The Fed & Debt Cancelation

I met a European trader in a bar this week, who brought up the possibility that at some point, the Bank of England might just rip up the UK government debt it has acquired through quantitative easing — just straight up throw it on the fire, and tell the government it no longer owes the money.

The Bank of England — just like the Fed — has bought a ton of UK government debt as part of its attempt to juice the economy.

This idea has been going around, and picking up buzz.  …

As the person I talked to put it: It’s really hard to see what would be so bad about it. Would the entire system of finance collapse? There’s just no reason to think it would.

Probably the worst thing to come out of it would be inflation. Right now, the Fed or Bank of England “prints” money in QE, but for every $100 injected into the system, $100 in equivalent securities are sucked out and put on the central bank’s balance sheet, so basically it’s a wash. This is why, despite the gigantic expansion of the balance sheet, inflation has been muted and (at least in the US) the trend remains towards disinflation.

via Business Insider.

An interesting idea.  Of course the author here, Joe Weisenthal, is absolutely wrong claiming there is disinflation in this country.  Food and energy prices have nearly doubled in the last 4 years.  That cars and machines machines are cheap is only because people simply don’t have the money to buy them.  The government (a/k/a the Obama administration) has so played with the CPI that it’s no longer reflective of how American’s actually spend their money.  Things people need are more expensive today than ever before.

But what would really happen if the Fed just cancelled the debt?  The truth is that life would go on and the entire financial system would not collapse.  That much is true.

But there is this thing called inflation that no one, NO ONE, wants to talk about.  Not Obama, not Romney, not Bernanke, not the media.  It’s coming.  Everyone knows it’s coming.  The Fed cannot inject several trillion dollars into the economy and there not be inflation.  The only question is whether we get 4-5% for a few years or we get 9-11%.  The former is desired the latter not so much.

This is all going to boil down to the velocity of money.  Right now, the Fed has printed so much money that it is still all sitting in the banks.  It has not yet been absorbed into the marketplace.  i.e.  It’s moving rather slowly.  However the banks are the bottleneck when it comes to money.  It takes them a long time to make decisions.  Once the money is clear of the banks it can move much — MUCH — more quickly.

Right now the Fed is driving with it foot on the gas & the pedal to the floor.  It’s pumping as much money into the system as the system will allow.

There will come a time when the Fed will have to get off the gas and hit the brakes… hard.

Cancelling the debt is kinda like cutting the brake line on the car.  I don’t know of any vehicle that is easy to control when driven hard throttle to hard brakes.  It’s certainly going to be much harder to control if you can only downshift because you don’t have any brakes.