Victims of Last Resort
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.
letter is here.
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.
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."
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.
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.
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,
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.
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?
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.
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.
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
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.
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.
the world would lose money, he says. I surely hope so. That might
keep them from financing the monster again. Anyway, for a couple
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.
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.
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?
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
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.
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.
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.
need to explain this.
columnists need to explain this.
TAXPAYERS: VICTIMS OF LAST RESORT
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
Why is this
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!"
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."
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.
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.
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.
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.
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
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.
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.
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.
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.
can are lots of IOUs. They are IOU's signed by Congress on our behalf.
We are the targeted victims of last resort.
won't be. At any rate, future voters won't be. The creditors 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.
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.
2011 Gary North
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