Debt ceiling absurdity: US Fed will now repay itself by printing money

Federal-Reserve-Seal-logoVivek Kaul 
It was widely expected that the Democrats and the Republicans will finally strike a deal and extend the debt ceiling of the government of the United States(US). And that’s precisely what happened.
A few hours before the US government would have reached its debt ceiling, both the houses of the American Congress, passed a short term bill, allowing the government to suspend the debt ceiling until February 7, 2014. The Senate passed the bill, 81:18. The House of Representatives passed the bill 285:144. The bill will also end the government shut-down in the United States and allow it to operate till January 15, 2014.
Governments around the world spend more than they earn. They make up for the difference by borrowing money. The US government is no different on this front. The only trouble is that it is not allowed to borrow beyond a certain limit. This limit is referred to as the debt ceiling and till yesterday was set at $16.69 trillion.
If the bill suspending the debt ceiling had not been passed, the US government would not have been able to borrow more. And given that it would have become difficult for it to meet its expenditure from its income. Today, i.e. October 17, 2013, the US government will have around $28 billion of cash on hand. The treasury secretary Jack Lew had suggested in early October that expenditure of the US government on certain days could touch even $60 billion.
Given this, it would be able to meet only a part of its expenditure and hence, someone was not going to get paid.
The tricky question for the government would have been to decide who that someone would be. Would the government decide not to pay out the pension cheques? Or would it be unable to pay salaries of its employees? Would it default on the interest payments that are due on its bonds? Or would it be unable to repay maturing bonds? The American government like other governments around the world makes up for the difference between what it earns and what it spends, by selling bonds.
Interest payments of around $6 billion are due before the end of October. Also, bonds worth around $90-93 billion need to be repaid between October 24 and October 31. A default on this front would be catastrophic. The US government bonds (or treasuries as they are more commonly referred to as) are deemed to be the safest financial securities in the world. And if the security deemed to be the safest financial security in the world is not safe, what is?
But these are points that I have made before (
you can read them here). The US government’s current debt stands at around $16.69 trillion. It has borrowed this money by selling bonds. Of this nearly $4.8 trillion is held by various agencies of the US government. Most of the US government agencies holding US government bonds are pension funds and retirement funds, which need to make payments in the years to come. To be able to make these payments, they need to invest now. Hence, they invest money in US government bonds deemed to be the safest financial security in the world.
The remaining US government debt of around $11.89 trillion ($16.69 trillion – $4.8trillion) is referred to as the debt held by the public. Of this, foreign nations hold around $5.7 trillion. China holds around $1.28 trillion and Japan $1.14 trillion.
What is interesting is that the Federal Reserve of United States, the American central bank, holds US government bonds worth $2.086 trillion. On the whole, this is only 12.5% of the total US government debt of $16.69 trillion. But what is interesting is that over the last five years the holding of the Federal Reserve has risen by 434%.
On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion. In comparison the debt held by foreign nations has gone up only marginally.
In the last one year, this holding has gone up by nearly $433 billion. What is happening here? The US government is spending substantially more than what it is earning. Since 2009, it has been running fiscal deficits of greater than a trillion dollars. Between 2009 and 2012 the US government ran a total fiscal deficit of $5.09 trillion. In 2013, it is expected to run a fiscal deficit of around a trillion dollars. Fiscal deficit is the difference between what a government earns and what it spends.
In a situation like this, if the US government would borrow all the money from the public, interest rates would shoot up, given that there is only so much amount of money that can be borrowed. And if the government borrows more, then there would be lesser amount of money for others(primarily the private sector) to borrow. This crowding out would lead to a situation where other institutions like banks would have had to offer a higher interest to borrow.
If a bank borrows money at a high rate of interest, it would have to lend it out at a still higher rate of interest, in order to make a profit. Higher interest rates would mean, higher EMIs. This would discourage the average American from borrowing and spending money, something which the US government believes is very important for reviving economic growth.
This is where the Federal Reserve stepped in. It has been buying the bonds being sold by the US government to finance its fiscal deficit. Where does the Federal Reserve get this money from? It simply prints it and hands it over to the government.
As we saw earlier, between 2009 and 2012, the US government has run a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
Hence, the US government financed nearly 23.6% of its fiscal deficit by selling bonds to the Federal Reserve. Federal Reserve handed over this money to the US government by simply printing it. This has helped keep interest rates low in the United States.
And that is the real story. A lot of the US government borrowing over the last few years has been directly from the Federal Reserve. And now that the debt ceiling has been raised, this will continue.
The money that is borrowed by the US government from the Federal Reserve and other sources, is used to fund its expenditure. A substantial part of the expenditure is repayment of past debts as bonds mature, as well as payment of interest on these bonds.
In the year 2012, the US government paid a total interest of around $359.80 billion on its bonds. The fiscal deficit of the US government was around $1.08 trillion. Hence, nearly one third of the fiscal deficit was because of interest rate payments.
The US government does not earn enough to repay maturing bonds. Hence, it has to borrow money to repay bonds. This is a perfect Ponzi scheme where the government is paying off old debt by issuing new debt. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
In fact, as bonds being bought by the Federal Reserve from the US government, come up for maturity they will be repaid by getting the Federal Reserve to print money and buy new bonds. Hence, the Federal Reserve will be printing money to repay itself. If that isn’t absurd, I don’t know what is. The US Federal Reserve is currently helping the US government run its Ponzi scheme by printing money and buying bonds.
Having said that, increasing the debt ceiling was important given that even a whiff of a default would have caused a global financial crisis. First and foremost investors would have started selling out off US government bonds. This would have driven bond prices down and bond yields up, in the process pushing up interest rates first in the US and then globally. This would have put the entire plan of the US government to revive economic growth by maintaining low interest rates in a jeopardy. It would have also led to investors all over the world selling out of various financial markets. The logic would have been that if the security deemed to be the safest financial security in the world is not safe, what is?
Of course, the trouble is that the US government will breach its debt ceiling again in a few months time. What happens then? The debt ceiling has been in place in the US since 1939. Since 1960, the American Congress has increased the ceiling 79 times. So what stops it from doing it the 80th time as well? Nothing really. But till when can this Ponzi scheme go on? Ultimately all Ponzi schemes collapse. The only question is when. And for that I really do not have an answer.
The article originally appeared on on October 17, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek)