Bonus 2011 Deficit FAQ: Why is the Federal Reserve buying U.S. Treasuries?

“An abundance of money which would lower the interest rate to two per cent would, in reducing the financing costs of the debts and public offices etc., relieve the King.”
 – John Law, Controller General of Finances of France, 1720

I realized the deficit FAQ was missing something, so here’s an update.

Why is the Federal Reserve buying U.S. Treasuries?
Short answer: they’re trying to prop up the U.S. government’s massive deficit spending.

Long answer: If the Federal Reserve wasn’t buying U.S. debt, the game would already be over. No one wants to buy that much U.S. debt at current interest rates. Would you want to buy the debt of a government that’s borrowing 40% of its annual expenditures?

The key phrase above is “at current interest rates.” If America had to finance its operations by selling bonds to private and foreign investors we would have to offer much higher interest rates. By purchasing U.S. bonds (Treasuries), the Federal Reserve is keeping interest rates down.

Lower interest rates have two advantages. First, it keeps interest rates low throughout the economy. The interest rates on U.S. Treasuries put a floor under interest rates. Investors can put their money in Treasuries and get a guaranteed, no-hassle profit with (virtually) zero risk. To put their money into any other investment they’re going to demand a higher interest rate than they can get in Treasuries. Keeping the treasury rate low keeps all interest rates low.

Second and dear to the government’s heart, low interest rates help contain the cost of government borrowing. Without artificially low interest rates the government couldn’t continue its path of endless deficit spending.

Charles Smith puts it well in Travesty of a Mockery of a Sham, Phase II:

The problem is, of course, that the system cannot support borrowing and spending $7 to create $1 of “growth” for long: eventually, as in all business cycles, the cost of borrowing will exceed the ability of the borrower to service that debt. That’s what Keynes failed to foresee: the way in which the partnership of Central State and Cartel-Capital requires ever greater credit and State debt expansion just to keep the system afloat, never mind growing.

If I loan you $1 trillion at zero interest, with no principal payments, then the cost of servicing that $1 trillion loan is zero. Pretty easy to service zero, isn’t it? That’s the core strategy of the Federal Reserve and the U.S. Treasury.

That’s been Japan’s “secret” for 20 years: as long as the lenders (the Japanese citizenry and life insurance companies, etc.) accepted near-zero interest, then the cost of borrowing additional trillions has been bearable.

But as soon as that $1 trillion requires a serious interest payment, then the ratchet-effect game ends. We are not there yet, but the endgame is no longer over the horizon.

Here’s a possible third reason to keep interest rates low, though I don’t know enough to say if it’s true.