Quote of the Day: How Democracy Made Central Banking Possible

Prior to democracy, loans were undertaken by monarchs, who were personally responsible for their loans. As Meir Kohn of the economics department at Dartmouth University writes:

The debt of a territorial government was essentially the personal debt of the prince: if he died, his successor had no obligation to honor it; if he defaulted, there was no recourse against him in his own courts.

Sometimes princes paid their loans, and sometimes they didn’t. For example, the Peruzzi were a leading Florentine banking house in the 14^th century. At one point, they lent Edward III of England 400,000 gold florins, which, for a variety of reasons, was never repaid. This led to the collapse of the Peruzzi Bank in 1343.

Deals were quickly made when a prince died, of course, but the bankers had a weak position. They had to negotiate the balances and promise to make more loans in the future.

On top of that, many rulers simply refused to pay loans they had taken. Probably the most prolific deadbeat was King Philip II of Spain. He refused to pay back his loans at least a dozen times.

Because of this, banks were seriously limited. They developed techniques of dealing with sovereign defaults, but central banking as we know it was more or less impossible. Bankers didn’t dare make the kinds of loans they do now.

Democracy, however, solved that problem for them. Under democracy, loans are not debited to an individual, but to the nation as a whole. All the citizens, and their children, become responsible for repaying the loan.

From the institution of democracy onward, loaning money to a government gave the banker a claim against the taxes of the people… a claim that never expires.

This was a clever trick: The person who signs for the loan ends up bearing almost no responsibility, and gets to spend all the money. At the same time, millions of people who never approved the debt—who probably had no way of even knowing about it—are left holding the bag… and passing on the obligation to their children.

(italics original)

This is from Free Man’s Perspective author Paul Rosenberg at the Casey Research

I would add that when persons X and Y votes to spend on person Z’s money, then such free lunch politics would extrapolate to more redistributive spending than what taxpayers (or the Z’s) can afford. Central banks, thus, basically assumes the indispensable role of bridge financers to the inadequacy of resources forcibly extracted from the public through taxes due to populist 'democratic' politics.

At the same time, the banking sector plays the fundamental function of intermediaries--as collection agents (as crucible for the public’s savings and or as tax collectors) and also as distribution agents (government debt sold to public)--of political institutions which central banks supervise and whose existence have even been guaranteed.

David Stockman: Financialization is a Product of Monetary Central Planning

I have written a lot about how the evolution towards “financialization”—where the finance industry has practically grown in such a huge size to eclipse traditional economic sectors as the industry and agriculture—has been due to the US dollar standard and how this has reconfigured today’s global financial and economic structure. As examples see here, here here and here. 

I have also noted that financialization has been an unintended consequence from Triffin Dilemma also brought about by the US dollar standard. 

Former politician and current iconoclast David Stockman eloquently explains how the tampering of the incumbent monetary system, or specifically the conversion from Bretton Woods 'fixed exchange standard' to the US dollar standard operating mostly on ‘floating exchange rate’ has sired “financialization” that has benefited mostly Wall Street.(from David Stockman’s Contra Corner) [bold mine, italics original]

Under the fixed exchange rate regime of Bretton Woods—ironically, designed mostly by J.M. Keynes himself with help from Comrade Harry Dexter White—there was no $4 trillion daily currency futures and options market; no interest rate swap monster with $500 trillion outstanding and counting; no gamblers den called the SPX futures pit and all its variants, imitators, derivatives and mutations; no ETF casino for the plodders or multi-trillion market in “bespoke” (OTC) derivatives for the fast money insiders. Indeed, prior to Friedman’s victory for floating central bank money at Camp David in August 1971 there were not even any cash settled equity options at all.

The world of fixed exchange rates between national monies ultimately anchored by the solemn obligation of the US government to redeem dollars for gold at $35 per ounce was happily Bloomberg-free for reasons that are obvious—albeit long forgotten. Importers and exporters did not need currency hedges because the exchange rates never changed. Interest rate swaps did not exist because the Fed did not micro-manage the yield curve. Consequently, there were no central bank generated inefficiencies and anomalies for dealers to arbitrage. Stated differently, interest rate swaps are “sold” not bought, and no dealers were selling.

There were also natural two-way markets in equities and bonds because the (peacetime) Fed did not peg money market rates or interpose puts, props and bailouts under the price of capital securities. This means that returns to carry trades and high-churn speculation were vastly lower than under the current regime of monetary central planning. Financial gamblers could not buy cheap S&P puts to hedge long positions in mo-mo trades, for example, meaning that free market profits from speculative trading (i.e. hedge funds) would have been meager. Indeed, the profit from “trading the dips” is a gift of the Fed because the underlying chart pattern—mild periodic undulations rising from the lower left to the upper right–is an artifice of central bank bubble finance.

And, in fact, so are all the other distincitive features of the modern equity gambling halls—index baskets, cash-settled options, ETFs, OTCs, HFTs. None of these arose from the free market; they were enabled by central bank promotion of one-way markets—that is, the Greenspan/Bernanke/Yellen “put”. The latter, in turn, is a product of the hoary doctrine called “wealth effects” which would have been laughed out of court by officials like William McChesney Martin who operated in the old world of sound money.

In short, Wall Street’s triumphalist doctrine—claiming that massive financialization of the economy is a product of market innovation and technological advance—is dead wrong. We need “bloombergs” not owing to the good fortune of high speed computers and Blythe Master’s knack for financial engineering; we are stuck with them owing to the bad fortune that Nixon and then the rest of the world adopted Milton Friedman’s flawed recipe for monetary central planning.

In short, the US dollar standard has spawned one colossal global bubble finance.

I recommend that the article be read in the entirety: via the link here

 

Another beneficiary of the financialization, of course, has been the government. Such has been accommodated through exploding global debt markets as shown in the chart above. 

