nice post, it’s refreshing to see, so simply spelled out, how things actually work.

People, if they’re paying attention, would do well by warming up the spooler, and hitting

A nice turn you’ve done.

The government spends by crediting bank accounts. The spending occurs before the sale of securities or the collection of taxes and results in an increase in reserves in the system. The sale of securities functions as a reserve maintenance operation and is done solely to sustain the Fed’s interest rate target. There is no “borrowing” per se.

Interest rates are set by the Fed–period. It targets the overnight lending rate but has the prerogotive to directly set rates along the entire term structure if it wishes.

The notion that the Treasury is selling securities to “fund” the bailouts is wrong. The Treasury is not “funding” anything. It spends by crediting bank accounts. Over the past two months actions taken by the Treasury and Fed have caused bank reserves to swell by $600 billion. The planned sale of $550 billion will simply reduce reserve balances. The public swaps a reserve balance (cash) for a higher paying Treasury security. The net financial position of the public has not changed.

Since the government spends by crediting bank accounts and doesn’t borrow per se, it needs to sell nothing more than the shortest term T-Bills to effectively manage reserves. The only reason the Treasury sells longer dated securities is because various maturity lengths are demanded by portfolio investors. It is simply satisfying that demand, but doesn’t have to. It has nothing to do with the need to lower borrowing costs because it doesn’t borrow.

Yields have plummeted recently because actions by the Treasury and the Fed boosted reserves by an historic amount. In other words the government provided the funds–in historic quantity–with which to buy the securities. It’s simple supply and demand: the Fed and Treasury have provided an enormous amount of money to the system, but the securities are being sold in relatively small amounts at intervals.

The Fed’s decision to buy longer term securities stems from a desire to set long term rates lower. It sets long term rates in the same fashion that it sets the overnight rate–by buying or selling securities from the public. This is being done on the assumption that it will lead to more credit demand. It may not work. It didn’t work in Japan. A boost in aggregate demand is what is really needed now. The Fed does not control that, but the Federal Government certainly can.

Using the example of Disney and its sale of long-term bonds is like comparing apples to oranges. Disney is not the Federal Gov’t. They DO need to borrow and their borrowing costs matter. It’s not the same for the government. Bad analogy and misses a critical, yet fundamental, distinction.

Again, the only reason the government sells anything other than the shortest dated T-Bill is to satisfy the demand of portfolio investors. Aside from that, it doesn’t need to.

It’s a brilliant idea and really embodies all aspects of the current crisis.

Let me short them.