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Fed Starts Printing Money   March 18th, 2009
The question of how to finance the deficit has now been answered       


More observations...

I wondered over a month ago where we were going to borrow enough money to pay for the mammoth deficit spending that has been proposed in the last two months. I pointed out that nobody in the world has $1.7 trillion to lend us so that we could borrow and spend it. So my conclusion was that "the Federal Reserve will start buying Treasury's" which would mean "we're going to borrow the money we can borrow... and print the rest."

I was absolutely correct.

The Federal Reserve announced today that it would purchase $1.1 trillion in Treasury Bonds and other securities over the next six months.

The Federal Reserve held a key interest rate steady near zero Wednesday, and added that it will start buying long-term government bonds, opening a new front in its battle to lift the country out of recession.

The Fed said it will buy up to $300 billion in long-term Treasury securities over the next six months...

The Fed also said it will buy more mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac, in a move to help the crippled mortgage market. The central bank will buy an additional $750 billion, bringing its total purchases of these securities to $1.25 trillion. It also will boost its purchase of Fannie and Freddie debt.

When the Federal Reserve purchases these securities and holds them (rather than turning around and selling them) it means we're essentially printing money--which means we're subject to all the inflationary risk that printing money entails (see Zimbabwe's inflationary crisis and what has often happened in third world countries). Money is being created out of thin air by the Federal Reserve and being dumped into the economy to purchase these instruments.

Interestingly, the spin put out by the media is:

Doing so could help the economy because many kinds of debt -- from mortgages to corporate bonds -- are linked to Treasury rates. Fed purchases would boost Treasury prices and drive down their rates. That would ripple through and lower rates on other kinds of debt.

True... when the Federal Reserve buys U.S. securities, it drives prices up which forces interest rates down. So it won't be surprising to see mortgage rates drop. For now. But there are two problems:
  1. Over the long-term, printing $1.1 trillion is inflationary. So while rates will most likely drop in the near-term, higher inflation will eventually lead to correspondingly higher interest rates.

  2. The alternative is that once the economy is in recovery the Federal Reserve will adopt a restrictive monetary policy. That means doing the opposite of what it announced today: Rather than dumping $1.1 trillion into circulation, it will need to remove $1.1 trillion from the economy. That will tend to work against the recovery and raises the possibility of accidentally forcing the economy into a secondary recession.
The other thing to note is that the $300 billion in securities the Federal Reserve is buying from the U.S. Government probably represents the shortfall that the Fed expected there to be in terms of the U.S. Government's ability to borrow money from the world market. In other words, after China, Japan, everyone else, and the domestic U.S. market loaned all the money they could to the U.S. Government, it still wasn't going to be enough. So the only solution is for the Federal Reserve to effectively print the remaining money and loan it to the U.S. Government.

So my conclusion from last month was 100% accurate:

That probably means the Federal Reserve will start buying Treasury's--something it has indicated it would do to keep the Treasury market from being flooded and driving up interest rates. But that means we're essentially going to be printing money rather than borrowing it. Or, actually, we're going to borrow the money we can borrow... and print the rest.

Indeed, we're borrowing everything we can from the world and from U.S. citizens and then the Federal Reserve is printing the rest.

Also note that this is just an announcement of what the Federal Reserve intends to do over the next six months. In order to continue funding the deficit spending, it's a pretty safe assumption that the Federal Reserve will end up printing some more money after that. $300 billion isn't enough to make up the shortfall for the proposed $1.7 trillion deficit. So in six months (or sooner, if the government ramps up spending faster) expect to see a similar announcement whereby the Federal Reserve will buy additional U.S. Government securities.

When you don't have enough money to cover expenses, that means you have to borrow from someone else and you're officially living beyond your means. But once you reach a point that you need so much money that nobody even has enough to lend you, and you have to print money, that means you're officially living beyond everyone's means.

We've started down a dangerous road. I guess we'll just have to see where it takes us.

Update An Hour Later: The move to purchase U.S. Treasuries seemed pretty obvious to me a month ago, but apparently the decision caught some people by surprise.

Many Fed watchers had expected officials to raise the size of the mortgage programs. However, the decision to buy Treasury securities came as a surprise since the Fed had sent no signal it intended to move so soon on that idea, first floated by Mr Bernanke in December.

