The government spends more than it takes in from taxes and other revenue sources. This gap between spending and revenue is often called the budget deficit.
The government borrows the money to pay for the additional spending.
It pays interest on the money it borrows, and this interest becomes another kind of government spending.
Congress has set a limit on the overall amount of debt the government can accumulate. If we reach that limit, the government is not permitted to borrow any more money. No new bonds can be issued.
The reason the debt ceiling is a potential crisis is that we’re running into the debt limit. If we cannot borrow or find a way to either immediately raise revenue or cut spending, we’ll have to stop paying certain kinds of obligations. Not all of them, of course. We’ll still have some income. But the government currently borrows around $125 billion each month—and so we’d need to find a way to take in an additional $125 billion each month or cut $125 billion from our monthly spending.
One potential source of new revenue is the Federal Reserve, which is required by law to remit its profits to the Treasury Department. If the Fed sold part of its enormous Treasury holdings, the profits from these sales would be new revenue for the government. That revenue isn’t borrowed—and so it doesn’t count as new debt.
The Fed could sell even more than just its Treasuries. It has acquired a portfolio with lots of other financial assets that could be sold.
All profits would be revenue for the Treasury Department.
Of course, no one knows exactly how much money this would generate.
It’s never been done before. It’s really only a possibility because of the massive expansion of the Fed’s balance sheet in recent years.
I know it sounds a bit mind-boggling to say the Fed could sell the U.S. government debt it bought to prop up the economy and use the profits from those sales to fund the U.S. government. It almost sounds like the government is double dipping, issuing the same debt twice.
In a way, this is right. Welcome to the wonderful world of modern monetary policy.
Javers objected that the Fed selling Treasurys would drive prices down. This is usually what happens when the Fed sells. But I’m not sure it would happen this time around. Think about it. With the Treasury Department not selling any new bonds, there would be a market shortage. The Fed could sell without driving up interest rates or prices down because it would simply be filling the gap left by the Treasury Department’s exit.
Would this be “massively contractionary?" Ordinarily, it might. But in this case the proceeds from the sale would go to fund government spending—which could actually be economically expansionary. Certainly it wouldn’t be any more contractionary than a budget deal that includes massive tax hikes and massive spending cuts.
Will this happen? I’m not so sure. It’s very far afield from the usual actions taken to support monetary policy. Quite a few of the bigwigs at the Fed would likely object to engaging in this kind of creative policy making.
On the other hand, some inflation hawks may view the temporary lack of new bond issuances as an opportunity for the Federal Reserve to shrink its balance sheet without shrinking the economy.
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