The “Debt Monetization” Myth

With the recent turmoil in the repo market, the Federal Reserve has once again stepped into the fray and announced a new program of Quantitative Easing (QE) aimed at increasing liquidity in the overnight markets. While Fed officials are loath to label this new round of bond purchases as “QE”, the mechanics of the operation are precisely the same, with bonds being purchased from the private sector by the Fed in exchange for newly created bank reserves. Predictably, critics are once again accusing the Fed of engaging in “debt monetization”, repeating the same accusations they have been making ever since QE first began in the aftermath of the 2008 financial crisis.

Briefly, debt monetization is the process by which the government issues debt to finance spending, but rather than obtaining funding by borrowing from willing lenders in the private sector, they instead obtain funds directly from the Fed with money that is simply “printed” into existence. Because the Fed is regularly required to return all of its profits back to the US Treasury, all interest payments made by the Treasury on this debt simply flows back to the government as profits remitted by the Federal Reserve. Thus, funding is obtained by the US government to finance deficit spending, but, thanks to the Fed, this is now achieved at zero cost to the Treasury. In essence, the US government has essentially obtained free money by obtaining loans at zero-percent interest.

Unfortunately, due to the way the banking system is currently structured, the theoretical process of debt monetization described above is not quite as advertised. In practice, the US Treasury does not actually receive a net benefit from the purchase of bonds by the Federal Reserve as many critics like to claim. When the Fed engages in QE they purchase US Treasury bonds from the private sector and pay for these bonds with bank reserves which they effectively create “out of thin air”. While it is true that the interest payments from these newly-purchased bonds do flow back to the US government as Fed profits, what is nearly always forgotten by those who label QE as debt monetization is the fact that the creation of bank reserves comes at an offsetting cost to the Fed.

This cost is what is known as Interest on Excess Reserves (IOER), which is the interest that the Fed pays on the balance of excess reserves that banks hold in their accounts at the Fed. IOER functions to reduce Fed profits, which reduces the income flowing from the Fed to the Treasury. Because every dollar of bonds purchased by the Fed results in an equivalent amount of excess reserves in the banking system, the much-touted “interest savings” resulting from this so-called debt monetization is reduced by exactly the amount the Fed pays on the newly created reserves. Ultimately, at the end of the QE process, interest paid by the Treasury is indeed returned to them via Fed profits, but this amount is subsequently reduced by the increased payments the Fed now must make to banks on their larger balances of excess reserves.

IOER currently sits at 1.8%, and the yield on the 10-year treasury is sitting at just a touch below that number at 1.76%. This means that on balance the Fed’s profits from QE are being reduced through IOER payments by a greater amount than it is increasing through US Treasury Bond payments. Essentially, on net, the government is actually losing more money from its QE operations than it is gaining. If debt monetization was actually the goal of these renewed QE operations, both the Fed and the government have grossly miscalculated its benefit from a fiscal standpoint. The Treasury would have been better off had they simply issued debt to the private sector, made good on their interest payments, and left the Fed out of the equation entirely.

Debt monetization therefore isn’t really the point of QE, since on aggregate the operation results in no fiscal benefit to the government as currently structured. Having said that, is it possible to simply change the operational workings of the banking system so that debt monetization were possible using the current QE bond purchase program? The answer is yes. The Fed could simply stop paying IOER, although this would undoubtedly give rise to an entirely new set of problems for the banking sector. The Fed obviously hasn’t gone down that path as of yet, but that’s not to say they won’t at some point in the future. Until then, talk of QE being “debt monetization” is somewhat of an inaccurate description based on an incomplete understanding of the flow of funds between the Federal Reserve and the Treasury.