Debtor's Prison

Greetings Fellow Inmates and Truth Warriors:

Once again, it has been a long 11 days since we last convened in these hallowed halls.   To you, the faithful readers, it might seem the regularly of our posting has become increasingly erratic, and for that we apologize.   But let us assure you, not a moment goes by when we are not thinking about our prison, economic and otherwise.   Our relative silence for the first month of the Gregorian year has fortunately provided Our Mission with many blessings, and has been partly intentional.     As recent initiates into the Information Superhighway, we have recently begun to utilize a few means of disseminating our Conversations to direct other Inmates to participate.    For this single post, we will not utilize these, and try to remain as Silent as possible.   We only do this because what we have to say is important, and we wanted the faithful to assemble quietly.

There are many of you reading this that have been here from the beginning; when we first gathered nearly a year ago underneath the Platanus occidentalis in The Yard to discuss our prison; some of you were probably here when we made our first attempt to prove that Everything Does Indeed Happen for a Reason (EDIHR).    Well, we are about to give it a Second Go, and this time we intend to follow through.

If any of the above makes any sense to you, then you probably have a deep understanding of our utter contempt for Judy Greenscam.   You might even have begun to realize that she is nothing but a symbol for the depraved nature of our penitentiary system.    The Truth is that We are prisoners on many levels, not only economically.    We have discussed economics because it seems like that’s what most of The Enforcers are concerned with, or at least that at which they are good.    While we certainly dabble on the philospiritual at times, and will again, we promise to stick mostly to economics, on a macro level.  

Our wholehearted compassionate-anger towards Judy has certainly come to a crossroads.   We’ve come to realize that perhaps we have been using our Energy unwisely by being “flippant”, as a ModernMystic recently called Us.  Well Friend, perhaps you are right.    The time for double-entendres is over; not only is greenscamspeak bad for the soul, Judy is not the best-looking of tango partners.  

So, here is the Truth.   This Space has been used as a testing-bed of ideas amongst a select few Friends and the wandering travellers that sat in to participate.    Amongst our most fervent beliefs from Day One have been that EDIHR and Truth Always Wins, as it is The Law.   Rooted in these beliefs, we are 100% fully confident that the ideas are brewing that will finally deal Judy the final ignominious death for which she has been yearning.    We will begin to compile the most succinct, thorough, true, and rational treatise on economics that we are humanly capable of producing.   Though some of the ideas contained in this Prisoner’s Journal are merely notes, there have been some worthy nuggets of wisdom that will make it into the Final Work.  Not only will some bits of staff work be reproduced, but also some readers have already earnt enshrinment in the Book; Discipulus, CM0101, Mr. Petri, Buddha, Teonanacatl and Ramos, to name a few.  

In any case, very strong evidence will be forthcoming once we DEFINITIONISTS deals those ECONOMISTS a swift death.   Surely, we recognize the magnitude of this endeavour, and for that, we are giving ourselves Time.   This forthcoming Volume will be finalized by 12.21.12, a little less than three years from now.   The authorship of the book will be assigned to each correspondent in relevant parts, according to their alphanumeric id here in this prison.   The real author is Truth; hence the names of these parts of the eMouthBrainWikiMachine are unimportant.    If you are reading this message here today, then you will physically receive a copy of the book by 07.11.13 (we will see who you are and find you).   We give Ourselves 7 months to find you only because some of you live off-the-grid in places accessible only by mule.     We sincerely hope that on the day you receive The Book, you will move one step closer to believing in EDIHR.

Surely, it seems like we are the Underdogs, sort of a David and Goliath story.   After al, The Economist camp features such stars as MiltonKeynesSmith.   But, we sure as hell going to try; inmates, after all, have nothing but Time on Their Hands.     In our first attempt to prove EDIHR we made a small wager (which You have yet to claim – hurry!).   In this one, we will make the ultimate wager.   If we do not produce such a Volume on economics and deliver it to You by 11.07.83, we will cease our Work in these hallowed halls.   We decided this because not only is this enough time for us to achieve our Initial Purpose, but also because we know that it will be our Best Effort and ultimately because we get bored studying the theory of scarcity when we would rather be enjoying the reality of abundance. 

How will a band of wholly destitute inmates and brothers stand against such a formidable opponent as Judy, with her 666 talents of gold?   Well, we have Faith than when the Time Comes, 777 Archons of Truth, will come to our aid.   Finally, before we resume our study of economics next week with a Series of on-the-field posts from correspondents in China, we Wish to say this.    This Call to Arms is but the beginning of a Series of Missions, code-named Please Help Ireland (PHI).   We strongly urge you to participate not only in the creation of this Volume on economics, but also in the larger mission, whose emblem we BOLDLY reproduce below.   When you see this Judy, be afraid;  We’ll meet you in the Field of Darkness, 777, G;G;G   



Greetings Fellow Inmates,

It has been a long 20 days since we last convened, so we wish all our readers and friends all around the global penitentiary system a prosperous start to 2010.  We have spent these 20 days on leave in a fruitful little corner in The Yard; we played, we toiled, and return refreshed to our regular routine.   For this first post on the new year, we thought to begin with what will be one of the central themes of our discussions in 2010; money, itself.    In many ways, we have already spent a great deal of time thinking about what constitutes money, its sufficient and necessary conditions, and attempted to come up with some draft definitions.   2010 is likely to be a year that will lead to many people to question very basic notions about risk, wealth (what it means and how to preserve it) and well-being.   Now, let us be clear and specific.   We have thus far made very few predictions about 2010. As many of our readers know, we are weary of prognostication; we mostly like to spot problems and inconsitencies, whose eventual consequences become impossible to time given the chaotic nature of herd behaviour and information absorption coefficients.  We did predict however that by 11.07.10, Uncle Benny will have increased quantitative easing, and put our money where out mouth is.  The most recent Fed Board Minutes confirm our suspicions.   This alone could be enough to trigger a collective “realization” that QE is getting out of control, and in combination with the rising inflation pressures continuing and worsening in 2010 could really lead investors worldwide to seriously question the viability of the current UST/USD-denominated system.   Therefore, we are strongly predicting a very significant lack of confidence in the UST/USD-system, as qualitative as this is.  Will 2010 be enough to break the greenback’s back?  Who knows, but the first flowerings will certainly appear this year.  Make no mistake about it, the coming crisis will be one of confidence, a break of the faith in the system.    A central tenet of the broken faith will be to shift from paper/digital assets into real ones.   When the full crisis is set and done, most of us will have been forced to re-evaluate what constitutes “real” wealth, and how to best store it; a discipline we have long forgotten generationally (since 1933), and will thus lead us to question basic notions about money.

Tonight, our discussion will be framed by an exceptional essay written by one of the most notorious characters in the twentieth century, Judy Greenscam.  As a brief aside, we’d like to direct our readers to “The Enforcers” section, where we have just added a bio sheet for Judy Greenscam.  Once again, this section is highly recommended reading and well worth your while.   Moreover, we would like to announce a contest where the first reader to correctly identify the origin of the nickname “Judy” will win an autographed copy of Judy’s book, The Age of Turbulence shipped anywhere in the world, as well as permanent enshrinement in Judy's biosheet; we have left ample clues throughout the website.    Anyway, back to the essay.

The piece, grandiosely titled “Gold and Economic Freedom”, first appeared on 01.06.66 in Ayn Rand’s “The Objectivist” Newsletter.  It really is a marvellous brief treatment of the gold standard and how it protects/defines wealth so much better than a paper fiat system.  Imagine that: Judy at one point was succinct, precise, thorough and piercing.   Of course she was!  The whole greenscamspeak charade was nothing but a smoke-and-mirrors show, at which Judy maniacally and hysterically laughed in private.   But that is neither here nor there.   The true value of Judy’s piece, which we recommend you read in its entirety, is its attempt at clear and unquestionable definitions of money, wealth and savings.   Judy’s words ring just as true today as they did in 1966, and will remain true for the foreseeable future: such is the nature of exact and rigid definitions.   We will quote Judy in italics, and we begin with the most basic definition of all. 

Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.

General and robust, we shall adopt it; whenever we use the word “money”, we mean the above.  Beyond this literal definition however we will, of course, still explore all the ontological, philosophical and ultimately practical nuances of properly defining/designing a form of money, or store of wealth.    Judy then proceeds to describe some of the features of such a medium of exchange, in much the same way we have attempted to do many times here at DP.   Quite fundamentally, she asserts that a universally accepted medium of exchange allows market participants to “store wealth”, or rather, “save”.   This is of course, the crux of the issue, and one that we will continue to flesh out in 2010, just as we started way back when back when in “A Brief Commentary on Intrinsic Value and Stores of Value”.

Judy proceeds to make several bold statements concerning gold’s role as protector and insurer of economic freedom.   It is extremely ironic, yes, but also mind-bogglingly ridiculous that such an intelligent person, capable of emitting such harsh maxims and syllogisms about gold as economic liberator can then become the Chief Architect of the system created specifically to remove said gold standard¸ and thus, according to Judy, created to economically imprison the populace.    If you are unable to see how this is an enormous case of doublethink then we suggest turning off your BlackBerry, your BloomBerg, and stop listening to Barack oBama.  Judy’s following statements about gold are, again, mostly interesting when juxtaposed to the actual system, for which Judy is perhaps most single-handedly responsible.

Thus, under the gold standard, a free banking system stands as the protector of an economy's stability and balanced growth.

When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. 

It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World Was I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

The statements speak for themselves, but we mostly emphasize the nature that gold leads to quick and efficient market corrections, as it inhibits the accumulation of excesses (unlike paper).   There is ample historical evidence for this, and we strongly urge you to verify this yourself.   Perhaps at some point, we will model this in history (some sort of depth studies of recessions on/off gold standard), but for now our intent is not to expound on the nature of the gold standard, nor even evaluate the merits of Judy’s claims.  We merely point out again the deep and troubling irony of Judy’s avowed knowledge about the nature of the gold standard, 21 years before she became Chairman of the Fed, acting directly against the interests of “Economic Freedom” as she defined it here in 1966.   It’s almost like Judy likes playing the “contrapositive”, or the “receptive” end of the negative.  Hmm.

If banks can continue to loan money indefinitely-it was claimed-there need never be any slumps in business. And so the Federal Reserve System was organized in 1913.

This is a marvellous quote that aims a painful arrow of truth at the Fed’s little heart-place-holder.   This is the principal alleged reason why the Fed was created; to eliminate the business cycle.   If a central bank could create liquidity at will, it was claimed, businesses would never run out of money.   Well, this hypothesis has now been unequivocally, often and robustly proven to be false.    Hence, on its outwardly public purpose, the Fed has failed miserably.   It should be abolished, and a new system devised.   The one thing the Fed has done however though, invariably, is to increase inflation.   Just look at the CPI chart in our previous post.   At creating inflation, the Fed has been an enormous and unwavering success.   This, we believe, was the actual real purpose of creation of the Fed: to create a persistent and stable inflation and thus deprive the populace of their wealth.   The people in charge of the world are very successful at achieving their aims, so as the obvious architects and players in the Fed (again, see The Enforcers), we are confident in assuming that the actual purpose of the Fed is precisely that at which it is the most successful, creating inflation.   This amounts to the grandest-scale theft, a gargantuan erosion of the wealth, a mass impoverishment of the world’s peoples.   Some might call us histrionic, but we beg to differ, and so does Judy.   We are simply sticking to definitions, as was Judy back in her 1966 pre-greenscamspeak days:  a system that creates/promotes a persistent inflation is equivalent to a system that discourages long-term saving, erodes wealth and deprives its participants of economic freedom.   Or as Judy says, remember, way back in 1966,

The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods.

Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.

We could have hardly said it any better, right on Judy.   Let us repeat, “Deficit spending is simply a scheme for the confiscation of wealth.”  Scheme. Confiscation.   Strong words.    We would absolutely love to simply sit Judy, Uncle Benny Obummer, Granpa Volcker, and Mayo Larry in a room as ask them to respond, in the most clearly-worded way possible to the above quotes.   They are largely irrefutable, barring any semantic Idea Shape-Shifting such as that Judy would later-on perfect.  Deficit spending causes greater in debentures, which only increases the ratio of claims to assets, leading not only to further economic imprisonment (in time-terms), but also much greater risk of systemic fiat collapse.

It’s amazing to think the kind of world we would currently live in if the person that wrote this article in 1966 would have actually served as the Chief Monetary Authority in the World for 19 years.   Instead, what we got was Judy, one of the puppeteer’s many masks (also one of the most funny-looking ones).    

