Can a Sovereign Government Run Out of Money? Part 2

This blog continues my argument from last week, addressing the question raised in the title. (www.benzinga.com/daily-blog-watch/11/04/1005127/can-a-government-run-out-of-money-part-1) The issue gained new urgency this week as S&P warned that it was downgrading US federal government debt from stable to negative. http://www.nytimes.com/roomfordebate/2011/04/18/is-anyone-listening-to-the-standard-poors/ignore-the-raters This appeared to be a blatantly political move, designed to influence the debate in Washington, adding fuel to the fire to cut budget deficits. The deficit hysteria has nothing to do with economics, government solvency, or involuntary default. A sovereign government can always make payments as they come due by crediting bank accounts—something recognized by Chairman Bernanke when he said the Fed spends by marking up the size of the reserve accounts of banks. http://www.cbsnews.com/stories/2009/03/12/60minutes/main4862191_page2.shtml Similarly Chairman Greenspan said that Social Security can never go broke because government can meet all its obligations by “creating money”. http://www.benzinga.com/news/11/03/899135/deficit-impasse-what-should-we-cut Instead, sovereign government spending is constrained by budgeting procedure and by Congressionally-imposed debt limits. In other words, by self-imposed constraints rather than by market constraints. In addition, government needs to be concerned about pressures on inflation and the exchange rate should its spending become excessive. Finally, it should avoid “crowding out” private initiative by moving too many resources to our public sector. However, with massive unemployment and idle plant and equipment, no one can reasonably argue that these dangers are imminent. Ironically, the ratings agencies recognized long ago that sovereign currency-issuing governments do not really face solvency constraints. A decade ago Moody's downgraded Japan to Aaa3, generating a sharp reaction from the government. (http://www.cfeps.org/pubs/pn/pn0201.html) The raters back-tracked and said they were not rating ability to pay, but rather the prospects for inflation and currency depreciation. After ten more years of running deficits, Japan's debt-to-GDP ratio is 200%, it borrows at nearly zero interest rates, it makes every payment that comes due, its Yen remains strong, and deflation reigns. So, as I predicted two days ago, the market reacted to the US government's credit downgrade with a big “Ho-Hum”. As I argued last week, anyone can make purchases by “creating money”—by issuing an IOU to her bank, with the bank crediting her demand deposit. The “money” is created simultaneously with the spending. When we talk about a private spender (household or firm), the bank is concerned with credit-worthiness. There are, indeed, additional constraints put on the bank, including reserve ratios and capital ratios—plus whatever other regulations and oversight government puts on its regulated banks. In practice, reserve ratios do not constrain banks because the development of inter-bank lending markets (called the fed funds market in the US) plus access to the central bank's discount window ensure that banks can always get reserves—at a price. Capital ratios can bind, although again in practice the constraint is loose since a bank faced with a good borrower can move assets off the balance sheet, seek additional capital, or use creative accounting to finesse the requirements. And, as I argued last week, growing lending and spending can have consequences at the aggregate level: inflation and currency depreciation should spending be too large relative to capacity. That is why governments use a range of policies to try to constrain lending and spending—monetary and fiscal policy as well as direct limits on bank lending and (in rare cases) wage and price controls. When government refuses to oversee and regulate private banks, underwriting standards tend to fall—which allows lending and spending to grow quickly, which can have inflationary consequences. But worse, it can lead to a catastrophic financial crisis—as we are witnessing. What is particularly strange is the way that we treat sovereign government. As I discussed, the treasury's bank is the central bank—which handles its payments and receipts. The treasury writes checks on its demand deposit at the central bank and moves tax receipts from its accounts at private banks to the central bank when it wants to spend. In the US, the Treasury tries to end each day with a deposit of $50 million at the Fed. In all these respects, the Treasury and Fed relation is much like that between a household or firm at its bank. With one big exception: the credit worthiness of the sovereign issuer of a currency cannot be called into question by financial markets because it can always make payments as they come due. But there is another big difference when it comes to “borrowing”—that is to issuing IOUs. The Treasury can sell its IOUs (bills or bonds) to anyone EXCEPT its own bank. It can sell bonds to households, firms, or private banks but NOT to the Fed (there is a small exception that we need not go into here). So when the Treasury is deficit spending (meaning it needs to write checks for more than its deposit at the Fed), it cannot simply issue an IOU to the Fed. It must instead sell its bills