CEPR - Center for Economic and Policy Research

Multimedia

En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press The Post Is Confused About Interest on the Debt

The Post Is Confused About Interest on the Debt

Print
Thursday, 17 February 2011 06:12

The Washington Post had a front page article highlighted the rising interest payments made by the federal government as a result of its rising debt. It would have been useful to point out that the decision to pay interest to wealthy bondholders is a policy choice, not a fact of nature.

It is possible for the Federal Reserve Board to buy and hold government bonds. In this situation interest on the government debt is paid to the Fed, which then refunds the money to the Treasury, creating no net interest burden for the government. Last year, the Fed refunded nearly $80 billion to the Treasury based on the large amount of mortgage backed securities and Treasury bonds it now holds.

While the Congressional Budget Office projects that the Fed will sell off these assets over the next few years it could opt to buy and hold a large amount of debt (e.g. $3-4 trillion). To prevent inflation when the economy recovers it could raise reserve requirements, the same route that China's central bank is now pursuing to head off inflation in China.

The decision to not have the Fed hold bonds is a policy decision. This policy choice should have been discussed in the article. Having the Fed buy and hold bonds would be one way to avoid imposing a large tax burden on the general public as a result of the countercyclical measures necessary to lift the economy out of this downturn. Readers should be informed about it.

This piece is really an editorial intended to scare readers into supporting harsh measures to reduce the deficit. It makes not effort to place the budget deficits in any sort of historical context and includes scary sounding assertions with no real meaning, such as:

"The borrowing the United States did over the past decade - to pay for the 2001 tax cut, the wars in Iraq and Afghanistan, and propping up the economy during the steep 2009 downturn - is coming due this decade."

There is no way in which this statement makes any sense. Bonds are coming due every month of every year. There is nothing "coming due" this decade that does not come due every decade.

It also would be useful if the Post did not rely exclusively on economists who failed to see the $8 trillion housing bubble as its sources in its economic reporting. 

 

Addendum: It is also worth noting that the ratio of interest payments to GDP is not projected to rise back to its early 90s level until well into the next decade. So the idea that we will be facing an unprecedented interest burden is not accurate. Thanks to Gary Burtless for reminding me of this point.

Comments (10)Add Comment
retired econ professor
written by richard hattwick, February 17, 2011 5:56
Kudos to Dean Baker for periodically making this point. This is a major area of economic literacy. I only wish that other economists who write for the public would join Baker in making this point .... and doing it often enough that the message finally becomes part of the public's understanding of how the world works.
Just More Fear Mongering by the WaPo
written by Paul, February 17, 2011 9:46
The WaPo is not "confused"; it is prevaricating. Bloomberg has the facts which WaPo ignores:

"Demand for Treasuries remains close to record levels at government debt auctions. Investors bid $3.04 for each dollar of bonds sold in the government’s $178 billion of auctions last month, the most since September, according to data compiled by Bloomberg. Indirect bidders, a group that includes foreign central banks, bought a record 71 percent, or $17 billion of the $24 billion in 10-year notes offered on Feb. 9.
Foreign holdings of Treasuries have increased 18 percent to $4.35 trillion through November. China, the largest overseas holder, has increased its stake by 0.1 percent to $895.6 billion, and Japan, the second largest, boosted its by 14.6 percent to $877.2 billion."

And the U.S. debt service to GDP (income)ratio is far lower than some other major economies:

"U.S. spending on debt service accounts for 1.7 percent of its GDP compared with 2.5 percent for Germany, 2.6 percent for the United Kingdom . . . while Japan’s is 2.9 percent and Brazil 5.2 percent."
http://www.bloomberg.com/news/2011-02-14/geithner-quietly-tells-obama-debt-to-gnp-cost-poised-to-increase-to-record.html
You are not Serious
written by Mark, February 17, 2011 9:48
Very Serious People (you know, the ones who thought invading Iraq was a great idea, knew that houses only go up in value, say that social security benefits need to be reduced but never mention Medicare) all say that you are wrong and the Post is right.

Who should we believe - them or our lyin' eyes?
Question
written by Doug O'Keefe, February 17, 2011 10:55
Why would raising reserve requirements prevent inflation? Thanks.
Reserve requirements and inflation
written by Jeff Z, February 17, 2011 12:34
Doug,

It inhibits the ability of banks to make loans, and reduces the money supply, all else equal.

