Quantitative Easing is a Ponzi Scheme in which the Government is the Greatest Fool

US Government debt now exceeds 90% of GDP

Bill Gross, one of the world's largest bond fund managers, in his November Investment Outlook finally called quantitative easing what it is: a Ponzi scheme.  According to Gross, both the government's financial stability and the value of its current bonds depend largely on the existence of new buyers willing to buy future bond issuance.  In other words, the government can issue IOU's and expect them to retain value only as long as there continues to be a supply of customers willing to buy new bonds in exchange for the promise of a "certain" return.  As long as this situation persists, the government can pay its earlier bond buyers interest with the money it gets from its newer buyers, and so on ad infinitum.

Of course, one might wonder if the interest on existing bonds can't simply be paid with tax receipts.  Unfortunately, tax receipts do not cover all the government's funding needs.  So, even though the interest on existing bonds could be paid entirely with tax receipts, this could only happen if the government cut other spending.  The current gap between government expenditures and government receipts is such that without a constant influx of new money raised from bond sales, the government would be forced to cut expenditures drastically just to have enough cash to make interest payments on existing bonds.  The chart below illustrates the difference between government expenditures (the orange line) and receipts (the black line).

Government expenditures exceed receipts by a wide margin

This chart illustrates a situation in which new bonds must be sold in order to raise money to pay the interest on existing bonds and to fund ever-expanding government spending, since tax receipts alone will not cover all the government's costs.

Unfortunately, this sounds an awful lot like a Ponzi scheme.  And it all starts to unravel when the government can no longer find enough willing buyers for its debt (e.g. the Chinese, banks, and money managers like Gross), because buyers have lost confidence in the government's ability to keep the scheme going.  So, the government is forced to buy its own debt by printing more money and then using it to buy its own bonds.  This money can then be used to pay the government's earlier customers (e.g. the Chinese, the banks, and money managers like Gross) their interest, keeping the game going for a little while longer.  But then the money itself starts to seem questionable.  After all, any new money that's printed simply dilutes the value of money already in circulation, does it not?  The Fed isn't creating any new value when it prints another trillion dollars, is it?  In fact, what Gross points out is that the Fed is actually creating inflation (their stated goal, by the way), which is bearish for bonds and ultimately means they will fall in price and rise in yield as the market adjusts to higher inflation.

In the end, this means that the government is probably buying at the top of the market, and savvy investors will likely be lining up in droves after Wednesdays QE announcement to sell their bonds back to the government. Gross' article reads to me like a pretty clear indication that he plans to do exactly that.  And he owns enough bonds to really move the market.  It can't be long until other large players follow his lead, and (in Gross' words) "the Fed’s announcement will likely signify the end of a great 30-year bull market in bonds..."  If this scenario pans out, then the government- by buying trillions worth of bonds at their peak- will essentially be playing the role of the greatest fool in a game of selling-to-the-greater-fool that has run out of fools.

An ancillary- but possibly even more outrageous-  byproduct of this action, as Gross points out, is that it changes the government's role from being the referee who guarantees that the invisible hand of capitalism is allowed to work (i.e. by providing a rule of law, enforceable property and contract rights,  and maintaining a competitive marketplace by inhibiting monopolies, etc.) to being an active participant in the market.  The government is now a player in the game, not just the referee.  And, at the moment, it is the biggest player.  As such, the government threatens to squeeze out all the other players and, in fact, has already created a distorted macro market environment in which all assets move primarily based on what people believe Bernanke will do next.  Other considerations- like earnings, employment, supply and demand, etc.- are trumped by one all-important factor: how much money Uncle Sam is planning to print (here's a good video on the recent synchronized movement of assets and a good piece by Michael Santoli of Barron's in which he mentions this dynamic). 

This is not a healthy situation and one that is likely to end in another crisis for the financial (and political) system.  If it doesn't happen right away, and we enjoy some illusory prosperity thanks to money printing, then we will be experiencing nothing different from what Weimar Germany or Zimbabwe first experienced when they tried printing their way to prosperity.  Inflation feels good- at first.  But, after people realize that the currency raining down upon them in the form of higher wages and/or asset prices isn't holding its purchasing power in the face of even more rapidly rising prices for essential goods and services, then bad things can happen.  Did I already mention Weimar Germany as an example?  I think we all know what happened after that.

For more reading on the subject of sovereign debt, I highly recommend Reinhart and Rogoff's "This Time is Different."  One of R&R's essential points is that once a country reaches a debt-to-GDP ratio that exceeds 90%, it is extraordinarily difficult to avoid falling into a debt trap in which the compounding costs of servicing debt eventually exceed the government's ability to pay, and a default becomes inevitable.  It's worth noting that the U.S. government's debt-to-GDP ratio currently exceeds 90%.