The Government does create, indirectly via the issuance of Treasuries, money.
Government debt may have a value equivalent to cash if you are large financial institution able to trade them. But it's not monetary base, it's long term debt. You can't buy a Big Mac with bonds. They are not legal tender. You can't deposit them in bank for interest, they are already producing interest. If you are a bank you can't use them to constitute minimal reserves at the Fed onto which to extend credit. The bulk of debt is held by institutional investors for years or decades, and it's not traded. Debt held by foreign governments in reserve is rarely if ever traded, the same for debt held by pension funds or inter-governmental debt.
The velocity of treasuries is one order of magnitude lower than monetary base, so if you really want to count them as money you would do so towards the M3. As any macro professor will tell you,
financing by bonds is less inflationary than financing by monetary expansion.
See here,
http://www.federalreserve.gov/releases/h41/current/h41.htm. This shows U.S Treasuries being counted towards Reserve Requirements. So yes Government Debt is a close equivalent to cash.
I can deposit the Treasury with the bank, and they will issue credit over it. Why? Because the Treasury is obligated to pay an amount of 'legal tender' notes in the future. From the Bank's perspective, the Treasury is an asset, and is willing to lend credit. You can then go purchase a Big Mac meal. The bank can then exchange the Treasury for cash with other banks or the central bank. It can use this money to issue new loans, and fulfill reserve requirements. IMO Krugman is very good fictional writer, who is looking out for vested interests.
If the supply of Treasuries compared to cash is too great, then the Central Bank will step in, and purchase Treasuries with new cash.
The Central Bank is under no obligation to do such a thing. The Central European Bank certainly did not step in to buy hundreds of billions of Greek debt when the supply was too great. And it is certainly too great: investors are currently unloading them at 50-70% discounts. The Central Bank can purchase bonds, but it's a policy option towards it's main goal of inflation, exchange rate or interest targeting.
I meant interest rates are affected by the amount of cash circulating relative to Government Debt. This has an affect upon interest rates, which the Central Bank will respond to, given that inflation is within the target band.
Also the Greek Situation is a little different, because Greece doesn't issue its own currency. If it did, then like Japan there would not have an issue with its public debt.
The central bank could give money directly to the government for spending when it would decide to expand the money supply. The advantage of borrowing it to the government is that when inflation hits the excess liquidity can be sterilized by forcing the government to tax and pay the debt.
Please explain to me how bond holders have the power to force Governments to raise taxes to pay debt??
From the money the Fed has created, a vast quantity sit as excess reserves in the Feds accounts. They are simply idle because the banks are unable or unwilling to find able borrowers. You will notice that the shape of the curve matches the total monetary base curve almost perfectly, and by subtracting the former from the later you will get the total monetary base that actually circulates in the economy. From the 1900 blns created since 2008 only 300 are circulating; the other 1600 blns are simply numbers in the fed's computers. That, coupled with a deflationary economic environment is the real the reason you don't see massive price inflation.
I don't see the point of your graph. For the FED to create reserves it must purchase an asset. Therefore the growth in red-line means that the balance-sheet of the FED has dramatically expanded. That means that the FED has purchased assets from the Private Sector, in exchange for monetary base. A % of the 'new' monetary base, may stay with the FED(excess reserves), for which the FED will pay interest on, a tool the FED got in 2008.