H/T ‘Bonds & Battleships’ graph by CHRIS BROWN
In a May ’17 speech (05/23/17) at the Bank of Japan (BOJ) entitled “Some Reflections On Japanese Monetary Policy”, former chairman of the Federal Reserve Bank Ben S. Bernanke suggested that Japan’s fiscal and monetary policymakers ‘coordinate’ their programs to improve the Japanese economy. What he was saying was that it would be great if somehow Japan could maximize fiscal spending while at the same time (with a ‘team effort’), minimize federal borrowing. If so it “could make fiscal policymakers more willing to act and increase the impact of their actions.”
On June 27, 2011, about a month before S&P downgraded U.S. federal gov’t debt (Treasury bonds) from AAA to AA+, former Texas Republican congressman and then-presidential candidate Ron Paul was discussing Greece’s fiscal trouble with Iowa radio host Jan Mickelson. He offered a solution to the debt ceiling imbroglio which appeared five days later in a post on the New Republic website entitled “Ron Paul’s Surprisingly Lucid Solution to the Debt Ceiling Impasse” by Dean Baker, a Ph.D. in economics and co-director of the Center for Economic Policy Research in Washington DC. He wrote that during the radio show Ron Paul had suggested an idea that might give some reassurance to the markets and could make investors gain confidence. “If the U.S. were to wipe out (write-off) the debt (the Treasury bonds) that the Fed was holding on their balance sheet (bought during Quantitative Easing), they (the fiscal policymakers in Congress) will all say ‘Hey, they’ve just reduced the deficit by over a trillion dollars, now they can handle it, and they can go back to meeting their other obligations’.
What a fantastic idea…
Let’s call it ‘Quantitative Redemption’…
In a QR, the Fed would announce that the $2.4T in Treasury bonds presently on their balance sheet are, effective immediately, redeemed (‘called’ before maturity date). We are only redeeming the Treasury bonds (20yr< maturity) and Treasury notes (10yr – 20yr maturity) on their balance sheet, not the other $1.8T in Agency bonds and Mortgage Backed Securities (MBS) the Fed also bought and are also on their balance sheet.
The Fed’s holdings (the Fed’s ‘balance sheet’) of these Treasury bonds are in the System Open Market Account (SOMA), with an approximate combined 120 month average maturity (‘duration’). The duration of the Fed’s US Treasury bond portfolio hasn’t changed much since the Large Scale Asset Purchases (LSAP) program ended, because to this day when any of those Treasury or MBS bonds mature, the Fed automatically reinvests (‘rolls over’) the proceeds in new securities of the same type and the same maturity. Of the $2.4T of the SOMA Treasury bond holdings, approx 92% have a 10-year maturity or more.
Effective June 15, 2017, the Rate on Required Reserves / Rate on Excess Reserves (IORR / IOER) is 1.25%. The amount of reserves sitting at the Fed is approx $2.3T, meaning that to target the Fed’s desired level of overnight rates (‘Federal Funds Rate’), the Fed is paying out 1.25% interest costs on that $2.3T of reserves. The average weighted coupon of the Fed’s Treasury bond portfolio on its balance sheet is approx 1.75%, meaning the Fed, which is a part of the federal gov’t (‘independent within the federal gov’t’), is getting ‘paid’ from the federal gov’t about 1.75% interest income on that $2.4T of Treasury bond holdings. Two more quarter-point rate hikes by the Fed, which could happen within a year, and that so-called profit from that difference (‘spread’) disappears so it is no coincidence that the Fed is now jawboning about unloading (‘unwinding’) these bonds (selling them back to the secondary market) starting at the end of the year. Furthermore, redeeming the Fed’s Treasury bond portfolio (losing this annual interest income the Fed earns), would not cause a liquidity (‘negative equity’) problem because QR is not redeeming any of the Agency bonds. The Fed would still have $1.8T of MBSs throwing off approx $54 billion/yr, and that’s using a conservative 3% rate, so if they did QR there would be plenty of cash (‘fiscal space’) and no problem at all for the Fed to keep paying IOER.
