Here’s how the conventional narrative goes. The government must tax from the people, and uses this tax money to pay for its spending. If the government wants to spend more than this, it can go into debt, but only by paying interest, and this is risky. If the government keeps borrowing more and more every year, its debt will rise and so will the interest payments. Eventually the debt and interest will be so large that the tax revenue won’t be large enough to cover the interest, and at that point, the story goes, we enter a death spiral. The government will be borrowing just to cover the interest, and eventually investors will refuse to lend to the government. This will cause interest rates to spike, forcing the government’s obligations even higher.
At this point, there’s no choice: the government must (*gasp*) print money. All that extra money chases too few goods, and prices rise. And so, the government doesn’t pay its debt through the direct theft of taxation, but through the indirect theft of inflation. But either way, it is we the public who pays for the government’s failure to balance its books, like any responsible household or business.
Well, you can rest a little easier because pretty much every part of this story is wrong. But this article will focus on that last section, where the government “inflates the debt away.” It is impossible. In real life, if the government “prints money to pay the debt” (also known as “monetizing the debt”), there is unlikely to be much if any inflation, and it might even be deflationary.
Huh? If the money supply goes up by huge amounts, how could that be deflationary??
You’d think we’d have figured out by now that changes in the money supply aren’t what cause changes in prices. John Maynard Keynes explained it to us 80 years ago. Central banks attempting quantitative easing in the aftermath of 2008 gave us a real world experiment. And even statistical data shows it’s not true.
This myth is extremely persistent. So, let’s go through the usual logic underlying this story. Now, the simplest argument goes that the more of something there is the less its value is, and so the more money there is the less its value will be. Hence, inflation will happen if the government prints money to pay the debt. This one is very easy to debunk. Suppose the government prints $100,000,000,000,000,000. There’s so much more money now, its value should go to zero, right? But what if the government simply locks all of it in a room and does nothing with it? This gets to the heart of the matter: what is the mechanism that determines the value of a thing? Clearly, not just a raw count. I mean, who’s doing this count, and how are they letting us know the results? In our modern capitalist system, the value of things doesn’t come from counting, it comes from haggling in the market. So for the “value” of money to change, it is at minimum necessary for these dollars to be involved in a market transaction of some kind. Locking dollars in a room can’t do that.
But ok, lest I get accused of taking down strawmen, let’s up the argument a little bit. More sophisticated debaters will actually point to an equation, called the “equation of exchange.” It looks like this: MV = PY. M is the money supply, V is the “velocity of money,” P is the price level, and Y is real GDP. If you’ve got some economics savvy, you might realize that PY = nominal GDP, or in other words, the prices paid for all final goods and services produced in a given time period.
The logic of this equation, these people explain, is that it’s an accounting identity. The velocity of money refers to how many times a dollar changes hands. So, if the money supply is $100 (M = $100), and we sold $500 worth of goods and services in a year (PY = $500), then each dollar must have gotten used on average 5 times (V = PY/M = $500/$100 = 5).
Velocity, their argument continues, is very stable, it doesn’t change very much. How many times each dollar changes hands is determined by consumers, and how much saving or spending they do, and this mostly isn’t affected by policy. Same story with Y. Y is equal to the output of goods and services produced in the economy, which is determined by real things, like how many factories there are, raw materials, how productive workers are, etc. So in the short run V won’t change much and Y won’t change much. This means that if M increases, the only variable left to change is P:
Well, frankly, there are a million problems with this argument, and we could be here all day if we went through them all, so I won’t. The big problem here lies with Velocity. V is postulated to be determined by consumers, by their spending and saving and how they feel and such, and to be mostly or completely unaffected by policy. This is wrong.
You see, V is not actually a tangible thing that can be measured. M, P, and Y are though, and that’s how they come up with data for V. Economists go out and measure the money supply, measure prices, measure output, and end up with 3 numbers. Then they plug them into the equation above, V = PY/M, and solve for V (read the text under the graph). This makes V a residual quantity: given M, P, and Y, then V takes on whatever value is necessary to make the equation true. It’s no coincidence that this is how I found V in the example above; if we go out and measure PY to be $500, and M to be $100, then V has to be 5 or else the equation wouldn’t be true. It’s the residual.
