“I am more concerned with the return of my money than the return on my money.”
– Mark Twain
In the last two weeks, two federal interest rates hit all-time record lows. On December 16, the market was taken by surprise when Fed Chairman Ben Bernanke lowered the federal funds rate (the interest banks pay to borrow the reserves they need to meet their reserve requirement) to zero. The explanation given was that the Federal Reserve was just setting the rate closer to where banks had already been trading with each other for weeks. 1
In an even more stunning development, the week before that the federal government itself began borrowing money for free. “We were all watching it agog,” said a Treasury spokesman of the December 9 auction of three-month Treasury bills. Investors were so hungry for Treasury debt that they were snatching up the T-bills at zero percent interest. In the secondary market (investors buying from each other), Treasuries were actually trading at a negative interest rate. That meant buyers were paying more than they would get back when the Treasuries came due. Even at these unprecedented rates of non-return, the Treasury was having trouble keeping up with the demand. Four times as much money wanted in as was sought by the government, indicating much more demand than availability. 2
What is going on? The credit market remains so tight that state and local governments are being forced to pay interest rates as high as 20 percent. Why is the debt of our insolvent federal government so much more desirable that investors are clamoring to buy it when the return is zero or even negative? The U.S. government is the most indebted nation in the world, with an official federal debt topping $10 trillion. Everyone knows that this debt never can or will be paid off with taxpayer dollars, now or in the future. Commentators have been warning for years that the federal debt would soon be so crippling that foreign investors would flee and the interest alone would be more than the taxpayers could pay. Why are investors now rushing in to buy the U.S. government’s exploding debt, even at a 0% return? Wouldn’t their money be safer and more liquid tucked under the mattress or left in cash in the bank?
Why Lend Money for Free?
The explanation proffered by commentators is that mattresses are vulnerable to thieves; and the U.S. government, though insolvent, is less likely to file for bankruptcy than either your local bank or your local government. If your bank goes bankrupt, your money will become part of an FDIC receivership. You may get it back eventually, but you could be doing without it for longer than you would like. Another problem with cash, for investors who have a lot of it, is that it can’t be moved from place to place without reporting it; and huge amounts of money are difficult to convert to currency, making it more convenient to just park the funds in Treasuries.
What makes the debt of the insolvent U.S. government less risky than that of state and local governments is that the federal government has the power to print its way out of any dollar deficiency. Not that the Treasury actually prints Federal Reserve Notes (dollar bills) – the Federal Reserve does that – but the Treasury can always print more bonds, which the Federal Reserve can then be counted on to buy with new dollar bills (or, more often, with new computer entries in bank accounts).
Something More Interesting than Interest?
While that may all be true, it still doesn’t seem to explain a sudden surge of interest in a potentially risky investment that generates zero profit. Or could it be that the profit is coming in other ways than interest? For banks, U.S. Treasuries are highly sought after regardless of interest rate, because the securities are considered “risk-free” for purposes of meeting the “risk-weighted” capital requirement of the Bank for International Settlements. Under the Troubled Asset Relief Program (TARP), banks can bolster their balance sheets by swapping T-bills for riskier “toxic” collateral, including those pesky derivatives that are messing up their books. Banks are allowed to buy Treasuries with their “excess reserves” (the amount by which the bank’s deposits have not been leveraged by a factor of ten or so into new loans). 3 By putting these lendable funds into T-bills, the TARP recipients can remove them from the reach of riskier borrowers. The fact that the Fed is now paying interest on the reserves that banks hold at the central bank could also factor into the equation. 4
Adding to the heavy demand for federal securities may be competition from the Federal Reserve itself. On December 1, 2008, Chairman Bernanke announced that the Fed could soon be providing “liquidity” to the frozen credit market by buying “longer-term Treasury and agency securities on the open market in substantial quantities.”5 For the Fed to buy U.S. Treasuries with money created on a printing press is actually nothing new. The process is called “open market operations” and is how the Fed has always expanded the money supply. But the Fed is now talking about “substantial quantities,” and today that could mean trillions. The Los Angeles Times reported on November 30 that the loans, commitments and guarantees of the Treasury and the Fed together now come to $8.5 trillion. 6 That’s roughly half the gross domestic product of the whole country; yet Congress approved only $700 billion in its latest bailout excursion in October. Where is the other $7-plus trillion coming from? The Fed is obviously just creating it with accounting entries on computer screens. 7 A trillion here, a trillion there, as the saying goes, and pretty soon you’re talking real money.