Shock B: I'll Bust a Cap in Your Curve, And Then Some...

Ben Bernanke and his gangsta bankas have been following the approach outlined in this paper from 2004, Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment, which is excerpted below, and also in his famous 'printing press' speech on avoiding deflation from 2002.

I have written about this before several times over the years, but perhaps it is a good time to review the Fed's game plan.

The first item, communications to model and influence the perception of the markets, is obvious. Jawboning is a major element of any financial intervention. Acknowledging or denying the intervention is all about the message as well.

The most recent statement from the Fed, for example, about keeping rates at the zero bound for the next two years, depending on how the economy fares, is a good example of this. Other actions they may take through their own speeches, and the statements of informal intermediaries in the industry and the press, are good examples as well.

The expansion of the Fed's Balance Sheet is also known as quantitative easing, and that has been done at least twice now, and in epic proportions.

The third option, the targeted purchasing of certain assets, has been done to a large extent to support the banking and mortgage system, but not necessarily the real economy.  This is the program by which the Fed has been taking non-traditional assets into its portfolio in the various vehicles it has constructed in order to shore up the shaky creditworthiness of the TBTF asset profiles.

What the Fed is not doing in a major program yet, although it certainly has done it in the past, is to conspiculously shift the duration of its Treasury bonds portfolio in order to achieve certain interest rate objectives, effectively setting caps on target rates up the curve.

In 1961 in a program called Operation Twist, the Fed moved the duration of its portfolio to help lower longer term rates.  It should be noted that OT1, if you will,  was conducted during the fixed exchange rate period known as Bretton Woods I, which included the redeemability of dollars for gold.  Also, although the short end of the Treasury curve was not at the zero bound,  it was not viewed as adjustable for policy constraints than the zero bound.

So there are some subtle differences perhaps in any OT2 which the Fed might announce this week, or soon thereafter.

John F. Kennedy was elected president in November 1960 and inaugurated on January 20, 1961. The U.S. economy had been in recession for several months, so the incoming Administration and the Federal Reserve wanted to lower interest rates to stimulate the weak economy. Under the Bretton Woods fixed exchange rate system then in effect, this interest rate differential led cross-currency arbitrageurs to convert U.S. dollars to gold and invest the proceeds in higher-yielding European assets. The result was an outflow of gold from the United States to Europe amounting to several billion dollars per year, a very large quantity that was a source of extreme concern to the Administration and the Federal Reserve.

The buying of the longer end of the curve, moving out from the bills to the shorter notes, has been telegraphed repeatedly to the markets this year. So it does appear likely.

The effects would be to lower real rates more broadly across the curve, perhaps taking them all negative, or at least closer to zero on the longer end depending on how one wishes to calculate inflation. I think the Fed uses their chain deflator.  I doubt its accuracy for practical purposes, but let's not quibble.

This is 'bad' for the dollar and good for gold and longer dated Treasuries which will enjoy a brief rally. However it will drive yield hungry investors to seek other alternatives, perhaps in the stock market and overseas.   It may shake up the Treasury markets on the longer end moreso than we might expect if there is an erosion in confidence in the US' ability to put its house in order without devaluation of the dollar debt.  That erosion may be well-founded.

Such a policy move is intended to stimulate consumption and investment in situations where the middle of the curve and out is used as a benchmark for setting non-governmental interest rates.  There is thinking that by moving out from the short maturies, the pull lower on the even longer rates will be more pronounced.

I do not think this alone will work. Banks are reluctant to lend at any price, and lowering the rates would not improve the credit risk profile of potential borrowers.

The Fed could also reduce the interest it pays on reserves to zero, or even place a negative rate on it. This would stimulate banks to put the money to work in the markets for projects with positive yields. This is not so different from the Fed's actions in driving consumers out of short term bonds and zero interest savings accounts, which they have done from time to time.

There is some further indications that the Fed will be using a reverse repo mechanism in order to grow bank credit in a more targeted fashion.  I will not get into that further here, because if it does develop I am sure there will be much more lucid explanations given in some detail based on Fed announcements.

But it does follow the theme of actively stimulating lending in ways other than lowering rates, even on the longer ends of the curve.

The Fed might couple this with government guarantees on loans for example, for certain situations where the government wishes to stimulate activity, such as housing for example. It is hard to imagine anything like this passes through the dysfunctional Congress.

There is another option that the Fed has, which is not cited in the summary of this paper shown below.

For this we have to turn to Chairman Bernanke's famous speech on Deflation in 2002 in which he stated that 'the Fed's owns a printing press' and highlighted various steps which they might take to insure that deflation does not happen in the US, the ability and the resolve of the Fed to prevent it, and some of the options the Fed might have if they reach the infamous zero bound:

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy...

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.

There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities...

If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. (Obviously the Fed has already been doing this as well).

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money. (I think the Obama Administration used this as the rationale for extending the Bush tax cuts).

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets. (I believe the Fed has already been doing this with the help of a few Primary Dealers.)

In summation, I think Bernanke's next move will be to start capping the two and three year rates, with the five year to follow. The purpose will be to keep rates low for the purpose of enabling spending and devaluing the dollar. I do not think he will have to expand the Fed's Balance Sheet to accomplish this.

But it is important to note that while the Congress can enforce a debt ceiling on the US Treasury, there is no such hard ceiling on the Fed's Balance Sheet. And this is probably the genesis of Presidential candidate Perry's scarcely veiled threat to Mr. Bernanke and the use of the word 'treason.'

I am not saying that the Fed is right in what they are doing. I am using Bernanke's thinking, and his own words, to determine what the Fed is likely to do next. I have been using this model for the past five years, and it has served me well. 

I have some sympathy for Bernanke, because he has few allies, especially among the libertine left and the luddites of the right, and the serpentine Obama.  The major obstacle to the US recovery is a failure in governance.

I have very little sympathy for the manipulation of certain markets traditionally viewed as safe havens, based on the rationale outlined in Larry Summer's paper about Gibson's Paradox, and the linkage between interest rates and gold.  That appears to be roughly analagous to machine-gunning the lifeboats.
Deflation or inflation are truly policy decisions in an unconstrained fiat currency regime such as that enjoyed by the US. On this Mr. Bernanke is correct, and anyone who thinks otherwise does not understand a fiat money system.  It really is that simple.  To their credit, the Modern Monetary Theorists understand it very well, except for the downside of excessive money creation in a co-dependent world, even if one does enjoy the exorbitant privilege of the world's reserve currency.

Various interests have been seeking to restrain the Fed, ranging from large creditors such as China, and the domestic monied interests who have already received their bonuses and bailouts, and who do not wish to see their dollar wealth erode. One is richer if all around them are made relatively poorer, or so some lines of thinking go.  And of course there are the prudent savers, who have been fleeing the dollar to the relative safety of some foreign currencies and hard assets like gold and silver.

I would hope that by now that any reader here would know that, at least in my judgement, deflation through hard money and austerity, or inflation through stimulus and money printing, are both unable to achieve a sustainable economic recovery because the system is caught in a credibility trap in which the governance of the country is unable to act justly and reform the system without implicating themselves in the compliant corruption that caused the unbridled credit expansion, massive frauds, and financial collapse in the first place. 

This was a major contributor to Japan's lost years.  The lack of will was in the failure of their largely single party system to correct the inefficiencies and crony capitalism of the banks and their keiretsus that provided a drag on all stimulus and the real economy, siphoning off the additional money into unproductive projects and support for zombie corporations.

The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustained recovery.

Federal Reserve
Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

Ben S. Bernanke, Vincent R. Reinhart, Brian P. Sack

8 April 2004


Abstract

 The success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound.

When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely on “non-standard” policy alternatives. To assess the potential effectiveness of such policies, we analyze the behavior of selected asset prices over short periods surrounding central bank statements or other types of financial or economic news and estimate “no-arbitrage” models of the term structure for the United States and Japan.

There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.


Non-Technical Summary

 Central banks usually implement monetary policy by setting the short-term nominal interest rate, such as the federal funds rate in the United States. However, the success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives.

