The US federal government is now statutorily limited on its borrowing power upon hitting a “debt ceiling” of $14.294 trillion. As such, the treasury is constrained from issuing new debt to cover short-term cash flows or financing deficits if such borrowing pushes the debt beyond the legal limit.
While much is said about protecting the “full faith and credit” of the US government, this is a side show since all the federal government must do to avoid is meet its interest payments. In all events, the lack of a plan to control public-sector spending poses a greater threat to the US’ credit standing than whether the public sector debt limit is raised.
As it is, the US 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 has a lot to do with the course of the US economy and the global status of the dollar. The bottom line is that a continued increase in the US government debt aided by a higher debt ceiling will lead to more “quantitative easing” (QE). And that more the monetary pumping associated with QE will almost certainly lead to a nasty bout of consumer price inflation that will sweep the globe.
Central bankers use QE as a scheme to prop up deteriorating asset prices by overpaying for them. In the US, an initial round (QE-1) pumped in new money to support the prices of so-called toxic assets followed by QE-2 that aimed principally to support US treasury bonds.
While the primary aim of QE was to offset deflation, it also supported an unprecedented spending binge by the US government. Despite claims of independence, the Fed shifted from being “lender of last resort” for the US financial sector to become the “buyer of first resort” for US government debt. As it is, Fed purchases have amounted to 85% of all US government debt sold by the treasury since QE-2 began in November 2010.
This means that the Federal Reserve monetized about half of the federal budget deficit of fiscal year 2011 with QE-2 and reinvestment returns from asset purchases of QE-1.
As it is, raising the debt ceiling may not avert default on US government debt since the Fed will have to step in when historical buyers for treasurys shun dollar-based debt. And that requires more quantitative easing and artificially low interest rates kept at near zero that will build in more instability to the US economy and beyond.
As they are, arguments for QE reveal either fundamental misunderstanding or wanton disregard for the impact of monetary policy on the real economy in the US and elsewhere.
It starts with central bankers primarily focusing on how monetary policy affects 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 and massive increases.
But an inflated money supply finds its way into the economy in other ways. These include higher asset or 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 that are most certainly understating the impact of excess liquidity from the Fed’s expansionary monetary policy. As it is, 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.
As the Fed purchases treasury bonds or other such assets, it creates new dollars that tend to undermine its foreign exchange value. Indeed, the US dollar is more than 9% lower against a broad basket of currencies from what it was a year ago, the lowest point since 2008 and down more than 40% 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. Gold is up 22% since August 2010 while silver rose 143%, putting both at nominal record highs. And according to Standard and Poor’s GSCI Index that tracks commodities indicates that they are up 16.5% this year.
Other financial assets are bubbling up. After the initial announcement for QE-2 of $1.5 trillion of purchases of public sector debt in August 2010, investors moved towards riskier investments, leading to a rally in corporate bonds. Since then Standard and Poor’s 500-stock index gained 28% and prices of generally-riskier shares listed on the small-company Russell 2000 Index went up 41%. Even subprime mortgage securities are back in demand!
Given that many polls show that a majority of US citizens oppose any increase in the debt limit, it would be a smart political move not to do so. But more importantly, it would be a wise economic move to decrease the rate of increase in US 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 of the US federal government and less uncertainty about future price increases.
Christopher Lingle is visiting professor of economics at Universidad Francisco Marroquin in Guatemala and research fellow at the Centre for Civil Society in New Delhi.
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