The Fed’s Role in Eroding Real Federal Debt

Both Jerry O’Driscoll and Jerry Jordan have emphasized that switching from the rules-based regime of an international commodity standard to a discretionary national fiat standard dramatically loosens the fiscal constraints on the national government.  Here are some numbers about how the Federal Reserve has responded to the removal of the gold standard’s constraint against accommodating the U.S. Treasury.  The ratio of nominal gross federal debt to nominal GDP stood at 130 percent on the 1st of January 1946, following the Second World War.  The monetary base stood at $33.3 billion.  Twenty-four years later, on the 1st of January 1970, the debt-to-GDP ratio had fallen to 40%.  How was that accomplished? 

During the same period the Fed roughly doubled the monetary base (to $62.2b), and as a result the price level (CPI) had roughly doubled.  (Real income had grown, of course, but so too had the velocity of the monetary base as a result of the rising inflation that the Fed had created.)  The debt ratio fell because the doubling of the CPI contributed to expanding nominal GDP but did not increase the number of dollars owed on previously issued Treasury bonds.  The holder of a 30-year Treasury bond issued in 1940-1946 saw more than half of the real value of its principal washed away by inflation.  Inflation rates were even higher in the 1970s, such that by 1981 the debt ratio had fallen to its postwar low of 31%.  Since then chronic and recently acute deficits have built the debt ratio back up.

In 2012, for the first time since the postwar erosion, the ratio of gross federal to GDP rose above 100 percent.  The pressure on the Fed to once again help to erode the real debt is not to be dismissed.  Once again the market yields on US Treasury debt do not incorporate any substantial premium for expected inflation.  The absence of any rule that prevents unexpectedly inflationary monetary policy means that there is nothing tangible to stop the Fed from once again giving into the pressure to inflate enough in order to reduce the real value of the accumulated federal debt.


Also from this issue

Lead Essay

  • Gerald P. O’Driscoll reviews the history of central banking. He argues decentralized banking is possible, but getting there will be difficult. Under a commodity money regime, central banks are neither necessary nor particularly dangerous, while under a fiat money regime, central banks are capable of exerting substantial influence on monetary policy. The Fed’s use of that influence has been, in O’Driscoll’s words, “unenviable.” Governments have come to depend on central banks to run deficits and spend more than they otherwise could. To do without central banking, however, we will first have to shrink the federal budget itself, and this will be no easy task.

Response Essays

  • Lawrence H. White explains that the Federal Reserve has “dramatically increased secular inflation.” Additionally, it has increased price level uncertainty, while failing either to tame the business cycle or to reduce unemployment. Instead, throughout its history, it has bowed to political pressures and expanded the money supply again and again.

  • Scott Sumner argues that monetary policy needs to respond to crises, and that commodity standards don’t meet that test. He argues that a politically independent central bank tasked with keeping a low rate of inflation will generally be able to fulfill that obligation, and that rigid monetary regimes do much greater harm when they ultimately collapse. In particular, the failures of such regimes have usually been attributed to free-market capitalism, and the result is ever-greater financial regulation.

  • Jerry L. Jordan argues that legislative restraints on monetary policy tend to fail; in this area, we just can’t trust government to watch itself. Standards intended to preserve the value of the currency have all fallen, as legislatures simply find it too convenient to siphon away value through inflation. Jordan is skeptical even of a balanced budget amendment, noting that state governments with such amendments have still come to fiscal grief. One of his most important concerns is that the public right now is dangerously apathetic about this underappreciated issue.