The public debt of a government that can issue its own currency is the amount the government has spent into the economy which has not yet been taxed back.
If you were the government of the only village in the world, and you had the only money printing machine in the village, why would you borrow money from the villagers to build a new bridge? Why wouldn’t you just print the money to pay for it?
One reason might be that if you put more new money for the school into the village economy the existing dollars in the economy would be worth less than they were before you printed the money. In other words, inflation might result. Then again inflation might not result if the new bridge means that there is more growth in the village economy sufficient to absorb the new money.
Why not raise the money to pay for the school by taxing the villagers? One reason might be that the villagers might then not have enough money left over to spend on other things. Plus, the villagers might get angry and rebel.
A government that can issue its own currency only needs to borrow if it wants to spend without increasing the overall supply of money in the economy (because of inflationary pressure) or because it does not wish to offset that spending through taxation (which is deflationary and might be politically difficult).
How does a government borrow?
Normally the Treasury issues securities, mostly government bonds, equivalent to the amount it wishes to borrow.
Bonds are a very secure investment because they are government-guaranteed. They provide a fixed interest return over the maturity period of the bond- usually 2, 5, 10 or 15 years.
Inflation is controlled because the government raises the borrowing from the non- government sector. This means it is borrowing money that is already in the economy. It is not increasing the overall money supply.
But Michael Ashton, in ‘What’s Wrong with Money’, says that the government can also have the central bank buy up the bonds.
In Australia this occurs by our central bank, the Reserve Bank of Australia, buying the government’s bonds in the secondary bond market. There is a rule against the Reserve Bank buying bonds directly from the Treasury.
The buying of bonds on the secondary market by a central bank is called ‘open market operations’. But in the end, the effect is still that one branch of government (Treasury) ends up borrowing money from another branch of government (the central bank).
The transaction results in the Treasury exchanging the debt (represented by the bonds) for new money created out of thin air by the central bank.
If the bonds mature while the central bank still holds them, the bank can choose to simply retire the debt. Then the Treasury never needs to pay back the debt. The debt has been “monetized”.
But if the bonds are sold back into the market prior to maturity, then the transaction has been reversed. The debt is again held by the non-government sector. The government will still have to pay interest upon the maturation of the bonds. So, no monetization has occurred.
So, whether public debt is monetized depends upon whether the acquisition of the bonds by the central bank is permanent, or temporary.
If the acquisition is permanent, then it is reasonable to expect that the corresponding supply of new money would also be permanent and would remain in the economy- either as cash in circulation or as bank reserves.
As the interest earned on the bonds is remitted by the central bank to the Treasury, the federal government essentially can borrow and spend this new money for free. Thus, under this scenario, money creation becomes a permanent source of financing for government spending.
But if the acquisition is only temporary and the bonds are eventually sold back into the market before maturity, then the debt is not wholly monetized. The central bank is simply managing the supply of money in accordance with the goals of its inflation target. Even if the RBA sells bonds before they mature a small amount of monetization will occur in that the central bank should still receive coupon payments for the duration that holds it. Assuming that these payments are eventually credited back to the treasury via the central bank dividends this would also be considered monetization. But coupon payments are usually quite small compared to the face value of the bond.
Some means other than money creation (usually an increase in taxation receipts or cuts to government spending) will then be needed to finance the Treasury debt which has been returned to the public through open market sales.
Likewise, Biaggo Bossone describes two models for the monetization of public debt.
Under model 1 the central bank simply creates new money and transfers it to the Treasury without repayment obligations. Monetization occurs because the debt that would have arisen if the Treasury had borrowed the money has been avoided.
Under model 2 the more convoluted process described above occurs.
The government issues bonds in the primary market and the central bank purchases an equivalent amount of government bonds from the secondary market. But for this model to replicate model 1 the central bank must:
- hold the purchased bonds in perpetuity;
- roll over all the purchased bonds that reach maturity, and
- return to government the interest earned on the purchased bonds.
Model 2 to above could be amended to just have the central bank hold the bond till maturity and then return the profit to the Treasury in the form of its annual dividend. Though rolling over the purchased bond gives the central bank an asset that it could sell in the future if it needed to, for example, if inflation becomes too high.