“Romney: Yeah, it’s interesting… the former head of Goldman Sachs, John Whitehead, was also the former head of the New York Federal Reserve. And I met with him, and he said as soon as the Fed stops buying all the debt that we’re issuing—which they’ve been doing, the Fed’s buying like three-quarters of the debt that America issues. He said, once that’s over, he said we’re going to have a failed Treasury auction, interest rates are going to have to go up. We’re living in this borrowed fantasy world, where the government keeps on borrowing money. You know, we borrow this extra trillion a year, we wonder who’s loaning us the trillion? The Chinese aren’t loaning us anymore. The Russians aren’t loaning it to us anymore. So who’s giving us the trillion? And the answer is we’re just making it up.”
This is particularly interesting to me because I was reading this monstrosity of a paper (issued by the Fed, Treasury and SEC) last night on the Government securities market that explains why Romney’s comments are deeply misleading:
“the Treasury believes that the government securities market, and hence the Treasury, have benefitted from the primary dealer system. The FRBNY has required that the primary dealers make markets in all maturity sectors of Treasury securities, and that each primary dealer’s share of customer trading volume must equal at least one percent of total secondary market volume. The FRBNY also expects primary dealers to demonstrate their continued commitment to the market for Treasury securities by bidding meaningfully in all Treasury auctions. If a dealer fails to bid meaningfully in an auction, the FRBNY typically contacts that dealer to remind it of its so-called “underwriting” responsibilities.
The Treasury believes that the existence of a group of dealers with a commitment to the government securities market has been of great benefit to the Treasury. The dealers’ underwriting responsibilities have served to “backstop” Treasury auctions, considerably reducing the risk of insufficient auction cover.”
Emphasis is mine. Now, some stuff has changed since this was written in 1992, but the basic gist is the same. The US government uses the banks to procure funds. They’re required to bid at auctions and maintain a reasonable market in government securities. This creates a backstop and a form of permanent demand for government bonds. This is why, if you study just about every government bond auction, you’ll notice that the auctions go off without a hitch and are routinely oversubscribed by the Primary Dealers by 2X. You could eliminate all the other bidders and it wouldn’t matter.*
So Romney’s concerns about failed government bond auctions are misleading and proves he doesn’t fully understand the institutional design of the monetary system. This form of misunderstanding leads to unnecessary and misguided fearmongering and inevitably misinformed policy decisions. So it’s absolutely crucial that people understand this. If you don’t I would recommend reading my paper on the monetary system and if you’re really hungry for knowledge read MR’s Contingent Institutional Approach.
*As I’ve mentioned before, the only environment in which the Dealers would likely break the rules and fail to bid is in a hyperinflation when it would become intolerably unprofitable for them to own US government securities. The Fed would likely buy on the primary market (as opposed to the secondary market as they do now) and you’d have a nice little case of currency collapse on your hands. But that’s an inflation constraint. Not a solvency constraint like having an inability to fund the government. BIG DIFFERENCE.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.