People don’t understand how central banks work (Part 2)

by pdxblake

To see where this post started, refer back to Part 1 which describes the argument about why “you can’t fix a debt problem with more debt” is wrong.  This part of the post will focus on why the Federal Reserve and other central banks are not “printing money” when they do monetary policy and specifically quantitative easing.

First, most central banks including the Fed are not able to directly buy government debt from the government.  They are independent of the government (in part to avoid political pressure that might lead to them buying government debt directly).  Stripping away this independence, which the Republicans actually recently endorsed by passing an ‘audit the Fed’ bill, is how the Fed could start ‘printing money’.

There is a big difference between ‘printing money’ and the Fed’s monetary policy.  Since they are independent and can only buy bonds on the secondary market, the money they create does not directly fund government spending.  Direct purchases of bonds from the government, where the Fed creates money and buys bonds from the government sending the money to be directly spent by the government can (but will not always) lead to out of control inflation.  In cases where it does, it usually is because the government’s ability to level taxes does not function, so it must instead resort to taxation through inflation.  This will show up in the statistics as high and growing levels of inflation, not something that comes across in the data.  It is also the reason for maintaining the independence of the Fed.

In contrast, when the Fed undertakes monetary policy that does not entail it handing over banknotes to the government to pay for current spending, it creates an asset on the balance sheet (whatever bonds it purchases) that offsets the liability it has issued (the currency).  In order to undo the stimulative effect of the bond purchases, it will sell the bonds and retire the currency, leaving it back where it began.

The difference between the direct funding of government spending and normal monetary policy is that the bonds the central bank gets when it buys bonds directly from the government to fund current spending (because the government can’t collect tax revenues) is that the asset it gets in return has little or no value since there is not a revenue stream of tax receipts backing the bond to fund future repayment.  In contrast, government bonds that the Fed is buying are very valuable (just look at the yields on 10-year US debt; yields fall as bond prices rise).

If investors believed that the Fed policies were inflationary, the yields they would demand of the government to hold these bonds would be rising, not falling.  Sometimes though, ideological preferences for the idea that the Federal Reserve can’t possibly be doing anything right, or anything which could help the economy without creating future inflation just choose to ignore inconvenience evidence rather than reconsider their beliefs.