The Greenspan Puzzle

During his time as Fed chairman, Alan Greenspan seemed to have an uncanny understanding of the US economy. He’s since taken a lot of heat for the Fed’s role in the financial crisis, but still I have regarded him as an unusually astute economic analyst. That’s why I’m so surprised by the statement he made yesterday on Meet the Press, to the effect that there’s no default risk in US government securities because “we can always print money” to service our debt.

This statement is mind-bogglingly incorrect, for a very simple reason that Mr. Greenspan should know better than just about anyone else on the planet. That reason is that the bulk of US Treasury debt is of relatively short maturity, so that borrowing costs are only fixed for a short period of time. Here’s an informative chart, taken from James Hamilton’s excellent blog Econbrowser:

Average Maturity of U.S. Debt, in weeks, January 1990-December 2009

Why is the maturity structure of the debt relevant to our ability to service it by printing money? Very simply, over any reasonable period of time, money creation by the Fed causes inflation. Interest obligations that are fixed in dollar terms require less taxation in “real” terms thanks to inflation. As is so often remarked, inflation redistributes wealth from borrowers to lenders. So far, Greenspan seems to be making sense.

But as the old saying goes, “Fool me once, shame on you; fool me twice, shame on me.” As would-be purchasers of new government debt realize what’s going on, they become unwilling to buy new debt issues at the same prices as before. New issues of debt must sell at a discount relative to their previous prices, which means that the Treasury has to sell more bills in order to raise the same revenue. In short, the yields required by lenders rise–typically by the full amount of expected inflation, or even more depending on the tax treatment of interest income. Once the bond market correctly prices new debt, there is no gain to the Treasury from inflation. The Fed can devalue existing debt by “printing” money, but it can’t devalue new debt.

Here’s where the maturity structure of the existing Treasury debt comes into play. If this were 1990, with lots of long-term debt outstanding, the Fed could inflate away a good chunk of the Treasury’s debt service. Thanks to the steady policy of replacing long-term debt with shorter-term debt that the Treasury pursued during the Bush Administration, there is much less scope for the partial repudiation of the debt through inflation. (The chart makes it clear, though, that reducing the maturity of Treasury debt is one Bush policy that the Obama Administration has definitely reversed. As grateful as I am for any evidence of foresight in this administration, I find this particular policy reversal ominous.) Holders of long-term bonds would be screwed, but the T-bill market (maturities less than a year) wouldn’t stand for this.

Does this mean that money creation by the Fed can’t help the Treasury at all? No. The Fed has expanded the “monetary base” (basically, bank reserves) at an incredible rate through Quantitative Easing. Just look at this:

U.S. Monetary Base, 1984-2011

In case you’re wondering, that long, steady trend line represents an annual growth rate in the monetary base of about 6.5%, while the increase in the base since September 2008 works out to nearly 40% per year. There’s no greater evidence of the degree of uncertainty, or even fear, in the economy since the fall of 2008 than the fact that the demand for safety has jumped by so much that even this almost unbelievable flood of liquidity has not triggered more than the 3.6% inflation rate of the past year.

The link from growth in the monetary base to a reduction in the Treasury’s debt-service liability is direct, because the standard way in which the Fed increases the amount of reserves in the system is by purchasing Treasury bills from the private sector. After that, the Treasury “owes” some of its debt service to the Fed, which subsequently returns its earnings (net of its operating expenses) to the Treasury.

Can the Fed keep earning revenue for the Treasury this way after the public’s thirst for liquidity has been quenched? Not really, because since October 2008 the Fed has paid interest on bank reserves at a market-determined rate (the federal funds rate minus ten basis points), which puts the Fed in the same position as the Treasury. When it inflates through fully anticipated money creation, it increases its interest expenses at the same rate as its revenues, just as happens to the Treasury.

In short, Mr. Greenspan is simply, utterly, breathtakingly wrong. What the Federal Reserve can accomplish through money creation is a one-time partial default on the Treasury’s debt obligations by depreciating the value of the dollars that debtholders receive. But that temporary respite from the burden of debt service would come at a tremendous price, because it would rekindle inflationary expectations throughout the economy. The lesson of the 1970s and 1980s that I thought had been learned by economists, policy wonks, and even politicians–thanks in large part to Alan Greenspan’s tenure as Fed chairman–was that inflation is easy to start and very costly to stop.

So why in hell is Greenspan spouting such reckless nonsense now?

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