Geithner's Victims of Last Resort
by Gary North
Recently by Gary North: The #2 Port in the Academic Storm Is About to Close
You may have heard that the Federal Reserve System is the lender of last resort. This is a misleading concept. The Federal Reserve loans the U.S. government newly created fiat money. The government issues the FED an IOU. It is backed by the full faith and credit of the United States government. But who stands behind the United States government, wallets in hand? You do. And so do I.
We are the victims of last resort.
On May 13, Timothy Geithner wrote a letter to Colorado's Senator Michael Bennet. In his letter, he presented the case against freezing the debt ceiling. The letter is here.
Geithner began with a statement that is muddled almost beyond belief. "As you know, the debt limit does not authorize new spending commitments." Quite true. The debt limit does not authorize anything. It prohibits the authorization of any further borrowing. Officially speaking, prohibiting borrowing is the idea behind the debt ceiling. That is why Congress keeps raising it. Congress does not want to cut spending. It also does not want to raise taxes in order to pay for the spending.
The sentence says the opposite of Geithner's point. We know this because of what came next. "It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past."
He therefore did not really mean that "the debt limit does not authorize new spending commitments." He meant to write this: "An increase in the debt limit does not authorize new spending commitments." Therefore, he reminded Bennet, to raise the debt limit does not authorize any new spending commitments. Geithner, in his befuddled way, was trying to offer Congress a fig leaf to cover its nakedness. By raising the debt ceiling, Congress will be perceived by the voters as spending recklessly, which is an accurate perception. Geithner was trying to say this: by raising the debt ceiling, Congress does not automatically pass new spending laws.
Millions of voters understand this shell game. If the ceiling gets raised, Congress can then vote for new spending bills. If it doesn't get raised, Congress cannot pass new spending bills without cutting existing spending. The debt ceiling inhibits Congress.
Geithner's sales pitch is simple: Congress must raise the debt ceiling in order to meet its existing commitments. He is giving Congress a way to justify this ceiling hike to constituents. "We're not wild spenders. We're merely making it possible to fulfill previous Congressional commitments made to the public. You don't want us to break our promises, do you?"
He then wrote: "Failure to raise the debt limit would force the United States to default on these obligations, such as payments to our servicemembers, citizens, investors, and businesses." This is correct. This is the famous bottom line.
Do you see what this implies? A rising debt ceiling is built into American politics. Using Geithner's logic, there is no escape from an ever-larger national debt. Every year, the ceiling will have to be raised. Medicare is in the red. Social Security is in the red. Combined, they are about $100 trillion in the hole, according to some estimates.
Who is going to buy this Treasury debt as it rolls over every 50 months (today's average maturity)? For how much longer? This money will have to come from somewhere. It will come from money that might otherwise be invested in the private sector.
Ever since November 2010, the money has come mainly from the Federal Reserve System: $600 billion in newly created money. This will stop after this week. Then what?
The constant absorption of capital by the U.S. government cannot go on forever. It will undermine the growth of the economy by transferring investment capital to the Treasury. When the economy stops growing, the deficit will get worse. At some point, investors will stop lending to the Treasury at anything except very high rates. This will turn a recession into a depression. The government will raise the debt ceiling, but it will not get the funds required to keep spending. This process of ever-rising debt will not go on. As economist Herb Stein observed decades ago, when something cannot go on, it has a tendency to stop.
This means that when the Federal Reserve finally stops buying U.S. debt, there will be a great default. I mean finally. I do not mean temporarily. I do not mean this year. The fear of another recession may keep the safe-haven money flowing into the Treasury this year. But, at some point, investors will demand higher interest rates. Geithner's letter raises this specter of higher interest rates if the debt ceiling is not raised. But this threat will also exist if the debt ceiling is raised and raised again, as it will be.
The Federal Reserve at some point will start buying Treasury debt again to keep rising rates from crippling the economy. This means price inflation will return, as it did in the late 1970s. Then it will move above that era's rate of rising prices. This is why the FED will eventually have to face the music: either hyperinflation or the Great Default. I believe that it will choose the Great Default. If it refuses, then the dollar will collapse.
