Interest rates balance the supply and demand for financial assets. Households and firms that save some of their incomes demand financial assets. Households and firms that borrow to invest in productive capital or for whatever reason supply those assets (mortgages, bonds, etc.). Rates on longer term assets reflect the expected value of the short-term rates over that period. Thus the interest rate on a ten year bond reflects the expected value of one year bills over the ten year period plus a small risk premium because the string of short term loans are an alternative to the single fixed rate ten year loan.
The policy interest rate of the Federal Reserve is set by the Fed to pursue its objective of stable money (defined by the Fed as 2% inflation) and high employment (the Fed’s dual mandate imposed by Congress).
This note reviews the Fed’s policy rate. Since 2008 the Fed’s policy rate has been the rate it pays banks for the money they keep on deposit with a Federal Reserve Bank (of which there are twelve but that is unimportant for understanding the role of the policy rate), which on Aug 6 amounted to $3,332 billion. This rate is known as the Interest on Reserve Balances (IORB).
If the IORB matches comparable market rates for equally liquid funds (the so-called neutral rate), banks will maintain their existing Fed deposits. If it is set above that level, banks will have a financial incentive to place more money with the Fed, i.e. lend less in the market, thus creating fewer deposits and reducing the money supply. If the IORB is set lower than the neutral rate, banks will draw down their Fed deposits to lend more in the market thus increasing deposits and the money supply.
The IORB is currently (Aug 6) 4.5%, where it has remained since Dec 2024. At this rate broad money (M2=bank demand, time and savings deposits) has grown between 4% and 5% (from a year earlier) over the last three months. Given that inflation remains above the Fed’s target of 2% it would not seem wise to lower the policy rate and increase the rate of monetary growth especially as higher tariffs go into effect.
To repeat from earlier blogs (because it is so important), if markets anticipate higher inflation in the future (next few years), market interest rates on longer term debt will increase to preserve their real (inflation adjusted) value. Lowering the Fed’s policy rate prematurely would increase the market’s anticipation of higher inflation rates in the future. In other word, lowering the IORB now is likely to increase interest rates on longer term debt. Leave the Fed alone to do its job as best it can.
A trade deficit is the difference between what we buy from the rest of the world and what it buys from us. To that extent rather than buying our goods and services, the rest of the world holds our dollars. These dollars are most often held in the form of US securities (Treasury bonds, etc.). Though trade deficits help finance Uncle Sam’s spending that is not financed with tax revenue, and thus reduce the crowding out of domestic investment by government deficit spending, President Trump doesn’t like them. Our trade deficit in 2024 was $918 billion.
Trade deficits can be reduced by reducing our imports (this is what tariffs tend to do) and/or by increasing our exports. We export many things including food and oil. Tourism and foreign students studying in the US generate about 9% of our export revenue. This has dropped sharply this year as the Trump administration has blocked or discouraged foreign students and badly treated other visitors, denying entry to some. It has suspended entry of new foreign students to Harvard and is threatening to revoke existing student visas at Harvard.
Trump has not only reached into the affairs of Harvard (and those of many other “enemies”), he is also demanding that the US dollar surpluses held by our trading partners be invested as dictated by the Trump administration. This was stated explicitly by US Treasury Secretary Bessent in an interview by Larry Kudlow on Fox Business. https://www.youtube.com/watch?v=IgcmRJpE1pc
It is hard to see much free market here. Gregg Ip nails it in his recent WSJ article “The U.S. Marches Toward State Capitalism With American Characteristics”https://x.com/greg_ip?lang=en
Newspapers are full of articles about the deaths or other losses that will result from proposed budget cuts. Today’s Washington Post, for example, headlined a story on USAID cuts “USAID cuts may cause 14 million more deaths in next five years, study says” “Washington post /2025/07/01/”
If the government’s spending on X is reduced (aside from any improvement in efficiency) the benefits of that spending will be lost. But our resources are limited. If we spend more on X we have less to spend on Y. So when we lament the losses from reduced spending on X we should take account of the gain from the increased spending on other things.
