I think some of my readers are confusing my claim that United States essentially cannot end up like Greece with the claim that any amount of government spending can financed through money creation.
The US could, in theory, end up like Zimbabwe. Indeed, in the column that started it all Greg Mankiw used that example and I didn’t dispute it. It is entirely possible to print your way to hyper-inflation.
This is different, however, than the claim that high levels of borrowing would force the United States to default.
Let me take the issue by another handle to see if I can explain.
The fact that US T-Bills are traded for reserves means that barring a complete financial collapse the US government can always extract funds from the banking sector.
What happens is not that banks refuse to lend money to the government – this is never sensible – it is that in order to reign in inflation the Federal Reserve must contract the total quantity of reserve and drive up interest rates on all borrowing.
Or put another way: as the interest rate on T-Bills rises then money will flow out of the Federal Funds market and into the T-Bill market. This will cause the Federal Funds rate to rise.
Normally the Federal Reserve would then step in and buy T-Bills. The way they buy T-Bills is by simply increasing the reserves the bank has with the Fed. This causes the supply of reserves to expand and the Federal Funds rate to fall.
In theory the Fed could simply not do this – though this would be a radical change in monetary policy. Then money would continue to flow out of the Federal Funds market into the T-Bill market.
The Federal Funds rate would start to rise. In response banks would then curtail lending. Credit card offers would dry up. Financing costs for cars and trucks would rise. Business loans would be harder to come by, etc.
This action would restrain the growth of the economy and keep inflation from occurring.
In the data you would see retail sales fall and the savings rate rise to cover the large budget deficit. This is exactly similar to what is going on now, accept for different reasons. In this case the private sector recession would accommodate the fiscal expansion.
Now as always there is a limit on how much the government can extract from the private sector. At some point you are going to generate a banking crisis. Rising short term interest rates are going to lead to falling asset prices, including the assets on bank balance sheets. Eventually, the banking system will find itself insolvent and will collapse.
This can indeed happen, but this is different than the Greek scenario. Importantly while Greece’s problems were caused by a recession, this situation would be eased by a recession.
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Monday ~ October 24th, 2011 at 4:49 pm
Johnnie Linn
Why would the federal funds rate rise? Banks need to borrow in the federal funds market if they cannot meet their reserve requirements, but banks are awash in huge amounts of reserves that they are not lending out because they are being paid interest on them by the Fed.
Tuesday ~ October 25th, 2011 at 3:13 pm
geerussell
“Or put another way: as the interest rate on T-Bills rises then money will flow out of the Federal Funds market and into the T-Bill market. This will cause the Federal Funds rate to rise.”
Rise… but no higher than the discount rate, yes? At that point banks could turn to the discount window for reserves, placing an effective ceiling on short term rates. If that’s the case then the rate is always a policy tool under control of the fed, not something that would blow up as a market response to deficits.
One can only hope that in the hypothetical circumstance where rates were increased in response to high inflation, they would also be reduced as the desired effect was achieved.
Also, this works a lot better if it’s coordinated with fiscal policy. Cutting spending and/or raising taxes are also an appropriate prescription for high inflation. Of course hoping for coherent fiscal policy is going beyond hypothetical into real crazy talk so I’ll just quit now.