Government's Money-Manipulating Wizardry

By Mr Practical  AUG 27, 2009 12:20 PM

Explaining the mechanics of Federal Reserve operations.


There's great debate about inflation versus deflation. Most who are buying stocks aren't doing so because they see good fundamentals, but are doing so because they're worried about inflation. Clearly the Federal Reserve is doing “unconventional” things (perhaps I should use better words such as crazy and irresponsible) which have a lot of people worried about a crashing dollar.

In order to clarify my position, I want to describe to you some mechanics of Federal Reserve operations, the wizardry behind the curtain. I recommend you send this to all of your friends so they can decide for themselves. This is long and tedious, but I think worth it.

The Federal Reserve is a private bank, albeit special. It has shareholders that care about profits and risk. These aren’t normal shareholders, but other banks or the boards of those banks. The Fed was given certain powers by Congress in 1913 to regulate the money supply of the US. That benign-sounding statement has vast implications on capitalism and liberty itself.

Capital can be loosely defined as wealth, unencumbered assets of various forms like cars, buildings, manufacturing plants, and land. Capital is created through productive processes that lower costs, develop new technologies, and raise living standards.

An example of a productive process might be one of specialization. Two farmers grow their own food, make their own clothes and cut down their own firewood. It takes each 15 hours a day to do all this work. They realize one has better land and the other one makes better clothes so they barter to exchange goods. This bartering results in each working only 12 hours a day. One farmer can then take the extra time and sew more clothes and thus barter it with another farmer for more firewood. The extra clothes can be described as “capital” that can be used to raise living standards. Capital can only be created through the production process.

In today’s world, non-liquid wealth in the form of hard assets can be converted into something called money. Money is merely a medium of exchanging hard assets. Money is the liquid form of wealth in only this sense: it is a store of wealth only based on this exchange value. You can’t eat or drink or live in money. Hard assets have a price in dollars to convert them to liquid money.

There's always a defined amount of wealth at any one time in the world, as created by productive processes that increase living standards. This is the real pool of savings. The more production, the more wealth is created. This is a very important statement as you will see later.

Capital can be lent to a borrower. Someone with capital would forgo its use in the present to generate a return. Normally capital is converted to money to be lent. The price of money is an interest rate, how much one charges to use the money.

It makes sense that only those with capital can lend it. Someone can borrow capital from someone else and then lend it to another, but it all starts with the person with capital.

The first red flag is this then: A government, which has no capital of its own, which produces nothing on its own, cannot lend money unless it borrows that capital from another or takes that capital in the form of taxes (but taxpayers must have capital to pay taxes).

The Fed controls interest rates (to a certain extent in normal situations; to a large extent in special situations) to influence the demand and supply of money. Again this innocuous-sounding statement has vast implications. Here is how it works:

There are times in an economy when those with capital don’t want to lend it. It almost always is a time when they see too much risk for too little return.

If we have too many condos in Florida those with capital say I don’t want to lend money to build more condos because there is too high a risk that they won’t sell and I won’t get my money back. So they raise the price of money; they raise the interest rate they charge to compensate for too much risk.

This is how an economy naturally controls itself. It’s called capitalism: the allocation of capital based on risk and return.

When this happens, when an economy has overcapacity, when it has built too many strip malls and lenders restrict the supply of money as a consequence, the economy may temporarily slip into slower growth or even negative growth. But notice this is not a bad thing because the economy is nipping in the bud overcapacity. Why build things if they aren't productive? But the important point is it leaves capital available for a productive process that come along and makes sense to the lender.

Now for several reasons, like political influences, over the last 20 years or so the Fed has taken the stance that any and every recession (caused by lenders raising the price of money) is unacceptable. When lenders (those with capital) want to raise rates, the Fed lowers them to stimulate borrowing and lending by “speculators”: lenders who don’t have their own capital.

Because we already know that lenders with their own capital don’t see productive uses to lend to, by definition the Fed is stimulating lending and borrowing for less productive or even unproductive uses, like building condos when we have too many condos.

How does it do this? It lowers a very special interest rate: the federal funds rate, which is the rate large banks can borrow money from the Fed through the REPO (sale and repurchase agreement) market. The Fed arranges a loan at a lower-than-market rate to a large bank like JP Morgan (JPM). At the lower rate, JP Morgan will earn a higher spread, but assume a higher risk.

There are several reasons why banks have decided to take higher risks over the years. One is simply greed, but this is not enough by itself. Large banks should have been monitored by the Fed for this problem, but apparently they didn't. In fact the Fed implicitly encouraged it by doing nothing and the government explicitly encouraged it through quasi-government entities like Fannie Mae (FNM) and Freddie Mac (FRE), which constantly bought and guaranteed mortgage debt.

So let’s look at an example: JPM decides at an interest rate spread created by the Fed that they're willing to lend money out to build extra condos. They execute a $5 billion repo with the Fed: the Fed makes a credit entry on JPM’s books for $5 billion and JPM delivers t-bills as collateral. The Fed’s balance sheet grows by $5 billion and JPM has $5 billion of fresh “money” on its balance sheet. Where did the Fed get this “money”? Well, from nowhere, it was created out of nothing, out of leverage.

The $5 billion just entered what is called a fractional banking system. A bank only needs to keep a small amount of that REPO as capital and then can lend out the rest.

Before 1987, let’s say, JPM had to keep $0.18 (4.5 x leverage) for every dollar it lends out as capital. Alan Greenspan lowered margin requirements at banks in response to the 1987 crash and never raised them back. So now JPM only had to keep $0.09 as capital (10 times leverage).

Then in the 1990s, derivatives, which offer huge leverage, became the new conduit for liquidity, estimated at creating 80% of all leverage in the system. How do they do that?

