The beginning of the end

The U.S. Federal Reserve is going to buy about $1.2 trillion (yes, trillion) of government debt to help boost the economy. On the surface, this looks like a great move to add liquidity to the market and get things moving again. How can $1.2 trillion of cash not make money easier to get?

The U.S. Federal Reserve does not just have $1.2 trillion sitting around, they printed it. Printing money reduces the value of the U.S. dollar and more money in the economy is going to create inflation. Since the announcement of this purchase, the price of gold has increased substantially and the value of the U.S. dollar has dropped against all major currencies (information gathered as of about 4:00 PM CST on March 19, 2009). This is a major problem for the U.S. because once inflation starts to take hold, they’re going to have to raise interest rates to keep it in check (see: 1980s). This is going to increase the cost of borrowing, slow economic growth, and cripple the U.S. economy.

But this isn’t even the worst part. Yeah… they printed money… but why does the U.S. Federal Reserve have to buy the U.S. government’s debt in the first place? The U.S. has been issuing debt to countries around the world for years. They’ve had a trade deficit every year since 1991. When you run continuous trade deficits, you run out of cash on hand pretty quickly. This leaves debt, the promise of payment in the future, as the only way to pay for all the stuff you’re importing.

So what’s the big deal? Well, why couldn’t the U.S. get Saudi Arabia to accept $1.2 trillion for oil or China to accept it for… well… anything? These things are as good as cash because the U.S. would end up buying them anyways. This payment plan, as it is, has worked for years. The problem however is exactly that: it has worked for years.

The only reason Saudi Arabia, China and the rest of the world accepted U.S. debt as payment is that they had confidence in the fact they would eventually get their money. With the U.S. having over $10 trillion in debt, desperate bailout plans, and no hope of returning to surpluses in the foreseeable future, how can the rest of the world have any confidence in being repaid at all? The answer is, they can’t, and they’re starting to realize it.

The U.S. is too. That’s why they had to buy the debt themselves.

So how are they going to make their debt more attractive? Yep, you guessed it, raise interest rates. The riskier the investment the higher the return must be for the investor. So, the more risk there is that they will not be repaid, the greater the return other countries will demand on their loans.

Like I said before, raising interest rates, whether to curb inflation or make debt more attractive, is going to grind the U.S. economy to a halt. People can barely afford to borrow money at the current rates around 0% to 0.25%. A rate of 1% or more is going to cause a panic.

But there’s no other option. The U.S. has nothing anyone else wants. So they either raise interest rates and destroy their economy, or leave them low and start turning away ships at their ports.

There’s no easy solution. Heck, there may not be any solution. The best the U.S. may be able to hope for is the ability to see this coming and prepare, somehow, to ride it out.