And as pointed out earlier, 

"the real reason why governments promote the quasi permanent inflationary boom is to have access to money (via credit markets and taxes) to support their pet projects. And proof of this is that global debt, according to the Bank of International Settlements have ballooned to $100 trillion or a $30 trillion or a 42% increase from 2007 to 2013 due mostly to government spending. Such colossal diversion of resources is why the world is now faced with a clear and present danger of a Black Swan economic and financial phenomenon." 

In other words, financialization functions as a key instrument to rechannel or divert economic resources from society to political agents and their cronies backed by guarantees from central banks. And bubble blowing is just one of the major consequences. 

Yet what is unsustainable will eventually stop.

Quote of the Day: Success in all endeavors is requires absence of specific qualities

Success in all endeavors is requires absence of specific qualities. 1) To succeed in crime requires absence of empathy, 2) To succeed in banking you need absence of shame at hiding risks, 3) To succeed in school requires absence of common sense, 4) To succeed in economics requires absence of understanding of probability, risk, or 2nd order effects and about anything, 5) To succeed in journalism requires inability to think about matters that have an infinitesimal small chance of being relevant next January, ...6) But to succeed in life requires a total inability to do anything that makes you uncomfortable when you look at yourself in the mirror.

This is from mathematician, philosopher, author and my favorite iconoclast Nassim Nicolas Taleb from his collection of Aphorisms, Maxims & Heuristics.

Let me add my two cents. I will piece together, like a jigsaw puzzle, anecdotally of what I think as interrelation from these variables.

#2 or the "absence of shame at hiding risks" would seem as not only relevant or applicable to much of the banking sector but generally (but with a few exceptions) to other financial market participants as well, including both sellside and buyside institutions. Think Wall Street (and their equivalents worldwide).

#4 I believe represents the essence of the mainstream “economics”. Shout enough statistics and or economic models (technical/econometric gobbledygook) for one to be reckoned as practicing “economics” by the uninformed public (who has little understanding of economics) overwhelmed by mathematical abstractions. Never mind if the practitioner/s have been entirely blind to the "risks" from "2nd order effects". 

Of course #4 is related or tied to #2; in the context that # 4 (the ideological foundation for the absence of risks) serves as justification for the actions of #2 (blatant hiding of risks). 

Think of "mania" or the frantic bidding up of asset prices regardless of risks of ballooning debt underlying such bidding binge, where "euphoria" has mostly been premised on statistical growth stories or from the prospects of more central bank support.

#5 (or the focus on the sensational rather than to the relevant) could most likely be part of the design to promote the interests of the entrenched political-economic order. When people see or tunnel at the sensational at the expense of the relevant then they are most likely to become complacent or dismissive of "risks". For instance, the mainstream have been oriented to see property booms as equivalent to economic growth, while disregarding the 2nd order effects of soaring property prices to the economy (via dramatic changes in relative price levels) and to politics (benefits the asset holders at the expense of to the non-asset holders that becomes part of the issue underlying the inequality controversy).

#2, #4 and #5 are linked in the sense that these sectors most likely constitute the central bank-banking-government cartel. 

Moreover, #3 is connected to #5 in that this represents the indoctrination process. The absence of common sense (and critical thinking) makes #5 (mainstream journalism) credible and reliable sources of information. And this applies, as well as, to the extent of ideas promoted by #2, #4 and #5 that becomes popular knowledge or mainstream dogma.

And finally, when a vast majority of the population becomes agreeable or complacent to #2, #4 and #5, then #1 appears easy to be implemented. This via social policies of financial repression (where inflationism is part of) which entails the (direct and indirect) redistribution of resources from society to the political class helped by their allies #2, #4 and #5 (also #3), who are also beneficiaries, in the "absence of empathy" transfers.  

And when a crisis occurs #5 blame such economic-financial malaise on "greed" from capitalism. But #2 and #4 gets a bailout from the government and or from the central bank, deepening further the financial repression policies.

#6 now depends on where you stand. 

So when Mr. Taleb in another quote (117th) from the same source says "there is this prevailing illusion that debt is a renewable source", then such illusion signifies a product of the 5 "absence of specific qualities" ingredients of "success".

The IMF Hearts Debt

In the implied promotion of debt by the IMF, Sovereign Man’s Simon Black caustically asks, what are these people smoking? 

You may recall the case of Harvard professors Ken Rogoff and Carmen Reinhart who wrote the seminal work: “This Time is Different: Eight Centuries of Financial Folly”.

The book highlighted dozens of shocking historical patterns where once powerful nations accumulated too much debt and entered into terminal decline.

Spain, for example, defaulted on its debt six times between 1500 and 1800, then another seven times in the 19th century alone.

France defaulted on its debt EIGHT times between 1500 and 1800, including on the eve of the French Revolution in 1788. And Greece has defaulted five times since 1800.

The premise of their book was very simple: debt is bad. And when nations rack up too much of it, they get into serious trouble.

This message was not terribly convenient for governments that have racked up unprecedented levels of debt. So critics found some calculation errors in their Excel formulas, and the two professors were very publicly discredited.

Afterwards, it was as if the entire idea of debt being bad simply vanished.

Not to worry, though, the IMF has now stepped up with a work of its own to fill the void.

And surprise, surprise, their new paper “[does] not identify any clear debt threshold above which medium-term growth prospects are dramatically compromised.”

Translation: Keep racking up that debt, boys and girls, it’s nothing but smooth sailing ahead.

But that’s not all. They go much further, suggesting that once a nation reaches VERY HIGH levels of debt, there is even LESS of a correlation between debt and growth.

Clearly this is the problem for Europe and the US: $17 trillion? Pish posh. The economy will really be on fire once the debt hits $20 trillion.

There’s just one minor caveat. The IMF admits that they had to invent a completely different method to arrive to their conclusions, and that “caution should be used in the interpretation of our empirical results.”

But such details are not important.

What is important is that the economic high priests have proven once and for all that there are absolutely no consequences for countries who are deeply in debt.

And rather than pontificate what these people are smoking, we should all fall in line with unquestionable belief and devotion to their supreme wisdom.

Well, who has benefited from debt?

