Money is debt

It’s just another type of debt.

Following Thomas Sargent’s recent Nobel Prize, I came across this excellent excerpt from a 1989 interview:

The essential job of the Fed from a macroeconomic point of view is to manage the government’s portfolio of debts. That’s all it does. It doesn’t have the power to tax. The Fed is like a portfolio manager who manages a portfolio made up wholly of debts—it determines how much of its portfolio is in the form of money, which doesn’t cost the government any interest, how much is in the form of T-bills and how much is in 30-year bonds. The Fed continually manages this portfolio. But it doesn’t determine the size.

Exactly. The Fed can trade money for bonds, but this doesn’t change the overall level of government debt—just its composition.

This is important to understand the fallacy in common arguments for “helicopter drops”. You often hear people saying roughly the following:

The Fed has the power to create money and hand it to consumers, stimulating the economy. Normally, the problem with this policy would be inflation, but clearly the dominant risk today is deflation, not inflation—so what’s the downside?

I agree that inflation is low on the list of important risks, but this is nevertheless a deeply flawed argument. Holding more debt in the form of money now is not an inflation risk, but the money doesn’t magically disappear after a few years. It’s still out there, and it’s still on the Fed’s balance sheet. It’s still debt.

Suppose that the Fed creates $1 trillion out of thin air and sends every American an equal share. For a while, this will be fine. Assuming that the intervention doesn’t drastically change the demand for currency, the new money will be held mainly in the form of reserves. The Fed will pay 0.25% on these reserves—not a big deal. So what’s the problem?

Again, the money doesn’t go away—the Fed still has an enormous liability on its books. With so much money in circulation, the marginal investor won’t be willing to pay a premium to hold money. The federal funds rate will therefore be roughly the same as the interest rate paid on reserves, which will also be roughly equal to the rate the Treasury pays on T-bills. In other words, holding debt as money won’t be any cheaper than simply holding it in the form of short-term bonds. The government can’t escape the cost of financing its liabilities. Giving money to households via a helicopter drop is fundamentally the same as giving them money via an act of Congress, with all the usual benefits (improved aggregate demand in the short term) and costs (burdensome future taxation to pay back the debt).

Admittedly, it’s possible that the increase in debt load will cajole the Fed into pursuing easier monetary policy in the future. The more nominal debt you’re trying to finance, the more tempting it is to push down interest rates and spur inflation. (In fact, Sargent and Wallace’s famous paper deals with an extreme case of this phenomenon, where the central bank is forced to make up for the fiscal authority’s inadequacies.) If you’re trying to create expectations of future inflation, this is arguably a good thing.

But it’s not clear why a helicopter drop should provoke such a change in incentives, unless it’s of truly overwhelming magnitude. Excluding intragovernmental holdings, the public debt is currently over $10 trillion. Even a $1 trillion helicopter drop would only add 10%. Is a 10% increase in debt enough to dramatically change the Fed’s incentives in the future? It’s possible, but I’m skeptical. Historically, we’ve seen much larger swings in the government’s balance sheet, and the Fed’s response has been minimal at best.

Bottom line? Money is a form of debt. Whether an operation’s short-term financing comes from “bonds” or “money” makes no difference; the cost is the same, and the usual tradeoffs of fiscal policy remain.

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18 Comments

Filed under fiscal, macro

18 responses to “Money is debt

  1. Kevin Donoghue

    “Even a $1 trillion helicopter drop would only add 10%.”

    Isn’t 10% rather a large fraction in this context? If I saw a fleet of choppers dropping that quantity of dollar bills, I would drastically revise my expectations of future inflation. If you’ve got a model that says I shouldn’t, then I think you really need to look at it more closely.

    • Well, I’m using a model where agents form rational expectations about future Fed policy, given that the Fed will act to optimize a particular objective function.

      I agree that in the real world, expectations have a substantial non-rational component, and sufficiently dramatic demonstrations could have an effect by shaping those non-rational expectations. So yes, dropping dollar bills from helicopters would probably make the public expect much more inflation. But if we’re willing to go down this route, we have to consider the many other ways that the Fed could shape expectations—like saying that they want inflation. That alone would be enough of a departure from usual Fed practice and shock enough people that it would have the desired effect. (Assuming that you think agents with highly non-rational expectations have a substantial influence.)

    • Kevin, I think Matt is spot on here. It may have an impact through some sort of shock and awe effect but in the current context it’s not really very much.

