If a corporation takes a loan from a bank, the bank decides the interest rate on the loan. Hypothetically, if the borrower gets to determine the rent on money, it would naturally choose the lowest possible interest rate. However, when investors lend money to the government, the borrower decides the interest rates unilaterally. Like corporations have a treasury department, the government too has a treasury department and an in-house banker?the central bank. For instance, in the US, the treasury department issues securities whose yields, in effect, gets determined by the Fed.

Currently, if you lend money to the US government by buying its Treasury securities, the return that you get on your investment is 0.02% for three months. If you lend for a bit longer, say, for one year, you make 0.11%. Even if you lend for three years, the yield that you get is only 0.39%. If inflation is, say, 3.5%, which is what it is in the US right now, you end up receiving less than what you invest. The main reason why interest rate is low is because the government?s banker?the Fed?has kept interest rates low and has also explicitly stated that it is going to keep it low for years to come.

Contractionary monetary policy, like in India right now, entails increasing interest rates to fight inflation while expansionary monetary policy, like in the US, involves decreasing interest rates to increase money supply. An increase in money supply spurs investment. It also puts more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. However, the Fed has reduced short-term interest rates to near-zero already, so it can?t use this monetary policy tool any more to increase money supply. The Fed has been using unconventional monetary policy by injecting money supply directly instead of using the interest rate lever. It embarked on a new tool called Quantitative Easing (QE) to stimulate the economy by purchasing long-dated financial assets. When government purchases these long-term assets, it injects money in the system because it pays for the purchases by printing money. Obviously, if the government had money to spare, it won?t be borrowing in the first place. Under QE1, the Fed bought bank debt, mortgage-backed securities, and a lot of other long-dated instruments, by injecting $2.054 trillion. QE2, similarly, injected $600 billion. To understand the effects of an increase in supply of money, I quote from the famous speech that Ben Bernanke gave on November 21, 2002, ?Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. People know that inflation erodes the real value of the government?s debt and, therefore, that it is in the interest of the government to create some inflation.?

We have already seen that the US government has shown great ability to spend, if you really need some ability to do that. Surely, you need ability to reduce spending as Greece, Italy, Portugal, the UK and many others are discovering now. Not for nothing is Ben Bernanke nick-named ?helicopter Ben?. Like in a natural disaster, food is dropped from a helicopter, Bernanke?s solutions in the current crisis have been akin to air-dropping cash into the monetary system. Circulating more printed paper serves no good. Sooner or later, it would trigger off high inflation with investors in Treasury securities losing value.

Not only does the government control the interest rate it pays on its borrowings but it also decides how much money to give back. Investors in Greece?s sovereign bonds have learnt this painfully in the last few months. Investors would probably learn another disconcerting lesson in future that a government can ?default? if it follows a monetary policy that would trigger off high inflation as the investors end up getting less than what they invested.

We saw in recent times that there has been a flight to safety with investors and portfolio managers looking for the protective embrace of the US government debt. The US government has shown a lot of ability to spend but hasn?t yet shown the capability to curtail spending. So, logically, either of these should happen?default or inflation or both. Some of our myths have got shattered in the last four years?that economic problems don?t happen in developed countries, big banks cannot fail, sovereigns cannot default. One more may get added to the list sooner than later??you can?t go wrong by investing in US Treasury?.

The author, formerly with JP MorganChase, is CEO, Quantum Phinance