Let's be real: It should be obvious to anybody that debt doesn't meaningfully drive up interest rates.

For the past decade, the finance world has been fixated on unconventional monetary policy. Here's the mechanism in a nutshell. Replacing government bonds with interest bearing reserves reduces the supply of duration in the market place, this lowers bond yields because a scarcity of long-dated assets pushes up the prices of longer-term securities. For a time, I was fascinated by this research. I dug deep into the measurement of the effects of the so-called 'scarcity channel.' I read lots of papers and crunched the numbers myself.

Of course, the scarcity channel is at odds with any arbitrage-free model of the term structure.  That is:

1) Long rates are merely the expected geometric average of future short rates.

2) The market is efficient at pricing bonds, thus, over the long term, nobody can earn more than the short term risk-free rate whether they hold securities or money market instruments. (Or some portfolio with bonds of multiple tenors and cash)

In the real world, some segmentation exists in the capital markets. Certain investors find it particularly costly to hold securities outside a limited range of maturities. This might allow for some supply and demand effects to exist in certain sections of the yield curve. Also, the compensation required by investors to take on duration risk rises in times of uncertainty, mainly because the path of short rates becomes less clear.  For this reason, the yield on the ten-year note was around 350 basis points for much of 2009 and 2010. It just wasn't clear yet how long rates would stay at zero.

For the reasons above, it is certainly plausible that QE lowers long term rates both via the scarcity channel, and by removing duration risk from private sector balance sheets during times of financial or economic stress. And it would be naive to assert that the effects of QE or the supply of long term debt are zero. (Although some efficient market fundamentalists have claimed this.)

That said, traditional monetary policy, is traditional because historically it has worked. At least insofar as central banks have been able to tightly control interest rates regardless of the supply of government debt. The past week has borne this out. Despite the US Treasury posting record deficits, longer-term interest rates fell as the Fed signaled that it would likely stop hiking rates.  Strikingly, despite a much higher debt load, and a strong economy, the 10 year note yields110 basis points less today than in 2009 when the US economy was on life support. Oh, and Japan.

Some may claim that this is all very convenient for me. I am a fiscal dove who is sympathetic to MMT and its historical antecendents. However, I seriously investigated the effects of QE, which operates on the idea that excess long term government debt drives up rates. Thus, loose fiscal policy financed with long bonds could be seen as a form of reverse QE. Indeed, buying into the power of QE requires one, for consistency's sake, to be concerned about the level of long term public debt. I approached this issue with an open mind. I thought the effects were larger, but today, given bond market pricing action, I am convinced that forward guidance is what really matters.  Deficit hawks do themselves no favors by ignoring the lessons from QE and its small effects. In fact, by relying on such flimsy arguments, deficit hawks are letting the doves soar and make much stronger claims than they otherwise would. 

 At some point, the evidence just becomes overwhelming. Forward guidance is a much more powerful tool than QE.  The debt doesn't affect interest rates in any meaningful way when money markets are working normally. And if sudden market segmentation develops, the Fed can do QE or the Treasury can do debt buybacks financed by issuing the securities that end investors actually want to hold.  It's time to move on from the faulty claim that government debt meaningfully drives up interest rates.

What Riding Metro Taught me about the National Debt

Here's a nightmare that all frequent users of public transportation have:

It's morning, you've just woken up, the sun is shining bright. Suddenly you realize that you've over-slept your alarm, and you've got an important meeting. You scramble out of bed. You somehow manage to get your disheveled self to the metro station. Then disaster strikes. As you pull out your metro card, you realize that you have a negative balance. So you race over to the pay kiosk and whip out a bank card. But it's too late, your train has literally left the station.

Obviously, there's an easy way to prevent this series of unfortunate events, and many metro riders employ it, including yours truly. I basically never let my metro card balance fall too low. (Actually, I have an auto-refill that is triggered at ten dollars, but you get the picture) Many, if not most, metro riders always keep a balance on their cards that they never spend. This has policy implications for the metro system. And, as I will show, the US government.

Keeping a non-trivial balance at all times on your card, crucially never to be spent, is effectively an insurance policy against being caught flat footed. That is, there is a demand for metro credit that is beyond merely the desire to take rides on public transportation.  Owning metro credit (as opposed to filling your card every time you take metro) has value beyond just taking metro rides. And metro earns a premium for providing this value. Effectively, all those metro riders are floating WMATA an interest free loan.

The consolidated Federal government also issues liabilities.  Rather than metro credit, it issues Treasury debt, reserve balances at the Fed, and physical currency. Like metro credit, they have special properties which provide value beyond simply exchanging them one day for real goods or services. Physical cash provides an anonymous, secure, and easy way to make payments.  As of now and probably forever, it is the only way to pay anybody on Earth.  As with WMATA, these benefits earn the US government a premium.  The government is issued an interest free loan. (The supply of cash is expanded by having the Fed purchase government debt.) Treasury bills serve as a medium of exchange in the financial system, and are frequently used as collateral. Again, the special properties of government issued financial liabilities increases the demand for them. This demand in turn greatly expands the capacity of the government to issue debt without fears of inflation. 

