Fri 3/30/12 3:10 PM – The Fed, Not China is the Biggest Buyer of Treasury Debt

Right now the U.S. federal government is borrowing about 40% of every dollar it spends. I have not heard much talk about this lately but it is deficit spending on a huge scale.

I have written about the troubles that high debt levels have caused several European countries including Ireland, Iceland, Greece, Portugal, Spain and Italy. Recently I mentioned that we are on the same road, just not as far along. But, with that kind of borrowing, begun by Pres. Bush and accelerated by Pres. Obama we are headed for big trouble.

One participant in this that I haven’t written much about has been Ben Bernanke and the Federal Reserve. An article in the Op-Ed section of yesterday’s Wall St. Journal addresses this well.

To borrow money for deficit spending the U.S. needs investors to buy U.S. Treasury bonds as new ones are issued. People assume that China is the biggest investor. Well, they would be wrong. The biggest buyer of new U.S. Treasury debt is . . . drum roll, please . . . the U.S. government, specifically the Federal Reserve.

How much is the Fed buying? To quote the article, entitled Demand for U.S. Debt is Not Limitless, “Last year the Fed purchased a stunning 61% of the total net Treasury issuance, up from neglible amounts prior to the 2008 financial crisis.”

To quote the article further, “This not only creates the false appearance of limitless demand for U.S. debt but also blunts any senses of urgency to reduce supersized budget deficits.” How does the Fed buy all this debt? – simply by writing a check, which it can do without the tax dollars to back it. While the money appears out of nowhere it is real debt that must be repaid. The U.S. government is therefore by far the biggest holder of U.S. debt, bigger than China, bigger than any country.

As seen in this chart, foreigners have actually been sharply reducing their purchases of U.S. debt for the last three years. Because of their reduced demand, it has been the Federal Reserve stepping in as a huge buyer that has allowed the interest rates on this debt to stay extremely low, as if there was huge actual demand for it. There is not.

At some point the Fed will have to stop this. What then? When real demand for U.S. debt is the only demand, there will be a huge increase in the rates and a correspondingly large increase in how much interest the U.S. must pay as it continues to borrow because no Democrat in Washington, including the president, has the stomach to stop borrowing 41% of everything the federal government spends, especially in a presidential election year.

When rates on government bonds go up sharply, so will mortgages, so will rates on corporate and municipal bonds, increasing the cost of business for companies, municipalities and citizens. At that point, you will see slowing growth and we will be back to the high interest and no-growth days of Jimmy Carter and of these European countries today.

There is a day or reckoning folks and at the current rate it will likely happen in the next 5-10 years. It seems no one in Washington has both the clout and the courage to do the right thing before it causes real pain. When their terms are up, the debt will remain and the rates will be much higher. People will likely blame whoever the new president and Fed chairman are but the blame will belong to President Obama and his chief financier, Ben Bernanke.

I don’t say this as a political statement but as an economic reality. Like the Old Testament prophets who saw the future but saw no change and like the mythical Cassandra who saw the future but was cursed so that no one believed her, this is a frustrating position. There are a number of people pointing it out, but alas, we are not in office nor running the news media.