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Friday, November 30, 2007

The National Debt - Who is the Creditor?

On the Ron Paul forum, someone asked me via private message:

If the Fed Reserve is gone, then we won't have to pay interest for paying them for printing their valueless money.. but someone pointed out that the American treasurer receives the interest? is this true?

I posted this, but this guy responded back:

3) The destruction of the Federal Reserve would lead to a halt on the interest we pay to them for the pleasure of using their valueless paper."

The American treasurer receives the interest from the valueless paper that's you and I.

can you help?

That's a broken link.

This is another question that deserves its own separate post.

I see the fool is quoting Edward Flaherty. I've already mentioned that Edward Flaherty is a paid disinformation agent. Edward Flaherty is an economist who makes a lot of posts on the Internet. He says things like "There's no such thing as the Debt Virus.", which is another name for the Compound Interest Paradox. His arguments are frequently cited by clueless people, who say "This guy has a PhD in economics, so what he writes must be true."

The problem is that university economics professors are primarily funded by government grants. Someone who writes articles critical of the Federal Reserve will *NEVER* get a research grant and thus be out of a job. If you want a good analysis of economics, someone with a PhD in economics is the LAST person to ask. Mainstream orthodox Keynesian economics says that the Federal Reserve is better than sliced bread. Anyone smart enough to question that is weeded out from the economics field.

In the above counter-argument, there is one small grain of truth. The Federal Reserve owns about 10% of the outstanding Treasury Bonds at any given time. The interest the Federal Reserve earns on these bonds is first used for the Federal Reserve's own expenses, and the remainder is turned back over to the Federal government. However, this is a tiny fraction of the actual interest paid on the national debt, and it's a tiny tiny fraction of the humongous government subsidy the financial industry receives.

Hidden in your your question is another question, which is what you're really asking:

Who's the creditor for the national debt?

According to this official government document on the GPO website, the amount paid in interest on the national debt was 2% of GDP. That document only includes debt held by the "public". Some debt is held by US government agencies, such as the Social Security Trust Fund.

There's another interesting observation from that table. The statistic "2% of GDP used to pay interest on government debt" is fairly constant over time. That makes natural sense. If the value got too high, there would be inflation. The US national debt is continually being defaulted on due to inflation, due to negative real interest rates. The default is at a rate of 1%-10% per year, depending on whether you consider M2 or M3 to be a reliable measure of inflation.

About 2% of the total wealth generated in the USA last year was used to pay interest on the national debt. The wealth confiscated by income taxes and paid in interest on the national debt doesn't vanish into thin air. It winds up in someone's pockets.

Suppose a bank decides to invest in Treasury Bonds. Banks are allowed to use a leverage ratio over 100x when investing in Treasury Bonds. The 2 year Treasury Bond yield right now is around 3%. This means that the average expected Fed Funds Rate over the next 2 years is around 2.8%. If it were higher, banks would short sell 2 year bonds and lend the proceeds at the Fed Funds Rate. If it were lower, banks would borrow at the Fed Funds Rate and buy bonds. This arbitrage mechanism insures that the Treasury Bond yield approximately equals the average future Fed Funds Rate plus a little more. It isn't exactly equal, due to transaction costs.

Suppose the average Fed Funds Rate over the next 2 years is expected to be 2.8%. Banks know this by predicting the Federal Reserve's interest rate policies. They know that the Compound Interest Paradox will force the Federal Reserve to continue cutting interest rates, because otherwise there would be a deflationary crash of the dollar.

Suppose the bank has $10 billion in capital. The bank is allowed to use 100x leverage, so it is able to buy $1 trillion in Treasury Bonds. This means the bank is borrowing at an average rate of 2.8% to buy a bond that yields 3%. This spread of 0.2%, multiplied by the leverage ratio of 100x, yields a profit rate of 20%.

Hedge funds can also use this high leverage trick when buying Treasury Bonds. They have to pay higher transaction fees than banks, so hedge funds would normally borrow to buy other types of debt or buy stocks.

