Below is article explaining currency madness of the Fed...
Exponential Growth is spades? Hyperinflation? Massive societal/political Impacts?
Currency Collapse seems assured.
by Eric deCarbonnel
At least 70 percent of all US currency is held outside the country, and this means the US monetary base is considerably smaller than the fed’s overall balance sheet. Take, for example, the true US domestic money supply at the beginning of September 2008, before the fed started its quantitative easing. From the Federal Reserve’s website, we know that currency in circulation was 833 Billion. This translates as 583 Billion dollars circulating abroad (70 percent), and 250 Billion dollars circulating domestically (30 percent). Since the bank reserve balances held with Federal Reserve Banks were 12 billion, that gives us a 262 Billion domestic monetary base as of September 2008. Now compare that to the projected US domestic monetary base for September 2009 which is 3,818 billion (4,500 billion – 583 billion (dollars circulating abroad) – 99 billion (other fed liabilities not part of the money supply)). The fed’s planned balance sheet expansion results in a 15-fold increase in the base money supply.
262 Billion = US monetary base as of September 2008 (minus dollars held abroad)
3,818 Billion = projected US monetary base in September 2009 (minus dollars held abroad)
3,818 Billion / 262 Billion = 15-Fold Increase
This is a staggering devaluation of the US currency! That means for every dollar that existed in America in September 2008, the fed is going to created fourteen more of them! Below is a rough sketch of what this Increase in US monetary base would look like:
1) The toxic assets filling its balance sheet
Expanding the money supply is easy. All the fed has to do is print dollars and then use them to buy assets. There is no effective limit to how much the fed can print and spend.
Shrinking the money is much trickier. To shrink the base money supply, the fed sell assets and takes the dollars it receives for them out of circulation. The amount the fed can shrink the money supply is therefore effectively limited by the market value of assets on its balance sheets. Since the fed is in the process of loading up on toxic securities trying to restore health to the financial sector, it is now sitting billions of unrealized losses. These unrealized losses means the fed has little ammunition available to bring the money supply under control.
Once September rolls around, If the fed wants to reverse the expansion of its balance sheet and shrink the monetary base back down from 3,818 billion to 262 billion, then it will need to sell 3,556 billion worth of assets. However, the market value of its assets will only be worth a fraction of that.
2) Political constrains on fed's actions
Even if the fed does try to shrink the money, it is likely to run into political constrains on its actions:
A) Selling toxic assets at a loss could become a crippling source of major embarrassment for the fed, undermining its authority. For example, last year when the fed took 29 billion toxic assets to help JPMorgan’s takeover of Bear Stearns, it assured Americans that by holding those securities till maturity, the cost to taxpayers would be minimal. If the fed sells those toxic Bearn Stearns assets at a catastrophic loss, it would cause fury and outrage from voters and lawmakers.
B) Selling assets at below book value will quickly cause the fed’s equity to turn negative. The federal reserves would then need to be recapitalized by new debt from the treasury, which would increase the national debt.
3) The benefits from of its balance sheet expansion which would be lost if the fed starts selling assets
The fed is accumulating toxic mortgage backed securities, long term treasuries, and other assets to unfreeze the credit markets and spur economic growth. Turning around and selling those assets would result in the collapse of the credit markets and the financial system, which the fed has been desperately trying to prevent.
Below are the nine factors which will cause yields to move higher:
The biggest force of upward pressure on treasury yield is without a doubt the trillions of debt the treasury is going to sell to finance the US’s enourmous 2009 budget deficit. There is nowhere near enough buyers to this supply. The graph below demonstrates the challenge facing the treasury in trying to fund this year’s deficit.
Federal and state agencies will be selling treasury reserves. For example, the Deposit Insurance Fund (a.k.a. FDIC) will be selling treasuries to pay back depositors of failed banks, and the Unemployment Trust Fund will be selling treasuries to make payments to the unemployed.
State and local governments will be selling treasury reserves. As an example, states have already begun drawing down reserves as their budget troubles worsen. The bulk of those reserve remain, and they will be sold over the course of this year.
