Fiscal Responsibility and the Fed
Fed emergency QE in bad shocks like COVID perpetuates irresponsible fiscal policy
There’s a lot of focus at the moment on the unsustainable trajectory of US fiscal policy. That’s good, but so far this focus completely ignores the role of the Fed, which is a key enabler. That’s because the Fed did emergency QE during COVID to cap rising Treasury yields, ensuring the government could keep issuing debt at low interest rates. This intervention was done in the name of financial stability and maybe it was the right thing to do. But the inevitable consequence of this is that it reduces any incentive for lawmakers to do unpopular things like spending cuts or tax hikes. Why bother with such things when the Fed ensures low yields in bad shocks?
Fed intervention during bad shocks is incredibly impactful. That’s because fiscal space - the ability to issue lots of debt at low yields - really only matters when bad shocks hit. Such shocks tend to weigh on tax revenues because growth slows, while spending needs rise as unemployment goes up. If markets think you’ve been running excessively large deficits in good times, they’ll push up interest rates in bad shocks as bigger deficits loom, making it more expensive for governments to issue debt. That in turn can spark a debt crisis. Such a crisis would get lawmakers’ attention in a hurry and put fiscal responsibility at the front of their minds. But if someone like the Fed comes along and acts as a buyer of last resort - keeping yields low - that removes the left tail of the distribution (the bad one) from lawmakers’ minds. This - at least in part - is why fiscal policy in the US (and elsewhere) keeps running out of control. Fed intervention is muting what otherwise would be a very negative verdict from markets.
The chart above shows how massive Fed intervention was during COVID. It shows total net new debt issuance by the US government (black line). The bars show who bought that debt, with the Fed (blue bars) during peak COVID accounting for the bulk of demand. If you count purchases of Treasuries by money market funds (red bars) as a direct extension of Fed policy - the Fed cut policy rates to zero, pushing lots of savings into money market funds - the Fed arguably accounts for ALL buying of Treasuries at this time. The Fed - in other words - took the US government off the market at a time when the bad track record of US fiscal policy could have really hit Washington, DC.
Of course, if the Fed hadn’t done emergency QE, the US might have experienced a much deeper contraction in GDP and stratospheric unemployment. But that doesn’t change the fact that the Fed is - inadvertently - accomplice and enabler of bad fiscal policy. The hard reality is that you can have yield caps in bad shocks or you can have responsible fiscal policy. You can’t have both simultaneously.
This problem isn’t unique to the US. It’s very much an issue in the Euro zone, with the added complication that ECB yield caps in bad shocks reward high-debt sovereigns at the expense of low-debt ones, and of course it’s extremely relevant for Japan with its 240 percent of GDP debt load.
I guess you’ve been making more or less the same point I have in my replies to your posts over these last few weeks. But you’ve made them more leisurely, more expansively and with more data. However, on the subject of government debt — and in particular US federal government debt — Ray Dalio seems to think that all this Scott Bessent frippery is just that and the deficits will keep on growing and by implication so will the stock of debt. Financial repression and/or inflation is unavoidable.
I suppose JGB has indirectly done something like the former — and your point is so did the COVID-era Fed and ECB — and only the weak JPY and the appearance of nascent inflation forced them to pull back. But looking ahead: more speculatively: If the Fed becomes even more “captured” than the BoJ what route will it take? What would the economic interests that undergird this Administration prefer? The extractive, manufacturing base that supports him can live with inflation (the electorate be damned!) but the financial and globalized industries, who have also moved in support of this government, loathe it. Elections (free and fair, if they are held) also need to be taken into consideration.
These questions transcend politics (in the banal sense in which we Americans marinate in it daily) and enter the realm of political economy. Intra-class warfare among the elites will determine the course of this country’s economy.
Covid was a self imposed non crisis. Had politicians been forced to pay for it up front they would simply have ended the lockdowns and we wouldn’t owe all this money.
It’s very hard for me to care about $300b a year in tax cuts when we spent 20x that in 2020/2021.