thedrifter
04-16-09, 07:08 AM
April 16, 2009
Economic Prosperity vs. Deficit Spending
By Tom Suhadolnik
On April 14th, the US Federal Reserve continued on a path that was almost unthinkable as little as six months ago.
The Federal Reserve Bank of New York bought $7.3 billion in US Treasuries on Tuesday, part of a program to improve conditions in private credit markets and spur lending. The debt bought included notes maturing between 2013 and 2016. Dealers submitted $26.4 billion in debt to be purchased. The Fed will continue its buybacks with a third operation this week, heading towards purchasing $300 billion in Treasury securities over the next six months.
To put this in perspective, $300 billion is larger than the annual entire federal deficit for the years 2005 to 2008 (before TARP). The Federal Reserve is essentially printing this money.
Foreign central banks, particularly the Chinese, have lost their appetite for US debt. They have also publically raised concerns about the drastic increase in US debt over the last six months and America's ability to repay it.
Although seemingly absurd, this move by the Fed will in fact help private credit markets in the short term. Since the Chinese have stopped buying US debt, the Treasury would have to attract new buyers by offering higher interest rates. These higher interest rates would take money out of the private credit markets. By buying this debt at an artificially low interest rate the Fed is helping the private sector.
Normally this would be highly inflationary. When foreign governments, little old ladies and even the government itself buy US debt it is not inflationary. Those dollars, whether they are from US tax revenue or the sale of Chinese products, have economic activity associated with them. The dollars in effect printed by the Fed do not have economic activity associated with them.
With the economy in recession inflation is not an immediate problem. Deflationary pressures from the recession, particularly falling real estate prices, are countering the Fed's inflationary actions. As long as the inflationary forces (money going into the system) and deflationary forces (money coming out of the system) stay even, the money supply (the number of dollars in the system) stays stable. A stable currency and low interest rates are critical to economic growth.
However, as the economy begins to recover and real estate bottoms out, the deflationary pressure will disappear. The Fed, Treasury and Obama administration will be faced with unpalatable options.
It is important to note these options are not mutually exclusive. It is far more likely a combination of these options will be used. But we will not return to the economic boom of the 1980s and 1990s.
Option 1: The US Treasury raises interest rates on US debt instruments to attract new buyers. This would make the private sector compete with the government for credit. The double digit interest rates normally seen on credit cards would make their way to mortgages and car loans.
This is what consumers experienced in the late 1970s and early 1980s. It ended with the deflationary pressures brought by the recession of the early 1980s. Without a recession these higher interest rates would remain. If the interest rates rise too high they will definitely slow private sector economic activity.
Also, this means the US government, and not the Fed will be driving US interest rates. The Fed has a stated goal of keeping the currency stable and promoting economic growth. The US government has a tacit goal of continuing to spend money and provide services to Americans.
In the 1980s the Fed increased interest rates, tightened the money supply and forced the US into a recession to stop inflation. With inflation gone and investors willing to buy US debt with very low interest rates there was no tension between government spending and economic growth. We emerged from the recession and entered two decades of prosperity.
Today, with investors openly questioning how the US can repay its debt (which stands at roughly $36,100 per citizen of the US) they will soon demand higher interest rates. The US Treasury, not the Fed, will be driving interest rates as it tries to convince increasingly skeptical investors to buy debt to support government spending. The Congress and President will have to choose between government spending and economic growth driven by low interest rates.
Option 2: The Fed could continue to print money to buy US debt. This would continue to increase the money supply without deflationary pressures. Interest rates could stay low because the government would not be competing with the private sector for credit. The Fed could buy treasuries at whatever interest rate they see fit. However, more dollars chasing the same number of goods means prices will rise.
The dollar would then weaken against foreign currencies. Major exporters, particularly energy exporters, would be encouraged to stop conducting commerce in US dollars. If we cannot convince countries like Russia, Iran and Venezuela to go against their own interests, the US dollar would lose its status as the world's de facto reserve currency. The cost of goods in terms of US dollars, especially imported goods, would continually rise as the money supply is increased to fund government spending.
Option 3: The Chinese return to purchase US debt essentially supporting the US standard of living. This would require the Chinese economy to dramatically improve. It would also require the Chinese to have faith in our ability to pay off the nearly $2 trillion in debt they already own. Chinese actions and statements over the last 30 days make this seem unlikely.
The US might be able to elicit temporary support from the Chinese if we support, or at least turn a blind eye, to Chinese adventures in Asia. But this quid pro quo would not be permanent. As US real and perceived power wanes, so does the incentive for the Chinese to pay tribute to the US by purchasing debt. Eventually, US prestige and the incentive for Chinese purchases of US debt will be expended.
Option 4: The US government could slash spending to a level supportable by non-Fed purchases of government debt.
In short, the purchase of US debt by the Federal Reserve has created a direct link, and conflict, between economic growth and government spending. It is unlikely that most members of Congress comprehend this looming disaster. It is even more unlikely those who do have the political power to stop it.