A simple example: Let’s say you want to buy a stock. Reg T says you have to put up 50% in cash to buy it. Instead, if you go to your friendly broker he can enter into a performance “swap” with you: if the stock goes up $1 he will pay you $1 and if the stock goes down $1 you pay him. But to do that derivative, which has the exact same economics of owning the stock, he makes you put up only 0.25% -- basically nothing.

In this case, the broker (which in today’s world is a bank) effectively lent money with almost no margin requirement. In the same way interest rate derivatives, which have the same economic risks as loans, are vast on banks’ balance sheets.

The latest estimate of total derivatives worldwide is about $600 trillion. If those derivatives are mismarked by only 1%, that's $6 trillion in potential losses.

So through derivatives, banks and quasi-financial companies like General Electric (GE) were able to achieve leverage levels unheard of. Instead of $0.09 it became $0.03, or 32 times leverage!

JPM as a primary dealer doesn’t lend directly to condo buyers, they lend to regional banks. So JPM has to keep 3%, or $150 million, as capital and then can lend $4.85 billion to a regional bank. In turn that regional bank can lend $ 4.7 billion to another. In this way the original $5 billion in new credit issued by the Fed works its way down through the banking system eventually to consumers and creates $4.85 billion/ (1-0.97) = $162 billion of new credit in the system. In this way the Fed created $4.5 trillion in new credit in 2006 with very little expansion of their own balance sheet.

All that credit fueled the housing boom. All that credit expanded the money supply or liquidity pool vastly by adding huge amounts of consumer/mortgage debt: the money supply grew from $8 trillion in 1987 to $750 trillion in 2006.

Did we have a 100 fold increase in our standard of living? Of course not. So real wealth or capital did not grow even a fraction as much as the amount of money/debt in the system. I am now going to introduce a new term: moneydebt.

The process I just described is what people refer to as printing money. But notice the Fed is not really printing new dollar bills, they are creating new debt.

This is my definition of inflation: inflating the money supply with debt. When they create new debt (from nothing) they are creating dollars that the debt is denominated in. When you create more dollars you devalue them. When you devalue dollars, prices of things (including stocks) rise because price is how many dollars it takes to buy something.

Because inflating the money supply with debt almost always leads to higher prices, people think of inflation as rising prices.

Moneydebt as a measure of wealth as I referred to earlier is a non-sequitur. The Fed can print (the process I just described) as much as it wants as long as there is a willing borrower and lender. But here is the key: without either, the Fed cannot print high-powered moneydebt.

What happened to the fractional banking system? In mid-2008, when the president went on TV and said we have to bailout the banks, very simply banks were so levered they ran out of treasuries as collateral. They couldn’t lend anymore.

To stop the rapid deflation that was ensuing (deflation is the destruction/reduction in credit; deflation unwinds a massive inflation which is the creation of credit just described), the Fed invented the Troubled Asset Relief Program (TARP): It began accepting other forms of debt stuck on the balance sheets of the banks (such as mortgage debt and their derivatives) as collateral and gave treasuries back to the banks.

This was not printing moneydebt, this was just exchanging bad debt for good debt on the balance sheet of the Fed. This worries its shareholders, but they know where their bread is buttered. They are willing to do this up to a point.

Since then, we have had all types of programs and stimulus. But in my opinion none are highly inflationary (creating vast amounts of moneydebt): You need a fractional banking system to do that.

The Fed has monetized (quantitative easing): It created moneydebt from nothing to buy treasuries in order to keep interest rates lower than the market wants them. In fact, they're doing this as we speak: secretly telling dealers they will buy treasuries after auctions. So far they have monetized (printed dollars) around $250 billion this way.

This is only marginally negative for the dollar because it is not going through the fractional banking system. It is dwarfed by the amount of debt being forfeited/paid back with lots more to come.

The Fed would need to do a tremendous amount of monetization by buying up vast amounts of existing debt for it to devalue the dollar in a great way. The Chinese don’t want to see this and, I believe, have made this very clear to the Fed. In addition, the Fed’s custody account is swapping agency debt owned by foreign central banks for treasury debt, something they promised to do when they backed FNM and FRE debt.

This could amount eventually to $8 trillion and all the guaranteeing of bank debt could amount to another $15 trillion. In this way, the Fed essentially controls the swap and London Interbank Offered Rate (LIBOR) markets.

But again, this is merely plugging existing holes: the Fed is merely exchanging various forms of moneydebt for other forms. This is what Japan did for a decade. Although egregious, this is not new news.

The Fed is having a great deal of trouble devaluing the dollar because there is just so much debt out there that needs to be supported: There is not enough income being generated by the economy so it is defaulting. This is why the banks are being force fed profits by an artificially steep yield curve, to subsidize future losses on debt write-downs. And this is why they are not lending out the vast reserves created by profits at taxpayer expense.

I still believe there is something like $8 trillion to $12 trillion in debt to be written down. It’s possibly more if the government continues down the path of supporting moneydebt at bad prices.

When moneydebt is destroyed by forfeitures, the dollar is being destroyed. When the dollar is being destroyed it rises in value. When the dollar rises in value relatively prices go down.

This is exactly what the market wants, for prices to go down. When prices go down, real savings/capital is released as the risk for reward dynamics become more favorable. This is exactly what the government doesn't want. They want to subsidize debtors by keeping prices and collateral values high. It’s a fool’s journey.

This is why I've taken an extended vacation in the US and keeping my capital safe: I am willing to accept a very low return on that capital because if prices come down 40%, I am effectively earning 40% interest on my capital, which is real.

Risk is very high.

P.S. I left for another time the international aspect of imbalances created through the Faustian deal between the US Treasury and other central banks.
No positions in stocks mentioned.

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