Inflation and Asset Price Responses, and the (Non)Correlation to the Central Bank Policy Stance

I was asked recently to reconcile my position that Quantitative Easing (or similar activity) is not inflationary. Especially when viewed against a ten-year chart of virtually any commodity denominated in US Dollars.

This is a very loaded question and touches on all aspects of economics and the markets (and yes, these are very different things). I also think the framework for the question and its comparison is also incorrect because it make the implicit assumption that the main driver of this price rise is US Monetary Policy (i.e. the US Federal Reserve). This is also very interesting because I have been taking a lot of flak for my positions (both on CAPS and MTaA).

If I was asked this same question two years ago, I would likely have given a very different (and likely far more rigid) answer.

First let me say what I am not:

I am not a Keynesian
I am not an Austrian
I am not an MMTer
I am not a Fed apologist
I am not a Gold Bug
I am not a Paper Bug
I am not a Permabull
I am not a Permabear
I am not dogmatic on any economic theory or economic analysis

So who am I and what do I believe?

I am a student of the market
I am an avid amateur who studies all economic schools of thought and picks out that which makes sense
I do believe macroeconomic analysis is a useful endeavor
I do believe technical analysis is a useful endeavor
I do believe cycles analysis is a useful endeavor

As such I will never take any argument that someone makes completely on faith or at face value. By the same token I will not dismiss any analysis out of hand without considering its merits. This also means that as I incorporate new ideas into my own thinking process, I will let go of previous misconceptions if I believe that they are in error. And I do think some of my previous macroeconomic analysis has been in error. As always, I fully reserve the right to be wrong, and to change my stance upon the discovery of better (more accurate) information and ideas.

Like I have said before (Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis) the study of economics is a study in subjectivity. As such there are only shades of gray and there are two (or more) sides to every position. Anyone who says otherwise is trying to sell you something.

And I have nothing to sell.

I am not trying to convince anybody of anything. I have an analytical mind and I lay out my analysis for anybody to consider. My only goal is to point out things that may not be obvious and to further reasonable discussion and observations regarding macroeconomics and the markets. Maybe you agree with me. Maybe you think I am full of crap. Maybe you don't care either way. I am fine with any of these reactions. As long as one of my posts caused you to think, or to perhaps look at something in a slightly different way, then it did its job.

The reason I say all of this preamble is because I will likely discuss things in a very unpopular light. I might even have some parts of my argument where you are nodding your head in agreement and then I will get a "WTF!" in the very next paragraph. There are a few mainstream ways to looking at inflation vs. deflation, commodities vs. stocks, deficits vs. surpluses, stimulus vs. austerity, and I am convinced that most of the mainstream thoughts are partly (if not completely) incorrect.

You might expect me to throw down some gauntlet, but that is not my intention. Like I said above, I am not trying to convince anybody of anything. And at the risk of sounding harsh, I really don't care if you agree with me. Garnering agreement is not the point of this point. I am just laying down thoughts for consideration, that is the only point of this post.

Understanding the Fiat Currency Monetary System and How the Banking System Works

This is the most important aspect to understanding macroeconomic consequences and to attributing proper causes and effects (and to disregarding fallacious 'causes' and 'effects'). I think the vast majority of macroeconomic analysis is incorrect because it either doesn't properly understand the monetary system, or it assumes the monetary system works now the way it did under a convertible currency system.

Let me first say that I am not agreeing that this is the best monetary system to have. My interest in studying it is to recognize how the system behaves. The point of this post and analysis is not to explore what 'should be'. It is neither praise nor condemnation of our current system. But denying the reality of our system would make me both a bad analyst and a bad investor. And I have no desire to be either.

There are some posts that I have written which are very good background for this topic, and I highly suggest reading those first. I will be doing a lot of summarization in this post (it will be quite long enough as it is).

(1) The Matter of Deficits, Sovereign Default, and Modern Monetary Theory, explores the history of our monetary system, from the gold standard to fiat money, and describes the role of government bonds in both systems.
(2) Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability, describes why banks are not reserve constrained, and shows how OMO (of which QE is nothing but a variant) actually works and why it is nothing but an asset swap.
(3) One of the smartest comments I have read yet regarding Quantitative Easing, Bank reserves are not lent out to the private sector. QE adds banks reserves in exchange for bonds (the swap) and does not give the banking system any more ability to do anything that it couldn't do before.

The first thing to understand is that the money multiplier model is a myth (see here and here). There are so many that point to the massive increase in bank reserves (as a result of QE) and say that 'this is increasing the monetary base and will inevitably be inflationary'. This displays an extreme lack of understanding of how our banking system actually works. If you do want to know how the banking system works (and to understand that banks are not reserve constrained but are rather capital constrained, and targeting reserve levels does nothing to increase the propensity to lend) please read references (1) and (2) above.

What policies like QE and interest rate targeting assume is that monetary policy can drive behavior in the banking system (i.e. that the behavior is driven by the supply side of the equation). And we have seen time and again that this assumption is invalid, that the primary driver of activity in the banking system is from the demand side.

Were low interest rates the primary cause of the housing bubble? Or were lax lending standards? I believe that it is incontrovertible that it was the latter. If someone has a $30,000 income and can buy a $400,000 mortgage (based on no down payment, and either dubious paperwork or loan officers that are very aggressive) on the belief that they can flip the house for a quick profit, would it have mattered if the interest rate was at 8%? Conversely, if interest rates were at 0%, but a 20% down payment was required would people be buying able to buy houses to flip as we saw during the bubble?

My point of discussing all of this in the context of this section of the post is to disabuse you of the notion that Monetary Policy is 'all-powerful' or that it is the primary driver of what happens in the economy. It is a popular theory, and I also believe that it is incorrect.

What this means is that the Federal Reserve is not the all-important entity controlling the markets. Contrary to a lot of stated rhetoric, I think the Federal Reserve is largely an impotent organization. They can 'grease the skids' when inflation expectations are high and they can try to 'jawbone' higher inflation expectations, but at the end of the day their toolset (OMO, QE, etc.) targets only the supply side of the banking system and can purchase assets that only already exist.

I recently had a comment leveled at me that 'I just don't get it', that this is not the way this works, that 'Ben could drop money from helicopters like he said in his speech'. ... Except that he can't. The Federal Reserve cannot arbitrarily print money and drop it on the markets, either literally via helicopters or though the banking system.

Suggesting so displays a lack of understanding of how the banking system works. Everything that happens in the banking system is completely horizontal in nature. Every time the bank issues an asset (a new loan or creation of 'money from nothing') it must also record that loan as a liability. This means that all transactions within the banking system net to zero, and hence the description 'horizontal'. This includes the Federal Reserve. It can change the composition of assets within the banking system (it can create reserves out of thin air in exchange for Treasuries) but it doesn't change the net amount of assets within the banking system.

The only party in the banking system that can can the net amount of assets is the US Treasury.

It is the only entity that can create money 'vertically' (that is, create an asset in the banking system with no corresponding liability). This is critical to understand in order to view the entire monetary system properly. So, if this doesn't make sense to you yet, read ref (2) above and here (read the whole thing, but the section titled 'Mechanics of Federal Spending' is extremely relevant). Conversely, the US Treasury is the only entity than can drain money from the banking system. When the US Treasury spends more than it taxes, money (specifically Federal Reserve Notes = fiat currency) is created. When the US Treasury taxes more than it spends, money is destroyed.

When you realize that full scope of this concept - that all transactions in the banking system net to zero and that the US Treasury is the only entity can add net assets to the banking system - you immediately come to the correct conclusion that Federal Government spending is the source of all money in our currency system.