An extensive literature has discussed monetary policy alternatives at the zero bound, but for the most part from a theoretical or historical perspective. Few studies have presented empirical evidence on the potential effectiveness of non-standard monetary policies in modern economies. Such evidence obviously would help central banks plan for the contingency of the policy rate at zero and also bear directly on the choice of the appropriate inflation objective in normal times: The greater the confidence of central bankers that tools exist to help the economy escape the zero bound, the less need there is to maintain an inflation “buffer,” bolstering the argument for a lower inflation objective.

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes:

1. using communications policies to shape public expectations about the future course of interest rates;
2. increasing the size of the central bank’s balance sheet, or “quantitative easing”; and
3. changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate.

We describe how these policies might work and discuss relevant existing evidence...

Additional Reading:
The Upcoming Expansion of US Bank Credit - Alasdair MacLeod

Gold and Interest Rates: More than Joined at the Hip - Rob Kirby

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.”

John Kenneth Galbraith

Inflation, Deflation, and Stagflation, Japan and the US

Here is a question from a reader which I found to be well stated and probably of a more general interest.

"I was thinking about your general forecast which you posted a while ago, and I wanted to see if my understanding of it was correct.

You had said that your forecast for the US was stagflation because the US is a net importer, unlike Japan which is a net exporter, despite both countries pursuing a policy of ZIRP + QE.

Is the reason for Japan's deflation that all the excess liquidity leaves Japan in search of a yield (due to ZIRP + QE), and not into tangible goods (due to Japan being a net exporter/net producer)? This would be in contrast with the US, where much of the excess liquidity from ZIRP + QE flies into tangible goods due to the imbalance caused by the US being a net importer/net consumer (though undoubtedly much of this excess liquidity leaves the US in search of a yield as well). Is this correct?"

This is a very nice summation of a portion the effects, but misattributes the causes.  And like most summations it crushes many of the key points of a slightly more complex theory and overstates the importance of current trade balance.

In a fiat currency not constrained by external standards or other exogenous constraints, monetary inflation and deflation are always and everywhere a policy decision. As latitude on the monetary supply is constrained, so obviously the freedom to decide (choose if you will) is obviously constrained to a similar degree. 

If you are Greece and under some contraints imposed by the ECB that controls your currency, you have fewer choices and greater prices to pay in making them. If one controls their own currency and is large and 'important' enough to make their decisions stick it is another matter altogether.  The Wall Street banks understand this all too well.

The US is a democratic republic and a huge net debtor, in both current and future obligations. The choice of genuine deflation as such would therefore be a national economic and political suicide favoring foreign holders of its debt. I cannot think of a reasonable scenario for such a choice except for coercion such as war reparations and under heavy constraint. But it is a possible choice.

Further complicating the decision is the inescapable fact that the US holds what is still the world's reserve currency despite a movement to alternatives. A stronger dollar and monetary deflation would crush the world economy by destroying the interconnected global banking system as it is now constituted, in addition to devastating its own domestic economy.  Deflation does favor the ends of a powerful few, however, so it cannot be said to be off the table.

Further complicating matters is that the people of the US are more independently minded, educated, and well armed than is normal around the world, despite a more recent program of cororatist propaganda that seems to have co-opted  their news media.  They are more like the Swiss in some regards.  I know this comes as a surprise to most of them, but it is how it is.  The US is a beacon of liberty to the world for good reasons, although that beacon occasionally flickers and suffers abuses, sometimes seemingly irrecoverable.

Their increasingly predatory financial system, together with the ownership of the world's reserve currency, probably dictated the accumulation of that large debt, significantly held by foreigners, if one subscribes to the theory of Triffin's Dilemma, which I do.   The US had to print more than it consumed to supply currency for growth in the developing world,  which was unfortunately engaged in currency manipulation and state mercantilism, and the financial system turned this into debt which it owned.

So the obvious choice is for a monetary inflation to soften the blow of what is going to be at least a de facto default on what is now a mathematically unpayable debt. Let's be clear about this. The US is facing a default and the bulk of the discussion now is about how to distribute the pain, and not fix the problems which caused the crisis in the first place.

The mercantilists who hold dollars, as a result of their gaming the global trade and fiat regimges, wish the US to suck it up and take it all.  This is preferable to growing their own domestic economy and allowing their people to become more independently powerful, thereby threatening them.  And the domestic monied interests wish the pain to fall largely on the weak and the many, the elderly and the poor. All of these actors are in a power position because they were the greatest beneficiaries of those structural distortions that have led the world to this crisis in the first place.

And yet the monetary inflation will not be able to have its usual effect, the magic that fiat has worked in the post WWII environment. This is because the economy is distorted, and organic growth of jobs and the median wage has been rendered untenable without significant reform in the domestic economy and global trade.

And the powers that be and the thought leaders are stuck in a credibility trap, through which they cannot effect the required reforms without indicting themselves, or at the least, dismantling the socioeconomic structure to which they own their ascendancy, whether it was through sheer luck and positioning in one of the bubbles, or in service to the monied interests by dismantling the regulations and promoting the frauds.

So the most likely course is an ineffective attempt to maintain the status quo, which cannot possibly become self-sustaining. And this is stagflation, which will continue until some crisis is large enough to change it.

It is tempting to use Japan as an experimental counterpoint to the US, but highly misleading and the cause of much misunderstanding.

Japan is most unlike the US, although the Yanks like to think of the rest of the world as little Americas, yearning to evolve into their image. The political structure is that of a one party government that was imposed on a military oligarchy which in turn had evolved from a relatively recent system of feudalism. There was no popular revolution in Japan that created their system of government.  It was imposed.  And the people have adopted it to suit their own preferences.  There is nothing wrong with that.  Nations should be able to have the type of society that suits their national character within some reasonable degrees of freedom of choice.  One size does not necessarily fit all.

The Japanese economy is highly controlled and centrally planned, following an industrial policy formed by an entrench bureaucracy in MITI and the handful of kereitsus that essentially run the country like feudal lords of old.

It is a closed society, an island, with a largely homogeneous population and limited immigration. The oligarchy has a sense of national honor and responsibility. The social mores would not permit the type of personalities of the 'greed is good' world view, at least not explicitly.

Deflation suited them, and that is what they obtained. But it is important to realize that the people did not suffer deprivation because of the social contract between rulers and people, the lords and serfs. This social contract is essential to understanding the situation. And of course the fact that the people continue to have a decent, if somewhat constrained by western standards, style of living that has been consistently acceptable to them for many years.

Lower prices yes, but the losses and deprivations were not visited on the people, at least not yet. There is not the same cult of selfishness and greed, and denigration of obligation as there is in the states. Contrast CEO pay in Japan and the US.  The losses were exported around the world and finessed by an increasing government debt, much of it wasted on the keiretsu's pet projects, despite the ongoing trade surpluses. But Japan appears to be heading for a change as the corruption and mismanagement of the oligarchy continues to peak through the studied facade.

So this is more the basis of my forecast, and I do not see a change in this until the US changes its financial system, and reforms its political system in a meaningful way, to diminish the influence of wealth and power and restore a balance with the voting public.  There are no such things as free trade or free markets, just as there is no free lunch.  All is subject to imperfection and abuse, and requires diligent effort, frank discussion, transparency, and conscious intentions.  Opening your markets to slave labor makes everyone a slave.

The world economy is a very complex system, and those who think they understand it with slight effort are probably wrong and sometimes tragically so.  Unfortunately they are also easily led, and in the pursuit of simple solutions may choose power over wisdom, to their own destruction.

Jim Grant Discussion with James Turk on Money, Bonds, the Fed, International Trade, and Gold

"...I have a dreadful confidence that existing [monetary] arrangements will not last."

James Grant

This is an excellent discussion of some of the key topics affecting global currency and the roots of the financial crisis.

It provides some background for the unfolding currency war and the evolution of the global reserve currency which is in progress today.

I think it is fair to say that very few people understand this, and yet it is having a tremendous impact on their lives, and that effect will be increasing, perhaps exponentially, over the next few years.

It is said that a shark must keep growing and moving to remain alive, and can never be at rest. It must continually devour all that it can to survive.

