A Seeming Paradox About Inflation

Dr. Harper is a member of the staff of the Foundation for Economic Education.

“You say that it is inflationary for the government to sell its bonds in order to finance a deficit in its budget. But I have also heard it said that it is inflationary when the government buys bonds. How can that be? How can both buying them and selling them be inflationary?”

This seeming paradox must be resolved if one is to understand how our present money system works and how inflation continues to erode the worth of our money and other savings.

In order to grasp the full picture, it might be well to start back a few notches in the history of money.

Many things have been used for money, including wampum, cattle (pecus, cattle; pecuniary, pertaining to money), and gold. But let’s skip directly to gold.

In the beginning, gold metal itself was used for money. Whether as dust, nuggets, or minted into coin, it was traded for things in the market.

Then, later, the local goldsmith became the safekeeper for the gold, giving receipts redeemable in gold in return for the gold deposits made with him. These receipts, rather than the gold itself, then began to circulate as the money of trade.

Noting that not all depositors redeemed their receipts in gold at one time, the goldsmith began to write “extra receipts” as loans to persons who had no gold to deposit. For this he charged a fee. These persons could use these receipts for money-just like gold. How could it ever become known that no gold was there to redeem these extra receipts? If one or two persons should test the validity of their own receipts, the goldsmith would be able to meet their demands from the gold stock lying there unused, for which valid receipts had been issued.

This game of providing “extra receipts” had its limits, however. The goldsmith must be ready to meet whatever demands might be made for gold at any time. He must have this much actual gold in reserve, in relation to all outstanding claims. Thus arose the original “fractional reserve” plan, whereby the goldsmith set his own limit on “extra receipts” as a protection against peaks of claims for redemption in gold. If, for instance, he should assume that half the receipt holders might someday descend on him and ask for their gold, he would then need a 50 per cent reserve. But if he should assume that only one-fourth of them would do so, a 25 per cent reserve would suffice.

These “goldsmiths” eventually became “bankers,” and more or less the same process continued. The “extra receipts,” or “loans,” gave the borrower a deposit claim on lawful money. Lawful money of an earlier day meant that it was redeemable in gold at a specified rate -for a long time at the rate of one ounce of gold for $20.67 of these paper claims on gold.

The “goldsmith’s panics” of old then became the “bank panics” of later days. In both instances these terms described a situation where the demands for gold exceeded the reserves available to meet them. There were “runs on banks,” as people tried to get the gold they normally did hot really want, but which suddenly gained appeal when they found that perhaps it couldn’t be obtained on demand.

In 1913, the Federal Reserve System was established by law in the United States. Under this arrangement the twelve regional Federal Reserve Banks became the central depository for reserves of all commercial banks that became members of the System-representing, at the present time, about three-fourths of all bank deposits. Under this System, Congress sets broad limits of reserve requirements, and the Board of Governors of the Federal Reserve sets the specific requirements. At the present time the average reserve requirement is about one-eighth of total deposits in member banks.¹

---

1.   The different reserve requirements for banks of different classes, and for demand deposits as against time deposits, are not separately identified in this overall illustration.

---

With this background, we are now ready to unravel the seeming paradox about government bonds and inflation.

Deficits and Inflation

Let us say that in a given year the federal government has a deficit of $100. This is the amount of excess of its spending over its income from all forms of tax revenue. Being unable to pay, out money it doesn’t have, the additional $100 must be obtained somewhere. The government must borrow what it has been unable to obtain in any other way, before it can pay all its bills.

So the government writes an IOU for $100, for which it must find a buyer.

Perhaps you, as a private individual, buy the bond and pay for it from cash in your pocket or from your bank account. The government then has the $100 to pay its unpaid $100 bill. And you, as a consequence, have $100 less to spend. There has been no inflation here, since the total of money has remained the same as before. The $100 has changed hands-from you to the person who received it from the government in payment.

