The Evils of Serial Quantitative Ease and the “Welfare of Everyone”

Officials from the Federal Reserve have agreed that their quantum asset purchases, financed with new money through a process known as Quantitative Ease (QE), will conclude next month — that is, unless they find a new problem on the horizon for which another dose of quantum money seems in order.


And lest we presume that we have lived through the conclusion of this epic historical monetary experiment, we now find the European Central Bank [ECB] has re-ignited. And ditto for the Bank of Japan, as things are not going well in either location.

And just like the Fed — in an effort to take Keynesianism not just to the limit, but beyond the limit of credulity — the ECB has set a negative nominal rate target.

Now, it’s one thing to set a service fee on deposits that exceeds any interest paid to achieve a negative rate. But if you can image it possible, market yields of traded European sovereign bonds have actually turned negative for possibly the first time in human experience, as shown below:


This is achieved when an investor voluntarily pays a price for a debt instrument that is higher than the investor will receive back in both principle and interest. And mind you, this is by contract, not by default.

Not since the days when Mark Twain’s Tom Sawyer charged his friends for the privilege of painting his fence has the world gone quite so upside down and backwards.

And upside down and backwards it is when central bankers, in their zeal to entice borrowers to borrow in the hope that they will spend and generate income, have now pushed interest rates not to zero but actually into negative territory. This amounts to the subsidization of borrowers (whether they are consumers, businesses, or governments) saying: “Please, take the money and spend it, and you don’t have to pay it all back.”

So the question is, why would central banks do this? Well let’s examine the rationality in Fed Chairwoman Yellen’s own words:

“The Fed provides this help by influencing interest rates. Although we work through financial markets, our goal is to help Main Street, not Wall Street. By keeping interest rates low, we are trying to make homes more affordable and revive the housing market. We are trying to make it cheaper for businesses to build, expand, and hire. We are trying to lower the costs of buying a car that can carry a worker to a new job and kids to school, and our policies are also spurring the revival of the auto industry. We are trying to help families afford things they need so that greater spending can drive job creation and even more spending, thereby strengthening the recovery.

When the Federal Reserve’s policies are effective, they improve the welfare of everyone who benefits from a stronger economy, most of all those who have been hit hardest by the recession and the slow recovery.”

Well I beg to differ with you, Madame Chairwoman, on your narrow-minded concept of the “welfare of everyone.”

Who, other than central banks, has the luxury of being more or less indifferent as an investor in zero (let alone negative-yielding) market debt? The trillions spent to put the relatively small group of now-reluctant workers with challenged skills to work inflict serious economic pain on the other side of the coin, so to speak.

And on the other side of the cheap money coin is the absence of investment income of a large generation of savers and future retirees called Baby Boomers (amounting to 30 percent of the U.S. population), as well as their supporting institutions such as pension funds, insurance companies, and endowments that provide medical and educational benefits.

Zero interest rates do not come anywhere near the assumed earnings rate of individuals or institutions to service future retirement or endowment obligations.

But normalizing to higher interest rates generates another larger problem than the immediate problem of a semi-lackadaisical economy.

And that problem is that a subsequent shift to normalized higher interest rates (to create investment income for institutions and individuals for retirement purposes) causes the enabled borrowers in the ultra-cheap money scheme to face rising costs of repayment, which in turn requires them to reduce their spending.

This is the conclusion of the Bank of England with regard to central bank encouraged household debt and the fiscal austerity in Europe and the implementation of a national sales tax in Japan is a de facto recognition that previous borrowing binges at cheap interest rates compromises the economic future.

This demonstrates that Keynesian notions of debt-enabled spending policies have maxed-out, as there is too much accumulated debt, and the process has become counterproductive. For the U.S., we have a bit more running room until we hit the wall, but in the decades ahead, Baby Boomers will suffer the consequences of previous central bank myopia.

Ultra low interest rate enticements to spend create multiple future problems. Those with the debt subsequently seek to deleverage especially when interest rates normalize thus creating future recessions. Then in an effort to prevent those future recessions, the central bank returns to yet, lower interest rates for a longer period of time thus compromising the calculations and welfare of savers. This is the story of Japan and now Europe. They’ve returned to the money well as the Fed itself has done three times since the onset of the Great Recession

When will the Fed’s monetary zealots understand that future recessions and diminished investment income is not in the “welfare of everyone?”

Debt-generating demand policies were not meant to be a long-term, ceaseless debt accumulation but rather a short-term, cyclical shoring-up of an economy to allow for debt retirement in an ensuing period of prosperity.

At this point, all that is left is supply-side policy, and in that there are rich dividends. Countries will seek out a Plan B, as discussed here that nurtures companies and commerce with a minimum of regulation and taxation to foster economic growth. Keynesian, demand-side policies have been taken to their logical, counterproductive conclusion and the Chairwoman’s sense of “the welfare of everyone” is in the best interest of no one.

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

An Ode to George Bailey, Credit in a Banking-less World and How Much QE Is Enough


There was a time not so long ago when many high-traffic count intersections in America were home to a Savings and Loan Association. To many of us, an S&Ls is still visualized in the image of the Bailey Building and Loan Association as captured in the cinema version of “It’s a Wonderful Life.” If you missed it, it will no doubt re-run this Christmas. It always does.

