Friday, February 20, 2009

The Circle of Lies

Circular Money(TM): at least that's the PG-version of what several correspondents are calling it and we'll explain later. But first a little background. Quite a few folks have expressed concern about the Fed "printing" massive amounts of dollars and putting them into the economy, which will trigger inflation. This is certainly a reasonable fear given the numbers being thrown around and the rhetoric coming out of the Treasury and the Fed. However, we do not believe that the fear is well-founded and our evidence come from the Fed itself. Consider the latest report on reserve balances.

The total balance sheet has expanded by an alarming $1 trillion or 110% in 12 months - very disturbing. But the key question would be is any of this actually printed into existence? To determine this, look at the other side of the balance sheet - the liabilities and capital. Liabilities have expanded by $1,032 billion and capital by $3 billion. Liabilities mean the the assets are funded by borrowing. Real printing would go straight to capital since it creates no offsetting liability. The minuscule increase in capital is easily accounted for by interest on the Fed's bond portfolio so we may safely conclude that little or no actual printing is taking place - much less the monstrous quantities that some would suggest. So the money is being borrowed; now let's look at the liability details to see from where the incremental money is being borrowed.
  • $78 billion worth of Federal Reserve Notes has been issued - increasing the amount in circulation by 10%. This is a function of demand for cash, not Fed policy. Increasing distrust of banks naturally leads to an increased preference for cash instead of deposits.
  • $32 billion of reverse repos - that is the Fed borrowing from other financial institutions using its Treasury holdings as collateral
  • $917 billion of "deposits" - now a deposit is a loan so this is the Fed borrowing once again. Let's break this down further:
  • $216 billion is borrowed from the US Treasury - through the general and supplemental accounts
  • $699 billion is from "depositary institutions" - i.e. banks.
This last one really should get your attention. You might say "I thought the Fed was lending money to the banks!?!" and you'd be right. Then the banks are turning right around and lending that money back to the Fed. It would be as if George "lent" money to Bob and then Bob turned around and "lent" that money right back to George. If the "loans" were for $1, they each now have an asset (the loan) and a liability (obligation to repay) of $1. But that is a sham transaction, whether for $1 or $1 billion. They have both expanded their balance sheet, but how much actual lending took place there? In reality, nothing changed except a meaningless book entry and the same is true with the Fed and the banks. George and Bob could exchange "loans" of $1 billion dollars and it would be just as ineffective as what the Fed has done. This is what we have dubbed Circular Money(TM).

Keep in mind, this is Circular Money(TM) only to the extent to which the entries offset and that is not a perfect match but very close. TAF loans increased by $388 billion and "other loans" (the rest of the alphabet soup) by $139 billion for a total of $527 billion vs $599 billion the banks lent to the Fed. The remainder comes from assets the banks sold to the Fed to raise cash. Clearly a large portion of the $34 billion in agency bonds and $65 billion in mortgage-backed securities (MBS) also was sold by banks. The money comes from the Fed and goes right back to them. Here again we see the Fed's actions in light of their attempts to maintain the deception. They started to pay interest to the commercial banks on required and excess reserves in October 2008. They are currently paying the banks 25 basis points (0.25%) on all reserves deposited with the Fed. Note that the Effective Fed Funds rate is a nearly identical 22-24 basis points. The ability to pay interest on the reserves was critical to offset the interest cost of borrowing. This way the imaginary accounting entries can be maintained nearly indefinitely with interest paid neatly offsetting interest received as well. The interest differential on huge sums of non-existent money would have unmasked the deception fairly quickly otherwise.

The Big Con
This game has no effect in reality, so what is the purpose of the Circular Money(TM) deception? It is yet another con game by the Fed to convince people that dead banks aren't really dead because Ben Bernanke says so. As long as a critical mass of people continue to buy the party line, the zombie banks will continue to lurch about spastically. We have long contended that the Federal Reserve is a very weak entity in reality and it's greatest power is that people THINK it is powerful. They announce things intended to influence the behavior of those under this illusion. They threaten to "print" in order to stoke fear of inflation and get people to act accordingly - they seem to be hoping to restart financial speculation by scaring people into draining their savings or taking on debt. But if the Fed could actually induce inflation, then we should already have it already as they've been taking radical action now for over 18 months. When the current threats fail to become reality, the already damaged credibility of the Fed will be severely compromised.

The concerns about inflation would be very serious if any actual printing were taking place but that would destroy the banking system - which is the last thing they want. As things stand, the money exists only in theory and cannot be lent outside the banking system since it doesn't really exist. In order for it to exist outside this circle of lies, the Fed would have to find a large funding source beyond the banks themselves to replace any funds the banks lend out to the economy rather than back to the Fed. They would have to compete for that funding with the Treasury who needs to borrow over $1 trillion in short order. Now do you see why the Fed prefers this deception to going to the market and trying to get that funding? If they tried and failed, it would reveal the Great Oz as the helpless little man behind the curtain that he really is.

Tuesday, February 3, 2009

Smaller Piece of a Smaller Pie

We would just like to summarize the macro picture of the era we are leaving in order to understand the era we are entering. We have been blogging about the credit dangers on Financial Jenga since 2007 and warning about them even longer than that. The global scope of the financial crisis should surprise no one. Didn't we hear all about "globalization" for many years during the synchronized boom? That level of integration virtually guaranteed that any bust would be synchronized as well.

Nearly all other economic ills stem from the mainspring of a deformed and distorted credit system. For many years now, the foundation of the entire world economic system has been the willingness of the average American to spend their entire income - and more besides. This blog described the magnitude of that "more" in its very first entry. That foundation is collapsing and the global system is flying apart as American households suddenly realize that they are in a hole and stop digging. Savings rates have rebounded from negative territory almost back to 3% per the Bureau of Economic Analysis. The fact that Americans are saving again is viewed as a disaster by the Keynesian orthodoxy, which seems oblivious to the need for savings as a source of capital. They are going to have an absolute coronary when US savings rates begin to approach the historical norm of 10% +/- 2%.

The renewed interest in savings certainly will impose short-term pain on a distorted economy based on excessive consumption. The foundation of the economy will have to shift to something more balanced. The simultaneous and related desire to reduce debt is going to accelerate the shift. The pie of funds available to spend is shrinking as income falls in real terms and willingness to take on debt disappears. In addition, the slice of the pie going to consumption is shrinking (it couldn't exactly grow much beyond 100%) as a tiny piece is actually being allocated to savings again. Activities dependent on profligate spending are suffering badly. It was this insight that led us to forecast the consumer spending collapse and the subsequent implosion of the export-dependent economies.

As the cure of a mountain of debt, our government now proposes to borrow in OUR name thus fitting our children and grandchildren for the chains of debt slavery. We must exert ourselves to stop the madness. Though it is financial rather than political, this quote from George Orwell's 1984 seem utterly apt. As Inner Party member O'Brien explains to the protagonist:
If you want a vision of the future, Winston, imagine a boot stamping on a human face forever.