The US Federal Reserve’s Debt Purchases Are a Warning
As was true during World War II, the US Federal Reserve needs to buy Treasury debt on a sustained basis to prevent crippling interest-rate spikes. This “new normal” is a clear warning that the US must address new generation-spanning challenges such as excessive government debt with a wartime sense of urgency.
ALEXANDRIA, VIRGINIA – In a 2017 speech, John Williams, then the president of the Federal Reserve Bank of San Francisco, warned that, “post-financial crisis, things are returning to normal. But normal may look and feel quite a bit different from what you’re used to.” More recently, Williams, now in charge of the New York Fed, pointed to retiring baby boomers, falling fertility rates, and declining productivity growth as reasons for falling trend growth in the United States.
Weak labor-force and productivity growth are textbook causes of economic slowdowns. But in the case of the US, we also must consider the well-known negative effects of debt. In his recent book Fiscal Therapy, William Gale, one of the founders of the Urban-Brookings Tax Policy Center, points to numerous studies showing that “higher debt levels reduce economic growth by economically significant amounts.” And the seriousness of the US debt problem is evident in the increasing frequency with which the US Federal Reserve has had to intervene in government-debt markets with quantitative-easing, repo, and bill-buying operations to prevent huge congressionally enacted deficits from driving up interest rates and crippling the economy.
Likewise, in his book Principles for Navigating Big Debt Crises, the prominent hedge-fund manager Ray Dalio describes what central banks have historically done when government debt issuance exceeds the market’s appetite. He argues that the Fed today is in a situation similar to that of the early 1940s, when it had to finance the government deficits needed to win World War II. The war deficit, like current US fiscal policy, was a political decision. To help America win the war, the Fed had to give up its independence. It set the overnight rate at zero and the ten-year Treasury-bond rate at 2%, and bought whatever debt the Treasury needed to issue to finance the war effort. Dalio refers to such measures as Monetary Policy 3, or MP3.
In May 2019, one of us (Dugger) used Dalio’s framework to argue that the Fed was again at risk of slipping into MP3 and losing its independence. A few months later, the Fed responded to the repo-market and dollar-shortage crisis with large repo and Treasury-bill-buying operations to keep interest rates under control. Together with continuing weak growth and rising government debt levels, these moves confirmed that the Fed had become an MP3 central bank.
This “new normal” is not sustainable. On the contrary, it is a clear warning that US policymakers must wake up and act with the same urgency that their predecessors showed in World War II. With unemployment at a 50-year low, the economy should not need massive amounts of fiscal and monetary support. Continuing the “new normal” will merely perpetuate the vicious circle of growth-sapping debt. But getting out of this quicksand will require a generational shift in thinking.
In World War II, the existential threat was fascist imperialism, and MP3 was part of America’s response. Today, the US has backed into MP3 in the face of a less obvious but equally existential threat, namely short-termism and widespread disregard for generation-spanning crises such as climate change and excessive government debt.
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Lobbyists and their clients exploit this disregard for next-generation welfare when they manipulate the machinery of elections and government, and steal from the future by means of unjustifiable tax cuts, self-serving spending, and self-enriching regulatory policies. Short-termism has enabled today’s elites to over-exploit the environment, over-leverage the government, and underinvest in young people. The result is rising inequality, intensifying weather extremes, a massively indebted government, a young adult population whose education level ranks near the bottom among advanced countries, and an economy being kept alive by huge deficits and low interest rates.
As Dalio rightly argues, when faced with existential threats, “The worst thing a country, hence a country’s leader, could ever do is get into a lot of debt and lose a war because there is nothing more devastating.”
The US should instead start a war on short-termism, by enforcing the tax laws already on the books. In 2019, tax evaders cost fellow citizens over $600 billion per year. Allowing such levels of tax theft is corrosive and encourages cheating across the board. How can we ask anyone to obey tax laws, or any laws for that matter, if tax cheaters can steal with impunity?
Without doubt, the activities of tax criminals contribute to the kind of generation-burdening “excessive debt” that Alexander Hamilton warned against in his first letter to Congress as Secretary of the Treasury. In fact, collecting what is owed would reduce the $900 billion deficit the US is now running by two-thirds. At the same time, it would confirm for the public that the US is serious about the rule of law and basic fairness, and set the tone for the shift in budget priorities that the US urgently needs.
This shift should be guided by the interests of future generations. Most people would agree that young and yet-to-be-born Americans have a right to a livable environment, a right not to be burdened by excessive debt, and a right to an education that will enable them to become productive citizens. By focusing on such priorities, the US can escape the MP3 quagmire and overcome the scourge of short-termism for the benefit of current and future generations.