Guest Post: Currency Wars: RIP Shadow Banking System, Long Live QEx!

Tyler Durden's picture

Submitted by Gordon T. Long of Tipping Points

RIP Shadow Banking System - Long Live QEX

We have unwittingly become trapped in the snarled net of years of bad Public Policy. Like corporations that look no further than this quarter's results, our politicos never stop campaigning to start the tough task of ruling responsibly. A winning election simply represents 'rewards' and 'spoils' to all before quickly resuming the next campaign. 

Image has become reality!

As a result the never ending political pandering has led to false expectations, undeliverable entitlements and false optimism in the electorate that rejects the immediate and obvious realities. 

The result of a degenerated political leadership process is we are on the brink of a massive and sudden reduction in the US standard of living.

IN A BOX

In 1971 President Richard Nixon rather than face the harsh realities of excessive US military spending, took the US dollar and the world Reserve Currency off the Gold Standard. It unleashed the greatest global debt pyramiding scheme the world has ever seen - or ever will see again.

To ensure all our readers truly appreciate what this decision meant and where we stand today, we need to revisit some basics.

First, in a the fractional reserve banking system which we currently operate under, money can only be borrowed into existence. Currency can be printed but the money supply only grows when debt is actually created. When the US Treasury issues bonds (debt) and it is taken on the Federal Reserve books as an asset, magically money is brought into existence via the issue of currency (or bank deposit) to the US Treasury. This is why the US dollar is a Federal Reserve note. It is an IOU to the Federal Reserve.

Secondly, Inflation is first and always a result of Monetary policy. If more money is put into the economy we will have more money chasing the same number of goods and  it results in price inflation. 

Thirdly, for an economy measured by GDP to grow, the money supply must grow faster than GDP or the economy will be starved of liquidity. If more money is created for economic growth and it consequentially produces inflation, then the money supply must maintain its growth at a faster pace than inflation. This is one of the reasons why when the inflation genie is released it is so hard to get 'back into the bottle' and to contain it. We learned this difficult lesson in the 1970's for those old enough to remember.

In theory therefore:

Money Supply Growth must be > Growth of the Economy

Since Money can only be loaned into existence and inflation is a Monetary phenomena

Money Supply must be larger > Inflation

Inflation must be larger  > Real Growth (NOMINAL GROWTH MINUS INFLATION)

In a theoretical CLOSED economy there must always be a level of money growth which is slightly larger than inflation which is slightly larger than REAL economic growth.

Healthy Economy - Examples

4% GDP Growth with 5% Inflation means Money Growth is larger than 5% with a -1% Real Growth
6% GDP Growth with 7% Inflation means Money Growth is larger than 7% with a -1% Real Growth
9% GDP Growth with 10% Inflation means Money Growth is larger than 10% with a -1% Real Growth
Therefore you can see REAL Growth must always be zero or negative.

It Is Money CREATION that correlates with the growth of the NOMINAL value of the market

Unhealthy Economy - Examples

2% GDP Growth with 3% Inflation means Money Growth is larger than 3% with a -1% Real Growth
0% GDP Growth with 1% Inflation means Money Growth is larger than 1% with a -1% Real Growth
-2% GDP Growth with 0% Inflation means Money Growth is larger than 0% with a -2% Real Growth

Broken Economy - Examples

2% GDP Growth with 3% DEFLATION means Money Growth is larger than 1% with a +1% Real Growth
0% GDP Growth with 3% DEFLATION means Money Growth is larger than 3% with a +3% Real Growth
-2% GDP Growth with 3% DEFLATION means Money Growth is larger than +1% with a +1% Real Growth
-2% GDP Growth with 5% DEFLATION means Money Growth is larger than +3% with a +3% Real Growth

Therefore you can see Real Growth is always positive

Therefore when you have no growth and DEFLATION (due to deleveraging, malinvestment, default, bankruptcy) you still must have Money Growth. This forces the Fed to print it into existance or the government to take on the debt to grow the money supply or we have a liquidity trap.

To appreciate this fact you must remember that interest on outstanding debt STILL compounds every year.

The economy may stop growing but the carrying cost of outstanding debt doesn't.

The Federal Reserve in essence must make sure that DEFLATION is absorbed by adding money or the debt payments will shrink the economy

(Note: It is argued that it is actually the first derivative or rate of change of the increases/ decreases above, not the actual rate, that must be maintained. Even if this is true, the sign doesn't change which is the important point here.)

The major issue arises when even by increasing debt (somehow) it no longer generates growth.

This happens when we arrive at the consequential point of Debt Saturation relative to economic growth.

THIS IS THE PROBLEM WE NOW FACE, BUT KNOW ONE WANTS TO TELL YOU!