In order to hammer this point home, consider this question: "What would happen if the US Federal Government issued a one-time 100% asset tax?". Everything would be liquidated and owned by the government. So after this event, how would one acquire a US Dollar if all assets were owned by the government? The government would have to spend new dollars into existence so that the private sector could accumulate them. I am stating this merely to illustrate the point that the US Government is sovereign issuer of the US Dollar and as such is the source of all US Dollars. I am not saying this is good, I am not saying this is bad, I am saying that in our current monetary system this is a fact that should be self-evident.

So let's return to the 'money helicopter drop' idea.

Like I have said repeatedly, the Federal Reserve cannot arbitrarily print money (i.e. cannot increase net financial assets in the banking system, it can only create reserves [out of thin air] in exchange for assets that already exist). But there is one entity that can: The US Treasury.

The US Treasury acts under direct control from Congress. This means that a 'helicopter drop' is NOT a monetary operation. It is a fiscal operation. The US government could instruct the Treasury to credit everyone's bank account by $10,000. Or if it wanted to put on a big show, it could actually print the money and 'drop it from helicopters'. But think about these mechanics. The Federal Reserve actually prints the money. So what happens is that the US Treasury instructs the Fed to increase its account size at the Fed and to print money equal to that account size and transfer it to the Treasury (and would then give it to the Air Force with instructions on where to drop it). So again, the Federal Reserve cannot arbitrarily print money. It can only change the composition of assets that already exist. And in this case the Treasury is the only entity that can arbitrarily increase net assets.

This might seem like I am being facetious, but I am not. This leads to a very important point:

Where does inflation come from? (Hint: It's not 'Debt Monetization')

It comes from Congressional spending.

Monetary inflation and price inflation are not the same thing. They are very different phenomena. One does not always beget the other (especially in terms of relatively short term timing), I will discussing this in more detail shortly. But the very long trend throughout US history of deficit spending goes hand in hand with the long term trend of inflation.

At this point, I will not call inflation 'bad' or 'good'. The point of the post is to simply understand the current system how how things like inflation manifest themselves. Because you can't have an intelligent discussion about outcomes and risks if you misidentify/misunderstand causes and sources.

It doesn't come from the Federal Reserve. I know it is extremely popular to thing of the Fed as some evil organization of banking dictators that can arbitrarily tip the dollar into hyperinflation due to reckless 'money printing'. But that view is completely incorrect.

So why is it so popular to think that? Why do analysts inevitably link inflation coming from the Fed and Debt Monetization?

A quick history lesson is in order. I describe this in much more detail in ref (1) above.

Under the Gold Standard the US Government was required to have all currency issued backed by gold. When the government need to finance spending (say to pay for a stimulus or a war) in excess of held gold reserves, the US government would issue bonds. In this case, the term financing is accurate, US Government bonds under the gold standard were most definitely debt. The US Dollar, being convertible into gold, had that constraint on it. Which meant that the US government was most definitely revenue constrained. That taxes were a repayment of Dollars such that the outstanding liability of conversion back into gold was reduced. Under Congressional mandate, all spending in excess of taxation must be accompanied by US Government bond sales. Sometimes the non-government sector would buy the Government bonds. But sometimes they would be bought by the Federal Reserve. And this is where the term 'debt monetization' comes from. Under the gold standard, US Dollars were convertible into gold which made US Government bonds, which were convertible into Dollars, indirectly convertible into gold. So when the Federal Reserve would issue currency in exchange for those bonds, the debt would become 'monetized'.

That is very different that what happens today in a fiat currency system, and why 'debt monetization' is (at best) an inapplicable and (more often at worst) highly misleading concept.

Since 1971 the gold window was closed. And as I showed in ref (1) this was accompanied by some very ad hoc activities. Namely the issuance of US Government bonds. Since the US Dollar is no longer convertible into gold, it is no longer debt in the literal sense that it had under the gold standard. Since 1971, the US Dollar is one thing only: a tax credit. I have seen many people try to conflate the idea between debt and a tax credit, but this again shows a lack of understanding of how significantly things are different under the two monetary systems. This means the US Dollar has no intrinsic worth. The Federal government issues currency and sets taxes payable only in that currency. It (via the Treasury) is the only source of said currency. It's value is literally fiat. This means that operationally the US Government is never revenue constrained (i.e. that it will always be able to credit accounts without any liabilities via the Treasury to purchase assets and to service interest payments denominated in US Dollars), and it never needs to 'finance' it's spending. This means that under the current monetary system Federal taxes 'fund' nothing and the US Government bond issuance 'fund' nothing.

So then why does the US Government issue bonds now when it deficit spends? Because it is a holdover from the the gold standard days. Nixon closed the gold window but did not think through all of the implications of transitioning to a fiat monetary system. And so original rule issued under congressional mandate was never changed by a new congressional mandate and hence we have this anachronism still in place causing all sorts of confusion with people trying to understand the monetary system.

So then what do US Government bonds 'do'? They allow the Federal Reserve to maintain its target short term rate. Deposits within the banking system create reserves. A bank manager has a few options with what to do with those reserves, after using a portion of those reserves to ensure balances are cleared and other maintenance activities, and to maintain reserve requirements (and it is worth noting that many banking systems in other countries have no reserve requirements at all). They could let it sit in the vault as cash (earning no interest). They could keep it on account at the Federal Reserve (which relatively recently now earn a mere 25 bp, they earned 0 for a very long time before that). They could lend the reserves overnight (at an interest premium) on the interbank lending network to banks that require reserves to meet requirements. Or one of the few options beyond that is the purchase of US Government bonds. Reserves are not lent out. With the purchase of the bonds the banks are able to earn more interest in a very liquid asset (the US Treasury market is by far the biggest on the planet).

This is how this manifests in the current system: The Federal Reserve has a mandate to maintain short term interest rates consistent with its policy goals. If the banking system has a system-wide deficit of reserves relative to requirements, then competition overnight on the interbank network will drive up the short term interest rate. The Fed reacts to this by buying US Treasury bonds on the open market and prints reserves (out of thin air) in exchange for those bonds. The result is a system wide increase in reserves and a system wide decrease in the amount of US Government bonds (an asset swap). This allows the Fed to put a cap on the short term interest rate relative to its policy goals. On the flip side, If the banking system has an excess amount of reserves relative to requirements, then competition overnight on the interbank network will drive down the short term interest rate. The Fed reacts to this by selling US Treasury bonds from its portfolio on the open market. The banks trade their reserves in exchange for the bonds. The result is a system wide decrease in reserves and a system wide increase in the amount of US Government bonds (again, nothing but an asset swap). Since the Fed is the entity that 'printed' those reserves to begin with, they disappear 'into the ether' when they are returned to the Fed's balance sheet.

The only reason for a US Government bond to exist in today's banking system is to allow the Fed to meet its short term lending rate based on OMO. In fact, there is no real physical reason for this song and dance. The same policy objective could be accomplished by the Fed setting a remuneration rate at their policy interest rate. The only reason in the current system that banks juggle between reserves and Treasuries is the opportunity cost in obtaining a higher yield with the excess reserves. If the interest rate and the remuneration rate were the same, then there is no opportunity cost differential and the banks would find themselves at no disadvantage to holding on to excess reserves. In this fashion the US Treasury could stop selling 'debt' and the system would be significantly cleaner, and much less confusing.