We thus conclude this little post.  We will now resume regular postings on DP after our little vacation.  We will resume many of threads we began late last year and cover some of the most pressing developments in our financial and economic universe.    Ultimately, it is important for DP staff to constantly evaluate and reiterate the purpose of our little endeavour.   We are truly immersed in a life-quest to unravel the different risks and economic shackles that imprison us.   We have found that some of the simplest questions pose the most difficult conundrums and are the most problematically dealt with in our current world.  We do not, however, believe we are bound for eternal failure.   It is entirely within the grasp of human intellect to arrive at sound and robust definitions of value and money, to at least a modicum of self-consistency, and build an economic system around them that does not violate or “fuzzy-up” these definitions.    We will attempt this exercise for ourselves, as it will offer invaluable insights for the rearranging of our own lives and risk, and we will fervently hope that our discussions here help further the mental discourse of at least a few survivors that will shape the system of tomorrow.

May your capital be safe and your investments prosperous,

MAAA

Greetings fellow inmates,

As we contemplated whether our last post of the year should be the standard “Predictions for 2010”, we can across a post on the great Jesse’s Café Américain.  In an article entitled What Will the New World Reserve Currency Regime Be?, Jesse discusses the apparent imperative of ushering in a new monetary system in the form of a single world currency.   One Single World Currency (SWC) is a topic that we have discussed many times from the very early days of this blog.    For months, our discussions have focused on the causes behind the eventual collapse of the current USD-backed financial system, the apparent INEVITABILITY of this collapse and the very high LIKELIHOOD that the proposed solution to this will be a global monetary system backed by a single currency unit – perhaps a modified version of an IMF SDR as Jesse suggests, or something new altogether.    While most of our energy has been spent demonstrating the high likelihood (in our opinion, inevitability) of a SWC, we have been cowards when it comes to taking a stance on a SWC either way.  Our apparent neutrality thus far has been largely motivated by a desire to remain unbiased while we explored some of the Numbers/definitions first.   Having set these foundations and thought about the matter for some time, the gloves finally come off and we declare ourselves to be VEHEMENTLY OPPOSED to a SWC, both technically and in principle and spirit.   Naturally, building our case against SWC will be a task that will span several posts, but this post will aim to give you a broad overview of our thinking.    Perhaps some might consider it a futile exercise to refute something that seems inevitable.   However, it is an Obligation to speak up against a new system that aims to imprison us even deeper than we already are.  Besides, the “inevitability” of the system around us should never be a reason for complacency since, after all, we will never be able to break our shackles unless we understand their weakness.   Ultimately, unlike many of you fellow inmates who despair at the prospect that we have all been sentenced for life with no possibility of parole, we remain optimistic that we will one day escape this debt prison and emerge into a world built on solid, better foundations.   Our discussion of a SWC will naturally touch on very abstract and foundational topics such as “value”, “money”, “debt”, “production”, “the future”, “density”, “cyclical and dynamical theory”, amongst others.   We will also provide Numbers and calculations for all these premises in the next few posts, but for now, we aim to give you an overview of the battle ahead.  Let us start at the beginning.

Despite our silence, we have intuitively been averse to the idea of a SWC for a long time.  Mostly because we know that a SWC will be administered by the Ancient Clan of Wizards of the Black Arts, who boast of a millenary record of imprisoning every man, woman and child they can get their hands on and then bleeding them dry.   The staunch severity with which several prominent people have endorsed the idea of a SWC as the only solution to our current problem also makes us sceptical, since it smacks of the traditional modus operandi of The Powers That Be (TPTB) when they aim to justify the implementation of heavier control following a crisis.  Our initial bias notwithstanding, let’s begin by thinking about potential benefits of a SWC.

At first rational glance, there seem to be several advantages to having a SWC.   For starters, proponents argue that it would be more efficient than the current system of mostly sovereign currencies.  Having multitudes of national currencies means that every time one currency is exchanged for another, some value is lost since the bank usually keeps the bid-ask spread (the difference in the rates they use when they buy or sell a given currency).  In aggregate, a SWC would not really cause a significant change in the value of these “erosion” losses, but simply transfer wealth from banks to the productive element in the economy.  In other words, the institution of a SWC would create an effective tax cut in transactions across the board, of varying magnitudes depending on your position in the local supply chain.   We do not have estimates at the moment on what would be a likely distribution of the “beneficiaries” of that tax-cut, but for the moment let’s assume it’s just the global economy as a whole.  Bear in mind that if we consider the economy as a whole, of which banks is a subgroup, the benefits of this tax cut would be decreased, if not totally cancelled, by all the profits the banks would be unable to make anymore off FX. We will explore this in more detail and give more precise estimates on it in a future post.

Another alleged benefit of a SWC is that it could foreseeably cause a substantial reduction in capital flow volatilities across borders.   A SWC would cause individual sovereign currency risk to disappear, or in other words, there would no longer be the risk that a country will become too trigger-happy with its printing press and devalue its currency to the point it isn’t able to pay its foreign-currency debts.   This is the traditional problem/catalyst for massive outflows of foreign capital, especially for emerging countries. The elimination of currency risk would thus greatly reduce cross-border capital flow volatility, permitting much more stable growth, especially in emerging countries.   Clearly, this is a great potential development in and of itself.   We can even take it one step further and claim that a SWC could even potentially bring down economic volatility; no, not like Judy Greenscam’s imaginary “Great Moderation”, but a real reduction.   Since countries would not be able to manipulate their own currencies, allegedly less trade imbalances could be built up, therefore reducing the prevalence of extremely unstable situations (like excessive dependence on exports for example).   In juxtaposition, many people believe that a big cause of today’s broken financial universe was China’s manipulation of the Yuan, keeping it cheaper than it should be in order to subsidize exports and as a result allowing the US to run up huge deficits and a mountain of debt.   This sort of thing could foreseeably not happen any more, which is ultimately a good thing right?  Well, yes and no.   Remember that we are talking about a reduction of imbalances, in general.   Therefore, though a SWC eliminates the possibility of cross-border imbalances, it simultaneously creates the problem of potential global imbalance.  This, we argue, is much more dangerous, since it does not have the self-cancelling effects of individual sovereigns allegedly acting in their own self-interest and partially off-setting each other.  

Other potential benefits of a SWC are the apparent reduction in commodity-price volatility, which has been so correlated to currency fluctuations in the past.   One must be careful to realize however, that commodity price volatility is responsive to exchange rate movements in the currency in which they are denominated, or rather the prevalent reserve currency (ie; the price of oil being very affected by movements in the USD).   If a SWC came to pass, then presumably all commodities would then be denominated in the SWC, and hence would now be subject to monetary volatility on this NEW fiat paper currency.    This brings us to the crux of our opposition to a SWC: it would be a larger, hence potentially more destructive, version of the same faulty system we have now.   Though there are more potential benefits we have not discussed, the nature of our claims is such that we believe that any potential benefits, in aggregate, are overwhelmed by the negatives and all the reasons why we should NOT implement a SWC.   We intend to develop quite a strong case against an SWC, and for what it’s worth, we intend to disseminate it far and wide, so that in spite of the seeming inevitability of a SWC we will not remain silent in the face of this oppression and hopefully build foundations with those individuals that will construct the new world once the SWC collapses, A-G-A-I-N.   Let’s begin with a very vividly understood notion.    Below is the renown chart of the purchasing power of the USD since the creation of the Fed in 1913:

Look at it, it is truly pathetic.   $1 in 1913 is now worth only 4 cents, really, pathetic.   This is the pure and sole legacy of the Ancient Clan of Wizards.   This is the price WE paid to participate in an allegedly more stable banking/financial system that would do away with the “panics of yesterday”.  (Sound familiar?)    Please pay close attention to the following narrative of what happened since the creation of the Fed in 1913.   Below is a chart of US inflation, as measured by the CPI, since 1666.   This chart is an equivalent alternative way to see the lower purchasing power.  

Notice that from 1666 to the early 1900s, an inflation-deflation cycle was inherent.   It seems natural of course, as we would argue that in principle, an oscillation between growth and contraction in prices around a baseline level is the only way to ever achieve price stability.  This is part of the Great Swindle, which is the belief that low, “moderate” inflation should be the perpetual state of any economy.   Uncle Benny and Co’s idiotic 2% inflation targets “seem” reasonable only because they are an annual figures.   Sure, perhaps most of us wouldn’t be seriously hurt by losing 2% of purchasing power in a year, but guess what happens if we have 2% inflation for 35 straight years? Well, prices double, and your wealth is now worth half (forget for now the fact that inflation will be much higher than this). And to would-be nay-sayers that would propose the trite and tired argument of rising wages, we respond that that is absolutely irrelevant when considering the value of “savings”.  In order words, suppose you save $100k now; over the course of 35 years the value of your savings will erode, by half, regardless of whether or not your future wages keep up with inflation or not.    The point is that generating inflation ALWAYS and never allowing deflation leads to the INEVITABLE erosion of wealth and savings.    All the “blue”(inflation) at the end of the above chart, with none of the corresponding “green” (deflation) is what has created the great erosion in the value of the USD since 1913.   Remember, we are talking about THE SYSTEM here, so we care about all time magnitudes as we should seek long-term sustainability.   Why would we want a system that discourages long-term saving?   One of our strongest objections to a SWC would be that it would simply be a continuation of this same system.     There is absolutely NO indication whatsoever that these policy views expressed by the public face of TPTB, mostly maintaining a consistent and pernicious inflation rate, are even being considered for revision.   What is overwhelmingly likely to happen in the institution of a SWC would be a simple re-juggling of some definitions, sleight of hand by skilful magicians (as CM01 suggested a while ago) and a resetting of price.   In other words, all the physical assets in the world would get re-valued, reappraised, and assigned a characteristic value in terms of SWC units, at which time then prices would begin to float.   Over the course of a few decades following that, we are likely to see the same erosion and destruction of wealth as each SWC will lose value and eventually collapse, in the same way that the current fiat, centrally-controlled reserve currency, the USD, has done.

We’ve already mentioned that sovereign imbalances would be eliminated by an SWC, however, potential new global imbalances could emerge.   This is quite simple to illustrate and see.   Take the one-size-fits-all approach of the Euro and the problems it causes for certain European nations.   It is quite evident than even in a relatively homogenous Europe, economic conditions vary so widely across countries that many find themselves dangerously restricted and hampered to undertake necessary monetary actions their economies demand.     For example, there have been countries that really needed to stimulate their crumbling economies with lower interest rates, but instead were bound to what Jean-Claude decided.   This argument could easily be extended to a global scale of course, where economic differences are MUCH more pronounced.   Can anyone realistically explain to us how it is possible that ONE monetary policy could EVER possibly prescribe ideal, or even appropriate, conditions for ALL local and regional economies?   No, because it’s impossible.   The potential dangers of this are gargantuan.   Imagine some broad global monetary aggregate that would be used to some degree to calibrate monetary policy at the Single World Bank (SWB); it would necessarily have to be aggregate and average.  As such, coordinating monetary policy based on this would clearly create inflationary/deflationary extremes at different localities in the world where the inflationary conditions varied significantly from the mean (as they will, since inflation conditions would not be homogenized by a SWC).   In general though, and this is an idea that we will develop further, individual sovereign systems might create imbalances, but at least there are some checks and balances where some imbalances might offset each other.  In a global system such as a SWC, there are NO checks-and-balances; the overshooting of monetary policy (as has NEVER failed to happen) would then result in GLOBAL economic destruction, as opposed to today’s regional kind.    Moreover, local imbalances would actually still arise, but they would simply be “masked” underneath the rigidity of the monetary union, and if they were to get bad enough, could threaten the entire union with what would have been an otherwise regional problem.   This issue of locality brings us to our last point of the night, and perhaps the most important and we believe the check-mate for the SWC, that of trade granularity.  

            Trade granularity is a complex and highly technical concept that we will develop over the course of the next few posts.   For now, imagine granularity as simply the amount of different important “trading” hubs on a map, represented by a dot, each hub connected to other hubs trough lines, or “trade routes”.   The size of each dot/”hub” is determined by the volume of its trade, and all the lines on the map represent all the possible trade routes.  The “thickness” of each line connecting hubs is also proportional to the volume of trade between those two hubs.   In case there are no direct trade routes between points A and B on the map, then you can find alternate routes.    If we were to take a time-evolved "movie" of what this “trade-density” (or “granularity”) map would look like in the past 100 years, it would certainly get more and more populated, more and bigger dots, more and bigger lines, until it began to seem like lines and points covered the whole map.   We will attempt to model this, and maybe provide numerical and visual simulations, though it is truly a gargantuan task and we have to teach ourselves how to use our new abacus.   This effect is otherwise known as globalization.   While 50 years ago they never would have known each other existed, Johnny in Bumblefuck USA can now purchase some nice gold bars from Baruti in Edenville, South Africa on eBay.  This has not only created a direct line between those two points on the map, it has made the line connecting them thicker.   So, we think you get the picture, this visual “trade map” has become much denser and more “filled in”, as globalization has increased trade capacity across the world, removing large “super-clusters” of trade that then fed into their local systems and replacing it with a more diffuse, interconnected and dynamic trade network.   And what comes of this?  Well, remember, the whole PURPOSE of foreign exchange, the whole purpose of CURRENCY is TRADE!  Get back to the basics.   Having established this a priori, we argue that the significantly increased trade granularity of the past few decades diminishes the need for a SWC, and in fact, creates ideal situations for the establishment of more localized currencies, which would be infinitely more stable than a SWC.  As trade between any given two regions increases, so does the amount of transactions and exchanges of one currency for the other, reducing bid-ask spreads.   It seems to us that this would provide a much more stable system since local conditions would adjust themselves accordingly.  What exactly do we mean by local? Well, anything is possible, anywhere from regions to states to cities to individual banks could issue their own currencies; we believe market forces would largely decide the appropriate size of each marketplace.   In other words, what we are suggesting is that increased trade granularity (which is a fact) increases the pheasibility and stability of local, floating currencies, to the point that they might be a preferable alternative to a SWC.   Over the next few weeks we hope to demonstrate this convincingly.  