This is the nature of a Ponzi scheme as well, since it is founded on nothing more than a growing believe, and misplaced trust. It can ultimately tolerate no dissent, and needs continue to add converts to it, whether it be by persuasion or force.

And therefore we have the not incidental connection between a global fiat currency such as the American Dollar or the British Pound and a far reaching military-political empire. When the empire stops expanding, the currency begins its slow but inexorable decline.

This discussion is presented as a contrast to Modern Monetary Theory.

Eisenbeis: What's A Central Bank To Do Besides Printing Money (And Pursue A Hidden Agenda?)

I thought this was a fairly nice thumbnail sketch of the problem facing the world's central banks vis à vis the US dollar as reserve currency and globalization. I have to add that this current impasse was not unforeseen.

I suggest you take a look at a very brief description of Triffin's Dilemma.

The Triffin dilemma is a theory that when a national currency also serves as an international reserve currency, there could be conflicts of interest between short-term domestic and long-term international economic objectives. This dilemma was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country whose currency foreign nations wish to hold (i.e. the global reserve currency) must be willing to supply the world with an extra supply of its currency to fulfil world demand for this 'reserve' currency (foreign exchange reserves) and thus cause a trade deficit.

The use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: some goals require an overall flow of dollars out of the United States, while others require an overall flow of dollars in to the United States. Currency inflows and outflows of equal magnitudes cannot both happen at once.

The Triffin dilemma is usually used to articulate the problems with the US dollar's role as the reserve currency under the Bretton Woods system, or more generally of using any national currency as an international reserve currency.

The problems with any domestic currency operating as the world's reserve currency are well known, and yet the United States decided to pursue this after Nixon closed the gold window. Perhaps that is because the risks to the many were outweighed by the benefits to a few.

I enjoyed the author's flat out statement that "it is undeniable that the world's central banks collectively have flooded world financial markets with liquidity by printing money."

If someone tells you that central banks, in a fiat regime, cannot create money out of nothing, then they simply do not know what they are talking about, no matter how many rhetorical flourishes and convoluted rationales they may produce. They can do it, they are doing it, and they will keep doing it until they reach what they consider to be a sustainable equilibrium, or they exhaust their ability to print based on the limits I have previously described.

The problem is that none of the equilibria they have produced in the last twenty years have been sustainable, except for a few years, and the half life of the monetary bubbles appears to be contracting.

The US dollar is at the end of its rope as the reserve currency for the world. Nothing could be more clear.   What will be done about this is another matter.  The Anglo-American banking cartel will enter the next phase of the evolution of money resisting change every step of the way.  What they most desire is to maintain and extend their control of a worldwide fiat currency, not even in the interests of their own people, but for the benefit of a few.

Institutional Risk Analyst
What's a Central Bank to Do?
By Bob Eisenbeis, Cumberland Advisors
April 25, 2011

Faced with largely the same set of facts when it comes to their inflation outlook, some of the world's major central banks have come to markedly different conclusions about the appropriate policy.

The ECB began to exit from its accommodative policy by increasing its policy rate by 25 basis points to 1.25% on April 7. The ECB noted that growth was improving moderately, but inflation had increased to 2.6% and was up from 2.45% the previous month. The rise was largely due to increases in energy, food, and commodity prices. The concern was the potential second round effects and that these increases could become embedded in inflation expectations.

The same day, the Bank of England kept its policy rate at 0.5%, despite the fact that inflation had been running well above its target rate of 2% for more than a year and was likely to remain so through 2011. Again, the Committee noted that the near term path for inflation was higher due to energy, imported commodities and other goods. Concern was also expressed about inflation expectations having risen in the UK, the US and the euro area relative to what they had been before the financial crisis. Finally the UK real economy was softer than that of the EU generally with output having declined by 0.5% in the fourth quarter of 2010.

While the FOMC will meet this week, Fed Chairman Ben Bernanke and Vice-Chair Janet Yellen have already signaled that they view the recent increases in commodity, energy and food prices as transitory. Governor Yellen in particular provided an extremely thorough and detailed dissection of the inflation data and her views on the real economy and employment in her April 11th speech in New York. She indicated clearly that the causes of the run-up in food, energy and commodity prices were rooted in increases in global demand, combined with energy supply shocks and uncertainty about oil flow from the Middle East. Like the Chairman, she expressed the view that the increases were transitory.

Most notably she attempted to debunk the widely discussed view that accommodative policies in the US were the cause of the increase in global prices. She was very clear that the main concern was for the US expansion and employment situation, that the current stance of policy was appropriate, and that QE II would be completed as scheduled. So we don't expect any notable news coming from this week's FOMC meeting.

These three views on the appropriate stance of policy and how individual-country central banks may think about policy shows a growing disconnect between traditional approaches to monetary policy and globalization. For example, the US economy historically has been largely isolated from the rest of the world. International markets were not particularly significant (exports and imports were roughly balanced and accounted for less than 13% of GDP). Inflation was largely a domestic issue and could be directly affected by changes in US policy rates. From the 50s through 70s, the main channel for monetary policy was through housing: when interest rates exceeded the Reg Q ceilings that banks and thrifts could pay for funds, the supply of funding to housing was cut off. Then construction declined and the effects rippled through the rest of the economy. Most of the economic models have that structure and international isolation embedded within them. Yet this is not the world that policy makers are now dealing with, as the above descriptions of the causes of the current inflation aptly illustrate.

If the major causes of inflation are external to an economy, and policy makers have domestic tools and targets for inflation and local employment, either explicitly or implicitly, then how should they respond to externally generated causes of inflation? What is the link between the central bank's domestic policy interest rate tool and the external causes of price increases? These key questions are not currently addressed within contemporary policy frameworks employed by the FOMC, the ECB, or the Bank of England, as best one can determine.

In the current inflation environment, one can justify any one of three alternatives, and some of these are clearly being adopted. Furthermore, all can be mostly right or mostly wrong.

First, a policy maker could attempt, as the US did during the 1970s oil crisis, to insulate the real domestic economy from the contraction supply shock by keeping rates low. This policy seemed appropriate and was politically acceptable, especially since the price increases were viewed as temporary. But it clearly failed, and we paid the cost with higher inflation.

Second, if one believes that the energy, food and commodities price increases are transitory, then no response is called for; and this can justify focusing on domestic employment, as is currently being done in both the US and UK. Even if the increases are permanent, doing nothing may be the appropriate policy. Permanent increases in energy, commodity, and food prices will shift these prices relative to other goods and services and generate substitution and accommodative responses by business and consumers. We may, for example, drive less and adopt more hybrid transportation alternatives -- moves that are already beginning to take place -- than we would if the energy price increases were viewed as being temporary.

But doing nothing also has its own risks. Maintaining an accommodative policy too long risk overheating an economy and fueling both an increase in domestically-produced goods and services prices and passing along the increased prices of external goods and energy prices as second round effects. As always, timing is everything when it comes to exiting from an accommodative policy.

Third, a central bank can move to increase its policy rate to choke off inflation, as the ECB has begun to do. But this policy has certain risks associated with it. If the causes of the inflation are external to the economy, then one would not expect those prices to be responsive to a policy move by a domestic central bank. But the increase in rates will clearly impact those domestic and non-international activities that are affected by rising interest rates. Economic activity in those areas will contract, including production, employment, and prices. So the impact of responding to an external inflation source is to force a decline in an aggregate price index by contracting domestic economic activity. This seems a risky path indeed. Right now it may appear less so because policy, as ECB President Trichet stated, is still viewed as being extremely accommodative.

So what is a central bank to do, especially when policy is overly accommodative? While Vice-Chair Yellen may argue that the increase in world prices is not our fault, it is undeniable that the world's central banks collectively have flooded world financial markets with liquidity by printing money.

This situation is likely to become even worse in the near term if Japan resorts to inflation as a means to finance the cleanup and rebuilding necessitated by the recent earthquake, tsunami, and nuclear disasters. When domestic economies are no longer insulated from international markets and forces, individual central banks can no longer go-it-alone with their policy decisions. In such a world, perhaps the best policy is to remove the distortions cause by current policies, and then attempt to avoid extremes. Unfortunately, how to get from here to there in a non-disruptive way is not at all obvious, as the ECB may soon find out..

