Wednesday, December 16, 2009

The Treasury’s Monetary Policy

For decades, many economists have argued that the effectiveness of fiscal policy is limited because public borrowing “crowds out” private investment. There are several versions of the “crowding out” story. One version goes something like this:

There is a certain amount of money in circulation, which people are holding in their portfolios along with other assets. Money is a special kind of asset, because it’s the only one that can be used to make payments. Therefore people like to hold a certain fraction of their assets in the form of money. (For simplicity, let’s take the plausible case where it’s a constant fraction, independent of their total quantity of assets.)

When the government borrows, it introduces new non-money assets (government securities, in this case) into the system. That means that the fraction of money in people’s portfolios is now too small, since their total assets have increased but money has not. They will compensate by reducing the quantity of other non-money assets. Therefore, businesses will have trouble raising money for capital spending by issuing bonds or by selling new stock, and private investment will have to decline.

In this simple “constant-fraction” version of the story, the crowding out is 100%. People will not be happy with their portfolios until the amount of outstanding private-sector non-money assets declines by exactly the amount of the increase in public sector debt. Thus there is no net stimulus from public spending, because it is offset by reductions in business spending by the amount that businesses can no longer raise in capital markets.

About 30 years ago, Harvard economist Benjamin Friedman asked a question which turned the whole “crowding out” debate on its head. What if people treat government securities in their portfolios more like money than like private-sector assets? (After all, government securities are highly liquid. You can’t normally use them directly to make payments, but you can sell them quickly whenever you have a payment to make, and you can usually have some confidence about the price at which you will be able to sell them, at least in comparison with most private sector assets.)

If so, then, when the government borrows, it is increasing the fraction of “money and money-like assets” in people’s portfolios. Instead of buying less of the (non-money-like) private-sector assets (to get the fraction of money their portfolios back up), they will buy more such assets – to get the fraction of “money and money-like assets” back down. Instead of “crowding out” private investment, public borrowing will “crowd in” private investment.

He also pointed out that some government securities are clearly more like money than are others. Perhaps 30-year Treasury bonds are very much like corporate bonds, in that their prices can fluctuate dramatically with interest rates. But 3-month Treasury bills are a whole lot like money. Whenever you need actual money to make a payment, you can sell your Treasury bills quickly at a reliable price. Most likely, when the government issues Treasury bills, it makes people’s portfolios safer, and thus it increases, rather than decreases, the incentive to purchase private sector assets. Accordingly, Professor Friedman concluded, the Treasury can expect its financing policy to have macroeconomic effects: the more short-term financing the Treasury does, the larger economic stimulus it provides.

When I first read the paper (in a graduate school course taught by Ben Friedman, about 10 years after it was written), I found the idea intriguing, but it seemed not to have a whole lot of relevance at the time. In those days the US inflation rate was still higher than most economists preferred, and the burning issue was not how to provide the most (or the least) stimulus but how to get the inflation rate down without causing a recession. Moreover, there was little question as to the efficacy of conventional monetary policy in providing any stimulus or restraint that might be needed. Treasury financing was at most a minor side show.

Times have changed. The inflation rate is now lower than most economists prefer, and the economy remains extremely weak despite the recent upturn in the business cycle. The burning issue is how to find the most cost-effective and politically feasible way to stimulate the US economy, and conventional monetary policy is not an option.

And today Treasury bills are not just more like money than like other assets; from a portfolio point of view, on the margin of new issuance, Treasury bills are exactly like money. Holders of short-term Treasury bills are willing to hold them without receiving interest. Anyone who is willing to hold them is placing no value whatsoever on any liquidity or safety advantage that might be had from holding those assets in the form of money.

Issuing more short-term Treasury bills will have exactly the same effect as issuing more money, since people are indifferent between the two. For practical purposes, as long as their interest rate remains at zero, short-term Treasury bills are part of the money stock. A Treasury bill is a million-dollar bill in the same sense that a Federal Reserve note with Abraham Lincoln on it is a five-dollar bill. Conventional monetary policy, which exchanges money for Treasury bills, is ineffective because it is no policy at all: it simply exchanges one form of money for another.

