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Fairy Tales of the Coming State of the Union: If We Borrow More the Bond Markets Will Raise Our Rates

letsgetitdone's picture

In "All Together Now: There Is No Deficit/Debt Problem,” I warned against the message calling for deficit reduction that the President will probably deliver in his State of the Union Address next month. I view the coming narrative as very likely to be composed of a number of fairy tales. In previous posts in this series I've analyzed and critiqued four of the fairy tales I expect the President to tell us in his coming State of the Union speech. In this post, I'll discuss a fifth fairy tale: the idea that if the Government borrows more money, the bond markets will raise our interest rates.

This fairy tale assumes that the bond market actually controls the interest rates that Governments like the United States must pay. Sure, they can determine interest rates if the Government sits idly by, and lets them do so. However, the Federal Reserve and the Treasury, can target bond interest rates and set these for the bond markets by manipulating overnight bank reserves. Specifically, one way to do this, is that the Treasury can cease issuing long-term bonds, and sell only three-month bonds. Three-month bond interest rates are generally controlled by overnight rates for bank reserves, and overnight rates can be driven down to near zero by flooding the banks with excess reserves. That's basically how the Japanese keep their bond interest near zero, and that's how we can do the same.

Alternatively, the Fed is currently driving down interest rates through its policy of Quantitative easing (QE). QE currently involves providing banks with cash reserves in return for non-cash bank assets including Treasury Bonds. QE results in an increase in cash reserves, which drives down overnight interest rates for borrowing such reserves. Low rates in the reserve market again, drives down bond market interest rates on three month Treasuries, and exerts downward pressure on bond market interest rates across the board.

Yet another move we can make to remove the effects of the bond markets and the ratings agencies upon public finances, is for Congress to stop requiring new debt issuance in coordination with deficit spending, and for the Treasury to stop issuing debt for every dollar it deficit spends. If we did this, interest rates in the bond market would be driven down because of the shortage of treasury bonds in the marketplace.

Of course, if Congress did that, the Executive Branch could choose to issue no more debt and then bond market interest rates wouldn't be an issue at all. However, even though this possibility illustrates how higher interest rates could easily be avoided, and shows us what an idle threat the fairy tale is, it doesn't contradict it because in this circumstance the Government would not be borrowing any more money when it deficit spends.

This last possibility illustrates the logical course of action for people who think that rising interest rates represents a problem for the US Government. That is, if you're one of those people, and you feel really strongly about it, then ask Congress to stop requiring that the Executive issue debt when it deficit spends. If they do that, then voilà, no interest rate problem, and after a decade, pretty much no debt for the United States either.

In short, the bond markets aren't in control of US public finances. They are not in a position to influence what our taxing or spending policies ought to be, or whether we will default on our obligations. In fact, at this point in our history, Congress is mandating that we have a national debt. It is forcing us to have one. It mandates that we borrow our own previously created money from the Chinese, Japanese, and Middle Eastern nations and pay them interest on a commodity (our money), that we have an unlimited ability to create.

At the same time, they also complain about the very same national debt they are always re-creating and increasing, and then tell us that we can't afford unemployment insurance, enough Federal Spending to create full employment, Social Security, Medicare for All, good educations for our kids and grandkids, and emergency programs to create new energy foundations for our economy. Yes, it's all pretty irrational, unless your purpose is delivering shock doctrine to persuade people to accept unnecessary and destructive cuts in Government programs. Either way, worrying and complaining about the national debt either should stop, or the people who want to complain about the national debt, work to remove the Congressional mandate to issue debt, and let the Government pay the damned debt off, so we can get to the real issues.

(Cross-posted at All Life Is Problem Solving and Fiscal Sustainability).

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wuming's picture
Submitted by wuming on

Just wondering about some of the operational details.

If we take a look at the money used to purchase Tsys, isn't at least some of that created via the private debt creation system, i.e. banks making loans?

Here's the lifecyle I'm thinking about:
Real Estate Developer borrows funds to buy a piece of land, call it Blackacre, from Bob.

When the R.E Dev buys the property he borrowed funds from MegaBank which created the funds when it credited R.E. Dev's account. MegaBank creates an equivalent debt on its balance sheet, owed by R.E. Dev.

Bob takes the funds and buys a Tsy; he's decided to cash out of real estate and park the money somewhere safe.

Does that make sense or am I missing something?

beowulf's picture
Submitted by beowulf on

Not sure why it is that the FFR target is 0.25% and yet the 3 month rate is 0.15%. You'd think the overnight rate would be lower since the 3 month is lower than 6 month (0.17%) which is lower than 1 year (0.25%).

No matter, Fed and Tsy could decide on their own to stop issuing anything longer than 3 months, but it'd be even better if Congress made that the law and cap it at 0.25% while they're at it. It makes perfect sense, except for the annual debt limit drama would continue. Of course, that's avoidable too since Tsy's in-house Federal Financing Bank is off-budget, if Congress allowed FFB to borrow from the Fed directly at 0.25%, it could finance $500 billion in infrastructure spending for annual interest cost $1.25 billion.

So instead of Congress taking the $30 billion a year from the 18 cent gas tax to (under-)fund highway projects, it could simply allocate the gas tax revenue to paying the interest to the FFB for the infrastructure debt (as it rolls over every 3 months). It wouldn't add a penny to the deficit or the statutory debt.

Of course Congress loves the idea of earmarking project money itself. However it'd be better if they handed over project decisions to an appointed commission, something like FDR's National Resources Planning Board. In 1943, conservatives in Congress killed and bury the NRPB in the National Archives, behind the Ark of the Covenant, after they took a gander at this report.
Perhaps the NRPB didn't do themselves any favors moving outside their lane and proposing an economic bill of rights. :o)