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The Shell Game - How the Federal Reserve is Monetizing Debt 
Tuesday, August 25, 2009, 10:44 am, by cmartenson
Below is the first part of a Martenson Report from a few weeks ago, previously available only to enrolled members but now available for free to everyone.
To read the full report, click this link:
The Shell Game - How The Federal Reserve Is Monetizing Debt
Sunday, August 2, 2009Executive Summary- The Federal Reserve and the federal government areattempting to "plug the gap" caused by a slowdown of privatecredit/debt creation.
- Non-US demand for the dollar must remain high, or the dollar will fall.
- Demand for US assets is in negative territory for 2009
- The TIC report and Federal Reserve Custody Account are reviewed and compared
- TheFederal Reserve has effectively been monetizing US government debt bycleverly enabling foreign central banks to swap their Agency debt forTreasury debt.
- The shell game that the Fed is currentlyplaying obscures the fact that money is being printed out of thin airand used to buy US government debt.
The Federal Reserve is monetizing US Treasury debt and is doing soopenly, both through its $300 billion commitment to buy Treasuries andby engaging in a sleight of hand maneuver that would make a streethustler from Brooklyn blush.
This report will wade through some technical details in order toilluminate a complicated issue, but you should take the time to learnabout this because it is essential to understanding what the future mayhold.
One of the most important questions of the day concerns how thedollar will fare in the coming months and years. If you are working fora wage, it is essential to know whether you should save or spend thatmoney. If you have assets to protect, where you place those monies isvitally important and could make the difference between a relativelypleasant future and a difficult one. If you have any interest at allin where interest rates are headed, you'll want to understand thisstory.
There are three major tripwires strung across our landscape, any ofwhich could rather suddenly change the game, if triggered. One is asudden rush into material goods and commodities, that might occur if(or when) the truly wealthy ever catch on that paper wealth is a doomed concept. A second would occur if (or when) the largest and most dangerous bubble of them all, government debt, finally bursts. And the third concerns the dollar itself.
In this report, we will explore the relationship between those last two tripwires, government debt and the dollar.
Replacing private credit with public creditOur entire monetary system, and by extension our economy, is a Ponzieconomy in the sense that it really only operates well when inexpansion mode. Even a slight regression triggers massive panics anddisruptions that seem wholly inconsistent with the relative change,unless one understands that expansion is more or less a requirement ofour type of monetary and economic system. Without expansion, thesystem first labors and then destroys wealth far our of proportion tothe decline itself.
What fuels expansion in a debt-based money system? Why, new debt(or credit), of course! So one of the things we keep a very close eyeon over here at Martenson Central, as they do at the Federal Reserve,is the rate of debt creation.
One of the big themes in the current credit bubble collapse is theextent to which private credit has been collapsing and thecorresponding degree to which the Federal Reserve has been purchasingdebt and the federal government has stepped up its borrowing. Inessence, public debt purchases and new borrowing has attempted to plug the gap left by a shortfall in private debt purchases and borrowing.
That's the scheme right now - the Federal Reserve is creating newmoney out of thin air to buy debt, while the US government is creatingnew debt at the most fantastic pace ever seen. The attempt here is tokeep aggregate debt growing fast enough to prevent the system fromcompletely seizing up.
How are they doing?
The debt gapOne of the great perks of living in a relatively open society isthat we generally get access to pretty good information. The FederalReserve routinely publishes a document called "Monetary Trends," where they collapse all their points of interest into a nice, tidy collection, and then make it available for all to see.
Here's what caught my eye in the most recent one:
What we see here is federal debt (bottom chart) exploding at anearly 30% yr/yr rate of change in response to a collapse in corporateand consumer borrowing (top charts).
This raises a most interesting question: "Who is lending the money to accommodate all that federal borrowing?"
Here's where the story gets interesting.
Treasury International Capital (TIC) flowsLately, a number of observers have made note of a troubling declinein foreign demand for US paper assets, notably bonds. Worse, it's eventurned into outright selling which will ultimately translate intodollar weakness.
The relative demand for the dollar "out there" in the internationalForeign Exchange (or "Forex") market directly impacts the dollar'sstrength. If there are more sellers then its value will fall; if thereare more buyers, then its value will rise. One way to assess thisdelicate balance is to ask, "In total, are foreigners buying or sellingUS assets and what are they doing with those proceeds?"
Luckily for us, the exact answer to this very question is releasedin a monthly report put out by the Treasury Department, called the Treasury International Capital Flows report, or TIC report for short.
