Commentary: What Money Market Mutual Funds Tell us about the National Debt

With impending rules changes coming this October, the money market industry is back in the news.  Beginning October 16, funds which invest in corporate and municipal debt will be required to float their share values.  These funds will also be allowed to charge redemption fees and halt withdrawals in times of low market liquidity. Funds which only invest securities issued by the Federal Government or its agencies will be exempted from these changes, and will continue to keep a fixed $1.00 share price.  

Several interesting developments have occurred in the market place.  Short term dollar funding rates have risen in anticipation of a stampede out of non-government funds after the October 16th drop dead date.  Several large funds have converted to government only funds to avoid being subject to the rules changes.  This has upped the demand for short term Treasurys, which the Federal Government has somewhat accommodated by increasing its bill issuances.    

Perhaps most interesting is that the very existence of money market mutual funds basically debunks a commonly held notion that deficit spending financed with debt is less inflationary than deficit spending financed with money creation.  The MMMFs finance their investments in T-bills by issuing shares which can be redeemed for money at any time.  Checks can be written against MMMF accounts.  Some funds have debit cards.  Many funds are FDIC insured.  In other words, shares in MMMFs are perfect substitutes for bank deposits or money. 

The very idea that government debt issuance requires some economic agents to delay consumption to finance the government's deficit is proven false.  The private financial sector, through the magic of maturity transformation, converts Treasury securities back into money-like instruments which can be spent to purchase houses, cars, or cheeseburgers. Finally, if the MMMFs ever faced a mass of withdrawals, the Fed could and would supply the liquidity necessary to meet these redemptions through open market purchases. In other words, the Fed would remove Treasurys from the market place and supply the cash the public was demanding.  If these redemptions were due to an increase in nominal spending, then inflation would occur.  However, if the withdrawals came because shareholders doubted the soundness of certain funds' investments, as was the case in 2008, inflation would not take hold because there would be no corresponding increase in nominal spending.   

Therefore, a preemptive buyback of short term government debt financed by printing money would be largely innocuous.  Lacking investment outlets, the government MMMFs would wind down and return their shareholder's money.  For their part, shareholders would likely invest in bank deposits, which are also a cash substitute.  Rather than holding a money like spendable IOU issued by an MMMF, they would hold a spendable IOU issued by a bank.  Crucially, the nominal spending power of the private sector would remain unchanged and hence no inflation would occur.  

In sum, money and banking matter when it comes to the national debt.  Trying to understand the economic significance of the national debt by just adding up numbers or targeting magic debt-to-gdp ratios will only take some very large numbers out of context, and cause you see all kinds of crises that aren't really there.