Ben Bernanke and the Implications of The Great Monetary Hail Mary

These are epic times in the developed world’s attempt to deal with the implications of government and consumer over-indebtedness. A general unshakable malaise has set in due to sluggish spending and a deleveraging banking sector, and as a result, employment growth is suffering. Governments in turn are faced with diminished tax yields and deficits remain bloated. As shown in Europe, ultimately they run out of willing buyers of government debt.

Inevitably central banks are called in to treat all these related symptoms of the underlying debt disease. That momentous time has arrived for Europe as the debt symptoms have progressed to adversity in the selling of government bonds. Meanwhile, the more stressful symptom for the U.S. at this time is unemployment.

In the past weeks, the central banks of the developed world have taken the next big step, a monetary Hail Mary, to combat these symptoms. A Hail Mary is an act of desperation associated with putting all the chips on the line when your team is behind and time is running out. The ECB offered to support the bonds of those Euro countries that have lost willing private buyers and Germany — the last holdout — has accepted the offer. This will be a four-decade bond support program given the demographic-related deficits that will occur. For the baby boomer generation, their related entitlement spending has only just begun.

The Fed then made an open-ended Hail Mary of mega asset purchases that will ostensibly continue until the labor market is healed through self-sustaining growth.

This could be a long period of time given Bernanke’s claim that 2 million jobs have been created as a result of $2 trillion of QEs to date. If this estimate is correct — and there is ample evidence that it is an overestimate of monetary effectiveness — it implies that each added job comes at a cost of very close to a million dollars of monetary expansion.  These are very expensive jobs.

The Fed’s estimate is imbedded in its macro model of the economy, which is based on the good old times when the Fed could be effective when not faced with the retardant effects of an over-indebted consumer wishing to deleverage and a banking system that does respond to more base money (See Eisenbeis Critique).

But for the sake of argument, let’s accept the Fed’s estimate of the employment response to base money increases to allow us to ballpark the needed size of the current QE. There are more than 12 million unemployed and 9 million labor force dropouts since the onset of the Great Recession, some of whom would return to the labor force if jobs were forthcoming. Furthermore, in the years ahead there will be new labor force entrants which number over a million per year.

To make this both easy and highly conservative, let’s assume that jobs will be created for only half of the jobless and half of the recent labor force dropouts, setting aside the future labor force entrants. That works out to about 10 million new jobs — a policy victory that the Fed would happily claim.

At the Fed’s implied rate of dollars per job created, this implies an asset purchase/monetary injection of perhaps $10 trillion on top of their original (pre-QE) balance sheet of $1 trillion and a current balance sheet of nearly $3 trillion.  This would take the Fed’s balance sheet to $13 trillion — which, interestingly, is the size of the moribund commercial banking system that contributes no balance sheet expansion in response to the Fed’s base liquidity. Basically a beefed-up Fed would fill the gap of the petrified banking system, at least in term of the quantity of assets held by financial institutions.  Too bad the Fed doesn’t have loan officers to make small business loans to make the effects really comparable.

This lack of commercial banking response to central bank liquidity growth is demonstrated (thanks to Gary Shilling) in the accompanying graph. M2 is approximately the sum of the balance sheets of the commercial banks and the central bank is shown relative to the central bank monetary base. It has shrunk by two-thirds as a result of the tripling of the central bank monetary base without much follow through by the commercial banking system.

Hence, to get the same monetary punch by itself, the central bank would need to expand to be an equally sized banking system as a replacement for the petrified banking system that hopes to survive by not lending.

But this is not the end of the epic monetary growth story. It didn’t take long for these QE announcements to have expectation changes that will lead to further second-round monetary expansion coming from abroad.

In response to the Fed’s actions, investors imbued with the Milton Friedman Reflex of money causing inflation are known to move wealth to countries with less exposure to what they believe is an inflationary future in the countries receiving the high doses of money.  These dollars run to some alternative port that would cause the recipient country’s currency to appreciate, as occurred with QE2.

In anticipation of this, central banks around the world are stepping in with plans to preempt a loss of export competitiveness that occurs when inflows of foreign capital cause currency to appreciate. As a defensive measure, the central bank sells its currency on foreign exchange markets to offset a currency appreciation. But the same money, when deposited in its still-intact banking system, is parleyed with banking system expansion. All in all, this makes inflation more likely with money flowing from central banks worldwide.

Japan will be the first big domino to fall in this monetary knock-down process, and Brazil, Turkey, and Korea are likely to follow. The Swiss are prone to offset currency appreciation, and so is China if capital washes up on its shores. So, the ripples of mega money expansion from the U.S. and Europe in turn creates mega monetary expansion in countries that were simply minding their own business and wishing to buy some protection their currency appreciation as a byproduct of the developed world’s debt problems.

This phenomenon, last seen in the depression years of the l930s, has a few names associated with it in the history books, but the clearest tag is competitive (currency) devaluations.

