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ISSN 0007-7011

Federal Reserve Bank of Philadelphia

NOVEMBER • DECEMBER 1986

Are Government
Deficits Monetized?
Some International Evidence
Jeremy J. Siegel

PHOTO BY ANNE GRIFFITH-McNALLY

Aris Protopapadakis and

Federal Reserve Bank of Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
NOVEMBER/DECEMBER 1986

LOW-GRADE BONDS: A GROWING SOURCE
OF CORPORATE FU N D IN G .....................................................................................

Jan Loeys
Low-grade bonds— rated as speculative investments by the rating agencies—recently have
stirred the interest of investors. In part, their growth is due to improvements in information
technology that have lowered the costs of monitoring these securities. In addition, because of
increased economic uncertainty, institutional investors have shifted their focus toward assets
that are somewhat more marketable, as low-grade bonds are. As a result, certain smaller, less
well known firms that traditionally relied on bank loans and private placements can now issue
low-grade bonds and borrow directly in the public capital markets.

ARE GOVERNMENT DEFICITS MONETIZED?
SOME INTERNATIONAL EVIDENCE ..............................................................

Aris Protopapadakis and Jeremy J. Siegel
The enormous federal deficit has a lot of people concerned. One of the more subtle issues is
whether economic and political pressures force the monetary authority to "m onetize" the
debt— does the central bank buy up much of the deficit, thereby pumping more money into
the economy, and ultimately leave us with high inflation? While a precise answer is difficult to
provide, we can look at historical experience both here and in other industrialized countries to
see if large deficits are accompanied by high money growth.
The BU SIN ESS REVIEW is published by the
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Act, the System is an agency of the Congress, in
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its operating surpluses.

Low-Grade Bonds:
A Growing Source of Corporate Funding
Jan Loeys*
In recent years, a growing part of corporate
borrowing has taken the form of "low-grade
bonds." Called "junk bonds" by some, and "highyield bonds" by others, these bonds are rated as
speculative by the major rating agencies, and
they are therefore considered more risky than
high- or investment-grade bonds. Lately, lowgrade bonds have received a lot of public atten
tion because of their use in corporate takeovers.
But in fact, most low-grade bond issues are not
used for this purpose.
Corporations that now issue low-grade bonds
*Jan Loeys is a Senior Economist in the Macroeconomics
Section of the Research Department at the Federal Reserve
Bank of Philadelphia.

are firms that, because of their lack of size, track
record, and name recognition, used to borrow
mostly via bank loans or privately placed bonds.
Recently, investors have become more willing
to lend directly to smaller and less creditworthy
corporations by buying these low-grade bonds.
There are several reasons for the new popularity
of these bonds. But before discussing those rea
sons, it is useful to examine in more depth exactly
what low-grade bonds are and how their market
first developed.
WHAT ARE LOW-GRADE BONDS?
Low-grade bonds represent corporate bonds
that are rated below investment grade by the
major rating agencies, Standard & Poor's and
3

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

Moody's. These ratings, which firms usually re
quest before issuing bonds to the public, reflect
each agency's estimate of the firm's capacity to
honor its debt (that is, to pay interest and repay
principal when due). The highest rating is AAA
(for firms with an “extremely strong" capacity to
pay interest and repay principal), and then A A
(“very strong"), A (“strong"), and BBB (“ade
quate"). Bonds rated BB, B, CCC, or CC are
regarded as “speculative" with respect to the
issuer's capacity to m eet the terms of the obliga
tion.1 Firms generally strive to maintain at least a
BBB rating because many institutions or invest
ment funds cannot, because of regulation, or
will not, because of firm policy, invest in lowergrade bonds. This explains why bonds rated
below BBB are also known as "below-investment"
grade bonds.
There is no set formula for determining a
bond rating—the rating agencies say they look
at the entire spectrum of financial and product
market conditions. But a certain issue may be
considered too risky to be rated investment grade
for several reasons. For one, certain financial
ratios—such as a high debt-equity ratio or a high
ratio of interest expenses to total incom e—may
indicate that even moderate fluctuations in cash
flow could endanger the issuer's capacity to pay
the bondholders. Or the firm's assets may not be
well diversified (too dependent upon a single
product), which also makes the firm's revenues
highly variable. Alternatively, if the firm is rela
tively new and thus lacks a proven track record,
the firm's cash flow might be hard to predict.
Finally, the firm or its industry may be considered
in decline, which increases the likelihood of a
default.

attention from the press in recent years, largely
because of their association with certain corpo
rate takeover techniques.2 But low-grade bonds
have been around for a long time. In fact, during
the 1920s and 1930s, about 17 percent of domes
tic corporate bond offerings (that is, new issues)
were low grade.3 Furthermore, as the Depression
of the 1930s wore on, many bonds that were
originally issued with a high-grade rating were
downgraded to below-investment grade. These
so-called “fallen angels" were bonds of compa
nies that had fallen on hard times. By 1940, as a
result of both these downgradings and the earlier
heavy volume of new low-grade offerings, lowgrade bonds made up more than 40 percent of
all bonds outstanding.
After 1940, the market for new public offerings
of low-grade bonds shrank significantly. Many
investors avoided low-grade bonds due to their
high default rate during the 1930s—an average
of almost 10 percent of outstanding low-grade
bonds (valued at par) defaulted each year.4 Most
additional low-grade bonds represented only
new fallen angels. By the mid-1970s, only about
4 percent of all public corporate bonds out
standing in the U.S. consisted of low-grade
bonds.5

2For a discussion of these issues, see Kevin F. Winch and
Carol Kay Brancato, "The Role of High-Yield Bonds (Junk
Bonds) in Capital Markets and Corporate Takeovers: Public
Policy Implications," in The Financing of Mergers and
Acquisitions, Hearing before the Subcommittee on Domestic
Monetary Policy of the Committee on Banking, Finance and
Urban Affairs, House of Representatives, 99th Congress, 1st
session (May 3, 1985) pp. 246-297.
3See W. Braddock Hickman, Corporate Bond Quality and
Investor Experience, (Princeton University Press, 1958)
p. 153.

THE MARKET FOR LOW-GRADE BONDS
Low-grade bonds have received widespread

Investor Experience, p. 189.

1 These are the ratings for Standard & Poor's. The corre
sponding ratings for M oody's are Aaa, Aa, A, Baa, Ba, B, Caa,
and Ca, with ratings below Baa considered below investment
grade. For both agencies, the rating C is reserved for bonds
on which no interest is being paid, while bonds rated D are in
default.

5Edward I. Altman and Scott A. Nammacher, "The
Anatomy of the High Yield Debt Market," Morgan Stanley
(September 1985), Table 2. These and the following data
refer only to publicly issued, nonconvertible debt that is
rated below BBB (or Baa). Including unrated debt, which
would probably be low grade if it were rated, and debt that is
convertible into stock, would raise the outstanding amount
of low-grade bonds by up to 30 percent.

