View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

§

JkCG)
11
JF ©\1h1 n CC
ff CC CG)

May 7,1 982

Financing the Defi ci t
According to Congressional Budget Office
estimates, Federal budget deficits in fiscal
years 1982 and 1983 cou Id reach $11 9
billion and $1 82 billion, respectivelyseveral times the size of any previous budget
deficit -i n the absence of any revenue or
expenditure changes. These deficits must be
financed by Treasury sales of bills, notes and
bonds. Some of this new debt will be purchased by the Federal Reserve System, but
the vast amount-perhaps 95 percent on the
basis of the last two years' experience-will
be purchased by private investors.
Also, in view of the increased strength of the
dollar, foreign official institutions probably
will not purchase as much of the new debt as
they formerly did, when they were able to
purchase Treasury securities with funds
obtained from buying cheap dollars in the
exchange markets. For example, foreign purchases of new privately-held public debt
dropped from 29.2 to 19.8 percent between
the June 1976-June 1980 period, when the
dollar was weak, and the June 1980-June
1981 period, when the dollar was much
stronger. This means that the burden of a
larger deficit will affect domestic financial
markets more than it did previously.
Large Treasury financing needs coupled with
high interest rates portend high interest costs
for the Treasury. These interest costs have
more than doubled in recent years, from
$29.1 billion in 1 977 to $73.3 billion in
1 981 . As a percentage of tot a I Federal expenditures, interest payments thus rose from.7
percent to more than 10 percent over that
period (Figure 1). In light of President
Reagan's call for reducing the cost of government, the question of how to minimize the
interest cost of the new debt becomes
especially important.

Minimizing cost
The Treasury could attemptto minimize costs
by ,affecting either the supply of or the de-

mand for its securities. The amount of cash
needed by the Treasury in any fiscal year is
given by the size of the deficit, so the Treasury
cannot choose the total supply of securities it
will issue. It can, however, vary the composition and maturity distribution of its supply of
bills, notes, ancibonds, and this choice could
affect the current and future interest costs of
the new debt. Alternatively,the Treasury
could minimize costs by increasing the demand for its securities, specifically by issuing
more attractive types of securities.
.
On the supply side, the Treasury could limit
the transaction costs that arise every time it
issues new debt. For example, it could issue
longer-term debt that would require fewer
refinancings. More importantly, itcould try to
minimize interest costs. This can be done
specifically by "playing the term structure."
That is, the Treasury could issue debt based
on what it believes to be the future course of
short- and long-term interest rates, and minimize its interest costs according to these
expectations.
Most theoretical work on the term structure
of interest rates follows the expectations
hypothesis, which states that in a world of
. certainty the yield on a multi-period security
(where the number of periods equals "n")
equals the yield that could be attained by
holding a series of one-period securities over
"n" periods. The term structure of interest
rates therefore wou Id provide predictions of
the future course of shorter-term interest
rates. For example, a positively-sloped term
structure-with long rates higher than short
rates-would imply an expectation of a future rise in short-term rates.
According to the expectations hypothesis,
securities of different maturities are highly
substitutable by both sides of the debt
contract. Given such substitutability in an
efficient capital market, the term structure
should not, in the long run, be greatly affected

Opini()jb
eXfji't.:ssed iii
nevvsiettei" do i'lOt
nCC2ssa ri
reflect the ViE\VS cd the management
Ear"ik ()f Sail FrarlCiscc),
of the
01 of the Board of Covernors of tht' Federal
Resl:.'rve SvsleiTl.

by an increase in the supply of bonds of any
particular maturity. If, over time, long-term
rates approximated the average of current
and realized
future,short-term rates, the
maturity distribution of new Treasury debt
makes little difference in cost. One could
argue that the government faced a rule analogous to the "Modigliani-Miller theorem"thatthe average cost of long-term financing to
a firm is independent of the debt-equity mix. -I
One mightthen argue that, with efficient capital markets, the government has no optimal
long-term/short-term debt mixture. In the
short run, however, this need not necessarily
be so. By appropriately altering the supply of
debt of different maturities, the Treasury
could potentially reduce its costs, just as private corporations do by funding short-term
when long-term interests rates rise above
what appear to be suitable levels.

A constant-purchasing-power bond would
induce lenders who fear inflation to purchase
the Treasury securities rather than real assets
such as gold. Furthermore, such a bond
would restore the role of Treasury securities
as "riskless assets," since both default and
inflation risk would be absent. Given the
enormous new supply of Treasury securities
overhanging the markets in the next two
years, this increased demand would be welcome. Finally, tying the interest cost of the
debt to the inflation rate wou Id force the Federal government to take stronger measures to
reduce the inflation rate. Issuing a constantpurchasing-power bond would appear to be
a positive step toward reducing the nominal
interest cost, especially if inflation were to
decelerate faster than expected by private
investors.

Increasingdemand

With a large deficit, Treasury financing operations can exert a severe impact on the financial markets. By issuing securities with a
broad range of maturities, the Treasury could
minimize its distortion ofthe term structure of
interest rates determined by the marketalthough as discussed earlier, there may be
little distortion in any event. Most empirical
work indicates that Treasury financing operations only temporarily affect the structure of
interest rates, with the effect largely disappearing within a month's time.

