It is the end of your second day touring Washington D.C. It has been a lovely and awe inspiring two days but you are one plaque away from your poor brain melting like a hard drive in Phoenix. As you finish up the tour of the White House you’ve scheduled months in advance and are making your way out the East entrance, you pause for one more photographic proof of where you’ve been. The receptionist at the desk smiles obligingly, while the tour guide looks pointedly at his watch. Feeling a little bad about stretching his patience, you decide to tip him on the way out the door. You pull a $10 bill from your pocket and notice something interesting. The picture on the back of that bill looks strikingly like the building facing you on the other side of the White house perimeter fence. You would be right. The picture on the bill is of the United States Treasury building which sits adjacent to the White House. Like many of the government buildings in D.C. it has a quiet, but monumental grandeur to it. In your rush to make the bus, you only have time for a passing glance at its fascinating rows of stone columns. Your bus driver is proud to tell you the little-known fact that the original Treasury building was the first Federal government building in Washington. When the officials for the newly formed government moved from Philadelphia, this building’s predecessor was the only building finished. So, everyone took offices in it, and for a brief time all three branches of the Federal government resided under the same roof. However, when you ask your friendly bus driver what exactly the Treasury does, he throws back his head, laughs, and informs you that’s a question for the internet.
Role of the Treasury
Simply put, the Treasury is the federal government’s bean counter. It is an agency of the Executive branch, and as such, carries out a surprising array of enforcement tasks on behalf of the president. Of course, the one most familiar to all of us is the task of one of its branches, the IRS. However, because the Treasury is the government’s accounting office, and because Congress actually controls the government purse strings, the Treasury also has a very close relationship with lawmakers on Capitol Hill. Congress decides tax, spending, and debt policy. The Treasury collects those taxes and issues checks to whomever has it coming. It also makes limited decisions about how and what kind of debt will be issued. The office of the President has little to do with the day-to-day operations at the Treasury, but the Treasury usually advocates in lockstep with the President’s agenda. The Treasury itself also has considerable influence on congressional policy, for just as a good business man takes into consideration the recommendations of his accountant, so does Congress.
The Treasury is an agency as sprawling as the building it occupies. However, the thing we’re most interested in knowing is what does the Treasury have to do with my business?
Somewhere deep inside that beautiful building is the office of the Secretary of the Treasury. Its current occupant, Janet Yellen, though small of stature, is one of the most powerful people in Washington – partly because of her unique career. She is considered an intellectual giant by politicians on both sides of the aisle, and has the university credentials to prove it. She has been involved in more professorships and research projects than most people could accomplish in two lifetimes. Even that impressive resume fades beside the fact that she is the only person in United States history to have been the head of the White House Counsel of Economic Affairs, Chairman of the Federal Reserve, and Secretary of the Treasury. These are the three most influential economic institutions in our government. Until Yellen breached that barrier, it was considered inappropriate for a former Fed Chair to occupy the Treasurer position. Yet her influence was so great she breezed through her confirmation in the Senate. What she says and thinks matters. Even though she does not set fiscal policy, she has the ear of those who do.
So, what does she think? In general, she is an advocate for the Keynesian school of thought, which leans heavily toward governmental management of the economy and away from free market capitalism. During her time as a staffer under Greenspan at the Fed, she led the charge in promoting “targeted inflation” as a policy goal for that institution. She failed to convince Greenspan, but a few years later, from the vantage of a more powerful position, she successfully implemented that policy, which has been the status quo ever since. The original mandate for the Federal reserve was “price stability,” which was traditionally interpreted to mean preventing inflation. Yellen’s doctrine takes a more pragmatic view of inflation and focuses on managing inflation. While that may seem like a semantic nuance, the double-digit inflation of recent history demonstrates that a small difference in wording can have seismic consequences.
Political pressure from the Treasury
In our last article, we explored how only the Federal Reserve can create or destroy its own reserves, or as we know it, money. This is called monetary policy. We also mentioned two reasons why the Fed would do that. The first is economics and we talked about that. The second is political. Here’s how it works and how the Treasury influences both the Federal Reserve and Congress.
Conceptually, the Federal Reserve is apolitical. They are not a branch of government, but were conceived as an institution apart from the three branches specifically so that their policy decisions would not be influenced by election cycles. Reality is likely somewhat afield from the ideal. That means that any first term Fed Chair, as well as every other voting member of that board vying to take his place, are quite aware of election cycles. This political pressure has only ramped up as the government has assumed an increasingly active role in managing the private economy. If a politician campaigns on the promise that he will “fix” the economy, then his electorate naturally holds him accountable to do so. Since the most visible branch is the Executive branch, they tend to be the political focal point on economic policy. Many presidents have foolishly made promises they cannot keep. The President cannot directly control either the Federal Reserve and their monetary policy, nor Congress and their fiscal policy. But since the Presidency is the only branch of government defined by a single person, he commands public attention more than the other branches. He also happens to appoint Federal Reserve members as well as the Treasury Secretary. If he feels the economy needs some help, he will use his power to influence the Federal Reserve to enact policy he feels most likely to help his party’s reelection prospects. The Treasury Secretary is a cabinet appointment, so he or she is naturally and automatically aligned with the President’s viewpoints. If the President and his Treasury have a preference on how monetary policy should be handled, then the Federal Reserve will feel a lot of pressure to handle it that way even if they fundamentally disagree. The natural misalignment between short term political expediency and healthy, long-term economic objectives is usually only reconciled by a crisis forcing everyone temporarily to the same playbook. This has led to many boom-bust cycles as both monetary and fiscal policy have swelled and retreated on the tides of political fortune. As business people, we do well to pay attention to whether the tide is coming in or going out. Who the current Secretary of the Treasury is and what they think is an important indication of that. Janet Yellen sits at the nexus of Presidential, Congressional, and Federal Reserve policy. Her views are generally “dovish” and have been a major factor in the expansionary (inflation causing) monetary policy at the Fed for a couple decades. She is also comfortable with almost unlimited borrowing by Congress. She even advocated for and accomplished the complete suspension of a borrowing cap for the remainder of the current president’s term. Have I mentioned that her opinion matters?