      After all, to get traction what’s needed is the promise to allow slightly higher inflation after the liquidity trap is broken. Presumably that’s at least a couple of years away, but even at standard money growth rates you get 10% money growth within a few years.

      Now, you might say the effect comes from the Fed making a 10% injection while still maintaining the same growth rate, but then your back to relying on expectations to do the work. Whether or not we get a response in the here and now entirely depends on expectations of future money supply, it’s no different than if they just promise a future injection.

      Ex a somewhat irrational response there’s no reason that a 10% monetary injection should change anything, in the context of the money supply evolution over several years it really is nothing much.

  2. Bill Woolsey

    I agree that “helicopter” drops are fiscal policy and that money is debt to the Fed and the government.

    There are two problems with your argument.

    You are assuming some kind of nominal target other than the quantity of money itself. I think this is realistic and desirable. But it is a necessary condition for treating fiat money as debt. If the issuer doesn’t care about the value of money, and is either completely irresponsible or is solely contrained by a quantity limit on base money, then it really isn’t debt. It is like paper gold.

    The other problem is that central banks can purchase private assets. For the Fed, of course, it is better described as loans for the most part. They can lend using all sorts of private securities as collateral. Though I think banker’s acceptances are closer to a open market purchase of a private security.

    I think the Fed should be able to directly purchase private securities if necessary.

    • You are assuming some kind of nominal target other than the quantity of money itself. I think this is realistic and desirable. But it is a necessary condition for treating fiat money as debt. If the issuer doesn’t care about the value of money, and is either completely irresponsible or is solely contrained by a quantity limit on base money, then it really isn’t debt. It is like paper gold.

      This is true. My (implicit) reasoning here is that any Fed with a sensible objective function would not distinguish between interest-paying money and other nominal debt, since this distinction by itself has no economic implications. (Except insofar as it can affect expectations, which only makes sense if either (1) expectations are irrational or (2) the Fed is expected to have an objective function that inexplicably does draw this kind of distinction—which is circular.)

      The other problem is that central banks can purchase private assets. For the Fed, of course, it is better described as loans for the most part. They can lend using all sorts of private securities as collateral. Though I think banker’s acceptances are closer to a open market purchase of a private security.

      This is also true. The point I want to emphasize, though, is that a Fed purchase of assets with interest-paying money is essentially the same as a Treasury purchase of assets with interest-paying T-bills. In practice, the Fed has much more latitude to purchase private assets than the Treasury does, and perhaps institutionally this is a good thing. But if someone advocates private asset purchases by the Fed as a stimulative measure, he should recognize that in principle (ignoring of the political economy realities of implementation) a purchase by the Treasury would do exactly the same thing. Or else he should have a much richer story of signaling and expectations formation up his sleeve.

  3. JKH

    I don’t see the debt classification as being that useful. It invites debate about the definition of debt. And it’s obvious from history that this debt doesn’t necessarily need to be paid back. The important point is that there is some balance sheet classification that views money on par with bonds.

    The idea that the Fed is managing the portfolio of debt is a slightly biased. Neither the Fed nor the Treasury has the last word on the composition of debt, since both have the option to adjust it according to their own operational responsibilities. Every new Treasury issue includes not only a size decision but a term structure decision.

    The Fed must price its “share” of the debt in such a way as to ensure its policy interest rate objective. The demand for currency in the form of notes is determined by the public. Reserve requirements are determined by legislation. Government balances held at the Fed are the result of treasury operations. The demand for uncompensated excess reserves is determined by the banks. All liabilities/debt in excess of this must be compensated consistent with the Fed’s target interest rate.

    The entire debt could be replaced functionally with compensated excess reserves. This effectively merges the Fed with Treasury.

    Helicopter drops are fiscal. It’s too one-off to mix the Fed in with this function. There’s no benefit to having institutional separation between Treasury and the Fed at all if the Fed starts doing helicopter drops.

    • I agree with basically everything you say here—I guess we’re just putting different spins on it. Traditionally, the Treasury has been (almost) solely responsible for term structure decisions, while the Fed has been solely responsible for deciding how much of the short-term liabilities will be held in the form of money. In practice, the Fed has been constrained in making decisions about quantities because it’s passively managed the money supply in order to hit interest rate targets. Now, however, that it has a separate tool for managing interest rates (interest on reserves), it has both (1) more or less total freedom in its traditional role of deciding what fraction of short-term liabilities will be held as money (though this isn’t really so important) and (2) substantial power to manage the term structure of the government’s overall liabilities.