Suppose no individual or business outside the banks wants to buy that bond. The government may then turn it over to a commercial bank, which accepts the bond as evidence of a loan and enters a deposit of $100 in the name of the government. The government can now draw a check against this deposit and pay its unpaid $100 bill. When this course is followed, there has been created at once an additional $100 of money which was not in existence before. There has been an inflation of $100 at this point. It is like an expansion of credit-money through any other kind of bank loan, except that in this case the borrower happens to be the government rather than a corporation or individual.

Pyramiding Inflation

Up to this point there has been an inflation of $100, due to the government’s borrowing the $100 of newly-created credit from a bank.

Now let us assume that prior to this transaction commercial banks had already loaned up to the limit allowed by their reserves. In other words, their deposits-including all unpaid prior loans-were already eight times their reserves at the Federal Reserve Banks. No further expansion of deposits through further loans would have been permissible until more gold or other legal reserves had been sent to the Federal Reserve Banks. Buying the $100 government bond and adding $100 to its deposits would at once make the bank $12.50 short of reserves.

But the shortage of reserves can easily be met, since the law provides that this very same government bond is as good as gold in meeting reserve requirements. So to square their reserve requirements, the bank would merely have to send a $12.50 fractional bond to the Federal Reserve Bank, thus meeting the reserve requirement of one-eighth of the new deposit of $100.

If there are no private borrowers wanting to borrow more funds on safe terms, the local bank would probably send only the $12.50 and keep the remaining $87.50 as an interest-bearing investment of its own. But if good potential borrowers are waiting to be served, the bank will probably send the entire $100 government bond to the FRB and increase its reserves by the full amount. Then it will be able to loan an additional $700, and keep within the reserve requirements. In doing that, the increase of reserves of $100 will meet the one-eighth reserve requirement for $700, in addition to the $100 loaned to the government in the beginning.

After this has taken place, we can see how the issuance of the single government bond to meet a federal deficit of $100, creating an initial inflation of only $100, subsequently grows into a total inflation of $800. This process is sometimes called monetizing the debt because the increase in government debt has been turned into new money that can be carried around in our pockets. Or the process might be called inflationary pyramiding of the federal deficit because the effect is one of building an inflation pyramid upon a government deficit.

One phase of our seeming dilemma about government bonds and inflation has now been explained. And the conclusion is that selling government bonds to banks in order to finance a government deficit is, in fact, inflationary. It may even be violently inflationary, if the pyramiding effect which has been described is carried out in full.

How Buying Bonds Is Inflationary

Now comes the other side of the seeming paradox. Is it true that under present monetary management “it is inflationary when the government buys bonds”? For have we not just concluded that it is inflationary for the government to sell its bonds to banks in meeting a deficit?

Were the government itself-the United States Treasury-to buy back its own bonds, the process would be the reverse of what has just been described. If it were to rebuy bonds from individuals, it would cause neither inflation nor deflation because there would be only a shift of money from one individual to another; the government would have to collect $100 from some taxpayer in order to get the $100 with which to buy the bond from some other individual. But if the bonds were to be re-bought from banks, it would be deflationary because there would have to be liquidation of outstanding credit in the process, reversing the inflationary credit expansion just described.

But it is not the buying of bonds by the government that is referred to under present monetary management. What is being referred to in this connection is not the re-buying of its own bonds by the government—by the United States Treasury. What is meant is the purchase of government bonds by the Federal Reserve Banks instead of by the government. These two, as buyers, are quite separate and distinct from one another, and the effects of the two are quite the opposite of one another so far as the effect on inflation is concerned.

When the Federal Reserve Banks buy a bond, it is similar to our earlier illustration where the local bank deposited a new $100 government bond with the Federal Reserve Banks in order to replenish its reserve requirements. Then, as will be recalled, the sale of $100 in bonds to the FRB paved the way for a large increase in new money—pyramiding inflation. And it is the same when the Federal Reserve buys bonds in its open market operations. The only difference between the two is the matter of where the initiative lies in the transaction. In the first instance, the local bank took the initiative and sent the bond to the Federal Reserve as a sale in order to replenish and expand its reserves. In the latter instance, the Federal Reserve took the initiative and went into the open market to buy the bond. Let us say it was bought from this same bank. The effect on reserves is the same in both cases, no matter which way the transaction was initiated. In both instances, the reserve balance-the credit base-has been expanded by as much as eight times the amount of the bond deposited with the FRB.

