Who Is Financing the Federal Government?

Matt Klein reports that while the Federal government is currently financing the Federal government foreign demand is up ticking, "...The U.S. federal government has sold about $5.4 trillion in bills, notes, and bonds since the end of 2019. Who has been on the other side? In practice: the U.S. federal government. Most of the borrowing has been effectively self-financed. The reason is that federal deficits have facilitated a surge in household and business holdings of bank deposits, money-market fund shares, and other safe liquid assets. Much of those savings have then been recycled into purchases of Treasury debt. At the same time, generous federal aid to states and localities—plus unexpected budgetary windfalls due to soaring housing and stock markets, robust income growth for top earners, and sustained consumer spending, which in turn can be explained in part by the federal government’s extraordinary support programs—have left America’s subnational governments with huge surpluses that have been recycled into Treasury bills, notes, and bonds. The net effect is that most of the money that the Treasury borrowed to disburse to the rest of the economy has been lent back to the federal government.... The main change is that demand from “rest of the world” has soared, which is why average quarterly demand for all of 2020Q1-2021Q2 was almost identical to 2015Q1-2019Q4 despite the unprecedented selling that occurred in the first half of 2020. More Treasury notes and bonds were bought by investors domiciled abroad in the first half of 2021 ($364 billion) than in any other two-quarter period outside of 2010. That’s more than offset the ongoing liquidation of bills accumulated during the peak of the panic. For better or worse, the rebound of foreign purchases represents a return to normalcy. It also helps explain the persistent strength of the dollar in the face of a rising current account deficit. How much of this buying can be attributed to explicit or surreptitious currency intervention by foreign governments is a subject for another time...."

Matt Klein, "Who Is Financing the Federal Government?,"The Overshoot, October 1, 2021, https://theovershoot.co/p/who-is-financing-the-federal-government

Who Is Financing the Federal Government?

The U.S. federal government has sold about $5.4 trillion in bills, notes, and bonds since the end of 2019. Who has been on the other side? In practice: the U.S. federal government. Most of the borrowing has been effectively self-financed.

The reason is that federal deficits have facilitated a surge in household and business holdings of bank deposits, money-market fund shares, and other safe liquid assets. Much of those savings have then been recycled into purchases of Treasury debt.

At the same time, generous federal aid to states and localities—plus unexpected budgetary windfalls due to soaring housing and stock markets, robust income growth for top earners, and sustained consumer spending, which in turn can be explained in part by the federal government’s extraordinary support programs—have left America’s subnational governments with huge surpluses that have been recycled into Treasury bills, notes, and bonds.

The net effect is that most of the money that the Treasury borrowed to disburse to the rest of the economy has been lent back to the federal government.

According to the latest release of the U.S. Financial Accounts, the major buyers of marketable Treasury securities since the end of 2019 have been, in descending order of importance: the Federal Reserve (about $3 trillion), money-market mutual funds ($1.2 trillion), state and local government treasuries ($555 billion), and U.S. banks and credit unions ($535 billion).1

That’s a big change from before the pandemic.

From 2015Q1—just after the Fed had fully tapered its bond purchases from LSAP3—through 2019Q4, the U.S. Treasury issued about $207 billion in bills, notes, and bonds more than it repaid each quarter, on average.

Pension plans, insurers, money funds, mutual funds, and ETFs bought about $84 billion each quarter on behalf of savers, on average, while U.S. banks, credit unions, and U.S. branches of foreign banks bought about $20 billion.

“Households and nonprofits”, a category that includes hedge funds,2 bought about $56 billion each quarter on average, with the biggest purchases in 2018 and early 2019. The “rest of the world”, which includes U.S. hedge funds legally domiciled in the Caribbean, the offshore subsidiaries of U.S. multinationals that recycle retained earnings into U.S. fixed income to avoid taxes, as well as foreign insurers, pension plans, and central banks, bought about $29 billion each quarter, on average. The Fed was letting its portfolio shrink by about $10 billion each quarter, on average.