Once you view reserves and US Government bonds in the proper context as outlined above, you come to the realization that in the current monetary system, bonds are nothing more than a savings account at the Federal Reserve. That's all they are. The US Government issues bonds. The US Government is not revenue constrained and can always 'afford' to service interest payments. The Government instructs the Treasury to pay the interest. The Treasury instructs the Fed to 'print the dollars to service the interest' (i.e. add new numbers to a spreadsheet) via crediting a bank account at the Fed. That is the process. All of the manipulation of 'servicing the debt' happens on the Fed's balance sheet. When an entity sells a Treasury bond the Fed takes the Treasury bond which is logged on the US Treasuries account at the Federal Reserve, removes it from the US Treasuries balance sheet and credits that entities bank account. It is all simply movement of numbers between accounts at the Fed, in exactly the same fashion that one moves money between a checking and savings account at a bank.

Why the Federal Reserve Follows Both Inflationary Cycles and Credit Cycles and Doesn't Lead Them

As I explained above, the Federal Reserve manages the level of reserves in the banking system consistent with it's policy interest rate goals, and can do nothing to affect the level of net financial assets in the banking system.

Moreover, as also discussed above, the Federal Reserve via Monetary Policy is a blunt instrument targeting only the supply side of lending equation. It can force a surfeit of reserves (as it has recently) but there is absolutely no correlation between the level of excess reserves and horizontal lending activity in the banking system.

Under neo-classical economic theory, a large amount of excess bank reserves will lead to an increase in bank lending via the Money Multiplier Model. The very abbreviated version goes like: In a Fractional Reserve Banking System the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves. Which means the higher amount of reserves, the more loans / credit money can be created.

However there are a number of issues with the Money Multiplier Model in terms of being the driver of forcing monetary policy. It basically is a 'supply side' theory in which the bottleneck is the banking system. By increasing the reserves in the banking system, more loans will be made because there is a higher capacity to create loans. This does not hold up with empirical observations (see here).

Operationally, banks are never really reserve constrained. Reserves only need to be met against a 14 day average, which means if you are a bank you can make a loan absent the required reserves at any point. Reserves can be acquired either through interbank lending or the discount window. Moreover, reserves need to be carried against demand deposits (checking accounts). Sweeps have been routinely implemented to move demand deposits into a special purpose savings account (a savings account is not a demand deposit) obviating the need for higher reserves.

In a fantastic paper by Austrian Economist Vijay Boyapati (see here) observation has shown that bank reserve creation by the Fed actually lags banking sector lending

Given that commercial banks are effectively operating without a reserve requirement and that loan issuance is not constrained by reserves, it would be sensible to reconsider the temporal causality posited by the money multiplier theory of lending. If the causality were correct, one would expect changes in reserves to precede changes in the issuance of credit, ceteris paribus. Citing an empirical study on business cycle statistics conducted by the Federal Reserve, Steve Keen explains that the opposite is true:

…rather than [reserves] being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and [reserves were] then created about a year later.

From an Austrian perspective, an empirical argument based on a temporal correlation is not definitive proof of an underlying causality — although it may be illustrative and suggestive of that causality. An explanation for the counterintuitive temporal sequence is provided in a Federal Reserve study of the institutional structure of the US banking system since 1990, conducted by Carpenter and Demiralp. They demonstrate that “reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source of funding, either.” Their point is that when a bank makes a loan, the matching liability used to fund the loan does not need to be reserves created by the Fed.

These two important observations [1) Reserve creation in a 'normal' credit cycle follows, not leads, created loans, 2) Banks are never operationally constrained by reserve levels when making a loan decision, reserves are always found after the fact] should make you question and doubt anyone making the claim that the large increase in excess reserves will result in inflation.

Why the Federal Reserve is a Redundant and Unnecessary Institution and Should be Abolished

I just spent several paragraphs explaining why the Federal Reserve is largely an impotent institution from the perspective of forcing any real macroeconomic activity. So what's with the abolishment rhetoric?

This is one of the few times in this post that I will suggest a course of action, and not simply illuminate the current workings of the system, because the Fed's presence, while impotent, is not innocuous.

Please read reference 4 below for more details:
(4) The US Treasury and the Federal Reserve: Redundant Institutions

Assuming that we will have a fiat currency system for some time (and there is no reason to think that we won't) then having this formally redundant split between the Treasury and Federal Reserve obfuscates the fact that they are really two halves of the same balance sheet. There would be significantly more transparency in how our system works if we did away with this anachronism.

Moreover, the possibility (and likelihood) for corruption is high during times of crisis. The Fed took all kinds of toxic mortgage garbage on its balance sheet (yes, in exchange for reserves printed out of thin air) to save the banks. However, the Fed didn't buy everything nor did it buy unilaterally. It bought selectively and potentially with bias in mind. It has a very cushy relationship with several banks.

So as explained in the monetary operations section above, there is no advantage to be gained by pretending the Fed and Treasury are completely independent institutions when that is obviously not the case, and there are many potential downsides. The upside is a massive gain in transparency, and I think that should be very welcome.

Business Cycles / The problem with attributing a specific period of price rise to 'inflation'

Contrary to all of the statements from mainstream economists in the 1990's, the business cycle is not dead. It was not 'conquered'. The 'Great Moderation' is a myth. The reason why these pronouncements were made was because inflation was down-trending and private sector productivity was increasing (although in the latter half of the 90's, this was not true because of the increasing financialization of the US economy, which is inherently unproductive). This was all attributed to the 'correct balance of monetary policy'.

But as I discussed above, Monetary policy is only useful at greasing the skids during times of moderate to high inflation expectations. It is completely ineffective during a balance sheet recession. And the current balance sheet was not at all predicted by mainstream economists, especially not those in charge of US Monetary Policy.

Because all of them thought (and continue to think) that the economy can be managed from the supply side. And I think that is a very bad assumption.

For every seller there must be a buyer, and for a rational economy (and by extension a rational market) to exist all market actors must behave rationally and respond 'correctly' to all available information, making the economy and the markets 'efficient'. This is obviously not the case (if it was ever the case at any point in time).

Market actors are not always rational, and hence economic behavior cannot be fully determined by supply side actions, because the demand side is not always rational (which further compounds the lie because it assumes that all actions taken by the supply side actors [a.k.a the government economists and the Fed] are inherently rational, which I think is a crock). Let us return to the housing bubble example. Historical data showed the even in the middle of the bubble (before things got really crazy in 2006-2007) that never in America's history did the ratio between home prices and incomes become so large. There were numerous statistics that anyone with an internet connection could have browsed that gave a hint at the unsustainability of the current trend, and the information clearly pointed against a trend continuation. So if all of the actors on the demand side of the equation were rational, how could a bubble form?

The urge to speculate is a powerful phenomena and we see evidence of this over and over again.

If markets were completely efficient, why would there be any P/E variation in the market? Maybe we could explain a minor variation in P/E via cyclical adjustments in the market, but that is not what we see. A 100 year chart of Price/Earnings for the S&P Composite / S&P 500 shows that P/E changes from 5 to 40 on a cyclically adjusted basis. This is not rational.

Markets are cyclical because social mood is an inherently cyclical phenomenon.

Consider this from a slightly different angle: If the long term trend of inflation is caused by the long deficit spending position of the US Government (and I believe it is), why would there be any cyclical variation in prices? Why wouldn't prices march in lock step with the size of the accumulated deficit?

Because markets and market participation is cyclical.

This gets us to the answer to the original question.

- Is inflation directly attributable to the position of the Federal Reserve? NO.
- Is inflation directly attributable to the position of the fiscal policy stance of the US government? LONG TERM YES, SHORT TERM NOT NECESSARILY.
- Are markets cyclical? YES.
- Is cyclical participation combined with long term inflation trends a more accurate description of market behavior? YES.

