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A Brief Economic Digression

By March 12, 2021Commentary

Only a truly, truly complete, and I mean complete in every respect, idiot like AOC, or a senile political hack like our current president, could actually think the so-called stimulus bill is a good thing and will cause no harm to the economy or Americans.  Most people don’t understand how government debt works and how it is related to the money supply and to inflation and interest rates.  I made this point within the last couple of weeks.  In the long run, the Federal Reserve does not control interest rates, the market does.  And after the massive pork bill passed, and with the Democrats saying they intend to pass even more unnecessary and wasteful spending, the benchmark ten-year treasury yield spiked up again., because the market is concerned about the level of spending and debt.  It is going to keep going up, and up, and up.  Here is why.

Who buys all this debt the government has been issuing over the last decade and especially the last year?  Many of the buyers are private entities, individuals,financial institutions to meet reserve requirements, companies like insurance companies, mutual funds and others.  Foreign governments buy a lot of it, partly in regard to currency strategies and partly because historically those government securities have been safe.  But the entire market over the last decade of runaway spending and debt has been backstopped by the Federal Reserve itself, which has purchased trillions and trillions of dollars of US debt.  There are several effects of this.

Here is one, just basic economics.  Government securities are something you can buy, just like anything else and just like anything else you can buy, the laws of supply and demand apply.  If the Federal Reserve didn’t buy and hold those trillions and trillions of dollars in US debt, someone else would have to.  That would increase supply dramatically and remove a huge source of demand.  What would happen then?  To persuade people to buy its debt issuances, the US government would have to lower the price in essence and raise the interest rate paid.  Given the amount of outstanding debt, raising the interest rates on even part of that debt, which is constantly rolling over, creates a need to issue even more debt.  An obviously vicious cycle.  The private buyers and foreign government buyers appreciate this risk and they are not going to be fools and pay low interest rates for higher risk securities.

The Federal Reserve purchases have the effect of lowering interest rates which supposedly helps the economy but which most importantly, helps keep the federal government from going bankrupt, which it is headed to, since without the fed’s intervention it would eventually be unable to pay the interest or the maturing principal on all that debt it has issued.  The Fed claims this is just short term, but it never completely reduced its holdings from the financial crisis of 2008 and now it has even more government securities holdings and is facing an unprecedented issuance of new government securities.  Even the Federal Reserve can’t prop up the US government at this level, and the bond market has figured that out.  Buyers are demanding higher yields to hold these obviously more risky securities.

In addition to basic supply and demand and perception of the solvency of the US government in the long-run, the Federal Reserve’s purchases are stoking inflation.  Higher interest rates are themselves are factor in true overall inflation.  If it costs consumers and businesses more in interest payments to borrow money, that is inflation in the cost of money.  And there is a lot of private borrowing.

But here is a basic question; how does the Federal Reserve pay for those US government securities it is buying?    It does so by buying the securities from financial institutions and giving them “credits” which the financial institutions can then treat as “money” and lend out.  This increases the total money supply.  That is happening at the same time that the government is giving away money, hundreds of billions of dollars, to individuals as “stimulus”.  More money, lots more money in this case, flying around to buy products and services and financial assets, tends to raise prices.  Demand is growing faster than supply, prices go up.  The money supply has been growing at an astounding 30% plus for the last year.  But don’t worry, no inflation from that.  You have to be insanely delusional to believe this fairy tale.

And by the way, technically the US government has to pay interest to the Federal Reserve on all that debt it holds and has to pay the principal when the securities mature.  Where does the government get the money to do that?  You guessed it, issue even more securities, which then have to be bought by the Fed to keep the whole con game going.  It is just as ugly as it sounds.

At the same time the US government and the Federal Reserve are pumping up the money supply and creating rising interest rates and inflation, the new administration is doing everything it otherwise can to hinder growth.  Kill the US energy industry, pass labor legislation that substantially raises labor costs and causes job losses, have a large percent of US gross domestic product be represented by completely unproductive federal, state and local spending, create regulatory morasses that hinder projects, and on and on.  So we are going back to the lovely days of stagflation.  We are going to have higher unemployment, lower real-dollar measured growth and higher interest rates and prices.

