In a Guest Contribution today, John Kitchen (U.S. Treasury, formerly Chief Economist, Office of Management and Budget) addresses the issue of “Financing U.S. Debt: Is There Enough Money in the World — and at What Cost?”. The comments are based on a paper recently published in International Finance (Winter 2011), co-authored with Menzie Chinn. The views expressed are the author’s and do not represent the views of the U.S. Treasury.
From the abstract to the paper :
With the outlook for continued U.S. budget deficits and growing debt — and the uncertainties regarding their financing — we examine the role of foreign official holdings of U.S. Treasury securities in determining Treasury security interest rates, and the resulting implications for international portfolio allocations, net international income flows, and the U.S. net international debt position. … Although relationships suggest that the world portfolio could potentially accommodate financing requirements over the intermediate horizon, substantial uncertainty surrounds the likelihood of that accommodation and the associated effects on interest rates and adjustments in international portfolios. Notably, unprecedented levels and growth of foreign official holdings of U.S. Treasuries will be required to keep longer-term Treasury security interest rates from rising substantially above current consensus projections.
Although the United States has had little trouble financing its large budget deficits in recent years and at low interest rates, the results of the paper show the extent to which Federal Reserve policies (from expanding its holdings of Treasuries and government-backed securities) and the large purchases of Treasuries by foreign governments and central banks (foreign official assets) have contributed to keeping longer-term Treasury security yields low (and low relative to the low short-term interest rates from Federal Reserve policy). Once the U.S. and major developed world economies return to a more established economic expansion, however, the United States likely will face greater challenges in financing its debt — and at a higher cost with much higher interest rates.
The preferred equation in Kitchen and Chinn for estimating the effects of the various factors determining U.S. Treasury interest rates is given by:
- i10YR is the constant-maturity yield on 10-year Treasury notes;
- i3MO is the secondary market interest rate on 3-month Treasury bills;
- UNGAP is the gap between the unemployment rate and the NAIRU;
- INFL is the deviation of consumer price inflation from the Fed’s target inflation rate;
- STRSURP is the Federal structural budget surplus as a percent of potential GDP;
- FOREIGN is foreign official holdings of U.S. Treasuries as a percent of potential GDP;
- FED is the change in the Federal Reserve’s holdings of long-term Treasury and government securities as a percent of potential GDP.The results in the equation generally conform to prior estimates in the literature for the effects of the budget deficit on long-term Treasury yields – and for the effect of the change in foreign official holdings, as well. The coefficient on the structural surplus variable is negative as an increase in the structural budget surplus (a fall in the deficit) would reduce the relative supply of Treasury securities and reduce risk and uncertainty for longer-term Treasury securities, leading to a lower long-term yield relative to short-term (short-run-policy-determined) rates. The estimated effect is 33 basis points on the 10-year yield relative to the short-term yield for each one percentage point of GDP for the structural budget deficit. The coefficients on the change in foreign official holdings of U.S. Treasuries, and for Federal Reserve holdings of long-term Treasuries, MBS and U.S. agency assets, are also negative; an increase in official/monetary holdings (foreign or domestic) is effectively an exogenous demand shift for Treasury securities (at that point in time) that would lower longer-term yields. And, the estimation results confirm that the constraint that the effects are the same — that the coefficients are identical — cannot be rejected. (Note that the paper also presents an Appendix with various estimates and discussion regarding the roles of deficits vs. debt — i.e, flows versus stocks; the preferred equation uses budget deficits.)
Given that the Federal Reserve is expected to draw down the size of its balance sheet over time as the economy returns to its potential growth path, the results of the paper indicate that the interest rate projections from public and private forecasters are effectively and implicitly based on an assumption (even though most probably don’t even know they are doing it) that foreign governments and central banks will continue to purchase a large share of U.S. Treasury securities. If the foreign purchases aren’t forthcoming at those large amounts, longer-term Treasury yields would be higher than forecasters project. Under such a scenario in the paper in which foreign official holdings of Treasuries are steady relative to U.S. GDP rather than continuing outsized growth, the 10-year Treasury yield would be 2-1/2 percentage points higher in 2020 at 7.9 percent compared to the 5.4 percent of the base case (CBO January 2011). To keep the 10-year Treasury yield down at 5.4 percent, the paper estimates that foreign official holdings of Treasuries would have to rise from 5 percent of world GDP to over 20 percent of world GDP by 2020. Given the large demands for funding governments worldwide, imagining such an increase for the U.S. alone seems challenging at the least.
But the challenges don’t stop there. As also discussed in an alternative forum (at a conference at the Baker Institute of Rice University on “Defusing the Debt Bomb”), the underlying required balancing relationships of international macroeconomics for financial flows and trade flows mean that exchange rates and the U.S. trade position will be affected by the extent to which foreign funding occurs. The high amount of foreign official funding flowing into Treasuries over the past decade has corresponded with China’s policy of keeping the exchange value of the renminbi (RMB) low relative to the dollar and with the U.S. running a large trade deficit, as well as other flows from other foreign central banks and sovereign wealth funds. In practice, then, it is unlikely that the United States — as it returns to a potential growth path — could simultaneously have relatively low long-term Treasury yields and a large improvement in its trade position. Yet that is what the “consensus” of private forecasters (as in the Blue Chip) shows. If foreign funding of U.S. Treasuries continues at a large pace and keeps interest rates lower than otherwise, then the United States will run a higher trade deficit, ceteris paribus. If, alternatively, foreign funding of U.S. Treasuries wanes, then the U.S. trade deficit will be lower, but interest rates higher, ceteris paribus.
The paper also considers another alternative for funding — partial monetization of the debt through increased purchase of Treasury securities by the Federal Reserve (i.e., the Fed keeps its balance sheet permanently higher relative to what would be consistent with the pre-financial crisis position). Under standard relationships, that would result in higher inflation, higher nominal interest rates, and a lower exchange value of the dollar. The higher inflation would erode the real value of existing bonds.
In short, the analysis and scenarios illustrate that there is “no free lunch” for funding U.S. government debt, with some combination of “costs” from higher interest rates and debt servicing costs, an adverse trade balance effect, or negative effects on the real valuation of existing bonds.
As we conclude in the paper, the escape hatch from these challenges and costs is to implement a “responsible” fiscal policy rather than the current policy outlook for the U.S. in which public debt rises to nearly 100 percent of GDP by 2020 (and higher and higher in the years beyond):
Ultimately, measures that reduce the deficit by changing the trajectory of tax revenues and spending, particularly in the latter years of the horizon we consider and beyond, would mitigate concerns about the financing of the U.S. budget and current account deficits. In the absence of such actions, it is unlikely that the rest of the world would finance our needs at the terms that are currently being projected, and American policymakers will become less and less the masters of our own economic fortunes.
This guest contribution written by John Kitchen.