The recent TIC reports have been quite alarming, because they notonly reveal the most sudden deceleration in flows in history, but alsothat they have been negative for some time now. This chart is from the Federal Reserve:
What we see here is that from the early 1990's onward until 2007,foreigners bought progressively more and more US assets and did so bybringing their money to the US and leaving it there. It is only overthe past seven months, out of decades, where that process has reversed and become negative. This is a significant event, to say the least.
On the surface, the above chart hints at a potential disaster for acountry that is embarking on the largest-ever federal debt binge inhistory.
After all, if US assets are being shunned by foreigners, how will we find enough buyers? And what will happen to the dollar?
The answers are: "We won't" and "Nothing good."
Digging inIf we dig into deeper into the detail of the report, we findsomething even more interesting. While the overall flows have beennegative, there is an enormous difference between the behaviors offoreign central banks and private investors. Fortunately theTIC report distinguishes between these two broad classes of buyers.
Since the start of 2009 and continuing through the month of May, private investors sold $364 billion dollars worth of US assets, while central banks purchased $50 billion dollars worth (source is a .csv file available here from the Treasury). Added up, some $314 billion dollars of foreign money has left the country since the start of the year.
What this demonstrates is the utter reliance of the entire house ofcards upon the continued purchase of US financial assets by foreigncentral banks. Without the continued cooperation of the foreign centralbanks in accumulating US assets, suffice it to say that the dollar willfall a lot lower than it already has.
The dollarNot surprisingly, the dollar recently put in a new closing low forthe year (YTD 2009) and is approaching a major area of support andresistance. If it breaks through, we could be looking at a rapidgame-changer here.
Of course, I've said all this before, and every time we seem to getclose, there's been an upside surprise in store. The forces aligned toprevent a dollar collapse are numerous.
But the same risk remains, and the fundamental picture concerningthe dollar has not changed since I first became wary of its fortunes in2002. In fact, it's grown worse. Federal deficits are higher than Iever imagined possible (13% of GDP!), and now the TIC flows arenegative. The only somewhat bright(er) spot is that the trade deficithas shrunk quite a bit. However, it, too, remains solidly in negativeterritory, meaning it continues to apply pressure to the value of thedollar by increasing the total number of dollars that need to find aquiet resting place outside of the country.
Treasury auctionsDuring this past business week (July 27th - 31st,2009), the US Treasury auctioned off more than $243 billion worth ofvarious Treasury bills and bonds. "Indirect bidders," assumed to bemainly central banks, took an astonishing 39% of the total, or nearly$95 billion worth.
With the exception of the 5-year auction, which mysteriously stankup the joint with a worrisome bid-to-cover ratio well below 2.0 (thebond market behaved poorly upon the release of that news item), the story here is that foreign central banks are buying up vast quantities of Treasury offerings.
Wait a minute, hold on there…I thought we just talked about how theTIC report said that foreign central banks have only bought $50 billionin total US paper assets through May - and now they are said to bebuying $95 billion during a single week in July alone?
Something is not adding up here.
To understand what, and to get to the essence of the shell game, weneed to visit one more source of information - something called theFederal Reserve Custody Account.
The Federal Reserve Custody AccountIt turns out that when China's central bank (or any other foreigncentral bank) decides to buy either US agency or Treasury bonds, theydo not walk up to some window somewhere, hand over a pile of cash, andthen take some nice looking bonds home with them in a suitcase.
Instead, what happens is that the Federal Reserve actually holds thebonds (or rather an electronic entry representing the bonds) in aspecial account for these various central banks. This is called the"Custody Account" and it holds US debt 'in custody' for various centralbanks. Think of it as a magnificently vast brokerage/checking account,run by the Federal Reserve for central banks, and you'll have the rightimage.
Although the TIC report shows flows of capital into and out of thecountry, it does not show you what is going on with those funds thatare already in the country. If you look again at the first chart inthis report, and behold the vast flows of money that came into theUS between 1995 and 2008, you can get a sense of how much money gotsent to the US and mostly remains parked there.
The custody account currently stands at $2.787 trillion (with a "t")dollars. It has increased by over $430 billion the past 12 months andby more than $275 billion in 2009 alone (through July 29). These aretruly shocking numbers, and they tell us that foreign central bankshave been accumulating US debt instruments throughout the crisis.
As we can see in the chart below, there has been absolutely nodeflection in the growth of the custody account as a consequence of thefinancial crisis, bottoming trade, or the local needs of the countriesinvolved. It's almost as if the custody account is completelydisconnected from the world around it. If you can spot the creditbubble crisis on this chart, you have sharper eyes than me.
What does such a chart imply? We might wonder what sorts ofdistortions are created by having such a massive monetary spigot aimedfrom several central banks towards a single country. We also mightquestion just how sustainable such an arrangement really is. It is acomplete mystery how such a chart can display nary a wiggle, despiteall that has recently transpired.
