Fed to Purchase National Debt

Some are saying that the step announced this week by the FED (Federal Reserve Board) is a measure of desperation.  They believe that for the FED to announce that they will begin buying US securities and/or bonds (basically an IOU from the US Government), that it is a last-ditch effort to try to stimulate the US economy.

That may sound like a good plan to you.  At this point, you may want anyone to do anything to get things going again.  Let the FED buy the debt, after all, it will be bought by someone, it might as well be the Fed.

When a central bank (the FED in the US), which controls the money supply for a nation, buys the debt of the nation, it is called "monetizing the debt" (we will call it MTD).  It is correct, that when the US issues IOUs, someone buys that debt in exchange for the stated interest rate they will earn during the term until the debt is paid in full.  As the national debt has skyrocketed over the past two years to over $13.3 trillion (which equals over $40,000 for every man, woman and child in our country), the typical buyers of the debt are getting nervous about their investments. 

Due to the out-of-control spending in Washington, along with the earmarks, bailouts, and stimulus plans; BO continues to need more cash to fund his agenda.  That results in the government issuing more IOUs and needing someone to buy them.  In other words, the government prints an IOU on a piece of paper and sells it for however large of a number they chose to write on the bond.  The buyer pulls cash out of the money supply and uses it to purchase the IOU.

When the FED told us they would begin buying US debt (MTD), that was an admission that the previous buyers of our debt did not want to buy any more.  In the current situation, in order for the US to have additional cash to continue to fund all the social programs, etc., the FED has found it necessary to MTD.  This is bad news.  To MTD is different than when someone else buys the debt.  Others use existing cash to buy the IOUs.  The FED prints additional cash to use to MTD.  The result is the US prints the IOU on a piece of paper and trades it for a pile of case that the FED just printed on paper.  The FED creates new cash.  The US takes this cash (laughing about how easy it was to get a pile of money) and throws it into the US economy.  This results in more cash in the money supply.

A cause of inflation is the over supply of cash in the money supply.  As more cash is added to the supply, the result is that things of value (a home, a car, food, gas, etc.) end up costing more dollars = inflation.  A larger supply of cash makes each dollar have less value.  This, then, takes more of the dollars to buy the same thing. 

As inflation takes root in our economic system, portions of the economy suffer.  The more IOUs sold to the FED, the higher the money supply becomes.  The FED just announced that they will buy the US debt.  As this new policy takes effect, we will begin to see inflation.  As inflation becomes more of an issue, the FED will adopt a policy to try to prevent hyper-inflation.  Hyper-inflation is the situation where the prices are increasing at an alarming rate and the value of a dollar is dropping as you drive to the store.  The FED policy will be that they must pull extra cash out of the money supply to try to lower the rate of inflation.

How will the FED decrease the money supply?  They will sell to the public the IOUs they have been holding.  With the economy in distress and the US government on the verge of bankruptcy, the FED will have to offer the IOUs at a much higher interest rate than they were getting from the US.  When the interest rate gets high enough to attract buyers, it affects the other interest rates in the economy.  The FED move will result in higher interest rates that directly affect you and I.  The cash paid to buy the IOUs from the FED will be taken from the money supply. 

MTD by the FED will lead to inflation and higher interest rates.  Both of these will be hard on an already struggling economy. 

Since the direction we are headed will lead to further economic crisis, what should we be doing, instead?  The answer is, short-term pain will lead to long-term gain.  We need the US Government to drastically reduce spending, cancel many social programs, stop pork-barrel projects, reduce the size of the government payroll, reduce burdensome regulations, stop raising taxes, adjust the pay and benefit packages of government employees to no higher than the private sector, stop redistributing the wealth, etc.  These steps may cause some temporary pain as the public adjusts to less government benefits and more personal responsibility, but the long term benefits will be a more stable economy and healthy nation.