Keith Hennessey was a senior White House economic advisor to President Bush. He recently started a very interesting and informative blog. On Wednesday, he discussed (and disagreed with) Budget Director Peter Orszag's claim that the effective government debt is smaller than the reported number because the government owns a sizable amount of assets that should be netted against that debt.
http://keithhennessey.com/2009/04/08/dont-hide-the-debt/
I've enjoyed Hennessey's blog, but he appears to be confused about the way a fiat currency system works. I don't think he's alone among top government economists. For starters, Hennessey refers to Treasury bonds as IOUs which need to be redeemed in cash, which he seems to imply is something tangible.
It is not only Treasury bonds that are IOUs, of course, but money itself. A little green piece of paper with Benjamin Franklin's picture on it is nothing more and nothing less than a government IOU. When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.
In the UK they are somewhat more explicit about the credit-based, fiat monetary system there. The 5 pound notes read "I promise to pay the bearer on demand the sum of 5 pounds." The "I" refers to the Bank of England, and if you take the note to the Bank, they will indeed exchange it for 5 pounds -- either another 5 pound note or a handful of smaller notes and coins which add up to 5 pounds.
The point is that a dollar, whether it is green or electronic, is an IOU of the United States government, where the government is somewhat vague about what it in fact owes the holder. The IOU is imbued with value by two things: 1) the willingness of the government to provide some real goods and services in exchange for those IOUs ; and more importantly, 2) the government's demand that certain people pay IOUs back to the government in exchange for staying out of jail (i.e. taxation). These two things create demand for government IOUs and make them valuable.
The government, of course, can create as many IOUs as it wants. Sometimes it does it in the form of interest-bearing Treasury bills, notes, or bonds, and sometimes it does it in the form of non-interest bearing numbers in a reserve account at the Fed (i.e. cash). Actually, sometimes it does it in the form of a promise to pay pension and medical benefits in the future (e.g. Social Security and Medicare), but that is a discussion for another time.
Of course, there is a practical limitation on how many IOUs the government can create before inflation becomes a problem. Inflation can be mitigated by tempting people to exchange some of their non-interest bearing IOUs for interest-bearing ones (whether Treasury bonds or deposits at the Fed) which can't be spent easily. The Fed does this by offering a higher interest rate on overnight repurchase agreements, thus reducing aggregate demand for real goods and services by incentivizing people to save rather than spend. But if the government continues to create IOUs much faster than nominal GDP is growing, it is inevitable that the IOUs will depreciate against the value of real goods and services, and we will have destabilizing inflation.
With all of that said, I'll address two points that Hennessey made with which I strongly disagree. First, he disparages Orszag's idea of netting out assets of the government with the outstanding stock of IOUs. Looking at the assets of the government as being available to pay claims, i.e. to pay off and extinguish IOUs, netting is certainly appropriate to some degree because the assets help to maintain the value (real and perceived) of the IOUs backed by the government. In the case of financial assets, particularly relatively liquid, relatively short-term assets which actually spin off cash flows, the fungibility with IOUs is apparent. Financial assets should clearly be netted, although the financial assets do need to be valued appropriately (i.e. not anywhere near face value).
Second, Hennessey claims that when the government borrows to buy financial assets there is a "crowding out" effect. This is pure rubbish. There is no such thing as "crowding out" due to the issuance of Treasury bonds, whether it was done to offset government spending, investing, or tax cuts. For every dollar the Treasury receives from the issuance of Treasury bonds, a dollar is sent back to the private sector, by definition. Net IOUs remains the same.
The fallacy embedded in Hennessey's Alan I. Gorp example is that Alan would have the $100. Alan either spends that $100, pays down his own bank debt with it, or deposits it in a savings account at another bank. As long as Alan doesn't put the money under his mattress, it ends up at a bank. If the money did end up under a mattress, then the Fed could inject (i.e. create) an extra $100 into the banking system without spurring inflation.
Expanding the example back to the government level, we see that if the government issues $1T of bonds to pay for $1T of so-called toxic assets, the next effect is that the private sector in aggregate has received $1T of low-interest government IOUs in exchange for $1T of toxic assets. No doubt this would make the private sector a lot more confident about the creditworthiness of financial intermediaries and counterparties. It would also provide $1T of good assets that could be used to collateralize lending. I'm not saying such a swap is the right thing to do, but it certainly would spur investment and aggregate demand, rather than "crowd" it out.
The only way for the government to starve the private sector of investment funds is to run a budget surplus. This removes IOUs from the system, thus reducing aggregate net financial wealth. The reduction in aggregate net financial wealth would tend to reduce aggregate demand and be disinflationary/deflationary.
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When the government redeems Treasury bonds, it is simply replacing an interest-bearing IOU (barely interest-bearing, in the case of short-term T-bills today) with a non-interest bearing IOU.
