Saturday, December 20, 2008

Federal Reserve is Damned Either Way...

I’ve been saying for the last couple of years that the Fed is caught between a rock and a hard place. We have now arrived at ZIRP. “Quantitative Easing” (QE) is all that’s left. The unintended consequences of which will become clear within the next year.

For growth to occur, this year’s credit creation must be larger than the last year’s, then the next year’s must be larger and so on. The securitization of debt process created that exponential growth and that bubble has now burst. Since that debt creating process was unregulated and untracked by the government, the size is not directly quantifiable. However, if the growth rate in the derivative world is any guide, to create growth at this point, the amount of QE is, I would contend, far greater than the clowns in the government realize. The math does not work. To create growth at this point will require extreme amounts.

The fundamental problem with Bernanke’s theory is that we have reached macro debt saturation. The amount of income generated by our economy cannot handle the current debt, much less exponential future debt (Please read my article “Death by Numbers:” http://economicedge.blogspot.com/2008/11/death-by-numbers.html).

There are two and only two ways to pay back debt. The first is to pay it back (with interest), the other is to default. The correct thing to do was to let the holders of bad debt default. That’s why we have bankruptcy laws. Instead, the government is passing the bag of bad debt from those who hold it onto the taxpayer. The debt never went away, it’s still there and still has to be serviced. This is the end of the growth line whether we like it or not. That said, yes, it is possible to crank out sums so vast as to create growth going forward, but those sums are vastly greater than the trillions being discussed so far. And, the velocity of money has fallen to extreme low levels which means that when people get dollars they are simply using them to make debt payments instead of putting them to work in the real economy.

And because the tax payer is on the hook for those debts, the burden by the taxpayer is going to increase dramatically (those taxpayers are still saturated with debt, so now they are saturated twice). Thus the government needs more money while at the same time less money is actually available to them. That’s why we now see our deficits doing a moon shot. Those debts are already beyond the math that can service them, thus they will be defaulted upon at some point. The question WAS who defaults? Them (the banks) or us (our nation). Our leaders already chose us. As this article from the U.K.’s Telegraph points out, the ship is upside down:
Federal Reserve is damned either way as it battles debt and deflation

We know what causes a recession to metastasize into a slump. Irving Fisher, the paramount US economist of the inter-war years, wrote the text in 1933: "Debt-Deflation Theory of Great Depressions".

By Ambrose Evans-Pritchard
Last Updated: 6:34PM GMT 18 Dec 2008

"Such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but a tendency to depart further from it," he said.

Today we call this "Gladwell's tipping point". Once it goes, you can't get back up. This is why the Federal Reserve has resorted to emergency measures that seem mad at first sight.

It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is Quantitative Easing, or just plain 'QE' in our brave new world.

The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.

The reason why it "departs further" from equilibrium is more or less understood. The burden of debt increases as prices fall, creating self-feeding spiral. This is what Fisher called the "swelling dollar" effect. Real debt costs rose by 40pc from 1929 to early 1933 by his count. Debtors suffocated to death.

Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1pc from its peak last year. Meanwhile household wealth has fallen 14pc as property crashes, a loss of $6.67 trillion. The debt-to-wealth ratio is rocketing.

Clearly the US is already in the grip of debt-deflation. "The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price," he said.

Fed chief Ben Bernanke does not need prompting. He made his name as a Princeton professor studying the "credit channel" causes of depressions. Now fate has put him in charge of the channel.

Under his guidance, the Fed has this week pledged to "employ all available tools" to stave off deflation - and damn the torpedoes. It will purchase "large quantities of agency debt and mortgage-backed securities." It will evaluate "the potential benefits of purchasing longer-term Treasury securities," i.e, printing money to pay the Pentagon.

Put bluntly, the Fed is deliberately stoking inflation. At some point it will succeed. Then the risk flips quickly to spiralling inflation as the elastic snaps back. There will be a second point of danger.

By late 2009, if not before, the bond vigilantes may start to fret about the liquidity lake. They will worry that the Fed may have to start feeding its holdings of debt back onto the market. The Fed's balance sheet has already risen from $800bn in September to $2.2 trillion this month. It will be $3 trillion by early next year.

"The bond markets could go into free fall," said Marc Ostwald from Monument Securities.

"The Fed went into this all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.

New Star's Simon Ward said all three measures of the US broad money supply are flashing recovery. M2 has risen at annual rate of 17pc over three months.

"It has all changed since the Fed began buying commercial paper in October. If the money supply is booming at 20pc in six months, inflation will become a concern. Given that public debt ratios are already on an explosive path, we risk a debt trap," he said.

For now, the bond markets are quiet. Futures contracts are pricing five years of deflation in the US. Yields on 10-year US Treasuries have halved since early November to 2.09pc, the lowest since the Fed's data began. Three-month dollar LIBOR has plummeted to 1.53pc.

It is the same pattern across the world. 10-year yields have fallen to 1.27pc in Japan, 3pc in Germany, 3.2pc in Britain, and 3.49pc in France.

The bond markets seem to be betting that emergency action by central banks will take a very long time to work, if it works at all. By cutting to zero, the Fed has come close to shutting down the US 'repo' market that plays a crucial role in providing liquidity. It has caused havoc to the $3.5 trillion money markets - as the Bank of Japan, burned by experienced, had warned. It has become even harder for banks to raise money. Some argue that extreme monetary policy is already doing more harm than good.

Mr Bernanke is known for his "helicopter speech" in November 2002, when he nonchalantly talked of the Fed's "printing press" and said it was the easiest thing in the world to "reverse deflation."

Less known is his joint-paper in 2004 - "Monetary Policy Alternatives at the zero-bound". By then doubts were creeping in. He admitted to "considerable uncertainty" as to whether extreme tools will actually work. Liquidity could fail to gain traction.

Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.