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Friday, January 18, 2008

The Monetizing the Debt Scam

I've mentioned this topic in other posts. After seeing people Google searching for "How does monetizing the debt work?", I decided to make a post dedicated to this topic.

Money is continually destroyed due to the Compound Interest Paradox. Almost every day, the Federal Reserve needs to create new bank reserves so that the Fed Funds Rate equals the target rate.

The Fed Funds Rate is the rate that banks charge each other when they lend each other surplus reserves. Banks with surplus reserves loan them out to other banks. Banks with a shortage of reserves borrow reserves from other banks. Only the Federal Reserve has the power to create new reserves, via its "Monetizing the Debt" trick.

Suppose the Federal Reserve decides that it needs to increase bank reserves by $1B so that the Fed Funds Rate target is at its target rate. The Federal Reserve buys Treasury Notes that are nearly expired. Suppose these Treasury Notes have a market value of $999M. The Federal Reserve creates $999M of new money in the account of the bank that sold the Federal Reserve the Treasury Notes. The Federal Reserve's account looks like:

debit: -$999 million (money just created)
asset: $999 million (Treasury Notes with a market value of $999M)

A few days later, those Treasury Notes expire. The Federal Reserve redeems them with the government for $1B, the face amount. Now, the Federal Reserve's account looks like:

debit: -$999 million (money just created)
credit: $1 billion (redeemed Treasury Notes)

In other words, the Federal Reserve has a profit of $1M. The Federal Reserve makes a guaranteed riskless profit as long as interest rates are positive. The scam is that the Federal Reserve has no cost of capital. It was able to create the $999M out of thin air. The $1M that the Federal Reserve collected in interest payments was never created. It came from other loans that were taken out.

There is now a PERMANENT money supply shortfall of $1M. Every time the Federal Reserve "monetizes the debt", it puts society in a deeper and deeper debt hole. The $1M required to pay the interest was NEVER CREATED or put into circulation.

Instead of an outright purchase of Treasury Notes, the Federal Reserve sometimes does a "repurchase agreement". The Federal Reserve agrees to buy Treasury Notes for a few days, creating reserves, and then sell them back in a few days, destroying reserves. The interest accrued in those few days is subject to the Compound Interest Paradox, just like when the Federal Reserve makes an outright Treasury Note purchase.

It is only at this step in the money creation process, when the Federal Reserve "monetizes the debt", that the Compound Interest Paradox operates with the full force of law. When a bank loans out customer deposits, all the loan revenue is recycled as interest payments and bank expenses and profits. However, banks in aggregate need to borrow from the Federal Reserve every day. The Federal Reserve keeps creating new money to subsidize negative real interest rates.

Whenever someone gives you a hard time about the Compound Interest Paradox, construct an example. Once you see an example of debt-based money in action, the Paradox stands out. If you look at the books of any individual bank, their books balance. If you look at the books of "society as a whole", the Paradox is obvious.

1 comment:

Unknown said...


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