Oh No.... (Foreign Debt Bought by The Fed)

[BradLohaus]

Besides having such a high debt, where I see a problem coming up is when people no longer want to buy treasuries to finance the debt. Interest rates will have to return to double digits like we saw during the Carter presidency. Selling of treasuries alone pose no problems.

That’s the problem that I’m talking about. The amount of new treasury debt doubled from 2007 – 2008 and it will probably double again from 2008 – 2009, and it could triple or more. And there's no end in sight in the years to come. Foreigners will have to eventually decrease the percentage of total new treasury debt that they buy, but then who is going to buy it to fund the government? The Federal Reserve will have to. If they didn’t then the price of treasury securities would plummet and the interest the government would have to pay on the debt would shoot up. In the 70s this wasn’t a problem because foreigners didn’t hold trillions of our debt. Here’s the portion of the original article that I linked to that explains it:

1. Buy assets (Bear Stearns debt, et.al.)
2. Low fixed-term loans (e.g. TAF, TSLF, etc)
3. Acquire real or financial assets (TARP anyone?)
4. Treasury issues debt which the Fed then purchases with newly-minted money (Fed Balance sheet doubling anyone?)
5. Announcing an explicit ceiling on long-maturity Treasury debt.

Why is this last one important? Because all of this coupon printing (Treasuries) along with 1-4 is extraordinarily inflationary. I know, Ben said its not in his Congressional testimony. He's lying. It is. You doubt that? Go look at the price of 30 year mortgage money and what has happened to it in recent weeks. Longer-term debt is very sensitive to potential future inflation and will turn upward long before the inflation actually appears, because the lender is stuck with the note for the entire period.

So how do you stop long maturity Treasuries from shooting the moon on yield?

You announce that you are capping the yield through unlimited purchases of same.

That is, you'll buy as many as you need (printing as many dollars as necessary) to hold the price high and yield low.

There is one problem with this - it is insanely inflationary, especially when the government is running a fiscal deficit...

Here's why.

We currently require about $2 billion a day in foreign flow of funds into our Treasuries to fund our government's operation. We have "gotten away with this" and "enjoyed" unreasonably low yields on long maturity government debt because we buy a lot of foreign things - most specifically Chinese toys and oil. As we do so these governments become awash in dollars - effectively, we are exporting our (monetary) inflation to them in return for their imported goods. To prevent this inflation from destroying their economy they "sterilize" these dollars by buying Treasury securities with them, thereby removing the dollars from circulation and dampening the inflationary impact.

Well I don't want to just re-quote the whole article. The point is that the Fed can keep the treasury security prices up and their yields low at the same time that interest rates in the rest of the economy go up. The problem with that plan, as the author points out, is that it is insanely inflationary, and, as the author later points out, the foreigners will know what is going on. They will know that they are getting devalued dollars at artificially low, manipulated yields. I guess the hope is that they all already hold so much treasury debt that none of them will want to risk doing anything that might trigger a collapse in treasury prices that would really destroy the dollar and the value of their remaining dollar denominated holdings... like trying to sell them.