There is yet another major economic indicator we can glean from inside that stone building. The Secretary also drafts the President’s budget proposals. These proposals are rarely passed unchanged in Congress, but they are the foundation from which Congress debates fiscal policy. Congress cannot create money. Only the Fed can do that. But Congress can borrow money. This is important to business owners. You and I don’t really care how much money the Fed creates or destroys. What we actually care about is the purchasing power of our dollar. As the Fed expands or contracts its balance sheet, those effects ripple through the economy. Similarly, we don’t necessarily care how much money Congress borrows. But we care about the effect it has on the economy. Here’s how it works.
Economic effect of Congress borrowing money
Congress, just like your business, has to manage its finances. It has a revenue stream, i.e. the taxes it levies. It has expenses, i.e. the money it spends on things like defense and social programs. Its revenue must exceed its expenses or it will run out of money the same as you do. If Congress runs out of money, they have three options. They can raise taxes to increase revenue – a choice that often leads to thorny questions during the next reelection campaign. They can lower expenses – a choice even less desirable, because it not only leads to prickly conversations, but also tends to make campaign donations dry up like the brook Cherith. Or they can borrow money. This third option seems ironically to be the choice with the least political consequences. We seem to live in a day when almost any long-term result is preferable to any near-term discomfort. As a result, Congress has rarely passed a balanced budget since 1970.
When Congress decides and the President approves (remember, the President signs every budget into law) borrowing more money, then the Treasury swings into action by issuing bonds. These bonds can be bought by a variety of people or institutions. Foreign governments buy them. Foreign and domestic corporations buy them. Commercial banks, small businesses, and individuals buy them. These bonds can be resold on the secondary market known as the “bond market.”
What if foreign governments, banks, corporations, and individuals don’t want to buy the bonds? What if there has been so much debt issued there are simply no more buyers? Can the Treasury still issue more debt? The answer is yes. There is one buyer I didn’t mention. It is the Federal Reserve. If Congress has been on a spree so drunken that all the normal buyers have been tapped out, the Federal Reserve can still buy government debt. And since they can create their own reserves to buy them with, the sky's the limit on how much they can buy. You might ask, “is the Fed obligated to buy them?” And the answer is yes and no. The Fed has the autonomy to refuse buying government debt, and indeed has made veiled threats in that direction very recently. However, because of the political realities mentioned above, it will almost always step in as the “lender of last resort” when push comes to shove. Sometimes the pushing and shoving results in the Fed buying bonds and increasing its balance sheet in direct opposition to its own policy objectives. Rarely has it actually limited congressional spending.
The thing to remember about the Fed is that, while it is legally autonomous, its very autonomy is granted by Congress. That means it can be taken away at any time. I have had the hunch for some time that the next congressional election cycle may correspond with a shift in mood toward the Federal Reserve. Lawmakers may decide to bring the Fed to heel by requiring them to fund federal deficits. We’ll see if that guess comes to pass. The important thing to know is that regardless whether or not they are required to fund those deficits, they mostly do. That fact, along with the natural inefficiencies of government funded programs, means that when the Treasury issues debt, it can be every bit as inflationary as the Federal Reserve creating money. For one, if the Fed ends up buying all or part of the new debt issued, then by proxy, Congress is actually printing money. In addition, government funded programs tend to have a much lower rate of economic output per dollar spent than the same dollar spent in the private economy. So, every dollar of debt issuance represents an inherent loss of efficiency within the economic machinery.
Effect on your business
What does all this mean for you and I as business owners? I would say there are two possibilities we should be mindful of.
The first is almost self-explanatory. As long as our current regime is dominated by the Yellen school of thought, we should expect an inflationary environment. Congress will continue to spend more than it brings in, and the Fed will likely be drug kicking and screaming into funding it.
The second is less intuitive. Expect a tipping point where things change quickly. On one hand that could mean a doubling down on inflationary policies as the discussion above would indicate. Conversely, it could mean an unexpected and dramatic reversal known as an austerity regime as we have seen in Germany in recent years.
If you were to look back two reports to the Q4 2023 Bear Report entitled “The Rhymes of History”, you might notice a reference there to getting the “Hillbillies” back to work. That quote was in direct reference to a book entitled “Hillbilly Elegy.” In that article I wondered if our country is ripe for a mood shift toward fiscal austerity. Fiscal austerity is not just a focus on limiting spending, but on getting more productive results with our money. Remember that inflation is the result of an increase in money supply without a corresponding increase in productivity. That is why borrowing our way out of either private or public debt is a near impossibility. The recent choosing of J.D. Vance, author of “Hillbilly Elegy,” as Trump’s vice-presidential candidate makes me wonder if we are edging closer to a fulcrum moment where the nation’s attention will focus on shrinking our debt and becoming more collectively productive. God knows and time will tell. In the meantime, pray that when that shift comes it will be peaceful. He is still on the throne!
The Arrow Team
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