Digitized 4for FRASER

4 See W. Braddock Hickman, Corporate Bond Quality and

FEDERAL RESERVE BANK OF PHILADELPHIA

Low-Grade Bonds

Jan Loeys

In 1977, Drexel Burnham
Lambert, an investment bank
that was already making a
secondary market in fallen
angels, started an effort to
revitalize the market for
original-issue
low-grade
bonds by underwriting new
issues and subsequently
making a secondary market
in them. By 1982, low-grade
bond issuance had grown
gradually to about $2.8 bil
lion per year (or 6 percent of
total corporate bonds issued
publicly that year). In 1983,
the market started growing
much faster, reaching an an
nual issue volume of about
$15 billion in 1985 (or 15
percent of total corporate
issues that year; see Figure
1). Most low-grade bonds
were issued by industrial
companies and utilities, ac
counting for more than a
third of the bonds raised by
these firms in 1985. By the
end of 1985, the total stock
of low-grade bonds out
standing reached about $75 billion (or 14 per
cent of the total), less than a third of which
consisted of fallen angels.
Historically, default rates on low-grade bonds
have been much higher than those on highgrade bonds, lending credibility to the specula
tive rating of low-grade bonds. A recent study
finds that between 1970 and 1984, this average
annual default rate for low-grade bonds was
only 2.1 percent, while the default rate for invest
ment-grade debt was close to zero percent.6

This average for low-grade bonds, however,
hides a lot of year-to-year variability: it varied
from a high of 11.4 percent in 1970, when Penn
Central went under, to a mere 0.15 percent in
1981, when only two firms defaulted on their
bonds (see Figure 2, p. 6).
To compensate investors for the risk they bear
by holding low-grade debt—or indeed any debt
of private firms—rather than (presumably)
default-free Treasury securities, firms promise
to pay higher yields on their debt than the

6Edward I. Altman and Scott A. Nammacher, "The
Anatomy of the High Yield Debt Market: 1985 Update,"
Morgan Stanley (June 1986) Table 10. One must be careful
in interpreting these data. A default does not necessarily

mean that bondholders lose all of their investment. If the
firm in default has some assets left, bondholders may still
retrieve part of their investment, although it may be some
time before these funds are returned.

BUSINESS REVIEW

NOVEMBER/DECEMBER 1986

Actual realized returns frequently differ from
promised returns, however. Aside from the prom
ised return, the actual return includes capital
gains and losses due to defaults, upgradings and
downgradings, and changes in market interest
rates. For example, from 1978 to 1985, lowgrade bonds realized an average annual return
of 12.9 percent, compared with 10.8 percent on
Treasury bonds.9
This average return hides a lot of variability,

however. In 1983, low-grade bonds outper
formed Treasury securities by almost 20 percent
age points (see Figure 4, p. 8). But in 1982, and
again in 1985, as yields on new Treasury issues
dropped much more than the yield on new lowgrade issues, the larger capital gains on Treasury
securities allowed them to beat low-grade bond
returns by almost 10 percentage points. There
fore, although low-grade bonds have yielded a
higher return than Treasury or investment-grade
bonds on average, there is no guarantee that
they will do so in any given year.
Treasury does.7 This difference between yields
is called a "risk premium." In general, the lower
a firm's rating, the higher the risk premium will
be. As Figure 3 shows, high-grade (AAA) bonds
usually yield only 50 to 100 basis points more
than Treasury bonds, while medium-rated (BBB)
bonds may yield from 150 to 300 basis points
above Treasury yields. The risk premium of
lower-grade bonds over Treasuries, however,
has run from 300 to 600 basis points over the last
five years. But default risk is probably not the
only reason for these yield differentials. Lowgrade bonds may require a higher return to
compensate investors for the fact that the secon
dary market for low-grade securities is much
less liquid than that for Treasury securities.8
7Sometimes this compensation takes the form of a “war
rant," which gives the bondholder the right to buy equity in
the firm at an attractive price, or an option to convert the
bond to the comm on stock of the firm. These so-called
"equity kickers" allow bondholders to benefit from any
improvements in the value of the firm.
8In addition, unlike most Treasury securities, most cor
porate bonds are callable; that is, the issuer has the option to

Digitized 6for FRASER

The recent revival of the low-grade bond mar
ket raises the question of why this product has
become successful again. One popular miscon
ception is that these bonds are used solely to
finance corporate takeovers. But while the sud
den rise in corporate mergers and acquisitions
in the last few years did contribute to the growth
in low-grade bond offerings, the market had
taken off well before the first major use of lowgrade bonds in corporate takeover attempts in
1983. And even in 1985—a year of unprece
dented merger activity—low-grade bonds issued
for takeover purposes made up only about 38
percent of total low-grade bond issuance (see
LOW-GRADE BONDS AND TAKEOVERS, p.

pay off part (or all) of the issue at a predetermined price
during a predetermined period prior to maturity. The issuer
pays for this option in the form of a higher yield.
Q
Edward I. Altman and Scott A. Nammacher, "The
Anatomy of the High Yield Debt Market: 1985 Update,"
Table 1. See also Marshall E. Blume and Donald B. Keim,
"Risk and Return Characteristics of Lower-Grade Bonds,"
Rodney L. White Center for Financial Research, University
of Pennsylvania (August 1986).

FEDERAL RESERVE BANK OF PHILADELPHIA

Low-Grade Bonds

Jan Loeys

FIGURE 3

Percent

Promised Yields
On Treasury and Corporate Bonds

SOURCE: Salomon Brothers and Moody's.

9). Rather than reflecting a rise in one particular
use for low-grade bonds, the reemergence of the
market paralleled more fundamental changes in
financial markets that made low-grade bonds
relatively more attractive compared with other
forms of financing.
WHY DID THE MARKET GROW?
The main alternative to issuing public debt
securities directly in the open market is to obtain
a loan from a specialized financial intermediary
that issues securities (or deposits) of its own in
the market. These alternative instruments usu
ally are commercial bank loans—for short- and
medium-term credit—or privately placed bonds
—for longer-term credit. Unlike publicly issued

bonds, privately placed bonds can be sold di
rectly to only a limited number of sophisticated
investors, usually life insurance companies and
pension funds.10 Moreover, privately placed
bonds are held for investment purposes rather
than for resale, and they have complex, custo-

10The Securities Act of 1933 exempts privately placed
bonds from the normal registration process that the Secu
rities and Exchange Commission enforces on public securi
ties offerings. For more details on this market, see John D.
Rea and Peggy Brockschmidt "The Relationship Between
Publicly Offered and Privately Placed Corporate Bonds,"
Federal Reserve Bank of Kansas City Economic Review,
(November 1973) pp. 11-20, and Patrick J. Davey, "Private
Placements: Practices and Prospects," The Conference Board
Information Bulletin (January 1979).

