The Federal Reserve Is Enabling Obama And Congress’ Out Of Control Spending

 In the past twelve months the federal government has increased the national debt held by the public by $697 billion while the total debt has grown by $820 billion. Since revenue collected by the government is at record highs, these enormous deficits must be due to spending. Among the many extraordinary measures taken by the Federal Reserve over the past five or so years are several that are serving to enable President Obama and Congress in continuing to spend with little, if any, restraint. If we hope to get spending under control, it would help if the Fed stopped encouraging so much wasteful spending.

yellen_small The Federal Reserve Is Enabling Obama And Congress' Out Of Control Spending

The Federal Reserve believes, with little evidence over the last five years to back them up, that government deficit spending and low interest rates can stimulate the economy and boost economic growth. The Fed has significant influence over interest rates, but no role in federal spending or taxes, so how does it enable the federal government in running deficits? The answer is by its purchasing of Treasury securities which holds interest rates down and its refunding of all its profits to the Treasury.

The Federal Reserve does not directly buy U.S. government bonds, but it has been buying them in the secondary market at a rate of about $45 billion per month as part of its policy of quantitative easing. Of the $697 billion that the federal government has borrowed from the “public” in the last twelve months (Feb 27, 2013-Feb 26, 2014), the Federal Reserve has indirectly purchased $528 billion based on the changes in its holdings of U.S. Treasury securities.

For all the talk about China buying U.S. government bonds (and they do own quite a few), to the best of the Treasury’s estimation all the foreign governments in the world only increased their holdings of U.S. government securities by $22 billion last year. That means that foreign governments funded 3 percent of our borrowing in the past year, individual investors funded 21 percent, and the Federal Reserve funded 76 percent of the new debt issued.

The federal government sells its securities (bills, notes, and bonds depending on the time to maturity) at auctions. Buyers submit bids stating the highest price they will pay or, equivalently, the lowest interest rate they would accept in order to purchase a set amount of the offered securities. The Treasury then starts from the lowest interest rate bids and continues until it reaches the amount it wishes to borrow at that auction; all buyers receive the highest accepted interest rate bid.

Because other participants in the debt markets know that the Fed stands ready to buy government securities, some are willing to accept lower interest rates from the government. By increasing demand for Treasuries, the Fed raises prices, which lowers the interest rates on the debt the government needs in order to continue spending so much money.

Further, the federal government can increase the national debt without worry that the dreaded bond vigilantes will suddenly stop buying its debt or bid the interest rate up to unaffordable levels as happened with several European countries (such as Greece). After all, as long as people believe the Federal Reserve will buy enough government securities to keep interest rates low, interest rates will not rise too much and buyers will not shy away. The Fed is essentially providing free insurance on your investment in government bonds against capital losses from falling prices and rising interest rates. This insurance is not complete (interest rates have risen about one percent over the past year), and the Fed can cancel the “policy” whenever it chooses (as it may slowly be doing through its gradual exit from quantitative easing, generally referred to as the taper), but it still increases demand for government bonds. The taper suggests that the deductible on this insurance policy is increasing, but it has not been cancelled yet.

Making the enabling behavior even worse, the Federal Reserve refunds its operating profit to the U.S. Treasury, a total of over $77 billion last year. That means that the portion of debt held by the Fed has an effective interest rate of zero. In total, the Federal Reserve holds almost $2.3 trillion in U.S. government debt (18 percent of the total outstanding). The U.S. Treasury reports a blended interest rate on the national debt of almost exactly two percent, so the Federal Reserve is saving the U.S. government about $45 billion per year in net interest payments.

By lowering the cost of the national debt through these two mechanisms—keeping interest rates artificially low and by refunding its share of those interest payments—the Federal Reserve enables President Obama and Congress. They do not need to bear the true cost of all their spending, but rather are allowed to borrow at artificially low rates, lowering the burden of both past deficits and current ones.

The Federal Reserve’s actions introduce a form of moral hazard, encouraging risky behavior by the federal government in the form of extra spending and borrowing. The Federal Reserve’s goals are supposed to be to control inflation and keep unemployment low. It is supposed to be an independent agency, not part of the federal government. Yet, it has spent most of the past five years enabling federal spending on an unprecedented scale, tripling its own balance sheet, venturing into the mortgage backed securities market, and forcing interest rates to historic lows. It is hard to think of a policy that a Fed which was part of the Obama administration might have followed that the supposedly independent Fed has not.

Out of control government spending is hurting the economy. The distortions caused by the government’s market interference mean slower economic growth than would otherwise be realized. By enabling such reckless spending, the Fed is contributing to the problem rather than steering the economy to a stronger footing with a more normal balance between the private and public sectors. We all would be better off if the Fed simply went back to ensuring a stable dollar rather than facilitating the latest untested fads in macroeconomic policy. A stable dollar will help the economy more than any amount of deficit spending.