The Fed earns interest on the U.S. government bonds that it holds, but at the end of the year it remits its interest earnings — after deducting a couple of billion dollars to pay for its own operations — back to the Treasury. Currently, it is remitting back more than $100 billion a year, making the government’s cost of debt service very low. Again, it is important to understand that Fed and the Treasury are running an unsustainable scheme — whereby the Fed creates an artificial demand for government debt, driving down the interest rates, and then remits most of the interest earned back to the Treasury. If a private party engaged in such activities, it would be called “money laundering,” and the participants might well go to jail.
The reason this monetary game has not resulted in inflation up to now is that even though the Fed is buying the bonds from the banks with money created out of thin air, the banks are increasingly subject to greater regulatory restraints on what they can do with the money. The big banks have “bank accounts” with the Fed. The Fed started paying a small amount of interest on these accounts to the banks. So the big banks, in essence, get free money from the government on which the government pays them interest. If the banks lend the money to private parties who are willing to pay a higher interest rate, the banks risk fines, or worse, if the loans happen to go bad. As a result, the banks increasingly restrict their lending to big companies and the politically favored where the risks are perceived to be lower — rather than to small business and entrepreneurial enterprises that create most of real jobs.
Because of all of the new financial regulatory restrictions that make it more difficult to borrow, the demand for loans is artificially depressed. At the same time, the population pyramid is changing. Young people typically are borrowers — for education, homes and autos. As people get older, they tend to increase their savings rates to prepare for old age and borrow less. As a result of the decline in birth rates and an aging population, there are fewer borrowers and more savers. As the real return on savings declines, many save more, as the Japanese have been doing for the last few decades, to make up for the lower rate of return on the savings.
The Fed has no costless way to wind down its massive holdings of U.S. government debt and its holdings of government-backed mortgages that it bought from Fannie Mae and Freddie Mac. Who would buy all of this stuff if the Fed decided to sell, and at what price? If the Fed interest rate subsidy to the Treasury stops — the cost of debt service will soar, either crowding out other spending or forcing massive tax increases or inflation.
Rapid economic growth is the only real solution to the government debt problem and negative interest rates for savers. Such growth will require large cuts in regulatory costs, a far less damaging tax system, and major real cuts in government spending. Which politician is going to deliver that?