Henrik Ræder Clausen, after doing some research on the Fed and the current economic crisis, started out to write me a “Hey Baron, this is interesting” email, and it became the following guest essay.

The Fed and the US federal debt
by Henrik Ræder Clausen

While usually the stuff of conspiracy sites, I found that the question itself makes sense: who actually does own the Fed, and how does it work?

So I set out answer this question, and first found this.

While it contains a lot of basic facts (for example, the Fed was set up in 1913, not in 1917 as I thought before), the conclusions (more centralized power) didn’t make sense, nor did the loonie-left stuff on the page.

Then I came across this long, tediously detailed, article.

Now things start to make sense. Having private banks own ‘stocks’ in the Fed makes it look like it’s privately owned, but the use of the word ‘stock’ in this context is misleading, for the ‘stocks’ cannot be bartered like normal stocks can, nor do they give the same kind of influence that stocks in normal corporations do. The Fed is a peculiar construct; control is actually clear enough. It’s a system similar to the way high court judges are appointed, albeit not for life, but for the (still very long term) of 14 years, which lends credence to the idea that the Fed is somewhat independent of the political system. As for the Fed generating a huge unaccounted profit for the owners, that is rubbish. The surplus of the Fed ($22 billion in 2006), mainly interest on government securities, is returned to the US Treasury. There is also interest paid on the deposits of the member banks, but this is benign in context.

The Fed was established in 1913 after a bank run in 1907, in order to have a ‘lender of last resort’. It has nothing to do with Woodrow Wilson and his problematic policies. It is a system that made sense then, but might make less sense now.

Why less sense? Well, apart from the ‘lender of last resort’, the main function of the Fed is to issue currency. Print them and put them into circulation. Now, one can’t just print money and circulate them, some collateral is needed. It used to be gold, but we left the gold standard in stages long ago, ultimately abandoning it in 1971. The collateral for the dollar is US federal bonds.

Now, that is a potential problem. The US federal debt is ballooning, at the moment with no end in sight. This obviously has to be halted, and ultimately reversed, or a bankruptcy will ensue. That would seriously tank the value of US bonds, which in turn would destroy the dollar, as the collateral for the currency has vanished. This, of course, is a nightmare scenario.

One may wonder, then: Who owns these bonds? The US Treasury gives figures here. The top five are:
– – – – – – – – –

China has risen fast on the list. The Chinese economic system requires government institutions to hold large amounts of foreign currency, which it has to place somewhere. US securities are an obvious choice. The underlying cause for this is obviously the huge trade surplus generated by the many Chinese factories. The fruits of real Capitalism.    🙂

That the UK (including Cayman Island) is rising too, is attributable to its status as a financial center, not to the underlying UK economy. We cannot know for sure who holds these securities. The same goes for Caribbean holdings, of course.

OPEC countries have risen from spot 11 in 2006 to spot 5. Possibly the friends of Bush are heeding his call that he wants his oil money back, and this is the way he gets it, in purchasing US securities. That also helps the Fed secure collateral for issuing dollars, but constitutes a political risk, one that may limit the ability of the US government to act independently in foreign policy matters.

In a report by the Danish National Bank, it was noted that large direct investments (FDI) in the US have a surprisingly low Return On Investment compared to smaller investments in the US, or comparable investments from the US abroad. One possible cause not mentioned in the Danish report is that the US government has persuaded other governments to hold disproportionate amounts of US securities as a gesture of political goodwill. If that is so, and the goodwill evaporates, this is a potential problem that could destroy confidence in US securities.

This all leads back to the core issue — the US federal debt. Issuing bonds to increase the dollar supply might be all fine and dandy, but if the debt becomes unsustainable, this looks like a rather bad idea. The US national debt is detailed here.

There are many aspects of debts; this is not as simple as a household economy. For one thing, an increase in debt is not equivalent to the budget deficit, not at all.

The overall federal debt is currently hovering at 65 of GDP, which is rather high, and it shows no signs of abating. Clinton managed to stall the growth, but under both Reagan and Bush deficits went rampant. In defense of Reagan, he mastered the ending of the Cold War, leaving a considerable ‘peace dividend’ to his successor. I do not believe the Bush administration leaves behind a similar dividend, possibly to the contrary. In any case, Reagan left behind a dangerous legacy of federal debt that is not under control.