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

ties in the public capital mar
kets. For smaller, relatively
Realized Yields on Treasury
new or unknown firms, the
expense was usually pro
and Low-Grade Bonds
hibitive. Because of the risk
of underwriting low-grade
Percent
bonds, investment bankers
45 —
———
—
—
would demand hefty under
writing fees. Also, less credit
worthy issuers would have
had to pay a very high pre
mium on their debt because
investors perceived them as
particularly risky invest
ments.
Such borrow ers thus
found it more economical
simply to obtain a loan from
a bank or to place a private
bond issue with a life insur
- 1 0 1 - — L_
I - — i
L— - - -L — ...... - -J
ance company. These alterna
78
79
80
81
82
83
84
85
tives proved cheaper because
banks and life insurance com
SOURCE: Edward L Altman and Scott A. Nammacher, "The Anatomy of
the High Yield Debt Market: 1985 Update," Morgan Stanley (June 1986)
panies specialize in credit
Table 1.
analysis and assume a large
amount (if not all) of a bor
mized loan agreements (covenants). The restric rower's debt. Consequently, they could realize
tions in the covenants range from limits on important cost savings in several functions, such
dividend payments to prohibitions on asset sales as gathering information about the condition of
and new debt issues. They provide a series of debtor firms, monitoring their actions, and
checkpoints that permit the lender to review renegotiating loan agreements.
The reemergence of a market for public originalactions by the borrower that have the potential
issue low-grade bonds suggests that this situ
to impair the lender's position.11 Thus, these
ation is changing. Certain lower-rated corpo
agreements have to be regularly renegotiated
prior to maturity. As a result, these privately rations now apparently find it economical to
placed bonds in effect are much more like loans issue their own bonds directly in the public
capital markets (see THE GROWTH OF SECU
than public securities.
Before the reemergence of original-issue low- RITIES MARKETS, p. 10). As with many finan
grade bonds, only large, well-known firms with cial innovations, it is impossible to identify all
established track records found it economical the factors responsible for this development.
to raise m oney by issuing their own debt securi But it is possible to suggest several important
ones that may have made a contribution to the
reemergence of original-issue low-grade bonds,
and three seem particularly noteworthy—a
11 See Edward Zinbarg, "The Private Placement Loan
greater demand by investors for marketable
Agreem ent," Financial Analyst Journal (July/August 1975)
pp. 33-35 and 52.
assets; lower information costs; and changes in
Digitized8 for FRASER

FIGURE 4

FEDERAL RESERVE BANK OF PHILADELPHIA

Jan Loeys

Low-Grade Bonds

Low-Grade Bonds and Takeovers
Low-grade bonds became the center of public attention because of their association with corporate
takeover attempts. In a takeover, one firm or a set of investors acquires the stock (and thus ownership) of
another firm. W hen the stock purchase is not financed with cash or newly issued stock of the acquiring
firm, the acquisition is financed by borrowing funds. As a result, equity in the combined firm is replaced
with debt and its debt-equity ratio rises. Many of these cases involve so-called "leveraged buyouts"
(LBOs), in which a group of investors, usually including the management of the firm being acquired, buy
out stockholders in order to take the firm private.3
In the past, there was little LBO borrowing and what there was took the form of bank loans. However,
because an increased debt-equity ratio raises the default risk of a firm's debt, bank loans usually come
with a lot of restrictions and collateral requirements. In response to an increased demand for LBO
financing, Drexel Burnham Lambert, in late 1983, started using its extensive network of private and
institutional buyers of low-grade debt to float LBO bonds. These bonds are frequently rated below
investment grade, especially when they are junior to already existing debt, and when cash flow
projections barely exceed the higher required interest payments. The flexibility of this new source of
LBO financing allows some investors to attempt acquisitions of firms several times their own size.b
In contrast to the amount of public discussion about this topic, low-grade bond issues actually
involved in takeovers make up only a small part of the market. During 1984, LBOs amounted to only
$10.8 billion, compared with $122.2 billion in total merger and acquisition activity.c Drexel estimates that
of about $14 billion in publicly issued low-grade bonds in 1984, only "approxim ately 12 % was issued in
acquisition or leveraged buyout transactions, of which a de minimis amount was connected with the
financing of unsolicited acquisitions."*1 By 1985, however, other analysts had estimated that the propor
tion of new low-grade issues used to finance acquisitions and LBO transactions had risen to 38 percents

aFor details, see Carolyn K. Brancato and Kevin F. Winch, "M erger Activity and Leveraged Buyouts: Sound
Corporate Restructuring or Wall Street Alchem y?" U.S. Congress, House, Committee on Energy and Commerce,
Subcommittee on Telecommunications, Consumer Protection, and Finance, 98th Congress, 2nd Session (November
1984).
bEarly in 1986, the Board of Governors of the Federal Reserve System ruled that bonds that are issued by a
corporation with no business operations and no assets other than the stock of the target company, are functionally
equivalent to borrowing to buy stock (that is, buying stock on margin). Therefore, these bonds are subject to a 50
percent margin as required by Regulation G. That is, only 50 percent of the stock purchase can be financed with
borrowed funds. However, the Board specifically excluded bonds that are issued simultaneously with the consum
mation of the m erger or LBO— a standard practice in LBOs—because the assets of the firm, and not its stock, would be
the source of repayment of the bond issue. For details, see Federal Reserve System 12 C.F.R. Part 207 (Regulation G;
Docket No. R -0562).
CW. T. Grimm & Co. "1984 M erger/Acquisitions Set Ten-Year Record: Total Dollar Value Rose to 67% to a RecordBreaking $122.2 Billion," (Chicago: W. T. Grimm & Co., 1985). Press release, undated, duplicated.
dDrexel Burnham Lambert, Inc., "Acquisitions and High Yield Bond Financing," submitted to the Subcommittee on
Telecommunications, Consum er Protection, and Finance (March 20, 1985) p. 14.
eMartin Fridson and Fritz Wahl, "Plain Talk About Takeovers," High Performance (February 1986) p. 2. Fridson and
Wahl use a more restrictive definition of the size of the low-grade market than Drexel does.

investors' risk perceptions.
Marketability vs. Covenant Restrictions. One
reason for the growth in the public issuance of
low-grade bonds is that buyers of privately placed
bonds have becom e more willing to trade some
of the safety they found in the contractual restric

tions they placed on borrowers in return for the
marketability and higher yields of publicly issued
low-grade bonds. Private placements are bilat
eral, customized loan agreements with complex
contractual restrictions on borrowers' actions.
However, the lack of standardization of these
9

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

The Growth of Securities Markets
The growth of low-grade bond offerings is not an isolated phenomenon. In several other financial
markets there is also a growing tendency for corporate borrowing to take the form of negotiable
securities issued in the public capital markets rather than in the form of nonmarketable loans negotiated
with financial intermediaries. For example, in the short-term credit market, commercial paper has
become increasingly competitive with bank loans. By the end of 1985, bank loans constituted only 24
percent of short-term debt at large manufacturing firms, compared with 59 percent in early 1974.a And
even in the Eurodollar market, large corporations are more frequently bypassing syndicated loans in
favor of financing arrangements that allow them to issue debt under their own names. In fact, by 1985,
financing in the form of securities made up 80 percent of total funds raised in international financial
markets, compared to only 33 percent in 1980.b
This move towards borrowing in the form of securities reduces the role of the traditional intermediary
that just makes loans and issues deposits. These financial intermediaries will still help link ultimate
savers and borrowers, although the way in which they do business may change substantially. The
traditional intermediary provides all forms of financial intermediation under one roof: it pools the funds
of many small savers, issues insured deposits, provides a payments mechanism, and lends out the funds
in a different form to a diverse set of borrowers. The new growth of securities markets implies an
"unbundling" of this process with many of these services being provided by different intermediaries: a
commercial bank or thrift may originate the loan; an investment bank may package it into a security and
distribute it; an insurance company may insure it; and a mutual or pension fund may end up financing it
by attracting funds from a large number of small savers.

aLarge manufacturing firms are firms with more than $1 billion in assets. Source: Quarterly Financial Report, U.S.
Department of Com m erce (1st Quarter 1975) p. 69, and (4th Quarter 1985) p. 134.

bFinancial Market Trends, OECD (March 1986) p. 7, and earlier issues. See also Recent Innovations in International
Banking, Bank for International Settlements (April 1986) Chapter 5.