      This blurs the institutional separation between the Fed and Treasury, but there’s still an important distinction between the two entities: the Treasury (directed by Congress) is pretty much exclusively responsible for making decisions about net government debt. Fed-sponsored helicopter drops would fuzz up this distinction as well, which (to both of us) seems pointless and possibly counterproductive.

    • Hmm, on second thought point (2) in my first paragraph doesn’t make too much sense. Even when it passively set the money supply, the Fed had some power to adjust the term structure of the government’s debt; it just rarely used that power. It could, after all, have traded the T-bills on its portfolio for 10-year notes, but it usually didn’t (except in Operation Twist), presumably because (A) it would put the Fed’s balance sheet in more danger, and the Fed and Treasury’s balance sheets are not perfectly integrated, (B) there was a perceived benefit to certain patterns of institutional separation. (e.g. Treasury takes care of term structure, Fed takes care of interest rates.), and (C) when the Fed was away from the zero lower bound there was no reason to use a more complicated instrument like term structure when interest rates were still available.

    • …and (D) its power was more limited, since the size of its balance sheet was constrained.

  4. Hello Matt
    If you define money as debt, then there is no room for discussion.

    In a footnote in TGT, Keynes said that we can draw the line at any convenient point between money and debt — suggesting both that money is debt and that it is not.

    I know there is a big difference between money I earn and money I borrow. In order to describe this difference, I must have a word for “debt” that is not the same as my word for “money.” I use the words “debt” and “money”.

  5. Dan Kervick

    I really can’t see that much conceptual or theoretical clarity is advanced by defining money as debt. If I have a debt, then I have an obligation to deliver something to someone at some definite or indefinite point in the future, and my debt has not been discharged until I have made that delivery. Is money really like this, whether it is in the hands of the government that produces it or the entity that acquires it in exchange for some non-monetary good or service?

    It seems better just to think of money as a product. It is a product whose sole value to its holder lies in its exchange value. The product confers purchasing power on its owner, and is thus something for which people are usually willing to exchange something else in their possession, if the exchange price is right. It is also a product that that can be manufactured at essentially zero cost. In the contemporary world, it is mostly produced by governments as a public utility to lubricate exchange, and in response to private sector demand for more money as the availability of goods and services increases.

    Yes, the product is accompanied by the government commitment to exchange any quantity of its money for an equal quantity of its money. But since the product can be manufactured at zero cost, that commitment doesn’t seem to amount to a non-negligible liability. For example, if I manufacture cell phones, and make a commitment to anyone who purchases an initial cell phone from me to exchange a brand new cell phone at any time for the old one, I have incurred a real liability. But suppose I can both manufacture and deliver as many cell phones as I like out of thin air, at virtually zero cost. Then the liability associated with my sale of the initial cell phone is negligible.

    Assuming that the intervention doesn’t drastically change the demand for currency, the new money will be held mainly in the form of reserves.

    I don’t understand this. Won’t most of the additional money exist only in the form of unreserved deposits? Why would it cause an increase in reserves equal to the total amount of the disbursement? I don’t think that you can get this conclusion by appealing to some fixed demand to hold currency. Acquiring more money, for virtually every participant in the economy, always dominates over not acquiring more money. And the quantity one desires at t1 to spend/hold throughout some interval t1 to t2 is relative to one’s money stock at t1 and one’s anticipations at t1 of income throughout that interval. But if one’s monetary income is increased, one will like revise both one’s spending desires and savings desires upward.

    And I don’t understand where the “burdensome future taxation” necessarily comes from. If I’m the government, I can always manufacture whatever additional money I need to supply the banking system’s demand for additional money to pay interest on additional aggregate deposits. Whether to offset some expenditure of brand new money by taxing away – now or later – some amount of existing money is optional. The determination is based purely on on policy considerations – in this case, how much money to leave in circulation with an eye to managing the price level. It is never something the government is forced into because the money it issues constitutes a “debt”

    A pure helicopter drop of the sort fiscalists like me would like can’t be accomplished in an efficient way under our current institutional arrangements. We would need a special act of Congress overriding ordinary operations and grounded in Congress’s constitutionally inherent monetary authority. The way things are set up currently, Treasury can’t spend without taxing or issuing debt. And although the Fed can buy up some of the debt, the public then still owes the principle to the Fed. Only the interest is waived. But the fact that the Treasury can’t spend without either taxing or taking on debt isn’t due to the fact that the money itself is debt.