What this means for investors is that market uncertainty is likely to remain high for some time to come, and attempting to play in international markets carries with it huge foreign-exchange and real risks that need to be hedged.

Although I may say uncomplimentary things occasionally about Messrs. Bernanke and Greenspan and their colleagues on Wall Street and in government, I most definitely do not think they are fools, or naive, or uncomprehending of what they are doing. Therefore I find their actions difficult to square with a sincere fulfillment of their stated objectives, and the oaths of their offices, unless there is another dimension to their plans which has not been disclosed, and which I do not yet understand.

"And some of us who have already begun to break the silence of the night have found that the calling to speak is often a vocation of agony, but we must speak. We must speak with all the humility that is appropriate to our limited vision, but we must speak...Perhaps a new spirit is rising among us. If it is, let us trace its movements and pray that our own inner being may be sensitive to its guidance, for we are deeply in need of a new way beyond the darkness that seems so close around us."

Martin Luther King

Gold Daily and Silver Weekly Charts - Something Wicked This Way Comes

Today was a very early April options expiration for US equities, and we saw quite a few antics in the stocks. Of special interest to many were the games being played with the mining stocks.

There is intraday commentary on gold and silver and the closing of the retail gold window at the Belarus central bank here.

April is supposed to be one of the better months for stocks, but so far it has been correcting fairly steadily from the early April highs.

Gold and silver are starting to get a second wind in this breakout, and the increasing inflationary environment in the global fiat currencies, particularly the dollar, are driving them higher.

This is the latest on US inflation from John Williams at Shadowstats. John tracks the underlying inflationary trends better than anyone else that I know.

"The pace of consumer inflation is accelerating rapidly, with annual CPI-U at 2.7% and CPI-W at 3.0%, while the annualized quarterly, seasonally-adjusted inflation rates have hit 5.2% for the CPI-U and 6.0% for the CPI-W.

These higher inflation numbers are tied directly to the Federal Reserve's successful and ongoing efforts to debase the U.S. dollar, which in turn have boosted dollar-denominated commodity prices such as oil. The inflation pace here normally would be of concern to the Fed, except the U.S. central bank officially ignores inflation tied to food and energy prices, even though, again, those debilitating price increases for consumers are a direct result of Fed policy.

Of particular discomfort to consumers, this inflation has not resulted from booming economic activity and wages, but rather from Fed monetary policy in the context of stagnant/declining broad economic activity.

Inflation has gained the upper hand in retail sales, with sales gains now more than accounted for by rising prices. A pending benchmark revision (April 29th) should show a much weaker recent history for retail sales activity, as the just-published benchmark revision to industrial production did for that series...

Inflation Above 3% Tends to Rattle Consumers. Where consumers look at inflation in terms of out-of-pocket expenses, the threshold of pain has been crossed, with popularly used consumer price indices at or within one month of topping 3% annual inflation. Further, for those who do not get paid in seasonally-adjusted dollars, the 0.5% adjusted CPI-U monthly gain felt more like the 1.0% unadjusted gain."

Modern Monetary Theory: The Sophistry of the US Dollar

soph·is·try (s f -str ). n. pl. soph·is·tries. 1. Plausible but fallacious argumentation. 2. A plausible but misleading or fallacious argument.

This is a very well written and important piece by Mr. Cullen Roche at his site Pragmatic Capitalism.   It does a good job of capturing the essence of modern monetary theory that I like to think of as post-Nixonian fiat, gaining its realization and fruition in Reaganomics and the Greenspan Fed.

Sophistry does not refer to the author or his argument who I assume believes exactly what he is saying, and of which reasonable people can make what they will.  And he is certainly not alone in his thinking.  More recently thought leaders have said the very same thing, and sometimes couched as an attack on anything else to stand up to the value-is-whatever-we-say-it-is crew of central planners and their financial engineers. 

I have done him the courtesy of including the entire piece with a link, with my comments in italics along the way.  I dislike it when someone 'cherry picks' something I have written, setting up a silly strawman argument and a false premise, and then attacking it often in a clumsy manner.  And I think this argument of Mr. Roche is well said, and worth considering seriously.  He might be right. 

But I do not think so.  I think his reason jumps the tracks at a key juncture and runs into the weeds thereafter. I fear this is a system that requires an exponentially greater reach of control and misdirection to keep working as in a late stage ponzi scheme.  And that is what makes it especially dangerous, because it must at some point silence all dissent, and promote its provisions and arrangements amongst the unwilling, or fail.

So as I said, he does a very good job of explaining it well, and many intelligent and people with weighty credentials and position seem to agree.  But many of these same people also said they ardently believed in the efficient market theory and the benefits of deregulation, and we see how quickly that belief system has collapsed under the weight of the financial crisis, although its remnant echoes are continually reappearing in various places and policies.  Old ideas die more slowly than old soldiers, especially when they continue to enrich a powerful status quo.

Rather, the sophistry is in the evolving nature of US dollar and its role as the world's reserve currency, and too often the discussions that surround it.   Perhaps rationalization would be a better word, but sophistry captures the intent of it I think.

As you may recall, the basis for the unilateral departure of the US from the Bretton Woods regime and the gold standard under Nixon was that the full faith and credit of the US Treasury, with an independent Fed as guardian of the realm, would force the Dollar to act as though it were still externally constrained, as in the case of a gold standard.   As Greenspan said, the dollar works as long as it acts as though it were on a gold standard.

This is why, as I recall, the Fed is prohibited by statute and custom from buying debt directly from the Treasury.  It must first pass through the public markets at auction, in the belief that market discipline will prevent excess money creation by legitimate price discovery and higher interest rates as required.

It might be useful to consider at this time a different definition for monetization, that is not the archaic 'printing of money.'  Monetization might best be described as those actions which consciously misprice the decreasing value and prospects of money, normally a currency, and by corollary the associated risk and returns.  As you can see this includes the debasement of specie money through various means, but also the more modern method of egregiously tinkering with interest rates beyond merely policy rate adjustments.

As I have pointed out previously, to circumvent market discipline merely requires a Fed with the will to do it, and a few complicit primary dealer banks to play along with it.  This can work well as long as no one with sufficient sovereign standing calls them on it, or the people who are the users of the currency rise up en masse against it.  This is convenient arrangement amongst regulators and market fixers is merely an impasse, and is not sustainable in a floating exchange rate system.  The arrangement requires ever increasing duplicity and threat of force. After these many years, the dollar is now literally hanging on to its value with its reserve currency nails.

And so I think a collapse of the dollar is more possible now than at any time in the past.  It is only sustained by the trauma which the decline of such a large economy would cause on the world markets and those central banks unfortunate enough to hold its debt.  This is the best case one can make to explain a hyperinflation

Pragmatic Capitalism
The Fed Is Not Monetizing U.S. Government Debt
By Cullen Roche
February 9, 2011

The Fed’s purchases of Treasuries continue to attract a huge amount of attention. Despite solid evidence that the program is failing to have any real fundamental economic impact, there are other worries about the program. None has been more apparent in recent weeks than the Fed’s supposed monetization of the US government’s debt. These fears of monetization are unfounded due to the various myths that are perpetually touted by the mainstream media, supposed experts on the US monetary system and even Fed officials. (Quite a collection of the mistaken, certainly not the hoi polloi and not so easily dismissed, but let's read on.  I have to add though that flags get raised in my mind whenever I pick up this tone in an argument early on. - Jesse)

In an article Monday, Bloomberg reported that the Fed has been buying an exorbitant proportion of the recently issued Treasury debt:

More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.

