by Edwin M. Truman, Peterson Institute for International Economics
© Institute for International Economics. All rights reserved.
The author is a senior fellow at the Institute for International Economics. He served as assistant secretary of the US Treasury for international affairs from December 1998 to January 2001. Before joining the US Treasury, he was director and later staff director of the Division of International Finance of the Board of Governors of the Federal Reserve System beginning in June 1977. He joined the staff of the Federal Reserve in July 1972 and was on the staff of the Federal Open Market Committee from March 1977 until he resigned from the Federal Reserve.
This policy brief is based on remarks delivered on 23 February 2001, at an American Enterprise Institute Conference “Is It Really Good Policy to Pay Off Publicly Held Treasury Debt?” and on testimony delivered on 22 March 2001, before the Committee on the Budget of the US Senate.
The debate about what to do with the projected substantial federal budget surpluses over the next 10 years focuses on three basic options: cut taxes, increase expenditures, and retire or pay down federal debt. The result will be a combination. The issue is that of relative proportions. Larger tax cuts imply that a smaller share of projected surpluses will be devoted to increasing expenditures or paying down debt. Paying down more debt means that tax cuts or expenditure increases will have to be smaller.
Consequently, the arcane subject of debt management has come under intense scrutiny as part of the larger debate over the budget surpluses. That scrutiny focuses on two analytical questions, one normative and one positive: How much US Treasury debt in the hands of the public should be paid down? How much US Treasury debt can be paid down? Both questions have international aspects, which are the principal focus of this policy brief.
I conclude that, as long as the overall health of a growing US economy is maintained, longer-term prosperity will be enhanced by maximizing the extent to which we pay down the Treasury’s debt. The international economic and financial implications are fundamentally benign if the process is part of a coherent, credible, and confidence-inducing long-term fiscal policy strategy, and the technical aspects are well prepared.
Foreign holders (private or official) do not present an obstacle to paying down at reasonable cost to American taxpayers a significant amount of outstanding Treasury debt maturing after 2011.
The largest international risk with respect to paying down the debt is that a failure to carry it through undermines international confidence in US economic and financial policies (specifically hard-won achievements in eliminating fiscal deficits and sustaining that record of fiscal rectitude for several years), and reduces national saving in the face of a growing current account deficit. If confidence in US economic and financial policies is undermined by decisions on longer-term fiscal policy, it could contribute to a collapse of the dollar on foreign exchange markets and, thereby, adversely affect the overall performance of the US economy.
Paying down the $3.4 trillion in publicly held US Treasury debt (including debt held by the Federal Reserve) should be a net benefit to the US economy. As Chairman Greenspan has testified, “all else being equal, a declining level of federal debt is desirable because it holds down long-term real interest rates, thereby lowering the cost of capital and elevating private investment.”1 As a result, the capital stock would be larger, the US economy would be more productive, and standards of living would be raised for most Americans. The central question is whether we can reasonably assume that everything else would be equal.
Answering this question with regard to fiscal policy involves issues in addition to matters of debt-management policy. For example, is projected aggregate demand likely to be too weak or too strong in the period immediately ahead and beyond? What is the proper role and size of the federal government in society? How should a better balance between saving and investment in the economy be achieved? The principal, significant economic issue is whether the associated trajectory for US Treasury debt, appropriately measured and discounted, can reasonably be expected to be sustainable. The US economy can maintain full employment with a debt of 40, 20, zero, or minus 10 percent of GDP so long as the path is not explosive. However, that is a low bar. The key issue for fiscal policy is which of these levels of debt is optimal for the overall longer-term health of the economy; recent experience suggests that lower is better.