The McKinsey & Company diagram above reveals of the distribution of the US $225 trillion capital market as of the second Quarter of 2012.

The biggest beneficiaries in terms of growth rate from 2000-2012 (red rectangles) has been the government bonds and non-securitized banking loans. A close third are corporate bonds.

Add to the above the recent dynamic where central banks accepts various bonds from banks and financial institutions as collateral in exchange for loans to buy government debt meant to push down bond yields...plus where the IMF gets their funding...we can deduce on 'whose pipes these people have been smoking on'.

Central Bankers are the Real Centers of Political Power

Central bankers have already been portrayed or regarded by media as superheroes.

In the modern economy, which operates on fiat money based fractional reserve banking system, central bankers have served as the proverbial power behind the throne. 

Such dynamic has especially been reinforced in the post 2007 crisis landscape, where monetary policies via asset purchasing program has encroached on the fiscal space (Hussman 2010)

Sovereign Man’s prolific Simon Black explains why central bankers, led by the US Federal Reserve, have been in command of the US political economy since 1971: (bold mine)

Check out this chart below. It’s a graph of total US tax revenue as a percentage of the money supply, since 1900.

For example, in 1928, at the peak of the Roaring 20s, US money supply (M2) was $46.4 billion. That same year, the US government took in $3.9 billion in tax revenue.

So in 1928, tax revenue was 8.4% of the money supply.

In contrast, at the height of World War II in 1944, US tax revenue had increased to $42.4 billion. But money supply had also grown substantially, to $106.8 billion.

So in 1944, tax revenue was 39.74% of money supply.

You can see from this chart that over the last 113 years, tax revenue as a percentage of the nation’s money supply has swung wildly, from as little as 3.65% to over 40%.

But something interesting happened in the 1970s.

1971 was a bifurcation point, and this model went from chaotic to stable. Since 1971, in fact, US tax revenue as a percentage of money supply has been almost a constant, steady 20%.

You can see this graphically below as we zoom in on the period from 1971 through 2013– the trend line is very flat.

What does this mean? Remember– 1971 was the year that Richard Nixon severed the dollar’s convertibility to gold once and for all.

And in doing so, he handed unchecked, unrestrained, total control of the money supply to the Federal Reserve.

That’s what makes this data so interesting.

Prior to 1971, there was ZERO correlation between US tax revenue and money supply. Yet almost immediately after they handed the last bit of monetary control to the Federal Reserve, suddenly a very tight correlation emerged.

Furthermore, since 1971, marginal tax rates and tax brackets have been all over the board.

In the 70s, for example, the highest marginal tax was a whopping 70%. In the 80s it dropped to 28%.

And yet, the entire time, total US tax revenue has remained very tightly correlated to the money supply.

The conclusion is simple: People think they’re living in some kind of democratic republic. But the politicians they elect have zero control.

It doesn’t matter who you elect, what the politicians do, or how high/low they set tax rates. They could tax the rich. They could destroy the middle class. It doesn’t matter.

The fiscal revenues in the Land of the Free rest exclusively in the hands of a tiny banking elite. Everything else is just an illusion to conceal the truth… and make people think that they’re in control.

Money, which represents half of almost every transactions made every day, has been in the control of a few unelected technocrats who have the capacity to run society aground.

Said differently centralization of money equates to a top-down dynamic of risk distribution in terms of money thereby making risks systemic, e.g. boom bust cycles, stagflation and hyperinflation

Unknown to many, central planning and control of money represents one of the 10 planks of the communist manifesto:

5. Centralization of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly.

It's an oxymoron for the public, who supposedly oppose communism, to adhere to one of communism's major creed. 

Yet the rapidly expanding role by central banks applied today will lead to a train wreck. As Austrian economist Thorsten Polleit warns:

Central banks will become the real centers of political power. You could even say they are on the way to assuming the role of a “Politburo.” Central banks will effectively decide who is going to get credit at what conditions. They will decide which governments, which banks, and which kind of business sectors and companies will flourish or go under. The truth is that if the fiat money regime is not brought to an end — either by political will or by economic collapse — the economies will end up in a kind of socialist-totalitarian dead-end. But I tend to be optimistic: namely, that the fiat money scheme will break down before such a situation is reached.

European Economic Recovery? ECB Cuts Interest Rates

The mainstream has been adamantly insisting about a supposed economic recovery in Europe. 

But if true, then why the need for the European Central Bank (ECB) to cut rates?

ECB President Mario Draghi was quoted by the CNBC at last night’s press conference saying that “risks to the outlook remain weighted to the downside”

In addition, Mr. Draghi raised the issue of the risks of deflation to justify such actions.

From Bloomberg

The European Central Bank unexpectedly cut its benchmark interest rate to a record low in a bid to prevent slowing inflation from taking hold in a still-fragile euro-area economy.

With inflation at the weakest level in four years and less than half the ECB’s target, the Frankfurt-based bank halved its key refinancing rate to 0.25 percent in a shift anticipated by just three of 70 economists in a Bloomberg News survey.

“Our monetary-policy stance will remain accommodative for as long as necessary,” ECB President Mario Draghi told reporters in Frankfurt. “We may experience a prolonged period of low inflation…

Euro-area inflation surprisingly deteriorated in October to 0.7 percent, below the ECB’s goal of “close to but below” 2 percent, sparking fears of a deflationary cycle. Unemployment of 12.2 percent is the highest level since the currency bloc was formed in 1999, while the euro’s almost 4 percent rise against its major peers this year is challenging exporters. The ECB will better detail its economic outlook when it releases forecasts next month.

While it is true that the Euro zone’s CPI has been falling which reflects on the declining monetary aggregate M3, that’s only half of the picture.

The other half of what the mainstream doesn’t tell you when discussing central bank policies: Financial markets in the Eurozone has been booming. 

Europe’s crisis stricken economies (Portugal-PSI 20, Spain’s IBEX and the Irish ISEQ) has produced returns of significantly more than 20% over a one year window. Greece’s Athens Index has generated more than 40%!

