A New Peek at the Secrets of the Fed?

In December, the Levy Institute issued a working paper that asked how the economy might be affected by the seemingly unusual fiscal and monetary policies implemented by the Fed and other central banks since 2008. The authors, Dimitri Papadimitriou and I, used a phrase that is not often spoken in this era by governments and central banks around the world: “monetizing the deficit.” This phrase traditionally describes the practice of financing a government deficit with money that is “printed” rather than borrowed or raised by taxation. We feel perhaps a little more comfortable with our use of these words in light of a recent blog entry on the Financial Times website Alphaville. The blog reports that the Fed has come close to running out of securities to buy in the markets for certain types of government bonds, having bought so many of them already. Hence, it is increasingly resorting to the purchase of recently issued bonds and notes, which it had apparently sought to avoid. This development makes the link between deficit spending and monetary policy initiatives such as the current round of “quantitative easing” in a monetary system like ours easier to grasp. If the Fed buys a Treasury security almost immediately after it is issued, there is less reason than ever to think of the financing process as anything other than the use of the Federal Reserve’s “printing press” to pay for government operations–an essential use of “monetization” to stimulate the economy and avoid drastic fiscal measures during a time of weak tax revenues. Some worry still, but this practice has been used many times by numerous governments around the world and seems unusual only in light of common but unrealistic beliefs about monetary systems and how they normally work. Hence, those in Congress should not give credence to arguments that it is necessary to eliminate entire government programs or freeze major parts of the federal budget in order to restore some fanciful state of budgetary normalcy.

February 10 addendum on recent news: A short and interesting article on the implementation of quantitative easing policies was posted very recently on the New York Fed’s website. The article mentions changes in the composition of the Fed’s asset purchases, including the recent increase in purchases of newer issues that was reported in the Alphaville blog entry linked to above.  On the other hand, the new piece, based on a speech by a Fed official, finds no evidence that the Fed’s purchases have caused “significant market strains.” The article covers some other important issues associated with the recent policy actions involving long-maturity securities and might be interesting to people wanting detailed information about these topics.