The talk about the U.S. federal debt, while always present, has ratcheted-up during the past year as the U.S. has added an additional $4 trillion of debt during this period. Most of this new debt is the result of successive COVID-19 related legislative packages.
Debate over this debt will continue for decades, much of the debate will be directed towards who should bear the burden of this debt. The burden for payment of this debt will be directed towards the working and middle classes unless these economic classes pay attention to what is going on and insist that the burden be placed elsewhere.
For 60 years we have watched progressive tax rates decline–a trend which accelerated during the 1980’s, while deficits mounted. For unexplainable reasons, the working and middle classes succumbed to the idea that it would be better to borrow from the upper economic classes rather than tax this class for federal government expenditures.
But now that the debt is here, what are we to do? The answer to this question is ultimately a policy choice and to make the right policy choices we will need to understand ways in which the debt can be managed.
It is important from the start to recognize that the U.S. Federal budget is unlike a household budget so we need to be careful not project our household budget experience on to the federal government. The U.S. government as a sovereign authority with its own currency has complete control over the creation and destruction of its currency. It creates money when it spends, it destroys money when it taxes and borrows. Money creation and destruction should be calibrated in a manner which maximizes well-being while avoiding inflationary pressures in the goods, services and asset markets. The federal government has also delegated money creation to the Federal Reserve, the nation’s central bank, and by extension to the commercial banking sector through this sector’s lending activities. For our purposes we need not consider commercial bank money creation activity.
So let’s run through a few different ways in which the debt can be managed. The Federal Reserve (FED), a creature of Congress, can purchase Treasury debt in the private markets and then simply extinguish the debt. The debt extinguishment, however, would knock an equal chunk off the asset side of the Federal Reserve’s balance sheet. Under current practices, over time, this loss would pass to the Treasury Department–which would undo the public benefit of the debt elimination. To avoid this, the FED could create an intangible asset category, perhaps entitled: “For the Good of America” intangible asset category which would offset the loss from the debt extinguishment. This is merely an accounting maneuver but the account would reflect real intangible value for the American people: debt elimination. This is not unlike an intangible asset category found on a corporate balance sheet. During the 2011 federal budget ceiling crisis, Senator Rand Paul proposed legislation which called for the FED to extinguish federal debt which the FED held on its balance sheet (H.R. 2768). It is unclear how the accounting was to be handled under Paul’s proposal.
The Treasury could also mint a platinum coin stamped with a value equal to the proposed debt extinguishment and exchange the coin for the debt held by the Federal Reserve. This would amount to a debt pay-off. This idea, also proposed during the 2011 debt ceiling crisis, found support in both the financial and legal communities.
Another option would be the FED could purchase privately held Treasury debt and simply roll the debt over into perpetuity. Federal Reserve earnings are paid to the Treasury Department so FED earnings on Treasury securities would be returned to the Treasury Department. This would amount to an interest free loan which would never have to be paid-off.
The problem with all three scenarios is that it likely involves the Federal Reserve entering the financial markets through an exchange of newly created dollars for the privately held Treasury debt. This would add substantial liquidity to the financial markets further inflating financial asset values in what may already be inflated asset markets. Taxation within this market would be needed, not to fund the Treasury securities purchases, the FED would create new money for this purpose, but taxation would be necessary to absorb excessive liquidity out of this market due to the FED purchases of Treasury debt. Tax increases in this market need not equal the debt purchases, but rather should be calibrated in a manner which removes excessive liquidity from the financial markets.
There are other possible ways to manage the debt in a manner which avoids placing the burden on working and middle class families. The important thing to remember is that the federal government is not like a household. It, unlike a household, has the authority to create its own money, restrained only by the inflationary impact of such money creation. Taxation and borrowing are tools of money destruction to be used to control this inflationary impact. In our case, taxation in the asset markets would be utilized to deflate inflated asset values which may result from the Federal Reserve’s purchase and extinguishment of Federal debt.
The federal debt can be managed in such a way that it is not a burden to the working and middle classes. But it will be a burden to the working and middle classes if we are unaware of how all of this works. Armed with this knowledge, we can destroy the analogy of the federal budget to that of the household budget, and more appropriately allocate the burden, if necessary, to that segment of the population which has benefited from debt financed federal deficits.
(originally published on March 26, 2021)