Notice that the bank or hedge fund has performed NO REAL WORK, yet they get to make a huge practically riskless profit.

That is where the interest on the national debt goes. It goes into the pockets of banks and hedge funds. They borrow at the Fed Funds Rate and buy Treasury Bonds. Further, the yield on other debt is set by the Treasury benchmark. Suppose a corporation wants to borrow for 2 years. The 2 year Treasury yield (3%) plus a spread (3%) equals what the corporation is charged for borrowing, around 6%. This spread is pure seignorage profit for banks and hedge funds.

At any given time, about 10% of the outstanding Treasury Bonds are held by the Federal Reserve. Due to a 10x reserve ratio, banks can then create, via fractional reserve banking, the money required to purchase the rest of the national debt. The Federal Reserve creates 10% of the money needed to purchase the national debt, and banks can create the remaining 90% by fractional reserve banking.

The interest paid on the national debt shows up as seignorage income for banks when they create money.

Consider China, who holds around $1 trillion in US Treasury Bonds. Is wealth being transferred from the USA to China via interest on the national debt? NO! China has an *UNLEVERAGED* long position in US dollars. China doesn't have only $10 billion and is borrowing $990 billion like a bank would. China actually has $1 trillion in US dollars.

China owns $1 trillion in US Bonds without using ANY leverage at all! China is being credited with 5% interest on this debt, but inflation actually is 6%-15%. China is earning a NEGATIVE return on its investment in US Bonds. Purchasing power is moving AWAY from China and towards someone else!

The mechanism whereby China acquires dollars is interesting. Suppose there is a factory in China that manufactures lead-painted toys for sale in the USA. The Chinese factory sells the toys to a US corporation in exchange for dollars. However, the Chinese factory doesn't pay its workers in dollars; they get paid in yuan. The factory turns the dollars over to the Chinese government in exchange for newly printed yuan. The Chinese government has an unlimited supply of yuan, just like the Federal Reserve has an unlimited supply of dollars.

The Chinese government wants to keep the dollar/yuan exchange rate stable, so it prints more yuan. This causes inflation in China. The USA is, literally, exporting its inflation to China. Who gets to profit when new yuan are printed? It's *NOT* China. It's banks and hedge funds and the USA! China is, literally, subsidizing the profits of banks and hedge funds in the USA.

China's government is content to hold dollars and lose ground to inflation. If China took its dollars, bought tangible goods, and put them into China's economy, then printing more yuan would NOT be inflationary. For example, if China spent its dollars buying copper to be used in China, then there would be more yuan in China but there would also be more copper/goods, and people in China would not experience inflation.

Is this a bad deal for China? A lot of US companies are building factories in China. China is getting advanced US manufacturing technology. However, China needs the customers in the USA, to justify all the factories that have been built there! Right now, China is shipping the USA manufactured goods, and the USA is giving China technology along with a piece of paper with a number printed on it. When China catches up to the USA technology-wise, then they probably won't be as eager to export to the USA in exchange for a piece of paper.

Summarizing, China is earning a NEGATIVE REAL RETURN on its Treasury Bond investment. The US financial industry is booking a seignorage profit exactly equal to the purchasing power China loses due to inflation.

The above argument applies to all foreign central banks that hold dollars, not just China. They are subsidizing seignorage profit to the US financial industry, from their willingness to earn a negative real return on their Treasury Bonds. Every foreign central bank has substantial dollar reserves. All those reserves are beings slowly eroded due to inflation.

Similarly, suppose an elderly retired person is invested in Treasury Bonds. Like China, they have an unleveraged long position. Like China, they are losing their purchasing power to inflation.

The Social Security Trust Fund is similarly invested in Treasury Bonds. The Social Security Trust Fund earns a negative inflation-adjusted return. The Federal Reserve is slowly stealing the Social Security Trust Fund by crediting it with a negative real interest rate.

