FED BANKRUPT BY 2016 or 2017?
Last week we had Fed minutes released that showed disagreement about how quickly Fed QE operations should be dismantled. This sent the markets down sharply for two days -- then the rationalists took over, explaining there was no way the Fed could stop easing.
What generated all this uncertainty? Apparently it was a paper written by Fed think tank, the US Monetary Policy Forum, co-written by former Fed Governor and former Bernanke right-hand man, Frederic Mishkin.
What did this paper state? Well, the paper caused Ambrose Evans-Pritchard at the British Telegraph a former passionate advocate of Bernanke's easing policies to write the following article, in which he seems to be throwing in the towel:
"TRADE PROTECTIONISM LOOMS AS CENTRAL BANKS EXHAUST QE"
A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution's capital base could be wiped out "several times" once borrowing costs start to rise in earnest.
A mere whiff of inflation or more likely stagflation would cause a bond market rout, leaving the Fed nursing escalating losses on its $2.9 trillion holdings. This portfolio is rising by $85bn each month under QE3. The longer it goes on, the greater the risk. Exit will become much harder by 2014.
Such losses would lead to a political storm on Capitol Hill and risk a crisis of confidence. The paper -- "Crunch Time: Fiscal Crises and the Role of Monetary Policy" -- is co-written by former Fed governor Frederic Mishkin, Ben Bernanke's former right-hand man.
What does "Crunch Time" actually say?
Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Such feedback is left out of current long-term U.S. budget projections and could make it much more difficult for the U.S. to maintain a sustainable budget course. A potential fiscal crunch also puts fundamental limits on what monetary policy is able to achieve. In simulations of the Federal Reserve's balance sheet, we find that under our baseline assumptions, in 2017-18 the Fed will be running sizable income losses on its portfolio net of operating and other expenses and therefore for a time will be unable to make remittances to the U.S. Treasury. Under alternative scenarios that allow for an emergence of fiscal concerns, the Fed's net losses would be more substantial.
This is a 'smoking-gun' declaration that QE is a failure. This paper was not written by Bernanke-bashers. The authors want Bernanke to be successful, but have lost faith.
[The paper] argues the Fed is acutely vulnerable because it has stretched the average maturity of its bond holdings to 11 years, and the longer the date, the bigger the losses when yields rise. The Bank of Japan has kept below three years.
Trouble could start by mid-decade and then compound at an alarming pace, with yields spiking up to double-digit rates by the late 2020s. By then Fed will be forced to finance spending to avert the greater evil of default."Sovereign risk remains alive and well in the U.S, and could intensify. Feedback effects of higher rates can lead to a more dramatic deterioration in long-run debt sustainability in the US than is captured in official estimates," it said.
Europe has its own "QE" travails. The paper said the ECB's purchase of Club Med bond amounts to "monetisation" of public debt in countries shut out of global markets, whatever the claims of Mario Draghi.
"We see at least a risk that the eurozone is on a path to become more like Argentina (which of course is why German central bankers are most concerned). The provinces overspend and are always bailed out by the central government. The result is a permanent fiscal imbalance for the central government, which then results in monetization of the debt by the central bank and high inflation," it said.
In America, the Fed would face huge pressure to hold onto its bonds rather than crystallize losses as yields rise -- in other words, to recoil from unwinding QE at the proper moment. The authors argue that it would be tantamount to throwing in the towel on inflation, the start of debt monetisation, or "fiscal dominance". Markets would be merciless. Bond vigilantes would soon price in a very different world.
Investors have of course been fretting about this for some time. Scott Minerd from Guggenheim Partners thinks the Fed is already trapped and may have to talk up gold to $10,000 an ounce to ensure that its own bullion reserves cover mounting liabilities.
What is new is that these worries are surfacing openly in Fed circles. The Mishkin paper almost certainly reflects a strand of thinking at Constitution Avenue, so there may be more than meets the eye in last week's Fed minutes, which rattled bourses across the world with hints of early exit from QE.
Evans-Pitchard concludes that QE has failed; and that 'protectionism' is the next stage. Evans-Pritchard defends QE as a stop-gap response to deflationary pressures in 2008 -- he supported QE until today we will remember -- now he blames the collapse on flaws in the structure of globalism.
But the "Crunch Time" paper puts a lot of emphasis on the magic level of debt, with a special eye on government debt at 80% of GDP as being the tipping point, from which there is no return.
Mr Bernanke is not going to snatch the punch bowl away just as the US embarks on fiscal tightening this year of 2pc of GDP, one of the most draconian budget squeezes in the last century. But he may have concluded that the Fed is sailing too close to the wind, and must take defensive action soon.
Monetarists say this is a specious debate -- arguing that the losses on the Fed balance sheet are an accounting irrelevancy -- but Bernanke is not a monetarist. What matters is what he thinks.
