OpenEconomist's  Instablog

The Federal Reserve has opened up swap lines with foreign central banks around the world in order to provide liquidity[1]. This is similar to what they did during the initial liquidity crisis in 2008 when banks would not lend to each other.

In their swap agreement with the European Central Bank, the ECB notes this:

"The Governing Council of the ECB decided to reactivate, in coordination with other central banks, the temporary liquidity swap lines with the Federal Reserve, and resume US dollar liquidity-providing operations at terms of 7 and 84 days. These operations will take the form of repurchase operations against ECB-eligible collateral and will be carried out as fixed rate tenders with full allotment. The first operation will be carried out on 11 May 2010."

Just last week, on May 3rd[2], the ECB decided that Greek Bonds, despite their ratings downgrades, are acceptable collateral. This means that the ECB will be entering into repurchase agreements with holders of Greek Debt in exchange for US Dollars that were printed by the US Federal Reserve.

This is extremely inflationary.
Right now in the US, the M1 money multiplier is below 1. It has been below 1 pretty much since the crisis started. What this means is that no matter how much liquidity the Federal Reserve provides to banks in the US, the funds are not making their way out into the economy. Instead, they are being held as excess reserves. A money multiplier above 1 indicates that new money is moving through the economy.

This swap deal with foreign central banks is directly injecting US Dollars into foreign economies. By design, this enforces a money multiplier greater than 1. This essentially means that the US has printed new dollar bills, flown them over to Europe, and is exchanging them for newly printed Euros that are backed by Greek Debt. If you think this is going to be good for the US Dollar, please please please leave a comment and let me know what kind of logic you are using. I will be very curious to see how this inflation will manifest itself. Will these new US dollars find their way back to the US Economy? Will they instead be used to purchase US Treasuries?

Perhaps the US saw this as an opportunity to help boost demand for its own debt. By making available US Dollars to foreign entities, it is increasing the likelihood that those dollars will be used by foreign banks to purchase US Debt.

Think about it. If you owned Greek Bonds, and someone offered you a way to turn your Greek Bonds into US Treasuries would you say no?

Would you lend someone money if you know the only way they could pay it back was when their Greek Bond matured? Well, the Federal Reserve did that for you!

If the US is already printing new money to help bailout Europe from their own debt problems, then I hardly think there is any question around whether or not it would print new money to bailout US States and the US Federal Government from their own debt when it comes due.

Any lingering questions about whether or not the US will inflate its currency to pay off its large debt have now been answered.

References:
[1] www.federalreserve.gov/newsevents/press/...
[2] www.businessweek.com/news/2010-05-03/ecb...
www.opensourceecon.com/main/us-federal-r...