a “desperate” extension of existing policies (“solving debt with more debt”). No consideration is heeded that the mechanism which may have caused the 98% decline in the purchasing power of the Dollar since the establishment of the Federal Reserve may now be broken.

It is this authors contention that it is not primarily the credit creation policies of the Federal Reserve that will eventually bring it down, but the change in circumstances surrounding the end of the “willingness to lend and borrow” on the part of the private sector. It is then, when the money multiplier process begins to work in reverse gear, that the actions of the Fed will be negated and its intentions bring about opposite effects.

The test of whether the unprecedented post-2008 policies will have the same inflationary effects or not, as prior policies have had, cannot be verified by the historical data. The validation still lies in the future. The recent private credit contractions being experienced is not helping the cause of the inflationists, even if these are only to be regarded as temporary setbacks or something that can be swamped away with public credit (to which the conclusion now emerging in the minds of inflationists must be that it was not yet enough and even more must be inevitable).

Lack of historical experience is no excuse for not being able to derive foresight. However, those claiming foresight primarily on the basis of history must be seen to be at a disadvantage (for example, by means of linear extrapolation of historical trends or observation of historical correlations - a common mistake incurred by many economists and all those who base their underlying philosophy on material determinism or the belief that Newtonian concepts of mechanical cause and effect apply equally to the social sciences).

Before continuing it is necessary to agree on a definition of debt monetisation and to distinguish it from its cousin, debt forgiveness. Too often the term is loosely employed by pundits, substituting for policies considered to be “effectively” the same as debt monetisation (as in having “substantially” the same effects), without mincing any further mental energies on subtle differences or possible misconceptions.

Debt monetisation is the substitution of “existing” debt with newly created money where

a) the debtors are released from all obligations to repay and service their debts and

b) creditors are effectively repaid with the “new” money.

a) The implications of monetisation are that debtors are let off the hook/have their slates wiped clean and can make a new (unencumbered) start. The effects are essentially the same as debt forgiveness from the partial perspective of the debtor.

b) The implications to creditors differ substantially from those arising from debt forgiveness. Under debt forgiveness, creditors incur an instant loss of wealth. Under monetisation they are recompensed with instant liquidity. The distributary effects are vastly different in that creditors end up with a greater proportion of purchasing power (all the new money) under monetisation.

I assume that when pundits claim monetisation, a lot of the time they are not referring to existing debts of the public sector, but either to

a) newly issued public debt (including rollover of existing debt maturities) in which it is assumed that the government maintains the fiction of having to pay interest to the Fed, where it may as well have printed the money without liability and handed it over to the Treasury directly or

b) bank credit assets (private debt) sold to the Fed.

I shall therefore have to deal with these two objections by allowing for a slight contortion of the above definition of monetisation where

a) would correctly be termed money printing if the fiction could be dropped and

b) monetisation cannot be considered complete (or even properly started) when it is realised that no net change of purchasing power has been effected in the overall economy. This would remain so until the new money can be made to leave the bank vaults through voluntary private lending and borrowing. To see this in perspective, one first has to recognise that a bank constitutes an intermediary for credit and not one-sidedly as a creditor. The ultimate creditors of banks are depositors (the liability side of their balance sheets). I ignore for convenience of exposition the thin margin of equity that may or may not also be residing on the liability side.

Public debt forgiveness without monetisation

This would have to be enforced by decree and would constitute overt wealth redistribution and confiscation (of the wealth of creditors). Disaffected parties would not only be foreigners and their central banks, but also for example, pension funds and anyone holding wealth in what was for a long time meant to be considered as the lowest risk investment.

Third world debt forgiveness programs have worked in the past because creditors were largely constituted of banks and the economic environment was generally supportive of credit inflation. The banks could be made to agree on loan write-downs if this was to result in a resumption of new lending (possibly together with other concessions from central banks, their governments or their accountants). Better to earn interest on new loans than nothing at all on delinquent ones. Banks make a lot more money on intermediation through the expansion of credit which will always be preferred to steady (rolling) or contracting credit.

Any bankruptcy procedure is effectively a debt forgiveness scheme, albeit an involuntary one. Such procedures also work well during inflationary periods (and are healthy occurrences in correcting entrepreneurial errors), but are devastating to bank balance sheets during deflationary times. Credit contraction, once the conditions are ripe for it, is not a once-off event, but continues unabated until overall private debt levels reach sustainable levels and confidence is restored. This is because when a loan defaults, the bank is constrained from new lending until sufficient other loans have been repaid to restore its liquidity ratios. Such repayments mean a decline in overall bank deposits (as deposits are needed to be withdrawn from somewhere else in the banking system to repay loans) which in turn leads to further pressure on banks to refrain from extending loans.

I leave the reader the task of weighing up the feasibility of a voluntary debt forgiveness scheme for the US. How can agreement be reached amongst its disparate group of creditors and how can they be appeased or what consolation do they get?

