Uncle Sam has a new credit card. It’s flashy and different. It’s also potentially destabilizing — but like many people who get a new credit card, he’s thrilled to have it and is having a hard time seeing any downside to its use. This enthusiasm could prove to be shortsighted for the long-run health of U.S. finances.
For most of his life, Uncle Sam has relied on an older, less flashy credit card. It is accepted everywhere and by everyone and comes with an incredibly low interest rate. It’s served him well and has allowed him, at times, to run up large balances without becoming viewed as a credit risk. This older credit card is better known as the U.S. Treasury, and its “balances,” now near $15.5 trillion, are the U.S. public debt.
The new credit card is not accepted everywhere. In fact, very few places take it, and typically it charges a higher interest rate than the older card. It is, in other words, inferior, but Uncle Sam seems happy to have it at his disposal. After several years of trying it out, he officially became a permanent card holder this year. The new credit card is the Federal Reserve, and its “balances,” now near $1.5 trillion, are excess bank reserves.
The new card arrived in January, when the Federal Reserve announced it was going to indefinitely stick with its post-financial crisis “floor” operating system. This system allows the size of our central bank’s balance sheet to be independent from its stance on monetary policy.
What does this mean? Well, for example, the Fed can now expand its balance sheet by creating money to purchase new assets without causing its target interest rate to change. The Fed, in other words, can now make new money without adding stimulus to the economy. This money, however, can only be used by banks and is why Uncle Sam cannot use this new credit card everywhere.
This money is called excess bank reserves and, unlike cash, earns a return from the Fed called interest on excess reserves (IOER). The IOER typically has been higher than the return on treasury bills. Banks have been eager, therefore, to hold all excess bank reserves sent their way. But this is also what makes Uncle Sam’s new credit card more expensive than the old one.
The Fed’s floor system, in short, has turned part of its balance sheet into a credit card for Uncle Sam. He can tap the excess-reserves option at any time to fund spending activities.
So far, Uncle Sam has used the new card only to transfer balances from the older Treasury card. That is, the Fed took Treasury debt off the market and in its place put excess reserves. But as any financial planner can tell you, paying off one credit card with another, higher-interest card — and one accepted by fewer merchants — is poor debt management. Moreover, the balances on Uncle Sam’s older credit card are a much sought-after asset in the global financial system. Uncle Sam, consequently, strains global financial markets when he transfers balances onto the new one.
Going forward, Uncle Sam is likely to see the balances grow on his new credit card for several reasons: First, whenever the next recession happens, the Fed is likely to rely on “quantitative easing” — buying up financial assets to spur the economy — because there will be little room to cut interest rates. Second, at some point, the temptation for politicians to use the new credit card to fund new activity such as the Green New Deal, and not just balance transfers, will inevitably become too hard to resist.
This not only will result in poor debt management and global financial strain but also might push inflation uncomfortably high. To avoid this outcome, Uncle Sam should transfer credit balances back onto the older, lower-interest card, and shut down the new one.
That means moving the Fed to a “symmetric corridor” operating system, like Canada’s, to control interest rates. This approach discourages banks from holding excess reserves by pushing the IOER below treasury-bill interest rates. Banks would start holding more treasury bills, and the Fed would be forced to mop up the unwanted excess reserves by shrinking its balance sheet.
Sometimes simplicity is best. This is as true for Uncle Sam as it is for you or me. Sticking to the older, less flashy U.S. Treasury credit card is simple and the most stabilizing financial path forward.