When the federal government runs a budget deficit, that budget has to get funded somehow. Well, since it's a budget deficit, that means the treasury doesn't have enough money from taxes to fund the budget. So what they do is sell "treasury securities" (also called "treasuries" or "securities". I'll use those terms interchangeably). An investor (bank, individual, foreign government, etc.) buys those treasuries, the treasury gets extra money and the budget gets funded. The securities are then paid back to the investor after a period of time, with interest of course.
These securities come in 3 forms. The first type of treasury securities are called T-bills. They are short term securities that generally mature in a year or less. Another type is called T-notes and they mature in 2-5 years. The last type of security is called T-bonds. They are the longest term and mature in up to 30 years.
Ok, that's basically all you need to know. At least it better be, because that's basically all I know.
As I mentioned before, the treasury department will sell these securities to fund budget deficits. Sometimes, the federal reserve (the fed) will announce that they want to buy some of these securities in order to increase the money supply. That is called quantitative easing and it's how the fed gets money into the system in order to stimulate it. But the fed cannot buy directly from the treasury. I think it's actually a law. So what the fed does is it tells certain banks that it deals with that they are going to buy up some securities. The banks wheel and deal and make bids to the fed and whoever has the lowest bid gets to sell the securities to the fed. Long story short, the banks buy treasuries from the treasury and then sells them to the fed, at a higher price of course.
Banks give cash to the treasury, the treasury can fund the debt, and then the federal reserve pays the banks. That's where it gets interesting. When the fed buys the securities from the bank, it does so with new money. Money that never existed before. Money that has nothing tangible backing it up. Fiat money. Money that's not worth the paper it's printed on. Actually, they don't even really print the money. They just add a few zeros to the bank's balance sheet. The money is all digitized, created out of thin air and added to a computer as 1's and 0's. I guess you could say it's money that isn't worth the paper that it's not printed on. Anyway, that's where all the inflation fear comes from. More money starts to chase the same number of goods and inflation is the result.
I mentioned that the different types of securities all have different rates of maturity. A lot of the debt that has been funded in the past year or so has been with the short term T-bills because the interest rate is so low. When those T-bills mature, then the treasury has to pay back the principle and interest. But remember, that money was used for funding the government. When those T-bills come back, the treasury will still have to sell many of those same bills again, plus a lot more to service the new debt on the new budget deficit that congress passed in the meantime. It's as if you max out your credit card but can't afford to pay it off at the end of the month and your solution is to get 2 more credit cards. One to pay off your first card and another one to buy more stuff you can't afford. Actually, you are doing that because it's your money that they're spending. Neat, huh?
When the global financial crisis hit, a lot of people rushed to buy treasury securities. The conventional wisdom is that when everything else is doing poorly, the safest place to have your money is in American guaranteed dollars. I guess old habits die hard. With so many people wanting to buy bonds and bills and notes from the treasury, the treasury didn't have to offer a whole lot of interest to the buyer. The interest rate on the 30 year bond went down to about 3.5%. That's extremely low. It also means that it's extremely cheep for the treasury to service the federal debt. That means that congress is more likely to have budget deficits and issue more debt. That cycle continues, and it can only exist with plenty of people willing to buy treasuries and low interest rates.
But what happens if people start to get the mindset that the only thing worse than owning the dollar today is to own a promise to be paid in dollars 30 years from now? People, banks and foreign governments can sell those bonds on the open market. If you're worried about inflation, you would probably want to sell your $100 treasury bond for $80. That way you get today's dollars and not an inflated, worthless dollar in 30 years. Then it becomes more difficult for the treasury to sell new bonds unless they raise the interest rate. Would you buy a $100 bond from the treasury when you can get it from someone else for $80? Not unless the treasury was going to offer a much higher interest rate on the new bond.
But as I said before, all of these budget deficits were only possible because the treasury could find buyers of their securities and the interest rates were so low. When interest rates rise, then the treasury goes into more debt and does so faster because it's paying more interest to service that debt. And without new money coming in, either in the form of a budget surplus (feel free to laugh at that) or new bond buyers, it becomes impossible to fund government. Unless of course congress stops funding government services beyond what it can afford (feel free to laugh at that) or the fed comes to the rescue and buys up those securities in exchange for a few extra digits on a bank's balance sheet punched into a computer that represents money. And it seems extremely likely that the fed will do just that. If you're expecting this new congress to cut spending in any significant way, well, let's just say I wouldn't hold my breath.