Finally, we come to the end this initial Battle Cry against a Single World Currency (SWC).   Our opposition to a SWC runs very, very deep; to the very depth of our shivering spirit in this cold and damp concrete floor in prison.  It will likely shape much of our own thought, discourse and activism in the coming future.   However, before we even touch on the higher and spiritual depths of this problem, we will aim to deconstruct the notion of a SWC, economically and rationally.    Go ahead Judy, we challenge you. Assemble your disparate, rag-tag, assembly of court jesters, pundits and cowards with your shape-shifting economic platitudes and greenscamspeak; we shall meet you in the field of battle, armed with nothing by Numbers and Reason!   A SWC will not prevail, So Mote it Be!

May your capital be safe and your investments prosperous,

MAAA



Greetings Fellow Inmates,

Today, on 12.25.09, as we celebrate the sun’s rising from its lowest point in the celestial horizon, we rejoice for its brilliance and the prospects of a renewed Universe, at least until the next cycle.   In commemoration to a similar form of worship, today we will look take a broad, but detailed look at gold, in what will be the first of a series of posts on the truly precious metal, the barbarous relic.   Gold’s recent price swings have been the cause of much speculation and forecasting.   Rather than contribute to this debate, we will simply take a look at the Numbers and extract any interesting and noteworthy facts we can.   The following will be a potpourri of snapshots of different market statistics and indicators pertaining to gold.   We will look at a detailed breakdown of current supply and demand, holdings by country, correlations to other commodities, comparative returns versus equities and others.   Finally, we will begin a discussion that will be the subject of several posts whose ultimate aim will be to answer “Where has all the gold gone?!” by discussing some issues related to exchange traded funds (ETFs) and futures exchanges.  

For starters, since this will be a forest-through-the-trees variety, let’s begin with the largest scale.   In the history of the world, about 161,000 tonnes of gold have been mined, according to National Geographic.  This amount of gold could be represented by a solid cube of side length 20.28m.   Since gold is effectively indestructible, this is theoretically the amount that should exist in the world today.  Though tracking all of it is a cumbersome task, we will take a look at just some indicative snapshots now, in order to calibrate our order of magnitudes for future discussions.

Most of the following data comes courtesy of the authoritative World Gold Council (WGC), a non-profit that represents the largest mining companies in the world (collectively producing 40% of total output) and whose stated purpose is to stimulate and maximize the demand for gold.   Their data is some of the most complete and trusted in many respects, but, as always, consider the source! We recommend you sign up for free to be able to download all the reports directly from them, but we provide them here for your convenience.  We have also aggregated certain segments of the data into our own tables here, in XLS format,  in more readable and commented on format. The table below presents a variety of information about the breakdown in gold demand up until from 2007 to Q3 ’09.

In Q3, gold demand was 800 tonnes ($24.7bln), up 15% from Q2 and down 34% from Q3 ‘08.    This might seem surprising given the increase in the price during the same time.  We’ll look at supply below.  In 2008, total demand was about 3,800ton, or roughly 2.4% of the total ever mined.  Every single category of investment was down year-over-year (YoY) in Q3, but the most dramatic drop in demand came from investment demand (-46%) in general and ETF demand (-72%) in particular.    The drop in ETF demand is definitely significant as ETFs demanded 465ton in Q1 and only 41ton in Q3.   While, it is certainly true that risk aversion has dropped in that time frame, as measured by other risk perception indicators, we do not know the reason for this decimation.   We will look at this issue in more detail in a future post as we try to answer “where has all the gold gone?”, but for now, we simply point out that it is very significant.    As a result, we are now back to historical norm in the distribution of total gold demand by category.   Jewellery consumption makes up 59% of the total, while Industrial and Dental 12% and Investment 28%.   So, remember this, as it is a fact oft forgotten by would-be gold- provocateurs: most of gold demand comes from jewellery consumption.    Now, let’s take a look at supply.

Several interesting things become apparent.   For starters total supply went down 5% YoY in Q3 ’09.  Total mine supply has also gone down by 3%.   Very interestingly, we notice that official sector sales, meaning sales of gold held as reserves at central banks and sovereign treasuries, accounted for a significant portion of total yearly supply: 14% in 2007 and 7% in 2008.   However, in Q2 ’09, the official sector became a net buyer of gold, once again, when we all thought that we had given up on the whole “gold being money” thing and were full fiat ahead!  In any case, we will look at sovereign holdings next, but for now bear in mind that several developed countries had entered into agreements during the 90s and early 2000s to sell agreed-upon quantities of gold in a timeframe.    What is evident now is that Q2 saw the culmination of a trend in which the official sector went from being a net seller of gold, proving up to 14% of total global supply, to being a net buyer.   This is the primary reason why the TOTAL supply has fallen.   

Also of note, as we notice from the orange row in the above table, in 2007 and 2008, demand outstripped supply, but in 2009 there has been much more gold supplied than demanded.   So, having looked only at both sides of the supply-demand equation, we cannot explain why gold prices rose so markedly in the first 3 quarters of this year.  However, we can say that the physical supply-demand picture was not correlated with the price in any significant way. Of course, there are many other factors involved in determining prices, and the gold market has one of the most pernicious and devious price manipulation and gouging in a rotten infrastructure that goes all the way to the top of the golden pyramid.     Since we intend this to be a data post, we will leave this discussion for a later time.

Finally, we note that old scrap has been a significant source of supply and has grown markedly since 2008?   Hmm, could this have anything to do with all those commercials we see on TV urging us to send our gold in for some cash?  In any case, in 2008 old scrap account for 34% of supply, and that number is likely to be much larger in 2009.

Before you take a look at the detailed data of official sovereign gold holdings, keep in mind that the TOTAL GLOBAL OFFICIAL SECTOR has about 31,000 tonnes, alledgedly, held as reserves.   This means that about 19% of all the gold ever mined is sitting in central bank vaults.   The following table lists the total gold reserves (and as a percentage of total reserves) allegedly held by the top 33 government holders across the world.    You can download all the WGC reserves data here. 

Yellow boxes denote supranational organizations while orange ones denote those countries that have been net buyers of gold during the first three quarters of 2009. 

The US is by far the largest holder of official gold, with 8,133ton, followed by Germany and the IMF with 3,407ton and 3,217ton, respectively.   In a future post on gold, we will revisit how the IMF came to acquire all their gold and what (if anything) has happened to it ever since.   China’s enormous jump from 600ton to 1,054ton represents an “accounting entry”, as the purchase of 454ton of gold that had occurred ever since 2003 was reported.  You can download a very nifty summary of all significant official sector activity since 1990 here.  Anyway, we can safely say that the Chinese have been very active in procuring gold, having only 395ton as late as Q2 2001, versus the current 1,054ton.   Russia, top 10 holder, has also been a very prolific buyer for the past few years, starting its purchases in Q3 ’06 when its reserves stood at about 387ton, rising 53% to 591ton in Q3 ’09.   Could Russia and China’s mad frenzy for gold have something to do with their concerns about the stability of the USD, in which they hold their massive reserves?   Perhaps, but this isn’t meant to be a speculative post, we merely wish to point out that Russia and China have indeed purchased a lot of gold and to peripherally note the coincidence that these happen to be two of the most vocal proponents of an alternative to the USD.    It is also interesting to note that while China and Russia have been buying lots of gold, the fraction of gold they hold as a percentage of total reserves is still very low:   1.5% and 4.6%, respectively.   This is substantially lower than developed countries like the US, Germany, Italy, France, the Netherlands, Portugal, Austria and Belgium whose holdings of gold as percentage of total assets range between 50% and 84%.    This of course makes sense as developed countries issue sovereign debt that is traded internationally, and used as reserve currencies which the developing nations like Russia and China are compelled to hold. 

The chart below contains the correlation coefficients of weekly returns for the past three years between gold and other commodities. 

Not much surprise here.   Clearly, silver is the most correlated (with a hefty r = 0.82) as it is equally sought after as a store of wealth.  Recently, Inmate Ramos commented in The Yard that in the aftermath of a fiat collapse, silver would be even more sought after than gold, as a means of transacting smaller notional amounts necessary for immediate survival and consumption (ie: an oz of gold might buy a house).   Platinum (r = 0.59) is also highly correlated, presumably because of its increasing appeal as a precious metal, and thus a store of wealth.   Palladium (r = 0.45) is the last of the statistically significant partners, for similar reasons as above.   There must certainly be some cross-correlation effect from similar industrial uses amongst each precious metal (as opposed to purely financial as we suggest), but it is beyond us to estimate what that might be at the moment.   Finally, gold is not significantly correlated (as has always been the case) with its lesser base metal cousins.   

The following graph compares gold to the SP500 since 2001.

The graph speaks for itself.   Can you imagine what it would have sounded like at the beginning of 2001 if someone told you to sell all your stocks, extract any value stored in paper (and not locked away in legal structure – IRA – SS benefits) and BUY gold?   The one in a million persons that would have listened to this “lunacy”, would be 3.5 times richer today, as opposed to barely trying to get all the money back up to its nominal value (without regard to the inflation of the past 8 years).   But, alas, the point is not to dwell on this window into the past, as it is in no way guaranteed to continue into the future.   One thing we can infer from this window however is that part of the reason for the parabolic baseline growth we see in the price of gold in the past 8 years has been the great surge of claims, paper claims, on gold, driven in larger part in recent years by derivatives and ETFs (more on this below).   We will do a quantitative exploration of this hypothesis in a future post, though this idea provides a perfect bridge for this next discussion.

For a long time, the gold futures and swap markets have been actively manipulated and built on unsound principles.  The nature of this edifice is one that will take us a few posts to tackle down, but for now we limit ourselves to saying that it is in this pyramid scheme of yet more paper claims, that we see a huge potential systemic risk.  It is very important to understand from the get-go (we’ll deal with the details later), the paper nature of the gold derivatives and swap markets, amongst others.   In recent years, the explosion in popularity of ETFs has led many people to be confused as to the nature and risks associated with them.  The GLD ETF is a prime example.   It allegedly has 1,050 tonnes of gold.   However, its 10K report to the SEC reveals that its main asset is classified as “Investment in Gold”, rather than just “Gold”.   Lately only 5% of total assets were listed as gold “receivable”, which one could more easily compare to actual physical bullion, maybe.  “Investments in gold” however are debentures, swaps or any other arrangements in which gold is promised to be delivered at a future time and are thus NOT equivalent to owning the metal itself, but rather just another paper scheme.    We would go as far as to say that GLD has probably less than one tenth of its stated “Investments in Gold” as physical bullion.  Why can’t we know for sure?  Well, they don’t really have to be audited, and the “investment in gold” line is a conniving manoeuvre to avoid audit of the physical and, in this case, non-existent, gold.    The same inherent flaw is found across all levels in the gold markets, be it loans, swaps, futures or other derivatives.   To make matter worse, in a development we will explore in much more detail later, now futures contracts on the COMEX, in which many people expect to get settled and be able to take delivery of physical bullion, are now actually settled in equivalent GLD shares.  

Think of it this way, there are way way way more claims on gold than there is physical gold; in effect we have “smeared out” the “existence” of real physical gold into a imaginary time distribution into the future, thus allowing ourselves more capital now.   We contend that this “smearing out” is, once again, mostly supported on faith.   If there were to be a significant enough rush into gold and many more people demanded delivery, we might very well approach the point where there would not be enough physical bullion to deliver.    This would wipe out all the multitudes of other claims on gold, not to mention the derivatives associated with them, and the non-negligible tidal waves it would send through markets, possibly exchanges and clearing houses themselves.   Of course, this is still very unlikely, though as you know we enjoy entertaining thought experiments to see if they teach us something about potential current risk in those Fat Dark Wings.

On that note, we will end this little piece commemorating the ancient Sun and Gold worshippers who both stem from the same twisted pathology.   We will look at more historical details on the flow of gold and the evolution of holdings, the composition of the evil paper markets and much much more in future instalments.

