Is Money Supply a Relative Absolute?

There has been discussion over the weekend regarding an intriguing blog entry from friend Cassandra Inflation v. Deflation with regard to the Fed's monetization of debt. The principle assertion seems to be that if the Fed is merely replacing existing credit dollar for dollar as it is written off, then the result is not inflationary.

If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

Implicit in this of course are two conditions. The first, that the level of wholesale borrowing and lending had not been and would have continued not to be inflationary, and secondly, that the expansion of the Fed's balance sheet is equivalent dollar for dollar with the debt it is said to be replacing.

These distinctions will be lost on most, but they are quite important, and we urge to reader not to gloss over them in preparing a rebuttal to support their bias du jour.

Let's consider an hypothesis someone put to us some time ago. They claimed that the appropriate rate of growth for any money supply is zero, which they considered 'neutral.'

To this we put the question, "If one holds the money supply static for a long period of time in a country whose population is growing at 10% per annum, and GDP is growing at 10% as well, is this a neutral money supply growth rate?

The answer of course is no. Money supply that remains static in a growth situation, whether one measures it in a ratio to economic growth or per capita, is obviously on a deflationary trend because supply is not growing at a rate equivalent to the increase in demand.

Seems obvious in this perspective right? We are not saying it is good or bad, appropriate or not. It is what it is, a growth in money supply that is lagging the growth in demand for money.

Conversely, if money supply is kept static in a country where the population is decreasing, and economic growth contracting, is it neutral? No it is inflationary, since the growth rate of money supply (zero) is greater than the growth rate of the demand for money, which is in decline presumably.

Now, one can imagine all sorts of possible scenarios as exceptions because there are lags in all economic cause and effect. To complicate matters there is no instantaneously correct rate of money supply growth without a context since reality is inherently in a state of flux.

However, though, it is clear that a static money supply is not necessarily neutral compared to the state of the growth of the money supply in a different economic context.

Secondly, we will postulate something we are not quite ready to prove yet, and that is that credit is not the same as money supply. We offer a piece instead that was blogged some time ago in which the various components of money supply are discussed.

Money Supply: a Primer

Its something to consider, and has received too little attention in our opinion.

If you have one thousand dollars in cash, in your pocket, is it completely equivalent to one thousand dollars worth of honey which you have at home in your pantry, in terms of its affect on inflation or deflation?

Forgiving the pun, the honey is decidedly less liquid than the cash.

What if you have one thousand dollars in cash, and another thousand is owed to you by an acquaintance in a distant city who promised to pay it back on demand the last time you spoke to them a year ago. Are those equivalent dollars?

Does it matter who is holding the money? What if the bulk of the money being added to to the economy is being given to gamblers in Las Vegas, rather than lets say farmers in Pennsylvania. Is there a difference in that money's effect on inflation or deflation? Yes there are few differences in the very long run, but sometimes the run becomes so long that it is irrelevant to the policy questions at hand.

This essay does not seek to provide answer to these questions at this time, since this is basis for a new perspective in economics. And unfortunately the discussion is premature. It is rather like a room full of well seasoned drunks, after a week long binge, gathering to attend a lecture on sober thought. We have so utterly lost the conception and relationship of value and risk that we must sober up a bit before we can even think about it once again.

Rather, the purpose of this essay is to cast doubt on the certainty that what we call money is always and everywhere equivalent in force and power and influence as an economic actor no matter where and how it is held.

Having said all that, it is obvious that the Money Supply as measured by the means at our disposal is growing at a rate more significant than economic growth, and that difference is now even greater as the economy slows and contracts. As an engineer and an operational business unit manager we always tend to fall back on what can be measured, what is real and knowable, when theory fails and the bosses are lost in flights of fancy.

The Fed is Monetizing Debt and Inflating the Money Supply

As water is added to the ecosphere, it flows and pools in many places. Money as water in the econosphere is evaporating through debt retirement, but perhaps not through debt destruction, or at least not in the same way. Someone must lose if a debt is written off right? What if that loss is booked at the Fed, and they realize that loss by simply 'making it go away' at least as far as the real economy is concerned? Is there a contraction in the money supply anywhere?

