Surpluses aren't without challenges

Bruce Bartlett
Posted: Aug 10, 2000 12:00 AM
On Aug. 2, Gary Gensler, the Treasury Department official responsible for the federal debt, announced that $221 billion of the debt will be paid off this year. Over the last three years, the debt has declined by $360 billion. Based on the latest projections from the Congressional Budget Office, it now appears that the debt held by the public may be extinguished by the year 2009. Although a debt will still exist because some long-term bonds will not yet have matured, the Treasury will have a cash balance greater than the outstanding debt. So far, the federal government and the public have treated the impending end to national indebtedness as an unmitigated blessing. But there are potential pitfalls. Economists and bond traders are only just beginning to focus on them. In coming years, they could create serious problems for the U.S. economy. The main problem has to do with the interaction between monetary policy and debt policy. That is because the Federal Reserve conducts monetary policy exclusively through the buying and selling of Treasury securities. When it buys securities it simply creates the money to pay for them, thus causing the money supply to expand. When the Fed sells securities it draws money out of the economy, causing the money supply to contract. Although the Fed is not limited to conducting monetary policy solely through Treasury securities, they are, by far, the best instrument for its purpose. The first advantage is that the market for Treasury securities is so large, so diverse in terms of its term structure, and so liquid that the Fed generally does not risk disrupting the market when it conducts open market operations. As the market for Treasury securities shrinks, however, the risk of disruption becomes greater and the Fed must compete with private investors for a share of the available Treasuries. The second concern for the Fed is that if it begins buying corporate bonds it creates problems of governance. In fairly short order, assuming that the supply of Treasury securities falls as expected, the Fed could, in effect, own a big chunk of the debt of our major corporations. Even the largest of them occasionally run into financial difficulties and may need to restructure their debt. Thus, unlike with Treasury securities, which have a zero default risk, corporate debt has risks that can create serious problems for the Fed. Another area of concern has to do with the unique relationship between the Treasury and the Fed. The Fed is essentially the Treasury's bank. Thus, when the Treasury makes a deposit, it has the same effect as an open market operation, causing the money supply to shrink. Conversely, when the Treasury writes checks to pay Social Security benefits or anything else, it causes the money supply to expand. The Fed must constantly monitor the Treasury's cash flow in order to keep the money supply at its target level. Such problems may seem extremely technical -- and they are -- but the impact on the economy of mishandling them can be severe. This is especially so since neither the Treasury nor the Fed have any recent experience with budget surpluses. When Britain ran budget surpluses a decade ago, it created serious economic problems that actually caused interest rates to rise sharply. In the 1980s, Britain, like the U.S., ran budget deficits that were quite large, as a share of the gross domestic product. In 1986, Britain's deficit equaled 2.4 percent of GDP. By 1988, however, the deficit had turned into a surplus of 1.5 percent of GDP -- a remarkable turnaround. It continued to run large surpluses in 1989 and 1990. Yet, during this period, long term interest rates not only did not fall, they rose from 9.36 percent in 1988 to 11.08 percent in 1990, despite the surplus. The reason has to do with the way the Bank of England handled the surpluses. It viewed the permanent reduction in debt the same way it treated a temporary cash surplus by the Treasury -- as a reduction in the money supply. Consequently, it offset the surpluses by permanently expanding the British money supply. This ultimately led to a rise in inflation and a fall in the value of the pound in international markets, which caused interest rates to rise. Ironically, it was the return of deficits in 1991 that fixed the problem and led to a fall in long term interest rates. In a recent article in the Wall Street Journal Europe, Warwick Lightfoot, a British Treasury official during this period, had this to say: "What the British experience tells us is that budget surpluses present genuine technical challenges for the operation of monetary policy. There is a tension between the important objective of reducing the outstanding stock of government debt and the requirements of prudent monetary control. Budget surpluses have the potential to create technical difficulties for central banks both in relation to their objective of achieving reasonable price stability and in relation to their role of maintaining well functioning, efficient and liquid markets." This is not to say that budget surpluses are bad, only that they present challenges that so far have not been addressed. When policy makers treat them as if there is no downside whatsoever, they run the risk of overlooking potential problems that could cause something universally viewed as positive to quickly become an economic negative.