The Fed should never buy Italian bonds

If the Federal Reserve were to load up on Italian bonds, the Fed would be exposed to default on foreign currency assets. If Italy defaults, then the Fed is on the hook. Offic

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Here’s some out of the box thinking:

If Europe’s woes threaten to push the US economy into a recession, shouldn’t US policy makers do something about it?

More specifically, if unsustainable Italian interest rates are rebounding to crush the US economy, shouldn’t the Federal Reserve direct its monetary policy in ways that will lower those interest rates. Shouldn’t the Fed announce a target rate for Italy?

Let’s imagine how this would work. The Fed could announce that it will not allow rates on Italian sovereign debt to exceed a certain level.

It would buy Italian bonds with newly created dollars until the rates hit the target.

This would probably be a massive buying program. It would expand the money supply.

John Carney, CNBC

John doesn’t say this is a good idea. He actually says “So this almost certainly won’t happen. But we certainly could do it if we wanted to.”

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Even so, its important to stress that this is a BAD idea. Central banks can go broke.

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First of all, a central bank’s buying dodgy assets is always a solution to a liquidity crisis that is fraught with peril. if those assets go bad and losses are crystallized, it could render the central bank technically insolvent and undermine confidence in the central bank. Fear of this technically insolvent outcome was a major reason the Europeans did not allow the ECB to participate in the ‘voluntary’ haircuts that it has attempted to coerce onto the private sector in the latest Greek bailout.

Clearly, the ECB could just print money and use the seigniorage from that printing to earn its way back into solvency without having been declared insolvent. But you can see the problem. To maintain the ECB’s credibility it would need to be recapitalised.

But if the Federal Reserve were to load up on Italian bonds, then the seigniorage route is out. The Fed would be exposed to default on foreign currency assets. If Italy defaults, then the Fed is on the hook. Officially, the Fed is under Congressional jurisdiction. The US Congress has oversight of the Federal Reserve and Congress should never allow the Fed to make unsecured loans to foreign governments without prior and specific Congressional approval.

The Fed should never buy foreign currency assets. And if it does, Congress should intervene.

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