May your capital be safe and your investments prosperous,

MAAA

Greetings Fellow Inmates,

On this venerable Winter Solstice, 12.21.09, or 12.19.16.17.2 in the Mayan Calendar, as the Sun traverses its lowest daily course through the celestial horizon, we here at DP staff contemplate the significance of this event and its allegorical importance to what is happening in the financial universe.   Many ancient cultures conceived the Winter Solstice to be the Sun, or God’s, lowest descent in the sky, signalling the end of an era (a year, or otherwise) and a 3-day window of uncertainty about whether the Sun would rise once again, thus renewing the existence of the Universe into a new era.    In the same way, we find ourselves at a financial dusk, when the current financial system will become unstable enough to warrant a massive systemic transition into a new system.   In this spirit, we will expand on the discourse from the last post, Monetary EASING, not tightening awaits us, by looking at Excess Bank Reserves (EBR).   As you know, EBR are part of the Monetary Base, and hence form the most fundamental type of liquidity in the financial system.   EBR are otherwise known as high-powered money due to the fact that it is this money that is supposed to course its way through the financial system and down the economy into people’s pockets.   It is precisely these EBR that are the digital zeros Uncle Benny creates out of thin air with his trusty computer to fund all his emergency lending programs and long-term debt purchases of US Treasury, Agency and Agency MBS.   Bear in mind that the entire focus of the media has been on the credit programs themselves, and we’ve all been dizzied into numb confusion by the endless barrage of the alphabet soup and asset purchase programs (quantitative easing), or in other words, the asset side of Uncle Benny’s Balance Sheet (FedBS).  We find truly astounding the degree to which the main-stream media, so-called economists, and policy makers have ignored the liability side of the FedBS – especially considering that it is precisely there that the problem and major cause of the upcoming fiat currency crisis lie.    Clearly, understanding EBR is of paramount importance not only to all of our own individual personal finances but also to the root causes that will lead to the collapse of the USD-backed global monetary system.  

As in our last post, we begin by introducing you to questionable literature from “reputable” sources; this time from the Federal Reserve Bank of New York.   The December 09 publication of “Current Issues in Economics and Finance”, entitled Why Are Banks Holding So Many Excess Reserves?, “authors” Todd Keister and James J. McAndrews attempt to explain in simple terms the cause and some potential consequences of the vast increase in EBR.   Similarly to our last post, we find much amiss in this publication as arguments are often weak, based on unlikely or nonexistent conditions, backed by little or no evidence and easily proven to be incorrect.   The paper attempts to explain that EBR are nothing but a “by-product” of Uncle Benny’s credit programmes, and dismisses them as largely inconsequential in the long run, with little or no inflationary effects.   We vehemently disagree with these statements and will attempt to demonstrate our refutations below.  The paper uses simple conceptual thought-experiments, which will serve as a good platform to explain how EBR work in practice.  We will use these experiments to highlight some important concepts as well as some uncertainties, unlikely or erroneous assumptions, devious misinterpretations and transparent manipulation/obfuscation in the original paper.   We will only partially use the paper to explain EBR and not quote as much of it as last time in order to not hurt the “authors”’ feelings like we did JEG’s, who apparently did not appreciate the rigour.  We really recommend you read the whole paper, it’s only 10 pages and some of this discussion might be clearer.

Quotes are in bold italics.

The paper’s abstract:

The buildup of reserves in the U.S. banking system during the financial crisis has fueled concerns that the Federal Reserve’s policies may have failed to stimulate the flow of credit in the economy: banks, it appears, are amassing funds rather than lending them out. However, a careful examination of the balance sheet effects of central bank actions shows that the high level of reserves is simply a by-product of the Fed’s new lending facilities and asset purchase programs. The total quantity of reserves in the banking system reflects the scale of the Fed’s policy initiatives, but conveys no information about the initiatives’ effects on bank lending or on the economy more broadly.

From the very onset we realize how vacuous this paper truly is.   Banks are in fact amassing funds, it doesn’t merely “appear” that way, it is a fact.   While reserves or EBR are a “by-product” of Uncle Benny’s credit programmes, they could equivalently be thought of as enablers/facilitators of the programmes.   They are in fact, opposite sides of the same coin.     EBR not only “reflect” the size of Uncle Benny’s initiatives, they are in fact the principal tool through which those initiatives are executed.   The exact level of EBR does in fact convey information about the “effect” of monetary policy on bank lending, as the authors inadvertently assume in their simplified model.  While on its own, the EBR level does not encode information about the economy at large, other well-established indicators do and we will explore them further below to conclude that in fact EBR are NEITHER negligible nor dismissible but rather are unpredictable, significant, inflationary, and difficult to manage.

Let’s begin by taking a look at what has happened with EBR for some perspective.

Notice that the growth was explosive since the collapse of Lehman.   We are currently near all-time highs and are they are likely going to grow even more as we have prognosticated before.   Previous to the Lehman crisis, total bank reserves were about $50bln, almost none of it EBR.   That means that during that time, no banks had any interest in holding EBR and would rather lend all the money out and earn the interest.   Keep this in mind for later.  Today, total reserves are $1.15tr (a 2,200% increase!), the vast majority of which is EBR.   This great increase corresponds to the great increase in Uncle Benny’s monetary adventures.    Below is a visual break-down of how the assets and liabilities on the FedBS break down.

Let us remind you, as you might notice from the graph that assets must be exactly the same as liabilities on the FedBS.  Therefore, an enormous increase in EBR is in fact necessary to support the great increase in the asset side of the FedBS.   It is not merely a “by-product”, it is a requirement, the only available tool, and co-consequential.   Increases in the asset or liability sides of the FedBS have no causal relationship between them insofar as they are always concurrent and equivalent.   Of course, one could argue that the given intent of a particular monetary policy could target a specific sector of the economy or financial system by employing either side of the FedBS, inevitably forcing the other side to adjust accordingly.  Therefore, manipulations of either side of the FedBS are not the cause of manipulations of the other, nor is either a “by-product” of the other.  They are both used simultaneously every time to achieve a given monetary aim.   In other words, much like our current situation, if the Fed wished to support a given credit market (like MBS) by purchasing bonds or to provide banks with emergency lending (thus using the asset side of the FedBS), it could only do so by increasing EBR (the liability side) by the same amount.   

The authors present a conceptual thought-experiment to illustrate what happens practically and sequentially to bank lending, deposits and EBR during a credit crisis.  We again recommend you read the paper to follow through some of the following details.   Succintly, the paper illustrates through a series of steps how in the case of a “credit crunch”, in which banks refuse to lend to each other and the Fed subsequently steps in to provide liquidity, EBR rise as a result of this liquidity.   Remember, EBR are not the “result”, but rather they are the liquidity.   I any case, the “authors” show in their example that an increase of $74bln in EBR would lead to a $20bln increase in total bank lending and an increase in $60bln of deposits. In other words, each dollar increase in ERB would lead to an increase of $0.27 in bank lending and an increase of $0.81 in bank deposits.  This is completely different than what is actually happening, as seen in the Numbers below.  The authors are careful to argument that the monetary easing through increases in EBR are not intended to increase bank lending, but rather to stop it from contracting.   In other words, as one bank demands repayment (or more collateral) from or refuses to lend to another bank, the Fed provides that liquidity so that the affected bank (Bank B) does not have to demand payment from its customers (the economy).   Let’s examine what has happened to total bank lending and total bank deposits in actual reality.  Below is a table of what has happened in the last 13 months, data courtesy of Uncle Benny.   Here is all the data, in XLS format.

We notice that from November 2008, only two months after Lehman, to December 2009, the Monetary Base increased by 66.6%.   If we take out the cash component of the Monetary Base, we see that EBR increased by 92.7%.   In the same time, total Bank Deposits, more representatively measured by Money of Zero Maturity (MZM) - a broad measure of deposits across the whole system -, grew by only 7.8%.   Meanwhile, bank loans actually declined by 6.3%.   In other words, in reality, for every dollar increase in EBR, there has been a proportional decrease of $0.07 in bank lending and an increase of only $0.08 in total deposits.  Clearly, reality is wholly different than the “authors”’ illustration of the allegedly “workings” of the banking system.   This alone is reason enough to discredit it entirely.   But, we continue on a couple of more points.  

Below is a chart of the Money Multipliers, which are the ratios of the broad monetary aggregates, which are in turn measures of the amount of immediate-term demand deposits in the banking system of swathes of the economy of increasing size.   In other words, in the traditional conception of the money multiplier model, which is supposed to be a repercussion of the fractional reserve banking system we are supposed to have, the banks’ lending of the monetary base money creates an expansion in the broad money supply.   As we have often said, the Money Multiplier Model is in fact disproven by data.  But let’s assume for now that it works.  

Notice the dramatic action!  While the MZM multiplier consistently increased starting in the mid 1990s.   It rose from 6.5 in 1995 to near perfect plateau of 10.0 during the 13 months leading up to Lehman’s collapse.  The value of 10 is curious, as this is the most often used rule-of-thumb in traditional economics textbooks to explain the “multiplying” effect of the fractional reserve banking system.   During the go-go ra-ra years of snake oil selling investment bankers and European, Latin American and Asian suckers, the MZM multiplier really took up.  Then, after Lehman, it collapsed to 4.6 today, and it shows no signs of stopping down this precipice.  In other words, whereas before the crisis, each dollar increase in EBR would coincide with about an $8-10 increase in total bank deposits (as measured by MZM), today, each dollar increase in EBR coincides with only a $4.5 increase in deposits, as measured by MZM.   M1, which measures a smaller section of the economy (excluding savings deposits, small-denomination time-deposits, money market mutual funds and institutional money funds) shows an even more troubling case.  While previous to the crisis each dollar increase in EBR would coincide with an increase of $1.8-3.0 in M1, now a days the ratio is only 0.81.   This means that for every dollar Uncle Benny pumps into the economy through the EBR, less than one dollar comes out into the first next measuring radius of deposits in the economy at large.   Where is this value disappearing into?   Well, good question, and one that the “authors” of this paper don’t even attempt to answer.   One plausible explanation, in our opinion, is that some of the increase in EBR, which are obviously just sitting there, are going simply to cover losses from bad debts.   New credit is still hard to come by to the larger economy.   So, though new debt is not likely to be significant, existing debt is also being ramped down, as evidenced by the lower bank lending.    In other words, Uncle Benny is simply attempting to mitigate the haemorrhage of wealth destruction caused by the falling asset prices underlying most debt.  He is not being entirely successful, when he technically should be perfectly able to; yet for all his wanton monetary looseness, he only manages to paper over 81% of the wealth destruction happening as deposits decline (relatively).  

Finally, we end this discussion with another strong disagreement with the paper’s affirmations.   The following quote is one of the main premises of the paper:

A large increase in the quantity of reserves in the banking system need not be inflationary, since the central bank can adjust short-term interest rates independently of the levels of reserves.

As we have said before, most lately in the last post, we completely disagree with this idea.  In fact, we go as far as to say that Uncle Benny has rendered the Fed Funds Rate effectively powerless to affect broad money supply and longer term interest rates by increasing the size of his balance sheet.    Remember, again, while the authors try to pull a switcheroo and focus on the liability side now, this is in fact that SAME THING as the asset side increase.  In other words, due to the composition of the increase in the asset side of the FedBS, which is mostly made of long-term debt securities, then the liability side (which is inherently short-end) is equally important and thus hindered.    More specifically, the authors suggest that Uncle Benny will be able to affect short-term interest rates in spite of having a long-term portfolio of assets because he now pays interest on EBR.   In other words, if the Fed raises the interest rate it pays on reserves (which is pegged to Fed Funds), then banks will not be encouraged to lend, thus preventing inflation from becoming rampant.    This is of course, how they say it is allegedly supposed to happened, and not like it actually happens.    

The authors greatly omit the fact that the Fed would thus incur losses on its portfolio, which would easily spiral and reveal its effectual insolvency.   This would happen because Uncle Benny would have a portfolio of long-term bonds (average maturity of about 10yr, including MBS) that would earn him the low interest rates of today (less than 4.5%), whereas he would be paying high interest rates (likely in excess of 5%, see Grandpa Volcker) if inflation does become a problem.   Given that the balance sheet is quite hefty and suppose we have $1.25tr of EBR, each basis point difference between the average yield on the Feds asset portfolio and the interest paid on EBR would result in a $125mm loss for Uncle Benny.   In other words, supposed Uncle Benny raises short term Fed Funds to 5.0% (a perfectly normal pre-crisis level), then using the long-term yields prevalent today, he would incur a loss on the FedBS of $6.25bln.   Trust us, if there is one thing Uncle Benny is proud of is that in its 99-year history, the Fed has never lost money.  

So, clearly, Uncle Benny is severely limited in his ability to fight inflation as he is limited to a ceiling for the Fed Funds, determined by the weighted average yield of the long-term asset portfolio, which is currently 4.5%.   What if inflation gets as bad as it did in the 70’s (which did not have the gargantuan, untested, and unprecedented monetary experiments of today), and we predict it will get worse, and Uncle Benny needs to raise the Fed Funds to 15%?   Well, he would lose $131bln.   This is an enormous amount to lose on a central bank balance sheet.   He wont do it, trust us, we know him.    Even moreso, these are purely cash-flow losses from the incoming and outgoing interest payments, and they don’t even reflect the “mark-to-market” losses incurred as the long-term portfolio losses value as the bonds drops in prices.   We are being rather generous and assuming they are held until maturity only because we think the point has been made.

