Monday, March 26, 2012
by Gary North
This report will deal with quantitative easing (QE). To prepare you for this report, I ask you to watch a short video. It is under 3 minutes. This video is the best thing I have seen on quantitative easing. I wish Bernanke would be this forthright, but I suppose this will never happen.
I will assume from this point on that you have seen the video. If you deal with colleagues who have been confused about what QE really means, forward it to them.
The problem with the video is this: the economics profession, the financial services industry, the financial media, and Paul Krugman have not been able intellectually to make the connection that the interviewer did. He did it effortlessly, but the professionals who are paid to explain things to the public are on the payrolls of special-interest groups that have a direct financial stake in the continuation of the present system. When men are paid very well to see things in a particular way, they become impervious to alternative explanations of causes and effects.
FROM HELICOPTER TO HURRICANE
Bernanke became famous in 2002 because of a line in a speech that he delivered in late 2002. It was on combating price deflation. He described policies that in fact were being implemented as he spoke: Bush's huge (in those days) Keynesian deficit and Greenspan's monetary expansion.
In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
The line led to his description as Helicopter Ben. There are cartoons and Photoshopped images all over the Web that use this as their theme.. He will always be known by these images. No other Federal Reserve Board chairman has achieved such poster-child status.
The problem with the helicopter image is that it does not convey the serious nature of the threat. Picturing a bearded man tossing bills out of a helicopter is amusing.
Of course, the image itself is incorrect. The commercial banks are the source of the money, not the Bureau of Engraving and Printing. Dollars are mostly digital. The mental image of German wives in 1923 with wheelbarrows full of paper bills applies to hyperinflations, but it does not apply well to monetary creation in a digital world.
The conceptual difficulty with digital money is that it is lent into circulation at specific points. It can be lent as credit card money or as bank credit. Credit card money is used by card-holders to buy things. Bank commercial credit money is used by entrepreneurs to purchase goods and services used in production.
When central banks buy government IOUs, governments send out welfare checks and pay other special-interest groups. The recipients spend money. This sends a signal to entrepreneurs: demand is increasing. They begin to respond by expanding their facilities to increase output. They go to banks to borrow the money.
There has been no increase in saving. There has merely been a central bank purchase of government-issued IOUs. But businessmen begin to bid up the prices of factors of production. If they are willing to borrow, and if bankers are willing to lend, this creates competition for resources. Customers want finished goods and services immediately. Businessmen want factors of production, in order to produce goods for sale later. Businessmen initially win this competition. They can outbid customers.
Of course, if businessmen are not persuaded that the flow of new digital money will continue, or if they are already deep in debt, commercial banks will lend to governments, or to consumers, or just hand over the money to the central bank as excess reserves. The banks have been building excess reserves ever since 2008. This has kept prices from climbing to match the increase in central bank purchases of government IOUs.
If the American economy begins to recover to the degree that businessmen are willing to borrow and bankers are willing to lend to them, the monetary base that the FED holds will at long last push up consumer spending by the employees of businesses. The M1 money multiplier statistic will increase as people spend this money on customer goods.
At that point, the FED will have to decide how to offset this in order to head off major price inflation. If it does not sell assets, mainly Treasury bonds and Fannie Mae and Freddie Mac mortgage bonds, it will face mass inflation (15% to 25%). If commercial banks still lend, the near tripling of the monetary base in 2008-10 will produce a near tripling of consumer prices. That will be the hurricane.
THE MOMENT OF DECISION
At some point, all central bankers will face this decision. They can continue to buy assets, thereby increasing the monetary base. But this increase will produce hyperinflation. This has happened after major wars among the losers. The German and Austrian inflations after World War I are legendary. Even worse was the hyperinflation of Hungary after World War II. In our day, Zimbabwe's hyperinflation early in this century became the worst since Hungary's.
No major West European government has experienced this. The German economy from 1945 until June of 1948 was a ration-based economy. It had repressed inflation. The Allies printed paper money. Then they imposed price and wage controls to hold down inflation. Production then shifted to the black markets. This ended the day after Ludwig Erhard unilaterally abolished the price controls and shrank bank money by 90%. General Clay, who was in charge, backed him. The German economy revived. That was the basis of the "economic miracle" – a miracle only in the eyes of the price controllers.
If Bernanke decides to stop buying U.S. government debt and all other forms of debt, and the FED ceases to create new reserves, there will be a recession. If the FED sticks to its guns, the fractionally reserved banks – very large banks – will fail. That will shrink the money supply. That is what happened in the United States from 1930 to March 1933. About 9,000 banks failed. The FED bailed out the biggest ones.
The problem next time will be this: the biggest banks are leveraged 33 to one. This meets the "stress test" which the FED conducted earlier this year. This is twice as high as the former head of the FDIC says it should be. She thinks big banks will be under great stress in the next financial crisis. She wants a more bare-bones banking system.
Financial institutions fail when they cannot meet their debt obligations. Equity can absorb losses. In contrast, debt is a fixed legal obligation. When you have unexpected losses, as is the case in a financial crisis, you need a significant cushion of equity to absorb the losses. The more debt an institution has in comparison to its equity, the more likely it is that the institution will fail. Short-term investors will pull their loans quickly from a highly leveraged institution, even when it is still solvent. Insured deposits and long-term debt are more stable. That is why it is important to stress liquidity as well as capital to make sure financial institutions can survive a highly stressed environment. (http://bit.ly/BairBones)
She went through the 2008-9 crisis as FDIC chairman. She watched hundreds of banks fail. She watched Wachovia go under. So, she is alert to the risk.
