In April 2013, the University of Maryland hosted Jaime Caruana, who at the time was general manager of the Bank for International Settlements. His talk highlighted the extraordinary tools central banks have to calm markets during times of stress. However, he cautioned that when deployment of such tools outlive the crisis, they facilitate the damaging elongation of unsustainable fiscal practices. While his remarks were about the global financial crisis, I cannot think of a time in our nation’s history when Jaime’s warning was more prescient than now.
In March 2020, large portions of the U.S. economy were shutting down. To “flatten the curve,” stay-at-home orders were issued across the nation — not just where COVID-19 was rampant, but everywhere, so that areas would not replicate the experiences of early outbreaks like those seen in New York. To facilitate this public health strategy, Congress passed, and the Trump administration quickly implemented, the CARES Act.
The Federal Reserve likewise acted quickly. They took the target for the federal funds rate down to 0% to 0.25% and provided liquidity to a number of financial markets, including for U.S. Treasuries. Over the past year, the balance sheet of the Federal Reserve has grown significantly as it has monetized much of the increased federal debt that has been issued to fund the CARES Act and subsequent economic initiatives.
While the recession was deep, the feared depression did not materialize. Financial markets stabilized rapidly, and we continue to see new valuation highs across markets. Most areas of personal consumption rebounded quickly, household savings has grown significantly, and unemployment peaked in April 2020. Thanks to the ingenuity of the U.S. biotechnology sector and the investment of Operation Warp Speed, we are seeing an ever-greater percentage of our population realize full vaccination. Social distancing measures are being relaxed, and schools are on a path toward full reopening. Americans are eager to return to restaurants and visit the family and friends they have had to avoid for the past 15 months.
As the real economy returns to normal, so must the Federal Reserve. During the greatest economic crisis to our nation since the Great Depression, its actions were necessary and pivotal. However, now that the crisis has abated, continuation of those extraordinary actions risks causing more damage than it prevents. Temporarily low interest rates and provision of liquidity ease fears, but that does not occur without a cost.
The first cost is that it masks the true debt service costs of fiscal policy. Prior to the pandemic, the U.S. fiscal situation was already on an unsustainable path and the trillions in debt issued during the pandemic will only hasten the financial reckoning that must take place. The Social Security Trust Fund was projected to exhaust in 2035, and the Medicare Trust Fund was projected to be exhausted in 2026. While it is uncertain how much these exhaustion dates will accelerate following this recession, we are running out of time to get our fiscal house in order. Yet, despite these existing imbalances, the Biden administration and congressional Democrats are calling for an additional $4 trillion in spending, much of it financed with even more debt. Instead of allocating proposed tax receipt increases to cover existing structural deficits, they are looking to create new unfunded entitlements.
Second, extraordinary actions increase the calls by some for an alternative reserve currency. International counterparties are looking for responsibility and stability on the part of the country issuing the world’s reserve currency. In exchange, that country realizes low interest rates and substantial liquidity. However, the U.S. is not endowed with that privilege, and that role is put at risk when irresponsible dollar management persists.
Instead of facilitating irresponsible fiscal policy and placing our reserve currency status at risk, it is time for the Federal Reserve to end its interventions. Interest rate policy should be placed on a path back to pre-pandemic levels, and the balance sheet must be managed toward a smaller size that is long-term sustainable. Instead of perturbing price discovery and masking the costs of profligate spending, the Federal Reserve must restore market participants faith in the free functioning of financial markets. It is time for Jerome Powell to show the Federal Reserve’s independence and remove the punch bowl from the party.
Michael Faulkender (firstname.lastname@example.org) is a professor of finance at the University of Maryland’s Robert H. Smith School of Business and former assistant secretary for economic policy in the United States Department of the Treasury.