This is why I have a huge problem when anyone tries to attribute the rise in commodity prices over any period of time to 'monetary policy/money printing/quantitative easing/etc'. It doesn't jive at all with how our monetary system works. It doesn't jive at all with how actors participate in the markets. The monetary stance of the central bank controls the supply side of the lending equation. That's it. It does not either implicitly or explicitly increase the propensity of borrowers to change their position relative to their own balance sheets.

Cycles in any asset class (commodities, corporate investment, housing, etc.) happen independently of the central bank policy stance. They are much more susceptible to changes in the fiscal and regulatory environments (i.e. Congressional action or inaction). Attributing credit booms and busts primarily to central bank activity displays a misunderstanding of both the banking system and the role of the central bank within the monetary system.

Do Deficits Matter, Debt and Deleveraging, Resource Constraints, In/De/Hyper/Stag/etc./flation, Part I

This post is a follow-up to my last post The Matter of Deficits, Sovereign Default, and Modern Monetary Theory found at MTaA or on my Caps blog. Also in the process of writing this post, the length kept increasing that I decided to break it up into a series. This will be Part I.

The purpose of my last post was very specific: To get an answer to the question 'What is the default risk on US Sovereign Debt?'. To be very specific, I was referring to technical / nominal default only.

Another way to pose the question would be this way: 'What should the Credit Default Swap (CDS) rate be on US Sovereign Debt?'

You have to understand exactly what I was asking. In my last post, I was *not* asking 'What is the credit worthiness of United States Government (USG) debt?'. That is a separate issue to whether a sovereign currency issuer can default on their own debt.

The answer I come up with to the question: 'Is there a monetary reason for the USG to ever technically default on its debt?' is NO

Even though this is not the most important question (credit-worthiness and the 'value' of USG debt and the Federal Reserve Note [FRN, a.k.a. the US Dollar] are the far more important questions), it is still a very important question and a very important point to make. Because there is the perception today that the USG can technically be forced to into a position to default on it's debt. And per my last post, the conclusion that I came to and painstakingly demonstrated is that this is an incorrect operating assumption.

But now that we have settled that point (which is important because we can now adequately separate credit risk from default risk) we can get to the more important questions.

From my last post I wrote this definition:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.

This last sentence is not technically clear enough and will be the entire crux of this series of posts. Here is the way I should have written it:

From the standpoint of servicing it debt (not considering the value of the currency), the US Government is never revenue constrained

As I will discuss in-depth in this series of posts, there is a very big difference between technical default (which as I argued in the last post has no monetary basis for occurrence for a sovereign currency issuer) and effective default.

The point of this series will be to answer (or at least explore) the ideas of deficits, credit worthiness, and scenarios where the USG can effectively default.

In my last post, in order to properly answer the question 'What is the default risk on US Sovereign Debt?' we had to first understand more fully the fiat monetary system we currently have. We needed to understand the role of the US Treasury and the Federal Reserve in the current system, and it helped to understand the historical reason for them coming into existence. Please, if you have not done so already, read my last post (MTaA or on my Caps blog) since I will be drawing heavily upon and continuing this line of thought.

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Okay, let the fun begin :). In order to explore these ideas I will start out with two examples which will be necessarily basic and contrived, in order to get across key ideas clearly. But I will add more realistic complexity later on, so please bear with me and (hopefully) enjoy the ride :)

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Lets say in the entire world there are only two countries: Joeyland and Bobtenstein. They are sovereign entities. Moreover Joe is the leader/ruler/owner/dictator/what-have-you of Joeyland and Bob is the same for Bobtenstein. This makes Joe and Bob the only two sovereign entities in the world. And lets further say that the population of each country is identical with, I don't know, 1 million people each.

As sovereign rulers both Joe and Bob are responsible with coming up with and administering monetary systems. Bob comes up with a gold standard and calls his currency the 'shiner' and Joe comes up with a fiat money system and calls his currency the 'joeybuck'.

Further: Bobtenstein does not sit on any gold deposits. Everything was mined out of the ground and is in Bob's possession. As such there is a fixed amount of gold in Bobtenstein which the population is already aware of. Also Joeyland starts out with a fiat money system. This is different than the United States which started out on gold standard and transitioned to a fiat money standard. This was a scenario that I explored in-depth in my last post. So as such, Joey does not have a Central Bank or a Treasury (which as I demonstrated previously have no real use in a completely fiat system). Bob on the other hand only has a Treasury. There is no Central Bank of Bobtenstein (we will address this one in a bit).

So here we go. We have two countries, two rulers, two currencies. How do things work? Or more importantly, how do things get 'started'?

Lets start with Bobtenstein

Bobtenstein is a beautiful, but large country. There are isolated villages each living near various natural resources: lakes, grasslands, forests, mineral deposits, etc. They are happy, keep mostly to themselves, and are just living off the land. Bob, who is a nice guy and wants to do right by his people (we will call him a benevolent dictator), thinks that natural resources near one village could benefit the inhabitants of another village, and so he wants encourage the sharing of natural resources. Essentially he wants to Bobtenstein engage in commerce. Now, like I said, he is a nice guy and wants people to be happy. And he thinks the best way for this to occur is for people to determine for themselves what things are worth. Not to divvy up all of the natural resources (some of which are significantly more labor intensive to extract than others) and spread them out equally.

So Bob calls up his Treasury (after all he needs a building to warehouse the gold), tells them the plan, and takes half the gold (the 'shiners') in the Treasury and goes to every villager and gives them an equal share of the shiners. He explains his idea, says that every shiner is exactly the same. In order to get things started, he sets the price of a good based on the amount of labor it took to produce. But he then further explains that these prices are not set permanently, because he knows that eventually supply and demand will determine the actual prices and that they will change over time based on harvests, good fishing years, lumber quality, etc.

Bob is a happy guy, his people are happy. Bob has no army. He just wants things to be pleasant. But Bob is a busy guy checking up on the villages, and doesn't have time plant, fish, chop wood, etc. But he has the other half of his country's gold in his treasury. So what Bob does is spend just enough out of the Treasury that it takes himself to live on and what it costs to employ the keepers at the Treasury. But realizing that this action would create an imbalance, Bob implements a tax. The tax is shared among everybody, so that each person pays a small percentage of the amount of gold they hold and when totaled equals that which Bob spends in a year. This way his budget is balanced. His Treasury takes in what goes out so that it always contains half of the gold in existence. And the gold in circulation is always constant.

Commerce develops. People become more connected. Villages become more connected. People start to specialize in their crafts/labors. Bob likes what his country is becoming. Everybody is happy.

Now lets go to Joeyland.

Joe and Bob, despite being separate sovereign rulers, are good friends. Joeyland is very similar to Bobtenstein in that it has isolated villages and diverse natural resources. Bob tells Joe what he has been doing in Bobtenstein, says that it is great! He is happy, his people are happy, life just seems richer with everybody interacting.

Joe likes what he is hearing. But he thinks Bob's gold as a currency idea is dumb. First Joe doesn't have any gold anyways (that is the only real difference between Bobtenstein and Joeyland) and second he thinks gold is dumb. It is shiny and it is heavy. He finds it unwieldy. Third, he hates the name 'shiner', he thinks it is idiotic. But Joe does want Joeyland to benefit from the same style of commerce that Bobtenstein does. Joe is also a very nice guy and he wants his people to be happy. So in lieu of gold, Joey implements his 'joeybuck' idea.

