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The money supply is backed mostly by U.S. government debt. So to answer the question of what the Federal Reserve and GSEs are doing to the money supply, you have to look at what's happening with debt.
The story is rather amazing. The quarterly Flow of Funds report, which is posted on the Federal Reserve's website, indicates that there's $33 trillion (with a T) of debt outstanding in the U.S. economy.
To that $33 trillion of existing contractual debt, we should add the $44 trillion net present value of the federal government's future fiscal imbalance. That figure comes from the paper by Gokhale and Smetters, published by the American Enterprise Institute. Most of the imbalance comes from Medicare and Social Security. These are not contractual debts, but they are promises that our whole society is relying on, and there will be consequences if they aren't paid. In cash flow terms, they become burdensome when the Baby Boomers start to retire toward the end of this decade.
So adding up $33 trillion existing debt and $44 trillion future fiscal imbalance, you don't need a PhD in economics to realize that the total of $77 trillion (which is seven times annual GDP) is a hole that we can never get out of. Just the annual interest on that sum at 5%, to stop it from compounding and getting bigger, would be almost $4 trillion annually or 40% of GDP.
Well, obviously we aren't paying 40% of GDP to hold this obligation from getting bigger. We couldn't, because it would collapse the economy. So the $77 trillion obligation will continue compounding and getting bigger, until one day a cash flow crisis makes clear that it can't and won't be paid.
Going back to the $33 billion of contractual debt, about ¼ of that is government sector, ¼ is private households, and the other half is business (both financial and nonfinancial). But since government issues the money supply, government is the key sector to watch.
Due to the government's own debt problems, the potential exists for a hyperinflationary runaway. It starts with the fact that during the past 5 years, federal revenues have been growing only 1.5% annually, while expenditures grew 6.5% annually. That pushed a cash flow surplus into a $400 billion deficit this year. Obviously if you extend those trends linearly, the gap between them (= the deficit) grows ever wider.
But that's not the only factor to consider. The average interest rate on the nearly $7 trillion of federal debt has fallen to less than 5%, which resulted in an annual interest tab of about $300 billion in the fiscal year 2003.
As the outstanding debt inexorably compounds from the rising deficits, and as the Fed eventually raises T-bill rates above their current 1% yield, the interest cost will rise and become a larger percentage of the federal budget ... which engenders yet higher interest rates, higher interest cost, and an expenditure trend which accelerates beyond the 6.5% trend mentioned above.
Here's the actual result of one version of the spreadsheet:
(values in $ billions)
........................................Total...Int......Int......Int. as
Year......Recpt....Expdt....Deficit.....Debt....Rate.....Amount ...% Expdt.
2004......1904.....2209.......-440......7244.....5.3%......383.....14.8%
2005......1985.....2581.......-596......7840.....6.0%......468.....16.5%
2006......2044.....2827.......-783......8623.....7.1%......613.....19.5%
2007......2128.....3144......-1016......9639.....9.1%......874.....24.4%
2008......2257.....3587......-1330.....10968....12.4%.....1360.....31.9%
2009......2469.....4267......-1798.....12767....18.2%.....2323.....42.7%
2010......2845.....5437......-2593.....15359....28.4%.....4363.....56.7%
2011......3567.....7697......-4130.....19489....46.3%.....9027.....71.7%
2012......5112....12596......-7484.....26973....76.2%....20613.....84.4%
2013......8866....24432.....-15566.....42538...121.8%....51797.....92.7%
*Interest amount in each year is included in the next year's expenditures,
to avoid circular cell references. "Close enough for government work."
As the interest amount becomes a larger portion of the annual expenditure, the interest rate rises. Laid on top of pre-existing structural deficits, the process becomes self-reinforcing. Higher interest rates make for bigger annual interest cost, which adds to the mountain of debt.
By the year 2012, the $27 trillion debt exceeds 150% of GDP (where Japan is now). Beyond that point, Treasury borrowing from the private sector becomes difficult. The next year's $15.6 trillion deficit is simply monetized by the Federal Reserve, sending interest rates soaring into hyperinflationary territory of 100%. From that point, the doubling of interest rates and inflation can compound monthly or even biweekly. Multi-octave logarithmic charts are needed.
Ultimately, that's the end game of the system. Rather than outright first-world debt default, the debt gets inflated away by a hyperinflation. The very real losses of the bondholders will wipe out the middle class, as occurred during Germany's Weimar inflation in 1923. At that point, the pieces are picked up and life goes on (austerely). Except that there's no non-U.S. entity big enough to bail out the U.S. So the deflationary Dark Age after the hyperinflation burns out could last for decades, or centuries.
As mentioned, I project the hyperinflation to occur by 2012. That happens to be 99 years after the Federal Reserve was founded in 1913, with its doomsday inflation machine. G. Edward Griffin's The Creature From Jekyll Island is the classic explanation of the Federal Reserve doomsday machine. This projection also coincides with the end of the Mayan calendar in Dec. 2012. So I'll project that 2012 is the year we blow out.
That leaves us with perhaps two more business cycles, before the final plunge into nightfall begins.
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