The prospects of a US$ Banana Republic??

Paul Keating has made his inimitable mark on Australian politics, first as Treasurer and later as Prime Minister. He was the self-proclaimed "Placido Domingo of Australian politics". He certainly was (and mostly remains) a man of words.

In 1983, as Treasurer, he did away with the fixed exchange rate mechanism of the Aussie Dollar, allowing it to float. It floated like a rock. Interest rates jumped up to 20%.

As one admiringly critical website explained,

In spite of the lower value of the dollar, many areas of the manufacturing sector were not competitive with more technologically advanced industries in Asia, especially South Korea and Taiwan. Imports continued to rise. By 1986 foreign debt was higher than anticipated.

Treasurer Keating warned that if Australia did not "get manufacturing going again and keep moderate wage outcomes and a sensible economic policy, it would end up being a third-rate economy . . . a banana republic."

His "banana republic" remark, made off the cuff in a radio interview if Guambat's memory doesn't fail (most unlikely), had the same salutary effect as Alan Greenspan's "irrational exuberance" quip.

But it was Keating's banana republic quote that came to mind whilst Guambat was perusing the most recent soothing words from David Stockman, who once advised The Other Great Communicator -- the American one.

Commentary: Trillion-dollar deficits don’t matter

According to CBO’s August update, the two-year, cumulative red ink under current law (FY 2011-2012) will total $1.7 trillion. But that doesn’t count the upcoming lame duck session’s predictable one-more-stimulus bacchanalia.

Juiced up by their election rout, the tax-side Keynesians in the GOP are certain to ram through a two-year extension of the Bush tax cuts for one and all.

In return, the hapless White House will insist this one-half trillion dollar gift to the “still haves” be matched with several hundred billion more in presently unscheduled funding for emergency unemployment benefits and other safety net programs for the “no-longer-haves.”

In combination, these measures — along with more realistic economic assumptions — mean that the FY2011-2012 deficit will be $700 billion higher than current projections, pushing the two-year total to at least $2.5 trillion. Read Minyanville’s “What a Republican Victory Means for Equity Markets.”

These considerations make one thing virtually certain: After the new Congress sinks into rancorous partisan stalemate and does absolutely nothing about this fiscal hemorrhage, the Treasury will be selling at least the $100 billion per month of new government paper for so long as the New York Federal Reserve is open to buy. Stated differently, national policy now amounts to monetizing 100% of the federal deficit.

In the olden times — say three years ago — the idea of 100% debt monetization would have been roundly denounced as banana republic finance. No more. Earlier this week, William Dudley, who occupies the Goldman Sachs permanent seat on the Fed’s Open Market Committee, helpfully clarified that the new-age Fed should be judged by what’s in its heart, not what’s on its balance sheet. He said:

“I am mindful of concerns… that [the Fed’s actions] could be interpreted as a policy of monetizing the federal debt. However, I regard this view to be fundamentally mistaken. It misses the point of what would be motivating the Federal Reserve.”

They may devoutly believe in their hearts (if hopefully not in their minds) that it’s economic milk and honey that they’re bringing to America, but in fact what they’re dispensing is digital greenbacks.

At the moment, the five-year note yields barely 1.0%, and the maturities below that quickly descend toward zero — with the 2-year at 35 basis points and 90-day bills at 12 basis points. Those maturities account for in excess of 90% of the $9 trillion in Treasury debt presently held by the public. So, in the world of ZIRP, the public debt is now essentially non-interest bearing.

Moreover, with a stroke of the “repo” key it can also be turned into cash — that is, legal tender — in a millisecond.

But what emergency motivates today’s greenback experiment?

It would appear to be two self-evidently foolish objectives.

The first is the claim by the Fed’s money printer’s caucus that QE2 in the magnitude being contemplated might lower the 10-year benchmark rate by 50 basis points.

Stunning.

We have a nation drowning in 19 million empty housing units owing to the Fed-engineered housing bubble, households still buried in $13 trillion of debt from the same cause, and idle business capacity on a scale not seen since the 1930s — and we’re supposed to believe that taking down the current all-time low interest rate by another 50 basis points will make a difference?

Worse still, [the other] salutary effect of this dubious proposition, according to chief apothecary Brian Sack, is that risk asset values are likely to be elevated to levels “higher than they would otherwise” reach — thereby encouraging consumers to go back to their former spending ways -- owing to the illusion of higher net worth, as conjured by the Fed.

These are pretty pathetic reasons for issuing massive quantities of digital greenbacks.

Like all other experiments in printing-press finance, its main impact will be to give a destructively erroneous signal to fiscal policymakers on both ends of Pennsylvania Avenue: Namely, that chronic trillion-dollar deficits don’t matter because the Fed is financing them for free.