Considering how many Americans resent banker bailouts, it’s difficult to imagine that a sentimental movie capturing hard times at a building and loan association could garner six Academy Award nominations. But it did. More astonishingly by today’s perspective, the movie is ranked number one on the list of America’s most inspiring movies. Those were the days when a lending officer such as George Bailey who cared about his clients was pure American apple pie.

It turns out Bailey’s Building and Loan was not the only S&L to bite the dust, as the industry has imploded from 12,804 institutions in 1927 to barely 500 today. Since financial institutions are “institutions,” something rather dramatic must have happened for them to become an endangered species.

Well, a glance at today’s high-traffic count intersections reveals that commercial banks have expanded into many of the same physical locations vacated by the S&Ls, but they too will eventually find themselves an endangered species for the same reasons the hometown S&Ls bit the dust.

The reason is really quite simple: The government doesn’t want to cover their losses anymore.

What both species of institutions have in common is, decades apart and for different reasons, they both took large hits to their asset values, and the government’s financial safety net required bailouts. These bailouts came in the form of either deposit insurance payouts or subsidies to the banks to prevent large-scale deposit insurance losses. This is what TARP and the Fed’s QE were all about.

What happened to the Bailey Building and Loan Associations, and what’s happening to commercial banks today, is that regulation has erected significant barriers and costs to both borrowers and lenders for the purpose of reducing the government’s exposure to future bank bailouts. Fewer loans and smaller guaranteed banks are preferred by a financially strapped government.

But when credit is deflected from regulated and insured institutions, entrepreneurs find new ways to fill the void in the financial marketplace. So long as borrowers wish to borrow and savers seek investment income, finance will take place. The question then is in what form this finance will take and how much will it cost. Also evolving is what we will call the “banks” or “building and loans” that take their place. Furthermore what will be the stylization of the financing documents or financial packages and whose newly created or expanded balance sheet will host these financial obligations?

It turns out that the demise of the S&L held mortgage loan was engineered around by entrepreneurs (mostly investment banks) who purchased residential mortgage loans and securitized them into financial packages that were dubbed some form of “mortgage-backed bonds.” The securitization part is important because many financial entities can only hold SEC-registered securities. Furthermore, to provide the newly created mortgage bonds with pedigree, rating agencies rated the mortgage bonds so that some third party could claim they were high quality.

This opened up the way for the erstwhile S&L mortgages to be packaged and held by a great variety of entities such as insurance companies, pension funds, endowments, and even commercial banks here and especially abroad.

Hence the end-run around the George Baileys of the world was complete.

Much the same is happening today to engineer credit around the commercial banks, whose hands are tied by post-financial crisis regulators to whom no loan is good enough. But in many cases, there are those with a less-jaundiced eye who tend to look more approvingly at the same loans or securities that banks must turn away from. This is the world of non-bank banks, which are sometimes characterized as shadow banks when less is known about them.

A good  example these days is United Development Funding, which itself is an SEC-registered non-traded REIT that is securitizing erstwhile bank loans to homebuilders at interest rates that range between 11% and 15%. The information on its latest offering and the details on the underlying loans can be found on pages 37-40 of its 3rd Quarter 2013 filing with the SEC.

What is most revealing is that homebuilders traditional were commercial bank clients, and the audacious rates paid for credit in these days of “zero interest rate” policy are an indication of how much borrowers will pay for funding, so long as it does not involve the regulatory costs, delays and burdens of the due diligence process imposed by post-financial crisis regulation. This barrier is better known as qualifying for a loan and is what bank credit restrictions do.

Investor access to be a funder in this market place is subject to broker dealer compliance review of the offering and investor suitability requirements so that the SEC gets into the business of regulating the non-bank bank financial offering primarily for disclosure and investor suitability rather than making a judgment on the credit quality of the underlying loans in the package.

The common shares of the non-traded REIT are distributed via participating registered RIAs, for example, from Beck Capital Management in Austin, TX where I learned of them. As a result, though with the usual caveat that this is a fact and not a recommendation, I find myself in the position of being a shareholder of the non-bank REIT in which the dividend rate has been upwards of 8% plus additional quarterly distributions.

Other non-bank banks include Business Development Corporations, CLOs, Money Market Mutuals, hedge funds or even open-ended exchange-traded funds or mutual funds. Some of the loan packages are leveraged, some are not, and there are combinations of either debt or equity claims against the packages of loans that investors can access.

An even more unusual species of the non-bank today is typified by Apple, Inc. In April of this year, the iPhone maker borrowed (for the first time in almost 20 years) $17 billion despite having a cash hoard of $147 billion on hand. The market cost of funds to Apple of 0.51% for its three-year debt securities, 1.07% for five years, and 2.41% for ten years proved too tempting to not stockpile yet more “cash” — which it no doubt quickly invested into higher-yielding securities.