To put a bit of flesh on this issue, consider the following: “The administration has cut more than a hundred contracts and grants from the President’s Emergency Plan for AIDS Relief, the HIV and AIDS program credited with saving millions of lives in poor countries. President Donald Trump has shut down the agency that signed off on most PEPFAR spending and fired other staffers who supported it.” “Rubio-pepfar-aids”
Evaluating whether this cut is “good or bad” is not easy because determining the likely alternative use of the money saved is not easy. If we stick to a fixed government budget total, the alternative use by the government of the money saved might save even more lives (or maybe not). But the saving could also be given to tax payers whose use of that money would reflect their own personal needs and priorities.
The process used by Elon Musk’s DOGE to arrive at the spending and/or personnel cuts they proposed was not transparent thus is largely unknown to us. But I have serious doubts that it was appropriate. Semafor offers the following advice:
“A lot of US government work is highly inefficient, says the science reformer Stuart Buck. Federally funded scientists say they spend 44% of their research time on bureaucracy, federal procurement is “broken” and often results in the government buying products that don’t work, and “the Paperwork Reduction Act paradoxically results in endless paperwork.” “Many such cases,” says Buck. “We should have an official effort to address these issues… We could even call it a ‘Department of Government Efficiency.’” As you might be aware, there is one: It is “widely viewed as a failure,” but the basic idea is sound. How could we make it good?
“The first step, says Buck, would be taking a long time to deeply understand how each government agency works, so you don’t mistake routine human error or some statistical artifact for fraud. Second, it should focus on high-value reforms, like outdated data systems or software. Third, it should learn from previous attempts to cut red tape — because there have been many, not all of which worked. And importantly, a good DOGE would not mistake things we don’t use for “waste” — like an insurance policy, we hope pandemic preparedness infrastructure and fire departments are never used, but they’re in place in case we need them. The real-world DOGE is a failure, says Buck, because it ignored all of these strictures.” “Semafor.com/newsletter/06/30/2025/”
I think some, if not many, government programs or activities should be reformed or eliminated. But those the public really want must be paid for by the public paying additional taxes or lending to the government (buying US bonds). U.S. debt is dangerously high (123% of US GDP) and continuing to grow. So to the extend spending is not reduced, taxes should be raised.
If no changes are made to the Social Security law: “Starting in 2034… Social Security will only have enough money to pay 79% of its promised benefits.” “Day of reckoning for Social Security draws closer” The system promises a given pension upon retirement (a defined benefit) that is financed by a given payroll tax. It is not a pool of saving that is drown down at retirement. It is pay as you go. “Saving Social Security”.
This financial problem results from the fact that Americans are living longer and thus receive their SS pension for more years if there is no change in the retirement age. Moreover, the growth in the population has slowed so that the ratio of workers (i.e. those paying the tax financing the pensions of the retired) to retirees has fallen from approximately 3.3 in 1970 to 2.9 in 2020. It is projected to fall further to 2.0 by 2030.
The system must and will change, the only question is how. Legal immigration could be increased to increase the number of workers. The wage tax could be increased. Retirement age could be increased (20% voluntarily work after retirement already). As people live longer many choose to work longer for more than just the extra income. Pension benefits could be indexed to inflation rather than to wage growth (which has been greater than inflation). But more recently I have proposed replacing Social Security and other safety net programs with a Universal Basic Income for every man, woman and child without exception. Such a remake of our social safety net would have several very good features. “Replacing Social Security with a Universal Basic Income”
America has a labor shortage. We need to widen the door to legal immigration and patrol our borders against illegal immigration and drug smuggling more effectively. The Biden administration has requested several billion dollars for that purpose and Congress should approve it. But how should it be paid for. “Congress funding of border control”
Every person and every country’s resources are limited. Their use for one thing means that they are not available to be used for something else. Budgets reflect our choices—our priorities. Increasing our border security would save tens of thousands of lives a year from reduced drug smuggling alone.
I suggest that we close our military bases in Europe and apply the money saved to increased border security and deficit reduction (sadly it would not be enough to reduce our debt only the deficit –i.e., the annual increase in debt). Our European bases cost $24.4 billion in 2018 (the latest figure I could find and with our support for the war in Ukraine it could only have increased). Our EU basses save no lives and add nothing to our security. They largely reduce the incentive for EU countries to provide for their own defense. But our immigration policy and border controls are a mess and should be improved.