Joe goes around to all the villages explaining his idea, just like Bob did. But instead of handing out gold, Joe hands out pieces of paper with his face on it. He says that this is legal tender for trading purposes. He gives everybody an equal share of the joeybucks. And basically does the same thing as Bob. He prints up a bunch of them, gives half to the population and keeps the rest for himself (and he doesn't need a Treasury, they are just stacks of paper).

He also implements a tax, just like Bob did and for the same reasons. Joe is very happy to see that commerce does ensue in Joeyland just like it did in Bobtenstein. People are happy, they like the joeybucks (Joe is a handsome guy so it is a nice picture which the ladies definitely appreciate), they like the trade, they like the interconnectedness. Joe is happy.

Okay.

So I apologize for the cartoon-ish story, but I wanted to set up something simple first to illustrate some ideas to come.

If you recall from this post (The Gold Blog and scroll down to just before comment #1) I put together criteria for defining money and the characteristics it should exhibit, which are: 1) Money must be valued equivalently by all parties in the exchange, 2) have enduring value, 3) be regulated, 4) be liquid and 5) be fungible. I went through a similarly cartoonish (but ultimately useful) example of the failure of trying to use Snickers bars as money. If you haven't read that post before, I would encourage you to do so now. I wrote it over a year ago but I think many of the concepts are still useful. You will also notice, if you read the entire post, that I talk about debt servicing burdens and default risks of the US Government. I make some observations in this gold post that I have proven incorrect in my last post. My own view and understanding of this topic is constantly evolving. I have no problem admitting when I am incorrect in an assumption and I am willing to put my thoughts down as an object lesson so that you can see where I either make good points or learn from my own past mistakes. My hope is that my reasoning is useful, even if it takes me awhile to come to the right conclusions :)

The first observation to be made is that both systems behaved effectively identically. In this case the gold standard was operationally equivalent to the fiat money standard. Why? Precisely because the money supply was fixed in both cases. This being the case, because Bobtenstein and Joeyland have materially similar natural resources and the same population, the pricing structures of those natural resources will also be materially similar. The gold standard was neither better nor worse than fiat money in this case.

But here is another subtle point. The populace of Bobtenstein knew already that there was no more gold. That the amount of gold that Bob had was all there is. Therefore they knew a priori that Bob couldn't make more and that each shiner was always going to be worth the same. The populace of Joeyland did not have that luxury. They were being handed a piece of paper which might or might not be fixed in scarcity and told to exchange it for goods, as opposed to the Bobstensteinians who did know that their shiny yellow rocks were fixed in scarcity. But since Joe personally vouched for the fixed supply of Joeybucks, and everybody trusts Joe, and Joe has never given them a reason to think otherwise, they do trust the joeybucks. And everybody is happy.

What I am trying to (hopefully successfully) get at is the idea of trust in a currency. Trust is *not* just applicable to fiat money, but the gold standard as well. I mean why didn't the Bobstensteinians trade yellow rocks before? What was the reason to trust it? It is because Bob set up the framework within which gold could act as a currency. And once it became accepted as such, the idea is self-perpetuating, because the Bobstensteinians knew that the gold in circulation was a fixed quantity. Once the trust in the shiner was started, there was never any reason to 'untrust' it. This is not quite true for the Joeylanders. There is an initial ramp up in trust required for the joeybuck, just like there was for the shiner. But there must be renewed trust with each transaction since the only reason for the fixed quantity of joeybucks is based on Joe's word. As long as the trust between the currency holder and the sovereign currency issuer remains intact, the currency will always be viable. Trust is the key.

There is another salient point to make here. Recall this statement from my last post:

The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!! Is this true, does this even make any sense? The answer is yes.

Lets apply this statement to the example of Joeyland and Bobtenstein.

Neither the Joeylanders nor the Bobstensteinians had a currency before Joe and Bob introduced it. So, by definition, when Joe and Bob invented their currencies, and they are the sovereign entities, they had all the money and the population had no money.

But we need to think a little more philosophically here. Let's say I am the only person in the world, the last man on Earth so to speak, and I have a billion dollars, just stacks of $1 dollar bills sitting around, do I actually have money? It is true that it looks like money and has George Washington's face on it. But is it 'money'? .... The answer is no. Because for money have have any meaning, for it to exist there must be two or more parties that a) have goods to exchange for it (otherwise they are just passing the same papers back and forth) and b) all parties must be willing to accept that the money as a store of value (otherwise why trade real goods for it). So as the last man on Earth, even with a billion pieces of green paper, I don't have money. Or said another way, money is the potential of a currency to enact commerce. If there are no other parties, or the other parties don't have money and goods, then commerce is not possible (I am referring to the trade of goods for legal tender, not bartering which can obviously happen without money).

So in exactly the same manner, since the populations of Joeyland and Bobtenstein has no money, and Joe and Bob were the only ones that did have money (and for the purposes of this example Joe and Bob cannot trade with eachother, e.g. the SHN/JBK is not a recognized symbol :) ) money for all practical purposes doesn't exist.

It comes into existence the moment that both Joe and Bob spend it into existence. In the example above, they simply give half to the populace. They simply spent without getting anything in return (like a donation is a charitable action, but it is still technically spending). But the point is that the money was effectively 'spent into existence'

Further, now that the money is in existence, then the second observation from the previous post can be made: This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity. The population has (is saving) half of both Joe's and Bob's original amount. It is savings for the private sector and identically debt for the public sector (in this case Joe and Bob).

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...Okay! This is very good!

We now have operational concepts for money, savings, currency trust, as well as a set of (albeit simple) examples against which we can exercise and verify some of the concepts from my last post.

Now, let's make things more interesting .... :)

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This post is already long enough, so I will save the more realistic additions for the next post in the series. Unfortunately both Bobtenstein and Joeyland will be subject to 'monetary innovation' and 'creative accounting', and our happy land will not be so happy soon :(

Using the example countries defined in this post, the next post will cover these topics: revenue constraints, deficit spending, structural debt, private/private debt, public/private debt, bonds, taxation, etc.

I think this will end up proving a rather useful exercise. Stay tuned!

The Matter of Deficits, Sovereign Default, and Modern Monetary Theory

Okay, fair warning. This is going to be one of my "thinking (and probably unfortunately rambling) out loud" posts. But I really do hope you read it because I am looking for feedback in this post. Because some of the conclusions I come to are ..... disturbing.

Let me also preempt the reading of this post and any subsequent discussions that I am not advocating for *anything* in this post. I am simply exploring what the world would look like if I were looking through Modern Monetary Theory's eyes.

The reason for this post:

I am very concerned about sovereign debt risks and the possibility of sovereign defaults. From a traditionalist standpoint, the US is running massive budget deficits, and issuing bonds at an alarming rate to try to keep the stimulus going but also just to simply keep the government running. Tax revenues are falling. This also seems incredibly unhealthy and unsustainable.

So from this point of view, the default risk of United States sovereign debt is certainly not zero. There are arguments regarding the size of the risk (based 90% debt-to-GDP, 100% debt-to-GDP, etc.). There are a whole host of ways to look at sovereign risk in historical terms.

Now there is another point of view, the Modern Monetary Theory view, regarding the sovereign default risk of the US

.... and it is 0. Not 0.0001%, not 0.00000000000000001%, but precisely and identically zero.

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I have been doing a lot of reading, thinking and pondering on this topic. I want to take you all along for my thought experiment ride. And I want to solicit feedback regarding the validity of my analysis. Again, I am not looking for ideas on whether the current framework is 'good or bad' (even though inevitably some of my own thoughts on the matter are likely to show through). I am trying to simply understand it. Understanding is, after all, the key to risk evaluation.