Indeed, as recently as two weeks ago, New York Fed president William Dudley said: "At this point in time, the Fed has judged buying long-term Treasuries is not the most efficient means of easing financial-market conditions."

This actually kind of confirms what I wrote above... that the impact on the market is more spin than the real motive. I think the real motive is, in fact, to make sure the U.S. Government can borrow all the money it needs. In the last month the U.S. has been going to great lengths to convince China that loaning money to the U.S. is still safe and a good idea. But China remained cautious and, even if it weren't, there simply isn't enough money for the U.S. to borrow.

So I think the main justification behind buying $300 billion in U.S. Treasuries is to make sure the U.S. Government can borrow all the money it needs. Any other impacts, such as lower interest rates, are at best desirable side-effects.

But a headline such as "Not Enough Money in the World for the U.S. to Borrow" certainly would've shocked worldwide markets. So, instead, they're just printing some more.

Update About an Hour Later: For anyone that doubts we're just printing money, here's some additional supporting information:

But in a surprise, it dramatically increased the amount of money it will create out of thin air to thaw out the still-frozen credit markets that have cramped lending to consumers and businesses alike....

While the central bank had said for some time that it was considering the possibility of buying longer-term Treasury bonds, Fed officials had played down that idea in the past month as they focused their attention instead on more targeted intervention in the credit markets.

In their statement on Wednesday, however, the Fed policy makers offered little explanation for the decision to go ahead with the Treasury purchases after all, saying only that the move was intended to 'improve conditions in private credit markets.'

The second two paragraphs seem to further confirm my speculation as to the motive: Making sure the government could borrow all the money it needed. The information available as far back as at least a month ago made it clear that there wasn't going to be enough money for the government to borrow. I'm not sure why this move was so surprising to so many people.

Update same evening: Not unexpectedly, the dollar dropped against major currencies in response to this. When you print more money, the value of the money drops so it becomes weaker against other currencies.

The dollar traded near the lowest in two months against the euro after the Federal Reserve said it will buy $300 billion of longer-term Treasuries, spurring speculation the central bank is debasing the currency.

The Dollar Index may fall for an eighth day, the longest stretch in a year, against its major trading partners after falling yesterday by the most in 23 years as the Fed prepared to flood the market with dollars...

'This is a surprisingly strong move by the Fed to inject massive amounts of money into the system,' said Motonari Ogawa, director of currency trading in Tokyo at Barclays Capital Inc., the world's third-largest foreign-exchange trader. 'It is likely to diminish the appeal of the dollar as a safe haven and lead to further weakness...'

This is potentially the start of a vicious cycle.

As I wrote above, the Federal Reserve probably is printing money in large part to make up the shortfall between what the government wants to borrow and what the world is willing to loan. The problem is that this has already caused the value of the dollar to drop. All the money that China and the world has invested in the U.S. just lost value today. So they'll be less likely to invest more money in the U.S. in the future which means the shortfall between what the government wants to borrow and what the world is willing to loan it will increase... which means the Federal Reserve will need to print more money to make up the difference, which will further decrease the value of the dollar, which will lead to the world lending even less money to the government, and so forth. The world will loan the U.S. government less and less money as we print more and more money which is worth less and less.

In addition, a decreasing value in the dollar will lead to imports being more expensive. Anything that's imported--computers, television, oil, etc.--will become more expensive for us to buy. This leads to inflation.

The only way this has a happy ending is if the policy succeeds in reactivating the economy real quick so the cycle above can be broken--but it will only be broken if we reign in deficit spending which Obama's budget proposals don't plan to do anytime in the next decade. Otherwise, the vicious cycle described above is looking extremely likely.

This is a potentially risky move by the Federal Reserve. We all have to hope it works, because the consequences of failure could be severe.

Further update this evening: Forbes confirms what I wrote earlier.

For anyone asking how the government is going to pay for the $787 billion stimulus and the $700 billion bank rescue, ask no more. The Federal Reserve will simply print new dollars. That was the word from the Federal Reserve today....

No more fretting if enough buyers will materialize. Printing new money for this purpose is known as monetizing the debt--"A strategy that appears in the encyclopedia under the heading, 'how to trigger inflation,'" says a note from Guy LeBas, a fixed-income strategist at Janney Montgomery Scott...

