CHICAGO – Japan, the United States and other countries with sovereign debt equal to or greater than total GDP need to reduce their budget deficits to prevent their debts from reaching frightening levels. The problem is particularly worrying when a country faces higher real interest rates, as budget deficits increase further when the government refinances debt. But even more worrying is the possibility of a vicious cycle, with higher rates driving higher deficits, which in turn produce even higher rates as investors lose confidence in public finances.
Admittedly, higher market interest rates could also be a healthy wake-up call if the government, fearing the vicious cycle, took steps to reduce the deficit. However, fiscal consolidation requires painful austerity, and few politicians want to subject their voters to that.
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In the past, some governments have tried to postpone the pain by having their central bank buy their debt, which was financed by issuing reserves to commercial banks (a practice known, in more colloquial terms, as money printing). However, in the process, commercial bank lending expanded, businesses and consumers spent more, and the ensuing boom drove inflation.
To avoid runaway inflation, the central bank had to drastically slow down the economy, raising interest rates well above the inflation rate. The end result was a worse fiscal situation, because the boom and bust hurt the economy, and the government was left with higher debt servicing costs. Over time, these countries realized the problem and banned direct financing of the public deficit by the central bank.
In recent years, however, this financing has once again been used in economic policies. As interest rates could not be reduced much below zero following the 2007/08 financial crisis, central banks decided to stimulate the economy by purchasing government bonds from financial institutions, paying with the central bank’s liquid reserves.
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The hope was that these financial institutions would exchange government bonds for long-term loans to businesses, thus stimulating the economy. Furthermore, the huge expansion of central bank reserves was expected to dispel fears of a lack of liquidity, further stimulating lending.
Proponents of these programs, which became known as “quantitative easing” (QE), did not see them as central bank financing of the government. Although the central bank has purchased government bonds, it has not purchased them directly from the government.
Most importantly, the government didn’t actually need the funding. QE was a purely monetary operation, they argued, and bonds held by the central bank could be sold without difficulty through “quantitative tightening” (QT) once the economic recovery took hold.
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Unfortunately, while QE was easy to perform, QT was not. After three rounds of QE between late 2008 and 2014, the US Federal Reserve’s holdings of Treasury bonds grew from $800 billion to about $2.5 trillion.
However, when the Fed tried to reduce them through QT in 2018, the markets ended up collapsing, and the Fed started buying bonds again in September 2019. Then, as the US government spent huge amounts during the Covid-19 pandemic, the Fed returned its support. By mid-2022, the Fed’s Treasury holdings had grown to $5.8 trillion.
With the US economy today fluctuating and inflation still high, now would be the time for the Fed to reduce its holdings. But not only did he pause his most recent QT with Treasury holdings still at $4.2 trillion (five times the 2008 level), he also promised to buy more Treasuries as needed, starting with a $40 billion purchase in January.
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What was monetary operation when inflation and government financing needs were low now looks like fiscal financing when the opposite is true.
As an excuse, the Fed can say that it is only supporting the economy’s liquidity needs, which have grown since 2008. But liquidity needs include indirect fiscal financing.
The natural long-term holders of Treasury bonds are pension funds and insurance companies, with long-term liabilities. As a recent study by my Booth School colleague Anil Kashyap and his co-authors shows, these institutions find Treasury bond yields unattractive and buy corporate bonds to earn incremental yields.
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But because there are relatively few long-term corporate bonds, they buy shorter-term corporate bonds and increase the duration by buying Treasury bond futures.
To sell these institutions the enormous amount of futures they need, something similar to a Rube Goldberg machine emerges.
Hedge funds take the other side of the transaction, protecting themselves by purchasing government bonds, financed in the repo market with huge amounts of short-term loans, which are in turn supported with liquidity provided by the Fed.
Given these dynamics, it is difficult to believe that the Fed is not a key player in financing the public deficit, both through its own holdings and indirectly through its willingness to provide the liquidity that hedge funds need.
No one would suggest that a vicious cycle in the US is imminent. However, with government interest rates held below their natural level, Congress has little incentive to reduce the deficit, which increases the risk of this scenario.
Furthermore, because the Fed finances its own public debt holdings with reserves that are revalued daily, its losses will increase quickly if interest rates rise, contributing to the vicious cycle.
And with government bond rates unattractive to insurance companies and pension funds, hedge funds will continue financing more than $1 trillion in long-term government bonds with short-term loans. That’s hardly a recipe for stability.
The Fed is not the only central bank involved in direct or indirect fiscal financing. The current situation raises troubling questions for central banks, including whether the commitment to provide abundant reserves to the system increases the instability of public debt financing. For the sake of the long-term health of their economies, central banks need better answers.
Translation by Fabrício Calado Moreira
Raghuram G. Rajan, former director of the Reserve Bank of India and chief economist at the International Monetary Fund, is a professor of finance at the University of Chicago Booth School of Business and co-author (with Rohit Lamba) of Breaking the Mold: India’s Untraveled Path to Prosperity (Princeton University Press, May 2024).
© Project Syndicate 1995–2026
