The National Debt Can Never Become Too Big: The Bond Vigilantes
The National Debt Can Never Become Too Big: The Bond Vigilantes
A tour through the banking system, the U.S. Treasury Department, and the U.S. Federal Reserve, to explain why private investors will never stop buying U.S. government debt.
I had to put my “Annoying MMT Guy” hat on in my last newsletter. I realize Modern Monetary Theory’s 15 minutes of fame came and went. But as the subject of reserve currencies shows, if you’re not clear on the fact that the U.S. government creates U.S. dollars, and thus can never run out of U.S. dollars—and thus doesn’t actually need anyone to lend it U.S. dollars—you can get very confused very quickly on a whole raft of topics.
Of course, the point that MMT is really known for is that the U.S. government can never borrow “too much” in U.S. dollars. After all, if you can’t run out of U.S. dollars, you can always pay back what you borrow in U.S. dollars.
Thus, the national debt can never become “too big.”
Period. Ever.
Thankfully, American politics seems exhausted with the whole topic of the national debt these days. You hear little talk of fiscal discipline or the need for “belt tightening,” God forbid. But various pundits are still trying to convince the politicians to return to the old-time debt-fearing religion. So I figured I’d nail down my own version of this argument, hopefully in a way that’s as accessible as possible. ( I called this newsletter “The Workbench,” after all.)
For instance, this piece by Dylan Matthews at Vox is a useful presentation of orthodox economic concerns with the size of the national debt. And it suffers from orthodox economics’ common confusions. First and foremost: Matthews can’t decide what exactly will happen if the national debt does become “too big.” Will private markets just stop lending to the U.S. government? (The dreaded “bond vigilantes” scenario.) Or will all that borrowing by the government drive up interest rates for everyone, choking off investment and economic growth? (The dreaded “crowding out” scenario.) Or will the national debt eventually lead to hyperinflation?
I’ll tackle each supposed threat, and why it’s not actually a threat, in a separate newsletter. Today it’s the bond vigilantes—why the U.S. national debt will never become so large that private markets simply cease lending to the U.S. government.
The Government Play-Acts Like It Can Run Out Of Dollars
Congress passes the laws that determine how much the federal government will tax and spend, and then the U.S. Treasury Department carries those laws out. It brings in tax revenue from the Internal Revenue Service, and it disperses payments in accordance with Congress’ spending decisions. When there’s more spending than tax revenue, the Treasury Department faces a budget deficit. And the law says those deficits must be covered by borrowing. So the Treasury Department sells bonds to the private markets.
“The law requires” is a key phrase there. The U.S. government is the legal issuer of all U.S. dollars; it says so right there in the Constitution. It doesn’t need to borrow dollars to finance its deficits, the way you or I or any private household or business do. It could just create them. Nonetheless, laws passed by Congress require the Treasury Department to play-act as if the federal government can run out of dollars. Selling Treasury bonds when the federal government deficits spends does come with certain practical advantages, which we can save for later. But none of these advantages include actually providing the dollars with which the U.S. government spends.
That brings us to the U.S. Federal Reserve—the United States’ central bank, created in 1913.
The Fed serves several purposes at once: It is the creation point for all electronic U.S. dollars. (Physical cash and coin are created by the U.S. Mint, housed at the Treasury Department.) It also operates as a “bank for the banks.” Every major bank in the country maintains an account at the Fed, where they store their reserves of U.S. dollars. The U.S. Treasury Department has an account at the central bank as well, making the Fed the connection point between the Treasury Department and the rest of the U.S. banking system. After all, when the federal government pays a contractor or sends someone their Social Security benefits, it doesn’t print up a stack of physical U.S. dollars and mail it—it just pays them electronically, via their bank account.
Finally, as a “bank for the banks,” the Fed is also the “lender of last resort.” It stands ready to loan U.S. dollars to banks in an emergency, which helps keep our financial system stable and functional.
Here again, this setup is designed to play-act as if the federal government can run out of U.S. dollars. The Fed play-acts like it’s just another for-profit bank seeking to maximize revenue. And The Fed and the Treasury Department play-act like they’re separate economic actors, and that the Fed is a “bank” for the U.S. government the same way an actual bank is for you or I.
But none of that is true.