Why does this matter? Because it gives the appearance that the US government is directly funding itself via the Fed’s purchases. This would be nefarious if it were true and would give credence to the endless complaints about the high rate of inflation in the USA (which is currently running at a staggering 1.5%-2.25% depending on the source). Fortunately, the concerns are unfounded.  (Unfortunately they are not, but read on. - Jesse)

The issuance of bonds continues to this day due to Congressional mandate. In reality, our bond market funds nothing and serves only as a reserve drain which helps the Fed maintain its overnight target interest rate. It has nothing to do with funding the government.  (It would be interesting to test this theory.  For example, if the US were to have a failed bond auction this year. - Jesse)  When the US government wants to spend money they do not call China and ask for a line of credit. They do not count tax receipts. And they most certainly do not call the Fed to ensure that we have any money left. No, the truth is that the USA never really has nor doesn’t have any money. So the entire implication that the Fed is helping to fund US government expenditures is entirely inaccurate and anyone who implies as much is still working under the now defunct gold standard model and clearly doesn’t understand the workings of the modern monetary system. 

(This is the heart of the sophistry.  For the theory as it stood for many years was that market discipline and an independent Fed would take the place of the gold standard in placing some constraint on the value of the bond and the dollar.   Otherwise why would the Treasury simply not create the bonds to satisfy its obligations and place them on the Fed's balance sheet?  Or better yet, just issue currency and skip the interest?  Because the theory is that by using interest rates as a governing mechanism and forces the debt to be placed through an open system of auction, the efficiency in valuation of the market would act as a standard and as a restraint. - Jesse)

When the US government was working under the gold standard the US Treasury would literally print up certificates to purchase gold from the gold mines. These gold bars would be delivered to the government and the Treasury would issue a check to the miner. This new money would end up at the Federal Reserve Bank in the form of deposits. This would naturally increase the money supply. An increase in the money supply is scary for obvious reasons. So, the term debt monetization has its origins in the days of the gold standard, but persists to this day despite the fact that we are no longer on a gold standard. Not surprisingly, the term is still used today despite the fact that the US government can’t monetize its debt via Fed purchases (I elaborate below). 

(This description of the gold standard is regrettably cartoon-like, and completely ignores the role it played as a market force in international trade.  Most of the gold volume was related to the exchange of goods in trade, and not through the purchase of new supply from miners.  In a situation where a nation consumed more than it produced, the decline of its gold holdings would weaken its currency, forcing a unit devaluation vis a vis gold.  And vice versa with those countries with a mercantilist bent.  Since actual gold was changing hands, and a relatively modest increase is added each year to total supply, it was difficult to game the system.  Monetary policy in the form of devaluation was still very possible, but a bit awkward if one used actual specie instead of certificates. But it was enforceable and transparent. I am on the record as not favoring a return to the gold standard in the US at this time, because its financial system is too unstable and corrupted.  But gold and silver represent a major attraction for international trade in some manner, for the reasons outlined above.  The US dollar was purported to serve this purpose as the world's reserve currency post 1971, but it has failed in the exact manner predicted by those who said it could not work because of the vagaries of human weakness and the corruptibility of policy. - Jesse)

This issue was magnified yesterday when Richard Fisher of the Dallas Fed invoked the evil “debt monetization” term in his speech:

The FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we will be purchasing the equivalent of all newly issued Treasury debt through June. By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: “Monetary policy responsibility cannot substitute for government irresponsibility.”

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”

Fisher’s implication is that the Fed is directly helping to fund the US government’s spending. After all, if they’re buying the debt then they’re obviously funding the spending, right? Wrong. As regular readers know, the US government is never constrained in its ability to spend. Our monetary system underwent a dramatic change when Richard Nixon closed the gold window. It removed any constraint on the US government’s ability to spend. Nonetheless, the operating structure of the gold standard (issuing bonds, etc) still largely remained intact.

(The constraint is softer, and more pernicious than when the US was on a gold standard. The constraint is now the external valuation of the bond in the generic sense, and the dollar, which is a bond of zero duration. During the Carter administration, for example, the dollar was constrained by monetary inflation, the decreasing valuation placed on the bond and dollar by the rest of the world. A gold standard acts as a hard restraint, stopping the monetary authority from debasing the currency early on. Without that constraint perception make the process non-linear. Rather than a hard stop, with a transparent and visible devaluation process, the value can erode slowly over time until it reaches a tipping point, and a more precipitous slide into a collapse. The Fed is confident they can stop this based on the Volcker experience. This remains to be seen. They have no prove of it in theory because it involves human behaviour and significant, if not critical, international exogenous variables. - Jesse)

For a brief instant, Mr. Fisher appears as though he is on the verge of understanding the system he now heavily influences as a new voting member of the FOMC. Mr. Fisher says that the spending effectively comes first:

But here is the essential fact I want to emphasize and have you think about today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place….The Fed does not create government debt; Congress does.

Lights should be going off in Mr. Fisher’s head at this point as he says this. This is important because Mr. Fisher is essentially acknowledging that the Fed is not the entity that actually conducts helicopter drops. Of course, spending comes before debt issuance. It can be no other way in a monetary system such as ours. The Fed’s role in this process is purely monetary. It has nothing to do with the fiscal side. The Fed does not “print money”. Congress is the entity that prints money via deficit spending.  (And the Fed is supposedly the independent constraint on this, and of course the printing of money that occurs in the private banks and the shadow banking system. - Jesse)  And they always decide how much to spend before considering any potential constraint from taxes or bond issuance. Unlike a household or state the US government does not need money before it spends. (The Fed is the only relatively unrestrained source, as well as being the regulator, the governor if you will.  Because the US must issue a bond at some point to cover its spending. This is not a mere detail.  It is a rhetorical device to argue the timing, for it is implicit in the process of governance..  But only the Fed can expand its balance sheet ex nihilo, from nothing.  - Jesse)  From a common sense perspective, you would think that this would set alarms off in most people’s heads, however, it does not. The idea that the US government is never revenue constrained is so foreign to most people that their minds repel it. (And rightfully so, since such an outlook is a tenet of the Robert Mugabe School of Business, University of Zimbabwe - Jesse)

By now you might be thinking that this is all semantics. Who cares if the Fed isn’t helping to fund the spending? They’re still buying the bonds and the spending is occurring regardless of the Fed’s actions. Well, it’s important for several reasons:

1.  Someone who understands the modern monetary system understands that a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue. Therefore, it should not be treated as if it is a household, business or state. (This sounds as though it could be  the motto of the Weimar school of modern monetary economics.  What is missing is that for this to be correct that monopoly must be comprehensive, ie, there must be some force that cause the misallocation of wealth in the world from a central planning commission, and a mispricing of risk.  In other words, its necessary to be the world's reserve currency and to own the ratings agencies. Otherwise the only floating that gets done is the value of a currency printed ad infinitum down the drain.  The value of a fiat currency is tenuously based on the belief that the monetary authority will not assume it has no solvency issue because it owns a printing press and is willing to use it recklessly, that the currency retains some stable relationship to some useful goods.- Jesse).

2.  If solvency is not a concern (and here reason departs from reality, especially given the many serious instances of high inflation experienced by countries not on a gold standard since the end of World War II.  Technically Russia was not insolvent when the Soviet Empire collapsed. It merely re-issued a 'new ruble' after knocking a few zeros off the old one.  Tell the good news to those whose life savings were destroyed. - Jesse)  then clearly the concern is inflation or potential hyperinflation. But as we’ve seen over the last few years the Fed has not succeeded at creating inflation anywhere close to the historical average and certainly not dangerously high levels of inflation. To someone who understands how the modern monetary system functions it not surprising then, that the Fed has been unable to generate inflation during a balance sheet recession. (Inflation is how one measures it.  I would submit that the Fed is quite expert at generating asset inflation in things like financial assets and housing, having done it quite well a few times now.  But I would agree that this is not sustainable, for the reasons noted by Jefferson so many years ago, that this printed money is used for merely speculative as in gambling, not adding the 'mass' of the economy but merely serving as a subtle means of wealth transferal.  For fiat money is not wealth, but merely the means of allocation and transference. - Jesse)

3.  Fear mongerers want you to believe that the Fed is the evil entity that “prints money”. The truth is that the Fed can do no such thing. Only Congress can print money and it’s clear that their actions in recent years have failed to generate significant inflation. This is a sign that the government’s spending has been ineffective and misguided. Although I acknowledge that the US Congress is never constrained in its ability to spend this by no means implies that the US Congress should spend beyond its means. To do so can possibly result in malinvestment or very high inflation.  (As a general rule of thumb, name calling, also known as poisoning the well of a counter argument, often introduces and highlights the weakest points in a discussion. Having said that, in a fiat system the interest rates are a key bellwether and governing mechanism to the money supply and the expansion of credit which is the source of money. To this extent to say that the Fed is not involved is to use the same defense that the Wall Street banks used in the subprime mortgage crisis.  They did not originate the loan. They merely bundled them, helped to misprice them, and then sold them to the unsuspecting, the marks in this great con game. - Jesse)

