Brother, Can You Spare a Billion?

Money
It's a gas
Grab that cash
With both hands
And make a stash

-Pink Floyd

Last week, for the first time in seven years, England had a government bond auction fail. This effectively means the Bank of England offered up some newly minted bonds for sale and investors said, "(Burp!), I'm full. Thank you anyway."

With all the talk about what the U.S. would do should foreign investors shy away from Treasuries, we have an example right across the pond. The answer: finger-pointing and government predictions that the next auction will be well-received.

Here in the U.S., a failure would not occur because there are too many "back up" buyers available. First of all, the 19 prime dealers are all beholden to the Treasury who has made it very clear over the years that they should buy a certain amount of Treasuries at each auction regardless of client interest. If these dealers refuse to lend to the Treasury, they will surely find themselves out of future auctions and perhaps under some scrutiny by other government agencies. This is the reverse model of the mafia loan shark: You must lend to us or else!

Even if that fails, the Fed will surely step in. Effectively, when the Fed buys Treasuries they are printing money. To see this, one must realize the Treasury is selling bonds in order to finance some sort of government spending. Well, if the government spends and then borrows from itself to fund that spending, that is the same as cranking up the printing press.

If, however, the primary dealers and perhaps other banks buy up the supply for their own accounts, it will lead to inflation as well. To see this, one must realize these banks are low on capital. Any increase in their balance sheet - even with so-called "zero-risk-weighted assets" such as Treasuries - decreases important capital ratios. This leads banks to turn back to the government for further capital injections, which then must be funded by issuing more Treasuries.

Over the last year, the money supply - defined as currency, savings accounts, small time deposits and retail money funds (AKA M2) - has grown 9.8 percent and is on schedule to grow much more quickly going forward. Rational thinkers suggest this will lead to inflation, which it surely will if American consumers ever get their hands out of their pockets and back into their wallets.

On the other hand, we have government in charge of the punch bowl at this money party. As the economy shows signs of recovering, the Fed and Treasury can dial down recent stimulus, government guarantees and cheap money programs. This tapping of the brakes on the economy will help keep inflation in check, but surely requires some superhuman abilities to perform correctly. In any case, I can't be completely convinced hyperinflation is on the way.

This monitoring activity, of course, will be truly un-populist. And that is exactly why it is important to set and control monetary policy independent of politics. American consumers are no different from alcoholics in the sense that more is deemed better. Our economy is some 70 percent consumption-based and until that changes (think 50 years, not five), governors on a growth economy will remain unpopular.

The joint statement between the Treasury and the Fed last week made clear Bernanke's greatest worry that the Fed would potentially be politicized. Specifically, Bernanke is clearly attempting to retain sole authority to reign in the market support programs as the economy recovers. We must retain an independent Federal Reserve to help keep us out of inflationary trouble.

Let's all decide now to place our car keys in the fish bowl once we get to the party.

Key Developments

Durable goods orders in February rose 3.4 percent versus expectations for a drop of 2.5 percent. Reviewing the numbers over the past year, orders remain some 23 percent lower than a year ago. When economic activity slows at such a dramatic pace, the data inevitably become more volatile leading to "surprises" like this, which should not be confused with recovery.

The Bureau of Economic Analysis reported its final estimate for fourth quarter's gross domestic product growth at minus 6.3 percent, slightly lower than the previous estimate. The net downward revision to estimated activity was $2.9 billion.

Personal income continued to decline, while spending picked up 0.2 percent in February. Contrary to the hope that the economy has bottomed, job losses continue to rise and incomes continue to fall. Though spending has picked up somewhat in the first quarter, analysts attribute this to pent-up demand from the fourth quarter along with rising gasoline prices.