The Shell Game and the Pied Piper

by Richard K. Brawn, CCGA, MPA | September 22, 2008

The Pied Piper knows exactly when to appear. It is when the last shell is lifted and there is no pea beneath it, either. Secretary Paulson has just lifted the last shell…

The Regan image of a thousand points of light has gone out leaving only a few to light the way. We completely lost our way in the debt forest. We completely forgot that debt requires a lender who must forego consumption and the borrower must INVEST that which is borrowed so it can produce the income necessary to repay the lender. The current concept of debt is “somewhat” different. The current concept is that lending does not need to start with savings. Instead, the capital needed by a borrower can be printed. The borrower then invests the newly minted money. The borrower then repays the principle on the loan and the interest. The money used to pay the principle is then torn up and the money supply is not inflated. Part of the interest payment stays in circulation as an increase in the money supply. The increase in the money supply is justified because the investment by the borrower has caused the economy to expand by an amount equal to the interest payment. Another part of the interest payment pays the principle on lending that went bad. In order for the money supply not to increase, the principle due on the bad loans has to come from somewhere.

According to this theory, the money supply can be held stable by actions of the FED to drain or increase the money supply by selling or buying Treasuries. So what happens when the Politicians borrow $700 billion? Where does that money come from? Let’s assume that the new paradigm about lending actually works. That $700 billion will be “temporarily” printed. The Treasury will use the income received from the various types of paper that it buys with the $700 billion to slowly get rid of the excess $700 billion. This would be done by receiving the payments and destroying the dollars as they come in until the $700 billion of “temporarily’ printed money is eliminated. But, wait a minute. Those loans are already non-performing. Suppose 10% of the paper that the Treasury buys end up paying nothing toward wiping out that excess $700 billion. Where does the $70 billion that is a real loss come from? It has to come from that tiny tranche of the interest on other loans that are performing.

But, since this is government, then tax collection can be used to destroy some of the $700 billion that the FED minted. Maybe not!! The problem is that revenues of government come nowhere near meeting the expenditures. So where does the tax money come from to pay the $70 billion?

Perhaps one should try another scenario. Instead of printing the $700 billion, suppose the government borrows the $700 billion from “the market”. From whom does the government borrow that kind of cash? Two sources exist. One is private individuals but that would jack up interest rates. The other is to turn to a foreign central bank. Let’s use the country of Bongo to do the job. Its currency is the Bongo Buck and ten of these currency units would appear as B 10. Bongo prints lots of their currency and uses that newly minted currency to buy US Dollars from the FED. The FED uses that newly minted foreign currency (B 700 billion) as an asset to back the printing of new US Dollars. So in the end, the FED has $700 billion in Bongo Bucks issued by the Bongo central bank on the FED books and the central bank of Bongo $700 billion in US dollars to back the issuance of the Bongo Bucks. Bongo then lends the Treasury the $700 billion. So instead of actual cash dollars on their balance sheet, the country of Bongo has Treasuries worth $700 billion to back their newly minted Bongo Bucks. Where did the Bongo Bucks end up? First they went to the FED that now holds B 700billion. So the Bongo Bucks are not floating around anywhere. But the $700 billion is now in the hands of the Treasury and will most certainly be floating around in the US markets as the Treasury buys non performing paper.

The Federal Reserve Bank is responsible for managing the money supply. If there will be a sudden increase in money supply coming from the Treasury, the FED would be obligated to remove it from the banking system. In theory, the banks and others would be giving up the illiquid paper and receiving dollars in exchange. The FED could drain that same amount from the money supply by selling treasuries that it owns. It could also raise bank reserve requirements. But, doing so would takes money from the working part of the banking and financial system. Draining money from the banking system would work against creation of additional money for lending. So, will the FED do that? Then there all those Bongo Bucks held by the FED and what will the FED do with those? The Treasury is on the hook to service the treasuries sold to Bongo. Possibly the Treasuries will be serviced using payment in Bongo Bucks rather than US dollars in order to keep the money supply more stable.

But, what will be the effect of all the systemic leakage and congressional interference? What is the cost to the economy of having $700 billion tied up in something that produces no new economic goods and services, and still have to pay interest on that $700 billion? Revenues to pay for all of this must come from somewhere but cannot come from tax revenues. All revenues are completely committed elsewhere and the fiscal deficit is already at too high a fraction of the GDP. Then there is the Gordian knot called the $60 trillion unfunded liability coupled with declining productivity due to demographics.

My purpose of writing this essay is to show that there is no scenario in which the $700 billion does not heavily impact the money supply. Every penny of the US dollars used to sop up the paper clogging the banking and financial system will appear on the streets (Wall & Main) and compete with every other dollar held by consumers for goods and services.

Contact Information

Richard K. Brawn, CCGA, MPA | Petaluma, CA USA | Email
California Certified General Appraiser (CCGA) | Master Public Administration (MPA)