Monetizing the Debt - Explanation For Non-Economists, Bankers and Other Laymen

Friday, May 08, 2009

As I see uncountable search engine inquiries with the phrase "monetizing the debt" landing at this blog I begin to realize there is a huge void of knowledge not only amongst interested economic laymen but also among employees from what were highly prestigious financial institutions only 2 years ago. Let me fill in with the executive briefing version.
In order to monetize the debt you need the following:
  1. An economy in shatters that cannot produce enough taxes for the state
  2. A parliament/congress/senate full of incompetent politicians eager to continue showering their constituencies with pork regardless of a nation's declining tax income
  3. A people that has never received any macroeconomic education in their schools (otherwise they'd be shouldering the pitchforks by now)
  4. A central bank with a transaction computer running under Unix (Windows would probably crash before any real economic damage could be done)
  5. Commercial banks with executives searching the web for an easily understood explanation of the said term and no idea about monetary inflation either, but a perfect understanding of their contracts sweetened with lavish bonuses, no matter whether they remain prudent or crash the cart against the wall.

Now that we got our most important players together (starving retirees, widows and kids will only appear on the scene after the monetizing-the-debt-party has sunk the world into a depression) we take a punch bowl (literal), fill it with cheap credit and pass it around to everybody except the central bank computer (it has to work hard very soon.)
In contrast to all commodities unbacked fiat money is created at virtually no cost. This is most comfortable as it means the central bank computer can keep the party going.
All that needs to be done are a few keystrokes (maybe they already have macros for the task) and a screen wide enough to accommodate the ever growing number of zeroes after the $/€ sign.
So they enter a number, e.g. €60 billion as the ECB will do somewhen in the coming weeks, and wire this digitally created money to the commercial banks who in return hand over other serious looking papers that are called "securities" as collateral. In our fractional reserve banking system banks can use this central bank money to hand out ten times as much in loans. For 10 money units lent they have to hold one money unit as "reserve," just in case some investors want their deposits back. 
It truly is a thrilling business: Put one money unit in the cash register (for which they currently pay 0.25% (Federal Reserve Notes) to 1% (Euros), let the borrowers come in and lend them 9 money units at anything between 5% (mortgages) to 12% (business loans.) You do the math yourself. It is virtually impossible not to turn a profit, weren't it for the rocket scientists with their Excel spreadsheets who think about new ways (derivatives!) on how to produce still more income that will be paid to them in form of a bonus. This is why the bankers drive Ferraris, but rarely their customers.
If you now wonder, what this has to do with "monetizing the debt," you are right. It doesn't. But it explains that banking would be such a surefire business, had they not hired mathematical whiz kids who came up with those derivatives Warren Buffett calls "weapons of financial mass destruction."
Ok, I will try to continue explaining the original subject in comprehensible words (which is a tough issue, I say after having spent already six hours on this post and far from over.)
So here we go again: As it didn't cost the central bank more than a few cents to create this money/credit but the unknowing hard working public will accept it as compensation for their labour, we are already a step further in the Ponzi scheme called fiat money creation.
Now the politicians have to act plainly ignorant (which should not pose a problem for most of them) and develop still more ambitious spending projects. As their Keynesian advisers had told them that a slowing economy is best countered with stimulating spending they scratch their heads, wondering where the money will come from. Their advisers had missed out on telling them that John Maynard Keynes had also recommended to build reserves during the good economic times.
Diabolic help arrives in the form of a delegation from the central bank that will offer a solution so easy that the politicians immediately jump on their bandwagon.
"If you issue a bond we will buy them for the amount you write on your piece of paper," whispers the pin-striped central banker into the finance minister's (treasury secretary) ear. The politician is jubilant now as this appears to be such an easy game with winners only.
So the Treasury prints a government bond and writes, let's say 100 billion on it.
As the economy has slowed for reasons that fill the long evening discussions of economists, without reaching a decisive answer, potential investors have no more money left to buy this bond.
US Treasuries: The Longest Running Ponzi Scheme In the World
So the central bank creates this wonderful stuff called MZM (Money Zero Maturity) or unbacked central bank fiat money and "buys" (hahaha) the bonds for itself. The state turns around, starts new "growth projects" and is comfortable as it watches the mere mortals without any macroeconomic education working hard in order to get a part of this funnily coloured money.
This game usually lasts for a few years before the broad public starts scratching its heads. They begin to see (or gut-feel) a recurring scheme: Public projects fill almost everybody's wallets but prices are ratcheting up too. That's called monetary inflation as the quickly rising amount of fiat money is spread over a slower growing amount of produced goods and services.
Politicians, eager to keep up economic growth in order to get reelected, will want to keep the game going and issue the next bond, confident that their central bank will - hahaha - "buy" the next issue again with the next round of freshly created fiat money.
This game could go on and on if there were no rational and prudent private bond buyers around. As in every Ponzi scheme the only disturbance arises once these prudent investors want their money back. As the state has no money it will beg the central bankers for the next shot in the arm. This usually works as the central bankers know they are in the end at the mercy of the politicians.
The end of the monetizing the debt game is always the same. This time it will be the Chinese who have amassed so many FRNs (look at a greenback: it nowhere says US dollar!) that they will cozy up to the idea of throwing all their FRN holdings on the market in exchange for some real assets like commodities because the FRNs are only backed by future tax income. But in a recession this tax income shrinks too and therefore this backing is worth less and less.
A truly diabolical circle and we haven't yet touched the next due issue, called hyper inflation...
NOTE: Nothing is more difficult than explaining high finance in simple terms. Please let me know in your comments whether this attempt (after busying myself with the subject since 2001) was useful to you. I will strive to improve as this is the single most important issue in the process of ruining a country.


