Debt vanishes, woes appear

I’M going to make the entire US debt disappear before your eyes — and you are not going to like the way I do it.

Let’s start with the Federal Reserve’s announcement last week that it planned to shrink the size of its $4.5 trillion balance sheet. Sounds pretty simple. But those simple words are fraught with such complexity and danger that the inflation-haters in the world should rise up and demand a full accounting of how that will be done.

I’ll start at the beginning. But in the end you’ll see how it would be possible for out-of-control politicians in Washington to make what the Fed is about to do into something that could hurt generations of future Americans.

The Federal Reserve had assets of only $800 billion when the 2007 financial crisis began. By late 2008, Fed Chairman Ben Bernanke decided that he needed to keep interest rates extremely low — lower than he could through conventional methods.

So he adopted an idea that had been used in other parts of the world but never here: quantitative easing.

The idea has that name because when enacted, QE keeps interest rates low. In other words, the Fed would “ease” credit conditions — by increasing the quantity of money.

This isn’t the type of money that has presidents’ faces on it. It is electronic money, and the Fed used it to buy government bonds.

With the Fed utilizing this newly created e-money, it acted as a shill — and a very, very big one at that — at US Treasury auctions.

And with the Fed shilling, the demand for bonds was bound to be strong.

It would be like your aunt bidding up the price on your uncle’s car at an auction. It may look as though there is strong demand for the car, but it’s all fake.

And the stronger the demand for bonds, the higher the price — and the lower the interest rate. That helped the Treasury Department keep the federal deficit lower than it would have been.

QE was also a great benefit to Washington in another way.

Each year, by law, the Fed has to turn its profits over to the Treasury. And since the onset of QE, the profits from those $4.5 trillion in bonds have sharply reduced our annual deficit, which in turn has helped keep down this country’s debt level.

The US debt is almost $20 trillion right now. But without the Fed’s help — the profits from those QE bonds purchased with newly created e-money — that figure would be closer to $20.6 trillion.

Or, put another way, the US had an extra $600 billion to spend thanks to QE profits.

Problems will occur if Washington gets it into its head that there’s extra money to spend because of the QE money being returned to the Treasury.

If that happens, the fake QE money will cause higher prices on goods, including housing and other asset bubbles — and even more irresponsible spending by loony politicians who only care about the here and now and not about the future.

Worse, increasing the amount of currency in the economy could cause the currency of the US to be less attractive to foreigners. And, a further result, foreigners may con- clude that investing in the US isn’t worthwhile because of an untrustworthy currency.

All of this could happen despite that Bernanke promised that QE money wouldn’t leak into the real economy. And it could get worse. The Fed’s latest announcement that it wants to shrink the size of its balance sheet will cause the country to enter a new phase. The Fed will not only turn over the profits it is making on those QE bonds but also have to turn over the bonds themselves when they mature.

At its peak, it looks as though the Fed will be ridding itself of bonds worth up to $30 billion a month, or $360 billion a year.

How will this be done? It’s simple and exceedingly complex at the same time. You’ll have to follow the bouncing ball to understand.

When bonds mature, the Fed will hand them back to the Treasury. The Fed will get cash in return. But then the Fed will be “stuck” with cash — instead of the bonds — on its balance sheet. That doesn’t accomplish what the Fed wants, which is to reduce its balance sheet and return to normal.

So, as it is obliged to do with its annual profits, the Fed will have to return that cash to Treasury as well.

Unless someone has another idea when this whole process is completed, the Fed will have turned over up to $3.7 trillion to the Treasury — it will keep on hand at least $800 billion in bonds. It will also hand over the profits that continue to accrue on those still-held bonds.

Now, let’s take this to the extreme and see how Washington could get rid of all its debt — and at the same time jeopardize the financial health of the country.

What if the Fed decided — maybe during the next recession — to create $20 trillion in e-cash so it can buy $20 trillion in bonds? Then it could go through the same process — create e-cash, buy the bonds, turn over the profits to Treasury and, in the end, turn over the bonds themselves. There would be no debt left. Zero!

But all that I’ve really done is create e-cash to pay off the debt. That’s a surefire way to create massive inflation, which nobody would want.