The incestuous relationship of Obama's Treasury and the Fed

My last blog post was an email to my son about Obamacare and the deficit. I copied a couple of friends on the email. One of those friends, Gene, sent a reply to me and my son with some general comments about how both liberals and conservatives are to blame for the financial pickle we find ourselves in. Here is a new email I sent to my son commenting on Gene’s email and clearing up some of the things he said.

Dear Son,

Gene always likes to masquerade as a kind of Solomonic figure: fair, impartial, apportioning equal amounts of blame to both ends of the political spectrum. But, come November, he will toe the line and vote for Obama and the rest of the Democrats. And, whenever I point that out to him, he flies into a rage.

There is one thing, however, that I do agree with Gene about: the Federal Reserve, under the stewardship of Ben Bernanke and in conjunction with Obama’s Treasury Department, is continuing its massive devaluation of the American dollar. Here’s how they do it.

The Obama administration continues to spend dollars it doesn’t have, running up trillion dollar deficits. When it comes time to pay the bills, the Obama Treasury Department borrows money by issuing debt. That is, the Treasury prints up a bunch of fancy-looking, gilded Treasury certificates that say: "The Treasury Department solemnly promises to repay the face value of this certificate, say, $1000, with interest after 10 years." The Federal Reserve then buys a bunch of those certificates, crediting the Treasury Department’s account with $1000 for each certificate the Treasury Department sells to it. So now the Treasury Department has additional dollars in its account and the Obama administration can keep on spending.

Where, you might ask, do the dollars come from that the Fed credits to the Treasury Department’s account? Excellent question. The Fed creates them out of thin air, with the stroke of a pen (or, in this day and age, with the flow of a few bits over the Ethernet). In other words, the Fed simply declares that now the Treasury has $1000 more in its account, and, voila, $1000 appears in Treasury’s account. This is what is called "fiat money." The Latin word "fiat" means "let there be," as when God said "fiat lux" or "let there be light." So, "fiat money" is money that is created out of nothing; the Fed simply declares "let there be dollars" and the dollars are created.

If this sounds too good to be true, that’s because it is. As with anything, the more you have of it in the marketplace, the less it is worth. Likewise, the more dollars that are circulating through the economy, the less each individual dollar is worth (that is, the less it can buy). This is inflation. There are individuals, like Paul Krugman, who scoff at the threat of inflation, and, so far, they have had the better part of the argument, since inflation has remained relatively tame. But, the signs of increasing inflation are already starting to show up (for example, I spent $4.59 on a loaf of fucking Columbo French Bread in Sacramento the other day and I spent $3.65 this morning to buy your mother a Chai drink at Starbucks; also just look at how much the price of gas has soared over the last ten years). But, regardless of what the current level of inflation is, what normally happens when you flood the economy with enormous amounts of new money is: eventually, hyperinflation rears its ugly head. And, there is no good reason to believe that the Fed’s current actions will not have the same outcome.

Another consequence of the Treasury and Fed's incestuous activities is that, as the Treasury Department issues more and more Treasury certificates, there will be fewer and fewer outside parties that will be willing to buy them. This is already happening, as countries like China have cut way back on their purchases of Treasury certificates. Eventually, the only party that will be willing to buy these certificates will be the Federal Reserve. But, even the Federal Reserve’s capacity to absorb Treasury debt is limited since, as already noted, buying too much of this debt will flood the economy with dollars and trigger hyperinflation. Eventually, the only way the Treasury will be able to sell new debt to outside parties will be by promising to pay higher and higher interest rates. But this will just make potential buyers suspicious that the US will not be able to repay all this debt and will eventually default. And this suspicion, in turn, will just make those buyers even more reluctant to buy Treasury certificates and demand even higher interest rates. This is what’s called a “vicious circle” and is precisely what is happening in Greece, Spain, and Italy right now. Those governments need to keep borrowing more and more money to keep their governments operating, but fewer and fewer parties are willing to buy that debt because they realize how much debt is already outstanding and how shaky the governments already are. Consequently, interest rates for Greek, Spanish, and Italian sovereign debt spiral ever higher, weakening those countries even further.

So, financial Armageddon is coming. As noted, it is already happening in Europe. The Europeans are better off than the Americans, however, in that at least the Europeans are already standing at the edge of the abyss and consequently are actually trying to implement austerity measures that will keep them from plunging in. As Paul Krugman points out, these austerity measures will cause tremendous short term pain in Europe since the European economy will contract and there will be a recession or even a depression there as the governments cut back on their spending and borrowing. But, at least there is some recognition (primarily in Germany) of the problem and some hope that over the long term Europe will eventually get its fiscal house in order and emerge from the other side of this economic minefield. Americans, on the other hand, still delude themselves into thinking that somehow they are special, that the normal laws of economics don’t apply to them. They mock the Germans for fearing hyperinflation and for insisting on austerity. They laugh at Greece and Spain and Italy and say things like: “Nothing like that could ever happen over here.” Americans are like people who have smoked, drunk, and eaten fatty foods all their lives and think that, simply because they have not yet gotten cancer or sclerosis of the liver or had a heart attack, they are healthy. Ha!

The only people who really sense the impending doom are Republicans like Ron Paul, who has been preaching the evils of the Federal Reserve and fiat money for years, or Paul Ryan, who, unlike the Democrats in power, actually proposes a budget, or Grover Norquist, who sees through the "one dollar in new taxes for every three dollars in cuts" bullshit the Democrats always try to pull (they add the one dollar in taxes, but the three dollars in cuts never materialize). So, don't believe for a moment anyone who, like Gene, tells you that the Republicans are just as responsible for the fiscal mess we find ourselves in as the liberal, tax and spend Democrats.

Loving you always and firm in my belief that as your mind ripens you will abandon the liberal path (LYAAFIMBTAYMRYWATLP),

Dad

Update:

Gene replied: "The Fed does not buy Treasury notes directly from the Treasury. That is illegal. Likewise it cannot "credit" the Treasury"s account by purchasing notes directly."

My response to Gene: Technically, that is correct, but the outcome is the same as I described even if the transactions take place in the open market. The Fed is monetizing Treasury debt like crazy. Lawrence Goodman, a former Treasury employee, wrote in WSJ in March:

Last year [2011] the Fed purchased a stunning 61% of the total net Treasury issuance, up from negligible amounts prior to the 2008 financial crisis. This not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits. … The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit. Similarly, the Fed is providing preferential credit to the U.S. government and covering a rapidly widening gap between Treasury's need to borrow and a more limited willingness among market participants to supply Treasury with credit.

The fact that the Fed and the Treasury conduct their activities through open market operations is just an enormous money laundering scheme.