QEs, Currency Wars, the Trillion Dollar Platinum Coin and the Route to “Modern” Inflation

A government faced with financing its deficits in quantities some multiple of private saving must resort to monetary schemes in order to keep its promises to spend. Monetary schemes are essentially costless ways to pay the government’s bills today while ignoring long-term consequences. Understanding the schemes reveals them to be disarmingly simple, but effective.

Some varieties of these schemes include monetization of Treasury debt, monetization of Treasury coin and Treasury currency.

Monetization requires the Treasury to issue something (debt or coin) that the central bank purchases from the Treasury with dollars, which in turn provides the dollars to the government to deliver on its spending promises. In both monetization schemes, consolidating the balance sheet of the government and its financing arm, the Federal Reserve, reveals dollars outstanding as a liability and government investment items purchased (such as infrastructure) as an asset after the financing is accomplished and the money is spent.

The rest is spent for consumption items with no remaining asset to put on the consolidated balance sheet.  In both cases, with each occurrence of monetization, the government becomes more upside-down (insolvent) as long-term asset accumulation is but a fraction of its additional liability issuance.


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To make the debt not just saleable but also costless, the interest consequence of the sale of the debt held by the Fed is negated. This occurs when the Fed, as the owner of the debt, is paid interest by the Treasury (ostensibly from tax proceeds) which it in turn remits to the Treasury, less their costs of operation. How convenient.

This renders the net interest carry paid by taxpayers inconsequential. With the Treasury issuance of coin, interest is not paid and hence there is no need to tax in order to make an interest payment — and hence, there is no need to remit interest. Thus the Treasury coin sold to the central bank is almost the ultimate in costless government finance.

But yet there is another way to accomplish costless government finance and make it even slicker with less fanfare.  This would be Treasury currency issuance that doesn’t involve the Fed at all — nor does it involve selling anything or collecting interest payments. In this scenario, Treasury (not the central bank) prints currency to make good on the government’s promises.

This was done during the Civil War and continued up until 1971. The legislation is still in place, but it would require some fine–tuning, such as eliminating ceilings on issuance of Treasury currency. However, that strategy could become a political nightmare if it is exposed as an end run around the debt ceiling because, by law, Treasury currency is considered to be infinite-maturity, zero-coupon debt. What could produce less friction than Treasury printing cash and making good on the promises to spend, without the need to involve or embarrass the Fed, struggle to sell its debt, or pay interest?

In another dimension of Fed support of Treasuries and the housing market there are ongoing QEs in which the Fed is also purchasing market debt from investors in the public capital markets. Investors who sell securities to the Fed receive cash, which puts them in a difficult position: They would have an investment mandate to earn positive returns in a Fed-induced zero interest rate (ZIRP) financial market environment.

This drives some investors into purchasing foreign assets, which turns the Fed QEs into a global Currency War in the following way: Converting dollars to another currency in order to participate in foreign financial market investments sends the foreign currency price upward relative to the dollar. While these countries might be momentarily pleased by the interest shown in their securities and currency, the capital inflow stiffens their currency values, making exports a more uphill proposition.

The central bank, not wanting to lose what they consider to be their fair share of net exports and trade surpluses, responds by selling its currency into foreign exchange markets. That is to say, the Fed’s QE goes global when foreign central banks seek to offset their currency appreciation, which is fought off with more money issued by foreign central banks and sold in the foreign exchange markets. Japan is the latest recruit in reacting to the Fed, and from all indications, it plans to do so in a big way.

This is the Currency War that is now gripping many countries across the globe. And the recent developments with the Fed’s QE are not the first cases of this happening. Bergsten and Gagnon of the Peterson Institute indicate that 20 countries have been in the currency manipulation business to their advantage for some decades, but that has increased recently due to Fed QEs.

Now monetization is ramping up again with QE3, giving more reason for foreign currency offsets to the Fed’s QE. The recent G-20 meeting to discuss Currency Wars resulted in a conclusion to continue with currency intervention but not talk about it in public and keep it out of the press.

However, despite stonewalling and denials by governments and central banks, we know foreign currency appreciation is being offset simply by observing the balance sheets of the foreign central banks that accumulate foreign exchange reserves.

These assets held by foreign governments or central banks are the byproduct of currency intervention, which can’t be brought back home as it would offset their currency offset. In many instances, their purchase of U.S. dollars in the foreign exchange market gives them the dollar purchasing power to in turn purchase U.S. Treasuries — and they did so to the tune of $555 billion in 2012.

Thus the Fed’s direct Treasury purchases — targeted to be close to $500 billion this year — are more than matched by foreign official purchases, so the promises to spend continue to be met. Certainly a half-trillion dollars in U.S. Treasuries purchased by foreign officials is not the byproduct of taxing their own nationals to purchase U.S. Treasuries. While they might love America, it’s not likely to that extent.

So Currency War deniability is necessary in order to contain inflation expectation pricing in financial markets, but it isn’t something that is likely to occur without U.S. acquiescence. Moreover, the U.S. must be in silent support as long as the foreign officials keep purchasing U.S. Treasuries at ridiculously low interest rates that the private market would not tolerate.

So we are off to a Brave New World of money expansion and money supply multipliers that go global. The inflation is likely to first hit in the emerging market countries that are most participating in defending the cheapness of their currency and with more limited excess supply capability of producing goods. Brazil, for example, has an inflation rate above 6% and rising. Their inflation becomes imported inflation to the otherwise deflating developed countries stuck in economic and financial distress.

Certainly an investor needs to be Brave in this New World of interactive monetary policies that struggle to make good on the government’s promises.

For a video version of this discussion go here.

Currency Wars





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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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