The chart below will likely come as a surprise to most. It shows total nominal US defense spending, more importantly it shows that such spending has been rapidly declining since 2010. And while on the surface it is great news the US is becoming more “pacifist” (apparently mass killings using drones are relatively cost-effective) and the result for the US is even better as it means lower deficits, there is one person who is very unhappy with this outcome – Ben Bernanke.
Why is Ben unhappy? Simple – as a reminder, the only reason Ben is even contemplating tapering has nothing to do with the economy. After all the Fed chairman (and/or his successor) is willing to send the stock market into stratospheric overdrive and would be very happy to add not subtract from the monthly QE $85 billion notional since it means more “wealth effect” and thus brings the US closer to the “Keynesian successful endgame” (that the logic here is completely inverted is well known to all but the most die-hard Keynesian fanboys and is not in the scope of this article).
However, the fact that the gross US debt issuance is declining (if only until the demographic and healthcare crunch hits in 2015 and deficits explode once more) means Bernanke has less primary issuance to monetize. Were Bernanke to maintain his monetization run rate into a lower deficit regime, the Chairman would destabilize the liquidity in the already increasingly illiquid Treasury market in which the Fed now holds over 30% of all 10 Year equivalents and its holdings increase by 0.3% every week. This illiquidity is manifesting itself most directly in the “special” repo rates that have become a norm in the past few months especially in the 10 Year, and which indicate an ongoing shortage of TSY collateral.
Of course, there is a very simple and elegant solution to declining defense spending, one which has been used time and again in US history when the US government needed to provide the Fed with more securities (i.e. deficit) to monetize: war.
