Stupid Wager or Clever Prestidigitation?
"Heads — you win; tails — I lose." Such is the message the Fed sends to bond speculators. But why would the Fed offer such a stupid wager? Read on.
The Fed is trying to bribe bond speculators with risk-free profits. That's how the Treasury/Fed check-kiting conspiracy makes sure that there will always be plenty of buyers for government debt, regardless of the size of offering.
Ten years ago I started writing about my theory that, wittingly or unwittingly, the Fed has become the quartermaster general of the coming deflation and depression. I offered a logical, closely argued reasoning for this thesis. My argument had to do with the contention that the open market operations of the Fed make bond speculation risk-free, which explains the perpetual bull market in bonds. Bond speculators, knowing that the Fed must needs buy bonds in order to keep the money supply growing, front-run (or, to use the old-fashioned term: pre-empt) the Fed's open market operations. They buy the bonds beforehand, and pocket risk-free profits when they sell them to the Fed. Speculators will allow the bond price to fall only so much. Then they show up as buyers for another ride of the escalator upstairs.
Incidentally, my theory also gives the coup-de-grâce to Keynesian and Friedmanite economics. Keynes, and later Friedman, advised governments to discard the gold standard thus destabilizing foreign exchange. That would give them free hand to pursue monetary policy — euphemism for the license to engineer unlimited depreciation of the currency. Scarcely did they consider that their scheme was to back-fire. They were shooting for inflation only to bag deflation. They wanted rising prices; instead, they got falling prices.
A falling interest-rate structure engenders a falling price-level structure. It is most destructive to the economy. It devastates existing capital and blocks the accumulation of new capital. The 30-year old regime of falling rates destroyed the once flourishing American industry forcing it to flee the country. There is no chance to accumulate new capital as long as interest rates keep falling. Continuation of this trend will cause excruciating pain to those producers who remain. They will not be able to compete with newcomers who carry a much smaller burden, thanks to their lower cost of capital. The squeeze of the old-guard producers will show up in the falling price level. The "grapes of wrath" — the seeds of which were planted by Keynes and Friedman — will come to full maturity when hoards of angry and hungry unemployed people will roam from city to city and country to country.
It is not the Fed who is in the driver's seat. It is the bond speculator. The Great Depression was not due to low demand for goods, as argued by Keynes. It was due to high demand for bonds, courtesy of speculators who understood the dynamics of the bond market better than policymakers did. The GFC is just a repeat performance.
Check-kiting is the name for the conspiracy, typically between two banks, to tap the float (the mass of checks in the process of clearing). The conspiring banks send one another third-party checks that lack any backing whatsoever. They cover the liability of one unbacked check by crediting the other, ad infinitum. It is similar to wildcat banking in Scotland in the 17th century, when the coach hired by the banks carrying gold was front-running the coach carrying bank inspectors from one bank to the next. Small wonder the inspectors found the gold reserve of every bank on their beat in good shape. Check-kiting is a crime to defraud the public dealt with by the Criminal Code. Except, that is, when practiced by the Treasury and the Fed, in which case it is called monetary policy.
Let us bypass the question on what valid grounds do the Treasury and the Fed issue liabilities which they have neither the inclination nor the means to honor. The practice boils down to clever prestidigitation: to mislead the public into believing that the Emperor does have clothes. He is cheered on by an enthusiastic crowd of bond speculators praising the garment. Until... until... a naughty little boy starts howling: "Gee whiz, Dad, the Emperor is stark naked!"
Suppose the Fed wants inflation and thinks that the best way to go about it is to keep buying bonds ad nauseam and call the practice by the acronym QE-X. The belief that pumping up the money supply through unlimited bond purchases by the central bank will bring about rising prices is a tragic mistake. A higher price level will never be achieved in this way. Bond speculators will have a field day. They would just buy the bonds in any amount. A vicious spiral of falling interest rates is engaged that, like the black hole of zero gravitation, will suck in and gobble up the world economy. Keynes and Friedman were hoping for inflation they could control; instead they got deflation they could not. They cut the tragic figure of the Sorcerer's Apprentice who stole the Master's password to turn on the spigots, but he has forgotten to steal the other password to turn them off when enough is enough.
Having been a lonely voice crying in the wilderness for ten years, I am still in a minority of one. Most economists expect Fed action to cause inflation (according to some, hyperinflation). The few who dare mention the d-words, deflation and depression, hasten to add that, of course, this would follow hyperinflation, not precede it. Same as in Zimbabwe. Reports from that unhappy country say that it has 90% unemployment after the worst hyperinflation on record.
