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Debt and Financial Repression


Despite all the Sturm und Drang surrounding this summer’s debate concerning the debt limit, there was never any doubt that Congress would vote to increase it. It was all political theater because there was never the political will on Capitol Hill to impose the kind of spending cuts that would have been necessary had it not been raised.

So the 112th Congress voted to raise the debt ceiling just as every Congress has done since 1930.

The U.S. Treasury has now been given the green light to issue new debt. That, of course, does nothing to address the federal government’s fiscal problem. Indeed, it adds to it even as it postpones the day of reckoning. The new lenders that the government must attract are likely to demand a risk premium (higher interest rate). That will make future interest payments more burdensome and will require more borrowing to pay them.

There is one lender, however, who is always able and willing to lend dollars to the U.S. government: the Federal Reserve. The folks at the Fed are so generous, they don’t even require a risk premium. Of course, the Fed’s “generosity” stems from its ability to create money out of thin air. The Fed’s purchases have supported bond prices and kept interest rates at a manageable level, thus enabling the U.S. government to borrow more money.

But as the Fed buys more government debt without reducing its holdings and the Congress fails to get its fiscal house in order, bond yields will increase in response to inflation expectations. The Fed’s inflationary intervention into the bond market only postpones the inevitable, while penalizing all holders of fixed-dollar assets and wage earners. Moreover, the Fed’s inflation inevitably results in a widespread malinvestment and prevents the necessary liquidations from occurring.

While the Fed’s debt monetization is destructive, it will continue because inflation serves the immediate interests of the country’s political and financial elite. Without the Fed’s inflation pushing up asset prices, the banking system’s insolvency would be exposed. And, as mentioned above, the Fed’s debt monetization also keeps interest rates artificially low in the short term, thus enabling the U.S. government to keep borrowing money and continuing with its spendthrift ways.

As large as the federal debt is now ($14.7 trillion), it is dwarfed by the U.S. government’s overall fiscal gap, which is estimated by economist Laurence J. Kotlikoff of Boston University to be more than $200 trillion. A study conducted by the International Monetary Fund found that the U.S. government would have to double its taxes in order to close the gap. That will not happen. A tax increase of that size would exsanguinate an already-anemic economy.

But if Congress does not move to close the fiscal gap, bond yields will rise regardless of Fed policy. Rising bond yields raises the specter of default because higher interest rates will make the federal government’s debt unmanageable.

The federal government’s aversion to default is not a matter of honor. A failure by Congress to meet its debt obligations would force an immediate and radical contraction in spending, and congressmen rely on spending to stay in power. Moreover, the political fallout from any meaningful reduction in government spending would be devastating, as the majority of Americans have become dependent on a variety of government transfer payments.

The first thing to remember is that the government will not default outright. As former Fed chairman Alan Greenspan candidly admitted on Meet the Press, the government can always print money to make the necessary payments. So bondholders will at least be paid in nominal terms. The primary beneficiaries of such a scheme will be the U.S. Treasury, which gets to paper over its debt with inflation, and the financial elite, who will exploit their early access to the new dollars to purchase hard assets. The vast majority of Americans, however, will be forced to cope with increasing prices and high unemployment as their dollars lose purchasing power and the economy, deprived of genuine capital, stays mired in recession.

Addison Wiggins of the Daily Reckoning calls what is happening today “financial repression” — a system that imposes negative interest rates on savers while providing what is essentially free money for the speculative schemes of the financial elite.

This policy has been in place for almost a century but has recently been intensified in response to the global economic meltdown. The destruction of the gold standard in the last century led to a credit expansion which, in turn, encouraged excessive leveraging. When the debt bubble burst in 2007-08, the market demanded widespread de‑leveraging and liquidation. That spelled oblivion for a few well-connected Wall Street firms and presented a serious problem to the U.S. government, as the inevitable credit contraction would have made it impossible to finance its gargantuan debt.

So the nation’s political and financial elite got together and orchestrated a series of bailouts and sweetheart loans that enriched a few insiders and propped up the bond market, all at the taxpayers’ expense. The global economy may have been ruined, but Wall Street and Washington were saved.

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    Tim Kelly is a columnist and policy advisor at The Future of Freedom Foundation in Fairfax, Virginia, a correspondent for Radio America’s Special Investigator, and a political cartoonist.