QE3, Treasury Style
By Scott Fullwiler
What happens on August 3rd if the US Congress cannot reach a resolution to the debt ceiling negotiations? This column argues that Treasury could go around, not over the debt ceiling limit by using its constitutional authority to mint money.
It also notes that the proposal does not suggest any more/less spending than Congress has authorized, as that would be illegal. This column argues that Treasury deposit the coin(s) at the Fed (i.e. the coin(s) never circulate among the public; the effect is simply to reduce the term structure of the national debt, just like QE2).
Cullen Roche’s excellent post at Pragmatic Capitalism explains—via comments from frequent MMT commentator Beowulf (see here) and several previous posts by fellow MMT blogger Joe Firestone (see the links at the end of Cullen’s post and also here and here)—that the debt ceiling debate could be ended right now given that the US Constitution bestows upon the US Treasury the authority to mint coins (particularly platinum coins). Further, this simple change would lift the veil on how current monetary operations work and thereby demonstrate clearly that a currency-issuing government under flexible exchange rates cannot be forced into default against its will and is not beholden to “vigilante” bond markets. As Beowulf explains in a later comment, “The anomaly it addresses is that the US Govt has a debt limit yet an agency of the US Govt (the Federal Reserve) does not have a debt limit. Clearly this is a structural defect.”
The following is a description of how the process would work and the implications for monetary operations:
- The Treasury mints a $1 trillion coin, or whatever amount is desired.
- The Treasury deposits the coin into the Treasury’s account at the Fed. The Fed’s assets (coin) and liabilities (Treasury’s account) increase by the same amount. As Beowulf notes later in a comment to the same post from Cullen, were the Fed to resist, the Federal Reserve Act clearly states that “wherever any power vested by this Act in the Board of Governors of the Federal Reserve System or the Federal reserve agent appears to conflict with the powers of the Secretary of the Treasury, such powers shall be exercised subject to the supervision and control of the Secretary.” The Fed is legally an agency operating at the pleasure of the government, not vice versa. Regardless, the actions I describe here and below by the Treasury in no way interfere with the normal operations of monetary policy (explained in various places below).
- The Treasury buys back bonds (thereby retiring them) until total market value purchased is equal to the dollar value of the newly minted coin. The result is a decrease in the Treasury’s account at Fed and an increase in bank reserve balances held at the Fed.
- Total debt service for the Treasury falls, too, as higher interest earning bonds are replaced with reserve balances earning 0.25%. Effective debt service on purchased bonds now is 0.25% since interest on reserve balances reduces the Fed’s profits that are returned to Treasury each year.
- The retirement of bonds is an asset swap, no different from QE2, except that the Treasury has purchased the bonds instead of the Fed. But since the Treasury’s account is on the Fed’s balance sheet, there is no operational difference. That is, this is effectively “QE3, Treasury Style.” As with QE2, no net financial assets have been created for the non-government sector. The net effect, like QE2, is to reduce the term structure of US debt held by private investors, as bonds have been replaced with reserve balances.
- The increase in reserve balances is not inflationary, as Credit Easing 1.0, QE 1.0, and QE 2.0 already have shown. Banks can’t “do” anything with all the extra reserve balances. Loans create deposits—reserve balances don’t finance lending or add any “fuel” to the economy. Banks don’t lend reserve balances except in the federal funds market, and in that case the Fed always provides sufficient quantities to keep the federal funds rate at its target—that’s what it means to set an interest rate target. Widespread belief that reserve balances add “fuel” to bank lending is flawed, as I explained here over two years ago.
- Non-bank sellers of the bonds purchased by the Treasury now have deposits earning essentially 0%. Again, this is not inflationary. There are three points to make in explaining why.
First, sellers of bonds were always able to sell their securities for deposits with or without the Treasury’s intervention given that there are around 20 dealers posting bids at all times. Anyone holding a treasury security and desiring to sell it in order to spend more out of current income can do so easily; holders of Treasury securities are never constrained in spending by the fact that they hold the security instead of a deposit. Further, dealers finance purchases of securities from both the private sector and the Treasury by borrowing in the repo market—that is, via credit creation using securities as collateral. This means there is no “taking money from one person to give it to another” zero sum game when bonds are issued (banks can similarly purchase securities by taking an overdraft in reserve accounts and clearing it at the end of the day in the federal funds market), as what in fact happens is that the existence of the security actually enables more credit creation and are known to regularly facilitate credit creation in money markets that are a multiple of face value. Removing the security from circulation eliminates the ability for it to be leveraged many times over in money markets.
Second, the seller of the security now holding a deposit is earning less interest can convert the deposit to an interest earning balance. Just as one holding a Treasury can easily sell, one holding a deposit can easily find interest earning alternatives. Some make the argument that the security can decline in value and so this is not the same as holding a deposit, but this unwittingly supports my point here that holders of deposits aren’t necessarily doing so to spend. Deposits don’t spend themselves, after all.