CNN reported today on the compromise bill to raise the Federal debt ceiling agreed between Biden and McCarty, saying that:” The Congressional Budget Office estimates the bill would reduce budget deficits by $1.5 trillion over the next 10 years, and reduce discretionary spending by a projected $1.3 trillion from 2024 to 2033.”
Language can be tricky. Debt and deficit are not the same. Reducing projected spending need not mean a reduction in actual spending. In fact, the package agree to by Biden and McCarthy will continue to increase the Federal debt (though at a slower rate than was proposed initially by Biden) and all categories of spending will continue to grow. Not only will they continue to grow, they will be growing from the abnormally high levels reached during the COVID pandemic.
If we really want all of these expenditures, we should, and will ultimately need to, raise taxes to pay for them. But do all of them pass the cost benefit test? Do all of them contribute to American wellbeing?
One Republican blind spot is defense spending (which, by the way does not include foreign aid to, for example, Ukraine). The defense budget for 2023 is 9.8% higher than in 2022 and is projected in the Biden/McCarthy package to continue to grow over the next two years covered by that deal. Our huge defense budget has resulted from (or encouraged?) American military adventurism that does not contribute to our security.
What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.
It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).
The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.
The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)? “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”
Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset. When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).
The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.
The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years. See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”
Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits. Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.
The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?
Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”
When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available. The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”
Prices of many goods and services have increased in recent months. Are these increases permanent or temporary or will they continue rising in the future? Before exploring those questions, it is important to understand the measures of inflation we are considering. What is the current rate of inflation in the United States? U.S. inflation in September was 3.0% (Compound annual rate of change for Consumer Price Index without food and energy prices over the month of September), or 4.0% (percent change from a year ago) or 5.4% (percent change from a year ago including food and energy prices). What does it mean if this is temporary or long lasting?
If prices remain where they are today after the 5.4% increase from a year ago, inflation going forward would be zero even though the cost of living would be permanently higher. If inflation is long lasting it means that prices will continue to rise for some time (years). What are the factors that influence the future behavior of prices? What should we expect in the U.S.?
The price of a good or service increases when its demand exceeds its supply and similarly for prices in general (when aggregate demand exceeds aggregate supply). As prices are measured in a country’s currency, supplying too much of the currency (generally when the money supply grows more rapidly than the supply of goods and services) causes its value to fall (i.e., prices in the country’s currency to rise).
On the cost side, firms will hire workers and pay them a particular wage (and related benefits) when it adds more to the company’s income than it costs, which includes the cost of the tools they use (capital). Workers will accept a job when its benefits (pecuniary and nonpecuniary) are the best they can find. The inflation expected by the employer and the employee over the period of the wage contract is an important factor in determining what will be offered and what will be accepted.
Because of changes in consumer demands, worker preferences, halving of work visas for immigrants, and supply chain disruptions, labor markets are temporarily in turmoil. September unemployment in the U.S. was 7.674 million while there were 10.4 million job vacancies. Employers are raising wages in an effort to fill those vacancies. As reported by Scott Lincicome: “Goldman Sachs analysts saw a ‘perfect storm of factors that have significantly reduced the supply of workers who are currently looking for jobs at the same time that labor demand—as measured by job openings—has risen to an all-time high.’ This includes… state and federal benefits, early retirements, severely restricted immigration, a switch to self-employment, fear of COVID, and a geographic mismatch between unemployed workers and available jobs. Combined, these factors account for most of the missing workers out there.” “What if the labor shortage isn’t transitory?”
In short, the labor force has shrunk just as the demand for output is increasing. This excess demand for workers is driving up labor costs and thus pushing up output prices. If the 5 or 6 percent price increase experienced over the present year is expected to be temporary, i.e., if prices are expected to return to their level a year ago, because the supply of labor returns to its pre-pandemic level, wage increases should be temporary as well, falling back to their pre pandemic level and growing thereafter on average with labor productivity plus the 2% inflation target of the central bank once there is full employment and better labor market balance.
More likely, if the inflation is expected to be temporary, i.e., the current 5 to 6 percent inflation stops but prices remain at their increased level, wages will remain at the increased level, but their real (inflation adjusted) value will fall back to their original level. In other words, if these higher prices are expected to be “permanent,” the nominal wage increases now being experienced will not result in any increase in real wages and the worker short fall might remain.
