Reducing the Deficit: Should the Fed Monetize the Federal Debt?

Desperate times call for desperate measures.  We've seen yet another dysfunctional mess from the political process, and have to think expansively.

The recent fiscal cliff deal was largely a failure.  It raised taxes on most Americans, while doing virtually nothing to reduce federal spending.  While income taxes were not increased for the middle class, Social Security taxes were increased for all workers at all income levels.  The well-off (the $400,000 plus crowd) face a higher income tax rate of 39.6% (20% on qualified dividends and capital gains) and wealthy dead people now pay a 40% tax rate (instead of 35%) on the portions of their estates exceeding $5 million ($10 million for married couples).  The automatic spending cuts required by the cliff were deferred for two months (except for $24 billion in cuts that do go into effect), so spending largely continues apace.  Presumably, there will be a second face off over spending cuts when the President asks Congress to increase the debt ceiling in the next few weeks (even though the White House insists it won't negotiate over the debt ceiling).

One thing to take away from the cliff deal is that spending cuts are really hard to agree on--so hard that the Dems and Republicans simply kicked the can down the road.  But they will be even harder to agree on two months from now.  The Republicans have lost significant leverage by agreeing to tax increases now.  The tax side of the fiscal cliff has been resolved, more or less favorably to the Democrats (although some liberal Dems are still unhappy).  What incentive do the Dems, who control the Senate, now have to agree to spending cuts?  Of course, the Dems would agree to some spending cuts (the defense budget would be their target number one).  But Republicans are focused on hurting core constituencies of the Democratic Party through Social Security, Medicare and Medicaid cuts.  With the Dems having largely won on the tax issues, they have little reason to make concessions on the social safety net.  Even if the President is willing to give the Republicans some of what they want (which he seems to be), he may have a problem in the Senate, where Social Security, Medicare and Medicaid were stoutly ring-fenced and defended during the fiscal cliff talks.

Realistically speaking, we shouldn't expect our dysfunctional elected government to find grand solutions to the fiscal deficits.  Due to a variety of bad and intractable political dynamics, that simply won't happen.  We have to look elsewhere for solutions.

The next logical candidate to get the hot potato would be the Fed.  The central bank has played a central role in combating the Great Recession, not without some success.  In the course of its massive quantitative easing programs, it's accumulated a balance sheet of close to $3 trillion.  This total is likely to grow as the Fed continues to purchase debt on the open markets.  Slightly over half of the balance sheet consists of U.S. Treasury securities.  Total federal debt is about $16 trillion.  Thus, the Fed holds about 10% of all federal debt.

Why not have the Fed simply forgive some or even all of the U.S. Treasury debt it holds?  In other words, it would declare that the Treasury wouldn't be required to pay the debt.  That, by definition, would reduce the federal deficit by reducing the amount of federal debt outstanding.  And it's what happens anyway.  When the Fed receives debt payments from the Treasury (usually consisting of interest payments), it simply remits those funds back to the Treasury Dept. (except for a small amount retained to finance the Fed's budget).  Debt forgiveness by the Fed would simply expand on what happens in the ordinary course.   

Of course, such debt forgiveness would be tantamount to monetizing the debt, and has the potential to be inflationary.  But precisely what the heck do we think is going on now?  When the Fed launches repeated quantitative easing programs, with ever more asset purchases but not the tiniest hint of when, if ever, it would unwind its Brontosaurian balance sheet, it has functionally monetized the debt.  With the economy expected to be a sick puppy for years, reality is the Fed may hold a lot of its current inventory of U.S. Treasury securities until they mature.  When they mature, it will remit the principal payment it receives from the Treasury back to the Treasury (or use the funds to make more open market purchases of Treasury securities).  The federal debt has been monetized, even though no one on the government's payroll is going to admit it. 

Such debt forgiveness wouldn't fully resolve all the deficit problems.  But it could reduce the scope of the crisis, and would amount to little more than accurately accounting for what is actually going on.  If inflation flared, the Fed could suspend debt forgiveness and raise short term interest rates, combating inflation as it traditionally would.  But as long as inflation is subdued, debt forgiveness could contribute to resolving a problem that politicians clearly won't be able to solve, at least not comprehensively.

