Fed vs. Fed


One of the oldest and grandest of conspiracy theories has picked up some steam in recent years:  Who Owns and Controls the Federal Reserve?  In an attempt to answer this question, Dr. Edward Flaherty has addressed the theories of authors such as Eustace Mullins and Gary Kay, and others in this well laid out article.

Me personally?  I don’t really care whether the Federal Reserve system is the love child of the Rothchilds (or whoever).  Of course, that might well matter in the long run, still, it remains unarguably true that the Federal Reserve is a private banking concern with a special, publicly granted license to control the nation’s money supply.  It is also true that both bankers and politicians benefit from the relationship.

Politicians benefit largely because they need help buying votes.  When they pander to special interests, they must, inevitably, spend more than they can raise through taxes.  The Fed facilitates this process mostly by artificially lowering interest rates that would otherwise rise as a result of deficit spending.  Bankers benefit because they get a sweetheart deal for their own borrowing needs, rarely needing to rely on the savings of the nation, which through inflation is guaranteed to be a paltry sum in any regard. 

For the bankers and the politicians who grant them their franchise, this is clearly a win-win situation, oh, so long as you don’t consider the interest of the American public, who are stuck with the inevitable inflation and amplified business cycles.  So, if you’re convinced that programs like Social Security are hardly better than a Ponzi scheme, well then, the central banking model is, inherently, a much bigger scam. 

Still, on practical grounds, I’m much more interested in whether or not the Fed’s interests may, at some point in the (near?) future begin to diverge from that of the Federal Government.  This may prove to have some pretty significant implications.

Consider for a moment what might happen when the Fed is (inevitably) unable to prevent a crash of the bond market?  Among mainstream economists, this eventuality hasn’t really been given much thought.  Why is it inevitable?  Let me count the ways:

  1. New treasury issues amount to more than a 10% annual increase in the overall supply of Federal government debt, with something on the order of 70% of that now being bought by the Federal Reserve with newly minted money.  The net effect of this is an immediate 7% (+/-) annual dilution in the value of all existing treasury debt.  Added to this, of course, is the “official” rate of inflation – 3.8% over the last year.  In aggregate, merely using the official data, bond holders must realize that their “real” yield is at least 10% or 11% lower than the face rate of the bonds they are buying.  Just how much negative yield are they willing to accept, do you think? 
  2. With an annual growth rate of 10% (or more), the supply of treasury debt has a doubling time of only 7 years.  This means that, assuming the rate of growth doesn’t continue to grow, the US government will owe more than $30 trillion by 2018.  However you slice it, this rate of growth easily outpaces any real (market-driven) demand for it, which is why the Fed has needed to step in to become the single largest buyer already.
  3. Since the existing debt is comprised of mostly shorter-term maturities, it must be refinanced on a regular basis at the prevailing “market” yield rate.  If rates climb from the (unbelievably) low 1.5% average rate now being paid, the budget deficit – and, thus, the amount of new debt that must be sold – will escalate exponentially.  That 7-year doubling could, quite quickly and easily, become a 2 or 3 year horizon.
  4. From the demand side of the equation, clearly the Fed’s role as the single largest buyer tells us we’ve already reached the upper limit.  So, for those that think “the Chinese have to buy”, think again.  While they (along with the rest of our trading partners) will certainly face substantial demand destruction, the only way they can avoid this 10%+ (and growing) annual depreciation of their dollar holdings is to free-float their currency and, thus, adjust their export prices.  This is why many of the most forward-thinking economists expect import prices to rise dramatically.  This, of course, would result in significant demand destruction – both for their export goods, but also for their need (i.e. demand) to buy US treasury debt.

All of which is to say about the treasury debt market:  a) demand is already limited and likely to shrink, while b) supply is extraordinarily high and likely to explode to the upside.  What, do you imagine, will that do to treasury yields and, thus, to the value of existing bond values?  If you think the housing bubble burst rather suddenly, well, you ain’t seen nothing yet.

Oh, but, the Fed has done an amazing job of pushing yields down.  That is true, much to PIMCO’s Bill Gross’s chagrin.  It seems that the value of existing bonds have continued to appreciate.  But, we might recall the “writing on the wall” in the 2006 housing market, when prices were beginning to level off, demand dry up, the market limping along with ever-growing reliance on subprime financing.  This was the quite before the storm, the last months before the curtain call.