Even Europe’s blue chip index the Stoxx 50 has strongly risen year-to-date.

And it’s not just stocks…

European sovereign bonds has had a robust performance. The spread of PIGS relative to the German bond has significantly narrowed* after peaking in early 2012.

In other words, the ECB and the mainstream sees TWO different self-contradicting worlds: risks of “deflation” in the economy—based on CPI inflation measures, while alleged “recovery” in the economy based on rising markets.

Or differently put, the mainstream sees financial markets as seemingly irrelevant or unrelated to the real economy unless it serves as convenient alibi to justify rising asset prices.

Yet zero bound rates function as a one size fits all policy that would have different impact on distinct European economies. 

As one would note, bank credit to core Europe has been in the positive (although stagnant) while crisis stricken periphery remains in negative territory*.

Of course, looking at the aggregates can be deceiving. While it may be true that general bank lending has been falling, in breaking down the details we find the Eurozone’s banking system credit to the government has exploded even as credit to the private sector has weakened.

In short, government borrowing has taken the slack from the private sector.

The complex maneuvering by the troika, the ECB, the banking system and the government to keep rates low has resulted to a massive expansion of debt.

The Eurozone’s debt as % to the GDP has been skyrocketing

Yet banks have not been the only source of lending.

 

Europe’s High Yield corporate bond issuance is at record highs*!

Europe’s corporate debt has also been ballooning*.

Corporate debt in core Europe has modestly increased from 2007…

While corporate debt at the periphery has been robust over the same period

Bottom line: Contra policymakers and the mainstream, the risks of deflation remains a popular bogeyman used to justify the “euthanasia of the rentier” via zero bound rates and QE.

While the Eurozone’s banking system remains clogged or the transmission mechanism broken due to impaired balance sheets, substantial credit growth has been taking place at the bond markets.

And credit growth in the bond markets fired up by ECB and government policies has been redistributing resources or has been benefiting the asset markets (via asset inflation) at the expense of the real economy (revealed by CPI disinflation). 

The real intent of the ECB’s rate cut has been to keep interest payments low for the rapidly swelling the Eurozone’s government debts since the Eurozone government’s refusal to reform, France should serve as an example. 

A second unstated goal has been to boost asset markets in order to keep their 'broken' banking system afloat. 

European politicians, bureaucrats and their mainstream lackeys have been pulling a wool over everyone’s eyes.

And it seems that for the first time this year, the unexpected credit easing by a major central bank has hardly been welcomed warmly by the global equity markets. Europe’s markets appear jaded as US stocks fell considerably. Asian markets are down as of this writing.

Has the global financial markets seen ECB’s actions as insufficient? Or has the positive impact on financial markets from credit easing policies reached a tipping point in terms of diminishing returns?

We surely live in interesting times

* charts from the Institute of International Finance November 2013 Capital Markets Monitor and Teleconference

Why a US debt default extrapolates to the END of the US dollar hegemony

I previously pointed out from the public choice perspective why a debt default today by the US government is unlikely and has mostly likely been part of the political theatrics in the contest of power.

Politicians will hardly fight for an unpopular cause or principle, particularly against a system deeply hooked on entitlement or dependency programs, which will only cost them their careers and their privileges as political leaders.

The two-day bacchanalia by US equity markets where the Dow Jones Industrial skyrocketed by 434 points or 2.9% is a testament to this chronic addiction to the entrenched debt based entitlement culture. 

There is another major reason why the US the default card serves as another political poker bluff: A debt default extrapolates to the END of the US dollar hegemony.

Writing at the Project Syndicate, economist and political science professor Barry Eichengreen spells out the likely consequences of a US debt default. (hat tip Zero Hedge) [bold mine, italics original]

But a default on US government debt precipitated by failure to raise the debt ceiling would be a very different kind of shock, with very different effects. In response to the subprime disruption and Lehman’s collapse, investors piled into US government bonds, because they offered safety and liquidity – prized attributes in a crisis. These are precisely the attributes that would be jeopardized by a default.

The presumption that US Treasury bonds are a safe source of income would be the first casualty of default. Even if the Treasury paid bondholders first – choosing to stiff, say, contractors or Social Security recipients – the idea that the US government always pays its bills would no longer be taken for granted. Holders of US Treasury bonds would begin to think twice.

The impact on market liquidity would also be severe. Fedwire, the electronic network operated by the US Federal Reserve to transfer funds between financial institutions, is not set up to settle transactions in defaulted securities. So Fedwire would immediately freeze. The repo market, in which loans are provided against Treasury bonds, would also seize up.

For their part, mutual funds that are prohibited by covenant from holding defaulted securities would have to dump their Treasuries in a self-destructive fire sale. Money-market mutual funds, virtually without exception, would “break the buck,” allowing their shares to go to a discount. The impact would be many times more severe than when one money-market player, the Reserve Primary Fund, broke the buck in 2008.

Indeed, the entire commercial banking sector, which owns nearly $2 trillion in government-backed securities – would be threatened.Confidence in the banks rests on confidence in the Federal Deposit Insurance Corporation, which insures deposits. But it is not inconceivable that the FDIC would go bust if the value of the banks’ Treasury bonds cratered.

The result would be a sharp drop in the dollar and catastrophic losses for US financial institutions. Beyond the immediate financial costs, the dollar’s global safe-haven status would be lost.

It is difficult to estimate the cost to the US of losing the dollar’s position as the leading international currency. But 2% of GDP, or one year’s worth of economic growth, is not an unreasonable guess. With foreign central banks and international investors shunning dollars, the US Treasury would have to pay more to borrow, even if the debt ceiling was eventually raised. The US would also lose the insurance value of a currency that automatically strengthens when something goes wrong (whether at home or abroad).

The impact on the rest of the world would be even more calamitous. Foreign investors, too, would suffer severe losses on their holdings of US treasuries. In addition, disaffected holders of dollars would rush into other currencies, like the euro, which would appreciate sharply as a result. A significantly stronger euro is, of course, the last thing a moribund Europe needs. Consider the adverse impact on Spain, an ailing economy that is struggling to increase its exports.

