New stimulus: Let's buy our own debt

Despite the failure of the Obama administration's $787 billion stimulus plan to move unemployment below 9.5 percent, the White House has a new idea – maybe the United States should just begin once again buying its own debt.

Remarkable as the concept seems, reputable news agencies are beginning to telegraph the concept.

"With interest rates already close to zero, the Fed will have to execute any monetary stimulus through the management of its balance sheet," the Financial Times in London said today.

What this means is that the Obama administration, through the auspices of the Federal Reserve, is about to resume buying Obama administration debt issued through the U.S. Treasury Department to finance what is likely to be a $1.5 trillion federal budget deficit in fiscal year 2010.

"Killing Wealth, Freeing Wealth" predicts the torching of the dollar and explains what you can do to protect and expand your own wealth.

As recently as March, the Federal Reserve announced terminating an earlier plan under which the Fed had purchased $1.25 trillion in federal-government mortgage-backed securities issued by Freddie Mae and Fannie Mac, The Wall Street Journal reported.

In October 2009, the Fed terminated an earlier program to purchase $300 billion in U.S. Treasury debt.

Last year, the federal government bought its own debt in an effort to keep interest rates low.

Until now, the Fed has managed to keep federal-funds rates in the historic low range of zero, a policy that traces back to December 2008.

In the process of buying federal debt, the balance sheet of the Federal Reserve has gone from under $1 trillion in 2008 to approximately $2.3 trillion today.

Having the Fed buy federal debt involves a process economists typically call "monetizing the debt," in that the Federal Reserve essentially is printing money to purchase U.S. debt in a process most Americans would understand as using the MasterCard to pay the Visa bill.

"Out of nearly $2.1 trillion of net issuance across the Treasury, Agencies and (mortgage-backed securities) markets from June 2008-9, the Federal Reserve has accounted for nearly 40 percent of the total demand, buying more than every foreign government combined," Jon Harooni, a senior analyst at Glenhill Capital, a hedge fund in New York City, and Ravi Tanuku, a research analyst at Fred Alger Management, an investment firm in New York City, wrote in October 2009, criticizing the policy being implemented by Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner.

"It is not much of a stretch to say the Fed has become the entire mortgage market; it has purchased nearly $500 billion of (mortgage-backed) securities during a period where there was only $350 billion issued," they continued.

"Looking at the first seven calendar months of 2009 yields similarly startling results: of the total $1.1 trillion of net issuance across these markets, the Fed has purchased $861 billion or almost 80 percent."

The dollar as a carry trade

In Nov. 2009, New York University economist Nouriel Roubini argued in the Financial Times that by keeping federal-fund interest rates at zero, Bernanke has stimulated a stock-market rise fueled by money investment managers borrow from the federal government.

Roubini warned that the dollar has become the "mother of all carry trades" and that it faces "an inevitable bust" that will cause asset prices to plummet in what will amount to a global stock-market crash of historic proportions.

By definition, a currency is in a "carry trade" when it can be borrowed at relatively low cost and invested for what appears to be a certain or "locked-in" gain.

Asking rhetorically what is behind the stock-market rally in which the Dow Jones Industrial Average has shot above the 10,000 benchmark after reaching a low of 6,547.05 on March 9, 2009, Roubini said the dollar's replacement of the Japanese yen as the world's carry trade of choice has caused U.S. stock markets to be hit by "a wave of liquidity from near-zero interest rates."

Roubini's analysis was reminiscent of the attack launched against President George W. Bush that Federal Reserve Chairman Alan Greenspan had caused the "mortgage bubble" by keeping interest rates artificially low at 1 percent in 2003-2004 to stimulate the post–Sept. 11 U.S. economy.

The bursting of the mortgage bubble is widely credited with being the precipitating cause of the economic recession that officially began in December 2008, following two consecutive quarters of negative growth in U.S. gross domestic product.

"The U.S. dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time," Roubini wrote.

As long as U.S. stock markets continue to go up, investors participating in the carry trade look like geniuses, Roubini argued, capable of realizing total returns in the 50-70–percent range since March.

But the carry trade cannot last forever, Roubini warned, noting that at some point the Federal Reserve will no longer be able to continue buying U.S. Treasuries and other federal-agency debt securities to keep interest rates depressed.