The Fed and the Debt
by Ron Paul: On
the Elimination of Osama bin Laden
the US House of Representatives, Committee on Financial Services,
Subcommittee on Domestic Monetary Policy: Hearing on Monetary Policy
and the Debt Ceiling: Examining the Relationship between the Federal
Reserve and Government Debt
I am very pleased
to hold this hearing today. For far too long, monetary policy and
fiscal policy have been viewed as completely separate issues. Congress
controls fiscal policy, the Federal Reserve controls monetary policy,
and never the twain shall meet.
however, is that fiscal and monetary policy have always been tightly
intertwined. In fact, the Federal Reserve has served as the enabler
of bad economic policy for many decades. Without the Fed’s relentless
expansion of the money supply during both the Greenspan and Bernanke
eras, the U.S. Treasury never would have been able to issue the
staggering sums of debt that now threaten our economic well being.
This Treasury debt is the very lifeblood of deficit spending, permitting
one Congress after another to spend far more than the Treasury collects
in taxes. It is precisely this unholy alliance between the enabling
Fed and a spendthrift Congress that I hope our witnesses will address
the United States operated on a gold exchange standard, meaning
dollars could be redeemed in gold by foreign governments. The dollar
was thought to be "as good as gold" because the US would
never renege on its gold exchange commitment. The US had to keep
that commitment or risk gold outflows that presumably would keep
the government from engaging in loose fiscal and monetary policy.
the system did not in fact keep government spending in check. The
federal government ran large budget deficits throughout the 1960s,
with the Federal Reserve duly covering the gap and inflating the
money supply. Foreign creditors understood that the dollar was being
devalued, and increasingly began to exchange their dollars for gold.
Rather than bring monetary and fiscal policies back into balance,
however, the federal government under President Nixon defaulted
on its obligations by closing the gold window in August of 1971.
the United States' position as the world's largest economy and the
de facto leader of the Western world enabled the dollar to maintain
its position as the world's major reserve currency. We’ve also enjoyed
having OPEC price oil in dollars, creating enduring worldwide demand
for our currency. But without any effective structural restraints
on Congressional spending or Fed monetary expansion, our unchecked
fiat paper money system has led to an explosion of debt over the
last 40 years.
governments (especially those that have large trade surpluses with
the United States) continue to purchase Treasury debt in order to
keep their excess US dollar reserves from losing value to relentless
inflation. Because of the dollar's continued status as the world's
reserve currency, there is still a highly liquid market for Treasury
securities. These Treasury securities are backed by the full faith
and credit of the US government, meaning they are backed by the
government’s power to levy taxes.
the increase in US national debt over the past several years and
the likelihood of continued trillion-dollar deficits has caused
many of our creditors to rethink their position on Treasury debt.
China slowly has begun to reduce its holdings, and indicated that
its $3 trillion total foreign exchange reserve is excessive. The
investment firm PIMCO completely divested itself of Treasuries,
and its co-founder Bill Gross publicly warned of a US debt default.
If foreign governments and large institutional investors begin to
shy away from US Treasuries, the Federal Reserve will face increasing
pressure to monetize new Treasury debt issues.
increases in fiscal deficits have been unprecedented. The $1.4 trillion
dollar deficit in FY 2009 was almost as large as the previous five
years combined, and FY2010's deficit was not much smaller. Half
a decade's worth of new debt could not possibly have been absorbed
by the financial markets, at least not without a significant increase
in interest rates. The Fed, however, absorbed this deficit by inflating
the money supply. Since summer of 2008 the Fed's balance sheet has
tripled to $2.7 trillion, while the monetary base has tripled to
problem is that Congress cannot and will not cut federal spending
and balance the budget. When Congress cannot balance the budget,
it must cover the shortfall by raising taxes or borrowing money.
Because the burden of taxes falls on current voters, while the burden
of interest payments on debt falls largely on future voters, borrowing
money has always been the politically favored method of funding.
Both the public
and most members of Congress do not understand the mechanics of
how the Fed and the Treasury Department work together to create
new money and new debt. It’s a circular process, but one that affects
all Americans perhaps even more than the actions of their elected
In order to
borrow money the Treasury department creates new debt securities,
which it sells at auction to banks. However, banks generally do
not maintain excess liquidity for the purchase of additional assets,
but rather loan out funds up to the limit of their reserve requirements.
In order to
facilitate the purchase of new Treasury debt, the Federal Reserve
creates money out of thin air to purchase old Treasury debt from
the dealers in the market. Banks then find themselves holding excess
reserves, which they wish to get rid of by purchasing new assets--
in this case newly issued Treasury debt.
These new excess
reserves have an expansionary effect on the banking system. Given
a reserve requirement of 5% and thus a money multiplier of 20, $1
billion of asset purchases by the Fed can result in $20 billion
of new credit creation, as the initial $1 billion is loaned out
through the banking system. This entire system is purely inflationary
and causes prices to rise and the purchasing power of the dollar
As price levels
increase and the value of the dollar falls, holders of existing
dollar-denominated assets see depreciation in the value of their
holdings. This makes them both less willing to continue to hold
dollar-denominated assets, as well as less willing to purchase more
dollar-denominated assets in the future. But the continued operation
of the profligate federal government is contingent upon finding
purchasers for new Treasury debt.
Given the anxiety
of institutional and government investors, the Fed increasingly
must act – in effect – as the buyer of last resort for US Treasury
debt. Of course the Fed is prohibited from purchasing Treasury debt
directly from the Treasury, as this outright monetization would
indicate that the nation's fiscal situation is so bad that the Treasury
could not find sufficient debt purchasers to fund its fiscal deficit.
So while the Fed does not directly purchase Treasury debt, the number
of instances in which it has purchased freshly issued debt directly
from primary dealers has begun to gain public attention. This is
merely a step away from direct monetization.
sales to a central bank are always seen as the last resort of a
failed regime, as the central bank at that point acts merely as
a rubber stamp for the government's fiscal profligacy. History teaches
that the next step is severe inflation, if not hyperinflation, with
investors and savers completely wiped out. The only reason we have
not experienced hyperinflation so far is that the Fed has managed
to keep the monetary base increases in check by paying interest
on excess reserves held by banks. If these excess reserves begin
to be loaned out, however, all bets are off.
We are told
that Congress must raise the debt ceiling limit or else the financial
markets and the US economy will suffer great harm. In reality, raising
the debt ceiling will allow the government to continue its fiscal
profligacy. Fed financed deficits will continue; foreign investors
will continue to divest their holdings of Treasury securities; the
Fed will be forced to monetize new debt issuances, and prices will
continue to rise as the standard of living of the average American
continues to plummet. If we have learned anything from history,
we should know that printing money out of thin air cannot lead to
prosperity. It can only lead to penury.
I believe Congress
should refuse to raise the debt ceiling. It would be one of the
best things that could happen to this country. Congress finally
would be forced to address the spending issue once and for all.
Outlays would have to be covered by receipts, and Congress would
have to get serious about eliminating unconstitutional government
departments and programs. It is my hope that this hearing will help
to examine the symbiotic relationship between the Federal Reserve's
monetary policy and the Treasury's debt issuance, and I look forward
to the testimony of our witnesses.
the Ron Paul File
Paul is a Republican member of Congress from Texas.
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