After eight months of diving deep into federal budget projections for decades to come, the Obama-created National Commission on Fiscal Responsibility and Reform has just released its report of fiscal austerity recommendations entitled 'The Moment of Truth'.
While I generally favor federal fiscal austerity, I feel compelled to pen this article to point out the elephant that the Commission has completely missed—U.S Treasury debt erasure through monetization by the Federal Reserve.
The Commission’s entire 66 page report fails to recognize that the Federal Reserve has a ‘printing press’ to retire Treasury debt at will. Thus, the report’s painstakingly-detailed future budget projections will prove to be dramatically overly pessimistic. The Commission’s completely overlooking Fed monetization of the debt is quite surprising with their report coming on the heels of the Fed’s QE2 announcement that by July 2011 it will have created $600 billion out of thin air to buy (retire) U.S. Treasury debt. The Fed additionally hinted at more such quantitative easing to come that could eventually pay off trillions of the $14 trillion national debt.
The Commission's report inaccurately compares the U.S.A.’s national debt situation to that of insolvent Greece—a country that of course cannot create new money to pay off its debt since it has adopted the euro as its currency. This is what happens when non-experts (a task force composed mostly of members of Congress) dabble in Finance. Notwithstanding, many of their recommendations to cut spending and enhance federal tax revenues seem sensible. But this article is not about that. Instead, here I would suggest that Fed monetization is an extremely powerful tool that in years to come will in fact create some great news in mitigating the U.S. Treasury’s debt problem, while causing only modest inflation, if any. Such an unexpected improvement in the U.S. national debt picture of course augurs well for the U.S. economy, and moreover for U.S. stocks. Although in less than two years the major stock indices have already rallied a phenomenal 70% from their lows during the financial crisis, there should be lucrative additional gains to come in the decade ahead. Despite the naysayers, ‘Buy and Hold’ should once again perform very well for U.S. stocks.
How the Fed’s “Printing Press” Works to Monetize the National Debt
The Federal Reserve is the only entity that can create new U.S. dollars on its own behalf. It can do so at any time, in any amount, and for any purpose. (Of course, there are fraud prevention restrictions so that Fed employees and its member banks [owners] cannot benefit from this money creation.) The Fed simply creates any amount of money with a few keystrokes of the computer, and sends it as payment to the recipient’s bank account. No physical currency or coin need be created in this act of ‘printing money’.
The Fed rarely exercises this power of money creation except in financial emergencies. During the financial crisis of 2008-9, it unprecedentedly created a colossal amount (over $1.5 trillion) to buy potentially toxic debt to stabilize the financial system. Unlike TARP, no approval or appropriation by Congress was needed, and no announcement was required at the time.
In the case of buying U.S. Treasuries, the Fed can buy existing Treasury debt in the open market or buy new issues directly from the Treasury. The Fed creates the purchase money with a few keystrokes and sends it to the seller—either the Treasury itself or the party selling the Treasury bonds. This is brand new money that directly boosts the money supply of the economy. The Fed then becomes the new holder of the debt. Technically, the Treasury must then pay the Fed the interest and the principal at maturity.
However, this is only a technicality. Since the Fed can create money at will, it has no need to ever collect any payments. Because of the Fed’s hand-in-glove relationship with the Treasury, it can simply forgive (erase) the debt and/or the interest. The Fed will reflect such debt forgiveness by writing the Treasury bonds off of its balance sheet. The Fed does not incur a loss since it bought the debt with conjured money anyway. Voilà, it's a U.S. Treasury debt disappearing act!
The “No Free Lunch” Theories of Inflation
If this money creation process to pay off government debt seems far too easy to you, you have plenty of company. They say, quite adamantly, that there can be no free lunch. The price to be paid is supposedly currency devaluation caused by the inflating of the money supply. It has long been assumed in economics that price levels throughout an economy are a direct function of the overall abundance of money. Very much ingrained in economic thought are such notions as “too much money chasing the same goods causes inflation” and that "supply and demand of money" somehow determines the value of the money (indirectly through the pricing of goods and services).
However, the highly questionable idea of money supply increases necessarily causing proportionally higher prices is a purely macroeconomic notion that fails to hold up when scrutinized at the microeconomic level, where real-life economics resides. This is addressed in much greater depth in my book.
Future Federal Deficits Will Be Much Lower Than Expected
These days doomsday projections of the national debt and future deficits certainly abound. Many say an inevitable monetization of some of the national debt will have catastrophic consequences for the dollar. I am always surprised at how many economists and pundits are quick to exaggerate the dire inflationary consequences that would supposedly result from Fed monetization of some portion of the Treasury debt, while completely ignoring the undeniably real benefits of such monetization.
The benefits are actually very large and compelling while the inflationary risks are far lower than is generally believed. Some very real benefits when the Fed forgives the current QE2 $600 billion worth of Treasuries will be:
- $600 billion or roughly 4.3% of the National Debt will be simply cancelled.
- Assuming an average interest cost of 1.75%, the Treasury’s interest expense would thus be reduced by over $10 billion per year, reducing all future years’ deficit projections by a similar amount.
- There will sooner or later be a large stimulative effect from the newly created money being spent and re-spent throughout the economy in perpetuity ($600 billion in new money is the minimum; fractional reserve banking allows that the private banks can create additional money by writing new loans against this amount up to a maximum of approximately 9 times the $600 billion; thus, from the initial $600 billion, eventually the money supply could increase by as much as several trillion dollars.)
- There will be a major boost to tax revenues caused by the continual circulation of the new money. Additionally, if there is much increase in the velocity of money through the stimulative effect, tax revenues could jump very sharply at all levels of government. (This would occur without even raising tax rates.) The tax revenue boost from the new money would be sustained for as long as the money continues to be spent (since the government taxes transactions rather than held wealth). In a full economic recovery (with low unemployment) the additional tax receipts generated by the new money could be truly dramatic and lasting (at the same time that entitlement spending falls from lower unemployment). All the pessimistic deficit projections I've seen fail to take into account this large new revenue source—the taxes generated in perpetuity from new money that is one day simply conjured into existence by the Fed.
The Commission’s report claims: "If the U.S. does not put its house in order, the reckoning will be sure and the devastation severe." Fortunately the Commission is very much wrong in this assessment, as their report completely ignores Fed monetization.
While some views I express in this article may seem overly confident for what is currently considered to be an extreme position, I assure you that I am cautious in the forming of my views. I make few predictions and express publicly even fewer. But one thing that is clear to me is that prices are generally not a function of the size of the money supply, as many would insist. Should the Fed eliminate a couple trillion of our National debt in the coming years, the stimulative and deficit-shrinking benefits could be enormous without causing anything remotely approaching a proportional loss of the dollar’s purchasing power through inflation.
Not convinced? Put a link to this article on your Outlook or Google calendar five years hence and reread it then. I expect that any Fed QE will stimulate the economy, shrink projected deficits, and boost tax revenues much more than is expected, and without excessive price inflation. The future for the U.S. and U.S. stocks is much brighter than it currently would seem.
 The empirical evidence supports a strong correlation of price levels to size of money supply only in very long term comparisons over decades, which is not meaningful in arguing causation. The correlation of price levels to money supply size over any shorter periods is poor to ambiguous.
Disclosure: Long SPY and various U.S. individual stocks.