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Friday, August 7, 2009

Monetizing debt

First, it is important to understand the term, Monetizing debt. Lets look at Wikipedia definition:

In the United States, and in many other countries, the government does not have the right to issue currency to pay its bills. In this case the government must finance its deficit by issuing bonds to the public to acquire the additional funds to pay its bills. However, if these bonds do not end up in the hands of the public, the only alternative is for them to be purchased by the central bank. For the bonds not to end up in the public hands the central bank must conduct an open market purchase. This action by the central bank increases the monetary base, through the money creation process. This process of financing government spending is called monetizing the debt.[1] Monetizing debt is a two step process where the government issues debt to finance its spending, the central bank purchases the debt from the public, and the public is left with high powered money. When government deficits are financed through this method of debt monetization the outcome is an increase in the monetary base, or the money supply. If a budget deficit persists for a substantial period of time, then the monetary base will also increase, shifting the aggregate demand curve to the right leading to a rise in the price level.[2]

To summarize: a deficit can be the source of sustained inflation only if it is persistent rather than temporary and if the government finances it by creating money, {through monetizing the debt}, rather than leaving bonds in the hands of the public.

In a nutshell, "real" governments don't print up cash to pay for it's debts. That results in hyperinflation and destabilization of governments and societies.

OK, so what does this have to do with US economy and the stock market? The blogs Zero Hedge and The Market Ticker have blog entries discussing recent discovery that the US Federal Reserve, working in concert with the US Treasury and a "third party" are basically printing money to pay off debts. (Monetization of debt) Click on the name of each blog to read up on this topic.

The result of this, if left unchecked, is destabilization of US dollar. One thing the US economy has for it, is any "cheating" like this doesn't result in the dollar collapsing overnight like Iceland. But it can destabilize and start a panic collapse over the course of weeks.

This and other practices is why I like natural resource based investments as a hedge. Everyone should have a minimum 20% invested in some sort of long term resource hedge. I for one trade in/out of resource stocks foolishly trying to make more money rather than buy and hold.

But for now the jury is out, this may be a complete misunderstanding by Zerohedge. Naked Capitalism posted a blog entry critiquing Zerohedge on why he is wrong in his analysis. Frankly, I wouldn't put it past the Fed/Treasury in doing such things. And since their operations are under a cloud with only pieces of information released, there is no real way to tell......until it is obvious to everyone.

However, if true, this would likely lead to interest rates to skyrocket, along with resources, and force houses to collapse completely, if left unchecked. For now, its worth watching, not time yet to run for the boarder. This gets an honorable mention as a "Ground Zero" event, but will be truly a ground zero event only if this is true and the Fed continues these actions.

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