The Other McCain

"One should either write ruthlessly what one believes to be the truth, or else shut up." — Arthur Koestler

What Interest Rate Would You Charge Yourself for a Loan of Monopoly Money?

Posted on | April 24, 2011 | 7 Comments

This is the question posed by the Fed policy of “quantitative easing”:

The Federal Reserve’s experimental effort to spur a recovery by purchasing vast quantities of federal debt has pumped up the stock market, reduced the cost of American exports and allowed companies to borrow money at lower interest rates. . . .
The Fed limited the program to $600 billion under considerable political pressure. While that sounds like a lot of money, the purchases have not even kept pace with the government’s issuance of new debt . . .
The Fed’s decision to buy bonds, known as quantitative easing, emulated Japan’s central bank, which started buying bonds in 2001 to break a deflationary cycle.
The American version worked well at first. From November 2008 to March 2010, the Fed bought more than $1.7 trillion in mortgage and Treasury bonds . . .
As the economy sputtered last summer, Mr. Bernanke indicated in an August speech that the Fed would start a second round of quantitative easing, soon nicknamed QE 2. The initial response was the same: Asset prices rose, interest rates fell, and the dollar declined in value.

So: In the past two-and-a-half years, the Federal Reserve has printed enough currency — just created it out of thin air — to purchase $2.3 trillion in Treasury debt. You can call it “quantitative easing” if you wish, but the proper term is monetizing the debt, using inflation to hide two facts:

  1. The government can’t pay its bills, and
  2. The government also can’t get enough new credit to cover its current obligation if it were forced to rely entirely on loans from (i.e., bond sales to) private investors.

Without this Fed bond-buying policy, the government would be paying higher rates to service its debt, which cost would then result in higher interest rates for everyone. By making the Fed the default consumer for Treasury bonds, then, “quantitative easing” artificially lowers interest rates, which would otherwise rise to reflect the oversupply (or under-demand) for U.S. debt. And the actual cost of this policy is simple: Inflation.

The failure of QE2 to have the as much Keynesian “stimulus” effect as hoped for (this failure being the main topic of the article quoted) is reflective of the fact that, while the Fed can print money, it does not thereby create wealth, and the resulting inflation is a drain on the national economy.

Why is the effect of “quantitative easing” on my mind today? Here’s Peter Suderman of Reason magazine:

The administration is arguing that we shouldn’t worry about a debt crisis because investors are demanding low interest rates in exchange for loaning money to America. The argument is that if investors were actually worried about the long-term U.S. fiscal outlook, they would be expressing that concern by demanding a higher rate of return. Essentially, the administration is arguing that we can safely use interest rates as a warning system.

But wait: If  a rise in interest rates would signal the onset of a debt crisis (i.e., government’s solvency being threatened by a reluctance of private investors to buy bonds), and if “quantitative easing” artificially lowers interest rates, isn’t it possible that QE and QE2 represent efforts to obscure the market signals of U.S. debt problems?

Even with a $2.3 trillion price-tag, the Fed’s inflationary intervention has been a modest monetary Band-Aid on a very large fiscal wound. And if that Band-Aid holding down interest rates should come unglued, as Suderman says, the hemorrhage of a full-blown debt crisis may hit quite suddenly.

Monday’s warning from Standard & Poors about the long-term prospects for U.S. sovereign debt reflects the inherent risks of the game that Ben Bernanke and Tim Geithner have been playing with fiscal and monetary policy. Matt Welch points out that the reaction by liberals — from the HuffPo’s R.J. Eskow to the Atlantic‘s James Fallows — was to derogate S&P. (Hat-tip: Instapundit.)

Let them scoff all they want, but the fact remains that these Monopoly-money manipulations cannot continue forever. If the current policy of massive deficit spending continues, the supply of new Treasury debt will eventually outstrip investor demand to the point that these Bernanke-Geithner “quantitative easing” games won’t be able to hide the gap, at which point higher interest rates will be required. What Team Obama is counting on is that either:

A. The day of reckoning can be postponed past Nov. 6, 2012; or
B. If the day of reckoning comes early, they can somehow pin the blame on Republicans.

The prospects of a return to Carter-style “stagflation” are very real, and the denouement may be even uglier than that. The current policy is unsustainable in the long term and the longer it continues, the closer we get to the point when “the long term” becomes tomorrow.

UPDATE: “But how in the world did Mrs. Palin, who is supposed to be so thick, manage to figure all this out so far ahead of the New York Times and all the economists it talked to?


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