Central Banks and the Dangerous Dance with Government Deficits
Former Reserve Bank of India governor Raghuram Rajan has raised a critical question about modern monetary policy. He asks whether central banks worldwide are accidentally helping create a dangerous cycle of unsustainable government spending. This issue goes far beyond the United States Federal Reserve, touching economies across the globe.
The Growing Mountain of Debt
Many nations now carry sovereign debt that equals or exceeds their total economic output. Japan and the United States stand as prominent examples. To prevent debt levels from reaching terrifying heights, these countries must reduce their fiscal deficits. The challenge becomes especially severe when real interest rates climb higher.
Higher rates directly increase government borrowing costs, making deficits even larger. This situation creates a potential nightmare scenario. Economists call it a "doom loop." Here is how it works:
- Rising interest rates push government deficits higher.
- Those larger deficits make investors nervous about a country's finances.
- Nervous investors demand even higher interest rates to lend money.
- The cycle repeats, pushing borrowing costs ever upward.
In theory, higher market rates could serve as a useful warning. They might force governments to cut deficits before a crisis hits. However, fiscal consolidation requires painful austerity measures. Most politicians hesitate to impose such hardship on voters, especially near election time.
The Historical Temptation of Money Printing
Faced with this political difficulty, governments have often turned to their central banks for help. Historically, some directed their central banks to buy government debt directly. The central bank would create new money—essentially printing it—to make these purchases.
This injection of cash led commercial banks to lend more freely. Businesses and consumers spent that money, creating an economic boom. Unfortunately, that boom invariably fueled inflation. To control runaway prices, the central bank then had to slam on the brakes. It would raise policy interest rates sharply, often above the inflation rate.
The final outcome was worse than the original problem. The boom-and-bust cycle damaged the overall economy. Meanwhile, the government still faced higher costs to service its debt. Learning from these painful experiences, many countries eventually banned direct central-bank financing of government deficits.
The Return of Indirect Financing Through QE
That ban did not last forever. After the 2008 financial crisis, a new method emerged. With interest rates already near zero, central banks needed another tool to stimulate growth. They turned to large-scale asset purchases, known as quantitative easing or QE.
Under QE, a central bank buys government bonds from financial institutions like banks. It pays for these bonds by creating new central bank reserves. The stated goal was monetary stimulus. Officials hoped banks would use the cash from bond sales to make new loans to businesses.
Proponents insisted this was not fiscal financing. The central bank bought bonds from the market, not directly from the treasury. They argued it was a pure monetary operation, reversible through quantitative tightening when the economy recovered.
Why Quantitative Tightening Proved So Difficult
The theory sounded good, but practice told a different story. Launching QE was easy. Reversing it through QT proved incredibly hard. The US Federal Reserve's experience illustrates this perfectly.
Between 2008 and 2014, the Fed's Treasury holdings ballooned from $800 billion to about $2.5 trillion. When the Fed attempted to reduce this balance sheet in 2018, financial markets reacted badly. The selling pressure caused market turmoil, forcing the Fed to stop and start buying again in 2019.
Then came the COVID-19 pandemic. Massive government spending required support. By mid-2022, the Fed's Treasury portfolio hit a staggering $5.8 trillion. Today, with the US economy strong and inflation persistent, logic suggests it's time to reduce holdings.
Yet the Fed has paused its QT program. Its Treasury holdings remain at $4.2 trillion—five times the 2008 level. Furthermore, it has announced new purchases of Treasury bills, starting with a $40 billion buy in January. What was once called a monetary operation now looks suspiciously like fiscal support.
The Indirect Channels of Support
The Fed might claim it is simply managing system liquidity. However, Rajan and his colleague Anil Kashyap point to a complex chain of indirect financing. Natural long-term investors like pension funds find government bond yields too low. They prefer corporate bonds for better returns.
Since long-term corporate bonds are scarce, these funds use a workaround. They buy shorter-term corporate debt and then use Treasury bond futures to extend their portfolio's duration. This creates massive demand for these futures contracts.
Hedge funds step in to sell the futures. To hedge their own risk, they buy actual government bonds. They finance these purchases in the repurchase market with enormous short-term borrowing. This entire structure relies on ample liquidity supplied by the Federal Reserve.
This intricate system makes the Fed a central player in deficit financing, both through its own bond holdings and by providing the liquidity that keeps the hedge fund mechanism running. It supports the market for government debt in a roundabout but critical way.
Risks of Instability and Complacency
No one suggests an immediate doom loop for the United States. The risks, however, are real and growing. Artificially low government borrowing costs remove pressure on Congress to reduce deficits. This lack of incentive raises the long-term danger.
Furthermore, the Fed itself faces financial vulnerability. It finances its Treasury holdings with reserves that reprice daily. If interest rates rise significantly, the Fed's losses will mount quickly, potentially worsening a fiscal crisis.
The current arrangement is inherently unstable. Hedge funds now finance over a trillion dollars of long-term government debt with fragile short-term borrowing. This is not a solid foundation for economic stability.
The Federal Reserve is not alone in this predicament. Central banks globally are entangled in similar direct or indirect fiscal support. Their commitment to supplying ample reserves may actually increase the instability of government debt markets.
Rajan concludes with a sobering thought. For the long-term health of their economies, central bankers need to find better answers. They must address whether their current policies are quietly enabling fiscal risks that could one day erupt into crisis. The time for clear-eyed assessment is now, before the doom loop becomes a reality.
