For an interesting comment on my recent dialogue with David Altig over Charles Krauthammer’s view that the Social Security Trust Fund’s assets are worthless piece of paper, see William Polley’s What Does It Mean to Default. Among the many very sensible passages is this one:
If the Fed is really independent, it can honor its commitment without regard to the Federal government defaulting on its IOUs.
In other words, our Central Bank could behave very much like many private banks. Of course, private banks hold an array of income producing assets beyond Treasury securities. If a few of the entities that a private bank lends to defaults on their obligations, it is still possible for the private bank to remain solvent.
The 2018-just-IOUs-yahoos, which Mr. Krauthammer seems to be a member, seem to think that the Federal government is on a default path. I suspect David and William share this concern as do I given the enormous General Fund deficits and the total lack of will from this White House to change the course of its fiscal irresponsibility. If this fiscal irresponsibility is maintained for another 20 years, the prospect of Federal default does seem to be a genuine problem.
William is saying we might trust an independent Central Bank to honor its commitment even if we do not trust the Federal government to honor their commitments. But there is still the solvency question, which goes to what income producing assets are held by the Central Bank. While I reject Krauthammer’s disdain for seeing paper (financial assets) as an asset, one does have to wonder whether a private bank would hold 90% of its loan portfolio in the form of IOUs from a borrower that has significant default risk. Yet, the Federal Reserve holds about $720 billion in Treasury securities out of a total asset base near $800 billion. Its holdings in Mr. Krauthammer’s favorite asset – gold – are quite modest. Then again, the Social Security Trust Fund holds all of its assets in the form of Treasury securities.
What are market interest rates telling us about the risk of Federal default? As of February 17, 2005, the nominal interest rate on 20-year Federal bonds was 4.65%. Even with this modest nominal interest rate on long-term Federal bonds, foreign Central Banks and private agents were willingly holding these IOUs.
Of course, we all know that the market’s expectations of an entity’s credit worthiness can rapidly change, which is one reason why some economists have argued for an independent Social Security Trust Fund completing Al Gore’s call for the “lock box”. If the Federal Reserve and this Trust Fund were truly independent, they could hold whatever portfolio of assets made the most financial sense.