Likewise, small economies’ currencies – for example, the Canadian dollar and the Norwegian krone – would shoot through the roof. Even emerging-market countries like South Korea and Mexico would experience similar effects, jeopardizing their export sectors. They would have no choice but to apply strict capital controls to limit foreign purchases of their securities. It is not inconceivable that advanced countries would do the same, which would mean the end of financial globalization. Indeed, it could spell the end of all economic globalization.

Once the confidence on the US dollar as a global reserve currency collapses, the outcome will be massive protectionism,  a horrific devastation of the global economy, widespread social unrest and worst, this will likely trigger a world war.

But the above doesn’t go far enough. Aside from global central banks taking a hit from their US dollar reserve holdings, the banking system outside the US will also come under duress or face the risks of collapse as the value of US dollar portfolios (reserves, assets and loan exposure) plunge. 

The highly leveraged currency markets itself will likely fail or seize up. The US dollar constitutes 87% of the $5.3 trillion currency market trades a day under today’s circumstances or conditions.

Domestic defaults, considering the  vastly expanded debt levels are likely to explode as financial flows freeze.

This will be compounded by a standstill of trade and economic activities, which should severely affect the the banking system’s loan portfolios.

And the icing in the cake will likely be a crash of financial markets, where financial assets makes up a key part of the banking sector’s balance sheet.

And given the systemic defaults ex-US government bonds are unlikely to function as safehaven too.

As of the 2nd quarter of 2011, US bonds account for 32% of the $99 trillion global bond markets which about half are government bonds.

And there surely will be huge impact on the global derivative market at $633 trillion as of December 2012

In short ramifications from a contagion of a US dollar collapse seems incomprehensibly catastrophic.

Given this scenario, I am not persuaded that ex-US dollar currencies will rise in the face of a US dollar meltdown.

This assumption will hold true only if ex-US banks have been prepared for such a dire scenario which is a remote possibility. 

But the fact that the US dollar remains a major part of the global foreign currency reserve system demonstrates the continued dependency by the world on the US dollar.

The global banking system whose architectural foundations has been built on the US dollar system are likely to disintegrate too along with the US financial system.

In my view, a collapse of the US dollar standard will extrapolate to the destruction of the incumbent paper money standard. The world will be forced to adapt a new currency standard, whether gold will play or role or not is beside the point. 

Yet I would like to add that the US Federal Reserve holds $2.87 trillion of US treasuries according to the weekly updates on the Factors Affecting the Reserve Balances as of October 9th. The accounting entry by the USTs held by the FED are at “face value” which according to them is  “not necessarily at market value”

This also means that the Fed is susceptible huge losses even if the Fed can resort to changes in accounting treatment to evade insolvency.

The bottom line is that if all the FED’s credit easing programs has been meant to shore up the unsustainable debt financed political system anchored on privileges for vested interest groups operating under troika of the welfare-warfare state, crony banking system and the US Federal Reserve, a debt default would essentially negate the FED’s actions, annihilate such political economic arrangements and importantly leads to the loss of the US dollar standard hegemony.

These are factors which the political “power that be” will unlikely gamble with, lest lose their privileges.

Yet given the persistence of the current debt financed deficit spending and other political spending trends, a debt default and a market driven government shutdown signifies as an inevitable destiny.

Phisix: Will the Fed’s Spiking of the Punchbowl Party Be Sustainable?

Right now, the FOMC has “a tiger by its tail” - it has lost control of monetary policy.  The Fed can’t stop buying assets because interest rates will rise and choke the recovery.  In short, today’s decision not to taper was driven by unimpressive economic data, the fear of a 3% yield on the 10 year Treasury and gridlock in Washington.  If the economy cannot handle a 3% yield on the 10 year, then the S&P 500 should not be north of 1700.  It is remarkable that the equity market continued to buy into easy money over economic growth.  QE3 has been ongoing for nearly a year and the economy is not strong enough to ease off the accelerator (forget about applying the brake).  Simultaneously, the S&P 500 is up 21% year to date and the average share gain in the index is over 25%.  Maybe today’s action will turn out to be short covering, but if it was not then paying continually higher prices for equities in a potentially weakening economy is a very dangerous proposition.  Mike O'Rourke at JonesTrading

How promises to extend credit easing (inflationist) policies can change the complexion of the game in just one week.

Spiking the Punchbowl Party, Negative Rates

In a classic Pavlovian response to the intense fears in May-June where central bank policies led by the US Federal Reserve would have the “punch bowl removed just when the party was really warming up”[1], to borrow the quote from a speech of the 9^th and longest serving US Federal Reserve chairman William McChesney Martin[2], retaining the “punch bowl” electrified the markets across the oceans.

Badly beaten ASEAN market made a striking comeback this week.

A week back, sentiment rotation from falling global bond and commodity markets have begun to spur a shift of the rabid speculative hunt for yields towards equities. This has been justified by discounting the impact from the FED’s supposed taper

Yet this week’s dual events of the Larry Summer’s controversial withdrawal[3] from the candidacy of the US Federal Reserve chairmanship and the FED’s stiffing of the almost unanimous expectations of a pullback on central bank stimulus which proved to be the icing on the cake that spiked this week’s punch bowl party. 

The above highlights much of how financial markets have been hostaged to policy steroids

The markets apparently saw Larry Summers as a “hawk” and a threat to the punch bowl party. This is in contrast to the current the Fed’s Vice Chairwoman Janet Yellen who has been seen as even more a “dove” than the outgoing incumbent Chairman Ben Bernanke.

Ms. Yellen, according to celebrated Swiss contrarian analyst and fund manager Dr. Marc Faber[4], will make Dr. Bernanke “look like a hawk”, because the former subscribed to negative interest rates.

Instead of the banks paying depositors, in negative rates, it is the reverse; depositors who pay the banks. And as likewise as analyst Gerard Jackson noted[5] “It is a situation in which the buyer of treasuries pays the government interest for the privilege of having loaned it money; a state of affairs in which a person's real savings are being continuously reduced”. In short, creditors will pay borrowers interest rates. This puts the credit system upside down.

