Probably nothing good will happen in the discussions
surrounding the “fiscal cliff” in January 2013. Federal spending
is almost impossible to cut meaningfully, because most of it is
“mandatory” entitlements. The remainder of federal government
spending consists of other welfare programs (hard to reduce in the midst of
persistent unemployment), defense (which Republicans won’t want to cut
unless they get some big cuts in welfare and entitlements), corporate
subsidy, and Big Bird.
The result is likely near-stasis on spending, and, despite Republicans’
efforts to the contrary, some tax rate increases. This is the
“austerity” approach that is not working at all in Europe. The
tax increases will cause more economic weakness and won’t raise any
additional revenue. In the midst of a crumbling economy, people will be even
more dependent on government assistance, and spending will be impossible to
Deficits will likely continue and perhaps get even larger. The economy will
deteriorate, while the rest of the world slips into its own recession. The
EU’s statistics office just declared a recession in eurozone, rather
belatedly to some.
This puts pressure on the Federal Reserve to keep the game going a bit
longer. The Treasury will have to find buyers for perhaps $1.2 trillion of
new debt issuance in calendar 2013, on top of rollovers of existing debt.
Recently, the big buyer of bonds over five years in maturity has been the
Federal Reserve, through “Operation Twist.” The most recent QE3,
by raising prices for MBS, also creates buying interest in longer-maturity
The Federal Reserve doesn’t want to let long-term interest rates rise
by any appreciable amount, because that would demolish their hopes for some
kind of housing recovery. At the same time, an economic downturn creates the
justification for more easing policies.
All of this has led Fed-watchers to conclude that the most likely course of
action will be an expansion of QE3 in January 2013, perhaps announced in
December. Probably, the existing “Operation Twist” program, which
purchases $45 billion of long-dated Treasury bonds per month, will be
replaced at its completion in December by a corresponding $45 billion per
month of printing-press financed Treasury buying via QE3+.
Chicago Federal Reserve president Charles Evans outlined this strategy at the
beginning of October. Evans is widely regarded to have been a chief architect
for QE3, and apparently has Bernanke’s ear.
Thus, the Federal Reserve would be buying $85 billion per month of Treasuries
and MBS, financed with the printing press. That is $1,020 billion per year,
not coincidentally about the expected amount of the Federal budget deficit.
The Federal Reserve will make many promises about how it won’t let
things get out of hand. In practice, I suspect that they will find that backtracking their present course is as difficult as it is
for Congress to solve its deficit problem.
It is a little-known fact that the U.S. Federal government has used
printing-press finance whenever it ran large deficits. Until recently, these
large deficits appeared only in wartime. In the 1780s, the Continental
Congress financed the Revolutionary War with the printing press. The result
was the hyperinflation of the Continental dollar. When war with Britain broke
out in 1812, the Treasury began issuing Treasury Notes, a paper banknote, to
The outbreak of the Civil War in 1861 soon led to the issuance of United
States Notes, known as “greenbacks.” As the U.S. entered World
War I, the Treasury pressured the then-new Federal Reserve to help finance
its debt issuance by managing long-term interest rates. This resulted in
excessive money issuance. During World War II, again the Treasury pressured
the Fed to put a lid on long-term interest rates, which again led to
excessive money-printing by the Fed.
In most of these situations, the war ended quickly, spending was reduced,
deficits disappeared, and the Treasury no longer had to print money or
pressure the Fed to help with deficit financing. At that point – not
before — a monetary contraction took place and the monetary system
returned to a peacetime gold standard system. This was the case in 1818,
1865-1879, 1920, and 1951.
Probably, this will end badly. Next year might be quite exciting. Eventually,
when the time comes, let’s do what we did in the past: return to a
peacetime gold standard system.