Ultimately, the best solution to the deficit problem is to boost economic growth.  Greater growth means higher employment levels and more income and corporate profits to be taxed.  If the economy were growing briskly and unemployment were around 5%, we probably wouldn't feel we have a deficit crisis.  Housing seems to be stabilizing, although its long term prospects remain clouded.  So we can't count on housing to be the engine for growth.  Measures the government could take include:  (a) rebuilding infrastructure--this is something the government has historically done well, and should do more of given the crumbling state of our infrastructure; (b) loosen up immigration restrictions for well-educated people and people who can invest substantial capital in America to create jobs--we need more innovators and entrepreneurs; (c) improve education, not by handing out loans to anyone who has a pulse and a signature (there's way too much student debt already, and it will be the next big debt bubble), but with measures to make education more efficient and inexpensive, like expanding Internet-based educational programs.  Achieving greater economic growth will take time, but it's a lot easier than trying to use the political process to agree on budget cuts. 

Over the Fiscal Cliff and Through the Woods

Over the cliff and through the woods,
To a grand recession we go.
Congress knows the way to waste its last day,
raising taxes and adding woe.

Over the cliff and through the woods,
To a grand recession we go.
The Fed is on deck, printing money like heck,
Investors are losing dough.

Over the cliff and through the woods,
To a grand recession we go.
The Dems go their way to make the rich pay,
Republicans say no no.

Over the cliff and through the woods,
To a grand recession we go.
Where the deficit shrinks, while the jobless drink,
Eating cake is for the po'.

Happy New Year.

The Fiscal Cliff Negotiations: Just Who Is Barack Obama?

Recent negotiations over the fiscal cliff, which seem to be faltering after initial signs of progress, raise a persistent question about Barack Obama:  has he any political principles?  After campaigning this fall to protect the poor and middle class, he agreed in fiscal cliff negotiations to changes to the income tax structure and Social Security that are more damaging to the poor and middle class than the prosperous segments of American society.  By accepting Republican demands for the Social Security inflation adjustment to be the Chained Consumer Price Index, Obama has effectively reduced inflation protection for Social Security recipients, military retirees and federal civilian retirees, the vast majority of whom are low or middle income.  At the same time, because the same inflation adjustment would be made to income tax brackets, the brackets would rise more slowly during inflationary times.  That would effectively result in heavier taxation across the board, a seemingly regressive result.  Additionally, Obama agreed to raise the threshold for higher tax brackets from his original position of $250,000 to $400,000.  To be cynical, this might be viewed as a gift to the upper middle class professionals who often are his supporters and contributors.  And to be more cynical, it can be observed that many lower income folks, especially older whites heavily reliant on Social Security and/or military pensions, tend to be Republican more often than Democrat.  Perhaps the President sees little to lose in imposing austerity on them.

One wonders if Obama, after four years of dealing with the Great Recession, understands even the basic structure of the U.S. economy.  Our economy is 70% consumption.  Money in the hands of the poor and middle class gets spent.  They don't have enough to save hardly a penny.  This spending stimulates the economy.  Money in the hands of the upper middle and upper classes is frequently saved, allowing the rich to get richer relative to other income categories.  By raising taxes on the poor and middle class while cutting benefits to Social Security recipients, and military and federal civilian retirees, the President is reducing consumption and its stimulative impact on the economy, while exacerbating the inequality in wealth distribution.  What policy sense does this make?

During his first term, Obama demonstrated time and time again at critical junctures that he is a clever politician and dealmaker much more than a leader.  He craftily co-opted his most serious Democratic rival, Hillary Clinton, by making her secretary of state.  And he kept the liberal wing of the Democratic Party at bay by putting one of their number, Joe Biden, in the Vice President's residence.  But he has few loyal constituencies.  His one signal achievement, the Affordable Care Act, may transform life in America.  But transformational legislation doesn't necessarily bestow greatness on a President.  Lyndon Johnson's Great Society programs transformed America far more than anything Barack Obama has done or will do.  Indeed, the Voting Rights Act of 1965 enfranchised black and other disadvantaged Americans, paving the way for Obama to win the White House.  But Johnson has been denied the mantel of greatness.  While this is due in large part to his foreign policy catastrophe in Vietnam, it's also because Johnson, like Obama, was a consummate politician without any large loyal constituencies.  There's no one running around singing Johnson's praises.  Obama will always be remembered as the first nonwhite President, and there's a measure of greatness in that.  But John Kennedy was America's first non-Protestant President, and in 1960 that was an achievement not far from Obama's achievement in 2008.  Kennedy is remembered today for his charisma and charm.  But he doesn't rank among the great Presidents.  And, because Obama seems to value a deal more than principles or loyalty to constituents, neither will he. 

