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Saturday, January 09, 2010

Who's Buying Our Debt?

There are things that make you go "Huh!"

There are some assumptions that are common and are simply wrong. For example, if you ask the average person who our biggest trading partner is, most would answer "China." They would be wrong; it's our frozen northern neighbor: Canada. Canada is also our biggest foreign oil supplier. But here's something that I bet do don't know: who is buying most of our debt?

Would you guess China?

You would be wrong. Thanks to PIMCO's Bill Gross (via Art Cashin) it's the US Federal Reserve.

Here’s the problem that the U.S. Fed’s “exit” poses in simple English: Our fiscal 2009 deficit totaled nearly 12% of GDP and required over $1.5 trillion of new debt to finance it. The Chinese bought a little ($100 billion) of that,other sovereign wealth funds bought some more, but as shown in Chart 2, foreign investors as a group bought only 20% of the total – perhaps $300 billion or so. The balance over the past 12 months was substantially purchased by the Federal Reserve. Of course they purchased more 30-year Agency mortgages than Treasuries, but PIMCO and others sold them those mortgages and bought – you guessed it – Treasuries with the proceeds.

The conclusion of this fairytale is that the government got to run up a 1.5 trillion dollar deficit, didn’t have to sell much of it to private investors, and lived happily ever – ever – well, not ever after, but certainly in 2009. Now,however, the Fed tells us that they’re “fed up,” or that they think the economy is strong enough for them to gracefully “exit,” or that they’re confident that private investors are capable of absorbing the balance. Not likely.

Various studies by the IMF, the Fed itself, and one in particular by Thomas Laubach, a former Fed economist,suggest that increases in budget deficits ultimately have interest rate consequences and that those countries with the highest current and projected deficits as a percentage of GDP will suffer the highest increases – perhaps as much as 25 basis points per 1% increase in projected deficits five years forward.

So what the Fed did was buy the Agency mortgage bonds for its own account so that the PIMCOs of the world would use the cash to buy treasury bonds. A swap, in other words, designed to get someone to buy the treasury issuance in the absence of foreign buyers.

This explains the call by some in Congress for an audit of the Federal Reserve. If it turn out that the federal government has not really sold the bonds that it issued, but bought them from itself, that puts the debt and the creation of money in a different light.

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