Tom Suhadolnik is a serial entrepreneur and management consultant living in Kent, Ohio. Tom can be reached at tom - at - suhadolnik.com
Ellie
Economic Prosperity vs. Deficit Spending
By Tom Suhadolnik
On April 14th, the US Federal Reserve continued on a path that was almost unthinkable as little as six months ago.
The Federal Reserve Bank of New York bought $7.3 billion in US Treasuries on Tuesday, part of a program to improve conditions in private credit markets and spur lending. The debt bought included notes maturing between 2013 and 2016. Dealers submitted $26.4 billion in debt to be purchased. The Fed will continue its buybacks with a third operation this week, heading towards purchasing $300 billion in Treasury securities over the next six months.
To put this in perspective, $300 billion is larger than the annual entire federal deficit for the years 2005 to 2008 (before TARP). The Federal Reserve is essentially printing this money.
Foreign central banks, particularly the Chinese, have lost their appetite for US debt. They have also publically raised concerns about the drastic increase in US debt over the last six months and America's ability to repay it.
Although seemingly absurd, this move by the Fed will in fact help private credit markets in the short term. Since the Chinese have stopped buying US debt, the Treasury would have to attract new buyers by offering higher interest rates. These higher interest rates would take money out of the private credit markets. By buying this debt at an artificially low interest rate the Fed is helping the private sector.
Normally this would be highly inflationary. When foreign governments, little old ladies and even the government itself buy US debt it is not inflationary. Those dollars, whether they are from US tax revenue or the sale of Chinese products, have economic activity associated with them. The dollars in effect printed by the Fed do not have economic activity associated with them.
With the economy in recession inflation is not an immediate problem. Deflationary pressures from the recession, particularly falling real estate prices, are countering the Fed's inflationary actions. As long as the inflationary forces (money going into the system) and deflationary forces (money coming out of the system) stay even, the money supply (the number of dollars in the system) stays stable. A stable currency and low interest rates are critical to economic growth.
However, as the economy begins to recover and real estate bottoms out, the deflationary pressure will disappear. The Fed, Treasury and Obama administration will be faced with unpalatable options.
It is important to note these options are not mutually exclusive. It is far more likely a combination of these options will be used. But we will not return to the economic boom of the 1980s and 1990s.
Option 1: The US Treasury raises interest rates on US debt instruments to attract new buyers. This would make the private sector compete with the government for credit. The double digit interest rates normally seen on credit cards would make their way to mortgages and car loans.
This is what consumers experienced in the late 1970s and early 1980s. It ended with the deflationary pressures brought by the recession of the early 1980s. Without a recession these higher interest rates would remain. If the interest rates rise too high they will definitely slow private sector economic activity.
Also, this means the US government, and not the Fed will be driving US interest rates. The Fed has a stated goal of keeping the currency stable and promoting economic growth. The US government has a tacit goal of continuing to spend money and provide services to Americans.
In the 1980s the Fed increased interest rates, tightened the money supply and forced the US into a recession to stop inflation. With inflation gone and investors willing to buy US debt with very low interest rates there was no tension between government spending and economic growth. We emerged from the recession and entered two decades of prosperity.
Today, with investors openly questioning how the US can repay its debt (which stands at roughly $36,100 per citizen of the US) they will soon demand higher interest rates. The US Treasury, not the Fed, will be driving interest rates as it tries to convince increasingly skeptical investors to buy debt to support government spending. The Congress and President will have to choose between government spending and economic growth driven by low interest rates.
Option 2: The Fed could continue to print money to buy US debt. This would continue to increase the money supply without deflationary pressures. Interest rates could stay low because the government would not be competing with the private sector for credit. The Fed could buy treasuries at whatever interest rate they see fit. However, more dollars chasing the same number of goods means prices will rise.
The dollar would then weaken against foreign currencies. Major exporters, particularly energy exporters, would be encouraged to stop conducting commerce in US dollars. If we cannot convince countries like Russia, Iran and Venezuela to go against their own interests, the US dollar would lose its status as the world's de facto reserve currency. The cost of goods in terms of US dollars, especially imported goods, would continually rise as the money supply is increased to fund government spending.
Option 3: The Chinese return to purchase US debt essentially supporting the US standard of living. This would require the Chinese economy to dramatically improve. It would also require the Chinese to have faith in our ability to pay off the nearly $2 trillion in debt they already own. Chinese actions and statements over the last 30 days make this seem unlikely.
The US might be able to elicit temporary support from the Chinese if we support, or at least turn a blind eye, to Chinese adventures in Asia. But this quid pro quo would not be permanent. As US real and perceived power wanes, so does the incentive for the Chinese to pay tribute to the US by purchasing debt. Eventually, US prestige and the incentive for Chinese purchases of US debt will be expended.
Option 4: The US government could slash spending to a level supportable by non-Fed purchases of government debt.
In short, the purchase of US debt by the Federal Reserve has created a direct link, and conflict, between economic growth and government spending. It is unlikely that most members of Congress comprehend this looming disaster. It is even more unlikely those who do have the political power to stop it.
Tom Suhadolnik is a serial entrepreneur and management consultant living in Kent, Ohio. Tom can be reached at tom - at - suhadolnik.com
Ellie