The Fed Has Overseen a Transfer of Wealth From Bondholders to Taxpayers

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About the author: David Beckworth is a senior research fellow with the Mercatus Center at George Mason University and a former international economist at the U.S. Department of the Treasury.

Questions about U.S. financial stability are taking center stage in the wake of Silicon Valley Bank’s collapse and the U.S. Federal Reserve’s upcoming decision on interest rates. Just beneath the surface, for better and for worse, is something amazing that’s happened to U.S. taxpayers: The burden they face on the national debt declined dramatically over the past three years. The reasons for this should be part of the Fed’s calculus as it navigates the situation.

This largely unnoticed development may seem counterintuitive, since public debt has increased by roughly $5 trillion over the same period. But at the same time, the market value of U.S. Treasury securities has gone from a high of 108% of the economy to its current value of 85%. This is one of the fastest declines in the U.S. debt burden and puts its value close to the prepandemic level.

This sharp decline, however, is also the reason we now face increased financial stress. The windfall gain going to taxpayers has come largely at the expense of bondholders, including banks that have taken big losses on their bond investments. It is important, then, to take a closer look at how this rapid decline in the debt burden occurred and consider what it means for financial stability.

The origins of the dramatic change begin in the spring of 2020. The dollar size of the economy fell sharply as federal spending surged. These developments both raised the debt burden by shrinking the tax base from which the debt could be paid and by increasing the national debt. In addition, interest rates dropped to near 0%, making the existing Treasuries worth more since they paid a higher interest rate.

Bondholders, in other words, suddenly had a better-than-expected return on their Treasuries, and taxpayers were footing the bill. All together, these three developments raised taxpayers’ debt burden to the 108% level.

The dollar size of the economy, however, quickly recovered from the pandemic shutdown and was back on trend by mid-2021. This lowered the debt-to-GDP ratio by about nine percentage points. Next came the inflation surge, which further reduced the debt burden by 14 percentage points, bringing it to the current value of 85%. It did this through two channels. First, the high inflation pushed the dollar size of the economy about $1.89 trillion above the pre-pandemic trend.

Second, of course, is that the inflation surge caused the Fed to sharply raise interest rates, which lowered the market value of Treasuries by roughly $1.9 trillion. The fate of bondholders, therefore, changed. They suddenly were holding bonds that were worth far less than they had expected, both in inflation-adjusted terms and relative to other newer interest-bearing securities that paid more.

Bondholders, in short, paid for much of the reduction in the debt burden via the higher inflation. To be clear, bondholders are taxpayers too, but they are only a subset of taxpayers. Moreover, the loss to bondholders is more acute and visible to them than the prospect of a lower future tax bill is for taxpayers. 

This remarkable transfer of wealth away from bondholders was not limited to the $24 trillion treasury market. Other fixed-income markets like the $12 trillion mortgage-backed securities market and the $10 trillion corporate bond market also saw big losses in market value. This is a key reason why banks, which hold such securities, are currently under stress. A recent study found that such assets in the U.S. banking system are overvalued by $2.2 trillion due to mark-to-market losses. This loss means many banks could not cover all the claims of their depositors should they flee en masse.

The banks’ precarious position is a big problem for financial stability, as noted by U.S. regulatory authorities. It is also why the U.S. government insured all depositors at the recently failed Silicon Valley Bank and Signature Bank and why the Fed decided to accept loan collateral at face value rather than at market value in its new liquidity facility. Regulators are concerned about a market-to-market time bomb on the balance sheets of U.S. banks. These are bondholders who have unwittingly given a large transfer of wealth to their debtors and may not be able to afford it.

There are many reasons we have come to this moment, but probably the most important one is the Fed’s rapid interest rate hikes over the past year. Most bondholders, including the Fed, have been surprised by the speed and scale of the hikes given the expectations created by the past decade of low interest rates and the Fed’s own projections just a year ago. The Fed hopes these interest rate hikes will end the inflation surge, but in the meantime they have harmed bank balance sheets and impaired credit creation moving forward. Hopefully, this will end the high inflation in an orderly manner rather than as a financial crisis.

We are living in an amazing period. There is no easy path forward, but here’s hoping the Fed can successfully navigate through these tricky waters.

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