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Feb. 12 2010 - 10:06 am | 10,738 views | 1 recommendation | 5 comments

U.S. government, on its way to bankruptcy, Part 4

In Part 1 of this series, I made the case for a U.S. government that is quite literally out of control, a government that has committed to obligations so big, that unless policies change, it’s a government that’s on its way to bankruptcy.

Starting with the simple fact that the U.S. government has NO money, that it must tax Peter to spend it on Paul, I posited that in addition to the ever constant cry for more government spending in support of Paul, it’s the way the government taxes Peter that allows the government to spend so much on Paul.  Lay the bill bare and its likely Peter throws a fit.  But mask Paul’s true cost and it empowers the government to commit to obligations far beyond the ability of Peter to ever pay the bill.

I then introduced the 3 kinds of government tax forms – Tax Peter now, Tax Peter later and Tax Peter don’t tell him – and further posited that it is the latter two, Tax Peter later, better known as borrowing, and Tax Peter don’t tell him, namely the inflation tax, which have been instrumental in masking the true cost of Paul and putting the U.S. government and therefore Peter in a deep financial hole.

In Part 2 of this series, I demonstrated that the tab being run by the U.S. government is years in the making and it’s going from bad to worse.  I further demonstrated that the policy of deferring the costs of all this spending largesse, by Taxing Peter later via borrowing instead of Taxing Peter now, has helped create obligations so huge, a bill so big, that it can never be paid.  And I concluded that unless millions of Pauls are about to be told that they are not getting what they were promised, because it simply costs too much, or that millions of U.S. government debt holders are not getting their money back, because Peter can’t afford it, there will come a time when the only way out for our politician friends, to make good on their promises, will be via the wholesale use of the Tax Peter don’t tell him policy of inflation.  In other words, by devaluing those obligations by printing money.

National bankruptcy through the Federal Reserve’s printing press.

In Part 3 of this series, I introduced Peter and Paul friends, the creditors of the U.S. government, who in no uncertain terms are the reason the U.S. government has been able to fund its spending programs without resort to the wholesale use of the Tax Peter don’t tell him policy of inflation.  Armed with their hard earned savings, they buy all those treasury bills, notes and bonds issued by the U.S. government, funding the excess of spending over tax receipts, so that the Federal Reserve doesn’t have too.

But as I argued, this funding policy is unsustainable, for when it becomes clear that the U.S. government can not possibly make good on its mounting debt obligations by taxing Peter, that the only way out of those obligations is via inflation, the U.S. government’s creditors, fearing the debasement of the dollar and therefore the value of their investments, will go from friends to foes, from eager buyers of those treasury bills, notes and bonds to eager sellers.  And as they do, indeed because of it, the Federal Reserve will be forced into action like never before, to become THE buyer of these bills, notes and bonds en masse, a vicious circle which could eventually lead to the destruction of the dollar.

In other words, national bankruptcy through the Federal Reserve’s printing press.

And the trigger for this exit from U.S. government debt?  Foreign creditors, not only the primary buyers of all these obligations and a funding source too big to be filled by U.S. based creditors for long, but, unfortunately for the U.S. government, the creditors most sensitive to the purchasing power of the U.S. dollar.

In fact, as the protestations of a growing number of foreign creditors over the health of the U.S. government’s finances suggest, protestations supported by actual foreign investment flows to boot, foreign based creditors may already be pulling back from U.S. government debt.  And that in turn suggests the Federal Reserve is beginning to grind its monetary engines in response.

And despite Ben Bernanke’s protestations to the contrary indeed it is.

In Part 4 and the finale in this series, where we are in this dynamic and what’s next.

If you have not yet read Part 1, 2 or 3 of this series, I would encourage you to do so now.  You can find them here:




Part 4.  Peter and Paul are about to get fleeced

Recall, the inflation tax begins with the Federal Reserve entering the capital markets and buying the government’s treasury bills, notes and bonds with money printed out of thin air, through a check the Federal Reserve writes on itself, so that the U.S. government can in turn take that money and spend it on Paul.