In this way, we thus explain our objection to any notion that Uncle Benny's long-term purchases are independent of short-term interest rates.   Remember as well that he is effectively locked in since he can't sell the long term bonds without incurring losses and potentially causing/fueling a massive exodus from US debt.  The fact that he must now pay interest on EBR means that Uncle Benny is capped to how much he can raise Fed Funds, mainly the weighted average yield of his long-term asset portfolio, without incurring losses.   If one thing the Fed is averse to doing and has never before done is lose money.

So, in conclusion, the great increase EBR is very significant.   It is likely to be very inflationary, if only for the effective cap it places on the Fed Funds, let alone the eventual deterioration in faith in the system.    The latest issue of “Current Issues in Economics and Finance” from the New York Fed really illustrates a couple of key points.   One is that The Powers That Be, and their appendant mouth/bodies, of which the NY Fed is one of the biggest, are very interested in disseminating faulty research and misinformation.   It also begs the question of who is actually reading this material?   This paper has been shown to have many easily deconstructed assumptions, fallacies, results and arguments and in general plagued by an all-around lack of corroborating evidence and much contradictory one.   Presumably, it is “economists” that read the NY Fed’s “Current Issues in Economics and Finance”.   If so, we pity the discipline!

As we watch the sun rise into its lowest daily trajectory in the sky, we also wonder if it will rise in the next three days.   Chances are overwhelmingly that it will, as it always has.    Other cyclical things, such as financial systems, might not be so lucky.

May your capital be safe and your investments prosperous,

MAAA



Greetings fellow inmates,

Seeing as the end of the year approaches, we thought we would revisit an earlier prognostication we made earlier in 2009, shortly after Uncle Benny’s announcement in March of the quantitative easing (QE) program, in which he would purchase $1.75tr of long-term US Treasuries, Agency debt and Agency MBS (at $300bln, $200bln and $1.25tr, respectively).   In spite of its unprecedented size, we predicted it would not be the end of it.   More precisely, we stated that Uncle Benny would commit to purchasing up to $1tr of additional long-term US Treasuries.   Our reasoning behind this belief in further monetary easing was then, as it is now, that the cost associated with the bailouts, existing and upcoming, combined with the enormous reduction in income caused by the economic downturn will require that Uncle Benny purchase more of the debt coming out of the Treasury.   Simple, the US, and other advanced economies, must fund their multi-trillion dollar packages by issuing more debt since they are all running deficits (barring a few), and with China, OPEC, Russia and the rest of the suckers, or rather, prisoners, having much less money to spend on US Treasuries, then Uncle Benny has to step in to support that market.   That is of course the reason why he has already committed to purchasing such a gargantuan amount of MBS debt, $1.25tr, since the Russkies and everyone’s mother started dumping it.   The same will happen with USTs.   The simple fact that there are $2tr of short-term Treasuries (due within a year), means at least that much more debt needs to be issued.   There is just no one with the money to significantly take that down, not even the Chinese.   The natural answer is of course for Uncle Benny to gracefully agree to purchase much-many more of them.    Though there are only two weeks left in the year, we are sticking with our guns.   If not, then we will proceed to make a significant wager that it will definitely happen within the next six months.   We will discuss the gory details in the next couple of weeks, but todays post we will begin with some validation of our views from a “well-respected” and “accomplished” “economist” over at a world-leading and policy-setting think-tank.  

In December, the Peterson Institute for International Economics (PIIE), published a Policy Brief entitled The World Needs Further Monetary Ease, Not an Early Exit, written by Joseph E. Gagnon.      The PIIE is often referred to as the world’s TOP think-thank.  Its policy recommendations are almost always implemented, and it has shaped a significant tract of US policy in the past 3 decades.   Its Board of Directors features some of the top talent in the entire world, to name a few, Stanley Fischer, Jacob Frenkel, Mo Greenberg, Paul O’Neill, David Rockefeller, Lynn Forester de Rothschild, Jean-Claude Trichet, Granpa Volcker and Ernesto Zedillo.  One of its 3 honorary directors is none other that Judy Greenscam herself!  Wow, the whole gang is here!  So nice of you to show up to our little discussion.  We do advise readers to take some time and learn a bit about each of these people, we shall post some bios in The Enforcers soon.   But, in any case, what the PIIE says, the US likely does.   So, not only is this paper a significant leading indicator of what might happen, but it is also more drastic than even our own estimates.    As a very strong side-note, we cannot restrain our utter contempt for this un-digestible garbage, so we thought to give you a factual synopsis of what this “author” recommends, as well as extract some notable garbage for commentary, inspection, ridicule, and all-around humiliation.   Please feel free to peruse the original report yourself, and if you feel so inclined, communicate your thoughts to the “author”, at jgagnon@piie.com.  We will.

Quotes are in bold italics.

THE FACTS

In particular, central banks in the main developed economies should push long-term interest rates 75 basis points below the levels they would otherwise be by purchasing a combined $6 trillion in long-term public and private debt securities.

The Federal Reserve should purchase an additional $2 trillion of longer-term debt securities with an average maturity of around seven years.

The European Central Bank (ECB) should lower its main refinancing rate to 50 basis points, continue to extend unlimited 12-month credit to the banking system at this rate, and purchase €1 trillion of longer-term debt securities.

The Bank of Japan should state more clearly its intention to return inflation to at least 1 percent over the next two years, purchase an additional ¥100 trillion of longer-term debt

The Bank of England should purchase an additional £200billion of longer-term sterling bonds or an equivalent amount of longer-term foreign-currency bonds with the interest and principal hedged using currency swaps.

These purchases would be announced now but could be implemented over the course of 2010.

Clearly, Joseph E. Gagnon (JEG) anticipates a much larger increase in central bank purchases than we do.   He estimates $6tr is needed worldwide ($2tr from Uncle Benny) in order to lower long-term yields, particularly the 10-year UST, by 75bps, hence raising GDP by 3% in two years.    Moreover, he indicates that this could be implemented imminently, to be executed in 2010.   We believe the timeframe JEG, your Masters command it, and so it shall be.   

THE GARBAGE

An Open Letter to JEG:  

In light of high and rising levels of public debt, additional monetary stimulus is preferable to additional fiscal stimulus. Indeed, monetary stimulus reduces the ratio of public debt to GDP by reducing interest expenses, increasing GDP, expanding tax revenues, and enabling an earlier start to fiscal consolidation.  

We strongly contest that “monetary stimulus reduces the ratio of public debt to GDP”.  It can be easily seen that were it not for Uncle Benny’s QE, then the US Treasury would not have been able to issue as much debt.   Let’s get it clear, Uncle Benny bought USTs, because everyone else didn’t have enough willing money to do so.    Hence, it clearly follows that had monetary policy been limited to Fed Funds, then UST issuance would have been lower and/or we would have had to accept higher yields (which is natural anyway). 

Reduces interest expenses how JEG?  By monetizing them?

“Expanding tax revenues”?  Are you joking?  Can you please attempt then to explain the M1 Money Multiplier being below 1.0?   We would all LOVE to hear you try.   Each of those dollars flushed down the monetary black hole has resulted in less than a dollar to the broader economy.  This statement of yours JEG is equivalent to 1 + 1 = 3.

Compared with the status quo, additional monetary stimulus gets the economy back to potential sooner and permanently reduces the national debt by about 3% of GDP.

You are one stubborn little man aren’t JEG?   One day, a few years from now, we will find you and read you this very quote.

Studies typically find that the peak effect of monetary policy on economic growth occurs after one year and the peak effect of monetary policy on inflation occurs after two years.

This VERY notion is what should severely restrain your delusional monetary looseness because there is no evidence whatsoever, nor will there be for another 1.25 years, of the initial inflationary effects, of the earlier round of QE.    In other words, after having deployed a gigantic monetary nuclear experiment with potentially catastrophic inflationary consequences, JEG, you are suggesting that we double it, before any evidence arrives?     Let’s leave alone for once second your blind, misleading, hard-headed and downright stupid adherence to your beloved little Money Multiplier Model.   What happens then 3 years down the line, if let’s say the economy “heats up”, and the initial round of QE did prove to be too inflationary, well, you can’t roll back the second round of QE which you are already suggesting.  Because, remember, JEG:  These are l-o-n-g term bonds, with their inversely correlated prices/yields and all, which are being held on the central bank balance sheet.  “Rolling back” this monetary stimulus is tantamount to selling those bonds, which at the $3.75tr you suggest, would send long-term yields skyrocketing, on everything.   This would not only squash any nascent recovery, but would also compound the inflation problems as people would pile reserve wealth previously stored in government debt into physical assets.   But on NEITHER of these two issues JEG are you even remotely closely to providing an answer or even furnishing a half-intelligible definition.   But, we digress, the point is, if inflation does prove to be too high in 1.25 years, and we have already taken your suggestion JEG, then we will put ourselves over an irreparable edge.  Thanks man.  

Even if it became apparent only after purchase were completed that GDP growth or inflation was considerably stronger than expected, there would be some ability for policy makers to implement a correction through a sharp temporary increase in short-term interest rates.

Just when we thought you couldn’t get any worse JEG.   For starters, let’s remind everyone that you are operating on the premise that inflation will only pick up through a reduction in slack GDP, or in other words, the broad monetary aggregates.   Alright, before you even begin thinking about those things JEG, go read about the M1 money multiplier < 1, inform yourself.  It is highly dubious, if not outright imaginary, that policy makers would be able to implement a correction to such conditions you speak of JEG.  For starters, your Money Multiplier model has been discredited by data, so Uncle Benny’s vestigial Fed Funds, has little or no and lagging effect on broad monetary aggregates.   Moreover, the Fed Funds is even more meaningless now since the massive long-term debt portfolio, which you are suggesting we double, sits there, like an albatross around all your necks.   While those BONDS are there, then bank reserve balances (high-powered money) have to remain greatly elevated, on the liability side of the FedBS.   There is no incentive for banks to keep those reserves there (even at a modicrum of a short-term rate as you suggest), hence they would lend them, greatly increasing inflation.  In other words, Fed Funds, would be meaningless, as long as bank reserves remain elevated, which they must under an inflated balance sheet.   Either that or physically print more dollars.   But that has nothing to do with inflation, nooooo.   They couldn’t teach you that at Stanford, Harvard, the Treasury or the Fed huh JEG.

A bubble occurs only when asset prices significantly exceed their fundamental value. 

We threw this one in for laughs.   “Fundamental value”, hahaha.   Good one JEG, Rumfoltuckerschnitzel!

Finally, we will not quote the four paragraphs of absolute gibberish in your response to any potential Inflation Scare.  Not only is this pitiful section unworthy of lengthy discussion, it is downright gibberish.

Thanks for nothing JEG,

XOXOXO

--------------------

In case you have not realized, many of the arguments used against JEG could easily be applied to the whole notion of further QE.   If we are so adamantly opposed to these premises, why are we so adamant about Uncle Benny’s imminent QE increase?  Our conviction in its imperative, given the conditions (engineered and spontaneous), and The Powers That Be (TPTB)’s determination to steer this current financial system into collapse does NOT mean we endorse it.   We simply view it as inevitable.   There is no more money left to buy the gargantuan amount of debt to be issued in 2010.   Uncle Benny and Co will have to buy it, and they are already out of money.   There are TWO WEEKS left, show us your Poker Face Uncle Benny!   Even if our initial timeframe proves incorrect and we have to enshrine our shame in Vomit Cleanup Duty, we are willing to put our penitentiary money where our mouth is.   If Uncle Benny does NOT buy another $1tr of UST by 07.11.10 (roughly six months), then we will fund a $500 community service project.  

May your capital be safe and your investments prosperous,

MAAA



Greetings Fellow Inmates,

It is no secret that we are staunch believers that Uncle Benny and Co’s wild monetary adventures will result in massive inflation down the line.   To describe the inflationary effects that are likely to result from such monetary expansion we have often invoked the term SuperInflation, which we have defined as a Consumer Price Index (CPI) reading of 25% annual change, irregardless of how long it stays there.   For some context, this has only happened 3 times in the history of the US, and only briefly each time.  In traditional economics, it’s all about timeframe; it is said all you must do is wait long enough and you will always be correct.   For that reason, we have also given a timeframe over which we expect SuperInflation to happen, within 2-3 years time.    Clearly, at the moment, regulators, the media and some portion of the public are more concerned about the prospects of deflation.    In the near future, we will do a post on the whole deflation/inflation debate from a Hegelian perspective.    The purpose of this post is, instead, to hypothesize about what would happen if SuperInflation does indeed come to pass, as we expect it will.   Specifically, we will be looking at the interest rate/yield curve because a) the potential, implicit solution to such SuperInflation is raising of interest rates and b) the magnitude of our sovereign debt problem makes it quite likely that SuperInflation would be intimately linked to sov debt crises/currency collapses.  