I am the only one saying that the U.S. is not Zimbabwe, and for the U.S. the forecast is deflation first, hyperinflation afterwards — at least until the prestidigitation in the bond market is exposed.
Seldom do I get a tail-wind in the form of newspaper reports confirming that there is, after all, such a thing as front-running the Fed's open market operations, that bond speculators do indeed buy the bonds only to dump them in the lap of the Fed at a hefty premium. I have certainly never ever expected the New York Times to provide that tail-wind. Well, on January 10, 2011, that bastion of central planning published an article from the pen of Graham Bowley. It quotes Josh Frost who is in charge of buying hundreds of billions of dollars of Treasuries for the Fed: "We are looking to get the best price we can for the taxpayer". Then the article goes on to quote an authority on bond trading, Louis V. Crandall, chief economist at the research firm Wrightson ICAP, who flatly contradicts Frost: a buyer of $100 billion a month is always going to pay the worst (highest) price. "You can't be a known buyer of $100 billion a month and get a good price."
In my papers I have commiserated with traders of the Fed facing, as they are, hungry lions in the arena bare-handed. The latter are the bond speculators who, unlike the former, are not working for wages. They work for profits. (If the profits happen to be risk free, so much the better.) True, the loss the Fed's traders habitually make is not their loss. They are passed on to the taxpayers with a shrug. It is the taxpayers' blood that is spilled so valiantly.
This reminds me of the object-lesson offered by George Soros. He made mincemeat of the traders of the Bank of England some years ago who were trying to fend off his serial attacks to sell the British pound short. Soros took the traders to the cleaners and, to rub it in, he bragged about it in his book. No need to feel sorry for the forex traders of the Bag Lady of Threadneedle Street. It was not their blood anyway that was flowing so abundantly. It was the blood of the British taxpayers.
I didn't know the identity of the Fed's traders facing the hungry lions. Now I do, thanks to the New York Times. They are babes in Toyland. All three of them are in their 20's. Their only prior experience in trading comes from playing Monopoly. One of them is still a student at NYU. According to the story in the NYT, "most days" they talk to the big banks. How is that for guarding against conflict of interest? Their supervisor, Josh Frost lives in Brooklyn and every morning he takes the subway to commute to work. As one may figure, not for too long. Wonder how one gets such a rags-to-riches job at the Fed? Well, take the example of Josh Frost's boss, Bryan P. Sack, age 40. In 2004 he co-authored a paper with Ben Bernanke, the future chairman of the Fed and another economist about "unconventional measures for stimulating the economy in extraordinary times" — by buying Treasuries in batches of hundreds of billions of dollars. "We didn't know then that some day the Fed would be putting it to test" — Brian is quoted as saying.
The best part of it all is that the line between success and failure is hopelessly blurred. If the rate of interest goes down in consequence of Fed action, then: "hooray, we're dead on with targeting inflation. And that's good news". If, on the other hand, the rate of interest goes up, then: "hooray, the economy is turning around. Rates have risen for the very reason we were hoping for: investors are more optimistic about the recovery. It is a good sign."
The fact that in the meantime the economy is wiped out, gets lost in the noise of loud self-congratulation.
The Federal Reserve, the Quartermaster General of Deflation, A. E. Fekete
There Is No Business Like Bond Business, A. E. Fekete, www.professorfekete.com, January, 2010
Front/Running the Fed in the Treasurys Market,
www.jessescrossroadscafe.blogspot.com, January, 2010
The Fed`s QE2 Traders, Buying Bonds by the Billions, Graham Bowley, The New York Times, January 10, 2011
Meet the Fed's POMO Desk... by Tyler Durden, www.zerohedge.com, January 10, 2011
Posted by John Danforth on 01/18/11 11:14 PM
@Peter An Coppenolle;
Thank you for your thoughtful reply.
I believe I understand your points. It looks to me like if any real deflation appears because of the effects you describe, it will be manifested as a short-lived trigger that punctures the bond bubble, after which hyperinflation will rear its ugly head as the currency from all those years of exported inflation comes flying back home all at once.