This turned Apple into a non-bank bank as well as a manufacturer of techware. They are living on their interest rate spreads just like a bank does. Corporations with record cash of $1.84 trillion (or 7% of their balance sheets) have, in effect, become members of the credit-creating non-bank bank world.  Apple is not alone as this year corporate bonds issuance has surpassed $1 Trillion.

Today, the non-bank banks are in an ascendance, not just as a way to work around bank regulation, but also because the  massive QEs generate cash for those who sold their assets to the Fed . This provides the funding to either purchase corporate securities or other newly created financial packages, or to fund the non-banks’ ability to purchase the thusly created conduits.

So it’s no coincidence that the Federal Reserve Bank of New York recently estimated that the annual rate of non-bank credit creation was running $1 trillion per year, which essentially matches the annual rate of the Fed’s QE. This rate of credit expansion by all sources is found in the Federal Reserve Flow of Funds reporting with The Net Acquisition of Financial Assets in Q2, 2013 running at a $940 billion annual rate, just short of the annual rate of QE additions to the monetary base.

In contrast, commercial bank loans and leases — while growing at a modest rate shown to the left— have only offset the contraction experienced during the Great Recession.

A better indicator that banks have been constrained from the credit expansion mechanism is that banks’ loans and leases as a percent of deposits have dramatically declined as shown below.

If one were to view the Fed’s role as creating credit so that borrowers have the resources to invest or spend, the QEs have been effective as of late.

While it’s true that the non-bank banks cannot multiply the increase in the monetary base by “creating” deposit money at the good old multipliers of near 10, as banks could. This implies that to obtain the same credit creation by the non-bank banks requires nearly 10 times the amount of base money to finance the same lending and spending outcome via the non-bank banks and the securities market.

The same credit expansion without commercial bank deposit expansion is a very fundamental rethinking of our understanding of the economic and financial world.

Because the restraining bank credit regulation is the result of Dodd-Frank legislation, the Fed is basically offsetting the lending repression induced in the normal expansion of commercial bank lending.

Hence, paradoxically the Fed is providing ultra-low rates but in a great Catch-22, few can borrow.

The latest reports indicate that we are possibly on the verge of yet another mutation of the monetary response to the Great Recession.

The Fed is trial-ballooning another patch on the broken system of bank credit availability —  negative interest rates on bank cash holdings — as a perverse incentive to entice banks to make loans for which few can qualify.  If so, banks will likely respond with negative deposit rates to maintain their spread between assets and liabilities. In this case, savers will really migrate away from funding the dormant banks, and finance will further migrate into the shadows. It would amount to a regulatory Dark Ages of financial repression in which bank loans rates will be even tantalizingly cheaper, but no one can have one.

In this ode to the George Baileys of yore, there are important observations to be made:

First, credit creation is occurring, but it’s neither coming from the usual lenders, nor taking its usual form. It’s also not being captured in the usual monetary statistics.

Second, a $1 trillion per year credit expansion — which amounts to 7% of GDP — is sufficient to finance a cyclical economic expansion, so we are getting a GDP lift that is now showing up in the employment numbers. Credit expansion is taking place via the securitized route rather than bank loans.

Third, taking away commercial banks’ ability to ramp up credit with the usual multiplier (taught in undergraduate economics for six decades) due to lending (and capital constraints) requires an outsized central bank expansion to generate the same credit for an economy.

So the size of the appropriate QE needs to be evaluated in these terms, so long as banks are largely taken out of the credit equation and credit is pushed into the non-bank shadows.

Offsetting financial repression with indefinite QE is a second-best solution at best, but forcing a negative deposit rate on banks is straight out of the regulatory Dark Ages as it further shrinks the banking system.

A first-best solution would be to free banks from the yoke of financial repression, require them to play the game with their own capital (as opposed to government bailouts) as a self-regulatory device, and eliminate the smothering financial regulation that pushes finance into the shadows at usurious rates.


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

A Tiger by the Tail: The Fed and QE3

With the third round of Quantitative Easing (QE3) last fall, the Fed grabbed a tiger by the tail and, for obvious reasons, it cannot let go: Agitated tigers come after you.

The story behind why the Fed created the risks that are now haunting them is a revealing one, and it has perverse implications for the future.

QE3 is a monetary extremum. It arose out of frustration from years of unsuccessfully stimulating the economy the old-fashioned way — by purchasing securities that resulted in mountains of cash being deposited at banks at record low rates with the unfulfilled expectation that the cash would be loaned and spent.

Lead by Bernanke, a still-determined Fed embarked on a policy tweak that they hoped would cause banks to lend, encourage businesses to borrow and invest in plant and equipment, and drive consumers to spend on durables. The scheme also encouraged investors to drive up financial prices, hence creating a wealth effect that would provide the resources for more spending.

The idea was to tweak expectations that arose out of the simple notion that people invest in physical plant or financial shares based on their probabilistic expectations of the cash flows from future economic growth. Key to that projection is what they believe policymakers will do to maintain growth. Inside of academia, this notion became known as rational expectations, a theory that has been glorified with the award of at least two Nobel prizes.