covenants and the frequent need for renegotia
tion when borrowers want to transgress the
covenant restrictions make it very costly to have
a lot of lenders per issue, or to change the identity
of the lenders. As a result, there is not much of a
secondary market for private placements. That
is, they are not marketable.
Low-grade bonds, in contrast, are public
securities and are issued with relatively simple,
standardized contracts without cumbersome
restrictions on borrowers' actions, in order to
facilitate their trading in a secondary market.
And in exchange for the added freedom from
covenant restrictions, borrowers pay a higher
yield on low-grade bonds than on private place
ments. The marketability and liquidity of lowgrade bonds still are not comparable to those of
Treasury or high-grade bonds. But the recent
development of a secondary market for lowDigitized10for FRASER

grade bonds and the increasing number of dealers
in this market do make these securities much
more liquid and marketable than privately
placed bonds.
Historically, life insurance companies, to
which most private placements were sold, had
no great need for marketability or liquidity. They
held long-term liabilities and received highly
predictable cash flows. They had no particular
preference for marketable securities because
they expected to hold their investments to
maturity.
But recent economic developments have
forced life insurance companies to abandon their
traditional buy-and-hold-to-maturity policy and
to become more active in money management.12
12
See James J. O'Leary, "H ow Life Insurance Companies
Have Shifted Investment Focus," Bankers Monthly Magazine

FEDERAL RESERVE BANK OF PHILADELPHIA

Low-Grade Bonds

On the asset side, life insurance companies, as
well as other financial intermediaries, have been
faced with increased interest rate volatility and
higher credit risk.13 On the liability side, in
creases in loan requests by holders of whole life
insurance policies and the growth of "separate
accounts"—accounts managed temporarily for
pension funds or other types of mutual funds—
convinced life insurance companies that their
liabilities have becom e much more volatile. In
order to gain more flexibility in responding to
unexpected cash outflows or to changing per
ceptions about firms, industries, or interest rates,
life insurance companies shifted their invest
ment focus away from nonmarketable, illiquid
assets, such as private placements, toward pub
licly traded securities, including low-grade
bonds.14
Information Costs. A second factor contribut
ing to the growth of the low-grade bond market
is that, in recent years, it has become much easier
for individual and institutional investors to obtain
and maintain information about the condition of
corporate borrowers. Thus lenders are now more
likely to find it cost-effective to lend directly to
smaller and less well-known corporations, rather
than indirectly through financial intermediaries
such as commercial banks.

(June 15, 1982) pp. 2-28, and Timothy Curry and Mark
Warshawsky, "Life Insurance Companies in a Changing
Environm ent," Federal Reserve Bulletin (June 1986) pp. 449459.
13The early 1980s saw severe sectoral problems— for
example in the farm and the energy sectors— and a thirdworld debt crisis. From 1980 to 1983, the business failure
rate— that is, the annual number of failures per 10,000 listed
enterprises— averaged 76, more than twice its level during
the 1970s. See The Economic Report of the President
(Washington, DC: GPO, February 1986) Table B-92. For
evidence on interest volatility, see Harvey Rosenblum and
Steven Strongin, "Interest Rate Volatility in Historical
Perspective," Federal Reserve Bank of Chicago Economic
Perspectives (January/February 1983) pp. 10-19.
14Timothy Curry and Mark Warshawsky, "Life Insurance
Companies in a Changing Environment," p. 456, report that:
"In recent years, however, life insurance companies have
been committing to private placements smaller percentages
of their investable cash flow: 25 to 30 percent in 1984, down
from a historical level of 40 to 50 percent."

]an Loeys

Indeed, recent technological improvements
in such areas as data manipulation and tele
communications have reduced greatly the costs
of obtaining and processing information about
the conditions—whether international or domes
tic, industry-wide or firm-specific—that affect
the value of a borrowing firm. Any analyst now
has computerized access to a wealth of economic
and financial information at a relatively low cost.
New information reaches investors across the
world in a matter of minutes. Given the reduction
in information costs, the cheapest method of
lending to certain smaller and less creditworthy
borrowers may no longer require a specialized
intermediary as the sole lender to these bor
rowers, especially after recognizing the other
expenses of using the intermediary.15 For many
institutional investors—such as mutual funds,
pension funds, and insurance companies—the
costs of being informed about certain borrowers
have dropped enough that it has become profit
able to acquire relatively small amounts of debt
directly from those firms. As a result, firms that
now issue their own low-grade bonds in the
open market face a growing acceptance of their
securities.
Risk Perceptions. A third explanation of the
growth in low-grade bond offerings is more on
the psychological side. Investors are not only
better informed about the risks they take on, but
they may have also become more willing to
invest in risky securities. After the 1930s, the
market for newly issued low-grade bonds shrank
as most investors—with the losses incurred dur
ing the Depression still vividly in mind—turned
to high-grade securities and left it to financial
intermediaries to manage the risk of lending to
less creditworthy borrowers. But as time passed
and the memory of the 1930s faded, portfolio
managers probably started to discount the proba-

15These added costs of using a financial intermediary
instead of lending directly to a firm by buying its debt secu
rities involve, for example, taxes, administration costs, and
the costs of monitoring the condition and behavior of the
intermediary.

BUSINESS REVIEW

bility that the economy would again become
subject to a m ajor system-wide shock.16 It is thus
possible that, as new generations of portfolio
managers with no direct experience of the
Depression took over, financial markets as a
whole became more receptive to riskier securities,
such as low-grade bonds.
SUMMARY
Low-grade bonds are bonds that are rated
"speculative" by the major rating agencies and
that are therefore considered very risky invest
ments. These bonds are either corporate bonds
that have been downgraded, or, more recently,
bonds that are issued originally with a rating
below investment grade. Original-issue lowgrade bonds are issued mostly by corporations
that previously borrowed in the form of commer

16For a discussion of this type of behavior, see Jack
Guttentag and Richard Herring, "Credit Rationing and Finan
cial Disorder," The Journal of Finance (December 1984) pp.
1359-1382. As an example, the authors describe the behav
ior of a driver who has just witnessed a car accident. His
immediate reaction is to drive much more cautiously. But
gradually, as time passes and the image of the accident
recedes from m em ory, the driver reverts to less cautious
behavior.

Digitized12
for FRASER

NOVEMBER/DECEMBER 1986

cial loans or privately placed bonds.
Several factors seem to have contributed to
the growth in low-grade bond offerings. For
one, increased volatility in their sources of funds
and a worsening of interest rate and credit risk
have forced life insurance companies, which are
the major buyers of private placements, to shift
their investment focus towards assets that are
somewhat more marketable and liquid, such as
low-grade bonds. Also, improvements in com
puter technology have lowered the information
and monitoring costs of investing in securities
and have thus allowed smaller and less known
corporations to borrow directly from private
and institutional investors. Third, it may be that
the favorable post-World War II default experi
ence on low-grade bonds has made investors
more receptive towards investing directly in
riskier securities, including low-grade bonds.
The growth in low-grade bond offerings thus
represents mostly a rechanneling of corporate
borrowing, away from individually negotiated
loans, towards public securities. As such, it
exemplifies a continuing effort by financial
market participants to search out the most costeffective way to channel funds from lenders to
borrowers.

