Authored by Lawrence Kotlikoff, via Yahoo
Exchange blog,
In his parting act, Federal Reserve Chairman Ben Bernanke has decided to
continue printing some $85 billion per month (
6% of GDP per
year) and spend those dollars on government bonds and, in the process,
keep interest rates low, stimulate investment, and reduce unemployment.
Trouble is, interest rates have generally been rising, investment remains
very low, and unemployment remains very high. As Lawrence Kotlikoff points
out, echoing our perhaps more vociferous discussions,
Bernanke’s
dangerous policy hasn’t worked and should be ended. Since 2007 the Fed
has increased the economy's basic supply of money (the monetary base) by a
factor of four!
That's enough to
sustain, over a relatively short period of time, a four-fold increase in prices.
Having prices rise that much over even three years would spell
hyperinflation.
The Treasury
dance
And while Bernanke says this is all to keep down interest rates,
there is a darker subtext here. When the Treasury prints bonds and
sells them to the public for cash and the Fed prints cash and uses it to buy the
newly printed bonds back from the public, the Treasury ends up with the extra
cash, the public ends up with the same cash it had initially, and the Fed ends
up with the new bonds.
Yes, the Treasury pays interest and principal to the Fed on the bonds, but
the Fed hands that interest and principal back to the Treasury as profits earned
by a government corporation, namely the Fed. So, the outcome of this shell game
is no different from having the Treasury simply print money and spend it as it
likes.
The fact that the Fed and Treasury dance this financial pas de deux shows how
much they want to keep the public in the dark about what they are doing. And
what they are doing, these days, is printing, out of thin air, 29 cents of every
$1 being spent by the federal government.
QE an unsustainable
practice
I have heard one financial guru after another discuss Quantitative
Easing and its impact on interest rates and the stock market, but I’ve heard no
one make clear that close to 30 percent of federal spending is now being
financed via the printing press.
That’s an unsustainable practice. It will come to an end once Wall Street
starts to understand exactly how much money is being printed and that it's not
being printed simply to stimulate the economy, but rather to pay for the
spending of a government that is completely broke -- with long-term expenditures
obligations that exceed its long-term tax revenues by $205 trillion!
This present value fiscal gap is based on the Congressional Budget Office's
just-released long-term Alternative Fiscal Scenario projection. Closing this
fiscal gap would require a 57 percent immediate and permanent hike in all
federal taxes -- starting today!
Prices will
rise
When Wall Street wises up to our true fiscal condition (and some, like Bill
Gross, already have), it will dump long-term bonds like hot potatoes. This will
lead interest rates to jump and make people and banks very reluctant to hold
money earning no return. In trying to swap their money for goods and services,
the public will drive up prices.
As prices start to rise and fingers start pointing at the Fed for
fueling the inflation, QE will be brought to an abrupt halt. At that point,
Congress will have to come up with an extra 6 percent of GDP on a permanent
basis either via huge tax hikes or huge spending cuts. Another option
is simply to borrow the 6 percent. But this would raise the deficit, defined as
the increase in Treasury bonds held by the public, from 4 to 10 percent of
annual GDP if we take 2013 as the example. A 10 percent of GDP deficit would
raise even more eyebrows on Wall Street and put further upward pressure on
interest rates.
What are we waiting
for?
But why haven't prices started rising already if there is so much money
floating around? This year’s inflation rate is running at just 1.5 percent.
There are three answers.
First, three quarters of the newly created money hasn’t made its way
into the blood stream of the economy – into M1 – the money supply held by the
public. Instead, the Fed is paying the banks interest not to lend out the money,
but to hold it within the Fed in what are called excess reserves.
Since 2007, the Monetary Base – the amount of money the Fed’s printed – has
risen by $2.7 trillion and excess reserves have risen by $2.1 trillion. Normally
excess reserves would be close to zero. Hence, the banks are sitting on $2.1
trillion they can lend to the private sector at a moment’s notice. I.e., we’re
looking at a gi-normous reservoir filling up with trillions of dollars whose dam
can break at any time. Once interest rates rise, these excess reserves will be
lent out.
The fed says they can keep the excess reserves from getting lose by paying
higher interest on reserves. But this entails poring yet more money into the
reservoir. And if interest rates go sufficiently high, the Fed will call this
practice quits.
As excess reserves are released to the economic wild, we’ll see M1, which was
$1.4 trillion in 2007, rise from its current value of $2.6 trillion to $5.7
trillion. Since prices, other things being equal, are supposed to be
proportional to M1, having M1 rise by 219 percent means that prices will rise by
219 percent.
But, and this is point two, other things aren’t equal. As interest
rates and prices take off, money will become a hot potato. I.e., its velocity
will rise. Having money move more rapidly through the economy – having
faster money – is like having more money. Today, money has the slows; its
velocity – the ratio GDP to M1 -- is 6.6. Everybody’s happy to hold it because
they aren’t losing much or any interest. But back in 2007, M1 was a warm potato
with a velocity of 10.4.
If banks fully lend out their reserves and the velocity of money returns to
10.4, we’ll have enough M1, measured in effective units (adjusted for speed of
circulation), to support a nominal GDP that’s 3.5 times larger than is now the
case. I.e., we’ll have the wherewithal for almost a quadrupling of prices. But
were prices to start moving rapidly higher, M1 would switch from being a warm to
a hot potato. I.e., velocity would rise above 10.4, leading to yet faster money
and higher inflation.
No easy
exit
I hope you’re getting the point. Having addicted Congress
and the Administration to the printing press, there is no easy exit strategy.
Continuing on the current QE path spells even great risk of hyperinflation. But
calling it quits requires much higher taxes, much lower spending, or much more
net borrowing (with requisite future repayment) from the public. Yet weaning
Uncle Sam from the printing press now is critical before his real need for a fix
– paying for the Baby Boomers’ retirement benefits – kicks in.
The one caveat to this doom and gloom scenario is point three –
increased domestic and global demand for dollars. The Great Recession
put the fear of God into savers worldwide. And the fact that U.S. price level
has risen since 2007 by only 15 percent whereas M1 has risen by 88 percent
reflects a massive expansion of domestic and foreign demand for "safe" dollars.
This is evidenced by the velocity of money falling from 10.4 to 6.6. People are
now much more eager to hold and hold onto dollars than they were six years
ago.
If this increased demand for dollars persists, let alone grows,
inflation may remain low for quite a while. But our ability to get
Americans and foreigners to hand over real goods and services in exchange for
very few green pieces of paper is hardly guaranteed once everyone starts to
understand the incredible rate at which Uncle Sam is printing and spending this
paper. Once everyone gets it into their heads that prices are taking off,
individual beliefs will become collective reality.
This brings me to my bottom line: The
more money the Fed prints, the more it risks everyone starting to expect and,
consequently produce, hyperinflation.
Got a Few Dollars Laying Around? Not for Long