Banks and insurers will be selling off their treasury loan-loss reserves. Financial institutions have been building their treasury loan-loss reserve for the last year in anticipation of growing defaults. In 2009, this process will reverse as loans go bad and insurers make good on claims.
Even China could become a seller of treasuries as it mobilizes its dollar reserves. The Chinese government has sent clear signals that it is shifting from passive to active management of its reserve and is exploring more efficient ways to use its reserves to boost its domestic economy.
2150 billion (Federal old-age and survivors insurance trust fund)
615 billion (Federal employees retirement fund)
318 billion (federal hospital insurance trust fund)
217 billion (federal disability insurance trust fund) (for more on these four funds, see where social security tax amounts deposited)
3300 billion total
Today, the accumulation of treasuries by government retirement funds is now over. Baby boomers are beginning to retire, increasing outflows, and unemployment is rising, cutting inflows. More importantly, the 3.3 trillion already accumulated in these funds provides an enormous political incentive to prevent treasury prices from collapsing. Faced with a run on treasuries, politicians, rather than explaining to baby boomers that their retirement savings are gone, will instruct the fed to monetize treasury bonds. This alone will prevent the fed from reversing its current balance sheet expansion.
These higher risk premiums are the result of reversing the process by which credit-default swaps were leveraged up and packaged into investment vehicles. Some examples of these horrors are:
Synthetic CDOsAs opposed to regular CDOs (which contain actual bonds), synthetic CDOs provide income to investors by selling credit-default swaps on hundreds bonds from companies and governments.
To juice returns, these synthetic CDOs disproportionally insured the riskiest AAA rated debt, such as Lehman’s bonds. Synthetic CDOs are estimated to have sold insurance on between $1.25 trillion to $6 trillion worth of bonds.
constant-proportion debt obligationsCPDOs are specialized funds which work exactly like synthetic CDOs but with one major difference: they used leverage to boost returns. These CPDO
credit derivative product companiesCDPPs are another group of specialized funds which work exactly like synthetic CDOs and CPDO funds, except for one key difference: they used an insane amount of leverage, as much as $80 for every dollar invested. CDPP funds together with subprime CDOs squared are finalists for the title of “most idiotic financial instrument ever created”.
Since these leveraged investment vehicles sold an enormous amount of insurance, the premiums for CDS insurance dropped sharply, making corporate debt seem safer and lowering interest rates. In effect, the process of building up the 53 trillion CDS market created an era of artificially low risk premiums on all forms of debt. Unfortunately, the pendulum is now swinging in the other direction, and the pain has just begun.
As investors attempt to get out of synthetic CDOs and CPDO/CDPP funds try to deleverage, they push up the cost of default insurance. In turn, that raises the risk premium on all forms of debt since most investors use the cost of default insurance as a guide when deciding at what interest rate they will buy bonds.
The graph below shows how the cost of insuring the debt of EU nations is being driven up.
The rising cost of insuring debt is impacting treasuries too.
Step 1: Wall Street embraces a false paradigm
“Housing prices never fall”
“gold is a relic” or “gold is in permanent downtrend”
Step 2: Wall Street makes billions embracing this false paradigm…
US/UK Financial institutions made billion in fees from making mortgage loans and securitizing them.
US/UK Financial institutions made billions via gold carry trade. Here is an ultra quick explanation how it works from zealllc.com
Commercial banks and speculators are left inescapably short gold. This ridiculous short position is best captured by John Hathaway in his 1999 article,
Gold prices shoot up after the 1999 Washington Agreement on Gold (EU central banks agreed to limits on gold sales/leasing).
This gold bear trap is best described by Reginald H. Howe in his report about central banks at the abyss.
Step 5: The US fed and UK do everything in its power to “safe the financial system”
Royal Bank of Scotland bailout
Bear Stearns bailout
US/UK Quantitative easing
Leasing out all US/UK gold to bullion banks
Gold swaps with foreign central banks (then leasing out the gold)Convincing allies to sell gold
Writing naked call options on gold
Britain’s 1999 gold salesPre-emptive gold sales
Allowing JPMorgan’s and HSBC’s manipulation of COMEX futuresEtc…
Make no mistake, gold prices have suppressed, but calling this process a “conspiracy” would be inaccurate. Gold suppression by the US and UK is better characterized as a desperate cover-up. Furthermore, while a side affect of the gold carry trade and gold suppression was to drive down interest rates, that was never the .