Monetising the existing public debt

It is an illusion that debt monetisation benefits the debtors merely because they are let off the hook of repaying their debts. Only in the case of debt forgiveness would this be true. Monetisation implies that the holders of those debts don't lose out either. The creditors are recompensed with money, substituting their perceived loan instrument valuations with instant (new) liquidity. The debtors are, however, ultimately left with nothing. Yes, they are wealthier for lack of their debts. But to the extent that their debts (application of funds) have already been consumed or their returned collateral have fallen in value, they are left with nothing. The creditor on the other hand is given instant liquidity in return for what could have been an illiquid or unredeemable debt instrument. A redistribution of wealth in favour of creditors will therefore have occurred. As a large proportion of the US's creditors constitute foreigners, such action would lead to an impoverishment of the American people.

If most of the creditors are foreigners, why would the US grant them this instant advantage in competing for current and future dollar resources? Wouldn't it be wiser for the US to let foreigners squirm about how they are going to get value from their bond holdings, without causing a crash in those very values if they wished to cash out all at the same time?

Monetising new public debt

This appears to be the path attempted through current policies of quantitative easing to the extent that the Federal Reserve may have purchased government bonds directly from the Treasury and not from private individuals. Otherwise (if purchased from the public) this would have constituted “normal” open market operations for the purposes of increasing liquidity. But for this to count definitively as monetisation, the government must be under no pressure or obligation to pay interest or to have to repay it at a later stage.

It appears plausible that only in this case can debt monetisation be carried out without “giving away” too much to existing creditors, at least not overtly. The problem then becomes one of what the recipients do with the proceeds of the new money (i.e. after the government has spent it on services and payroll costs). Do the recipients go out and spend the additional money to drive up prices or do they (have to) use it to pay off some private debt obligations first? If the latter, then as I have argued previously on this website, deflation triumphs despite the metaphoric money printing.

Or to discard the above question in favour of another: are existing private debt levels not already heavy enough a burden so as to act as a black hole against reflation attempts? (1)

Monetising private debt through bank recapitalisation

There are a number of reasons why banks are finding it hard to launch a program of new lending on the basis of the new money provided to them by the Fed. Money that has been provided in substitution for delinquent loan assets.

There appears to be a general principle at work that if a bank fails, the remaining banks become stronger. This is because under deposit insurance, the depositors of failed banks get to redeposit in any of the surviving banks. The loan assets of the failed bank go into a purgatory of insolvency procedures outside the “liquid” banking system (or are partially taken over at “cleaned up” values that do not impinge too much on the solvency ratios of the surviving banks).

It is therefore in the interests of each individual bank to ensure that they are not the next marginal bank to fail and to hope that enough other banks fail first in order to redeem themselves. For this reason, the willingness to re-lend will only be made to the most creditworthy of borrowers. Under current economic conditions, where survival is indeed under threat, survival takes precedence over income generation through credit expansion.

Unfortunately for the banks, the most creditworthy are often not the most willing to borrow in a potentially deflationary environment. A complete mismatch between willing borrowers and lenders emerges.

Another problem alluded to in the introduction is that when viewing the bank as a credit intermediary and not one-sidedly as a creditor, the new money on the balance sheet of the bank does not represent purchasing power. In their role of credit intermediaries, banks cannot spend nor can they consume. Therefore any “monetisation” through the banking system can only be effective if it can find its way into circulation. As far as our current monetary system is designed, this can only occur through an act of voluntary lending and borrowing through the private sector. Forcing it becomes pushing on a string.

However, the complexity of the problem does not end here. I would like to illustrate how this form of perceived “monetisation” folds back onto the Fed by using the example of the purchasing of mortgage securities by the Fed.

Assume Joe is underwater on his mortgage and decides to walk away “debt free” from his house by simply handing over the keys. Though he is saved from repaying the loan (a form of debt forgiveness), he is also without the asset (his former house). The Federal Reserve (who has bought the mortgage loan from the bank) is ultimately left with an empty house at a suspect market value on its balance sheet.

Many pundits consider the sale of the loan from the bank to the Fed as constituting a form of monetisation. This is because the banks have succeeded in converting an illiquid loan asset on their balance sheets into readily loanable “high-powered” money. It is further believed that we need only wait for an overnight kick-start to the motor of money velocity. This idea is often encapsulated by the phrase “hyperinflation is a monetary event, not an economic one.” Though it sounds good, this author struggles to fathom what exactly it might mean. (2)

Returning to the dilemma being faced by the Federal Reserve. It believes that it can ultimately resell the house (or preferably the overlying debt security) at a value close to that of the money originally passed to the bank. It will furthermore be able to do so without having to carry out any forced liquidations (which would only depress values).

For the sale at nominal (original) values to work, Joe would have to find a job in which he would prove to be as creditworthy as he claimed to be (or as the banks assumed he was) at the time when the bank originally granted his mortgage pre-2007. To the extent that all the Joe's can never lay claim to a better job or higher income as originally claimed or assumed, it becomes difficult to mathematically prove how the value of the marginal supply of houses built on the back of the former credit expansion can equate to the original value passed between the Fed and the banks.

