The Great Deformation (130 page)

Accordingly, the job of the Fed would be to do what J. P. Morgan's young men did night after night in the great financier's library during the panic of 1907. They did not pontificate on their intentions for the GDP and the Russell 2000 in the manner of Greenspan and Bernanke but, instead, put on their green eyeshades and examined the nitty-gritty of the balance sheets of supplicants for emergency loans who came to the Morgan Library at Madison Avenue and Thirty-sixth Street. As seen, solvent institutions got liquidity injections; insolvent ones met their maker.

Ironically, Pierpont Morgan's top green eyeshade was Benjamin Strong, who went on to become the first great US central banker as president of the New York Fed in the 1920s. Had Strong stuck to his 1907 role as collateral examiner, the Fed-enabled financial bubbles of the later 1920s would
not have happened, nor would there have been the Great Crash of 1929 and its aftermath. Likewise, had Alan Greenspan rejected the perfidious implications of the Humphrey-Hawkins Act and simply declared that sound money under a mobilized discount rate was the surest route to low inflation and full employment, the financial calamities of the present era could have been avoided.

Needless to say, today's wanna-be masters of the universe who populate the monetary politburo would have been cut down to size; their job would have been that of penurious, flinty-eyed bank examiners, who would scour the collateral of supplicants for Fed discount window loans one application at a time. They would have no dog in the stock market hunt. Nor would they care about the latest swiggle in the GDP reports or tick in the unemployment rate. Most assuredly, these humble bank examiners would never pretend to manage the rise of national wealth or the rate at which the people on the free market create new output, savings, investment, and consumption.

Under a mobilized discount rate the cardinal rule of sound finance would have been respected; to wit, no man can borrow unless another man first saves. Accordingly, the free market interest rate would become the honest balancing wheel, undistorted by central bank bond buying and cash injections into the money market. With the freedom to soar when the demand for credit sharply exceeds the supply of savings, free market interest rates would automatically check creation of new credit in the banking system and rehypothecated credit in the shadow banking system.

The reason is straightforward: in a financialized economy, the marginal demand for credit consists of funding for the carry trades in one form or another. Yet this is the very perversion which permits the politicians to carry on with deficits without tears. When the Fed drives overnight money to zero and promises to keep it there through long-dated points on the calendar, it creates a false demand for government bonds.

Much of this false demand is financed in the repo market where fast money traders are happy to harvest the spread on the Fed-managed yield curve. They buy ten-year treasuries at a yield of 180 basis points (1.8 percent) and fund 98 percent of their position with 10-basis-point overnight borrowings—all the while sleeping peacefully because Bernanke has promised that short-term rates will not rise until 2015. This amounts to robbing a bank without criminal liability. Not surprisingly, the banks themselves have gone in for this kind of legalized larceny. Since Bernanke slashed deposit rates to essentially zero, bank holdings of government and agency bonds have nearly doubled, rising from $1.2 trillion to $2 trillion.

Here lies the Great Deformation. Over the last several decades the implicit choice has always been between a régime of free market interest rates
and a mobilized discount rate versus a régime of financial repression and unchecked private and public debt creation. The former route would have limited the Fed to the role of “bankers' bank,” providing emergency discount loans at market-driven interest rates plus a penalty. The latter route, explicitly chosen by Greenspan and carried to an absurd extreme by the Bernanke Fed, has turned the Fed into a destroyer of honest financial markets, an enabler of financial speculation on a scale never before imagined, and a reallocator of society's income and wealth to the 1 percent.

But worst of all, it has transformed the nation's central bank into the handmaiden of fiscal calamity. Today the US Treasury can borrow money from ninety days out to five years, thereby encompassing most of its issuance, at rates between 10 basis points and 80 basis points. Washington's mega-deficits are thus being funded with essentially free money. The Fed's utterly foolish interest rate repression has stripped the politicians buck naked in the face of the free lunch propensities of the democracy and the raids and plunderings of crony capitalists in a political system where money rules.

