The Fed's Inflation bomb

John Carney, writing in The Business Insider, questions the Fed's ability to shrink its expanded monetary base to avoid a major inflation. "One of the sources of the growth of the monetary base has been the $1 trillion of purchases of mortgage backed securities by the Fed. . . Much of it is on deposit with the Fed itself, where banks can earn risk-free interest instead of lending it to home buyers at risk of losing their jobs or businesses still suffering from diminished consumer demand."

When bank lending starts to accelerate, the Fed will have to withdraw those funds by finding market buyers for them.

The market’s knowledge that the Fed has become a seller rather than a buyer for mortgage backed securities will likely result in the pricing of these securities falling. In order to bring the yield of these securities up to a level acceptable to the market, they will have to be sold at a discount. This discounting means that the Fed will not be able to withdraw as much liquidity as it added, leaving some portion of that $1 trillion (plus its multiplier effect) in the economy to create inflation.

Think of it this way. If the Fed bought a mortgage backed security for $100 but can only sell it for $90, there’s a 10% inflationary discount occurring. Which is to say, the Fed’s MBS has inflation built right into it. There’s no way out.

But suppose the Fed tries to fight inflation by paying higher interest rates on bank deposits at the Fed?

Right now the Fed gets away with paying very little interest, since demand for loans is low and lending risks are still perceived as high. But as opportunities in the economy grow, the Fed will have to increase the interest rates to prevent inflationary lending.

The higher rates from the Fed, of course, will cause political outrage. Essentially, bankers will be able to make handsome returns by not lending to businesses and consumers. It will be perceived—rightfully so—as a super-perverse subsidy.

And those higher rates will make it harder to sell the mortgage backed securities. The Fed will have to sell at even greater discounts, since bankers would rather just earn interest from the Fed unless the discount on the MBS—and therefore the yield—grows high enough. And, of course, each discount makes the inflation-fighting impact of the mortgage-backed-security sale less effective.

Phantom buyers of Treasury debt

Eric Sprott & David Franklin in their Markets at a Glance calculated that the U.S. government would "need to sell $2.041 trillion in new debt - or almost three times the new debt that was issued in fiscal 2008" to balance its 2009 budget.

But who is in a position to buy so much debt? The writers dug into some government publications and came up with the three biggest buyers:

1. Foreign and International buyers who purchased $697.5 billion.
2. The Federal Reserve who bought $286 billion.
3. The Household Sector who bought $528 billion to Q3 – which puts them on track [to] purchase $704 billion for fiscal 2009.

But wait -- what is "the Household Sector"? For an answer, they turned to the "Federal Reserve Board of Governors Flow of Funds Data which provides a detailed breakdown of the owners of Treasury Securities to Q3 2009." This mysterious group - the Household Sector - bought "35 times more government debt than they did in 2008."

Amazingly, we discovered that the Household Sector is actually just a catch-all category. It represents the buyers left over who can’t be slotted into the other group headings. For most categories of financial assets and liabilities, the values for the Household Sector are calculated as residuals. That is, amounts held or owed by the other sectors are subtracted from known totals, and the remainders are assumed to be the amounts held or owed by the Household Sector. . . So to answer the question - who is the Household Sector? They are a PHANTOM. They don’t exist. They merely serve to balance the ledger in the Federal Reserve’s Flow of Funds report. . . .

Is this a Ponzi scheme?

As we have seen so illustriously over the past year, all Ponzi schemes eventually fail under their own weight. The US debt scheme is no different. 2009 has been witness to spectacular government intervention in almost all levels of the economy. This support requires outside capital to facilitate, and relies heavily on the US government’s ability to raise money in the debt market. The fact that the Federal Reserve and US Treasury cannot identify the second largest buyer of treasury securities this year proves that the traditional buyers are not keeping pace with the US government’s deficit spending. It makes us wonder if it’s all just a Ponzi scheme.

Shostak critiques Bernanke

In a long column addressing a speech Fed chairman Ben Bernanke gave at the Economic Club in Washington, D.C. on December 7, Austrian economist Frank Shostak concludes with these remarks:

Bernanke: "Our regulatory structure requires a better mechanism for monitoring and addressing emerging risks to the financial system as a whole." He goes on to say he favors the creation of a "a systemic oversight council, made up of the principal financial regulators, to identify developments that may pose systemic risks, recommend approaches for dealing with them, and coordinate the responses of its member agencies."

Shostak: "We suggest that the threat of future crises will disappear once the Fed stops tampering with interest rates and the money supply. Furthermore we suggest that the act of money creation out of thin air is going to disappear once the present paper standard is replaced with a gold standard. If we allow a market-chosen money to fulfill the role of the medium of exchange, the issue of inflation will also disappear."

Characterizing the decade

Time magazine describes the first 10 years of this century as "the decade from hell." Peter Schiff disagrees, saying it had striking parallels to the Roaring Twenties. "[T]he decade now closing gave us the biggest and most irresponsible spending orgy in U.S. history. The past decade was the party; the one ahead will be the hangover."

Schiff goes on to say:

For now, Congress and the President remain as clueless as Time. To show its resolve to "get to the bottom of things," the Obama Administration has impaneled a commission to investigate the causes of the financial crisis. Do not expect the proceedings, which are just getting underway, to come up with anything but the most politically useful explanations.

