The Federal Reserve is the engine that drives the biggest government in history.
Without the central bank’s machinations, the U.S. government wouldn’t be able to borrow and spend to the extent that it does. Congress wouldn’t be able to sustain deficits running in the trillions of dollars year after year. Instead, it would have to rely on direct taxation and borrowing smaller amounts for shorter terms. Because higher taxes are politically untenable, the government would be forced to constrain its spending, putting a natural check on both the warfare and the welfare state.
But with the Federal Reserve monetary operation in play, the government can borrow and spend far more than it otherwise could. And that means the government is far bigger than it otherwise would be.
HOW WE PAY FOR GOVERNMENT
To understand the role of the Federal Reserve, you have to understand how we pay for government.
The first crucial point is government is never free. Every penny the government spends comes out of the people’s pockets.
Direct taxation serves as the most honest funding source. In this scenario, the government collects money directly from the people and uses it to pay for programs and expenditures. It’s money in, money out. It’s the most honest way to fund government because the people can clearly see the amount they’re paying.
The problem is direct taxation isn’t popular. The government can only push taxes so high before the people balk. You’re far more likely to hear politicians talk about cutting taxes than raising them. Even those who push for tax increases emphasize they don’t mean raising them on the “middle class” or the poor – by far the majority of the population.
To make up the shortfall between sustainable taxation and spending, the government turns to borrowing. This effectively kicks the can down the road. Nobody has to pay today, but eventually, the people who buy the bonds – the lenders – have to be paid back. The taxpayers of the future foot the bill. Meanwhile, the taxpayer of today still has to pay the interest on the borrowed money.
Borrowing is more popular with politicians because taxpayers perceive it as less painful. But borrowing also has its limits, and the federal government has pushed far beyond it.
Enter the Federal Reserve.
HOW THE FED BACKSTOPS BORROWING
The U.S. government borrows money by issuing Treasury notes and bonds. Banks and financial institutions around the world buy Treasuries at auctions. After an allotted amount of time (2,10 and 30 years are common), they get their money back plus interest.
Banks and financial institutions hold some Treasuries on their balance sheets and sell some on the open market. For instance, a bank may buy a bunch of Treasuries, hold them until the price goes up, and then sell them to another investor for a small profit.
The investment community considers U.S. Treasuries one of the safest investments. The rate of return is pretty low, but most people assume the U.S. government will never default. You won’t make a fortune investing in Treasury bonds, but they believe you almost certainly won’t lose your money. Because bonds are a popular investment vehicle, the U.S. government can issue a lot of them. But as with anything, bonds are subject to the law of supply and demand. If the government issues too many, the price will fall, and the yield (interest rate) the government has to pay will increase. Higher interest rates mean bigger profits for investors. As rates rise, it entices more people to buy bonds.
But rising rates pose a problem for the U.S. government. They push up interest expenses meaning it costs Uncle Sam more and more to borrow. This theoretically puts a cap on borrowing since interest expense can only rise so high and remain sustainable.
This is where the Federal Reserve steps in.
As the government floods the market with bonds, there simply isn’t enough investor demand to sustain the borrowing, so the Fed eases the supply pressure. With an operation called quantitative easing (QE), the Fed creates artificial demand for bonds in the marketplace and holds interest rates artificially low. This allows the U.S. Treasury to issue more bonds than it otherwise could at a lower interest cost.
THE MONEY PRINTER
How does the Fed pay for these bonds?
By printing money.
The central bank doesn’t literally print $100 bills in the basement of the Eccles Building, but the effect is the same. The Fed creates digital money, sends it to the seller, takes possession of the bonds, and then holds the Treasuries on its balance sheet. This process is called “debt monetization.”
For instance, during the Great Recession in the wake of the 2008 financial crisis, the U.S. government ran trillion-dollar deficits for the first time. During that time, the Fed expanded its balance sheet by more than $4 trillion. It ran a similar operation during the pandemic. In effect, the Fed monetized every dollar borrowed in 2020.
Theoretically, the Fed would only hold these bonds temporarily. At some point, it would sell the bonds back into the market and suck up that excess money that it created. When Ben Bernanke launched the first round of quantitative easing in 2008, he swore it wasn’t debt monetization. He said it was an emergency measure that would be unwound. You’ll be shocked to learn it was never unwound. Between 2008 and 2021, the Fed added $8 trillion to its balance sheet, injecting an equivalent amount of new money into the U.S. economy.
The Fed has to frequently intervene like this or the bond market would completely melt down. Without the central bank’s big fat thumb on the market, bond prices would tank and interest rates would skyrocket. This is a simple function of supply and demand. With the U.S. government on a massive spending spree and borrowing billions every month, there are simply too many Treasuries being issued for the market to absorb. The Federal Reserve has to always be at the ready to backstop U.S. government borrowing.
Even when the Fed isn’t running QE, it often still buys Treasuries to hold its balance sheet at a steady level. As bonds mature, the Fed buys new Treasuries to replace them, keeping its thumb on the market. The only time the Fed shrinks its balance sheet is when price inflation gets too hot.
Why does this matter?
When you step back and look at the numbers, it becomes clear that repaying the national debt is impossible – not with money that has any real purchasing power. In fact, the debt has grown so large that if we had a market-based rate of interest, the government would struggle just to make the interest payments. So, the only way left for the government to fund its expenditures is through an inflation tax.
All of this money creation is inflation by definition. As the Fed injects more and more new money into the economy, prices go up as the purchasing power of the money falls. The Fed is literally stealing your wealth to prop up Uncle Sam’s spending spree.
In a nutshell, Inflation is a tax. It may not take dollars out of your bank account, but it erodes the purchasing power of the dollars you have. The net effect is the same. You can buy less.
A lot of people labor in the dangerous misconception that all of these government handouts are “free.” They aren’t. You will pay – either with higher taxes or higher inflation – most likely both.
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