President Joe Biden enters the presidency inheriting an enormous deficit, a central bank with an unprecedented balance sheet size, and an economy reeling from the pandemic.
His first proposal was a $1.9 trillion COVID-19 relief package. If implemented, much of it will be funded with additional government debt and eventually bought by and added to the Federal Reserve’s balance sheet.
The deficit is the annual difference between what the U.S. government spends and what it collects through taxation. The debt is the sum of yearly deficits.
The federal government ran a $3.1 trillion deficit in the fiscal year 2020, more than triple the fiscal year 2019. That year’s debt was 15.2% of the GDP, the most significant deficit as a share of the economy since 1945.[i]
In 2015, the deficit was $438 billion, roughly 2.5% of the GDP. In 2009, at the height of the Great Recession, the deficit rose to 9% of the GDP. During the Reagan presidency, when the deficit entered public discussion, it averaged 5% of the GDP.
A deficit of $3.1 trillion is the amount the government spent in excess of the taxes it collected. To make up for the shortfall, it sold $3.1 trillion in government bonds, many of which end up being owned by the Federal Reserve.
By December 31, 2020, the national debt had jumped to $28 trillion, up 39% from $20 trillion when President Trump was sworn in.[ii] The government owns $5.73 trillion of this debt (most of it by the Social Security Trust Fund and federal pension funds).[iii] This means that, in some years, the government took in more money than it paid out and used the surplus to buy US Treasury bonds.
The Federal Reserve, the government’s bank, owns almost $5 trillion. Most of it was bought after 2010 through the unconventional monetary policy of quantitative easing or QE, so the government owes itself about 36% of the debt.
The Federal Reserve
Before the 2008 financial crisis, the Fed’s balance sheet was about $1 trillion. After implementing QE, it ballooned to almost $5 trillion. As the economy recovered, it shrunk to around $4 trillion. However, responding to the COVID-19 pandemic with additional QE caused it to balloon to approximately $7 trillion, a jump of almost $3 trillion in three months.[iv]
Government securities comprise $4.8 trillion of that $7 trillion. The rest consists mostly of mortgage-backed securities (MBSs). MBSs are mortgages bundled and sold as a security.
You might be surprised how much the government is involved in the housing market. Total mortgages in the United States amount to around $10 trillion, so the Fed, at $2 trillion, owns about 20% of all outstanding mortgages.[v] Fannie Mae and Freddie Mac (President Trump’s plan to move them entirely into the private sector never happened), two companies that package and guarantee half the mortgage-backed securities and were casualties of the 2008 financial crisis, remain 80% government-owned.[vi]
The Road to Japan
Japan’s central bank, the Bank of Japan, owns about 45% of Japan’s total government debt, and its balance sheet is about the size of the nation’s economy.[vii] It has even resorted to buying equities to spur economic growth.
For context, the Federal Reserve owns about 18% of our government’s debt, and its total balance sheet equates to roughly 33% of GDP. Assuming President Biden’s full economic proposal is passed and all new government debt ends up being owned by the Federal Reserve, it will bump up the Fed’s percentage of government-held debt to around 25% and a total balance sheet of approximately 35% of GDP.
Japan still has a market-based economy but is less capitalistic, meaning more and more of its money is generated by government spending and less by bank lending.
Get ready for more talk of socialism or the evils of government debt. However, that ship has sailed. The government’s outsized role in the economy was here to stay once the powers decided it was a better option than a global depression.
Here in the U.S., before the 2008 financial crisis, commercial banks created most of the economy’s money. For example, when a customer went to a bank to request a loan, the bank would do its due diligence. If they decided to give the customer a loan, that loan created new money, as the bank credited the borrower with a new bank deposit.
The government’s role was relatively small. For example, currency dollar bills were only obtained by exchanging a bank deposit. Government spending was paid for by taxes or bond sales. Neither activity resulted in any new bank deposits; instead, existing money moved around within the economy.
