By Simon Grey, on February 8th, 2012
The Federal Reserve Open Market Committee (FOMC) has made it official: After its latest two day meeting, it announced its goal to devalue the dollar by 33% over the next 20 years. The debauch of the dollar will be even greater if the Fed exceeds its goal of a 2 percent per year increase in the price level.
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. [Emphasis added.]
The black letter of the law mandates stable prices. “Stable,” by the way, is defined as: a : firmly established : fixed, steadfast <stable opinions>
b : not changing or fluctuating : unvarying <in stable condition>
Quite simply, the Federal Reserve is commanded, by law, to maintain stable (i.e. not fluctuating or changing) prices. Failure to do this is a clear violation of the law.
Now, there is no way to argue that debauching the dollar by 33% over 20 years will maintain stable prices because the economics of the situation is very simple: If you increase the supply of money without a consequent increase in the production of consumer goods, prices will increase. That is, prices will not be stable. The laws of supply and demand always apply, and money is no exception. Increasing the amount of currency in a system will, ceteris parabis, lead to an increase in nominal prices. Always.
As such, the Federal Reserve System is in clear violation of its charter. It should have its charter revoked and be disbanded, and those who acted to violate its charter should be arrested for violating the law.
By Simon Grey, on January 30th, 2012
Make no mistake, the problem does not lie with The Fed per-se. The Fed’s “low interest rates” are there to permit the profligacy of the government, yet the longer it goes on and the more the government abuses this deadly embrace the further into the coffin corner The Fed and Congress go. As the debt accumulation rises the maximum interest rate that can be absorbed goes down until finally you reach the boundary where even a slight increase in rates results in instantaneous bankruptcy.
Denninger is a smart man—well-versed in the law, particularly constitutional law, and has an immense knowledge of politics and economics. And yet, here he is once again calling for enforcement of the laws governing The Fed even though history has shown repeatedly and conclusively that it is politically impossible to manage inflation through a central bank. In theory, it is possible that a central bank will act prudently and responsibly, and not inflate the currency. In reality, though, a central bank is nothing more than yet another mechanism by which the government can tax the people.
This is why the solution to inflation is ending the fed, or at least government-mandated fiat currencies, and to allow multiple competing currencies. Relying on the government to properly manage a monopolistic money supply is an exercise in futility. Though it would be theoretically better to do it this way, history has shown quite clearly that a competitive currency market is preferable to a government-controlled currency, and it is therefore better to accept the fluctuations of market-based currency system over the guaranteed degradation of a government monopoly.
By Ajay Shah, on January 27th, 2012
Reportage by Robin Harding and Michael Mackenzie in the Financial Times:
The rate-setting Federal Open Market Committee predicted low interest rates until late 2014 and set a formal inflation objective of 2 per cent, reflecting chairman Ben Bernanke’s long-held goal of providing greater transparency.
The FOMC downgraded its estimate of growth in the coming quarters from “moderate” to “modest” and Mr Bernanke indicated that another monetary boost for the economy – most likely another round of quantitative easing, or QE3 – remained an option.
“We are prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target,” Mr Bernanke said.
The Fed also published its first detailed forecasts of future interest rates.
…
Adopting the 2 per cent objective is a historic move that binds the whole FOMC to a defined goal that will endure after Mr Bernanke leaves. It means the FOMC can easily justify more easing if it wants to because its inflation forecast for 2014, of between 1.6 and 2 per cent, is below target.
The FOMC voted for Wednesday’s decision by 9-1. The only dissenter was Jeffrey Lacker, president of the Richmond Fed, who wanted to leave the late 2014 date out of the policy statement.
The US suffers from legacy legislation, which predates modern monetary economics, which places the burden upon the Fed of pursuing both price stability and low unemployment. The evolution of the US Fed has been led by human energy within the Fed. Starting from Paul Volcker, who took charge in August 1979, the US Fed has run a Taylor rule with a nice strong above-1 inflation coefficient. In a recent column in the Indian Express, Ila Patnaik tells us about Paul Volcker’s story and how it matters to us. In effect, from Volcker’s chairmanship onwards, the behaviour of the US Fed has been that of an inflation targeting central bank. This was the de facto reality. Everyone knew that the US Fed targets inflation at 2%. What is new now is that the Fed has put greater credibility behind this, by going closer to de jure inflation targeting.
A key dharma of good central banking is to say what you will do, and then do what you just said. By saying that there is an inflation target, there is now full alignment between the words and deeds of the US Fed.
The day will come when India will enact high quality legislation which puts monetary policy on a sound institutional foundation. But we should not accept mal-performance by RBI until that day. It is possible for RBI to do much better, when compared with the present, even though the present legislation is really badly written. The US Fed is a good example of how technical capabilities within the Fed, and not an external legislative mandate, have driven improvements in the functioning of the Fed. This sort of progression is what RBI can and should aspire to, and this does not require waiting for a high quality RBI Act.
