To Solve the Debt Ceiling, We Must Solve the Dollar

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Both sides of the political aisle keep talking about the debt ceiling showdown in the context of financial Armageddon. That was certainly how Treasury Secretary Geithner put it in a letter he penned to House Speaker Boehner. Absent a Republican/House-led effort to give the Treasury Department flexibility to borrow above the statutory limit set only a little more than a year ago, Geithner believes that all manner of fiscal Gremlins await the credit system.

The talking point on the Democratic side seems to be that failure to budge is the equivalent of default. Secretary Geithner characterized it as,

"Even a temporary default with a brief interruption in payments that Congress subsequently restores would be terribly damaging, calling into question the willingness of Congress to uphold America's longstanding commitment to meet the obligations of the nation in full and on time."

The consequences of this "default" scenario seem to be obvious, particularly to the conventional consensus of the media. Geithner, in an obvious yet blunt expectation, spelled out his scenario of "default":

"Interest rates would skyrocket. Instability would occur in financial markets and the federal deficit would soar."

It is very curious that the Treasury Secretary would appeal to the base prospect of higher deficits due to interest rate increases and debt payments. For the recently concluded fiscal year of 2012, total interest expense reported by the US Treasury was just under $360 billion. That amount itself seems massive (and it really is, in any meaningful context), but, in spite of a run of trillion dollar deficits since fiscal year 2009, that 2012 interest expense is actually far less than when the total debt was far lower.

We paid $451 billion in interest in the fiscal year 2008. The average interest cost for total interest bearing debt at the end of fiscal year 2008 was 4.188% (not counting, according to the Treasury calculations, TIPS averages). That was down remarkably from fiscal year 2007 which saw an average cost in September 2007 at 5.009%.

By way of comparison, the average interest cost in December 2012 was 2.523%, down about 30 basis points from December 2011.

The dramatic decline in interest cost allowed the US government to increase total debt outstanding from just over $10 trillion in September 2008 to about $16.4 trillion currently without a serious increase in strain on the US treasury budget. Our elected leaders were afforded a crisis-driven opportunity to move into position where a small increase in average interest cost will devastate our fiscal position.

For his part, Federal Reserve Chairman Ben Bernanke stated on October 1, 2012, that his private agency was not "monetizing" the national debt. In his words, the distinction between QE's and outright monetization boils down to whether or not QE is a permanent source of financing government spending.

"In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size."

Setting aside the fatuousness of a monetary program that buys government debt from primary dealers only days or hours after they have been auctioned to the "open market", Mr. Bernanke's assertion is, on its face, wrongly construed in the context of interest costs. His single-minded purpose toward ZIRP (zero interest rate policy) and extending the Fed's heavy hand of intervention down the yield curve has sourced the Treasury's budget with enough interest rate cover to make a 64% increase in debt barely noticeable in the fiscal calculation. Maybe he is right as far as his semantic approach to monetizing debt, but even he cannot deny this interest subsidy.

Monetary intervention is, and has been for decades, the finger on the interest rate scale of the Treasury budget. Mr. Bernanke's argument devolves into nothing more than sophistry as the real world of national debt and fiscal reality demonstrate the obvious trajectory when such a subsidy exists.

That subsidy has only been more obvious under ZIRP than in the pre-crisis period, but that does not mean it was absent. Ever since the gradual replacement of the traditional depository banking system by the investment banking/shadow market/derivative system, particularly after the adoption of Basel rules in the early 1990's, there has been an undercurrent of "unearned" demand for government debt.

By placing OECD government debt at the top of the bank pyramid (with its zero risk-weighting), demand for deficit financing has been driven by the banking system's desire for monetary expansion more than consideration of US fiscal finances. The term "bond vigilante" does not apply to a banking system with the US dollar as reserve currency and a massive need to collateralize dollar-denominated financial arrangements (from repos to interest rate swaps). Mr. Bernanke's ZIRP has only given an obvious push to the financial system's growth in bond appetite wholly unrelated to actual credit conditions of the US government.

Without any significant market restraint to interest rate costs, political administrations of both parties have been given nearly free reign (from market forces) to borrow. So it is more than disingenuous for Secretary Geithner to appeal to bond vigilantism now as the blunt force of some assumed market-based effort to force Republican hands on the debt ceiling. Is it any less believable that a QE 5 would be instituted should any of the terrible promises of Geithner's letter actually be fulfilled?

Disruption is not something that Chairman Bernanke will countenance at this stage. The Federal Reserve has made interest rate policy, and thus directly affected net interest costs, since the late 1980's. Debt ceiling or no, Bernanke is determined, wrongfully, to impress upon the financial system dollar repression by any means. If the economy worsens still further, all the more "liquidity" to enter the financial system, and thus embedded demand for US debt.

In these terms the debt ceiling itself is almost meaningless. The fiscal position of the United States is gamed not by Congressional or even administration abdication of responsibility, though that is certainly part of it, but by the monetary system that has removed the most crucial and relevant checks upon the power of unfettered deficit financing. The growth in "big government" is the symptom of monetary imbalance and banking "evolution".

The politics of the debt ceiling really should be concerned with monetarism rather than focused solely on spending or deficits. But that is a hard position for either party to take. Democrats won't because their interests are aligned with monetarism, while Republicans have at many times embraced monetarism with equal passion. Neither seems to want to move outside conventional economics that salutes as policy success a 64% increase in total debt without any perturbation in interest costs.

We have not just a fiscal problem, but a persistent and massive monetary imbalance through dollar debasement that is directly related to both the debt disaster and the weak economy. Without directly facing it and working toward currency stability, we will be stuck with both the continued debt trajectory and no real growth. Neither can be adequately solved without first solving the dollar by ending capital repression.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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