No Free Lunch For Government Debt

Matt Yglesias has a post advocating fiscal stimulus in the form of checks sent to all Americans. While discussing the bonds that would be issued to finance the increased deficit, Yglesias makes this claim:

The federal government needs to pay interest on the bonds, but that interest becomes Fed profits which are rebated to the Treasury so there’s no actual cost.

Of course, the total federal debt will go up, but the more important “debt held by the public” will not since the extra debt will, by law, be perpetually held by the Fed rather than by the public.

That would be true if the bonds were bought with zero interest currency notes, and the currency notes stayed in circulation forever. Most of the debt, however, will be purchased with interest-bearing bank reserves. This is because a large permanent increase in the stock of zero interest currency would likely cause the Fed to overshoot its 2% inflation target. Maybe not right away, but certainly after the economy recovered and interest rates rose above zero.

So let’s assume that the deficit is financed by issuing Treasury debt, and the Fed buys the debt with interest-bearing bank reserves. In that case, there is not likely to be much Fed profit to offset the interest burden on the Treasury. Yes, the Fed will earn interest on the bonds it purchases, but it will pay interest on the bank reserves that it injects into the economy.

In general, the interest rate on bank reserves is roughly equal to the interest rate on T-bills. While it is usually (but not always) the case that interest rate on bank reserves is below the interest rate on longer-term bonds, that sort of “profit” could be earned simply by shortening the maturity of the Treasury’s outstanding debt. For various reasons, the Treasury prefers to borrow by issuing bonds of a wide range of maturities.If the Fed bought longer-term bonds with bank reserves they would probably earn a profit, but there is risk involved.

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