So now the monetary Hail Mary is “QE Squared” or “QE to the Third Power” (or more, depending on how many follow suit. So where does that take us?

This scaling up of monetary expansion with so little in the way of positive economic impacts calls into serious question the efficacy of Keynesian economics as it is currently understood, but this will not stop academia from teaching it. Keynesianism will likely remain the gospel for some time, but hopefully it will at least be amended to include the important idea that aggregate demand generation only works if there is not a debt load to scuttle spending and a well-capitalized flexible banking system to ramp up the monetary base. These pre-conditions cannot be taken on faith.

Furthermore, this blatant policy failure scuttles the 60-year era of faith in the efficacy of not just monetary policy but also fiscal policy to smooth out the business cycle. Emphasis is shifting to supply-side issues as opposed to more demand-side fixes that, in the words of David Rosenberg, have gone to infinity without positive effects.

While the Fed intended for QE3 to aid the unemployed, little or no mention was made that it has been financing approximately 60 percent of net new government debt issuance in recent years. So, there are both stated and unstated purposes of this monetary Hail Mary. On the sly, the Fed is doing the same thing the ECB is doing, which is treating both the employment symptom as well as the government finance symptom of the debt overload disease.

While the need to treat the government finance symptom in the U.S. will be more evident in coming years, as it is in Europe today, the more immediate goal is to maintain as near to zero nominal interest rates all along the yield curve with a constrained but positive inflation rate. The net result of that magic is that the real cost of borrowing is negative — hence benefitting debtors both private and public. But this is confined only to those able to refinance into today’s negative real interest rates.

This leaves out perhaps the most important stressed consumers: those with upside-down mortgage debt relative to home values.

While this monetary Hail Mary is good news for some debtors, the flip side to investors is known as financial repression. This does significant damage not just to the “moneyed” class (in today’s class warfare terms) but to everyone with hopes for either a private defined-benefit or defined-contribution retirement plan with income generation based on microscopic yields in the fixed income market. This also includes state and muni pensions (which are seriously underfunded to boot,) as well as the Social Security Fund that to the extent it is funded is 100 percent invested in U.S. Treasuries.

So saving the unemployed and creating the ability to honor entitlements today comes at a high cost to future cash flows for retirees and institutions hoping to survive on a steady income flow. The classic Keynesian marginal investment function is not responding to the lowest interest rates ever available. Few benefits and lots of costs have been the result of this over the top monetary Hail Mary.

But given that the inhibition to run the printing press is now passé, the race to the bottom (the cheapest currency) is a race to produce more money that enters the economic system not as money in our pocket but as money chasing assets that have a chance to appreciate. That has included stocks to some extent, though that movement seems overstretched relative to floundering profit growth tied to a floundering economy.

Taking all this policy action and associated responses, the markets will put premiums on real assets, especially those producing income that have some inflation sensitivity. There are not many assets in this category. As an example, the yield on Treasury TIPs has appreciated to the point where the yields are now negative based on the fixed return component, requiring a 2.7 percent future inflation to have an equivalent positive yield compared to the fixed income equivalent.

The most desirable asset class is the long duration and real income producing variety, especially if financed with fixed rates — which augurs well for income producing real estate or infrastructure. This includes the new respect given dividend paying stocks. Gold and precious metals are also up there despite not producing income.  These are the premium assets in today’s markets, especially if found in the few countries that might not move to offset currency appreciation until seriously burned in the export markets. That might be Canada, for example, given its bent for market-determined exchange rates and financial prices.

There are endless issues raised by these historic and monumental QEs. For now I will note a few of them: The Fed will most certainly lose some of its cherished independence as a result of this overreach, especially in that it has created income redistribution. That is, it has stepped on a Congressional prerogative. The only question is how much Congress will dictate future monetary policy. It depends on how inflationary it actually becomes. As a reminder, in the inflationary 1970s, Congress stepped in to restrain the Fed with the Humphrey-Hawkins Act, even under a Democratic majority and president. For better or worse, Ron Paul’s status as cult hero is growing.

Secondly and perhaps most sadly, given the Fed’s inability to stimulate the economy under the circumstances of a consumer and government debt burden and a petrified banking system that fears future losses and an over-dictatorial FDIC driven by self-defense rules. This means the Fed’s Hail Mary is destined to fail under today’s circumstances. The market will consider the Fed de-fanged even if it is not de-fanged by Congress. It will be considered the toothless tiger of Constitution Avenue.

With such a fall from grace, the intangible but important confidence factor in the Fed as a reliable rudder to the system will be lost for a long time to come. The Fed will cease to be held with reverence but rather will be considered irrelevant.