The mere buying of the bond by the Federal Reserve in the open market was not, in a technical sense, inflation. For the act itself created no more active money. Rather, it should be called potential inflation. The reserve base is thereby increased so that there can be a subsequent increase of credit, and new money, by as much as eight times the amount of bond deposited.

For this broader credit to become inflation in fact, there must be persons who want to borrow and banks willing to lend them the expanded credit which has now be’ come possible. Only then will there be loans-new money, inflation. The reason why the buying of government bonds in the open market by the Federal Reserve Bank is said to be inflationary is the assumption that credit will be expanded as a consequence. And normally that is a safe assumption.

Thus, as to the seeming paradox, it is true that selling government bonds and buying government bonds are both inflationary. The distinction which resolves the seeming paradox is the matter of who does the buying and who does the selling.

In summary, we might unravel the seeming paradox this way: When the government sells a bond to the banking system, it is inflationary. It may even be highly inflationary if that bond comes to rest in the Federal Reserve Banks to serve as reserves for additional credit expansion. And that is why we say that it is inflationary when the Federal Reserve Banks buy bonds in the open market. It is similarly inflationary whether the commercial banks take the initiative and send bonds to the Federal Reserve Banks to increase their reserves, or whether the FRB takes the initiative and enters the open market to buy the bonds. Both are highly inflationary. []