Lending by commercial banks, buying financial assets from commercial banks, and paying commercial banks’ employees created most of the new money.
Post Financial Crisis
A central bank implements QE by buying financial assets. It can buy them from commercial banks or nonbank entities such as pension plans, mutual funds, or any other entity that owns financial assets.
When the Federal Reserve buys a bond from a bank, it pays for the bond by crediting the bank’s reserve account at the Fed. Reserves are how banks pay other banks. However, they don’t increase the public’s money supply.
When the Federal Reserve buys a bond from a nonbank, the seller’s bank credits them with a deposit. The Federal Reserve provides the bank with an equal number of reserves to offset that deposit. That deposit is new money since no one’s bank account gets reduced by the amount.
For example, on March 9, 2020, the money supply was around $4 trillion. By the end of the year, it ballooned to $6.7 trillion.[viii] Some of that was probably from new loans as companies activated lines of credit to offset the pandemic. Some was also from the Federal Reserve’s massive new QE program, which included buying financial assets from nonbanks.
The Road Ahead
It is over. Capitalism has changed. The Fed’s balance sheet is now a tool in the economic toolkit. That was the risk once they decided to use it to prop up financial assets and encourage the wealth effect.
It is too big to reduce. The Federal Reserve tried reducing it in 2018 when the number of treasuries and mortgage-backed securities (MBS) not being reinvested ($50 billion per month) by the Federal Reserve was close to the level of maturing treasury bonds and mortgage payments from homeowners.
After switching to Quantitative Tightening (QT), the Dow Jones Industrial Average went down 16%, the S&P 500 dropped 18%, and the NASDAQ fell 22%.
Reducing their holdings of treasuries would require the public to purchase trillions of new government bonds, which could cause interest rates to rise and jeopardize any economic recovery. Reducing MBSs shrinks the money supply which also challenges economic growth.
Remember, the old system of banks producing the money supply was not some grand plan but the result of competing interests struggling for power. Most likely any new financial system will result from that same struggle.
[i] Robb, Greg, “U.S. federal budget deficit soars to record $3.1 trillion in 2020.” MarketWatch, October 16, 2020, https://www.marketwatch.com/story/us-federal-budget-deficit-soars-to-record31-trillion-in-2020-2020-10-16
[ii]Sloan, Alan and Cezary Podkul, “Donald Trump built a national debt so big (even before the pandemic) that it’ll weigh down the economy for years.” Christian Science Monitor. January 17, 2021, https://ctmirror.org/2021/01/17/donald-trump-built-a-national-debt-so-big-even-before-the-pandemic-that-itll-weigh-down-the-economy-for-years/
[iii] Bartash, Jeffrey, “Here’s who owns a record $21.21 trillion of U.S. debt.” MarketWatch, August 23, 2018, https://www.marketwatch.com/story/heres-who-owns-a-record-2121-trillion-of-us-debt-2018-08-21#:~:text=Today’s%20Insights.&text=The%20U.S.%20government%2C%20for%20its,%2485%20billion%20since%20June%202017.
[iv] Board of Governors of the Federal Reserve System,https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
[v] Tappe, Anneken, “Americans’ mortgage debt soars to a record $10 trillion” CNN Business, November 17, 2020, https://www.cnn.com/2020/11/17/economy/third-quarter-household-debt/index.html
[vi]Scott, Amy,”Trump administration ends push to restructure Fannie Mae and Freddie Mac.”Marketplace, January 15, 2021, https://www.marketplace.org/2021/01/15/trump-administration-ends-push-to-restructure-fannie-mae-and-freddie-mac/
[vii] Nagata, Kazuaki, “After massive COVID-19 spending, how large is Japan’s debt?.” The Japan Times, December 29, 2020, https://www.japantimes.co.jp/news/2020/12/29/national/pandemic-japan-fiscal-sustainability/
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.