All this invites major Congressional recapture of the monetary compass, which is its Constitutional prerogative and would be the largest setback of all.  For if that were to happen, Congress, not an independent Fed, would at the time of  U. S. government bond market stress be in the driver’s seat to do just as the ECB is doing in Europe. The Fed’s has sadly extended its reach beyond its grasp with ill consequences ahead.

Some will say that academic lessons are sometimes learned well, but not wisely. This could well be the final ultimate test of Keynesianism or more broadly demand generating economic policy. Not only can they not be afforded, but they are also not effective in today’s circumstances, but they will still try.


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Milton Friedman and the Monetarist Reflex: Can the Fed create inflation?

These are complicated times, especially when it comes to inflation.

An excess of debt, both private and public, has retarded the spending stream, resulting in sluggish economic growth. Given the Fed’s legislated commitment to prevent financial implosion and unemployment, rounds of central bank monetary responses have followed. The intuition of more money in our pockets chasing a limited supply of goods, as well as our long intellectual history of monetarism, sets off the reflex that printing results in inflation. That hasn’t appreciably happened yet, but multiple rounds of QE keep markets on edge given the teaching of Milton Friedman,

To add to the inflation paradox, last January, for the first time, the Fed committed to producing moderate inflation (2 percent) “over the long run“. However, as recently reported by David Rosenberg, inflation at the producer level was flat over the last quarter, and given the Euro recession and continued U.S. sluggishness, it appears likely that the inflation goal might not be reached. Indeed, many credible sources are forecasting long-run deflation, a la the trend in Japan.

On top of that there is the conjecture, mentioned in a recent post that in the (likely) event of an uncontrolled government deficit, the role of the central bank would be to generate actual inflation that exceeds the expected inflation premium that had been priced into interest rates. The purpose would be to reduce the real cost of government debt. This seems to suggest that the long-term Fed inflation target is to keep expectations anchored at a number the Fed hopes to exceed.

But in the longer run, while accumulating four decades of baby boomer entitlement debt, it would take one surprise after another to exceed expected and priced inflation. And each would have to be larger than the last to continuously have actual inflation exceed that which is priced by the market. This is the implied path to what is journalistically called “runaway inflation.”

The Fed inflation targeting in the long run is one thing, but the real question is whether the Fed can deliver when it so far has not.

The paradox of strong growth in the monetary base without the inflation implied by monetarism first surfaced when the first Federal Reserve balance sheet leap occurred in 2008. At the time, many people believed that a doubling of central bank money chasing a short term fixed supply of goods would bring about a doubling of the price level.

Obviously, that didnt happen. The question is why not.

First off, at that time, the commercial banking system did not have the requisite regulatory solvency (an excess of asset values relative to deposits) to expand balance sheets if they had the risk tolerance. That is, today’s excess cash reserves of $1.5 trillion held by banks and a commercial bank money supply multiplier of say 10 would normally result in $15 trillion of lending and spending. A surge in bank-financed spending could roughly double the present $15 trillion annual flow rate of GDP and, with it, inflation.

The predicted proportionality of prices to money didn’t occur, as spending not only failed to increase appreciably with more central bank base money, but fell short of the economy’s supply potential so that deflationary forces from excess capacity still exist today. (This same phenomena to monetarists would be the explanation for the decline in the velocity of money.)

So the issue of inflation depends to a large extent on the ability and willingness of commercial banks to run with the base money given to them. The most recent reading of that is not encouraging to either the growth of spending or inflation, as the graph above shows.

Despite having been given a stealth capital buildup via an essential zero cost of funding program (in addition to the TARP subsidy), the commercial bank books claim solvency, but lending contracted in the first quarter. The Keynesian notion of the liquidity trap is still alive and festering with banks pointing to a lack of borrowers and borrowers pointing to a lack of willing lenders. The problem, more than loan risk analytics, is likely behavioral. As aptly discussed by Kevin Flynn:

“For the last 50 years banks have been behaving the same way — turning a profitable sector into a credit fad and then drowning it in the name of market share, management bonuses, takeover avoidance, or whatever. Once they blow a sector up, nobody wants to hear about lending to it again for another generation of CEO management, which runs for about five to 10 years (the last thing that managers brought in to replace disgraced managers want to do is more of what got their predecessors sacked). Banks finally got around to blowing up housing, so now we have a generation of bank executives in place whose unifying feature is the determination to avoid a housing bust that won’t happen again for another 70 years or so. The Fed can’t do anything about it.”

Given these impediments to produce monetary expansion and lending through banks, there are other routes by which the Fed might reach its inflation objective. Without bank follow-through, the impact of monetary expansion is limited to the Fed’s first round of financial purchasing power. This limitation of its firepower is what turned the Fed to large scale QEs, since there would be no commercial bank follow–through: They had to do the job themselves. But since the Fed is not a commercial lender, it mainly relies on what is known as a Pigou effect — a generalized market value of wealth spreading from bonds to equities and other assets that in turn induces limited spending but not at a rate sufficient to create inflation.

