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Laurence J. Kotlikoff

Laurence J. Kotlikoff

Posted: August 25, 2010 09:24 AM

First, some background. The U.S. is bankrupt.

Don't take my work for it. Take the IMF's.

In its recent review of the U.S. economy, the IMF said "The U.S. fiscal gap is huge for plausible discount rates." And "... closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP." (See section 6 (PDF))

The fiscal gap is the value today (the present value) of the difference between projected spending (including serving official debt) and projected revenue in all future years.

To put 14 percent of U.S. GDP in perspective, total revenues currently constitute only 14.9 percent of GDP.

The Congressional Budget Office's Long-Term Alternative (i.e., honest) Fiscal Scenario projection shows, if anything, an even greater degree of insolvency. Using the CBO's spreadsheet, I measure the fiscal gap at $202 trillion.

Congress may cut some spending and raise some taxes, but it's not going to come up with anything close to 14 percent of GDP on an annual basis without radically reforming and simplifying our tax, retirement, healthcare, and financial systems, each of which is an incredibly complex and hugely inefficient mess. Congressman Paul Ryan's Roadmap offers such radical, simplifying, growth-promoting, and physiologically-inspiring reforms.

If Uncle Sam doesn't come up with a KISS (keep it simple, stupid) like Ryan's or mine (see my recent book, Jimmy Stewart Is Dead, including the Afterword), which entails ironclad control on growth in federal spending, Uncle Sam will be forced to make money the third-world way -- by printing it.

Let's consider this most likely scenario. I.e., let's consider the fact that Uncle Sam has a time-path of expenditures net of taxes, which he can only "finance" by printing money. I put the word finance in quotes because printing money is simply a way of imposing a hidden and subtle tax, which economists call seignorage.

In printing money and spending it, the government meets its obligations. But the extra money leads prices to rise by more than would otherwise occur. This reduces the purchasing power of the money and of the government bonds people already hold. And this loss of purchasing power of existing money balances and the decline in the real value of government debt represents the seignorage tax.

So monetary policy is a form of fiscal policy, and we have to think about the Fed's actions from the perspective of fiscal policy. If we take it as given that Uncle Sam will print money to "cover" his bills, the only question is when. He can print money today to pay off future bills or he can wait until the future to do so. Printing money today to buy long-term Treasury bonds is an example of the former. Sam can also print money today to buy assets that will generate income over time. The return on those assets can then be used to pay future bills.

For example, the Fed could print $9 trillion this morning and buy back all outstanding Treasury bills and bonds. (Note, the Fed would need to print more money if the price of these securities rose as it was buying them up). This afternoon, it could print, say, $25 trillion and buy up half the world's stocks. These two acts would make a big improvement in Uncle Sam's finances.

But the prices of goods and services would skyrocket and the dollar would lose all of its value. Worse, everyone would see they'd been taken and that they should never have held dollars or anything denominated in dollars. Overnight people would make the yuan, the Canadian dollar, or some other more trustworthy money the reserve currency.

So as much as Uncle Sam would like to print $9 trillion this morning and $25 trillion this afternoon and shave $34 trillion off his $202 trillion fiscal gap, he's not likely to do so for fear of exposing his racket.

Instead, Uncle Sam, actually, Uncle Ben (as in Ben Bernanke), has decided to print money to buy back U.S. bonds and to buy private assets, but on a smaller scale. We heard this week of the Fed's plans to further expand its "balance" sheet and purchase longer term U.S. Treasury bonds. The Fed also will, it appears, continue to indirectly purchase private assets, primarily in the form of mortgage-backed securities issued by Fannie Mae and Freddie Mac.

This makes sense. When prices are stable or falling, the ability of the public to see through to what's really going on is that much less. Indeed, exacting the seniorage tax is easiest when prices are falling because the public doesn't realize that had the central bank not printed so much money, prices would have fallen even further and they would have enjoyed a bigger increase in the purchasing power of their money and government bonds. I.e., when prices are falling and the government prints money, it effectively taxes holders of money and government bonds by limiting their real capital gains on these holdings.

Yes, this is very subtle, but that's what's going on.

So, to get back to the question of what monetary policy the Fed should be running right now, my answer is that if the Fed is ultimately going to need to print money to pay the government's bills, this is the time to do it or, at least, more of it. The danger, though, is that when the economy returns to normal, there will be so much money sloshing around that prices will rise dramatically.

The Fed is very worried about this outcome having printed $1,152 trillion since August 2007 and jacked up the monetary base by a factor of 2.4. Indeed, the Fed is so worried about this extra money getting into the economy's blood stream that it's been bribing banks to horde this money as excess reserves. The bribe is coming in the form of paying interest on the excess reserves. This bribe has also been used to pass money under the table to the banks so they could "earn" money in a completely safe manner and, thereby, remain solvent.

In worrying about inflation and in keeping the banks afloat via payment of interest on excess reserves, the Fed has undermined it's other objective, namely getting the banks to make more loans to the private sector. I think it's time to focus on that objective. Hence, I'd also recommend that the Fed stop paying interest on deposits and take the risk on inflation. Jobs, at this point, are more important than prices.