A Weird Outcome Of The Fed's Money Printing

by: Rodney Johnson

Summary

One of the outcomes of the Fed printing more money is that the government actually owes less debt.

The Federal Reserve owns $2.5 trillion in U.S. Treasury bonds, which they are legally allowed to hold to maturity, and then send back to the U.S. government as cash.

Any bonds held to maturity can be thought of as forgiven debt.

I keep reading that the U.S. debt is out of control. That we're spiraling toward a certain financial death, evidenced by the fact that we now owe more than 100% of annual GDP.

According to a recent study by Rogoff and Reinhart, this is well beyond the threshold of where economies struggle. And we're not alone. Several other countries have the same high level of debt outstanding, and Japan is at the top of the list, owing almost 250% of GDP. Clearly, we're all going to die.

The only problem is, we're still kicking.

Markets still function, ATMs still work, and inflation remains tame. It's possible these things could change. We could hit a point in our debt load where things suddenly become unbearable, the U.S. dollar and other currencies become unhinged, and prices soar as currencies implode.

But I don't think that's going to happen, and we have an unlikely group to thank -- central bankers.

I'm no fan of the Fed, the Bank of Japan, the ECB, or most any other central bank for that matter. I think their misguided policies, especially quantitative easing, have done more economic harm than good, stealing money from savers while pushing on a rope to encourage spending.

But one weird outcome of money printing is that the government owes less debt.

Small, unstable countries typically print more money when the government is unable to borrow in foreign markets. To keep paying their bills, they print more currency, which causes everyone -- domestic and foreign -- to run for the exits. The outcome is predictable. The currency falls faster, leading to runaway inflation.

But when large, stable countries, such as the U.S. and Japan, print money, it's for a different reason. We have no trouble borrowing, a function of the Treasury, which is obvious given our extremely low interest rates.

Instead, our central banks print money to battle a lack of inflation, and even outright deflation, which has nothing to do with Treasury actions. However, the central banks are affecting the government coffers because of what they choose to buy, and what happens after the purchase.

Typically, central banks buy assets to put more cash in the economy, which is supposed to drive down interest rates and make loans easier to get. These are the main reasons for quantitative easing.

At some point in the future, when inflation is ticking higher, central bankers are expected to sell the bonds they've purchased. This will take cash out of the economy and drive interest rates higher.

But what if they don't?

The Federal Reserve owns $2.5 trillion in U.S. Treasury bonds. There is no law or regulation stipulating the bonds must be sold. Instead, the Fed can hold them to maturity… and then send the cash right back to the U.S. government.

Since the Fed sends all extra cash back to the U.S. Treasury, then any U.S. bond the Fed buys and holds to maturity can be thought of as forgiven debt. The U.S. Treasury will pay the interest and principal to the Fed, but the Fed will send it right back a few days later.

If the Fed holds all of its U.S. Treasury bonds to maturity, and remits the funds to the U.S. Treasury instead of buying more bonds, then effectively the central bank has reduced our debt load by $2.5 trillion, or roughly 13%.

For other countries, the effect is even bigger. The Bank of England holds 15% of Great Britain's outstanding debt, and the Bank of Japan owns a full 25% of all Japanese government debt.

When these amounts are removed from our debt calculations, the numbers get a bit more manageable. U.S. debt outstanding drops from 110% of GDP to 95%, while Japan's debt falls from 250% of GDP to 187%.

Currently, the U.S. federal budget deficit stands at around $517 billion. Based on this relationship, in which the Fed can hold bonds to maturity and send the cash to the U.S. government, the Fed could effectively "print" $517 billion, and voila. Zero new net debt is added.

The problem with this approach is that it probably would not survive the extreme bound of the logic.

If we were able to attack our government debt through money printing, then why not have the Fed print another $16.5 trillion, buy it all, and be done with it?

At that point, we might lose the one thing that keeps all current currencies afloat -- confidence. Without any tangible backing, currencies have value only because investors and citizens have confidence that they will not be excessively devalued through government or central bank action.

In developed countries where central banks are trying to create inflation, how much printing is too much?

There is no answer. It's only knowable after the fact. Given the horrible social consequences of a failed currency, it's not something I'd like to see tested in the U.S., or anywhere else for that matter. So even though money printing might have an odd positive attribute (lowering government debt outstanding), it's not worth the risk.

Instead, we should reduce our government debt the old-fashioned way, by living within our means. Unfortunately, that policy has no chance in our current political climate.

That could change with another financial crisis.

While the Fed could hypothetically print half a trillion dollars to stop debt from rising further, that won't be possible if the economy takes another nosedive, and annual deficits quickly climb back to $1 trillion, as Harry Dent argues in our Boom & Bust for July. In 2009, the deficit actually reached $1.4 trillion.

At that point -- when deficits balloon out of control, and debt rises dramatically with no end in sight -- government will have to make some cuts.

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Rodney

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.