If savers today are being punished under zero bound rates, negative rates will likely worsen such conditions. In a world where only spending drives the economy, ivory tower theorists mistakenly assume that savings will be forced into “spending” in the economy.

And Wall Street loves this because they presuppose that this will magnify the transfer or subsidies that they have been benefiting at the expense of the Main Street. In the real world, money that goes into speculating stocks represents as foregone opportunities for productive investments.

While the amplification of Wall Street subsidies may be the case, this may also prompt for an upside spiral of price inflation.

But on the other hand, if creditors (savers) will be compelled to pay debtors interest rates, assuming that under normal circumstances interest rates incorporate premium for taking on credit risk which will be reversed by edict, then why will creditors even lend at all? Why would depositors pay banks when they can keep money under the mattress? Or simply, why lend at all?

Denmark has adapted a negative deposit rate for the banking system in July of 2012[6] But this has not been meant to encourage spending but as a form of capital controls, viz prevent influx.

While the Danish central bank claims that this has been a policy success story, indeed capital flows have declined, the other consequence has been a sharp drop in net interest income (lowest in 5 years[7]) which has been due to the marked contraction in loans extended to the private sector. 

Economic wide, the Danish negative rates has been a drag on money aggregates (M3), sustained “spending” retrenchment as shown by retail sales (monthly and yearly) and a growth recession based on quarter and annualized rates. So instead of inflation, in Denmark’s case it has been disinflation.

The problem is that once the US assimilates such policies, such will likely be adapted or imported by their global counterparts. The European Central Bank has already been considering such policies[8] last May.

The Denmark episode may or may not be replicated elsewhere. The point is that such adventurous policies run a high risk of unintended consequences.

The Fed’s UN-Taper: Spooked or Deliberately Designed?

The consensus has declared that the US Federal Reserve has been “spooked”[9] by the bond vigilantes as for the reason for withholding the taper.

They can’t be blamed, the FOMC’s statement underscored such concerns, “mortgage rates have risen further and fiscal policy is restraining economic growth” and “but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market”[10]

However, I find it bizarre how stock market bulls entirely dismiss or ignore the impact of interest rates when the Fed authorities themselves appear to have been revoltingly terrified by the bond vigilantes.

But if the FED has been petrified by the bond vigilantes then this means that they likewise seem to recognize of the fragility of whatever growth the economy has been experiencing. In other words they have been sceptical of the economy’s underlying strength.

Some economic experts have even been aghast at the supposed loss of credibility by the US Federal Reserve’s[11] non transparent communications.

But I have a different view. I have always been in doubt on what I see as a poker bluff by the FED on supposed exit or taper strategies since 2010, for four reasons.

1. The US government directly benefits from the current easing environment. Credit easing represents a subsidy to government liabilities via artificially repressed interest rates. In addition, the current inflationary boom has led to increases in tax revenues. Both of these encourage the government to spend more.

As I previously wrote[12],

Given the entrenched dependency relationship by the mortgage markets and by the US government on the US Federal Reserve, the Fed’s QE program can be interpreted as a quasi-fiscal policy whose major beneficiaries have been the political class and the banking class. Thus, there will be little incentives for FED officials to downsize the FED’s actions, unless forced upon by the markets. Since politicians are key beneficiaries from such programs, Fed officials will be subject to political pressures.

This is why I think the “taper talk” represents just one of the FED’s serial poker bluffs.

2. The second related reason is that by elevating asset prices, such policies alleviates on the hidden impairments in the balance sheets of the banking and financial system. The banking system function as cartel agents to the US Federal Reserve, which supervise, control and provides relative guarantees on select elite members. The banking system also acts as financing agent for the US government via distribution and sale of US treasuries, and holding of government’s debt papers as part of their reserves.

For instance the reserves held by the Federal Deposit Insurance Corporations (FDIC) are at only $37.9 billion, even when it insures $5.25 trillion of ‘insurable deposits’ held in the US banking system or about .7% of bank deposits. According to Sovereign Man’s Simon Black[13], the FDIC names 553 ‘problem’ banks which control nearly $200 billion in assets or about 5 times the size of their reserve fund.

In short should falling asset markets ripple across the banking sector, the FDIC would need to tap on the US treasury.

Essentially the UN-taper seem to have been designed to burn short sellers with particular focus on the bond vigilantes, where the latter may impact the balance sheets of the banking system.

3. Credit easing policies have been underpinned by the philosophical ideology that wages war against interest rates via the “euthanasia of the rentier[14]”. Central bankers desire to abolish what they see as the oppressive nature of the “scarcity-value of capital” by perpetuating credit expansion. So zero bound rates will be always be the policy preference unless forced upon by market actions in response to the real world dynamic of “scarcity-value of capital”

4. In the supposed May taper, where the markets reacted or recoiled with vehemence, the markets selectively focused on the taper aspect “moderate the monthly pace” even when the FED explicitly noted that “our policy is in no way predetermined” and even propounded of more easing[15].

This dramatic volatility from the May “taper talk” even compelled Fed chair Dr. Ben Bernanke to explicitly say “I don't think the Fed can get interest rates up very much, because the economy is weak, inflation rates are low. If we were to tighten policy, the economy would tank”[16]

In other words, the taper option functioned as a face saving valve in case the rampaging bond vigilantes would force their hand.

For me Dr. Bernanke’s calling of the Poker “taper” Bluff has been part of the tactic.

The bond vigilantes have gone beyond the Fed’s assumed control over them. And since the Fed construes that the rising yields has been built around the expectations of the Fed’s pullback on monetary accommodation, what has been seen a Fed “spook” for the mainstream may have really been a desperate ALL IN ante “surprise strike” gambit against the bond vigilantes. The Un-taper was the Pearl Harbor equivalent of Dr. Bernanke and company against the bond vigilantes.

