No free lunch for government debt
By Scott Sumner
Matt Yglesias has a post advocating fiscal stimulus in the form of checks sent to all Americans. While discussing the bonds that would be issued to finance the increased deficit, Yglesias makes this claim:
The federal government needs to pay interest on the bonds, but that interest becomes Fed profits which are rebated to the Treasury so there’s no actual cost.
Of course, the total federal debt will go up, but the more important “debt held by the public” will not since the extra debt will, by law, be perpetually held by the Fed rather than by the public.
That would be true if the bonds were bought with zero interest currency notes, and the currency notes stayed in circulation forever. Most of the debt, however, will be purchased with interest-bearing bank reserves. This is because a large permanent increase in the stock of zero interest currency would likely cause the Fed to overshoot its 2% inflation target. Maybe not right away, but certainly after the economy recovered and interest rates rose above zero.
So let’s assume that the deficit is financed by issuing Treasury debt, and the Fed buys the debt with interest-bearing bank reserves. In that case, there is not likely to be much Fed profit to offset the interest burden on the Treasury. Yes, the Fed will earn interest on the bonds it purchases, but it will pay interest on the bank reserves that it injects into the economy.
In general, the interest rate on bank reserves is roughly equal to the interest rate on T-bills. While it is usually (but not always) the case that interest rate on bank reserves is below the interest rate on longer-term bonds, that sort of “profit” could be earned simply by shortening the maturity of the Treasury’s outstanding debt. For various reasons, the Treasury prefers to borrow by issuing bonds of a wide range of maturities. If the Fed bought longer-term bonds with bank reserves they would probably earn a profit, but there is risk involved.
It’s also possible that interest rates will stay at zero forever. But in that case there would be no cost in financing the deficit even if the debt were not purchased by the Fed. So money creation does not perform any fiscal miracles.
On the other hand, because the demand for currency rises over time, the Fed earns a certain amount of seignorage from adding to the stock of currency. But that profit (sometimes referred to as the “inflation tax”), occurs regardless of what fiscal policy is doing. And it’s a very small share of GDP, relative to the entire federal budget.
PS. Some might argue that the US should copy Japan’s “zero interest rates forever” policy. But Japan did not achieve that outcome with easy money; they did so by producing ultra-slow NGDP growth, which drove the Japanese natural rate of interest down to zero. People who favor proposals to monetize debt and/or permanently hold interest rates at zero, are generally people who favor expansionary policies regarding aggregate demand. Anyone in that camp should NOT be citing Japan, which among the major economies has the worst performing aggregate demand growth in modern history. That’s why Japanese interest rates are stuck at zero. Nonetheless, I recall seeing a few MMTers cite Japan as an example of a zero interest rate policy.