Rog2 said...

This has been published for a year with no comments? Good explanation, thanks. So does monetizing the debt basically come down to the Fed buying treasuries that the tax payers end up having to pay interest on? We create money out of nothing and assume the interest obligation on the new money?
This link prompted me to learn more about this:

04 May, 2010 16:32

All comments on almost all posts were lost during a layout upgrade of this blog.

04 May, 2010 16:36
Karthik Kumar said...

This is truly one of the best explanations i've ever read anywhere including academic books.

10 May, 2010 11:33
TraderMark said...

Simply, quite brilliant. Top marks for explaining a complex area of finance in a way which is much more fathomable for the average joe out there.

11 May, 2010 13:28
Anonymous said...

I don't see the problem. As inflation becomes a problem, you simply raise taxes (perhaps on the 15% of people who own, literally, 85% of the wealth in the country). This contracts the money supply.

The alternative is to cut spending, and no one wants to stop our wars (too scary, eh), and the increasing number of retirees will fight you tooth and nail for daring to touch their social security.

Thank you for your work on this blog, btw.

10 June, 2010 23:34
FIREBIRD said...

I'll need to read and re-read this to grasp it all - but you keep it interesting with a splash of humor.... I will definitely be back looking and reading more...... and sharing your site with others

19 July, 2011 14:05
Kevin said...


Is it true that exchange traded funds such as for gold and silver suffer the same problem? A banker told me that they have to back each share of gold with that equivalent, but I heard from someone else that they can sell as many as 100 shares (each share of gold being 1/10 of one ounce of gold) for each ounce of gold. Is that correct? If so, what the hell good is an ETF for?

29 July, 2011 21:36
Anonymous said...

This is a great explanaiton of the process. If I understand this correctly it means every "dollar" printed by the Fed comes into existence with the public owing interest on it back to the Fed automatically. Thus the Treasury taxes its people to purchase the instrument that is devaluing their assets (i.e. labor, property, capital etc) and the "organization" that is creating these valueless notes (i.e. fiat money) accumulates huge profits and enjoys cultural and governmental hegemony to perpetuate the economic deception. Banking and financing houses reap huge profits as well accumulating vast supplies of fiat credits. As long as everyone is compelled to accept these fiat notes as tender the bankers enforce their monopoly power to be the sole provider of the nation's money (which as you will recall is a money-making business that outlaws any competitor).

28 August, 2011 17:12
Debts said...

It's really one of the best explanations I have ever read anywhere, including school books.

09 September, 2011 19:08
Andrea T said...

It is quite clear from your description of money printing that the government can never default on its debt. So any argument against rising government deficit must be based on inflation forecasts, not on default risk.

04 October, 2011 17:47
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05 October, 2011 13:53
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07 October, 2011 04:53

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