By Claus Vistesen, on January 5th, 2012
One point that I have been shouting from the proverbial roof tops in my research, to partners and colleagues is that 2012 may well be the year when all major central banks will be conducting both conventional and unconventional monetary easing at the same time. I think this is a very strong testament not only to the severity of the ongoing debt crisis in the developed world, but also to the propensity of central banks to choose inflation as the desired route to recovery. We need not initially discuss whether they are deploying the proper set of policies or even whether such policies represent moral hazard or a ponzi scheme on government debt.
The main thing is to realise that this is an unprecedented global monetary experiment.
My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won’t work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy.
In so far as goes the idea that an investors’ interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. I believe that
From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time.
Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below).
750 Billion USD, and counting …
Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.
In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe’s banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.
Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?
Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.
The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history.
While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.
I base this on two points.
- The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.
- ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.
The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons. When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.
I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.
As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012 as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.
The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular).
Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.
John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds.
Well the Euro fix is in. Whether it works – that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.
I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this.
The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010.
Quote Reuters
The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB’s overnight deposit account.
The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won’t act as a drag on their respective sovereign’s balance sheet as long as the ECB is involved.
I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank.
Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10.
However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out.
Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn’t assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day.
This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign’s banks and postponing the day of reckoning which is bank failures or nationalisation or both.
If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won’t be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds.
But Edward makes another interesting point;
Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.
(…)
Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.
It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little.
The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.
In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB’s balance sheet and, quite possibly, Fed’s USD swap lines.
–
(1) – Even if such purchases have been fully sterilised.
By Doug Gentry, on December 30th, 2011
Was it Popeye’s friend, Wimpy, who kept asking for a hamburger on credit? Today’s credit markets are anything but robust, with reduced demand and supply for borrowed funds. Always eager to find obscure terms for modern dilemmas, economists refer to this condition as a liquidity trap. With a little prodding from Facebook friend and neighbor, Patrick, we’ll give the concept a once over.
Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.
OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.
 Fed Funds Rate – St. Louis FRED database One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation. One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.
There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.
On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.
This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.
This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.
By Christopher Briem, on December 28th, 2011
So to admit upfront, this is all parasitic on some neat reporting from Bloomberg out on the Analytic Journalism frontier. They have acquired and made available to the public (which means they want us to use it right?) data as they describe “Once secret ” from the Federal Reserve on its lending to major banks during during the peak of the financial crisis.
As they describe it in detail the data:
The data reflect lending from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, the Term Auction Facility, the Term Securities Lending Facility, the discount window and single-tranche open market operations, or ST OMO.
Got that? I have pulled the files for PNC and National City which now are one of course. Some may recall there was a certain bit of angst up the Turnpike that for some reason National City was denied TARP funding that might have kept it around a bit longer. The PNC takeover followed immediately on the heels of the government’s denial of TARP dollars. Some thought it a bit less than fair since along the way PNC used some of the same money to implement the takeover.
Well.. if there is any doubt over the flawed logic of a straight one on one comparison of the financial situation of the two banks at the time, here is what the Bloomberg data has for Fed lending to the two institutions as a percentage of their market capitalizations day by day.
Yes at one point near the end, Fed lending to National City well exceeded its market capitalization. PNC’s lending looked to be in itinerant blocks of a billlion. I am speculating completely when I wonder if that was $ pushed by the Fed as it wanted to shore up confidence in the system.. not really money desperately needed by PNC at the time.
By Simon Grey, on December 15th, 2011
Researchers with the Federal Reserve Bank of New York found that investors who used low-down-payment, subprime credit to purchase multiple residential properties helped inflate home prices and are largely to blame for the recession. The researchers said their findings focused on an “undocumented” dimension of the housing market crisis that had been previously overlooked as officials focused on how to contain the financial crisis, not what caused it.
More than a third of all U.S. home mortgages granted in 2006 went to people who already owned at least one house, according to the report. In Arizona, California, Florida and Nevada, where average home prices more than doubled from 2000 to 2006, investors made up nearly half of all mortgage-backed purchases during the housing bubble. Buyers owning three or more properties represented the fastest-growing segment of homeowners during that time.
“This may have allowed the bubble to inflate further, which caused millions of owner-occupants to pay more if they wanted to buy a home for their family,” the researchers noted.
Investors defaulted in large numbers after home values began to drop in 2006. They accounted for more than 25 percent of seriously delinquent mortgage balances nationwide, and more than a third in Arizona, California, Florida, and Nevada from 2007 to 2009.
Sweet Keynes but the banksters just do not have a clue. Somehow, the FRB of New York has come to the hilarious conclusion that somehow, mysteriously, those who “flip” houses are the root cause of the recession. Talk about clueless.
The question that the NY FRB is apparently too stupid to ask is: Why would some people suddenly decide to “flip” houses? Answer: because it’s generally profitable due to the increased demand for houses as a result of a)artificially low interest rates from The Fed, b) massive fraud among the banks in regards to loan application, c) the Federal Government’s willingness to subsidize market risk, and thus eliminate moral hazard, through the agencies Freddie Mac and Fannie Mae, and d) the general tendency of the government to encourage and subsidize home ownership through, among other things, federal income tax breaks. Basically, the government as at the root of most of the problem here, and the Federal Reserve played a major role.
