^{Wealth & Poverty Review} Sovereign Wealth Fund or Not, the Fed Has Some Issues

Recently, noted Wall Street economist David Malpass suggested that the Federal Reserve “is looking like a sovereign wealth fund,” with its $4.5 trillion balance sheet of Treasury and mortgage-backed securities exposing the Fed to massive interest-rate risk while creating distortions in financial markets that contribute to slow growth and a low savings rate. While few would disagree with the details of the outcome Malpass describes, he misses the elephant in the room.

Sovereign Wealth Funds are typically created when governments have budgetary surpluses and have little or no international debt. The Fed undertook its QE bond buying not by choice, but by necessity. Consecutive years of trillion dollar deficits created a debt supply that exceeded demand both at home and abroad, which required monetization by the Fed. Additionally, the Fed was able to mask the true funding costs of deficits and debt by forcing interest rates down to artificially low levels. The Fed is now in a box where it may not be able to raise interest rates without creating a new budgetary and fiscal crisis. The increased debt service cost from allowing interest rates to normalize would alone exceed the entire current defense budget.

If and when markets recognize that the U.S. borrows not only to offset deficits but also to cover a large portion of its outstanding debt service costs (borrowing to pay the costs of previous borrowing), there may be a rude awakening and a reevaluation of the creditworthiness of the U.S. Such a crisis would likely cause federal debt service costs to skyrocket–potentially beyond historic norms, triggering a downward-spiraling liquidity crisis ending with the U.S. government unable to finance its obligations.
Thwarting this day of reckoning goes beyond the winding down of the Federal Reserve portfolio. It will require courage and good judgment–probably from people who haven’t been part of the problem.
This article was adapted from Scott Powell’s September 13, 2014 Wall Street Journal letter to the editor.