Trump is Right on Sovereign Debt

by Jeffrey Zirlin

In May, Donald Trump gave an interview where he proclaimed that the U.S. will never default “because you print the money”. Pundits dismissed this logic as dangerous and ill-informed, citing inflation concerns and creditor unease. However, Trump’s statement was basically a synthesized version of an argument made by Warren Buffet on July, 8th 2011, when he stated on Bloomberg news that “…we’ve got the right to print our own money, so our credit is good.”

These statements on money printing bring up some interesting issues that are worth exploring a bit further. From 2009 to 2014 the Federal Reserve (abbrev. Fed) engaged in Quantitative Easing (abbrev. QE). Through this mechanism, the Fed bought (using freshly “printed” dollars) Treasury bonds and mortgage backed securities from banks. The rationale was that the banks would take the proceeds from these bonds and then lend them out, thereby increasing the money supply and counteracting the deflationary effects of the Great Recession. The Federal Reserve currently holds 2.4 trillion dollars in Treasury Bonds as a direct result of its QE program. These bonds yield interest, and the payments from these holdings are sent back to the US Treasury, essentially making the portion of our debt held by the Fed interest free. This means that our government is now indebted to the Fed — a benevolent creditor to say the least. In fact, as long as the Fed never sells these bonds back into the market — we can consider the debt held by the fed to be paid off. In my opinion, the fed should never sell these treasuries back into the market and we can now consider our “real debt to be 17 Trillion(19.4 Trillion minus the 2.4 trillion held by the Fed).

Inflation Is Still Muted

Even while the Fed printed enough money to buy 2.4 trillion of our 19 trillion dollar debt, inflation, measured by the Consumer Price Index, still sits comfortably below the Fed’s 2% inflation target. Why is this? The Fed expected (or said it expected) banks to lend money out into the economy; with more available credit, consumption would increase and push up prices, but this transmission mechanism never materialized.

Instead, we see in the graph below that the amount of money that banks hold at the Fed has spiked since Fed began its QE program in 2009. This correlation suggests that instead of lending out the newly minted cash, banks returned large portions of that money to the Fed. Given the fact that the QE program’s money has been sent back to the Fed, the QE has not caused inflation. The QE money sits at the Fed now, generating an interest rate of .5% (.5 % is the rate that the Fed pays to banks on excess reserves held at the Fed). Thus, the net effect on inflation has proven minor, because this money has not actually entered circulation, but has been lent to the Fed at a rate of .5% per year.

zirlingraph

Economists generally calculate inflation rates by multiplying the amount of money in the economy by the velocity of its circulation. Because the QE money is not in circulation, it cannot cause inflation. Thus, the Fed has bought 2.4 T of our 19 T dollar debt without causing inflation. All they’ve really done is take Treasuries off the balance sheet of the banks and replaced it with cash — a large portion of which was just handed right back to the Fed.

Why didn’t the banks lend out the money? A banking executive could probably answer this question better than I, but my hypothesis is that the risk free rate of return offered by the Fed is a much more compelling option than actually lending out the money and taking risk. The 0.5% is pretty high when you consider that there are 9 trillion dollars of global bonds(European and Japanese) yielding negative interest rates.

Can We Buy Even More?

Now that we understand why the Federal Reserves bond buybacks have yet to cause inflation, an intriguing question emerges. Why can’t we buy back more? Would inflation actually materialize?

This question depends on who we buy the bonds back from and what they end up doing with the money they receive. So far, the Fed has bought Treasuries from the banks(giving these lucky banks a nice opportunity to take profits after a 30 year bond bull market) but what if we started buying back the debt owned by China? In this scenario, the Fed creates money and uses it to buy back the Treasuries held by the Chinese.

So new money flows from the Fed into Chinese capital markets while the Treasuries end up on the Fed’s balance sheet. This could end up causing some inflation in China but we would still be assuming that the cash is more liquid (greater velocity) than a Treasury — however, Treasuries are one of the most liquid assets in the world so the inflationary effect on the Chinese economy could still be quite low! If we see the Fed’s balance sheet as a closed system- from which capital cannot easily escape- it is easy to understand that when the Fed switches newly created cash for a treasury and then keeps that treasury “trapped” in its balance sheet, the net effect on the money supply is actually quite low.

Complex problems require innovative solutions that are often counter-intuitive. Trump’s suggestion that we can print money to buy back the debt might not be as crazy as it sounds. We’ve already bought back 2.4 trillion of the debt with few negative consequences for our currency — the dollar remains the only viable, large, currency due to problems in Europe and Japan. We should take advantage of our envious position and explore this question of further QE. Because that’s what Trumps plan would amount to — a continuation and expansion of the policies implemented by former Federal Reserve Chairmen Ben Bernanke during the financial crisis.