Similarly, with respect to monetary policy, the stability of the US financial system does not require that the Federal Reserve purchase only US Treasury debt for the asset side of its balance sheet to match increases in its liabilities. For many decades, it has been convenient to implement US monetary policy primarily within such a framework. Absent sufficient US Treasury debt to continue to operate within that familiar framework, technical questions will have to be addressed and, perhaps, laws changed. However, as Chairman Greenspan has reported, the Federal Reserve is well on its way toward meeting the challenge to the implementation of monetary policy associated with the prospective decline in Treasury debt outstanding.2 It will find acceptable substitutes, though ultimately the Federal Reserve may have to ask Congress to broaden its authority order to do so, for example, to permit the Federal Reserve to purchase a wider range of assets or operate in a wider range of markets. There is, moreover, every reason to believe that the Federal Reserve will be an active, constructive, and positive participant in the process of paying down the US Treasury debt, including that portion of the debt held by the Federal Reserve itself.
Thus, from a domestic macroeconomic perspective, the case is compelling for maximizing the pay down of Treasury securities in the hands of the public as long as short-term stabilization policies maintain a healthy growing US economy.
International Economic and Financial Implications
The international economic and financial implications of a prospective decline in Treasury debt outstanding are fundamentally benign. Financial market institutions and financial market participants (foreign and domestic, private and official) will adjust and are adjusting. The net result should be only a few paragraphs in international monetary and financial history, perhaps, with a few interesting footnotes. The best public policy would be to lay out a realistic trajectory for paying down the stock of Treasury debt, provide reasonable advance notice about how debt-management operations will take account of that trajectory as it evolves, and inform and consult market participants (including foreign official holders that will need to respond smoothly to changes) along the way. The key to a successful pay down of the debt will be the smoothness and predictability of the process. The “glide path” should be well prepared.
We already have preliminary aggregate data on adjustments by international investors to the reduced supply of US Treasury obligations because of budget surpluses and to the pay down of that debt. These data clearly demonstrate that market institutions and foreign holders of US Treasury obligations are adjusting. These data confirm the basic conclusion of an International Monetary Fund study on this issue: “The shrinking supply of US Treasury securities has already resulted in significant changes in US and international financial markets, particularly in terms of the instruments that are used by market participants for various purposes.”3 Indeed, a close reading of that study suggests that while the process of adjustment to the disappearance from the market of US Treasury securities is not yet complete, at this point it could be highly disruptive to reverse it when the market is already gearing up and changing its modi operandi.
It is useful to distinguish between foreign private and foreign official holders of US financial obligations and also to recognize that, today, the former group is far more important than the latter. In 1980, foreign official authorities held 40 percent of foreign-owned assets in the United States, other than direct investment. Twenty-five percent of the total was accounted for by foreign official holdings of US Treasury securities. By contrast, by the end of 2000, foreign official authorities held less than 15 percent of all foreign-owned nondirect investment assets in the United States and less than 9 percent of the total was official holdings of US Treasury securities.4 Thus, private investors hold the bulk of all foreign financial claims on the United States, and by the end of 2000 almost 90 percent of the claims of private holders were non-Treasury instruments.
Going forward, the attitudes of foreign private investors toward US financial assets and markets are much more important that the views of official holders of US Treasury securities. Their assessments of overall US economic and financial conditions, and the prudence of US economic policies, are much more important than what they may think about the potential absence of US Treasury obligations in the array of potential investment instruments. Moreover, foreign private holders of US Treasury debt behave similarly to domestic private participants in US financial markets. They adjust quite rapidly to changing market conditions. Their recent behavior with respect to Treasury securities supports this view.
At the end of 2000, foreign private holdings of US Treasury securities were a slightly larger (10 percent) share of total foreign-owned financial assets in the United States than were foreign official holdings of such assets (9 percent). The private share had risen from only 3.5 percent of total foreign-owned financial assets in the United States in 1980, but the share was declining. In 1999, foreign private holders sold (net) $20 billion of Treasury securities; they purchased $331 billion of all other US securities. Last year, net sales of Treasuries rose to $52 billion; at the same time, purchases of all other US securities rose to $466 billion, as the US current account deficit widened further.
Between 1997 and 2000, foreign private holdings of financial claims on the United States (total foreign private assets in the United States less direct investment claims) rose by an estimated $1.7 trillion. Over the same period, foreign private holdings of Treasuries declined by about $20 billion. Foreign private investors added about $1.4 trillion to their holdings of US stocks and bonds, $191 billion to their claims on US banking organizations, $136 billion to their claims on nonbanking organizations, and $40 billion to their holdings of US currency. Thus the share of Treasuries in total foreign private holdings declined from 17 percent in 1997 to only 11 percent by the end of 2000.