So as it stood last fall, expectations were “rationally” priced into economic activity and market securities, but the rational level of activity was not very satisfying to the body politic or to the Fed. Given the impasse and the mounting fears of a further setback from the looming fiscal cliff, the Fed decided on a Hail Mary policy play. Fortified by the academic acclaim of rational expectations, they thought it clever to manipulate existing expectations to cause agents to do what they wanted them to do, which was to generate more real investment spending.

In rational expectation logic, in order for the policy change to have an effect on the outcome, it needed to be a policy surprise, otherwise the outcome was already reflected in existing activity and prices. Hence, it can be said that the Fed sought to create irrational expectations of growth. What especially makes it irrational is earlier QEs have already revealed that growth doesn’t necessarily follow more money. But if the market believes and acts on it, expectations can become self-fulfilling.

In the good old days of pre-government debt distress and Great Recessions in which commercial banks would take excess cash and actually lend it, the policy options were spoken of as either Open Market or Open Mouth. Open Market means the Fed shapes market prices by actually going to the open market and buying, whereas with Open Mouth, they merely imply they will be buyers, which causes front-running investors to change the prices for them without the need to load up their own balance sheet.

In todays world of the Great Quagmire after more than five years and counting in which at least two other predecessor QEs did not do the trick of extracting the economy the Fed believed the only way to generate some traction would require both Open Mouth and Open Market with breathtaking amounts of monetary increase never previously witnessed, anticipated or priced in.

To do so they needed to oil up the printing press and but also ramp up Bernanke’s Open Mouth skills to exude some confidence in order to move the expectations needle — not an easy task for a rather dry academician. To do this, it is reported that Bernanke hired a media coach and scheduled unprecedented press conferences never before conducted by a central bank Chairman in the manner of King George VI of Great Britain, who needed to announce his country’s entry and progress through WWII.

What was most important in the Fed’s announcement of QE3 was the notion that they would not take their foot off the monetary accelerator until we were out of the Quagmire, however long that would take, in an open-ended commitment. This is something akin to the wartime philosophy, “We do not stop until unconditional surrender.”

And while its way too early to determine the extent of the success of the gambit as it relates to jobs, economic growth, and a little bit of inflation, these effects only occur after a bit of time, which even in less challenging times would require 18 months to be noticeable.

But rather than waiting that long to judge the leading edge of the results, after only about 8 or 9 months or so of QE3, the Fed hinted that it would throw in the towel on Quantitative Easing. To lay the groundwork for exiting, it backed off the timeless open-ended commitment by defining targets of unemployment and inflation that would allow them to exit, and more recently it forecasted time limits for reaching those targets which now is but a fuzzy time limit for QE3. Gone is the open-ended commitment, replaced by a strong hint that they wish to back out.

So now we have it as to why the Fed started QE3 — but why are they now backing off the strategy known in Bernanke (and speech coach) gibberish as “tapering,” which was met with a disconcerting thud in the financial markets.

Basically to date, while there is no clear evidence that real investment is taking place as a result of the policy, but it is clear that financial market participants took the Fed’s promise of growth along with cheap money and ran with it. Given their “do not fight the Fed” culture, they responded to the Fed’s unanticipated announcement in minutes, not the months or years the real economy requires to assess the response.

Basically the financial investors salivated at the ultra-low rates offered to borrow and purchase financial assets — a process known as leveraging — which drives a wedge between financial pricing and the underlying economic income streams they were purchasing. It is also known as an asset bubble, which tends to collapse.

Well, the asset bubble pricing started to collapse on its own weight, prior to the Fed hinting that it will be exiting earlier than planned. That occurred because of a new monetary phenomenon that is important to understand. It involves new realities of global financial intermediation.

QE3, with its eager financial market participants, enabled a great deal of low-quality debt to be not just sold but scooped up by financial leveragers with borrowed funding. Leveragers do, after all, live off the difference in the yields of the assets they purchase less what they pay for the borrowed funds required to purchase the assets. This is known as spread.

So while low-quality debt assets were flying off the shelf into the hands of the leveragers, generally known as the shadow banking system, outstanding amounts of high-quality debt securities in the form of U.S. Treasuries were being scarped up by the Fed in its QE3 operation.

Ironically, this ended up limiting the amount of low-quality assets the shadow banks could purchase, because they are required by their funding sources to collateralize their borrowings with high-quality debt.

The critical nature of the availability of high-quality debt is amplified when they don’t simply borrow once against the high-quality debt, but they instead use their high-quality collateral repeatedly to borrow yet more funds and purchase yet more assets making available Treasuries in the secondary markets the defining limit of their balance sheet size.

It would be like you or I pledging our same house over and over again as collateral to succeeding lenders to borrow yet more funds for unrestricted uses. Yes, borrowing over and over again against the same collateral might not be legal for you or I, but it is legal up to a point in the shadow banking system.  The extent to which this can happen is called the re-hypothecation multiplier.

In this way, by removing Treasury collateral from the available asset pool, the Fed’s QEs caused the shadow banking system to contract. Because the shadow banks are at least twice the size of commercial banks and the only eager lenders at this time, this greatly squeezed credit.

