Read of the Day: The Biggest Myth About the Fed

David Beckworth has a nice post over at his site in which he argues that the Fed is not monetizing the debt.  He makes arguments that are similar to the ones I’ve previously made.  But I think the debate over monetization is even simpler than David notes.  The purpose of the fear mongering over the term “monetization” is to imply that the Fed is funding the US government.  The term is used with an intended negative connotation that implies some sort of solvency constraint, as if the government couldn’t fund itself without this back stop which would result in us looking more like Greece with yields surging and on the brink of bankruptcy.  This is just patently wrong and those fear mongering over “debt monetization” have seen their scary inflationary or default scenarios fall flat in recent years.  In other words, they’ve been wrong because they’ve misinterpreted what the Fed is doing.

In the end, this debate is rather simple and has already been won by those of us who predicted the market reactions in real-time .  If the Fed were needed to fund the US government then the fear mongers would have all been right when QE2 ended and yields would have surged because there would not have been enough demand for US government debt.  Investors like Bill Gross called the end of QE2 “D-Day” because he was concerned about a lack of funding when the program ended.  I said, in real-time that he would be wrong and that yields would not surge and that there would be no lack of buyers.

Of course, Bill Gross wasn’t the only one saying this.  It was a common refrain back in 2010.  And despite their dire predictions, the exact opposite occurred when QE2 ended.  Yields declined!  The Fed was not directly funding the US government and the Fed was not needed to fund the US government.  After all, the US government always harnesses its banking system to fund its bond sales.  To argue that the Fed needed to back stop the Treasury is to misunderstand the dynamics at work between the Primary Dealers and the US government.  This is just one of the many misunderstandings surrounding QE2 and despite having already been thoroughly proven wrong, the myth somehow still persists….

Read David’s piece here.