We’ve had a whole lot of talk about raising the debt ceiling in the last few months and the conversation, frankly, is mostly just hot air. The US is most likely headed for a financial wall at high speed without regard to action on the debt ceiling and that howling that if we don’t raise the ceiling we’ll damage the “full faith and credit” of the US government is laughable. It’s happening right now and is about to accelerate like the space shuttle leaving it’s launch pad.

Here’s a simple explanation of why we’re about to go into the “face meets wall mode”.

First let’s look at how we finance the US government. The financing mechanism for Uncle Sam is made up of a number of cash in-flows:

• Federal income taxes.
• Tariffs and fees.
• Borrowing through the use of US Treasury bond auctions.

Tariffs and fees account for a miniscule portion of the revenue, taxes are the major revenue producer and the debt auctions have to make up the difference between “income” (taxes, tariffs & fees) and “expenditures”, the total of on and off-budget spending by the Administration and Congress. With me so far?

I’m going to assume that our readers understand the tax revenue stream so I’m not commenting on that here. If you have questions, post them in the comments and they can be answered individually. Tariffs and fees fall into the same category and are a generally small portion of overall revenue.

Which brings us to the Treasury auctions. The US auctions off Treasury bonds on a regular basis. Very generally, the auctions work like this:

• The Treasury schedules an auction and announces it will be selling $X billions of dollars of bonds at Y% yield.
• Buyers purchase said bond offerings.
• Buyers include: other countries (China, etc), private bond investment houses.

Here’s where it starts to get hinky. Let’s say the Treasury is offering $100B in bonds at a 3% yield. The auction produces $65B in purchases at that offering. The Treasury now has two options, they can take the $65B and not sell the other $35B or they can raise the yield above 3%. The conundrum is this. If they don’t sell the $35B they have, in effect, lowered the debt ceiling and will not be able to meet the cash expectations of the appropriators effectively cutting the budget by that $35B. They also send a loud message to bond holders/traders that demand is down, and think about the basic law of supply and demand here. When demand is down for automobiles, the cost of the car will go down to bleed off supply overages. When demand is down for financial instruments, the yield of those instruments must go up in order to increase demand.

Bottom line, can’t sell the bonds this time, the next time that 3% will 4% or higher. That raises the interest cost line in the federal budget and makes it necessary to either get more money (borrow more) or reduce spending in other places by a comparable amount. See the spiral effect?

Lately, the Treasury is having problems finding buyers for their bonds so the federal reserve has undertaken a program of buying up the left overs in order to keep the yield low. Let’s see now, where does the federal reserve get money since they can’t tax or charge tarriffs or fees. Oh yeah, they print it. The net effect is that there have been significant shortfalls in bond sales to third party buyers and the US government is buying up the debt, in effect lending money to themselves. Think Ponzi.

OK, so you’ve got the basics now and you see that the federal government is buying it’s own debt to finance operations. Here’s the problem. Come June the federal reserve is planning on stopping the printing press. They’ve said that they’re going to get out of the bond buying business. Well hey, there’s always the Chinese and the private bond traders, right? Jim Lacey at National Review lays out the ugly scenario in detail, please read the whole article, he’s much better at this than I am.

Researchers at [a major bond investment house] estimate that in the last quarter, the Fed purchased 70 percent of all new Treasury debt. This is a disaster in the making. By printing new money to buy debt, the Fed is both holding interest rates artificially low and flooding the world with dollars. Fed purchases have lowered rates to the point where there was no room for further decreases. With no more upside potential to holding debt, investors are fleeing on the assumption that the Fed will soon exit the market, causing rates to rise dramatically. Such a rate rise lowers the value of all current U.S. debt…

Lacey notes that pretty much all of the major investment houses have stopped or dramatically curtailed US Treasury purchases and many are dumping their current inventory of Ts on the expectation that new auction yields will jump dramatically. Other major holders are also dumping inventory, namely the Chinese.

So what’s on the horizon? If you’ve got a weak stomach, stop here.

Come June, the Fed will be in a bind of its own making. If it stops pumping money into the system, interest rates will increase, and not just on Treasury bonds. Mortgage rates will rise and business credit will become more costly. The recovery could be strangled in its infancy. If it keeps on buying bonds, however, it risks never being able to wean the markets off the equivalent of monetary crack. Worse, the flood of dollars will continue to drive down the value of the dollar, raise commodity prices, and propel global inflation.

There pretty much is NO upside here. Rates go up and or inflation takes off. Mr. Obama you need to bring Jimmy Carter back from North Korea and add him to your stable of economic advisors who’ve never held real jobs.

Enjoy May. We’re in for a really long hot summer. And when you can’t borrow money or the cost of the borrowing is so excessive that the cost no longer justifies the purchase you’re left with about one alternative. Downsize. This is why the arguments about the debt ceiling are hot air. And why Paul Ryan’s budget proposal may begin to look like nothing more than trimming around the edges. The reality is – and we’ll likely know over the next three or four months – the government may well shut down and not because the Congress didn’t pass a budget or raise the debt ceiling, rather because nobody will lend us money any more.

Sure is going to be an interesting primary election season.