Monday, September 27, 2010

The Economy: "U.S. Money Printing Presses at Warp Speed"

"U.S. Money Printing Presses at Warp Speed,
Stealth Monetization of U.S. Debt"
by Gonzalo Lira

“Insofar as money is concerned, governments and central banks should be kept as far away from one another as a pedophile from Dakota Fanning. If ever the twain should meet, very bad things would happen. This is because of the disparate natures of government, on the one hand, and the central bank, on the other.

Governments spend money. They spend money on social programs to keep the people docile and happy, wars to keep up the illusion of safety and security, and – almost as an afterthought – infrastructure. Ordinarily, they get the money for all of these things from taxes and other fees that the government collects. On the other hand, central banks print money. Most of the world’s economies depend on fiat currency – currency that has value because someone says it has value. The person who says it has value is the central bank. They are the custodians of the currency – they take care that it retains its value.

Tons of people say that a fiat currency is unstable, and doomed to fail, and that we will all rue the day that we accepted that abomination into our lives! – and blah-blah-blah, rant-rant-rant. But in most cases – all cases, actually, regardless of what the tin-foil hat brigade might rant – fiat currency works like a charm. The proof of this is the last 40 years: All of the world’s major currencies have been fiat since at least 1970. The dollar has been fiat since 1973, and by certain definitions, fiat since 1933, or even 1913 – and it’s still around. That’s been because of the Federal Reserve (the U.S.’s name for its central bank).
Central bank independence is key for a successful fiat currency. If the government ever got its hands on the central bank’s printing presses, all hell would break loose. Rather than raise taxes and collect fees – which are politically unpopular – the government could (and would) direct the central bank to print all the money needed to carry out the government’s various programs.

This is monetization. What would happen once monetization took place is pretty obvious: So much of the currency would be printed by the government that businesses and ordinary people would lose faith in the currency as a stable medium of exchange. Since fiat money depends on people’s faith in it, this would become a self-reinforcing situation: The currency would fall leading to people losing faith in it, leading to the currency falling even more. This is the mid-stages of hyperinflation. Eventually, the currency would become worthless, wrecking the economy of the currency.

It’s happened more times than one would imagine. But the last time it happened in an advanced economy was Germany in 1922, the so-called Weimar episode. Since then – even during total war in WWII – there has not been an incident of hyperinflation in any advanced economy. (Though as I wrote in Was Stagflation in ‘79 Really Hyperinflation?, there have been bouts of high inflation that had all the traits of incipient hyperinflation.)

A collapse in the currency is why the government and the central bank are kept separate from one another – the fear of monetization, and what could happen, keeps the two apart. However, now, in the good ol’ U.S. of A., monetization is taking place – and it is happening right before our eyes, even though no one is realizing it. This monetization is invisible to sophisticated analyses, but obvious to anyone looking at the situation. Like one of those stealth fighter jets that are visible to the naked eye of a goat herder, but invisible to the radar and infrared and other sophisticated equipment of the professional military? Same thing: It’s what I call stealth monetization.

What happened in the Fall of 2008? Essentially, banks found themselves holding debts that would never be repaid – which meant the banks could never pay back the money that they in turn owed to depositors and other creditors. The bad debts the banks owned – the so-called “toxic assets” – were bonds made from the real-estate and commercial real-estate mortgages, as well as other collateralized debt obligations. Since the properties underlying these bonds had fallen in price – because their prices had been a speculative bubble to begin with – the bonds made from these bundles of loans would never be fully paid off. In other words, they were bad loans. Therefore, the banks which had made the loans – the banks which owned these toxic assets – would lose so much money that they would go bankrupt. If they did go broke, the U.S. and world economies would take a massive hit.

So in order to avert this fate, the Federal Reserve bought these toxic assets from the banks – but the Fed didn’t pay the market value for these toxic assets, which were pennies on the dollar: Instead, the Federal Reserve paid full nominal value for the toxic assets – 100¢ on the dollar. The banks the Fed bought these toxic assets from became known as the Too Big To Fail banks – for obvious reasons. How did the Fed buy these dodgy assets? Simple: In 2008 and ‘09, the Fed “expanded its balance sheet.” That’s fancy-speak for, “The Federal Reserve created about $1.5 trillion out of thin air.” That’s essentially what they did. The Fed just decided, “We’re going to create $1.5 trillion” – and lo and behold, $1.5 trillion came to be. What did the Fed do with this $1.5 trillion it conjured out of thin air? Why, it used it to buy up all the toxic assets and other dodgy assets from the TBTF banks. What did the TBTF banks do with all this cash? Why, they turned around and bought U.S. Treasury bonds.

U.S. Treasury bonds are called “assets” by sophisticated finance types – in fact, sophisticated finance types call all bonds “assets.” But they’re really just debt – including Treasuries. U.S. Treasury bonds are certificates of debt that the U.S. Federal government issues, in order to finance its shortfall, the deficit. The U.S. Federal government has been running monster deficits for a number of years now – but lately, it’s gotten pretty bad. In 2009 as well as 2010, the Federal government shortfall was over $1.4 trillion. This is roughly 10% of total U.S. gross domestic product – both in 2009 and 2010: A staggering sum of money. And it is likely that for 2011, the deficit will be another $1.5 trillion or so. The Federal government has so much outstanding debt that it is unlikely to ever be able to pay it back.

