Originally published November 7, 2011 on the New Economic Perspectives blog.
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–a sovereign government that issues its own currency through keystrokes can never face a financial constraint. However, it can choose to “tie its hands behind its back” by imposing rules and procedures that limit its keystrokes. It could,for example, simply impose a limit of “100 keystrokes per year”. It could require the Treasury Secretary to climb Mount Everest or to seek approval from terrestrial or extra-terrestrial gods before he is allowed to enter a keystroke. It could require a solar eclipse or similar “miracle” before government is allowed to credit a balance sheet.
We should not be fooled by such self-imposed constraints. We should be able to see through them to understand that since they are imposed by government on itself, they can be removed. Unfortunately, virtually all economists and policymakers come to see such self-imposed constraints as “natural”, something to never violate. Today we will look at the US “debt limit” that consumed policymakers in the US last summer—and will likely be visited again.
Before we proceed, let me acknowledge that I’ve promised our wonky readers some balance sheets and a detailed treatment of internal operating procedures used by the Fed and Treasury to get around the self-imposed constraints. I have not forgotten. That is a matter for a later post.
In the United States Congress establishes a federal government debt limit. When the outstanding quantity of federal government debt approaches that limit Congress must approve expansion of the limit. Note that this debt limit is established by policy, not by markets—that is, Congressional action is required by Congress’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 interest rate it would pay on the debt it sells.
In the aftermath of the Global Financial Collapse of 2007, the US budget deficit increased (mostly due to loss of tax revenue, as discussed in a previous blog). Predictably, the amount of debt outstanding grew to the limit, and so each year Congress has had to increase the limit.
This blog will look at current procedures to see if there is an alternative to increasing the limit—while allowing the Treasury to continue to spend. We examined most of the details of the operating procedures in a previous blog; in this blog we extend that understanding to come up with an alternative procedure. We will use the distinction between High Powered Money (Federal Reserve Notes, Reserves, and Treasury Coins) and Treasury Debt (bills and bonds)—only Treasury Debt is included in the debt limits, although we know that all of these are government IOUs.
So let us see how we can untie Uncle Sam’s purse strings while living with current debt limits. It is actually a relatively easy thing to do, requiring only a modest change of procedure.
First we need to review how things usually work. Congress (with the President’s signature) approves a budget that authorizes spending. Treasury then either cuts a check or directly credits a recipient’s bank account. While the US Constitution vests in Congress the power to create money, in practice the Treasury uses the US central bank, the Fed, to handle its payments. Current procedure is for the Treasury to hold deposits in its account at the Fed for the purposes of making payments. Hence, when it cuts a check or credits a private bank account, the Treasury’s deposit at the Fed is debited.
The Treasury 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 with special private banks. When it wants to replenish its deposit at the Fed, Treasury moves deposits from these banks. Obviously there are two complications: first, tax receipts bunch around tax due dates; and, second, the Treasury normally runs an annual budget deficit—more than a trillion Dollars in 2011. 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 directly to the Fed, which would credit the Treasury’s demand deposit at the Fed, offset on the Fed’s balance sheet by the Treasury’s debt. Effectively, that is what any bank does—it makes a loan to you by holding your IOU while crediting your demand deposit so that you can spend.
But current procedures prohibit the Fed from buying treasuries from the Treasury (with some small exceptions); instead it must buy treasuries from anyone except the Treasury. That is a strange prohibition to put on a sovereign issuer of the currency, if you think about it, but it has a long history that we will not explore in this box. It is believed that this prevents the Fed from simply “printing money” to “finance” budget deficits so large as to cause high inflation–as if Congressional budget authority (and threatened Presidential veto) is not enough to constrain federal government spending sufficiently that it 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 its deposit at the Fed. And then the Fed buys treasuries from the private banks to replenish 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 demand deposits in its account at the Fed—which is what it wanted all along, but is prohibited from doing directly. The Treasury then cuts the checks and makes its payments. Deposits are credited to accounts at private banks, which simultaneously are credited with reserves by the Fed.
In normal times banks would find themselves with more reserves than desired so offer them in the overnight Fed Funds market. This tends to push the Fed Funds rate below the Fed’s target, triggering an open market sale of treasuries to drain the excess reserves. The treasuries go back off the Fed’s balance sheet and into the banking sector. (With the Global Financial Crisis, the Fed changed operating procedure somewhat—it began to pay interest on reserves, and adopted “Quantitative Easing” that purposely leaves excess reserves in the banking system. That is a topic for another blog.)
And that is where the debt gridlock problem bites. Treasuries held by banks, households, firms, and foreigners are counted as government debt (and nongovernment wealth through accounting identities!) and thus subject to the imposed debt ceiling. Bank reserves, by contrast, are not counted as government debt. (One solution is to just stop the open market sales of treasuries in order to leave the reserves in the banking system. That is essentially what Bernanke’s Quantitative Easing2 does: the Fed is buying hundreds of billions of treasuries to inject reserves back into banks—the reserves that were drained by selling the treasuries to banks in the first place.) So we are getting treasuries back onto the Fed’s balance sheet, and yet gridlock remains because there are still too many Treasuries off the Fed’s balance sheet.
Here is a proposal to change procedures in a way that eliminates the need to raise debt limits. When Uncle Sam needs to spend and finds his cupboard bare, he can replenish his demand deposit at the Fed by issuing a nonmarketable “warrant” to be held by the Fed as an asset. With the full faith and credit of Uncle Sam standing behind it, the warrant is a risk-free asset to balance the Fed’s accounts. The warrant is just an internal IOU—from one branch of government to another—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 its holdings of these warrants (to be deducted against the excess profits it normally turns over to the Treasury at the end of each year). In return, the Fed would credit the Treasury’s deposit account to enable government to spend. When the Treasury spends, its account is debited, and the private bank that receives a deposit would have its reserves at the Fed credited.
From the Fed’s perspective it ends up with the Treasury’s warrant as an asset and bank reserves as its liability. The Treasury is able to spend as authorized by Congress, and its deficit is matched by warrants issued to the Fed. Congress would mandate that these warrants would be excluded from debt limits since they are nothing but a record of one branch of government (the Fed) owning claims on another branch (the Treasury). The Fed’s asset is matched by the Treasury’s warrant—so they net out. And Congress would not need to increase the debt limit when a crisis hits that results in growing budget deficits.
This proposal just shows how silly it is to tie the Treasury’s hands behind its back through imposing debt limits. We already require that a budget is approved before Treasury can spend. That constraint is necessary to impose accountability over the Treasury. But once a budget is approved, why on earth would we want to prevent the Treasury from keystroking the necessary balance sheet entries in accordance with Congress’s approved spending?
The budgeting procedure should take into account projections of the evolution of macroeconomic variables like GDP, unemployment, and inflation. It should try to ensure that government keystroking will not be excessive, stoking inflation. It is certainly possibly that Congress might guess wrong—and might want to revise its spending plan in light of developments. Or, it can build in automatic stabilizers to lower spending or raise taxes if inflation is fuelled. But it makes no sense to approve a spending path and then to arbitrarily refuse to keystroke spending simply because an arbitrary debt limit is reached.