Many years ago I wrote that the fate of the US will be expressed in three words--INFLATE OR DIE. We are there now. Printing trillions of dollars of Federal Reserve Notes must end in inflation.-- Richard Russell, Dow Theory Letters, May 13, 2009
In a speech he gave in 2002 when he was a Governor of the Federal Reserve, Fed Chairman Ben Bernanke signalled his preference for aggressive Fed action to counter asset deflation should it occur on a sustained scale in the United States: "If we do fall into deflation," said Bernanke, "we can take comfort that the logic of the printing press...must assert itself, and sufficient injections of money will ultimately always reverse a deflation." In short, Bernanke argued that when traditional monetary actions to stimulate demand, i.e., reducing the short-term interest rates at which banks borrow money from the Fed, are exhausted, the Fed could and should "drop money from a helicopter" if necessary to increase (inflate) the number of dollars in circulation and effectively raise the dollar price of goods and services. This then-theoretical policy prescription earned Bernanke the nickname "Helicopter Ben."
In early March 2009, Bernanke's theory met reality. With the Fed funds rate practically "zero bound," the Federal Open Market Committee (FOMC) announced it was going to buy--monetize-- up to $750 billion of agency mortgage securities (i.e., securities issued by Fannie Mae and Freddie Mac) and $300 billion in long-term (30-year) Treasury bonds. The implications of this are manifold. First, the Fed doesn't have the money to buy over a trillion dollars of assets, so it has to "create" it out of thin air. This is accomplished by the Fed "borrowing" electronic credits from the Treasury which is then used to buy the assets. The issuance of these electronic credits is the digital equivalent of printing money.
Second, the debt instruments the Fed is buying are financing the "stimulus" and all of the other deficit spending of the last year and this year. In essence the Fed is soaking up the inventory of these instruments and thus keeping their prices up. This has the effect of keeping interest rates low (a bond's yield typically falls as its price rises), which in turn (theoretically) stimulates mortgage and commercial borrowing. But this comes with a price: the artificial creation of a "bubble" in bond prices, which cannot be sustained indefinitely.
Third, the monetization of agency debt and Treasuries poses a significant risk to relations with our trading partners, who get get nervous when they see what looks like the intentional debasement of our currency. An over supply of fiat dollars lessens the value of all dollars in the system. China holds more than a trillion dollars of dollar-denominated bonds in its reserves purchased with dollar surpluses from its exports to the U.S. They are rightly concerned that those reserves will lose value if our dollar is trashed, and so they are already curtailing their U.S. debt purchases. This will lead to higher interest rates forcing the Fed to come in and buy up even more debt with more printing press money, further debasing the dollar.
A devalued dollar will make our exports more attractive than those of our competitors in Europe and Asia, leading them to devalue their own currencies to save their economies. This sort of competitive devaluation leads to trade wars, which often lead to something more deadly.
It is instructive to note that although Bernanke in 2002 believed in the Fed's ability to cure deflation by injecting liquidity into the system, he believed even more in the Fed's ability to prevent deflation in the first place. Judging from the Fed's actions of late we are already past the point of prevention and now trying to effect a cure. Can it not be said that the Fed's anti-deflation policy has already failed, and that the policy prescription of printing fiat (paper) money and debt monetization is a last ditch effort to save the system?
Ah, you ask, hasn't the deflation risk been wiped away with the "green shoots" of the economic recovery we've been hearing about? And with the financial system awash with all this fiat money, shouldn't we turn our concern to inflation, maybe even super-inflation? Well, no. And yes.
The powerful stock market rally over the last two months has created the illusion of market and economic recovery. But it is well to remember that the rally was powered by the surprisingly strong first quarter bank earnings released in early April. A look behind the numbers, though, reveals two things. First, the banks benefited from a change in FASB Rule 157(e), allowing the banks to manipulate the balance sheet value of their assets. Second, the banks benefited from the low cost of borrowed funds as a result of the Fed's suppression of the Fed funds rate and the monetization policy. According to investment guru John Mauldin, this is the "equivalent of the US government reducing the cost of goods to zero for the embattled car companies and then going on to buy--courtesy of the US taxpayer--a couple of million cars that nobody really needs." In that environment anyone can show a profit.
Whenever you hear the financial mass media promoting "green shoots" and stoking a new bull market, it is wise to be cautious if not downright skeptical. If the financial pundits of CNBC say something, the opposite is likely true. The sobering fact is that the U.S. may be slipping further towards "outright deflation, just as Japan did," according to Albert Edwards of Societe Generale, the large French bank. Companies and consumers are retrenching en masse, with the former laying off workers and the latter hoarding cash and paying down debt.
In fact, some analysts calculate that the 15 largest banks have experienced reductions on their balance sheets of $3.6 trillion, with another $2 trillion more yet to be written off this year. And the problem may be worse in Europe. The IMF believes that European banks have written off less than half of total losses related to the credit crisis.
The media and many investors may be buying the "green shoots" spin, but clearly Bernanke is not. He has access to all the Fed's data and then some, and so he must know that another wave of the credit crisis approaches. Delinquencies on Alt-A and adjustable mortgages are accelerating, and prime and jumbo loans are now starting to suffer. And rumor has it that commercial real estate loans are the next shoe to drop. Another wave of losses means that more banks fail, credit gets tighter, businesses contract, layoffs accelerate and spending plummets.
That we are in deflation now may not be apparent in the prices of goods and services--yet--but is evident by the fact that the Fed is risking massive inflation in order to reflate the economy. Bernanke is frightened to death of deflation, because it is so devastating and so hard to climb out of. It is an economic death spiral of sorts. The Fed is doing everything it can to prop up the monetary system, by dropping money into it while at the same time propping up the bond market by buying medium and long-term Treasuries.
What if it doesn't work? Bernanke's theory as expressed in 2002 didn't anticipate a concurrent banking crisis, at the heart of which is a credit crisis caused by toxic assets of unknown value sitting like a cancer on the balance sheets of the banks. The data suggest that the injection of money into the financial system by the Government (through bailouts, guarantees, preferred stock purchases and mortgage purchases) is still trapped in the financial system. The banks are leaving their electronic money in the electronic vaults of the Fed because they are afraid to lend to one another. This means that all that created money has no "velocity," and doesn't have the stimulative effect intended by the Fed. Thus the country risks sinking further into the deflation trap.
And inflation? It is coming, sooner or later. The Fed's "inflate or die" policy ensures that it will do whatever it takes to get out of the deflation ditch, and eventually we'll recover. The question is, what impact will the government's deficits and the Fed's money policy have on our currency and on the rating of our bonds? According to the IMF the US has racked up almost 12 trillion dollars in debt with another 45 billion in off-balance sheet obligations, not to mention multi-trillion dollar annual deficits for years to come. Medicare and Social Security will go bust before 2017, threatening even more debt in the out years. Surely this will have consequences.
My guess, and its just a guess, is that we will end up defaulting on our debt. This will be done by cheapening the dollar through super- or hyper-inflation to the point that our creditors may as well forgive their loans to us. This may be less bad then it sounds because most other nations will be in the same boat. But the price we will pay for this is the loss of King Dollar as the world's reserve currency. Whatever else that means, it certainly means the loss of our economic sovereignty.
So what happens next is anyone's guess, but for clues keep your eye on the bond market. Thats where the real money is. Yields on 10-year Treasuries, which anchor mortgage rates, are over 3%. The Fed will try to suppress these rates with more debt purchases, but at some point they will run out of bullets. If and when that happens, rising rates will threaten the bond market.
I don't know quite what would follow a crash of the bond market. But I suspect it wouldn't be pretty.
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