Why Treasury Debt Matters More than the End of QE

Large markets for standardized goods tend to be impersonal. The market's ability to function depends more on the quantity and quality of goods for sale than on who buys the goods. This applies to markets for financial assets too — and it's important to keep in mind when weighing the potential effects of the current volume of U.S. Treasury debt against the impact of the Federal Reserve's decision to end quantitative easing.

Under the Fed's historic bond-buying program, the central bank purchased longer-term Treasury debt and Fannie Mae and Freddie Mac mortgage-backed securities from primary dealer banks like JPMorgan Chase and Citigroup. The Fed then paid the banks by putting credits into their accounts with the Fed, known as reserves. Increasing banks' reserves was supposed to stimulate the economy by encouraging banks to lend, and possibly even removing some risk from bank balance sheets by purchasing the mortgage-backed securities. Any evidence that it worked seems limited at best.

Some critics worried that quantitative easing could cause severe price inflation, possibly even a hyperinflation, since increasing bank reserves also means boosting traditional measures of the money supply. That doesn't seem to have happened. Banks have earned interest on reserves similar to the interest they would earn on short-term U.S. Treasury debt. Professor John Cochrane at the University of Chicago observed in 2010 that this helps make dealer banks indifferent between reserves or short-term Treasury debt and may well limit the extent to which banks turn excess reserves into new loans. If banks aren't significantly boosting lending, there's a cap on the potential for big spending increases to drive up prices. So for now, at least, quantitative easing appears to have been a wash.

It's also interesting to note that the effect of quantitative easing may have been mitigated by the fact that the Federal Reserve operates like a private, regulated monopoly banking corporation that pays a very high tax rate. It has a monopoly on issuing U.S. dollars, and earns income in the form of the interest it receives from asset holdings like Treasuries. The Fed then pays its expenses and dividends to member banks and turns the rest back over to the Treasury. As an active participant in the market for Treasuries, the Fed through quantitative easing simply changed who holds the debt.

Going forward, a bigger concern is the quantity of Treasury debt, which as of Oct. 28 was just shy of $18 trillion, and whether the market will want to hold that amount in the future. For now Treasuries are in high global demand: foreign central banks and investors here and abroad want them. (Fed economist Carol Bertaut and co-authors show in a series of papers that this global element of demand may in fact be what keeps Treasury debt prices high and yields low.) Basel-type bank capital requirements favor the use of highly rated sovereign debt like Treasuries; Treasuries also play a key role as collateral in many financial transactions. As long as demand exists, the large quantity of Treasury debt isn't a problem.

Should the Treasury signal that it cannot pay back its bondholders, however, the demand to hold them would vanish. Herein lies the hyperinflationary scenario. For example, if Congress decided not to raise the debt ceiling, that might trigger events leaving the U.S. Treasury no choice but to default on the debt. This would lead people in the U.S. and abroad drop Treasuries at the same time, leaving only taxes and the money-printing presses to finance government spending, which could in turn produce hyperinflation. For this reason, discussions about how to curtail future government spending have become particularly urgent in recent years.

As Alexander Hamilton once observed, "A national debt, if it is not excessive, will be to us a national blessing." With quantitative easing out of the way, it's time to focus on curbing the excessive volume of U.S. Treasury debt by addressing spending.

Stephen Matteo Miller is a senior research fellow and member of the Financial Markets Working Group in the Mercatus Center at George Mason University.