More and more people have become familiar with the impact that Federal Reserve policy has on the economy. It’s easy to latch on to popular criticisms which deliberately leave out finer details for the purpose of saving time. We’ll now look into some of these finer details to more clearly understand the process by which the Federal Reserve finances the federal deficit, and then we’ll examine the consequences that deficit financing has on the economy.
The U.S. federal government ran a 1.3 trillion dollar deficit in 2011, and we should expect a similar number for 2012. In order for the government to borrow 1.3 trillion dollars, the U.S. Treasury must issue 1.3 trillion dollars of debt by selling notes, bills, bonds, and securities. The federal government then takes the money made from those treasury items and spends it as outlined by the federal budget. Unfortunately for the federal government, the treasury does not always sell enough notes, bills, bonds, and securities to pay for the deficit. This is especially true when the federal government runs large deficits as it did in 2011. As such, the Treasury sells all of its debt to the so called lender of last resort, the Federal Reserve.
Historically, central banks have monetized government debt. That means that instead of lending money to the government (either directly or indirectly), the central bank simply prints new currency and gives it to the government. Although the Federal Reserve does not technically monetize the debt, it effectively monetizes debt by the period of time it takes for the Treasury to pay back the debt. So, for example, if the Federal Reserve buys one trillion dollars worth of 30-year Treasury bonds for a five year period, there will be a five million dollar raw increase in new money which won’t decrease until 25 years after the last bond purchase. If the Federal Reserve consistently purchases 30-year bonds every year for 30 years, it will take 60 years from the date of the first bond purchase to fully recover from the inflationary effects. Because the new money lent out by the Federal Reserve goes to the government, we see severe levels of inflation, specifically in those areas in which the government spends money. Unfortunately for the public, those areas tend to be the most important ones (housing, education, healthcare, etc.) Those sectors see a distorted level of demand because they receive brand new money from the government on top of the money that individuals already spend in those areas. Individual citizens do not have access to Federal Reserve money, so they don’t have the funds to match the artificially high prices that prevail in those industries.
If the Federal Reserve stops financing the deficit, the government will no longer be able to guarantee spending for specific industries (housing, education, healthcare, etc), and prices for those industries will decrease dramatically.