There was a fascinating article in The Wall Street Journal several weeks ago.* Lawrence Goodman wrote about a recently released Federal Reserve report that showed who was buying the bonds and notes the US Treasury was issuing in 2011; i.e., who was lending money to the U.S. government so it could pay its bills. Throughout most of the 2000s it was mainly foreign buyers who were lending to the Treasury, with the private sector and the Federal Reserve loaning small amounts (less than 0.5% of GDP in the case of the Fed).
When the financial crisis hit in 2008, foreign government lending to the US went up initially, as did private purchases of Treasury bonds and notes. But in the middle of 2010 private purchases dropped like a rock. Foreign financing of the deficit didn’t fall as much, but it decreased, too. Foreign net purchases of Treasury securities, as a percentage of GDP, went from over 5.5% of GDP in early 2010 to 2% of GDP at the end of the 2011.
So who is funding our deficit if it isn’t foreign countries and it’s not the private sector? It’s the Federal Reserve. In 2011 the Federal Reserve purchased 61% of the total net issuance of debt by the U.S. Treasury. In other words, our deficit is being financed, and paid for, by the Federal Reserve’s printing presses. Foreign countries no longer want to lend to the U.S. The private sector in the United States (banks, mutual funds, individuals, etc.) no longer wants to lend to the federal government. So we are paying our bills (or, more appropriately, 61% of the bills that we have to borrow money to pay) by printing money.
Now it could be that, if interest rates go up, the private sector would buy more Treasury bonds and notes; i.e., lend more money to the federal government. That seems likely. Of course, higher interest rates will increase the deficit, but that is still better than just printing money.
But what about foreign buyers? Are they staying away because of low interest rates – or because they do not want to lend us more money; i.e., because they are worried lending too much money to any one country. If they are staying away because of low interest rates, then if rates go up, they’ll return. On the other hand, if interest rates go up and foreign buyers don’t come back, then the Fed’s printing presses will have to continue turning out money so we can pay our bills.
The problem with economic crises is that you never know when they are going to come. Well, that is not exactly correct. Sometimes you can tell that a crisis will come if trends continue and people don’t start turning things around. But you don’t know exactly when the crisis will hit – because you don’t know what will finally set it off. In the fall of 2008, people knew that the economic system was shaky. But did anybody realize what was going to happen when Lehman Brothers went bankrupt? Obviously not or we wouldn’t have let Lehman Brothers go bankrupt. If we had known what was going to happen, we would saved Lehman and immediately instituted a whole series of reforms. But we didn’t know, so we waited, and we got slammed.
Our current situation with how we are financing our deficit seems to me to be a pre-Lehman Brothers situation. It has been amazing how long we have been able to finance our federal deficit at such low rates. But now, with foreign purchasers buying so much less of our debt, and the private sector buying less, too, how long can the Fed print money to finance the deficit – at least without a major surge of inflation?
At some point the United States is going to find that it can no longer finance hundreds of billions of dollars of debt at interest rates just a little above zero. Either interest rates will go up in order to attract enough private and foreign lenders to lend us the money to pay our bills. Or all the money the Fed is printing will spark some serious inflation, which will result in interest rates going up.
Once interest rates start going up, the deficit will get even bigger because of higher interest costs.** And if that spooks lenders, what then? Will we become Greece, where lenders just won’t lend and other countries get to tell them how to run their country? Probably not – because we can print our own money. But what happens if we have to continue using our printing presses to pay our bills? I don’t think anybody knows for sure – but it can’t be good. And that’s scary.
But the thing that scares me even more than that is how few people in Washington seem to be scared. I don’t know how many of them realize how precarious things really are. Representative Paul Ryan (R-WI), chairman of the House budget committee, gets it, and he is trying to design a budget and programs to start us down the road of dealing with it. His plan isn’t perfect, but at least he’s trying.
Democrats (including President Obama) merely talk about higher tax rates on the rich and use Medicare scare tactics against the Republicans. They like to claim that their proposals will cut the deficit more than Representative Ryan’s plan does for the next ten years. What they don’t like to talk about is what projections of their proposals show after ten years: A deficit and debt explosion.***
On the Republican side, there is Paul Ryan’s plan, which is a step in the right direction. Unfortunately, too many other Republicans focus just on cutting taxes without explaining how they are going to pay our bills. There is a solution: broadening the tax base (i.e., getting rid of a lot of the deductions and credits, many of them mere tax-breaks for special interest groups), which could increase tax revenues while allowing for some reductions in tax rates, but not enough Republicans are supporting it.****
The key thing is this: If we don’t at least start doing something about this situation now, the crisis is going to come. We just don’t know when it’s going to come or what will finally cause it. But it will come. And it could make the crisis after the Lehman Brothers bankruptcy look like the proverbial Sunday School picnic.
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* Lawrence Goodman, “Demand for U.S. Debt Is Not Limitless,” The Wall Street Journal, March 28, 2012.
** At least some of those saying we do not need to worry about the deficit, point to the low interest rates that the U.S. government is borrowing at to show there is no problem. The only trouble with that reasoning is that it is true until, all of a sudden, it’s not true. And that is the point I am making. If things continue as they are, when the crisis comes, it will seem sudden and surprising, except in retrospect, where it will be obvious and not surprising in the least.
*** I have previously linked to this exchange between Treasury Secretary Geithner and Representative Ryan. When Secretary Geithner talks about the “budget window,” he is talking about ten years. But as for the long run, according to Secretary Geithner, the Administration doesn’t have a plan of its own. It just knows it doesn’t like Representative Ryan’s plan. In Secretary Geithner’s own words: “We're not coming before you to say we have a definitive solution to our long-term problem. What we do know is we don't like yours.”
**** This was the proposal of President Obama’s National Commission on Fiscal Responsibility and Reform (the Simpson-Bowles Commission). If you remember, during the 2010 campaign, when the question of the deficit, etc., came up, President Obama would say that he had appointed a commission and he was waiting for them to report. They reported, after the election, according to the schedule he set, and he ignored their recommendations. But it didn’t matter. They had fulfilled their purpose: giving the President an excuse to not present a plan to deal with the deficit during the election campaign.
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