By Brai Odion-Esene

WASHINGTON (MNI) – Kansas City Federal Reserve President Thomas
Hoenig warned Thursday that if no action is taken on the high levels of
U.S. government debt, the Fed will face pressure to monetize the debt.

“If we don’t address the issue … I am absolutely confident that
there will be mounting pressure on the Federal Reserve system to help
finance this through monetizaion of debt,” he said in testimony prepared
for delivery to House Financial Services Oversight and Investigations
Subcommittee.

The resulting outcome will a rise in inflationary pressures and a
strong impact on the dollar in the long-term, he told lawmakers during a
hearing focused on the high debt and leverage levels.

“We will endanger our economy and stagnation is a possibility …
if we don’t take action now.” Hoenig said.

Hoenig also noted that the ongoing debt crisis in Europe underlines
how importance it is that there is no “doubt” in the mind of investors
when it comes to U.S. Treasury securities.

“Once there is a shred of doubt, it’s too late,” he said.

Any doubts investors would mean higher interest rates as well the
value of the U.S. dollar, Hoenig warned.

The American people must be made to realize that “we have to engage
in shared sacrifice,” he told the panel, both in terms of spending cuts
and higher taxes.

After all the extraordinary steps taken to tackle the financial
crisis and the resulting recession, it is now time to “carefully and
systematically” reverse course.

Even the Fed, he continued, needs to reduce its balance sheet.

Hoenig, a voter on the Federal Open Market Committee this year,
also said the Fed’s monetary policy is adding to incentives for firms to
increase their levels of borrowing.

“When you keep interests rate exceptionally low for an extended
period you add to the incentives by keeping interest rates lower than
they would otherwise be under normal market supply and demand
conditions,” he said.

“That’s one of the issues we have to confront,” Hoenig said.

Hoenig said financial reform legislation must include “firm”
constraints on leverage, even if it restricts growth. “That’s the nature
of sound, fiscal management — that your capital requirement limits
you.”

Hoenig repeated his call to address the issue of too-big-to fail
and its “perverse incentive system,” as it unfairly benefits large
financial institutions who face less costs when raising capital compared
to a regional bank.

“It perpetuates the ever increasing size and consolidation of the
financial industry,” he said, as more banks seek to merge in order to
cross the too-big-to fail threshold and bring their costs down.

If the problem is not tackled, Hoenig warned lawmakers, the
consequence is things will get worse through the next cycle. He said
that putting restraints on leverage would inhibit the growth of some
large institutions by taking their funding advantage away.

Too-big-to fail institutions should not have to be bailed out in a
crisis, he said, rather they should go through a controlled process in
which the firm is dismantled.

Asked to comment on financial reform currently being debated by the
Senate, Hoenig said legislation should ensure better disclosure by
financial institutions of the derivatives they hold, as well as
requiring that they keep a portion on their balance sheet.

He also said he is “very strongly supportive” of proposals to
create a central clearing house for over-the-counter derivatives and
place them on exchanges. Having a clearly regulated exchange or clearing
house “would be the best outcome for the American people and the
financial industry.”

** Market News International Washington Bureau: 202-371-2121 **

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