This week we will look at a “special case”, and one that preoccupied Washington recently.As we know, governments spend by keystrokes that they can never run out of–asovereign government that issues its own currency through keystrokes can neverface a financial constraint. However, it can choose to “tie its hands behindits back” by imposing rules and procedures that limit its keystrokes. It could,for example, simply impose a limit of “100 keystrokes per year”. It couldrequire the Treasury Secretary to climb Mount Everest or to seek approval fromterrestrial or extra-terrestrial gods before he is allowed to enter akeystroke. It could require a solar eclipse or similar “miracle” beforegovernment is allowed to credit a balance sheet.
We shouldnot be fooled by such self-imposed constraints. We should be able to seethrough them to understand that since they are imposed by government on itself,they can be removed. Unfortunately, virtually all economists and policymakerscome to see such self-imposed constraints as “natural”, something to neverviolate. Today we will look at the US “debt limit” that consumed policy makersin the US last summer—and will likely be visited again.
Before weproceed, let me acknowledge that I’ve promised our wonky readers some balancesheets and a detailed treatment of internal operating procedures used by theFed and Treasury to get around the self-imposed constraints. I have notforgotten. That is a matter for a later post.
In theUnited States Congress establishes a federal government debt limit. When theoutstanding quantity of federal government debt approaches that limit Congressmust approve expansion of the limit. Note that this debt limit is establishedby policy, not by markets—that is, Congressional action is required byCongress’s own rules, and not by market pressure. Hence, it is not a questionof whether the US government could sell more bonds, or even over the interestrate it would pay on the debt it sells.
In the aftermath of the Global FinancialCollapse of 2007, the US budget deficit increased (mostly due to loss of taxrevenue, as discussed in a previous blog). Predictably, the amount of debtoutstanding grew to the limit, and so each year Congress has had to increasethe limit.
This blogwill look at current procedures to see if there is an alternative to increasingthe limit—while allowing the Treasury to continue to spend. We examined most ofthe details of the operating procedures in a previous blog; in this blog weextend that understanding to come up with an alternative procedure. We will usethe distinction between High Powered Money (Federal Reserve Notes, Reserves,and Treasury Coins) and Treasury Debt (bills and bonds)—only Treasury Debt isincluded in the debt limits, although we know that all of these are governmentIOUs.
So let ussee how we can untie Uncle Sam’s purse strings while living with current debtlimits. It is actually a relatively easy thing to do, requiring only a modestchange of procedure.
First weneed to review how things usually work. Congress (with the President’ssignature) approves a budget that authorizes spending. Treasury then eithercuts a check or directly credits a recipient’s bank account. While the USConstitution vests in Congress the power to create money, in practice theTreasury uses the US central bank, the Fed, to handle its payments. Currentprocedure is for the Treasury to hold deposits in its account at the Fed forthe purposes of making payments. Hence, when it cuts a check or credits aprivate bank account, the Treasury’s deposit at the Fed is debited.
TheTreasury tries to maintain a deposit of $5 billion at the close of each day.Taxes paid to the Treasury are first held in deposit accounts it has withspecial private banks. When it wants to replenish its deposit at the Fed,Treasury moves deposits from these banks. Obviously there are twocomplications: first, tax receipts bunch around tax due dates; and, second, theTreasury normally runs an annual budget deficit—more than a trillion Dollars in2011. That means Treasury’s account at the Fed is frequently short.
To obtain deposits, the Treasury sells bonds(of various maturities). The easiest thing to do would be to sell them directlyto the Fed, which would credit the Treasury’s demand deposit at the Fed, offseton the Fed’s balance sheet by the Treasury’s debt. Effectively, that is whatany bank does—it makes a loan to you by holding your IOU while crediting yourdemand deposit so that you can spend.
But currentprocedures prohibit the Fed from buying treasuries from the Treasury (with somesmall exceptions); instead it must buy treasuries from anyone except theTreasury. That is a strange prohibition to put on a sovereign issuer of thecurrency, if you think about it, but it has a long history that we will notexplore in this box. It is believed that this prevents the Fed from simply“printing money” to “finance” budget deficits so large as to cause highinflation–as if Congressional budget authority (and threatened Presidentialveto) is not enough to constrain federal government spending sufficiently thatit does not take the US down the path toward hyperinflation.
So,instead, the Treasury sells the Treasuries (bills and bonds) to private banks,which create deposits for the Treasury that it can then move over to itsdeposit at the Fed. And then the Fed buys treasuries from the private banks toreplenish the reserves they lose when the Treasury moves the deposits. Got that?The Fed ends up with the treasuries, and the Treasury ends up with the demanddeposits in its account at the Fed—which is what it wanted all along, but isprohibited from doing directly. The Treasury then cuts the checks and makes itspayments. Deposits are credited to accounts at private banks, whichsimultaneously are credited with reserves by the Fed.