4.  The idea that the Fed is buying government debt might imply that there are is a shortage of buyers of US debt. This is impossible as government debt issuance serves only as a reserve drain. Auctions are designed around calculated reserves and are carefully designed so as not to fail.  (There are a shortage of buyers at certain prices, so the Fed steps in to buy them in the act of mispricing of risk. - Jesse)

5.  Voting members of the FOMC do not understand the actual workings of the Federal Reserve System and the US monetary system and have played a direct role in the misguided policy response in recent years. Of course, this is nothing new. This problem has persisted throughout the entirety of the last 40 years and is largely to blame for the structural flaws in the US economy currently. (If those voting members included Greenspan and Bernanke and I would most heartily agree, but I do not think that is what Mr. Roche intends. - Jesse)

6.  The overwhelming majority of US citizens have no idea how the US monetary system actually functions and therefore are reluctant or unable to force any sort of real change. (As I recall those same citizens rose up almost en masse and besieged their Congressmen to vote against TARP.  They were ignored by the Congress which has been inundated by money from the banking lobby. The desire for change is clearly there.  What is lacking is choice, and I think it is fraud with intent. - Jesse) Those with political or monetary motivations tend to invoke fearful language that incites anger and in truth only adds to the problems in the US economy by driving the voter base to react to their emotions and not their knowledge of the system in which they reside.

7.  Quantitative easing does not increase the money supply and is therefore not inflationary. (Apparently the Adjusted Monetary Base escapes his attention, in addition to the Fed's role as 'the standard in proxy' acting in lieu of an external standard such as gold or a peg to a hard currency - Jesse) Although this operation can have significant psychological impacts (such as inducing undue speculation)  (You bet your ass it does, and it is doing it right now - Jesse) QE can only work in the same manner that traditional monetary policy is implemented at the short-end of the curve. This occurs by setting a target rate and by being a willing buyer of any size at that rate. This is NOT how the current policy is designed. The current structure of QE leaves interest rates entirely controlled by the marketplace and not the Fed. Therefore, the mixed results should come as no surprise to anyone as the policy was poorly designed to begin with and is likely doing little more than contributing to excessive speculation and promoting the continued financialization of the US economy. The Fed’s implementation of such policies (such as QE) and complete misunderstanding of such policies does nothing but help create disequilibrium in the marketplace and increase the odds of future instability. (What Mr. Roche seems to be saying is that the Fed should just set rates across the curve, and chuck the marketplace.  Now THAT's bare-knuckled monetization.  It might work if the Fed could also set a price for oil, food, gold and silver, and make that stick for example.  They are trying with gold, and silver with less success, but not even that much for the others. - Jesse)

8.  Monetization is achieved by act of Congress via deficit spending and is independent of the Fed’s monetary policy. Anyone who uses the term in the context of the Fed’s contribution of government spending does not understand how the modern monetary system works. In a strict technical sense, monetization is always

(This ignores the role of private banks in creating credit which becomes money. Certainly the Congress plays a key role in the creation of money through government spending and the issuance of debt. But the private banking system plays a key role as well. And the gatekeeper for all this is the Fed.   This also ignores the Fed's new ability to buy purely private debt and mortgage obligations. Indeed, as I recall in those distant days when there was a misplaced fear that with its illusory surplus the Fed might run out of sovereign debt to buy, the Fed reassured us that it could buy debt from many other sources. They can do it, and they are doing it. - Jesse)

End Note: It is disappointing to find that these types of discussions too quickly devolve into name calling and sloganeering for one's team, to little benefit except for page clicks and crowd persuasion, which faux reasoning seems to drive too much of the financial reporting today.

Indeed, there seems to be little actual investigative reporting in general being done anymore in the states. And we are seeing far too little reasoning being done from those quarters from which we might expect better. It is too often talking head versus talking head in the staged manner of professional wrestling.  And conspicuous in this deficiency is the economics profession, which too often become a pliable mouthpiece for this or that well-heeled constituency. But it is as one might suppose it to be. There is nothing so corrosive to intellectual integrity as the cover up of a well-intentioned but artificial and inherently deceptive scheme gone badly, and one is caught in a credibility trap.  And of course a status quo based on position and privilege always has its allures.

Many people have raised a voice about the frauds at the center of the financial collapse, and we are at the point where this type of discussion does not matter overmuch; people are going to believe what they wish to believe based on self-interest and the principle of relativism and expediency. Chartalism holds wonderful rewards for those that can pull the levers, and punishment for those who step out of line. 

The problem with these sorts of central command and control constructs is that they assume that men can act with a wonderful enlightment, with the wisdom and selflessness of angels.  Unfortunately they do not often do this.  Such a system is the preferred tool of autocrats, and is inherently inimical to openness and democracy, always requiring secrecy and unilateral power.

“The Constitution is not an instrument for the government to restrain the people, it is an instrument for the people to restrain the government - lest it come to dominate our lives and our interests.” Patrick Henry

One can rationalize almost anything in the service of the power that sets all value and serves none other.  It becomes a matter of duty, of merely following orders.  As an official of another empire destined to its decline once asked, "What is truth?" and then turned and washed his hands of it, which was the expedient thing to do.  Truth is what the few say it is, when the hubris of the will to power is at its zenith. And then it consumes all, for the will to power serves none but itself.

I think there will be a tipping point, some catalyzing event which will spark an unavoidable reaction in the public, in which the people will finally stand and demand justice.  And then some change will come, for good or ill. We are seeing the early stages of that in the world today and in many places where the people are suffering.

The Inflation and Deflation Debate Deconstructed

'What most people call reason is really rationalization. Given a new set of data, most people will search through it only for those examples that support their existing beliefs. Their beliefs are really opinions, a tenuous collection of myths, anecdotes, slogans, and prejudices based largely on justifying personal fear and greed. This is what makes modern propaganda so powerful; people do not bother to think critically and objectively and act for the greatest good. And in their ignorance they can find the will to do increasingly monstrous things, and rationalize them.' Jesse

In a purely fiat regime, the question of a general (monetary) deflation and inflation is a policy decision. Anyone who does not understand this does not understand the modern mechanism of money creation. As the pundit said, "The mind rebels..."

But rather than engage in the usual facile intramurals about the topic, let's consider something more important. How does one 'play this' which is really what all these discussions are about: self interest.

The champion of deflation is the Treasury Bond (and the Dollar), and of the inflationists, Gold.

There are extremes on both sides, and probably more sense in the middle, since life rarely sustains the extreme unless there are people messing about with it. The only naturally efficient markets are in ... nature, and that only as measured over the long term.

Anyone who doesn't think Treasuries have been in a long bull market are blind fools.

But the same is true of gold.

I will leave the dollar aside for now to simplify the discussion, but it hardly lends itself to the deflationary theory.

People who have taken positions and held them in both Treasuries and Gold over the past ten years have made money, a very nice return. When one has a theory that consistently and reasonably encompasses that, you might have something worthwhile.

The deflationists will say that gold is a bubble fueled by mistaken speculators, and the inflationists will say that the Treasuries are being supported and manipulated by the Fed. Neither is able to look out from their deep wells of subjectivity.

You may wish to consider that the great part of this discussion, inflation versus deflation, is a diversion. But that is a discussion for another time.

The question for all failing theories is, as always, what next. What is the alternate count.

Oh boy oh boy, [our desired outcome] is finally coming and when it gets here its going to be good. We are finally turning [Japanese / Weimar].

Things are in bull markets, or bear markets, until they are not. The undeniable trend break is the best indication of change in momentum.

But things in the world of complexity are rarely as simple or straightforward as the average mind will allow, or can accept.