Of course, the FRB is not going to admit to wrongdoing, particularly since greedy businessmen make for a more compelling villain in this narrative. But blaming people for responding to incentives at the margin, as clearly happened in this case, is indicative of just how worthless mainstream macroeconomic analysis clearly is. Quite simply, it takes an astonishing amount of either dishonesty or short-sightedness to come to the conclusion that greedy businessmen are to blame for the current recession instead of the incentive system in which they operated.
The shallowness of this analysis, if honest, is simply evidence that those who are currently in charge are simply too stupid to merit the power with which they’ve been entrusted. If, on the other hand, they are liars, the case for their removal from power is not in any way diminished. In sum, there is no excuse for those presumed to be intelligent, and thus deserving of power, to be offering analysis this putridly vapid; they must be summarily dismissed and the system must be dispatched with.
* Cf. Dr. Sowell’s book Applied Economics.
By The Gold Report, on November 29th, 2011
 Among the specters lurking in ShadowStats.com’s Editor John Williams’ gloomy outlook for the U.S. are the demise of the dollar, hyperinflation and the ongoing lack of political will to take sound corrective measures. Still, as he tells The Gold Report in this exclusive interview, investors have options. Williams contends that turning to gold, silver and strong foreign currencies would protect wealth and position savvy investors to take advantage of extraordinary opportunities likely to flow out of the turmoil ahead.
The Gold Report: When we talked in May, you predicted that hyperinflation could be a reality as soon as 2014, something you addressed at length in your Hyperinflation Special Report. Have six months of euro debt crises, Middle East revolts and U.S. Treasuries’ downgrading altered your outlook?
John Williams: Not a bit. We still seem to be moving down that road to a relatively near-term break toward hyperinflation. The most important thing that’s happened since we last talked was the global response to the U.S. legislators’ negotiations over the debt-limit ceiling and the deficit reduction problems at that time. Clearly, no one controlling the White House or Congress was serious about addressing the nation’s long-term solvency issues. That sparked a panic selloff on the dollar against currencies such as the Swiss franc, and of course gold, which made the gold price rally sharply.
TGR: Did the politicos learn anything from those “negotiations,” as you just described them?
JW: Not at all. In fact, I’ll contend that everything that’s happened since then has been just a playing out of what resulted in a complete collapse in global confidence in the dollar. The ensuing rapid shift of market focus to crises in the euro area was really more of a foil to distract the global markets from the dollar. Following that horrendous performance by Congress and the White House, the global markets indicated a major loss of confidence in the dollar that had been coming. I think that’s now established and in place. The dollar is doomed to lose its reserve status eventually, and any day now, we may see things heat up again over the deficit negotiations.
TGR: What steps would we see on the way to the dollar losing its reserve status?
JW: Probably the biggest thing would be heavy selling pressure against the U.S. dollar, along with a spike in the stronger currencies such as the Swiss franc. The more the pressure builds for selling of the dollar, the more expensive and disruptive it will be for the Swiss National Bank to keep supporting the euro so I don’t think that intervention will last long.
As heavy selling of the dollar develops against the Swiss franc, the Canadian dollar and the Australian dollar, and the gold price rallies, we’ll see a very strong effort by those who are dependent on the dollar—such as the Organization of the Petroleum Exporting Countries (OPEC)—to have the dollar removed from the pricing of oil. Along with that will come a movement to change the dollar’s reserve status.
TGR: If other countries start demanding payment in alternative currencies, how can investors protect themselves against a shift from the dollar standard?
JW: I’m not a day-to-day timer in this. My outlook has been consistent that we’re heading into U.S. dollar hyperinflation, and the effective purchasing power of the currency as we know it will disappear. If you’re living in a U.S. dollar-denominated world, you don’t want to be in dollars—you want to move to protect the purchasing power of your assets, your wealth.
To do that, I look very specifically at physical gold, preferably gold coins and silver, and assets outside the U.S. dollar. The currencies I like the best are the Swiss franc, the Australian dollar and the Canadian dollar. This is something you do for survival over the long haul because you’re likely to see all sorts of volatility in the short term.
But once you ride through the storm, if you’ve been able to preserve your wealth and assets in terms of their purchasing power and to maintain liquidity—which the physical gold and the currencies will give you—you’ll be in a position to take care of yourself and take advantage of some extraordinary investment opportunities that likely would flow out of the turmoil ahead.
In the interim, I wouldn’t start betting that next week we’re going to see the dollar do this or that. This is a long-term hedge strategy, an insurance policy against the hyperinflation that I view as inevitable due to the long-range insolvency of the U.S.
TGR: Is that long-range insolvency also inevitable?
JW: Severely slashing social programs such as Social Security and Medicare would be the only way it could be avoided. I don’t have any problem per se with Social Security or Medicare, but you can’t bring things into balance without addressing them. If you look at the U.S. annual deficit on a GAAP basis—generally accepted accounting principles—with accounting for the year-to-year change and the net present value of unfunded liabilities in Social Security, Medicare and such, you’re seeing a federal deficit in excess of $5 trillion per year.
Putting that in perspective, if you wanted to raise taxes, you could take 100% of people’s salaries and the government would still be in deficit. You could cut every penny of government spending, except for Social Security and Medicare, and you’d still be in deficit.
