Taking Away the Punchbowl   (June 3, 2011)

Federal spending has risen by 40% since 2008 and the deficit has soared to over 40% of Federal spending. That's the punchbowl Wall Street fears might be taken away.

Whenever I unleash a tirade at home about how Federal spending has leaped 40% in three years and how the government is now borrowing 42% of its spending, my wife points out that nobody cares because the deficit doesn't impact them at all. This always stops the tirade in its tracks, because it's so obviously true.

As long as the Federal checks keep being issued and everyone gets their 17 "low-cost" meds paid by Medicare, the National Defense State gets unlimited billions to spy on the citizenry and indeed, the entire world, gasoline at $1,000 a gallon flows freely in Afghanistan and other distant corners of the Empire, and Wall Street writes itself billions in bonuses, then nobody cares about the deficit.

The only way anyone will feel the deficit is if their share of the Federal swag is trimmed to pay the interest on the ballooning debt. But the Federal Reserve has a solution to that eventuality: keep interest rates (and thus yields on new Federal debt) super-low.

At zero interest, $50 trillion in debt costs nothing. Heck, you and I could handle the interest payments on $50 trillion at zero interest. At 1%, the interest is "only" $500 billion a year--no big deal, as we can easily borrow another $500 billion a year, no problem. After all, the bond market hasn't barfed yet and we're already borrowing $1.65 trillion a year, plus hundreds of billions "off-balance sheet" in "supplemental appropriations."

(Of course the bond market has been "helped" by the Fed buying $600 billion new Federal debt over the past nine months, but there's no limit on that "help" either: there is literally no limit on the Fed's balance sheet, because $50 trillion in Federal debt is an "asset" that pays a yield. A nice, solid balance sheet, loaded with assets.)

As long as short-term interest rates remain near zero, the deficit spending game can run a long, long time. Here is the current yield on Treasury debt, courtesy of the U.S. Treasury: Daily Treasury Yield Curve Rates. The yield on one-year Treasuries is .18%. Given that "official" inflation (Consumer Price Index) is 3.2%, and unofficial (a.k.a. real-world) inflation is running much hotter, the investor/mark is losing 3% a year by investing in T-bills at .18% yield--or perhaps in real-world terms, 5% or more.

It's like a subprime "teaser rate" mortgage that never adjusts. Imagine having a $100,000 mortgage at .18% interest. The interest would only be $180 a year. On $1 trillion, it's only $1.8 billion--a trivial sum (at 10%, the interest is $100 billion, at 1%, it's $10 billion.)

As long as the Treasury can borrow money this cheaply, there is no visible limit to how much the Federal machine can borrow.

And Wall Street likes it that way--a lot. If you read between the lines of this story-- Moody's sounds alarm over U.S. debt limit and deficits, then you see what correspondent Kevin M. observed when he sent the link to me:

This underscores your point about the unholy alliance between Washington and Wall Street.

On the surface, one might expect Wall Street to be in opposition to federal borrowing because it crowds out investment in private offerings, like stocks. But clearly Wall Street has abandoned it's traditional view of business and the economy, and is now pinning it's hopes entirely on government liquidity.

This is truly scary. The force of interests pulling in opposing directions has always served to bring balance to the economy. That no longer exists, as if all of the forces are crowding on the same side of a sinking ship.

In effect, the income which should flow to savers and owners of surplus capital in an economy that isn't centrally managed (a.k.a. the People's Republic of America, complete with A Natural Security Apparatus, unaccountable Central Bank, kangaroo-court judicial system (just look at ForeclosureGate) and phony elections where the choice is always between hand-picked stooges of the Ruling Elite) is diverted to Wall Street and the "too big to fail" banks.

The one thing uniting the nation is dependence on the Federal punchbowl. But as I noted yesterday ( Can We Please Stop Pretending the GDP Is "Growing"?), there is a unique dynamic to this "recovery"--Federal deficit spending just keeps rising as the economy "recovers."

Many people have noted the parallels with Japan, which has managed decades of profligate Central State largesse by keeping the yield on its government debt near-zero, and relying on its citizenry to take both sides of the trade, that is, to be the owner of the debt and the recipients of government spending via pensions, etc. Put another way, the citizen who buys a bond is also the counterparty.

But Japan had a prodigious savings rate until recently, and securities laws which limited citizens' investment options that effectively channeled much of the nation's savings into government bonds. This dynamic has enabled Japan to balloon its sovereign debt to 225% of GDP.

But the U.S. savings rate is low. It is currently around 5%, up from minus 1% in the housing bubble era, but the official measure of "savings" included paying down debt. Ahem, that isn't savings. If I pay off my $5,000 credit card with $5,000 in cash, I do not have $5,000 in surplus capital, i.e. savings which I can tap. I have zero cash.

The reality is the U.S. doesn't generate enough surplus capital to support $2 trillion (remember to add in the supplemental appropriations and other off-balance sheet borrowing) in Federal debt each and every year until Doomsday.

The other reality is that nobody in their right mind wants to buy debt yielding 0.18% when inflation is 3.2% at best. It is not "attractive" because the buyer can only make money if rates drop further, boosting the value of the bond. At near-zero, there isn't much room for bonds to drop further.

Readers often write me to note that there is no interest due on money the Federal government might just print, rather than borrow via selling bonds. This is true. As I have detailed before in Is the Recovery "Self-Sustaining"? Here's a Test (March 22, 2011), the costs of alleviating the suffering caused by the recession (food stamps and extended unemployment) is about $100 billion a year--a modest 2.6% of the Federal budget of $3.8 trillion.

If the Treasury printed $100 billion and distributed it via food stamps and unemployment (or workfare, etc.) then the effects in a $14.5 trillion economy (that's actually shrinking minus Federal spending) would be modest.

But printing $2 trillion a year to prop up the Status Quo might have consequences. As I have noted here before, according to a study by adherents of the Austrian School of economics, hyperinflation has never occurred in economies in which State spending is funded by selling debt rather than printing money: Deflation vs. Inflation (An Austrian Analysis).

The reason is obvious: interest payments and the willingness of investors to buy more government debt act as governors on spending. If investors balk, and rates rise, then the deficit spending punchbowl gets drained or taken away.

There are no governors on printing money (or on the Fed's balance sheet, which in our system is the money-printing machine).

But alleviation of immediate suffering is only the excuse offered for runaway Federal deficit spending; the real reason why Federal spending has leaped from $2.7 trillion in 2008 to $3.8 trillion in 2011 is to prop up the Status Quo profiteering of cartel-crony capitalism and its partner, the Savior State.

As long as the Fed engineers a near-zero interest rate, the punchbowl can be refilled essentially forever. But if the Fed loses control of rates and they rise, then eventually-- say, when the interest costs $1 trillion a year instead of $400 billion--then the interest costs will crowd out other spending. Sacred cows of one type or another--every dollar of Federal spending is "essential," even though we somehow got by a few years ago with $1.1 trillion less--will be sacrificed.

Somehow I doubt Wall Street and the "too big to fail" banks will suffer much. Their partnership with Washington is just too strong. It's a marriage of more than convenience-- it's a marriage of money and power in virtually unlimited quantities.

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