That US debt ceiling and the Fed

We are now into a second week of a partial Federal Government shut-down, which is causing considerable concern, centred on the Government’s ability to finance its debt and pay interest without a budget agreed for the new fiscal year. Should this continue into next week and beyond, the Fed will have to enter damage-limitation mode if the Treasury cannot issue any more bonds because of the separate problem of the debt ceiling.

Most likely, QE will have to be switched from financing the government to buying Treasuries already owned by the private sector. Any attempt to reduce the monthly addition of raw money will simply result in bond yields and then interest rates rising. And indeed, already this week we have seen yields on short-term T-bills rise in anticipation of a possible default. The market is naturally beginning to discount the possibility that the Fed may not be able to control the situation.

The T-bill issue is very serious, because they are the most liquid collateral for the $70 trillion shadow banking system. And without the liquidity they provide securities and derivative markets, we can say that Round Two of the banking crisis could make Lehman look like a picnic in the park.

This is the sort of event deflationists have long been expecting. According to their analysis there comes a point where debt liquidation is triggered and there is a dash for cash as assets collapse. But they reckon without allowing for the fact that deposits can only be encashed at the margin; otherwise they are merely transferred, and only destroyed when banks go under. This is the risk the Fed anticipates, and we can be certain it will move heaven and earth to avoid bank insolvencies.

Furthermore the deflationists do not have a satisfactory argument for the effect on currency exchange rates. Iceland went through a similar deflationary event to that risked in the US today when its banking system collapsed and the currency halved overnight. Today a dollar collapse on the back of a banking crisis would also disrupt all other fiat currencies, forcing central banks to coordinate intervention to conceal the currency effect. This leaves gold as the only true reflector of loss of confidence in the dollar and therefore all other fiat currencies.

Those worrying about deflation ignore the fact that it is the fiat currency that takes it on the chin while gold rises – every time without exception. This was even the experience of the 1930s, when Roosevelt suspended convertibility, increased the price of gold by 40% to $35 per ounce, and the banking crisis was contained.

Of course there is likely to be some short-term uncertainty; but against the Fiat Money Quantity (FMQ) gold is down 30% compared with the price pre-Lehman crisis. This is shown in the chart below.

With gold at an extreme low in valuation terms, current events, whichever way they go, seem unlikely to drive it much lower. A wise man perhaps should copy the Asians, who know a thing or two about paper currencies, and are buying gold in ever-increasing quantities.

This article was previously published at


  • Alasdair Macleod repeats the popular view, namely that the banking system needs government debt as form of collateral. Well let’s think about that, shall we?

    Say a borrower wants to borrow money to engage in some legitimate form of economic activity: let’s say buying a house or some machinery. By way of collateral, the borrower can offer the title deeds or the house or ownership of the machinery to the bank. Or the borrower could offer government debt.

    But suppose there was no government debt. It wouldn’t make a blind scrap of difference to be basic and legitimate form of economic activity that the borrower wants to engage in, assuming that form of activity was viable.

    As Alasdair rightly said, government debt is a very liquid form of collateral. Indeed, it’s little different to money itself. And as he rightly said it helps the “securities and derivatives” market. Quite. That’s the type of activity which Adair Turner referred to as “socially useless”.

    • Gary says:

      Govt Bonds are the ultimate collateral under this system. The fractional reserve money multiplier determines the maximum amount of money that can be created by commercial banks through lending. That amount is a multiple of reserves. Commercial bank reserves are central bank created money created by repos of govt bonds. ie govt bonds underpin the entire monetary system.

  • Paul Marks says:

    In theory there is nothing to stop the United States Federal government honouring its debts after Thursday without any increase in the debt limit.

    After all the Federal government could simply just spend as much money as it gets in taxes – and it gets HUNDREDS OF BILLIONS OF DOLLARS more in taxes than it pays out on the debt.

    However, that assumes an Executive that is acting in good faith – and it may not be acting in good faith.

    Contrary to the propaganda of the msm (including the Economist magazine) it is not the Republicans who have refused to compromise.

    On the contrary Paul Ryan in the House offered a six week debt exchange for talks on government spending.

    And the ultra moderate Senator Susan Collins offered a six month debt extension in return for talks on government spending

    The Obama people turned down both proposals (and every other compromise they have been offered) – they turned them down flat.

    They demand a BLANK CHEQUE.

    What people still seem to not understand is that it was BARACK OBAMA who wanted the government shut down (because he knew his friends the media would blame the Republicans for it).

    And it may will be that Barack Obama who wants chaos on Thursday – and after.

    As for banking – I agree with what I think Mr Musgrave is saying here.

    Banking should be a matter of banks using REAL SAVINGS to finance PRODUCTIVE INVESTMENT.

    The way that banks have become dependent on disguised government subsidies (borrowing newly created money from the Central Bank, on the understanding they will lend this money back to the government – at a higher rate of interest) is both economically demented and morally obscene.

    The system can last much longer.

  • Paul Marks says:

    Sorry – that should read “the system can NOT last much longer”.

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