If you don’t understand what’s going on with the Federal Reserve, the national debt and rising interest rates, you don’t understand what going to happen to the economy. Hint – it isn’t good news. Another hint – Trump ain’t gonna fix it. Tom Woods and David Stockman break it down.

Editors Note: This post was originally published at SchiffGold.com.

As we reported earlier this month, the federal government is borrowing money at record levels. The US Treasury’s net borrowing totaled $488 billion from January through March, adding to an already enormous national debt. In fact, the entire world is drowning in debt.

When we bring this fact up, a lot of people still just shrug and say, “So what? We’ve been running up debt for years. It hasn’t really caused any problems. Why worry about it now?”

David Stockman recently appeared on the Tom Woods Show. During the interview, the former Officer of Budget and Management director under Ronald Reagan explained exactly why we should worry about it now.

LISTEN:

In the first place, it’s a pure matter of scale. Stockman said when he first started warning about deficits during the Regan administration, debt was about 30% of GDP.

Here we are 35 years later; it’s 107% and heading toward 140. That’s a different ballgame. At 30%, you’ve got some running room. You’ve got some headroom to borrow a little bit and live high on the hog. But sooner or later you use up your borrowing capacity.”

More significantly, for 30 years the Federal Reserve and the world’s other central banks made the job of digesting all of that debt easier by monetizing it.

That’s really what this fancy word of QE and ZERP and all the rest of it is all about. They buy the debt with money made out of thin air from the dealers on Wall Street, put it on the Fed’s balance sheet, and thereby remove it from the supply and demand equation, and take some of the pressure on interest rates or yields out of the market.”

Stockman recalled when he was a congressman in the 1970s, they were warning Democrats about their efforts to increase deficit spending, saying it was going to drive out private investment, push up interest rates, make it difficult for middle-class Americans to afford a mortgage, and slow business investment by driving up the cost of capital. That was the argument that kept the lid on the whole fiscal equation and the national debt for decades and decades. But when Alan Greenspan took the reins at the Fed in 1987, it marked the beginning of a new era. Stockman calls it “bubble finance.”

They began in a systematic and then a massive way to monetize the debt, buy in the government bonds, and thereby avoid the day of reckoning, thereby sort of putting their big fat thumb … on the scale of supply and demand down in the bond pits and the canyons of Wall Street – and for years were able to keep interest rates dramatically lower than they would be if we were honestly financing these massive debts in the market and out of the pool of private savings that’s available. So, that’s why for 30 years the day of reckoning was deferred. It wasn’t eliminated. It was simply parked on the balance sheet of the Fed.”

How much did the Fed intervene in the bond market? Consider this. When Greenspan took over the central bank in 1987, its balance sheet was at about $200 billion. A few years ago, it reached $4.5 trillion.

Now the Federal Reserve has realized it has to reverse direction. They have committed to pivoting out of quantitative easing and balance sheet expansion to quantitative tightening. In fact, the Fed has said it plans to drain $600 billion annually from its balance sheet by dumping bonds.

So, instead of removing supply and easing the pressure on yields … and preventing the crowding out, they’re going in the opposite direction now. They’re going to be adding to the supply.”

Let’s put this in some perspective.

In fiscal 2019, the Treasury Department plans to sell 1.2 trillion in new bonds. Meanwhile, the Fed will be trying to dump $600 billion in bonds into the same market. So, when you add it up, there is $1.8 trillion of homeless federal debt that is going to have to be absorbed.

It’s going to change the equation dramatically. Sooner or later, of course, it will be absorbed. Markets do clear. But not at 2.95% on the ten-year. They’re going to shoot through 3%, 3-and-a-half, through 4, and beyond. And as the yield gets driven up by supply and demand, and this $1.8 trillion tsunami of government debt looking for a home, it will ricochet through the entire financial system. In other words, the market is crazily overvalued today at 24 times earnings on the S&P 500. But that presumes interest rates can stay down in what I call the subbasement of history at 2.5% or a little higher indefinitely – permanently. And that’s just not going to happen.”

This is exactly what Peter Schiff has been saying. He pointed out in a podcast last month that if you go back to the Second World War and look at average bond yields, these low rates are an aberration. They’ve been low for a long time, but they aren’t going to stay low forever. And yet the market seems to think it’s going to go on for another 30 years.

Clearly, the market assumes that interest rates on 10-year government bonds are going to stay just barely over 3% for the next 20 or 30 years. I mean, that is crazy. Why would anybody think that?”

Of course, all of this has ramifications on the broader economy, as Stockman pointed out.

The whole predicate for this massively inflated bubble in the equity market is going to be pulled right out from under it. So, the problem starts in the bond pits, the problem originates out of Washington, and it’s going to spread very quickly from there into the equity markets around the world. So, we’ve got some pretty challenging and unprecedented financial pressures – I call it a collision coming not too far down the road.”

Mike Maharrey

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