In normaltimes banks would find themselves with more reserves than desired so offer themin the overnight Fed Funds market. This tends to push the Fed Funds rate belowthe Fed’s target, triggering an open market sale of treasuries to drain theexcess reserves. The treasuries go back off the Fed’s balance sheet and intothe banking sector. (With the Global Financial Crisis, the Fed changedoperating procedure somewhat—it began to pay interest on reserves, and adopted“Quantitative Easing” that purposely leaves excess reserves in the bankingsystem. That is a topic for another blog.)
And that iswhere the debt gridlock problem bites. Treasuries held by banks, households,firms, and foreigners are counted as government debt (and nongovernment wealththrough accounting identities!) and thus subject to the imposed debt ceiling.Bank reserves, by contrast, are not counted as government debt. (One solution isto just stop the open market sales of treasuries in order to leave the reservesin the banking system. That is essentially what Bernanke’s Quantitative Easing2 does: the Fed is buying hundreds of billions of treasuries to inject reservesback into banks—the reserves that were drained by selling the treasuries tobanks in the first place.) So we are getting treasuries back onto the Fed’sbalance sheet, and yet gridlock remains because there are still too manyTreasuries off the Fed’s balance sheet.
Here is aproposal to change procedures in a way that eliminates the need to raise debtlimits. When Uncle Sam needs to spend and finds his cupboard bare, he canreplenish his demand deposit at the Fed by issuing a nonmarketable “warrant” tobe held by the Fed as an asset. With the full faith and credit of Uncle Samstanding behind it, the warrant is a risk-free asset to balance the Fed’saccounts. The warrant is just an internal IOU—from one branch of government toanother—really not anything more than internal record keeping. If desired,Congress can mandate a low, fixed interest rate to be earned by the Fed on itsholdings of these warrants (to be deducted against the excess profits itnormally turns over to the Treasury at the end of each year). In return, the Fedwould credit the Treasury’s deposit account to enable government to spend. Whenthe Treasury spends, its account is debited, and the private bank that receivesa deposit would have its reserves at the Fed credited.
From theFed’s perspective it ends up with the Treasury’s warrant as an asset and bankreserves as its liability. The Treasury is able to spend as authorized byCongress, and its deficit is matched by warrants issued to the Fed. Congresswould mandate that these warrants would be excluded from debt limits since theyare nothing but a record of one branch of government (the Fed) owning claims onanother branch (the Treasury). The Fed’s asset is matched by the Treasury’swarrant—so they net out.
AndCongress would not need to increase the debt limit when a crisis hits thatresults in growing budget deficits.
Thisproposal just shows how silly it is to tie the Treasury’s hands behind its backthrough imposing debt limits. We already require that a budget is approvedbefore Treasury can spend. That constraint is necessary to imposeaccountability over the Treasury. But once a budget is approved, why on earthwould we want to prevent the Treasury from keystroking the necessary balancesheet entries in accordance with Congress’s approved spending?
Thebudgeting procedure should take into account projections of the evolution ofmacroeconomic variables like GDP, unemployment, and inflation. It should try toensure that government keystroking will not be excessive, stoking inflation. Itis certainly possibly that Congress might guess wrong—and might want to reviseits spending plan in light of developments. Or, it can build in automaticstabilizers to lower spending or raise taxes if inflation is fuelled. But itmakes no sense to approve a spending path and then to arbitrarily refuse tokeystroke spending simply because an arbitrary debt limit is reached.
Can we not see that the Fed redeems the government’s debts to the banks from borrowing to fund deficit spending
when the Fed buys the securities from the banks with money it creates out of thin air. If the Fed swaps the mature
securities it has bought from the banks with a new security to take its place, doesn’t the Treasury extinguish the mature security it has from the Fed? The Fed is a government entity. The securities are backed not by the Treasury but by the full faith and credit of the government, and any government agency with the money can redeem the government’s debt.
But how does the accounting go on the pile of securities at the Fed which are not yet resold to anyone? Why do they represent an actual debt as opposed to tokens of an abstract debt-obligation that someone may purchase from the government at the Treasury?
There is no real national debt problem, even now. Most of it has been paid off by the Fed buying the securities.
Those securities that have been sold to investors and banks will be repaid either from the time accounts at the Fed corresponding to the sold securities (like bank CD’s), or with money the Fed creates out of thin air.