The Fed's one great success

Jörg Guido Hülsmann is senior fellow of the Mises Institute and author of Mises: The Last Knight of Liberalism and The Ethics of Money Production. (See my review of the latter here.) He teaches in France, at Université d'Angers. In a commentary on the alleged independence of the Fed, he writes:

The Fed has had one great success: it is by far the largest funder of academic research in monetary and macroeconomics, employing hundreds of economists, financing conferences and seminars, providing paid consultancies, and so on. Is it any wonder that the majority of academic monetary and macroeconomists support the status quo?

By this he is referring to the 270 economists who have signed an "open letter" supporting the Fed's independence from serious audits. According to this letter, "Economic theory and a massive body of empirical evidence provide strong support for the independence of central banks in their conduct of monetary policy."

How can an institution be "independent" when it was created and is sustained by politicians? As Hülsmann notes, "A government bureaucracy that cannot function unless it is shrouded in secrecy and is not held accountable to the elected representatives of the people has no place in a free society."

I like Gary North's suggestion:

I, for one, do not trust Congress to be in charge of monetary policy. But I do not argue that the Federal Reserve System should maintain its independence from the Federal government. I maintain that it should be made completely independent of the Federal government: cut loose and left to fend for itself, just as the Second Bank of the United States was in 1836. It went bust. (emphasis added)

Please indicate your support of the Paul - Grayson bill to Audit the Fed by adding your signature here.

Currency competition

Ron Paul has a sign in his office that reads, "Don't steal - the government hates competition." Government is a monopolist, and one of the ways we've suffered from this monopoly is through its coercive control of money. Government dictates that money will be paper bank notes with no redeeming value and to give us a false assurance turns the production of paper money over to a central bank. The central bank, known as the Fed, falsely claims to be independent of political pressure and to be guided in its "policy" only by what is good for the economy. In return for this grant of privilege, the central bank sees to it that government remains flush with money to cover whatever project D.C. demagogues dream up - foreign war, health care, bailouts for their cronies. It does this by creating money out of nothing, much like a child would do playing make-believe. But when grown-ups do it, it's called counterfeiting. And counterfeiting is a form of theft.

Government counterfeiting usually works for awhile because of legal tender laws supporting government money. If someone offers it in payment of a debt, we cannot legally refuse it.

The monetary system we have now is built on the ignorance of the people and the deception of bankers and politicians who are aided and abetted by court intellectuals. It is a clever way for the government and bankers to steal, because most people don't understand - and don't care to understand - how it works. People are so used to playing monopoly under the auspices of the state they don't realize they could stop being suckers if the laws were different.

We could chose a sound money -- one that is not inflatable at the whim of twelve bureaucrats sitting around a table in a closed meeting. We could save this sound money and actually see it gain in value over the years. Without a handful of bureaucrats manipulating the supply of money, we could eliminate the trade cycle of boom and bust. We could control government spending because the Fed would no longer be able to print what government wants to cover its deficits. We would therefore have more control over our lives. We could have the beginnings of a free society.

Ron Paul understands all this (and much more). That's why he issued a statement introducing the Free Competition in Currency Act of 2009.

Is gold a hedge against inflation?

Steve Saville, one of my favorite commentators, addressed this question recently:

[U]nder the current system a high rate of monetary inflation is one of the two primary ingredients of a long-term gold bull market. Monetary inflation is not sufficient by itself, but when mixed with the second ingredient the result will be a powerful advance lasting many years.

The second ingredient is: enough economic weakness/problems to bring about a general increase in the desire to save. The economic problems cause both an increase in the desire to save and a reduction in the demand for growth-oriented investments such as equities, while a high rate of monetary inflation prompts people to save in terms of something other than the official currency.

Rather than saying that gold is a hedge against inflation it is therefore more correct to say that gold is a hedge against inflation under certain economic conditions. At other times, investments such as general equities could prove to be far better hedges against inflation.

Of course, Steve is not the only one to raise the question of gold as an inflation-hedge. Economics writer Robert Blumen wrote an article on the subject on March 6, 2007.

The problem with concluding anything based on the US$ price alone is that an analysis of US$ price of gold is as much an analysis of the US$ exchange rate against other fiat currencies as of the value of gold itself. The US$ exchange rate is affected by many political variables, including currency intervention by foreign central banks and the sometimes non-linear effects of the Fed’s inflation. Dollar inflation, working through what James Grant calls the "international monetary non-system" has in some periods had the paradoxical effect [of] driving up the value of the dollar against other currencies. During those periods, the dollar price of gold performs poorly, but the price in other currencies outperforms.

Relying extensively on the research of Paul van Eeden, Blumen says:

[W]hen the gold price is examined against a global weighted index of fiat currencies, it is rising approximately at the same rate as the purchasing power of fiat paper money is declining. Van Eeden’s data show that gold has done a good job maintaining purchasing power over time against fiat money inflation. In other words, gold functions as an inflation hedge. The market has priced it like other currencies on the international money markets.

Blumen adds:

As van Eeden explains, the poor performance of the US$ gold price during the 90s was primarily a reflection not of declining monetary significance of gold, but of the dollar’s overvaluation relative to other fiat currencies. The over-valuation of the dollar resulted from several factors: a massive asset bubble in the US; a series of currency crises fueled by debt implosions in the developing world; and the reluctance of Japanese central planners to allow the Yen to appreciate as they attempted to inflate their way out of the 15 years of doldrums following the collapse of their credit bubble in the 80s.

His conclusion:

The dollar price of gold can be flat or falling even when the quantity of dollars is increasing so long as the dollar exchange rate against other currencies rises. The non-buyer of gold, then, is speculating [on] an appreciating dollar exchange rate cancelling out the effect of currency debasement.