The Debt Limit: A Note on the G Fund and the Exchange Stabilization Fund

The G Fund is one of the funds offered to federal employees as part of the Thrift Savings Plan, the federal employee equivalent to a 401(k) plan.  This fund is invested in one-day non-marketable Treasury securities with an interest rate determined monthly. There is a special provision in the law creating the Thrift Savings Plan that makes the G Fund whole if the Secretary of the Treasury decides to disinvest it entirely or partially due to a debt limit problem once the debt limit issue is resolved. The nonmarketable Treasury securities in the G Fund count against the debt limit, thus, disinvesting the G Fund makes room under the debt limit for the Treasury to issue marketable Treasury securities in order to raise needed cash.

The G Fund is included in intragovernmental accounts. As of the end of December 2022, its assets were $210.9 billion.

The Exchange Stabilization Fund (ESF) is a fund managed by the Secretary of the Treasury. It is primarily used for foreign exchange operations. Here is the Treasury’s brief description of the ESF.

As of November 30, 2022, the ESF had $210.3 billion in assets, of which $17.6 billion were in non-marketable Treasury securities. When the ESF is disinvested because of a debt limit problem, the Treasury does not have the authority to make it whole once the debt limit impasse is resolved.

The Bipartisan Policy Center (BPC) has a description here of what it calls “the big three” extraordinary measures. These are the G Fund, the ESF, and federal employee retirement funds.

Interestingly, Jerome Powell, before he was nominated by President Obama and confirmed to be a governor of the Federal Reserve, worked at BPC. He took a particular interest in debt limit issues, which he knew first hand as an Under Secretary of Treasury for Domestic Finance in the George H. W. Bush Administration. (He was for a time my boss at Treasury.) Probably his efforts at lobbying Republicans in Congress on the debt limit while at BPC during the Obama Administration was a factor in his nomination to the Fed Board.

Debt Limit and Treasury Securities Held by the “Public”

The debt limit reporting in the media is fairly good on the political aspects of the issue, but less good on other relevant aspects.

One issue has to do with the size of the debt. The debt limit is $31.4 trillion and the debt subject to that limit is bumping up against that number. However, reporting I have seen fails to mention that of that $31.4 trillion, about $6.9 trillion is held by intragovernmental accounts, including the Social Security trust funds. The Treasury consequently reports that about $24. 6 trillion is held by “the public.”

However, included in “the public” is the Federal Reserve System. Federal Reserve outright holdings of Treasury securities currently stand at about $5.5 trillion. (The system also reports owning $2.6 trillion of mortgage-backed securities, which they state are “fully collateralized” by Treasury securities.)

Subtracting the $5.5 trillion from $24.6 trillion leaves about $19.1 trillion of “privately-held” debt of the type subject to the limit. This includes foreign holdings, including foreign governments and central banks.

While the Federal Reserve Banks are technically private corporations owned by the member banks, for most analytical purposes they should be considered part of the government. The Fed remits “excess earnings” to the Treasury. Its major expenses are for its operations, interest paid on bank reserves, and interest paid in connection with its open market operations. A major source of income is interest received on Treasury and other securities. (For more on this, see this Fed press release.)

While $19.1 trillion is still a large number, the current reporting misses that close to 40 percent of  the debt subject to limit is debt that the government essentially owes itself or to the Federal Reserve.

A Comment on "A Monetary and Fiscal History of the United States, 1961–2021" by Alan S. Blinder

Prominent economist and former vice chair of the Federal Reserve Board has written an interesting and accessible book on macroeconomic policy from 1961 to 2021. The title is deliberately similar to the tome written by Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960. Blinder clearly wants to emphasize that fiscal policy matters.

Blinder’s perspective of this history is mostly persuasive, and he effectively argues against Milton Friedman’s simplistic and often quoted statement: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” One of the weaknesses of monetarism as a policy guide is its assumption that velocity is more or less constant in the famous identity, MV=PQ. Monetarism holds much less sway among economists than it did in the 70s and 80s.

While I recommend the book for those interested in the subject from historical, political, or economic perspective, I will focus here on Blinder’s comments about economic policy in the first few years of the Reagan Presidency. I did not find Blinder’s analysis here convincing.

