Guest Author: L. Randall Wray, Professor of Economics, University of Missouri, Kansas City.
Washington’s deficit hysteria has morphed into gridlock over expansion of federal government debt limits. It is as if that stupid “debt clock” on Times Square had run out of electrons to keep the numbers racing ever higher. As we all know, the debt clock is actually tracking the growth of nongovernment net financial wealth—so if Washington really were able to stop the clock, it would also prevent private sector net financial wealth from growing. I presume that this is well-understood even inside the Washington Beltway, hence, the debate has more to do with politics than anything else. Still, it might be worthwhile to 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 see 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 our Constitution vests in Congress the power to create money, in practice the Treasury uses our 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—now amounting to a trillion dollars. 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 detail. 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 Zimbabwe and Weimar Republic hyperinflation.
So, instead, the Treasury sells the treasuries to private banks, which create deposits for the Treasury that it can then move over to its deposit at the Fed. And then “Helicopter Ben” 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. And for any reader still following along, in normal times banks would find themselves with more reserves than desired so will 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.
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!) and thus subject to the imposed debt ceiling. Bank reserves, by contrast, are not counted as government debt. The last time we came up against the debt ceiling I proposed that we solve the problem by simply ordering Helicopter Ben to stop the open market sales of treasuries. Leave the reserves in the banking system. Enter QE2: Uncle Ben 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 where they belong, and yet gridlock remains because there are still too many treasuries off the Fed’s balance sheet.
Here is the modest proposal. When Uncle Sam needs to spend and finds his cupboard bare, he can replenish his demand deposit at the Fed by issuing a nonmarketable, nonbond, nontreasury 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. 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.
So, 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. (The same can be said about Social Security Trust Fund holdings of nonmarketable treasuries, which also should be excluded from debt ceilings—a topic for another day.)
Unlike Swift’s modest proposal, no children get eaten. Instead, they get fed because with gridlock removed and spending released, school lunch programs are reinstated.
Fall of the New Monetary Consensus by L. Randall Wray