RecentTreasurybehavior

The Treasury could also reduce interest costs
by increasing the demand for Treasury securities. It might be able to do this by issuing a
new, more attractive type of security rather
than by relying on the traditional bills, notes,
and bonds. In 1941 , George L. Bach and
Richard A. Musgrave proposed just such an
innovation-a bond redeemable not for a
constant amount of dollars,but for an amount
of dollars representing a constant amount of
purchasing
power.The coupon on this bond
would be similarly adjusted. The real value of
a "constant purchasing power" bond would
not be affected by inflation, as traditional
security prices are.

In recent years, the Treasury has issued debt
in various maturities, generally emphasizing
consistency rather than innovation. Recently,
therefore, it has issued no new types of securities. Also, the Treasury has issued securities
of particular maturities on regular schedules,
apparently with the aim of increasing the
overall maturity of its debt outstanding (Figure 2). As a result, the average maturity of
private holdings of marketable interest-bearing public debt increased from two years
seven months in June 1976 to four years in
September 1981 .

This type of bond has several advantages. It
would eliminate the inflation-uncertainty
premium which some economists claim is
the cause of high real interest rates, since
inflation would not reduce the value of the
bond. This approach would immediately
reduce the nominal interest cost of the new
debt. Such a bond would place the inflation
risk on the borrower rather than (as at present)
on the lender, much as variable-rate mortgages do.

Again, there is no overwhelming evidence
that the Treasury's actions affect the general

2

. is to reduce transaction costs by decreasing
the number of times required to refinance its
debt. Still, given the high interest costs associated with this strategy, the approach may
cost the Treasury more than it saves.

level of interest rates. To some extent, however, the Treasury may be J/crowding out"
long-term corporate financing. The debt
structure of corporations increasingly has
become skewed toward short-term obligations (Figure 3). Many corporations would
liketo correctthis imbalance, butdo notwant
to pay the current high long-term rates. I f the
Treasury wanted to minimize the impact of
its financing operations on corporate operations, it might not issue long-term debt. Instead, it cou Id leave that segment of the
financial market to corporations, thereby
permitting them to restructure their balance
sheets and finance more investment. Why,
then, has the Treasury been lengthening the
overall maturity of its debt? Perhaps the idea

Treasury debt management has not been a
"hot" issue lately in academic discussions,
possibly because of a belief that Treasury
actions do notliffect the term structure of
interest rates. However, the government's
financing requirements will be very large for
at least the next few years, and will thus impose a heavy burden on domestic financial
markets. Given this fact, the issue of Treasury
debt management deserves more attention.
Joseph Bisignano and Brian Dvorak

Percent

10

Figure 1
9

8

Interest payments as percent of
federal expenditures

V

7

6

=aLI

I

1970

I

1972

I

1974

1976

1978

1980

SOURCE: National Income and Product Accounts
Changel%1
70
Figure 2

Maturity distribution

of change in federal debt

00
Vertical shading: change during fiscal years 1972-1976

50

Horizontal shading: change during fiscal years 1977-1981

40

2.4
2.2

30

2.0
20
1.8

10

o

_11-

1.6

SOURCE: Federal Reserve Board of Governors

Maturity lin yearsl

SOURCE: Treasury
Bulletin,various issues

Flow of Funds Accounts

3

.lSI;:
JI:I

!!eMeH •

• 4eln •
e!uJoJ!leJ

• epei\aN • o4ePI
euozpv
e>jselV

,/
(G)

.'!It!':)'O:lSput!'J:I
ut!'S
(,;SL
'ON llWH:Jd
OIVd
:J!lVlSOd 'S-n
11 SSV1:)lSHI:I
VW

.JJ

BANKINGDATA-TWELfTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets Liabilities
and
Large
Commercial
Banks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total #
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savingsdeposits - total
Time deposits - total#
Individuals, part. & corp.
(LargenegotiableCD's)

Weekly
Averages
of DailyFigures
MemberBankReserve
Position
Excess
Reserves+ )/Deficiency (-)
Borrowings
Net free reserves(+)/Net borrowed(- )

Amount
Outstanding
4/21/82

159,230
137,881
42,489
57,159
23,427
2,143
6,366
14,983
39,572
28,082
31,395
90,754
81,419
33,047
Weekended
4/21/82

-

35
198
163

Changefrom
year ago
Dollar
Percent

Change
from
4/14/82

1,079
·821
1 98
479
126
117
34
224
-1,425
297
277
469
569
- 141
Weekended
4/14/82
81
31
50

11,970
8.1
13,008
10.4
5,732
15.6
5,252
10.1
2.5
577
623
41.0
238
3.6
779
4.9
2,422
5.8
1,913
6.4
357
1.2
14,271
18.7
13,814
20.4
3,390
11.4
Comparable
year-agoperiod
17
225
208

* Excludestrading account securities.
# InCludesitems not shown separately.

Editorial
comments beaddressed theeditor(WilliamBurl(e) to theauthor.... Free
may
to
or
copies this.
of
andotherFederal
Reserve
publications beobtained calling writingthePublic
can
by
or
Information
Section,
Federal
Reserve
Bank SanFrancisco, Box
of
P.O.
SanFrancisco4120.Phone
9
(415) 544-2184.

C@I