So the idea that V is stable and determined by consumer is not based on anything, and is really the wrong way to understand the economy. Instead, we should understand that PY will change as it will, and M will change as it will, and V is simply the ratio between them, V = PY/M. No more than that. It can’t be measured, it can’t be seen, or felt, or heard, because it is not a real thing that exists. It’s just some mostly-meaningless number that you get when you divide PY by M, sort of like how you’d get a mostly-meaningless number if you divided the number of hot dogs by the number of umbrellas.
In fact, it’s very easy to construct a scenario in which the government can change V. I already gave you one at the top of the article. If the government prints $100,000,000,000,000,000 and locks it in a room, then V will plunge. PY stays the same obviously, but M grew enormously, so V will fall asymptotically towards zero.
So I hope you see, “more money = higher prices” is much too simplistic, and we’ve got to approach the problem in an entirely different way. Instead, we need to go back to where prices come from: haggling in the market. Supply and demand for goods and services determines prices. If demand grows but supply doesn’t grow to keep up, then the price will rise. So if we want to know what a certain change in the money supply will do to prices, we should start by asking, what will it do to supply and demand for goods and services?
So let’s suppose the government “prints money to pay the debt.” What will this do to supply and demand for goods and services? Obviously, since this is a purely financial transaction, it doesn’t do anything to the supply of things like hot dogs or umbrellas. But how about demand? Well, for demand to increase, people must spend more. So to say that demand rises, we’ve got to identify some people who become able to spend more after the government pays the debt.
But try as you might, there actually are not any. Let’s go through the operations. The US national debt isn’t like a credit card or a bank loan. Rather, the government sells Treasury bonds, and investors buy them. Suppose you are an investor. Once you and the Treasury agree on a price at auction, the Federal Reserve instructs your bank to debit your account, and then the Fed marks on its books that you own a Treasury security (yes, the Federal Reserve does the bookkeeping for US Treasury bonds). You’ve just changed the form of your wealth from bank deposits to an equal value in Treasury bonds. Assuming the Treasury quickly spends an equal amount of money back out, the total money supply held by the public won’t change.
“Printing money to pay down the debt” would be basically the opposite of this. The government creates money to pay off the bond. The Federal Reserve would direct your bank to credit your account, and then the Fed would delete the entry corresponding to the Treasury security you previously owned. Your wealth has now changed from Treasury bonds back to an equal amount of bank deposits. If the government doesn’t simultaneously reduce its spending or increase tax revenues by the same amount, then the total money supply held by the public would increase. Money has been “printed.”
Now, you might be tempted to think, “aha, after the money-printing, I have more money! I can spend more. That means increased demand, which means increased prices.”
But you’d be wrong.
First, notice that neither of these transactions actually made you any richer or poorer. They just changed the form of your wealth. You go from cash to bonds, or back, but your net worth is still the same. (It’s exactly like if you bought stock on the stock market. Nobody thinks that buying a share of Apple stock makes you poorer, do they? Of course not. You have the same total wealth, just in different form.)
“Okay…,” you mumble, “but can’t I still spend more because I have more money? Before my wealth was locked up in bond form, now it’s just pure cash. So my spending can increase.” But you’d still be wrong! Because Treasury bonds aren’t just sold by the Treasury, they also get sold by investors to other investors on the secondary market (sort of like how if you buy Apple stock, you almost certainly bought it from another investor, not Apple). And further, the US Treasury Bond secondary market is the deepest and most liquid market there is for government debt. This means that if you need cash to spend, there is ALWAYS somebody else who doesn’t and is willing to give you some in exchange for your Treasury bond.
What this means is that even though previous to the “money printing” your wealth was “locked up”, this didn’t actually stop you from spending that wealth whenever you wanted, because you could sell your bond and get money to spend nearly instantly, at any time. And if the government “prints money to pay the debt” by swapping your bonds for money, then really nothing has changed: you still have the same amount of wealth, which you could choose to spend whenever you want.
