Living Economics

The US federal deficit is estimated to be $1.6 trillion in 2010, $1.3 trillion next year, and $8.5 trillion for the next 10 years.

Commentators are deeply worried that such huge debt burdens might erode America’s global economic, political and military power since a large part of the debt must be funded by foreign countries.

This concern looks ironic from barely 10 years ago when the US Treasury and the Federal Reserve were troubled by ballooning budget surpluses. To stop the cash flood, the Treasury drastically scaled back the volume and frequency of Treasury bond sale. In November 2001, the Treasury finally announced that it will no longer sell 30-year bond, long the benchmark of the US bond market.

These budget surpluses have since been squandered away by the Bush tax cuts, two foreign wars in the Middle East and related national security expenditures. The Great Recession precipitated by the credit binge put a final nail in the surplus coffin.

But the fleeting budget surplus nevertheless opened a rare window into the role Treasury bonds play in the money market.

Treasury bonds play an indispensable role in regulating the supply of money. The Fed increases the supply of money by buying short-term Treasuries from securities dealers. If the cash-flooded Treasury no longer needs to sell bonds to borrow money and is instead retiring existing bonds from the market, the Fed could no longer increase the money supply by buying Treasury bonds.

The Fed could, of course, buy other non-Treasury securities if it is desperate to pump money into the money market. The credit crunch in the Great Recession offers a rare glimpse into what kinds of financial assets the Fed could buy. Specifically, they are longer-term Treasury bonds, government-guaranteed mortgage-backed securities and even private commercial paper from troubled financial institutions under the policy of “quantitative easing.” Quantitative easing is a desperate attempt to flood the market with money when even near zero short term interest rates are still powerless to revive the anemic economy. When longer-term securities are purchased instead of the typically shorter-term bonds, quantitative easing has the additional effect of lowering longer-term interests.