Another approach to inflation (which the Fed scoffs at) is un-lovingly called helicopter money. This was the first thing done when the financial meltdown occurred, in the form of the Fed putting money more directly into the hands of spenders (as opposed to financial asset markets). That is, rather than just continuing more of the same Fed expansion, helicopter money delivers fresh spending power directly to the end user (the consumer) over the heads of the moribund banks.

Believe it or not, this was implemented in the dark days of 2008, when the Fed purchased Treasury bonds that enabled the Treasury department to mail out an equal amount of government green checks directly to spenders. It flew under the radar screen as the checks were called tax rebates, and few knew the source of the funding. However, a wider distribution of government green checks coming from the Fed or the Treasury would require a more obvious money gift that would create contentious comparisons of need. To further rule out more green checks to consumers (especially voters), the Republican Party platform is now at odds with at grossly expansionary Fed tendencies, and the Fed is not likely to expose itself to legislative constrains to its independence.

If the government wishes to depreciate its debt and consumer debt with inflation, a more likely inflation alternative would be for the Treasury Department to turn to treasury currency, the United States Note. As previously explained, the government used this tactic to pay its bills during the Civil War.

In this case, the financing of government spending is facilitated by Treasury currency printing rather than Federal Reserve printing. Treasury currency would have a greater inflationary impact as it directly finances spending in goods markets. In this case, inflation would be a fiscal byproduct rather than a central bank contrivance.

Treasury currency would be more effective as it goes over the heads of the blocked banking system and reluctant spending units, and on behalf of the taxpayers, goes directly into the spending stream when the government pays for entitlements such as Medicare. As such it is a kind of super-helicopter money delivered to the goods markets rather than the financial markets or even to the consumer to be used for debt reduction as the new currency is injected into the spending and income stream.

When political leaders are pressed to “do something, it seems that this would be the “something” that could simultaneously finance entitlement spending, reduce the size of the fiscal cliff, and reach a desired inflation target. This is a something for nothing policy solution that politicians who take the path of least resistance would find difficult to ignore–and its in the law.

What an irony.  Despite the accusations being made, the Fed in these circumstances is only able to produce inflation expectations whereas Fed generated inflation is dependent upon a generational replacement of commercial bankers.

It seems the notion of an inflationary future one way or another is still alive and ticking. Recently, inflation adjusting assets including energy pipelines, gold, income producing real estate and infrastructure are now moving up in the markets and fixed income assets are moving downward. Though the Fed has struck out on the inflation front, the bet has switched at least at the margin to the government doing “something” in the long run to ultimately reach an inflation target. Keep tuned to see how these improbable policies and events work out.

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The Bond Market Rocket and Fiscal Unsustainability Are On a Collision Path

Recently, the bond market has been in rocket mode. It has achieved liftoff and slipped the surly bonds of earth. And some believe it will keep going.  The price of the U.S. Treasury 10-year bond recently reached an all-time high, generating yields at all-time lows. Moreover, the market yield on the British perpetual bond is reportedly at a 300-year low.  Bond mania has even spread to the sovereign debt of Denmark and Singapore and others where negative yields exist.  More astonishing is the ability of France to issue short-term sovereigns with negative yields!

The U.S. has eclipsed the record interest rates that prevailed when the 1930s Depression era came to an end with the onset of World War II, as shown in the chart to the right.

To get to the previous low yields of early December 1941, the U.S. economy had experienced a decade of depression with cumulative deflation of 30 percent.  With that decade-long trend influencing expectations, the future seemed to call for more of the same.  In that environment, investors favor long-term fixed income that appreciates in real terms as a result of deflation if the long bond is successfully paid and retired despite depression circumstances.  Hence the asset category of choice in a deflationary depression is survivable high quality debt.  In the ’30s, this also included surviving corporate debt that appreciated along with Treasuries, and the AAA-Treasury spread narrowed over the depression years.

Since we presently are in an era of Federal Reserve QEs, you might suspect that the Fed was possibly behind the rising Treasury prices and lowest yields of that era.  However logical it might seem in today’s context, the Fed was nowhere to be found on the buy side of the Treasury market during the depression (something Bernanke seeks to not repeat). Indeed, the money supply declined by 30 percent over the course of the depression, so the bond market did it all on its own, without Fed support. Indeed, being in a pre-Keynesian world, the rationale or desire for manipulating the interest rate or credit conditions was not part of the Fed’s understanding of how to run a central bank.

Then as now, the private market participants price the expected risks and costs of holding a debt instrument over its life, and they require additional yield for each risk and cost they anticipate will materialize.  They generally make this assessment of risk by extrapolating previous trends or by finding a similar historical episode to benchmark the likely gains or losses in value that might take place. Today we find many forecasts (even on this blog) citing the withering force of deleveraging due to over–indebtedness, which takes down an economy and softens demand and prices for goods.  Hence, today’s natural historical model for bond pricing would seem to be the 1930s.

