Demand for USA Debt is Not Limitless

Finally, a voice of reason appears in yesterday's Wall Street Journal asking the question, "Can the Federal Reserve continue buying U.S. Treasury's in massive quantities forever?"  That's the question we have been asking for four years now and simply can't get a straight answer.

For those of you who may be yawning before this blog post even gets started....just put on your thinking cap for one more minute.

The Federal Reserve 'bought' 61% of all U.S. Treasury's issued last year.  Yes...that is staggering...especially when you understand that the Federal Reserve has no real money to spend $trillions on buying IOU's.  This would be a little bit like when Bernie Madoff's Growth Fund was short of cash so he "borrowed" it from the Bernie Madoff Balanced Fund.  The funny thing was is that neither fund had any REAL money....that was long gone and spent....it was really just book entries on a tablet and all the investors had faith the "real" money was backing up all the book entries.

The conventional wisdom that nearly infinite demand exists for U.S. Treasury debt is flawed and especially dangerous at a time of record U.S. sovereign debt issuance.

The recently released Federal Reserve Flow of Funds report for all of 2011 reveals that Federal Reserve purchases of Treasury debt mask reduced demand for U.S. sovereign obligations. Last year the Fed purchased a stunning 61% of the total net Treasury issuance, up from negligible amounts prior to the 2008 financial crisis. This not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits.

The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit. Similarly, the Fed is providing preferential credit to the U.S. government and covering a rapidly widening gap between Treasury's need to borrow and a more limited willingness among market participants to supply Treasury with credit.

The failure by officials to normalize conditions in the U.S. Treasury market and curtail ballooning deficits puts the U.S. economy and markets at risk for a sharp correction. Lessons from the recent European sovereign-debt crisis and past emerging-market financial crises illustrate how it is often the asynchronous adjustment between budget borrowing requirements and the market's appetite to fund deficits that triggers a shock or crisis. In other words, budget deficits often take years to build or reduce, while financial markets react rapidly and often unexpectedly to deficit spending and debt.

Here;  http://online.wsj.com/article/SB10001424052702304450004577279754275393064.html?mod=googlenews_wsj

Words like "shock", "crisis" or "sharp correction" are certainly a possibility.  Just like it was a shock and a crisis to learn that Bernie Madoff was just passing out balance sheets that showed everything that investors wanted to see...and it was a "shock" and a "crisis" to learn that thousands of investors had lost everything.

What to you think might happen if 50% of the $000's that the U.S. government has created out of thin air and has sitting in cyber space on bank spread sheets...suddenly vanishes?  Could that be a shock to the global system? 

Might it surpass the breathless news of Whitney Houston's early death by drowning or who is going to be the next American Idol?