Ken Silva is a ConservativeHome College Columnist winner. He studied Economics and Politics at Kent State University.
When the Federal Reserve (the Fed) was created in 1913, it was given two mandates: keep prices stable and maximize employment. However, since its inception the Fed has unofficially taken on a third responsibility: financing the US’s national debt.
The Fed is the largest financier of US debt in the world, holding more than $1.6 trillion dollars of US Treasury bonds—nearly a half trillion dollars more than the US’s second biggest creditor, China.
The reason the Fed can buy US debt is because it has the power to regulate the money supply as a tool to fulfill its mandates, and it does so by buying and selling assets. The most common asset the Fed trades in is the US Treasury bond because it is widely considered the safest and most liquid asset in financial markets.
The fact that an entity of the US government can buy US debt has created a “moral hazard”—the idea that certain institutions can enable and even encourage reckless and immoral behavior. This moral hazard is apparent in the actions of the US Congress—members of Congress continue to overspend because the Fed is there to purchase their excess debt.
US lawmakers look at the Fed as a free lunch—the Fed buys their debt and they do not have to borrow money from foreign governments or upset their constituents by raising taxes. However, this lunch is not free, but paid for by those who can least afford it: the US’s lower and middle class citizens.
When the Fed buys any asset, it does so with newly created money. The newly created money then enters the economy and causes price inflation. While prices rise for everybody, people living on low and fixed incomes are hurt the most because the price inflation eats into a larger proportion of their income.
The Fed has purchased over $800 billion in Treasury bonds over the last calendar year—enough debt to make it the fourth largest budget deficit in the country’s history. This $800 billion will be felt by the American people through increased prices of food, energy, and other consumption goods.
What would happen if the Fed stopped buying government debt? The US would lose its biggest creditor, interest rates on Treasury bonds would rise, and the US government would have to live within its own means. This possibility frightens politicians who have promised their constituents jobs, healthcare, and other “free” government benefits.
While policymakers recognize the threat of inflation, they also know that the Fed discontinuing Treasury bond purchases would raise interest rates and stall the US economy’s already sluggish growth. While this would be good for the economy in the long run because government would shrink and capital could be used to fund private sector projects rather than government debt, it would slow the economy in the short run and thus seriously injure politicians’ chances of reelection. Therefore, one can expect the Fed to continue buying US debt at least until after the 2012 elections.
“Moral hazard” is a term that was commonly heard after the 2008 financial crisis, when it was used to describe that firms made careless mistakes because they were under the assumption that the federal government would bail them out. While that form of moral hazard is now apparent and used as textbook material for economic and political classes throughout the country, the moral hazard the Fed poses is something that needs to be recognized and brought to the forefront by anyone who supports the ideas of limited government and individual liberty.
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