This is where we are in the US debt market.  What do you imagine is the Fed’s exit strategy?  Not to mention their member-banks?  Will they get left holding their massive and rapidly growing pool of soon-to-crash debt?  Will they merely print more money to bail themselves out?  Will their political allies allow such a thing to happen?  Within the very near future, we’re talking about potential losses amounting to many (perhaps tens of) trillions of dollars.  

To what extent have they hedged themselves with risky derivatives?  This, we understand, may be the real elephant in the room, presumably hidden in the Fed’s “other assets” account.  And, speaking of hedges, who really owns the US gold reserves, reported to be in the neighborhood of 9,000 tons, reported on the books at only $35 per ounce.  (Today’s market value roughly $500 billion….oh but it could grow, now couldn’t it?)

I guess those are the questions at hand.  Does the Fed have an exit strategy and does it diverge from the interests of their political partners?  The Fed’s supposed charter to maintain full employment and pricing stability is intended to take precedence over their real prime directive…to maintain the solvency (and profitability) of the banking system.   

The political class is motivated by their own power and survival.  In the end, they’ll continue to do battle over exploding spending and the ignominy of default.  The question is whether the Fed will allow them to keep spending, since it requires them to keep buying ever more worthless debt.  Personally, I really doubt it.  But, what then?



4 responses to “Fed vs. Fed

  1. I understand that Sims and Sargent are worthy recipients, but I am disappointed that you didn’t take home the Nobel this year. But given that you didn’t and given the Reuters chart of the day, http://blogs.reuters.com/felix-salmon/2011/10/10/chart-of-the-day-median-income-edition/ don’t quit your day job just yet. 16% of the workforce can’t be wrong. Of course you might just quit to reinforce the Austrian principle that all unemployment in voluntary.

    • I understand both fellows have been working on the chicken/egg/circular-logic of policy effects on the economy. I’m sure they love their models (as I do mine), but alas, they might have saved themselves the trouble and simply conceded that, yes, government intervention almost invariably weakens economic efficiency….seems kind of like studying just how much vinegar you can add to milk before it curdles.

      Anyway, yeah, the household income situation is pretty grim….the vanishing middle class that we’ve both spoken about in the past. And, yeah, too many of us making buggy whips it seems. I’m still open to ideas on small scale (and necessary) products and services…. this circling around the toilet bowl is making me dizzy.


  2. Thinking about these questions, it is important to return to the question of agency. “Does the Fed have a mind?” Yes, the bankers have an exit strategy. It is called “If everything goes bad, I still got mine.” It is all about incentives, and the incentives are to discount institutional risk in the pursuit of career success and individual profit. It probably isn’t that scary to dance to musical chairs if you know that your cottage in the Hamptons is all paid off.

    • We all, I think, used to joke (grimly) about the fact that the government (or most anyone with any kind of a vested interest) would never ever tell the public just how bad things were going. Most of the time, I can’t do it either. Even assuming that they know the truth, there is always hope and, of course, the knowledge that perception does shape reality (if not always vice versa).

      The bond market implodes either because it must or, perhaps, because enough people begin to believe that it must. Cascading failure in the social sciences is always going to reflect human nature, the self-interest of billions on parade. Are central bankers (or any of the rich) any more or less susceptible to fear and greed? Probably not. I think they lie, because they feel they must, because the feel that they can yet steer clear of the rocky shoals, because they know that to tell the truth will make the future certain.

      In regards to an exit strategy, I’m inclined to view it in stages. If those in control of the Fed do see the writing on the wall (or see it the way I do at least), then, well yes, I’d have to assume that they’re probably making accommodations as we speak. If, on the other hand they’re actually a hell of lot smarter than me, or simply deluded, then I suppose not. I’m not entirely sure just how far you can wargame them, but I have to imagine that they do have a variety of contingency plans and one of them just might be saying “no” to Congress. Volker could, maybe Bernanke can too.

      Here, by the way, is a good quote from Mr. Volker himself from a recent article in the NYT (http://www.nytimes.com/2011/09/19/opinion/a-little-inflation-can-be-a-dangerous-thing.html)

      My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

      Sounds like he’d say “no” again.

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