FEDERAL RESERVE BANK OF PHILADELPHIA

Are Government Deficits Monetized?
Some International Evidence
Aris Protopapadakis and Jeremy ]. Siegel*
INTRODUCTION
One of the dominant economic concerns in
the current decade is the persistence and size of
U.S. federal budget deficits. The reasons for this
concern vary from the general public's feeling
that it is irresponsible for government to "live
beyond its m eans," to economists' traditional
concern that budget deficits may cause interest

*Aris Protopapadakis prepared this article while he was
Vice President and Economist in the Research Department
at the Federal Reserve Bank of Philadelphia; he is now
Associate Professor of Economics at Claremont Graduate
School, Claremont, CA. Jeremy Siegel, a Visiting Scholar at
the Philadelphia Fed, is Professor of Finance at the University
of Pennsylvania's Wharton School.

rates to rise and thus "crowd out" private
investment.
In the last few years, another reason to worry
about deficits has received widespread attention.
More and more, economists and informed citi
zens are claiming that large and sustained gov
ernment budget deficits are the root cause of the
high levels of inflation experienced by many
countries. They claim that large budget deficits
create economic and political pressures that force
central banks to monetize some of the debt, that
is, to create more money than is needed to accom
modate real growth. The concern is that the
resulting higher money growth translates into
more inflation in the future. But are these con
cerns indeed valid? Do large deficits necessarily
13

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

bring higher money growth and inflation? The
question is one about balance. The answer turns
on whether the economic and political pressures
to monetize sustained deficits are typically strong
enough to overcome the popular desire for a
stable monetary environment and low inflation.
We can answer the question by finding out
whether money growth and government debt
growth seem to be related historically. This
requires more than just looking at the U.S. data,
however. Finding a relation between debt and
money growth in the U.S., or in any one country,
may not mean that monetization forces are strong.
Economic circumstances specific to a certain
country, or even plain chance, could result in
money and government debt growing together
for some time, even when there is no causal
relation between them. But if the economic
forces to monetize are strong, then the growth
rates of debt and money should tend to change
together in most countries. Therefore, we study
the relation between government debt and
money growth for ten industrialized countries.
But in order to interpret the empirical findings,
first we need to define "monetization," to explain
its mechanics, and to examine closely the prin
cipal theories that claim that central banks tend
to monetize government debt.
MECHANICS OF DEBT MONETIZATION
Government runs a deficit whenever its reve
nues fall short of its expenditures. In order to
obtain the funds necessary to cover the deficit,
the treasury or the finance ministry must borrow,
that is, it must sell bonds. Thus deficits increase
the outstanding amount of government debt,
otherwise known as the national debt. Central
banks purchase government bonds, via what are
known as "open market purchases," either di
rectly from the government treasury or else in
the private financial markets.1 In either case,

1A central bank can create new reserves by purchasing
any asset from the public, not just government bonds. But in
practice central banks purchase government bonds almost
exclusively.

14for FRASER
Digitized

open market purchases create additional currency
and bank reserves.2 The additional currency
and reserves increase the monetary base imme
diately and provide more liquidity to the banking
system. This new liquidity enables banks to in
crease their lending, which, through a complex
process, ends up increasing the national money
supply, measured by M l or other, more inclusive,
monetary aggregates.3
In countries with poorly developed financial
markets, the relation between deficits and money
creation is usually quite direct. Since the finan
cial markets cannot absorb enough of the con
tinuing increases of government debt, the central
bank is forced to buy much of it. In these cir
cumstances, government deficits automatically
result in increases in the monetary base and thus
in the money supply.4*
In industrialized countries with well-devel
oped financial markets, the situation is quite
different. In these countries, new government
debt generally is sold to the private sector rather
than to the central bank. The central bank may
buy some of this debt as part of its monetary
policy, but generally it is under no obligation to
do so. In fact, in some countries, including the
U.S., it is illegal for the central bank to buy debt
directly from the government, except in emer
gency circumstances.
To summarize: in countries with well-devel
oped financial markets there is no direct connec
tion between budget deficits and new money
creation. Therefore, if there is a connection, it
must be indirect. Sustained budget deficits can
cause high base and money growth only if they
set in motion economic and political pressures
2

The term "bank reserves" used here refers to deposits
held by banks at the central bank.
Monetary base is currency in the hands of the public plus
bank reserves. M l is currency in the hands of the public plus
checkable deposits. For a precise definition of these and
other measures of money for the U.S., see a recent issue of
the Federal Reserve Bulletin.
4 Such countries sometimes can limit the effect their defi
cits have on their domestic money supply by borrowing
abroad.

FEDERAL RESERVE BANK OF PHILADELPHIA

Aris Protopapadakis & Jeremy J. Siegel

Are Government Deficits Monetized?

that make central banks reassess their monetary
policy and decide to create more money than
they would otherwise.
ECONOMICS OF DEBT MONETIZATION
If central banks do respond to increasing levels
of debt by creating more money, they are said to
monetize the debt. A useful definition of m one
tization is that, in response to high debt growth,
authorities create money at a rate in excess of the
growth in goods and services, or real output. In
other words, monetization is a relation between
the growth rates of debt and money, after sub
tracting from both the growth rate of real output
(see The Economic Meaning of Monetization in SOME
ELEMENTS OF MONETIZATION THEORY,
p. 21). According to this definition, government
debt is monetized if money growth rates follow
the pattern of the debt growth rates. This notion
of monetization is different from what often is
implied by the popular press—that monetizing
the deficit means that the monetary authorities
simply buy up the debt issued to finance a deficit
by issuing equal amounts of reserves.
Economists have come up with two principal
scenarios in which debt growing faster than real
output may create incentives for monetization.
The first is related to the premise that if govern
ment debt is growing faster than GNP and other
assets, the private sector is not willing to purchase
the additional debt at the going real interest
rates (nominal rates minus expected inflation).
In order for the private sector to hold more
government bonds in their portfolios relative to
their other assets and to their income, the real
rates on these bonds must rise.5 But the resulting
rise in real rates tends to reduce investment
spending and to slow real economic activity. To
the extent that a central bank is concerned with
helping to maintain the original pace of economic
growth, it may try to resist such an increase in

real interest rates by making the money supply
grow faster, and the result is inflation down the
road (see The Link Between Excess Money Growth
and Inflation in SOME ELEMENTS OF MONE
TIZATION THEORY, p. 22).
The second scenario involves governments'
incentives to lower the real burden of this debt
through inflation.6 Government uses some of
the taxes it collects to pay the interest on its debt.
The larger the debt, the larger the government's
interest expense, and hence the higher taxes
must be to pay the interest. Since these higher
taxes would go right back to the taxpayers who
own government bonds in the form of interest
payments, one might think that these taxes would
"w ash" in an aggregate sense. But this is wrong.
Taxation distorts economic decisions and creates
economic inefficiencies because it reduces the
relative attractiveness of taxed activities, like
working or investing, and it increases the relative
attractiveness of untaxed activities, like leisure.
The inefficiencies caused by taxing to pay inter
est on the debt are a major aspect of what econo
mists call the "burden of the national debt."7
This burden can be reduced only by finding
ways to reduce tax rates on the various economic
activities.
One way to reduce this burden is to engineer
a higher than anticipated inflation. Inflation must
be higher than anticipated because if the bond
holders had correctly expected the coming
inflation, they would have incorporated this
expectation into higher interest rates, in order to
compensate them for the expected loss in the
6For expository convenience, the discussion here assumes
that central banks react to whatever fiscal policy the govern
ment chooses. We do not mean to imply by this that monetary
policy is subservient to fiscal policy, or that the two policies
are not formulated jointly. The incentives to monetize that
we discuss operate regardless of the nature of the decision
making process, and they exist even under optimal public
financing policies.

