Be Afraid: Conclusions from The Federal Reserve of St. Louis

3
2074

The Conclusion from The Federal Reserve Bank Of St. Louis warns of the impossible arithmetic the United States faces. The trend of US Government Debt to GDP will be outrageously high.

[We’re becoming the Weimer Republic. In ten years, we will have $50 trillion in debt thanks to all the spending now.]

The conclusions of the report from the Reserve, titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, should terrify you.

CONCLUSIONS

As the result of the high current US government debt-to-GDP ratio and continuing projected deficits, we face a possible dollar inflation uncertainty nightmare: Continuing deficits, if unchecked, eventually will lead to a fiscal dominance problem. This problem seems likely, given the way Congress has behaved in recent years. A significant rise in long-run real interest rates also seems quite possible, given that the three decades of decline in real interest rates are poorly understood and may reflect tem- porary demographic influences. Such an environment would hasten the triggering of a fiscal dominance problem, leading to a messy monetization in the US, with ramifications worldwide.

Many things would likely change in a fiscal dominance scenario to make the inflation tax base larger to facilitate the funding of continuing deficits with less of a rise in inflation. Interest on reserves would likely be eliminated—otherwise, monetization would do little to relax the constraint on the government. Inflation would rise, potentially by a large amount, if that is the only policy used to create inflation taxation. If the elimination of interest on reserves were accompanied by a new large reserve require- ment, inflationary consequences could be much lower.

Dramatic Effects on Banks, Mutual Funds, Pension Funds

If the bond market does not anticipate a fiscal dominance shock sufficiently far in advance (where the definition of “sufficiently far” is determined by the duration of bonds held by the public), then bond investors would be caught with losses on high-duration bonds. All of these changes imply that the effects on banks and mutual funds and pension funds and others would be potentially quite dramatic.

In the 1970s and 1980s, major financial disintermediation from banks accompanied the rise in inflation taxation because rising inflation reduced the real rate earned on bank deposits. Similar pressures to disintermediate banks could rise again as the result of a rise in inflation taxation. If that occurs, however, banks and their political allies will redouble their efforts to use regulation to protect the bank- ing system from innovation and competition, as they have already been doing (see Calomiris, 2021). Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness.

They Won’t Address the Real Problem

What bearing does the most recent debt ceiling agreement have on the prospects for fiscal reform to avert monetization and inflation? The agreement was largely beside the point because it focused on government expenditures that are not related to Medicare, Social Security, or defense spending. Indeed, by doing so, it reinforced the view that there is no appetite for addressing the exploding deficits that are being driven by those categories of spending.

[Our stupid politicians won’t do a thing to stop this. We’re not even talking about BRICS here.]


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