Over the next year or two, we have front row, live, original performance seats to what will be talked and written about for ages as money printing's main act in history. Currency debasement is nothing new, of course; but it has always been a country here, an empire there. We here in 2012 get to witness for the first time all the globe trying to print its way out of its troubles.
It seems like the starting gun has been fired in the race to debase among the policy movers and shakers, leaving us little people to worry about the consequences.
Probably the first thing that we worry about is inflation. How can we be printing a hyper-blizzard of money and not be having hyperinflation? This is of particular interest to gold bulls, because gold is supposedly held to guard against currency debasement. A major reason we have such printing with little inflation is simply bad debt write-off. This takes the wind out of inflation's sails.
Gold bulls like David Nichols point out that bad debt write-off is an enemy of gold if it causes deflation as he explained in his recent article "The Next 17 Months In Gold". He gives a simple example of a house buyer having been lent $800,000 to buy a house. If he has to renegotiate the debt paid back to just $600,000, that is $200,000 removed from the money supply. To counter the deflationary effect of that, $200,000 must be printed. He adds:
It's absolutely critical for gold bulls to realize that this type of de-leveraging, with the accompanying deflation, is just terrible for gold. Gold gets creamed in this macro-environment, along with just about everything else.
This disappearance of printed money to cover debt that is never paid back is one factor that drives Bernanke to print such massive amounts of new money with no fear of inflation. In Nichols' opinion:
The reality is the beleaguered Fed can't create new dollars quickly enough to keep up with the dollars being wiped out by bad debts. This is why the Fed can pump trillions of dollars into the economy and not cause hyper-inflation.
There are other reasons explaining why we have been able to create money for many years without an inflation problem. Peter Warburton wrote an eye-opening explanation of some of these in "Peter Warburton: The Debasement of World Currency: It Is Inflation, But Not as We Know It" . He explains the good side of credit:
There are some things that only money can do. However, there are many other things that credit can do just as well. The avalanche of non-bank credit that has swept across the economic landscape over the past 20 years has altered it beyond recognition. On the one hand, it has enabled the monetary aggregates to grow much more slowly than the credit aggregates, helping to keep inflation lower. On the other hand, the non-bank credit avalanche has enabled a furious pace of fixed investment in physical assets that has promoted structural global excess capacity in virtually all manufactured products and exerted downward pressure on product prices.
A credit binge doesn't have to be a bill printing blizzard. And a credit binge tends to be put to good use creating a mega supply of goods and services for our bills to chase. If you look at a recent history of the Fed's balance sheet, as we will later, you see a very flat banknote creation curve. Of course, there are the financial debacles like the savings and load crisis of the late '90s that incite money printing. But as Warburton notes:
... In these stressful episodes, it is the financial markets themselves that are the principal driving force behind the monetary expansion. Hence, there is relatively little monetary impact on the product and labour markets, that is, on prices and wages...In this way, we can arrive at a crude understanding of the paradox of disconnection: how volatile and often rapid monetary growth rates can be consistent with seemingly low and stable inflation outcomes.
Peter Warburton is an economist who wrestled profusely with this whole money printing/inflation thing, and he came up with some very piercing insights. I'm going to show you a quote from his article, and I want you to guess about when he wrote it:
... Restraining the growth of the money supply does not prohibit the excessive expansion of the credit system, unless banks have a credit monopoly and operate only as lenders rather than investors ... I can assure you that consumer price inflation will not be a problem for such an economy.
Where is the flaw? In the limit, the construction of excess capacity gives rise to debt default, as the idle portion of capacity does not earn an income and cannot service the debt that financed its construction...What we see at present is a battle between the central banks and the collapse of the financial system fought on two fronts. On one front, the central banks preside over the creation of additional liquidity for the financial system in order to hold back the tide of debt defaults that would otherwise occur. On the other, they incite investment banks and other willing parties to bet against a rise in the prices of gold
Did you feel that he wrote this within the last three years? Well, he really had a grasp on the early weeds growing in our high debt Garden of Eden - because he wrote this in April, 2001. Think about that. It was before the bull market in gold even began, and no one but he and Jim Rogers were concerned about debt and the collapse of the financial system. In a section he titled "The Search is on for the Perfect Hedge" he gives a list that looks like everything popular today that was ignored in 2001 - things like arable land, oil refining, drinking water, commodities and precious metals. Then he plaintively asks, "Could these be the winning investments of the early years of the 21st century?"
