This flowchart graphic illustrates the “credit-debt machine” that underpins the U.S. monetary system in its present configuration. Let us examine it in detail. The credit creation process starts with the Federal Reserve when it issues borrowing credits or provides liquid funds through open market purchases of bonds to the banking system (green arrow labeled Borrowing Credit$), buys toxic banking assets from banks (TARP), or purchases bonds directly from the Treasury (QE credit$). The banks and shadow banks then turn these credits into high-powered money through fractional reserve lending (Credit Multipliers) to businesses, consumers, and mortgage borrowers, and through margin loans to investors. The banks make money by receiving interest payments on these loans in excess of what they pay to the Federal Reserve. Banks and investors also buy Treasury bonds, providing credits to the government at the market interest rate.
The U.S. Treasury must fund Federal government expenditures (Gov. Spending and Entitlements), either through taxes or through borrowing (by selling Treasury notes and bonds to private investors, banks, the Fed and foreigners). The Treasury must pay back principal and interest on these obligations (all the red arrows coming out of the Treasury). The principal is constantly rolled over by selling new bonds at the prevailing interest rate. The government never has to pay back all its debt; it only has to service its borrowing needs. This is because the government has an infinite life, so it never needs to “settle up.” However, if it needs to rollover an old bond at a low interest rate into a new bond at a higher interest rate, its debt payments will increase significantly.
We can see that this whole system relies primarily on the ability of taxpayers, which include businesses, consumers and homeowners, to continue to pay taxes to service a rising level of debt. It also relies on the willingness of foreigners to provide those credits by buying Treasury notes and bonds (Foreign credits). If the government borrows and spends to excess, this mechanism eventually must freeze up. The only policy options then will be a government default or paying off all debts with money newly created by the Federal Reserve. A default would invite a severe depression, while money creation risks hyper-inflation followed by a depression. Obviously, the rational choice is to avoid excess borrowing and spending. Why is this so hard to achieve?
For the answer we need to consider the incentives of the major actors in the game. First, government spending is authorized by politicians who are eager to get re-elected by delivering public goods to their constituents. To ask politicians to cease and desist from formulating and funding government spending programs is like asking lions to stop eating gazelles – it’s a form of political suicide.
Second, the banking and shadow banking industries feed at this same trough by providing the needed credit at a price. The more debt issued and credits provided to the government, the more the banks make in the difference between what they pay for credit and what they make in interest on loans or investments. In other words, they can borrow from the Fed at 0-1% and lend out to businesses, consumers, and homeowners at 5-18%. (Technically, this is like a form of modern seignorage – an arcane monetary concept that denotes the banking authority’s ability to collect the difference between interest earned on securities acquired in exchange for bank notes and the costs of producing and distributing those notes.) The banking system’s stake in credit creation and debt has enabled it to grow its profits from $32.4 billion to $427 billion in 25 years. These profits provide an enormous war chest for political lobbying and for placing financial industry alumni in government policymaking jobs. It’s difficult to imagine anyone in a position of financial or political power desiring to reform this system.
Lastly, we can see that the people who pay the bills—the taxpaying businesses, consumers, workers and homeowners—have little political input into this process. We might then label this system a blatant case of ‘taxation without representation.’ As hard as it may be to change the debt-based monetary system, its current practice is unsustainable. The recent debt ceiling political crisis and market sell-off is evidence of the growing awareness of this fact among voters and investors.