I am attempting to understand government debt better in order to predict what the next stage of the financial crisis is going to be. My current understanding is as follows:
If a government creates bonds and sells them to the private sector then this does not necessarily increase the money supply in any way because the bonds can be purchased with money that existed already. The only way it could perhaps increase the money supply is if people in the private sector were trading on margin - i.e. borrowing the money to purchase the bonds - but my guess would be that people generally would not do this because the interest rate on offer on these bonds is generally low.
For a the government to unwind this process then the have to spend a period taxing more than it spends.
If a government creates bonds, sells them to the private sector but then gets its central bank to purchase them, then this does increase the money supply because the central bank will create brand new money to do the purchasing. The (claimed) plan behind this process is that at some future time the government will reverse or unwind this process by paying off its debt to the central bank. The government would do this by using taxpayers money to pay back the money to the central bank. The principal part of this repayment would be extinguished and the coupon would be the profit for the central bank - which may mostly be given back to the government.
The unwinding is doubly tortuous for the government: for a while the government have to tax more than their spending but to make things worse the money supply will shrink at the same time as the loan money is extinguished. A shrinking money supply is painful for a variety of reasons, for example many people will find loan repayments harder to make.
Primarily if the rates on their loans go up. If the interest rate was fixed then that shouldn’t be a huge problem. A contraction in the money supply would yield you a higher purchasing power if your income didn’t decrease along with it. I know I didn’t really answer your question but in regards to paying off existing loans I don’t believe you should really fear deflation unless you have an ARM. The gripe I have with the loan repayment argument is that keynesians use it to justify inflation because it will make paying off loans “easier”
But thats a pretty big “if”… presumably if the money supply dcreased then peoples incomes would decrease correspondingly. If that wasn’t the case then we could all get rich by arranging for a smaller money supply and watch our purchasing power grow.
In theory, this is true. In practice, and in reality, the Fed would simply replace the maturing bond with another government bond it purchased on the open market.
In other words, the Treasury and the Fed would be continuously rolling over the debt, without any use of taxpayer money whatsoever, indefinitely.
This is technically true. But it would be highly unlikely the Fed would allow its balance sheet assets, and thus its liabilities of Federal Reserve Notes, to shrink over a long period of time, a.k.a. monetary contraction.
In a true free market economy yes that’s true. But in our current system we have “sticky” wages, minimum wages, and in the wake of deflation the government will go as far as imposing wage controls to prevent your wage from falling in this manner.
Would I be right in assuming that in the early days of government borrowing, governments generally sell most of their bonds to the private sector and people in other countries - but in the run up to crises and hyperinflations, most of the bonds are ultimately being sold to the government’s own central bank?
Or are there many more variations of how it can play out?
I don’t know the answer to your followup question. But it is very possible for the treasury to sell a bond directly to the central bank.
Here is an interesting outcome. If the Treasury sells the bond directly to the Fed, both of them can agree on an arbitrary coupon rate, e.g. as high as 20% or as low as 1%, and it wouldn’t matter to the Treasury.
“But it is very possible for the treasury to sell a bond directly to the central bank”
I know for a fact that this is illegal in the european union and I have heard that it also illegal in the US and Japan - but I don’t have a reference for thaem. I would guess that it was illegal in most countries.