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The Fed should never buy Italian bonds

Here’s some out of the box thinking:

If Europe’s woes threaten to push the US economy into a recession, shouldn’t US policy makers do something about it?

More specifically, if unsustainable Italian interest rates are rebounding to crush the US economy, shouldn’t the Federal Reserve direct its monetary policy in ways that will lower those interest rates. Shouldn’t the Fed announce a target rate for Italy?

Let’s imagine how this would work. The Fed could announce that it will not allow rates on Italian sovereign debt to exceed a certain level.

It would buy Italian bonds with newly created dollars until the rates hit the target.

This would probably be a massive buying program. It would expand the money supply.

-John Carney, CNBC

John doesn’t say this is a good idea. He actually says “So this almost certainly won’t happen. But we certainly could do it if we wanted to.”

Even so, its important to stress that this is a BAD idea. Central banks can go broke.

First of all, a central bank’s buying dodgy assets is always a solution to a liquidity crisis that is fraught with peril. if those assets go bad and losses are crystallized, it could render the central bank technically insolvent and undermine confidence in the central bank. Fear of this technically insolvent outcome was a major reason the Europeans did not allow the ECB to participate in the ‘voluntary’ haircuts that it has attempted to coerce onto the private sector in the latest Greek bailout.

Clearly, the ECB could just print money and use the seigniorage from that printing to earn its way back into solvency without having been declared insolvent. But you can see the problem. To maintain the ECB’s credibility it would need to be recapitalised.

But if the Federal Reserve were to load up on Italian bonds, then the seigniorage route is out. The Fed would be exposed to default on foreign currency assets. If Italy defaults, then the Fed is on the hook. Officially, the Fed is under Congressional jurisdiction. The US Congress has oversight of the Federal Reserve and Congress should never allow the Fed to make unsecured loans to foreign governments without prior and specific Congressional approval.

The Fed should never buy foreign currency assets. And if it does, Congress should intervene.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

  1. Would be worse than Fed swap lines to foreign central banks

    • hate the pensioners says:

      swap lines are covered by collateral (sovereign bonds)

      in principle i think that when they have opened a swap line with ecb they have done the same thing (but for low amount 1 2 bln)

  2. Agree 100% Sam. At least with the swaps, the ECB is the counterparty.

  3. Din Gee says:

    The Fed should never buy Italian bonds ?

    I never thought it was on the cards

  4. geerussell says:

    I offer a slightly different framing for why the Fed buying Italian bonds is a bad idea.

    That it makes the central bank technically insolvent isn’t the bothersome aspect to me. Viewed as part of the consolidated government/fed/tres sector, a government bailout of the fed is just internal accounting.

    What I find objectionable is the way that knowingly swapping cash for trash with a wink and a nod is essentially a fiscal option wrapped in a monetary cloak, when those losses crystallize and new net financial assets have to be spent into existence to make good the losses.

    I’m all for government applying the lever of deficit spending for public purpose but I have a strong bias towards conducting fiscal policy above board through the government channels where it is invested with political legitimacy.

    If the political leadership can get congressional approval to deficit spend to prop up Italy, that’s fine, but that should be the hurdle.

  5. blankfiend says:

    In Bernanke’s Nov 21, 2002 speech,footnote 16 states:

    “16. The Fed has committed to the Congress that it will not use this power to “bail out” foreign governments; hence in practice it would purchase only highly rated foreign government debt.”

  6. john says:

    As this whole thing is just thought experiment, suppose that in the moments he’s not reveling in pure evil Tim Geithner actually believes the Military Industrial Complex and FIRE are the two remaining comparative advantages America has in a globalized economy.

    In this context the IMF, World Bank and BIS remain exactly what they were created to be sixty years ago: instruments of American imperial power, the main change in this period is our motives (and the creation of a Weimar obsessed ECB, a cute surprise!). From this perspective the only thing in the world prettier than a fully armed predator drone is a TBTF US bank (another form of predator drone).

    Cascading defaults in Euro land and the swap swamp they will inevitably create here are just another toxic bog that H Ben can be spooked into draining onto the Fed’s balance sheet. Once we purchase all of Europe’s banks we can force them into mergers with Citi and BA and give our great zombie banks European brains to eat! As Ed pointed out last week, sans bad debt Europe is a pretty attractive property. And if you can get it with most of its citizens as serfs again, this is a once in a lifetime buying opportunity! Paranoid I know, but I’m just sayin’….

    Its really no different from what the ECB is proposing for Greece, just bigger. Pure power grab, plain and simple, a way to own Europe without the headaches of occupying! If it succeeded our “watchdogs” in Congress would just end up adding Euro zone bankers to their fundraising lists. A cynics worst case scenario.

    • David Lazarus says:

      If the european banks do collapse the chances are that the CDS market will wipe out the big US banks. Hence Geithners trek around Europe to ensure that no credit events are triggered. After the experience of Iceland I doubt that they will be willing to sell the remains to US banks anyway.

  7. But What Do I Know? says:

    The Fed buying Italian bonds is a bad idea, but I’ve never understood why central banks should worry about making losing trades. If you could create money at will, would you worry about losing it?

    I read the links regarding central banks going bankrupt, but I still don’t get how that could happen unless the Powers That Be wanted it to.

  8. James Dollinger says:

    The obvious way to recapitalize banks is to revalue the gold that they hold on their balancesheets. One would have to assume this is why their is a strong correlation between liabilities on a central banks balance sheet and the price of gold in the currency which they regulate.

  9. Frank says:

    I’m with John, except I actually believe this is not a thought experiment at all, but rather rhymes with the manner in which the EZ crisis will be “resolved”. And what will poor Congress do when the same H. Ben and Tim G. say this is the only way out, as floor debate occurs during the same moment that markets are crashing – they will cave (again), mark my word.