The FED-Debt Conundrum

I've spent a lot of blog space devoted to the issue of national debt. Its a big deal. But there's one big thing I don't understand. So that you can understand my dilemma, I'll try to explain bonds really quickly. When somebody wants to borrow money, one way they can handle it is by selling a bond. The bond entitles the holder to a specified "coupon" to be payed on a schedule, plus a guarantee to have his bond bought back from him at the same price he paid at some future date. This is called maturity. By buying the bond from this entity, the buyer transfers money (e.g. he "buys the bond" with cash), which the business entity uses for whatever business activity it so chooses. The business then pays the bond-holder (a "creditor") interest (the coupon), until the bond matures, at which point he must pay the bond-holder the money back. Any major business entity usually has lots of bonds outstanding at any one time. The process of selling new bonds is a lot like an auction. The bidders offer to buy at certain coupon rates, and the coupon rate becomes a large determinant of the value of the bond itself, since it determines the "payoff" of holding the bond. It also influences the value of other bounds out in the market, because people would rather have a bond with a higher rate than a lower one, all other things being equal. Because the rate is set at auction, the rate can be interpreted as "demand" for bonds: the lower the rate, the higher demand was when the bond was issued. High demand is usually the result of particularly good creditworthiness, since there is always the risk that the business might go bankrupt, and the bondholder won't get to collect his coupon or have his money returned at maturity. High demand can also result from other effects, like a simple excess of buyers (so-called "high-liquidity") or even from fear, since a bond is an agreement to return the money in the future, unlike a stock or commodity future contract. Among the three, the bond is considered "safer" so its demand will increase in times of uncertainty. Inflation, on the other hand, tends to decrease demand for bonds, because they are "fixed income" assets which will lose value as the value of the dollar, which is the fixed denomination of the asset, falls. A commodity future contract, on the other hand, should increase in value, because it represents a claim to "real-stuff," which is inflating in value. The higher the inflation rate, the higher the interest rate buyers will expect for holding a devaluing bond. Here is where we arrive at the dilemma. The government is the entity in question, in this case. It issues bonds, called Treasury debt, just like any business might, to pay for things the government wants to buy but doesn't have the money for, like giant bailouts and handouts to taxpayers. The Treasury will run up huge debts going forward, that's a given. That means that lots and lots of bonds are to be auctioned in a short time. It also means that the creditworthiness of the US will come into question, as the ability to repay the debt becomes strained and the temptation to default, either outright or through monetary inflation, increases. The demand for those debt certificates on the open market should fall as a result of all of these effects. Also a given. Therefore, interest rates should rise dramatically, making it ever more difficult for the Treasury to borrow more money. Enter the FED. In order to borrow at reasonable interest rates, the Treasury will depend on the Federal Reserve to buy up its bonds, increasing demand artificially, and reducing the interest rate it has to pay. This is where things get interesting, becaue the FED is a unique buyer. When the FED buys assets, new money enters the market, because the FED gets money "from nowhere." This is the primary source of monetary inflation. To make matters worse, that new money enters the fractional reserve banking system, beginning that miracle of miracles we have all heard about, the "multiplication of money," which gave us such wonderful things as the Great Depression, the tech and housing bubbles, and the present crisis. The new money gets multiplied even more. Obviously, the effect of this is mass inflation. But mass inflation reduces demand for Treasuries, remember? It increases interest rates, precisely the opposite of what the FED was attempting to accomplish by buying the bonds in the first place! The FED is the only buyer which has this effect, as other buyers do not increase the money supply as they buy. And with an increase of inflation, the holders of Treasury debt should increasingly sell these assets, as inflation reduces their value over time. It seems to me that the ONLY way for the FED to achieve low interest rates with this policy is to pretty much buy ALL the debt out there. Each new purchase it makes to suppress the interest rate induces more selling, which requires more buying by the FED to keep the rate steady. Its a self-feeding cycle. But by the time the FED buys all the debt, it will have to create on the order of ~$15 trillion dollars, and probably much more as inflation raises the prices of the things the government would like to buy! This would be added to the AMB, the Adjusted Monetary Base, the total quantity of money put out by the FED which circulates in the market. Up until ~3 months ago, the AMB was less than $1 trillion. That's an increase of 15 times, at the bare minimum! $1 trillion in circulation gave us a Federal Budget of ~$2.5 trillion, from a GDP of ~$14 trillion. Are we looking at a GDP of $210 trillion, even with no growth at all? Will all our assets lose >90% of their value over the next few years? I find it hard to comprehend how this could be the case, yet I see no alternative. Except, of course, for national bankruptcy. Does anybody else have any thoughts? I'd like to hear them...