There’s great concern over the sustainability of US deficits. Most of the fear mongering, hyperventilating, flat earth economists believe foreigners will at some point stop “funding” our spending. The hyperinflationist crowd likes to keep a very close eye on US government bond auctions hoping foreign demand for debt will dry up, auctions will begin to fail and interest rates (and inflationary pressures) will surge as the United States effectively defaults (which is technically impossible) and dies the death that so many of these people wish upon it.

Unfortunately, 99% of the inflationistas have a very poor understanding of reserve accounting so their arguments have not only been wrong for a very long time, but they never really carried any weight to begin with (as one reader eloquently put it – “at some point being right has to count for something” – the inflationistas have been horribly wrong throughout this downturn).  So what is really happening when the government auctions off bonds?  Let’s take a look.

First of all, we must remember that the US government bond market “funds” nothing.  As a sovereign issuer of currency in a non-convertible floating exchange rate system the US government never really has nor doesn’t have money.  For simplicity, the US government is much like an alchemist who simply presses a button (the government literally presses a button)  and abracadabra, they have money!  Inflationistas call this “money printing”, but in reality the government issues money that primarily offsets the dollars they debit from the private sector via taxation (in addition to a few other factors such as population growth, etc).

Second, we must remember that private sector net savings is public sector deficit (to be more precise: net household financial income = current account surplus + government deficit + Δbusiness non-financial assets).  This is simply an accounting identity.  To grasp this relatively simple yet unaccepted concept, imagine if the US government imposed a one time 100% asset tax on it citizens.  What would happen?  The public sector would have all the assets!  The private sector would have nothing.  So it’s important to remember that taxation debits the private sector and deficit spending credits the private sector.  But what happens to that money when the private sector “gets” it?  They deposit it at a bank or it is electronically deposited.  What does this do?  This creates excess reserves at the banks.  So government deficit results in excess reserves.  By definition.

What happens next is where the fear mongering flat earth economists get it all wrong.  They think the Fed issues bonds to fund spending, but the US government is never revenue constrained.  The government doesn’t get a gold coin when they auction bonds just like they don’t care whether you pay your taxes in cash.  In fact, if you did pay your taxes in cash the IRS would send the pile of money up to the Treasury and guess what they would do?  They would shred it, or, if it was pretty and new they would send it back out for circulation.  What they wouldn’t do is turn around and say “Well Mr. Obama, Joe Schmo just paid his taxes so it looks like you can spend some more”.  No, the US government as a monopoly supplier of currency just presses a button regardless of whether or not you pay your taxes.  This doesn’t mean deficit spending can be reckless or doesn’t matter, but that is not today’s topic of discussion….

So what happens when we auction bonds?  Well, the NY Fed has accounts all over the country.  The Treasury keeps very close tabs on excess reserves so as to avoid overdraft at the Fed.  So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves.  Why do they do this?  Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves.  Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

In today’s world where reserves pay interest the banks have already driven the overnight rate down.  The excess reserves that banks currently carry are not due to deficit spending, but rather the expansion of the Fed’s balance sheet.  For more on why banks are still holding excess reserves in today’s unique environment I would highly recommend reading this paper from the NY Fed which describes why excess reserves are not inflationary and also currently being caused by the Fed’s balance sheet expansion.

Getting back on topic though – much to the chagrin of the fear mongering inflationistas the auctions never seem to fail. The success rate of these auctions is unbelievably high – like shooting fish in a barrel. In fact, they are almost always oversubscribed.  Many bond market “experts” highlight the bid to cover ratio at these auctions as if disaster is imminent.  The bid to cover ratio is just the dollar volume auctioned off versus the actual receipts.  These auctions generally come in well oversubscribed.  For instance, the Treasury had three auctions yesterday.  In their 13 week treasury bill auction they issued the following results:

The Bid-to-Cover Ratio: $105,589,158,600/$27,000,182,600 = 3.91 which is WELL over their targeted levels.  Any bid to cover over 1 is sufficient to “cover” our “borrowing” costs though the fear mongerers tend to tell you that any bid to cover below 2 is worrisome (which is entirely false).  The levels are never below 1, however, because the Fed and Treasury coordinate the auctions to target the excess reserves the Treasury has already “spent”. For emphasis, the auctions are designed to succeed because they are coordinated to soak up the reserves the Treasury effectively “spent” – the same reserves they KNOW are in the banking sector and the same reserves they know they can offer a higher rate of interest on via bond issuance.

Where do these bond buyers come from?  They come from many places (in addition to the banks holding reserves – which is why they are always oversubscribed), but most important is the fact that there are excess reserves at the banks earning 0.25% and they have the option to trade these reserves in favor of higher earning assets with a marginally different risk structure.  It’s practically a no brainer trade for the banks.  Why would they not turn in their excess reserves?   The important fact here is that the money the Treasury has spent has ended up in the banking sector as excess reserves and the Fed is simply issuing securities to soak up those reserves and maintain their overnight rate.  It’s that simple.  The auctions never fail because there is always excess reserves if there is deficit spending.

This doesn’t mean that auctions can’t fail.  The Fed could fall asleep at the wheel and stop contacting the Treasury.  The bankers could be out playing golf all day and forget that they can earn a few extra bps on their reserves if they so choose.  But in reality, auctions should never fail.  The savvy market readers will note that a UK bond auction technically “failed” in March of 2009.  But what happened after this failed auction?  Absolutely nothing.  In fact, almost every single risk asset on the planet was not only bottoming but was on an upward trajectory.  Credit markets were in the beginning stages of one of the greatest recoveries in the history of markets.  The next few UK auctions were oversubscribed and their government was able to continue soaking up reserves after the banks foolishly failed to trade in their excesses at that particular auction.

So next time you hear someone hyperventilating over a US bond auction failure (please bear in mind that the Euro currency system is different and that bond auction failures very much matter there) give them a paper bag.  Tell them to breathe into it for 10 minutes and then tell them that everything is going to be okay.  Bond auctions have no operational reason to fail.  In fact, the only reason for them to fail in the USA is due to excessive golf playing – but considering the banks have traded in their 3-6-3 model in favor of the Enron banking system I think there’s no need to worry about that.