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§ JkCG)11 JFff©\1h1 CC n 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 realizedfuture,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 purchasingpower.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 11VW SSV1:)lSHI:I .JJ BANKINGDATA-TWELfTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected AssetsandLiabilities LargeCommercialBanks 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) WeeklyAverages of DailyFigures MemberBankReserve Position ExcessReserves+ )/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. Editorialcommentsmaybeaddressed to theeditor(WilliamBurl(e)or to theauthor.... 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