If sold at lower values, it would merely prove that collateral values were formerly too high and provide further reason why banks are finding it hard to extend loans for lack of collateral value in the broader economy. If sold at higher values (unlikely, but assuming the inflationists win their argument), net credit contraction would be a direct consequence as liquidity would be withdrawn from the market (thereby putting the lid back onto the inflationists' argument).

Concluding remarks

At this point the reader may well be asking what solution I may be proposing to the current debt conundrum facing the world. Solutions that may have seemed simple from a superficial understanding of the above options suddenly appear insurmountable. Perhaps I am to be accused of overcomplicating things, whereas we are supposed to conform to a “keep it simple” model of the world.

The free-marketers are relatively easy to satisfy with an answer. They would be able to infer a justification for simply not doing much from the above: let the process of debt contraction take its natural course to weed out the errors of the past and remove all obstacles in the way of the free market. One of those obstacles is the Federal Reserve and to free market pundits, the market has never really been free for as long as there has been a “central” bank.

Without inadvertently opening up any objections from free market pundits, except perhaps from a conviction that only an inflationary outcome is deemed permissible (as I believe most free market pundits to lie in the inflationist camp), I hypothesize that the answer may lie somewhat outside the field of economics involving a change in social values.

One has to be prepared to ask awkward questions such as why are we experiencing these problems not only socially, but in each of our personal lives, not from a narrow economic perspective, but possibly from a “moral” or “value” perspective? Admittedly this may require a jolted change in underlying philosophical outlook, especially if we are to do so without merely projecting scapegoats out into the world. How have our values evolved from that of our parents and grandparents and to what extent are these appropriate to our new world of the internet and instant connectivity? I believe the changes facing us today are far more monumental and space in this essay does not permit me to attempt an adequate answer.

I have alluded to how our values have become inverted in previous essays. I believe that what is required is not merely an economic plaster to our woes, but a forceful overhaul of institutional and political arrangements as well as general ways of doing things and going about in our lives. I fear that for now a fight is on between an extension of old centralised institutionalised patterns of authority and new ones founded upon a more decentralised network approach aligned with the new information era. Part of the economic problems we are facing today and their eventual resolution may be necessary to effect this change. Were it not for our current economic travails, we may simply have continued along, complacent in our habitual and inappropriately evolving ways, based on patterns more appropriate to former eras. The more we can recognise this, the less traumatic this change needs to be. Seen in this light, our economic problems are largely a reflection of our underlying “values” and how inappropriate or inadequate they have become in conforming with our present stage of social evolution. We are failing to keep up with the change in the times and the changes required from each of us. (3)

Notes and references:

(1) See “Why the Fed will fail”, Dec 22, 2009 where I show mathematically by reference to interest rates how the “black hole” effect works through a loss in traction of inflationary policies.

(2)To be fair to these pundits, here is my attempt: It is a monetary event primarily because of an inherent lack of restraint on the part of the monetary authorities to print unlimited amounts of fiat currency at all times and everywhere eventually. The day then finally arrives when people wake up to the realisation of what the authorities have done to their money and people find themselves holding increasing amounts of paper money relative to a possibly dwindling supply of economic goods. By the “not economic” part is simply meant that one should not try looking for non-monetary reasons.

What this view fails to fully comprehend is how money is actually created in today's monetary system. Pundits speak loosely about money printing and to their credit believe that whatever the basis upon which the money supply has grown, it must “in effect” be the same as literal money printing. To their disingenuity one can aptly say that the devil lies in the details. Readers are referred to my previous essays on the money mechanism and how today's money creation differs from that of say Weimar Germany's.

(3) A reader has recently referred me to the two philosophical novels written by Robert Pirsig which resonates with what I have to say about values and what Pirsig also refers to as “Quality”. Though I am only halfway through his second book (where the resonance is greater), I can nonetheless recommend his books. These appear to be emblematic of the late 1960s revolutionary era (for which they became best-sellers). Some traces of perhaps unresolved (or undigested) philosophical issues of that time may be resurfacing today. Though the second book is the more philosophically involved, they have to be read in sequence for a full appreciation.

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Jun 15, 2010
Robert Wutscher
The Shadow Economist
email: rwutscher@telkomsa.net

The shadow economist, Robert Wutscher, is a retired financial due diligence specialist who has taken up the study of economics. His study has turned to the shadow side of economics: what most economists ignore, suppress or fail to account for in their models under the light of mainstream economic consensus methodology. A rich resource exists in many old economists who have passed away with insights that do not sit comfortably in today's quantitative models and with warnings/lessons of the past going unheeded. The modern consensus methodology is primarily based on quantitative methods and generally considers only economic aspects and assumptions that are amenable to quantitative analysis, even if this can only be done with abstraction of reality or of the mathematics itself. It ignores other concepts essential to human decision making, that may be too hard to quantify and that may be hidden in the shadows of the aggregates and averages that form the edifice of macroeconomics and econometrics.

He welcomes constructive criticism. He can be reached at rwutscher@telkomsa.net

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