Whoa, that's cool. Great post.
Great post ESM!
I am, however, having some trouble understanding your point about how the Fed migitates inflation in he 7th paragraph. I don't think the Fed tightens monetary policy by offering higher interest rates on overnight repo agreements. If the Fed wants to tighten, they use open market operations to sell government securities from dealers, which leads to a decrese in reserves at the dealers' banks.
I am also having some trouble with your point on "crowding out". There is no question that government spending has knock-on effects to businesses and consumers (whether that spending is on toxic assets or food stamps or any number of other initiatives.) However the point that Hennessey tries to make is that there is increased competition for funds when the government issues an additional $1T in debt. The institutions that receive the money from the sale of toxic assets are better off; but what about a community bank that recieves no money, or a consumer that gets no bailout. They will be forced to borrow at higher nominal interest rates in the marketplace. Even the banks that sell their toxic assets to the government for a pretty penny will lend their new money at higher rates, because the government has forced interest rates higher.
You hit the nail on the head about these being extraordinary times and how Treasuries are paying extraordinarily low interest rates due to the flight to safety. But we still see interest rates inching higher for commercial and consumer loans with these new debt issues by Treasury. And the real interest rates on commercial loans and consumer loans were already sky high in the months after the crisis. The one loan category out of these commercial and consumer loans that has seen any relief are these ultralow mortgage rates.
I am also misunderstanding your point about budget surpluses starving the private sector of investment funds. I follow your logic, but empirically that is not the case. Take a look at all of those Asian, Middle Eastern, and Eastern European economies that were amassing huge amounts of budget surpluses and spending the proceeds on infrastructure, social programs, education, health care, etc. in the years before this crisis. These funds were essentially investment funds for every government-sponsored industry and a number of other industries in their respective countries. (Though, in hindsight, more of these funds came back to the U.S. and Europe than was sustainable.)
If you would address these questions I would greatly appreciate it. Loved the post. Please keep them coming!
-Joe Hill
Hi Joe,
Thanks very much for the feedback. I'm going to answer your points or questions one at a time, since I would like to have the answers in separate comments. Also, I have to run off in a bit.
Re: Fed mitigating inflation by raising interest rates
Open Market Operations by the Fed primarily consist of trading repurchase agreements. It is rare for the Fed to sell securities it holds outright. It is less rare for the Fed to buy securities for its own account outright, but until recently, it was not done daily. The Fed has historically purchased Treasury securities at Treasury auctions and through announced reverse Dutch auctions from time to time. In the past few months, it has been buying agency mortgage backed securities in shockingly large amounts, but this is not considered a traditional Open Market Operation. In any case, it doesn't matter for the purpose of adding or draining reserves/cash.
When the Fed wants to raise short-term interest rates, it lends more securities for a period of time through a repurchase agreement (i.e. a repo). In a repo trade, the Fed lends securities in exchange for cash. At the end of the repo term, the Fed returns the cash plus interest and receives the securites back. Repo traders will refer to this as "selling securities," but the Fed is not actually selling securities at a particular price/yield; it is borrowing money collateralized by those securities. The price/yield of the repo has nothing to do with the price/yield of the securities, but rather it is the interest rate the Fed is paying on the cash it is borrowing for the repo term.
So when the Fed wants to do more repo trades, it must entice primary dealers to borrow securites from (lend cash to) the Fed by offering a higher interest rate than the prevailing repo rate. Perhaps counterintuitively, this is known as hitting/selling the repo bid, which will raise the repo bid yield for the next trade. Hitting/selling refers to prices, which move in the opposite direction of rates/yields. The net effect, of course, is to drain reserves from the private sector, and this goes hand in hand with the higher interest rates being offered on repo by the Fed.
When the Fed wants to lower short-term interest rates, it borrows securities / lends cash. This is know as a reverse repo. When the Fed goes into the market to do this, it is not really buying securities, although that's what repo traders call it. It is buying securities on repo, and therefore lifting/buying the repo yield, thus lowering it (once again, the lingo is a bit counterintuitive to a non-bond trader).
So, in a sense the usual textbook explanation of Fed Open Market Operations has causality reversed, although it doesn't really matter except in the short-term for a handful of repo traders. The Fed actually does change short-term interest rates first, and the reserves follow accordingly until equilibrium is reached.
One other point. Inflation is directly related to the propensity of the private sector to spend (i.e. aggregate demand). If the net financial wealth of the private sector is increased, all other things being equal, aggregate demand will increase. If the interest rate available on savings is increased, all other things being equal, savings will increase and aggregate demand will drop.