This next table showing the yearly changes in the custody account actually surprises me quite a bit.
Despite everything that's been going on, the custody account is on track to grow by the largest dollar amount on recordthis year, nearly $500 billion dollars (if the current pacecontinues). Where is all this money coming from and for how muchlonger?
Understanding the gap between the TIC and the Custody numbersOne thing you might have noticed is that the TIC report only shows$50 billion in foreign bank inflows for 2009, while the custody accountgrew by $277 billion.
How is it possible for the TIC report to show smaller inflows thangrowth in the custody account? We can see that clearly in this table,which compares the two. (Note: These are 12 monthly yr/yr changes, so the numbers will be different than the YTD numbers I just cited):
One explanation is that the custody account, at some $2.7 trilliondollars, is accumulating a lot of interest. If those interest paymentsare not "sent home" and remain in the account, then the account willgrow by enough to more or less explain the difference. For example, the$135 billion difference shown above could be generated by a 5% returnto the custody account, which is not an unthinkable rate of interestfor that account.
International check kitingSome people view the custody account as nothing more than anelaborate version of check kiting, played at the central banking level.
Check kiting
An illegal scheme whereby a false line of credit is established bythe exchanging of worthless checks between two banks. For instance, a"check kiter" might have empty checking accounts at two differentbanks, A and B. The kiter writes a check for $50,000 on the Bank Aaccount and deposits it in the Bank B account. If the kiter has goodcredit at Bank B, he will be able to draw funds against the depositedcheck before it clears, i.e., is forwarded to Bank A for payment andpaid by Bank A. Since the clearing process usually takes a few days,the kiter can use the $50,000 for a few days, and then deposit it inthe Bank A account before the $50,000 check drawn on that accountclears.
In this game, Central Bank A prints up a bunch of money and buys thedebt of Country B. Then the central bank of Country B prints up a bunchof money and buys the debt of Country A.
Both enjoy the appearance of strong demand for their debt, bothgovernments get money to use, and nobody is the wiser. Except that theworld's total stock of central bank reserves keep on growing andgrowing and growing, as reflected in the custody account, which willsomeday result in thoroughly unserviceable amounts of debt, anunmanageable flood of money, or both.
If this strikes you as a scam, congratulations; you get it.
If that was all there was to the story, then it would be far lessinteresting than it actually is. When we dig into the custody accountdata, we find that the total picture is hiding something quiteextraordinary. Even as the total custody account has been growingsteadily and faithfully, the composition of that account has beenchanging dramatically.
Here we note that agency bonds peaked in October of 2008 at nearly atrillion dollars but have declined by $178 billion since then. Treasuries, on the other hand, have increased by over $500 billionover that same span of time. A half a trillion dollars! If you werewondering how the US bond auctions have managed to go so smoothly,here's part of your answer.
What is going on here? How is it possible that central banks arebuying so many Treasury bonds, at the fastest rate of accumulation onrecord?
It would appear that foreign central banks have been swapping agencybonds for Treasury bonds, but that's not how the markets work. First,they would have to sell those bonds, before they could use the proceedsto buy government debt. So to whom did they sell those Agency bonds inorder to afford the Treasury bonds?
Here we might recall that the Federal Reserve has been buying agency bonds by the hundreds of billions.
The shell gameHave you ever seen a sidewalk magician run the shell game, where apea under a shell is magically shuffled around - now you see it underthis shell, now you see it under that shell, now it disappearscompletely - or does it? The more it moves around, the more confusedyou get. If you can only figure out which shell the pea is hiddenunder, you win! But where is the pea? The point of the game, fromthe perspective of the street hustler, is to use complexity of motionto confuse the mark.
These are the three critical points to remember as you read further:
- The US government has record amounts of Treasuries to sell.
- Foreigncentral banks, which have a big pile of agency bonds in their custodyaccount, would like to help but want to keep things somewhat under theradar to avoid scaring the debt markets.
- The FederalReserve does not want to be seen directly buying US government debt atauctions (and in fact is not permitted to, but many rules have been'bent' worse during this crisis), because that could upset the wholeillusion that there is unlimited demand for US government paper, but italso desperately wants to avoid a failed auction.
For various reasons, the Federal Reserve cannot just up and startbuying all the Treasury paper that becomes available in record amounts,week after week, month after month.
Instead, it uses this three-step shell game to hide what it is doing under a layer of complexity:
Shell #1: Foreign central banks sell agency debt out of the custody account.
Shell #2: The Federal Reserve buys those agency bonds with money created out of thin air.