Suppose the Fed sets 10% reserve requirement. That means that is must keep 10% of the value of its deposits on reserve, either in its vault or on account at the Federal Reserve. Let's say the bank accepts a $1000 deposit. It does not want to sit on cash that it can loan out and earn interest on. It keeps 10% of $1000, or $100, and loans out the rest. (Or it tries to!) That means that it can potentially loan out $900 (1000-100). This money flows as deposits into other banks as deposits, who do the same thing, potentially creating another $10,000 in the system. $10,000 = (1000/required reserve ratio (rrr), or 10%) If you take out the loan to buy a house, you pay the seller, but they deposit the money in their bank, and the process repeats. The fraction 1/rrr captures this notion of the process repeating, and when it is applied to the initial deposit, it gives you the potential increase in the supply of money. [Money supply change = (change in deposits) x (1/rrr)]

Now, if the reserve requirement is 15%, for a $1000 deposit, the bank can now only loan out $850 (1000-150). The potential change in the money supply is 1000 x (1/requires reserve ratio) = 1000 X (1/.15) = $6667.

If the rrr goes up to 20%, the then change is $1000 X (1/.2) or $1000 / .2 = $5000.

1/rrr is the money multiplier, and as rrr goes up, the money supply falls, reducing inflation or inflationary pressure. It tells you what the change in the money supply is going to be when deposits change.
The WaPo is not Confused
written by Ethan, February 17, 2011 2:07
The WaPo and its editors and reporters are not confused. They are intelligent, educated, thoughtful people. They are simply shameless liars willing to say anything dictated by those who control the money.
It is the READERS of the WaPo who end up being confused because they are not told the truth.
Please clarify
written by Ian, February 17, 2011 2:50
Doug,

Given your logic, why not have the fed monetize all the debt outstanding and then raise reserve requirements to 100%?

I go to such an extreme for effect. If I'm not mistaken, then the reality of raising reserves to contract the money supply is that it's a form of taxation on banks. And such taxation leads to a weaker banking system that, in combination with higher interest rates, can severely depress output.

Hence, please go into more detail, thanks.
Banks can't lend reserves
written by JJTV, February 17, 2011 3:57
@ Jeff Z

Jeff there is no balance sheet transaction that can loan a federal liability (reserves) to a non-bank entity. Reserves are traded between banks and the Federal Reserve. Increasing the amount of reserves in the banking system simply pushes down the overnight lending rate but means nothing as far as lending. The money multiplier also does not exist and it is unfortunate that it has not been deleted from undergraduate texts. Banks make loans independent of their reserve positions and during the next accounting period borrow the reserves they need to meet their requirement if necessary (banks must pay interest on the borrowed reserves as a penalty). Bank lending decisions are affected by the price of reserves and not the reserve position. The demand for bank reserves is inelastic and the Fed supplies necessary reserves on demand. Even if banks could not get reserves from the Fed they have other financing options to meet the requirement as well as continue to make loans. It is a travesty that professors continue to teach students the money multiplier but do not tell them that it doesn’t exist in the real world. The money multiplier is a relic of the gold standard.
If the deficit is so bad
written by Lord, February 17, 2011 9:38
let's end it. Who needs to borrow?
...
written by Jeff Z, February 24, 2011 11:07
@JJTV,

Thanks for the lesson. It adds to my own understanding. You are right that it is a relic of the gold standard. I had not realized the impact on the money multiplier until I read your post.

I was probably better than some and worse than others. Even under the gold standard, banks had to be willing to lend and people/businesses had to be willing to borrow. So when I discussed this in the past, I pointed out that the impact was not automatic.

Can you clarify this?
Banks make loans independent of their reserve positions and during the next accounting period borrow the reserves they need to meet their requirement if necessary (banks must pay interest on the borrowed reserves as a penalty).
Maybe I doubled up on my idiot pills this morning, but doesn't this imply that banks don't make loans independent of their reserve positions? There is a cost to borrowing that the bank considers, right? They would have to consider the cost of borrowing to meet the reserve requirement should they cross the line. Maybe the loans they are making (or considering) justify the expense. Did I miss something? They still have to pay the penalty even if the Fed can (and does) create reserves at will.

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.

busy
 

CEPR.net
Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

Archives