For the entire history of Social Security, taxes collected have exceeded benefits paid. Where does that wealth go? It goes to the financial industry. The Federal government doesn't "store value" by holding Treasury Bonds, because the Federal government is the issuer of dollars. A government can't "store" a surplus in the currency it issues.

All the Social Security Trust Fund means is that inflation can occur elsewhere, without the average person noticing. They notice the Social Security taxes they pay, but they assume there's going to be a benefit later. After adjusting for inflation, Social Security is a ripoff to CURRENT retirees, much less those who will retire 20 years from now.

As a sidenote, when Kennedy issued his "U.S. Notes", they had a special clause on them "cannot be used to pay interest on the national debt". In other words, *ONLY* Federal Reserve Notes can be used to pay down the national debt. The Federal Reserve issues Federal Reserve Notes, and the national debt is GREATER than the M2 money supply! The national debt can *NEVER* be repaid unless the Federal Reserve Act is repealed or amended!

Federal Reserve Notes are printed by the Treasury, but they are promptly sold to the Federal Reserve for the printing cost. This gets around the loophole that says "only the government may print money".

Technically, Congress has unconstitutionally delegated its money printing authority to the Federal Reserve, a private corporation. The US Supreme Court does not care. The Supreme Court is controlled by the same bankers who control Congress and the President!

Back to your original question, which was:

Why can't Congress repeal the Federal Reserve Act and directly print and spend money?

The financial industry currently is the recipient of a government subsidy equal to the sum of:

- 2% of GDP, the amount paid in interest on the national debt


- the purchasing power that China and foreign central banks lose due to negative real interest rates on their dollar holdings


- the loss of purchasing power in the Social Security Trust Fund, due to negative real interest rates


- all the seignorage revenue that they incur by expanding the money supply. In other words, when the dollars in your pocket lose 10% of their purchasing power each year due to inflation, that wealth moves from your pocket to the pockets of banks.

[Some things are double-counted in the above list, but you get the idea.]

One minor adjustment is needed to the above calculation. When the Federal Government runs a budget deficit, some seignorage revenue is claimed by the Federal Government instead of by the financial industry. There can only be a certain amount of inflation before people get wise to the flaws in the monetary system. That's why a Federal budget deficit is "bad". By having a deficit, the Federal government is stealing some of the seignorage income from the financial industry.

However, the seignorage income earned by the financial industry is FAR GREATER than the seignorage income the Federal government earns by running a deficit. The benefits of printing new money accrue primarily to the financial industry, rather than to the government. If Congress reclaimed its money printing authority, then all this seignorage income would accrue to the government instead.

Banks borrow at the Fed Funds Rate and issue loans, expanding the money supply. The difference between the Fed Funds Rate and the loan rate is revenue for the financial industry. Banks can use leverage ratios of 10x-100x, depending on the type of loan. Even though real interest rates are negative, banks profit by issuing loans because they can borrow at a government-subsidized negative real interest rate.

If you add up all the above, I estimate that the financial industry receives a government subsidy of 10% of GDP or more. It's hard to come up with a clear estimate, because the details are carefully hidden through layers of loan transactions and derivative transactions.

Some of this money trickles down from banks to large corporations. Large corporations also receive a massive government subsidy, but not as large as the financial industry. Large corporations can borrow at 6%, while individuals and small businesses have to borrow at 8% or more.

That's the reason a corporation with a "sound capital structure" has a certain amount of debt. By having debt and paying only 6%, the corporation is profiting from negative real interest rates. If a corporation has "too little debt", then it becomes a takeover target by hedge funds. Hedge funds can profitably buy a corporation and load it up with debt because real interest rates are negative. The profits earned by hedge funds are paid by everyone else as inflation. The hedge fund industry didn't explode until after the gold standard was abandoned, because under a gold standard real interest rates can't fall below 0%.