So is Bernanke. If the FED puts on the brakes at any point and keeps them on, the contracting leverage will topple some very large banks. If the FED doesn't put on the brakes, there will be hyperinflation, which will lead the commercial banks to use their leverage for even more pyramiding of credit. Then what? Breakdown. Hyperinflation destroys traditional capital markets.
Bernanke is stuck with the helicopter image. The only way that he can escape this image is through a switch to Hurricane Ben. He does not want this.
If it comes down to making digital money available to big banks to bail them out vs. buying the government's debt, the Federal Reserve will side with the banks. That will tempt Congress to nationalize the FED. It legally can do this. Then monetary inflation will continue under the new, improved FED. At that point, Ben will bow out if he is still chairman at the time. He can live with Helicopter Ben. He can't live with Hurricane Ben.
No one at the FED will want to preside over the destruction of the dollar. The effects would be disastrous. The person in charge of a legally independent central bank will be on the hook. So will the members of the Federal Open Market Committee (FOMC), which sets policy. If Congress mandates the purchase of T-debt, someone will be hired to do the government's will. His excuse will be this: "I was just following orders."
We speak of the boom-bust cycle. The good times are followed by the bad times. But we can as accurately call it the bust-boom cycle. The boom in America has never become what Mises called the crack-up boom: the destruction of the dollar. It also has never become the market-clearing bust, when all insolvent banks are allowed to fail, and the money supply is allowed to contract accordingly. That would end the leverage once and for all.
We never get to once and for all. The government never releases the monetary ratchet.
FOREIGN CENTRAL BANKS
The magnitude of the federal deficits is concealed by purchases of T-debt by the central banks of China and Japan. But the main cause of low interest rates and rapid purchases of the debts is not Asia. It is the investing public in the United States. Foreign central banks purchase less than half of the $1.3 trillion a year that the government is forced to sell by the deficit.
China has bought no Treasury debt since July 2011. It has allowed $140 billion to lapse. It did not roll over these debts. Japan did keep buying. The Bank of Japan bought almost $200 billion. The increase from all foreign sources has been from $4.66 trillion to about $5.1 trillion. (http://bit.ly/TICreport) This is close to $400 billion. That is about half the deficit that is owned by the public. About $6.5t is held by the Federal Reserve and various U.S. government retirement trust funds. Check "Ownership of Federal Securities".
In the meantime, the total on-budget debt grew from about $14.3t in June 2011 to $15.6t.
The U.S. Treasury would be paying far above one-tenth of one percent on 90-day T-bills if the foreign purchasers were to decide to stop buying. If central banks just allowed their T-debt holdings to mature and then refused to roll them over, there would be a funding crisis at the Treasury. Rates would rise as the Treasury scrambled for lenders. But that would create a recession. Americans would stop buying as many foreign goods. Foreign governments don't want that. So, they keep inflating to buy dollars to buy T-bills to hold down Treasury debt rates.
If the FED ever stops buying U.S. government assets, there will be price deflation and a depression. If it never buys again, there will be a Great Default: federal bankruptcy. Bernanke will not preside over that, either.
But at some point, it will have to be one scenario or the other. The endless can-kicking will end. There will be too much federal debt to service. Rates will rise. The depression will hit.
The government dares not default on its short-term debt. It must roll it over to stay in business. So, it will have to find ways to cut off other outlays. It will have to abandon Keynesianism. It will have to balance the budget.
OXEN TO GORE
That will mean deciding whose oxen will get gored by default. The military budget is a sure loser. But that will not be enough. Means-testing for oldsters will be imposed: Medicare and Social Security. "Stiff the rich!" Politically, that will play in Peoria.
Medicare will cut payments to physicians and hospitals. Physicians will begin to stop treating Medicare patients. They will not be allowed to refuse. So, older physicians will retire. We can see where this is headed: real socialized medicine, not mere Obamacare. But that will not cut costs, either. Costs will rise.
In a full-scale depression, these measures will not be enough. The government will have to cut back on Medicare. That will be the day of generational reckoning. Who will pay granny's medical bills?
The assumption is that a hurricane will never come – not a deflationary hurricane or a hyperinflation hurricane. So far, this has proven to be the case. But the deficit rises relentlessly. The can-kicking continues. The bills will come due. The numbers do not lie. The bills will come due almost overnight, when central banks refuse to buy more Treasury debt at low rates, followed by the Federal Reserve, followed by the pension funds.
Keynesianism teaches that the day of reckoning need not come. Chicago School economists say it need not come. We will figure something out. Supply-siders say the same. Only Austrian School economists say that the can cannot be kicked forever, and that the day of reckoning will come.
It is getting close in Greece. Greece is the early warning signal to the whole world.
It is wise to begin to prepare for a hurricane. The problem is, which kind? Hyperinflation? Deflationary depression and default? Mass inflation followed by depression followed by another round of inflation?
The mainstream media do not discuss this. They all think we can muddle through. I don't think we can.
The timing of the hurricane's arrival is a matter of conjecture. But be prepared to batten down the hatches before it comes.