The contraction of the shadow banks showed up in the markets a number of ways: The prices of risky debt fell as shadow bank portfolios shrunk; the prices of the funding currency (cheapest source of funds) such as the Yen and the Dollar rose as leveragers were repaying their funders as they unwound their portfolios; and the leveragers closed shop on expansion by only accepting funds if the funder was willing to pay them for the transaction.

That is, negative funding rates occurred when the funders needed to pay shadow banks to accept their funds, rather than having the shadow banks pay for them.  This is the equivalent of walking into your friendly bank, asking the rate they offer on CDs and being notified that your money will only be accepted for a CD if you agree to pay the bank to take your money! Such is the surrealism in today’s markets.

That surrealism includes the commercial banking system with free cash to lend some great multiple of the available cash — yet they do not lend it, and the larger shadow banking system runs out of Treasuries to expand off. All in all, it is de facto restrictive credit conditions, despite the QEs.

So where are we now? For one, the above has revealed that maximum money is not optimal money. QE, at some point, makes credit conditions worse off. In fact, credit is restrictive. Another way to put it is that we have backward-bending reaction functions that are definitely not part of the Keynesian or monetarist textbook of how more money produces higher prices and improved economic conditions.

The Fed’s ability to move the dial on real investment and financial prices has been shown to have reached an upside limit, and their announcement effects in financial markets are now met with cynicism instead of awe as they vacillate back and forth on QE3.

The recent crumbling of debt and equity prices embarrassed the monetary authority and revealed that Open Market operations do not have the desired effect. This negates their power to move the markets with Open Mouth policy, as there are precious few left who believe the Fed will stick to an announced expansion.

Of course, not wanting to admit to impotence, the Fed claims mysterious “headwinds” prevent the effects they are seeking as a face-saver for those who question monetary policy. They clearly would like to put QE3 in the rear-view mirror and have vacillated between statements of tapering and then damage control to their reputation (and financial market wealth) by dispatching various Fed bank presidents to claim they are still in it until victory. They have the QE3 Tiger by the Tail, and they are afraid to let loose as they know their reputation will plunge on a scale equal to the market plunge that would follow.

Bernanke is lucky as his term as chairman (but not as a member of the board) is over in January. He might even leave earlier, as the president already publicly closed the door on a re-nomination when he said: “He’s already stayed a lot longer than he wanted, or he was supposed to.”

The irony is that he is being chastised for backing off of QE3 by the administration despite it being a doomed and embarrassing policy. One sort of graceful way out is to declare victory and leave, a strategy not without precedent in both war and peace.

The far larger issues ahead are not the future of QE3, or of Bernanke or the stock market, but rather the Fed. The salad days of hard-earned market confidence that allowed Open Mouth Policy to have an effect have been built on 70 years of performance since the Great Depression. That confidence has been sacrificed, and it will not just return with the appearance of a new Fed Chairman in January.

Divining the short list of candidates to replace Bernanke has been tasked to Treasury Secretary Lew, so whoever it is will very likely be a Democrat, not just because of who is nominating but also because the appointment requires an advice and consent majority from a Democratic Senate. So whoever replaces Bernanke is likely to try it all over again in the faint hope that mega QEs both dazzle the financial markets and still provide economic uplift. Good luck to whoever that might be!

Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Slow-Moving Train Wreck Has Picked up Speed: Foreign Depositors in European Banks Will Be Outed

slow1In a recent Texas Enterprise presentation, I described how losses to Cyprus depositors could occur elsewhere. Moreover, I suggested that this was not a one-time aberration of our understanding of normal. Rather, this is the new normal, better described by a Texas Enterprise reporter as “a slow-moving train wreck.”

Since his phrasing was more eloquent than mine, let’s go with that as a title to this month’s blog. Except in the short time since that title was conceived, the impending train wreck has just picked up speed.

The notion of a train wreck for an economy is of course in sharp contrast to our notion of “old normal,” in which an economy chugs along spewing off the multiple gifts of jobs, income and wealth all by itself, even without much need for government locomotion or correction.

That is the way it was for a long time. Yes, there were occasional interruptions in that steady progress, most of which proved to be no more than minor and short-lived recessions. But the train kept chugging along, because economies do have natural self-correction mechanisms to keep the train on the tracks and moving at a normal speed. This is the notion of an equilibrium growth path.

Primary among the natural economic mechanisms are prices of inputs and currencies. In recessions, unemployment creates low wages, and low demand for capital causes yields to diminish. With capital outflows, currencies decline, and goods become cheaper to produce and eventually become attractive to foreign buyers. Hence the economy’s engine turns around all by itself and keeps on chugging. In an economy’s boom episodes, those same resources become expensive — which is a self-moderation mechanism that slows sales and production.

During booms, interest rates increase due to scarcity and the inflation premiums that markets price into debt contracts. This means that in that economic environment, there is relatively little need for the Federal Reserve to further raise interest rates.

However, after WWII, self-correction gave way to statutory imperatives to not allow prices to reflect scarcity, which somewhat deterred the self-correction mechanism. Minimum wages prevented the unemployed from offering their services at a lower market rate, and reserve currency prices had a built-in upward bias so exports would not pick up. Hence the self-correcting market mechanisms were somewhat compromised.