You can’t escape the eventual hyperinflation if those programs are not addressed. Originally, I was looking for hyperinflation by the end of this decade. I’ve advanced it to 2014, and it may well come before that. I think we’re already in the early stages of going through what has to happen for this to break.
TGR: But would politicians touch those entitlement programs in an election year?
JW: No one wants this, but the federal government and the Federal Reserve have backed us into a corner and there’s no other way of escaping. There’s no political will to address the long-range insolvency, so they kick the proverbial can down the road. They did that in 2008. They did everything they could to prevent a systemic collapse by creating, spending and guaranteeing whatever money they had to.
We’re coming to another point where we face risk of systemic collapse, and we’re likely going to see another round of quantitative easing (QE) as a result. That also could pull the trigger for massive dollar selling, moving us into much higher inflation. That will start the final process.
TGR: One of your recent newsletters showed that annual core inflation had risen for 12 straight months, ever since QE2. What would QE3 do to some of the indicators you watch—gold, silver, commodities?
JW: Gold tends to anticipate the inflation problems. All sorts of factors hitting gold create tremendous volatility, but generally it will continue to move higher as the broad crisis deepens. Then as we get into the high inflation, it will start soaring. People have to keep in mind that they’re preserving the purchasing power of the dollars that they put into gold. If gold gets up to $100,000/ounce (oz) as you start breaking into the hyperinflation, and they bought gold at $2,000/oz, it isn’t that they made $98,000 per ounce. Instead, they’ve maintained the purchasing power of the dollars they put into gold.
They’ve also lost the purchasing power of the dollars that they didn’t put into gold or some other hard asset. That’s a different view than most people look at with investments, but this is not a normal investment environment. Again, this is one where you batten down the hatches and look to preserve wealth and assets, as opposed to trying to make money day to day in the markets. Once you have your basics covered, then you take gambling money and go play Wall Street’s casino.
As to core inflation, the Fed likes to ignore energy and food prices, using the rationale that those prices are too volatile and don’t hold over time. Yet, oil is probably the most important single commodity in terms of domestic inflation. Not only does it hit basic energy costs, but it also affects the cost of transportation of all goods. Beyond what is defined as basic energy costs, oil is also the basic raw material for many products, ranging from chemicals to fertilizers to pharmaceuticals and plastics.
As oil prices rise, the Fed just takes out the energy component in so-called core inflation. But the inflation still spreads to the broader economy. When they started to jawbone on QE2 in October of 2010, year-to-year inflation on a core basis was at 0.6%. In the consumer price index reporting of October 2011, despite a drop in the gasoline prices, core inflation was at 2.1%. In response to QE2, gold rose against the dollar and the dollar weakened against other currencies. The weaker dollar, in turn, spiked oil prices. The higher oil prices spiked gasoline prices and broader inflation, which still is boosting consumer inflation in the U.S.
With the next round of Fed easing, the dollar problems will intensify again. That will put new upside pressure on oil and gasoline prices, further intensifying the spreading broad inflation pressures in consumer goods and services.
The Fed’s mandate from the government is to try and sustain reasonable economic growth and contain inflation. From the Fed’s standpoint, however, those are secondary to maintaining the solvency of the banking system. Nothing in the outlook for the system has changed meaningfully since the crisis in September 2008. The banking system still is in a solvency crisis, the economy continues to worsen and we’ve had no real recovery. The stopgap measures to prevent collapse of the system did nothing but kick the crisis a little further into the future, and now, we’re coming to peak period of crisis again.
TGR: You’ve repeatedly said that the global economic crisis is not Europe’s fault but part of a pending systemic collapse that started with the manipulation of the U.S. financial markets—the moves you’ve been talking about. What countries or sectors will suffer the most if the crisis continues?
JW: The more closely they’re tied to the dollar, the greater the inflation impact will be in other areas, but the runaway inflation I’m talking about will be largely in the U.S. and for people living in a U.S. dollar-denominated world.
That’s from an inflation standpoint. Yet, it also will have an extremely negative impact on the U.S. economy, and problems in the U.S. economy indeed will have a global impact. The U.S. economy is still the largest in the world, and you can’t push it deeper into a depression without having negative economic consequences outside the U.S.
But while the global economic problems will worsen, systems can ride out bad economies. We can’t ride out a hyperinflation because the currency becomes worthless. That’s an ultimate crisis that forces a resetting of the system.
TGR: Can Europe or China do anything to counteract what’s going on in the U.S.?
JW: Dump the dollar. China needs to delink from the dollar, and it will be forced to do so. It’s importing inflation. If China doesn’t want that inflation problem, all it has to do is cut its link with the dollar, and oil suddenly becomes a lot cheaper.
TGR: But how practical would it be for China to sell off all the U.S. dollars and U.S. Treasuries it holds?
JW: In terms of insulating itself against U.S. inflation, all China has to do is delink its currency from the U.S. dollar. That’s true of other currencies as well. The Swiss franc is artificially linked to the euro now, but because of the general weakness in the dollar, it’s ironically also intervening to support the dollar against the euro.
Whenever major holders of dollar-denominated assets decide to sell those assets, that will determine how large a loss they will take on the U.S. currency.
TGR: Will the euro survive?