We will begin this discussion by comparing today’s situation with a relevant historical example.   As we have said recently, history can be useful if at least to glean some perspective into what is possible.   Of course, circumstances, underlying causes, their interrelationships and correlated forces might make for a different outcome, but the historical comparison is still worthwhile if taken with a cautious tone.  We will proceed with the following historical comparison since, again, it is implied not only by economics, but by policy makers alike (with their vague and shapeshifting statements on risk management) that raising interest rates would still be the primary tool used to combat any potential run-away inflation.   There isn’t a man on Earth capable of striking the fear of death into inflation’s little heart more than Granpa Volcker, whose chairmanship at the Fed in the early 80’s was credited with ending the run-away inflation of the time.   In this post, we will examine the “actions” Granpa Volcker took to combat soaring CPI readings as well as the circumstances surrounding such actions – and what lessons, if any, Uncle Benny could learn if it ever came time to combat inflation on his watch.   As an administrative note, Granpa Volcker has the honor of being the first Enforcer in our newly titled section “The Enforcers”.   This new page will feature very prescient, succinct and relevant biographical information about the most noteworthy players in this global debt prison.   Many a-time, only a bit of research into the personal lives of decision-making people can yield wonderful insights into their motives, biases, associations, interests and inclinations.  Not only do we promise to never waste your time with trivial, uncorroborated or speculative biographical facts, but we also highly recommend you spend some time reading the bio sheets and perusing the links contained therein. 

Back to the post.   Let’s begin with some basic premises.   The Fed Funds Rate is the primary tool the Fed has used historically to exercise monetary policy or, in other words, to affect the “value” of money.   Managing monetary policy through a short-term rate, such as Fed Funds, is equivalent to affecting the price of money.    As the interest rate rises, it becomes more expensive to borrow money, decreasing the abundance of money, thus eventually decreasing inflation since there is less money chasing an (approximately) fixed quantity of goods.   At least, that is how it is supposed to work.    The yield curve is the term structure of yields on government bonds or, in other words, the linear sequence of yields charged on government bonds of different maturity.   Under “normal” circumstances, all else being equal, one expects yields on long-term debt securities to be higher than short-term ones.   This makes perfect sense, since we remember that a yield is the same as an interest rate.   The longer the loan, the more risk to the creditor, hence they demand a higher interest rate.   In other words, the lender/creditor is compensated for the time risk.   Sovereign yield curves certainly show this property most of the time, except when they are said to be “inverted”, or downward sloping, which is when long-term yields are lower than short-term ones.  Let’s say the yield on a 3-mo US Treasury (3m UST) is 5%, but the yield on the 10-Year US Treasury (10Y UST) is 3%, then The Market is expecting that in the next 10 years, interest rates will be lower than they are today.   Presumably then, an inverted yield curve signals or predicts an upcoming period of expansive monetary policy.   For this reason, inverted yield curves have traditionally been used as leading indicators of recessions, or at least economic deceleration, since The Market expects that in the future, monetary spigots will need to be turned on so to buoy a sagging economy.   

With these basics in mind, we can proceed to scrutinize Granpa Volcker’s reputation as a swashbuckling, inflation-squashing central banker – and any lessons Uncle Benny could take away.     We have aggregated a bunch of historical data on the yield curve, fed funds, and CPI from Uncle Benny’s archives.   You can download all the following charts and data here, we have color-coded and commented on relevant trends for easy digestion, we highly recommend the download.  

Below is a chart that compares the yield curve “steepness” - simply defined as the difference between 10-year yields and 1-year yield (10Y Yld – 1Y Yld), CPI and Fed Funds.   The data ranges from 01.01.1966 to 07.11.1983.   The long-term graph really does tell a very interesting picture filled with noteworthy details we comment on below

The inflation story begins in 1977.  CPI began a 30-month rise that would take it from 6.4% (10.1.1977) to 14.8% (03.01.1980).   Naturally an 8.4% rise in annual CPI is a whopping amount, even over a “baseline level” of 6.5%, which is substantially higher than our current alleged preference for a 2.0% annual CPI.    Quite interestingly, in the beginning of ’77, Fed Funds began what would be a 39(3x13)-mo rise that would see it rise exactly 13.00% from 4.61% (01.01.1977) to 17.61% (04.01.1980).   So, it is interesting to note that the very long, deep and consistent rise in Fed Funds preceded, or anticipated, the rise in inflation by 10 months.   Moreover, it is worth noting that Granpa Volcker entered office only in August 1979, so he was only responsible for exactly 6.66% of the total rise in Fed Funds, or roughly about 51.23% of the total rise.  So, while he is certainly the majority (by a slim margin) author of the Fed Funds rise credited with breaking inflation’s back, he owes much credit to his much less-famous predecessor, dead, Great-Granpa Willy.  Please take a moment to consider that the increase in Fed Funds began 10 months BEFORE the CPI began rising.   This clearly invalidates the notion that Fed Funds Rate increases of the late 70s were undertaken as a response to rising CPI.   They incontestably anticipated a rise in CPI.   Of course, it is possible to envision a situation in which the Fed, or other, could anticipate a impending rise in inflation and pre-emptively move against it.   One would only need a realistic measure of the velocity of money, or rather the amount of ­time-lag between the expansion of the monetary “bases” and the ensuing expansion of the broad monetary aggregates that lead to a rise in CPI.  Naturally, this is dependent on the money multiplier model working, which as we discussed a while ago in What if the Money Multiplier Model Doesn’t Work?, is highly unlikely.    But for brevity’s sake we will neglect this difference for now, since, after all, that is what the Ancient Clan of Wizards wants us to believe anyway. 

Back to the story.   In September, 1978, right after Great Granpa Willy raised the Fed Funds on 23 straight months by a substantial 3.84% AND 13 months after CPI began rising, the yield curve inverted.   In other words, The Market, began believing that the then-current Fed Funds Rate was “too high” and would have to come down from those levels in the long term, within 10years.   It could also be argued that the yield curve inversion anticipated the period of economic stagnation that would follow for the next 5 years.   The yield curve would remain largely inverted for the next 54 months.    So Granpa Volcker comes in on hard knocks, sent to combat a two-year rise in CPI, a year-long inverted yield curve, which was telling him he should already by thinking about cutting rates eventually.    Immediately after entering office he raises the Fed Funds by 6.66% in 10mo, and then proceeds to act very erratically thereafter.   Nine months after his inauguration, the CPI finally began to drop.  This would actually prove a turning point, as CPI would proceed to drop over the next 16 months a total of 5.2(4x1.3)%, and an ultimate drop of 12.3% in the following 39(3x13)months.    Immediately after CPI began to drop, before it could be determined if it was a fluke or a real turnaround, Granpa Volcker proceeds to massively slash the Fed Funds, a total of 8.6 (1.3x6.66)% over the next three months.  Yet, after his early, irrationally large, and unsubstantiated move to cut rates, he then proceeded to raise rates even beyond earlier levels, to record levels, in the next 10 months.   This, in spite of the fact that CPI continued dropping during this whole time.   The Market even began telling Granpa Volcker that rates were too high, since even 1-year yields were lower than Fed Funds.  In other words, The Market was saying, “Hey, Granpa Volcker, chill out, inflation has begun receding for the past 6 months.  You better cut rates within the next 12mos or else!”  Coincidentally, he finally cut rates almost exactly as CPI ended its 16mo decline.  So, after an initial splurge, in which he threw money around like a drunken sailor, premature in proclaiming the end of inflation, then he made a quick about face and raised rates for nearly a year and a half, IN SPITE of evidence of declining CPI.  And then, once he finally decided to cut rates, CPI began rising again.   Granpa Volcker acted erratically through the rest of his term, keeping interest rates high (above 5%), in spite of really low CPI readings at times.   So, in other words, we would characterize Granpa Volcker as a wild loose-cannon instead of a resolute monetary tightwad responsible of a reduction in inflation.    Grandpa Volcker was mean, he was wild, volatile and at times acted in contrary to what The Market and evidence would tell him.

This brings us back to today.   Remember, we are hypothesizing about the possibility of a disruptive wave of inflation in the near-future, more precisely a CPI reading of 25% within the next 2-3 years.     For comparison, the highest CPI Granpa Volcker ever saw was only 15%.   In other words, we expect SuperInflation will be at least 66.6% worse than the most recent earlier example of distruptive inflation.   Here is a chart with the current US Yield Curve, courtesy of BloomBerg (BB1).

So what is the yield curve telling us?  Well, for starters, it is anticipating that interest rates (Fed Funds) will remain below 1% for the next two and a half years.   Think about this, a 1% Fed Funds is very low; it is the level to which Judy Greenscam is widely criticized for lowering Fed Funds, thus fuelling the housing bubble that got us in this current mess.    The YC also anticipates interest rates will remain below 3% for the next 7 years.    Alright, to put this in perspective, in the 8-year reign of Granpa Volcker, Fed Funds never dropped below 5.85%.   Yet the yield curve now predicts we will stay below 3% for the next 7 years.   In fact, it predicts that not even in 30 years will we reach 5% again in the Fed Funds.    Seen in a very broad perspective, it can be easily deduced that the bond market is in no way worried about inflation for the next 30 years.   Wow, how stupid.   Well, Mr. Carville, we for one are not intimidated by something so stupid.   Think about it, in a way, the bond market currently assumes that CPI will not rise above 5% in the next 30 YEARS.   Either that, or it believes that people will continue buying US Treasuries even at negative real rates, meaning the whole world will agree to continue investing in something that for the next three decades is surely to erode wealth, as it fails to keep up even with inflation.  In either case, it is delusional.      But we’ll discuss that, market efficiency, and other popular follies in future instalments.  

Another couple of interesting background points for our current situation. The Yield Curve once again inverted in 01.01.06, thus predicting the current recession.  In other words, this marks the beginning when the Market became aware of the coming problems and that interest rates would have to be reduced as a consequence. In April, 2006, a mere two months after Uncle Benny came to office, The Market began telling him, and has continued to tell him for the next 34 months, that the Fed Funds rate was too high, and that we must lower it within 3m or else!   Though he held out for about a year, Uncle Benny has been overwhelmingly compliant ever since.  His notorious overwhelming proclivity for wanton monetary expansion makes it very difficult for us to ascribe him the resolve to raise interest rates as necessary once SuperInflation hits.  Even if he did want to, he has worked himself into a corner with quantitative easing, which has meant lowering the Fed Funds to zero and purchasing a lot of long-term US debt. Bear in mind that in order to regain control of the Fed Funds Rate, the Fed Balance Sheet (FedBS) must first be shrunk significantly, which means selling a lot of long-term debt securities, which will invariably mean higher long term yields.   In that case, The Market YC would be telling Uncle Benny that he better prepare to raise interest rates significantly above current levels in the long-term future.    In other words, even before regaining control of the Fed Funds rate, Uncle Benny’s sales of long-term US debt will create a situation equivalent to one where the Market becomes concerned about inflation down the road.   At that moment, Benny must begin to think about the possibility of raising interest rates.   In order to regain full control of the Fed Funds Rate, Uncle Benny must unload a huge amount of long-term USTs and MBS debt.  Given as the Fed has recently become the largest market for new-issue USTs, Uncle Benny’s sales could result in much higher long-term rates.   So, the market would tell him to expect to raise interest rates significantly within the medium term.   We could easily see the 7-Y yield at 5%, versus 3% today, if not much, much more.   If SuperInflation does indeed come to pass, would Uncle Benny be ready or even capable of interest rate hikes of the magnitude and timing necessary ?   Doubtful.

So, what would we say to Uncle Benny now? Mainly two things.  One, if SuperInflation comes your way, don’t act like Granpa Volcker.  Two, can you please for the love of God and Reason (GR) realize that you have lost all control over mid and long-term interest rates?  Can you please realize Uncle that the bond market, as reflected in the yield curve, is completely out of whack with the monetary reality you are bound to create or require in the next few years?   In effect, you, Uncle Benny are nothing but a shadow and vacuous conductor to an orchestra-cum-cacophony that long ago stopped listening or following your cue.  You don’t even control the broad monetary aggregates, but rather merely follow them, how pathetic. Then, please, please just stop waving your fruitless little hands in the air, and just tell me what you know.  What is happening at the margin, at those Fat, Dark Wings (corners), where all the important stuff happens?  The puppet-show of “policy debate” publicly displayed for us slaves is not only intentionally misleading and dilatory, but is often divergently different from the economic and financial reality, even as discussed in the same inner echelons of power that produce the puppet show.      So, Uncle Benny, rather than really concern ourselves with what you will do with your vestigial little tool, the Fed Funds Rate, which you continue to render more and more meaningless by the day, we would rather prepare for the potential risks.  Inflation can be a ruthless enemy and we are firmly convinced you have not only planted, fed and nurtured the seeds of SuperInflation, but will also be powerless to stop it, it will eat you alive and not even 6 foot 7 Granpa Volcker will be able to resuscitate you with one of his many powerful Black Incantations. 

