All Commentary
Wednesday, July 6, 2011

The Threat Is in the Spending

Ignore the sideshow.

The U.S. government is close to hitting its debt ceiling, and while much is said about protecting the “full faith and credit” of the United States, this is a sideshow since all the government must do to avoid default is to meet interest payments. In all events, the lack of a plan to control government spending poses a much greater threat to America’s credit standing than uncertainty over whether the debt limit will be raised.

The U.S. government has defaulted at least twice before: once in 1933 when it reneged on redemption of gold certificates and in 1971 when it stopped redeeming dollars for gold.

One certainty is that the outcome of this debate will have a lot to do with the course of the U.S. economy and the global status of the dollar. The bottom line is that a continued increase in America’s government debt, aided by a higher debt ceiling, will lead to more quantitative easing (QE). And that the monetary pumping associated with QE will almost certainly lead to a nasty bout of consumer price inflation that will sweep the globe.

Overpaying for Assets

Central bankers use QE as a scheme to prop up deteriorating asset prices by overpaying for them. In the United States an initial round (QE1) pumped in new money to support the prices of so-called toxic assets; this was followed by QE2, which aimed principally to support Treasury bonds.

While the primary goal of QE was to offset deflation, it also supported an unprecedented spending binge by the U.S. government. Despite claims of independence, the Fed shifted from being “lender of last resort” for the U.S. financial sector to become the “buyer of first resort” for government debt. Fed purchases have amounted to 85 percent of all U.S. government debt sold by the Treasury since QE2 began in November 2010.

This means that the Federal Reserve monetized about half the federal budget deficit for FY2011 with QE2 and reinvestment returns from asset purchases of QE1.

While raising the debt ceiling may avert a conventional notion of default on U.S. government debt, it will only work if the Fed steps up when historical buyers for Treasuries shun dollar-based debt.  And that will require more quantitative easing and interest rates kept artificially near zero – which will build more instability into the U.S. economy and beyond.

Ignorance or Disregard?

Arguments for QE reveal either fundamental misunderstanding or wanton disregard for the impact of monetary policy on the real economy in the United States and elsewhere. It starts with central bankers primarily focusing on how monetary policy impacts price levels, usually measured by consumer price indices (CPIs). If consumer prices rise within a “targeted” range, there is no reason to alter monetary policy.

Based on low reported rates of increase in consumer prices, the Fed refuses to budge from an unprecedented growth of money and credit with historically low interest rates. Nor is it in a hurry to stop ramping up asset prices  or propping up real estate prices.

An inflated money supply finds its way into the economy in other ways. These include higher commodity prices, rising bond prices, a weakened currency, or a distortion in production from changes in relative prices.

Consider the nature of supposedly benign changes in the CPI, which almost certainly understate the impact of excess liquidity from the Fed’s expansionary monetary policy. Technological progress and China’s depressive effect on product prices should have caused a deflationary trend in consumer prices.  Even a zero rate of increase implies that that they have actually been rising. To be sure, however, the Fed’s payment of interest to banks on idle reserves since 2008 has muted CPI increases, no matter how it is measured.

Dollar Down

As the Fed purchases Treasury bonds or other such assets, it creates new dollars that tend to undermine the currency’s foreign exchange value. Indeed, the dollar is more than 9 percent lower against a broad basket of currencies than it was a year ago, the lowest point since 2008 and down more than 40 percent against the same basket over six years. Federal Reserve data indicate that when adjusted for inflation, the dollar is at its lowest value against major trading partners’ currencies since it began fluctuating in January 1973.

The impact of the glut of global liquidity from QE and artificially cheap credit has also pushed up asset and commodity prices. In April, gold and silver set records due to hedging against a weakening dollar, with the price of gold up by 32 percent in the past year and the silver price more than doubling.

Other financial assets are bubbling up. After the initial announcement for QE2 of $1.5 trillion of purchases of government debt in August 2010, investors moved towards riskier investments, leading to a rally in corporate bonds. Since then Standard & Poor’s 500 stock index gained 28 percent, and prices of generally riskier shares listed on the small-company Russell 2000 Index went up 41 percent. Even subprime mortgage securities are back in demand!

Given that many polls show that a majority of Americans oppose any increase in the debt limit, it would be a smart political move not to raise it. But more important, it would be a wise economic move to decrease federal spending since it will lead to significant improvement in economic activity by removing the impetus for more QE. And the end of QE will lead to a stronger dollar, an improved balance sheet for the federal government, and less uncertainty about future price increases.

  • Christopher Lingle is senior fellow at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquín, Guatemala.