However, while there are similarities, there are also big differences. Today it is the government that is over–leveraged, whereas in the l930s it was the corporate debt sector which makes today’s long Treasury yields suspect.   Though the economy is weak today, we are not in a decade-long depression, and while inflation is low, it is not in a cumulative deflation.  And while the Fed held back this week, they still have a commitment to positive inflation.

The greatest difference is today’s checkmated body politic, which is unable to resolve an ultimately un-financeable Federal deficit. This week we had another episode of kicking the can down the road, with the agreement to run the debt meter another six months before facing the music. This is all in sharp contrast to a much lower government debt load and an obsession to run a balanced fiscal budget despite the depression that prevailed in the 30s.

While the growth/inflation profile is different in the two eras, it is more important to note the difference in long-term fiscal sustainability.  Somewhere during the unfolding drama there will be an unspoken need (not mentioned in legislation or treaties) for the Fed to pull a “Super Mario” Draghi — who, last week, signed up to “do whatever it takes,” which apparently meant ignoring the ECB mandate and directly supporting Spain’s bank and government debt because the market no longer will.

Indeed, in the U. S. at the outset of WWII, the Fed presented the patriotic idea of wartime bond support to the Treasury, not the other way around. Central banks are not shy in the ultimate moment of money needs.

In what should be considered a “white paper,” the Fed’s role in these dire circumstances is recently discussed by Renee Haltom and John A. Weinberg in the Richmond Fed Annual Report, 2011, titled Unsustainable Fiscal Policy: Implications for Monetary Policy. In a rare Fed admission they indicate that “a central bank can reduce the government’s debt burden by creating inflation that was not anticipated by financial markets.  Inflation allows all borrowers, the government included, to repay loans issued in nominal terms with cheaper dollars than the ones they borrowed.”

Indeed, if the Fed were to create inflation, it would not be totally unanticipated.  This is the outcome seen by many observers, including Bill Gross of PIMCO.

And Bill Gross is not alone, as the bond-buying public seems to believe little of the fiscal sustainability story.  Indeed, the flow of funds data, at least for 2011, indicates that the private sector purchased a minority of net new government debt issuance.  Hence, private investors are not the leading purchasers of U.S. Treasuries, causing the all-time depressed bond yields. The graph indicates that the Federal Reserve is buying the lion’s share of net new Federal debt, and foreign investors are in second place. That market thrust no doubt represents a flight from European sovereign exposure, which is in a more advanced state of fiscal decay at the moment.

No doubt some have bought the1930s deflationary depression story as a model outcome to justify buying and holding sovereigns, but this time around it doesn’t lead to the necessary conclusion that sovereigns will appreciate from here.  At today’s entry point of taxable low nominal yields and negative real yields, betting on both a deflationary depression with fiscal sustainability is not only a long shot but is mutually inconsistent.

A deflationary depression doesn’t generate government tax revenues to reach fiscal sustainability unless the voting public is willing to accept a substantial entitlement haircut. Moreover, if the low bond yields were to be maintained it would systemically cause defined-benefit pension plans to underperform.  They would become forced sellers of sovereign bond holding to meet payouts — as is now finally occurring with Japan’s Government Pension Investment Fund.

The bond market rocket can glide for a time, perhaps years, until it collides with fiscal unsustainability. At that time it will be revealed plain enough for all to see when the private demand evaporates, much as it did with Spain this week. At that time, the U.S. Treasury is no longer a riskless debt instrument, nor is it immune from inflation.

(That being said, it leaves open the question of whether intentional inflation is bravado in the absence of bank lending, which will be addressed in a subsequent blog.)

When the market comes to understand that sovereign bond strength from a central bank is a mixed blessing — as it both purchases government bonds but also intentionally seeks to create “unanticipated” inflation —the bond market rocket is susceptible to the gravitational pull of Earth.

When that happens, there will be a large debris field for those who entered this untenable crowded trade (or stuck with it) so late in the game, supported not by the bond-buying public but only by a central bank wishing to do its patriotic duty — which includes inflation generation.

This indeed is not the 1930s.


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Denial, Default or Treasury Currency: the Hobson’s Choice

Spain’s financial vulnerability has been in the spotlight recently. The trickle-down from a single bank’s insolvency gives us a glimpse of how country funding shortfalls are likely to be handled in the coming decades.

The Spanish bank in question, Bankia, was short $23 billion of regulatory capital — small change compared to Spain’s existing debt and additional debt to make good on future baby boomer entitlements over the next four decades.

To plug the hole in Bankia’s capital shortfall, the Spanish government offered a promissory note to Bankia, which to the bank is an asset. To pay for this asset, Bankia offered equity shares of Bankia in favor of the Spanish government. With ownership of the bank shifting to the government, bank “nationalization” was alleged to have occurred.