There are all questions worth considering, and we will have much more data as the results of Mr. Bernanke's experiments produce additional data.

But one thing is certain in our minds, and that is certainty in this situation is an illusion. We do not think that even the Fed knows exactly what they are doing. Rather, they are feeling their way through uncharted waters, projecting perhaps a confidence, but this is primarily for effect, not as a genuine state of mind.

And based on first principles, deflation, while possible, is never a certainty in a fiat regime where there is a central monetary authority that holds the power to monetize debt. The only boundary on their power is the acceptability, or value, of the money they produce, and that is also known as inflation.

Obviously the Fed may do a poor job or an outstanding job of managing the nation's money supply and economy. We will not really know until after the fact given the lags in these sorts of machinations.

But what is different, what is dangerous, is that the Fed has grasped the reins of a highly complex system, that is now more global than at any time before, and is trying to pull it in a certain direction, without immediate feedback on what it is that is happening. The last five or six times in which the Fed has done this something 'unexpected' has occurred.

Another factor most do not consider which is of some importance is the potential for systemic reform in the economy that is the context for the actions of the money supply. Without serious financial reform we most likely will take spin on the wheel of boom and bust again, with a greater disparity of wealth and a greater loss of democratic freedoms.

Either state is possible, make no mistake, but the probability is highest that the loss of control will be an inflation, with the key metric being 'how bad' and 'how difficult to subdue once it is unleashed.' Why? Because inflation is the default condition of a fiat currency that becomes uncontrolled. Deflation requires a sustained effort for whatever reasons, generally policy error or a conflict in desired outcomes.

A softer, much more judgemental reason, is that those who are now telling us that inflation is not an issue are the very ones who have been acutely wrong, for whatever reason, since this crisis began, if not years before that. They speak their book, and shamelessly. But that is no determinant, merely a confirmation of sorts.

What concerns us most is that the Fed is quite confident, in their own words, that they know how to deal with inflation after Volcker. That reminds us too much of hubris, and the classical myth of Phaëton who confidently took the reins of the chariot of the Sun from the golden Apollo, and very nearly burned down the world in the process.

Bernanke's Gamble on the Dollar

There are several things of interest this week. The first and foremost is the Fed's FOMC two day meeting with their announcement on Wednesday at 2:15.

It is important despite the fact that rates are effectively at zero, and the Fed has declared for 'quantitative easing.'

How does the Fed intend to implement this quantitative easing? Another way to ask this is to say, "What is the next bubble?"

Quantitative easing implies market distortion, and traders will be keen to understand where and how that distortion will play, because they are still geared for supercharged returns in an environment where fewer and fewer opportunities exist.

The Treasuries seem like a safer place, because lower interest rates are to the economy's benefit. Foreign entities may not like the monetization aspect, but we wonder how many real 'investors' are left in the bonds? Most in there are domestic parties seeking safe havens with any sort of return, and foreign central banks supporting political and industrial agendas.

So the focus will be on the wording of the Fed's statement once again, looking for clues with regard to the Fed's easing implementation and potential distortions that provide market inefficiencies.


Bloomberg
Bernanke Risks "Very Unstable" Markets as He Weighs Buying Bonds
By Rich Miller
January 25, 2009 19:01 EST

Jan. 26 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and his colleagues may try once again to cure the aftermath of a bubble in one kind of asset by overheating the market for another.

Fed policy makers meeting tomorrow and the day after are exploring the purchase of longer-dated Treasury securities in an effort to push up their price and bring down their yield. Behind the potential move: a desire to reduce long-term borrowing costs at a time when the Fed can’t lower short-term interest rates any further because they are effectively at zero.

The risk is that central bankers will end up distorting the Treasury market, triggering wild swings in prices -- and long-term interest rates -- as investors react to what they say and do. “It sets forth a speculative dynamic that is very unstable,” says William Poole, former president of the Federal Reserve Bank of St. Louis and now a senior fellow at the Cato Institute in Washington....

Inflated Prices

Recent history shows the economic danger of inflating asset prices. After a stock-market bubble burst in 2000, the Fed slashed interest rates to as low as 1 percent and in the process helped inflate the housing market. The collapse of that bubble is what eventually helped drive the U.S. into the current recession, the worst in a generation.