The question now is if the actions in the yield curve have indeed been a function of perceived “tapering”. If yes, then given the extended UN-taper option now on the table, bond yields will come down and risk assets may continue to rise. But if not, or if yields continue to ascend in the coming days that may short circuit the risk ON environment, then this may force the FED to consider the nuclear option: bigger purchases.

But of course there have been technical inhibitions that may force the Fed to taper.

With shrinking budget deficits, meaning lesser treasury issuance and with the FED now holding “$1.678 trillion in ten year equivalents, or 31.89% as of August 30^th total according to Zero Hedge[17], the Fed’s size in bond markets have been reducing availability of collateral. Reduced supply of treasuries, which function as vital components of banking reserves will only amplify volatility.

The Fed’s policies are having far wider unintended effects on the bond markets.

Should the Fed consider more purchases it may expand to cover other instruments.

The Fed has Transformed Financial Markets to a Giant Casino

While targeting the bond vigilantes, the FED’s UN-taper has broader repercussions; this served as an implied bailout to emerging markets and Asia.

Mainstream analysts have been quick to grab this week major upside move as an opportunity to claim that the Fed’s actions vastly reduced risks to the global economy. They conclude without explaining why despite the huge (more than double) expansion of assets by the major central banks since 2008 which now accounts for about 12-13% of the global GDP, economic growth remains highly brittle.

They even point out that current conditions seem like a replay of the May 2012 stock market selloff (green ellipses) where emerging markets stocks (EEM) and bonds (CEMB Emerging Market Corporate bonds) as well as ASEAN stocks (ASEA) eventually climbed.

They forgot to say that the selloff in May 2012 had been one of a China slowdown and signs of market stress from the dithering of the Fed’s on QE 3.0[18]. Importantly markets sold off as yields of 10 year US notes trended to its record bottom low in July.

Today has been immensely a different story from 2012. UST yields have crept higher since June 2012 (red trend line). The effects on UST yield by QE 3.0 a year back (September 13, 2012) had been a short one: 3 months. This means in spite of the program to depress bond yields, bond yields moved significantly higher.

The upward ascent accelerated a month after Abenomics was launched and days prior the sensational taper talk. Nonetheless, media and authorities believe that rising yields have been a consequence of a purported Fed slowdown and from ‘economic growth’

What has been seen as economic growth by the mainstream has really been an inflationary boom which indeed contributes to higher yields. Yet the consensus ignores that rising yields may also imply of diminishing real savings and deepening capital consumption via implicit revulsion towards more easing policies that has only been fueling an acute speculative frenzy on asset markets driving the world deeper into debt.

As analyst Doug Noland at the Credit Bubble Bulletin notes[19]

Last week set an all-time weekly record for corporate debt issuance. The year is on track for record junk bond issuance and on near-record pace for overall corporate debt issuance. At 350 bps, junk bond spreads are near 5-year lows (5-yr avg. 655bps). At about 70 bps, investment grade Credit spreads closed Thursday at the lowest level since 2007 (5-yr avg. 114bps). It's a huge year for M&A. And with the return of “cov-lite” and abundant cheap finance for leveraged lending generally, U.S. corporate debt markets are screaming the opposite of tightening.

And such “all-time weekly record for corporate debt issuance” has coincided with the equity funds posting the “second largest weekly inflow since at least 2000” according to the Bank of America Merrill Lynch as quoted by the Zero Hedge[20]. The year 2000 alluded to signified as the pinnacle of the dot.com mania.

How will rising stock prices reduce risks in the real economy?

In the case of India, the Reserve Bank of India led by Chicago School, former IMF chief and supposedly a free market economist Raghuram Rajan sent a shocker to the consensus by his inaugural policy of raising repurchase rate rates by a quarter point to 7.5, which is all not bad.

However Mr. Rajan contradicts this move by relaxing liquidity curbs by “cutting the marginal standing facility rate to 9.5 percent from 10.25 percent and lowering the daily balance requirement for the cash reserve ratio to 95 percent from 99 percent, effective Sept. 21. The bank rate was reduced to 9.5 percent from 10.25 percent.”[21]

So the left hand tightens while the right hand eases.

Sure India’s stocks as indicated by the Sensex have broken into the year’s highs and is at 2011 levels, but it remains to be seen how much of the record highs have factored in the risks from such policies and how of the current price levels have been from the Summer-Fed UN-taper mania.

As one would note in the Sensex or from ASEAN-Emerging Markets stocks, current market actions have been sharply volatile in both directions. And volatility in itself poses as a big risks. Financial markets have become a giant casino.

QE Help Produce Boom-Bust Cycles and is a Driver of Inequality

It is misguided to believe that QEternity extrapolates as an antidote to an economic recession or depression. 

The reality is Quantitative Easing extrapolates to discoordination or the skewing of consumption and production activities which leads to massive misallocation of capital or “malinvestments”. QE also translates to grotesque mispricing of securities and maladjusted price levels in the economy benefiting the first recipients of credit expansion.

And all these have been financed by a monumental pile up on debt and equally a loss of purchasing power of currencies.

Eventually such imbalances will be powerful enough to overwhelm whatever interventions made to prevent them from happening, specifically once real savings or capital has been depleted.

As the great Austrian Ludwig von Mises warned[22]

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.

QE also means a massive redistribution of wealth.

 

Rising stock markets have embodied such policy induced inequality.

US households have the biggest exposure on stocks with 33.7% share of total financial assets according to the Bank of Japan[23].

In Japan, only 7.9% of financial assets have been allocated to equities. This means that Abenomics will crater Japan’s households whose biggest assets have been currency and deposits. The Japanese may pump up a stock or property bubble or send their money overseas.

In the Eurozone, stocks constitute only 15.2% of household financial assets.

The above figures assume that each household has exposure in stocks. But not every household has exposure on stocks.

In the US for instance, while 51.1% of families have direct or indirect holdings on the stock markets as of 2007[24], a significant share of stock ownership have been in the upper ranges of the income bracket (green rectangle).