By changing short-term interest rates, the Fed is trying to manipulate aggregate demand by altering the propensity of the private sector to save versus the propensity to spend. There is no direct effect from the reduction in reserves because the private sector still counts the cash lent to the Fed as a valuable asset. That is, the Fed does not change aggregate net financial wealth. Only the Treasury does that through budget deficits and surpluses.
ESM
Joe,
To address your second point about "crowding out:"
If the government is issuing $1T of debt, it is because it has already transferred net $1T of cash to the private sector. That $1T is available to buy the $1T of new Treasury debt. There is no reason for interest rates in general to rise.
Think about it this way. Cash is like a hot potato, passing from hand to hand (via purchases/sales of goods and services, purchases/sales of assets, repayment of debt, and transfers). At the end of the day (literally), a person or entity with cash on hand has to find a home for that cash in a government security (including a repo at the Federal Reserve) or else earn 0% on it overnight. Purchasing any security other than US government debt does not do the trick, since whoever sold that security has the hot potato. Only the US government (I'm including the Fed here) is willing to borrow cash at 11:59pm and pay a positive interest rate on it overnight.
What I am driving at is that the US government does not issue Treasuries to borrow money. It doesn't need to borrow money. The purpose of Treasury security issuance is to provide for a positive interest rate, to provide a risk-free investment for savers, and to manage the amount of cash in the private sector. Treasuries are not so much debt instruments as liquidity sponges. The government could accomplish the same thing with overnight interest bearing deposits at the Fed, but for some reason this has never been tried.
The "crowding out" argument makes no sense because the extra amount of Treasury issuance exactly matches the extra number of "hot potatoes" running around looking to earn a positive interest rate overnight.
Now if the government decides to issue a boatload of 30-year bonds that would certainly cause 30-year bond yields to rise. But that's a decision that has nothing to do with raising/borrowing money. It's not the amount of money that has been borrowed which would cause 30-year rates to rise in this case, but rather the amount of duration risk that the government has asked the bond market to absorb. It is not for lack of private sector funds that interest rates would rise, but limited risk appetite.
If the government issued 3 month T-bills instead, average interest rates wouldn't budge, although I would expect T-bill interest rates to rise a little and other short-term rates (e.g. on commercial paper) to fall a little. The reason I say this is that some of the $1T that was injected into the private sector makes its way into the hands of people who want to take a little more risk and earn a higher interest rate than that paid by T-bills. Those people would buy other bonds instead (e.g. commercial paper), and the Treasury would have to sell the remaining number of T-bills at a slightly higher rate to the people who used to own commercial paper (and sold it to the first guys).
So my bottom line is this. The net effect of $1T of government spending funded by $1T of T-bill issuance is a small increase in T-bill yields offset by a small decrease in the yields of other short-term debt instruments -- no direct effect on interest rates.
I should point out also that there is no empirical evidence to suggest a positive correlation between government budget deficits and interest rates, in the United States, or any other developed country. Quite the opposite in fact -- the correlation is strongly negative, although I'll admit that this almost certainly has to do with the fact that budget deficits tend to rise during recessions.
ESM
Joe,
On your last point/question:
I am not aware of any country in the blocs you mentioned that ran budget surpluses. Certainly not Japan, whose budget deficits (usually running 5-8% of GDP) have been much larger than ours, and whose total debt is 170% of GDP (dwarfing ours at 65% or so).
China runs fairly sizable budget deficits, although it's debt/GDP ratio is low and its accounting is not to be trusted in any case. I can't think of a single emerging market country that runs a budget surplus, although there are some that were running primary surpluses (which doesn't count interest expense on the outstanding debt) until recently.
I think you're confusing current account surpluses with budget surpluses. A current account surplus, however, is a surplus generated in dollars by the country as a whole with the rest of the world. It does not specifically have to do with the government's finances, and it does not have anything to do with its own currency.
Generally, the governments of countries running the largest current account surpluses are implementing mercantilist policies designed give a boost to the export sector and depress domestic demand for imports. One of the ways to do this is to exchange local currency for dollars (e.g. buy dollars / sell renminbi). The dollars are invested in Treasuries and held in the account that the central bank has with the Fed. The extra local currency that was created to buy the dollars creates excess domestic demand which stokes inflation. In order to tamp down inflation, the government issues lots of local government debt to soak up the excess currency and keep interest rates at a reasonably high level.
So in fact the countries you are referring to are probably injecting a lot of net financial wealth into the domestic private sector, and inflation is generally a problem for such countries. You just have to look at it from the point of view of their own fiat currency, not from a dollar-centric point of view.
ESM
Thanks a million ESM. Didn't know that about repos, completely changes my thinking. Crowding out makes a bit more sense too, though i feel i may still have a question or two for you tomorrow. got to run now, but thanks again! You really clarified for me!