SITUATIONAL ANALYSIS

1- Debt growth now takes away from growth

2- Since the US is not a CLOSED economy and in fact is the world's reserve currency, money created by the Fed does not necessarily stay in the US.

In fact Quantitative Easing has presently ignited a massive global US dollar carry trade.

To put the above into perspective we need to understand that Money or more specifically Credit prior to 2008 had been growing not just through the banking system regulated by bank regulators but rather through what is referred to as the Shadow Banking System.

The Shadow Banking System as the prime pusher of toxic debt instruments collapsed in the 2008 financial crisis and so far it simply has not re-emerged in some sort of hybrid fashion.  The Federal Reserve desperately needs this to happen and this has been another reason for the Fed's "Extend & Pretend" policy. Extend & Pretend was not only to give the economy time to rebound and push asset prices up (helping book collateral values), but also to allow asset appreciate to re-ignite a new and improved Shadow Banking System. It simply is not happening fast enough.

Here is the latest figures from the Federal Reserve's Flow of Funds report for Q4 2010. The report was startling since Q3 2010 was even worse than thought after final adjustments were made.

We had aQ4 2010 decline of $206.4 Billion in Shadow Banking liabilities with $440 Billion in combined Shadow and Conventional Banking System Liabilities.

This almost guarantees that the Federal Reserve must continue QEX.

THE SHADOW BANKING SYSTEM IS NOT RETURNING

THEY CAN'T STOP THE CRUMPLING BAD DEBT

It will take too much printed money by the Fed, created so fast, that the collateral fallout damage would be economically fatal.

Even the TRADITIONAL Banking System is shrinking on a M3 basis (it is no longer reported)

CONCLUSION

The collapse of the Shadow Banking is not resulting in the degree of asset deflation you might expect because the assets deflating are what has been referred to as toxic debt. The underlying basis for these instruments is real estate which is correspondingly being stopped from collapsing by the halting of Mark-to Market and other Fed sanctioned accounting gimmickry. Meanwhile the offsetting Money creation by the Fed is flowing into equities and bonds. This is creating the asset inflation that the Fed wants and needs.

A major problem for the Fed is not just being able to generate the amount required to offset the Shadow Banking System erosion, but also the rate at which the it can realistically make this happen. The Fed needs to buy more time.

Unfortunately there are other major problems that are boxing them in.

DEBT SATURATION

Global growth has been pushed to the level of a desperate high octane race as a result of one bad public policy after another.

Exponential money growth has resulted in excess global capacity, underutilized production capabilities and unprecedented levels of mal-investment.

Everything that even hints at a slowdown or problem has continuously been met with rapid additional money supply expansion. The result is a global economy that can no longer absorb new debt at the same or faster rate and is burdened with existing debt payments that are simply  not fundable without ever shrinking interest rates or easy roll-over banking covenants.

At nearly zero interest rates and slowing growth we have a potent cocktail for an economic disaster.

JOB CREATION & REAL ECONOMIC GROWTH

We additionally have a global crisis of job growth to match population employment needs.

Schumpeter's creative destruction is operating at full throttle with the internet and Information Technologies continuously obsolescing untold jobs worldwide.

Manufacturing through major process changes, supply chain integration and robotic automation has reinvented itself over the last 15 years. Gone are the days of thousands of factories employing thousands of people. Today it is hundreds of factories employing hundreds of people with thousands wanting to work there.

Yes China was the recipient of many of the 46,000 factories that left America but they employ much fewer people than they did when they were in the US.  China has 30 million people a year leaving the rural farmland looking for factory work. India, Malaysia, Indonesia, etc face similar problems. There are not enough new factories needed to fill this requirement. This is deflationary in nature until the base commodity increases of manufacturing outstrip labor and capital cost savings.

New technology companies like Bio-Tech employ one tenth to one hundredth the employees that were employed during the computer communications technology era of the 80's and 90's. Higher education is required in these new industries and there is a much higher number of Master and PhD workers. However, the growing numbers of thousands of students with advanced degrees can't all be jammed into these too few corporations.

Unemployment is elevated and growing everywhere with more and more higher educated youth unable to find appropriate work. Sovereign nations globally face the daunting challenge of achieving employment levels that will stop social unrest. Some as we are witnessing in North Africa and the Middle East with 15- 30% unemployment are failing to do so.

RESOURCE SCARCITY

To say we have a looming global resource scarcity issue seems obvious, however I seldom ever read that we do? We see prices in all commodities continuously rising, food of all types rising, energy of all crack levels rising; yet no one talks about the realities of a systemic long term problem.