From 2020Q1 through 2021Q2, the Treasury issued about $898 billion of marketable debt securities each quarter, with about half of all that borrowing taking place in 2020Q2. That extra issuance has been absorbed entirely by the Fed, money-market funds, state and local governments, and U.S. banks and credit unions.

The surprise windfall

State and local government tax receipts have surged 10% compared to before the pandemic. Personal income tax revenue is running 20% above pre-pandemic levels, corporate profit tax revenue is running 27% above, and sales tax revenue is 11% above.

Residential and commercial property taxes are the single biggest revenue source for states and localities. Collections are up only 3% so far, but the recent 20% surge in house prices should get baked into assessments and provide another tailwind to government revenues in the years ahead.

State and local government policymakers hadn’t expected any of this when the pandemic began. They remembered the last downturn, when tax revenues fell 9% from 2008Q2 to 2009Q2 and took years to recover in nominal terms. The initial reaction to the pandemic was therefore to slash investment budgets and to lay off workers quickly. Capital spending net of depreciation was 9% lower in 2021Q2 than in 2019Q4 on a seasonally-adjusted basis, while payrolls are still about down about 1 million from February 2020.

The net effect is that the underlying budget deficit of the aggregate state and local government sector was 19% smaller in 2021Q2 than in 2019Q4 on a seasonally-adjusted basis. On top of all this, state and local governments got about $350 billion in general purpose aid from the federal government ($150 billion in 2020Q2 and $200 billion in 2021Q2), as well as around $20 billion in additional Medicaid funding.

So far, treasurers of the states and localities have used their windfalls to buy Treasury debt in unprecedented size, although it’s likely that these surplus holdings will be liquidated in the years ahead to provide additional public goods and services.

With the exception of state and local governments, the big buyers of Treasury debt—the Federal Reserve, money-market funds, banks, and credit unions—are intermediaries. They buy Treasury bills, notes, and bonds only to the extent that others are willing to hold their liabilities. So if we want to answer the question of who is financing the Treasury, we must therefore look at who is financing these other entities.

A brief tour of the Fed’s balance sheet

The biggest and most obvious buyer of Treasury securities during the pandemic has been the Fed. After buying about $820 billion in March 2020 and $675 billion in April 2020, the Fed has settled into a purchase schedule of about $80 billion a month, or $240 billion each quarter. That’s about half of what the Treasury has borrowed, on average, in the first half of the year. (Note that the Fed is likely going to start “tapering” these purchases by the end of this year and could be entirely out of the bond-buying business by next summer.)

The Fed has financed its purchases—as well as its purchases of $1.1 trillion of mortgage-backed securities—by creating offsetting liabilities. The yields on these liabilities currently range from 0% to 0.25%, which is substantially less than the yields on the securities that the Fed buys. That difference explains why the Fed pays about $100 billion a year to the Treasury in profits. The central bank’s purchases effectively transform longer-duration debts yielding 1-3% into money-like claims yielding roughly zero. The government’s debt doesn’t disappear, but the effective interest costs paid by the government are reduced by about a fifth.

Since the end of February 2020, the Fed has created about $2.4 trillion in additional deposits held by banks as reserves (of which about $700 billion are additional reserves held by the U.S. branches of foreign banks), about $1.5 trillion in repo liabilities3 (mostly to money-market funds) and about $400 billion in physical currency.

Reserves

Banks hold reserves at the Fed to settle payments with other banks, to manage their cash needs, and to satisfy regulatory requirements to back their short-term debts (mostly deposits held by households and businesses) with high-quality liquid assets. The Fed creates and destroys reserves by buying and selling securities and by adjusting the size of its lending programs. The banking system as a whole can only get rid of reserves by transforming them into other Fed liabilities, which generally requires the cooperation of other sectors of the economy.4

Problems can flare up when banks need to hold more reserves than are available to them. That’s why the Fed bought about $300 billion in Treasury bills in October 2019-February 2020—before the pandemic—to ensure that there were enough reserves to keep the banking system stable. It also did about $200 billion in repo lending to securities dealers during that period to ensure there was enough money available to prevent interest rates from spiking.

