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Didn’t Chairman Bernanke say, “The Federal Reserve will not monetize the debt.”

Yes he did, as clear as day to the House Budget Committee back on June 3, 2009. And yet 17 months later Bernanke gave us QE II, which not only means the Federal Reserve will be purchasing about $75 billion a month in assets for the next 8 months, but as it so happens, some $110 billion in Treasury Notes and Bonds too. That’s enough to finance the U.S. government’s projected fiscal deficit right up through June 2011, in full.

THE CONTRARIAN TAKE says, what gives!

Echoing his June 3 rd testimony, said Bernanke to Congressman Ron Paul and the House Financial Services Committee on July 21, 2009, “We are not intervening, or actively trying to… make it easier for the government to issue debt.” Well, QE II may or may not be aimed at “monetizing the debt’ but monetizing the debt, and in robust fashion, it nevertheless is.

We here at THE CONTRARIAN TAKE love to crunch numbers. So we asked the question, just how big are these debt monetization activities in the light of historical precedence? Given the impact these activities have on the currency and bond markets, we’re thinking its something we all want to know. What we found is that these activities are a whole lot bigger and a whole lot more pervasive than even we thought.

Before we show you just how big and pervasive, some preliminaries…

Intro to U.S. Government Debt Monetization, Our Take

The traditional take on U.S. government debt monetization activities is centered on U.S. Treasury debt and the Federal Reserve. To wit, the Federal Reserve purchases or monetizes Treasury debt by issuing checks on itself, in effect printing the money with which to purchase the debt. Certainly true, but in our minds, too narrow a view for two reasons:

• Treasury debt is not the only government debt.
• The Federal Reserve is not the only central bank actively monetizing government debt.

Treasury Debt, Not the Only Government Debt

What other government debt is there, you ask? The obligations of the government-sponsored enterprises (Agencies) Fannie Mae and Freddie Mac .

On December 24 th 2009, recognizing the dire state of the housing market, a market that just so happens to be dominated by the Agencies, the U.S. government gave the Agencies, already in conservatorship and under government control, unlimited access to the U.S. Treasury, effectively making them divisions of the U.S. government and their mounting losses the government’s own. On that date, the long standing implicit guarantee bestowed on Agency debt by the U.S. Treasury was turned lock, stock and barrel into and an explicit one, making Agency debt obligations the defacto debt of the U.S. government.

In our minds, that means that when the Federal Reserve buys Agency debt, in a very real way, it is monetizing the debt of the U.S. government.

Federal Reserve, Not the Only Central Bank Monetizing the Debt

The Federal Reserve has some friends that help it monetize both Treasury and Agency debt. Those friends are the central banks of the world, largely the central banks to America’s Asian trading partners. They buy U.S. Treasuries and Agencies in large quantities, by printing their own money with which to do it, not because they are really friends of the Federal Reserve, but because in their eyes it lends support to their country’s export driven economies. The Federal Reserve relishes their help because the bid those central banks provide – for the U.S. Dollar, for Treasuries and for Agencies – is a bid that would be left largely to the Federal Reserve. James Grant, editor of Grants Interest Rate Observer , has a way with words, so we will let him explain the how and the why…

…Consuming much more than it produces, this country ( America ) discharges its debts in dollars. Having no use for dollars, their recipients, America ’s Asian creditors, sell them for local currency, which their local central banks duly print. The dollars, meanwhile, go winging their way back to America in exchange for Treasurys and agency securities. So far, so sweet: Everybody seems to win. Asian asset markets levitate, and Treasury yields collapse. But the sheer volume of dollars emitted, Treasurys purchased and Asian currencies printed should make even the most sanguine bond bull stop and stare.

Grants Interest Rate Observer, September 3, 2010 . Vol. 28, No.17

As Grant opines, the benefit the Federal Reserve receives from the monetization activities of these foreign central banks appears to be a clear win for the Federal Reserve, the U.S. Dollar and the U.S. government bond market, for as long as these banks and their respective governments find it worth their while. The problem is the other side of this debt monetization partnership is a whole lot of monetary inflation, both in America and abroad, a situation which clearly can not last forever (that though is a subject for another day).

U.S. Government Debt Monetization, the Numbers

Let’s bring these concepts to life with some numbers…