For the most part, following WWII, monetary policy and contra-cyclical fiscal policy added to demand so as to keep the locomotive running at the highest maintainable speed, never mind a little inflation. In addition, the Fed’s routine fine- tuning required flexibility and timely policy to keep the engine’s mechanisms in working order — the locomotive would lurch forward when policymakers gave it some gas, and it would slow down when they applied the brakes.

But now, what was considered “normal” back then is almost unachievable: Not only is the engine in sad repair, but the ground under the tracks is giving way.

One reason for this is that we are now facing what the Fed calls “headwinds” — when they push the accelerator to the floor, there is no acceleration, but it’s not due to lack of trying. Same is the case in Europe and Japan: They are trying but getting no traction.

But now the old locomotive has sprung several more disconnects. For one, it suffered through The Great Recession just as old age caught up with both machinery and the work force. The aging population also requires fiscal resources to make good on government entitlements. That process tends to slow the old locomotive, as the government finances entitlements by diverting private resources.

Another slowdown occurs when the government foists its entitlement debt on first banks, financial institutions and, most recently, on central banks across the world — making them weaker and compromising the engine’s traction even further.

But now in a new bold move to come up with the funding for entitlements, European governments have chosen to cannibalize depositors in their own banks (and, in turn, the banks themselves) by forcing them to reveal the identities of foreign depositors to their home governments.

The end to Euro bank secrecy has already given rise to witch hunts for depositors, basically requiring them prove to their government that they paid taxes on funds in their foreign bank accounts. But since the truth will not be revealed until the end of the year, depositors have ample time to seek new ports for their holdings — which will no doubt be outside of the EU. The total amount of the deposits that are likely seeking a new home is estimated at about $21 trillion, or about twice the amount of U.S. commercial banking system deposits.

If that were not enough incentive for depositors to flee Europe’s banks or seek other alternatives, the EU has also made it clear that the ad hoc Cyprus bank formula for large bank resolution — in which depositors and other debtors take a hit when the bank goes insolvent — will be applied across all future EU bank insolvencies.

Needless to say, holding government bonds as assets is a leading cause of bank insolvency — if the government can’t service its debt, it certainly can’t rescue the bank’s supposedly insured depositors.

To add to the risks that Euro depositors face, the IMF has indicated a new policy for assisting financially strapped governments that rationalizes not assisting them. The IMF wisely decided that it will not rush in and be a lender to distressed sovereigns an act which often provides the funding needed to save banks.

Instead, it will wait until after the sovereign defaults on its existing debt as it wants no part of being written down with the rest of the bond holders.  This no doubt removes an important source of emergency funding for the sovereign and the bank depositor, which the IMF has come to realize simply enables the sovereign to keep on spending at its expense.

With support for bank deposits being removed, the conclusion is Euro depositors are at risk without much in the way of government back-up whether or not deposit accounts are anonymous. So Cyprus is the new rule and not the exception.

Banking and moreover, financial globalism — a system in which capital is free to flow toward the best use that promotes economic growth — is being sacrificed to support state deficits.  But the sacrifice will not be confined to Europe, as the U.S. and the Euro zone are placing maximum pressures on all haven countries to do the same so as not to lose competitive advantage.

So with Europe in the sixth consecutive quarter of recession, the slow moving train wreck has just picked up speed, no matter how much gas the monetary authority gives the aging locomotive. 


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

Is the Printing Press Engaged for the Duration?

spell1A  printing press is a handy thing to have. When a government or central bank can fund itself with money or claims on money, it can buy a lot of things and solve a host of problems, all without the need to tax. I wish I had one.

Developed world governments have lots of problems these days and hence are using the printing press overtime. And with lots of problems comes the thought, at least to an orderly mind, to somehow prioritize the buying. Or, if there is no order, than the disorder of whatever comes next is the order.

This Great Recession experience of the past five years has been an epic chapter of buying in the nearly 100-year history of the Federal Reserve.

In the modern era, economy-wide sustainable growth has been the Fed’s guiding light. It worked quite well for some 50 years to temper the oscillations of the business cycle, both the highs and the lows. And the modern business cycles orthodoxy and Keynesian upbringing is causing the Fed to turn on the printing press to achieve an unemployment rate of 6.5% in this Great Recession, so they claim.

While defining success in terms of unemployment brings clarity as to what Fed policy is about, it opens up monetary policy to an unintended exit if factors other than economic recovery were to reduce unemployment. And financial markets in a bubble state as a result of the Fed’s buying fear that outcome.

As it happens, labor force dropout due to demographics or inadequate skills is occurring. Furthermore, work is being reorganized and parceled out so employees do not exceed 30 hours per week, lest their employers become subject to the Obama Health Care tax. All these factors are bringing down the unemployment rate more quickly than fundamental economic improvement.

Each month, there is a dread fear in financial markets that unemployment will decline sufficiently to cause the Fed to exit QE as they have pledged. Indeed it is the major risk to investors holding positions in an asset bubble market, whether it be in debt, equity, commodities or real estate.

spell2So as we approach the target unemployment rate without much economic recovery, the question is, can and will the target be redefined to be the unspoken necessity of supporting Treasury debt obligations? 

