The Warsh Paradox
Ed Lane
James E Keenan
>
From the Abstract:
This paper examines the “Warsh paradox”: the tension between Federal
Reserve Chair Kevin Warsh’s preference for a smaller Federal Reserve
balance sheet and the objective of materially lower long-term borrowing
costs, particularly mortgage rates. The Federal Reserve directly
administers short-term interest rates but ordinarily permits longer-term
Treasury yields to be determined in financial markets. Balance-sheet
contraction returns duration risk to private portfolios and, when
combined with heavy Treasury issuance, may place upward pressure on term
premia and long-term yields—unless private demand rises sufficiently or
the Fed intervenes to defend prevailing yields.
The paper identifies three possible outcomes: a credibility dividend, in
which lower inflation expectations outweigh supply effects; a steepening
trap, in which short-term rates fall or remain stable while long-term
borrowing costs rise; and an elastic-crisis pattern, in which financial
instability repeatedly forces the Fed to suspend its commitment to a
leaner balance sheet. It also argues that permitting the yield curve to
steepen is itself a monetary-policy choice because the Fed can intervene
across the Treasury market.
Developments through August 3, 2026, provide an early test of this
framework. Warsh has reduced forward guidance, expressed willingness to
recognize market-driven increases in long-term yields as a source of
monetary restraint, and initiated a review of the Fed’s balance-sheet
framework. At the same time, the Fed continues to maintain ample
reserves rather than pursue rapid quantitative tightening. These
developments increase the probability of the steepening-trap scenario
without yet establishing the Fed’s longer-term balance-sheet regime.
Because the minutes of the July 28–29 FOMC meeting have not been
published, conclusions concerning the Committee’s internal deliberations
remain provisional.
This is a substantially revised and expanded version of the original
paper. The revision adds a formal literature review grounding the
argument in the empirical research on term premia, large-scale asset
purchases and their reversal, and fiscal-monetary interaction; a new
section presenting a Modern Monetary Theory analysis alongside the
mainstream account and real-time evidence through August 2026, including
Kevin Warsh's confirmation as Federal Reserve Chair and the July 2026
FOMC meeting.
Jay Mills
A few places still slip back into the financing story.
For example:
“The Treasury must continuously roll over maturing debt while also placing new issuance to finance the current-period deficit.”
No.
Treasury securities don’t finance dollar spending in any operational sense.
A maturing Treasury security is simply shifted from a securities account at the Fed to a reserve account at the Fed.
Government spending adds dollars.
Taxes remove dollars.
Treasury securities exchange reserve balances for interest-bearing balances.
That’s the basic operation.
Likewise:
“Unless investor demand grows proportionately … yields rise to clear the market.”
Only if the government chooses to let that happen.
The Fed is the monopoly supplier of reserve balances.
Treasury and the Fed together determine the interest-rate structure they are willing to support.
There is no market-determined solvency rate for the issuer of the dollar.
So I think the paper is exactly right here:
“The rise in long-term yields … is therefore … not a constraint the Fed confronts but a policy choice the Fed makes.”
That’s the key point.
I’d just take it one step further.
There isn’t really a “bond vigilante constraint” to restore.
There is a government decision to pay whatever interest rates it chooses to pay.
If Treasury offered only three-month bills, the long Treasury rate disappears.
If the Fed pegged the 10-year at 2%, the 10-year trades at approximately 2%.
Japan demonstrated the operational point.
The other issue I’d add is interest income.
The paper describes higher rates as tightening and notes that they increase the government’s interest bill.
But the government’s interest bill is somebody else’s interest income.
Higher rates mean larger federal interest payments to the non-government sector.
So with a sufficiently large stock of government liabilities, raising rates also adds fiscal income.
That can be inflationary rather than disinflationary.
Mosler’s objection to the whole framework would therefore be something like:
The constraint isn’t “Can markets finance the deficit?”
They can’t supply dollars to the issuer of the dollar.
The constraint is:
What happens to prices when government spending, taxation, interest payments and private credit interact with the economy’s available real resources?
Everything else is institutional plumbing.
And once you see that, the Warsh “paradox” gets simpler.
A smaller Fed balance sheet and higher long rates aren’t market discipline.
They’re policy choices.
The government is choosing to pay more interest.
And then calling the resulting higher interest expense evidence that it needs to spend less.
That’s the part Mosler would probably find backwards.
On Aug 12, 2026, at 6:33 AM, Ed Lane <edc...@gmail.com> wrote:
I hope you find this interesting: https://papers.ssrn.com/abstract=6537821
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