A desire to hold interest rates would not have been enough to push the fed or bank of England to manipulate the price of gold. It was only the threat of the total collapse of US/UK financial system which prompted the suppression of gold. The unwinding of the gold carry trade would have (and will) drag the some of the biggest US/UK banks under (JPMorgan, HSBC, etc…) and that was what had to be prevented at any cost.
Stay away from any form of paper gold: GLD (HSBC is custodian), gold pools and unallocated gold accounts, gold futures, etc… Paper gold investments are guaranteed to default before this crisis ends.
Besides leaving the financial system inescapably short gold, the gold carry trade also drove down yields on treasuries and other US debt, as commercial banks invested the proceeds from the sale of borrowed central bank gold and other naked short positions. Unwinding the gold carry trade involves the purchase of physical gold, but also the sale of the investments linked to the gold short positions. As the fed begins 15-fold expansion of the monetary base (which logically should eventually send gold prices up at least ten times where they are now), the unwinding and fallout of the gold carry trade seems imminent.
While the accumulation of oversea dollars has been beneficial in the past, today the large pools of dollars circulating outside the US pose a threat. With many dollar alternatives becoming available, US oversea currency looks increasingly likely to start flowing back home. The main currencies with the potential to displace dollars are:
A) Chinese yuan is becoming an international currency
B) Gulf states are launching their own currency called the Khaleeji and possibly be backed by gold.
C) Euro with its partial gold backing
Furthermore, now that the fed has begun creating money at an accelerating rate, the extensive foreign holdings of US currency might exacerbate the effects of inflation fears. As foreign dollar holders’ confidence in the dollar is eroded, they will trade their dollars for alternate stores of value (yuan, euro, gold, etc…), potentially sending a flood of currency back to the US. If the Fed failed to reduce the supply of currency to counteract dollars being unloaded from abroad, the inflationary consequences would be made worse as the mass reversal of currency flows from foreigners to the US becomes overwhelming.
Same as with the gold carry trade, while the explosive growth in interest rate derivatives did reduce interest rates by creating demand for bonds, I am not sure about the conspiracy element. From everything I have seen and read during the credit crisis, the wizards of Wall Street (ie: the creators of the subprime CDO squared, and other horrors) and the federal reserve seem more like children playing with dynamite rather than masterminds capable of pulling off vast conspiracies.
The greater threat posed by interest rate swap
Besides creating artificial demand for bonds, interest rate swap market pose an even greater systematic risk than the credit default swap market because of its enormous size and the fact that each interest rate swap contract offers the potential for unlimited losses. The graph below should help show this danger.
In a currency collapse (which is where we are headed with Bernanke’s 15-fold increase in the money supply), interest rates follow inflation to astronomical heights. Loans for 24 hour periods and interest rates in the five or six digits are common in hyperinflation, and, should they occur here in the States, anyone “short the swap” (the floating-rate payers) will be crushed into oblivion. At least with credit default swaps, there is a limit to how much investors can lose.
8) The liquidation of the 8 Trillion dollar holdings of overleveraged European banks
European banks increased their dollar assets sharply in the last decade which help drive down US interest rates and absorbed a large portions of America's growing debt. Their combined long dollar positions grew to more than $800 billion by mid-2007. This $800 billion was then leveraged into $8 trillion in US assets. The low capital ratios of these dollar positions were acceptable to regulators because European banks are allowed to apply a lot more leverage as long as they are buying exclusively AAA rated securities.
Unfortunately, as we have learned over the past 18 months, AAA is not always AAA. While much of the AAA rated securities bought by European banks were treasuries and agencies, some of these AAA rated securities were senior securitized loans that are still marked close to par on the balance sheet of European banks despite the fact they trade around 70 cents on the dollar in the markets. The enormous unrealized losses of their US holdings are only one of the problems facing European banks.