The Fed is not a for-profit entity seeking to maximize revenue; it could just create U.S. dollars and give them away. But policymakers want to impose at least some facsimile of market discipline on the banks. So the Fed loans the dollars.1 Nor will the U.S. Federal Reserve ever stop banking for the U.S. Treasury Department or “allow its checks to bounce.” The two are both agencies of the same federal government! That’s why their names both begin with “U.S.”2
In fact, while the Fed brings in revenue from all the financial assets it owns, all the “profits” it makes over and above its operating expenses are remitted right back to the Treasury Department as federal revenue. The two agencies form a closed loop.
The Federal Reserve Decides
The Fed’s other key role, of course, is running monetary policy—setting interest rates in the overall economy. Which it does by adjusting the total amount of U.S. dollars in the reserves of the country’s banks.
The banks themselves can trade U.S. dollars back and forth, and in fact they loan dollars to one another all the time. But they do that because, unlike the Fed, they can run out of dollars. They cannot increase or decrease the total amount of U.S. dollars in the banks’ reserve system. Only the U.S. Federal Reserve can do that.
How the amount of U.S. dollars in the reserve system affects interest rates is a basic supply and demand story: As the amount of dollars in the reserve system increases, the “cost” of making loans decreases—monetary policy becomes “looser,” and banks become more willing to lend money at lower interest rates to you and me and everyone else in the private economy. Vice versa, as the amount of dollars in the banks’ reserve system goes down, monetary policy becomes “tighter,” and the banks become stingier with their loans and insist on lending at higher interest rates.3
As mentioned, one way the Fed adds to the reserve system is by lending dollars to the banks. But loans eventually have to be paid back. So the Fed also conducts “open market operations,” in which it buys (or sells) U.S. treasury bonds from (or to) the banks. When it does so, it adds U.S. dollars to the reserve system (by buying the bonds) or sucks them out (by selling them).
This is the key place where the Fed’s creation of U.S. dollars happens. Since the law requires the U.S. Treasury Department to borrow to cover it’s deficits, the Fed is not creating U.S. dollars on behalf of Treasury Department, in that sense. But when the Fed buys financial assets from the banks or grants them loans, it’s creating the dollars out of thin air.4
The upshot of all this is the Fed has total power over how many U.S. dollars are in the banks’ reserve system. Which means the Fed has total power over our economy’s interest rate environment. “Market forces” play a role here only to the degree the Fed allows them to play a role.
This also gives the Fed enormous—not total, but enormous—power over how unemployment, economic growth and inflation play out. When the Fed lowers interest rates, credit creation and spending in the economy speed up, businesses invest, people get hired, wages rise, and the economy grows faster. But inflationary pressures also rises. By contrast, when the Fed raises interest rates, it eases inflationary pressure, but at the cost of slowing economic growth, job creation and wages.
The Fed cannot avoid navigating this trade-off. The fact that it is the creation point for U.S. dollars, combined with its Congressionally-mandated mission to stabilize the financial system, means it must choose how many dollars are in the reserve system. It must set monetary policy somewhere. It can’t “decide not to decide.” Which is why Congress gave the central bank the dual mandate, obligating it to set interest rates in a way that balances maximum employment against stable prices.
Why U.S. Debt Will Always Have Buyers
Now that we’ve done our quick tour of the public finance system, we can return to the subject at hand: Why the U.S. government will never run out of people to buy U.S. Treasury bonds and thus lend it dollars.
The first key thing to realize is something I already noted: when the U.S. Federal Reserve conducts open market operations to adjusts interest rates, it’s buying U.S. Treasury bonds. It does sometimes buy other financial assets like corporate bonds, corporate stocks, or mortgages. But that’s considered pretty unorthodox and outré; a manipulation of the economy the Fed should generally avoid.
Furthermore, it’s illegal for the Fed to buy bonds directly from the U.S. Treasury Department. First, the Treasury Department must sell its bonds to the private market in regular auctions. And only then can the Fed buy the Treasury bonds from those private buyers.
Put these two facts together, and you realize the Federal Reserve is also the “buyer of last resort” for U.S. Treasury bonds. Which is just another way of saying the U.S. government, with its endless supply of U.S. dollars, is the “buyer of last resort” for its own debt. If the Fed and the Treasury are a closed financial loop, the private markets are just the middle man in between them.
The mistake that Dylan Matthews and others make is they fall for the government’s play-acting. They see the Treasury Department borrow, they see it pay interest, they see it borrow to pay interest, and they see it pay interest on the borrowing it did to pay interest, and they think “Oh my God this can’t last.”
