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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How Monetization Happens: Being at the Helm When the Ship Goes Down

The consequences of excess debt are now facing the leaders of Europe head on, and a monumental decision must be made whether explicitly or implicitly. Excess debt leads to a long chain of D words: Deleveraging in an attempt to retire debt results in a depressed economy and declining asset prices. The depressed economy breeds private debt defaults that in turn produce distressed banks. The chain then runs through depositor flight from the banks, producing a financial crisis and in turn a devaluation of the currency as capital flees. When foreign goods become more expensive there is a declining standard of living as import prices rise faster than wages. Then in an effort to stop the government debt trap, there is a default on promised entitlements under an austerity program leading to the swift defeat of the political leaders. But ultimately there is a sovereign restructuring or a default of the government debt. Most, if not all, the D words are visiting Europe at the moment and its leaders are falling by the wayside.

There is not a precise science that tells us when the debt trap begins the downward spiral that takes the ship down, but there are some rough guidelines. Reinhart and Rogoff (This Time is Different) have found to the extent one can generalize when a country’s debt-to-income ratio reaches the 90 percent level the ship of state begins to list and currently the OECD aggregate of 30-country gross debt-to-income ratio is 105 percent.

The sustainability of a country’s stock of debt is assessed by the market relative to the income flows that will be taxed in order to support the overhead cost of interest, even assuming an endless capability to rollover principal. The unraveling occurs when the financial markets lose confidence that the debt problem will be resolved successfully through income growth, austerity, or both and the refinanced debt carries the new higher market yield.

At that point, the overhead cost of the debt load is ever more depleting of the income stream that must be taxed to pay the higher interest carry. Now on a daily basis, there is a market panic attack if the market yield on Italian sovereigns rises above 7 percent. (Note the yield was close to 5 percent earlier this year so sovereign default is indeed being priced.)

After holders of Greek debt “voluntarily” accepted an arm-twisted 50-percent haircut, the market now believes that a sovereign default by a Western democracy is no longer a fairy tale. Furthermore, the default can’t be reliably hedged by CDS contracts, which proved to be voidable at the whim of the government, thus converting hedged risks into naked risks for the holders of distressed government debt. To make matters even dicier, the BIS regulators are backing away from continuing to award capital shields to the holders of sovereign debt, as explained in my last blog (The Dumpster for Toxic Euro Sovereign Debt). Also, the market has come to believe the world is without remaining Rich Uncles willing to rescue the Poor Uncles of Europe. All these factors cause investors to revert back to pricing sovereign debt based on risk fundamentals rather than government pledges of invincibility or confidence in financial insurance.

At this point, the remaining options to avoid reaching the tipping point to the D chain explained above are few, and the decisions to be made are momentous. The options are: submit to what the market is doing to you; take the lead and offer a debt restructure at a fractional payout; or run the printing presses to purchase enough sovereign debt necessary to contain the market yields. Halfway measures such as strengthening the EFSF no longer buys even a day’s worth of market forbearance.

It certainly must be crossing the minds of the Euro leaders that there are consequences for being at the helm when the ship goes down. The alternative is to orchestrate your own departure, which was cleverly done by Papandreou in Greece by calling for an austerity referendum. In Italy, Silvio Berlusconi’s departure was orchestrated quite literally, as reported by Reuters:

“Italians sang, danced and drank champagne in the streets to celebrate the resignation of scandal-plagued billionaire Silvio Berlusconi, and an impromptu orchestra near the presidential palace played the Hallelujah chorus from Handel’s Messiah”.

Not even in my most Machiavellian thoughts had I conceived of the possible value of being “scandal-plagued” as a means to a back-door retreat from an uncomfortable situation. Given its frequency among politicians it seems to be an undervalued asset in politics. But the strategy doesn’t seem to fit Ms. Merkel, so she is stuck at the helm of the ship of state and is looking for a life raft.

And the consequence of being at the helm when all the D words cascade is more chilling when one witnesses what has happened to the Icelandic captain when his country’s ship went down. Iceland’s ex-premier is facing a formal indictment charging him with criminal violations against the laws of ministerial responsibility and “serious malfeasance of his duties as prime minister in the face of major danger looming over Icelandic financial institutions and the state treasury.” (See: Ex-Premier Charged)

We have reached the point where government bluff, bluster and promises no longer control the markets, and criminal indictments for those at the helm are threatening. If it is not possible to orchestrate an early exit, it would seem the only remaining life raft is the printing press — but that would not be easy for a German government to do out in the open, given their Weimar inflation history, as shown in the chart to the right.

The monetization of government debt is undoubtedly being conceived of as only a bridge to buy time to form a tighter Euro fiscal union with strict budget discipline. Indeed, this is being counseled by Joseph Ackermann, who seems to be the influential behind-the-scenes advisor.