Why would the fed do this if it will cause high inflation? First, they claim that injecting new money into the system will cause job creation. Second, it's possible that the treasury is having a tough time finding buyers for their treasuries. That would mean that the treasury has to pay much higher interest on our debt. We currently pay about a half a trillion dollars on interest alone. If rates rise even moderately, we could easily be paying over a trillion dollars a year on interest, not to mention the principle.
Why would congress continue to issue more debt? Because the alternative is to take government services away from people. Trust me, if they started to do that, there would be a lot of angry people. Once the government starts to provide a service to people, the people become dependent on that service and feel like it is essential to their lives. Then it's nearly impossible to make cuts to those services without political backlash. Hell, even the tea party people are against cuts to medicare and social security, which are by far two of the largest contributors to the deficit.
Without any other buyers of treasury securities, and without major spending cuts, the only thing we can do to keep the gravy train rolling, at least for a while, is to have the fed buy treasury securities and wait for the inflation to steal any wealth we may have.
SIGNS THE PARTY IS ALMOST OVER:
One main reason we can have such low interest rates is because Moody's gives us a AAA rating. They recently said that could change if budget deficits continue to increase.
There are some early signs that investors are selling off their treasury securities. Last week saw the largest 2 day sell off since the collapse of Lehman Brothers in 2008.
The interest rate on the 10 year treasury note recently reached a 6 month high, and most economists expect the trend to continue.
Last November gave us a budget deficit of $150.4 billion. That's the largest November budget deficit in history.
It's not just the new tax deal without spending cuts that has the world spooked about our economy. The truth is that the world reacted very negatively when the fed announced a new round of quantitative easing back in November.
The American public is also losing faith in the effectiveness of the fed.
Investors all around the world are starting to realize that there is no way American can ever pay back its debt. David Bloom, currency chief at HCBS, recently said "If yields are rising because people think America's fiscal situation is unsustainable, then its Armaggedon." There is also growing concern among investors that the federal reserve simply doesn't care about the dangers of inflation. This is making owners of treasuries very nervous. Stephen Lewis of Monument Securities also said "There is a feeling that the fed doesn't care about inflation, in fact wants more of it, and that is certainly not in the interest of bondholders"
Over the next 12 months, the U.S. government is going to be rolling over trillions of dollars in debt (the treasury securities will be maturing) along with all of the new borrowing that it is going to be doing. In fact, the U.S. government is somehow going to have to find a way to finance debt that is 27.8% of GDP in 2011.
For decades our leaders have told us that "deficits don't matter". What we're all going to find out is - spoiler alert - our politicians have been lying to us. The sad part is that most people still don't understand the magnitude of our debt problems. As the federal government's total debt approaches 14 trillion dollars, that only represents a small fraction of the real problem. The government has reached a "fiscal gap" of 202 trillion dollars. That "real debt" includes our current federal debt plus all the other unfunded liabilities that the government has made commitments to pay but has no actual plan or ability to pay. Just to put it in perspective, if the government taxed 100% of everyone's money in the country, it would have to do so for nearly 13.5 years to pay off that "real debt". Does anyone actually think we'll ever pay that money back?
Let me try to recap the federal government's actions into a very simple statement. Our national debt needs a continual source of new treasuries buyers in order to pay off the old buyers of treasuries once they mature. Without a new supply of buyers, we can't pay the people we promised money to.
What I just described there is the textbook definition of a Ponzi scheme. They are exactly the same. Tweak a few words and those two sentences could also read like this: Bernie Madoff needed a continual source of new investors in order to pay off the old investors once they retired. Without a new supply of investors, he couldn't pay the people he promised money to.... and anyone who was financially invested in him lost everything they had.
As a citizen and a taxpayer, we're all financially invested in the federal government. And thanks to our government, the entire economy is one gigantic Ponzi scheme.