The last time the priority of Fed buying switched from supporting banks and the economy to supporting the government effort to sell Treasury bonds was at the beginning of WWII.

In the three months following Pearl Harbor, given the expectations of the size of wartime debt issuance and with some inflation expectations thrown in, long Treasury yields ratcheted up.

The Fed then approached Treasury (not the other way around) indicating its willingness to enter an agreement to support Treasury bond prices at the March 1942 level for the “duration” of the war.

The Fed did this by buying enough Treasuries along the yield curve to prevent their prices from falling and the market yields from rising — a policy that became known as the Fed’s interest rate peg. It took a tripling of the Fed balance sheet in four years to do the job, which is roughly in the same league as the Fed balance sheet growth since the commencement of the Great Recession.

When the war concluded, federal government deficits turned into surpluses, and there was no longer pressure for the Fed to be the buyer of net new government debt.  And furthermore, there was high inflation. This caused the Fed to claim the “duration” had arrived and that it was time to exit (there’s that word again).  But there was a catch.

To Treasury Secretary John Snyder, exit in the name of economic stabilization was all academic heresy or a potentially expensive distraction from the core responsibility of a government to finance its debt at the most affordable rates. That is, he didn’t care for the idea that Treasury bonds would not be supported ad infinitum at par in the primary and secondary debt markets. Furthermore, he was backed by a gentleman in the White House by the name of President Harry S. Truman. Such is the core concern of a government as to the cost of its interest expense.

The Fed’s post-WWII exit attempt spilled over into widely followed Congressional hearings conducted by Senator Paul Douglas before the Joint Economic Committee. The core question was, did the Fed’s responsibility for full employment and controlling inflation trump the need for propping up the price of Treasuries so interest rates would not rise?

Despite Congressional support for the Fed to exit, it still took years until the Fed became determined to pursue a path independent of Treasury dictates, as inflation soared at the commencement of the Korean War.

While the brouhaha concerning exit continued from 1946 until 1951, an opportunity to back out of the Treasury bond support agreement occurred in 1951 (almost six years after the “duration”). At that time Treasury Secretary John Snyder was incapacitated and in the hospital and his next-in–line at the Treasury, William McChesney Martin, negotiated an exit agreement with the Fed at the White House with the President presiding. The agreement became known as the Accord and was the monumental turning point that allowed Fed independence to foster economic growth without inflation for the next half century.

However, there was a catch. The Accord set the Fed free to pursue economic stabilization so long as there continued to be a strong tilt to Treasury bond support. To accomplish that, Martin suggested, or perhaps insisted (as the folklore goes) that he be installed as Chairman of the Federal Reserve Board of Governors to represent Treasury’s interests in monetary policy — which required a resignation of the existing Fed Chairman. This was all accomplished before Snyder left the hospital. Such is the difficulty of Fed exit when the government’s ability to sell debt and service the interest expense is at stake. (For a revealing account of that history go here.)

What was most interesting about the 1951 exit is that after becoming Fed Chairman, Martin had a Beckett moment, or more like a Beckett career. In his almost 20 years as Fed Chairman he constantly tilted in the direction of containing inflation and would not peg Treasury rates below market even during the Vietnam War, which caused Lyndon Johnson to unsuccessfully seek his resignation.

In the context of today’s financing strains that will grow over the next four decades due to Boomer entitlements, consider the following: The U.S. gross debt-to-income ratio is in excess of 100%, and the CBO projects that ratio to reach 400% in the out years of entitlement growth. Hence, each hundred-basis-point increase in the average interest rate the U. S. pays to service its debt (above the present 2 percent average carrying cost) requires additional taxes to drain another percentage point from the income stream — a drain we can ill afford. You can do the math for the required tax drain when the debt-to-income ratio approaches 200% or 300% and if interest rates were allowed to reflect sovereign or inflation risk.

The CBO has estimated that in the out years of  Boomer entitlements, tax revenues will need to be as much as 25% of annual income as compared to today’s 2% to merely service the projected interest expense on the debt, (even if market yields were to remain at average historical levels).

spell3Today there is a de facto peg already in place. It goes under the title of zero interest rate policy (ZIRP). It is also known as financial repression, which includes ZIRP along with positive inflation causing real yields to go negative all the way out to almost 20 year maturities and has become the explicit policy of the Japan and implicitly of Europe as well.

Given the perspective of the machinations at the end of WWII, is it reasonable to expect that Treasury (and the President and Congress) will allow the Fed to exit its already existing de facto peg? The new “duration” is the length of the entitlements.

Hence, the only likely exit for Fed QEs is an exit from the pretense that QE is an economic stabilization policy that can go away if unemployment hits the Fed’s target. It’s a cover story that is about to be uncovered. Fed buying is the supporting backbone of the Treasury bond market with $500 billion in annual purchases which, in turn, promotes foreign central bank currency wars. With the proceeds, they are investing as much as the Fed is in U. S. Treasuries.

Hence, current Treasury Secretary Jack Lew will have an important say as did John Snyder, in the selection of the next Fed Chairman (if he doesn’t wish to stand in himself). The change of guard will likely occur before the year’s end, when Bernanke returns to Princeton to write his account of the Great Recession.

