US Government Debt Different - Finance Department - University of ...

Peter R. FisherCentral bank mythology would have us believe that central bankliabilities, in this case those of the Federal Reserve, are the base assetin our monetary regime. Central bank reserves are “high-poweredmoney” that banks hold as their reserve asset and use as the startingpoint for the money multiplier underpinning the process of creatingmoney with which financial institutions can buy more assets.97The myth is that central banks do not and should not monetize sovereigndebt. The myth continues that the central banks’ liabilities are“the real thing.” The fact is that central banks can and do monetizesovereign debt and that central bank reserves are a “second-best” substitutefor sovereign debt, rather than the other way around. This isparticularly so for U.S. Treasury securities because of the extraordinarydepth, liquidity and breadth of this market.This creates an awkward reality for central banks. If sovereign debtis the base asset in our monetary regime (and central bank liabilitiesare not), then finance ministries and treasuries are in charge of thequantity of the monetary base through the accident of fiscal policydecisions about spending and taxes. This would mean that centralbanks do not control the quantity of the monetary base; they onlyinfluence its price. That is exactly what is going on.Once you recognize that central banks’ key tool is their influenceover sovereign debt pricing it is easier to understand why the ECBfelt bound to intervene in Spanish and Italian bond markets last year:because if a central bank loses its influence over the pricing of thesovereign yield curve it has lost its principal means of conductingmonetary policy. This also provides the context for understandingwhy the Federal Reserve feels compelled to tell us that they are likelyto hold short-term rates extremely low through 2014: they are usingtheir direct control over short-term rates to influence our expectationsabout the future path of short-term rates in order to influencethe pricing of long-term Treasury debt.To be clear, central bank liabilities are a “pretty good” substitute forsovereign debt and central banks can and do liquefy sovereign debt.