In either case, the division of labor will contract. In either case, there will be bankruptcies. There will be massive unemployment of people and resources.
We are nowhere near this moment of truth. I know there are lots of people out there who say that hyperinflation is imminent. They are wrong.
DEFAULT NOW
Geithner is facing a default if the debt ceiling is not raised. He said that a default would call into question for the first time the full faith and credit of the United States government. He is correct. I can think of no more liberating event. The monster would go bust.
Investors around the world would lose money, he says. I surely hope so. That might keep them from financing the monster again. Anyway, for a couple of years.
He thinks there will still be buyers, but at higher rates. That would restrict the government's spending, since the government would have to pay investors rather than subsidize new boondoggles.
Default would increase borrowing costs for everyone, he wrote. He did not say why this would be the case. If the government defaults, people will invest elsewhere. It seems to me that this would be good for the private sector. Geithner needs to prove his case.
"Treasury securities are the benchmark interest rate," he wrote. They are? Why should a FED-subsidized interest rate be the benchmark? Why should an out-of-control international debtor set the standard?
THE MOB
"A default would also lead to a steep decline in household wealth, further harming economic growth." Think about this. A thief sticks a gun in your belly. He says, "hand over your money . . . forever." He then shares this money – after handling fees – with his fellow mobsters.
Geithner is saying that if the victims ever decide not to let the thief steal any more of their money, this will reduce household wealth. It will indeed – the household wealth of the thieves. It will increase the household wealth of the victims.
"Higher mortgage rates would depress an already fragile housing market, causing home values to fall." Fact: home values have fallen even as the U.S. Government's debt ceiling has soared. There is a reason for this. As the government has borrowed more money, thereby reducing the money available to the private sector, housing prices have fallen. He did not explain this economic fact. He did not mention it. I can understand why not.
"This significant reduction in household wealth would threaten the economic security of all Americans and, together with increased interest rates, would contribute to a contraction in household spending and investment." He meant the households of politicians, bureaucrats, and everyone who is on the take from the U.S. government.
But what about the victims? What about the taxpayers whose net worth is being used as collateral for Treasury debt? Why would a ceiling on the government's pledge of their future wealth produce a "significant reduction" in their future household wealth? He needed to explain this.
Keynesian economists need to explain this.
Keynesian financial columnists need to explain this.
They never do.
AMERICAN TAXPAYERS: VICTIMS OF LAST RESORT
"Default would also have the perverse effect of increasing our government's debt burden, worsening the fiscal challenges that we must address and damaging our capacity for future growth." So, if Congress votes to cap the government's debt, this will produce even greater debt. We must therefore seek national solvency through additional debt. Solvency through debt! I am reminded of another group of slogans: war is peace, freedom is slavery, and ignorance is strength.
What else would a default do? "It would increase rates on Treasury securities, which would significantly increase the cost of paying interest on the national debt." Yes, it would. But the question arises: If the government defaults on its debt, why would it bother to pay any interest at all? The whole idea of default is to stop paying.
It's just like people who owe more on their homes than the homes are worth. They stop paying. If they are evicted – most are not for months or years – they will rent. They will pay less in rent than they pay on their mortgages. In the meantime, they pay nothing except property taxes. (Governments will foreclose when lenders won't.)
The idea of the debt ceiling is to keep the government from running up its tab, based on the future net worth of taxpayers. The idea behind opposing any increase of government debt is this: "Let's stop any new spending projects." Higher interest rates, if they come as Geithner said they will come, will reduce the ability of the government to start new wealth-distribution boondoggles. The money that would have funded the new projects will have to go to creditors in the form of interest payments.
Why is this bad?
It is bad if you are a member of a group that gets payoffs from the Federal Godfather. It is not bad if you are not.
He said that a default will lead to weaker growth. It will lead to more unemployment. A sagging economy will lead to lower tax revenues and "increased demand on our safety net programs." Whose safety net programs? "Ours."
