Fiscal Cliff Compromise Will Lead To Stepped-Up Money Printing
November 16, 2012
(This item originally appeared in Forbes.com on November 16, 2012.)
Probably nothing good will happen in the discussions surrounding the
“fiscal cliff” in January 2013. Federal spending is almost
impossible to cut meaningfully, because most of it is “mandatory”
entitlements. The remainder of federal government spending consists
of other welfare programs (hard to reduce in the midst of persistent
unemployment), defense (which Republicans won’t want to cut unless
they get some big cuts in welfare and entitlements), corporate
subsidy, and Big Bird.
The result is likely near-stasis on spending, and, despite
Republicans’ efforts to the contrary, some tax rate increases. This
is the “austerity” approach that is not working at all in Europe.
The tax increases will cause more economic weakness and won’t raise
any additional revenue. In the midst of a crumbling economy, people
will be even more dependent on government assistance, and spending
will be impossible to cut further.
Deficits will likely continue and perhaps get even larger. The
economy will deteriorate, while the rest of the world slips into its
own recession. The EU’s statistics office just declared a recession
in eurozone, rather belatedly to some.
This puts pressure on the Federal Reserve to keep the game going a
bit longer. The Treasury will have to find buyers for perhaps $1.2
trillion of new debt issuance in calendar 2013, on top of rollovers
of existing debt. Recently, the big buyer of bonds over five years
in maturity has been the Federal Reserve, through “Operation Twist.”
The most recent QE3, by raising prices for MBS, also creates buying
interest in longer-maturity Treasury bonds.
The Federal Reserve doesn’t want to let long-term interest rates
rise by any appreciable amount, because that would demolish their
hopes for some kind of housing recovery. At the same time, an
economic downturn creates the justification for more easing
All of this has led Fed-watchers to conclude that the most likely
course of action will be an expansion of QE3 in January 2013,
perhaps announced in December. Probably, the existing “Operation
Twist” program, which purchases $45 billion of long-dated Treasury
bonds per month, will be replaced at its completion in December by a
corresponding $45 billion per month of printing-press financed
Treasury buying via QE3+.
Chicago Federal Reserve president Charles Evans outlined this
strategy at the beginning of October. Evans is widely regarded to
have been a chief architect for QE3, and apparently has Bernanke’s
Thus, the Federal Reserve would be buying $85 billion per month of
Treasuries and MBS, financed with the printing press. That is $1,020
billion per year, not coincidentally about the expected amount of
the Federal budget deficit.
The Federal Reserve will make many promises about how it won’t let
things get out of hand. In practice, I suspect that they will find
that backtracking their present course is as difficult as it is for
Congress to solve its deficit problem.
It is a little-known fact that the U.S. Federal government has used
printing-press finance whenever it ran large deficits. Until
recently, these large deficits appeared only in wartime. In the
1780s, the Continental Congress financed the Revolutionary War with
the printing press. The result was the hyperinflation of the
Continental dollar. When war with Britain broke out in 1812, the
Treasury began issuing Treasury Notes, a paper banknote, to finance
The outbreak of the Civil War in 1861 soon led to the issuance of
United States Notes, known as “greenbacks.” As the U.S. entered
World War I, the Treasury pressured the then-new Federal Reserve to
help finance its debt issuance by managing long-term interest rates.
This resulted in excessive money issuance. During World War II,
again the Treasury pressured the Fed to put a lid on long-term
interest rates, which again led to excessive money-printing by the
In most of these situations, the war ended quickly, spending was
reduced, deficits disappeared, and the Treasury no longer had to
print money or pressure the Fed to help with deficit financing. At
that point – not before — a monetary contraction took place and the
monetary system returned to a peacetime gold standard system. This
was the case in 1818, 1865-1879, 1920, and 1951.
Probably, this will end badly. Next year might be quite exciting.
Eventually, when the time comes, let’s do what we did in the past:
return to a peacetime gold standard system.