Faced with the danger of a deflationary decline in output, prices and wages, the Fed is considering steps to revive the moribund economy. On the table besides bond purchases: firming up a pledge to keep short-term interest rates low for an extended period and adopting some type of inflation target to underscore the Fed’s determination to avoid deflation.

The central bank has been buying long-term Treasury debt off and on for years as part of its day-to-day management of reserves in the banking system. Yet it has always gone out of its way to avoid influencing prices. What it’s discussing now, says former Fed Governor Laurence Meyer, is deliberately trying to push long rates below where they otherwise might be.

Fed Purchases

Bernanke raised this possibility in a speech on Dec. 1. While he didn’t specify what maturities the Fed might buy, in the past he has suggested that purchases might include securities with three- to six-year terms. (This is around the sweet spot for foreign Central Banks - Jesse)

Investors immediately took notice, with the yield on the 10-year note falling to 2.73 percent from 2.92 percent the day before. Yields fell further on Dec. 16, dropping to 2.26 percent from 2.51 percent the previous day, after the central bank’s policy-making Federal Open Market Committee said it was studying the issue....

Yields have since risen, with the 10-year note ending last week at 2.62 percent. Behind the reversal: expectations of massive fresh supplies of Treasuries as the government is forced to finance an $825 billion economic-stimulus package and a possible new bank-bailout plan. This week alone, the Treasury is scheduled to auction $135 billion worth of securities.

Jump in Yields

David Rosenberg, chief North American economist for Merrill Lynch in New York, says the jump in yields may prompt the Fed to go ahead with Treasury purchases.

This isn’t the first time Bernanke and the Fed have discussed buying longer-dated securities and ended up roiling the market. Bernanke touted the idea as a tool to fight deflation in speeches in November 2002 and May 2003.

Egged on by his comments -- and later remarks by then-Fed Chairman Alan Greenspan that the central bank needed to build a “firewall” against deflation -- many investors became convinced the central bank was poised to buy bonds. The yield on the 10-year Treasury note fell to 3.11 percent in June 2003 from 3.81 percent at the start of the year.

Traders quickly reversed course as it became clear the Fed had no such intentions, sending the 10-year Treasury yield soaring to 4.6 percent just three months later, on Sept. 2.

‘Miscommunication’

Poole, who was then at the St. Louis Fed, was critical at the time of what he called the central bank’s “miscommunication.” He now sees the Fed making the same mistake with its latest suggestions that it might buy longer- dated securities.

“If they do it, it’s going to be disruptive to the market,” says Poole, who is a contributor to Bloomberg News. “If they don’t do it, it will impair the Fed’s credibility and erode the confidence the market has in the statements that the Fed makes.”

Meyer, now vice chairman of St. Louis-based Macroeconomic Advisers, says the Fed should, and probably will, go ahead with purchases as a way to lower borrowing costs. “The story is stop talking and start buying,” he says.

Still, he notes that not everyone at the Fed is enthusiastic about the idea. One concern: Foreign central banks and sovereign-wealth funds, which are big holders of Treasuries, might cool to buying many more if they believe prices are artificially high. (The buyers of our debt now are supporting their own industrial policy we would hope. Any other reason borders on mismanagement of funds while anyone in their country is hungry or unemployed - Jesse)

Undermine the Dollar

That may undermine the dollar. “There’s no guarantee that international investors would switch to other dollar- denominated debt if flushed from the Treasury market,” says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co. in New York, says foreign investors might also get spooked if they conclude that the Fed is monetizing the government’s debt -- in effect, printing money -- by buying Treasuries. (They already are, and they already are - Jesse)

Bernanke himself, in his 2003 speech, said monetization of the debt risked faster inflation -- something bond investors, foreign or domestic, wouldn’t like.

Some economists argue the Fed would help the economy more if it bought other types of debt. (Such as corporate bond - Jesse) Even after their recent rise, 10-year Treasury yields are still well below the 4.02 percent level at the start of last year....