To put it another way, since the Treasury can issue bills that are exactly like money, it is now the Treasury that is in charge of monetary policy. And whatever one may think of the policy it chooses to follow, we should be holding the Treasury responsible. If you’re worried about “exit strategy” and the possibility of inflation in the near future, then perhaps you should congratulate the Treasury for its policy of financing more of its debt long-term. If you’re worried (as I am) about the persistence of a weak and potentially deflationary economic environment, then you should be critical of the Treasury’s policy. By increasing its maturities the Treasury is essentially following a tight-money policy exactly when a loose-money policy is needed.

The Treasury, of course, has its reasons. Officials expect interest rates to rise over the next several years and would like to lock in today’s low rates, to limit how much it will cost to service the national debt over a longer horizon. I’m skeptical, however, of the assumptions underlying these reasons.

Are interest rates going to rise over the next several years? Perhaps, but if so, then why are people being foolish enough to hold longer-term Treasury securities when they could be holding bills and waiting for a better deal? If it’s just a matter of the future course of interest rates, then it’s a zero-sum game. If the Treasury wins, bondholders lose – and bondholders usually make a point of trying not to lose. Are Treasury officials so much smarter than bondholders?

You might argue that it’s a matter of risk. When the Treasury locks in today’s low interest rates, it may not end up paying less (since it gives up even lower short-term rates), but it makes the payments more predictable. Even if the Treasury is likely to end up paying more, the hedge is worth the price, because the Treasury receives some insurance for the worst case, where rates rise more than expected.

But are rising interest rates really the worst case? Interest rates will rise when and if the economic recovery gains enough speed and traction to give the Fed and bond markets reasonable confidence in its eventual convergence toward our potential growth path. As an ordinary citizen, that’s not an outcome against which I would feel a need to hedge. I don’t want to buy insurance against good news. I’d rather hedge against the opposite outcome, where the recovery peters out and interest rates fall.

The US economy has been knocked far off its potential growth path, and it will take fairly rapid growth, for a fairly long period of time, to get back to it. (Either that, or we’ll remain so far off the path for so long that potential will be significantly reduced, in which case we likely have many of years of low interest rates ahead of us before we get to that point.) With rapid and persistent growth, federal revenues will rise, government “bailout” investments will perform well, benefit payments will decline, and the primary federal deficit will fall. Because of higher interest rates, the government will be paying more to service its outstanding debt, but because of an improving economy the government will be accumulating less new debt, compared to the alternative case. So it’s not clear to me that rising rates would be a “worst case” even for Treasury finances, let alone for the general national interest.

It is also argued that, by increasing the maturity of its debt, the Treasury is reducing the risk of default, thereby improving its credit profile and allowing it to finance at lower interest rates than otherwise. If that’s true, I’m not sure it’s a good thing. When the private sector is having such difficulties as it has now, wouldn’t it be better to make Treasury securities more risky and thereby encourage people to put their money in private sector assets instead?

In any case, I’m not sure it’s even true. For Treasury investors, inflation risk is much more important than credit risk. By refusing to be kept on a short leash, the Treasury is increasing the future incentive for the US to “inflate away” its debts. That might make Treasury securities less attractive rather than more so. Of course, as I said, making Treasury securities less attractive wouldn’t necessarily be a bad thing, since it would help the private sector: but if the Treasury does so by issuing more long-term securities, the benefit gets lost, because the Treasury is then also competing with the private sector for funds.

Be that as it may, I know I’m not going to convince everyone about the specific policy that I think the Treasury should follow. I hope, however, that I have at least convinced some readers that, in today’s environment, the decision is a macroeconomically important one that deserves a great deal more attention than it has gotten. I second Rajiv Sethi (hat tip: Mark Thoma), who finds it “a bit surprising that while the size of the deficit is a topic of endless controversy, there is such little debate about the manner in which the deficit is financed.”

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.