When I first started making more money than I was spending, I asked my partner to recommend someone to help me do my taxes. “You should speak to Sid,” he told me. He does my taxes and he’s good. Plus, he got rich as an accountant, and that’s not easy to do.”
Sid was his father-in-law. He must have been in his 60s back then, in the early ‘80s, but he looked older. He was tall and gaunt with an angular face and thin gray hair. He was shocked when he discovered how little I knew about money.
Perhaps for that reason he adopted an avuncular attitude towards me. He advised me on taxes, but that was just the beginning. He quizzed and lectured me on sales and marketing and business communication. And he advised me on investing, too.
“Why are you spending all that money on art?” he would exclaim. “It’s just decoration! Just pictures on the wall!”
He failed to dissuade me from collecting art, but he was a big influence in helping me develop a philosophy of wealth building. “You’re making good money now, kid,” he said after I received my first big dividend. “But if you’re not smart, you can lose that much and more with a single stupid move.”
Sid had been a very aggressive businessman (as was his son-in-law). But when it came to investing, he was a conservative as one can be. He bought for himself and recommended to me only two asset classes: triple-A municipal bonds and Treasury bonds.
“What about stocks?” I frequently asked him.
“Stocks are for shmendriks and schmucks,” he’d howl. “Bonds! Buy bonds!”
The Corona Economy, Part IV
War, Debt, and the Eve of Destruction
“I found this national debt, doubled, wrapped in a big bow waiting for me as I stepped into the Oval Office.” – Barack Obama
In Part I of this series, we looked at our government’s financial situation the way an investor would look at the financials of a business. The conclusion: From a P&L and balance-sheet perspective, it looks awful.
In Part II, we saw how much worse those financials are going to be at the end of this year: a bigger deficit (by $6+ trillion), a smaller GDP (by about 20%), a much larger debt (around $30 trillion).
In Part III, we rued the fact that these facts are not understood by 98% of the voting public, and are misunderstood and/or ignored by 80+% of our elected officials and the media that report on what they’re doing.
And in case you’d want to be one of the 2% of the population that does have at least a basic understanding of how money works at that level, we provided an introduction to US fiscal and monetary policies (as we understand them). Today, we continue where we left off.
The Idiot’s Guide to Monetary and Fiscal Policy in the US (continued)…
When our government spends more money than it takes in, it covers the difference (the deficit) by borrowing money. It does that through its Treasury, which sells bonds (government IOUs) for the dollars it needs for its overspending.
Treasury bonds are attractive to savers and investors for two good reasons. (1) They are generally considered risk-free because they are “backed by the full faith and credit of the US government. And (2) as “fixed-income securities,” they provide the investor (bond buyer) a guaranteed return paid out on a predetermined basis.
Guaranteed returns by the world’s largest and “strongest” economy? Of course there will be a big demand for T-bonds. Individuals want them. Banks want them. Pension funds want them. Even foreign countries want them. Not necessarily as a primary investment, but as an asset they can count on when everything else is in flux.
Whether the bond buyer is a retired plumber or a sovereign nation, Treasury bonds promise a solid foundation for any portfolio, providing a sense of security that’s the next best thing to gold. Think about it. Holding T-bonds is like owning a share of America! So long as America doesn’t declare bankruptcy, those IOUs will pay off.
A Wee Bit of History
The history of US debt is the history of its wars. Before the Civil War, the national debt was relatively modest, because before then there was no income tax. Wars were funded with sales taxes and the like.
The Civil War changed that. Between 1860 and 1866, the debt rose from $64.8 million to more than $2.7 billion, approximately $42 billion by today’s standards. To keep the nation whole, President Abraham Lincoln pushed debt to nearly 30% of gross domestic product and introduced the first income tax in American history.
After that, every war led to ever-higher debt levels. WWI elevated the national tolerance for federal debt, bringing it to $27 billion. More importantly, Woodrow Wilson changed the way debt was approved. Congress’s previous approach was to approve each bond sale individually. Wilson introduced the “debt ceiling,” whereby the US Treasury was told how much it could borrow overall and the administration was allowed to manage the sale of individual rounds of debt. This law has remained in place ever since.
President Franklin Roosevelt made a big “contribution” to raising our debt through the New Deal, elevating borrowing to over $40 billion to fight the war against the Great Depression — nearly doubling the national debt when he took office.
WWII was the next big step in the history of US debt, with the government spending more than $323 billion ($5.8 trillion in today’s money) to defeat Germany and Japan. Much of that money was borrowed. And between 1940 and 1946, US debt climbed from $42 billion to $269 billion, much of it held by individual Americans in the form of Treasury bonds.
But between 1965 and 1978, two more “wars” dramatically boosted the national debt. One of them, from 1965 to 1975, was the Vietnam War. The other one began in 1966 when Lyndon Johnson signed the Medicare program into law. Like the Vietnam War, it was a battle we would not win. But unlike the Vietnam War, the costs of fighting it have never ended or even diminished.
Since then, the national debt has not stopped growing. It grew under President Reagan and under George H.W. Bush and Bill Clinton. (Although the rate of growth slowed considerably after Clinton got Congress to enact tax increases early in his first term.) In the year 2000, our government went into the new millennium with a debt of $5.65 trillion.
Debt slowed a bit in the 1980s and 1990s. Then, on Sept. 11, 2001, President George Bush Jr. spearheaded yet another war – the war on terror. But the invasions of Afghanistan and Iraq were not funded by additional taxes. They were funded by debt, growing at a rate of $400 billion to $500 billion per year.