Needless to say, the Fed has painted itself and the nation into a dead-end corner. Sundown comes because the Fed dares not let interest rates rise by even a smidgeon, let alone “normalize” or ever again approach something like an honest price for money and debt on the free market. If it did, the vast army of fast-money speculators who have rented Treasury bonds and notes on 98 percent repo would sell in a heartbeat, causing the price of government debt to fall sharply. Then the slower-footed bond fund managers would be forced to liquidate in the face of retail investor redemptions and eventually even banks and insurance companies would panic, selling into a bidless market for government debt and everything tied to it.

Standing at the edge of a financial abyss, the Fed is thus hostage to its own four-decade excursion in money printing and macroeconomic management. It cannot stop buying government debt because it is being front run by a herd of speculators which will turn on a dime unless it keeps buying and pegging the price of Treasury notes and bonds. At the end of 2012, its policy was to buy government and GSE debt outright at a rate of $1 trillion per year, which means that its balance sheet would be $6 trillion by the end of Obama's second term.

THE GLOBAL MONETARY BUBBLE

It won't get that far, however, because there are powerful countervailing forces gathering momentum; namely, a global beggar-thy-neighbor currency depreciation war that will dwarf the conflagrations of the 1930s. As indicated earlier, the Fed has been the lead ship in a convoy of monetary
roach motels since the 1970s. Not surprisingly, Bernanke's balance sheet expansion spree during the BlackBerry Panic spread like wildfire.

The top eight central banks, including the ECB, Bank of Japan, and the People's Printing Press of China, had combined balance sheet footings of $5 trillion before the financial storm erupted in 2007. Now they total $15 trillion and are expanding at explosive rates. Following in the footsteps of the Fed's 4X increase in its balance sheet and the embarrassingly blatant spree of money printing by the Bank of England, the practice of buying unwanted sovereign debt has become universal.

The ECB's $1.2 trillion so-called LTRO money-printing operation during late 2011 and 2012 was merely a thinly disguised backdoor means of financing the debt of Spain, Italy, Greece, and others that genuine investors did not want to buy at current interest rates. And the announcement by Japan's new LDP government in late 2012 that the Bank of Japan should print money at whatever rate it may take to bring inflation back to life in a bankrupt economy simply carried the money-printing régime to a new extreme.

But it was the Swiss National Bank which was the ultimate canary in the mine shaft: it has been forced into massive expansion of its balance sheet in order offset the destructive flare-up in its exchange rate owing to flight capital out of the euro zone into the “swissie.” Indeed, when the Swiss central bank, the paragon of “hard money” in modern times, is forced into negative interest rates on deposits and an explicit policy of trashing its own money, then the currency wars have started, and there is no turning back.

The new government of Shinzo Abe in Japan has already fired the warning shot on the matter of competitive currency depreciation and the on-coming race to the bottom. Its outright attack on the Fed is epochal, and contrasts dramatically with the actions of the Nakasone government which came to the Plaza Hotel in 1985 to receive the “Texas treatment.” Implicitly referring to the “Connally treatment” of a decade earlier, the Japanese statesmen meekly declaimed, “We enjoyed that, may we have another?”

No longer. The Japanese government has buried itself in debt building roads to nowhere and implementing every hoary fiscal stimulus device ever conceived. With government debt at 250 percent of GDP, it now stands not only as a monument to Keynesian folly, but as a potent warning about how thoroughly and swiftly financial discipline has been destroyed by the Fed and its convoy of monetary roach motels.

At a meeting in early 1981, a high-ranking delegation of Japanese financial officials came to the White House to politely and discreetly ascertain whether the Reagan administration really intended to create massive and permanent fiscal deficits. At that point, Japan's niggardly public debt stood
at less than 35 percent of GDP and their officials were genuinely astonished that the American government would risk violating every standard of fiscal prudence by implementing big tax cuts without paying for them.