Government operations are not funded from these accounts.
Securities at the Government Trust Funds (e.g. Social Security, etc.) can be cleared by the Treasury issuing securities to get money for their purchase from banks. Fed will buy those securities from the banks and end up swapping them for new securities. Treasury will extinguish both the original securities at the Soc. Sec. Trust fund and the securities it got from Fed in the swap. Until the new securities are sold by the Fed in open market operations to fight inflation, there is no real debt to anyone in particular in those securities. The Treasury may carry them on their books as
potential liabilities, but they are not actual liabilities until sold.
I should add that any government agency with the money and the authorization to buy government securities in the open market can redeem the debt. That points to the Fed.
It is stupid to include the securities held by private and foreign investors (as opposed to lenders) in the debt ceiling. The securities are backed by the money deposited at the Fed for the investors in acquiring the securities. So, there is no problem with repaying that portion of the debt. And it is a large part of the debt-ceiling count.
It is stupid to include the securities held by the Fed in the debt-ceiling. These securities do not represent a debt obligation to anyone in particular. The debt obligation to the banks or whomever held them has been paid when the Fed bought them from the banks or other holders. The obligation on the books of the Fed is just the obligation of the government to pay the holder the face value of the security on or after maturity of the securities. But there is no eligible holder to pay the debt to.
The Fed is not an eligible ‘holder’ . It is a government agency. It acts for the government. To believe that it is owed for the face value of the securities would be like believing a bank clerk is owed for the securities he/she has bought for the bank with bank money from bank customers. The clerk is just an ‘agent’ for the bank. Someone has to do the work of moving money and securities around. The clerk gets a salary.
The Fed gets its income for doing the work of buying and selling securities in the form of transaction fees.
These are calculated by law as 6% of the interest on the security. That allows the Fed to remain independent of the Congress’ influence on its decisions and actions, by not depending on Congressional appropriations for the Fed’s operations.
Aside from private and foreign investors, and banks holding securities for deficit spending (which the Fed can pay back, or which Treasury can roll over by swapping new securities for mature securities), there are only the intragovernmental debts which are counted in special government series securities which cannot be traded on the open market and which the Fed cannot buy. This includes securities at the Social Security Trust Fund and other Trust Funds of the government. Those can be paid off by Treasury issuing marketable securities to get money to buy back these securities from the Trust funds. These will be sold at public auction to banks. The Fed will then be able to buy these marketable securities from the banks with money it creates out of thin air. That redeems the government’s debt on these marketable securities to the banks. It also redeems the debt of the government to the Trust funds. It is presumed that the Trust funds will not want to cash in all their securities at one time, but only as needed. For example it is projected that even when the Social Security will have insufficient funds collected in FICA taxes to cover only 75% of the benefits it is obligated to pay to retirees, the Trust funds will only be used to provide funding for the remaining 25%. Again this will only occur on a monthly or yearly basis, which will be easy to handle without generating major inflation.
MMTers should note that the system I have described above satisfies MMT requirements for regarding a fiat money system as being under a government sovereign in its money.
When the Treasury borrows from banks for deficit spending using Treasury securities, banks will eventually sell their mature securities to the Fed at public auction. That redeems the debt to the banks on the deficit spending money. That makes deficit-spending money debt free.
Furthermore, because the deficit-spending money equals the amount of money the Fed created out of thin air to purchase the securities, we can regard the deficit-spending money as ‘fungibly’ equivalent to the Fed’s debt free money created in buying the securities directly from the Treasury. (But in actuality no money goes directly from Fed to the Treasury. It is an immaculate creation).
So, deficit spending money is debt-free and new money entered into the economy.
The money added to the reserves of the banks by the Fed’s purchase of the securities just restores the reserves with respect to the money lent the Treasury. So that can be regarded as ‘old’ money. If the banks go ahead and lend against their restored reserves, that creates new money also, but it is debt and not debt-free money.
So, why isn’t quantitative easing by the Fed with the banks inflationary? It could be. Except the Banks haven’t lent new money against their restored reserves. It’s as if the new money was absorbed into a black hole somewhere and the deficit-spending money is just old money moved from the banks and spent into the economy. But inflation concerns excess money in circulation chasing goods and services. The lending of money to the Treasury is money creation by the banks. And the Treasury’s spending that money is chasing goods and services. But the Fed neutralizes the debt aspect of that money when it buys back the securities for the government and restores the banks’ reserves. So, why do the banks have to lend against their restored reserves to have the new money from the Fed regarded as inflationary via the deficit-spending? Scott Fullweiler, can you help me out on this?