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If you spend any time reading about economics on the internet, you’re aware of the many virtual pamphleteers who loudly portend the impending downfall of the American government and global financial system in general. It’s become somewhat fashionable to proclaim America a banana republic, arguing that she is financing her debt with central bank purchases of government bonds, a strategy that is unsustainable and often ends in a blaze of hyperinflation and economic collapse.

No serious observer really believes that the U.S. faces this fate in the near term. Perhaps much of this hyperbolic rhetoric is merely an effort to get the U.S. to rein in its debt – something, long term, it certainly needs to do. But a strand of this thinking has made its way into the mainstream and is distorting the debate about the federal government’s attempts to steer the economy out of a recession.

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Lawrence Goodman opined in the Wall Street Journal last week that, “Demand for U.S. Debt Is Not Limitless.” In the piece, Goodman takes aim at those who have argued that demand for U.S. debt is strong, and that regardless of what the rating agencies say, the marketplace believes the U.S. will pay its bills. In particular, he highlights the “stunning” fact that in 2011 the Fed purchased 61% of the debt issued by the Treasury, up from negligible amounts prior to the 2008 financial crisis. This, he added, “not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits.”

That 61% figure is indeed eye-popping. Most people don’t understand how a majority of the debt issued by the U.S. government last year could be purchased by an arm of the very same government. The economics of central banking are complicated. But one of the important things to realize is that the Federal Reserve isn’t buying this stuff directly from the Treasury, it’s purchasing Treasuries on the open market. This is a key distinction and a chief tenet of modern central banking. There must first be demand for the government bonds on the open market for the Fed to then purchase them.

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So why did the Federal Reserve end up with 61% of all the 2011 issuance of government debt? It is the effect of the much-talked-about “quantitative easing” program the central bank began in the wake of the financial crisis to suppress interest rates. By purchasing these bonds, the Fed drives up the price of government debt and drives down the interest rate the government pays on that debt. The purpose of this is not to “subsidize U.S. government spending” as Goodman suggests, but to drive down rates for the rest us and stimulate the economy.

Setting interest rates is a primary function of a central bank. And these bond purchases are merely an extension of that responsibility.

Does this artificially drive down the interest rates that the U.S. pays on its debt and therefore understate true budget deficits? Yes. But this is a collateral effect of the policy, and not its intended purpose.

Does it mean there isn’t demand for U.S. debt? Absolutely not. According to Lewis Alexander, Chief Economist at Nomura Securities, demand for Treasuries has been strong throughout the crisis and remains so today. “It’s hard to look at how the Treasury market has reacted really since 2008 without being impressed by the consistent demand for U.S. securities,” he says. Yes, the Federal Reserve is successfully keeping rates lower, but absent those actions, Alexander believes that interest rates on government debt would be somewhere between 0.5% to 1.0% higher than they are now. That’s a significant difference, but not one that indicates the global market is suspicious of America’s willingness or ability to pay its debts.

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In a post-crisis world with all kinds of land mines in the path to global recovery, investors have fewer safe assets to choose from, not more. It is not a law of nature that the world must hold its reserves in U.S. Treasuries. There are many complex reasons why investors do, but one of them undoubtedly is that they believe that Treasuries are the safest possible investment. “During the worst times of the crisis in 2008 and 2009, when you had a bad event, Treasuries would rally, in spite of all the fiscal commitments the U.S. was making,” says Alexander.

He went on to posit that nobody in American government is arguing that, in the long run, debt isn’t a problem. Both Democrats and Republicans have recently proposed budgets that would put us on a sustainable fiscal path, and despite the drama that has plagued Capitol Hill, a reasonable compromise is quite conceivable. It may be difficult to see how these two parties will find that common ground themselves. But if you believe in the wisdom of global marketplace, we’ll somehow get the job done.

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