Anyone who thinks the Fed is impotent has not been paying attention to the last one hundred years. The Fed is not impotent, merely constrained. Their constraint is the policy arm of the government, the dollar, and the bond, in the absence of some external standards including external force.

Until one understands that, nothing can or will make sense. That is why the current discussion is so nasty and propaganda-like. It is not about what will happen, but rather about a public policy decision, about what people want to happen.

Consider that these debates are merely diversions, to distract people away from the most significant factors in their troubles, which are exploitation and fraud, and a military-industrial complex that is largely unproductive in terms of organic growth, and is quite simply no longer sustainable.

Paid professionals who were arguing the virtue of credit expansion as the bubbles blossomed are now arguing just as strenuously for austerity now that the bubbles are collapsing, their masters having taken their spoils. They will say for pay, without regard for the solutions that are in the best interest of the country. Few are thinking of their country anymore, as the individual is conditioned to think of themselves as globalized abstractions.

As always, be careful what you wish for, because you may get it. In this current climate, this class warfare, the American nation is a house divided. And you know what happens to those.

And the winners may inherit the wreckage, a pyrrhic victory indeed, but they can console themselves with the satisfaction that they have won the irrelevant debate.

China and the Goldfinger Syndrome

I have had some interesting discussions recently with correspondents about the problem which China has with its very large US dollar reserves.

To summarize what I think, China is attempting to diversify their portfolio of US Treasury dollar holdings. They are obviously accumulating 'real goods' including stockpiles of basic materials, gold, silver, oil and investments in the means of production in their own region and in key regions around the world.

This is more difficult than it might appear on the surface. Real goods are often strategic, and governments are sometimes reluctant to allow them to be acquired by a government considered a potential threat. The first difficulty is the strategic importance of some assets, such as the China's offer for the purchase of Unocal.

But there is also a need for confidentiality, stealthiness if you will. If word were to leak out that 'China is dumping its Treasuries' there would be a run on the market and the Chinese could lose a portion of their reserve wealth rather quickly.

Now, would it matter. Well, yes. It would matter because US dollars are still the currency of choice for most international trade including the all important international commodity, oil. If you think that philosophically dollars have no value because they are just paper, I would be more than happy to dispose of them for you. Limited time offer, of course.

I also posited that China, while accumulating its real goods quietly against the constraint of perturbing the markets, could do short term hedges against the less catastrophic scenario of further dollar devaluation by going into the very deep and liquid financial assets markets, and hedging risk with CDS and other obvious investments including shorts of various types.

As anyone who has attempted to acquire a company or take a substantial position in or out of an asset or company, at some point you can affect the price, making other participants aware that the asset is in play, and end up selling or buying against yourself. In the case of China it could also trigger a run on the bank of the US, which is an immediate endgame.

With regard to the use of financial instruments, someone raised the obvious issue of counter party risk. Well, of course it is an issue. But less so if you are merely hedging a portion of the portfolio for the devaluation scenario, and not a catastrophic default. And the choice of counter parties can be managed to some degree. It is a big world out there and the Swiss are always open for a bet.

But correctly, if there is a catastrophic failure of the dollar, they will be carrying banks and brokers around the world out on stretchers and almost all financial assets, or bets, will be in default. Those who are holding leap puts as insurance against a collapse may as well be holding food vouchers for a restaurant in Brigadoon.

China would most likely not lose the value of its reserves in the extreme case of a US default, even if every one of their remaining Treasuries and the financial hedges on those Treasuries became worthless. Why?

It's the Goldfinger Syndrome. As you may recall, Auric Goldfinger did not wish to steal the US gold supply, at that time the currency of the nation, from Fort Knox. He merely wished to eliminate it, making his own substantial gold holdings significantly more valuable. It is a form of increasing value through deflation, a concept that is much more familiar these days thanks to quite a few amateur economists patiently waiting for the US dollar to gain in value because of it.

If the US were to actually default, the value of real goods, from basic materials to gold and silver and oil, would absolutely soar in terms of dollars of course, but in most other fiat currencies of the developed world as well. The perception of the risk of a fiat currency would border on hysteria.

Returning to the deflation meme, the elimination of US financial assets from the 'world currency base' would make all the other currencies extremely valuable, and China would be flush with them. For real goods are a form of currency suitable for the exchange of wealth. They are merely less liquid, and not often used as the unit of value anymore. But real goods are a form of currency. They just cannot be printed, except perhaps on the Comex and at the LBMA it appears, and they would be absolutely discredited and out of business.

So, that is something to think about. China need do nothing but slowly and stealthily acquire real goods, and hedging their positions along with way with financial instruments, waiting for the US to play itself into some beneficial outcome for them. I think the financial hedging is important because of the relative illiquidity of some of the real goods, and the difficultly of acquiring them in sufficient supply without triggering a 'run on the dollar.' The financial markets are deeper and more discreet than the markets for real goods.

The problem facing the holders of dollars is not inflation or deflation, per se. They are merely particular manifestations of currency risk, and the uncertainty of holding substantial assets denominated in a fiat currency that is risky, meaning something abnormal or unstable in the classic sense of the term. A serious deflation or inflation are both unusual and risky.

This is not hair-splitting. Rather it is essential to understanding why gold can increase in value during periods of both a significant deflation and inflation, which on the surface seem like opposites. In fact they are similar if view in the terms of probability. They are both the opposite of currency stability, what I call currency risk. The further one gets out on the probability curve with a currency, the better gold looks in relation to it. Gold is the ultimate in stability, almost inert, and highly resistant to corrosion and decay, bordering on the timeless, comparatively uniform in its supply.

There are those who say that when the time comes, and what is happening becomes apparent, they will buy some real goods, foodstuffs, land, gold and silver. I can assure you that when that time comes, there will be little or none available at almost any price. One has to have lived through a currency crisis first hand to understand the phenomenon.

You are holding a currency in decline and there is little or no place to spend it except as a throwaway, because no one wants it anymore. Barter becomes predominant, and any hard currency is king. This is how it was in Russia in the 1990's with the old rouble before it finally imploded, at which time I was thankfully out of country. It was quieter than you might imagine, despite the headline antics of their mafia, and a sense of quiet desperation as people watched their life savings simply evaporate.

There is almost no doubt in my mind that this is how the Chinese are playing this, and certainly Russia and a few others as well, who are playing the long game. It explains some of the recent moves in price of certain forward looking assets, a phenomenon so little understood by the many, even now.

I still see the greater probability for the US as a devaluation and a stubborn stagflation for quite a few years. But the policy errors being committed by Bernanke and the Obama Administration are making the possibility of an actual collapse more likely than I would have thought even six months ago. I suppose it is never well to underestimate the self-destructive tendencies of obsessive greed.

See also The Last Bubble: The Problem of Unresolved Debt in the US Financial System and Currency Wars: Selling the Rope

How I Learned to Stop Worrying And Love the Currency Collapse

The title is a reference to the culturally significant film, Dr. Strangelove, a satire on the fear of nuclear war that was so integral to the post war generation in the US.

If one reads this carefully, the BIS is really referencing a devaluation of about 22% which is hardly 'a collapse.' Here are some examples of post WW II currency collapses.

It depends on the timeframe, specifically the rate and extent with which the devaluation occurs. Also, it matters about what the devaluation has been against. Is it a relationship primarily to a reference point like the US dollar, largely affecting a narrow band of imports, or is it a true and general devaluation marked by soaring prices and monetary inflation domestically.

As I recall, China devalued the yuan by about 33% in the 1990's, and then pegged to the dollar, while 'persuading' first Bill Clinton (remember the Chinese campaign contributions scandal) and then George W. (whose family has a long history of supporting tyrannies for personal economic preferences) to allow them to maintain favored nation status, with the dispensation of 44% import tariffs, even while maintaining an artificially devalued currency, under full currency controls, and that fixed in a peg to the dollar.

"I am moving, therefore, to de-link human rights from the annual extension of Most Favored Nation trading status for China." --President Bill Clinton, announcing MFN status for China, White House, 5-26-94.

1994, Jan. 1 – China unifies its dual exchange rates by bringing the official and swap centre rates into line, officially devaluing the yuan by 33 percent overnight to 8.7 to the dollar as part of reforms to embrace a “socialist market economy”.