When Reagan entered office, the Federal Reserve under Paul Volcker was pursuing a very tight monetary policy and the economy was suffering from a recession. In the summer of 1981, the Congress passed and Reagan signed The Economic Recovery Tax Act of 1981, which provided large tax cuts. Also, there was a large increase in defense spending, and the federal budget deficit increased dramatically.

In other words, monetary policy was contractionary and fiscal policy was expansionary. As we know, this policy mix eventually worked. Inflation came down and the economy recovered. However, in discussing this episode, Blinder attacks economist Robert Mundell.

Blinder states that “according to the mainstream view, contractionary monetary policy (à la Volcker) raises real interest rates, though perhaps only transitorily, and slows the growth of aggregate demand...[E]xpansionary fiscal policy (à la Reagan) raises real interest rates and speeds up the growth of aggregate demand. Put them both together at the same time, as Reagan and Volcker did, and you should expect real interest rates to rise sharply while the net effect on real output depends on how the tug-of-war just sketched works out.” (p. 143). 

He contrasts this conventional view with what Mundell wrote in a 1971 paper: “Monetary acceleration is not the appropriate starting point from which to initiate the expansion [in 1971], because the risk of igniting inflationary expectations. Tax reduction is the appropriate method. It increases the demand for consumer goods, which reverberates on supply...Because of the idle capacity and unemployment, in many industries increased supply can generated without causing economy-wide increases in costs. Tax reduction is not, therefore, inflationary from the standpoint of the economy as a whole.” (p.144). 

There does not seem to be a huge difference between the two views, but Blinder asserts without much discussion that there is. He views the “Reagan-Volcker policy mix” as “a bold experiment” and asks: “Which side of the policy mix debate came out looking better?” He answer that it is “the conventional side, by a country mile.” To prove that, he discusses an increase in real interest rates (defined as the Treasury ten-year rate minus CPI inflation over the past 12 months) and an increase in the dollar exchange rate. However, he has not provided any information about what Mundell may have said about the effect on real interest rates or exchange rates. 

While one can criticize both the size and the details of Reagan’s enormous tax cuts, the size and details of the increase in defense spending, and the effect on the lives of many people suffering from unemployment at least partly due to monetary policy, it is nonetheless true that the economy recovered and inflation came down. Blinder does not like the argument that Mundell essentially made: the government had two policy goals (ending the recession and reducing inflation) which should be addressed with two different policy instruments (fiscal and monetary policy). Blinder may have good reasons to disagree with using fiscal and monetary policy differently when faced with stagflation, but he does not effectively argue why. 

It is not clear whether Reagan or his economic advisers had developed their economic policy with any formal analysis of the combined effect of a contractionary monetary policy and an expansionary fiscal policy. They may have stumbled into it for polical or ideological reasons. Blinder is surely right that Republicans have since then seemed to think that tax cuts are always the answer to whatever the current economic problem is and are effectively more relaxed about budget deficits after the Reagan experience (no matter their rhetoric arguing for balanced budgets).  

It is disapointing though that Blinder does not have a better analysis of the policy mix in the early Reagan years and whether he thinks that there could have been better policies at the time. A better thought out and explained argument against what Mundell was advocating would have been interesting.     

A Note on Liz Truss, Pension Funds, Financial Markets, and Systemic Risk

The common wisdom is that the financial markets punished Liz Truss and her Chancellor of the Exchequer, Kwasi Kwarteng, for their plan to cut taxes and increase deficit financing. However, Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, in a Bloomberg Opinion article (also appearing here in the Washington Post), and others argue that the Bank of England is responsible for the end of the Liz Truss government. Kocherlakota writes: 

The common wisdom is that financial markets “punished” Truss’s government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting Sept. 23, when the Truss government announced its mini-budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to bring a government to its knees.

The big change came in the price of 30-year UK government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds. These funds had bought long-term gilts with borrowed money and entered derivative contracts to the same effect — positions that generated huge collateral demands when prices fell and yields rose. To raise the necessary cash, they had to sell more gilts, creating a doom loop in which declining prices and forced selling compounded one another.