JW: I wouldn’t bet on a long-term survival of the euro, but I think it will survive the current crisis as long as its survival is needed to prevent a systemic collapse in the U.S. The Fed will do whatever it has to do to keep Europe’s problems from imploding the U.S. banking system. It can create whatever money it wants to do that.
Long term, I would not look at the euro as surviving in its current form. The loss of the dollar eventually will force a reexamination of the global currency structure. That might be a time when other currency disorders get resolved and we may see the euro break up. It was never practical to think that all the countries within the euro would be able to align their economic and fiscal policies in a way that would enable them to operate together. The euro was doomed from the beginning.
TGR: Let’s go back to gold. According to your research, the September 2011 high of $1,895/oz gold was below the historic high of $850/oz in 1980, if the 1980 figure was adjusted for inflation. The $850/oz in 1980 would have equaled $2,479/oz in Consumer Price Index–all Urban consumers (CPIU)-adjusted dollars, or $8,677/oz Shadow Government Statistics (SGS)-alternate-CPI-adjusted gold prices in 2011. Is gold underpriced if you put it into that context?
JW: On that basis, yes, it is. It also depends on when you measure it. My hyperinflation report looks at what has happened to the dollar over a longer period. Since President Roosevelt took the U.S. off the gold standard domestically in 1933, the dollar has lost 98–99% of its purchasing power. People tend to forget that. But if you look at the gold price movement since 1933, it actually has moved a little more than the government-reported pace of inflation. My estimate of what inflation should be if we had consistent CPI reporting shows that the loss of the dollar’s purchasing power against gold is the same as it is measured by the CPI.
So over time—and this is true over millennia—gold tends to maintain purchasing power, which means it holds its value net of inflation. Not that you’d break a piece of gold down to a small enough unit to buy a loaf of bread, but if you did, it also would have bought a loaf of bread in ancient Rome.
TGR: For the same amount of gold.
JW: Same amount of gold. Gold has a long tradition as store of wealth. That’s why—globally—gold generally has been viewed as such. It only got bad press in the U.S. because private ownership of gold was outlawed after Roosevelt’s action. It became legal for Americans to own gold again after Nixon abandoned the international gold standard. Yet, even today, some on Wall Street discourage investment in physical gold, largely because they cannot make a commission on it, as they do with stocks and bonds.
Given the gold ownership limitations after 1933, those in the U.S. who wanted to buy gold turned to buying gold stocks. But because of what happened in the 1930s—that’s now two generations or so ago—gold as an investment and as a hedge to protect wealth lost some of what had been its commonly recognized value in the U.S. Outside the U.S., almost everyone views gold as a traditional hedge.
TGR: That’s physical gold. What about exchange-traded funds and gold equities in the juniors? Will those investments also preserve wealth?
JW: I wouldn’t count on the financial system working as it should. I look at physical gold, preferably sovereign coins, not only as a store of wealth, but also for purposes of liquidity.
Gold stocks also should preserve wealth over time, but I would look at them as longer-term holdings. There could be periods of systemic failure with resulting interim liquidity issues.
TGR: You talked about hyperinflation coming as early as 2014, or even before that. But 2012 is just weeks away. What can people expect next year in terms of the data you watch and maintain versus some of the government-issued statistics?
JW: I can tell you that the economy is weaker and will remain weaker than the government reports. We don’t have an economic recovery in place. We’ll tend to see higher inflation.
TGR: Something to watch out for. Thank you, John.
Walter J. “John” Williams has been a private consulting economist and a specialist in government economic reporting for 30 years, working with individuals and Fortune 500 companies alike. He received his bachelor’s in economics, cum laude, from Dartmouth College in 1971 and earned his masters in business administration from Dartmouth’s Amos Tuck School of Business Administration in 1972, where he was named an Edward Tuck Scholar. Williams, whose early work prompted him to study economic reporting and interview key government officials involved in the process, also surveyed business economists for their thinking about the quality of government statistics. What he learned led to front-page stories in the New York Times and Investor’s Business Daily, considerable coverage in the broadcast media and a joint meeting with representatives of all of the government’s statistical agencies. Despite a number of changes to the system since those days, Williams says that government reporting has deteriorated sharply in the last decade or so. His analyses and commentaries, which are available on his ShadowStats.com website, have been featured widely in the popular domestic and international media.
By The Gold Report, on November 8th, 2011
 A war-mongering U.S. government could be less than 18 months away from decimating the last 5% of value left in the dollar, says Richard Maybury, the author of the U.S. & World Early Warning Report. Until some new exchange-traded-fund-like basket of natural resources provides a store of value, this “juris naturalist” has some advice about how to protect your wealth during the coming collapse.
The Gold Report: Richard, last month, you made a presentation at the Casey Research/Sprott Inc. “When Money Dies” Summit entitled “The War that Will Kill the Dollar.” You explained that the corrupting influence of power had sent our country’s leaders shopping for war, disregarding Westphalian respect for sovereignty and hastening the collapse of society. What are the signs that we are reaching a critical point? And, is there any way we can change course?
