Thursday, March 10, 2011

"Monetization of Debt Today - Inflation Tomorrow"

Sydney M. Williams
Thought of the Day
“Monetization of Debt Today – Inflation Tomorrow”

March 10, 2011

Everybody is concerned about the size of the federal debt and its relationship to GDP, as well they should. (Yesterday, Moody’s downgraded Spain’s debt. Their government debt to GDP is 60%. Ours is 96%.) Yet the reluctance by Congress to cut programs is paralyzing Washington. Leadership is needed and it is missing. Only the President has the pulpit, not only to preach the need for fiscal restraint and reform, but to propose real cuts. Instead, we heard him yesterday, in the wake of two scandal-forced resignations, defend the continuing funding of those indispensable institutions, NPR and public broadcasting.

Polls reflect the quandary in which the people find themselves. While the polls suggest people view the deficits as significant problems, they also do not want programs cut or taxes raised, especially when they affect them personally. Despite all the talk and all the press, neither Congress nor the President has elevated the problem of the deficits to a level of exigency they belong. There is also the probability that a recovering economy, and the increased tax receipts that will follow, will diminish the critical urgency of state and federal deficits. Kicking the can down the road to beyond 2012 just may work. But a temporary alleviation of the problem will leave the damaged structure in place. Even Keynes, father of deficit spending during recessions, believed surpluses should be generated during boom times. Boom times for Washington, in this regard, are always around the next corner. Procrastination is the politician’s friend.

Members of President Obama’s deficit commission, whose advice has thus far been ignored by he who appointed them, have become increasingly vocal in their warnings of the path we are treading. Even Alice Rivlin, the first director of the Congressional Budget Office, a senior fellow of the Brookings Institute and a member of the deficit commission, recently said, “…our creditors will begin to worry that we’re not creditworthy, they will demand a higher price, and interest rates will go up.”

Structural deficits that appear permanent in nature, with a Congress and an administration loathe to make the tough decisions necessary to kick the spending habit, have already limited our options and risk impeding the recovery before it recovers to historical levels. Richard Fisher, President of the Dallas Fed, and representing the other side of the political spectrum from Alice Rivlin, in a speech on Monday, pointed out that “…liquidity tanks are full, if not brimming over. The Fed has done its job.” Business must now be incentivized to commit that liquidity and create jobs in America. That is a job for Congress, not the Federal Reserve. Mr. Fisher had been quoted earlier comparing Congress to Lindsay Lohan, “a beautiful creation…but waylaid by addiction…and by a proclivity to shoplifting.” Term limits, anyone?

Much is made in the press by the idea that we have, like Jabez Stone, sold our soul to the devil, in this case sold our debt to foreign entities. China, for example and according to Reuters, owned $1.16 trillion of U.S. Treasuries – about a third of all U.S. Treasuries owned by foreign holders at the end of December. Over the past twelve months the yield on the 10-Year has risen four basis points, suggesting the price is essentially flat. During the same time, the Yuan has risen about 3.8% versus the Dollar, suggesting a nominal loss, after interest income, for the Chinese over the past year – an untenable situation over any extended period. An expectation of a 6% rise in the Yuan this year only makes ownership of low-paying U.S. Treasuries more unattractive for the Chinese. As Ms. Rivlin recently said, buyers will demand higher returns.

However, the bigger problem, in my opinion, is that the Federal Reserve has become the single biggest buyer of U.S. Treasuries over the past year, adding about a trillion dollars to their balance sheet in the past year. In the last half of 2010, the Fed represented about half the buying of treasuries. This is no more than a monetization of debt. Having one governmental department print money and another buy it does not represent market-determining pricing. Wage pressure may be absent in our economy, but the monetization of debt inevitably leads to inflation. Food, cotton and mineral prices are up substantially in the past year. The Fed appears in denial, but if it walks like a duck and quacks like a duck, it is probably be a duck.

Additionally, the larger the Fed becomes, as an owner of Treasuries, the tougher will be the unwinding of their positions. Mr. Bernanke may prove a magician, but I suspect that is a low probability bet.

The Federal Reserve, in lowering rates at the end of 2008 and helping to provide liquidity to the financial system in 2008 and early 2009, helped stave off what could have been a dramatically worse problem. We owe them thanks for the role they played in helping to save the capital markets. Quantitative easing has helped the still-ailing housing market by keeping mortgage rates low. But part of what got us in trouble was a proliferation of too-low interest rates for too long, which encouraged leverage within households and financial organizations. The risk now is that the government is simply encouraging the markets to repeat the mistakes of the past.

The Fed, as Mr. Fisher said, has done its job. Now it is the time for Congress and the President to act on fiscal policy. If they don’t, if they duck their responsibility until 2013, and simply pass the job temporarily onto the monetary authorities, the result will be inflation, higher interest rate costs and a devalued currency.

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