A lot of people think this. A lot of sensible people think that a day will come when the markets no longer believe in the Federal government’s promise to pay back its debt. A lot of sensible, smart people think that, one day, no one will buy any more Treasuries – yet every week, Treasury bonds get sold with numbing regularity. The U.S. Federal government has never put Treasuries up for auction which did not get bid on. Who are the people who buy these Treasury bonds? The primary dealers – that is, the Too Big To Fail banks. In other words, the TBTF banks are financing the Federal government’s massive deficits. How are they doing it? With money the Federal Reserve gave them for their toxic assets. This is one leg of stealth monetization.

Buying up toxic assets following the 2008 Global Financial Crisis was not the only way that the Federal Reserve got money into the hands of the TBTF banks, and thereby the Federal government – the other thing the Fed did was open up “liquidity windows.” Liquidity windows are simply the mechanism by which the Federal Reserve lends money to the banks. The interest rate the Fed assigns to this money it lends to banks is called the Fed funds rate. Right now – and for the past several months – the Fed funds rate has been 0.25%. That’s right: One quarter of one per cent. The interest is substantially lower than the inflation rate. This means that the Fed has essentially been giving away free money to the banks.

What are the Too Big To Fail banks doing with this free money? Why, they are buying Treasury bonds: The TBTF banks are borrowing money from the Fed at absurdly low rates, and then turning around and lending it to the Federal government by way of Treasury bond purchases. This is the other leg of stealth monetization.

In these two ways, the Federal Reserve has been monetizing the Federal government’s debt. The Fed bought up toxic assets from the TBTF banks, which then went and bought Treasuries. And the Fed is lending money for free to the TBTF banks, which are then buying Treasuries. Take a step back, and you get the picture: The Too Big To Fail banks are the sewer system by which the Federal Reserve supplies money to the Federal government for all its deficit spending.

This is stealth monetization. It’s not even particularly stealthy, actually – it’s happening right out in the open. It’s just that nobody is pointing it out – or perhaps because it is an obscure, complicated system, nobody has realized what it actually is. But it’s monetization, pure and simple. The Fed is printing up all the money the Federal government wants and needs.

To put it more bluntly – and disturbingly – the pedophile is in the room with Dakota Fanning.

One of the pernicious effects of this stealth monetization is the dis-incentive it gives banks to lend money to small- and medium-sized businesses. Everyone – including the Fed – is complaining that the banks aren’t lending to businesses. But I don’t know why they’re complaining – it makes perfect sense. See, the TBTF banks get money for free from the Fed, and then they turn around and lend it to the Federal government by way of buying Treasury bonds. Treasury bonds are paying absurdly low yields, because they’ve been bid up so high by all those freshly minted dollars that the Fed printed up. But to the TBTF banks, it doesn’t matter how low the Treasury yields are – it’s still guaranteed profits. Lending money to the Federal government is totally safe.

But a loan to a small- or medium-sized business? It’s a risk – and a risk for only a slightly higher profit. The business might miss a payment, or even go broke. Plus it’s a hassle, to lend to a business – all that administrivia! The paperwork, the loan applications, the due diligence– blah-blah-blah-blah! “Screw it,” say the TBTF banks. “Let’s just buy Treasuries.”

That’s how the American government’s massive deficit is sucking up all the available funds. Why bother lending to the private sector, when the Federal government is paying good interest on the Treasury bonds, and the Fed is lending an endless supply of money for free? This is why private-sector businesses are not getting any loans, no matter how long the Fed keeps interest rates at rock-bottom levels – the Federal government is hoovering up all that money, leaving the private sector with nothing, not even lint. Ben Bernanke and the Lollipop Gang at the Fed do not seem to understand the disincentive they have created – in fact, they just keep on adding even more liquidity: Backstop Benny has announced that QE2 is on the way – that is, further “expansion of the balance sheet,” so as to create more money to give out to more banks – so they can buy more Treasuries from the Federal government.

Other banks which are not TBTF are getting squeezed – everyone acknowledges that the banking industry is really hurting. But the TBTF banks are racking up monster profits, with monster bonuses. That’s because they’re monsters – or more precisely, they are zombies: The American Zombie banks. Now this is all good and fine, but is there a simple way to verify that this stealth monetization is indeed what is going on? Yes – look at the markets: Over the past few months, we have seen two things occurring simultaneously: Treasury bond prices are rising (and therefore their yields are declining), and the dollar has been falling against all commodities and all other major currencies.

This is a contradiction. This cannot be happening simultaneously for any sustained length of time – unless there is some exterior factor making this contradictory situation happen. It is a contradiction because, if over a sustained period of time the dollar is losing value against commodities and other major currencies, then it would not make sense for investors to be putting more money into Treasuries and bidding up their prices. Not when their yields are at such absurdly low levels. Stealth monetization: That’s what’s bidding up Treasuries, even as the markets are losing faith in the dollar.

Poor Dakota Fanning: She’s in the pedophile’s sights – and she has no idea what’s about to happen. But we do."

Gonzalo Lira (Dartmouth '95) is a writer, filmmaker, venture capitalist and economic commentator. He has lived throughout the United States and Latin America, and currently resides in Santiago, Chile. Visit his blog.

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