While some of those who withdrew from the labor force will probably return, it is not likely to fully satisfy the demand for various reasons (early retirement, fall in immigration, etc.). Filling (or attempting to fill) the remaining labor shortage will require additional wage increases (unless the public’s demand for goods and services falls–see below). In that case, firms will plan to pass on their higher cost of labor to their customers. If we, the customers, can continue to pay the higher prices, the inflation will continue. Expectations of higher prices and or inflation will be realized.
The Covid-19 pandemic caused a sharp fall in output and thus to most people’s incomes. The government provided extraordinary financial support to temporarily fill the resulting income gap. Such support did not increase the output of goods and services or even prevent their decline but rather temporarily redistributed income from those saving it to avoid hunger and defaults on rents, mortgages, and other financial obligations by those who lost it. “The new covid-19 support bill” Because personal incomes were substantially maintained while actual output fell, personal savings rates increased dramatically and continue to be well above pre pandemic levels.
The Federal Reserve pitched in by buying up huge amounts of the resulting government debt increasing its balance sheet from $3.5 trillion in February 2020 to $6.3 trillion in August 2021 (measured by the monetary base, M0). This fueled an increase in board money (M3–M0 plus bank deposits and similar liquid assets of the public) from $15.5.0 trillion in February 2020 to $20.8 trillion in August 2021. This increase, though substantial, was significantly less than the increase in M0 (which almost doubled) because the Fed paid interest to banks for keeping the new base money with the Fed (excess reserves) rather than lending it to the public, by paying banks interest on all bank reserves kept with the central bank.
Historical experience is that the public will not be willing to hold these larger amounts of money for ever. They will eventually attempt to spend them down to their traditional (normal) levels, thus adding to aggregate demand for goods and services (and inflationary pressure).
Eventually, the demand for goods and services (aggregate demand) must fall to match real output, or output must rise to match demand. But if the Federal Reserve continues to print money faster than its real value is being inflated away, the inflationary process will continue or accelerate. Similarly, if the government continues to redistribute income from those with a lower propensity to consume (generally higher income families with a higher savings rate) to those with a higher propensity to consume (generally lower income families that save little), aggregate demand will remain excessive perpetuating inflation.
Historically, hyperinflation episodes invariably exploded in the collapse of the currency. “Hyperinflation in Zimbabwe” Turkey has come closest to a high inflation “equilibrium.” From the mid 1980s to the end of the 1990s Turkey’s inflation rate varied between 80 and a 120 percent. A high inflation “equilibrium” would be characterized by nominal interest rates and wage rates that fully incorporate the ongoing expected rate of inflation in order to preserve the appropriate real (inflation adjusted) rates. Interest rates in Turkey in this period generally exceeded 100%, as did wage growth.
In its most recent World Economic Outlook, the International Monetary Fund stated that: “In settings where inflation is rising amid still-subdued employment rates and risks of expectations de-anchoring are becoming concrete, monetary policy may need to be tightened to get ahead of price pressures, even if that delays the employment recovery.” “World Economic Outlook-October 2021”
As stands out clearly from the increasingly but unevenly rising inflation in the 1970, the process of increasing inflation is not linear (see the chart above). As inflation increased, the Federal Reserve tightened monetary policy (raised interest rates to slow monetary growth) to slow inflation, causing real output to slow or decline. Policy then eased prematurely, and inflation and the expectation of higher inflation took off again, each time reaching a higher peak (until Paul Volcker stepped on the breaks and ended the game in 1979-80–the exciting year I worked at the Federal Reserve Board).
The Federal Reserve is smarter today than it was in the 1970s and has the tools to prevent the acceleration of inflation and the unhinging of inflation expectation. But the excess money balances and personal saving are very large and the government’s seeming willingness to run up unprecedented deficits create a powerful inflationary head wind. The tightening of monetary policy that will be needed (sooner rather than later in my view) will reduce the Fed’s purchases of Treasury debt and increase interest rates. Higher interest rates will increase government spending for debt service on its very large stock of debt, which will further increase government borrowing and debt or require cuts in spending for other programs. This must be added to the economic challenges of confronting climate change, the continuing recovery and adjustments from the Covid-19 pandemic, the deepening and destructive partisan divide that is stifling Congress, and the growing lack of public trust that drives it.
