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Before 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.
The truth, 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 today.
Until 1971 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.
Unfortunately, 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.
Despite this, 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.
Yet foreign 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.
Not surprisingly, 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.
The recent 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 $2.5
trillion.
The fundamental 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 Congress.
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 to fall.
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.
Direct debt 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.
Ron Paul
www.house.gov/paul
Copyright Dr. Ron
Paul
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