Here’s the 50 year record of U.S. government debt held by the Federal Reserve against total government debt sold to and held by the public, through the U.S. government’s fiscal year 2009:

DQGov essay_6853_image003

And the record of annual Federal Reserve purchases of U.S. government debt:

DQGov essay_6853_image004

After peaking at 24% in 1974, Federal Reserve holdings of government debt as a percent of total government debt went on an almost uninterrupted decline until bottoming in 1992 at 9%.  Those holdings then retraced about 45% of that decline topping out at about 16% in 2007.  Then came the 2007-2008 credit crisis, when the Federal Reserve sold about 40% of its government holdings in favor of short term targeted loans to bail out a failing financial sector.  And finally, as you can see, the Federal Reserve is rebuilding those positions, at least in dollar terms, to pre-crisis levels as the Federal Reserve unwinds those loan programs.

Looking at the bigger picture, it’s obvious that the Federal Reserve was much more important in financing U.S. government borrowing and spending 30 years ago then it is today, this despite the fact that the U.S. government has been taking more and more of America’s national savings.  And the reason, because our foreign creditor friends have been doing all the heavy lifting, so the Federal Reserve didn’t have too.

Here I suggest are the numbers to prove it.

Let’s start with the 50 year record of Federal Reserve purchases of U.S. government debt against foreign creditor purchases of government debt:

DQGov essay_6853_image005

Note the generally inverse relationship.

You can see that inverse relationship even better by trending U.S. government debt held by the Federal Reserve and debt held by foreign creditors, as percents of total U.S. government debt sold to and held by the public:

DQGov essay_6853_image006

More importantly, you can also see quite clearly that since the 1980s foreign creditors have been doing all the heavy lifting, so the Federal Reserve didn’t have too.

That is, as we suggested in Part 3, until perhaps now.

Let’s zoom in on the recent purchasing trends of the Federal Reserve against foreign creditors:

DQGov essay_6853_image007

Take note of the last few years.  Clearly, as foreign creditors have pulled back, the Federal Reserve has stepped up its purchases of U.S. government debt.

You might say, isn’t this recent surge in Federal Reserve purchases a bit deceiving?   As Ben Bernanke has said, the Federal Reserve is merely returning its holdings of U.S. government debt to pre-crisis levels, offsetting the unwind of the Federal Reserve’s credit crisis loan programs. And as such, this is not what one should call the beginnings of a wholesale inflation.

Plausible argument if it wasn’t for the fact that the Federal Reserve is not simply returning its U.S. government holdings to pre-crisis levels.  In fact, it is ballooning them, by buying mountains of the newest form of government debt, the debt of the government-sponsored enterprises Fannie Mae and Freddie Mac.

On January 8th, I penned an essay entitled Fannie and Freddie, another American taxpayer nightmare, where I made the case that the recent action by the U.S. treasury, to explicitly guarantee without limit the debt obligations of the government-sponsored enterprises Fannie and Freddie (GSEs), effectively makes the GSEs divisions of the U.S. government, and as such, supported by all three of the government’s tax venues.  That means GSE debt is indistinguishable from U.S. government treasury debt.  And that also means that when the Federal Reserve buys GSE debt, it is really buying the debt of the U.S. government.

With this in mind, let’s have a look at the purchasing activities of the Federal Reserve and foreign creditors in GSE debt, focusing on the recent trends:

DQGov essay_6853_image008

Interesting, no?  Foreign creditors may still be buying U.S. government debt, but over the last couple of years they have been selling GSE debt to the Federal Reserve with gusto.

Indeed, taken as whole, the picture is not pretty.  Have a look at combined U.S. government and GSE purchases, the Federal Reserve against foreign creditors:

DQGov essay_6853_image009

Foreign creditors are pulling back on their combined purchases of government and GSE debt.  And the Federal Reserve is buying both to fill the void, and then some.  And as we saw in Part 3, this should come as no surprise when America can not possibly finance the U.S. government’s borrowing needs when these needs are a growing multiple of U.S. savings, year in and year out.

