Racing Towards Stagflation

Right From the Start

Tuesday’s Wall Street Journal carried an article by Jon Hilsenrath describing a push by Eric Rosengren, president of the Federal Reserve Bank of Boston for a third, but unlimited, round of quantitative easing – a euphemism for monetizing the debt. Fortunately Mr. Rosengren is not a voting member of the federal reserve presidents who pass on monetary policy for the Federal Reserve Board.

In its simplest terms monetizing the debt means increasing the money supply (printing more money) in order to purchase additional government debt. Most responsible economists agree that such a practice increases the likelihood and depth of an inflationary cycle. There is a simple reason – increasing the money supply without increasing the underlying gross domestic output simply means there are more dollars to buy fewer products thus inflating the price for the products.

It is for that very reason that Federal Reserve Board Chairman Ben Bernanke, during testimony before the House Financial Services Committee stated categorically:

“We are not going to monetize the debt.”

But in Washington political “guarantees” have the half-life of a “quark.” Mr. Bernanke and his fellow monetary meddlers have twice led the Federal Reserve Board into “quantitative easing” – his term – or “monetizing the debt” – my translation. In the first instance, in 2009, as noted by Mr. Hilsenrath, the Federal Reserve increased the money supply in order to purchase $1.25 Trillion worth of mortgage backed securities (including sub-prime debt that was already failing), $300 Billion of U.S. Treasury securities and $175 Billion of debt issued by Fannie Mae and Freddie Mac – the champions of sub-prime mortgages to people who could not or would not repay them. That was followed by another round in 2010 and 2011 when the Federal Reserve purchased an additional $600 Billion of U.S. Treasury securities.

Mr. Bernanke justifies this practice as an effort to stimulate the economy. In theory by purchasing additional government debt, the Federal Reserve Board represses the cost of debt and discourages investors from “idling” their cash in low yield federal securities. The theory continues that by doing so that it will encourage investment in the private sector thus stimulating economic growth. But here’s where academic supposition meets market reality.

Quantitative easing is not working. Despite the pitiful returns on investment in government securities, private investors and businesses are not rushing to increase investment in the private sector. In fact, major business such as Microsoft, Google, General Electric, and others are estimated to be holding $1.7 Trillion in cash and that is after a substantial amount of cash has been spent by private business to reduce debt incurred when interest rates were higher.

And the reason that it is not working is that no amount of low cost debt can overcome economic policies that repress business growth. Investors and business simply will not risk capital investment for creation or expansion of business when government actively imposes additional burdens through regulation, and new programs such as Obamacare. As in most things involving politics, perception is king. President Barack Obama’s administration has earned the reputation of being the most hostile administration since President Richard Nixon sought to impose wage and price controls and President Jimmy Carter followed with simple ignorance. It is as much the known policies as the uncertainty of the next policies that have caused business to hunker down.

The quantitative easing policies have not only not worked but they have increased the risk of a vicious inflationary cycle coupled with low economic growth. For those with memories as short as Mr. Bernanke’s, they may want to reread the brief history of Mr. Carter’s “stagflation” in the 1970’s.

It is for that reason that I think the attention of the country’s politicians is misplaced. Both parties are talking about how to stimulate the economy. The Democrats want to raise taxes and increase government spending. Those Democrats, led by Mr. Obama have already demonstrated that such a “stimulus program” did nothing for economic growth and was used primarily to reward Democrat constituencies (public employee unions, community activists, and investors in “green energy” project that have failed or will fail without continuing government subsidies.) The Republicans champion reduced government spending and tax reductions in hopes that we can grow our way out of the economic doldrums and our massive federal debt.

But neither party provides focus on the biggest problem facing stabilization of the economy – the $15.9 Trillion debt which is projected to grow to the $16.4 Trillion debt ceiling by the end of November – some six to nine months before its anticipated date. Mr. Obama has no plan for dealing with the debt and, in fact, his proposed tax increase will all be used for increased government spending. The Republican plan can slow the growth of the debt but it will continue to increase until there is an aggressive attack on federal entitlement programs – welfare, Social Security, Medicare and Medicaid. (For a “teachable moment” you may want to visit a Social Security office and note the ratio of elderly to those requesting and receiving other benefits.)

I have noted previously that the existence of federal debt is not necessarily a detrimental thing. Most families and business maintain a level of debt – for families it usually represents a mortgage, automobile financing, and credit card, while for business it usually represent capital investment, inventory financing and working cash to smooth out seasonal fluctuations. But when debt exceeds the resources to repay the debt you are in trouble. For families and businesses that usually signals bankruptcy. For the federal government that reflects today’s reality where additional debt is accumulated to pay the interest on the existing debt. Today’s federal debt exceeds the Gross Domestic Product. Even with historical lows in interest rates, the interest on the national debt has been rising at an alarming rate over the half dozen years with a spiking in the last three and one-half years under Mr. Obama.

An increase of just one-quarter of one percent in the cost of the current debt will increase the cost by nearly $40 Billion dollars annually – one-half percent $80 Billion and $160 Billion for a one percent increase. Even a modest increase in interest rates could result in a cost in excess of $1 Trillion annually to service the debt. To put that in perspective, Mr. Obama’s most recent budget proposal recommended $3.8 Trillion of spending – nearly $500 Billion of that to service the current debt at current interest rates.

The current national debt exceeds the Gross Domestic Product. Until such time as we can reduce that debt load to the historical norms of one-half of GDP the country and its economy remains at substantial risk. Recessions and recovery are natural and recurring events for the economy. If the federal government will simply get out of the way – repeal Obamacare and roll back regulation to 2008 – the economy will recover rapidly and on its own. The same is not true for the mounting national debt. Additional increases in the debt ceiling will only exacerbate an already dangerous situation. A program of capping the national debt at the current level coupled with a dedicated stream of revenue to reduce the principle amount of the national debt until it reaches one-half of GDP (and thereafter reducing the cap by the principle payments) will do more to stimulate the economy than any amount of quantitative easing or government stimulus.

Short of that Washington’s politicians are simply whistling up a dark alley.