Graph of US Federal Debt

While the debt, as a percentage of GDP, is not at an all-time high, the situation is more difficult now than it was at the end of WWII. Back then, a first-class industry was without competition anywhere in the world, as Europe was being rebuilt from the ashes, Japan even more so, and even in the UK industry was worn down from the war effort. While the debt remained fairly stable in dollars, the % of GDP fell rapidly, and even the recession in the 1970’s made only a lesser dent in that development. The debt started ballooning with the Reagan administration in 1980 and is still rising rapidly as of this date.

Now, the figure “% of GDP” has an inherent danger: What happens in a recession, when the GDP shrinks? Well, the debt rises all on its own. If you add to that bailouts, stimulus packages, and the other standard measures of Keynes, the debt will spiral out of control, and the confidence in US securities will break. As we saw above, this would break the dollar, too.

Actually there is one more liability in this, and it’s a big one, $41 trillion on top of the $11 trillion federal debt: unfunded obligations.

These are obligations undertaken by the federal government for Medicare, Medicaid and Social Security. There is, to my knowledge, no usable plan on the table to meet these obligations, which constitute, to say the least, a significant economic challenge for the federal government.

Now, how does all this connect with the financial crisis? Rather directly, actually. What we saw in the collapse of the subprime market was that a significant amount of ‘money’ simply disappeared. Money based on supposedly sound collateral, housing. But the housing prices were inflated, based on extremely cheap liquidity from the Fed (remember the 1% Fed rate we had for years?), and when the rate went back up, the value collapsed and the collateral became insufficient. Money does disappear; it’s a weird phenomenon.

The exact amount of money that has vanished in the housing bubble is non-trivial to determine. This 2005 report from CEPR (5 pages PDF — also predicted the effects of bursting the bubble) estimates the size to be around $5 trillion, a huge amount by any account. When money of that magnitude vanishes through the bursting of the bubble, the need for replacement liquidity becomes acute. This is a root cause of the financial crisis.

This bubble could, however, never have taken place without the benefit of cheap liquidity. Post-9/11, the Fed quickly decreased interest rates to an all-time low of 1%, which not only fueled the bubble, but also disguised the underlying structural problems of the US economy by sugar-coating things with cheap liquidity.

As this IHT article reports, the drop also sent investment managers into a frantic search for investments which would yield some decent returns. The desired investments were the subprime loan packages, and Merrill Lynch plunged right in, never to recover. By the way — if you heard a story about a Turk and an Egyptian bringing down one of the main US banks, this is the one. Details are in the article.

Another problem of cheap liquidity is that it encourages businesses to base their day-to-day operations on it. Why shouldn’t they? In a highly competitive market, access to cheap credit is a cost-effective alternative to the classical virtue of consolidation. But then, when the liquidity dries up, the company goes bust. As an example, in Denmark we have cases of supposedly well-run companies who couldn’t make payroll because their credit line in the bank had been closed. Companies that do not use times of prosperity to consolidate themselves surely aren’t ‘well-run’. General Motors and other really big players have basically been hit by the same problem and are now begging for a solution and a bailout.

Bubble burst, bailouts done and banks nationalized, recession setting in, what does the Fed do? Return the interest rate to 1%…

One may then wonder: didn’t we learn anything from this? Of course we did. The subprime mania is not coming back, that’s for sure. Other regulations have been changed, and more are to come. The problem is that we probably didn’t learn enough. Low interest rates basically cause liquidity to flow away, which is not what we want. The federal government and the Fed can compensate for that by issuing more bonds all over again, but that doesn’t look like the proper medicine in the long run.

What is to be done? The budget needs to be reined in. That will be extremely painful, and the US government will have to re-evaluate its priorities and obligations radically. It means that Americans will need to work more and spend less, and preferably spend on US products, if possible. Granting billions to ‘peace-creating’ activities (Palestine, anyone?) and other US generosity, however popular they may be, would need to be abandoned.

For the climate thing, which is filling the airwaves and the newspapers here in Denmark, one may think that nothing can be granted by the US government due to budgetary constraints, but that is not so. What can be done should be for free, or even profitable. Increasing energy taxes is an easy (albeit unpopular) way to reduce energy imports and improve the budget. Licensing new nuclear power plants reduces trade deficit and improves energy independence.

Getting the situation under control will take much more work than either Bush, McCain or Obama have publicly admitted. And I must say that, if I had the opportunity in the first place, I would not desire to be in the position of a US President in these days. It’s going to get tough to avoid another crisis, and fundamentals need to be addressed. But since the alternative would be the federal government entering default, toughness would look like the milder alternative.