Perhaps what foreign creditors are saying is this:  Sure, I’ll buy your shorter-dated U.S. government debt, if you buy my longer-dated GSE debt.  But until you, the U.S. government get your house in order and prove to us you will not simply resort to the printing press to pay your bills, don’t expect too much of the former and expect a lot more of the latter.

Indeed, this is what any self respecting bond investor would do when they begin to feel the value of their investment is at risk – become cautious, shorten up on maturities and make sure you know the location of the exit door.

So, this Federal Reserve call to action, is this the start of some nasty inflation to come, perhaps even the beginning of wholesale inflation?

Before you answer that question, one last metric for your consideration.

For sure, none of these money printing activities by the Federal Reserve is inflation if it isn’t translating into growth in the money supply.  Well, have a look at the recent trend in money supply growth, this through December 2009:

RTMS essay_11652_image001

While I will leave a definitional discussion for a future post, TMS, the Austrians formulation of the “true” money supply, is growing at double digit rates and it is approaching decade highs to boot.  Looks like the start of some nasty inflation to me.  Still early in the game, but the beginnings of wholesale inflation this may be.

As I discussed in Part 1, we Austrians can’t think of a more sinister tax than the inflation tax.  Not only does printing money steal purchasing power from Peter for the benefit of Paul, but when pursued without limit, it will eventually reduce the value of that money to zero, and with it, the hard earned savings of anyone holding that money.

If these trends continue – U.S. government spending largesse, foreign creditor restiveness-turn-fear and a U.S government-Federal Reserve tag team with a bent to fill all government borrowing and spending gaps with money printed out of thin air, not only are we looking at a defacto national bankruptcy, but both Peter and Paul are about to get fleeced.


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  1. collapse expand

    Thanks for the great series. Do you think the Greek/EU situation could provide a flight to the dollar and create a short term deflationary condition in the US, the country with the fastest printing presses, before the inevitable inflationary spiral?

    • collapse expand

      Hi fleetlee

      Tx for the kind words

      I think Greece/PIIGS are to the EU as California, et al is to America. Neither can print money to fund their deficits, but unlike California, et al the PIIGS and the rest of the EU are only loosely tied politically. That gives the EURO both inflation risk and political risk. And in that context makes the EURO a bit riskier than the USD.

      So, in times of EU trouble, like we are seeing now, people will I think naturally look to the USD, still the reserve currency of the world, for cover.

      I think the best thing the EU/ECB can do from a EURO standpoint is show some monetary restraint and not bail out Greece et al in a wholesale fashion. That might give the EURO a better rep as a “hard currency” longer term and support it better vs USD. We will see

      The larger issue is the USD, EURO, YEN, etc are all fiat monies managed by pro inflation, interventionist nations. It’s kind of like who is the best of the worst. In the end, IMO, all these currencies will depreciate against “things” together, with each taking their turn.

      The inflationary spiral is only inevitable IF policies DONT change. I actually think the death spiral will be short circuited at some point by a policy change (I HOPE). Only, IMO, that will not happen until we see a lot more inflation first

      In response to another comment. See in context »
      • collapse expand

        I have just finished the Series. My assessment of same can be summed up by recalling Horatio’s inquiry of the Ghost in Act I of Shakespeare’s “Hamlet” when Horatio asks:

        If thou art privy to thy country’s fate, which, happily, foreknowing may avoid, O speak!

        I believe you have spoken, Michael, and have done yeoman service. Kudos to you. Now if only those we have elected to be our stewards will listen. Alas, I fear not, at least not until the maelstrom is upon us.

        In response to another comment. See in context »
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    About Me

    I am a retired Investment Banking professional, most recently Chief Operating Officer for the Bank's Cash Equity Trading Division. I am a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor.

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    Contributor Since: January 2010
    Location:New York