Obamas plan for stimulus includes extending unemployment benefits and aid for states for infrastructure projects.

So first you prop up the financial institutions who are holding all these assets (some bad and good) then you go and try to prop up expenditures by the government making long term investments in public goods. That is where the magical power of central banks can come in.

The world cannot bear a shock restructuring of America’s debt burden when there is till no clear substitute to the dollar.

Unfortunately Keynesian playbooks have been used for the wrong reasons. That is where corrupt governments come into play.

That ability to create debt by governments is a powerful weapon in the hands of authoritarian and weak states.

That is when the technocrats assume no ethical or moral responsibility in working for these governments.

In today’s world the dollar is the de facto reserve currency of the emerging markets of the world.

Whether we like it or not we are in Americas boat.

By removing the objective standard of a physical commodity to a subjective standard of a fiat currency system which is determined by a political standard (national governments).

Keynesian playbooks were designed mainly and exclusively for nation states and national financial systems. Bretton Woods was supposed to serve as the regulatory arm for national financial systems internationally.

Austrian based economists believed that one could not trust national governments to police their own international behavior with regards to moving to fiat currency system or standard based on political standards.

Nations will always be forced to protect national interest in times of strain and crisis.

Hence we have the present rising political tensions arising from the global crisis.

The beggar thy neighbor policies instituted by all governments including the U.S. in the 30’s led to the Second World war.

What will happen going forward when it is clear that the U.S. is forcing a solution on the rest of the world.

Will there be peaceful collaboration or will tensions rise?

China will have to be less concentrated on their manufacturing export model and look inward to creating a viable and stronger domestic market. Will she continue to keep it relatively closed. The ironic part of her success is that all her purchases of resources are paid for in dollars. She should now switch and revalue her currency upward and use it to buy more resources instead of using devalued dollars.

That is one way of correcting the reserve imbalances. The U.S. directly or indirectly is forcing her to make hard choices. It is like a game of chicken.

That would give Asian countries a choice in moving out of the dollar reserve system. The Japanese should do the same thing with their yen. Asian countries then would have a basket of currencies to base their exchange rates on.

The day is coming when the U.S. dollar system will be forced to accept other players in the game. As Obama said the world has changed. The U.S. has to change with it.

The only direct intervention the Fed has in its arsenal is the fixing of short term rates. The overnite lending rate. That rate is already close to zero…

That is the extent of monetary policy in the hands of the Fed. – J_ag

That’s how i initially understood it as well which is also how Paul Krugman explains it (which is why i asked my question at 26th Jan 2009 12:36 pm). However, Robert Lucas explained (in the linked essay) that it is not the case, i.e. even if short-term rates went to zero, the FED still has some room for action.

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds’ rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of “quality” assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves — or “printing money” — to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector. – Robert Lucas

He goes on to say that the availability of cash will discourage businesses from hoarding cash which is the main cause of the recession. However, as you have explained above (and as Krugman has also explained), it goes against the fact that the problem is that Banks are unable and/or unwilling to lend because they no longer have the capital to do so because of the amount of bad assets that they hold.

“Faced with the danger of a deflationary decline in output, prices and wages, the Fed is considering steps to revive the moribund economy. On the table besides bond purchases: firming up a pledge to keep short-term interest rates low for an extended period and adopting some type of inflation target to underscore the Fed’s determination to avoid deflation.”

“The central bank has been buying long-term Treasury debt off and on for years as part of its day-to-day management of reserves in the banking system. Yet it has always gone out of its way to avoid influencing prices. What it’s discussing now, says former Fed Governor Laurence Meyer, is deliberately trying to push long rates below where they otherwise might be.”

Fed Purchases

“Bernanke raised this possibility in a speech on Dec. 1. While he didn’t specify what maturities the Fed might buy, in the past he has suggested that purchases might include securities with three- to six-year terms.”

Investors immediately took notice, with the yield on the 10-year note falling to 2.73 percent from 2.92 percent the day before. Yields fell further on Dec. 16, dropping to 2.26 percent from 2.51 percent the previous day, after the central bank’s policy-making Federal Open Market Committee said it was studying the issue.

“Every time they mention it, the market reacts,” says Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut.

Yields have since risen, with the 10-year note ending last week at 2.62 percent. Behind the reversal: expectations of massive fresh supplies of Treasuries as the government is forced to finance an $825 billion economic-stimulus package and a possible new bank-bailout plan. This week alone, the Treasury is scheduled to auction $135 billion worth of securities.

Jump in Yields

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the jump in yields may prompt the Fed to go ahead with Treasury purchases.

This isn’t the first time Bernanke and the Fed have discussed buying longer-dated securities and ended up roiling the market. Bernanke touted the idea as a tool to fight deflation in speeches in November 2002 and May 2003.