Many economic models fully support this line of reasoning, which points to the obvious conclusion that the government is not subject to the strict solvency constraint that applies to private agents. (That is, the discounted value of net assets over the infinite time horizon must be greater than zero.) When someone in the private sector attempts to systematically to violate this constraint, we call it a Ponzi scheme.  It fails because there are a finite number of potential 'investors.'  However, suppose that the debt issued by Ponzi scheme had uses beyond merely the present value of the promised payoff. Thus, even with a finite number of economic agents, a permanent demand for Ponzi debt would exist, and the scheme may be able to continue indefinitely. In economics, this phenomenon is known as a 'rational Ponzi game.' 

The recent surge of interest in modern money theory, or MMT, has been met with scorn and disdain from the establishment. However, a crucial insight of MMT is that since the US government is a monopolist on risk free dollar denominated financial assets which can never be defaulted on in nominal terms, and demands tax payments in US dollars, its financial assets are special. There is a demand for them other than as a store of value. MMT rightly points out that this demand isn't unlimited, but also gets it right that solvency fears about the US government are misguided to say the least. Again, the capacity to run deficits (For example, to close the output gap and achieve full employment) without fears of inflation is much more than conventional wisdom suggests.
 
A simple thought experiment will put the debt fears to rest. Suppose WMATA didn't allow any metro credit, and riders simply had to pay for rides as they took them.  The metro system would never go into 'debt.'  It would never owe anybody metro rides. But riders would be worse off. They would lose their 'insurance policies' and be inconvenienced by constantly having to refill their cards.  WMATA should not be worried about the outstanding level of metro credit. In reality, as more and more riders join the system and keep that extra ten dollars on their cards for emergencies, the outstanding stock of metro credit will grow indefinitely.  That's right, most metro systems are issuing debt that they will never and should never repay. It's a rational Ponzi game.  By the same token, the US government, must continue to let its debt expand to meet the demands of population growth and a growing economy which will only want to hold an ever increasing quantity of financial wealth as the stock of real capital grows. We can therefore only reach the conclusion that fiscal policy should be set with respect to macro-economic outcomes, not achieving a specific budget target for its own sake.  

It's been said many times, but it bears repeating. Governments are not households. Because their debts hold special properties, such as acting as a medium of exchange, or as collateral in the financial system, governments with their own free floating currencies can and should maintain positive and increasing debt stocks into the indefinite future.  The kids are alright. We're not crushing them with the burden of debt. They won't cast scorn upon past generations for fiscal profligacy. In fact, if we leave future generations with an ample and abundant supply of government debt so that the financial and payment systems function smoothly, they might even thank us.  
   
         

My Letter to the Fed

The Fed is seeking public comments on a proposal to limit the payment of interest on reserves to institutions holding a substantial portion of their assets as reserve balances. The text can be read here. 

I submitted the following: 

To whom it may concern:

Scaling back or limiting IOER is counter-productive on several fronts, and the concerns of the FRB about so-called PTIEs are unwarranted. I will address those concerns in turn.

Monetary Policy Implementation:

It strains credulity to assert that allowing the private sector to strengthen the rate floor created by IOER would somehow weaken the transmission mechanism of monetary policy. On the contrary, it would provide an even firmer price floor for the short term funding markets. Concerns about rate volatility in the Federal Funds market are also overblown. Frankly, under a system of IOR which exists today, it is the expected path of rates paid on balances at the Fed, not overnight interbank lending that serves as a benchmark to price other forms of short term lending and even long dated securities. Fed Funds trades include non-negligible counter-party risk, thus while a widening spread between IOR and the Federal Funds rate would undoubtedly signal a heightened period of financial stress, it does not reflect the stance of monetary policy per se.

Balance Sheet Issues:

The release rightly points out that if the Federal Reserve allows the establishment of PTIEs, that it would in effect be supplying an unlimited quantity of reserve balances to the market.  To accommodate this, the Fed would likely need to maintain a large balance sheet for the indefinite future. However, it is unclear why a shift out of Treasury bills and into reserve balances is undesirable on its face.  Reserve balances are just one of many liabilities issued by the consolidated Federal government. Proper debt management would dictate that the demand for reserve balances be fully accommodated. The shifting out of Treasury bills and into reserve balances would merely be the marketplace substituting a more desirable financial asset for another. If anything, this would strengthen, not weaken financial stability.

PTIEs are a promising way to both strengthen the rate floor and improve Federal debt management. Furthermore, by acting as intermediaries between the Fed and public, PTIEs are an excellent avenue for the Fed to create a rock solid floor for short term rates without having to interface directly with individuals or businesses.  In sum, the Fed should welcome the emergence of PTIEs, not seek to constrain it.

Respectfully Submitted,

Michael Fellman