The financial trickery became more interesting when Bankia attempted to turn the Spanish government IOU into ECB currency by borrowing from the central bank and using the Spanish government note as collateral. Perhaps this plan could have worked with a cooperative ECB, which might have gone along with the scheme, as it is constantly lowering collateral standards in order to spread financial resources over Europe’s government and bank needs.

However, the ECB demurred in outrage with Spain’s scheme to access an ECB currency loan on grounds that the collateral was not suitable. The issue was not so much the collateral but the fact that the transaction would have set a precedent for how the individual governments of the Eurozone could get control of the Euro printing press for their own bailout needs.

It was a nice try, if you ask me, to put Spain in control of Euro monetary policy to fund its own bailouts — a practice called “monetary finance,” which the ECB insists was not part of its obligations to member nations.

But the scheme did indeed recapitalize the bank in question, allowing Spain to honor its financial guarantee to an insolvent bank, though it just couldn’t take it the next step to turn country IOUs into Euro currency.

However, in the U.S., using fiscal schemes to turn country IOUs into currency to pay the government’s bills is a far more straightforward operation with no “independent” central bank to say no.  Indeed, during the Civil War, when the government was faced with wartime expenditures well beyond its limited taxing authority and a limited market for its debt, the National Banking Act of l862 empowered the U.S. Treasury (not a central bank) to issue “money” to pay the government’s bills with payment to the soldiers being the most pressing expense.

Since it was unclear whether the Treasury possessed the Constitutional authority to create money to pay its bills, there was a workaround less complicated than Spain’s attempt to turn country debt into money.

The U.S. Treasury issued zero-coupon, infinite-maturity debt stylized as United States Notes, which are bearer notes denominated in dollars and, most importantly, had the sacred government-bestowed status of “legal tender.” This meant that these paper IOUs satisfied all private and public contracts, thus turning debt into currency.

The designation of legal tender can be seen in the fine print in the below image of a U.S. Note. To verify the point, merely take a look at the Federal Reserve Notes in your wallet and read the identical fine print regarding legal tender status.

The modern version of this U. S. Treasury debt stylized as currency looks familiar. It still exists (and circulates) 150 years later, though most of the Notes are locked up in numismatic collections.  The Treasury currency is similar in appearance to Fed currency designated as Federal Reserve Notes except the Treasury currency is designated as United States Notes across the top of the bill. Both are printed by the Bureau of Engraving and Printing which resides in the Treasury Department.

Now sit back and think of the possibilities presented by the Treasury’s direct money option to pay the government’s bills. This would allow the U.S. to cover the next four decades of baby boomer entitlements (which are well beyond the ability to finance in conventional style) and would also make the existing government debt load significantly more manageable.

It would free the Federal Reserve from the pressure to monetize government debt in round after round of QEs over the next four decades. The Fed could confine itself to matters associated with growth and employment and would be free of the stigma that it created the inflation that would no doubt occur.

In fact, in monetary finance, purchases with Treasury money would be for Medicare, Medicaid or Social Security flowing directly into goods markets rather than financial markets as the Fed conducts its operations. That is, the inflation would be goods inflation, not financial price inflation as we presently have with Fed QEs, which provides little spillover into goods markets.

How difficult would this be to carry out? Well, it would take getting a one-sentence bill through Congress and a Presidential signature to amend the National Banking Act to raise the Civil War maximum issuance of U.S. Notes from $300 million to some number in the trillions. Indeed, it could be treated as correcting a spelling error from millions to trillions, skipping billions altogether. It might even fly under the radar screen and only be a subject of interest to monetary wonks who pay attention to these things (such as the author) and Representative Ron Paul. A final detail that needs to be addressed is moving forward the time limit for new issuance of the currency.

What a game changer that would be, and not just to the prospects of avoiding an actual U.S. debt default down the road — which would happen if the baby boomer bills were to be paid conventionally with interest bearing market debt.  It would also eliminate the entangled political web of attempting to decide which promised (and in some cases paid–for) entitlements to cut and which taxes to increase. It would be more consistent with a growing economy, though the cost would be the damage done by 40 persistent years of inflation. Entitlements would be paid but watered down in real terms without further debate and we could refocus of attention to growth instead of income redistribution.

This is certainly not a first best policy. But it is offered as a forecast of what will be the way out of denial and debt strangulation. It does beat frozen government, an appalling deflationary economic contraction, and an almost certain government default down the road unless the same debt is monetized by a compromised Fed.

The major question would be the inflation rate and the damages and redistributions from it. Certainly it would be beneficial to debtors at the expense of creditors which is consistent with a Fed policy of a positive inflation rate.

From the stroke of the pen signing into law the enabling legislation of raising the authorized issuance, fixed income securities would dive in value, gold would salute and real return instruments would soar. Parenthetically, it would cure the housing price decline and consumer wealth decline almost instantaneously and cause the economy, though inflationary, to function better than it presently does.

