Tuesday, August 8, 2023

Paper: "Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements"

We have been arguing for the past two years (see also) that the path of least resistance for the central bank would be to do what is known as yield curve control. That concept dates back to WW II, when the Federal Reserve bought the debt issued by the U.S. Treasury, which had the effect of capping rates on longer-term Treasuries. This lasted almost a decade, from 1942 until the Treasury–Federal Reserve Accord in 1951.

Our "path of least resistance" thesis supposes two things: number one, that the government (meaning the Fed and the Treasury) will likely take the easy path in response to a challenge rather than something hard that might have greater long-term benefit. In other words, that the government has a very high discount rate or low pain tolerance. And number two, that printing money - in whatever euphemism you want to use to describe it - would be that easiest path.

In our review of Nick Timiraos' hagiography of Federal Reserve chair Jerome Powell, we observed that Powell has been closely involved in the response to six financial embarrassments or crises, and he has recommended, advised, or chosen the bailout every time. Had he chosen different courses, for example to discourage moral hazard, it would have been at the cost of greater short term pain. But we are aware that Powell's commitment to bailouts has never been tested against conditions of rising inflation. He sure has been talking tough about inflation for the past year. How can we predict what he is actually going to do?

Along comes a paper by an academic economist named Charles Calomiris titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, just published by the Federal Reserve Bank of St Louis. Calomiris is a "system man," a baby boomer economist who went to Yale and got a PhD in economics from Stanford, before being part of a number of think tanks. He has had four commentaries published by the Wall Street Journal in the past year. For all we know, he was in Skull and Bones. The abstract of his article:

As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio. But when exactly will the United States hit the constraint of infeasibility and how exactly will policy adjust to it? This article considers fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. Is it a serious possibility for the United States in the near future? And how might various policies change (especially those related to the banking system) if fiscal dominance became a reality?

What is utterly fascinating about this paper is that he is looking at an impending crisis - the over-indebtedness of the federal government - and reasoning through the possible responses, looking for the easiest one: the path of least resistance. Broadly speaking, he sees three possible choices:

First, reduce fiscal deficits. He confesses that it "may be a hard policy to enact," since the main contributors to the deficit are Medicare, Social Security, and the defense budget. Look at a long term chart of Unitedhealth Group or Lockheed Martin. Does the market seem worried that those budgets are going to get axed? Social Security and Medicare are the only benefits that normal, hard working people get from a lifetime of federal income taxation. It says a lot about Paul Ryan that his main political priority was to try to cut these benefits. Anyway, Calomiris does not think that this would be a path of least resistance.

Second, increased income taxation. Calomiris says that it is an unlikely path, "not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset" any benefit that it might confer. 

The third choice is what the paper is really about. Calomiris thinks that the path of least resistance would be "inflation taxation," which is implemented by large and inflationary purchases of government debt.

"To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-bearing debt is beyond the ceiling of feasibility, the government's next bond auction 'fails' in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative."

The Federal Reserve would buy the bonds that the Treasury issues, thereby funding government budget deficits. It is the same as printing money to fund the deficit, but with a fig leaf of euphemism and confusion. The "inflation tax" refers to the amount of real value that government bondholders lose to inflation. If there is $25 trillion of federal debt held by the public and there is a ten percent inflation (devaluation), then the inflation tax raises $2.5 trillion, a healthy amount in relation to the current annual expenditure level of $6.5 trillion.

The euphemism and confusion part of the inflation tax is actually very important because it allows the government to collect more than it would be able to if it were honest about what was happening. Here is how Calomiris explains it:

"When fiscal dominance hits and leads to monetization [printing money], if this is not anticipated sufficiently far in advance, it also causes some or all existing bonds (long-term bonds with existing low coupons that aren't indexed to inflation) to fall in nominal value. This is a one-time gain to the government because, going forward, the government will pay a market interest rate on all new debt issues that incorporates the future rate of inflation. If the average duration of government debt is sufficiently long, and fiscal dominance is not anticipated years in advance, the government could benefit from a substantial capital gain from the unexpected inflation tax, which increases its real capacity to issue new interest-bearing debt by a similar amount."

