By Ryan McMaken of the Mises Institute
With the Federal Reserve’s annual Jackson Hole symposium there’s been much talk about when the central bank might allow interest rates to rise, presumably through the process of “tapering.” Tapering would mean easing monthly bond purchases, which would “effectively increase interest rates.“
Much of the discussion over the Fed’s policies on interest rates tends to focus on how interest rate policy fits within the Fed’s so-called dual mandate. That is, it is assumed that the Fed’s policy on interest rates is guided by concerns over either “stable prices” or “maximizing sustainable employment.”
This naïve view of Fed policy tends to ignore the political realities of interest rates as a key factor in the federal government’s rapidly growing deficit spending.
While it is no doubt very neat and tidy to think the Fed makes its policies based primarily on economic science, it’s more likely that what actually concerns the Fed in 2021 is facilitating deficit spending for Congress and the White House.
The politics of the situation—not to be confused with the economics of the situation—dictate that interest rates be kept low, and this suggests that the Fed will work to keep interest rates low even as price inflation rises and even if it looks like the economy is “overheating.” If we seek to understand the Fed’s interest rate policy, it thus may be most fruitful to look at spending policy on Capitol Hill rather than the arcane theories of Fed economists.
Why Politicians Need the Fed to Keep Deficit Spending Going—at Low Rates
If all this spending were just a matter of redistributing funds collected through taxation, that would be one thing. But the reality is more complicated than that. In 2020, the federal government spent $3.3 trillion more than it collected in taxes. That’s nearly double the $1.7 trillion deficit incurred at the height of the Great Recession bailouts. In 2020, the deficit is expected to top $3 trillion again.
In other words, the federal government needs to borrow a whole lot of money at unprecedented levels to fill that gap between tax revenue and what the Treasury actually spends.
Sure, the Congress could just raise taxes and avoid deficits, but politicians don't like to do that. Raising taxes is sure to meet political opposition, and when government spending is closely tied to taxation, the taxpayers can more clearly see the true cost of government spending programs.
Deficit spending, on the other hand, is often more politically feasible for policymakers, because the true costs are moved into the future, or they are—as we will see below—hidden behind a veil of inflation.
That’s where the Federal Reserve comes in. Washington politicians need the Fed’s help to facilitate ever-greater amounts of deficit spending through the Fed’s purchases of government debt.
Without the Fed, More Debt Pushes up Interest Rates
When the Congress wants to engage in $3 trillion dollars of deficit spending, it must first issue $3 trillion dollars of government bonds.
That sounds easy enough, especially when interest rates are very low. After all, interest rates on government bonds are presently at incredibly low levels. Through most of 2020, for instance, the interest rate for the ten-year bond was under 1 percent, and the ten-year rate has been under 3 percent nearly all the time for the past decade.
But here’s the rub: larger and larger amounts put upward pressure on the interest rate—all else being equal. This is because if the US Treasury needs more and more people to buy up more and more debt, it's going to have to raise the amount of money it pays out to investors.
Think of it this way: there are lots of places investors can put their money, but they'll be willing to buy more government debt the more it pays out in yield (i.e., the interest rate). For example, if government debt were paying 10 percent interest, that would be a very good deal and people would flock to buy these bonds. The federal government would have no problem at all finding people to buy up US debt at such rates.
Politicians Must Choose between Interest Payments and Government Spending on "Free" Stuff
But politicians absolutely do not want to pay high interest rates on government debt, because that would require devoting an ever-larger share of federal revenues just to paying interest on the debt.
For example, even at the rock-bottom interest rates during the last year, the Treasury was still having to pay out $345 billion dollars in net interest. That’s more than the combined budgets of the Department of Transportation, the Department of the Interior, and the Department of Veterans Affairs combined. It’s a big chunk of the full federal budget.
Now, imagine if the interest rate doubled from today's rates to around 2.5 percent—still a historically low rate. That would mean the federal government would have to pay out a lot more in interest. It might mean that instead of paying $345 billion per year, it would have to pay around $700 billion or maybe $800 billion. That would be equal to the entire defense budget or a very large portion of the Social Security budget.
So, if interest rates are rising, a growing chunk of the total federal budget must be shifted out of politically popular spending programs like defense, Social Security, Medicaid, education, and highways. That’s a big problem for elected officials, because that money instead must be poured into debt payments, which doesn’t sound nearly as wonderful on the campaign trail when one is a candidate who wants to talk about all the great things he or she is spending federal money on. Spending on old-age pensions and education right now is good for getting votes. Paying interest on loans Congress took out years ago to fund some failed boondoggle like the Afghanistan war? That’s not very politically rewarding.
So, policymakers tend to be very interested in keeping interest rates low. It means they can buy more votes. So, when it comes time for lots of deficit spending, what elected officials really want is to be able to issue lots of new debt but not have to pay higher interest rates. And this is why politicians need the Fed.
The Fed Is Converting Debt into Dollars
Here’s how the mechanism works.
Upward pressure on rates can be reduced if the central bank steps in to mop up the excess and ensure there are enough willing buyers for government debt at very low interest rates. Effectively, when the central bank is buying up trillions in government debt, the amount of debt out in the larger marketplace is reduced. This means interest rates don't have to rise to attract enough buyers. The politicians remain happy.