If this is where the Fed is heading, the world is at a critical juncture. The US economy has not yet reached "escape velocity", and in fact shrank in the 4th quarter of 2012. Brussels has slashed its eurozone forecast, expecting a second year of outright contraction in 2013.
The triple "puts" of the last eight months -- Bernanke's QE3, Mario Draghi's Club Med bond rescue, and Beijing's credit blitz -- have done wonders for asset markets but have not yet ignited a healthy cycle of world growth. Nor can they easily do do since the East-West trade imbalances that caused the 2008-2009 crisis remain in place.
We know from a body of scholarship that fiscal belt-tightening in countries with a debt above 80pc to 90pc of GDP is painful and typically self-defeating unless offset by loose money. The evidence is before our eyes in Greece, Portugal, and Spain. Tight money has led to self-feeding downward spirals. If bond yields are higher than nominal GDP growth, the compound effects are deadly.
America may soon get a first taste of this, carrying out the epic fiscal squeeze needed to bring its debt trajectory back under control with less and less Fed help. Gross public debt will hit 107pc of GDP by next year, and higher if the recovery falters as pessimists fear.
With the fiscal and monetary shock absorbers exhausted -- or deemed to be -- the only recourse left is to claw back stimulus from foreigners, and that may be the next chapter of the global crisis as the Long Slump drags on.
'Claw back stimulus from foreigners.' What is meant by this? Beggar thy neighbors? We have seen this since 2008 with QE and ZIRP Now Japan crushes its yen and the prime minister threatens to stack of the supposedly neutral or at least independent Bank of Japan with a man who will follow Mr. Abe's orders for a trade war. Japan is desperate. Abe understands time is against Japan; and I believe he is willing to use war to attempt to wake Japan up from a deadly sleep. It's a shame he (and by this I mean the Japanese government) didn't use higher interest rates to cure his cancer; but this is a move that requires a strong belly and a willingness to be unpopular for awhile. A democracy tends to be gutless when it comes to making the difficult unpopular decisions -- this is the fatal flaw of a democracy.
Evans-Pritchard discusses the ideas in a new book by Professor Michael Pettis from Beijing University: The Great Rebalancing: Trade Conflict and the Perilous Road Ahead -- in which book Pettis argues that the Global Economic Crisis is a trade war masquerading as a debt crisis. (I admire Michael Pettis' ideas very much.)
Evans-Pritchard summarizes the Pettis argument:
There is too much industrial plant in the world, and too little demand to soak up supply, like the 1930s. China is distorting the global system by running investment near 50pc of GDP, and compressing consumption to 35pc. Nothing like this has been seen before in modern times.
This has nothing to do with the "Confucian" work ethic or a penchant for stashing away money. Fifty years ago the stereotype was the other way round. Confucians were seen as feckless. In fact, Chinese families never get the money in the first place. The exorbitant Chinese savings rate is due to a structure of taxes, covert subsidies, and banking rules.
Variants of this are occurring in many of the surplus trade states. Germany is doing it in a more subtle way within Euroland. The global savings rate is almost 25pc and climbing to fresh records each year. The overstretched deficit states in the Anglo-sphere and Club Med are retrenching but others are not picking up enough of the slack. Germany has tightened fiscal policy to achieve a budget surplus. This is untenable.
In the Nineties the $10 trillion reserve accumulation by Asian exporters and petro-powers flooded the global bond market. At the same time, the West offset the deflationary effects of the cheap imports by running negative real interest rates.
The twin policy regimes in East and West stoked the credit bubble, and this in turn disguised what has happening to trade flows. These flows were disguised yet further after 2008 by QE and fiscal buffers, but the hard reality beneath may soon be exposed as these old props are knocked away.
"In a world of deficient demand and excess savings, every country will try to acquire a greater share of global demand by exporting savings," he writes. The "winners" in this will be the deficit states. The "losers" will be the surplus states who cannot retaliate. The lesson of the 1930s is that the creditors are powerless. Prof Pettis argues that China and Germany risk a nasty surprise.
I would not be too quick to dismiss Mr. Pettis' view that the trouble with the global economy is a trade imbalance. He is an intelligent observer of the world.
"Crunch Time" is about fiscal deficits and the destructive nature of rising interest rates. We will remember that Bernanke has spent trillions on so-called 'toxic debt' and then used ZIRP (buying bonds furious) to keep interest rates down and to keep his portfolio from self-destructing. But how long can he do this? He is buy some 70-80% of TBonds the Treasury is issuing. But with each round of purchasing his balance sheet grows; and it is this very balance sheet which promises to implode when/if interest rates EVER go up.
"Crunch Time" continues:
In Section 4 we turn our attention to the impact of fiscal crises on monetarypolicy. We first discuss the role of monetary policy in promoting successful fiscal consolidations and the challenges confronting policymakers, noting that the political and logistical capability of the central bank to control inflation is directly tied to whether the government can achieve a sustainable path for fiscal policy.