Now the detailed description of how this all works is very complicated, but I think I have the essence of not only how it works but the effects will ultimately be.  No free lunch, anywhere, anytime.

The effects are already being seen in the government securities market and true inflation, not the phoney-baloney indices used by the government.  By the end of this year, it will be apparent where we are headed.  And if one of the CV-19 strains really takes off or can evade the vaccines, it will be a total apocalypse.  Hopefully voters will remember who brought them this disastrous mess.

Join the discussion 8 Comments

  • J. THomas says:

    I’m not disagreeing with you, but this is ‘historical’ economics. What’s scary is that apparently the morons on Pennsylvania Avenue have taken up MMT (Stephanie Kelton, the Deficit Myth and the Birth of the People’s Economy). As with all fiction books, words can be combined to create a believable story. Hers is a good one !

    The part of the story that I think you left out was that the only way to shrink the money supply and get all these new dollars off the street is to TAX. Taxation is apparently the control mechanism according the MMT. Either way, it’s not a good situation to be in. I’m not sure if you can bring down a whole country in 2 years, but by God they are giving it their best shot. If this country doesn’t put an end to this madness at the mid-terms, then I think we are doomed ! The history books are saturated with evidence of what happens to societies that head down this path.

    What really scares me is that I’m afraid there’s no peaceful way of correcting our path. I pray every day that I’m wrong. If the RNC can come up with a sensible moderate, divorce themselves from DJT and provide sensible competition to what’s been installed, we might have a chance. Maybe a Tom Cotton / Kristy Noem ticket? There are others … but I don’t think it can be done with the hate that DJT has created in the system.

    Thanks again for all of your time and energy to keep us enlightened !
    JT

  • Dan says:

    Thanks for writing this.

    I have to ask, is 2020 an exception to how things work? Meaning, did the US really issue debt for all this new spending? Isn’t the government simply digitally printing money, which does lead to inflation, but there is no debt and related interest to pay on it? Thanks for reading my question.

  • Kevin Roche says:

    The government issued debt for the amount of spending above revenues–taxes, basically.

  • D says:

    Many more things to deal with in this discussion.

    1. What happens if the Fed merely forgives the debt they hold?
    2. What would cause money velocity to increase? For quite some time, velocity has cratered allowing the massive liquidity injections to not effect prices.
    3. Demand for hard currency is through the roof and much of this is heading offshore further distorting a practical measure of velocity.

    Things that can’t go on forever will stop. However it’s really hard to predict when and things can go on a lot ongervthst you realize.

  • Alanson McCord says:

    The money machine has gone wacky. In the past year the USA has issued more than $300 billion of new currency (that’s the net addition to paper dollars in circulation over and above currency printed to replace old dollars). That’s astonishing. It amounts to about $900 new paper dollars for every man woman and child in the country. Granted, about half of that probably has gone outside the borders of the US (those dollars are hard to count, but estimates from studies at the Fed support that ballpark estimate). How many of you have an extra $450 dollars stashed in your sock drawers (one drawer for each member of the family)? More than half of those pieces of paper are $100 dollar bills – which means that by value nearly all of the value of paper money consists of $100 bills. What accounts for this splurge of paper printing?

    One clue to this can be seen in Mexico whose banks have accumulated gigantic stocks of US paper dollars. So large are these stocks that the Mexican banks are going broke holding them since US money laundering authorities will not allow those dollars to be deposited at US banks or their branches in Mexico. What this signals must be an enormous increase in drug consumption in the US.

  • So in addition to what you have stated above, many other interest rates are tied to the 10 year bond etc. as inflation picks up and rates continue to rise because they have to – all other rates will rise as well and you will have companies and people who cannot afford to service their debts. Then what? What have the “geniuses” that were elected this go round cooked up to address this issue? It’s literally as though these people have no idea what they are doing.

  • John L. says:

    So where is the best place to protect savings and investments over the next 6 months – 2 years from the inevitable collapse? Gold? Bitcoin?
    Thanks in advance for your insights.

  • Kevin Roche says:

    I am not really qualified to give investment advice but if we really see higher inflation and interest rates, and low growth, no place is particularly good. I don’t understand bitcoin so stay far away from it and the same goes for gold. Real estate usually hangs in there.

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