The Great Recession of 2008 brought deficits beyond the $1 trillion mark. And under Obama, that continued, although it did diminish by more than half during the second half of his presidency.
Then, in 2018, Donald Trump was elected president. Many hoped he would reduce spending, but that didn’t happen. Instead, he oversaw a deficit increase to $1.3 trillion during his first full year in office.
And now we have the war on COVID-19.
Bartering for Dollars
All of these wars since the Civil War have been funded by government debt. Initially, it was private citizens and businesses (and wealthy industrialists) that bought that debt. But in recent decades, it was foreign countries – countries like Germany, Japan, Saudi Arabia, and China – that were producing budget surpluses and looked at Treasury bonds as a safe haven for their extra dollars.
Germany was an early buyer of bonds. Japan became one soon thereafter. As the years passed, other countries became big buyers. When Saudi Arabia discovered it was sitting on an ocean of oil, it could think of no better way to save its excess dollars than by parking them in T-bonds, backed by the full faith and credit of the USA. After China abandoned government ownership of all businesses, it rapidly became a net surplus economy as well. And it, too, invested its extra dollars in US Treasury bonds.
Which is why you’ve probably heard some people say that the US dollar (and, actually, the American economy) has been supported in the last two decades by Germany, China, and Saudi Arabia.
But surpluses come and go. And about 6 years ago, China changed its priorities vis-a-vis saving its surplus wealth. It continued to buy Treasury bonds, but it also began to buy large amounts of gold. And perhaps more importantly, it began a massive investment in its own infrastructure and overseas ambitions.
“Luckily” for our government, large financial institutions (and particularly hedge funds) began buying (and trading) billions in US debt at the time. This increased the supply of dollars bidding for the T-bonds and, thus, kept the rates down to reasonable levels.
But in the last year, this supply of dollars diminished. That, and the continuing reduction in demand from China, put the Treasury in a terrible situation. If the supply got too small – less than the demand for dollars (our deficits) – it was possible that the Treasury couldn’t keep up with its payments. That would mean a literally bankrupt USA. And that would mean the end of the world’s economy, as we know it.
In Greek tragedy, the hero is sometimes saved by a deus ex machina – i.e., an intervention by the gods. For America, that came in the form of the Federal Reserve. To make up for the reduced demand from bonds from our traditional buyers, the Fed began buying bonds itself.
Now you may be wondering how the Fed can afford to buy bonds. After all, it is a semi-autonomous central bank that is required by law to balance its books.
Here’s how Tom Dyson explains it:
“The Fed doesn’t ‘inject’ money supply into the economy. Instead, it ‘trades’ it or ‘swaps’ it via transactions with the entities it’s giving the money to. So, for example, if the Fed wants to give the government some fresh money, the government must give it some Treasury bonds. If the Fed wants to give a bank some fresh money supply, the bank must give it something in return.”
It’s called “quantitative easing.” And that’s how the Fed balances its books. It sits on a pile of collateral representing every dollar it has printed and “traded” for something.
Tom again: “Basically, the Fed is a bank that makes huge loans and takes collateral. And the collateral serves as its capital base.”
That is all good and dandy so long as the Fed can unwind these trades when the economy has stabilized by returning the collateral and receiving the dollars back. But recently, the Fed has moved into uncharted territory – making loans whose collateral is questionable, at best. For example, the Fed has recently started accepting the equivalent of junk bonds as collateral. There’s even talk of the Fed purchasing equities with its printed money.
Quantitative easing, as it was done after 2008, was a way for the Fed to help the banking system and lift the stock and bond markets. Back then, the Fed was giving dollars to banks and helping them grow. This was great for the banks and for Wall Street, but it wasn’t good for the economy because the great majority of those QE dollars remained within Wall Street.
About a year ago, the Fed began doing something it hadn’t done since April 1942. It agreed to monetize the government debt. The government’s need for dollars was at all-time highs. But because the usual buyers of T-bonds (foreign countries and, more recently, hedge funds) were reducing their buying, a crisis developed in the Repo Market – a critical market where the government finances itself with short-term loans. There was a “shortage of dollars,” as many analysts put it. A dangerous thing.
So what the Fed did was step into the gap and start buying T-bonds. Billions and billions of T-bonds daily to prevent interest rates from skyrocketing, which would then skyrocket US debt payments and put the Fed on the verge of bankruptcy.
As Tom put it:
“There are no more lenders. So the Fed is now being forced to assume the role of ‘lender of last resort’ to the Treasury… financing the US twin deficits and monetizing the Treasury’s debt. All with printed money!”
Quantitative easing is problematic for many reasons, but it didn’t erode the value of the dollar after 2008 because the stock market went bullish and stayed bullish until this year. The world and its economists, its politicians and its journalists took the rise of the stock market and the modest (3%) rise in GDP as a sign that the US economy could be trusted again. But what the Fed is doing now is different. It is not trying to save Wall Street. It is trying to save the Treasury itself. As Tom put it, this new strategy is “Project Argentina.” [See “Worth Reading,” below.]
On Friday, I hope to finish this series of essays on The Corona Economy. I’ll talk about how this new desperately-seeking-recovery strategy will put our government in an impossible situation that can only be resolved by a miracle or a long and devastating economic depression. And how you can both gird yourself against economic disaster and, at the same time, invest in the miracle that could be.
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