Richard Maybury: You can see the signs very clearly in the Middle East and North Africa. The Federal government is involved in several wars there that have nothing to do with America. One of the best examples is Libya. U.S. officials are taking credit for Moammar Gadhafi’s death just a year after they were bragging about having tamed the threat. Now Libya is a mess. It will very likely be taken over by some sort of Islamic government that isn’t going to be very friendly to America.
TGR: Why do we, as a country, do this? If it’s not going to end well for us, what’s the economic or political reason to get involved?
RM: The U.S. government gets into wars in far corners of the world that have nothing to do with America because the leaders like getting into wars. That is how presidents achieve greatness in the history books. A president has no prayer of going down in history as great unless he has won a war. Look at Mount Rushmore. All four presidents featured there won wars. That seems to be the number one criteria historians use for deciding whether someone is a great president. It constitutes an automatic incentive to go out looking for wars.
TGR: What is the incentive for the American people to go war shopping?
RM: Nothing. It’s absurd. During the First Gulf War, people had a tremendous good feeling about going to war with Iraq. They would come home from work, order a pizza, sit in front of their TV sets and watch the war like it was a football game. War became a form of entertainment.
TGR: Is there anything we could do to incentivize our presidents to act peacefully?
RM: I doubt it very much. People go into politics because they seek political power. Once they get the power, they naturally want to use it on somebody. What is the point of having power if you can’t use it? So, no matter what kinds of controls you put on, future presidents will find a way around it.
The ideal situation would be one where war is used as a last resort. Westphalian sovereignty, a set of agreements dating back in the 1600s, established the precedent that the European powers would only go to war in self-defense. You had to have a clear and present danger before you could go to war. And, even then, it was supposed to be the last resort. That was the basis of international law up until this year. That isn’t to say that the Westphalia treaties weren’t violated a lot of times, but they helped. After Iraq, Serbia and now Libya, it is pretty clear that the policy is we can just go out and hit anybody we want for any reason we want as long as we believe the other guy is up to no good.
TGR: If this is the new reality, then let’s talk about some of the economics around it. War is expensive. You have pointed out that since the Federal Reserve was created in 1913, the dollar has lost 95% of its buying power. You said, “War destroys currencies.” It usually leads to governments printing more dollars to pay for guns and tanks. How much debt and overprinting can the country take before the velocity of economics, which is something that you also talked about in association with how quickly dollars are exchanged, catches up with reality and the dollar loses that last 5% of its value?
RM: Velocity refers to the speed at which money changes hands, and it is a measure of money demand. When people don’t really want the money, they start trading it away faster, trying to get their hands on things they do want, things that have value that they trust. The cost of this war in the Islamic world will continue going up. At some point, it’s going to be a major contributor to people losing what confidence is left in the dollar and people all over the world will start dumping it. This is a psychological thing. It’s about emotions, so it is hard to pinpoint when they will lose all confidence in the dollar.
TGR: What would it look like if that last 5% were gone? Are we talking about hyperinflation? Are we talking about banks collapsing? Are we talking about bartering? What would it look like?
RM: We are talking about all of that. It would be chaos. We saw it in Zimbabwe when the Zimbabwean dollar became worthless because the government printed so many that people wouldn’t accept them anymore. The country experienced enormous runaway inflation where prices were rising 50% a day before the Zimbabwe dollar collapsed.
It would probably start with someone somewhere in the world selling off his dollars and begin trading them for whatever it was he had confidence in. The foreign exchange value of the dollar would fall. Other people would notice; they would get scared and start selling their dollars. The foreign exchange value of the dollar would drop more. This process would continue until you have panic around the world to get out of dollars. Americans would be the last ones to get involved. We are always the last to know what is happening to America. Suddenly Americans would wake up one morning and find that a gallon of milk that cost $4 the day before costs $6 today. The next day they would find that it costs $12. And the next day they would find that it costs $36. That is when Americans would realize that they are in deep trouble; their dollars are about to become worthless.
TGR: Of course the Fed wants to avoid that scenario. You describe yourself as a follower of Austrian economics made famous by the Nobel laureates Friedrich Hayek and Ludwig von Mises. They describe financial systems as complex processes run by billions of constantly changing individuals rather than something that can be manipulated from a central point, which seems to be what is being attempted right now. If that is the case, what will be the outcome if the central government tries to force a more Keynesian control of the flow of money?
RM: They will mess it up even worse than they already have. The world has been living under Keynesian economics since 1971 when Nixon took the dollar off the gold standard. John Maynard Keynes was a semi-socialist. He believed that the way to fix the economy was to print a whole bunch of dollars and dump them out there. This has been standard procedure for the past 40 years. All currencies have been dropping in value during that time. Another round of quantitative easing (QE) could further speed the rate at which the money circulates, something that has the same effect as increasing the supply of dollars, creating a larger demand for goods and services and having an inflationary effect. I think Fed officials are dropping hints about the next QE because they are trying to cause velocity to rise, a secret QE if you will.
TGR: What if the stealth QE campaign doesn’t work? What form might a real QE3 take?