In other words, what if the $1.7 trillion addition to foreign private financial assets in the United States over the past three years had been allocated to investments in the same share as the stock of $3.9 trillion was allocated at the end of 1997? The answer is that 17 percent would have gone into Treasuries for an increase of $295 billion. That amount plus the $22 billion reduction in holdings of Treasuries that actually occurred, or a total of $317 billion, is measure of the dramatic reallocation of foreign private investment funds toward private US assets and a substitution away from Treasuries.5
Markets are adjusting to the reduced availability of US Treasury securities, and foreign private investors in US financial assets are adjusting right along with them without any pronounced effects on interest rates or exchange rates.
Foreign official holders of Treasury securities, on the other hand, normally are slower to adjust to changing financial conditions because profit maximization is generally not their paramount motivation. However, monetary authorities are not insensitive to changes in relative rates of return and the liquidity of their assets. Moreover, they tend to favor shorter-maturity obligations, and thus they will tend to be affected later by any growing scarcity of Treasury debt. A reasonable estimate is that no more than 5 percent of the roughly $575 billion in foreign official holdings of US Treasuries at the end of 2000 had a remaining maturity of more than 10 years.6 In other words, in evaluating, as I do below, the overall willingness of foreign holders of Treasuries to participate in the buyback program or a potential exchange program, official holders are not quantitatively significant even if, contrary to any reasonable assumption, they do not participate at all.
Foreign official holdings of US Treasury securities have declined slightly since the end of 1996. They have risen as a share of the shrinking total stock of publicly held Treasury securities but as a share of total foreign official assets in the United States they have declined. Between the end of 1997 and the end of 2000, total foreign official claims on the United States rose almost $90 billion, while their holdings of Treasuries declined $9 billion, from 71 percent of their total portfolio to 63 percent. Holdings of “other US government securities” (principally debt securities of US government corporations and agencies) rose $70 billion over this period and holdings of “other assets” (principally bonds and stocks) rose $28 billion. Over the same three-year period, if the share of Treasuries in foreign official assets in the United States had remained at the 1997 level (71 percent), holdings of Treasuries would have risen $63 billion instead of declining $9 billion.7
Foreign official holders also are adjusting to the reduced supply of Treasuries, responding to changing market conditions, and substituting away from Treasuries.
Late last year, the US Treasury took steps to encourage and facilitate the education and adjustment process for foreign official holders to the prospect of a reduced supply of Treasury debt. In mid-November, the Treasury announced that as of February 1, 2001, FIMA (Foreign and International Monetary Authority) account participants in Treasury auctions would be limited in the amounts they could roll-over and add-on to Treasury auctions via noncompetitive tenders. The effect of this change is to channel a limited number of large purchases by foreign official investors into the open market. This change has two important implications. First, it adds to the liquidity of primary and secondary markets by increasing volume. Second, in part as a consequence of the extensive consultations in advance of the announcement, the change has helped to sensitize foreign official holders to think well in advance about their investment strategies in a world where there will be a dwindling amount of US Treasury debt. It is instructive to note that the Treasury announcement on 14 November 2000 did not produce even a ripple of reaction in the US government debt market or in foreign exchange markets, nor was there any reaction when the new policy was implemented in early February 2001.
In this connection, it is highly desirable that the status of the government-sponsored enterprises and of their debt obligations is clearly established because of the potential for the obligations of these entities to be treated as close substitutes for US Treasury securities with a de facto official guarantee.8 The first-best policy would be for Congress to pass appropriate legislation regarding the regulation, supervision, and transparency of these entities and clarify the status of their liabilities. It is noteworthy that for statistical purposes the Commerce Department report foreign purchases of their debt instruments as “other US government securities.” Under these circumstances, it is hardly surprising that foreign investors view them as differing little from US Treasury securities, and the Commerce Department would be well advised to review its presentation or these data. Absent such legislation, the US monetary authorities should conduct an aggressive educational campaign to address the potential moral hazard issues involved in this view of these securities. This campaign should focus on foreign monetary authorities because too many of them operate in domestic environments where government guarantees are both implicit, and frequently and successfully implemented.