As for you dear readers, may your capital be safe and your investments prosperous,

MAAA

Greetings fellow inmates,

Much of our recent discussion has focused on the seemingly inevitable collapse of the US-debt-backed global financial system.   In continuation of that theme, today we will explore a specific aspect of this problem: the likelihood of a US default.   Many argue, quite fiercely, that a US default is technically impossible since it is the issuer of the world’s reserve currency.  In other words, the US will always be able to pay its debt in dollars because it can always print more of them to do so.   While this technicality is certainly correct, it is too narrow to really broach the nature of the problem.   For that reason, we will explore some different measures and indicators of a country’s ability to fulfil its debt obligations, when applied to the US.    As a starting point, we will use a benchmark developed by Judy herself, dr. Alan Greenspan, known as the Guidotti-Greenspan Rule (G-G Rule).

In short, the G-G Rule postulates that countries must hold liquid reserves, whatever that means, in a 1:1 ratio to short-term external debt.   In other words, a country must have enough reserves to fulfil all its obligations for a period of one year even in the case of a complete cessation of all influx of capital; reserves must cover 100% of short-term debt.   The rule makes sense, as it implies that a country must hold enough savings to be self-sufficient for at least one year.  The G-G rule has had some success in predicting sovereign defaults and currency crises, allegedly.  In the various interpretations of the G-G Rule in the literature, the terms reserves, liquid reserves and hard currency reserves are used interchangeably, while external debt is used interchangeably with foreign debt and simply debt.   As always, as stated in the About Us section, we believe that the first step to any problem is to properly define all variables and concepts.   This belief is rooted not only in the logical and rational necessity of it, but also our own observations and experience on the plethora of problems that arise simply due to faulty, vacuous, ambiguous and often deceptive definitions.  Our conviction in this is so strong that we would more likely label ourselves DEFINITIONISTS, as opposed to Judy, who is an ECONOMIST.  

Before we get to the nitty-gritty, let’s look at the current Numbers.    As of 10.31.09, the US Treasury owed about $1.8tr in T-bills, which are debts that must be repaid within the next 12 months.  You can download the latest monthly statement on US debt from the Treasury itself, and we advise you to check it regularly, it is, after all, one of the most important "scoreboards" of which to keep track as we stay tuned to the BIG SHOW.   These $1.8tr in reserves roughly matches the projected deficit for the upcoming year of $1.8tr.   Added together, they amount to little more than $3.5tr that must be financed within the next year.    Given the US’s fiscal and current account deficits, it is clear that this money must be borrowed since they are grossly spending more than the take in.   Therefore, it is evident that the US’s ability to fulfil its short-term debt obligations relies on its ability to take on more short-term obligations.  

Let’s focus again on the definitions.   The total $1.8tr in T-Bills represents the total US government short-term debt.   Of that, $600bln T-Bills are owned by foreigners, thus representing the total US government short-term external debt.   Though a more thorough treatment would require inclusion of private total short-term debt and reserves, we will limit our discussion to government debt since the data is more readily available and succinctly presented.    The US short-term external debt has tripled since the end 2007, when it was at $200bln.   This can be partly explained by the global fight to safety, which prompted investors to move money into the “safest” asset, mainly US T-Bills.   We believe this increase in short-term external debt is also the result of investors across the world, including foreign nations, shortening the maturity of their US debt holdings by letting long-term securities expire and rolling them forward into the short-end of the curve.     This tripling of short-term external debt should have been accompanied, according to the G-G rule, by a tripling of US reserves.   Let’s look at how that has fared.

The table below shows the official reserve assets of the US, as reported by Uncle Benny.

While official reserve assets grew dramatically in the first half of 2009, from $77bln in 2008 to $135bln in Q2 2009, it is not the requisite tripling.  The increase was mostly due to a huge increase in the US holdings of IMF Special Drawing Rights (SDR), which jumped from $9.3bln to $58bln in the first six months of 09.   We do not know as of now the reason for this, perhaps they were issued some more?  Perhaps some behind-the-scenes pre-emptive US bailout by the IMF?  Another peculiarity of the data is that gold stock is priced at $42.22 per troy oz, instead of its market value of about $1,200/oz.   If we use the market value instead, then total reserves rise to about $435bln in Q2 2009.    If we count the value of the oil in the Strategic Oil Reserve, then the total value of US reserves comes to about $500bln.  

Therefore, using these narrow indicators as inputs to the G-G Rule, we find that the US has about a 1:3.6 ratio of official reserves to short-term debt, or roughly only 27% coverage.    Meanwhile, it has a 1:1.2 ratio of official reserves to short-term external debt, or roughly 83% coverage.   On both counts, the US fails the G-G Rule.   While the latter ratio might seem to be reasonably close to this rule-of-thumb, it still fails.    Many believe this rule to be of limited value when applied to the issuer of the reserve currency.   However, as we said at the onset, this seems like a sensible rule given the rational underlying principle of having reserves at least equal to short-term liabilities.   Moreover, at this point in the discussion, definitions once again become important.

It is self-evident that the G-G rule implies that reserves can be used to pay for debt – if not, then it is truly vacuous, much like the sunken-in chest of one of its progenitors.   Then, the question is whether the official US reserves, in their current form, could be used to pay for the maturing T-Bills in case the world at large stops buying more of them.   Close to 60%, or $300bln, of the reserves are in gold.   We think it’s highly unlikely that Uncle Benny would give up that gold – after all there is nothing Wizards of the Black Arts love more than gold.  Ostensibly, the IMF SDRs (or roughly 15% of total reserves) could be used to pay for some of that external debt.   In effect, this would amount to little more than a digital debiting and crediting of individual country’s accounts at the IMF.   This of course is a clear example of a supranational entity serving as the enforcer of debt amongst smaller sovereigns a theme we have begun discussing in Transitioning to a Global Credit Regime Part I.  This might prove shallow comfort for US creditors, since the SDRs are nothing but a basket of currencies heavily weighed by the USD.   The roughly 10% of reserves held as foreign currency is arguably the most liquid component, which, in the case of a cessation of foreign capital to the US, would presumably appreciate substantially (depending of course on magnitude and duration of this cessation).    It seems then that official reserves may actually have limited scope as debt tender, which would lower the G-G ratio even more.   It is beyond the scope of the G-G Rule and of this post to quantify the willingness of a given country to use up their reserves to fulfil debt obligations, so we would rather be conservative and assume that every single ounce of gold could be sold.   In this case, the US would have about $300bln of gold ready to pay for $1.8tr of outstanding short-term debt, or roughly 16.666%.   The other 83% of people would have to be PAID-IN-KIND; receiving a new IOU from Uncle Sam.   

Given some of the narrowness of the G-G Rule, we decided to look at another indicator, which at first might seem peripheral, but illustrates some key points.  The following chart shows the ratio of USD currency in circulation to nominal US GDP, which we will call the currency cover, data courtesy of Uncle Benny and Co.  You can download all the data and charts here.  

We can take away a few notable points from the data.  After FDR ended the gold standard in 1933, the ratio of currency to GDP increased by 87% over the following 13 years.   In other words, over the course of 13 years, the fractional amount of total GDP that was covered by currency nearly doubled.  Bear in mind that this is different than a simple doubling of the total amount of currency in circulation (CIC) (since in that time period, CIC quadrupled).   Rather, it is the amount of currency necessary to grease the wheels of an economy of a given size and growth rate.  Since GDP is a measure of output, which is itself a measure of the amount of transactions, the currency cover is the amount of currency needed to ensure/collaterize those transactions.   Alternatively then, in the period between 1933 and 1945, the economy became twice as dependent on physical currency.   Of course, there are several reasons for this, most notably the end of the gold standard and WWII – and we will post about this in much more detail later on.  After 1945, this ratio dropped significantly by 67 % to its low in the mid-1980s, when the currency cover was only 4%, as opposed to its 1945 high of 12%.   This could be explained by the transition to a more digitized and globalized economy.   While we intend to post in the near future on the history of the actual currency location, our intuition tells us that in the past few decades we have seen a monotonic increase in the percentage of dollars in circulation that are held outside the US. For now, the relevant point is that physical dollars have become less necessary as collateral for transactions due to an increased collaterization based purely on credit, brought forth by a system of digital crediting and debiting.  

The relevance of this trend to this discussion lies in the US’s economy rate of growth as compared to the physical currency rate of growth.   While of course, “physical” is a term that we use lightly here since Federal Reserve Notes are actually financial assets with no intrinsic value, but they are nevertheless material, as opposed to digital.   The increased digitalization of the US economy exacerbates this trend towards an asymptotically vanishing RESERVE BASE that US creditors can legitimately claim.    The G-G rule evidences the inadequacy of US official reserves to cover short-term debts; even these official reserves could be largely illiquid (if we assume Uncle Benny will be unwilling to part with his pot of gold) or simply be an alternative form of debt (SDRs).  Then what can US creditors CLAIM?   Definitely not a chunk of the current economy, which is pervasively running deficits on all counts.   A claim on the future economy is, of course, nothing but more debt.    Then maybe, US creditors could claim physical commodities in US soil?  Perhaps, though you can easily imagine how thorny that would be.   What about claiming some intellectual capital in the form of patents and technological know-how?  Political influence, military might?  Now, things are getting interesting. Have your tanks on stand-by!

Ultimately, can the world at large expect payment from the US?  Of course not!   Even in the past, this scenario was also self-evident.   As we have often argued recently, the only reason this system seemed tenable for decades was the faith that the US will ALWAYS be able to roll over their debts.   One of the most prevalent and ingrained cognitive biases in human behaviour is the belief that things will not change even when the entirety of universal history proves that everything changes.  We are as certain as can be that this current US-backed global financial system will come to an end.   The risk US creditors are taking is enormous since there is no way to exactly predict when the crisis of faith will explode.  They have begun shortening the maturity of their holdings for this very reason, as a form to reduce risk of non-payment.   Eventually, this process will reach critical mass and the death-tsunami-avalanche many of us have been expecting will come in full force.  Hapless creditors left holding the BROWN, SMELLY bag will wonder, why o why didn’t I ASK myself, to what exactly does this paper entitle me?   Well, nothing Beverly, Judy has been trying to tell you that for years!  Do NOT lend your hard-earned money to Uncle Sam!

May your capital be safe and your investments prosperous,

MAAA

Greetings fellow inmates,

In our most recent posts, A large-scale look at debt, Count the Money v2.0 and A visual history of how US Treasuries became worthless, we have spent a good amount of time discussing the apparent inevitability of the eventual collapse of the global debt mountain and the monetary crisis that will follow.  Much of our focus has been on sovereign debt, specifically the US variety, since the USD is still the world’s reserve currency.   While we have become convinced of this inevitability, there is no certainty regarding its timing, the full magnitude of its effects and the subsequent global response.    The natural next step then in this rational discourse is to begin thinking about what comes next.    In that spirit, this is the first in a series of posts that will aim to discuss and dissect the more likely nature, features and requirements of the global monetary and debt system that will emerge once the current one disintegrates.   To be clear, we define the current system as consisting of fiat sovereign currencies collaterized by sovereign (and now private) debt, primarily from the US.   It is precisely this system that we have come to believe is unsustainable and will eventually crash in what many people call the Dollar Event Horizon (DEH).  What emerges after DEH must therefore not be of a sovereign nature, but of a global one; of that we are certain.   Though, as always, we will try to stick to Numbers, Facts and Reason (NFR) as much as possible, the nature of this particular discourse must necessarily include some speculative elements.   For that reason, we highly encourage all our readers to participate in this discussion as many minds are infinitely better than a few, and understanding the nature of this transition will be instrumental to financial survival.  

There are many variables, uncertainties and viewpoints when pondering what will come after the DEH.    Though we will at times distinguish monetary and credit issues, please keep in mind that for the purposes of this exercise, they are in fact the same thing:  Debt is money, money is debt.    In this first instalment, we begin by looking at the issue from a more monetary perspective.

Contrary to what many economic pundits propound , history often serves as a guide for future events.   At the very least, we owe it to ourselves as rational monkeys to explore some previous historical cases of transformational systemic change in the global monetary system, which is exactly what we expect is going to happen.  As a recent and eerily similar example, we take a look at 1933,  quite an eventful year in many respects.   In Germany, the Nazis rose quickly to power as Adolf Hitler became dictator of Germany, and spent a good amount of the year burning books, repealing civil liberties, building concentration camps and signing accords with the Pope.  Germany and Japan, the elder axis of evil, left the League of Nations.  The US and the Soviet Union formally established diplomatic relationships.   Paraguay declared war on Bolivia.  But none of this garnered any attention, relatively, as the Great Depression was raging on worldwide.  

