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Burning The Candle At Both Ends: Raising the Debt Ceiling, and Extending QE-2 Indefinitely

This coming May 16, the U.S. Federal government debt ceiling will be breached; that is, the national credit card—currently topped at $14,294,000,000,000—will be maxed out. (Yeah, I know: It’s one thing to read “$14 trillion” and quite another to see the actual number, written out with all those zeroes.)

It’s not like lighting farts . . .

Shortly thereafter, the Federal Reserve’s policy colloquially known as Quantitative Easing-2 (QE-2)—whereby the Fed created $600,000,000,000 of new money, and used it to purchase Treasury bonds—will end.

These two issues seem to be miles apart—notice, seem to be. But they are as intimately related as yin and yang—Mickey and Minnie—Ritz crackers and cheese.
Both policies aim to prop up the sliding U.S. economy, each of them coming at this effort from different directions—one from the demand side, one from the supply side. And the suspension of either policy will result in the exact same thing—government shutdown, and default on the U.S. sovereign debt.

Don’t believe me? Let’s look at them each in turn:

On the one hand, the deficit is the product of fiscal stimulus, whereby the Federal government spends and spends so that the aggregate demand of the U.S. economy does not fall because of the economic slowdown.

The rationale is, as the economy slows because of the recession, and people spend less, the Federal government steps in with more deficit spending, to prop up aggregate demand. Thus, the overall demand in the United States does not fall, as the economy recovers. And when it is finally back on its feet, the private sector in a sense takes over the spending burden that the Federal government has been carrying.

That at least is the rationale.

Quantitative Easing, on the other hand, is the Federal Reserve’s efforts to prop up deteriorating asset prices—that is, inflate prices which have fallen drastically. They do this by overpaying for assets, and thereby giving these assets price support. The first iteration of QE was Fed money-printing to help support the prices of the so-called toxic assets, while QE-2 has been the Fed money-printing to help support the prices of Treasury bonds.

Asset prices are falling because they were overpriced to begin with—overpriced for the better part of two decades, thanks to the Fed’s easy money policies. When the bubble in asset prices finally popped, not only did asset prices fall, they also dragged down the rest of the economy—this is more or less what we’ve been experiencing for the last three-four years.

So basically, the Federal government and the Federal Reserve are burning the candle—ie., the economy—from both ends: The Federal government by way of “stimulus spending”, and the Federal Reserve by way of Quantitative Easing, the one trying to make the economy “grow again” by bouying aggregate demand to the tune of 10% of GDP, the other trying to halt asset price deterioration by printing money.

Did I say “burning” the candle from both ends? Excuse me, I meant to say, they are putting a blowtorch to the economy—and whistling Dixie all the while.

Now, QE-2 is set to end in June, while the debt ceiling will be hit in mid-May. With these two deadlines looming, there have been a lot of people who think that neither will be extended—or at least hope neither will be extended.

These people are living in dreamland: The debt ceiling will be raised, and QE-2 will be extended. Both policies will continue not because I happen to agree with either one of them—in fact, I don’t. Rather, both policies will be extended because—if they are not—the Day of Reckoning will suddenly arrive:

The Federal government will become bankrupt.

If the debt ceiling is not raised, then the Federal government will not be able to issue debt and get the cash to pay for its obligations—including Social Security, the military, Federal employee salaries, etc. Most important of all, if the debt ceiling is not raised, then the Treasury won’t be able to raise the cash to pay the interests on Treasury bonds—which means that the United States will, for the first time in 220 years, default on its sovereign debt.

And if QE-2 is not extended, then the Federal government will not be able to find buyers for its debt issuance—and therefore won’t be able to get the cash to pay for its abovementioned obligations, including paying the interest on the Treasury bonds.

In other words, we are about to hit the wall. And the clowns running the circus are going to do everything in their power to avoid that splatter.

So they are going to extend the debt ceiling and extend QE-2—because that’s the only way they know to avoid hitting that wall. That’s the only way they can keep the Federal government from shutting down—and the United States from defaulting on its sovereign debt.

Many conservatives think (hope?) that the Republican party in the House and Senate will kill the raising of the debt ceiling. These conservatives are wrong, because whatever fiscal principles the Republican party might have, they do not want to appear to be the ones who forced the government to shut down.

They learned from their mistake in 1995, when Newt Gingrich forced the government to shutdown briefly. The electorate blamed the Republicans, and handed them a solid defeat in the next election.

The Republicans won’t repeat that mistake.