Whether our current inflation is temporary or longer lasting depends on how quickly and decisively the Federal Reserve tightens monetary policy and how quickly people go back to work. Whether the U.S. economy and the government’s large stock of debt continue to enjoy safe haven status around the world depends heavily on whether our government brings its spending and tax policies under better control.
Congress has authorized over 2 trillion dollars (so far) to help those harmed by the partial shutdown of the economy undertaken to slow the spread of the SARS-CoV-2 virus, and to facilitate its rapid recovery when it is safe for people to return to work. The idea is that as the government has requested/mandated non-essential workers to stay home, and non-essential companies (restaurants, theaters, bars, hotels, etc.) have chosen to close temporarily or have been forced to by risk averse customers or government mandates, the government has an obligation to compensate them for their lost income. Above and beyond the requirements of fairness, such financial assistance should help prevent permanent damage to the economy from something that is meant to be a temporary interruption in its operation. No good economic purpose would be served, for example, by lenders foreclosing on mortgage and other loans to workers sheltered in place at home with no income with which to service them. Some of the increased spending quite rightly will go to improve our ability to deal with covid-19 directly (expanded hospital capacity, virus testing capacity, vaccine research and development, etc.)
Obviously, it will be impossible to prevent some amount of waste and corruption from such a huge increase in expenditures. Every rent seeker on the planet has been lobbying Congress to get a piece of the action. In the design of these support programs every effort should be made to carefully target them on the people and activities appropriate to the “above objectives, to remove them and their associated distortions of economic resource allocation when the crisis has passed (i.e., keep them temporary), and to provide watchdog oversight of their implementation. Unfortunately, President Trump is already undermining such oversight. “How-trump-is-sabotaging-the-coronavirus-rescue-plan” Nonetheless, the objective of minimizing the economic damage of a temporary forced shutdown of a significant part of the economy is appropriate.
The question explored here is who will pay for it and how. The entertainment output of the economy (restaurants, movie theaters, hotels, vacation travel) is to a large extent non-essential, at least for a few months. If those are shuttered, about 20 percent (my guess for purposes of this analysis) of our economic output and the incomes of those producing them will be lost for the duration of the shutdown. A central goal of the “Coronavirus Aid, Relief, and. Economic Security Act” (CARES Act) is to prevent this necessary shutdown from killing that part of the economy and from spilling over into others. The goal is to enable it to restart as quickly and easily as health conditions permit. Thus, idled workers who would not be able to pay their rent/mortgage, or electric bill, or buy food without help should not be evicted for temporary nonpayment etc. The government might pay them for their lost income directly (unemployment insurance) or it might pay their employer to continue paying their wages for non-work under one program or another, thus continuing their health insurance and other benefits. These details are important but not the subject of this note. The simplest assumption is that they all receive cash payments sufficient to see them through the shutdown (universal basic income, guaranteed minimum income or whatever you want to call it).
The starting fact/assumption is that the economy’s output and thus income is 20 percent or so lower for the next few months than it was a few months ago. Everyone on average has 20 percent less income, but that average consists of those who continue working as before and those sitting at home earning nothing. If those unemployed are to receive income support (UBI), those still working and those clipping investment coupons must pay for it. Paying an income subsidy to the unemployed does not create income, it redistributes it.
The $2 trillion plus authorized by Congress for these purposes will be debt financed, i.e. the government will borrow the money (adding to its deficit of $1 trillion for 2020 already budgeted). So, to examine who pays for this program we must start by asking who will buy this additional debt? In the past the Chinese and Germans funded an important part of our debts (via their trade surpluses with the US. “Who-pays-uncle-sam’s-deficits” China’s current account surplus with the U.S. is now negligible and it and most every other country in the world will have the financing of their own covid-19 expenditures to worry about. Those purchasing the additional Treasury bonds will thus be largely Americans who must shift their spending from other things (other investments or consumption) to the bonds and thus to the incomes of the unemployed these programs are supposed to be helping. To the extent that new bond buyers are diverting their spending on other financial instruments interest rates on such instruments will tend to rise.