1.   The different reserve requirements for banks of different classes, and for demand deposits as against time deposits, are not separately identified in this overall illustration.
With this background, we are now ready to unravel the seeming paradox about government bonds and inflation. Let us say that in a given year the federal government has a deficit of $100. This is the amount of excess of its spending over its income from all forms of tax revenue. Being unable to pay, out money it doesn’t have, the additional $100 must be obtained somewhere. The government must borrow what it has been unable to obtain in any other way, before it can pay all its bills. So the government writes an IOU for $100, for which it must find a buyer. Perhaps you, as a private individual, buy the bond and pay for it from cash in your pocket or from your bank account. The government then has the $100 to pay its unpaid $100 bill. And you, as a consequence, have $100 less to spend. There has been no inflation here, since the total of money has remained the same as before. The $100 has changed hands-from you to the person who received it from the government in payment. Suppose no individual or business outside the banks wants to buy that bond. The government may then turn it over to a commercial bank, which accepts the bond as evidence of a loan and enters a deposit of $100 in the name of the government. The government can now draw a check against this deposit and pay its unpaid $100 bill. When this course is followed, there has been created at once an additional $100 of money which was not in existence before. There has been an inflation of $100 at this point. It is like an expansion of credit-money through any other kind of bank loan, except that in this case the borrower happens to be the government rather than a corporation or individual. Up to this point there has been an inflation of $100, due to the government’s borrowing the $100 of newly-created credit from a bank. Now let us assume that prior to this transaction commercial banks had already loaned up to the limit allowed by their reserves. In other words, their deposits-including all unpaid prior loans-were already eight times their reserves at the Federal Reserve Banks. No further expansion of deposits through further loans would have been permissible until more gold or other legal reserves had been sent to the Federal Reserve Banks. Buying the $100 government bond and adding $100 to its deposits would at once make the bank $12.50 short of reserves. But the shortage of reserves can easily be met, since the law provides that this very same government bond is as good as gold in meeting reserve requirements. So to square their reserve requirements, the bank would merely have to send a $12.50 fractional bond to the Federal Reserve Bank, thus meeting the reserve requirement of one-eighth of the new deposit of $100. If there are no private borrowers wanting to borrow more funds on safe terms, the local bank would probably send only the $12.50 and keep the remaining $87.50 as an interest-bearing investment of its own. But if good potential borrowers are waiting to be served, the bank will probably send the entire $100 government bond to the FRB and increase its reserves by the full amount. Then it will be able to loan an additional $700, and keep within the reserve requirements. In doing that, the increase of reserves of $100 will meet the one-eighth reserve requirement for $700, in addition to the $100 loaned to the government in the beginning. After this has taken place, we can see how the issuance of the single government bond to meet a federal deficit of $100, creating an initial inflation of only $100, subsequently grows into a total inflation of $800. This process is sometimes called because the increase in government debt has been turned into new money that can be carried around in our pockets. Or the process might be called because the effect is one of building an inflation pyramid upon a government deficit. One phase of our seeming dilemma about government bonds and inflation has now been explained. And the conclusion is that selling government bonds to banks in order to finance a government deficit is, in fact, inflationary. It may even be violently inflationary, if the pyramiding effect which has been described is carried out in full. Now comes the other side of the seeming paradox. Is it true that under present monetary management “it is inflationary when the government bonds”? For have we not just concluded that it is inflationary for the government to sell its bonds to banks in meeting a deficit? Were the government itself-the United States Treasury-to buy back its own bonds, the process would be the reverse of what has just been described. If it were to rebuy bonds from individuals, it would cause neither inflation nor deflation because there would be only a shift of money from one individual to another; the government would have to collect $100 from some taxpayer in order to get the $100 with which to buy the bond from some other individual. But if the bonds were to be re-bought from banks, it would be deflationary because there would have to be liquidation of outstanding credit in the process, reversing the inflationary credit expansion just described. But it is not the buying of bonds by the government that is referred to under present monetary management. What is being referred to in this connection is not the re-buying of its own bonds by the government—by the United States Treasury. What is meant is the purchase of government bonds by the Federal Reserve Banks instead of by the government. These two, as buyers, are quite separate and distinct from one another, and the effects of the two are quite the opposite of one another so far as the effect on inflation is concerned. When the Federal Reserve Banks buy a bond, it is similar to our earlier illustration where the local bank deposited a new $100 government bond with the Federal Reserve Banks in order to replenish its reserve requirements. Then, as will be recalled, the sale of $100 in bonds to the FRB paved the way for a large increase in new money—pyramiding inflation. And it is the same when the Federal Reserve buys bonds in its open market operations. The only difference between the two is the matter of where the initiative lies in the transaction. In the first instance, the local bank took the initiative and sent the bond to the Federal Reserve as a sale in order to replenish and expand its reserves. In the latter instance, the Federal Reserve took the initiative and went into the open market to buy the bond. Let us say it was bought from this same bank. The effect on reserves is the same in both cases, no matter which way the transaction was initiated. In both instances, the reserve balance-the credit base-has been expanded by as much as eight times the amount of the bond deposited with the FRB. The mere buying of the bond by the Federal Reserve in the open market was not, in a technical sense, inflation. For the act itself created no more active money. Rather, it should be called potential inflation. The reserve base is thereby increased so that there can be a subsequent increase of credit, and new money, by as much as eight times the amount of bond deposited. For this broader credit to become inflation in fact, there must be persons who want to borrow and banks willing to lend them the expanded credit which has now be’ come possible. Only then will there be loans-new money, inflation. The reason why the buying of government bonds in the open market by the Federal Reserve Bank is said to be inflationary is the assumption that credit will be expanded as a consequence. And normally that is a safe assumption. Thus, as to the seeming paradox, it is true that selling government bonds and buying government bonds are both inflationary. The distinction which resolves the seeming paradox is the matter of does the buying and does the selling. In summary, we might unravel the seeming paradox this way: When the government a bond to the banking system, it is inflationary. It may even be highly inflationary if that bond comes to rest in the Federal Reserve Banks to serve as reserves for additional credit expansion. And that is why we say that it is inflat
ionary when the Federal Reserve Banks bonds in the open market. It is similarly inflationary whether the commercial banks take the initiative and send bonds to the Federal Reserve Banks to increase their reserves, or whether the FRB takes the initiative and enters the open market to buy the bonds. Both are highly inflationary. [] 1.   The different reserve requirements for banks of different classes, and for demand deposits as against time deposits, are not separately identified in this overall illustration.