Given this observation, Kocherlakota draws two conclusions about the Bank of England. The first conclusion is that it failed in its regulatory mission and did not do anything about too many pension funds following similar investment strategies that go under the rubric “LDI” (“liability-driven investing”). This failure forced the Bank of England to buy gilts even though it was following a monetary policy of tightening credit conditions. Mr. Kocherlakota makes a good point here.

The second conclusion Kocherlakota makes is more speculative: “[The Bank of England] refused to extend its support beyond Oct. 14 — even though its purchases of long-term government bonds were fully indemnified by the Treasury. It’s hard to see how that decision aligned with the central bank’s financial-stability mandate, and easy to see how it contributed to the government’s demise.” The head of the Bank of England, Andrew Bailey, denies that he was trying to force Liz Truss out.

The Liz Truss government is history, but going forward this aspect of her downfall demonstrates potential problems in financial markets as interest rates increase. The advice that pension funds and other institutional investors receive may not have a full discussion of the risks, and regulators may have difficulty identifying these issues before they become major problems.

In the early 1980s when I was working on financial market issues at the U.S. Treasury, pension funds investing to manage their liabilities for defined benefit plans were generally advised “to immunize” their balance sheet. One way of doing this was to strive to have the same “duration” for their assets as for their liabilities. (Duration is not maturity; rather, in its simplest form, it is an average of the time to each cash flow, including interest payments, weighted by the present value of each payment.) When the durations match, a given change in interest rates will produce offsetting changes equal in magnitude to a pension fund’s assets and liabilities. For example, an increase interest rates will decrease the current value of assets but will also decrease the current value of liabilities by approximately the same amount if the portfolio is immunized.

Apparently, some investment advisers to pension funds have now proposed that defined benefit plans use derivatives so that only part of their assets are used to immunize their liabilities This frees up room for them to invest in assets they believe will achieve higher returns. The problem is that when interest rates increase, they may be subject to margin calls on the derivatives that are in effect long positions in some underlying asset. If the interest rate increase is significant, then the pension funds will need to sell assets to meet the margin calls. If a number of funds need to do this at the same time, this can cause problems, depending on their collective relative size. (For those interested, here is some marketing material for LDI for pension funds.)

As for the implications in the U.S., an article in Pensions & Investments, “U.K.'s LDI-related turmoil puts spotlight on use of derivatives,” indicates that people in the pension industry are thinking about it. I assume that the Financial Stability Oversight Council, chaired by the U.S. Treasury, and its member agencies are also looking at this issue, and, one assumes, that the Labor Department, which has responsibility for pension fund under ERISA, is also looking at it.

Of course, the move by corporations to offer their employees defined contribution plans rather than defined benefit plans means that the share of retirement money that need some sort of immunization strategy has declined. The Pensions & Investments article suggests that the risks of something similar happening in the U.S. to what happened in the UK are not that great, but of course the regulators have access to more complete information, should they choose to ask for it, than do reporters.

While it may be true that LDI, as implemented in the U.S., does not pose a systemic risk in the U.S., though it may be a significant risk to some particular defined benefit plans, there may be other systemic risk issues in the U.S. and internationally as the Federal Reserve increases interest rates. One aspect of the 2008 financial crisis highlights the problem. I remember that even shortly before the crisis hits in full force, many investment professionals were arguing and providing detailed charts in support of their contention that the subprime mortgage market was relatively small and that problems there would not be a big deal. Many probably even believed that.

I hope the U.S. regulators learned from that experience and can put aside their turf issues and their “clientitis” inclinations and examine what dangers may be lurking. The Federal Reserve, to its credit, has made no secret of what it intends to do in the coming months.

Inflation is a Global Problem

This New York Times newsletter focusing on global inflation is worth reading. One can debate whether supply chains, excessive government spending, or monetary policy is the chief culprit for the current inflation, though they all play a role. Here is, in part, what the newsletter written by German Lopez says:

“The big factors that drove up inflation in the U.S. also affected the rest of the world: the disruption of supply chains by both the pandemic and Russia’s invasion of Ukraine, and soaring consumer demand for goods.

“But increasing inflation has played out differently in different countries, said Jason Furman, an economist at Harvard University. The U.S.’s earlier, bigger price spike had different causes than Europe’s more recent increase. (Countries differ in how they calculate price changes, but economists still find comparisons of the available data useful.)

