just.a.guy

Monetizing the Debt: Open Market Operations and Statistics

> Honestly, this article was way over my head.
> Correct me if I'm wrong, but the bottom line is that the
> Treasury is selling bonds at auction week after week at an
> unprecedented rate, and the demand for this debt is weak,
> forcing the Fed or its proxies to buy it, in effect, allowing the
> Treasury to take in money being electronically created by the Fed.

This is correct. In case the other comments haven't made it clear, the transaction is akin to a proxy purchase like you mentioned. The implication of the article are that the mechanics go like this: The Fed, knowing that an auction of treasury securities is about to go badly, approaches a direct dealer and gives the wink and the nod of "hey, you buy this and hold onto it for a week or two, and I'll promise to repurchase it from you afterwards for the same price [or a fraction of a point higher]." The reason they'd do this is that a failed auction, or one in which the Fed directly purchased a lot of treasuries would set off many alarm bells.

It would be exactly like a single bidder bidding on a disturbingly high number of pieces of art at a Sotheby's auction. Perception would rightly be that the auction was failing, and that there wasn't really broad and deep demand, so maybe the asset prices weren't exactly accurate. Instead, Sotheby's and the bidder would be in cahoots, with the single bidder approach several other art dealers in the room and saying "hey bid $10 million on Painting X and I will buy it from you in the back alley for $10.1 million next week."

What you would see if you looked at the auction data is lots of broad demand among the "primary dealers" (here, art dealers). But if you looked at everyone's warehouse you'd see a disproportionate of the paintings all winding up in one warehouse -- that of the single bidder. Or in this case, the balance sheet of the Fed.

The practice isn't illegal per se, but it looks bad when the single big bidder (Fed) tells everyone "we aren't buying all the treasuries and monetizing the debt, the auctions are going fine" when in fact the auctions are clearly turning into a sham like the above example.

Except in this case the Fed is basically printing money along the way (like a single art auction bidder using counterfeit money that he launders into the art market via the after-auction back alley purchases outlined above).

The net effect in the above example is that $10.1 million of money is created by the Fed, of which $10 million winds up at the Treasury (and for which the American taxpayer is ultimately liable, plus interest), and the middleman art dealer winds up with $100K ($10.1 - 10.0 million) as a thank you for his participation in the scam.

The net result of this should be that credible third party buyers (i.e. the Chinese) start to drop out of the market, or another possibility is that it's a response to the fact that they've dropped out already.