Posted by Bionic Mosquito on 01/18/11 09:32 PM
(2 of 2)
To varying degrees, the Fed (with and through the banking system) has been creating money since 1913, accelerating since 1971 and supercharged since 2008. Yet, other than perhaps one year in the 1950s, there has been price inflation continuously. I wonder: is there some reason we should expect something different now? Why hasn't this great deflation that is so certain in our future happened at any time since the end of the war? The same practice has been going on for decades, without deflation. But somehow it is different this time. Let's get this one out of the way now: don't go back to the depression; the money supply shrank because of the lack of FDIC insurance. That isn't a problem today.
Now, it is quite possible we will see a deflation in asset prices, especially assets propped up by leverage in the banking system as currently configured. But a lower CPI? Highly unlikely.
The Fed wants people to watch the CPI. As long as it is benign, it is all systems go for money printing. And has been true with all money printing (or coin shaving, or whatever you want to call it), the money will eventually fail. I do not see how this can result in that same failed money gaining purchasing power.
Posted by Bionic Mosquito on 01/18/11 09:31 PM
(1 of 2)
I was going to go through a point by point commentary of this editorial. I cannot. As is usual with Dr. Fekete's writing, it is not very comprehensible to me. Make of that statement what you will: I have a feeling that there will be two camps with opposite and strong opinions of this as it relates to my competence.
It appears that the good doctor is saying that the actions of the Fed and other central bankers in the world will result in the purchasing power of the dollar and other fiat currencies to increase. If so, this would be a first in history to my knowledge. No wonder he is a self-proclaimed lone voice on this subject.
Of course, as with all discussions of inflation and deflation, one item missing here is a proper definition ‒ or at least a definition that the doctor would like us to use. Is he speaking of prices as measured by the CPI? Is he speaking of asset prices? Is he speaking of the money supply? Left unsaid, an Austrian would assume the topic refers to the money supply. I have no idea what the good doctor is referring to, but he seems to be discussing consumer prices as he refers to targets the Fed is aiming for. In the common lingo, this is consumer prices.
Posted by Not Anti-military Per Se on 01/18/11 09:04 PM
@Peter An Coppenolle
It does help. Thank you for your input.
My sense is Dr. Fekete has a great deal to offer.
His valuable insights are at times difficult to grasp.
Not necessarily due to any short coming but likely because they are often outside the paradigm we have all been conditioned to accept.
A principle tenant to this compulsory paradigm is the NECESSITY of modern day banking and finance. Raising capital OUTSIDE of invading the pool of savings (and then paying interest to a banker) has become as obtuse as traveling west to get to the East at one time must have been.
Alternative history points out how much of this paradigm has been strong armed into existence. As a consequence it becomes a challenge to understand concepts expounded upon by Prof. Fekete such as Real Bills and a Bills Market which historically (prior to WWI) were common place in commerce and in some instances mundane or even second nature. This history was of a time were credit from banks was not only obsolete, but a clear and unnecessary drain on productivity and employment.
Of course the PE who impose the present paradigm would like nothing more than ignore, vilify, or obfuscate Real Bills and Bills Markets and emphasize the vital necessity of modern day banking and finance built up from the Bond market, which unfortunately apparently arose alone from the ashes of the twentieth century World Wars. With the present paradigm apparently foundering, clarifying historically validated and functional mechanisms of facilitating exchange is much needed and appreciated when offered.
In Summary thank you again for your feedback regarding Prof. Fekete's view of deflation resulting from the Fed's bond purchases and if so inclined please weigh in again on other topics the Professor presents such as Real Bills.
Posted by Peter An Coppenolle on 01/18/11 11:40 AM
@ John Danforth.
As a follower of the honourable professor, I have been priviledged to lecture on his behalf a few times to his students. So here is my answer to the question regarding funds that slosh around and should create 'inflation.'
Please follow the trail: the bond speculators (banks, pension funds, insurance companies,...etc are locking in and realizing a capital gain, every time rates are pushed down by the Fed who overpays for the bonds it is acquiring, with created currency.
This gain is on the books of the speculators. It is therefore not used in productive enterprise and it will be applied all over again for the next round of bond speculation. IT IS NOT IN CIRCULATION. Despite the FED hoping it will find its way ...down. To be sure, there are always loans, but look at their terms...!
Conclusion: there is no money "sloshing" around. On the contrary even! Funds are withdrawn from productive enterprise to be applied in the one and only risk free bond (speculation ?) game, courtesy of the Fed, capital gains guaranteed. Why work for a wage ??
Contrary to popular belief, this wanted effect by the Fed causes the unwanted effect of deflation. This is the result of ever falling rates and prices (a fact observed not only by Kondratiev ).
