The Wall Street Journal recently reported that in 2011, the Federal Reserve purchased a mind-blowing 61% of Treasury debt issuance.
I'd wager that your average Joe Six Pack doesn't have the foggiest notion of what this means or why it is important. In this article, I will explain the consequences of the Fed buying Treasury debt and what it means for the future of the American economy.
When the U.S. needs money to fund its ever-expanding foreign interests, social welfare programs, or its war against dried flowers, it can obtain that money through a few different means. The least effective and most politically dangerous way for it to obtain money is to threaten American citizens with imprisonment if they don't fork over their dough. Historically, Americans have refused to hand over anything greater than 20% of GDP through taxes regardless of tax rates or the threats the state makes against their person.
Since the state has trouble getting Americans to hand over their money, it generally turns to the much easier second option to finance itself: printing money. In today's economy, the state prints money by issuing treasury debt. Normally it sells this debt to foreign nations, since this exports the inflation created by the issuance of new debt. However, there are natural limits to the amount of debt foreign nations are willing to hold.
The U.S. has reached that limit and then some. When foreign nations have had their fill of Treasury debt, no one is left to buy the Treasury debt that the U.S. state is looking to sell. When this occurs, interest rates rise in order to entice more people to buy the debt. However, the U.S. can not afford to have interest rates rise or it will bankrupt itself. Enter the Federal Reserve.
When the Fed buys debt, it is as if the government simply ran a printing press. All the inflation gets dumped on to the American public in the form of higher prices, such as we see with oil, food, and consumer goods today. This also has the effect of making foreign debt holders want to dump the debt they are still holding because inflation will outpace the returns they are getting on interest. This causes the Fed to buy ever more debt just to keep the interest rates from rising. Eventually this spirals into hyperinflation as the state tacitly defaults on the debt it owes the world.
Clearly the present situation is unsustainable. I contend that the U.S. will experience a currency crisis within the next few years. Sooner if it engages in yet another war with Iran.
The U.S. has enjoyed the privileged status of having the world's reserve currency which allows us to benefit at the expense of foreign nations by simply issuing new debt. This status will be going away shortly. China and other nations are already seeking to cut trade deals for oil and commodities outside of the dollar. China has stopped buying new U.S. Treasury debt and has begun reducing its holdings. Economist Gary North explains the dire consequences of this here.