Shell #3: Foreign central banks use that very same money to buy Treasuries at the next government auction.
Shuffle, shuffle, shuffle, shuffle, shuffle, SHUFFLE, shuffle! Confused yet?
Don't be. If we remove the extraneous motion from this strange act,we find that the Federal Reserve is effectively buying government debtat auction. This is exactly, precisely what Zimbabwe did, but with onemore step involved, introducing just enough complexity to keep theentire game mostly, but not completely, hidden from sight. They canscramble the shells all they want, but the pea is still there somewhere- the pea being the fact that the Fed is creating money to fund thepurchase of US debt.
At the time, the Federal Reserve program to purchase agency bonds was described like this:
Fed to Pump $1.2 Trillion Into Markets
Greatly Expanded Purchases Are Designed to Lower Interest Rates, Stimulate Borrowing
The Federal Reserve yesterday escalated its massive campaign to stabilize the economy, saying it would flood the financial system with an additional $1.2 trillion.
In its statement yesterday, the Fed said it will increase itspurchases of mortgage-backed securities by $750 billion, on top of $500billion previously announced, and double, to $200 billion, itspurchases of [Agency] debt in housing-finance firms such as Fannie Maeand Freddie Mac.
While "stimulating borrowing," "stabilizing the economy," and"lowering interest rates" are laudable goals, the primary goal of theprogram seems to have been something else entirely - to assureplentiful funds for the massive US Treasury auctions coming due. I sawnothing in any article I read about this program that even suggestedthat one of the goals was to allow foreign central banks to effectivelyswap their agency debt for US government debt using money printed fromthin air. But that's clearly one of the outcomes.
The Federal Reserve, for its part, has been quite open about thesepurchases of Agency debt. It even provides an excellent website withnice graphics, allowing us to track the purchase program.
(Source)
However, this openness only extends to the amounts themselves, not the source(s)of those Agency bonds. This is, in my mind, yet another reason the Feddesperately wishes to avoid an audit. The results would expose the gamefor what it is.
As we can see in the above chart, the Fed has purchased more than$640 billion of Agency bonds, and has promised to buy more in the nearfuture.
As we now know, at least some of that money has been recycled intoUS government debt, where "indirect bidders" have been snapping up anunusually high proportion of the recent offerings. (Note: Theway Indirect bidders are calculated has recently changed, and I am notentirely clear on how much this influences the numbers we now see….I'mworking on it).
A fair question to ask here is, "If there are green shootseverywhere and the stock market is racing off to new yearly highs, whyis the Fed continuing to pump money into the system at thesemind-boggling rates?" One answer could be, "Because things might notbe as rosy as they seem."
ConclusionThe Federal Reserve has effectively been monetizing far more USgovernment debt than has openly been revealed, by cleverly enablingforeign central banks to swap their agency debt for Treasurydebt. This is not a sign of strength and reveals a pattern of tradingtemporary relief for future difficulties.
This is very nearly the same path that Zimbabwe took, resulting inthe complete abandonment of the Zimbabwe dollar as a unit of currency. The difference is in the complexity of the game being played, not thesubstance of the actions themselves.
When the full scope of this program is more widely recognized, evermore pressure will fall upon the dollar, as more and more privateinvestors shun the dollar and all dollar-denominated instruments asstores of value and wealth. This will further burden the efforts of thevarious central banks around the world as they endeavor to meet thevast borrowing desires of the US government.
One possible result of the abandonment of these efforts is awholesale flight out of the dollar and into other assets. To USresidents, this will be experienced as rapidly rising import costs andincreasing costs for all internationally-traded basic commodities,especially food items. For the rest of the world, the results willrange from discomforting to disastrous, depending on their degree ofdollar linkage.
Under these circumstances, "inflation vs. deflation" is not theright frame of reference for understanding the potential impacts. Forexample, it would be possible for most of the world to experiencefalling prices, even as the US experiences rapidly rising prices (andhikes in interest rates) as a consequence of a falling dollar. Is thisinflation or deflation? Both, or neither? Instead, we might properlyview it as a currency crisis, with prices along for the ride.
Further, all efforts to supplant private debt creation with publicdebts should be met with skepticism, because gigantic programs are nosubstitute for the collective decisions of tens of millions ofindividuals and cannot realistically meet millions of individual needsin a timely or appropriate manner.
The shell game that the Fed is currently playing does not change thebasic equation: Money is being printed out of thin air so that it canbe used to buy US government debt.
My advice is to keep these potential issues and insights in sharpfocus, make what moves you can to diversify out of dollars, and beready to move rapidly with the rest. This game is far from over. |
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发表于 2009-8-26 03:48 PM
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