RM: It is hard to tell what they will do. One of the myths that everyone is taught is that the government has some sort of tremendous understanding of economics and the ability to make adjustments to economic activity. The term fine-tuning is used sometimes. Actually, we are talking about a group of human beings who don’t know much more about real economics than anybody else. They think they do, but they don’t. They just bounce around from one attempt to control things to the next, making a mess of the country. The economy is not a machine. It is people, human beings. It is a biological system, not a mechanical system. But, the government treats it like a mechanical system, so they are always making mistakes.
TGR: If war and hyperinflation are the inevitable future, how can investors survive or maybe even thrive during a time like this? What are the opportunities? Natural resources? Commodity equities? Where can we be safe other than putting that $100 bill under the bed?
RM: Well, I wouldn’t put $100 under the mattress, at least not for very long, because it will soon become worthless. But commodities, stocks of raw materials firms, gold and silver and platinum coins have value. Generally, I try to see the world in terms of two kinds of investments: dollars and non-dollars. You definitely want non-dollars, things that do not have their value tied to the value of the dollar. An example of a dollar asset is something like a bond or bank CD. Their values are tied directly to the value of the dollar. If the dollar falls, then their values fall.
Gold is a non-dollar asset. When the dollar falls, usually gold rises. The same is true with silver and oil. All of these things have values that are not tied to the dollar. My advice is to invest in non-dollar assets. Gold would be at the top of the list, silver and platinum and then oil.
TGR: In your Early Warning Report Newsletter, you predicted that gold will top $3,000/ounce (oz), silver will hit $50/oz and oil will exceed $300/barrel. Gasoline will go to $9/gallon. When will we see these rises? And what will be the catalysts that take them there?
RM: The next QE, which I expect to come along no later than March, could set off a flight from dollars. Then we could see those predictions realized within 18 months.
TGR: You said that once we have had this loss of the entire value of the dollar and people are looking for another way to trade, money could be based on some collection of metals with currency acting as a receipt for the tangible gold, silver, platinum and whatever else happens to be in that basket. What would that transition look like? How painful would that be? How would it be orchestrated?
RM: It doesn’t have to be painful. The markets are moving in that direction. People trade exchange-traded funds (ETFs) for practically everything now. I can envision a mutual fund or an ETF that is a collection of various things. It could be gold, silver and platinum. It could have oil in there. It might include Swiss francs. It could even have various patches of real estate. The ETF itself would then become a currency, not because anybody has it planned that way, but because the markets will see that there will be a demand for something that is a non-dollar asset that is easily tradable and seen as a store of value. There would probably be hundreds of these baskets of assets at the start. Some would work better than others would; the less workable ones would shake out. You might wind up with maybe a half dozen ETFs or mutual funds that are baskets of various assets circulating in the world. They would essentially become the currencies.
TGR: Would investing in ETFs now be a good way to prepare?
RM: No. I don’t know of any that are arranged that way. It may be a while until somebody catches the idea and decides to give it a try.
TGR: What about the precious metal equities? Would that be a good way to prepare?
RM: Yes. There are lots of good precious metal stocks. I own quite a few. That is another way to protect yourself. However, be sure to deal with a broker who really knows natural resources. You have to have some skill in picking those stocks. It’s not like going down and buying a gold coin where you just walk into the coin dealer and tell him I want a handful of American Eagles or Canadian Maple Leaves. You really have to know what you are doing when you are buying gold stocks.
TGR: Any final thoughts you want to leave with The Gold Report readers?
RM: The world has changed. When you look at the news and you say to yourself, “My God, America isn’t what it was; the world isn’t what it was,” have the confidence to know you are right. We are probably not going back to what America or the world was anytime in my lifetime. Therefore, you want to start learning everything you possibly can about this new condition and adapt to it.
TGR: Thank you for sharing your thoughts.
RM: Thank you, JT. I appreciate being here.
Richard Maybury, the author of the U.S. & World Early Warning Report, has written 22 books, including the Uncle Eric series, which focuses on economics, law and history. He has been interviewed on more than 250 radio and television shows. He is a Vietnam War veteran who served in the Air Force’s 605th Air Commando Squadron, a special operations unit involved in covert warfare in Central and South America. He has since lived and traveled the world, visiting 47 states and 45 countries. He considers himself a “juris naturalist” who believes in a natural law higher than any government’s law. You can visit his website at or phone 1-800-509-5400.
Want to read more exclusive Gold Report interviews like this? Sign up for our free e-newsletter, and you’ll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
 Join the forum discussion on this post - (1) Posts
By Claus Vistesen, on October 24th, 2011
As I read the latest round-up of comments by Fed officials that they are certainly not ruling out another round of asset purchases I am wondering whether this signals another round of actual quantitative easing by the Fed or whether investors should change their mindset back to before the crisis where it wasn’t the USD that acted as the global carry trade funder but rather the JPY (or maybe the GBP here?).
Quote Bloomberg
Fed Vice Chairman Janet Yellen said yesterday that a third round of large-scale asset purchases “might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.” A day before, Governor Daniel Tarullo said buying mortgage-backed securities “should move back up toward the top of the list of options.”
They join Charles Evans, president of the Chicago Fed, and Boston’s Eric Rosengren in calling for consideration of further stimulus to boost growth and bring down a jobless rate stuck around 9 percent or higher for 30 months. A stock-market rally and gains in manufacturing and retail sales may convince the Federal Open Market Committee, which meets Nov. 1-2, to decide that it’s too soon for a third round of bond purchases.
