No Pain Free Way Out

The average person does not understand and could care less about Fed policy, Government budget deficits, and the National Debt. All he wants to know about “finance” is how much he earns and how much he has to spend to maintain his lifestyle.

Be that as it may, these big picture items have a major impact on our lives.

When the Government spends more money than it takes in, that requires the overspending to be financed by borrowing. When the Government borrows, it adds to the National Debt. The government borrows by issuing interest-paying bonds. Someone has to buy those bonds. As the National Debt grows, buying the Treasury’s bonds is seen as riskier for the investor. Would you rather borrow from someone heavily in debt or from someone with less debt?

In order to entice reluctant potential bond buyers, the seller has to raise interest rates.

However, the Government does not want to have to raise interest rates, because it means increasing its cash outlays, even more, compounding its deficit problems.
What has been happening is that the Federal Reserve (the Fed) has been buying government bonds that the public does not want. If this strikes you as just the left-hand selling to the right-hand, you are correct.

Most of the ever-increasing Government deficit is currently financed by the Fed buying the Treasury’s bonds. A lot of this was done under various crisis programs called “Q.E.” (Quantitative Easing), which were intended to be temporary in order to spur public spending and avert a recession. The Fed would now like to sell some of those bonds in the private market, but since those bonds were issued with low-interest rates, there is not much demand for them other than a discounted price. That means selling at a loss.

What happens to any losses suffered by the Fed? Answer: They are transferred to the Treasury. (Remember the part about the left hand and the right hand?). Losses transferred to the Treasury increase the National Debt still more.

The Fed also is involved with controlling interest rates. Although it does not set all interest rates, its actions have an enormous impact. At the moment, a 30-year Government bond pays an interest rate of less than 2%. With inflation running at over 6%, that means an investor buying these bonds gets a real rate of return of around minus 4%. It should not be hard to understand why investors don’t want to buy Government bonds currently.

To counter this reluctance, the Fed wants to restore interest rates to a normal level. They have kept interest rates low for a long time to counter various crises over more than a decade. It is time to get things back to some sort of “normalcy”. Otherwise, the problem of financing the Government’s enormous debt will only get worse, eventually causing inflation to spiral out of control. This happens because a Government bond is “money”, and when money loses value, that is the definition of inflation.

Wait a minute! There must be other solutions. Government spending could be reduced. Lots of luck on that one! Two-thirds of the economy is powered by consumer spending. A large amount of that spending is supported by “transfer payments”, which means Social Security, Medicare, Medicaid, unemployment compensation, and other welfare payments. Transfer payments are part of Government spending.

Taxes could be raised. Unfortunately, it would take increases that are politically unacceptable. Even if virtually all of the wealth of the billionaire class were confiscated by taxation, it would only make a dent in the problem. Nearly half the population already pays no income tax, and Social Security and Medicare taxes are inarguably insufficient at current levels. To massively increase taxes on the “hard-working” middle class would cause a revolution.

We could default on the Debt, which is what many other countries have done in the past. They were not all poor countries. Countries like France and Spain, which were at one time the most powerful in the world, defaulted on their debts, costing them their pre-eminence.

Default is not an option for the United States. It would lead to the collapse of much of the world’s economy since economics is now a global issue.  We issue the “reserve” currency of the world, held globally in bond form.  A US default would trigger a worldwide financial panic.

The Fed is trying to navigate a fine line. They realize that they cannot permanently tolerate a bond market that offers negative returns. That means higher interest rates. They would like to reduce their bond holdings before they raise rates, in order to keep their value from plummeting. They also understand that raising interest rates too fast will crash the stock market since stock prices intrinsically reflect the discounted present value of future earnings. Discounting recognizes that the current value of profits earned in future years is not worth as much today as are current earnings.

More spending that is not properly funded (i.e., using the phony accounting employed by both Parties to sell their programs to an unsophisticated public) is only going to exacerbate the problems.

I was once told by my Congressman that the lack of financial understanding by members of Congress is appalling.

The hope is that the problems will disappear if the economy grows enough, and that justifies still more Government spending to stimulate growth. That would be fine if the evidence did not show that increased levels of government debt have diminishing returns. In other words, each level of new excess spending produces less and less growth over time. Wishing that was not the case does not make it so.

The Fed will likely adopt a gradual approach to reducing their bond-buying and the raising of interest rates in order to avoid spooking the financial markets. (Markets can handle anything except sudden changes in any direction of anything affecting them.) Their difficulty is doing it if inflation gets too high for too long. In that case, public and political pressure to “do something” will cause them to “go big” and in so doing crash the markets.

Of course, those on the Left would cut military spending in order to free up funds for their favorite projects. This would be a temporary solution until China attacks Taiwan, Russia attacks Ukraine, or Iran starts bombing Israel. The difficulty with being the world’s hegemon in a globally connected world is that we cannot simply sit back and say that whatever happens in the world is of no concern to us. Had we done that in WWII, might we all be speaking German today?

Another approach that might be employed that has not been suggested so far is to mandate that pension funds and insurance companies buy a certain percentage of Government bonds. That is not unusual in a number of countries. Of course, it means that returns on those assets are lower since Government bonds have lower percentage returns than private investments, but that disguises the problems from a politician’s point of view since the negative impact is spread over a much larger base. Of course, most pension funds are extremely underfunded today and are struggling to earn enough to enable them to meet their current obligations.

There are those who say, “To hell with financial markets. They only benefit the rich people.” However, that ignores the majority of people with 401(k) or other pension plans or savings that depend on investment performance for retirement security, as does Social Security itself. If financial markets plummet, the rich will find a way to protect themselves; the rest of us will suffer.

This budgetary conundrum sounds negative because there appear to be no pain-free choices.  There must be other solutions that shift the pain to someone else or make it disappear in a magical cloud.

Unfortunately, the only real solutions are a much more prosperous economy that generates the revenue and taxes to support what we want, or else we have to reduce our perceived needs to the level of our ability to pay.