The Unconventional Art of Borrowing: An Insight into the US's Monetary Strategy
Until recently, an agreement between Biden's administration and the GOP-led Congress on government debt limit remained elusive. In December 2021, the debt limit was raised by USD 2.5 trillion to USD 31.381 trillion, a move expected to sustain until January 19, 2023, as stated in a letter from Treasury Secretary Janet Yellen to congressional leaders. At that juncture, the Treasury Department will resort to using "extraordinary measures," accounting tools at its disposal, to avert a default on the government's obligations, according to Secretary Yellen. This is expected to permit continued borrowing until at least early June. However, when these measures are depleted, without a new deal to raise or suspend the debt ceiling, the Treasury will be unable to pay the nation's bills and result in a default.
Photo source: US Department of the Treasury
President Joseph Biden has come to understand that the debt ceiling is only the first skirmish in his battle with the GOP-led Congress. The real challenge lies in the forthcoming debate over the next fiscal year's budget, which requires congressional approval. The recent election of the House Speaker suggests that the GOP will be dominated by the hawkish Freedom Caucus, promoting budget cuts and fiscal discipline with various conservative agendas. Hence, neither Biden nor the GOP-led Congress is willing to yield in this game of chicken.
However, the GOP-led Congress has entertained the idea of Plan B. The conservatives have repeatedly proposed "debt prioritization" as a backup plan during past debt limit showdowns. By prioritizing payment to bondholders, they argue, the standoff can be reduced to a government shutdown, albeit a major inconvenience, but not catastrophic for the global financial system. This would give the GOP leadership greater bargaining power in negotiations.
Former Treasury Secretary Jack Lew, who served under President Barack Obama, has criticized these conservative views as "intellectually bankrupt."
According to the latest data from the Congressional Budget Office (CBO), released in May 2022, outlays amounted to USD 5.8 trillion, or 24% of GDP, in that year. (These outlays have been adjusted to exclude the effects of timing shifts.) As a percentage of GDP, outlays dip below this level for a few years before rising again. By 2032, outlays will again total 24% of GDP, with a deficit of USD 2.2 trillion and public debt at USD 40.2 trillion. The CBO has announced the release of its Updated Budget and Economic Projections on February 15.
It is worth noting that, in addition to government debt, the central bank, or the Fed, holds a balance sheet of USD 8.4 trillion. This balance sheet has undergone significant changes since the pre-financial crisis level of USD 995 billion on September 15, 2008, rising to USD 2 trillion and then surging due to the COVID crisis from USD 3.7 trillion before August 26, 2019 to its current level.
Fed's Balance Sheet: Source
It is important to note that government debt and the Federal Reserve's balance sheet are separate entities. Government debt refers to the total amount owed by the government to its creditors, such as individuals, corporations, and foreign governments. This debt is subject to a legislative limit, known as the debt ceiling, which restricts the amount of debt that can be issued by the government. On the other hand, the Federal Reserve's balance sheet reflects the central bank's assets and liabilities. The balance sheet can be expanded through various monetary policy operations, including quantitative easing (QE), where the Federal Reserve creates new money to purchase government bonds and other assets from banks. This increases the assets of the Federal Reserve, but also its liabilities, as the assets are held on its balance sheet.
Several Asian governments are concerned about the size of the US government debt and how it will be sustained in the future. The US government is attempting to reduce its budget by shrinking the defense budget, but it is expected to shift the burden by increasing spending on social security and healthcare welfare.
The backup theory supporting the US's decision to continuously raise the debt ceiling is based on Modern Monetary Theory (MMT), a post-Keynesian economic theory. MMT prioritizes government spending as a driving force in the economy and argues that governments with sovereign currencies have the capability to finance spending through money printing. This unorthodox approach challenges traditional economic principles and incorporates the ideas of John Maynard Keynes. It highlights the significance of aggregate demand, the influence of institutions on the economy, and the interconnectivity of markets. Proponents of MMT, including Stephanie Kelton, Bill Mitchell, Warren Mosler, and Randy Wray, believe that the theory provides a more realistic understanding of modern monetary systems and can help address issues such as inequality, unemployment, and underemployment. However, MMT remains a contentious subject and is not widely accepted by mainstream economists. The introduction of this theory into mainstream discourse was largely driven by progressive politicians, such as Alexandria Ocasio-Cortez, to support their progressive, welfare-oriented government budget agenda.
However, the implementation of MMT in developing economies faces several limitations. Firstly, exchange rate vulnerability is a major concern, as economies heavily dependent on exports can be vulnerable to fluctuations in the exchange rate. This can make it challenging for these countries to effectively implement MMT policies, as currency appreciation can make exports less competitive and harm economic growth. Secondly, dependence on foreign investment can also pose difficulties in implementing MMT, as large fiscal deficits can increase the country's risk profile and reduce its ability to attract foreign investment. Thirdly, limited monetary sovereignty is an issue for developing economies that borrow heavily in foreign currency or have a large amount of foreign debt, as it can make it challenging to effectively implement MMT policies. Finally, inflation risks also pose a challenge, as high inflation rates can make it difficult to implement MMT policies effectively, as large fiscal deficits and government spending can increase inflationary pressures and erode the value of the currency.
Even in developed economies, the application of MMT is not without its limitations and challenges. Firstly, there are inflation concerns. MMT's focus on an active fiscal policy can clash with the central bank's primary goal of maintaining low inflation. This can create a conflicting set of policy objectives between the government and the central bank, with the former pursuing growth and the latter focusing on keeping inflation in check. Secondly, interest rate risk. MMT's emphasis on government spending and its potential impact on sovereign debt may pose challenges in raising debt through sovereign bonds. An active fiscal policy may lead to higher interest rates, making government bonds less attractive to investors and potentially decreasing their value. Finally, pension funds: the focus on government spending and its potential impact on interest rates in MMT could also pose risks to pension funds that depend on low-risk, steady returns from sovereign bonds. If the government implements active fiscal policy and interest rates rise, it could result in a decline in the value of government bonds, potentially affecting the returns of pension funds. This can be seen as in the near-collapse of UK pension funds last year.
In conclusion, the US's ability to issue debt and implement monetary policy is a result of its significant economy, military strength, and role as the world's dominant reserve currency. This complex issue is subject to ongoing debates among economists and policymakers, and while other countries also have the ability to issue debt and implement monetary policy, the specifics of how they do so may vary based on their own unique conditions. Nonetheless, the US's unique position allows it to exercise a highly flexible fiscal policy.
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