Hawks at the Fed wouldn’t welcome such purchases. They are already uneasy that some of the central bank’s programs are effectively allocating credit to one part of the economy rather than others. Case in point: the Fed’s ongoing program to buy $500 billion of mortgage-backed securities, which Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has called “credit policy” rather than monetary policy. (Its nice to see that someone else is noticing that the Fed has crossed the Rubicon from central bank to central economic planner in the worst sense of the description - Jesse)

US Treasury Department Official Allegedly Aided and Abetted Banking Fraud (Again)

Darrell Dochow earns $230,000 per year at Treasury in banking regulation. He reportedly gave Indymac some suggestions on cooking their books, and then allowed the exception to the rules to accomplish it. It appears to have been a blatant and obvious accounting fraud.

Mr. Dochow is also the official who presided over the Lincoln Savings and Loan scandal. Having looked into Charles Keating's eyes and seeing him a good man, he reportedly overrode the protests and findings of fraud from the banking experts. After his S&L debacle he was apparently demoted, but brought back into a position of importance under the Bush Administration. All the details on this have not yet been made public.

Mr. Dochow is unlikely to do any prison time, but may lose his job. That is because this is 'criminal with a small c' according to this news report.

When this sort of behaviour becomes criminal with a 'capital C' and when people like Dochow find themselves on the business end of FBI probes and Justice Department indictments at least as serious as the one mounted against Eliot Spitzer and his hooker, we might make some approach to honesty and reform in this country.

Ok, Obama Administration, the buck is on your desk now. Time to take meaningful action to back up the rhetoric.


ABC News, New York
Government regulators aided IndyMac coverup, maybe others
By Brian Ross, Justin Rood, and Joseph Rhee
Friday, January 16, 2009

A brewing fraud scandal at the Treasury Department may be worse than officials originally thought.

Investigators probing how Treasury regulators allowed a bank to falsify financial records hiding its ill health have found at least three other instances of similar apparent fraud, sources tell ABC News.

In at least one instance, investigators say, banking regulators actually approached the bank with the suggestion of falsifying deposit dates to satisfy banking rules -- even if it disguised the bank's health to the public.

Treasury Department Inspector General Eric Thorson announced in November his office would probe how a Savings and Loan overseer allowed the IndyMac bank to essentially cook its books, making it appear in government filings that the bank had more deposits than it really did. But Thorson's aides now say IndyMac wasn't the only institution to get such cozy assistance from the official who should have been the cop on the beat.

The federal government took over IndyMac in July, after the bank's stock price plummeted to just pennies a share when it was revealed the bank had financial troubles due to defaulted mortgages and subprime loans, costing taxpayers over $9 billion.

Darrel Dochow, the West Coast regional director at the Office of Thrift Supervision who allowed IndyMac to backdate its deposits, has been removed from his position but he remains on the government payroll while the Inspector General's Office investigates the allegations against him. Investigators say Dochow, who reportedly earns $230,000 a year, allowed IndyMac to register an $18 million capital injection it received in May in a report describing the bank's financial condition in the end of March.

"They [IndyMac] were able to maintain their well-capitalized threshold and continue to use broker deposits to make loans," said Marla Freedman, an assistant inspector general at Treasury. "Basically, while the institution was having financial difficulty, it kept the public from knowing earlier than it otherwise should have or would have."

In order to backdate the filings, IndyMac sought and received permission from Dochow, according to Freedman.

"That struck us as very unusual," said Freedman. "Typically transactions are to be recorded in the period in which they occur, not afterwards. So it was very unusual."

One former regulator says Dochow's actions illustrate the cozy relationship between banks and government regulators.

"He did nothing to protect taxpayers in losses," former federal bank regulator William Black told ABC News. "Instead of correcting it [Dochow] made it worse by increasing the accounting fraud."

Meanwhile, IndyMac customers who lost their savings are demanding answers and are further infuriated after learning Dochow was also the regulator in 1989 who oversaw the failed Lincoln Savings and Loan, a scandal that sent its CEO Charles Keating to prison.

"He's the person who claimed that he looked into Charles Keating's eyes and knew that Keating was a good guy and therefore ignored all of the professional staff that told him that Keating was a fraud, and he produced the worst failure of the Savings and Loan Crisis at $3.4 billion. Now he's managed more than triple that," said Black, now an economics professor at the University of Missouri in Kansas City, Missouri.