But to keep things together until then, the ECB is no doubt on the job, if not directly purchasing Italian and other sovereigns, but lending to others who will purchase the same. But running the printing press does not stop with the ECB. Once QEs start for whatever reason and a number of countries are engaged, the very act of one major central bank printing to save a government drives capital offshore to perceived safer ports from inflation and a declining economy. This in turn sets up another dynamic that is well underway as other countries are driven to become sellers of their own currency in order to prevent its appreciation and maintain export market share. Thus, using the printing press to save the Euro debt leads to a global money race of competitive devaluations.

Now there is a confrontation of expectations in the markets, a bi-modal distribution if you will, of those believing the deflationary forces of the D chain above will dominate and those believing, now with greater justification, that the monetary produced inflationary route will be the Euro outcome.

Expect some inconsistent pricing in the market by those being moved to bet on inflation hedges side by side with those willing to bet on deflation hedges. What must be most maddening to a deflation hawk is the asset of choice in that circumstance, long-term government bonds, are at the very heart of the credit problem and are not the solution to protecting one’s portfolio. Nor is it the solution to the inflation hawks either. So the questionable sovereigns go begging among private investors with only the central bank as a friend.

The Dumpster for Toxic Euro Sovereign Debt

Some might be wondering why the euro zone rescue focus turned to saving banks as opposed to saving governments.  The reasons are illuminating. Consider the following: When a government has a debt bulge, the debt must be held as someone else’s asset. The designated chump to hold a large portion of it has been the banking system, as its portfolio of assets is easily manipulated by bank regulators. This is how it works.

Banks are incented by regulators to hold “safe” assets as a way of making them less vulnerable to failure. But—and you’ve probably already guessed it—regulators designated euro government bonds and even subprime residential mortgage securities as the banking system’s “safe” assets. As a result, the banks load up with the safe asset, which has the effect of over-financing that sector of the economy. This sets banks up for a debt crash down the road when there is more debt than income available to service that category of debt.

To make the regulatory system more convoluted, the incentive for banks to finance the safe asset—even when it is manifestly clear that the safe asset is no longer safe—is the regulatory rule that allows banks to hold less bank capital (preferred and common stock) on the right hand side of their balance sheets. Since bank capital is depleted as a result of the 2008 subprime mortgage write offs, there is a greater need for regulatory capital today.  This has caused Europe’s banks to load up with toxic sovereigns with its  banks holding 25 percent of their assets in government bonds as compared to 10 percent in the U. S.

These incentives to hold the designated safe asset allow greater bank leverage, which translates to a lower ratio of capital to assets. One might ask why banks are strong-armed by government to maintain bank capital. The objective reason is because bank capital in the form of bank equity serves as a protection for depositors when the bank’s assets depreciate because bank equity is in the first loss position in case of an asset write down. Bank capital is also important to governments because of their guarantee (whether explicit or implicit) to restore bank capital in the event the bank is unable to. Without bank equity, depositors lose when banks write off assets; when a bank goes down, its depositors lose their wealth, which causes them to vote in great numbers against the government in power.

Thus, incenting banks to hold “safe” assets systemically makes the system unsafe: it becomes more leveraged, with banks holding a concentration of assets made riskier. The “safe” designation led to decreased market discipline by governments issuing debt, which allowed them to sell too much of it at unsustainably low rates. The ultimate regulatory convolution is when over-financed sovereign defaults take the banks down—but the sovereign maintains the responsibility to save the bank depositors.

Hence, the essence of the great euro debt-saving operation is maintaining and expanding the buying capacity of stressed euro sovereign debt—but not just the previously issued debt but the new debt yet to come. Bank buying power is necessary for euro governments to maintain the market value of their existing bloated debt, which is especially critical at times when the existing debt reaches maturity and needs to be refinanced in the market. Just imagine the challenges of maintaining market values of the yet to be issued debt to cover baby boomer entitlement over the next few decades! This will require expanding the banks’ balance sheet, which is the convenient dumpster for government debt in excess of what the market will absorb.

The problem with maintaining the capacity of the dumpster is based on banks’ ability to recapitalize (sell equity) to meet regulatory minimums. Banks have few good options in that regard—if they did there would be no euro sovereign or bank crisis.

Private equity does not gravitate to banks that have more bad assets than the banks or the government stress tests will admit. Unwary investors take a fall when the truth about the bank’s asset quality comes to light or when governments decide that banks will “voluntarily” take 50 percent haircuts on their sovereign debt holdings.

Ironically, banks don’t want to be recapitalized because it dilutes existing stockholders’ interests and lowers the rate of return on capital. Instead they prefer a capital handout from the government, which has a growing need for “dumpster” capacity for increasing government toxic debt. Government recapitalization of banks usually takes the form of non-voting preferred stock so as not to water down the returns to the common stockholders.