Repayment of US Treasury Obligations Prior to Maturity
In a few cases, foreign central banks face legal restrictions with respect to the assets, including assets denominated in foreign currencies, that they hold as the counterpart of their monetary liabilities (largely currency). Most already invest in a broad range of dollar-denominated assets in addition to Treasury debt. As with the Federal Reserve, some may need to seek new legal authority to invest in acceptable substitutes in the future, but the amounts involved are not likely to be quantitatively significant.
Japan is the largest official holder of US Treasury debt by a large margin, but in the Japanese case, the principal holder is not the central bank but the
finance ministry and finance ministries typically have much greater discretion in this regard.
Notwithstanding the broad range of US dollar obligations held by foreigners (private as well as official), some may be reluctant to participate in US Treasury buyback or exchange programs for reasons of inertia or extreme risk aversion. However, the bulk of foreign investors do not fall in that category. It is more reasonable to assume that foreign investors’ preferences lie along a continuum with respect to how they view the trade-off between risk and return. Some foreign investors respond quickly to marginal changes in market conditions. Others may adjust more slowly. However, rapid adjustment is not required to accomplish smoothly a substantial pay down of US Treasury debt over the next 10 years, including through buybacks or exchanges for securities that mature after 2011.
Ex ante, the issue of judging the overall willingness to participate in programs to facilitate early repayment of Treasury debt rests on experience and analysis. To date, experience has been positive. In particular, foreign holders have not complained. That trend should be expected to continue. In the end, the facts will speak for themselves, but I see no a priori reason to presume that the recent buyback program will not continue smoothly and inexpensively. Moreover, buyback operations are small; they can be fine-tuned as Treasury gains further experience.
With respect to foreign holders of longer-maturity Treasury debt (maturing after 2011), the most reasonable assumption is that their behavior is the same on average as that of all other investors. However, it is useful to consider the potential magnitudes involved.9 As noted above, assuming that no more than 5 percent of total foreign official holdings of US Treasury obligations are invested in instruments maturing after 2011, the amount would be less than $30 billion.
Assuming that maturity distribution of foreign private holdings of Treasuries is the same as the outstanding stock of marketable Treasury debt currently in the hands of the domestic and foreign private sector (i.e., excluding the Federal Reserve and foreign official holders), the share of their Treasuries maturing after 2011 would be about 22 percent, or $140 billion. This leaves a great deal (about $320 billion) to be bought back from domestic holders even if foreign holders were completely unwilling to have their holdings retired in advance, which would be an extreme assumption, unsupported by the evidence or common sense.10 The data presented earlier on recent adjustments of foreign private and official investors in US financial assets demonstrate that they already are adjusting quite rapidly to the reduced supply of Treasuries and substituting away from Treasuries as they expand their portfolios.
In addition, it is highly likely that foreign private holders disproportionately prefer shorter-maturity Treasury debt, as in the case of foreign official holders, because of the interaction of foreign exchange and liquidity risk; in other words, the share of longer-maturity Treasuries in their aggregate portfolios is probably considerably less than 22 percent. Moreover, as Treasuries become scarcer, their liquidity declines, and foreign as well as domestic holders of Treasuries should welcome opportunities to liquidate their holdings by selling them to the Treasury. The central point is that foreign holders of Treasuries on average are not likely to be disproportionately reluctant to participate in buyback programs. Their risk-reward trade-offs are the same as for all other holders. They respond to similar market-based incentives.
Impact on the Dollar
Some may argue that paying down publicly held Treasury debt will adversely affect the dollar, that is, dollar exchange rates could come under intense downward pressure because the supply of risk-free, liquid Treasury debt will dry up. Such an event is not likely, especially if the US economy stays strong and US economic and financial policies remain prudent and responsible. My reasoning is as follows.
