Nowadays, concerns about fiscal policy have become the norm, but reality is far more complicated than it appears. Policymakers, like ordinary people, are driven by incentives: the market widely believes that the U.S. Treasury market will not completely collapse, because once the situation deteriorates, the Federal Reserve will step in to backstop yields. The most typical example is the early days of the COVID-19 outbreak, when U.S. Treasury yields surged in March 2020. The official narrative is that global market turmoil caused the basis trade to collapse, and the Fed had no choice but to intervene to stabilize yields. But there is another interpretation: the market pushed yields higher because it anticipated that the government would launch large-scale deficit spending, and the rise in yields itself was fully justified. The Fed's emergency intervention and the subsequent quantitative easing (QE) program were essentially about creating room for fiscal expansion. But looking ahead, if this mechanism keeps operating, what incentive would policymakers have to control the budget? We should have learned a lesson from the pandemic: the world is full of uncertainty, and fiscal budgets should remain prudent. Yet reality is not like that. After the pandemic, supporters of Modern Monetary Theory (MMT) loudly proclaimed that "deficits don't matter." Central banks around the world were precisely the drivers of loose fiscal policy, and the Federal Reserve was no exception. In the chart, the black line represents the scale of net new U.S. debt issuance, which can roughly be understood as the fiscal deficit. The colored bars represent the buyers of U.S. Treasuries, and I focus on the light blue bars, which show the Fed's net purchases of U.S. Treasuries. I marked several rounds of the Fed's quantitative easing programs with arrows, and two prominent features stand out: first, each round of QE was larger than the previous one, and the easing during the pandemic far exceeded earlier rounds; second, when the Fed began quantitative tightening (QT), its balance sheet never returned to its pre-easing state. A large amount of purchased U.S. Treasuries remains permanently on the balance sheet and is continuously rolled over. This runs counter to the original design intent when QE was first introduced in 2009. At the time, the explanation was that QE was merely an extension of countercyclical monetary policy after interest rates hit the zero lower bound. Under the original plan, after the global financial crisis (and similarly after the pandemic), the U.S. Treasuries held by the Fed should have quickly matured and exited the balance sheet, yet these bonds have been "stored" on the balance sheet for the long term. No wonder some people call it monetary financing. In my view, this is precisely why U.S. Treasury yields have been artificially suppressed: the so-called implicit yield—the yield the market would have formed without these Fed operations—is far higher than the level we see now. This directly transmits to the fiscal level: first, since yields have been artificially suppressed and the true implicit yield is significantly higher, the U.S. fiscal situation is far worse than it appears on the surface. So when people say "yields are low, so debt is not a problem," that view ignores the key backstop role the Fed is playing behind the scenes. Second, imagine if the AI bubble bursts, stocks plunge 40%, and U.S. economic activity sharply loses momentum. Now that QE has become normalized, the Fed will inevitably use it again when responding to a crisis. That operation will in turn pave the way for fiscal stimulus, and politicians will not pay a price for the huge deficits of consecutive years after the pandemic. If we want to straighten out fiscal policy, the core issue lies with the Federal Reserve. If the Fed once again backstops yields when the next shock arrives, it will only further strengthen the negative incentives for politicians, and the fiscal situation will continue to deteriorate.
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