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So the idea goes like this

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.

Why?

Because notice in our definition of the FRN the Fed does not have to look at tax receipts or the size of the national deficit or the success of bond auctions with China and Japan as buyers. It quite literally says 'I have a million/billion/trillion/etc. FRNs in my account today' and can subsequently fund the government with whatever it needs instantaneously.

Now I expect a lot of people are yelling at me right now and saying "it's not that simple!". Which is technically true. But the reason, which I will show in a second, is because of a hold-over from earlier monetary times. There is literally nothing that would stop funding of the USG in this manner in practical terms. But even the the term 'funding' requires clarification in the MMT framework which I will get to in a minute.

First, let me address the "it's not that simple!" criticism with a simple question:

What is a US Government Bond?

From here: A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company. A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France. It was in the form of a tontine.

This definition makes sense. It is what we are all used to. And let me illustrate why: The British Pound Sterling, or the US Dollar (not FRN, remember the Federal Reserve is a recent invention historically speaking) used to be convertible currencies. That is you could 'convert' the currency for a specified amount of gold or silver. In the past, governments were most definitely revenue constrained. There was a fixed amount of gold and silver in the world (new mining supply adds to the above ground supply historically by 0.25-1.5%, very small and largely insignificant).

So in this case, how does a government run a deficit?

You bet, it issued debt in the form of bonds. Creditor nations (ones that ran budget surpluses, based on collecting more taxes than they spent) could loan gold and silver, or their own currency (and since it was convertible was equivalent to loaning gold and silver), to debtor nations to fund projects. In the quote above, it was to fund a war.

The government bond market was basically invented as a way to get around the gold standard. Now, I am not trying to cast judgement, I am simply reviewing history to see what makes sense. Quite often a government felt an activity was so important that it felt like it needed more money than they had immediately (which generally boils down to two categories: wars or stimulus). Since the gold standard is by definition fixed, it requires all budgets to be balanced. You cannot spend more money than you have. Unless you have a alchemist in the back room turning lead into gold (which coincidently, alchemy was a *government* funded endeavor in the Middle Ages). The reason is simple. Again, I am not casting judgement, just making an observation. Politicians and Bureaucrats are not accountants and economists. They don't want constraints. Balancing a budget is hard. Fiscal planning is hard. Large expenses in the short term mean cutting elsewhere to balance. Politicians like to promise, and they are quite bad (historically speaking) at taking away.

So this is where the very rich history of sovereign defaults originates. When a government takes out debt and spends it on unproductive endeavors (war being most egregious form of an unproductive endeavor) or even endeavors that are simply less productive than the rate of borrowing (i.e. the debt incurred does not increase GDP and/or tax revenues to cover the servicing cost), then the deficit becomes structural. Historically the accumulation of too much structural debt is the primary reason for sovereign defaults under previous monetary systems.

... okay, so the point of that was to show why Government Bonds came into existence in the first place. Again. I am not labeling them as 'good' or 'bad'. I am simply trying to recognize where they came from and how they fit into today's world.

Now lets fast forward to 1971. (I am skipping over a lot of important details, such as The Federal Reserve Act of 1913, the Bretton Woods Agreement, etc. Because I am focusing on sovereign debt in this post and trying to answer questions regarding default risk)

Nixon closes the gold convertibility window. This means that the FRN (not the US Dollar anymore) is 100% fiat for the first time. The reason? To pay for the Vietnam War. Now I am sure a lot of economic historians will argue with me regarding its usefulness in removing the world from the shackles of gold or other ideological statements. My point in making this statement is that the conversion in 1971 was based almost completely on practicality. The US Treasury could not honor gold and silver commitments, we were engaged in an escalating war, the traditional route of USG bond offerings were getting progressively worse (interest rates), so it was time to change the rules of the game.

And the point of this post is to realize just how much they changed. And I have been thinking about this for a long time. I have written many posts regarding macroeconomics and the US Dollar, making many of these same observations that I have made in this post. But this point is, until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So, as a testament to the haphazardness of the implementation of the 100% fiat currency experiment, I will pose simply one question:

What happened to all the USG bonds?

Recall what I said at the beginning of this post:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are way that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve Note (FRN from now on), which is of course the US Dollar, is monopoly issuer of the currency and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs. What this means is that the US Government is never revenue constrained.

In 1971, we got rid of the gold standard and made our currency 100% fiat. In a 100% fiat system, the currency issuer is never revenue constrained. So in this system, government bonds are irrelevant.

Practically speaking it was something that the government did not want to deal with in war time. I mean countries all around the world held USG bonds. So what would have happened? Do we covert bonds to currency at prevailing rates (like I said, there is no limit to the amount of FRNs the Fed can produce, so it could have converted all the obligations with one stroke of the pen, this was before proliferation of computers :))? What happens to unpaid but implied future interest? Do we negotiate for foreign currency holdings? How should it have been handled? As you can see, it would have been an accounting nightmare. So what did they do instead? They punted.

They left a pre-fiat concept (from above: the government bond was invented as a way to get around the gold standard) in place in a newly 'minted' (sarcasm intended) fiat world, because it was too complicated to figure out how to sort it out, and go to this new currency regime, and fight a war all at the same time. Again, I am simply trying to look at this historically, not ideologically. Because what we have now is a mess, and it doesn't make sense. And I am trying to understand why it doesn't make sense.

So now I am going to fast forward to today. Again, I am going to skip over concepts like The Great Moderation (which is a huge debate, but I am not going there at the moment), and The Credit Bubble. Because I am trying to get at Sovereign Default Risk and the place of Treasury Bonds in our current monetary system.

What happens with a USG Treasury Bond today? What is it's function? purpose?

Remember again what I said at the beginning: In a 100% fiat currency system, the sovereign issuer is *never* revenue constrained. So in our new monetary system, we don't actually need to sell bonds to raise revenue. Japan nor China is our banker in this case. In China's case, they buy US Treasuries to manage the yuan exchange rate: Steve Saville: Getting Some Things Straight Regarding China

So what gives? The Fed-Treasury "dynamic duo" is one of the keys to how our modern financial system "works"... right? Let's see what's going on under the hood (from http://pragcap.com/when-will-the-bond-auctions-begin-to-fail):

So what happens when we auction bonds? Well, the NY Fed has accounts all over the country. The Treasury keeps very close tabs on excess reserves so as to avoid overdraft at the Fed. So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves. Why do they do this? Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves. Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit – TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

So now I need to back up for just a minute and address the The Federal Reserve Act. The idea of founding the Federal Reserve back in 1913 was to address the "booms and busts" that occurred under the gold standard. The idea being that the Federal Reserve could manage the money supply, expand and contract it somewhat around the gold standard to even out the boom/bust cycle [rant alert! I need to interject in my own thought because even though this whole idea sounds nice, neat and smart in theory, the fact of the matter is that booms and bust did *NOT* happen because of the gold standard, but because of deficit spending / bond issuance by not adhering to a gold standard. The boom/bust cycle is primarily driven by excess government indebtedness, which eventually migrates to the private sector leverage, which begets speculation. The formation of the Federal Reserve is simply the 'fix' to a misdiagnosed problem. end rant]. So they had a very specific function and mandate under a gold standard (and we can argue endlessly whether this is good or not), but they have no true mandate under a 100% fiat standard. I will finish this train of thought up in a minute.

I now have to return to the statement in bold near the top of the post: until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So what is this alien idea? It is expressed here which I will sum up (http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation)

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).

When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.

Basically it means this: The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!!

Is this true, does this even make any sense?