5This reasoning assumes that government debt is net
wealth. For a complete discussion of these issues, see Robert
Barro, Macroeconomics (New York: John Wiley and Sons,
1984), and Robert Mundell, Monetary Theory (California:
G oodyear Publishing Co., 1971).

This theory is based on the view that government has
strong incentives to maintain an efficient tax scheme. Alter
natively, if the government finds it politically impossible to
raise sufficient taxes, it may resort to inflation as a source of
revenue, even if this action results in an inefficient tax
scheme.

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

purchasing power of their investment. Higher
than expected inflation reduces the real value of
all the interest expense government has to pay
on the existing long-term, fixed-coupon bonds
until they mature.8 Since the government's
interest expense is in nominal dollars, its real
value declines with inflation, and this means
that tax rates can be reduced (or at least not be
raised). To the extent that the inflation is not
expected, it does not distort economic incentives.
Therefore, engineering an unexpectedly high
inflation substitutes a non-distortionary tax on
bondholders for the distortionary taxes levied
on taxable economic activities.9
Since the real burden of government debt can
be reduced only by inflating more than bond
holders expect, policymakers may be tempted
to keep raising the rate of money growth, and
hence inflation, to stay one step ahead of the
expectations of bondholders. And this could
lead to a continuously accelerating inflation.10
To counteract this temptation to inflate, other
economic and political forces push policymakers
towards lower money growth and lower inflation.
Once inflation gets started, people soon begin to
o

For this to work, at least some of the debt must be fixedcoupon, long-term debt. If all government debt were short
term (or if it all were floating-rate), then there would be no
time lag over which the government could gain from an
unexpected increase in inflation, since the government would
have to pay an inflation premium promptly, as it continually
refinances its short-term debt. And this will keep the real
interest expense, and the tax rates, from falling.
9For an analysis of the underlying economics of this mecha
nism, see Robert Barro, "A Positive Theory of Monetary
Policy in a Natural-Rate M odel," Journal o f Political Economy
93, 4 (August 1983) pp. 589-611. For an exposition of the
connection between inflation, the real value of the debt, the
burden of the debt, and the related tax issues, see Brian
Horrigan and Aris Protopapadakis, "Federal Deficits: A Faulty
Gauge of G overnment's Impact on Financial Markets," this
Business Review (M arch/April 1982) pp. 3-16, and Brian
Horrigan "The Tax Reform Controversy: A Guide for the
Perplexed," this Business Review (May/June 1985) pp. 3-15.
10This argument is one aspect of the general problem of
policymaking often referred to as the "time inconsistency"
problem of government policies. For a broad exposition of
the issues involved, see Herb Taylor "Time Inconsistency: A
Potential Problem for Policymakers," this Business Review
(March/April 1985) pp. 3-12.

Digitized16for FRASER

anticipate it, and anticipated inflation carries
costs of its own. High or accelerating inflation
is considered extremely detrimental in indus
trialized market economies, where individuals
and firms rely on the price mechanism to signal
the relative scarcity of goods. When the overall
price level is uncertain, it becomes difficult to
compare relative prices and to use the price
system for decisionmaking.11 Furthermore,
uncertain inflation increases the risks of long
term commitments, because it causes capricious
windfall gains for those who happen to hold the
right investments and losses to those who don't.
For instance, people who have put their savings
in fixed-interest long-term securities—like
government bonds—will find the purchasing
power of their income diminishing through
time, if inflation turns out to be higher than
anticipated.
For these reasons, the overwhelming majority
of people support price stability as an appro
priate goal of economic policy. Monetary policy
makers then must balance the benefits of
engineering an inflation in order to reduce the
burden of the debt with the costs of having to
live with the inflation. In the end, whether high
debt growth leads regularly to high money
growth depends on whether the inflationary
forces generated by large deficits are stronger
than the incentives for price stability.12*
Unfortunately, economists cannot run to their

There is very strong empirical evidence that inflation
and uncertainty about relative prices go together. See Stanley
Fischer, "The Benefits of Price Stability," in Price Stability and
Public Policy, (Federal Reserve Bank of Kansas City, 1984).
Though there have been various explanations for this phe
nomenon, there is no consensus as to its causes.
12
Of course, debt growth cannot forever grow arbitrarily
faster than money growth, or else the econom y will be
literally overwhelmed with government debt. If this hap
pens, the monetary authority must monetize the debt to
ensure the solvency of the government. Fora detailed analysis
of these issues, see Bennett McCallum, "A re Bond-Financed
Deficits Inflationary? A Ricardian Analysis," Journal of Political
Economy (February 1984) pp. 123-135, and Thomas Sargent
and Neil Wallace, "Some Unpleasant Monetarist Arithmetic,"
Federal Reserve Bank of Minneapolis Quarterly Review (Fall
1981) pp. 1-18.

FEDERAL RESERVE BANK OF PHILADELPHIA

Are Government Deficits Monetized?

laboratories and concoct experiments to find
out which forces will generally prevail. Instead,
we can examine the experience of several indus
trialized countries to see if increases in debt
growth in these countries tend to coincide with
increases in m oney growth. That is, we can find
out if debt growth and money growth are pos
itively correlated, even though the tradeoff
between the desire for low inflation and the
benefits from engineering an inflation is likely
to be somewhat different in each country. If the
inflation incentives generated by large deficits
are strong and pervasive, then we should find a
positive correlation between debt growth and
money growth across these countries.13 If we
find no correlation between debt growth and
money growth, then it is unlikely that mone
tization occurs regularly.
We want to emphasize that the statistical
results shown in the following section cannot
support or reject any of the individual economic
scenarios that may push towards monetization
or work against it. Rather, these results can only
show whether or not in fact monetization has
taken place systematically.
WHAT IS THE EVIDENCE?
Assessing the Data for Ten Countries. In order
to see whether countries typically monetize
rapidly growing debt, we examine the post-war
experience of ten industrialized countries:
Canada, Finland, France, Germany, Holland,
Japan, Italy, Switzerland, the United Kingdom,
and the United States. First we look at the behav-

Note that if there is a significant correlation between
debt and money growth, one still cannot conclude that debt
growth causes money growth. Establishing empirically which
way causality goes is an extremely complex and as yet un
resolved issue. Econometricians have developed tests for a
causal relation between variables under a very restrictive
definition of causality. These are called "G ranger causality"
tests. For more information, see Three Aspects of Policy and
Policymaking: Knowledge, Data, and Institutions Cam egieRochester Conference Series on Public Policy, Vol. 10,
(Amsterdam: NorthHolland, 1979), and "Exogeneity,"by R.
Engle, D. Hendry, and J. F. Richard, Econometrica 5 1 ,2 (March
1983) pp. 277-304.

