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Monetizing All the Debt, All the Time


Chronic, trillion dollar deficits don't matter because the Fed is financing them for free.

The oracles at Goldman say that $750 billion of QE2 is priced in to the market, and possibly $1 trillion -- a frightful prospect that was hardly diminished by today's lost jobs report. On top of that, there's $300 billion to $400 billion in annual GSE run-off that needs replenishment under QE1.5. So Brian Sack, the monetary apothecary who operates the New York Fed's drive-thru window, is going to be giving Wall Street a lot of POMO. Call it $100 billion per month of Permanent Open Market Operations, and be done.

Not coincidentally, it appears that there's also baked into the cake about $100 billion per month of new Treasury paper. According to CBO's August update, the two-year, cumulative red ink under current law (FY 2011-2012) will total $1.7 trillion. But that doesn't count the upcoming lame duck session's predictable one-more-stimulus bacchanalia.

Juiced up by their election rout, the tax-side Keynesians in the GOP are certain to ram through a two-year extension of the Bush tax cuts for one and all. In return, the hapless White House will insist this one-half trillion dollar gift to the "still haves" be matched with several hundred billion more in presently unscheduled funding for emergency unemployment benefits and other safety net programs for the "no-longer-haves." In combination, these measures -- along with more realistic economic assumptions -- mean that the FY2011-2012 deficit will be $700 billion higher than current projections, pushing the two-year total to at least $2.5 trillion.

These considerations make one thing virtually certain: After the new Congress sinks into rancorous partisan stalemate and does absolutely nothing about this fiscal hemorrhage, the Treasury will be selling at least the $100 billion per month of new government paper for so long as the New York Fed is open to buy. Stated differently, national policy now amounts to monetizing 100% of the federal deficit.

In the olden times -- say three years ago -- the idea of 100% debt monetization would have been roundly denounced as banana republic finance. No more. Earlier this week, William Dudley, who occupies the Goldman Sachs permanent seat on the Fed's Open Market Committee, helpfully clarified that the new-age Fed should be judged by what's in its heart, not what's on its balance sheet. He said:

I am mindful of concerns… that [the Fed's actions] could be interpreted as a policy of monetizing the federal debt. However, I regard this view to be fundamentally mistaken. It misses the point of what would be motivating the Federal Reserve.

It's doubtless true that the New York Fed Chairman, hereafter referred to as B-Dud in keeping with his brand of monetary doctrine, has run the Fed model and determined that each $100 billion of QE2 will result in a 9.895564 basis point reduction in the 10-year swaps rate. Still, B-Dud and his gang of merry money-printers on the Open Market Committee should be under no illusion that they have ascended to a new rung on the ladder of central banking sophistry.

They may devoutly believe in their hearts (if hopefully not in their minds) that it's economic milk and honey that they're bringing to America, but in fact what they're dispensing is digital greenbacks. In fact, nearly 150 years ago, Samuel P. Chase, Lincoln's Secretary of the Treasury and father of the original greenback, proved exactly how.

When the then-diminutive federal budget spewed massive red ink with the onset of the Civil War, Secretary Chase went the direct route and printed up some $400 million in fresh currency -- with his picture on it. It wasn't Chase's stern gaze, however, that caused his greenbacks to soon trade at a considerable discount to par, and thereby threaten a runaway inflation. Instead, speculators of the day had no problem effectively shorting (against gold) irredeemable paper money which threatened to be issued in limitless supply.

Chase was a lawyer and former senator from Ohio who nevertheless knew a thing or two about money. So seeing that direct money printing wasn't getting the job done, he came up with an artful backdoor route to monetization. Under the national banking system, which he designed, the Treasury got out of the money-printing business and thereafter issued fixed-term bonds (20- and 40-year maturities) bearing an honest monetary wage, that is, a coupon of about 6%. In turn, newly chartered national banks were given the right to print their own currency (national banknotes) -- so long as it was 100% backed by federal bonds and adequately reserved by gold and other legal tender.

In short, without a central bank research department or thousand equation macro-models, Chase came up with a debt monetization scheme that sufficed to finance the balance of the Civil War. In addition to help from the considerable salesmanship of a one-firm bond dealer community -- otherwise known as the union-wide boiler room operation of Jay Cooke and Co -- Chase was able to place more than a billion of financing without inciting new financial turmoil for an obvious reason. Unlike under the initial non-interest bearing, perpetual "greenbacks," the national banking act scheme involved the issue of bona fide government debt that bore a 6% coupon and was subject to a plausible redemption date after the war emergency had ended.

The irony, then, is that the current financial environment, the apparent national policy of monetizing all of the debt all of the time amounts to a relapse to Secretary Chase's original non-starter. At the moment, the five-year note yields barely 1.0%, and the maturities below that quickly descend toward zero -- with the 2-year at 35 bps and 90-day bills at 12 bps. Those maturities account for in excess of 90% of the $9 trillion in Treasury debt presently held by the public. So, in the world of ZIRP, the public debt is now essentially non-interest bearing.

Moreover, with a stroke of the "repo" key it can also be turned into cash -- that is, legal tender -- in a millisecond. Thus, the defining characteristic of Chase's greenbacks is that they were non-interest-bearing government debt that served as legal tender. Those characteristics precisely define the digital greenbacks being emitted today by Uncle Sam and his central banking branch.

Chase might be forgiven for his failed greenback experiment because his government faced the gravest emergency in the nation's history. But what emergency motivates today's greenback experiment? It would appear to be two self-evidently foolish objectives. The first is the claim by the Fed's money printer's caucus that QE2 in the magnitude being contemplated might lower the 10-year benchmark rate by 50 basis points. Stunning! We have a nation drowning in 19 million empty housing units owing to the Fed-engineered housing bubble, households still buried in $13 trillion of debt from the same cause, and idle business capacity on a scale not seen since the 1930s -- and we're supposed to believe that taking down the current all-time low interest rate by another 50 bps will make a difference?

Worse still, one salutary effect of this dubious proposition, according to chief apothecary Brian Sack, is that risk asset values are likely to be elevated to levels "higher than they would otherwise" reach -- thereby encouraging consumers to go back to their former spend-thrift ways owing to the illusion of higher net worth, as conjured by the Fed.

These are pretty pathetic reasons for issuing massive quantities of digital greenbacks. Like all other experiments in printing press finance, its main impact will be to give a destructively erroneous signal to fiscal policymakers on both ends of Pennsylvania Avenue: Namely, that chronic, trillion-dollar deficits don't matter because the Fed is financing them for free.

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