QE Is Debt Cancellation

With the financial markets in turmoil and the global economy now sliding rapidly back into severe recession, it can only be a matter of time before the Fed launches the next round of Quantitative Easing, QE 4.

That is good news because, as you will see below, the more government bonds the central banks buy, the more government debt they effectively cancel.

It is crucial that this point is understood, especially now that the calls for GQE (Green Quantitative Easing) and Quantitative Easing For The People are growing louder

The underlying logic

When a central bank creates money and buys a government bond, it is the same thing as cancelling that bond – so long as the central bank does not sell the bond and so long as it rolls it over when the bond matures.

That means the United States, the UK and Japan have far less government debt than is generally understood.

The same will soon be true for the eurozone governments. This has important policy implications that the world cannot afford to ignore.

The Federal Reserve has acquired $2.5 trillion of U.S. government securities, nearly 14% of all U.S. government debt. The U.S. Treasury Department pays interest on that debt to the Fed.

Then, at the end of every year, the Fed turns around and gives its profits to the Treasury, including the profits from the interest income earned on its government debt holdings.

Last year, the U.S. central bank gave the U.S. government $97 billion. It has given the government $500 billion since 2008. In other words, on the bonds held by the Fed, the U.S. government is paying interest to itself, which is the same thing as not paying any interest.

Bonds that do not pay interest have been effectively cancelled. Seen in this light, the ratio of government debt to GDP in the United States is not 105%, it is 89%.

Similar situation in UK and Japan

The UK government is paying interest to itself on the £375 billion of government debt owned by the Bank of England. That is 24% of all UK government debt.

Since the Bank of England is unlikely to ever sell those bonds, the ratio of government debt to GDP in the UK is actually 70%, rather than 92%, as it is now reported to be.

The Bank of Japan owns Japanese government bonds equivalent to 53% of GDP and it is acquiring new government bonds at roughly twice the pace that the government is selling them.

Once it is understood that Quantitative Easing is debt cancellation, the BOJ’s very aggressive QQE program makes sense. It may be the only way to prevent a fiscal crisis in Japan, where government debt is reported to be 245% of GDP.

The more government debt acquired (and effectively cancelled) by the central bank, the less likelihood of a fiscal crisis.

Fiat money creation on a large scale was supposed to cause very high rates of inflation, or even hyperinflation. It hasn’t because it has taken place at the same time that globalization has been driving down the cost of labor in the developed economies.

Fiat money and globalization

Under the Bretton Woods system, when trade between nations had to balance, aggressive fiat money creation would have over-stimulated the U.S. economy (for instance), quickly leading to full employment, full capacity utilization and wage-push inflation.

Under the dollar standard, trade no longer has to balance, so all domestic bottlenecks can be circumvented by buying from abroad.

In our new global economy, two billion people live on less than $3 per day. That means we will not hit capacity constraints in labor, leading to wage inflation, for decades.

And that, as the history of the past six years demonstrates, means that the central banks of the developed economies can create money and finance massive government budget deficits without causing inflation.

This combination of fiat money and globalization under the dollar standard creates a once-in-history opportunity. The government debt owned by the central banks should be held permanently and perpetually rolled over, effectively cancelling it.

More productive investments

It would then be clear that governments really have much less debt than is generally understood. The governments of the developed nations could then borrow more and invest that money in productivity-enhancing manners.

This includes investments into new industries and technologies to restructure their economies and to retrain and educate their workforce at the post-graduate level.

It would be a way to ensure that the standard of living in the developed world continues to improve, rather than sink to third world levels.

Furthermore, large investments in green technologies could be financed with GQE, Green Quantitative Easing, perhaps preventing an environmental catastrophe.

Heretical as it may appear at first impression, Quantitative Easing has already effectively cancelled trillions of dollars of government debt without causing inflation.

At the very least, this fact completely undermines the case in favor of further growth-retarding fiscal austerity. If this opportunity were fully exploited, investments could be financed that would not only restore global growth, but that would also improve the well-being of everyone on this planet.

Editor’s note: For all the details on how QE cancels government debt, watch this free Macro Watch video.