    • It seems better just to think of money as a product. It is a product whose sole value to its holder lies in its exchange value. The product confers purchasing power on its owner, and is thus something for which people are usually willing to exchange something else in their possession, if the exchange price is right.

      This paragraph may be either right or wrong, depending on how it is interpreted. Taken alone, the fact that money can be used to obtain real goods and services doesn’t really distinguish it; any financial asset can ultimately be used to pay for real goods and services. Typically, what makes money special is that it is more easily exchanged for goods and services; it’s completely liquid and can be used for any payment. This is why individuals have historically held money even though it has been dominated in yield by other securities with otherwise similar properties. In other words, it “lubricates” exchange (to take your term). It provides liquidity services that compensate for its lack of yield.

      The problem is that once you create enough money, its marginal usefulness (at least relative to many other financial assets) in lubricating exchange goes to zero. In fact, this is currently the case: the yields on money, short-term Treasuries and other similar securities are all very close to each other (and zero). At the current margin, money does not provide any liquidity service that justifies a nontrivial yield differential.

      In a world where money does not provide special liquidity services, what gives it value? The answer is simple: its value tomorrow. If government is paying 4% interest on reserves, and it can also credibly promise that a dollar tomorrow will have real value equivalent to $0.98 today, people will be willing to hold a dollar today as long as they are happy with a 2% real interest rate. (Again, they would be willing to put up with a lower real interest rate if money provided extra liquidity services, but when there’s enough money these services do not exist at the margin.)

      If they are not happy with a 2% real interest rate—because, say, it’s too low given their preferences and the projected state of the economy—then in the aggregate people will try to exchange money for real goods and services. Since this is not possible in the aggregate, we’ll see an inflationary boom (mainly inflation if the economy is already at full capacity). Unless the government steps in and starts paying a rate on money consistent with the market rate, this boom will be potentially unbounded.

      So unless it wants an inflationary explosion, the government needs to pay interest on money at a rate consistent with market demand. Or it needs to make money scarce enough that money provides implicit liquidity services that compensate for its lack of explicit yield. Either way, money must be providing—implicitly or explicitly—a yield that satisfies the market. In this sense, it is absolutely a form of debt.

      Now, you might say that this is still not a problem, because the government can pay interest on reserves by costlessly creating even more money, ad infinitum. The problem is that if interest rates are higher than the rate of GDP growth, the real stock of money will over time become infinitely large relative to the economy, which is impossible—at some point the Ponzi scheme will give out, everyone will rush to exchange their soon-to-be-worthless money for real goods and services, and you’ll get hyperinflation. It’s true that interest rates are sometimes lower than the rate of GDP growth, but—excluding countries that use financial repression to channel money into government bonds, which is an implicit tax—this is mainly a U.S. phenomenon, one that stems from the dollar’s unique role as a global currency. It is not some fundamental feature of the world, it is not stable, and it certainly does not hold for arbitrary levels of debt. In fact, the surest way to end this state of affairs is to run up debts to the point where they are only sustainable if investors around the world keep hoarding dollars—which, being a very risky policy, will probably persuade those investors to shift to some other currency and precipitate its own failure.

    • I don’t understand this. Won’t most of the additional money exist only in the form of unreserved deposits? Why would it cause an increase in reserves equal to the total amount of the disbursement? I don’t think that you can get this conclusion by appealing to some fixed demand to hold currency. Acquiring more money, for virtually every participant in the economy, always dominates over not acquiring more money. And the quantity one desires at t1 to spend/hold throughout some interval t1 to t2 is relative to one’s money stock at t1 and one’s anticipations at t1 of income throughout that interval. But if one’s monetary income is increased, one will like revise both one’s spending desires and savings desires upward.

      I’m confused. If the Fed creates more base money (in either the form of currency or reserves), that base money will remain in circulation (either in the form of currency or reserves, possibly reallocated between the two) until the Fed conducts an open-market operation to take it out. Such an open-market operation involves selling an asset in exchange for money—which is a hit to the asset side of the Fed’s balance sheet. Are you saying that the Fed will immediately conduct such an operation? If so, then my claim that money is effectively a form of debt is even more obvious: after it puts money into circulation, the Fed immediately pulls the money back out by selling its assets.

      Now, to be fair, I think I understand what you’re saying. You’re saying that if people receive money from a helicopter drop, the main change is that their wealth has increased (ignoring Ricardian equivalence and whatnot), and they are ultimately going to hold most of that increased wealth in the form of non-money financial assets.