First, because paying down Treasury debt in the hands of the public is good for the US economy, it will be good for the dollar. Economic theory predicts that, to the extent that a relative increase in the productivity of the US economy is the fundamental force producing a capacity to contemplate a program of paying down Treasury debt, we should witness, first, an appreciation of the dollar to accommodate the increased imports needed to support faster expansion and, later, a depreciation to facilitate the sale of an increased supply of goods and services.11 However, neither of these movements, if they occur and are not masked by other contemporaneous developments, should be associated with anything like a crisis of confidence in the dollar–quite the reverse. The dollar would merely be responding to economic forces.
Second, what about the effects of changes in interest rates on the dollar? If one accepts the productivity story, underlying US real interest rates should rise initially and ceteris paribus the dollar would be expected to appreciate. However, as the debt is paid down with the proceeds of increased tax revenues and the influence of higher US productivity is manifested in an increased supply of goods and services, US interest rates should decline across the board, which ceteris paribus would tend to depress the dollar. There is nothing to suggest that this channel should produce a collapse in the dollar. Quite the reverse: less US government debt, higher investment, a larger capital stock, and a more productive US economy would tend to enhance the overall attractiveness of US assets over the longer term.
Third, will not the dollar be adversely affected by a reduced attractiveness of dollar-denominated assets and less liquidity in US financial markets? As argued earlier, because the processes and policies (macro and micro) associated with paying down the stock of US Treasury obligations are good for the US economy, they should be good for US financial markets, which can and do adjust, and for the attractiveness of investing in dollar-denominated assets in US financial markets. In this connection, I see no merit, especially from an international perspective, in preserving the Treasury market while continuing to run substantial budget surpluses, for example, by investing excess budget revenues in private assets instead of paying off Treasury debt in the hands of the public.12
Fourth, in the absence of an available stock of US government obligations at a time of international financial crisis, will not the dollar’s role as a safe-haven currency be adversely affected? Although there may be differences of opinion on this point, the US government’s being a large-scale issuer of a safe-haven asset provides no overriding economic benefit to the US economy as a whole. The availability of Treasuries is a convenience for market participants but money flows into and then out of such assets with little lasting net effect on the real economy. The Treasury market provides a positive externality but it is not a public good in the sense that there is a demonstrated case that there is an inadequate supply of riskless or low-risk assets.13
Moreover, in recent times of crisis the dollar has not been systematically boosted by safe-haven considerations. International flights to quality in the form of US Treasury obligations, to the extent that they have occurred in recent years, have not been manifested in significant dollar appreciation. Perhaps, the increased availability and use of derivatives helps explain this pattern.
More broadly, the national and global financial systems have not just one type of asset but also a number of potential safe-haven (risk-less or low-risk) assets to which to fly at times of stress. Again, markets adjust to changing circumstances.14 They have time to adjust to the substantial elimination of US Treasury debt as a potential safe-haven asset but once the stock gets down to the irreducible minimum, whatever that figure proves to be, the availability of a few $100 billion more or less of Treasuries will make little difference.
Finally, what about the effects on the dollar of paying down Treasury debt operating through the channel of the US current account deficit?
If the evolution of the US fiscal position permits a substantial pay down of Treasury debt, that implies a further increase in US government savings, which should contribute to a rise in US savings relative to US investment. A reduction in the savings-investment imbalance would be mirrored in the narrowing of the current account deficit, perhaps, through the mechanism of the increased price-competitiveness of US goods and services, possibly associated with some depreciation of the dollar. On the other hand, recent experience has been that the positive swing in the US fiscal position and the associated increase in the overall US savings rate have been more than matched by an increase in US investment, and the current account deficit has widened.
Alternatively, if we do not pay down the debt, and instead divert increased fiscal resources to increased public or private expenditure, thus reducing national savings, conventional analysis suggests that the dollar would appreciate and the current account deficit would widen further. However, conventional analysis may again be incomplete and misleading; the dollar might, in fact, depreciate, perhaps because of a loss of confidence in the orientation of US economic policies and a further widening of the current account deficit. In my view, this is the principal international risk with respect to paying down Treasury debt: our failure to do so will undermine the strength of the US economy and confidence in US economic and financial policies.