The Fed’s pandemic-induced bond-buying fixed the reserve shortage, but it had the potential to create a new problem: banks were getting stuffed with low-yielding assets relative to their shareholder capital. That threatened banks’ ability to comply with the supplementary leverage ratio (SLR): a hard limit on the ratio of bank assets/equity, with no allowances for the quality of the assets banks hold. The leverage ratio was created as a backstop to prevent banks from gaming the risk-weighted capital requirements, as they had before the financial crisis.

The Fed and the world’s other major banking regulators had two workarounds. First, they created exemptions to the leverage ratio rules. Reserves would no longer be counted as assets against shareholder equity. (The Fed, unlike other regulators, also allowed banks to hold as much U.S. Treasury debt as they wanted without triggering the SLR.) Second, the regulators curtailed dividends and buybacks, forcing the banks to retain earnings. That lifted the equity side of the ratio, especially after factoring in the impact of government income support on loan losses.

But then the Fed allowed the SLR exemption to expire on March 31, 2021. At the time, I wrote—correctly, as it turns out—that this wouldn’t be a big deal. Banks might be constrained in their ability to grow their balance sheets by adding deposits and reserves, but the financial system as a whole would be fine as money-market funds expanded to fill the gap. And it turns out that the banks weren’t even that constrained, with reserves rising roughly $300 billion since mid-March, although the pace of increase has been slower than before.

The Treasury General Account and the Reverse Repo Facility

To understand the rise and fall of the Treasury General Account (TGA) balance—and the subsequent surge in the Fed’s repo borrowing—we need to look at Treasury bill issuance and at the behavior of money-market mutual funds.

On the eve of the pandemic, the face value of Treasury debt maturing in under a year was $4.9 trillion. By June, that number had jumped to $7.4 trillion. About 90% of the total increase in federal debt was financed by issuing extra Treasury bills, rather than notes or bonds.

This borrowing proved to be excessive. Despite the surge in spending associated with pandemic relief, the Treasury ended up raising a lot more cash than it needed. The result was a $1.4 trillion increase in the Treasury’s own deposits held at the Fed in the span of a few months. In other words, the Treasury was selling bills to the public and then depositing the proceeds at the Fed, which then went out and bought notes, bonds, and mortgages. That helped push down the supply of bank reserves as the Treasury effectively “sterilized” some of the Fed’s asset purchases.

The TGA balance has been liquidated in 2021 to finance the American Rescue Plan Act and, more recently, to cover the government’s spending needs as the debt ceiling strangled new debt issuance. (Once the debt ceiling is raised, the TGA should rise again.)

As the Treasury spent down its TGA balance into the broader economy, it provided cash to the private sector. Some of the money has ended up in the banking system as deposits, thereby re-entering the Fed as reserves.

But banks don’t want more deposits and reserves if it means bumping into the SLR, which could mean limits on dividends and buybacks. So they’ve been encouraging depositors to take their savings elsewhere by charging punitive fees. As a result, most of the money released from the TGA has gone outside of the banks and into money-market mutual funds, which have turned around and lent to the Fed via the repo market.

Money-market funds and banks

Money-market mutual funds bought about $1.2 in Treasury bills in March-May 2020, which was about half of the total amount issued. From then through February 2021, direct holdings of Treasury securities were basically flat. More recently, money funds have sold about $370 billion of direct holdings of Treasury debt and added about $800 billion in repo exposure to Treasury securities, with the Fed almost certainly on the other side of those transactions. (The main reason is that the Fed’s repo facility offers better yields and liquidity for money funds than Treasury securities.)

Banks have mostly added reserves to their balance sheet, rather than Treasury securities, but they have still bought a decent chunk of bills, notes, and bonds since the pandemic began. At least, they did plenty of buying after having sold off some of their holdings during the worst of the financial crunch in March and April.