Warburton's point about there being limits to the good things debt can do was also understood by another guy who goes way back further than him. Over a hundred years ago, this man commented on the current danger to our American homes. Our current debt equates roughly to $50,000 for every man, woman and child. Taking the 2007 census number for head of households of 111 million, you actually get $143,000 for every house in the country. That's the same as if every house took out a loan for $143,000 and paid the interest on it just to finance our government's fiscal foolishness. That's about the same burden as if every house in our land were buying another house. At this point, the consumer can't afford to buy anything the debt stimulus makes. It reminds me of Thomas Jefferson's warning, even before Warburton warned us:
If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered.
Well, we did allow it in 1913 with the creation of the Federal Reserve System, and we completely unfettered it in 1971 when Nixon removed the link between the currency and gold. And it is now driving us homeless and underwater just as Jefferson warned.
But it's all OK. We have no inflation. So if banknotes in circulation chasing goods and services and the CPI are not causing problem inflation, what currency debasement is the gold market all about? It's like this market looks at money printing as the "supply" of dollars and it doesn't care if it goes to offset bad debts in the money supply or if it goes into off-balance-sheet creativity or whatever. Gold is not about inflation, not as we know it. It apparently goes by the axiom J.P Morgan once gave: "Gold is money. Everything else is credit." It seems that all credit issued, good or bad, paid back or not, is viewed as eventual competing currency by the gold market.
The off-balance-sheet creativity we all fear did not stop running a muck with the mortgage bust. It has continued to flourish and endanger. In a recent article, "Derivatives Tide Rises at Big Banks" in the March 10, 2012 Financial News, the portions of derivatives the large banks reported on their balance sheets was presented - it averages less than 5% of what the banks actually own of these "financial weapons of mass destruction" as Warren Buffett calls them. And they're not too keen on bragging about that to their investors as the article notes:
It isn't until banks release quarterly securities filings, usually a few weeks after they post earnings, that investors see the footnote disclosures detailing the gross positions.
While investors haven't traditionally paid that much attention to the gross figures, they have become more relevant amid worries about financial contagion. The risk is that the failure of a counterparty could impair the value of a derivative asset. If so, a bank would be stuck with a liability that is no longer offset by an asset.
Admittedly, that is an extreme scenario, and derivatives trades are often backed by collateral. Still, investors would do well to pay some heed to the gross numbers. After all, when assets are counted in the trillions of dollars, even a very small problem can quickly become a big one.
This under-the-carpet derivatives growth seems to be coming to some kind of crescendo here in 2012. Eric Sprott recently wrote an article on this and felt compelled to name it "Unintended Consequences In The Year Of The Central Bank." "The Year Of The Central Bank"? This is the money printing show I was referring to above. Sprott reckons that OTC derivatives in the big banks have gone up 25% since the '08 crisis, not down. He feels the Dodd-Frank reforms are just forcing more work-arounds in what they were doing before.
The Truth of the matter is that both domestically here in the U.S. and globally, the amount of outstanding obligations is going up at an increasing rate - it is accelerating. When you unwind all of the gimmicks being employed to mask part of this increase - like asset hypothecation/rehypothecation - the rate of increase is going parabolic. A global debt/liability bubble. It's truly frightening. The tautological "offset" to this frightening rate of debt accumulation will be BOTH the parabolic increase in the "de facto" money supply AND a parabolic increase in the price of gold/silver. I say "de facto" because I am referring to both the currency in circulation plus the amount of money made available by credit. The ECB balance sheet has spiked higher than the Fed balance sheet. Make no mistake, the Fed will correct that shortly in order to devalue the dollar in relation to the euro. That's why the big banks are record short the euro via futures. Japan is printing to infinity, as is China. It's going parabolic.
I've drawn up a graphic in "The Bull Market in Money Printing" at my blog, which summarizes the above (see Figure 1). This is a basic chart of the Fed's official balance sheet over the last 20 years with the off-balance-sheet secret creativity of derivatives added in blue. Because of the propensity of massive derivatives to go wrong and the Fed's propensity to print money to fix those problems, one could view them as unofficial money printing.
You can see by the banknote count in the chart that money creation seemed to go flat after the '90s resulting in mild inflation - no blizzard of bills chasing our goods and services. But what came along to take up the slack in the parabolic rise of debt was derivatives. This created mega amounts of toxic garbage in secret places (not balance sheets) until some of the garbage had to suddenly be collected by the Fed's official balance sheet in 2008. The graphic leaves off at 2008, but now we have some $900 trillion in derivatives webbed together. But thank goodness there's no inflation.
In a follow up article either here or at my blog, I am going to look at the fractal nature of money printing. It has some serious implications for the next couple of years.