A Voice of Sanity – RobertRinger.com

[RR note: This article, by my longtime friend and brilliant economic analyst John Pugsley, will help you understand how and why the massive deficit spending the government is now engaged in will impact your financial life. Sadly, not one person in a hundred has a clue.]

By John A. Pugsley

When Congress spends more money than it collects in taxes, it authorizes the Treasury Department to borrow from the public by selling Treasury bills, bonds, and notes. The Treasury offers these securities for sale at public auction, and they are bid for and purchased by banks, pension funds, trusts, corporations, individuals, and even foreign interests. These are widely considered to be the safest IOUs around. After all, they are guaranteed by the U.S. government.

Inasmuch as Treasury securities are offered at auction, there is no chance they will not be purchased. The Treasury can offer as high a rate of interest as is necessary to attract buyers. Thus, investors, including individuals, pension funds, banks, and life insurance companies needing safety of principal are induced to sell other debt securities such as bonds, savings accounts, and certificates of deposit, and buy the government IOUs.

Sale of government securities thus absorbs the savings of individuals and corporations. The more that government borrows, the less money that is left over for other borrowers. As a consequence, other borrowers must offer higher and higher rates of interest in order to attract funds. Thus, when the federal government runs deficits, it tends to raise interest rates, and this in turn causes the cost of doing business to rise. As a result, business activity slows down, and both businesses and consumers curtail spending and the economy moves toward recession.

Recessions are politically unpalatable. Idled workers and distraught businessmen hound their government representatives to do something. The only way the politicians can meet the demands of their constituents to “do something” is to borrow even more money and spend it subsidizing business, paying unemployment benefits to idled workers, and buying products from the distressed companies. In other words, the government borrows a dollar from one person and gives it to another as a pretense of fighting the recession — which only makes things worse. Additional federal borrowing further depletes the supply of available credit and amplifies the recession.

It is widely believed that the Fed is sympathetic with the problems recessions create for politicians, and lowers interest rates in order to keep those politicians in favor with the public. That is not the case at all. The Fed is not a federal agency. It is owned and run by the banking industry. In fact, it is relatively insulated from political pressure, but it has other reasons to act.

What are they? A recession means bad times for the banks. People stop borrowing, corporations lose business, and bank profits drop. When borrowers get into trouble, banks get into trouble. If the recession turns into a full-scale depression, widespread bank failures may result, as they did in the 1920s. Since the Fed is an organization made up of banks, it is clearly in the best interests of those running it to ward off the recession by lowering interest rates. And it does so by expanding the money supply.

When the Fed determines that interest rates should be lowered, or at least prevented from rising any further, it contacts private dealers who make the market in (i.e., who buy and sell) U.S. government securities. The Federal Open Market Committee of the Federal Reserve meets and issues orders to purchase Treasury securities. (Remember, these are the same T-bills and bonds that created the rising interest rates in the first place by absorbing the savings of individuals and corporations.)

The Fed pays the dealers for the securities with Federal Reserve checks, which the dealers then deposit in their banks. The bond dealers’ banks then forward those checks to the Fed (where the banks have their reserves on deposit), and the Fed credits the reserve accounts of the banks.

Now the bank has new reserves against which it can make loans. These fresh reserves are just like new deposits from customers, and can be expanded by the same process that all bank deposits are expanded. Under reserve requirements in effect at any point in time (the Fed can change them at will), these reserves can be expanded by five, six, or seven times through what is calls “fractional reserve banking.” Thus, when the Federal Reserve buys $1 billion in U.S. Treasury securities, the banks can loan out $5, $6, or $7 billion to borrowers.

Where did the Fed get the money to buy the Treasury securities? It created it out of thin air. It credits the reserve account of a bank by a simple bookkeeping entry. What does the Fed have to back up its IOUs? It has the IOUs of the U.S. Treasury, that is, the Treasury’s bills and bonds.

The Federal Reserve accounts thus balance: They show a liability of the bank reserves and the offsetting asset of Treasury securities. The Federal Reserve Notes in your pocket or checking account mean that the Fed owes you money, and these are in turn backed up by the T-bills they hold — which means that the government owes the Fed money. The U.S. government continues to issue more and more IOUs to cover its ever-growing deficits, and the Fed continues to buy these up and issue its own notes in their place.

This whole process is known as “monetizing” debt, which means that the debt of the federal government is turned into money. The government borrows money to meet its deficits, and the IOUs it issues eventually are converted into Federal Reserve Notes. Those greenbacks in your wallet that you think of as money are only government IOUs broken up and reissued by the Fed.

Thus, in the long run, there is no difference between the government fighting a recession by borrowing money from Peter and giving it to Paul and the Fed fighting the recession by buying up Treasury bills and giving the banks new reserves. The only difference is in the timing. The effects of government borrowing are almost instantly offset by the effects of government spending. But when the Fed monetizes the government debt, it takes months, or even years, for people to offset the influx of new money by raising their prices. The Fed action just postpones the inevitable a bit longer than the government action does.

Federal deficits, then, are the primary cause of continued inflation of the money supply. Once banks have loaned out their depositors’ money to the maximum limit set by reserve requirements, the only source of new dollars is the Federal Reserve. Thus, the Federal Reserve is the real engine of inflation.

John Pugsley is an economist, best-selling author, the Chairman of The Sovereign Society, and editor of The Stealth Investor, an investment advisory letter specializing in natural resources. In the first quarter of 2009, while the Dow Jones Industrials average fell by over 11%, his Stealth Investor portfolio gained a stunning 43%. John has written extensively on the Federal Reserve and the Treasury’s stimulus package, and has generously offered to send a 30-page compilation of his recent articles to Voice of Sanity readers. To request a free copy, contact him at johnpugsley@stealthinvestor.com. Just tell him Robert Ringer sent you.

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