But banks and money funds are intermediaries just like the Fed. So how have they been financing their own balance sheets?

In both cases, the answer is: household and business savings accumulated thanks to the combination of cash infusions from the federal government and spending constraints. Households and nonprofits have boosted their holdings of bank deposits, money fund shares, and physical currency by $3.8 trillion since the end of 2019, while U.S. businesses (corporate and noncorporate) have lifted their holdings of deposits and money fund shares by $1.5 trillion. Not all of that cash has gone into Treasury debt or to the Fed, but most of it has.6

The bulk of the household saving boom can be attributed to the combination of nearly $2 trillion in federal government income support plus the rise in forced saving due to the pandemic’s impact on consumer services. As for companies, they drew on bank credit lines and sold bonds to raise cash early in the pandemic, but ended up not needing the money as sales and profits snapped back. That snapback in turn was a function in part of the government spending that supported both businesses directly as well as their customers.

What’s changed in 2021?

I’ve spent most of this piece looking at the total amount of debt the Treasury has sold since the pandemic began. But there have been some interesting shifts more recently that warrant some attention. Note that we only have comprehensive data for the first half of the year.

Most of the big buyers—the Fed, state and local governments, and U.S. banks—continued to be big buyers in 2021H1. “Households”, which likely means hedge funds, continued to be big sellers. Money funds largely stopped direct purchases, although their rising repo lending to the Fed means they are still big sources of indirect financing, as noted above.

The main change is that demand from “rest of the world” has soared, which is why average quarterly demand for all of 2020Q1-2021Q2 was almost identical to 2015Q1-2019Q4 despite the unprecedented selling that occurred in the first half of 2020. More Treasury notes and bonds were bought by investors domiciled abroad in the first half of 2021 ($364 billion) than in any other two-quarter period outside of 2010. That’s more than offset the ongoing liquidation of bills accumulated during the peak of the panic.

1 There have been other buyers, such as mutual funds, ETFs, pensions, and insurers, but those purchases have been largely offset by sales from hedge funds, U.S. offices of foreign banks, and U.S. securities broker-dealers. There has been a reallocation of Treasury holdings from more speculative buyers to “real money” investors, but these transactions aren’t financing the aggregate increase in issuance.

2 Hedge funds are lumped in with “households and nonprofits” and with “rest of the world”, depending on their legal domicile. The Fed publishes information on hedge funds’ consolidated balance sheet with a lag in the Enhanced Financial Accounts, but this includes changes in valuations/ So far, the data on hedge funds only go through the end of 2020. From 2019Q4 through 2020Q4, hedge fund holdings of Treasury debt fell by more than $300 billion even as the prices of individual bonds rose. The quarterly data on transactions shows that “households and nonprofits” sold $380 billion in U.S. Treasury debt from 2020Q1 through 2021Q2.

3 The Fed sells bonds to its counterparties for cash and promises to buy (repurchase) the bonds back the next day at a slightly higher price. The result is extremely similar to a deposit that pays interest. The main difference is that savings held at the Fed as repos can only be accessed once a day.

4 For example, an old-fashioned bank run where depositors demanded physical currency from their ATM en masse would destroy reserves without changing the size of the Fed’s balance sheet. The Treasury could destroy reserves by selling T-bills, taking deposits from the banking system and generating proceeds that could then be deposited in the Treasury’s account at the Fed. That’s more or less what happened with the Supplementary Financing Program in 2008, as well as in March-July 2020. The TGA, discussed in the next section, has a similar effect.

5 Bank reserves are up by a little more than $2.4 trillion. As of the end of August, money-market repo lending to the Fed was up around $800 billion. Total usage of the Fed’s reverse repo facility has gone up another $250 billion since then. But some of that lending might be from counterparties other than money funds.

6 About 72% of the total increase in bank deposits since the start of the pandemic has been matched by a rise in holdings of reserves and Treasury securities. Banks have also bought about $800 billion of agency MBS while money funds have sold about $300 billion.