and bonds to private households, firms or banks. Here's the problem. To spend, the Treasury must have deposits in its account at the Fed. It does no good to sell its bonds to the private sector, receiving a demand deposit at a private bank—because it cannot write a check on that account. Just as you can only write checks against your account at your bank the Treasury can write checks only on its account at its bank—the Fed. So, for example, it can sell a bond to Bank XYZ and receive credit to an account it holds at Bank XYZ. To spend it needs to transfer the demand deposit to its account at the Fed. This is accomplished by debiting the Treasury's account at Bank XYZ, and simultaneously debiting that bank's reserves at the Fed. The Fed then credits the Treasury's demand deposit. In normal times, banks do not hold excess reserves. (These are not normal times—banks in the aggregate now hold a trillion dollars of excess reserves. We will ignore that for now.) In that case, Bank XYZ would find itself short of reserves after the Treasury transferred its deposit. There are several ways a bank can get the reserves it needs: borrow in the fed funds market, borrow from the Fed at the discount window, or sell bonds to the Fed. Note that if there are no excess reserves in the banking system, turning to the fed funds market will only cause the fed funds rate to rise. This is the signal the Fed responds to—either lending reserves at the discount window or engaging in an open market purchase to relieve the pressure in the fed funds market. Ultimately, the Fed is the source of reserves banks need. Note that if the Fed lends reserves to banks, we end up in a position in which banks have essentially borrowed reserves from the Fed in order to “lend” to the Treasury (holding government bonds). If on the other hand the Fed buys the bonds in an open market operation, we end up in a position in which the Fed holds the Treasury's bonds, so has effectively “lent” to the Treasury—but only indirectly because it used Bank XYZ as the intermediary. Recall that all these operations are required because we prevent the Fed from buying the bonds directly from the Treasury, thereby providing the Treasury with the demand deposits it needs to write checks. So it is doubly ironic that this prohibition then requires either that the Fed lend reserves to banks so they can buy the bonds, or that it buy the bonds from the banks. Now, in normal times it really does not matter that we have adopted such a roundabout method of allowing the Treasury to do what any other spender can do—issue an IOU to its own bank. It all operates smoothly with the Fed using a private bank as intermediary to do what Congress prohibits it from doing directly. That is to say, what prevents the Treasury from spending its way toward Zimbabwe land is that it has a budget that must be approved by Congress and the President. The prohibition on Fed purchases of bonds directly from the Treasury is not a constraint at all. If we got a Congress and President that wanted Zimbabwean inflation, they could produce that result by agreeing on a budget of quadrillions of dollars of spending. So in normal times, we rely on rationality in Washington to constrain spending. But these are not normal times. The overall debt limit is repeatedly approached because we are running persistent deficits. And that is because tax revenue has been destroyed by the economic downturn caused by Wall Street's excesses. So Congress must repeatedly raise the debt limit so that the Fed, Treasury and private banks can perform their little charade to allow the Treasury to spend the budgeted amounts. This is usually done as a matter of routine. But the Republicans want to hold the debt limit hostage to politics—following Rahm Emmanuel's dictum that a “crisis” should never be wasted. They intend to gut the social programs they do not like on the pretense that this will reduce the budget deficits that threaten the US with bankruptcy. In fact, cutting the social programs will not significantly reduce overall spending (because they are too small) and the US government cannot be forced into involuntary bankruptcy. Hence, neither argument follows on from the facts. Indeed, if the US does default on any of its payment commitments, it will be because Republicans force it to do so. That is the nuclear option that party politics run amuck could lead to. I realize that whenever the actual operating details are made clear, the response always is: OMG if the government can spend simply by “keystrokes” then we are doomed to Zimbabwean inflation and eventual default on debt. In reality, it is Congress that holds the fate of the US in its hands. The budgeting procedures are what keep inflation at bay, and the normal financing “triangular” operation that uses the balance sheets of the Treasury, Fed and private banks ensure the government meets its payment commitments. Unfortunately, by using the debt limit as its hammer to destroy social programs, Congress is now threatening to disrupt financing—raising a possibility (albeit very small) that government might be forced by politicians to do what markets CANNOT force it to do: default on its commitments. So, ironically and through the backdoor, the Republicans might actually bring on a Zimbabwean-scale crisis on the argument that they are defending us from Zimbabwean hyperinflation.