How this QR works is ridiculously easy. There is nothing to actually do, except announce that instead of continuing to keep these Treasury bonds ‘impounded’ (held on the Fed’s balance sheet), the Federal Open Market Committee (FOMC) has declared all these Treasury bonds redeemed, and no longer exist. (The FOMC may decide to do this piecemeal, whatever). This QR wouldn’t be anything new. Redeeming bonds is not an exotic concept, it’s done all the time by everyone, the only difference being that this would be the first time the federal gov’t is doing it with Treasury bonds. For example, other bond issuers like businesses that issue debt (‘corporate bonds’) and municipalities that issue debt (‘muni bonds’) have called their bonds before maturity date. This happened a lot since the credit crisis (since the LSAP program) because prevailing interest rates fell way below the rates being paid out to bondholders, so these particular issuers exercised what is known as an embedded call option. Similar to an ‘assignment’ in any option trade that is exercised, if bonds are called by the bond issuer, the bondholder has no say in the matter. Bondholders are simply notified that their bonds are being returned to the issuer and the bondholders then receive a cash payment in full for the entire bond principal (‘par value’) plus any remaining accrued interest at the financial institution where the bonds are held (‘registered’). This is exactly what the Fed did to Wall Street bondholders during LSAP. A Main Street example of a bond call, if a homeowner decides to pay off a mortgage before the term (‘prepayment’), same thing, the homeowner called the ‘bond’ (the debt owed) from the issuer (the lender). What Ben Bernanke did during LSAP was also not much different from a company purchasing its own shares (‘buyback’), which if not retired, are held on the company’s balance sheet (‘Treasury stock’). In fact, as a US Treasury bond broker during the QE years, whenever I spoke to primary dealers or confirmed trades with their settlement departments, that’s exactly what they called QE, everybody referred to it as ‘Fed buybacks’. The beauty of this QR idea is that this buyback step is already done. There is *literally* nothing the Fed has to do. All of the $2.4T in Treasury bonds were already called, all of the Wall Street bondholders were already paid back their $2.4T, all of the markets already had their ‘temper tantrum’ and even though that net addition of $2.4T into the banking system (by the Fed to pay for those bonds) had an inflationary bias, it caused no inflation whatsoever.
If the Fed did a QR this year, it’s actually not a redemption of the Treasury bonds this year, it’s only making it official that there was a redemption of Treasury bonds during the LSAP years. On December 29, 2008 the Fed began QE1, and after a combined total $2.4T of Treasury bond buybacks, the Fed ended QE3 on September 24, 2014. Now let’s step back from the picture and take another look at what happened. Prior to the 2008 credit crisis, one arm of the federal gov’t (the Treasury department) sold $2.4T in Treasury bonds, and then after the crisis another arm (the Federal Reserve Bank) bought them back. Except unlike any regular Joe Blow who buys back his own IOUs, instead of ripping them up, the federal gov’t didn’t rip them up. The federal gov’t put those IOUs, their own IOUs, in their own pocket. Then the federal gov’t started making semi-annual interest payments to itself, from itself, on all $2.4T of these Treasury bonds, on its own IOUs (and still does to this day). The point is, that all those Treasury bonds could have been declared ‘paid off’ the day Ben Bernanke created dollars (‘reserves’) and credited the sellers of those bonds long ago, but the Fed didn’t do that.
The difference between Chairman Ben Bernanke and Joe Blow was that Ben did not have the authority from Congress to pay those bonds off. The Fed is only a ‘swap’ desk. Just like any other bank, the Fed can only create dollars in a swap of assets. The Congress is the ‘outright’ desk. Only Congress can allow any action (creation or destruction of dollars) that would outright change the cumulative count of previously authorized deficit spending (the ‘national debt’). The Fed cannot usurp the ‘power of the purse’ from Congress. Hence the Fed impounding the bonds during LSAP on the Fed’s balance sheet for a future unwinding (another swap that is ‘printing’ bonds back into the secondary market and simultaneously ‘unprinting’ dollars). So in reality a QR would just be the Fed going through the formality of getting permission to formally declare that the bonds were already redeemed.
If QR was done and the Fed redeems (debits) the Treasury bonds, there must be an equal and opposite ledger entry (credit) to replace them. In other words, something must replace these Fed assets (‘balance sheet repair’). Congress could authorize the Treasury to mint a $2.4T coin to be transferred to the Fed. Again, this would not be anything exotic nor unprecedented (The Gold Reserve Act of 1934 authorized the Fed to transfer all of its gold to the Treasury in exchange for gold certificates denominated in dollars). This would effectively replace the Treasury bonds (dollars with a coupon and a specific maturity date) with a coin (dollars without a coupon and a perpetual maturity date) without needing to create and enter dollars into the banking system (it was already done).
Here’s the best part. This QR, this redemption, this removal of $2.4T of previous ‘Debt Held By The Public’ will mark down the national debt from approx $20T to $18T, a TWELVE PERCENT DECREASE, not a bad day’s work. Furthermore, this partial removal of federal debt at the same time removes that financial specter which would give more fiscal policymakers the latitude to spend (and give more Americans the confidence to spend). Just the initial news leaks of this QR even being considered would encourage fiscal policy makers to quickly enact productive, counter-cyclical measures to boost the economy and get back to ‘serving the common good’ for a change (QR is a fiscal policyMAKER stimulus).
QR helps the Fed speed up the process of returning the Fed to business as usual (‘normalization’). After QR the Fed’s balance sheet no longer has all these Treasury bonds that were put there as a result of the credit crisis. This would be a dramatic signal that the US central bank is closer to being back to pre-crisis conditions, an important optic that helps assuage consumer concerns. As Ben Bernanke suggested in his BOJ speech, this QR, this ‘coordination’, between Congress and the Fed, would compliment future rate hikes and continued jawboning from Fed Chair Janet Yellen as per her March 15, 2017 statement that “the simple message is that the economy is doing well.”