Egged on by his comments — and later remarks by then-Fed Chairman Alan Greenspan that the central bank needed to build a “firewall” against deflation — many investors became convinced the central bank was poised to buy bonds. The yield on the 10-year Treasury note fell to 3.11 percent in June 2003 from 3.81 percent at the start of the year.

Traders quickly reversed course as it became clear the Fed had no such intentions, sending the 10-year Treasury yield soaring to 4.6 percent just three months later, on Sept. 2.

‘Miscommunication’

Poole, who was then at the St. Louis Fed, was critical at the time of what he called the central bank’s “miscommunication.” He now sees the Fed making the same mistake with its latest suggestions that it might buy longer- dated securities.

“If they do it, it’s going to be disruptive to the market,” says Poole, who is a contributor to Bloomberg News. “If they don’t do it, it will impair the Fed’s credibility and erode the confidence the market has in the statements that the Fed makes.”

Meyer, now vice chairman of St. Louis-based Macroeconomic Advisers, says the Fed should, and probably will, go ahead with purchases as a way to lower borrowing costs. “The story is stop talking and start buying,” he says.

Still, he notes that not everyone at the Fed is enthusiastic about the idea. One concern: Foreign central banks and sovereign-wealth funds, which are big holders of Treasuries, might cool to buying many more if they believe prices are artificially high.

Undermine the Dollar

That may undermine the dollar. “There’s no guarantee that international investors would switch to other dollar- denominated debt if flushed from the Treasury market,” says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, says foreign investors might also get spooked if they conclude that the Fed is monetizing the government’s debt — in effect, printing money — by buying Treasuries.

Bernanke himself, in his 2003 speech, said monetization of the debt risked faster inflation — something bond investors, foreign or domestic, wouldn’t like.

Some economists argue the Fed would help the economy more if it bought other types of debt. Even after their recent rise, 10-year Treasury yields are still well below the 4.02 percent level at the start of last year.

Corporate Bonds

Yields on investment-grade corporate bonds, in contrast, stood at 8.24 percent on Jan. 22, the latest date for which information is available, compared with 6.45 percent at the start of 2008, according to data compiled by the Fed.

Hawks at the Fed wouldn’t welcome such purchases. They are already uneasy that some of the central bank’s programs are effectively allocating credit to one part of the economy rather than others. Case in point: the Fed’s ongoing program to buy $500 billion of mortgage-backed securities, which Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has called “credit policy” rather than monetary policy.

J. Alfred Broaddus Jr., who was Richmond Fed president from 1993 to 2004, says the lesson from the early part of the decade isn’t that the Fed went too far in easing policy to avoid deflation — it’s that policy makers should have tightened more quickly afterwards and not allowed themselves to be boxed in by their pledge to keep interest rates low for a considerable period.

In the current context, that means buying bonds “is something worth looking at,” he says. Still, the Fed “needs to be careful and be ready to reverse course, especially given all the money that it’s pumped into the system.”

http://www.bloomberg.com/apps/news?pid=20601109&sid=aZ0bwWpcnFaM&refer=home

That is the extent of monetary policy in the hands of the Fed.

It is the Treasury however who borrows money in the markets to fund government deficits. The financial markets determine the rates at which government borrows short term and long term. That also serves as the benchmark for commercial bond rates and mortgages.

Congress is in charge of fiscal policy through the legislative process. The treasury executes the law – the budget.

In times of severe economic stress the Fed has the power to influence long term rates by buying long dated securities from the treasury itself to help bring down long dated securities.

When fiscal policy is to be used to pump prime economies headed for deflation the rationale is simple. The government has to step in in pump prime investments in public goods. That requires a long term horizon as business will not risk investing for the long term. In point of fact risk premiums go up for long term investments in a climate of fear.

So the only so called agent in the economy is government who can afford to wait and is a patient investor.

Keynesian playbook is primarily about government making long term investments when business refuses to do so. No one wants to lend long. Look at spreads between the ten year T-bill rate and the 30 year Fixed mortgage rates. It is almost double.

The U.S. treasury is going to be issuing hundreds of billions of long dated treasuries to fund the stimulus package.

The Fed can intervene to try to keep long dated notes low by buying Treasuries. The Fed creates the cash for the government and naturally competes with private funds thereby increasing the money supply and keeps long dated rates low to provide cheap funds for the government.

..the Central Bank issues cash in to the banks in exchange for the…securities that the latter is holding…In that way, more cash available for lending gets into the system.

As Robert Lucas proposes in the essay i linked to (26th Jan 2009 1:48 pm), once interest rates of short term Treasury Bills go to zero, the FED can still choose to buy other securities from the banks.