Needless to say, today Japan raises in tax revenue less than 50 percent of what its government spends, and it doesn't dare ask about fiscal prudence. With taxation at levels needed to finance its current spending, Japan's economy of old people and increasingly old industries would sink rapidly into the Pacific. Yet Japan's domestic savings rate has fallen from 18 percent at the time of the aforementioned White House visit to essentially zero today, and its long-running current account surplus is turning sharply and rapidly into deep deficits.

Accordingly, there is no place left to sell the vast outpouring of government debt promised by the new LDP government except at the Bank of Japan. Were Japanese interest rates ever to rise even to 3 percent from the current comically low rates pegged by the Bank of Japan (80 basis points for ten-year notes), the interest cost on Japan's gargantuan debt would absorb every single penny of government revenue. Japan's economy would thus sink into the Pacific by another route.

So the Bank of Japan is also hostage to its sovereign debt, and will print yen faster and faster in stride with the QE-to-infinity posture of the US Fed. The ECB will also have no alternative to rapid money printing, as its constituent national economies shrink into permanent recession under the weight of fiscal austerity policies needed to keep their bloated welfare state budgets afloat. More likely than not, the Germans will revolt in the face of extreme ECB money printing and the euro will blow up, sinking the continent into deeper recession still.

Likewise for China. It goes without saying that this towering edifice—of bank credit, rampant speculation by much of the populace, massive state-financed construction of what amount to pyramids and other unusable public infrastructure and unspeakable corruption—cannot function without its export economy: that's where it earns the real capital to keep going the monumental excesses and imbalance of Communist Party–managed economy.

So China's central bank must keep printing, too, and dares not allow the currency to appreciate much more than the token amounts of recent years in order to keep its export sector above water. Indeed, in a world of honest money much of China's export economy would have never arisen or would have sunk below the waves long ago. And with it, of course, would have gone the whole system of tributary raw materials and intermediate components suppliers that feed on the great Chinese Factory; that is, Australia
and Brazil in the former category and South Korea, Japan, Taiwan, Malaysia, and Singapore in the latter.

In short, the world economy is now extended on the far edge of a monetary bubble that has been four decades in the making. The next phase of money printing, however, may be the last because all the major, aging consumer economies of the world are failing; that is, the United States, Europe, and Japan. Accordingly, democratic politics will turn increasingly ugly, strident, and nationalistic in the face of chronic fiscal crisis, recession and quasi-recession, middle-class austerity, and bubble opulence among the 1 percent. It will result in protectionism, currency wars, and anti-capitalist policy interventions, including capital controls, punitive taxation of the “rich” (which few will actually pay), and endless bailouts and boondoggles.

During the final phase of the global monetary bubble, economic growth in the United States will be ground to a halt. As this happens, the $20 trillion of prospective debt now obscured in CBO's rosy scenario will become increasingly visible, causing the fiscal cliff to loom ever more forbidding and unmovable. American politics will consequently become more fractious and paralyzed, and the Keynesian state will inexorably sink into insolvency and failure.

The interim winners from this ordeal will be the gangs of crony capitalism and the opulent 1 percent who thrive off the central bank's money printing. But in the end sundown will descend upon the entire nation—even on the 1 percent.

CHAPTER 34

 

I
T GOES WITHOUT SAYING THAT WHEN HISTORY GETS INTO A DEEP RUT
it becomes hard to alter the course of affairs. But even at this late date the sundown scenario could be avoided. The Fed's financial repression and Wall Street–coddling policies could be pronounced a failure and abandoned. Crony capitalism could be put out of business by constitutional writ.

Likewise, the corpulent warfare and welfare states could be put into a constitutional chastity belt and the rule of no spending without equal taxation could be made the modus operandi of a shrunken state. Eventually, the free market could regain its vigor and capacity for wealth creation and, under a régime of sound money and honest finance, the 1 percent could continue to enjoy their opulence by earning it the old-fashioned way; that is, by delivering society inventions and enterprise that expand the economic pie, rather than reallocate it.