-Joe Hill
@ ESM,
Sorry about all the questions. Please don't feel obligated to answer them if you are short on time.
I think i follow your post on "crowding out". Government transfers money to private sector in the amount of $X, so the Treasury then issues debt in the amount of $X. And since behind every purchase is a hot potato that needs to find a home, then is it safe to say that the total wealth of all businesses and individuals in the U.S. is almost exactly equal to the amount of all government securities in the U.S.? I know that people hold cash in their wallets and safety deposit boxes, but those two numbers should still be pretty close right?
Also in your post about crowding out, is it not true that if the Treasury issues a bunch of 30 years, then interest rates on government securities of just about every maturity will increase, from 3 month to 5 year to 30 year?
Lastly, in your post about merchantilist policies, do those government that are large net exporters even need to create extra local currency in order to buy the dollars? I thought countries like Japan and China and the oil exporters were paid, in large part, with dollars. I thought that it was with these dollars that they purchased a large share of U.S. debt?
Thanks in advance, and on a side note, I have to present a thesis topic pretty soon, and I was wondering if there was any idea on your mind that you feel is worth pursuing in the way of fiat money or monetary policy or any other topic that you fancy?
Thanks again, I greatly appreciate you sharing your knowledge!
[ I think i follow your post on "crowding out". Government transfers money to private sector in the amount of $X, so the Treasury then issues debt in the amount of $X. And since behind every purchase is a hot potato that needs to find a home, then is it safe to say that the total wealth of all businesses and individuals in the U.S. is almost exactly equal to the amount of all government securities in the U.S.? I know that people hold cash in their wallets and safety deposit boxes, but those two numbers should still be pretty close right? ]Yes, you got it right. The total amount of private sector savings (to be precise, let's say non-US government savings) in dollars is exactly equal to the total amount of US government public debt plus cash (i.e. coins, bills, and electronic entries in reserve accounts at the Fed).
Warren Mosler (www.moslereconomics.com) has proposed that the National Debt clock in Union Square in NY should be renamed the Private Sector Savings clock. Not quite accurate, though, because the National Debt clock includes intragovernmental borrowing, which is really an accounting fiction.
To be precise on another point, we're talking about net financial dollar wealth. There are other kinds of wealth. If you have a house or a car or a piece of jewelry, that's wealth. If you own a business or own stock in a company, that's wealth too. But it's not financial dollar wealth. Owning a bond is financial dollar wealth, but if it is not a US government bond, then it is somebody else's offsetting liability.
[ Also in your post about crowding out, is it not true that if the Treasury issues a bunch of 30 years, then interest rates on government securities of just about every maturity will increase, from 3 month to 5 year to 30 year? ]Interest rates for maturities near 30 years will rise (e.g. 15-30 year), and probably interest rates on 10 year maturity bonds as well. Not sure about anything inside of 10 years. The bond trader in me says that the curve would obviously steepen. I expect that short-term interest rates (inside of 3 years) would fall. T-bill rates would almost certainly fall a smidgeon as the madding crowd rushed out of the long-end and parked their money in T-bills before trying to figure out what to do.
[ Lastly, in your post about mercantilist policies, do those governments that are large net exporters even need to create extra local currency in order to buy the dollars? I thought countries like Japan and China and the oil exporters were paid, in large part, with dollars. I thought that it was with these dollars that they purchased a large share of U.S. debt? ]Remember, it is not the government itself which is exporting goods and services and earning dollars. The private sector in that country is accumulating the dollars. If the government is behaving in a mercantilist fashion, it needs to remove those dollars from the private sector. Otherwise, those dollars would be spent, thus increasing imports and contributing to a rise in the exchange rate. By purchasing those dollars with local currency and holding them, the government depresses demand for imports.
A side effect of course is that there will be inflation. It is ironic that a country running a large current account surplus has to worry about inflation because in the aggregate it is producing more goods and services than it is consuming. But the very fact that it is running a current account surplus means that it is exporting a big chunk of its goods and services and not importing very much. The goods and services remaining for domestic consumption are bid up by the domestic private sector which is feeling quite wealthy due to all of its savings. If the government weren't interfering and depressing imports, then inflation wouldn't be a problem.
A corollary is that countries that run big current account deficits get to consume more without having inflation. A large chunk of aggregate demand is met by foreign produced goods and services.
[ Thanks in advance, and on a side note, I have to present a thesis topic pretty soon, and I was wondering if there was any idea on your mind that you feel is worth pursuing in the way of fiat money or monetary policy or any other topic that you fancy? ]I'll give it some thought. Certainly the optimal ratio of public debt to GDP is not well understood and probably depends upon the structure of an economy, the tax code, wealth and income inequality and cultural things as well. I'm not even sure where to begin attacking that problem though.
ESM
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