Washington, DC, November 9, 2010 --  

The Fed's plan to print more money makes it easier for politicians to put off cuts in spending. This won't end well.

When the Federal Reserve announced plans to print another $600 billion through June and funnel it into U.S. bonds, world reaction was sharply negative. After years of listening to American officials berate leaders of export economies (notably China) for manipulating their currencies, they noted more than a little hypocrisy when America announced plans to devalue the dollar to help its economy. And since foreigners' will lose money on their dollar-denominated savings, their anger came quickly to the surface. "With all due respect," said German Finance Minister Wolfgang Schaeuble, "U.S. policy is clueless."¹

Yet it is not America's foreign competitors but Americans themselves who will suffer most from the actions of the Federal Reserve. Former Federal Reserve Bank of New York President Gerald Corrigan said Bernanke's plan made him "uncomfortable" and risks hard-to-control inflation once the economy picks up.²

This may not be a serious consequence for the savings of Americans -- provided inflation stays in the single digits and savers can invest their money in safe places -- but it could cause a real crisis with the funding of the federal government.

The likely scenario goes like this: A binge of money printing and bond buying by the Fed in the short-term keeps the cost of borrowing government low. This makes it much easier for lawmakers, including the incoming Republican House of Representatives, to kick the can down the road about cutting the government's irresponsible credit-driven spending. When inflation and higher interest rates eventually kick in, the deficit will soar, bond investors will get spooked, and America will face a debt crisis. Not a pretty picture.

In the past year, the US government paid $414 billion in interest on the national debt.³ This may seem like a huge amount of money, but it is actually incredibly cheap given the $13.7 trillion size of the debt. This low cost of borrowing is thanks to Fed actions pushing interest rates to historically low levels. These rates make maintaining a huge and growing government debt affordable in the two year electoral time period that most congressmen care about.

But this affordability cannot and will not continue much longer. Unless the Fed plans to indefinitely continue printing money to buy U.S. government bonds (and action which would ultimately destroy the dollar by creating Zimbabwe-style hyperinflation), the interest rate that the U.S. government pays for its bonds will go up in coming years. This will be forced by both rising inflation and faster economic growth.

It is extremely likely that interest rates will before long return to historic levels of seven or eight percent (perhaps higher, depending on inflation), forcing a huge percentage of the federal budget to be devoted to interest payments. A surge in short-term borrowing has caused the average maturity date for treasury debt to drop to just over four years by the end of 2009, with 37 percent of the debt maturing in less than a year.⁴ It's as if the federal government took out an adjustable rate mortgage at a time of the lowest interest rates in decades. Not a smart move.

This rising cost of debt service will ultimately make the U.S. budget deficit much worse, likely spooking bond investors into demanding ever-higher interest rates to cover their risk. The end result is a Greek-style debt crisis. The only question is whether this will happen before American policymakers get serious about cutting spending.

The fear of a similar crisis hitting home played no small part in the British government's recent decision to slash public spending with in major austerity program.⁵ In Britain, like in the United States, opponents of budget cuts raised the specter of a failed economic recovery to ward off austerity. The British government has wisely chosen to risk short-term economic pain -- both in the form of spending cuts and the near-term risk of a return to economic recession -- in order to return the nation to fiscal health.

America, meanwhile, is taking the opposite path. The Federal Reserve is printing money in an attempt to lessen short-term pain of unemployment and prod some growth out of the stagnant economy. In so doing, it is increasing the longer-term risk of inflation, high interest rates and a public debt crisis. America's public officials are truly living like there is no tomorrow.

Related Web Columns:

Shaky Debts and Flagging Trust
The Dubious Future of Public Finance, May 11, 2010

A Greek Canary in an American Mine, December 15, 2009

From America to Zimbabwe, March 24, 2009

Persistent Problems, Painful Solutions, February 10, 2009

The Rise of the Mutant Beast, January 13, 2009

Yawning Toward Disaster, September 2, 2008

Notes:

1. ABC News, Bernanke Answers Fed's Global Critics, November 5, 2010

2. Bloomberg News, Corrigan Says He's ‘Uncomfortable' With Fed's Inflation Effort, November 4, 2010

3. U.S. Treasury Department, Interest Expense on the Debt Outstanding, November 4, 2010

4. Economic Report of The President, February 2010

5. Washington Post, Britain Plans $131 Billion in Spending Cuts by 2015, October 21, 2010