The people who control the large banks can easily afford to spend a fraction of their stolen wealth supporting the "right" candidates, to make sure that the US monetary system is never reformed. If you're able to transfer 10% of GDP into your own pockets *EACH YEAR*, it then becomes very easy to buy up all the TV stations and all the newspapers, making sure your misdeeds go unreported.

The bottom line is:

If the Federal Reserve Act were repealed, banks would lose this MASSIVE government subsidy they now receive.

The people who control the banks won't give up this massive loot and pillage scam without a fight.

This subsidy is REALLY VALUABLE, so the people who control the banks can afford to fight REALLY DIRTY.

They control all the TV stations and newspapers, guaranteeing that no fair analysis of the Federal Reserve is presented to the public. They control all the university economics professors, by making sure that research grants are only given to professors with the "right" viewpoints. They'll assassinate or harass Congressmen or Presidents who try to oppose their plans. Ron Paul is pretty much the only current member of Congress who has publicly stated his opposition to the Federal Reserve. The other Congressmen are either too corrupt and/or clueless to understand how evil the Federal Reserve is.

For some bizarre reason, the bad guys haven't been able to control or subvert the Internet. The Internet allows people to share information in ways that were previously impossible. The Internet is the tool that allows the bad guys to maybe be defeated. Isn't that odd?

The money the financial industry receives isn't just the 2% of GDP they receive in interest payments. The financial industry also receives the benefits of inflation. When your dollars lose 10% of their purchasing power due to inflation, that money doesn't vanish; it winds up in the pockets of large banks.

The vast majority of the people who work as bankers, traders, and hedge fund managers don't understand the arguments I'm outlining. They sincerely think they make a ton of money because they're brilliant and clever. They don't realize that they're receiving a massive government subsidy. Only a handful of people at the very top are fully aware of the details of this scam.

There is another problem. Suppose Congress repealed the Federal Reserve Act. Suppose interest rates were allowed to rise to the natural free-market level. The Compound Interest Paradox would cause all the money to drain out of the economy as more loans were repaid than issued. Congress would need to make sure adequate money remains in circulation. They would need to repurchase Treasury Bonds, purchase private debt, or directly spend money into circulation, just to make sure there was an adequate money supply. Currently, the money supply is only $7 trillion while total outstanding debt is over $50 trillion. An extra $43 trillion would need to be introduced into circulation so all those loans could be repaid.

There is another problem with Congress printing money to pay off the national debt. If Congress directly spent $10 trillion into circulation, it would cause $100 trillion of inflation. Fractional reserve banking would cause the money spent by Congress to multiply. It is possible to reform the US financial system, repealing the Federal Reserve, without a complete collapse of the economic system. I already have a detailed post about Ron Paul and the Federal Reserve.

However, the wealthy greedy bastards who control the US financial industry and the US government will *NOT* allow monetary system reform to occur. The current economic system and political system deserves to collapse.

I consider Ron Paul to be the only interesting candidate for President in 2008. However, I think that the agorism philosophy is better than putting your hope on a specific candidate. If Ron Paul fails to be elected, hopefully some of his supporters can be converted to agorism.

Does that answer your question? Leave a comment or E-Mail me if you still don't understand "Who is the creditor for the national debt?"


Ineffabelle said...

I wonder if you've seen this.

The basic idea is that the fed opened a window of ZERO reserve ratio in 1995, and since then, things have gone haywire.

Ineffabelle said...

oops forgot to post the link:
here it is

Anonymous said...

I think it would be cool to print an umpteen trillion dollar Federal Reserve Note and present it to the banksters as payment in full for the debt. It would be legal tender but if they tried to spend it any cashier would say, "sorry, I don't have change for a bill that big; got anything smaller?"

Anonymous said...

Some of this stuff makes your head spin.

Just a question that some people ask: If it's true that the banking industry is making obscene profits, wouldn't the rational thing to do be to buy stock in banks? Then we could all profit from this Ponzi scheme.

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