If that was too technical and abstract for you, then here’s the short version: a Treasury bond is nothing more than a savings account at the Federal Reserve: you put in money now, you get it back later with interest (technically it’s a Certificate of Deposit). When you buy a Treasury bond, the Fed moves money from your checking account to this savings account. When they pay off the bond, the Fed moves the money from this savings account, back to your checking account. The Fed is always capable of doing this, regardless of the level of government spending or taxation, because it is the issuer of the currency.
The people who believe that “printing money to pay the debt” causes inflation are basically arguing that moving this money from the savings accounts to the checking accounts causes people to go out on a spending spree, and drive up prices. In reality, does that make any sense? If your bank called you and told you it was closing your savings account and moving all the money to your checking account, would that make you go on a spending spree? There’s no reason to think so. You had the money before, and you could have spent it any time. There’s basically no difference between having the money in a checking account vs. a savings account.
Well, except one tiny difference, which is that savings accounts pay more interest. This is true for Treasury securities as well. If the government “prints money to pay down the debt,” then this eliminates the bonds, which also eliminates these interest payments made by the government to the private sector. All else equal, this reduces the government deficit and reduces the income of anybody who owned those bonds. This reduces spending in the economy, which will reduce demand for goods and services, which may put downward pressure on their prices.
Did you see what just happened there? Not only have we discovered that “monetizing the debt” doesn’t cause inflation, it might even cause Deflation! And this exactly matches the reality of what’s been happening in Japan. They’ve been monetizing their debt like crazy. So far they’ve “printed money” to pay down nearly the equivalent of the entire national debt of the USA. The government is even having trouble finding bonds to pay off! Yet, no inflation is created. In fact, we still periodically read about them slipping into deflation. Which is not all that surprising, now is it?
Of course, there are some other effects from this operation. All else equal, changing the money supply and makeup of financial assets in the private sector will change interest rates and asset prices. So yes, you can probably thank the Fed for that run-up in the stock market, which made the rich vastly richer. But would the price of a hot dog or an umbrella shoot up to 10 quintillion dollars if we eliminated the entire national debt tomorrow? There’s no reason to think so.
“So wait a minute, are you trying to tell me that the government can’t cause inflation?” you astutely ask next. Well, no. In fact, there’s a sure-fire way for the government to cause inflation. The reason that “monetizing the debt” can’t cause inflation is because its a purely financial transaction on both sides: It just swaps one extremely liquid government-issued asset for another, leaving the total amount of financial assets in the economy unchanged. But the government has a very easy method for actually increasing people’s incomes, wealth, and the amount of (net) financial assets in the private sector: spending.
If the government purchases goods and services without increasing taxes (aka increases its deficit), this immediately is new demand for good and services, and if the supply can’t grow to meet this increased demand, then prices will rise. When is supply unable to grow to meet demand? That happens when we hit full employment, at which point there are no more workers who can be pulled into the umbrella factories to help produce more hot dogs. Inflation happens when the government increases its deficit past full employment. (OK, in practice it happens a little before this, which is what the Job Guarantee is designed to address. But that’s a topic for a separate post). If for some reason you really wanted inflation, the government could always just spend more, past the point of full employment. Or we could easily get inflation if we stopped collecting taxes.
As we saw above, in terms of inflation, it really doesn’t make very much difference whether a government deficit is accompanied by bond sales or is just straight-up “printing money.” Either way, government deficits add financial assets to the private sector, and it is the spending that matters for inflation, not the makeup of private sector portfolios.
So, the debt hysterians ought to calm down a bit. The US government can never be forced to default on its debt, need never fear missing a payment, and we’ll never see any inflation from that. If anything, the lesson hysterians should learn from this tale is that the US Government is nothing like a household or a business. They ought to question why we issue debt at all, and whether we even ought to. In fact, they might as well just scrap the whole story, and go with a new one.