Jim Brown, March 15, 2015
McKinsey’s little monster
McKinsey & Co, the trusted consultant to captains of industry and heads of state, has just written one hell of a report.
“Debt and (not much) De-leveraging,” published last month, does a fine job — in 136 pages laced with charts and graphs – of reporting on the debts of the world’s governments, corporations, and households. Seven years after the Global Financial Crisis, worldwide debt has increased by $57 Trillion (with a T) and now comprises 286% of world GDP, up from 269% in 2007. HardMoneyJim recommends the entire report for its rigorous exposition of the facts and figures.
However, it was McKinsey’s policy recommendations, not their data, that raised our hackles. In virtually all advanced countries, the report relates, government debt has outstripped the ability of its citizens to repay it. The usual remedies – spending restraint, higher taxes, and faster economic growth – cannot restore balance to sovereign budgets. How, the report asks, can these obligations ever be met?
McKinsey answers the question by opening a door many have feared to look behind. We quote from pages 33-34 (bold italics added):
“…Today, the central banks of the United States, the United Kingdom, and Japan hold 16, 24, and 22 percent [of GDP], respectively, of government bonds outstanding in their countries. These holdings are largely the result of the quantitative easing programs that were employed to stimulate growth after the recession…
“But does government debt owned by the central bank (or any other government agency) pose the same risk as bonds owned by private creditors? In a sense, this debt is merely an accounting entry…Moreover, all interest payments on this debt typically are remitted to the national treasury, so the government is effectively paying itself. In assessing the risk and sustainability of government debt, it is the size of net public debt…that really matters….
“Whether central banks could cancel their government debt holdings is unclear…any such move could create backlash in the markets and, in some countries, by policy makers. Therefore, a simpler but equivalent measure would be for central banks to simply hold the debt in perpetuity and for the broader public to shift its focus to net debt rather than gross debt. …
In these few paragraphs, McKinsey unveils a little monster-baby previously known mainly to monetary policy wonks. Though the report doesn’t use the phrase, “monetizing the debt” has, for years, incubated like an alien in academic footnotes and Federal Reserve research papers. But the little critter has hatched and is now sprouting wings, to the apparent approval of the McKinsey crew.
“Monetizing the debt” is a two-step procedure employed by governments that need money. In Step 1 the government simply creates new money to spend. In Step 2 it uses said new money to pay its own debt obligations. That’s it in a nutshell. Read on for important details.
Step 1 works this way. An agency of government – usually the central bank – conjures up new money by fiat, or official order. In the ancient days of metal money this was called “seigniorage.” The king’s minions would melt down some copper or tin to mix with pure gold coins, thus creating more coins to spend. The cost? Much cheaper than mining new gold. Fast forward to the 20th Century, the age of paper money, when the process was called “money printing,” performed by a Chancellor or his treasury officials. Just crank up the old printing press and – presto! – new paper bills for the sovereign to spend. The cost? Very small – basically just the price of paper and ink. Today, in the digital age, it could be called “crafting cyber-currency.”Just strike a keyboard or click a mouse and – zip! – new money for the central bank to distribute. The cost? Zero. In any age, whether the new money is forged by a monarch or decreed by a central bank PhD, it originates not from a mine, but from a mind with political authority.
Now for Step 2: New money in hand, the central bank purchases the bonds of its own government. The seller of the bond (government, bank, pension fund, or private investor) is now free to spend the new cash. The central bank now owns the bonds, receiving interest and principal payments from the government just like any other investor. The government still pays interest on its bonds – but it now pays its own central bank. These interest payments are then returned to the government in the form of “dividends.” In 2014, for example, the Fed paid the US Treasury almost $100 billion in dividends. Most of that was paid from the Treasury to the Fed and was then recycled right back to the Treasury, effectively nullifying the debt. What was a debt has been turned into money, or “monetized.”
If it all still sounds a little obscure, let’s illustrate with a simple story.
Suppose you go on a big spending spree. You run up thousands of dollars in credit card bills. You get way behind on your payments, with no prospect of earning more money in the foreseeable future. There is no way you can pay off the credit card company. Your credit rating, your reputation, and your access to future credit – all of which might be critically important in an emergency – are at risk.
However, you have a dear, benevolent relative – let’s call her Aunt Janet – who has some savings. Auntie comes to your rescue, agreeing to help pay your debt. She loans you the money you need to pay off your entire credit card balance. Now you owe her the money, but it’s a very good deal because she charges you an interest rate much lower than your credit card rate. It’s the least she can do, she says – after all, she’s your dear aunt.
But then she makes the deal even sweeter: Every time you send her an interest payment on the money she loaned to you, she pays it right back to you by contributing to your kids’ college fund.
Assuming your pride or sense of independence didn’t get in the way, wouldn’t you like to have this deal? Who wouldn’t? It’s all in the family, and as long as you don’t actually have to repay, it really isn’t a debt, is it? And if you were truly irresponsible, you might go on another spending binge knowing your Aunt Janet would bail you out a second time, and a third. It’s as if your debts could simply be turned into cash! By going into debt you actually make money!
But our story does not end there. One day, you discover that Aunt Janet is not actually lending you money out of her own hard-earned savings. It turns out she has a high quality printing press in her basement, and she is lending you money she prints up in little batches whenever she needs it.
What do you think of your Aunt Janet now?
There are only two important differences between what central banks are doing and what your Aunt Janet are doing. The first, less important, distinction is that your Aunt is printing up only a few thousand dollars at a time, so her actions, while fraudulent, will have only modest impact on the broad economy. Central banks, on the other hand, print up trillions of dollars with the specific intent of having an earth-shaking economic impact. They call it “stimulus.”
The second, more fundamental difference is that when Aunt Janet prints up a few thousand dollars, that’s called counterfeiting, but when the Fed prints up a few trillion dollars, that’s called “quantitative easing.” The first activity, when performed by a citizen, is a felony. Your sweet old Aunt will do hard time if she is caught. But the same action, when performed on a massive scale by the Federal Reserve, is perfectly legal – as determined by our own elected Congress. If Aunt Janet were, say, the Chair of the Federal Reserve, she might even get a presidential citation instead of a prison sentence.
Before we end our story, HardMoneyJim would like to pose a question. Having discovered Aunt Janet’s little basement scam, how would you react?
Would you be horrified, disown your Aunt, and notify the police? Would you feign ignorance and just go along with the scam, hoping Auntie could keep the game going a little longer before she is caught? Or would you ask Aunt Janet to print up even more money to make you both really rich?
And knowing what you now know about your own central bank – what do you intend to do about it?
Next: “Monetizing Morality”