The answer is yes. Like I said, in 1971, the implementation of this system was ad hoc, basic questions about about the treatment of USG bonds were left unanswered, the role of the Fed (which is irrelevant in this system) was left in place to keep the hold-over "funding" mechanisms intact (even though as I have demonstrated above, they are not necessary. The Fed buys Treasuries to manage rates, not fund the government).

Again, I have touched on this idea in the past in my large gold and dollar posts, but never has it been so clearly and simply stated. I mean, it sounds so ridiculous when stated that way. But the government spent 100% fiat money into existence which is why we have money. This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity.

.... okay.

So let's answer this question first, before I go on:

Can the US Government default on its debt? The answer I come up with is: No.

There is no monetary reason at all for this to ever occur. Congress may do so out of spite, everybody at the Fed may get food poisoning and not be there to buy US Treasuries during an auction. But there is no monetary reason for the US to default on its debt.

.... I have thought long and hard about this, and this is my conclusion. So before I go on, the question I have of the group is: Does this make sense?

Moreover, any country that is the sovereign issuer of their own currency has no monetary reason to ever default. This would be notably Great Britain and Japan (more on this at a later time).

However, any of the Eurozone countries could default, since they cannot issue their own currencies. The ECB controls the currency and Eurozone members cannot create as much money as they wanted to service their debt. This means Greece, Italy, Germany, etc. all non-zero sovereign default risks.

DO NOT MISINTERPRET WHAT I AM WRITING! I am *NOT* saying that this situation is 'good' or 'bad'. I am first just trying to recognize 'what is' so that I can confirm my analysis and move on from there

..... If this is leaving you a little queasy feeling, you are not alone.

Because then it really further fractures the concept of money.

Fair warning, I will probably digress a little here, but I think it will be useful.

If the USG is not revenue constrained then there are three items in existence that had reason to exist in a gold standard but have no reason to exist in a 100% fiat money system: Federal Taxes, The US Treasury and the Federal Reserve.

Federal Taxes: If the USG is not revenue constrained, then taxes serve no true economic purpose. The tax code is complicated, antiquated, and wastes so much time and energy. So if the Federal government does not need tax revenues to operate, which by my observations above then it doesn't, then it is simply an unnecessary and costly (in terms of wasted productivity) hold-over from our earlier monetary system.

The US Treasury: It's main job was to hold the nations gold and silver, and to issue and manage debt offerings. None of these are applicable in the current system.

The Federal Reserve: It was invented to add flexibility that the gold standard didn't offer. Now it has a made up / ad hoc mandate of "targeting a stable inflation rate". The market can and should determine what the price of money is (which is what interest rates are) based on supply and demand.

.... These may sound extreme. But my point is stating these observations is that WE ARE LYING TO OURSELVES!. At the government level, we keep talking about funding, taxing, spending as if we were on an earlier monetary system. But as I observe, these are ad hoc holdovers based on a quick transition to a 100% fiat monetary system. The are confusing holdovers that should be eliminated.

But here is the crux of the matter: Governments always want a free lunch.

Look at the history I laid out. The bond market was invented as a way to get around the gold standard (free lunch with the risk of sovereign default), the Federal Reserve was invented as a way to get around the gold standard and the bond market (free lunch with the risk of sovereign default and bigger speculative bubbles), and the 100% fiat currency system is just the next evolution of the free lunch mentality.

At least I posit that it was when it was implemented.

The problem is that any government has never been a good steward of the peoples money. Yes, yes, I know this is a loaded statement, but I am sure good debates will ensue. But my point is that in a 100% fiat money system, the monetary supply is so much more susceptible to manipulation and politicization. We need to think very carefully if this makes sense for us or for the world.

The gold standard or the 100% fiat money standard is neither good nor bad in and of themselves. They are simply systems. How easily those systems are 'gamed' / subverted is the more pressing question here.

There is a whole other line of though regarding 'do deficits matter', 'deflation', 'hyperinflation', the current recession, stimulus spending, etc which speaks to 'good' or 'bad' and I will not address them here (however you can be sure I will in another post :) )

However.... I can foresee a 'good' outcome out of all of this (the ideological side of binve is shining through :). And that is if a government does spend money into existence, and the citizens either spend or save depending on where we are in the business cycle, and if there is no Federal Reserve then interest rates will reflect the actual demand for money. This would be a remarkably self-regulating system. Then when the government decides it wants to go to war, etc. interest rates will eventually reflect the citizens reaction to this. And interest rates are not important for bond auctions, but rather the cost of borrowing for the citizens (while the USG is not revenue constrained the citizens definitely are). And so while governments can spend like crazy, the health of balance sheets in the private sector is always the measure of a nations economic health (which is why we call this current recession a household balance sheet recession). Productivity doesn't come from the government, it always comes from the private sector. This is precisely the problem with centrally planned economies. But I am veering off topic and that is a discussion for another post.

I think this *could* be a step in the right direction towards more transparent Free Market Capitalism (assuming the Fed is abolished). Now I am not 100% no-government. They serve some very useful purposes such as the maintenance of environmental laws (at least the laws that are not written by corporate lobbyists. But we have crony-capitalism now, not free markets) and the funding of pure science endeavors that may not have immediate practical value but have far reaching beneficial human impacts. However, governments are very bad at economics and monetary policy and they should stop messing with both.

In a 100% fiat system, everything regarding the confidence of your system is reflected in your currency. And without the gamesmanship of 'selling bonds' when it no longer necessary, then a global economy could be more fruitful, productive, balanced and fair based on honest market driven exchange rates.

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So.... what do you think? Am I full of BS? Am I fundamentally not understanding the monetary system at play here? Do you agree / disagree?

Please discuss!!

Doctor, It hurts when I do this

Doctor: Well then don't do that .... (yuk, yuk)

So the question is, what is "Doctor Copper"'s diagnosis for the economy? I would say pretty crappy.

"binv you are just a stupid permabear! Copper has obviously been rallying so you are obviously wrong!!"

Maybe. But the rallies recently look a lot more like a reaction than the start of a sustainable bull move. I think we have a bit more upside in copper (few more days / weeks), but then I think it will start correcting again. I think the large corrective structure since the beginning of 2010 is not done yet.

Also, as I have stated many times, here is my observation that both equities as a general asset class and the Dollar can fall together: US Dollar Count Updates, and why I think real assets will certainly outperform purely economically correlated assets and have nominal gains as well: Long Term View. I am also one of those whackos that think Gold is money and not a commodity and am bullish on Gold first and foremost quite independent of the inflation / deflation debate: binve's Gold Foil Hat Zone: More Thoughts on Gold's Massive Bull Market

My point in stating all this is that while I am bearish on Copper for the intermediate term (next several months), I am quite bullish on Copper for the long term (next several years). This is NOT because of an "economic recovery", but because Copper is a real asset and I expect most real assets to perform well. I view the next several months as a potentially very good long term entry point, much like December of 2008 was (and yes I did buy a couple of Copper Miners there, but mostly Gold and Silver Miners).

Just a few thoughts at any rate.

US Dollar Count Updates

See this original post for why I am fundamentally and technically bearish on the US Dollar for the long term: Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog -   Sep 17, 09. And per my Dollar/Equity correlation charts, this does not make me "bullish" on equities. What this is illustrating is a loss of confidence in US Sovereign debt, the US currency and the US financial markets at the same time.

My contention is that this can absolutely all happen at the same time. And the question is not one of simply "inflation or deflation".

