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For decades, the American economy has relied on government deficits to pay for needed spending, as well as federal debt. In fiscal 2013, the federal government spent an astonishing $2.7 trillion on public debt. It would take a few pages to explain why that debt has gone up, but the short answer is that government policy decisions created the problem. But this is where the numbers become really fuzzy.
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The Federal Reserve system, the primary government lender, is designed to lend money to banks so they can buy government securities for their customers. If a bank has a good credit rating, Federal Reserve Bank deposits, plus interest, can support a bank’s operations, and the Fed is in charge of keeping the money circulating around the economy. But what if a bank has lousy credit ratings? If that bank gets the Fed interest on its deposits, the interest can be diverted to finance the bank’s activities, causing a debt-to-GDP spiral — a problem because banks have a natural incentive to lend money in order to buy the government’s securities — or else to make bad loans that the banks get caught on. Thus Federal Reserve policy has caused a huge debt trap, in which the banks in turn have created the problem. This has led to a situation where a large fraction of the government’s debt is owed by debtors with bad credit ratings, whose debt is actually backed by bad debts — and the government owes them a lot of money.
#ad#The Federal Reserve System is not designed to control any one of these problems; however, it is designed in a certain way to manage the system so that these problems are not multiplied. In particular, the system is designed to prevent any one of these problems becoming an “event.” If there is a financial crisis (say, the loss of a bank holding company), the Fed will be there to prevent that failure. If the economy becomes depressed, like it did during the Great Depression, that will prompt the Fed to step in and provide emergency assistance so that the economy can be restored.
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So, in theory, a financial crisis is no big deal; however, the Fed must have a system to manage for this to happen. In the last four years, the federal government has managed to run deficits — of around $800-$850 billion annually — in order to manage for these crises. Yet no one can understand that
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