Hence, what needs to be built is a graceful institutional transition for the Fed to exit stated economic stabilization priorities in favor of Treasury debt priorities without actually exiting its asset purchase program. Otherwise the Fed will morph from one pretense to another as they have done with a loss of their credibility.

So relax, bond market, interest rates will be pegged until inflation is no longer containable at the 2.5% level and that could well not stop them.


Sign up to receive the Spellman Report. Bracing financial and economic insight. Now with free delivery!

The Stock Market, QE3 and Voodoo Finance

As we look across the economic landscape there is an abundance of reason to anticipate a global economic slowdown. It is already well in the works as reflected in anticipatory data. It would not be a garden-variety recession emanating from some lull in spending but rather the grinding process of over-indebtedness and uncertainty due to tax and health care issues.

At the same time, over-indebtedness also creates a withering of financial valuations, which sets off another chain reaction called systemic financial meltdown.  This reduces the value of assets held by individuals and institutions such as banks, which in turn further dissolves financial wealth when assets are dumped in order to pay off fleeing depositors.

As a result, financial intermediation withers so that the process of matching of savers, if there are any, with investments is impeded. This in turn negates future growth. For example, systemic financial forces causing a recession visited the U.S.  in the late 1980s. At that time large commercial banks were overburdened with Latin American loan defaults and simultaneously savings and loan associations (remember them?) were decimated when inflation depreciated their book of long-term mortgages.  This limited systemic financial event resulted in a prolonged 1990 recession.

Hence whether the over-indebtedness first strikes spending or financial intermediation, it is difficult to discern as they interact and both income flows and financial valuations suffer, whichever occurs first.

Today, the developed world’s over-indebtedness reactions of the combined recessionary forces and bank runs are emanating from Europe’s southern tier. Unemployment numbers in Greece and Spain rival those of the Great Depression.

But the question on the table is the ability of Northern Europe and the U.S. (and, for that matter, the rest of the world) to escape at least temporarily the ill effects of the above degenerative process.

To gauge that, the market looks to the ability of monetary and fiscal policy to come to the rescue, and if the rescue is attempted will it work? Given the succession of bailout funds established but without the means to fund them, it is not a realistic option. To the extent country debt has been carried by other contributing countries, it is extremely limited and if, indeed, the Spanish bank bailout takes place, it exhausts all bailout funds from the Eurozone’s willing contributing countries.

Nonetheless, the contributing countries keep promising more and more, with the latest being a bank deposit insurance fund — and the market somehow believes it.

If fiscal resources from other contributing countries are extraordinary limited, what is the extent of monetary funding to aid both a recession and systemic financial meltdown? Well, there is some defense to the systemic financial event as long as the Fed and the ECB and other central banks are willing to keep expanding their balance sheets. There is no theoretical or legal limit to how much can be purchased to keep financial asset valuations afloat in order to prevent imminent financial meltdown, but to go overboard they are willing to give up all discipline of monetary control, and with it, holders of the currency go elsewhere.

Given the vulnerabilities present, how then can one explain stock price buoyancy? Since the beginning of the year the S&P 500 index is up approximately 6% and FTSE 100 index is up 2 percent despite the onset of recession and bank runs.

If there is any logic to it, it seems to be resting on less than a firm foundation. While equity investors rely on current known information such as earnings, they also project forward the value of the claims they are purchasing, hence making financial pricing a mixture of facts and a learned history to project forward.

What you often hear these days is a general awareness of the economic and debt problems but a faith that the bigger the problem, the bigger the government response will be. That is to say, any investor citing “in my 25 years’ experience” is a candidate to be projecting a future based on the Great Moderation Period of Greenspan Puts and currency solidarity in Europe.

Financial prices are inherently an extrapolation of a history, but it’s certainly not the Great Moderation, though that was the dominant influence in the thinking of the 25-year U.S. veteran stock market investor.

But then there is a newer history called the Bernanke Put, best characterized as a succession of QEs or other outside-the-box monetary stimulus, the latest of which is operation twist.

It’s now a common attitude that if the situation becomes bad enough there will be a response equal to the task needed to keep financial values afloat. Now being cited is the above chart showing how equity markets respond to QEs. It seems that the Fed has well trained stock market investors in Voodoo financial logic. The worse the economic problem, the better it is for stocks despite declines in earnings.

As a side note, QE faith stock valuations are throwing noise into the long term relationship of stock prices to earnings and as an early indicator of a recession. This is one of many structural changes that are occuring which implies that one must be careful of which history is chosen to extrapolate.

Before one relies on Voodoo finance and a faith-based QE3, one should note that additional Fed stimulus is almost certain in the face of a systemic financial institution collapse but is less certain and will be less dramatic due to a softening economy. Systemic financial defense was the raison d’etre for the Fed and remains its number one policy objective, but some token form of monetary aid has now become necessary to prevent a collapse of the Voodoo expectations the Fed has created. If that occurs, expectations have become self-fulfilling.


If you enjoy this blog, please forward it to others who may be interested. Links to forward and sign up to receive are in the right hand column.