Following the Lincoln scandal, Dochow was demoted and placed into a relatively obscure office, but later, inexplicably was brought back into the Office of Thrift Supervision.

Dochow declined to answer questions from ABC News.

After Ronnie Lopez was killed in Iraq, his mother Elaine invested the life insurance proceeds at IndyMac. She lost $37,000 of it.

"I was hysterical," she told ABC News. "I literally thought I was going to kill myself that day, because I felt so bad that I had let him down. I remember going to his grave and telling him "don't worry, I'm going to get that money back,' and I feel like he was saying, 'Hey, Mom, don't let them take that. I did the ultimate for that.'"

A group of angry investors has started a website, demanding answers on the extent of Dochow's actions.

"It's just the strife and anger," said IndyMac customer Lisa Marshall. "That this Dochow person is still employed. It's unbelievable, it's shocking."

While Dochow could end up losing his job, neither he nor his colleagues are expected to go to prison.

"This is criminal with the small 'c,'" said Black. "No one within the regulatory ranks may go to jail, but they have done the worst possible disservice to the taxpayers of America."

The Other US Border Fence - To Keep Your Wealth In

This is a special guest blog from a US ex-pat acquaintance who currently resides in central Europe. It represents the author's personal research and experience.

The Other US Border Fence

What most Americans don't realize is that construction of a legal fence to prevent US taxpayers from escaping from the IRS's controlled pastures is progressing on schedule. Congress has been expanding and strengthening this fence for decades, and the Heart Heroes Earning and Assistance Relief Act was only the latest nail in the soon to be tightly sealed coffin.

The US is the only country besides Libya that taxes the world wide income of it's non-resident citizens, and the HEART act has made expatriation much more difficult, and much more expensive.

Since the passage of HEART in June 17, 2008, any person seeking a green card, long term visa, or US citizenship should carefully consider whether they want to open their entire world wide finances to the IRS's thereafter eternally prying eyes, because of the Hotel California Problem.

Meanwhile, the IRS has been busy revising the 2001 Qualified Intermediary (QI) Agreement. A QI is a foreign financial institution that has agreed with the IRS to undertake certain U.S. withholding and reporting responsibilities and has agreed to audits by an external auditor. This is the agreement with the IRS that all international banks that allow accounts from US citizens have to sign.

The QI noose (er, agreement) will be tightened on December 31, 2009 in the following ways:

1) It forces the QI to identify parties responsible for QI enforcement to the auditors, and would open these parties to prosecution (a la Raoul Weil from UBS).

2) Allow the auditor to probe non-US bank accounts to see if they have characteristics of a US citizen controlled account. This would surely violate Swiss bank secrecy laws.

3) Requires Audit oversight and review by a US auditor.

These three points dramatically increase the costs for smaller banks to have US account holders and maintain status as a QI. This new QI agreement is forcing numerous Swiss banks to refuse to open new bank accounts for US citizens, and it is also forcing these banks to chase away their current US constomers. As we know UBS has left 19,000 US customers in a pinch and is forcing them to find new banks. No bank in Switzerland will accept these accused "tax fugatives" any more. It has long been impossible for a US citizen to legally open an account with any of Europe's discount brokers like Swissquotes or Internaxx, and now US citizens are having to search for financial services in a rapidy drying up pool of international offerers.

On January 15, the Taskforce on Financial Integrity and Economic Development met in Washington. Under the guise of chasing tax evaders and cracking down on tax havens, we will soon see new measures that will further restrict your financial freedom. Americans just don't understand the benefits of financial privacy, and the IRS and Congress have been working for years to convince citizens that this right to privacy is trivial compared to the necessity of taxing all wealth of people holding US citizenship papers wherever it may be held.

Some think that "high net worth individuals" will be the low hanging fruit for the tax collectors in the looming budgetary crisis. These not-sufficiently-rich-to-bribe-a-congressman-or-hire-a-team-of-lawyers type people have been corralled by the IRS, and when the time comes they will be easy picking.