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  • OK Fed, Just Forgive Some Treasury Debt So That We Can Continue To Lend What We Need

    The national debt is currently increasing at a rate of far less than $100 billion a month, while the Fed currently holds over $2 trillion of Treasury securities on its balance sheet. The Treasury needs to continue borrowing at the same rate to meet its debt obligations and pay bills as they come due, but cannot exceed the statutory debt limit. As it turns out, there is an easy solution to this apparent dilemma under the present circumstances. That solution is for the Fed to forgive the required amount of Treasury debt each month, so that the new Treasury borrowing can take place without exceeding the debt limit.

    Under ordinary circumstances, debt forgiveness generates a taxable event, since the IRS considers it to be a form of income. But of course the Treasury does not pay income tax, so this is of no consequence. But certainly, there must be something wrong with this approach, since it sounds too much like "free lunch". Let's see ... a QE Treasury bond purchased by the Fed is held as an asset on its balance sheet, and is offset by the liability corresponding to bank reserves held at the Fed. If the bond is extinguished through debt forgiveness, what happens to the offsetting bank reserves? Does the Fed need to send the reserves back to some bank in the form of currency to keep in its vault, or what? Perhaps the answer is that no such action is required. Instead, the Fed just generates an offsetting cash asset on its balance sheet to replace the forgiven Treasury debt. Since this cash doesn't go anywhere and doesn't pay interest, there is no consequence.

    By forgiving a fraction of its Treasury assets, the Fed will lose that portion of its Treasury coupon income that it would otherwise earn, and there will be no future return of principal in the amount of the face value of the Treasuries if they mature while still held. This income is not, however, retained by the Fed anyway. Instead, to the extent that its total balance sheet income exceeds its operating expenses, this income is periodically remitted to the Treasury. This income would ordinarily reduce the deficit by the corresponding amount, and this advantage would be lost as a result of the debt forgiveness. But we are talking about small potatoes here, relatively speaking, so let's just forget about that part.

    But there would seem to be another possible disadvantage. As long as the Fed maintains its Treasury assets on its balance sheet, it can eventually sell them when the QE stimulus is no longer needed, thereby reducing the size of total bank reserves. This ability might conceivably also come in handy if inflation should suddenly surprise to the upside and require some response. But actually, with the total size of the Fed's balance sheet as large as it has become, selling the Fed's QE assets would not be a practical method of inflation control anyway. Instead, the Fed's preferred approach under those circumstances would probably be to increase the rate of interest that it is paying on bank reserves held at the Fed. It is felt that the effect of such an increase would be to force up short term rates in much the same way as did the previous approach of increasing the Fed funds rate, which has been the preferred method of inflation control in the recent past. So it would not seem to be important to keep those Treasuries around just so that they can be sold at some later date.

    Wait a minute ... what about all those bank reserves at the Fed? What happens to them? If the Fed no longer holds the QE Treasuries that it purchased and can't sell them back at a later date, where do those bank reserves at the Fed wind up? This question does not really require an answer. The reserves are at the Fed only because they have no better place to go. The Fed fully controls the total amount of bank reserves through its open market operations. The only bank reserve change that the market can make on its own is in the balance between the reserves that are required rather than excess. Today, the vast majority of bank reserves at the Fed are excess reserves. But as bank lending takes place in the economy, the excess reserves morph into required reserves, and the money supply in the economy increases. So wait long enough, or create enough inflation, and the "problem" posed by excess reserves held at the Fed will take care of itself. Another non-problem disposed of.

    Hey, we are really onto something here, why not just extend this process to cover not only the new debt as it is incurred, but also some convenient fraction of the existing national debt. To begin with, the Fed could forgive all of the Treasury debt currently on its balance sheet, vastly reducing the size of the total outstanding debt, and thus the Treasury's annual interest payments due on this part of the debt. This could be extended even further, with the Fed purchasing additional QE Treasuries and then forgiving the debt. After all, the interest payments on the QE Treasuries are just being returned to the Treasury anyway, so what difference does it really make? But perhaps this wouldn't look good, replacing the forgiven Treasury debt with "fictitious" cash on the Fed's balance sheet. Golly, this might begin to look like (gulp) pure money printing. Perhaps no one will notice anyway, so it might still be worth doing.

    After all, there isn't really all that much difference between this approach and what we are already doing in the QE process, and nobody has complained yet. The Fed has said that it is not likely to sell its accumulated QE assets, instead simply holding them until they mature. When one of the Treasury bonds matures, the Treasury pays the face value to the Fed, which ultimately remits this payment back to the Treasury. In this process, the debts represented by these bonds are extinguished, and since the funds generated all along the way go to the Treasury, this is a form of slow-motion debt forgiveness for the Treasury bonds. Amazingly, this process also applies to the QE mortgage-backed securities (MBS) also held by the Fed. The deal in the case of the MBS is even sweeter for the Treasury. As interest and principal payments on these are made to the Fed, those funds are also handed over to the Treasury. They accumulate the proceeds for loans originally created by mortgage lenders, purchased by the Fed with printed money, with the proceeds then going to the Treasury. Treasury income without the need for taxation or borrowing. Isn't that special.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Oct 15 12:16 PM | Link | Comment!
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