If US economic and political developments produce a substantial pay down of publicly held US Treasury debt, and that process is well prepared, the pay down will have positive consequences for US economic performance. Paying down the debt should have benign international economic and financial implications. Market institutions and participants are already adjusting to the reality and the prospect of a substantially reduced availability of US Treasury obligations by shifting toward liabilities of the US private sector. Market institutions are adjusting as well. Foreign holders do not present unique obstacles to programs directed at paying down Treasury’s publicly held debt prior to maturity on reasonable terms. At present, the largest international risk is that a failure to carry through on the realistic prospect of paying down US Treasury debt at some point contributes to a disorderly collapse of the dollar on foreign exchange markets because that failure reduces national savings and undermines confidence in US fiscal policy.
4. The Commerce Department has not yet released estimates of the US international investment position for the end of 2000. The data cited in the text are constructed from the stock estimate for the end of 1999 plus transactions recorded in 2000, exclusive of valuation adjustments, except for data on holdings of Treasury securities as of the end of 2000, which include valuation adjustments.
5. A similar exercise involves looking at only the allocation of estimated earnings on the holdings of Treasuries at the end of 1997; if investors had earned over the past three years a total of 15 percent on the end 1997 stock of $662 billion and reinvested the resulting earnings in Treasuries, holdings would have gone up $99 billion rather than down more than $20 billion.
7. Looked at from the somewhat broader perspective of total foreign exchange reserves in dollars held either in the United States or elsewhere, and assuming that the dollar’s share of total foreign exchange holdings in 2000 was the same as in 1997 (about 60 percent), that total rose by more than $200 billion over three years. The share of Treasuries in the total declined from 60 percent to 49 percent. If the $200-billion increase in foreign official dollar reserves over the three-year period had been allocated to investments in the assumed 60 percent share that prevailed at the end of 1997, $120 billion would have gone into Treasuries compared with the actual decline of $9 billion. In fact, the latest estimates by the IMF show that the dollar’s share in global foreign exchange reserves rose from 62.1 percent in 1997 to 66.2 percent in 1999. International Monetary Fund, 2000 Annual Report, 109.
8. Securities of government-sponsored enterprises (GSEs) such as the Federal National Mortgage Association trade at a relatively narrow spread to US Treasury securities. Recently those spreads have been close to 50 basis points for two-year notes and somewhat wider for longer-maturity instruments.
9. Benchmark data on the maturity structure of foreign private and official holdings of US Treasury securities for end-1994, and soon for March 2000, are available to the Treasury, but have not been published.
10. Gary Gensler, former Treasury undersecretary for domestic finance, in testimony before Committee on Finance of the US Senate on 29 March 2001, estimated that “Treasury could smoothly retire one-half, and possibly up to two-thirds, of its current long-term marketable debt in private hands over the next 10 years” of which $460 billion matures after 2011.
11. An alternative story is that the recent acceleration of labor productivity in the United States has disproportionately affected traded goods industries and distorted the terms of trade between traded and nontraded goods in the United States, requiring a subsequent adjustment via currency depreciation.
13. Theoretically, the presence of a riskless asset encourages risk taking by allowing, through diversification, a reduction in the overall risk in a portfolio. In the case of the Treasury market, there are close substitutes. Diverting flows of funds into the Treasury market weakens banks and their role in the financial system; their assets are only slightly more risky, and with safe-haven flows of funds into banks there is only a limited price effect because banks’ balance sheets are more flexible. Moreover, to the extent that the Treasury market encourages risk taking, one can ask in today’s world whether it encourages too much or too little.
14. Chairman Greenspan has spoken of the development of quadruple—A securities, and said on this point, “you cannot replicate the degree of risklessness in US Treasury securities fully in the private market. You can get very close.” House Committee on the Budget, 2 March 2001. On 27 April 2001, addressing the Bond Market Association, he said, “I am confident that US financial markets, which are the most innovative and efficient in the world, can readily adapt to a pay-down of Treasury debt by creating private alternatives with many of the attributes that market participants value in Treasury securities.”
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