We then conduct a detailed analysis of the Federal Reserve's balance sheet and the implications for the Fed's future cash flow of a realistic exit strategy from its current expanded balance sheet. As interest rates rise, the Fed will need to pay more to persuade banks to hold any remaining large balances of excess reserves. And, should it sell assets to shrink its balance sheet as it has indicated is likely, the Fed will realize a capital loss on long-term securities that it bought when interest rates were lower.
In our baseline assumptions, these forces would result in losses equal to a significant portion of Fed capital by 2018, after which these losses could gradually be worked off. But departures from the baseline, such as large-scale purchases continuing past 2013, or a more rapid rise of interest rates (a distinct possibility given the analysis presented in Section 3) would saddle the Fed with losses beginning as early as 2016, and losses that in some cases could substantially exceed the Fed's capital. Such a scenario would at very least present public relations challenges for the Fed and could very well impact the conduct of monetary policy.
Many of us have argued that QE was a lie, and a foolish throwing of money into the Black Hole of Deflation. Some of us understand that there is a Deflation Season that MUST be honored, no matter how painful for the status-quo -- and that QE was the immoral transfer of wealth from the (relatively) poor taxpayers to the rich (the bankers mostly), in essence rewarding them for their stupidity and failure. The Debt Bubble was encouraged by bankers everywhere, including the two chiefs of the Bank in America, Greenspan and Bernanke. QE was a visionless denial of the truth: bad debt taken on in huge amounts at the end of the Business Cycle NEEDS TO BE DESTROYED.
This does not mean that such an honoring of deflation will be painless. Taking on massive amounts of debt is stupid and shows a total lack of leadership, and a lack of philosophical understanding, a misguided naivety that expansions last for ever. Expansions do not last for ever. They last for eighteen years; then the deflation also lasts for eighteen years.
We should have begun raising interest rates gently but persistently from 2001 through 2019. In this way we would have avoided much of the Debt Bubble catastrophe (that Bernanke embraced) -- he wanted to win; he did not want to lose (HUBRIS) -- we would have also begun a transfer of wealth from the elite few back to the mass of Americans in the form of investment in savings, which then becomes the launching pad of the next expansion, scheduled for 2019. We will see how this plays out.
Savings is the first stage fuel for the Growth Season (1911-1920; 1947-1956; 1983-1992); debt is the second stage fuel for the Growth Season (1920-1929; 1956-1965; 1992-2001) -- but then the debt must stop, and credit must become more expensive.
Evans-Pitchard defends himself by justifying the first few waves of QE -- but he is now off the band-wagon. He writes:
Some will take the Mishkin paper as an admission that QE was a misguided venture. That would be a false conclusion. The West faced a 1931 moment in late 2008. The first round of QE forestalled financial collapse. The second and third rounds of QE have had a diminishing potency, while the risks have risen. It is a shifting calculus.
The four years of QE have given us a contained depression and prevented the global strategic order from unravelling. That is not a bad outcome, but the time gained has largely been wasted because few wish to face the awful truth that globalisation itself -- in its current deformed structure -- is the root cause of the whole disaster.
It will be harder from now on if central banks conclude that their arsenal is spent. We can only pray that their help will not be needed.
Globalism is NOT the root cause of the disaster. Time is the root-cause of the disaster. Inflations/growths last eighteen years, no more. The inflation from 1983-2001 was spectacular, in many different dimensions. The globalism that culminated in 2001 was spectacular; and the symbol of its end, the attack on the World Trade Center (Twin Towers) was equally spectacular. 2001 signaled the end of the expansion; and the reverse beginning of the expansion of the powers of anti-matter whose job is to deconstruct the world we constructed in 1983-2001.
Our leaders did not understand that the expansion/inflation, the construction of the world, HAD TO END IN 2001. This is a law of nature. Eighteen years up; eighteen years down.
The global economy spent the Disinflation Season from 2001-2010 attempting to preserve what was dead, what had culminated, and what was now in a Harvest Season -- not another Growth Season. 2008 was August turning into September. We needed to be aware of this. Our leaders were pretending it was March and we were on the verge of another Spring growth season. In 2008, we should have 'harvested the crop' and prepared for the Season of Deflation with higher interest rates.
Nothing in nature grows for ever. There is growth; and then there is rest, harvest, culmination; then there is decay, darkness and gestation. Without a dark period seeds cannot gestate properly. The Deflation Season is about 1) destruction of Bad Debt (toxic matter); 2) growth in savings and in currency strength; 3) preparation for the next growth cycle. Every new growth cycle is symbolized and characterized by a new technology that makes the growth possible.
2001-2019 is our Noon-to-Midnight period, Summer to Winter. This is the age of decline, decay, downsizing, Nature triumphing over man. In the expansion, Man becomes a kind of God, a Master of the Universe; and in the Deflation Season man falls from Heaven, is punished for his hubris, returns to find God and after a season of darkness and remorse and trial by fire, rediscovering humility, petitions Nature for rebirth.
Michael J. Clark, CGTS