Will Stocks Drop Over the Cliff?

The stock market has been eerily calm in spite of all the sturm und drang over the fiscal cliff.  After a brief sell-off following President Obama's re-election, the Dow Jones Industrial Average has treaded water right around the 13,000 mark.  Evidently, the market believes the anonymously leaked assurances from both the Republican and Democratic sides that a deal on the fiscal cliff will be reached.  And, rationally speaking, that should happen.  So maybe the market is justified in its equanimity.

But is it?  Looking back at the most recent comparable instance of fiscal dysfunction, the 2011 debt ceiling scrum, we find that "resolution" of the political problem was followed by a drop in the market.

The debt ceiling fight simmered until June and July 2011, when all hell broke loose and records were set for political dysfunction in Washington.  Only at the last minute, on August 2, 2011, was a deal to lift the debt ceiling finalized and approved by Congress.  The Dow, which floated around in the 12,000s during July, fell below 11,000 within a week.  One might have thought that resolution of the debt ceiling battle would produce a market rally.  But, no, just the reverse happened.

The debt ceiling fight revealed the depths of America's political dysfunction.  Standard & Poor's cut America's credit rating on August 5, 2011.  The future looked, if anything, more uncertain than before the debt ceiling crisis.  The resolution to the debt ceiling problem was to kick the can down the road, and defer confronting the government's tax and spending issues until after the November 2012 elections.  Stalling and delaying isn't the kind of thing to inspire investors.  The market's frothiness before the deal and its drop after the deal seemed like a classic case of buy on the rumor and sell on the news.

Well, that may be where we are headed today.  There are plenty of nice sounding rumors being floated by politicians who have plenty of incentive to shade the truth.  Reality is that whatever compromise the Republicans and Democrats reach on the fiscal cliff will surely be ugly.  The pie is too small to be apportioned in a way that will make many, if any, happy.  With the "resolution" to the fiscal cliff likely to make most of the nation grumpy, stocks aren't likely to be exuberant.  Whatever you do, don't bet on politics to produce investment gains.

Political Risks of the Fiscal Cliff

Who faces the greatest political risks from the fiscal cliff?  It ain't the Democrats.  They could do nothing, and watch the pre-Bush tax rates go back into effect in 2013.  While this would have a near term negative impact on consumer spending, it would lower the federal deficit.  That would promote long term economic growth.  The President would take some heat for the economic slowdown, but the Democrats would have four years to recover before facing the 2016 Presidential election.  By then, the economy might well be improving.

If there is a deal on the fiscal cliff, it would probably include some cuts to Medicare and Medicaid, and perhaps to Social Security (although the latter is less likely, since Social Security is actually much less of a fiscal problem and more visible to the voting public).  The Democrats would blame these cuts on Republican insistence (of which there is plenty).  Meanwhile, the Democrats would take credit for whatever tax increases or enhancements or whatever else would be part of the deal, which probably would fall more heavily on the rich than the 99%.

The Republican insistence on no tax rate increases allows President Obama to replay his winning electoral strategy of advocating tax increases for the rich.  Republicans believe too much in their own P.R., that all taxes increases are invariably bad and that spending cuts would somehow be made to prevent taxes from increasing.  A majority of the electorate thinks otherwise, and the Republicans conceded these voters (let's call them the 51%) to President Obama. 

 The baseline problem with the Bush tax cuts is that they reduce federal revenues to the point where Social Security and Medicare--the two most sacred bovines of American politics--are imperiled.  It's one thing to attack federal funding of bridges leading to nowhere.  It's another to take away bread and butter from the elderly.  Republicans have managed to put themselves in a corner where they seek to protect low taxes for the wealthy while trying to squeeze pensioners having modest incomes.  They ultimately can't protect the wealthy from a tax increase--the Democrats can do nothing and those increases will take effect at midnight, Jan. 1, 2013.  But the Republicans can manage to look like Scrooge during the Christmas season as they advocate cuts for moderate income retirees.  Politically, it won't be the Democrats who tumble over the fiscal cliff.