Tuesday, November 9, 2010

What's the Big Deal with the Fed Buying Treasury Debt?

Last week the Fed announced that it was going to Buy $600 Billion in Debt, Hoping to Spur Growth.  The idea is to increase the amount of bank reserves so that it'll lower interest rates which will spur more borrowing to fund real economic activity(i.e. buying stuff and starting new businesses).  This move by the Fed was quickly followed by a lot of people freaking out about it (see hereherehere, and here).  The basic criticism that I see is that the Fed is "monetizing debt" which will - at some point - cause inflation.  Not being an economist, I feel that I must be missing something because I don't understand the logic of the Fed's actions nor the logic of its critics.

First, here's why I don't understand the Fed's actions.  Banks already have a record high level of cash reserves.  What that means is that the banks are already sitting on a pile of cash in their vaults(Okay, I know most of it is just numbers in a computer, but the physical metaphor makes it easier for me to comprehend).  The banks are already not loaning out this money.  What makes the Fed think that making them have bigger piles of cash will suddenly induce them to start making loans?  Will making already historically low interest rates go even lower get the economy going again?  My point is that I don't think monetary policy alone is going to get us out of our depression.

Now, onto the critics of the federal reserve.  The argument is that for the Fed to buy these treasury securities is that it will increase inflation either now or in the long-term.  To see the ridiculousness of this argument let's first review what treasury securities are:

United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries.
So, by law, every time the Treasury spends money that hasn't been collected in taxes, it must issue some type of treasury security to "finance" that spending.  For those who purchase this treasury securities(mostly domestic commercial banks and foreign central banks) they get to earn interest on the debt.  So if the United States spends $1,000 that it doesn't have and Chase Bank purchases the security, it will make $1,000 plus interest.  At 3% over 10 years, that will be 1,300 dollars.  When 10 years is up, the U.S. treasury pays Chase 1,300 dollars.  When all is said and done, Chase makes 300 dollars and the U.S. Treasury is out another 300$ on top of the original debt.  (This, BTW, is why people are worried about the growing debt)

Now let's look at what happens when the Federal Reserve buys the debt instead of Chase Bank.  The Federal Reserve gives the U.S. treasury a thousand dollars.  At the end of 10 years the U.S. Treasury gives the Federal Reserve 1,300 dollars.  The Federal Reserve just made 300 dollars.  Now, here's the kicker.  By law, any money that the federal reserve makes must go to the U.S. Treasury at the end of the year.  So that 300 dollars the Fed just made by loaning to the U.S. Treasury... goes back to the U.S. Treasury.  (addressing the absolute absurdity of this system is beyond the scope of this post, I will address it some other time)
Whether Chase Bank or the Federal Reserve purchases the original treasury security, neither scenario causes long term inflation as long as the Federal Government brings it's budget back into balance at the end of the 10 years. This is true because no money is "created".  The government eventually pays off its debt by collecting more tax dollars than it spends and that goes to paying its debt.

However, since the federal budget has only been balanced about 7 times during it's entire existence(and each time it lasted only 2 years or less), it would be a dumb assumption to assume that the debt won't continue to go up over time as it always has.  What that means is that when the debt comes due, the federal government will invariably have to issue new debt to pay for the old debt.  If Chase bank owned the debt, the U.S. Treasury will have to create $1,300(the original 1,000 plus 300 in interestprofit) in new debt to pay for the old debt.   If the Federal Reserve owned the debt, the U.S. Treasury will only have to create only a $1,000 in new debt because the Federal Reserve had to give back it's profit.

So, if you assume that the U.S. debt will still be growing in 10 years, which scenario is more inflationary:  Chase owning the Treasury security, or the Federal Reserve?  Chase owning it is more inflationary.  Why?  Because to pay Chase, the U.S. Treasury will have to create $1,300 total in new money to pay for the debt(1,000 plus 300 in interest) where as if the Fed owns the debt, only $1,000 dollars in new money gets created.  In other words, in the long run, it's actually less inflationary for the Fed to own this debt than private banks.  So all these people yelping about this causing long-term inflation are arguing for policies that will increase long-term inflation.

Now, I'm not an economist, so I admit that I could be wrong.  I could be missing something here, but as far as I can tell, the Federal Reserve's latest move won't jump start the economy, and neither will it be more likely to cause long term inflation.  Right now, the only things that can hurt or save us will be what our congress does to address the economy.
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