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Is the Fed’s proposed Treasuries gambit playing with fire?

Federal Reserve chair Ben Bernanke
Federal Reserve chair Ben Bernanke

The following excerpts sketch the pressures and some of the perils tied up in Ben Bernanke’s apparent willingness to direct the U.S.’s central bank to start purchasing U.S. Treasury bonds in quantity.

You’re welcome to take Paul Craig Roberts’ fears of hyperinflation with a grain of salt; policymakers are aiming for a degree of inflation now, and the prospect of runaway inflation is on no one’s mind. But the situation we’re in at the moment seemed unlikely to the great majority of observers a year ago.

Or just look at it this way: What could possibly go wrong with a plan to have your central bank print money to purchase your government’s debt?

Federal Reserve Chairman Ben S. Bernanke and his colleagues may try once again to cure the aftermath of a bubble in one kind of asset by overheating the market for another.

Fed policy makers… are exploring the purchase of longer-dated Treasury securities in an effort to push up their price and bring down their yield. Behind the potential move: a desire to reduce long-term borrowing costs at a time when the Fed can’t lower short-term interest rates any further because they are effectively at zero.

The risk is that central bankers will end up distorting the Treasury market, triggering wild swings in prices — and long-term interest rates — as investors react to what they say and do.

“Bernanke risks ‘very unstable’ market as he weighs buying bonds,” Bloomberg News 1/26

“Because we’re doing this [stimulus package] outside the budget process, it means no one has to talk about what the long-term effects of any of this might be,” said Alice M. Rivlin, an economist at the Brookings Institution and a former member of the Federal Reserve, who supports a major stimulus package. She testified recently in Congress about the need to separate short-term economic stimulus from a broader agenda — which embraces everything from fixing America’s schools to improving health care for children.

“We seem to be counting on the Chinese to keep investing to pay for this,” Ms. Rivlin said, referring to the huge amount of United States government debt held by China, “and we’re assuming that the rest of the world isn’t going to lose confidence once we use this moment to spend on a whole range of programs. And I’m just not sure that’s the right assumption.”

Ms. Rivlin raises what may turn out to be the most urgent question of all in a few months.

When Roosevelt took America down new roads, he financed it at home. Mr. Obama does not have that luxury: He must persuade not only Congress and the public but also world financial markets, which must decide whether — and at what interest rate — they are willing to finance his plan.

“A stimulus plan With dual goals: reform and recovery,” NYT 2/1

The federal government budget deficit for the 2009 fiscal year will be $2 trillion at a minimum. That is five times larger than the 2008 budget deficit.

How can the Treasury finance such a huge deficit?

There are three sources of financing. Possibly people will flee from stocks, bank deposits, and money market funds into Treasury “securities.” This would require a form of “money illusion” on the part of people. People would have to believe that investments can be printed, and that printing so many new Treasury bonds would not dilute the value of existing bonds or reduce their chance of redemption. They would have to believe that the bonds would be repaid with honest money, not by running the printing presses.

A second source of financing might be America’s foreign creditors. So far in our descent into massive debt foreigners have footed the bill. Our foreign creditors now hold very large amounts of US debt and other dollar-denominated “securities.” They are likely to develop a case of cold feet when they see a $2 trillion expansion in US debt in one year. Their most likely response will be to start selling their existing holdings.

Who would purchase them? The only way the Treasury can redeem the bonds that come due each year is by selling new bonds. Not only must the Treasury find purchasers for $2 trillion in new debt this year but also must find buyers for the bonds that must be sold in order to redeem old bonds that come due.

If foreigners cease buying and instead start selling from their existing holdings–China alone holds $500 billion in Treasury debt–a deluge will fall on an already flooded market.

The third source of financing is for the Federal Reserve to monetize the debt. In other words, the Treasury prints bonds and the Fed purchases them by printing money. The supply of money thus expands dramatically in relation to goods and services, and high inflation, possibly hyperinflation, would engulf America.

“Our Collapsing Economy,” Paul Craig Roberts, Counterpunch 1/12

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