While Spain attempted monetary finance this past month, the U.S. could pull it off without a central bank veto. While this would undermine the currency value though not so much in relative terms as most countries will gravitate to the same solution, it is better than destroying all faith in the government and its institutions in these days of government denial and paralysis.

This is a pragmatic look at the detestable Hobson choice facing the electorate and its government. It could be shortly or years down the road. All it would take is a Solomon P. Chase to focus on the art of the possible, perhaps known henceforth as the sesquicentennial solution to deal with the unfunded baby boomer entitlements. It’s a solution that’s been around for a long time and likely to be the only remaining option short of default on the entitlements or default on the debt to fund the entitlements.

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Warren Buffet and the New Calculus of Gold

There has long been a disconnect between gold and institutional investors. The instincts of these managers of large sums are typically tied to the generation of cash flows to feed the monster — that is, the institution’s cash flow needs. Alternative emphasis is given to growth, especially if obligations are long duration and not fixed. This is usually true for pension funds, endowments, some insurance companies or individuals investing for retirement.

For these investors, the preferred investment habitat tends to be a blend of income-generating fixed income and equity type investments that are thought to contain the potential for growth. Because gold, as an investment class, provides neither steady income nor systematic growth, it succeeds in only providing emotional discomfort for these investors.

Warren Buffet’s recent article in Fortune is a reflection of this sentiment. First on the list of asset categories to consider are bonds or, more generally, fixed income. His analysis is instructive.

From his point of view, over the relevant time frame of the 47 years he has been at the helm of Berkshire Hathaway, continuous rolling short term Treasuries bills would have averaged 5.7% annually. But if an investor paid income taxes at a rate averaging 25%, the return is reduced by 1.4 points. Buffet then goes on to point out that the return is then further reduced in real terms by the invisible inflation “tax” which would have devoured the remaining 4.3%. Hence rolling short-term Treasuries would have yielded nothing in real terms.

If one held long maturity Treasuries over this period — which included 30 years of general Treasury bond price appreciation — the investment outcome is questionable if you take into account the declining purchasing power of goods in U.S. dollar terms.  It is even worse when compared to a market basket of goods from around the world.

In Buffett’s terms, fixed-dollar investments have fallen a staggering 86% in real dollar value since 1965 during his tenure at Berkshire Hathaway. He points out that today it takes no less than $7 to buy what $1 did when he arrived in Omaha.

He concludes with the recommendation that fixed dollar income investments should come with warning labels advising you that they’re bad for your financial health.

What if contractual steady income doesn’t perform well? Asset categories outside the normal preferred habitat need to be examined. That’s where gold comes in, especially considering that for the first time in our monetary history the central bank has adopted positive inflation as a policy goal. Nonetheless, the institutional sale is a hard one, not just because it’s not been a member of the preferred habitat, but according to Buffet it has other fatal defects.

After conceding in a backhanded way that gold has performed well, with reference to its near $10 trillion in market capitalization, he argues that it doesn’t qualify to be in his preferred investment habitat because it doesn’t produce a growing revenue stream — and if it doesn’t grow, it doesn’t compound.

Rather, he states that his preference would be to employ his capital with growth commodities such as farmland or businesses that will continue to grow its bread-and-butter capacity that can be sold in real terms. That is to say, he rejects gold because it doesn’t produce gold sprouts. Gold is just inert, lying in neatly stacked bars in a subterranean vault. It has but limited use in electronics, jewelry, dentistry and few other applications.

Buffett then goes on to compare the rising price of the sprout-less gold to a Ponzi scheme, which depends upon finding a bigger fool to pay yet a higher price for the same subterranean inert matter. This is apparently proving easier to do by the day as the developed world continues to run outsized fiscal deficits and then compels its central banks to purchase its paper.

Instead, Buffett prefers investments such as Coca-Cola or See’s Candy, which have the ability to sell more candy in the future at the prevailing price level as a means to produce real growth.

That’s where I depart from the Sage of Omaha. While not arguing with the ability of See’s Candy to deliver and the American sweet tooth to be unaffected by the growing concerns for obesity, I believe he fails to see the new product that gold represents and its growing sales potential.

This is “the new calculus of gold.”

In a wealth-accumulating economy there is always demand for an ultimate store of value for wealth preservation. In finance terms, there is always a demand for some asset for which an investor takes no default risk, nor inflation risk, and can be obtained and sold on liquid markets.

For decades, U.S. Treasury debt took over from gold as the market’s preferred store of value. Treasury bonds mythically had no default risk and little inflation risk when central banks were not under pressure to be concerned about unemployment, lending to insolvent banks, or propping up the value of government debt. Moreover, U.S. dollar-denominated Treasuries served not only as the store of value but also sprouted interest payments.

