The Eleusian Mysteries

While we were all screaming about AIG bonuses, look what the Fed did today: Fed in Bond-Buying Binge to Spur Growth

The Federal Reserve ramped up its effort to revive the economy, declaring it would buy as much as $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities.

The Fed had already cut its benchmark interest-rate target to near zero. Unable to go lower, the central bank now is essentially printing money to raise the supply of credit and thus push down the longer-term rates paid by families and companies on mortgages and other key loans. The impact was immediately felt.

Um, my knowledge of Central Bank Practice is fairly limited, but: how can this possibly make sense? The Fed is buying US bonds? Isn't that like me "buying" $$ off my credit card and depositing it in my checking account? Yeah, I know. The Fed is a bank, while the Treasury Department is part of the executive branch. Ultimately, though, aren't US taxpayers on the hook for all this?

As with the AIG bailout, the grad school level explanation for this story is what you see in the papers: "the Fed is buying US Treasuries." It's almost like they don't want people to have the high school level of comprehension of what is happening here: the Fed is buying US debt, so the Treasury can print money - billions of it - in an incomprehensibly short period of time. The sums that the Fed is playing with are astonishing, even in the Age of Bailouts:

All told, the Fed will pump as much as an extra $1.15 trillion into the economy via bond purchases. The Fed will buy as much as $300 billion in long-term Treasurys in the next six months. It will increase the ceiling on purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to $1.25 trillion, up from $500 billion. The Fed also is doubling potential purchases of their debt, to $200 billion.

The obvious prediction is that this will lead to rampant inflation. Supposedly, this will be a boon because it will combat the deflation that has occurred in asset prices andnow consumer 

prices. But, is that really that bad? It's now clear that assets - especially real estate - were grossly inflated. They should come down in value to reflect their true market value, not their BS "flip this house" value. Mild deflation would seem to be a temporary boon to the average person trying to deleverage and increase their savings. Why bring inflation in with its power to destroy savings and potentially wreck the dollar?

A less obvious prediction, which I can't make is: what will this do to the bond market? We have seen the government distort markets in real estate, health care, and higher education. Now, the Fed is entering the market for US debt in a big way. What will this do to the private market for US bonds? Won't it break, like the stock market broke? With a fatally distorted market for US bonds, how can the gov't hope to fund its activities?

Speaking of real estate, Fannie and Freddie are mixed up in this, too. That should be a signal that we should run the other way. Instead, the Fed is strapping them to its chest with God knows what sort of consequences for our money, our savings, and our nation's well being.  

10 years ago, the people who ranted against the Federal Reserve were weedy oldsters like William Greider, Ron Paul, and Grandpa Simpson.  They seemed like ghosts from the world of McKinley and William Jennings Bryant.  Now, I have to wonder if they were a vanguard of the future, rather than dead enders from a vanished world.

UPDATE: You can always count on the The Market Ticker for the Doomsday scenario:

So what happens if half of that $2 trillion is no longer "money" from foreigners - it is a circle-jerk from The Fed and Treasury?  You can basically remove it, that's what.

Now look at that chart - you can't remove the "net interest" (about $250 billion), because that has to be paid.  "Other spending", that is, other than defense, interest, and social programs, is about $700 billion.  Defense is also about $700 billion.

If we find ourselves unable to sell debt to actual investors with actual money, and are circle-jerking ourselves; to balance this budget we would need to contract spending to roughly $1.0-1.5 trillion in total.

Since the interest payments are inviolate, that leaves us $1.25 trillion for everything else.  Assume we can cut half of the defense budget, and we've got $800 billion left.  Cutting "other spending" (that is, all other programs) by 50% would leave us with about $500 billion net-net for social programs - forcing a reduction of about sixty percent in Social Security, Medicare and Medicaid - all at once.

In short this would wind up costing us roughly a 50% across-the-board cut in every program within government on an immediate basis.  That in turn would force further reductions in GDP, which would further shrink tax revenues.

You can see where this leads, I'm sure, and it's not pretty.

Ben Bernanke may think he can extricate The Fed from this outcome before it happens.  But I must ask - exactly why would anyone believe that? He hasn't been able to extricate himself from anything he's tried thus far.

The danger here is that this really is "the last bullet in the gun."  If it fails, our currency and political system would appear to many who read this to go down the toilet in a hyperinflationary detonation.

Not so fast grasshopper.

See, if he fails, it won't be simply a United States phenomena.  Quite to the contrary.  That failure will in fact be global - Bernanke has guaranteed it by tying The Fed to every other major central bank in the world via his "unlimited swap lines."  We may be a cheap $5 hooker in the bar, but of the hookers, we've got crabs and everyone else has AIDS!

....

The nightmare scenario that is staring us in the face, right here, right now isn't hyperinflation.  It is in fact a collapse of monetary systems driving demand for dollars through the roof in a crescendo of attempted redemptions into collapsed ("no bid") asset prices - a demand that Ben will not be able to meet, as the collateral backing those dollars will have all been exchanged for toilet paper.  Whether Bernanke holds all this trash on his balance sheet or manages to scam Treasury into exchanging it for T-bills, the result is the same - there is no collateral behind Bucky and as employment collapses no production to replace it with either.