Qualitatively Wrong About Quantitative Easing

Qualitatively Wrong About Quantitative Easing

The Federal Reserve is under attack for its most recent extraordinary policy announcements. Angry and accusatory comment is streaming in from Brazil, Germany, China, leading lights in the financial industry and newly minted and empowered representatives of the GOP. Some fear inflation, others dollar devaluation. Financial firms are not excited about further stretching the gigantic Fed balance sheet. Lost in much of the cacophony is a very central part of what is going on. The Fed is buying American government debt at a rapid and impactful clip. The Fed now owns more Treasury Securities – US government debt – than China or Japan. By March 2011 the Fed will own more IOUs from Uncle Sam than China, Germany and Brazil combined. Our central bank is subsidizing the growing cost of our massive indebtedness. The Fed is buying more and more, longer maturity government debt. They have promised about $600 billion more in buying and will be turning some of their trillion dollars in mortgaged-backed securities into Treasuries as well. Unlike other buyers of US debt, the Fed refunds a significant portion of the interest it receives at the end of the year. Needless to say, this reduces the cost of the debt. Fed refunding of earnings on holdings will exceed $50 billion in 2011.

As the Fed moves to cushion the cost fallout of past and continuing fiscal policy excess, it is being assailed by once and future perpetrators and beneficiaries of this excess. All this buying of US debt pushes up the price and pushes down the yield of Uncle Sam’s IOU’s. Owners of government debt see the value of their assets rise. The government is able to borrow more and pay less for its borrowing. This is no minor matter as we rack up trillion dollar budget deficits year after year. Major exporters are reliant on US buying. Our public is tapped out; leading firms prefer the returns in distant lands. Our central government has stepped into the breach with excessive gusto. Now the Fed is trying to help out. In short, the Fed is trying to keep the weight of debt from damaging the federal government’s ability to keep acting as the engine of America’s economy. Subsidizing the value and lowering the cost of federal debt is a big part of the aim and impact of quantitative easing. It is a vast effort to keep the interest cost of our debt down and keep the ability of Uncle Sam to borrow up. Of course, there are some currency pressures and possible future inflation issues.

Everyone is talking about sovereign debt, default, bailout and quantitative easing II (QEII). Very few are connecting the dots. That is what this short piece tries to do. Above you see a graph, graph 1, made by your author. All data is taken from the US Treasury and the Bureau of the Public Debt.[1] Graph 1 looks at the billions that the US government spends each year to service its debt. We see that the annual interest expense on US government debt has been falling. I am measuring only interest, as we are constantly issuing more new debt than the debt we are paying off. Principle is growing, not shrinking. The cost of our mounting debt has been falling. This is counterintuitive and violates the presumptions of most formal models and arguments. Keep in mind that these are large figures – hundreds of billions of dollars – and represent well over 10 percent of tax collection revenues.

As we have borrowed more and more, we have had to pay less and less to borrow this money. The below graph, graph 2, employs US Treasury data to look at total US national debt outstanding over roughly the same period used in graph 1. It is clear that the total debt has been rising very rapidly. As we borrow more and more, we pay less and less as a percent of our debt. This phenomenon might remind you of the conundrum of Japan, where rising national debt and falling, low yields on government debt have been the norms for many years. It might also recast the present debates about deficits, debt and quantitative easing. The government could be borrowing for shorter time periods. As the length of a loan decreases, so too, does the interest rate – assuming normal times and circumstances. Shorter duration, or maturity, loans are cheaper; we did try that from 1999 to 2007. For the last few years, the average duration of US government debt has been slowly rising – the average maturity of US government debt is now about 70 months, a little less than 6 years.

The Federal Reserve’s November 3, 2010 announcement to buy $600 billion in additional US Treasuries could be seen as an effort to extend the ability of the US government to owe more and more and pay less and less for the privilege. This perspective would suggest that the vast majority of discussion, critical and laudatory, has largely missed the story.

Another way to look at the same phenomenon is to use data from the Federal Reserve on the interest rate paid on the three-year US Treasury. The graph below uses Federal Reserve data on select interest rates and displays these rates against the 39-year average rate on three-year US Treasuries.[2] In graph 3 the red line is the average yield on three-year Treasuries. The nearly 40-year average is 6.6 percent. Today the yield is under 1 percent. Graph 3 is a picture of the falling price of owing more for America. This trend has long been the order of the days, weeks, months and years.

Perhaps discussion of QEII could be profitably reframed to focus on this central, basic fact. The Fed is risking some reputation and significant political criticism to act aggressively to keep up the price and keep down the cost of US government borrowing. The Fed returns interest earnings on Treasuries, other loans and bonds to the US Treasury after it has taken what it needs to cover costs. In 2010, the Fed transferred nearly $50 billion to the US Treasury. 2011 will see the Fed transfer even more because earnings will rise on its large and growing pool of Treasuries and mortgaged-backed securities. Other investors in US government debt are not in the habit of partially refunding interest payments. Discussions of QEII that ignore the financial health of the US government miss a big part of the story.

1. US Treasury Department

2. Federal Reserve H.15 Select Interest Rates