But the reason lenders cut off private households and businesses from further borrowing is because private households and businesses can run out of money, which makes lending to them a losing investment. If a private business borrows buy selling bonds, their riskiness makes the bond worthless: No one wants to buy the bond because they’ll never get paid back, but also because no else wants to buy the bond either. Half the reason to own a bond is that it’s a form of savings, which you can cash out at a moment’s notice. Economists call that quality liquidity—how easily a financial asset can be sold for cash at a moment’s notice, and how much cash they can be sold for.
Matthews and others see buyers at a Treasury bond auction demanding slightly higher interest rates than usual, and assume that trend could continue ever upwards, until buyers just refuse to purchase U.S. Treasury bonds entirely. What they do not see is the Fed’s purchase of U.S. Treasury bonds sitting behind private investors’ purchases of U.S. Treasury bonds. Which means there will always be someone else to buy Treasury bonds from the private market. Thus, private markets will always have a reason to buy those bonds as well.
Under our monetary system, interest rates on U.S. Treasury bonds cannot be disentangled from interest rates in the economy as a whole. And as we’ve already established—and I don’t think anyone would dispute—the Fed is in command of interest rates in the economy as a whole. Granted, the Fed is not committed to buying Treasury bonds ad infinitum. But it is committed to buying however many are needed to keep interest rates in the happy medium between maximum employment and stable inflation. The size of the federal debt simply doesn’t enter into the calculus.
So the interest rates the U.S. government pays on its debt will never diverge too far from the overall interest rate environment. Sometimes the government’s interest rates will go higher or lower, as the economy ebbs and flows. But they will always remain within a certain envelope. Investors will never reach the point where they simply stop buying U.S. Treasury bonds, and they will never charge an interest rate too much higher than the interest rate the Fed has set.
Private Investors Are Not Complicated Creatures
It is a well-known fact that U.S. Treasury bonds are the global gold-standard for safe and low-risk investment.5 The facts we have just laid out are why. And this is true for any country that has the same monetary system we do. The U.S. government will never run out of U.S. dollars, just like the Afghanistan government will never run out of Afghanis.
Of course, no one wants to buy bonds denominated in Afghanis, because Afghanistan’s economy is a basket case.6 It has few profitable opportunities for investment denominated in Afghanis. But that affects the desirability of investing in Afghanis—not the chances that you’ll get your Afghanis back.
The United States, on the other hand, is productive and prosperous, which makes it very attractive to invest in U.S. dollars. And the next most valuable low-risk investments, after U.S. Treasury bonds, are the bonds of other rich and prosperous countries with the same monetary system as us: Britian, Canada, Japan, and so on.
For people to stop wanting to invest in U.S. Treasury bonds, the United States would have to first cease to be a rich and prosperous country. Barring a nuclear war or a zombie apocalypse—or a Trump dictatorship that features Hugo-Chavez-esque levels of economic mismanagement—that ain’t happening.
I suppose you could argue that private investors might mistakenly abandon U.S. Treasury bonds. They could look at the size of the U.S.national debt and wrongly conclude it’s a problem, they same way most people wrongly conclude it’s a problem. But the whole point of for-profit financial markets is that mistakes are punished.
Consider the case of Japan. As mentioned, Japan is a rich and prosperous country, and it has the same monetary system that we do, complete with a central bank and control of its currency. Japan also has an astronomical national debt load— well more than double that of the United States, relative to the size of its economy.
Wall Street players have repeatedly shorted Japanese debt, expecting that any day now, the borrowing will all become too much, and interest rates on Japanese bonds will go through the roof. Yet it never happens. Shorting Japanese debt is one of the most famous “widowmaker trades” in finance, because of how many people it’s bankrupted.
Or perhaps we’re worried that the Fed would deliberately stop buying U.S. Treasury bonds, and only buy other assets to conduct monetary policy, in some fit of rightwing ideological pique? That would be a remarkable defiance of established norms for monetary policy, and of Fed officials’ duties as public servants appointed by democratically elected representatives. It would also probably be illegal. And it would set off a firestorm in Congress.
But more to the point, there would no possible economic justification: For an institution that can create all the dollars it wants, there is no such thing as a “risky investment.”
In other words, if the Fed did that, it wouldn’t be because the Fed is boxed in by market forces the way a private for-profit bank is. The Fed is a political and policy actor, not a market actor. If the Fed were ever to defy the duties given to it by Congress—or even if it just failed to perform those duties well, and inadvertently hurt the U.S. economy—that wouldn’t be an economic problem, but a political one. And political problems require political solutions.
In short, as long as the Fed does the job Congress gave it, and does it reasonably well, it’s hard to imagine anything short of nuclear war or a zombie apocalypse—or a Trump dictatorship—destroying the value of U.S. Treasury bonds.
