Wednesday, February 22, 2012

Money, Banks, and National Debt Unmasked - V

In this blog we discuss what constitutes the “national debt” and how we come by it. It is widely misunderstood and is not nearly as important as is, say, unemployment.
National Debt? We Don’t Need It
In the first blog of this series, we reminded ourselves that all money is debt. It follows that when money is created by either printing it on paper or with computer keystrokes, debt is issued. There is no necessity for government to issue debt again by selling Treasury bonds. No country that has a sovereign, non-convertible, floating rate currency needs to sell bonds to fund its spending and thereby create a national debt. However, old gold-standard rules, procedures, and laws stand in the way of other rational options.
If one party is in debt, another party must be a creditor and hold the corresponding asset. A government debt is a non-government asset. The national debt clock could just as well be called the private Treasury savings clock. And, the proportionate distribution of that debt to families could be called family savings. Ironically, if this reality were understood, families would ask, ”Where is our share?” They would find those Treasuries mostly in the pockets of the wealthy.

Figure 1. Our National Savings Clock

If we don’t need it and don’t like it, why do we have a national debt?
The Fed Buys and Sells Treasury Bonds to Manage Bank Reserves
In the previous blog, we learned that without some way to manage day-to-day fluctuations in reserves, the Fed would be unable to manage the FFR (Federal Funds Rate). 
Government deficit spending results in excess reserves, and government surpluses bring about reserve shortages. To drain excess reserves the Fed sells Treasury bonds from its portfolio to commercial banks. This is equivalent to Anne buying a CD (Certificate of Deposit) with excess funds in her checking account. The CD allows her to earn a bit more interest on her funds. Banks are happy to buy Treasuries for the same reason, because they get more interest when they convert their excess reserves into Treasury bonds.
The Fed responds to a government surplus by purchasing bonds from the banks, which converts their bond holdings back into reserves to remove the shortage. This does not add to the “national debt,” it’s like depositing the funds from a CD back into the checking account.
Most importantly, we notice that these bond operations for managing reserves are carried out within the banking system. There are no foreign bond buyers required. The rating services of S&P, Moody’s, or Fitch have nothing to do with internal banking operations and are irrelevant. The Fed sets the interest rates not the external markets.
These bond “purchases” and “sales” are just a matter of moving numbers around on the Fed’s spreadsheet. The New York Federal Reserve Bank is responsible for conducting these Open Market Operations. You can read all about draining reserves at the NYFed website.
Other Options are Available
Bond sales and repurchases are only one way to manage bank reserves. Some ranking Fed officials have recommended that rather than sell bonds, the Fed could just pay the target FFR on the reserves held by the banks (see here and here). This would give the Fed precise control of the FFR and would be a boon to the banks rather than the current holders of Treasuries. 
It probably won’t happen, because it would pit the rich against their banks, which might be fun for the 99% to watch. Reserves would accumulate to large numbers in the banking system with no ill effect.
Another method, employed by Japan, would be to hold the FFR at zero and let the reserves accumulate. That would also be a political problem, because many of the rich and some, who hold bond mutual funds, want to have a base of risk-free, interest bearing bonds.
Quantitative Easing
Currently unable to influence bank lending by lowering the FFR, the Fed is paying 0.25% interest on reserves, which is the FFR. The Fed has purchased bonds under the quantitative easing programs, QE1 and QE2, in a misguided effort to encourage a little inflation. All that has happened is an extraordinary increase in excess reserves as seen in Figure 2. Although some claim this is inflationary “printing” of money, we know these reserves are tucked away in the banking system and will not spill out into the economy. 
Figure 2. Accumulation of excess reserves as a result of quantitative easing. It's dramatic looking but of little significance.
Actually, the bond purchases under QE are somewhat deflationary, because interest generated by the bonds is paid back to the Treasury to the tune of $50 to $80 billion a year, rather than going into the private sector. This is interest income that was not available for spending in the private sector.
How About Passing the National Debt to Our Grandchildren?
Please do! If I leave a house and mortgage to the kids, they will have to pay off the mortgage to keep the house. If I pass on to them some Treasuries, they will have excellent, risk-free assets that pay income or can be used as collateral for a loan. 
Most of the interest the Fed will have to pay goes right back into the economy. That the interest is paid primarily to the rich is a political rather than an economic problem.
Our national debt is the result of the way government has chosen to manage excess bank reserves. The issuance of debt to manage bank reserves, is optional. 
The government’s debt, according to fundamental accounting, represents assets in the private sector, not intergenerational debt. Our grandchildren are enriched rather than burdened by those assets. 
Quantitative easing, which increases reserves, is not inflationary.
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