“In the U.S., demand has played a bigger role in inflation than it has elsewhere. That is likely a result of not just the American Rescue Plan but also economic relief measures enacted by Donald Trump. Altogether, the U.S. spent more to prevent economic catastrophe during the pandemic than most of the world did. That led to a stronger recovery, but also to greater inflation.

“In Europe, supply has played a bigger role. The five-month-old war in Ukraine was a more direct shock to Europe than it was to the rest of the world, because it pushed the continent to try to end its reliance on Russian oil and gas. That prompted Europe’s recent jump in inflation.”

Trump Plans to Fire Civil Servants Involved in Policy If Reelected

This article in Government Executive caught my attention: “If Trump Is Reelected, His Aides Are Planning to Purge the Civil Service: Officials are looking to revive a controversial order issued in Trump's waning days and have already identified 50,000 federal positions to target.”

Trump wants to revive “Schedule F” and transfer civil servants into this new schedule which does not have the traditional civil servant protections. This was originally reported by Axios.

From the Government Executive article:

“The plan, as detailed to Axios and confirmed by Government Executive, would bring back Schedule F, a workforce initiative Trump pushed in the 11th hour of his term to politicize the federal bureaucracy. The former officials and current confidantes are, through a network of Trump-loyal think tanks and public policy organizations, creating lists of names to supplant existing civil servants. They have identified 50,000 current employees that could be dismissed under the new authority they seek to create, Axios reported and Government Executive confirmed, though they hope to only actually fire a fraction of that total and hope the resulting ‘chilling effect’ will cause the rest to fall in line.” 

From the Axios article:

“They [Trump allies] say Schedule F will finally end the “farce” of a nonpartisan civil service that they say has been filled with activist liberals who have been undermining GOP presidents for decades.

“Unions and Democrats would be expected to immediately fight a Schedule F order. But Trump’s advisers like their chances in a judicial system now dominated at its highest levels by conservatives.

“Rep. Gerry Connolly (D-Va.), who chairs the subcommittee that oversees the federal civil service, is among a small group of lawmakers who never stopped worrying about Schedule F, even after Biden rescinded the order. Connolly has been so alarmed that he attached an amendment to this year’s defense bill to prevent a future president from resurrecting Schedule F. The House passed Connolly’s amendment but Republicans hope to block it in the Senate.”

Father Coughlin ‒ Right Wing Predecessor of Tucker Carlson

Father Charles E. Coughlin was a right-wing radio personality in the 1920s and 30s. It is estimated that his radio audience reached 30 million at its peak. That is enormous.

Two articles on Father Coughlin: “When Radio Stations Stopped a Public Figure From Spreading Dangerous Lies” and “How a Canadian-born Irishman paved the path of hatred that leads to Tucker Carlson.”

From the Smithsonian Magazine article:

“In speeches filled with hatred and falsehoods, a public figure attacks his enemies and calls for marches on Washington. Then, after one particularly virulent address, private media companies close down his channels of communication, prompting consternation from his supporters and calls for a code of conduct to filter out violent rhetoric.

“Sound familiar? Well, this was 1938, and the individual in question was Father Charles E. Coughlin, a Nazi-sympathizing Catholic priest with unfettered access to America’s vast radio audiences. The firms silencing him were the broadcasters of the day.

“As a media historian, I find more than a little similarity between the stand those stations took back then and the way Twitter, YouTube and Facebook have silenced false claims of election fraud and incitements to violence in the aftermath of the siege on the U.S. Capitol – noticeably by silencing the claims of Donald Trump and his supporters.”

From the Yahoo article:

“It was a descendant of the Irish who became one of mass media's most famous racists and a fellow traveler of the Nazis. Father Charles E. Coughlin was a Catholic priest and the founder of the Shrine of the Little Flower in Detroit. Born in Canada, Coughlin preached a particularly poisonous brand of hatred and antisemitism in the 1930s. Through his radio show, he reached 30 million Americans a week, or one-quarter of the U.S. population at the time. For comparison, today's best-known racial dog whistler, Tucker Carlson, reaches about 3 million out of 340 million.”