How does the Fed monetize the debt? I don't understand this, yet I hear it all the time. It's one of those catch phrases that people often throw out there without really knowing what is going on.
Caroline Baum's "Handcuffing the Fed" Bloomberg column states that the Fed's powers are curtailed when the federal government runs deficits because the Fed is then forced to get involved in monetizing the debt when it could be doing other important things (e.g., tending to its dual mandate of keeping inflation and unemployment low, neither of which it has any direct power to affect).
But getting back to the claim that the Fed is hamstrung every time the government runs deficits -- well, this is just ludicrous.
First of all, the Fed cannot buy government securities directly from the Treasury. It is precluded by statute from doing this, so the idea that the Fed is writing checks to the government to enable the government's deficit spending is just plain false. The Fed buys securities in the secondary market, which means in the open market, from primary dealers or the customers of primary dealers who have already bought (and own) the debt that the government has sold.
Second, unlike any commercial bank, the Treasury is not allowed to overdraw its account at the Fed. Every single commercial bank can automatically run an overdraft in its account, which the Fed will automatically cover, but the Treasury is prohibited by law from doing this. So, while the Fed can fund or provide short-term liquidity to banks, it cannot do so for the federal government.
Third, how does the government get money if not from the Fed? It gets it by decree. That's right; Congress just decides to raise the government's issuance (borrowing) limit. We've just been through one of these increasingly nasty events. If the government hits a spending wall at $16 trillion, then Congress votes to say that it can now spend $17 trillion or $20 trillion or whatever it wants the number to be. That's what fiat money is all about. It's money by decree.
The bottom line is there is no such thing as debt monetization in a fiat currency system. And I know what some are going to say -- that it's crazy and that money needs some backing. Well, it does have backing. The fact that the government imposes and collects taxes means that there will be demand for the government's money because that is the only way to settle tax liabilities. The type of taxes imposed can be altered, but the act of taxing is what imparts value to the currency.
Finally, a word on the idea that deficits create a need for the Fed to fund the government. The deficit itself means that the government has spent more dollars into the economy than it has removed via taxation. So the dollars are there to buy the Treasuries. There is no net supplier of dollars outside the government itself.
On a totally different note, I see that the euro has recovered nearly all of its losses following the ECB's surprise rate cut last week, just like I said it would. And I believe I said I bought EUR-USD on that dip. I'm now taking profits.