Another point, that Treasury General Funds Account (GFA), where all federal spending is drawn (debited) from, that becomes overdrawn if federal gov’t spending exceeds taxes, which must be replenished (credited) with Treasury bond sales (which increases the national ‘debt’), that’s yet another bonus of doing a QR. Deficit spending was about $0.5T in FY16, so that means if you redeem $2.4T of the so-called national ‘debt’ in a QR anytime soon, that’s at least another four years of not hearing about the (nonsensical) ‘debt ceiling.’
QR is an idea that could be done quickly. As quickly as the Fed bailed out those banks in 2008. As quickly as the Fed facilitated AIG so they could honor their outstanding trades to Goldman Sachs. As quickly as AIG was made whole so they could send their Financial Products Desk executives on junkets to celebrate still getting bonuses. As quickly as those credit crisis measures back then that helped make some problems of the few go away, policymakers could right now make other problems of the many go away.
If the US did this, perhaps Japan, a country with a national debt of over ONE QUADRILLION yen, might follow suit. In a single day, the BOJ could announce a quantitative redemption amounting to approx 425 trillion yen of Japanese Government Bonds (JGBs) presently held on their balance sheet as of May 20, 2017. That would be an overnight reduction of their national debt of 43%…
Which would get people around the world thinking that the big bad national ‘debt’ problem might not be such a big bad problem after all (What MMTers have been saying all along)…
Thanks for reading,
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H/T ‘Bonds & Battleships’ graph by CHRIS BROWN
P.S. In March 2016, I ran this ‘QR’ idea by Narayana Kocherlakota (the 12th president of the Minneapolis Federal Reserve Bank) and he said “I’m skeptical.”
He was concerned that the Fed losing the interest income from the $2T of Treasury bonds held on their balance sheet would mean they couldn’t ‘fund’ themselves and the Fed would fall into ‘debt’.
“Would this make the Fed less willing to raise rates and more willing to tolerate potential inflation? Maybe – but, as I say, I’m skeptical,” he added.
Central Bank’s Balance Sheet to GDP as of November 2018:
Swiss National Bank 125%
Bank of Japan 100%
Federal Reserve Bank 20%
Bank of England 20%
On January 1, 1835, Andrew Jackson, the founder of the Democratic Party, paid off the entire US national debt.
However, as most MMTers know, running federal budget surpluses, like President Jackson did, is asking for economic trouble.
Similar to a private sector ‘deleveraging’ of debt (‘destroying’ of dollars) which can create a ‘paradox of thrift’, it can also trigger a full-blown ‘deflationary spiral’. So it’s never a good idea for the federal gov’t to pay down debt (to ‘destroy’ dollars)—unless federal policymakers intentionally want to slow the economy.
That’s why it isn’t a coincidence that all six depressions in US history, including The Panic of 1837, were preceded (were started) by sustained federal budget surpluses that decreased debt. Furthermore, it also isn’t a coincidence that the 2008 Great Recession and those six depressions were succeeded (were ended) by sustained federal budget deficits that increased debt.
This QR idea is another way to pay down the federal debt without needing to run a budget surplus (without using a single dime of tax dollars).
If alive today the 7th President of the United States would love this.
“It’s a great idea if they can legally do this, but the only problem with a ‘QR’—with saying that federal spending during a QE is ‘full-blown pure MMT’—it that QE only changed the form of $2.2T of those bank’s dollars. QE only swapped the asset composition of private bank’s $$$ (from $$$ with a coupon rate in a ‘securities’ account at the Fed, to $$$ without a coupon rate in a ‘reserve’ account at the Fed). After a ‘QR’ (after we start saying it’s pure MMT), the supply of money does not change (the dollars are still being supplied into the banking system same as before). Thus more of the same asset-price inflation—’by accounting identity’ ‘to the penny’—that we are experiencing now, would still occur in a full-blown MMT World. The liability of newly-created dollars by the federal gov’t will always remain (whether the word ‘debt’ is removed or not). The only thing that matters to an economy is the supply of currency (‘Debt’) vs productivity (to GDP). If we did a complete ‘QR’, (if we converted all $22 trillion of National ‘Debt’ from bonds to cash), that will only accomplish one thing, which is fooling the average Joe on the street into thinking that now the federal gov’t can spend any amount of money on any of the ‘populist’ ideas that we are now hearing from political ‘prescription’ MMTers. The average Joe being most of us, who are the borrowers (unlike the few of us, the 5%, who are the savers). Meaning that the liability of the newly-created cash that is financing federal spending will still remain WITH THE 95% when the currency devalues after these radical ‘prescriptions’ take effect. During a ‘QR’ you would be redeeming Treasury bonds and removing the word ‘debt’—while the bond market is still setting long-term US interest rates and while the foreign exchange market is still setting US currency rates? The supply of money will not change. The liability for the 95% always remains. Playing word games will not stop a sell-off of federal bonds nor a devaluation of a sovereign currency. Same as in a pure MMT world or not, it doesn’t matter…UNTIL IT DOES.”—Jim ‘MINETHIS1’ Boukis
AGREED MINETHIS1…No matter how it’s financed (cash or bond), in order to avoid throwing out the ‘productive’ baby out with the bathwater, federal spending always needs to be ‘disciplined’.