Third, these operations by the Treasury create no new net financial assets for the non-government sector (and can in fact reduce its net saving by reducing interest paid on the national debt as bonds are replaced by reserve balances earning 0.25%). Any increase in aggregate spending would thereby require the private sector to spend more out of existing income or dissaving, as opposed to additional spending out of additional income. The commonly held view that “more money” necessarily creates spending confuses “more money” with “more income.” QE—whether “Fed style” or “Treasury style”—creates the former via an asset swap; on the other hand, a true helicopter drop would create the latter as it raises the net financial assets of the private sector. Again, “money” doesn’t spend itself. Further, by definition, spending more out of existing income is a re-leveraging of private sector balance sheets. This is highly unlikely in the current balance-sheet recession and is aside from the fact that QE again does nothing to facilitate more spending or credit creation beyond what is already possible without QE. The exception is that QE may reduce interest rates, particularly if the Fed or (in this case) the Treasury sets a fixed bid and offers to purchase all bonds offered for sale at that price—though this again may not lead to more credit creation in a balance-sheet recession and has the negative effect of reducing the net interest income of the private sector. (As an aside, a key difficulty neoclassical economists are having at the moment is they do not recognize the difference between a balance-sheet recession and their own flawed understanding of Keynes’s liquidity trap.)
From points 5, 6, and 7, QE3, Treasury Style can only be as inflationary as QE2 (which is to say, not at all, aside from indirect, temporary effects of commodities speculators who believed QE2 would be inflationary), since operationally it’s the exact same thing in terms of the effect on the non-government sector’s financial position. Anybody arguing that QE Treasury Style would be inflationary must explain why QE2 wasn’t inflationary. Neoclassical economists are currently saying "interest on reserves" is why QE2 didn’t work (they’re completely wrong; see my update to the post here and also here), but QE Treasury style similarly requires interest on reserves or the Fed to drain reserve balances with time deposits offered to banks if the Fed is to hit an overnight target. In other words, there’s no such thing as QE Fed Style or Treasury Style without interest on reserves (or, alternatively, time deposits)
The debt ceiling crisis is averted, as US debt outstanding has been reduced by the dollar value of the minted coin, and can continue to be reduced as desired. This simple asset swap demonstrates that the self-imposed constraints of the debt-ceiling, counting Treasury securities held by the Fed against the debt ceiling, and forbidding the Fed from “lending” to the Treasury directly are just that—self-imposed—and are not operational constraints at all. The only constraint is in the flawed understanding of the monetary system that is standard today among the macroeconomists writing textbooks and advising policymakers, or acting as policymakers themselves. From points 6 and 7 above, this asset swap is not inflationary—spending without issuing bonds is not any more inflationary than spending with bond sales, as I explained here and here.
Fed is the monopoly supplier of reserve balances, the Treasury is the monopoly supplier of coins. Future deficit spending by the federal government could thereby continue to be carried out by minting coins and depositing them in the Treasury’s account at the Fed. It then would be clear to everyone that the Treasury’s spending is not operationally constrained by revenues or its ability to sell bonds. It would be obvious that the Treasury spends by crediting the reserve accounts of banks, who in turn credit the deposit accounts of the spending recipients. Deficits would increase the quantity of reserve balances circulating and currently earning 0.25%. As MMT’ers have explained for years (even decades), the operational purpose of the Treasury’s sale of a bond is merely to aid the Fed’s ability to achieve its overnight target by draining reserve balances created by a deficit. But even selling bonds isn’t operationally necessary if the Fed pays interest on reserve balances at a rate equal to its target rate. On the other hand, if the Fed set the rate on reserve balances below its target and the Treasury no issuing bonds, the Fed could issue its own time deposits (with Congress’ blessing) to drain reserve balances created by a deficit. Whether the Fed’s target rate were set above the rate paid on reserve balances or equal to it, effective interest on the national debt clearly would be a monetary policy variable (as interest paid on reserve balances or on time deposits by the Fed reduces the Fed’s profits returned to the Treasury), as it at the very worst can be even under current operating procedures (see here and here).
This approach to dealing with the debt ceiling is far better than the recent proposal by Ron Paul, as again it lifts the veil on current monetary operations and recognizes the currency-issuing status of the US federal government. Instead, Paul proposes that the Fed destroy its holdings of Treasury securities. What’s strange about the proposal is that it shows that Paul either doesn’t understand monetary operations or is trying to have it both ways. Destroying the securities requires reducing the Fed’s capital by the same amount. Given the Fed’s miniscule level of capital (because, again, it has virtually no retained earnings after transferring them all to the Treasury each year), its capital would be way into negative territory. This isn’t a problem operationally, given that the Fed is the monopoly supplier of reserve balances. But recall that Paul was one of those protesting Credit Easing and QE1 the loudest, claiming that these would surely destroy the Fed’s capital and leave it insolvent. (Again, this is only relevant operationally under a gold standard or similar monetary arrangement—Paul and others like him want to analyze the US national debt and the Fed as if a gold standard existed, and then claim that a going on the gold standard is the solution to all of our problems, but I digress.) So, effectively Paul’s proposal would leave the Fed in a state of (in his view) “insolvency”—perhaps he does know what he’s doing and his debt ceiling proposal is just part of his grand plan to “end the Fed.” Otherwise, it would have been simpler to simply propose exempting the Treasury securities held by the Fed from counting toward the debt ceiling.
Lastly, giving credit where it is due, I want to again recognize the efforts of both Joe Firestone and Beowulf in researching and explaining the legal basis for and operational implications of the Treasury’s Constitutional authority to mint its own coin(s). This post benefits significantly from their important, original work.
Scott Fullwiler is Associate Professor of Economics at Wartburg College. This article has been cross -posted from New Economic Perspectives.