National Debt Retirement Poses Difficulties for Monetary Policy
August 14, 2000
The Treasury Department has 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. The publicly held debt may be extinguished by 2009.
This could create serious economic problems because the Federal Reserve conducts monetary policy exclusively through buying and selling Treasury securities. When it buys securities it creates the money to pay for them, causing the money supply to expand. When it sells securities it draws money out of the economy, causing the money supply to contract.
As the market for Treasury securities shrinks, however, the risk of disruption becomes greater and the Fed must compete with private investors for available Treasuries.
In the 1980s, Britain, like the U.S., ran budget deficits that were quite large as a share of the gross domestic product. When Britain ran budget surpluses, it actually caused interest rates to rise sharply.
- 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 Bank of England viewed the permanent debt reduction the same as a temporary cash surplus -- as a reduction in the money supply. It offset the surpluses by permanently expanding the money supply. This led rising inflation and a falling pound, causing interest rates to rise. The return of deficits in 1991 fixed the problem and led long term interest rates to fall.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, August 14, 2000.
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