Tuesday, October 19, 2010


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I get an overwhelming number of questions regarding the U.S. bond market and the inevitability of a funding crisis at the government level as the dollar supposedly sinks down a rat hole and hyperinflation ensues.? Recent misconceptions regrading QE have exacerbated these fears and myths.? We have big problems in this country.? Bond auctions failing are not one of them.

As I’ve previously explained, the bond market doesn’t actually fund anything in the USA (see here if this is already confusing you).? As a monopoly supplier of currency in a floating exchange rate system the USA simply spends money when it wants to.? Like it or not, men and women walk into a room and type numbers into computers.? The amount of spending that is done by the U.S. government is intended to meet some public necessity or purpose (some of which is good and some of which is not) – population growth, economic growth, bankers bonuses (I kid – sort of), etc.? The issuance of government bonds is merely a monetary tool that allows the Federal Reserve to control the overnight rate.? It is not a fiscal financing tool.? As I have previously explained the auctions are designed not to fail – that’s why they never do.? But don’t take it from me.? Take it from the NY Fed:

“Staff on the Desk start each workday by gathering information about the market’s activities from a number of sources. The Fed’s traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers’ task of financing their securities positions is progressing. Desk staff also talk with the large?banks about their reserve needs and the banks’ plans for meeting them and with fed funds brokers about activities in that market.

Reserve forecasters at the New York Fed and at the Board of Governors in Washington, D.C., compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. The staff also receives information from the Treasury about its balance at the Federal Reserve and assists the Treasury in managing this balance and Treasury accounts at commercial banks.

Following the discussion with the Treasury, forecasts of reserves are completed. Then, after reviewing all of the information gathered from the various sources, Desk staff develop a plan of action for the day.”

So let’s connect the dots here.?? Treasury auctions bills, notes and bonds to “finance” its spending.? It announces these auctions periodically.? In the case of bills it announces the auction each week on Monday and the bills are auctioned that Tuesday.? This is due to a Congressional mandate because our politicians believe we must finance all of our spending via bond auctions – a myth that has persisted since moving off the gold standard.

What’s important to note here, however, is that Treasury and the Fed are working in partnership to track deposits and maintain a record of reserves in the system (Fed and Treasury are essentially the same entity as far as I am concerned).? Why is this important?? Because their reserve tracking and auction operations are actually just a monetary tool and NOT a fiscal financing tool.? When the Treasury auctions off bonds it does so only after discussing matters with the Fed’s reserve forecasters.? In essence, the government is soaking up reserves that had already been spent into existence in order to target the overnight rate.? It can be no other way.? Without Treasury having first spent the money into existence there is no money with which the Primary Dealers can “fund” the deficit.

This doesn’t mean auctions can’t fail.? They can.? But quite honestly, it wouldn’t matter all that much as the reserve drain would simply take place at a later date. The auctions are designed to succeed because they are merely targeting reserves that they KNOW are in the system.? There is no red phone at Treasury that Tim Geithner uses to call China before it spends money.? No red phone to Japan.? There is only a phone to the Fed where reserve forecasters communicate with the Treasury and the Primary Dealers to determine the size of the necessary auctions.? The reserve drain is thus accomplished, Congress thinks we have “funded” our spending and we can all go along our merry way.

So you can see that this is all well orchestrated monetary policy.? It is not a fiscal financing operation.? The Fed and Treasury are working in tandem with the Primary Dealers to track reserves.? After all, part of the agreement in becoming a Primary Dealer is to make a market in treasuries:

“The primary dealers serve, first and foremost, as trading counterparties of the Federal Reserve Bank of New York (The New York Fed) in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently as counterparty to the New York Fed in its execution of open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed’s trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.”

Therefore it is misleading to imply that the auctions might fail due to a lack of demand or some sort of funding failure.? The Primary Dealers are required to make a market in government bonds.? If they wanted, they could hedge their exposure to government bonds, but part of the deal in becoming a primary dealer is helping the government sell their bonds so demand is never really an issue.? The U.S. government can never run out of the currency which it alone has a monopoly supply of.?? That is as silly as assuming that an alchemist will somehow run out of gold.

Why does any of this matter you ask?? Because once you realize that foreigners do not fund our spending you begin to realize that everything your textbook taught you about our monetary system is simply not true.? A government with a monopoly supply of currency in a floating exchange rate system has no solvency risk unlike a nation such as Greece which exists in a single currency system with what is essentially a foreign central bank. The policy implications in such a system are astronomically different – particularly for a nation suffering a balance sheet recession.


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