And what happens to this debt as the Fed buys it up? It ends up in the Fed’s portfolio, and the Fed mostly pays for it by using newly created dollars. Along with mortgage securities, government debt makes up most of the Fed’s assets, and since 2008, the central bank has increased its total assets from under $1 trillion dollars to over $8 trillion. That’s trillions of new dollars flooding either into the banking system or the larger economy.
For years, of course, the Fed has pretended that it will reverse the trend and begin selling off its assets—and in the process remove these dollars from the economy. But clearly the Fed has been too afraid of what this would do to asset prices and interest rates.
Rather, it is increasingly clear that the Fed’s purchases of these assets are really a monetization of debt. Through this process, the Fed is turning this government debt into dollars, and the result is monetary inflation. That means asset price inflation—which we’ve clearly already seen in real estate and stock prices—and it often means consumer price inflation, which we’re now beginning to see in food prices, gas prices, and elsewhere.
This certainly isn’t a new trick. Just as we must look back to the Second World War to find similarly huge increases in government spending, the Second World War also provides an earlier example of this debt "monetization" scheme.
David Stockman describes the situation in his book The Great Deformation:
[During the war] the Federal Reserve became the financing arm of the warfare state. Making short shrift of any pretense of fed independence, Treasury Secretary Henry Morgenthau simply decreed that interest rates on the federal debt would be “pegged.” …
Obviously the only way to enforce this peg was for the nation’s central bank to purchase any and all treasury paper that did not find a private sector bid at or below the pegged yields. Accordingly, the Fed soon became a huge buyer of Treasury securities, thereby “monetizing” federal debt on a scale never before imagined.
This follows a textbook scheme that central banks have used during many wars and crises.
Joe Salerno describes this mechanism in his essay “War and the Money Machine”:
Under modern conditions, inflationary financing of war involves a government “monetizing” its debt by selling securities, directly or indirectly, to the central bank. The funds thus obtained are then spent on the items necessary to equip and sustain the armed forces of the nation.
But the money need not be spent on armed forces, of course. It can be spent on anything, such as bailouts and "stimulus." The possibilities are endless, and the scheme can be used for any type of perceived emergency. But the mechanism is the same.
Now, most of the time in the past, this was considered a very radical thing to do, but it’s now standard operating procedure in this alliance between Congress and the Fed. You want huge deficits? Call in the central bank.
The Fed has apparently been more than happy to oblige. As noted by David Wessel at Brookings, the Fed is definitely doing its part.
Between mid-March and late June 2020, the Treasury’s total borrowing rose by about $2.9 trillion, and the Fed’s holdings of U.S. Treasury debt rose by about $1.6 trillion. In 2010, the Fed held about 10% of all Treasury debt outstanding; today it holds more than 20%.
And, as noted by the Committee for a Responsible Federal Budget in May 2020,
Since the crisis began, neither domestic nor foreign holdings of debt have increased significantly. Instead, the Federal Reserve has sharply increased its ownership of U.S. debt…. In fact, the Federal Reserve has indirectly purchased nearly all new debt issued since the recent crisis began.
Another estimate concluded the Fed “bought 57 percent of all Treasury issuance over the past year.”
Indeed, measuring indirectly, we find that from the fourth quarter of 2019 to the fourth quarter of 2020, total public debt grew $4.5 trillion. During that same period, federal debt held by the central bank increased $2.5 trillion. That’s 55 percent of the increase in total debt. Not surprisingly, the Federal Reserve holds 24 percent of all federal debt as of the first quarter of 2021.
Of course, the Fed doesn’t need to buy 100 percent of the new debt that’s issued. There are still many factors that buoy the demand for US debt in addition to the central bank’s purchases. European regimes and China, among others, are all at least as profligate as the United States when it comes to debt and spending, and so US debt by comparison continues to look relatively stable and like a relatively safe bet.
But these other factors clearly aren’t enough to keep the interest rate paid on US debt as low as the politicians need it to be. So the central bank steps in to "help out."
Hiding the True Cost of Spending
The political benefit to the US government goes beyond just keeping interest rates low. Converting government spending into monetary inflation obscures the true cost of trillions of dollars of new spending.
Rather than raise taxes to fund spending, deficit spending is more politically feasible for policymakers, because the true costs are moved into the future, or they’re hidden behind a veil of price inflation.
Ludwig von Mises long ago noted the political importance of inflation as a means of allowing the regime to “free itself” from having to ask the taxpayers for another tax increase.
Or, as Robert Higgs puts it in Crisis and Leviathan,
Obviously, citizens will not react to the costs they bear if they are unaware of them. The possibility of driving a wedge between the actual and the publicly perceived costs creates a strong temptation for governments pursuing high-cost policies during national emergencies.
The Myth of Fed Independence
As Stockman notes, when this sort of monetization takes place, it is all the more clear that alleged “Fed independence” is a fantasy. The Fed is today a critical partner is enabling the federal government’s spending plans, and in manufacturing a politically motivated low–interest rate environment.
Economists and Fed watchers may pore over Fed documents and Fed commentary to try to figure out how the Fed views the economics of low–interest rate policy. And that surely is a factor. But the political realities are something else, and remain very much at the center of it all.