Your Examples Do Not Show What You Think
One last point. As historical evidence, Matthews cites instances where private markets did simply refuse to continue buying a county’s debt: “Mexico in 1982, Russia in 1998, Argentina in 2001, Greece in 2015. Near-misses that didn’t quite lead to default, like Spain and Italy in the 2010s or Indonesia, Thailand, and South Korea in 1997, are even more common.”
But Mexico in 1982 had been borrowing U.S. dollars, not Mexican pesos. And the Mexican government obviously cannot create all the U.S. dollars it wants. Those it can run out of. The same holds for the rest of Matthews’ list. Russia in 1998 had been borrowing in U.S. dollars and in euros. Argentina in 2001? Also U.S. dollars. Indonesia, Thailand and South Korea in 1997? You guessed it: U.S. dollars.
Greece in 2015 and Spain and Italy in the 2010s were borrowing in euros. And the eurozone is an interesting case: It’s a bunch of countries that all had the fiscal and monetary privileges that came with controlling their own currencies, and then they voluntarily gave those privileges up to join the eurozone.
The monetary policy of the eurozone is controlled by the European Central Bank, but there is no equivalent Europe-wide fiscal policy to counterbalance it. The European Union has a government, of sorts, but it doesn’t really tax or spend much to speak of. So the countries of the eurozone voluntarily transformed themselves into the equivalents of private households and businesses that can run out of the currency in which they operate. (Needles to say, I think the euro currency union was a terrible fucking idea.)
In short, Matthews’ list makes the key mistake I highlighted in my post on reserve currencies:
One of the most important distinctions in international economics is how much debt a country owes in its own currency versus foreign currencies; i.e. how much it’s borrowed in a currency that it controls versus a currency it doesn’t. Yet most analysts just mash the two types of debt together into a single category. Which is absolutely fucking maddening.
Yet I’m not picking on Matthews’ piece because it’s an outlier. I feel kinda bad for beating up on him so much. It’s just that, like I said, he expressed the orthodox economic wisdom on this stuff really well. And it is with the orthodox economic wisdom that the problem lies.
How well this facsimile of market discipline actually works—and the fact that, in many ways, all for-profit banks are effectively adjuncts of the U.S. government—is a whole can of worms unto itself.
The Fed’s “independence” is purely a matter of bureaucratic procedure. Fed officials are not supposed to take orders directly from the president or Congress in the same way the Securities and Exchange Commission, the Federal Election Commission, the National Labor Relations Board, the Environmental Protection Agency, or any other number of independent agencies aren’t supposed to.
If you want to get technical about it, the specific interest rate the Fed targets when it adjusts the supply of U.S. dollars is the federal funds rate. That’s the interest rate banks charge each other when they loan dollars back and forth within the reserve system. Then the federal funds rate sets the loan terms that banks offer everyone else. They’re not going to charge less than the federal funds rate, because why would they? It’s just leaving money on the table. Nor will the banks charge too much more, because that will drive away too many potential customers, and lose them revenue.
The Fed does have other tools for adjusting how much interest the banks charge each other. In fact, when the 2008 financial crisis hit, the Fed flooded the banks’ reserve system with so many dollars that it rendered open market operations’ effect on the federal funds rate largely moot. The Fed may eventually sell off enough of its portfolio, and drain the banks’ reserves enough, that the supply of dollars starts to move the federal funds rate again. In the meantime, the Fed relies primarily on those other tools to conduct monetary policy.
Economist Stephanie Kelton has a great story she tells about giving a talk in front of a bunch of finance industry types. She asks who thinks it would be a good idea if the U.S. government paid off all its debt. Tons of hands go up. Then she asks who thinks it would be a good idea if all U.S. Treasury bonds disappeared from existence. No hands go up. Being the gold-standard for low-risk investment, Treasury bonds aren’t just a key part of Americans’ savings; they’re a key part of all sorts of transactions throughout the global financial system. They’re the key instrument in which the U.S. Federal Reserve conducts monetary policy, and in which foreign countries invest their foreign exchange reserves. It’s rather hard to imagine how the global economy could operate without an abundant supply of U.S. Treasury bonds. The gag, of course, is that the questions are two different ways of asking the same thing: Paying off all U.S. national debt would erase all U.S. Treasury bonds from existence.
To no small extent, the fact that Afghanistan is an economic basket case is the fault of decades of stupid and destructive U.S. foreign policy. But that’s a separate matter.