The View From 1776

The Wall Street Journal reports (U.S. to Ratchet Up Borrowing, July 31, 2008):

With this fiscal year’s budget deficit expected to more than double from the previous year, the U.S. government plans to nearly quadruple its borrowing to $555 billion.

The Federal Reserve’s dilemma is that opening the money-supply spigot enough to provide funds for banks and other institutional investors to buy the $555 billion of new Treasury debt will contribute further to the inflation already under way. 

Imported oil is a prime example.  Measured in gold, the price of oil is about the same per barrel as it was a decade ago.  To a lesser extent, the same is true of oil measured in Euros.  Our spectacular oil price increase for imported oil is to a very large degree the result of past over-expansion of the money supply by the Fed, with its inflationary effect.

Alternatively, keeping the money supply steady will cause interest rates to rise and will have a crowding-out effect on non-government borrowers, from businesses, to people buying consumer durables like autos and homes.

This is particularly true in today’s financial markets, where lenders already have much reduced liquidity and pinched capital bases as a consequence of the subprime mortgage bubble-burst.  Banks are dumping subprime assets at fire-sale prices, while scrambling to find equity investors to rebuild their balance sheet ratios.

Both for lender equity-raising, and for absorbing new Treasury debt, the course of least resistance is to seek funds from overseas investors.  Foreign central banks in Japan, China, and other large exporters of merchandise to the United States are over-loaded with dollars, dollars that are depreciating in value via inflation.  To some extent those overseas dollar holders welcome income-producing investments for their great dollar holdings.  Needless to say, however, they will exact a high price, both in interest rates and in equity ownership.

As noted in Our Inflation is China’s Foreign Relations Weapon, continuing to expand the money supply to accommodate Federal deficit spending, in present circumstance, is tantamount to loading a pistol already pointed at our heads. 

Both by absorbing yet more Treasury debt, and by becoming the investors of last resort for financial institutions and for corporations seeking to stay afloat in the current credit crunch, foreign nations achieve a growing power to influence our foreign policies and ultimately to threaten our national sovereignty.

The Fed’s present dilemma - to fund yet more Treasury debt via over-expanding the money supply and thereby adding fuel to the inflationary fire, or to curb the excessive money supply to forestall inflation while squeezing the economy - has been inherent in our system since Congress’s passage of the 1946 employment Act.

That Act added to the mission of the Federal Reserve the task of maintaining full employment.  Ultimately that task is wholly incompatible with the Fed’s basic role, established in 1913, of maintaining a sound currency and acting as a temporary lender of last resort for banks during credit crunches.