Ruinous Symbiosis Between Congress And The Fed

Wednesday, November 2, 2011 at 3:07PM

The members of the congressional panel on deficit reduction are struggling to come up with something that will—I mean, let's be realistic—get them reelected and fill their campaign funds. Even if they come up with a plan that will reduce the gargantuan budget deficits a bit, Congress won't follow through. Reason: it doesn't have to, thanks to the symbiotic relationship between Congress and the Fed.

And please, Media, stop using "debt" reduction in your stories on the panel—you're lying to your audience. Even if Congress succeeds in reducing future budget deficits, the cumulative debt, which is now breaking the $15 trillion mark, will continue to skyrocket, just at a slower rate. For Congress to reduce the debt, it would have to produce an actual budget surplus! Here's Exhibit A of your sins: Bloomberg, Yahoo, New York Times, Washington Times, Washington Post....

Despite the grandstanding during the debt ceiling debacle, outlays in fiscal 2011 rose by 4.2% to $3.6 trillion. Excluding the $67 billion surplus from Social Security and other trust funds, the deficit came in at $1.365 trillion, a whopping 8.7% of GDP. A vertigo-inducing 37.9% of every dollar spent was borrowed money.

The issue, as we know from Greece, is serious. But the U.S. has an "advantage" that Greece surrendered when it joined the European Monetary Union: a central bank that is willing and able to force yields to near zero and print whatever it takes to monetize the deficits.

The Fed has a solid record: treasury yields are below the rate of inflation all the way up the yield curve, and so are yields for many municipal bonds, corporate bonds, all money market funds, savings accounts, and CDs. To get a positive real yield, one has to venture into junk with scary probabilities of default. Financial repression of this kind has a devastating impact not only on savers, but also on pension funds, Social Security, insurance companies, etc. And worse: inflation has outrun wage growth for twelve years. Both factors have impoverished the middle class by sapping its purchasing power. That's not the way to rejuvenate the real economy.

But the Fed and the twelve Federal Reserve Banks have a dual mandate: enriching their cronies and pacifying Congress. Congress created the Federal Reserve System, and Congress can unravel it. Already, anger at the Fed's actions has become a distinct chorus. The Bloomberg lawsuits forced the Fed to disclose information on some of the trillions it handed out in secret during bailout mania. Congressionally mandated audits by the non-partisan Government Accountability Office shed some sunlight on certain aspects of the Fed (For more: The GAO Audit of the Fed Doesn't Call It 'Corruption'.... But it should). And now, Ben Bernanke is getting defensive.

To pacify Congress, the Fed issues assurances that it will continue to force down interest rates and print money to enable the Treasury to fund the deficits that Congress produces. Bernanke's talk today included a whole slew of such assurances. As long as this symbiotic relationship continues, Congress won't bring the budget deficits in line; it doesn't have to because the Fed shields congressional decisions from the brutal but healthy discipline of the markets.

Greece ran into trouble because the markets started to impose a bit of discipline. Deficits and debt had gotten out of hand, and the markets rebelled—belatedly, but they did rebel. Market discipline keeps governments (and companies) in line. It's all part of the checks and balances of a well-functioning capitalist system.

But Congress couldn't care less because the Fed and to a lesser extent the Treasury (through ownership of Fannie Mae and Freddie Mac) control the U.S. credit markets. At the slightest squiggle, the Fed prints massively.

The textbook precedent is Japan. The Bank of Japan, the Ministry of Finance, government agencies, and government-controlled financial institutions own or control 95% of all Japanese Government Bonds outstanding. To heck with the unrelenting downgrades; ten-year JGB yields are near 1%. The Japanese system protects politicians, bureaucrats, and Japan Inc. from market discipline and enables politicians to run up huge deficits year after year. As a result, Japan's debt is now 230% of GDP. That this will blow up is clear. That this will be much worse than Greece is also clear. But so far so good....

Over a number of years, the U.S. has perfected this shield against market discipline. Remember the bond vigilantes? Annihilated by the Fed's printing press and rate policies. Congress has been watching the same movie. They know that borrowing 40% of every dollar spent is no problem because the Fed will cover it. And in return, Congress, as an institution, puts shackles on its few members that are too vocal about auditing, restructuring, or even eliminating the Fed.

The Japanese quagmire has been getting deeper for years, but the unique factors that supported its catastrophic indebtedness have reversed. And the endgame has started... How Long Can Japan Play The Endgame?


by Wolf Richter