Calomiris thinks that the inflation tax is the path of least resistance because people "are not aware that they are actually paying it, which makes it very popular among politicians." 

If you were running things, how would you maximize the amount you could raise via the inflation tax? You need to trick bondholders, otherwise the market interest rate on new debt issues will reprice higher for inflation. This seems to imply that the best strategy is periodic, large devaluations with the rest of the time spent talking very tough about inflation.


Allan F said...

"periodic, large devaluations with the rest of the time spent talking very tough about inflation."

Expect the period between devaluations to shrink. Used to be every 10 years. Now it's down to 8. The next one probably in less than 6.

viennacapitalist said...

Calomiris' "Fragile by design" is an excellent book.

I had read the paper and came away with a slightly different impression: I thought that Calomiris is worried that the usual, i.e. "low pain" way of inflating debt (Inflation taxation, i.e. seignorage) and undexpectd inflation are not available anymore given the size of the problem.
Currently there are no gains from seignorage, as the Fed pays interest on reserves (and is running at a loss). He argues that, cutting the interest paid will certainly come, but is unlikel to improve the fiscal position.

Unexpected inflation might not be sufficient either, as the US treasury has not utilized the opportunity to fund itself long-term (something he doesn't mention).

Interest on reserves are going to be cancelled (see ECB recently) - and bank profits will take a hit.
Corporate taxes (also offshore) are likely to be next, unfortunately he doesn't calculate this effect on the financing position of the government.

I do not see him advocating for the "high pain" type of inflation taxation: outright printing of money to fund the government. No government, or establishment (of which he is part) survives this. It looks to me like an (internal) wake up call.

CP said...

They already are printing money to fund the government, just with the fig leaf of having a "central bank" "buy bonds" from the government.

From Q1 2020 to Q1 2023, the federal debt by the public grew by $7.5 trillion.


The Fed balance sheet grew by $4 trillion. So the central bank bought just over half the issuance.


CP said...

Thanks for the book recommendation.

Cato review:
In Fragile by Design: The Political Origins of Banking Crises & Scarce Credit, Charles Calomiris and Stephen Haber tell them. Banking arrangements, they argue, are ‘not a passive response to some efficiency criterion but rather the product of political deals that determine which laws are passed’ (pp. 13 and 38). What is more, the laws such deals give rise to are, more often than not, detrimental to bank safety and soundness. In few words, banking instability has its roots, not in any fragility inherent to commercial banking, but in deals struck between governments and various interest groups.

NYT review:
“The game of bank bargains” is what Calomiris and Haber call the whole process by which the coalitions in power divvy up the spoils thrown off by banks and allocate the cost of bank rescues. At the heart of their book is a history of how this amorphous game has played out in five countries: Britain, the United States, Canada, Mexico and Brazil. The authors seem to have read everything on the subject, and their accounts, brimming with fascinating details and vignettes, are testament to their scholarship and breadth of knowledge.

Federalist Society review:
For most people, the Financial Crisis of 2008 was an unexpected, unforgettable, and harrowing event. For Charles Calomiris of Columbia University and Stephen Haber of Stanford University, however, the crisis was just the latest in a long series of banking crises throughout American history. By their count, the United States has endured 12 banking crises since 1840. In their view, the more surprising and consequential number is the number of banking crises experienced by Canada during the same time period: zero.

viennacapitalist said...

Yes, they are printing money, however since they have been paying interest on this money, seignorage, i.e. remittances to Treasury, has been significantly reduced (In the beginning of QE, bond yields were higher thant IR on reserves, now significantly less - the cumulative effect has been negative).
his is the "expected inflation finance" Calomiris talks about - so far this has been non-existent, i.e. the Fed has subsidized banks

Major point which often gets neglected: QE at low budget deficts has different effects from QE at high deficits. The former "merely" results in asset allocation shifts between asset holders (less bonds, but an excess of money), i.e. the hot potato effect, whereas the latter results in increased spending (consumption) and hence CPI inflation..
BTW, I happen to believe that QE at low deficts, i.e. creating asset bubbles is much more dangerous than creating good old inflation in the loang term - but this is another story