Morning Must Read: Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers on the Treasury Under Geithner and Lew Offsetting the Stimulative Effects of Federal Reserve Quantitative Easing

Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers: Government Debt Management at the Zero Lower Bound: 

Goals:
1. Quantify Fed vs. Treasury conflict in QE era.
2. Fed vs. Treasury in historical perspective.
3. A modern framework for debt management.
4. Ways to resolve Fed vs. Treasury conflict.


Pulling in Opposite Directions:
* The Fed’s Quantitative Easing (QE) policies have reduced the net supply of long-term securities.
* Meanwhile the Treasury was doing the opposite, extending the average maturity of its borrowings.
* Effect on Supply: Ten-Year Duration Equivalents:
* Federal Reserve: Quantitative Easing: -10.6%.
* Treasury: Maturity Extension +5.6%.
* Net Impact: -10.1%.


Market Impact:
* Relying on prior studies, we estimate that the Fed’s QE policies have lowered the yield on 10-year Treasuries by a cumulative 1.37 percentage points.
* Treasury’s maturity extension may have offset as much as one-third of QE’s market impact.
* Before 2008, the Fed’s balance sheet was far smaller. As a result, the Fed had little impact on the maturity structure of the
government’s consolidated debts.


Traditional Debt Management:
* Treasury’s traditional approach to determining the appropriate maturity of the debt traded off a desire to achieve low cost financing against the desire to limit fiscal risk.
* Issuing short-term is “cheaper” because it allows Treasury to capture the “liquidity premium” on T- bills and to conserve on the “term premium” investors demand to hold long bonds.

Fiscal Risks:
* Refinancing risk: if the government issues short-term, it is exposed to increases in interest rates; if the government issues long-term, it ‘locks in’ the cost of capital.
* Rollover risk: failed auctions and self-fulfilling bank runs.
* The desire to limit fiscal risk looms larger when the overall debt burden rises.
* Thus, Treasury has historically tended to extend the average maturity of the debt when debt-to-GDP ratio rises. Much like the Treasury is doing today.

Quantifying Fiscal Risk:
* We argue that the “fiscal risk” generated by issuing short-term debt is less important than traditionally thought:
* A standard deviation of debt-service costs of less than 1.5% of GDP.
* Purchased at an average price in excess average interest of 0.8% of GDP.
* Modern debt management recognizes that the maturity of government debt may also be a valuable tool for managing aggregate demand and promoting financial stability.
* Objectives of modern debt management have been assigned to Treasury and Fed, which exercise different policy weights.

Debt Management Conflicts:
* Expansionary monetary policy at ZLB
* Treasury extends average duration to mitigate fiscal risk.
* Fed shortens average duration to bolster aggregate demand.
* Fed and Treasury in direct conflict over objectives.
* Under contractionary monetary policy.
* The rise in premium on money-like assets increases the Treasury’s incentive to issue short.

Solving the Conflict:
* Outside of the zero-lower-bound, Fed sterilization of Treasury debt management is imperfect workaround.
* Fed gets last word using short rate.
* But sterilization no longer possible at the ZLB.
* Better solution: Treasury and Fed release annual joint statement on combined public-debt management strategy.
* Forces each agency to internalize other’s objectives.
* Fed charged with routine tactical adjustments because of its expertise in open-market operations.



Commenting, Federal Reserve Governor Jerome Powell appears to have said (i) that since quantitative easing had only minimal effects, its partial offset by the Treasury was no big deal, and (ii) requiring the Fed and the Treasury to talk to each other about debt maturity would infringe on the Federal Reserve’s autonomy by getting the Treasury unduly involved in monetary policy. His point (ii) I do not understand: the problem is that the Treasury’s debt-management already involves the Treasury in monetary policy, and coordination does not create that problem but merely recognizes it (and tries to mitigate it). His point (i) is strongly contested: the claim that the effects of quantitative easing have been minimal is an item of active debate where it seems to me that Powell is probably on the losing side.

Commenting, former Treasury Undersecretary for Domestic Finance Mary John Miller said that more cooperation would be highly problematic, but that she would not be surprised if in the future the Treasury revised what has been the Geithner-Lew debt maturity extension policies.

Commenting, Jason Cummins said that Fed-Treasury coordination would open the door to episodes like, as Binyamin Applebaum related it, “President Johnson’s summoning the Fed’s chairman, William McChesney Martin, to his Texas ranch, slamming him against the wall and telling him, ‘Martin, my boys are dying in Vietnam, and you won’t print the money I need.'”

Responding, Larry Summers said, in Binyamin Applebaum’s summary, that “his opponents… [were] ‘central bank independence freaks’ and… [that] it was ‘at the edge of absurd’ to suggest that debt management coordination would substantially erode the Fed’s independence.”