But all that has changed, perhaps not forever but likely for the next four decades, as developed world democratic governments will be under pressure from their constituents to make good on the social contracts of social security and comprehensive health care to the bulging baby boomer population. And, if need be, they will recapture the central banks (by legislative changes if necessary) if they fail to support U.S. Treasury prices.

Given the debt and monetary growth ramifications of these pressures, investors will seek an alternative embodiment of a store of value other than fixed dollar denominated assets, especially sovereigns. With all other developed countries in similar straits and emerging market countries exposed to inflation generation from developed country central banks, their currencies and sovereigns also fail to qualify. Hence, gold has reemerged to play the role of the store of value, despite its sprout-less property. Sprouts are the icing on the cake but not the cake itself — and many gold admirers remember Mark Twain’s old saw: ‘I am more concerned with the return of my money than the return on my money.’

The New Calculus of Gold has much more to its story than merely the market-designated good for inflation and default protection, with or without sprouts.

We are at a historic point in time when both consumer and government debt have grown dramatically relative to income, which is our underlying economic problem (See Roadblocks to Recovery: An Interview with Dr. Lacy Hunt). In the great debt run-up of the last few decades, lenders or bond investors underwrote debt or loans based on either the borrower’s cash flow to service the debt or based on the borrower’s collateral, or both.

But debt has a maturity, and when the maturity is reached, borrowers seek to go back to the well and roll the debt over. From the easy lending days of the turn of the 21st century, the value of what has traditionally been accepted by the lender as good collateral has declined in market value as well as market esteem. That includes residential houses and commercial real estate for mortgages, mortgages for mortgage-backed securities, and mortgage-backed securities for CDOs.  Even government securities and guarantees have been questioned especially from abroad when collateral value is set by the credit rating of the collateral. By that measure even U.S. Treasuries and government guarantees fail the test of good collateral given rating downgrades.

Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.

As described in the accompanying news story (J.P. Morgan to Accept Gold as Collateral), gold is now being accepted (or more likely demanded) as collateral for bank loans, which increases the demand for gold. Furthermore the scarcity of collateral has spread to Europe, where debt is now being priced according to the value of its collateral, and clearing houses are accepting gold as collateral and for exchange settlement. Furthermore in this environment of collateral scarcity, clearing houses that service the shadow banking repo loan closures are closing loans despite the arrival of the collateral (prosaically called settlement fails) but it doesn’t stop the loan from being closed without any collateral, either good or bad and is now causing a regulatory backlash to tighten up actual collateral.

In addition to the demand for gold as collateral to back private debt, there are growing instances of commercial banks and central banks stocking up on gold as assets to meet the perception of depositors that banks or currencies are financially healthy. In this regard there is a shifting of foreign exchange reserves of world central banks away from foreign currency (dollars) into gold as shown in the Figure.

Most importantly, China, in its not so secret desire for the Yuan to be a world reserve currency, is accumulating domestically produced gold as it bans exportation, and at the same time it is shifting its foreign exchange reserves from currency into gold. If the Yuan has a chance to have reserve currency status it likely would require gold backing. A gold-backed Yuan would make a big dent in the U.S. market for the dollar and Treasuries as the world’s store of value asset. A gold-backed Yuan would be the equivalent of gold certificates in a warehouse and denominated in a currency that would be on the upswing and very desirable as compared to developed country sovereigns or currency. It might even be more appealing than gold certificates stored in a Swiss warehouse, denominated in a currency that is not allowed by its central bank to appreciate.

We have entered an environment with elevated debt to collateral and elevated currency to goods, and gold is again demanded by market forces to enhance the value of debt paper and otherwise fiat currency.

What we are witnessing is a sea change in which market forces are driving a de facto return to the gold standard. All that is missing for this to be a de jure gold standard is some regulatory and legal recognition and one has been proposed. The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.

This implies banks would be regulatory blessed to operate with less equity capital than is normally required of banks if they held more gold as an asset. Basically,  regulators would allow banks to be more leveraged, meaning the banks would not suffer as much equity dilution to recapitalize after sovereign and mortgage write downs. Not only would gold then be backstopping debt and currency but also be backstopping bank equity capital.  So the realm of gold is expanding to fill the void of other “money good” assets and elevating its demand.

The world has gravitated from one gold-backed paper currency to another before, and it likely is happening again. It would depend on whether investors in liquid, default-free, inflation-free paper prefer gold-backed Chinese Yuan to Swiss warehouse receipts or deposits from large international banks with large gold positions that operate with lots of leverage. This is a market choice that will determine the gold linked paper store of value, but the point is that all the paper contenders derive value from the gold backing, and thereby expands the demand for the shiny metal. This is the new calculus of gold. This state of affairs is likely to remain until developed world governments no longer reach for the unreachable and pressure their central banks to finance it.

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