Why will unemployment rise if the government cannot spend borrowed money? Why won't taxpayers save more money, leading to greater economic output and therefore reduced unemployment? Why is it bad for the economy to allow taxpayers to spend more of their own money the way they want to? These questions apparently did not occur to Geithner, or if they did, he chose not to consider them.
A default will lead, he said, to a reduction in "productive investments in education, innovation, infrastructure, and other areas. . . ." He said "investments." That is a political code word for "government subsidies." A default would mean that the government will have to spend less in those areas of the economy in which (1) politicians buy votes, (2) salaried, Civil Service-protected bureaucrats spend money to innovate, and (3) the teacher unions prosper.
He warned that "Treasury securities are a key holding on the balance sheets of every insurance company, bank, money market fund, and pension fund in the world." This is true. This means that taxpayers' future wealth has been mortgaged to provide securities for these outfits. So, if we take this argument seriously, how will the government ever stop increasing the debt ceiling? It won't. The Federal debt system has addicted the world's financial institutions to the promise that American taxpayers are the victims of last resort.
The U.S. government borrows by promising that American taxpayers will fork over the money. The mob has bought itself fiscal credibility. It has guns and badges, and it can finance itself by assuring investors that these guns and badges will be used.
How can this ever be stopped? Geithner or his successors will be able to use this argument forever.
There are two ways that it can be stopped: (1) hyperinflation by the Federal Reserve, which will buy the Treasury's IOUs when other investors cease; (2) default whenever the Federal Reserve stops buying new Treasury debt. One or the other must happen, because (1) the Congress keeps running $1.5 trillion annual deficits, and (2) the Social Security and Medicare liabilities are unfunded.
In the meantime, Geithner implores Congress to kick the can one more time. He will be back for another increase in a year. He is a cheerleader. "Kick it again! Kick it again! Harder! Harder!"
GEITHNER'S PAULSON IMITATION
He said that a default would raise questions about the solvency of the institutions that hold Treasury debt. This could cause a run on money-market funds. It could be "similar to what occurred in the wake of the collapse of Lehman Brothers." He said that this could "spark a panic that threatens the health of the our entire global economy and the jobs of millions of Americans."
This sounds terrifying, but is it true? We have heard all this before: in September and October of 2008. Geithner's predecessor, Hank Paulson, and Ben Bernanke warned high-level Congressmen that this was about to happen. That was how they got Congress to fund TARP. But they never proved that a collapse was imminent. In a persuasive presentation, former budget director David Stockman has shown that no such collapse was imminent.
"Even a short-term default could cause irrevocable damage to the American economy." Irrevocable! Really? Is the American economy so dependent on Treasury interest payments that everything that Americans do or own is at risk? Why? Because "Treasury securities enjoy their unique role in the global financial system precisely because they are viewed as a risk-free asset." I see. Risk-free assets. But risk is inescapable in life. Geithner said that this does not apply to buyers of IOUs from the U. S. Treasury. Not yet, anyway.
When an IOU issued by an agency that is running a $1.6 trillion annual on-budget deficit is regarded as risk-free by investment fund managers, then my strong suggestion is that you not allow those fund managers to handle your retirement portfolio.
"Investors have absolute confidence that the United States will meet its debt obligations on time, every time, and in full." They do? Really? Then they are incapable of reading a balance sheet.
"That confidence increases demand for Treasury securities, lowering borrowing costs for the Federal government, consumers, and businesses." It does? Really? Let me understand this. The demand for Treasury securities increases, because investors with "absolute confidence" in the Treasury's IOUs hand over their money to the Treasury. Yet this transfer of funds somehow lowers borrowing costs for consumers and businesses. I am a bit confused. If the Treasury gets the capital, how can consumers and businesses also pay less for capital? If money goes to the Treasury, how is it simultaneously made available to consumers and businessmen?
You see my problem. I am not a Keynesian. I have this theory that money transferred to X cannot be simultaneously transferred to Y. If money is spent by X on what he wants to buy, it cannot be spent by Y on what he wants to buy. But this is not the case in the world of Keynes.
"A default would call into question the status of Treasury securities as a cornerstone of the financial system, potentially squandering this unique role and the economic benefits that come with it." I ask: Whose economic benefits? The fellow holding the badge and the gun or the fellow with the wallet?
