Expert: Scott Palmer - 7/13/2002

Question
I have heard the term "monitize the debt" a lot..  Can you tell me what it means?

Thanks

Answer
Dear Tim:

Debt monetization is one of the two main ways that national governments pay for their budget deficits.

When the US national government, for example, wants to spend more money in a given year than it has received in taxes, it must borrow the extra money. One way is to go into private capital markets to borrow the money. However, this means that the government is competing with private-sector businesses for a scarce pool of available loan funds. This can result in a "crowding out" effect, as government draws investment capital away from productive private-sector borrowers to pay for its own largely worthless programs.

As an alternative, the government can "monetize its debt" by borrowing from the US Federal Reserve system, which is nominally under private control but is really just another part of the government. In this case, the government sells its bonds to the Federal Reserve, which creates new bank deposits out of thin air and uses them to pay for the bonds. This process creates new money and expands the money supply: hence it is called "monetizing" the government's debt.

The process of debt monetization is too complicated to summarize in a 10-second sound bite on the TV news, so most people don't understand it. However, it's essentially no different from the historic practice of "coin clipping," whereby kings would reduce the amount of gold or silver in a country's coins and keep the extra gold or silver for themselves. When that happened, the coins were worth less, so the people lost purchasing power and it was transferred to the king.

Likewise, when a modern national government monetizes its debt, it reduces the value of the country's money, thereby -- in a sneaky way -- taking money out of the pockets of working people and giving it to government officials in a kind of "hidden tax."

Here are some additional sources of information for you:

Books:

* Gregory Mankiw, Principles of Economics 2nd edition, Ch. 27 ("The Monetary System")

* Paul Samuelson and William Nordhaus, Economics 17th edition, pp. 521-529.

* R. Glenn Hubbard, Money, the Financial System, and the Economy 3rd edition, Ch. 17 ("The Money Supply Process")

* Murray N. Rothbard, America's Great Depression

* Adam Smith, The Wealth of Nations, Book II, Chapter II; if you can get the University of Chicago Press 1976 edition, look especially at pp.310- 312. This is an early discussion of how fractional-reserve banking can increase the money supply. Note that Smith, who in 1776 stood at the beginning of modern economics, was dead-on accurate when he described the mechanics of monetary expansion, but was largely mistaken in his description of its effects.

Web links:

* The Federal Reserve Open Market Committee: http://minneapolisfed.org/info/policy/whatfomc.html

* The history of money and banking: www.mises.org/money.asp

I hope that this helps.

With kind regards,
Scott Palmer