Monday, March 23, 2009

Welcome to the Third World

Correct me if I am wrong, but I thought that monetizing the national debt was confined to third world banana republics. In those countries, governments are hard pressed to sell their debt offerings because of either of the threat of default or because the value of the offerings is constantly being debased by inflation. Thus, in order to finance ever growing deficits, those governments resort to "printing money". They actually don't simply print money, rather they have their central bank purchase the securities directly from their treasury department. In this way, the central bank props up the government and allows it to keep spending. The inevitable result is inflation.

Well, the United States is now an official banana republic (I can hear the reggae playing in the background). The Fed announced that it is buying $300 billion in long term Treasurys, essentially monetizing the national debt by "printing  money". Not surprising, the instant result was a sharp decline in long term treasury yields and a likewise sharp decline in the value of the dollar. What prompted the Fed to embark on such a course? Was it the worry by the Chinese Premier Wen Jiabao about the integrity of all the billions of US debt that China holds? Was Mr. Wen intimating the reluctance of China to buy a large chunk of the $2 trillion that will have to be borrowed by the Treasury to finance TARP/"stimulus"? Or for that matter was it the realization of the Fed about the Treasury's ability to borrow to finance the $2 trillion period?  

The Fed's  essentially  increased the demand and caused the yields on 10 year Treasurys to plummet as prices on those bond prices rose. However, the lower yields meant lower returns on dollar denominated instruments leading to the largest single day decline in the dollar vis-a-vis the euro in history. The Fed has rightly been criticized for this "lets cheapen the dollar policy" during the Greenspan era but this policy of monetizing the debt goes even farther. Now its cheapen the dollar, make it even more less attractive to buy Treasurys and increase inflation to boot. I have written elsewhere that once upon a time the Fed was actually the guardian of the economy making inflation job 1. I recall textbooks writing about the Treasury Accord during the Korean War when the Congress wanted low interest rates to reduce the cost of fighting the War while the Fed insisting on raising interest rates to help fight the inflation that would result from the increased levels of government borrowing and spending. Oh for those good old days! In the past, Congress was a bunch of children and the Fed was the adult. Today, there are no more adults.

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