Sunday, December 21, 2008

Why is the Federal Reserve contemplating issuing bonds?

When I first saw a little news squib that America's current central bank, the Federal Reserve, wanted Congress to grant it the power to issue bonds (long term IOUs), I thought it was a piece from The Onion, the hilarious king of print news satire. Had the story been real, I told myself, it would be plastered on every front page of every self-respecting business periodical in the country and CNN would soon have 15 to 20 talking heads babbling about what the news means for the nation and its teetering economy.

Well, it appears the story is real but hardly anyone noticed it or gave a thought to its implications. The Fed already issues debt, zero-interest debt, in the form of Federal Reserve notes. (You know, the money you used to carry around in your purse or wallet before the September crash.) It also issues deposits called bank reserves, on which it now pays a little interest but completely controls. It puts those liabilities or "sources of funds" to work on the asset side of its balance sheet, which includes interest-bearing Treasury bonds and loans to banks (and now non-banks too), gold, and some other physical assets. It's quite a lucrative business.

If the Fed wants to issue interest-bearing bonds, as the Treasury does, it must think that the demand for dollars (at 0% interest) is weakening or will weaken.* (Why issue debt at > 0% when you can issue at 0%?) But who would want dollars in the future if they don't even want dollars today? As Peter Schiff recently noted: "Perhaps the Fed feels this [paying interest] will make holding its notes more appealing. However, since the interest will be paid in more of its own script, I do not believe this con will work."

So what is going on? One possibility is that the Fed is preparing to issue bonds denominated in one or more foreign currencies. It can/will do so more quietly and privately than the Treasury can and will use its vaunted "independence" to hide the fact as long as possible. Or, perhaps, it will issue bonds that will be denominated in dollars but pay interest in a foreign currency or in gold or some other commodity. Or maybe the bonds will be collateralized by specific sets of its assets. The bonds it wants to issue, in other words, will have to be "sweetened" in some way in order to get people (firms, other nations' central banks) to hold them.

Another possibility is that this is just a ruse to keep the bailout from showing up in the national debt, which by convention includes only the Treasury's bonds. That was why the GSEs were spun off from the government in the late 1960s, btw, to get their debt off the Treasury's books. What I suggest is that we don't fall for the ruse and count any interest bearing bonds issued by any federal agency as part of the national debt.

Needless to say, we've been down this road before. Check out One Nation Under Debt for details.

Happy Holidays! It may be the last normal one for a long time.

*This is not as crazy as it sounds. During the Great Depression, Mexican pesos circulated in the border areas of the United States. Mexican pesos! See Amity Shlaes, The Forgotten Man, 138. Also, in the late 1970s the U.S. Treasury resorted to selling bonds, called Carter bonds, denominated in German marks. See this article for details.

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