US is monetizing its debt, despite what Bernanke says

By John Cheng

In most advanced economies, the government has assigned exclusive power to print its national currency to independently operated central banks. In the U.S., it’s the Federal Reserve. Department of the Treasury in the U.S. would manage federal finances, collecting taxes, duties and paying all bills of the U.S. government. They must pay with currency already in circulation, or else finance deficits by issuing new bonds, and selling them to the public or to their central bank so as to acquire the necessary money. For the bonds to end up in the central bank it must conduct an open market purchase. This action increases the monetary base through the money creation process.

This process of financing government spending is called monetizing the debt. In a nutshell, Department of Treasury issued bonds to get the money needed to run the government and now the Fed is buying more of them from the public with new money created out of thin air, practically replacing debt with more money in circulation. Bernanke has testified in front of the Congress saying: “The Federal Reserve will not monetize the debt,” but he is doing exactly that. The outspoken Bill Gross of PIMCO came out saying the Fed is running a Ponzi scheme in his monthly investment outlook titled “Run Turkey, Run,” saying the Fed has taken Charles Ponzi one step further, telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. He said: “Has there ever been a Ponzi scheme so brazen? There has not.” The increased money supply is already bringing up long-term inflation expectation, we think that’s exactly what the Fed wanted, making the “real interest rate” even lower, negative real interest rate would even be better, implicitly urging people to spend, not save because money will be worth less in the future. The Fed is also saying: Forget about deleverage, this is not the time to do so, go and borrow money to spend, it is the American way. (Real interest rate is approximately the nominal interest rate minus the inflation rate.) The second round of Quantitative Easing has already been effective as the Fed intended, S&P500 gained another 3.6 percent, commodity prices jumped with gold and silver hitting historical highs, oil price en route to hit US$100 a barrel next year. Export of U.S. dollars in search of higher returns are causing concerns from governments of most emerging countries for the speculative inflows are causing unwanted appreciation of their currencies, and inflated asset prices. Capital-control measures are being taken by the emerging countries but probably unable to stem the tide of massive inflow of dollars. China is probably going to divert the attention of RMB to concerns of the consequences of Quantitative Easing in the upcoming G-20 meeting. Asset-price bubbles are warned by the academics, but probably inundated by the euphoria brought on by QE2.