Financing American government

8 Conclusion

In closing, let us return to some of the questions posed in this insight, and provide an overview of the answers.

Who lends money to the US government, and on what terms?

Lenders are individuals and institutions worldwide, but the terms of lending are largely determined by the interest rate targets of the Fed. The rate of interest on short-term treasury bills cannot deviate significantly from the fed funds rate. The rates on longer term notes and bonds can differ from this, but again there are limits to the divergence, since people can borrow at one maturity to lend at another if interest rate differences get too large.

How did Congress know that funding for the CARES Act would be forthcoming as needed?

Congress knew that the Fed would hold interest rates low to fulfil its mandate, with unemployment high and inflation low. Given this, treasuries could be issued at low rates in the primary market. Banks could borrow in the fed funds market or use their excess reserves to bid for treasuries and make a profit even at relatively low rates.

Is there a limit on how much the government can borrow?

Although there is a statutory limit in the United States called the debt ceiling, this is generally raised by Congress whenever expenditure needs demand it. Aside from this, there is no fixed limit, since the Fed can issue base money without bound. However, the government cannot force the Fed to buy treasuries, and the failure of a Treasury auction cannot be ruled out. If the Fed chooses to raise interest rates, fearing inflation, for instance, the interest obligations of the government can become unsustainable.

Can we be certain that the debt will be repaid as it comes due?

As long as the government can continue to borrow to repay debt as it matures, there is a negligible risk of default. But if Congress fails to reach an agreement on raising the debt ceiling or the Fed decides not to keep interest rates low enough to keep debt payment sustainable, the possibility of missed payments cannot be ruled out entirely.

Final thoughts

The crisis faced by the US economy in 2020 will not be its last, and Congress, the Treasury and the Fed will doubtless be called upon to take aggressive emergency actions again. They have the experience and ammunition to do so. And just as we can learn about normal human physiology through a study of individuals suffering illness, we can learn about the normal functioning of an economy by closely observing economic institutions under crisis conditions. And as we have seen, the mechanisms of government finance revealed by this examination are less mysterious than they may first appear.