Many people think that quantitative easing monetises the government’s deficit spending. As I have argued in a much longer post, the question itself is meaningless. Government debt is already monetised when it comes into existence. Government debt is money. Ask any bank or insurer how they view their holdings of treasury-bills and they will tell you that they view them as money. More importantly, they can use their bondholdings as money. Market counterparties accept treasury-bills as collateral and if bondholders ever need “real” money, they can repo their t-bills for real money.

This “moneyness” of government bonds is not a new phenomenon. In the United Kingdom, it has been true since at least the 18th century when the East India Company repoed its bonds with the Bank of England for money. But the money supply is not “elastic” in this manner in all economies. Take a look at the ongoing Chinese liquidity crunch. In China over the last week it is not clear that T-bills can be repoed for money. But in most western economies, this has been the case throughout the central banking era. By limiting the elasticity of the money supply, the Chinese central bank effectively gives up control of the interbank interest rate (hence the spikes in the overnight interbank lending rate). In a financialised economy such as the United States, this would be a catastrophe. In China, it is unclear what impact this would have on the real economy. India suffered such liquidity crises with habitual regularity throughout the 90s with barely any impact on the real economy.

Inflation does not arise from the central bank’s purchase of the stock of existing government bonds. Inflation arises if the government takes advantage of the central bank’s bond purchases to increase its present and future spending. The central bank in Zimbabwe bought its government’s new debt issuance at a fixed price irrespective of the market demand or inflation. But the inflation arose because the government used this commitment from the central bank to embark upon an uncontrolled spending spree. Whatever your views on our current deficit situation, we are not in the same boat today.


Diego Espinosa

Ashwin, Another driver of inflation is an "unstoppable" increase in the issuance of debt/money. This occurs when an economy becomes addicted to continued fiscal stimulus, such that, without it, a depression occurs. Addiction implies a non-linear expansion in the issuance of debt/money. Agents' attempts to hedge against this create a self-fulfilling prophecy. The irony is that the inflation itself reduces the deficit. So when you look at this type of an economy (high inflation/moderate-but-chronic deficit), it seems like the deficit is not the problem. The tipping point between "stoppable" and "ustoppable" is hard to pinpoint. In 2013 the U.S. deficit came down with little ill effect, for instance. Does this rule out the "addiction" dynamic? Maybe that explains the gold price. IMO, jury is still very much out.


Diego - my tentative conclusion is that the US economy is probably addicted to the Greenspan/Bernanke put variant of monetary policy, rather than to fiscal deficits.

Diego Espinosa

Perhaps another way of saying it is that the economy is addicted to negative real rates.