"If the United States were forced to stop, limit, or delay payment on obligations to which the Nation has already committed," he said, "there would be a massive and abrupt reduction in federal outlays and aggregate demand." Again, I have this problem. I am not a Keynesian. I understand cause and effect as follows. If spending by Y (the government) decreases, this leaves more money in X's (the taxpayer's) wallet. When X spends his money without the middleman of the guy with the badge and the gun, aggregate demand does not change. I realize that this is not true in Geithner's parallel universe, but that's how aggregate demand works in my world.
I guess I need a formula. Without a formula, economists cannot perceive cause and effect. So, here goes: $X + $Y = $X + $Y.
To understand this, we need story problems. We all hate story problems, but they help us understand.
(1) "If X spends $1.6 trillion dollars, and Y spends no dollars, how much is aggregate demand?"
(2) "If Y sticks a gun in X's belly and says 'hand it over,' and then spends $1.6 trillion, how much is aggregate demand?"
(3) "If Y comes to X and says, 'hand it over, but this is a loan,' and X forks it over, when Y spends $1.6 trillion, how much is aggregate demand?"
Geithner does not operate in terms of this formula. So, he said that when the government (Y) stops spending, there will be a decrease in aggregate demand. Somehow, the excess money that is now in X's wallet will disappear. "This abrupt contraction would likely push us into a double dip recession." He did not define "us." He wanted Senator Bennet to believe that if Y spends less money, X will suffer a double dip recession. We're all in the same boat, he implied. Why? Because . . . a drum roll, please . . . we owe it to ourselves!
This is Keynesianism's parallel universe. It is a world of endless increases in the U.S. government's debt ceiling. It is a world of endless increases in the Federal Reserve System's monetary base, filled with IOUs from the U.S. government. It is a world in which guns and badges turn stones into bread.
CONCLUSIONS
Here is Geithner's conclusion: "It is critically important that Congress act as soon as possible to raise the debt limit so that the full faith and credit of the United States is not called into question." He went on to say: "I fully expect that Congress will once again take responsible action. . . ."
He and I define "responsible action" differently. He defines it as "authorize people with badges and guns to borrow more money in terms of their ability to get their hands on enough taypayer money to keep paying interest." It is a system in which the taxpayer is the victim of last resort.
I have a different conclusion. I think that Congress will authorize another increase in the debt ceiling. It will do this multiple times. As this limit is increased, there will be a reduction in the number of investors who have absolute confidence in the full faith and credit of the United States government.
Congress is not going to balance the budget, because there seem to be no negative consequences for not balancing the budget, either political or economic. So, the debt will get larger.
At some point, interest rates will rise. Then we will see the negative consequences that Geithner described in his letter.
Geithner is arguing for a delay. That is what most politicians argue for. Today, most politicians have adopted the faith of Dickens' Mr. Micawber: "Something will turn up." They are right: the debt ceiling, then interest rates, then the monetary base, then M1, then the money multiplier, then prices. So will unemployment. Up, up. up.
The key is the money multiplier. When it finally moves up, price inflation will move up with it. Until then, the Federal Reserve can join with Congress in the game of kick the can. The debt ceiling will rise.
Inside the can are lots of IOUs. They are IOU's signed by Congress on our behalf. We are the targeted victims of last resort.
We won't be. At any rate, future voters won't be. The creditors will be.
There will be a Great Default when voters finally say, "We're not going to pay." On that day, your net worth had better not rest on a pile of IOUs issued by the U.S. government. Otherwise, you will be like Thomas Mitchell, in "Gone With the Wind," sitting at his desk in 1865, mad as a hatter, insisting that he was rich. Why? He had lots of government bonds issued by the Confederacy.
So, the victims of last resort will not be the taxpayers after all. They will be the trusting people who retain absolute confidence in the full faith and credit of the United States government right to the bitter end. Either hyperinflation will ruin them or default will, or maybe both: as the Confederacy experienced.
June 29, 2011
Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.
Copyright © 2011 Gary North
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