I have been hammering on the topic because it is the critical issue to understand how all of the advanced economies government's action will not only fail to produce the desired effects, but will more importantly make matters worse. The main issue is  Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. It is critical to understand that an increasing debt load has decreasing marginal utility and there comes a point due to servicing requirements that all new debt has a negative economic impact. This is why we were NEVER going to be able to borrow and spend our way out of a crisis that was caused by too much debt to begin with.

This sets up an extreme deflationary environment (this debt load is unsustainable) within which the Federal Reserve will monetize unprecedented amounts of debt at unprecedented rates. Which will result in a simultaneous deflationary and inflationary outcome: stagflation. There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes.

I do think that most inflationists discount the amount of debt that is collapsing (even though most deflationists use measures like M2 and M3, which have a lot of non-monetary components to prove their point) while at the same time most deflationists discount the amount of monetary inflation the Fed can generate (they argue that the Fed creating base money is like pushing on a string because the banks don't have to lend, even though I am many others have pointed out that the Fed has gone around the banking system and has started monetizing private sector debt directly, which is a trend that is likely to increase not decrease). Most people on either side of the debate is not considering strong evidence that both forces are significant.

So in short, I not only think it is possible that we have falling equities and a falling US Dollar at the same time, I think it is likely.

binve's Gold Foil Hat Zone: More Thoughts on Gold's Massive Bull Market

WARNING!! binv's Tin Gold Foil Hat Zone !!


.... Just call me a Gold Bug. (In case you didn't notice, I am being sarcastic. Because anybody who is bearish on gold labels anybody who is bullish on gold a Gold Bug. But that's fine, I will take it).

I am very bullish on gold. This is no surprise. I have written on the subject of gold many times.

The main reason why I am bullish on gold is that it is in a massive bull market in comparison to fiat money. Gold is a currency. Like any currency, you don't own it because it has intrinsic value, you hold it because it is a store of wealth. So when I say gold is in a massive bull market in comparison to fiat money, I mean exactly that. Gold will hold its value while fiat money is devalued in comparison.

As Gary says: Gold is not about price, gold is about value

We have one of the final possible bubbles at it's apex: A Sovereign Debt Bubble. Economies all over the world are suffering and are trying to solve a debt related crisis with more debt. It was *never* going to work and will end badly.

So when ranking currencies relative to each other, and all the major currencies are engaging in some form of Devaluation / Quantitative Easing, they are all fighting debt with more debt.

The problem is debt.

And the Fed has made it very clear that monetizing as much debt as is necessary to keep the system going, at the direct expense to the Dollar, is not only a course of action that is open to them, but THE course of action that they are taking and will take. This plan will continue until there is no longer a Federal Reserve.

Yet the market is trying to purge excesses, and the Fed and the Treasury is not allowing it to happen.

This makes the outcome both simultaneously deflationary and inflationary. The market wants to, and desperately desires to save, but the Fed is directly hurting savers behind the backdrop of *extreme* monetary inflation.

I have been hammering on the topic because it is the critical issue to understand how all of the advanced economies government's action will not only fail to produce the desired effects, but will more importantly make matters worse. The main issue is  Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. It is critical to understand that an increasing debt load has decreasing marginal utility and there comes a point due to servicing requirements that all new debt has a negative economic impact. This is why we were NEVER going to be able to borrow and spend our way out of a crisis that was caused by too much debt to begin with.

This sets up an extreme deflationary environment (this debt load is unsustainable) within which the Federal Reserve will monetize unprecedented amounts of debt at unprecedented rates. Which will result in a simultaneous deflationary and inflationary outcome: stagflation. There is NEVER anything in economics and especially macroeconomics that has only one cause and one effect. There are always multiple effects with varying degrees of influence (both in absolute value and transience). There will be deflationary impulses and there will be extreme monetary inflation, the Fed will see to that. Which means that I think the most likely outcome will be a combination of the two: stagflation. Economically correlated assets go down in value (like your home and equities as a general asset class) and things you need to buy/consume (such as real assets / commodities) cost more. Really the worst of all possible outcomes.

I do think that most inflationists discount the amount of debt that is collapsing (even though most deflationists use measures like M2 and M3, which have a lot of non-monetary components to prove their point) while at the same time most deflationists discount the amount of monetary inflation the Fed can generate (they argue that the Fed creating base money is like pushing on a string because the banks don't have to lend, even though I am many others have pointed out that the Fed has gone around the banking system and has started monetizing private sector debt directly, which is a trend that is likely to increase not decrease). Most people on either side of the debate is not considering strong evidence that both forces are significant.

The result is and will be stagflation. It is really the worst of all possible outcomes. The economy needs savers and the Fed will not allow savers to be compensated for their risks. This will ultimately result in the collapse of the bond bubble as there is no longer any faith in Sovereign Debt. And the world will turn to real assets as a store of value.

And this sets up the final bubble ... the Gold Bubble.

Now I don't mean this pejoratively. And I am not casting a negative connotation on it. Bubbles are what they are. When Central Bank monetary policy forces all of us to become speculators by not rewarding savers, then bubbles are formed.

Gold doesn't care that it is in a bubble. It is quietly and quiescently preserving wealth. Again Gold is NOT about price, gold is about value.

I don't hold gold because I like shiny objects. I don't hold it because it makes the world go round. I hold it because it will be the last currency standing that preserves wealth as the world's economy goes through this painful deleveraging process.

No fiat currency will preserve wealth. Certainly not when this crisis has run its course. Some will fare better than others (many will fare much better than the US Dollar), but all will pale in comparison to gold.

The current trend of piling debt on top of debt is unsustainable: Debt Saturation - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=357428. And neo-economists and politicians have to get their collective heads out of their collective asses and not allow a vampire industry (financials) hijack the real economy. But since that won't happen willingly, then the market will force a crisis that will fundamentally change how we view politics and the economy. Crony capitalism will go away. Good laws like Glass-Steagall will become reinstated. Too big to fail will be abolished. Grass roots companies will grow like a new forest. The Mittelstand companies of Germany (small/medium firms, mostly family owned) is exactly the economic model that most of the western world should be following, and I believe will in the future.

And when the crisis nears a real bottom, I will be the first person to dump my gold and invest in the new world economy. One that produces goods, and solves problems, and increases the quality of life for humanity.

Gold is not an end in and of itself. It is a means to an end, a way to preserve value as the economy purges excesses so that the new economy can be invested in.

It is a way to save. And since the Fed is not allowing us to save in the Dollar or Treasury debt, people will turn to saving in real money.

I don't care if you don't agree with me. I don't care if you think gold is a useless shiny rock (it is, just like the Dollar is a useless piece of green paper). I am not here to convince anybody of anything. I am just stating my opinions and why I have them.

I have complied a long list of posts that I have written discussing my macroeconomic views on the Dollar, Inflation/Deflation/Stagflation, and Gold. These might be useful in understanding why I have come to these opinions:

--- Debt Saturation - LINK
--- Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR - LINK
--- What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations - LINK
--- Thoughts on the Euro, the Dollar, and a Long Term EUR/USD Count - LINK
--- Something Very Strange Is Happening With Treasuries - LINK
--- The Long View - LINK
--- The Gold Blog. Gold/Silver/GSMs (and a little Oil for good measure) - LINK
--- Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog - LINK
--- The Dow / Gold Ratio - LINK
--- The Gold / Silver Ratio - LINK
--- Gold Miner Performance Relative to Gold - LINK
--- Gold Miner Performance: A Look At Miner Cost Inputs vs. Gold Price - LINK

US Dollar






Bonds



Gold

Monthly Chart - tune out the noise



Elliott Wave Counts










.... at least that all makes sense if you are crazy like me :)

Thank You for visiting binv's Tin (and Gold) Foil Hat Zone