Is QE monetizing the debt, and what does that even mean?

Recently there has been a fervent debate on the Twittersphere about whether or not quantitative easing (QE) constitutes debt monetization, and more broadly — what that even means. While many believe that this is an academic argument with no significant impact to markets or the economy, I disagree. I believe it is an important discussion which tells us about government spending, it’s limits (or lack thereof), and the potential economic consequences of such spending.

Monetization is a loaded term which seems to cause a lot of angst among those arguing either side of the discussion. One definition is that any time the federal reserve creates additional base money (reserves) to purchase debt securities, it is monetizing the debt. This is the category that QE falls into. Others argue that QE is simply an asset swap, because from the private sector’s perspective, they are losing one asset (a treasury note, for example) and gaining another (a bank deposit) — no new net funds are added. I think both of these arguments have merit, but to me a critical difference is about the timing between when new debt is issued (current period deficit spending), and when the federal reserve purchases debt with newly created money (QE).

QE — purchasing existing debt

When the federal reserve buys securities on the secondary market with newly created reserve assets, it is expanding it’s balance sheet and providing the private sector with reserves in exchange for treasury securities*.

*If the seller of the treasuries is a non-bank, deposits also increase because the seller’s asset is the deposit account (which is a liability of their bank) and their bank’s asset is the reserve. From here forward I won’t distinguish between banks and non-banks, and I’ll refer to reserves with the understanding that this may also increase deposits depending on who the seller is. For more background read Joseph Wang’s excellent QE step by step.

There is no net change in private sector assets, which is why it is often called an asset swap. The argument that this is debt monetization is straight forward — the fed is creating new money (reserves) to purchase debt with. They are turning debt into money, even if there is no net change in private sector wealth. How impactful this is to the economy is difficult to measure, there were fears of hyperinflation when the policy was first enacted in 2008 and nothing of the sort ever materialized. I think there are a few reasons why QE ended up being less inflationary than feared:

• QE doesn’t change private sector wealth, only the composition of their assets
• People on the receiving end of QE were already savers, so the money they receive in return for their treasury securities was likely to be invested elsewhere rather than spent on goods/services
• Some of the funds created during QE stay within the banking sector (when the treasury seller is a bank) — the only way it gets out is if they make a loan or buy something from another entity.

One thing that QE does do, however, is push down bond yields and put upward pressure on other asset classes across the risk curve. So while QE may be less likely to cause broad-based goods and services inflation than some may have imagined, asset inflation is a different story. Stocks, bonds, housing, commodities, etc. all benefit from lower risk free rates, and their values were very likely buoyed by QE. How much QE inflated those prices is impossible to know without a time machine, but in general if one of the largest buyers of risk free assets removes themselves from the market, rates will go up, and that will put downward pressure on risk assets.

Fiscal Deficits

When the government runs a fiscal deficit, that deficit is financed by issuing new debt which the private sector buys. Mechanically, and avoiding some of the finer details* — it looks something like this:

• Treasury issues 2T of bonds
• Private sector buys the bonds (they now have 2T less in reserves and 2T more in bonds)
• Treasury spends the money they just collected back into the economy

*Before the MMTers dogpile on, yes… I know you think they spend first and issue later, but I don’t care because the end result is the same. Let’s save that discussion for another time.

After all is said and done, the private sector has the same amount of reserves, and 2T more of bonds. Their net wealth has increased, unlike the QE example. Will this cause inflation? Possibly. I would argue that deficit spending has a higher chance of causing goods & services inflation than QE, all else equal. There are two main reasons why I believe this.

First, deficits add net wealth to the private sector — they have more assets than before. Second, like in the QE example, the funds used to buy the bonds probably came from savings as opposed to circulating through the economy on goods & services. When the treasury receives money from the saver in exchange for its bonds, they are going to spend it directly into the economy. In effect, the treasury is channeling money from savers (who bought the bond) to spenders (who receive the funds raised from issuing the bonds). Put in monetarist terminology — they are turning low velocity money into high velocity money.

Deficit Monetization — purchasing new bonds

What I outlined above is how deficits are traditionally financed, but there is another option. Instead of the private sector buying bonds, the fed can buy them. Technically they are not allowed to buy direct from the treasury, so they simply use an intermediary to give the appearance of an arm’s-length transaction, but the effect is the same. In this scenario, these are the steps (omitting the intermediary for simplicity):

• Treasury issues 2T of bonds
• Fed creates 2T of reserves and buys them
• Treasury spends 2T into the economy

Like the previous example, private sector net assets have increased 2T, but this time in the form of deposits/reserves rather than bonds. There is no need to channel funds from private sector savers to spenders, instead the treasury provides money directly to the spender, money created by the fed. One key difference then, is that this form of fed monetized deficit spending results in an increase in the M2 money supply, because the private sector asset received is a deposit/reserve rather than a bond. Another key difference is that there is no limit on issuance if the fed is providing funds. If Congress wanted to issue 100T tomorrow (exaggerated for illustration) the private sector does not have enough funds to purchase that issuance. If the fed buys, there is no theoretical limit as they create funds at will.

This is what occurred in 2020 with the CARES act financing. Congress needed to raise ~4T in funds, and the fed provided the majority of it to shield the private sector from having to finance the deluge. In fact, the private sector didn’t even have enough funds (reserves) available without the fed as a buyer, so there really wasn’t a choice.

How inflationary is this type of spending? While we can’t know for sure that the high and persistent inflation we’ve been experiencing over the last few years is caused by this, the timing sure does line up well. Although there are still members of “team transitory” that think the supply shocks from COVID haven’t fully worked there way through the supply chain and are driving the inflation problem, I’m skeptical. Are we still going to be talking about temporary supply shocks 5 years later next year? I think increasing the supply of money by 40% in 2 years probably has a little bit to do with why prices are so much higher.

M2 Money Supply Composition

Monetization and Timing

All debt issued by the treasury originated from deficit spending. The total amount of outstanding treasury debt therefore represents the accumulation of deficit spending up until the current period. When QE is performed by buying bonds that were previously issued, that deficit money has already been spent at a point in the past. That is not to say that there is no effect — simply that the goods and services inflation would have been more likely to occur at the time of the deficit spending. As discussed earlier, QE still very likely impacts asset prices and inflation.

Performing QE at the same time as deficit spending is identical to monetizing the deficit. Whether the fed buys newly issued bonds, or bonds in the secondary market, they are increasing the amount of reserves in the system. When the treasury then issues, they are draining reserves and replacing them with treasury securities. Finally, the treasury spends funds gained from issuance back into the economy, replacing the reserves they just drained. In the end, there are more deposits/reserves (increasing the M2 money supply).

Conclusion

Whether or not the fed “monetizes” the debt is a contentious topic, and largely hinges on what you define monetize to mean. Personally, I am in the camp that any creation of new money to buy debt means monetizing, but I think what is more important is understanding how QE, deficits, and timing relate to one another, and how they can impact assets, the economy, and inflation. The combination of QE + large fiscal deficits results in a meaningful increase in high velocity money spending, and an overall increase in the M2 money supply, permanently destroying purchasing power.