What is Janet Yellen, new Fed chairman, really worried about?
Is it that reported unemployment will stay high, that the economic recovery will never get off the ground, that we will fall back into recession, or that consumer prices will fall, thereby further endangering the huge debts that already zombify the economy? These are big concerns, no doubt, but not her largest worry. Her largest worry has to be that foreigners will stop buying U.S. bonds.
This is far from a needless worry. Recent events, events of just the past few months and weeks, including the Russian invasion of Crimea, make it even more of a threat to the U.S. government. But, first, some background.
Foreign individuals and businesses cut back on their purchases of U.S. bonds years ago. Their place was taken by foreign central banks. The central banks simply created money in their own currency and used it to buy our bonds.
Why did they do this? The Japanese may have done this because they rely on us for defense and want to help support our economy. But most of the central banks did it to keep their own currencies from appreciating against the dollar.
The more dollars they bought, the less their own currencies appreciated against the dollar. In this way, they kept their export prices down and protected their export related jobs.
This was not unlike the trade wars of the 1930’s, conducted with tariffs, but this time the trade wars were conducted with currency manipulations.
The Federal Reserve always knew that we couldn’t rely on foreign central banks to buy our bonds forever. That is probably the main reason it began the program called quantitative easing, in which the Fed created money out of thin air specifically to buy back U.S. debt.
Quantitative easing was a kind of insurance policy. If foreign central bank buying of U.S. bonds collapsed, the Fed would already have a program in place to buy them back itself.
The Fed always said that quantitative easing was meant to create U.S. jobs. But this never made much sense. Even a hard core proponent of QE, Fed official William Dudley ( formerly of Goldman Sachs) admitted that the Fed’s own economic models could not explain how creating money out of thin air and using it to buy U.S. bonds would increase employment. Some link to rising stock prices could be demonstrated, but then rising stock prices could not be shown to create jobs either.