Prices fall, because of fire sales, defaults, withdrawal from enterprise,...etc. CAPITAL IS WITHDRAWN FROM PRODUCTION. There is no shortage of new production however, as pointed out by the professor above. Most likely abroad. But these new producers will soon become marginalised, due to costs of capital being finaced at too high a rate yesterday, compared to the newcomers of today.
In a deflationary period, the marginal utility of goods/services is lower than the marginal utility of money to pay down debts, incurred in the inflationary period, where the inverse marginal utility can be observed.
An inflationary period is characterised by dishoarding money and putting it in e.g. real estate and other tangible goods. One can choose the degree of liquidity: real estate is illiquid, diamonds may be more liquid. But once again, there comes a point where the marginal hoarder of diamonds turns around and liquidates his inventory and decides he is better of with bonds... (Eg period 1969-1980).
Coming to the eroding purchasing power of money, there is no linear relationship between the volume printed and its power to purchase.
For if this was to be linear, the US dollar, being the most printed currency, would command the least purchasing power. Quod non.(See the excellent paper of Sandeep Jaitly regarding this point.
The eroding purchasing power is however a fact. But it is rather a function of market speculation, I would venture.
In short: there is no reason why we should not have a deflation (collapse of productive enterprise and employemnt !) as well as an eroding purchasing power. Whether these two forces balance out is another matter. I would venture we rather lose our ability to calculate and count, due to the confusion... (This is my personal opinion).
Hope this helps,
Posted by John Danforth on 01/18/11 10:11 AM
I'd like to see a concise definition of this thesis, besides the obvious fact that GS front-runs the Fed and swallows up huge amounts of free money.
If the Fed 'buys' a Trillion in government bonds with magic air, and the government spends it directly on its power structure and favored voting blocs, does not that currency end up sloshing around the economy?
It's not as if GS et al are able to swallow up ALL of the currency that gets created and stuff it under a mattress to hide it away from the economy. If they spend this purloined wealth, it must be spent somewhere. Where can it be spent that it will cause deflation instead of inflation?
Seems to me the minute it appears that the gun and the whip will not produce wealth to pay off on bonds, the bond market will begin to sink. The ruse doesn't work unless some real wealth can be extracted from it, no matter which symbols (ever-larger numbers) are printed on the slips of paper.
When suckers will no longer buy bonds with real earnings, since we are informed that the government MUST keep increasing borrowing, the Fed (and GS) will be the buyers of last resort, with air-money, which is raw inflation.
Please educate me. What am I missing?
Reply from The Daily Bell
Unfortunately, given Dr. Fekete's erudition, we at the Bell are not always qualified to comment on his perceptions. Perhaps another feedbacker will wish to do so.
Posted by Stas on 01/18/11 10:00 AM
The value of our lives is being distroyed by the governments of the world. We, the people of USA are just a pawns that are following the financial markets. Why not go back to the Monroe Doctrine? America for Americans.
We have enough for our use in the country; we have water, oil, coal, gas, food, medicine and on and on. Let the muslims kill each other. Why should we kill some of the muslims and feed the rest of the muslims!
Lets face it, we elected lots of the new Congres men with brains! Why we need Obama? He is useless.
Posted by Chuck Smith on 01/18/11 09:20 AM
A bit snarky is how I would describe the author- towards me, a gold bug. Now, I am not a highly educated man (paper degree-wise)but I do get- MONEY PRINTING=DEVALUED CURRENCY.
Fekete, do us a favor. Ditch the snarky attitude and re-write this article in a way that explains your position that Deflation, rather than Inflation is coming step by step, as the opposing side has, or just continue to act elitist and have yourself ignored.
Posted by ScipioNasica on 01/18/11 08:24 AM
The wave of muni bond defaults Meredith Whitney talked about on 60 Minutes will never come to pass, then. How could she have missed this? There are simply too many nimble minds coming up with endless gimmicks.
Posted by Mountainview on 01/18/11 07:45 AM
Riots in Tunisia, Algeria and Egypt started about raising food prices. The reflation policy of the FED is globalized and will remain globalized.
In the US only the poor guy losing his job feels individual inflation. Instead of 10% of his current income he has suddenly to send 50% of his current income on food. And here he feels global inflation. In the US CPI calculations nothing of these will appear, as food has a minor weighting.
The QE2,3,4 ...and further will all go global and jobs will be created elsewhere but not in the US...
What can they do else? Call an end to the globalization frenzy and turn protectionist? A tested bad solution...