At this point very little money has been disbursed under CARES and no new government bonds to finance it have been issued. As individuals and firms miss rent and debt service payments, their lenders are being squeezed for the funds with which they must service those financing them (this is why we call banks financial intermediaries). Utility companies faced with nonpayments by their customers must borrow to continue paying their own employees, etc. Scrambling for such funds would drive up interest rates in funding markets where it not for the Federal Reserve’s willingness to provide the needed liquidity. Similarly, with regard to the supply of funds to financial markets (the other side of bank’s balance sheets), normal investors are interrupting or even withdrawing funding in order to cover their own income shortfalls. This again squeezes financial sector liquidity and the flow of funds from lenders to borrowers needed to finance the remaining economic activity.
Enter the Federal Reserve. In order to supply the missing funds–the missing rent and debt service payments–needed to keep the financial system flowing and in balance–the Fed has supplied almost $2 trillion to banks over the last 6 weeks, largely by outright purchases of treasury securities, though it has also opened a number of lending facilities. Bank reserve deposits at the Fed increased about $1 trillion over this period and M2 grew by about the same amount. On April 9, the Fed announced that it was opening or expanding facilities to support CARES Act objectives with up to another $2.3 trillion (leveraged by Treasury financial support to cover losses on any Fed loans provided in support of the CARES Act). Federal Reserve Press Releases This includes support for lending by the Small Business Administration (refinancing of SBA loans), the Main Street Lending Program administered by banks, Primary and Secondary Market Corporate Credit Facilities, and the Municipal Liquidity Facility. These are dramatic expansions of Fed credit operations and the details of eligibility of borrowers and of the facilities’ administration are critically important. Ensuring that this massive government intervention in the economy creates the right incentives for a quick rebound in the economy when it can reopen and that these interventions are indeed temporary will be difficult and is very important. But the question I want to address here is whether this monetary financing on such a huge scale will be inflationary.
Simplifying and reviewing, if economic output/income falls by, say 20 percent, and the loss is shared by those working with those temporarily laid off (or idle) by workers lending money to those idled, the Fed need not be involved. However, as is often the case with fiscal policy, it is simply beyond the administrative capacity of the government to launch and coordinate such a redistribution of income quickly and smoothly enough to avoid the disruptions of credit flows described above. Instead, the Fed has printed the money paid to those idled by shuttering 20 percent of the economy. As a result, the idled workers have their regular income (more or less) from newly printed money, and the rest have their regular incomes, but the economy is producing 80 less for them to buy. The “excess” income constitutes the inflationary potential. If this income is voluntarily saved (i.e. a temporary increase in the demand for money), the increased saving would be indirectly financing the spending of the unemployed. It is not unreasonable to expect this to reflect actual behavior for a shutdown of a month or two. But should it drag on for many months the extra saving held in anticipation of a reopening of restaurants and theaters, etc. will seek other consumption outlets and prices will begin to rise.
With luck, the economy will begin to return to “normal” after a few months and the Fed will begin to withdraw its monetary injection as loans and payment delinquencies are paid off from increased output/income. The artificially preserved incomes will increasingly be spent on restored output without significant inflationary consequences.
But the CARES Act provides for the forgiveness of loans by firms that kept or that rehire their workers promptly. As the Fed sells its treasuries back to the public (or allows them to mature without replacing them), the Treasury will be issuing the additional debt needed to fund the $2 trillion plus of CARES Act expenditures, including the forgiveness of debt described above. In short, to avoid the inflationary consequences that would normally flow from the Fed’s massive increase in the money supply, the monetary financing must be replaced with fiscal debt financing. It is hard to see where the money will come from to buy such a large increase debt (some, but not much, will probably come from the foreign financing implicit in an increase in our balance of payments deficits, but the rest of the world is now being saturated with its own debt) without an increase in market interest rates, potentially a significant increase in such interest rates. To the extent that financing remains monetary and pushes up prices, the rising inflation rate will be added to nominal market interest rates compounding the pressure of expanding real debt. The long looming US fiscal debt problem may be near.
