On March 19, the New York Times reported: “The Fed said it would purchase an additional $750 billion worth of government-guaranteed mortgage-backed securities, on top of the $500 billion that it is currently in the process of buying. In addition, the Fed said it would buy up to $300 billion worth of longer-term Treasury securities over the next six months.”

The Federal Reserve says that its purchase of $1 trillion in existing bonds is part of its plan to revive the economy. Another way to view the Fed’s announcement is to see it as a pre-emptive rescue. Is the Fed rescuing banks from their bond portfolios prior to the destruction of bond prices by inflation?

The answer to this question probably lies in the answer to the question of how the unprecedented sizes of the FY 2009 and FY 2010 federal budget deficits will be financed. Neither the U.S. savings rate nor the trade surpluses of our major foreign lenders are sufficient.

I know of only two ways of financing the looming monster deficits. One, courtesy of Pam Martens, is that the federal deficits could be financed by further flight from equities and other investments.

This is a possibility. If the mortgage-back security problem is real and not contrived, the next shock should arise from commercial real estate. Stores are closing in shopping centers, and vacancies are rising in office buildings. Without rents, the mortgages can’t be paid.

Another scare and another big drop in the stock market will set off a second “flight to quality” and finance the budget deficits.

The other way is to print money. John Williams (shadowstats.com) thinks that the budget deficits will be financed by monetizing debt. The Federal Reserve will buy most of the new bonds and create demand deposits for the Treasury. In effect, the money supply will grow by the amount of Fed purchases of new Treasury debt. Printing money to finance the government’s budget normally leads to high inflation and high interest rates.

The initial impact of the announcement of the Fed’s plan to purchase existing debt was to drive up the bond prices. If the reserves poured into the banking system by the bond purchases result in new money growth, however, and if the Fed purchases the new debt issues to finance the government’s budget deficits, the outlook for bond prices and the dollar becomes poor.

It will be interesting to see how the currency markets view the problem. The New York Times reported that “the dollar plunged about 3 percent against other major currencies” in response to the Fed’s announcement.

If the exchange value of the dollar works its way down, it will complicate the financing of the trade deficit and affect the decisions of foreigners who hold large stocks of U.S. dollar debt. The premier of China recently expressed his concern about the safety of his country’s large investment in U.S. dollar debt.

If the U.S. government is forced to print money to cover the high costs of its wars and bailouts, things could fall apart very quickly.

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