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Following the Money on the Deficit

This article was written by Francis Cianfrocca of The New Ledger.
So we have the Chinese that have roughly a $30 billion per month current account surplus against us. (Never mind how remarkable it is that this number is about 3% of GDP.) That surplus has to find its way into US assets somehow. That accounts for perhaps a third of the bid for Treasury debt that represents new issuance rather than rolls of existing debt.

The new issuance amounts to something like a trillion and a half dollars a year. That's the real amount of the federal budget deficit, shorn of the various bullshit stories that the president tells to make it sounds a little better than it is. This is the amount that is added to our public debt, which needs to be financed permanently (at unpredictable interest rates) or get paid off someday.

That trillion-plus dollars also represents spending in the overall economy. You can't deny that it's pumping up nominal GDP. You can very well deny (and I do) that it represents money well-spent or efficiently spent, on goods and services that actually improve people's lives or (God help me, but this sounds old-fashioned) reflect people's free choice as to what they want to spend money on.

But where's all that money coming from? Who are the investors that are willingly and freely lending a trillion-plus brand-new dollars to the U.S. government this year?

A lot of the money is coming from US banks. They get funds from the Federal Reserve in the form of overnight reserves, and then turn around and lend the money to the US Treasury by buying bills, notes and bonds. You can make a significant amount of money without taking any risk doing this, which means it's a very efficient use of bank capital, which in turn makes it very profitable.

This is a traditional way of getting the banking system healthy again after recessions, and it's also one reason why investors have been bidding up the stock prices of too-big-to-fail banks lately. It's going to take a lot longer than usual this time because the capital losses were unusually large, but it'll still work.

In the meantime, though, the Federal government has a ready source of funding for fiscal deficits. The Chinese are only supplying a relatively small piece of the new money we have to borrow every month. They only have to buy as much as their surplus amounts to. Under the previous Administration, when deficits were never bigger than a third of what they are now, the Chinese in some years couldn't buy enough Treasury paper to meet their needs (that's one reason why the yield curve inverted at mid-decade). Now, they'll never have any trouble. But again, they're nowhere near the whole amount.

The ultimate source of the money funding a very large part of the budget deficit is the Federal Reserve itself. The steep yield curve is making high deficits possible.

This would be entirely defensible and probably sustainable IF high deficit spending was intended solely as a temporary measure to get us out of recession. That indeed was the rationale for the $800 billion stimulus package we got a year ago.

But now the economy is out of recession, and we're STILL projecting trillion-plus deficits for the rest of the decade. We're mainlining on low-cost borrowings from the Fed to fund this spending, which isn't countercyclical at all. Instead, it's going to be about expanded entitlement spending, and (presumably) brand-new spending on health insurance, anti-carbon energy policy, and education subsidies.

At some point, the yield curve won't be able to keep funding those deficits. Bank balance sheets will become healthy enough to start funding riskier (and thus more profitable) lending. When that happens in normal recoveries, there's no problem because fiscal spending winds down as, by definition, it's not needed anymore.

But this government is now addicted to cheap borrowing. We're either going to have a nasty cold-turkey event in the medium-term, or else we'll never get out of this low-growth period. Either outcome is possible.

By Francis Cianfrocca:
Reprinted with permission from The New Ledger.