You see, the recent initiative of the Fed in the form of Operation Twist is not quantitative easing since it does not involve an expansion of the balance sheet. In stead, it is what we refer to as qualitative easing as the bonds the Fed intends to buy on the long end (to move long rates down to help the mortgage market) will be paid for by proceeds of selling bonds on the short end.
The biggest problem for the Fed here is not necessarily that Operation Twist is a bad idea. Indeed, to the extent that it fixes the effort squarely on halting the slide in the housing market and supporting volume and price in the primary and second market for mortgage securities I think it is an excellent idea.
But we are forgetting the auxiliary objective of QE by the Fed; to weaken the USD. Make no mistake that this is an important objective for the Fed even if they have never declared this formally. And herein lies the rub. Quite simply, with the recent announcement by the BOE of another round of QE worth £75 billion, with the ECB now willingly or unwillingly being forced into increased support of peripheral debt markets and with the BOJ also pledging more stimulus, the Fed is starting to look like the conservative central bank in the G4. [1].
In my opinion, this is very significant and also one of the reasons why Fed officials are busy ensuring markets that they have plenty of ammunition left should economic conditions merit it. But investors should not take anything at face value I think. Before the Fed actually starts to buy those MBS and/or moves to lower interest rates on excess reserves there is a real chance that especially the JPY will start to act more like the JPY of old, a.k.a global carry trade anchor of choice. Of course, this requires the BOJ to back up all the pledges with real action. For now though, the only thing we can say is that the Fed looks set to be outgunned by its peers in the G4.
EMU Outflanked
Is Europe now finally getting down to serious business or is it just another round of fudge from the fudge factory that investors have learned to respect for its ability to produce relief rallies out of nothing. Looking at the evidence I thoroughly inclined to go for the latter even if each failed attempt to shore up market confidence brings Europe closer to full fiscal union.
Even if Merkel and Sarkozy, and rightly so, appear most concerned with putting pressure on Italy, the most significant issue remains Greece which is now in default a fact that was un-sanctimoniously confirmed by the leaked bailout document which has the Troika admitting that the medicine they were mandated to administer would only make the patient worse and not better.
Quote FT
Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago.
The most recent estimate of haircut has now risen to 60% and this, mind you, would only reduce the debt to GDP to 110% and this without any consideration on how Greece is supposed to grow itself out of this level of debt while simultaneously dealing with the default. In addition and only adding to my disdain for the ECB, Reuters reports that the central bank opposed a 60% haircut on account that it the private sector would refuse likely refuse this leading to a “fullscale” Greek default.
I am continuingly amazed by the denial here. Ever since the first Private Sector Proposal (PSI) was put on the table, Greek has been in default and figuring out who would pay for recapitalising banks as a function of how large the final haircut ends up are merely steps in the actual default process.
The second issue on the table is what to do with the increasingly freakishly looking EFSF. There has been no shortage of suggestions on how to increase the scope of the fund using the same guarantee by the same countries for the same amount of money (currently €440 in effective capital). The suggestion that might actually work came from France which has aired the suggestion that the EFSF be turned into a bank which would then allow it to access liquidity from the ECB. Both Germany and the ECB however have vehemently denied this which indicates that there is still notable reluctance to allow the ECB to wield the full arsenal of quantitative easing.
The proposal which currently seems to have most traction is to turn the EFSF into a monoline insurer which would essentially use its capital to insure anything from 10% to 30% on any new issuance of sovereign debt by Italy and Spain. Crucially, the idea is that this “leverage” would bring calm to markets as this insurance could cover as much as 2 trillion worth of debt.
I really struggle to find adequate words here. I think this is madness and if any Eurozone politician were afraid that an equivalent of AIG would certainly enter the scene, they now seem content on creating one. The first and most widely flagged issue is this would obviously create a two tier bond market.
Quote Reuters
This would create a division between insured and non-insured debt, that could split a country’s investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt.”The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds,” said Commerzbank rate strategist Christoph Rieger.
Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.
I think this is significant, but we are missing the main point here. If this is set ut Spain and Italy will likely never be able to issue un-insured debt again and the contingent liability here is not only complex but will lock in future capital commitments to this aim of providing first loss insurance. For me, this is a horrible way to spend already scarce capital.
Another issue is obviously that it assumes that it will make the Spanish and Italian problem go away which it clearly won’t. However, much more fundamentally; while the idea is to ring fence Italy and Spain it almost guarantees painful haircuts in the case of Ireland, Portugal and Greece and once again, who will pay for those I might ask.
The only silver lining I have seen in the latest reports is that it seems to me that while the imminent objective is to fiddle with the EFSF, there has also been serious talk about bringing forward the ESM which would have a much stronger mandate and essentially constitute a first step towards socialising of sovereign risk in the euro zone. Until that happens, the EMU and her politicians will be continuously outflanked by economic realities.
—
[1] – I repeat that with the ECB not formally in ZIRP mode, the Fed still has the yield disadvantage here but do we really expect the ECB not to lower going forward?
|
|
Most Popular Posts