What is the Answer to the US Debt Problem? Give the Federal Reserve a 3rd Mandate.

There has been a lot of talk about solving the US debt problem. But so far, it’s been all talk and no action. Well today I am here to provide a path to action.

And here is that path — Have Congress provide the Federal Reserve (aka the Fed) with a 3rd mandate:

• Maintain price stability
• Maximize employment
• Minimize the Debt to GDP ratio

Before we jump into discussing why I believe this will help with our debt problem, let’s briefly review the history of the the Fed, so we have a better understanding of where the Fed is coming from.

The Fed’s History

Early Years

Back in 1907 the US suffered a financial crisis resulting in a stock market collapse and a series of bank runs which caused banks to fail. For the U.S. to survive this crisis, several private bankers, such as J.P. Morgan, had to infuse private capital to sustain the banking system.

As a result, and in large efforts to NOT repeat the 1907 crisis, in 1913, Congress established The Fed to stabilize the monetary system. In its early years, the Fed prevented potential crises by requiring banks to store extra capital with them, which the banks could obtain via loans, and this capital would serve as extra liquidity for the banks in the event of a potential crisis.

Early on, The Fed did not have direct control over interest rates. Instead, in order to loosen or tighten monetary policy, the Fed had to buy or sell US government securities (bonds) from the US Treasury. Buying US treasuries would “loosen” monetary policy and provide the US Treasury with more liquidity to manage recessions, while selling US treasuries would “tighten” monetary policy by reducing demand for treasures and making it harder for the US Treasury to obtain liquidity. The Fed maintained monetary policy this way through the 1920s, and, in an attempt to discourage speculative investing and reduce a rising stock market bubble in 1928, the Fed sold securities which contributed to the stock market crash of 1929.

The 1930–1950 period saw The Fed and US Treasury battle over different powers to better manage monetary policy and to help the US through the Great Depression and World War II. After a big inflation spike in 1950, the Fed gained the ability to control interest rates directly in 1951 through an agreement with the US Treasury.

Inflation in the 1970s

After a period of monetary stability and low inflation between 1950s-1960s, inflation began to rise towards the end of the 1960s and into the 1970s. Inflation growth was further exacerbated in 1971 when President Nixon decided to take the US off the Gold Standard because the US would not be able to meet its debt obligations if the dollar stayed pegged to gold. This allowed the US to print more money, decoupling the dollar from gold, and allowed the US to pay for budget items like the Vietnam War without being financially constrained to pay back dollars in gold at the same ratio.

Inflation got very bad during the 1970s and it caused a sluggish economy, so in 1977, Congress gave The Fed a “dual mandate”.

The Fed’s “dual mandate” is that the Fed must fulfill the following:

• Maintain price stability
• Maximize employment

Let’s briefly review how The Federal Reserve uses interest rates to influence monetary policy and fulfill its dual mandate.

Maintain Price Stability

In order to maintain price stability, the fed watches the consumer price index (CPI), among other benchmarks, to gauge how much the prices of various goods & services have risen over time. The CPI includes the prices for items such as food, beverages, housing, apparel, etc. When prices rise for these items over time, and they cost more to consumers, this is known as inflation.

In order to combat inflation, the Fed needs to INCREASE interest rates, so that individuals and banks will be incentivized to store their money with the government for a greater financial return, effectively pulling money out of the market and decreasing inflation. A side effect of high interest rates is that it becomes hard for individuals and banks to borrow capital because the interest repayment amounts increase.

Maximize Employment

In order to maximize employment, the Fed looks predominantly at two metrics: the Growth Domestic Product (GDP) and the unemployment rate. If the US GDP rate is increasing, it means that companies are likely creating job opportunities for people, and if unemployment rates are low, it means that people are employed.

In order to correct slow or negative GDP and/or a high unemployment rate, The Fed needs to DECREASE interest rates, so that individuals and banks will be incentivized to put their money in the market because the financial return from government backed securities, e.g. bonds, is not high enough. Additionally, lower interest rates make it easier for ALL entities to borrow, which means that entities can take on debt to make their NOW easier at the expense of the future. When the interest rate is lower, taking on debt has a lower impact on your future finances.

In order to control inflation, the Fed drastically increased interest rates which contributed to recessions in 1980 & 1982.

Interest Rates Over Time

Prior to the 1977 mandate, the Fed had focused predominantly on price stability, but the new mandate required them to also focus on economic growth.

After inflation was under control in 1982, the Fed was able to shift and prioritize the “maximize employment” mandate. Over the next 20 years, interest rates were, for the most part, gradually lowered, which stimulated the economy.

Modern Era

Inflation re-appeared towards the end of the 1990s and the Fed was forced to raise interest rates once again to combat inflation and the “dot com bubble” that ensued in 2000, contributing to the 2001 stock market crash. Following the 2001 crash, the Fed lowered rates to stimulate the economy.

Through 2007, interest rates stayed at very low levels, not seen for 40 years, and this contributed to reckless borrowing to invest in real estate, until a housing bubble forced the Fed to raise rates and the market crashed in 2008.

Rates were lowered to stimulate the economy following the 2008 crash, but because interest rates had been so low for so long, lowering interest rates alone was not enough to save the economy. The only way to re-stimulate the economy was for the US Treasury to print more money, which caused US debt to exceed GDP in 2012 for the first time since World War Two.

