Consulting by RPM || Free Advice Blog

Epiphany or Brain Fart? Government Debt and Inflation

As I think I have mentioned, I’m working on a textbook for junior high / early high school kids. (It’s a textbook on economics, not yoga, in case you are wondering.) I was being really anal about the precise connection between government deficits and price inflation, explaining that a budget deficit per se doesn’t create new dollars, and so by itself doesn’t push up U.S. prices.

But of course in practice there is a connection, since government debt gives the Fed an incentive to create new money. I mentioned that if we just thought about a printing press, there would always be the temptation for the government to pay its bills by simply creating the necessary number of $100 bills.

Finally I dealt with the complication of the Federal Reserve buying Treasury debt from the public, etc. etc. In our system, the government can’t literally just print up new money to cover a shortfall in revenue, and call it good.

But I wanted to show that things were actually quite close to the straight-up “counterfeiting” operation, where the Fed is literally just printing new money so the government can close its budget deficit. In doing so, I had an epiphany; the connection was even closer than I had realized before working on this section of the book. Here’s the footnote, and please tell me if this is basically right or if my black helicopter worldview has misled me:

If you are a sharp reader you might think that this isn’t truly printing up new money just to close a budget shortfall, because the federal government still owes interest and the return of principal to the holder of the bonds it issued. But guess what? The Federal Reserve is the recipient of these payments (since the Federal Reserve bought the bonds from the private dealers), and as standard operating procedure the Federal Reserve remits all of its excess earnings back to the Treasury. In other words, after the Federal Reserve pays it electric bill, employees, and so forth, any extra money it has, it sends back to the Treasury. Thus in the modern American financial system, things really can be quite similar to the operations of an outright counterfeiting operation!