AEP at the Telegraph wrote a very provocative article last week*, in which he argued that the BoJ should forgive a big chunk of the government’s debt. I have been thinking hard about this for the past week. Is this the Holy Grail, a costless way to deal with excessive government indebtedness, as well as a costless way to finance fiscal stimulus?
Under the gold standard, central banks were established in order to issue currency notes and maintain their gold content; provide liquidity to commercial banks; and to maintain a liquid market for the government’s paper. They were QANGOs, not owned by the government but by their members. In order to operate, CBs needed to hold very substantial resources in both gold and/or foreign currency. They had to not only be solvent but also to look solvent, in order to prevent excessive demands for currency redemption. No gold, no credibility; they could not print money.
But that was before President Nixon took the world off of the gold standard. Today, under the fiat standard, a CB is nothing more than a printing press issuing Monopoly Money. It doesn’t need assets or capital, because it can print its own liabilities. If you present a $100 bill to the Fed for redemption, it will be promptly redeemed with a newly-printed $100 bill.
The Fed has lent a few trillion to the U.S. government since the Crash, but that money was lent, not given. Supposedly those bonds will have to be sold back into the market someday, which will supposedly cause interest rates to rise and credit to contract.
But why can’t the Fed just write it all off? It would render the Fed “insolvent”, but how can a money printing press go bankrupt? The Fed can never default on dollar liabilities. There would be no impact on the monetary aggregates (which are the Fed’s liabilities, not assets).
The Fed would suffer a big loss both in terms of the amount written off and in terms of future interest income, but so what? The Fed has an uncapitalized intangible on its balance sheet called “license to print money”. That intangible is worth a lot more than a few trillion dollars. As MasterCard would say, it’s priceless.
This discussion raises a second question: Why can’t the government have a checking account at the Fed funded by the Fed. Chairman Bernanke: “When we buy securities from a private citizen, we create a deposit in their bank”. Well, why can’t the Fed create enough deposits for the government to pay its bills? Why lend money when you can print money?
Obviously, the Fed must fulfill both of its mandates, which means that it can only give so much money to the government without creating excess inflation. But aside from that constraint, there should be no limit on how much money the Fed can give the government. If the Fed is delivering 2% inflation, full employment, good growth and a balanced federal budget, what else matters?
Japan is the extreme example of a heavily indebted government with a fiat currency. Japan cannot repay all of that debt. It will have to be inflated away or defaulted upon--or forgiven. The commercial banks need to be repaid, but the BoJ does not: it can print yen, for free.
The Keynesians have been arguing that the most direct way to revive aggregate demand in a recession is via fiscal stimulus. The Right argues that this increases the government’s debt ratios. But what if, instead of paying for the stimulus with debt, we paid for it with free money from the Fed? Is there something immoral about free money? Don’t forget that it was free money that FDR used to get us out of the Great Deflation.
I need to think a lot more about the possible drawbacks to this idea. But I haven’t heard them yet. If the Fed can fulfill its mandates and fund the government at the same time, why not? I think I may have to read another biography of John Law.
*“Just set fire to Japan's quadrillion debt”, Ambrose Evans-Pritchard, Daily Telegraph, Aug. 9th, 2013