In the US, 1933 was a year of particular significance as many of the features of the current financial, monetary and regulatory infrastructure came into being.   On 03.04.33, Franklin Delano Roosevelt was inaugurated, famously proclaiming “the only thing we have to fear is fear itself”.   Pretty much immediately upon entering office, he instituted a sweeping set of reforms, mostly in the New Deal, to the financial and monetary system that would have deep repercussions for the world as a whole. The underlying causes/circumstances for these reforms were then, as they are now:  high unemployment, a deep economic recession/depression, threats of deflation and fear of an impending economic deathball-of-destruction (d-o-d).  The Agricultural Adjustment Administration (AAA), the Federal Deposit Insurance Corporation (FDIC), the Public Works Administration (PWA), the Glass-Steagall Act (expired), the Securities and Exchange Commission (SEC), and the Social Security Program were all enshrined into law within FDRs first two years in office.  Please, take a moment to think about how deeply your life is affected by these programs.   As if that wasn’t enough, in exactly 33 days, after entering office, he passed Executive Order 6102 (EO6201) and proceeded then to effectively end the gold standard as it had functioned for the past couple of centuries before that.   Beginning with EO6201, FDR prohibited the private ownership of gold and mandated that it would no longer be acceptable as legal tender of debts, except for foreign exchange.   In other words, every US citizen was forced to hand over part of their tangible wealth, and it became illegal to demand gold in exchange of your debt, at the penalty of death.   Let’s think about that for a second.   If we assume the notion that gold actually serves as a real store of wealth, then this was a gargantuan outright theft of the people by Uncle Benny’s Black Magick Money Wizard forbears.   Peoples were forced to give up their tangible assets in exchange for paper currency backed by government debt, forced to participate in the current fiat system.  While this example illustrates the theft very vividly because gold is a tangible asset as opposed to its financial paper successor, we argue that even the gold standard was in fact fiat.   Of course, gold does have some inherent qualities that make it well suited as currency (mainly density, malleabity, indestructibility and scarcity), but it still lacks a significant intrinsic value to humans as we cannot eat or drink it, nor shelter or clothe ourselves with it, nor economically build stuff.   It does have some value however since we use mainly for industry and jewellery, in addition to its remaining financial uses. In a future post on gold we will examine some of its history, where it went, and some of the intricacies of its true value.    For now however, we wish to simply focus on its monetary nature.  

These changes resulted in a 41% devaluation of the dollar.    This was partly motivated and justified by the rampant fears of deflation which, much like today, were used to galvanize a wantonly expansionary policy.   Check out the video “Inflation” in the Video Cart, (produced by MGM, curiously, in 1933), which explains to us poor dumb folk how money works and how inflation is good for everyone!   Two important things to note:  at that moment every unit of currency went from being backed by a tangible and finite asset of an agreed-upon “value”(price), into being backed by government debt, which is nothing but claims on the future production of US citizens.  In other words, effectively (and we would love some debate on this matter) US and global citizens alike, were deprived of wealth held in their physical possession and handed one that depended how hard they worked, or as is known in some circles, the ol’ “hand over everything you’ve got and I’ll give it back depending on how hard you work for me slave”.   This was a paradigm shift.

Clearly, there are some differences from 1933 and today, almost 77 years later.   Today, we are already operating under the notion that currency is backed by a potentially infinite supply of government debt, which in turn is claims on the future production of its citizens.    It is difficult to imagine the system changing significantly in this feature since the supply of money is already boundless.   In this respect, we can think of the 1933 repeal of the gold standard as having a larger philosophical implication than what seems likely today.    We will deal in more detail with the potential source/distribution of sources of supply of money collateral in a later instalment.  

More to the point, in 1933 the dollar was devalued by 41% as a result of this shift, resulting in large inflation.   The following is a chart of the USD Trade Weighted Index for Major Currencies (EU, CAD, JPY, GBP, CHF, AUD, SEK), data courtesy of Uncle Benny.

We can easily notice the multi-decade secular down trend in which the Index went from a high of about 150 in 1985, to about 73 today, or about a 51% decline in the value of the USD.   This, during a time of strong economic and financial expansion.   Combined with the 1933 example, it does not seem implausible that the dollar could lose 50% of its value once again, as a minimum (or for now merely representative) value for the worst case scenario in the systemic transition we expect will happen.    This amount of devaluation would lead immediately to the eradication, or rather expropriation, of about $2.7tr of foreign exchange reserves, which represent the total global amount of sovereign savings.  The Chinese would be especially hurt by this; have you ever tried to stiff one of them for even a few nickels?  We have, it got us shanked!

This should clearly lead to a wide exodus from US debt, greatly raising interest rates and make it nearly impossible for the US to continue financing the Ponzi scheme.   A massive wave of inflation, which we lovingly call SuperInflation, is likely to result as a means of alleviate the debt burden which is no longer able to be rolled forward.  Confidence, or faith in the system will crack.   However, as we said, it seems unlikely at this point that the fiat nature of a currency backed by a boundless supply of money collateral, which is in the form of claims on future production,  will change.    Rather, what we think will happen is a shift to globalize this dependency.  In other words, the world will have one money backed by a boundless supply of money collateral which are claims on the future production of the world, rather than individual countries.   The financial enslavement of the world will be then completed.  

Even though the shift from a largely unipolar sovereign monetary/credit system to a non-polar global system will have dramatic consequences, we must not fool ourselves:  it will still be fiat based on debt.     We will discuss what this means and how we could hopefully avoid it in more detail in next instalments of this Series.

That’s it for this instalment.  In the upcoming ones, we will discuss the nascent market for debt issued by international organizations (IMF, etc), the possibility of a global tax-collecting agency, more detailed examination of what would happen to the current debt, what kind of asset redistribution could take place, requirements of a single world currency, potential regulatory overhauls, and much much more.    Join us as we kick around this rusty ol can out in the Yard.  

May your capital be safe and your investments prosperous,

MAAA

Greetings fellow inmates,

It’s an age-old adage that in order to know where we are going we must first understand where we came from.     In that spirit, today we will explore a good tract of history of US government debt in a variety of contexts in order to get a firm footing on where we are today.  “Worthless” is a strong word and one that we don’t use lightly.   Worth or value is something particularly tricky to define or ascertain, and one of the quintessential problems in economics.   In the next few days we will be doing a more thorough post on this matter, but for now, we will omit some of the details and simply utilize the notion that US Treasury securities (UST’s) are claims against US citizens, or more specifically, tax-payers.   As we often do, we will take a broad view of the relevant Numbers and use simple, rational arguments to make a point.    All the following data comes courtesy of Uncle Benny and Co. at the St. Louis Federal Reserve.  The FRED database is an excellent resource for all you inmates looking for some data.    We’ve aggregated all the following data and charts onto this XLS file for your convenience.

We begin by looking at the total outstanding amount of US public debt.    The following chart includes both debt held by the public and intra-governmental debt.    Bear in mind for the remainder of the post that we are looking simply at public debt securities, which exclude a wealth of other current and future US government liabilities like Medicare, Medicaid, Social Security, Fannie and Freddie debt, and the wealth of other government guarantees undertaken during the GCC, which in total add up to several tens of trillions of dollars.   We mention these only cursorily for now, but we’ll treat them in more detail in a later post.

As of 10.31.09, total public US debt was at $11.9tr.    The preceding chart shows data from 1966 onwards, which is as far back as the FRED database goes.   We also note that a significant ramp up in public debt began in the mid 1970s.    Presumably, a big factor in this was the Nixon Shock in 1971, in which the USD convertibility to gold was terminated, thus eliminating the last remaining semblance of a gold standard.   With gold finally out of the picture, governments and investors worldwide needed another “store of value”, and given Uncle Sam’s “impeccable” credit history, US Treasuries became the natural substitute.   This surge in demand allowed for the explosion in supply clearly evident in the multi-decade trend from the 70s to now.  

All else being equal, one would expect, as traditional economic theory postulates, that supply of a given debt security would be inversely correlated with its price.   In other words, the more a debtor borrows the higher interest rate they must pay.   Curiously, we notice the exact opposite in the case of US Treasuries.   In Count the Money v2.0, we estimated that the average maturity of outstanding US Gov debt would be around 7 years.    We actually looked at the Numbers published every month by the US Department of the Treasury and calculated the weighted average maturity of outstanding UST’s as of Oct 09, to be approximately 6.2 years: not bad for a shot in the dark!  In any case, for the sake of this exercise we will use this maturity as “characteristic” of the total outstanding public debt.   Though this is a non-trivial simplification, it still illustrates the point.  The following chart shows the yields on 7-year UST’s.

Immediately following Grandpa Volcker’s crack-down on rampant inflation, we notice a secular decrease in yields, from 14% at the beginning of 1982 to 3% near the end of 2009.    During that same time, Uncle Sam’s debt grew eleven-fold, from $1.06tr in early 1982 to the current $11.9tr.    In 2005, Alan Greenspan, a.k.a “Judy”, described low bond yields as a “conundrum” given the macroeconomic picture at the time.   Well Judy, we are equally puzzled by this enormous 27-year reduction in yields during a time when public debt exploded.   Very broadly, we could assert that the world’s perception during this time has been that Uncle Sam has become increasingly able to pay all his debts, thus affording him lower borrowing costs.   Alternatively, and more likely in our opinion, this was due to an acknowledgement that UST’s were so fundamental to the global economy and wealth that other people would always demand more of them, hence people felt safe buying them.   In other words, the US Gov had become too-big-to-fail (TBTF)   One thing that the GCC has illustrated in vivid color is the peril in the belief that anything is TBTF.   A student of history can easily see that patterns repeat at all scales:  no bank, no insurer, no market, no nation, no empire is TBTF.  

On this point we remain absolutely rationally befuddled.   While we are able to grasp the notion that the world at large has continued amassing enormous amount of UST’s for the past three decades based on the belief that the US Gov is TBTF, we struggle to understand why.  As we have stated before, and will demonstrate later, the outstanding debt will never be paid off through real economic growth.    The chart below shows the Consumer Price Index since 1913, coincidentally on the same year of the establishment of the Fed.    In the same 27-year period, the CPI increased by 150%, greatly eroding the value of US debt.   Yet we have kept buying. 

It seems like the only explanation is Faith that the USD/UST’s will remain supreme forever.   This is of course the nature of our fiat system.   We’ll return to this point shortly, but let’s re-examine our earlier definition of UST’s as claims against US tax-payers.    Well what exactly can the holders of UST’s claim?   Allegedly, these are claims on units of output, as measured by GDP.   The chart below shows US GDP and gross federal debt, which differs from total public debt in that it excludes state and local bonds.  

Call us crazy, but it would appear as though nominal GDP growth for the past three decades has been in large part fuelled by borrowed money.   Of course, this makes sense, as money has flowed into the US either from abroad or in an endogenous generation, which has resulted in increased output.   But what exactly is this output that UST holders can claim?   Well, there’s physical infrastructure, science, art and consumable commodities and necessities.   The rest is left over in the monetary system.   The following chart shows the M1 and M2 money aggregators, which measure the amount of money in the system.  

This amount of money in the system should represent a store of wealth, to be cashed in at a future date for assets with real value.   Though we would welcome some debate on this point, the parabolic growth in these money measures is one and the same as the parabolic growth in total debt.   Seen in a different light, this growth in money is a necessity of the Ponzi nature of this debt edifice, where each participant’s future claims get increased as payment for their participation in kicking the can today.   In other words, as debt matures, more debt gets issued to pay the beneficiaries (creditors) on a large-scale, simultaneously as more money gets created to credit the digital accounts of smaller claim-holders.   The monotonic nature of the CPI irrefutably shows this (the BLS’s statistical chicanery notwithstanding), as more money has been created than needed for the procurement of a “representative” unit of physical goods.   

This Ponzi process has been happening for decades, supported by nothing but Faith.    Ultimately, as this process continues, then the only rational conclusion is UST holders will only have claims on more debt.   That if of course, barring those lucky few that will get to cash in their claims in exchange for real assets in time.   Eventually, the world at large will realize this, Faith will evaporate and the mad rush that will lead to SuperInflation will begin.  Ricardian equivalence will finally be dealt the ignominious death it so rightfully deserves. This crumbling edifice will collapse, in a gruesome tsunami of financial destruction that will dwarf anything experienced in the modern world. 

In the interest of brevity, we have skipped many details (some of which we’ll treat in future posts); a thorough history of US debt would require tomes in and of itself.   Nevertheless, we believe that even this cursory glance should be enough to make you question the nature of the claims represented by USTs and shake your Faith in them.    Naturally, the question arises as to how best protect oneself from this impending catastrophe.  We advocate taking a good, long, hard look at your assets; defining what wealth means to you without contemplating the claims provided by the system; wasting no time in turning your current claims into a sustainable source of wealth.   Ultimately, the best time-tested protection against systemic collapse is placing your Faith in nothing but yourself.  On that note, we shall retire to The Chapel for some quiet contemplation.

May your capital be safe and your investments prosperous,

MAAA