Another update evening of 3/18/09: Additional reports seem to support everything I've written here today.

The central bank, effectively, will print more money to pay for the purchases. Combined with the billions already deployed by the Fed, the new money dwarfs even the biggest government bailouts of financial companies...

The new purchases come with risks. They will balloon the value of the assets the Fed holds by about 50 percent, to more than $3 trillion. That could make it tricky for the central bank to draw that money out of the system once the economy starts to recover. The Fed would probably find it difficult to sell such massive volumes of assets, and if it doesn't handle the task adeptly, the nation could face high inflation because too much money would be in circulation.

"This will help the economy," said John Silvia, chief economist at Wachovia. "The challenge comes nine months from now, when the economy starts to recover and the Fed finds itself in a very delicate position. The challenge is the exit strategy..."

Some Fed leaders have resisted buying Treasurys in the past because they were unsure whether it would help reduce borrowing costs and because they feared that it would appear that the central bank was simply printing money to finance the government's deficit, a hallmark of countries with poorly managed economies.

This article was quite explicit in its agreement with what I've written about the purpose being to finance the deficit spending. It also adds an ominous warning about the future of the dollar:

'The Fed is basically financing our deficit by buying the debt issued by the Treasury,' she said. 'If the Obama administration pushes through another stimulus package, the dollar is done.'

And another article was also pretty direct:

Bernanke's economic strategy: Trillions now, worry later

The Federal Reserve made it clearer than ever Wednesday that it's willing to go for short-term gain at the risk of future pain...

So, what's the risk? As the Fed effectively pumps another $1 trillion-plus into the financial system, critics say it's setting a time bomb for a future surge in inflation...

On inflation, he suggests, Bernanke can afford the Scarlett O'Hara approach: "I'll think about that tomorrow."

This comes back to what I wrote back in December--we're living in economic denial. Everyone--including the president--has criticized businesses for not having a long-term perspective, at looking only at the next quarterly results. Yet the Federal Reserve, effectively forced by Obama's massive spending, is doing the exact same thing. They're trying to obtain immediate economic satisfaction and put off the hard decisions for tomorrow. But the whole idea of printing money should have risen a whole bunch of red flags.

We need to start thinking about the future today and stop putting off the hard decisions. It's not acceptable to say, "The situation today is so bad that we can't afford to think about future consequences." We can't afford not to.

The Federal Reserve could have prevented the U.S. Government from engaging in the destructive massive deficit spending that it is currently planning. That would have caused some short-term pain for the long-term good.

Instead, both the Obama administration and the Federal Reserve have opted for some short-term relief at the expense of long-term pain. That is precisely the short-sighted type of thinking we need to stop.

President Obama and Federal Reserve Chairman Bernake are basically betting the future of the world's economy on this.

Update 3/19/2009: More confirmations that this is something to be worried about:

Even though the central bank may have some initial success in depressing rates, analysts worry that monetary policy has passed a point of no return with the printing of money.

"We've crossed the Rubicon," said Howard Simons, strategist at Bianco Research in Chicago. "We have absolutely severed any connection between our dollar and reality. It's as fast as you can print it right now."

Update 3/23/2009: Putin has weighed in with a warning against printing money:

The government should tackle the deficit 'by using the reserves that have been accumulated in recent years, or if necessary by borrowing under market conditions,' Putin told the Cabinet in Moscow today, adding that Russia doesn't yet need to borrow and won't seek loans abroad. 'Resorting to a printing press would be unwise and extremely dangerous.'

Update 4/8/2009: Weeks later, the bond market is apparently still curious as to why the Federal Reserve started buying government debt when it did.

Bond strategists had said they were interested in why the Fed opted to surprise markets after the March 18 meeting by saying, months before most expected, it would buy $300 billion in Treasurys in the next six months. The Fed noted a worsening economic outlook forcing their hand.

The "worsening economic outlook" is a throwaway excuse. Everyone (including bond strategists) know the economic outlook, yet they're still curious why the Federal Reserve did what it did when it did it. Is it still not obvious? It wasn't about the market or economic conditions. It was about ensuring that the government could borrow everything it wanted/needed.

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