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.