During his filibuster leading to last week’s brief government shutdown, Sen. Rand Paul (R-Ky.) stated that: “When Republicans are in power, it seems there is no conservative party…. The hypocrisy hangs in the air and chokes anyone with a sense of decency or intellectual honesty.” He was protesting the compromise two-year budget just passed by the Senate and awaiting passage in the House. This budget, now signed into law by President Trump, adds over $300 billion in additional government spending this year alone on top of the $1 trillion dollar deficit created by the recently passed tax cut. “Why-did-the-GOP-vote-for-a-budget-busting-spending-bill-because-voters-dont-seem-to-care”
A few congressmen reacted with more principle. “’I’m not only a ‘no.’ I’m a ‘hell no,’ ” quipped Rep. Mo Brooks (R-Ala.), one of many members of the Tea Party-aligned Freedom Caucus who left a closed-door meeting of Republicans saying they would vote against the deal.
“It’s a “Christmas tree on steroids,” lamented one of the Freedom Caucus leaders, Rep. Dave Brat (R-Va.).” “Right-revolts-on-budget-deal”
Why should we worry about adding to the public debt? The “deficit” is the shortfall of tax revenue below expenditures in one year. This is now forecast to average about one trillion dollars in each of the next two years. “Bipartisan-budget-act-cements-return-trillion-dollar-deficits”. Each year these annual deficits add to the outstanding U.S. national “debt” currently at $20.6 trillion dollars. Even before the recent tax cuts and last week’s expenditure increases, the Congressional Budget Office projected Federal debt held by the public at $25.5 trillion or 91.5% of GDP by 2027. But that figure omits debt held by the Federal Reserve, Social Security “trust” fund, and other government entities, which must also be serviced and repaid. When these are included as they should be, gross federal debt is projected to be $30.7 trillion or 110% of GDP by 2027 and 150% of GDP in thirty years and climbing. And to repeat, this is before the recent tax cuts and budget increases.
As our economy grows so does the government’s capacity to carry and service (pay the interest on) the debt. But on the basis of existing laws and policies our debt will grow faster than the economy forever. But of course that is impossible. At some point taxes must be increased or expenditures cut, or the government defaults on its debt. In fact the problem is worse than these figures suggest because they fail to include the future taxes or borrowing needed to cover unfunded government liabilities. These are commitments, such as future Social Security pension payments, for which existing financing falls short. For example, Social Security payments already exceed its annual revenue from the wage taxes of current workers and the so-called trust fund will run dry in fifteen years. That will add still more to the deficit and the debt.
Senator Paul was rightly angry that not only was the need to face and correct this untenable future kicked down the road yet again, but the process of doing so was corrupt. Votes were bought by sticking in special tax and spending breaks for the constituents and friends of individual congressmen—the old earmarks by another name. “Budget-deal-retroactively-extend-several-expired-tax-provisions”. While it is true that the bipartisan budget deal wouldn’t have passed without these bribes, it shouldn’t have passed. Instead of draining the swamp the Republicans have joined with the Democrats to feed it. “In-big-reversal-new-trump-budget-will-give-up-on-longtime-republican-goal-of-eliminating-deficit”. And more repulsive is the fact that these are the same Republicans who rallied against spending during the Obama years. This is the hypocrisy Senator Paul lamented.
Congress has failed yet again to prioritize it’s spending to match the resources that taxpayers are willing to pay. The moral corruption of this way of doing business was reestablished and reinforced. As another example of blatant corruption, Presidents have rewarded (paid off) large contributors with Ambassadorships to nice places like London, Paris, and Rome (to name a few) for decades. This is pure corruption for which the country pays with lower quality representation and diplomacy than would be provided by Foreign Service professionals. Unfortunately we have grown used to it and barely notice it. This is dangerous.
All individual government expenditures and programs look worthwhile to at least some people, but at the expense of what? What do taxpayers or investors or other government programs give up to finance them. These are not easy choices and decisions but it is the job of our representatives to make these judgments in the best interests of the country as a whole. That is probably expecting more than they are capable of delivering, but it is their job. Those of you of Generation X, Y and Z will have to pay for this so you are the ones with an incentive to do something about it. We need more Rand Pauls. “The-5-biggest-losers-from-the-2018-budget-deal-are…”
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