Aris Protopapadakis & Jeremy /. Siegel

ior of the debt-to-GNP ratio in each of the coun
tries, since both of the monetization scenarios
discussed depend on the relation of government
debt to nominal income. (See Figure 1, DEBT
GROWTH IN TEN COUNTRIES, p. 18.)
The histories of the debt-to-GNP ratios of
these countries show strong similarities. Though
the levels of these ratios and their year-to-year
behavior vary from country to country, the ratio
for each country, except Italy, declines until 1974.
After 1974, each country's debt-to-GNP ratio
increases, and only in Switzerland and in the
U.K. does the ratio eventually resume its down
ward trend through the end of our sample period
in 1983. One reason for the growth in the debtto-GNP ratio after 1974 is the slow growth of
output in all these countries. But the primary
reason for the growth in the ratio is the explosive
growth of government debt in all ten countries,
unprecedented in the post-war period.14 Fur
thermore, this high growth of government debt
is sustained to the present in most of these
countries.
Whatever the reasons for this uniformly high
growth of government debt after 1974, this pe
riod provides an excellent setting in which to
assess the importance of the forces to monetize
deficits. In order to implement our tests, we
define excess debt growth as the growth rate of
government debt less the growth rate of real
output (real GNP). Similarly, excess money growth
is the growth of a measure of money (such as the
monetary base or M l) less real output growth. If
the pressures to monetize debt play a big role in
monetary policymaking, we should find excess
money growth increasing as excess debt growth
increases, so that countries with the largest
increase in excess debt growth should tend to
have the largest increase in excess money growth.
If monetization were systematic, a graph of
changes in excess debt growth and in excess

14For a review of the theoretical and actual characteristics
of the debt-to-income ratio in the U.K. and the U.S., see
Macroeconomics by Robert Barro.

BUSINESS REVIEW

NOVEMBER/DECEMBER 1986

money growth should show a very similar
pattern.
The Results. The facts are otherwise. Although
excess debt growth increases after 1974 in all ten
countries, excess money growth does not in
crease by nearly as much, and in some cases
it actually declines. Figure 2 illustrates this fact
for the case of the monetary base.15 Excess debt
growth in each period (1962-74 and 1974-83) is
calculated as average government debt growth
minus average real output growth. The change
in excess debt growth then is the difference in
excess debt growth between the two periods.
The change in excess money growth is calculated
the same way.
It is easy to see from Figure 2 that the relation
between excess base growth and excess debt
growth varies widely across countries. Three of
the ten countries in our sample, Germany, Japan,
and Switzerland, show reductions in their excess
base growth rate after 1974, despite high excess
debt growth. And in two other countries with
high debt growth, France and the U.K., the in
crease in excess base growth is negligible. The
other five countries, Canada, Finland, Holland,
Italy, and the U.S. do show some increase in
their excess base growth. However, in each of
these countries, the increases in excess base
growth are always much smaller than the in
creases in excess debt growth. Only in Italy do
the data suggest that substantial monetization of
deficits was taking place, because only in this
case are the debt growth and base growth rates
similar. By contrast, though the Finnish base
growth is substantial, it is only one third of the
growth rate of debt. So, in contrast to what we
would expect if systematic monetization was
taking place, the pattern in Figure 2 looks pretty
much random.
However, this analysis is rather casual. We
can make it more rigorous by performing a statis-

15We use the monetary base as the money measure to
illustrate the pattern that emerges, but the overall conclusions
are very similar when we use M l as a measure of money.

FEDERAL RESERVE BANK OF PHILADELPHIA

Aris Protopapadakis & Jeremy }. Siegel

Are Government Deficits Monetized?

FIGURE 2

The Post-1974 Increase in Excess Debt Growth Has Not
Been Matched By Similar Increases in Excess Base Growth
| Change in average excess debt growth be
tween 1962-1974 and 1974-1983. (Average
excess debt growth equals average debt
growth minus average real output.)
j

Annual
% Growth

Change in average excess m oney growth
between 1962-1974 and 1974-1983. (Average
excess money growth equals average mone
tary base growth minus average real output.)

32.2

tical test to quantify the relation between debt
growth and money growth. This requires making
a ranking so that the country with the lowest
average excess debt growth is at the top of the
list, and the country with the highest average
excess debt growth is at the bottom of the list.
Similarly, we rank countries according to their
excess money growth, from lowest to highest.
Then we calculate a statistic called the "rank
correlation coefficient," which measures how
similar the rankings in the two lists are. Now, if
higher debt growth is very closely related to
higher money growth, the countries will be
ranked in almost exactly the same order in the
two lists; in that case, the value of the rank corre
lation coefficient will be close to 1. If there is no
relation between high debt growth and high

money growth, the rankings in each list will look
quite random, and the coefficient will be near 0.
If the rankings are exactly opposite, then the
coefficient's value will be —1.
Table 1 (p. 20) presents rank correlation coef
ficients, which were calculated using both the
monetary base and M l as measures of money,
since the theories we rely on are not specific as
to which money measure is the more appro
priate. The first line in the table shows the statis
tical significance of the data in Figure 2. The
correlation across countries between changes in
excess debt and money growth is small and
statistically insignificant, whether the monetary
base or M l is used as the measure of money. The
second line in Table 1 shows a somewhat differ
ent rank correlation test. Rather than calculating
19

NOVEMBER/DECEMBER 1986

BUSINESS REVIEW

TABLE 1

Rank Correlation Coefficients
Debt-Monetary Base

Debt-Mi

Rank correlation of the change in excess debt
and money growth betw een 1962-74 and 1974-83.

0.36
(1.08)

—0.08
(0.22)

Rank correlation of average excess debt
and money growth, 1974-1983.

0.26
(0.70)

0.20
(0.58)

NOTE: t-statistics are in parentheses. None of the rank correlations is significantly different from zero, from a
statistical standpoint.

the correlation of changes of excess debt and
money growth between the two periods, we
calculate the correlation between the 1974 to
1983 average excess debt growth and the corre
sponding average excess money growth for the
ten countries.
The results suggest that not only were large
changes in excess debt growth not accompanied
by comparable changes in excess money growth,
but also high average excess debt growth is not
accompanied by high average excess money
growth. We conclude that in our sample of indus
trialized countries, it is unlikely that high excess
debt growth generates sufficiently powerful eco
nomic and political forces for monetization.16
CONCLUSION
Theories have been advanced to show that
large government deficits can create incentives
for monetary authorities to increase money
growth (that is, to monetize the debt) and thereby
cause inflation. These incentives take two prin
cipal forms. One is the desire to hold down
interest rates by purchasing some of the newly

floated government debt in the open market,
and the second is the desire to reduce the burden
of the national debt by generating unanticipated
inflation. But working against these inflationary
forces is the popular desire to keep inflation low
and to have a stable monetary environment.
We examine the period after 1974 for ten
industrialized economies to determine whether
excess government debt growth and excess
money growth are related across these countries.
This period is particularly appropriate, because
it is marked by such a rapid growth of debt in all
of these countries. We find that over this period
there is no evidence that excess money growth
is systematically related to excess debt growth.
Remarkably, even though government debt grew
rapidly after 1974 in all the countries in our
sample, the monetary base shrank or did not
grow in five of these ten countries over the same
period. Statistical tests we conduct lead us to
conclude that, for at least a period up to a decade,
it seems likely that monetary authorities can
pursue monetary policies that are independent
of the growth of government debt.

16A variety of additional econometric tests we conducted
on these data support these conclusions. For example, we
calculated regressions of money growth on its own lags,
lagged debt growth, and lagged real growth (4 lags each).
For all countries, we rejected the hypothesis that permanent
increases in debt growth increase money growth perma
nently. These tests ask whether debt growth systematically
led to money growth in any of these countries during the
post-war period. In contrast, the tests we present here ask

whether it is likely that countries responded to the uniformly
high debt growth after 1974 by increasing their money
growth, on average. For more detailed discussions of the
tests and the results, see Aris Protopapadakis and Jeremy
Siegel, "The Impact of Government Debt Growth on Money
Growth and on Inflation: Evidence from Ten Industrialized
Countries," Federal Reserve Bank of Philadelphia Working
Paper No. 86-11.

