Process by which Federal Reserve (or any other central bank) helps ease government debt burden by printing money and using it to purchase debt issued by the government.

Alas, with this issue, Pocket MBA may have scheduled a date with The Peter Principle. Hey get a non-economist to write about finance, and eventually he'll just sit there, scratching his head and drooling. We'll know in a few paragraphs whether debt monetization is my Waterloo. If so, well, it's been a great seven years, and, heck, the job market is improving anyway. Otherwise, volume 8 beckons in just a couple short weeks.

Turn on finance television and you'll hear all about monetizing debt, and whether this process is the last stop toward the end of the dollar as a reserve currency, or even a currency at all. Even as the economy rebounds, we are mired in debt. How can you pay off trillions? Is it as simple as turning your debt into money? And what does that mean?

The term itself, to monetize, seems easy enough. According to Merriam Webster's Online dictionary, there are three definitions for monetize:

1. to coin into money; also to establish as legal tender
2. to purchase (public or private debt) and thereby free for other uses moneys that would have been devoted to debt service
3. to utilize (something of value) as a source of profit

Pocket MBA could monetize the shirt on its back by selling it to you for $10. That is, we can assign a value to it. But neither the shirt, nor what you pay for it is debt. We're just engaged in a transaction where we trade a shirt for a piece of paper that says $10 on it. Arguably, when I sell you my shirt, we're doing definition three.

And while the head scratching has begun, PMBA is pretty sure that when we hear talk of monetizing the debt of the United States, we're talking about definition number two — because debt monetization involves the government selling debt to the Federal Reserve, which then prints new money for the government to use for paying interest on the bonds (debt) we've sold to foreign countries, like China. This is as opposed to, say, collecting taxes to pay the debt, which was the time-honored way of doing so before our fiat money system made printing new money a much easier way of achieving the same end.

Of course, definition one shouldn't be lost in the shuffle — countries have been monetizing gold and silver for a long time. In fact, under the Bretton Woods System, the U.S. dollar was a monetization of gold. Of course, as we saw last week, our money, now, has no intrinsic value, other than the belief by others that it has value and their demand for it that results from our economic power.

Monetizing debt doesn't have to be bad; it's just that when you have a devalued currency and a lot of debt to begin with, the monetization process can kill whatever value the currency has left, as the money printing process devalues the currency further. Pocket MBA will leave it to experts to determine whether and to what extent we are currently monetizing our debt. Just know that many think it is happening and that it will simply add to our economic woes, rather than solve them.

So how does monetizing the debt work? That is, how do we turn debt into money to pay off other debt? Note, only an entity with the power to print money can do this trick. Pocket MBA has some credit card debt, but has no way to monetize it. PMBA simply writes, gets paid and pays some of the money over to the credit card issuer. If Pocket MBA had a printing press in its basement, it could simply print enough money to pay the debt. Even that is not the same thing the federal government, in conjunction with the Fed, can pull off.

In true PMBA fashion, we're going to oversimplify this just so we can get a basic understanding of what debt monetization means. We'll avoid the variety of debt held by the public, as well as the accounting techniques that the Fed has to apply to achieve the monetization feat. Stripped to its most basic, here's what happens. First, you assume a country in debt — not hard to do. Being in debt simply means that the expenditures of the government outstrip its revenues (i.e. the tax base). In such a situation, the government (via the Department of the Treasury) can borrow money from other countries to pay for the shortfall by issuing treasury bonds, on which it will pay interest until maturity. The government can do this indefinitely so long as the foreign countries buy the debt and so long as the government can pay the interest on the debt.

In our current economic situation, where we've had a drying up of consumer credit and demand, the federal government has moved to fill the void by spending ever more money; it does so by issuing more debt. Leave aside the problem that our tax base can't cover the excess debt — we can always raise taxes, but politicians are loathe to do so, especially in a down economy. But let's assume that foreign entities refuse to buy any more government debt, or we decide that we can't pay for it because the tax base can't support the debt service. Then what? Enter the Federal Reserve. In order for this trick to work, you have to remember that the Fed is technically not part of the government, even though it seems like it is.

The Department of the Treasury can issue the same bonds it was selling to foreign governments, but instead of selling to them, it sells them to the Federal Reserve. Of course, the Fed can't raise taxes; it has no citizenry; it's a bank. But one thing the Fed can do is create actual fiat money, a feat the federal government can't do. In order to pay for the treasury bonds, the Fed simply creates new money, which it turns over to the Department of the Treasury which puts it into circulation for paying off other debts. Presto change-o, our debt has become monetized. That is, we've paid debt by issuing debt.

Of course, the problem with this is, as we saw last week in our discussion of fiat money, that printing ever more fiat money causes inflation, even hyperinflation. Substantial debt monetization is, therefore, almost by definition, inflationary. (In fact, that is the point of it — paying debt in cheaper dollars.) But that hurts consumers unless the Fed can figure out how to suck the money back in, which it would do by raising interest rates sky-high — at least that's how Paul Volcker did it in the early 1980s. The irony is that we have been fighting deflation risk this entire year. See Volume 7, No. 1. And as monetization is inflationary, it is certainly a tool to fight deflation, as well. This is one reason some say that the Fed is methodically monetizing the debt — to produce inflation. If you think deflation is worse than inflation, then monetizing the debt, along with all other forms of printing money is a qualified good, at least in the short run. But for the long-term, it's a pickle.

Anyway, that's monetizing the debt, PMBA style — if we're back here the week after New Year's, that means we got this basically right — even if I do get a bunch of comments and corrections from readers (and I always welcome them, especially on topics like this that some of you have actual experience with). Now, off to enjoy the Holidays, but unable to monetize them.