US government debt and money growth

Economic activity around the world has collapsed as governments in the US and elsewhere have put in place social restrictions to contain the spread of Covid-19.

A natural consequence is that tax revenues have fallen considerably as large parts of the economy are in effect in lockdown.

Taxes such as corporation tax and payroll tax aren’t being generated or collected to the degree they were prior to the pandemic.

We can see this in the US for which we have daily data on government tax receipts.

Since the end of March 2020, the amount of total federal taxes raised has fallen by around $200 billion on a 12-month rolling basis.

Unfortunately, daily figures for total US federal government outlays are not available.

However, we can glean some information about outlays from other daily time series - for example, unemployment insurance benefits.

Again measuring on a 12-month rolling average basis, spending by the Treasury on unemployment insurance has been climbing steeply, reminiscent of what occurred in the 2008/09 recession, although on this occasion unemployment claims have risen far more rapidly, suggesting a higher unemployment rate than at the time of the global financial crisis. 

Growing fiscal deficit

With federal tax revenues falling and outlays increasing, the fiscal deficit will continue to expand from an already high level.

Measured on a 12-month rolling sum basis, the fiscal deficit reached US$1 trillion in March 2020, equivalent to 4.8% of GDP.

It is difficult to put exact figures on the eventual size of the fiscal deficit, but on 24 April the non-partisan Congressional Budget Office forecast a deficit of US$3.7 trillion by the end of fiscal year 2020 (i.e. by end-September), five times the US$744 billion deficit at the end-March half-way point.

To finance the deficit, the US Treasury can issue either Treasury bills, notes, or bonds.

Bills have a maturity of up to one year, notes have a maturity of between two and seven years, and bonds have a maturity of over seven years.

In order to finance the fiscal response to Covid-19, the US Treasury has initially decided to issue Treasury bills.

In part this is to take advantage of the sudden increase in demand for highly liquid, perceived safe securities during the crisis.

The amounts needed for the recently announced household and business support programmes such as increased unemployment insurance, the payroll protection plan or help for small businesses are clearly very large.

As a result, net issuance of Treasury bills since late March has already increased total federal debt outstanding from US$23.6 trillion to US$24.7 trillion.

Who is purchasing this large volume of Treasury bill issuance?

Data from the US Federal Reserve (Fed) shows that commercial bank holdings of these securities are currently growing at slightly over 11% per annum (measured on a 13-week annualised basis), up from a growth rate of slightly under 4% per annum in late February 2020.

Combined with credit line drawdowns by commercial and industrial companies (which have raised loan growth from 4½% p.a. to over 13%), M2 money supply growth has surged to 17.8% p.a., its highest growth rate since 2011.

Another group of buyers of Treasury bills are the money market mutual funds.

In the US there are three types:

1. Government funds (which invest primarily in Treasury bills and repos on government securities),
2. Prime funds (which invest in riskier short-term instruments like certificates of deposit and commercial paper),
3. Tax-exempt funds (which invest in state and municipal debt).

Since changes in the regulations governing money market funds in 2016, the safer government funds have become by far the largest.

As the crisis intensified during March there was a huge shift from riskier securities into safer government money market funds.

Since the end of February assets held within these funds - which used to be included in M3 - have risen by over US$1 trillion, and now total US$3.8 trillion.

Unfortunately, and in our view mistakenly, the Fed ceased publication of M3 in 2006.

However, we can construct a definition of the money supply which approximates to the discontinued M3.

Our “Proxy M3” measure includes M2, large time deposits at commercial banks and institutional money market funds.

This measure of money has been growing at 18.4% p.a. (compared to 17.8% for M2) and has been primarily driven by very strong growth of government money market funds.

In summary, by selling T-bills either to banks or to the money market funds the authorities are relying on the creation of money to fund the debt.

To prevent this financing from becoming inflationary, a substantial part of the increase in federal debt will, in the longer term, need to be funded with “real money” savings from the domestic non-bank private sector (i.e. from domestic pension funds, insurance companies, and other corporate and individual savers, or from overseas).

In practice this will mean switching from T-bill issuance to issuing longer term debt and selling the debt to buyers other than banks or money market funds.

What are the implications for inflation of these recent, rapid rates of money growth?

In the short term we expect that sentiment will be dominated by the Covid-19 recession and the collapse in energy prices, and therefore expectations of disinflation or even deflation will likely prevail for most of 2020, and possibly into 2021. 

As explained above, the recent sudden jump in money growth stems not so much from injections by the Fed (which mainly go to the financial sector anyway) but from (1) the banks buying T-bills, and (2) the drawdown of credit lines by companies ahead of their anticipated need for liquid funds during the lockdown.

These credit facilities are then credited to their deposit accounts.

From filings by listed companies we know that over US$200 billion and possibly as much as US$400bn of the US$600bn increase in lending by US commercial banks in March and April came from such drawdowns.

In addition, the shift by investors from riskier assets into so-called safe haven government money market funds has added to broader definitions of money.

However, these rapid growth rates are likely to be short-lived because, once the intense phase of the crisis is over, behaviour will become less risk-averse.

We also know that unless rapid money growth rates are sustained for at least a year or more, there will be little impact on inflation.

Many of those who predict inflation focus on the monetary base or the size of the Fed or central bank balance sheet.

After the global financial crisis many such pundits claimed that quantitative easing was dangerous on the grounds that it would lead to inflation.

But it did not.

The reason was that there is no direct linkage between the size of the central bank’s balance sheet (or the monetary base) and inflation.

It is money in the hands of the public, not money on the books of the central bank that creates inflation.