Why The U.S. Is Europe: Central Bank Deficit Funding Thinly Veiled

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There is something eerily similar about the way the European Central Bank's (ECB) new bond buying plan (OMT) purposes to fund distressed sovereigns in Europe and the way in which the Fed and U.S. banks conspire to fund the U.S. deficit.

Recall that the ECB's plan involves the purchase of distressed sovereign debt in the primary market by Europe's rescue vehicles, while the central bank itself purchases bonds in the secondary market. The idea behind the structure is to avoid the accusation that the ECB is directly funding governments (hence the confining of the central bank's purchases to the secondary market).

Note the parallels between this scheme and the way in which the Fed buys assets. The Fed creates electronic dollars to make securities purchases from primary dealers (these are the secondary market purchases) and the primary dealers (banks) use the money they receive from the Fed to make purchases directly from the Treasury (the primary market).

In both cases, the central bank avoids the charge of deficit funding by simply using a middleman for its primary market purchases. For the Fed, the middleman is banks, for the ECB it is the rescue vehicles. As Pater Tenebrarum notes however, this is just a semantic trick:

"Some people have accused Ben Bernanke of lying when he denied that the Fed will monetize the government's deficit' in testimony. The chairman may actually be relying on a technicality here. As mentioned above, the Fed buys already existing bonds, so technically it is merely buying assets that represent deficits of the past, not current ones."(emphasis mine)

In practice, there is very little effort expended to hide what is going on. Consider that on June 13, the Fed bought nearly $5 billion in 10-year Treasury bonds at 11 AM. Just two hours later, the Treasury auctioned 10-year notes. The very next day, the Fed bought $2 billion in 30-year Treasuries two hours before the Treasury auctioned $13 billion in comparable securities. As ZeroHedge dryly noted at the time, the 10-year auction

"...priced at terrific terms as there was a $4 billion hole created courtesy of the Fed if only for 2 hours"

It is unsettling enough that the Fed is funding the U.S. deficit in the same manner the ECB purposes to fund Spain and Italy (no one wants to be compared to the eurozone periphery). Perhaps what is more disturbing however, is that in contrast to the prevailing situation in Europe, there is no conditionality attached to the Fed's generosity. This point was driven home by economist and former White House economic advisor Larry Lindsey who said the following on CNBC Thursday:

"The ECB has admitted they're...prop[ping] up fiscal policy...it's called fiscal dominance, they've confessed. In return, they're demanding conditionality, whether [Spain and Italy] follow through, we'll see. By contrast, the Fed has told Congress 'we're going to buy your bonds no matter what' and I think it's keeping the pressure off the president and it's keeping the pressure off Congress and it's not a good situation."

This is an extremely important concept to grasp. One of the main points of contention in Europe is that Spain and Italy do not want to be subject to the conditionality (spending cuts, fiscal tightening) that comes with OMT assistance. In the U.S., not only has the Fed attached no demands regarding fiscal restraint to its purchases (and if it were truly independent it could attach such demands), it has guaranteed it will undertake such conditionless purchases in perpetuity. In Lindsey's words,

"Why would any Congress not borrow and spend if they could borrow [unlimited amounts] at 60 basis points?"

When one looks at this dynamic it becomes clear that the Fed's real goal (forget price stability and unemployment) is to perpetuate government spending. As Charles Hugh Smith puts it,

"...the pathway of the freshly printed money goes from the Fed to Treasuries and through deficit fiscal spending into the real economy. The amount of "new free money" flowing into equities may be a lot less than the consensus believes, as $500 billion of it has already been committed to enabling Federal deficit spending on a monumental and seemingly permanent level."

Perhaps this is good in the short run - at least it's a more direct path to the real economy than that posited by proponents of the wealth effect - but the long-run implications are quite unpalatable. After all, it is yet another example of attempting to solve a debt problem with still more debt. Somehow, policymakers believe that if the debt burden shifts from private to public, the end result will be different.

It will not be different, and indeed the line between public and private debt has become blurred. When excessive government debt causes policymakers to institute financial repression in order to erode or refinance the debt away, it essentially constrains the ability of the private sector to deleverage by making it more difficult for savers to generate interest income that can be used to pay off old debt and repair household balance sheets.

In the mean time, the Treasury bubble is growing larger and larger with each passing month. A 'correspondent' quoted by Charles Hugh Smith in the above cited piece notes that

"Fed monetizing makes it so that Treasury borrowing doesn't negatively impact treasury markets and so Treasury rates don't increase."

In other words, the artificial demand created by the Fed is the only thing keeping the Treasury market afloat. If you believe that the Fed will eventually be forced to wind down its balance sheet (i.e. if you believe that the central bank's holdings will not simply pile up to the sky), then you can see how the Fed's actions and balance sheet actually pose the biggest systemic risk of all.

As I have noted before, when the Federal Reserve begins to unwind these positions, it is going to destabilize the Treasury market. In this way, the continual monetization of the U.S. deficit is creating perhaps the largest asset bubble of all time. I continue to believe that investors who place long-term bets against U.S. Treasuries (NYSEARCA:TLT) will one day be mentioned in the same breath as those who bet against subprime mortgages in 2006.

One day, quite a bit of supply is going to be dumped onto the market and it isn't clear why hundreds of billions of dollars in debt, which without the Fed would not have found a buyer now, will ultimately find a buyer when the Fed needs to sell it. I recommend a short position in U.S. Treasuries.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.