In the U.S., the Toxic Asset Relief Program (TARP) was a government fiscal operation that provided banks with near-costless government bridge financing that didn’t significantly dilute their common stockholders. But in Europe, the government debt financed multi-country funding source, the European Financial Stability Facility (EFSF), is capable (when and if it is funded) of covering only a very small portion of sovereigns and banks bailouts. How to backstop both sovereign debt and the dumpster banks has been center stage now for about a year and a half without resolution.

Written between the lines of last week’s sparse announcement of the “final” solution is a very tentative plan that still needs the approval of the German Bundestag, the last remaining “Rich Uncle of Europe” willing to bailout anyone. If Germany should balk at directly funding other governments or banks themselves or disallow changes in the treaty that would enable the European Central Bank (ECB) to do the same, where would the bailout funding come from?

Rather than relying on direct ECB support, the answer may lie in indirect ECB support through a newly created “Special Purpose Vehicle” (SPV). This legal financial entity looks a little like a bank in that the vehicle funds are used to purchase the assets the euros want off the table, and it is funded by a combination of debt and equity sources with the ECB being a primary contributor.

To give the SPV credibility, the equity portion will be the scant remaining 235 billion euros left in the EFSF (if and when fully funded). Using the bank model of leveraging, the scant capital is projected to expand the balance sheet a multiple of 4 or 5 times if there are takers of the SPV’s debt. This would create a much larger dumpster capacity to purchase toxic sovereign debt that no one else wants and perhaps even bank equity that no one is lining up for just now.

Does this sound familiar? It is the same model employed by Citibank to hide subprime mortgages offshore in an SPV or Enron’s partnerships used for the same purpose. How the government learns financial cover-up tricks from the private sector!

With the equity claims in the SPV held by the EFSF, the question is who will purchase debt claims in the SPV to leverage up the new debt dumpster in order to achieve the hoped for 4 to 5 times expansion of the SPV capacity to purchase bailout assets? Officials are traveling to China and Japan this week and will entertain other private debt investors in the SPV and make it juicer with as yet unclear government guarantees on a portion of losses of the debt investor’s losses in the SPV debt.

Hence, the SPV has a decidedly bank model flavor to it—except it is not subject to regulation and its transparency will be even worse than banks. At this point I believe it would be a heroic success to con individuals to do what bank depositors have become unwilling to do: continue depositing at banks whose assets contain bad government debt and whose deposits are “guaranteed” by the same insolvent governments.

Why would one think that the market will more likely invest in SPV debt than a euro bank deposit whose depositors are fleeing the banks with their money. If the SPV is the same dangerously leveraged model as the banks, with the same assets and the same guarantor, can you expect a different result?

What makes it seem possible is the (intentionally) still hidden role of the ECB. Since Germany will veto ECB participation in direct investments in the underwater sovereign assets, the SPV is a multi-government owned and controlled camouflaged bank that provides the indirect route for the ECB to uplift purchasing power in the toxic European sovereign debt market by purchasing SPV debt with printing press money. This designated role for the SPV in conjunction with the ECB keeps Germany’s hands clean, so to speak.

The ECB printing press provides the leverage for the SPV to increase the capacity of the dumpster. The SPV is also not banned from purchasing bank equity to maintain bank dumpster capacity if banks are unable to be recapitalized by the market, which is likely.

While the plan is a little convoluted, it offers governments the deniability of engaging in what some would call throwing good money (the EFSF funds) after bad (the Greek debt). Since the ECB provides unlimited debt expansion capacity for both the SPV and banks, one wonders why the euro zone heads of state became so caught up with creating the SPV functioning in parallel with the banks. Perhaps it was merely their political sense that the combined governments had to do something. They do, after all, run for re-election, and committing government fiscal resources to banks is not a popular thing to do.

But if the plan works, it will provide added SPV dumpster capacity alongside banks’ increased dumpster capacity, with neither German financial support nor direct ECB support.

The implication of monetizing the financing capacity of the SPV is no different than directly monetizing banks or governments. It supports the ability to have an expanded capability to purchase assets, keep them out of view (do you really expect transparency?), stop the debt unwind, possibly revive the economy with yet more new money, create an asset bubble and have inflation as a side effect. All of which seems better than an instantaneous euro zone unwinding and a debt deflation. Such are the machinations of colluding desperate governments who want to do something that appears on the surface to be helpful. How else can you run for re-election?

Folks, I can’t make this up. What might seem puzzling was the stock market rally late last week, both in anticipation of and following the long-awaited announcement. I can only presume the market was celebrating the fact that banks and the economy were not being deposited in the dumpster immediately, and an indirect vehicle to bring the printing press to bear has been created to increase the sovereign debt holding capacity.

Instead of imminent falling dominos, it is dominos re-inflating.