Furthermore, the Republicans will not put themselves in the position of being the party that forced a sovereign debt default of the United States for the first time in 220 years.

So before the May 16 deadline, they might talk tough about “fiscal austerity” and “cutting back on the deficit” and all that other sensible-sounding talk—but when the chips are down, the Republicans will vote for a raise in the debt ceiling, regardless of all the talk. Because the Republicans will not let the Federal government shut down, and they will not allow the United States to default on its sovereign debt.

And as to QE-2 morphing into QE-3?

As I have shown elsewhere—and it’s not controversial or even debatable—the Federal Reserve has been monetizing roughly half of the fiscal year 2011 Federal government deficit by way of QE-2 and QE-lite (the reinvestment of the excedents from the asset purchases of QE-1). That is, the Fed has been printing half of the deficit, and giving it to the government, the Too Big To Fail banks acting essentially as the intermediary of this unholy trade.

Between QE-lite and QE-2, the Fed is purchasing roughly $100,000,000,000 a month in Treasuries, out of the roughly $150,000,000,000 a month the Treasury Department needs to fund.

The simple fact is, the Treasury Department does not have buyers who can replace the Fed. They simply don’t, no matter how you cut it. Skipping across the globe, we see that Japan, China, South Asia, the Middle East and Europe simply do not have the cash—or the inclination—to lend $100,000,000,000 a month to the Treasury Department.

If the Fed were to end QE-2 come June, prices of Treasury bonds would collapse—regardless of what some pundits are saying, vis-à-vis the “markets have priced in the end of QE-2” and other such happy daydreams.

And they are daydreams—the markets haven’t priced in the end of QE-2. If they had, then PIMCO and Bill Gross wouldn’t have this new-found phobia for Treasury bonds. Like I’ve said before, PIMCO dumping Treasury bonds is like Baskin & Robbins dumping chocolate ice cream. The only reason they would exit Treasuries is if they foresee the potential for a major price dive—which is exactly what would happen if QE-2 ends on schedule in June.

Now with regards raising the debt ceiling: Fiscal year 2012 starts October 1, and it’s looking like that year will be another deficit of about +10% of GDP—in other words, a deficit north of $1,400,000,000,000.

Some people I’ve talked to expect the debt ceiling to be raised incrementally, so that the Republicans can milk every raise in the debt ceiling between now and the November 2012 elections.

That’s a shrewd analysis, but I’m not sure about it. I actually think it’ll be one big boost of $2 trillion: Enough to cover FY 2011 and FY 2012, but have the issue conveniently rear its ugly head in the summer/fall of 2012—just before the elections.

As to QE-3 (the extension of QE-2): The Federal Reserve will have to continue printing at least $75,000,000,000 a month, and probably closer to $110,000,000,000 a month. Like I said, it’s all a problem of supply and demand: The Treasury will be providing too much of a supply of Treasury bonds for the market to sop up. The Federal Reserve is the buyer of last resort. The buyer of only resort.

So! What happens after the debt ceiling is raised, and QE-2 is extended indefinitely?

Nothing.

Not immediately, at any rate.

Bonds prices will remain stable. There might even be a bump up, from shorts covering. Stocks might jump a bit, on the “good news”. Commodity prices will continue their steady, relentless rise.

So it will all seem so very, very “normal”, after the two policies are extended.

The only thing that will continue rising is consumer prices. And housing prices will continue to fall—in fact, there’ll be a continuing rise in defaults, as rising consumer prices put the squeeze on mortgaged homeowners.

And when the new debt ceiling is reached, and QE-3 ends? What then?

Why, they’ll be extended again—of course.

See, politically, it is always much easier to continue a bad policy—even a terrible policy—if it will avoid an imminent crisis.

The imminent crisis we got: The shutdown of the Federal government, the sovereign default of the United States. If the debt ceiling isn’t lifted, the government will shut down and default. If QE-2 isn’t morphed into QE-3, then the Treasury won’t find enough buyers for its issuance, so then the government will shut down and default.

If the choice is between having the government shut down and default on its debt, and kicking the can down the road, then there’s really no choice at all: Kick the can down the road! Extend QE-2, and raise the debt ceiling—full speed ahead!

Now of course, what will happen if this particular can is kicked down this path to oblivion? What will happen to the United States as it gets into more and more debt, while printing more and more money?

Guess.

If you’re interested, you can find my recorded presentation “Hyperinflation In America” here. I discuss in detail what I would do, if and when the dollar crashes.

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