      Holding yields constant, this is absolutely true! People hold very little of their financial wealth in the form of money; the rest is in non-reservable deposits, stocks, bonds, etc. The problem is that, barring an operation by the Fed to reserve the injection of money, the increased money supply is still there. In other words, following such an operation, the demand curve for money won’t have changed much, but the supply will have moved massively. You don’t need to have much economics training to figure out what will happen: the yield spread between money and other financial assets will fall until the quantity demanded of money equals the supply. It may fall to almost zero.

      Your problem is that you’re thinking about a demand curve without simultaneously considering supply. This leads to very weird inferences.

  6. TC

    Like JKH, I don’t find the debt classification useful either. Nor do I find a Fiscal Theory of the price level distinction between equity (cash) and debt to be useful.

    Balance sheet thinking is unit of account thinking and equity and bonds aren’t units of account – they are priced in the unit of account.

    Note, this is MMT “asset swaps” by another name and you can’t swing a cat in a room full of MMTers without hitting someone blabbing about “monetary policy is just an asset swap!”

    Also, when the Treasury makes the term structure decision, it limits the raw material the fed has to use. Usually this isn’t a problem, but it can be a problem. Treasury doesn’t issue notes with negative rates of interest, for example, and can’t issue bills that pay less than 100% of face value.

  7. John

    Matt

    In reading your comments the question occurs to me whether you really understand how a helicopter drop works.

    To make it simple, let’s assume we have an economy with one store and one product, a coconut that is priced at $10.00. There are many buyers with no money. The helicopter flies over and drops 10 $10.00 bills.

    The first buyer grabs a $10.00 out of the air and rushes to the store and buys the coconut.

    This gives the store owner a choice, go out of business or play the game and order more coconuts, trying to meet the new, higher demand, even though prices will rise.

    In sum, once one realizes that the intent is to make the store owner behave in a way that is not natural but is forced, one can see that helicopter drops need to be sudden and massive to be effective.

    Obama’s never did anything sudden or massive–thus he never changed behavior

  8. Good post mate. The thing is I am really amazed to see such huge discussion in your comment section. BTW I will also say, “Money is Debt”

  9. Roger Sparks

    Comment on “Money is Debt”.

    The blog posting and comments are now dated but certainly the subject is current. I hope the blog is still open for comment.

    I will try to present.a new perspective.

    First, let’s think of Money as “Evidence of Debt”. Our Green Cash Notes (GCN) are “FEDERAL RESERVE NOTE”(s), issued to the Federal Treasury in exchange for United States Treasury Bonds which are transferable. The Treasury, having received GCN, uses GCN to pay United States Government obligations of all kinds. Once issued, GCN remain in circulation until United States Government tax collections exceed expenditures, a condition that only occurred recently during the late 1990’s.

    Citizens who have received GCN think of the notes as debt or gift certificates depending (perhaps) upon how they were ‘earned’. Whether debt or gift certificate, the mechanical description of money in the United States is “Evidence of Debt”.

    Now we also have the United States Treasury borrowing money from citizens. Here we have the Government borrowing evidence of it’s own debt. A rather peculiar situation, it arises when Government does not really want savers to spend their own money (A vital concern during WW2 when all available resources were required for the war effort) or when Government does not want all the GCN holdings to trade rapidly fearing inflation. I would agree that the Federal Reserve exercises control of borrowing from citizens and control of interest rates to accomplish a smooth exchange between GCN, Treasury Bonds, and GNP.

    To the extent that citizens want to find a long term safe place to store savings, investing in Treasury Bonds seems like a safe investment. Of course investing citizens wish to have future purchasing power equal to the purchasing power existing at time of investment. Future purchasing power is always subject to risk from dilution due to additional issuance of GCN.

    We have great concern about how much interest is paid on the Federal Debt, noticing that interest is already a huge cost on the balance sheet. On the other hand, we seem to be very willing to expand the balance sheet for purposes of helping the unfortunate, defense, and a host of special interest close to the hearts of someone. If money is simply evidence of debt without need for repayment, why be concerned about paying interest? On the other hand, If interest is simply a payment to reward people for not spending immediately, why any interest in a time of low employment?

    Finally, will our kids really need to pay back these Treasury Bonds owned by citizens and the Federal Reserve, an argument frequently presented? Hmmm, I doubt that the Federal Reserve will ask for repayment. Citizens asking repayment will cheerfully be given GCN. Perhaps the concern about our kids is really an inept argument about another concern, the dilution of the current pool of GCN with additional GCN.

    Thanks for the original post and the opportunity to comment,

    Roger Sparks

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