Since the distribution of ownership of stocks has been tilted towards the high income groups, FED policies supporting the asset markets only drives a bigger wedge between the high income relative to the lower income groups.

This is essentially the same elsewhere.

In the Philippines, according to the PSE in 2012 there have been only 525,850 accounts[25] of which 96.4% has been retail investors while 3.6% has been institutional accounts.

And of the total, 98.5% accounted for as domestic investors while foreigners constituted 1.5%.

Amazingly the 2012 data represents less than 1% (.54% to be exact) of the 96.71 million (2012 estimates) Philippine population.

Meanwhile online participants comprised 78,216 or 14.9%[26].

In 2007 the PSE survey reported only 430,681 accounts[27]. This means that the current stock market boom has only added 22.1% of new participants or 4.07% CAGR over the past 5 years.

The media’s highly rated boom hasn’t been enough to motivate much of the public to partake of FED-BSP manna.

One may add that some individuals may have multiple accounts, or members of the one family may all have accounts. This means that the raw data doesn’t indicate how many households or families have stock market exposure. Under this perspective, the penetration figures are likely to be even smaller.

This also means that in spite of the headline hugging populist boom, given the sluggish growth of ‘new’ stock market participants most of pumping up of the bull market activities have likely emanated from recycling of funds or increased use of leverage to accentuate returns or the deepening role of ‘fickle’ foreign funds. I am sceptical that the major stockholders will add to their holdings. They are likely to sell more via secondary IPOs, preferred shares, etc…

And this means that for the domestic equity market to continue with its bull market path would mean intensifying use of leverage for existing domestic participants and or greater participation from foreigners. That’s unless the lacklustre growth in new participants reverses and improves significantly.

And it is surprising to know that with about half of the daily volume traded in the PSE coming from foreigners, much of this volume comes from the elite (1.5% share) of mostly foreign funds.

So who benefits from rising stock markets?

As pointed out in the past[28], the domestic elite families who control 83% of the market cap as of 2011.

The other beneficiary has been foreign money which accounts for the 16% and the residual morsel recipients to the retail participants like me.

So the BSP’s zero bound rates, whose credit fuelled boom inflates on statistical growth figures, likewise drives the inequality chasm between the “haves” and the “havenots” via shifting of resources from Mang Pedro and Juan to the Philippine version of Wall Street.

Interviewed by CNBC after the Fed’s surprise decision to UN-Taper, billionaire hedge fund manager Stanley Druckenmiller, founder of Duquesne Capital commented[29]

This is fantastic for every rich person…This is the biggest redistribution of wealth from the middle class and the poor to the rich ever.

Such stealth transfer of wealth enabled and facilitated by central bank policies are not only economically unsustainable, they are reprehensively immoral.

---

[1] Wm. McC. .Martin, Jr . Chairman, Board of Governors of the Federal Reserve System before the New York Group of the Investment Bankers Association of America Punch Bowl Speech October 19, 1955 Fraser St. Louis Federal Reserve

[2] Wikipedia.org William McChesney Martin

[3] see Lawrence Summers Out, Wall Street Cheers September 16, 2013

[4] see Video: Marc Faber: The Endgame Is A Total Collapse, But From A Higher Diving Board Now September 19, 2013

[5] Gerard Jackson Obama's Yellen appointment signals very bad news for the US economy April 5, 2010

[6] see Denmark Cuts Interest Rates to Negative July 6, 2012

[7] Bloomberg.com Negative Rates No Threat to Bank Health, Danish FSA Says May 30, 2013

[8] Bloomberg Businessweek Are Negative Interest Rates in Europe's Future? May 2, 2013

[9] Wall Street Journal Real Economics Blog Economists React: Fed ‘Was Clearly Spooked’ September 18, 2013

[10] Reuters.com TEXT-FOMC statement from Sept. 17-18 meeting September 18, 2013

[11] Huffington Post The Federal Reserve Has Lost Credibility And Hurt The Economy September 20, 2013

[12] See Phisix in the Shadows of a Bursting Global Bond Market Bubble June 24, 2013

[13] Simon Black After $1+ trillion, the Fed can’t even create jobs in the banking industry September 20, 2013 SovereignMan.com

[14] See Phisix: Will the ASEAN Meltdown Worsen? August 26, 2013

[15] See Phisix: The Myth of the Consumer ‘Dream’ Economy July 20, 2013

[16] Reuters.com HIGHLIGHTS-Bernanke's Q&A testimony to House panel July 17, 2013

[17] Zero Hedge The Fed Owns 31.89% Of The Bond Market: Up 0.3% In One Week

[18] see Phisix: The Correction Phase Cometh May 14, 2012

[19] Doug Noland, Financial Conditions Credit Bubble Bulletin Prudentbear.com September 20, 2013

[20] Zero Hedge.com BTFATH Is Here; 2nd Largest Equity Inflows Since 2000 Bubble Popped September 20, 2013

[21] Bloomberg.com Rajan’s India Inflation Battle Pressures Singh as Election Nears September 21, 2013

[22] Ludwig von Mises III. INFLATION AND CREDIT EXPANSION 1. Inflation Interventionism An Economic Analysis

[23] Bank of Japan Flow of Funds - Overview of Japan, US, and the Euro area – June 24, 2013

[24] Census Bureau 1211 - Stock Ownership by Age of Family Head and Family Income Banking, Finance, & Insurance: Stocks and Bonds, Equity Ownership Department of Commerce.

[25] Philippine Stock Exchange Retail investor participation grows by six percent in 2012, June 20, 2013

[26] Philippine Stock Exchange PSE Study: Online investing rose 48% in 2012 April 30, 2013

[27] Philippine Stock Exchange, Less than half of 1% of Filipinos invest in stock market, PSE study confirms 16 June 2008 News Release Refer to: Joel Gaborni -- 688-7583 Nina Bocalan-Zabella – 688-7582 (no available link)

[28] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20, 2013

[29] Robert Frank Druckenmiller: Fed robbing poor to pay rich CNBC.com September 19, 2013