As you may recall, in 1994 Bill Clinton also pushed through the NAFTA agreement which, in his words, would 'level the playing field' for American, Canadian, and Mexican workers. Only a few really understood the inherent danger in leveling the field without a thorough integration. The current Greek dilemma is a good example of a halfway done scheme in which monetary policy does not match up well with fiscal policy and national temperament.

When one uses globalization of trade to 'knock down barriers,' among the barriers that are placed at risk are things like the Constitutional safeguards which a free people enjoy in their own domestic method of organization, such as healthcare, the right to organize, freedom from indentured servitude, child labor, individual rights, and so forth.

These are the very barriers against the tyranny and despotism of the few on which the country was founded in a dramatically historical rebellion of the common people against the injustice of autocrats and empires. This was the rationale for the great Wars. Well, the one world government types play the long game, and if at first you do not succeed...

So yes, in this case China was able to export their structural employment problems largely to the US, which gutted its manufacturing sector primarily for the benefit of the Banks, who were able to cash in on the 'strong dollar' and the decline of government protection for its citizens from criminal control fraud.

Personally I think that high tariffs on Chinese goods would work much better for the US than a general currency devaluation per se given its position as a net importer, The downside would be that in the short term there would be less of a market for the export driven debts incurred by supporting the development of a non-democratic country engaged in blatant currency manipulation and mercantilism.

But do not fear, enough palms have been crossed so that one would never expect a simple solution to occur. Political and financial fraud dwells in the realms of artificial complexity. And the competitive but managed devaluations of currencies will serve to transfer more wealth from the many to the few quite well, a sort of hidden tax on the mob, while the wealthy continue to benefit.

But then again, the BIS may just be priming us for a crisis to come, which is consistent with the steady but quiet migration into gold by the wealthy, despite the propaganda they might put out for the masses to hear. As Pliny the Elder observed, "Ruinis inminentibus musculi praemigrant:" When collapse is imminent, the little rodents flee.

As an aside, here is a fairly good example of a man's thinking. Notice how Keynes changed his views of globalization from the euphoria of the British empire expressed the famous passage in "The Economic Consequences of the Peace" in 1920 which sounds like an Ode to the British Empire:

"What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages. The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice."

After a period of years we can see his shift in thinking, albeit reluctantly and with many caveats, towards practical National Self-sufficiency in 1933.

"I was brought up, like most Englishmen, to respect free trade not only as an economic doctrine which a rational and instructed person could not doubt, but almost as a part of the moral law. I regarded ordinary departures from it as being at the same time an imbecility and an outrage. I thought England's unshakable free trade convictions, maintained for nearly a hundred years, to be both the explanation before man and the justification before Heaven of her economic supremacy. As lately as 1923 I was writing that free trade was based on fundamental "truths" which, stated with their due qualifications, no one can dispute who is capable of understanding the meaning of the words...It is a long business to shuffle out of the mental habits of the prewar nineteenth-century world. It is astonishing what a bundle of obsolete habiliments one's mind drags round even after the centre of consciousness has been shifted. But to-day at last, one-third of the way through the twentieth century, we are most of us escaping from the nineteenth; and by the time we reach its mid point, it may be that our habits of mind and what we care about will be as different from nineteenth-century methods and values as each other century's has been from its predecessor's...For these strong reasons, therefore, I am inclined to the belief that, after the transition is accomplished, a greater measure of national self-sufficiency and economic isolation among countries than existed in 1914 may tend to serve the cause of peace, rather than otherwise. At any rate, the age of economic internationalism was not particularly successful in avoiding war; and if its friends retort, that the imperfection of its success never gave it a fair chance, it is reasonable to point out that a greater success is scarcely probable in the coming years...I sympathize, therefore, with those who would minimize, rather than with those who would maximize, economic entanglement among nations. Ideas, knowledge, science, hospitality, travel--these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national. Yet, at the same time, those who seek to disembarrass a country of its entanglements should be very slow and wary. It should not be a matter of tearing up roots but of slowly training a plant to grow in a different direction."

I wonder if he lived today Keyens would agree that globalization leads inevitably towards restraints among nations, and a bias towards one world government. I think he would, and he would not be favorable towards it. Make no mistake, some view this favorably as the final solution to managing the unruly masses, and preventing the wastefulness of war and sub-optimization of individual choice by those who they consider and portray as unfit to rule themselves. The shift in Keynes thought is unmistakable, and I admire the self-knowledge he portrays in analyzing, examining, and understanding his own prejudices. It takes a great mind to rise above oneself and their own age.

Quite frankly I do not expect the Fed and Treasury to ever let go willingly of the reins of the economy, or reigns of power if you will, through their aggressive financial engineering in partnership with the Banks. A return to normal will not be achieved without a significant amount of effort, conflict and most likely, pain. It appears to be unavoidable now. As you may recall, Dr. Strangelove was insane, and his dark vision affected the politicians around him. One has to wonder if Barack, Ben, Tim and Larry have their reservations made for a place in the mineshafts.

The customary price of freedom will be paid, as always. The light of freedom may be extinguished for a time, but like a spark that is cherished in thoughts and hearts of the true, will remain to be revived again on some future day.

Bloomberg
Currency Collapse May Stimulate Economic Expansion, BIS Says
By Matthew Brown

June 14 (Bloomberg) -- Currency collapses tend to spur a resumption of economic growth rather than fueling a decline in gross domestic product, according to the Bank for International Settlements.

Currency collapses are associated with permanent output losses of about 6 percent of GDP, on average, though the drop tends to appear beforehand, the Basel, Switzerland-based BIS said in its quarterly review yesterday.

“This suggests that it may not be the currency collapse that reduces output, but rather the factors that led to the depreciation,” Camilo E. Tovar wrote in the study. “To gain a full understanding of the implications of currency collapses on economic activity it is important to carefully examine the full circle of events surrounding the episode.” (How about the utter destruction of savings and the impoverishment of millions? That has a dampening effect as I recall from the stories that my grandparents told. - Jesse)

The positive effects of a weaker currency on GDP, including making local products cheaper than imported goods, may outweigh the negative ones, such as rising inflation. Currency collapses occur when the annual exchange rate drops by about 22 percent, according to the BIS, which identified 79 such episodes, “more commonly in Africa than in Asia or Latin America,” since 1960, Tovar said.

“They also occurred under all types of currency regimes, except possible floating-exchange-rate regimes, where there are simply too few observations to obtain meaningful estimates,” the BIS said.

Economic Contraction

The euro tumbled about 20 percent against the dollar between Nov. 25, 2009, and last week as investor concern over record budget deficits in countries including Greece spurred speculation the 16-nation currency union may split. The European Union in May crafted a 750 billion-euro ($908 billion) rescue package to stem the crisis.

Greece’s economy will contract 3.9 percent this year and 1.2 percent in 2011, after shrinking 2 percent in 2009, according to the median of eight economist estimates compiled by Bloomberg. The euro-region will expand by 1.1 percent this year and 1.5 percent in 2011, after falling 4.1 percent last year, median forecasts show.

Hans-Werner Sinn, president of Germany’s Ifo economic institute, said on June 3 that it would be best for Greece to leave the euro instead of implementing an austerity program to reduce its deficit. Greek Prime Minister George Papandreou pledged budget cuts worth almost 14 percent of GDP to bring the deficit within the EU limit of 3 percent by the end of 2014.

“The real solution for Greece would be to leave the euro followed by a depreciation” of the new currency, Sinn said in an interview at a conference in Interlaken, Switzerland.

Growth May ‘Dominate’

European Central Bank Executive Board member Lorenzo Bini Smaghi said on May 28 that there are “no alternatives” for Greece beyond following the austerity program.

“Before drawing policy conclusions we should emphasise that these results are subject to a number of caveats,” the BIS said in the report. “Most importantly, the analysis does not address the reasons why currency collapses occur in the first place. Our analysis also has little to say about the mechanisms involved after the currency collapse takes place. While we cannot disentangle the various factors, our results do suggest that expansionary mechanisms tend to dominate.”