Debt to GDP Over Time

Since 2012, the US Debt to GDP ratio has been elevated at or around 100%.

In 2020, the pandemic crisis further required economic stimulus, elevating the US debt to GDP ratio up to 120–130%. This resulted in inflation, and yet again, the Fed was forced to raise interest rates.

As you can see from the Debt to GDP chart, the US now has a debt problem. The US is spending MORE than it is earning, which means the US has started using the future to pay for the now. This is NOT sustainable.

The Debt Problem

With high and increasing debt, US debt service payments will continue to rise over time and when this happens, it means less government budget to spend on projects in education, healthcare, infrastructure, etc. It means less investment in the future of the US. The debt service payments just exceeded military spending as a proportion on the annual US budget.

Today’s US Treasury will try to tell you that the debt service payments are still under control, but I have my concerns. The first concern is that I am not convinced that the current US system is built to actually lower the debt meaningfully. The second, and more critical concern, is that if the US has another emergency, such as a pandemic or a war, that requires immediate spending, the only way for the US government to get that money would be to print it. Even with a debt to GDP already at 120–130%, the debt would go even higher!

The Fed’s 3rd Mandate

Thus far in its history, the Fed has focused exclusively on maintaining price stability and maximizing employment, whilst ignoring any side effects that don’t accomplish one of these goals. Unfortunately, by just focusing on these two goals at the expense of all else, in combination with other effects, the Fed has led the US right into a 120–130% Debt to GDP ratio.

If you ask the Fed, they will say they are just doing their job and following the dual mandate from 1977. Technically, they are right. In practice, the Fed doesn’t help the US debt situation by NOT acknowledging the role they play when they lower interest rates. Lowering interest rates encourages more borrowing and increases debt further — no debate there.

To solve this lack of responsibility, Congress needs to give a 3rd mandate to the Fed:

• Maintain price stability
• Maximize employment
• Minimize the Debt to GDP ratio

Here is why Congress needs to give a 3rd mandate to the Fed: Without this 3rd mandate, the Fed side can argue that spending responsibly and managing debt is the job of Congress, not the Fed, and that if the US has a debt problem, it is because Congress cannot spend within its means.

To this I say that government spending is not the responsibility of the Fed, so long as Congress spends within its means, but when Congress spends beyond its means by borrowing, and especially at low interest rates, then it becomes the Fed’s problem, after applying this 3rd mandate.

Under the 3rd mandate, The Fed would be restricted from lowering rates when the Debt to GDP is too high.

If Debt to GDP ratio is too high, then interest rates would need to be kept high also to discourage the government from borrowing to spend. It would require Congress to have harder conversations like “do we need to increase taxes?” or “can we reduce spending or entitlement programs?”. They would actually need to negotiate rather than just punting those conversations and borrowing to spend money the US doesn’t have.

The Fed has set an inflation target of 2%. I think a reasonable target for the new Debt to GDP mandate would be 60-70%. Certainly not 120–130%.

Ok, so if this is the solution, how can the US accomplish it?

Well for one, it would require Congress to acknowledge its limitations that it has not responsibly managed spending up to this point and implement an extra check on itself. It requires Congress to pass new legislation that effectively limits its spending powers, when it goes beyond its existing funds, for the good of the country.

Congressmen and congresswomen serve short terms and have to focus on getting re-elected. Often, they are just trying to survive by giving whatever financial benefits they can to their districts and state. As a result, if they can spend to save themselves and their seat, even if it means overspending, they will do it.

Passing this 3rd mandate would demonstrate an acknowledgement from Congress that the Fed, who serve longer terms and is not burdened by defending their seats in re-elections, is the best entity to own the US Debt to GDP ratio metric, since it is the borrowing that more critically impacts this metric, rather than the spending.

It puts ownership for the level of widespread borrowing on the Fed because when the Fed lowers rates too low, the Government takes advantage of the lower rates to borrow more for funding and increases the US debt. Lower interest rates should need to be something the US Government EARNS for its citizens once its finances are in order and it has a reasonable Debt to GDP ratio. Offering lower interest rates to the people to borrow responsibly for things like houses is also a privilege, but not a right, and especially if the government is not borrowing responsibly.

Another important reason for the Fed to factor in the debt to GDP metric when making interest rate decisions is because other countries decide whether to buy US bonds based on US ability to eventually pay them back (with interest). As US debt levels increase and become unmanageable, other countries lose confidence in the US financial abilities and require a greater reward (interest rate return) to take on a greater risk (buy a bond from an entity with more debt). When the Fed cuts interest rates, independent of debt levels, and does not consider this macro “demand” factor, it creates more long term problems for the country, even if cutting rates is stimulative in the short term.

As described in this article, the Fed’s responsibilities have evolved throughout history. I believe we are at a point in time where the Fed needs to evolve again in order to prevent a worsening US debt crisis.

If the Fed achieves price stability and maximum employment in the short term by lowering rates at the expense of an ever growing debt, is that a win for the country? It doesn’t sound like one to me.

We can do nothing, and who knows — history has shown that private wealth can bail out the government. Maybe that eventually happens again, and we just wait till the whole system implodes, and hopefully Blackrock or J.P. Morgan bails out the US government during a banking crisis.

However, my preference is that we come together to get this done. I’m counting on you Congress. Let’s get the Fed a 3rd mandate.

What do you say?

Thanks for reading :P