20for FRASER
Digitized

FEDERAL RESERVE BANK OF PHILADELPHIA

Are Government Deficits Monetized?

Aris Protopapadakis & Jeremy J. Siegel

Some Elements of Monetization Theory
The Economic Meaning of Monetization
W hen econom ists say that “deficits are m onetized," they generally mean that debt growth puts
enough econom ic and political pressure on the monetary authority so that it purchases some or all of the
new debt. In order to be able to interpret the empirical evidence, we need to develop a more precise
definition of monetization. To do so, first we need to introduce some simple macroeconomic equilibrium
growth concepts.
Suppose U.S. output (GNP) were growing in real terms by 3 percent a year. If money demand is
proportional to income (a reasonable approximation), then the econom y could absorb a 3 percent
annual growth rate in the monetary base without causing any inflation, since money growth would not
exceed real output growth. To give a sense of the numbers, the U.S. monetary base is currently around
$220 billion, so the Federal Reserve could increase the base by $6.6 billion next year (3 percent). The
econom y also could absorb a 3 percent annual increase in the level of government debt (that is, a deficit
equal to 3 percent of the debt) without causing any pressures on the financial markets, since other assets
and incom es would be growing at the same rate in this scenario. With our national debt slightly over $2
trillion, that means the Treasury could run a deficit of $60 billion next year without causing any increase
in the econom y's overall ratio of government debt to nominal income. This pattern could continue
indefinitely; it is an example of what economists call a "steady state," that is, an unchanging pattern of
econom ic growth. In such a steady state we would not say that the deficit is monetized, even though the
central bank buys $6.6 billion of the $60 billion deficit through open market operations in the next year.
This is because the central bank's purchases are intended to create enough m oney to support real output
growth with no inflation, and they are not caused by the deficits.
Suppose now that a change in fiscal policy sends the deficit to $200 billion, implying a 10 percent
growth rate for the debt. If the debt is not monetized at all, then the base will continue to grow at 3
percent. But what if the Federal Reserve decides to monetize the deficit? Can that mean that it must buy
the additional $140 billion of new debt?
The answer is, no! To buy all the additional $140 billion would expand the monetary base by almost 64
percent, and this would eventually increase the price level by over 60 percent! Instead, the Federal
Reserve could buy enough of the new debt to let the monetary base grow by only 10 percent to match the
debt growth. Then the base would expand by $22 billion (that is, the Fed would buy only an extra $15.4
billion of debt). That would mean debt and the monetary base would grow by 10 percent, and nominal
GN P also would grow by 10 percent. The 10 percent growth for nominal GN P would com e from the 3
percent real growth and from the 7 percent increase in the price level generated by the higher level of the
base. In the end, this particular strategy will leave the ratios of governm ent debt to money and to
nominal GN P unchanged, which is consistent with a steady state.
To summarize, monetization occurs when fiscal decisions cause the governm ent debt to increase at a
rate faster than the growth rate of real output, and when the central bank responds by increasing the
growth of the monetary base (and, hence, other measures of money, such as M l) to a rate also in excess of
real output growth.3
It is clear that there are various degrees of monetization. If, as in our example, the central bank decides
to match the growth rate of the monetary base to the new growth rate of debt, then the central bank is
m onetizing the debt fully, because such a decision will keep the debt-to-nominal GNP ratio stable, and

aThis notion can be amended to take account of some low underlying inflation rate that may be desirable for a variety
of reasons. If the desired inflation is greater than zero, then monetization occurs when the growth rate of the
monetary base exceeds the amount required to support real output growth plus this desired inflation.

BUSINESS REVIEW

NOVEMBER/DECEMBER 1986

this policy can continue indefinitely. However, the central bank could allow the base to grow by less than
the new growth rate of the debt (although faster than real growth), and only partially monetize the debt.
It is even possible that the central bank could let the base grow faster than debt for a time, and more than
fully monetize the debt.

The Link Between Excess Money Growth and Inflation
Technically, the link betw een money growth and inflation is quite complex, but it is possible to give an
intuitive description of the process by considering a few fundamental relations in the economy. Let us
start from an econom ic equilibrium in which money and prices are growing at some trend rate. For
simplicity, assume that m oney growth matches real output growth, so that the price level is stable. An
increase in the growth rate of the money supply initially leaves the private sector with more m oney than
it wants for its desired transactions. Individuals and firms try to buy more interest-earning assets or more
goods and services with the newly acquired money.
As they attempt to buy more such assets, they bid up the price of these assets and cause interest rates to
decline. The decline in interest rates leads to greater demand for goods throughout the economy. This
rise in demand com es from firms that find that the lower interest rates make it attractive to boost their
investment plans, or by consumers who increase their demand for durable goods. The decline in interest
rates and the increases in spending on goods and services are such that the private sector now wants to
hold all the new money, because now this new growth rate of money is consistent with its new spending
plans and the new interest rates.
The increase in demand for goods may translate into increases in real output in the short run,
particularly if there are unemployed resources in the economy. But increases in demand cannot always
be met with higher output, especially once all the resources in the econom y become employed. As
increasing demand outpaces the ability to produce more output, eventually the higher money growth
will force up the prices of goods and services in the economy. Therefore, money growth in excess of real
output growth will produce inflation in the long run. For instance, if money demand is proportional to
income, and if real output grows at 3 percent, then a 3 percent money growth rate will result in a stable
price level (0 percent inflation) while a 10 percent money growth will result in a 7 percent inflation.

Digitized22
for FRASER

FEDERAL RESERVE BANK OF PHILADELPHIA

BUSINESS REVIEW INDEX 1986
JANUARY/FEBRUARY

JULY/AUGUST

Carl E. Walsh, "New Views of the Business

John Bell and Theodore Crone, "Charting the

Cycle: Has the Past Emphasis on Money
Been Misplaced?"
Richard McHugh, "Productivity and the Pros
pects for Outgrowing the Budget Deficit"

Course of the Economy: What Can Local
Manufacturers Tell Us?"
Gerald A. Carlino, "D o Regional Wages
Differ?"

* ...

MARCH/APRIL

Brian C. Gendreau and Scott S. Prince, "The

SEPTEMBER/OCTOBER

Private Costs of Bank Failures: Some Histor
ical Evidence"
Donald C. Cox and Robert H. DeFina, "Warm
Feelings and Cold Calculations: Economic
Theories of Private Transfers"

Herb Taylor, "What Has Happened to M l? "
Stephen A. Meyer, "Trade Deficits and the

MAY/JUNE

Jan Loeys, "Low-Grade Bonds: A Growing

Dollar: A Macroeconomic Perspective"
NOVEMBER/DECEMBER

Mitchell Berlin, "Loan Commitments: Insur

Source of Corporate Funding"

ance Contracts in a Risky World"
Michael Smirlock, "Hedging Bank Borrowing
Costs with Financial Futures"

Aris Protopapadakis and Jeremy J. Siegel,
"Are Government Deficits Monetized?
Some International Evidence"

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RESERVE B A N K O F
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