The other is the loss of their dollar funding. The enormous leverage employed by European banks to purchase toxic AAA rated US assets was funded in great part by loans from US money market funds. After Lehman's default led to massive withdrawals from money market funds, European banks lost access to dollar financing to billions in dollar funding.
If European banks are forced to sell their 8 trillion US assets, it will crash the credit markets, and they will have to recognize enormous losses. Since the fed is desperate to prevent the collapse of the US financial system, it lent those European banks 600 billion dollars so that they wouldn't be forced to sell. Meanwhile, European banks accepted this 600 billion because they don't want to recognize losses on their toxic US securities.
What is going to happen next with these overleveraged European banks?
Well, if history is any guide, the outlook isn’t good for the US financial system:
“When the American economy fell into depression, US banks recalled their loans, causing the German banking system to collapse”
The same thing will happen in 2009, except the roles will be reversed. It will be European banks that will recall their loans and sell off dollar assets, causing the US banking system to collapse.
What could convince European banks sell off their US assets at firesale prices?
The answer is simple: fear of a dollar collapse. With the fed increasing the monetary base 15-fold, the strategy of waiting for impaired assets to recover becomes meaningless: if European banks fear the dollar might lose nine tenths of its value in the next year, then waiting for assets trading 70 cents on the dollar to recover is a senseless venture.
9) Inflation expectations
The US’s experience during the Great Depression has left America dominated by Keynesian thinking and prone to deflation fears. As a result, inflation expectations are about nonexistent right now despite the current financial crisis. However, the fed’s latest plan to expand the monetary base 15-fold should give pause to the most hardened deflationist. Indeed someone must be worried, because the fed’s Wednesday announcement has caused a dramatic collapse of the dollar:
The sheer size the fed’s monetary expansion and the dollar’s fall will soon increase both inflation and inflation expectations. This in turn will put upwards pressure on treasury yields.
Since the thirty years, long-term interests rates have steadily fallen in US, as demonstrated by the chart below
Logically speaking, the chart above makes no sense. The US fundamental underlying the US economy have grown steadily worse over the last thirty years. For example, in 2006, the US’s current account deficit nearly hit 9 percent of gdp, and economists usually consider 4% to be unsustainable. There are also the US’s chronic budget deficits and the massive projected social security shortfalls. Even more incomprehensible, over the last six months the yield on long-term treasuries has fallen in the face of a disintegrating economy and a massive expansion of the supply of treasuries. This is NOT how the world works: as the financial health of borrowers decrease, their interest rates are supposed to go up. The only rational explanation is that some combination of forces has been unnaturally driving rates lower. These forces, (outlined above) which have driven interest rates down in the last three decades, have today become threats and issues which need to be resolved before the current crisis can end:
The US budget deficit
The crisis in entitlement spending
The trade deficit and large holdings of treasury reserves
The credit-default swap market
The gold carry trade
The 580 billion dollar circulating overseas
The 8 trillion dollar assets accumulated by European banks
The interest rate swaps market
The Keynesian thinking dominating US economic and fiscal policy
Lots of stuff in that article by Eric deCarbonnel to digest, thanks for sharing. Will all the new monetization of debt by the Fed go right into circulation like he suggests? So far apparently the banks are just sitting on the money issued to buy toxic assets and bailouts.
Thanks for the post Nichoman. Very informative read!
Reading through the Skeptical optimist (a good site to get a look at the other side) it looks like the idea is that all this new debt will be null and void when "Later, when the economy recovers." The problem is that I havn't yet seen how this could happen and the 60 min interview with Ben didn't ask any real question like "what about the alt-a option arm mortgages" or "how exactly will the GDP go up when the GDP for the last 10 years has been based on inflating housing prices."
No one has any money left and it will continue as housing prices decline. I really really don't see where people are going to find all this money to spend to raise the GDP again. Are they just completely ignoring this issue? Is there somewhere they talk about this? Not to mention the the energy issue is wiped aside with a "alternatives will save us." I can see what their trying to do and I can see why it will fail.
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