Abandon the game and default on their debt... An untested experiment with "Tunisian" consequences...
No easy way out of the dilemma!!!
Posted by Chris Coles on 01/18/11 07:42 AM
While there is much to discuss about the actions of the FED, it is the Bond markets themselves that everyone should worry about.
I recently wrote a new thread for Click to view link titled: The problem is value, not debt. We need a Truth of Value Reconciliation Commission To avert an uncontrolled "Sudden Stop" " in the bond markets.
Click to view link
My paper is based upon the very interesting information provided by Mervyn King in has "Banking: From Bagehot to Basel, and Back Again" speech in Washington DC recently where he stated:
"Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part by the expansion of trading books (Brennan, Haldane and Madouros, 2010)."
From that starting point, I am arguing that with trillions of bonds in circulation of obviously "astronomical" leverage, there cannot possibly be sufficient real money value to re-purchase them and that will trigger a collapse.
Reply from The Daily Bell
Interesting. Thanks. Here's the beginning ...
The problem is value, not debt
We need a Truth of Value Reconciliation Commission
To avert an uncontrolled "Sudden Stop" - in the bond markets.
For some time now I have been pondering the seemingly insignificant matter of where did the money come from, to fund all of the Trillions of debt we keep hearing about? We never see parallel reports of trillions of savings that have been used, to be lent out as debt. Again, recently, we were told that another bond auction for the Euro had failed. Click to view link
What would cause such a bond auction to fail?
If we, as ordinary citizens, use ordinary cash money to pay for things we buy, then a £UK, Euro or $US earned will buy the same value of goods. We simply pass the money over the counter to pay for what we buy. Money goes in one direction; the same value comes back to us in the other.
Again, if what we have bought retains its value, a financial bond for example, then we may, at a later date, reverse the exchange by selling the bond on to another, say, at the same price we paid for it. Thus here, value passes away from us and money comes back to us. Ordinary cash money and money face value on any such financial instrument; in those circumstances, are always of roughly equal value and is why, printed on your bank note are the words; "Promise to Pay". Thus the entire financial system is built upon the idea that if a banknote is created, printed, the value is always available to balance the transaction. Yes, I do understand that, under fiat currency rules, these matters have become, shall we say; blurred. But I am not talking about the rules for fiat currency, I am talking about bonds; so please bear with me for a moment.
Returning to my earlier point about the missing money to fund the trillions of debt, if we took all the savings of the people and placed them into one pot, they would surely not come anywhere near enough to fund the debt? Why not? ...
Here is the King quote ...
Click to view link
Posted by Steve Cooper on 01/18/11 02:33 AM
I see the same thing as you, but from a slightly different angle. Central Banks have misled everyone as to their methods.
Central Banks say that they raise interest rates to reduce inflation, but with a time lag of a year or so. In my opinion raising interest rates increases the price level NOW. Companies' borrowing costs are driven up so they raise their prices. Reduce interest rates and their costs fall. prices can come down.
How does raising the price level "fight inflation"? It's the difference between the price level and inflation. Imagine we were due to get inflation of 10% next year. Prices would rise from 100 now to 110 next year.
There are two possibilities to "fight inflation". First, you could reduce the price level in the second year, from 110 to 100. Zero inflation. But this way the price level stays the same. No inflation, no freebies for the banks. Secondly, you could raise prices now, taking the price level to 110 immediately. Again, zero inflation. But the price level has risen in this case to 110. Freebies for the banks.
So how does the Central Bank achieve this? Raise interest rates now to increase the price level now. Reduce interest rates after one year to bring prices back down to the level they originally would have been at in year 2. Prices have gone up, inflation has gone down! Look to see how many times interest rates stay at a high for exactly one year. Especially in the UK.
Of course, a "side effect" of raising interest rates is to increase unemployment. This is obviously unacceptable at this time. Falling interest rates reduce the price level. Reduced lending by the banks lower the price level. Central Banks have no way to "stimulate" the price level, so we are stuck with constant deflation.
Hope this makes sense.
Posted by Philip Mccormack on 01/18/11 02:03 AM
DB Once again Professor Fekete puts things in perspective. The first President Bush had his ear for 4 years, "listened" and did nothing. No mainstream economist wants to debate him. 'tis no wonder.Years ago he explained the causes of the Great Depression, very few listened and so we as the months go by are being further robbed. What to do about it? Cut back the time politicians can stay in Congress and the Senate and Parliament, and stop them creating their own salaries and pensions would be a start. Happy days Philip