The One Chart Needed To Understand QE3 and the Taper; Why Bigger Deficits Are the Key to Stability

In Why Is The Fed Tapering? Did They Realize QE3 Is A Failure?, I looked at the change in annual federal deficits and the coming taper. As the chart below shows, federal deficit spending has delivered 150% of credit growth since 2008 (through Q1 2013). Federal deficits are shrinking now, so there's less debt to purchase by the Federal Reserve.

The Fed will taper because it is not printing money. The Fed is monetizing debt in order to encourage credit creation. If there is no credit creation, there is nothing to monetize and no need for QE because the Fed cannot print borrowers, it can only purchase existing debt. If the real economy does not grow and does not generate credit growth, the falling U.S. federal deficit could tip the economy into recession. A very weak president Obama would then need to convince Congress to increase deficits to offset this decline.

America is officially in bizarro world (and has been for some time). Larger deficits are required to generate the level of credit growth needed to support the economy. Without real economic growth, the economy must have a source of credit growth. Without that credit growth, the deflationary crisis will return, this time with deficit hawks in control of Congress and bipartisan opposition to bailouts.

Try this stat on for size. The total credit growth from 2008 through Q1 2013 was $3.7 trillion. The Fed's balance sheet grew by more than $3 trillion over this period, or 80% of the total. If the Fed continued QE at a rate of about $62.5 billion per month and the Federal deficit were to fall below $500 billion annually, assuming credit growth for the rest of the economy continues at the same pace, the Fed will be buying 100% of net new credit in the economy.

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