Shortages are always regarded as a temporary disruption or associated with some special situation. Folks, I hate to break the news but we are on the verge of major global resource shortages and scarcity. When Americans understand it is not their inalienable right to have gas at $3 per gallon while everyone else pays $9 they will quickly get the message. That day is fast approaching.

We will soon be in an era of worrying about how we pay for what we NEED versus how we can afford what we WANT.

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traderjoe's picture

Chart-porn - Bitchez!

Bank Holiday in 3...2...1...

IQ 145's picture

 Absolutely beautiful article. If Zero Hedge never did anything else at all; this would secure them a place as an important and meaningfull resource on the internet. The First chart is a real beauty. 

Sudden Debt's picture

this evening I gave a brilliant presentation about our economic future with 95% of stuff that I've taken from ZH.

I've really scared the shit out of people this evening and I've got the best questions ever: WHAT CAN WE DO!

My answer: Cut costs to the bone and if need cut the bone and hoard commodities.

I've got 9 meeting request when I left home and a invitation to give a presentation at the biggest entrepeneural network in my country.

 

IQ 145's picture

 I understand; but this article is outstanding. bookmarking the website on both browsers. The guy can speak english in whole sentences and he understands what's going on; purrr-fect.

Hacked Economy's picture

I've given lectures and classes on this very stuff for a while, specifically "cranking up" the frequency since December.  I haven't used much info from ZH in my discussions and articles (yet), but I've been gleaning quite a bit of useful tidbits that corroborate what I already have.  And just like you, Sudden, the people I speak with are aghast once the "aha!" light comes on in their heads.  They begin seeing the world around them in a different, more truthful way than ever before, and they're full of questions of what they should do to prepare for what's coming down the economic pike.

New_Meat's picture

Your answer==Cal Coolidge's answer in U.S. 1920-21-22 situation. - Ned

LMAOLORI's picture

As Bob Murphy says "More generally, "disrespectful-punk" websites catering to financial readers, epitomized byZeroHedge and EconomicPolicyJournal, take it as a matter of course that Bernanke has no clothes. The anonymity of the Internet ensures that plenty of respectable Wall Street pros turn to these alternative media to get the real news about the economy — when their boss isn't looking, of course."

http://mises.org/daily/5117/Everybody-Knows-Bernanke-Is-a-Joke


Golden monkey's picture

Very old, extremely smart gentleman.

Will leave us when capitalism crash?

 

michael.suede's picture

I disagree with this whole liquidity trap nonsense and the idea that the central bank has to print money or we will run out of it in a deflationary scenario.

There is never too "little" money and deflation is a good thing for savers.

Such notions are Keynesian nonsense.  Prices will adjust downward proportionate to the amount of debt that is liquidated and they will eventually stabilize once all of the bad debt is gone.

Bankruptcy is the slavation of the economy.

stollcri's picture

You might be technically correct, but there might be some problems holding society together under your scenario.

Consider that I have a mortgage that is well within my budget given my income, but after a certain amount of wage deflation the monthly payments may no longer be affordable. Should I have saved my money to buy my house like my grandfather did? Maybe so, but that wasn't the social contract at the time of my purchase decision.

Younger people would get screwed more in your scenario simply because they have not had the same amount of time to accumulate savings (and the prevailing social contract told them to take on debt that is exempt from bankruptcy to go to college to get the good paying job). I think that is part of the problem in MENA, no?

Slim's picture

You may disagree with it but this fits with what is experienced in credit crisis/financial collapse.  When velocity goes to zero and you wind up in a debt deflationary spiral, have to push people to invest/do something otherwise everyone keeps going to cash and a fractional reserve system blows appart as everyone simultaneously deleverages the economy as they unwind it to get to cash.  There is a reason they say that the Fed is pathologically afraid of deflation and this is it.  This is what made the Great Depression so bad when they bombed out the banks and were on the gold standard (which they then defaulted on in 1933 so it is no panacea or guarantee that bad things can't happen).

 

Of course when you look at all the money wiped out by the shadow bank collapse, people would have a hard time justifying a higher price of gold/silver today vs. 2006 on money supply alone (certainly risk premium would figure).  My sense is that a lot of people don't like to talk about this but really this is the issue with gold right now.  If you look at M1 growth, you better buy gold.  If you look at M3 or the net damage to total money supply spun up via velocity and out in the economy...gold should be down heavily (ex risk premium) and no where near where it is today.  This is the real issue here with gold/inflation/money supply and its odd that it isn't discussed more on this site regardless of which side certain people may be on in the argument.  Actually the fact that it never gets mentioned makes me a little suspicious of motivations.

cossack55's picture

Tipping Point my ass. I'm already upside down.

umop episdn's picture

Me too.  ;)

"Nixon...took the US dollar and the world Reserve Currency off the Gold Standard. It unleashed the greatest global debt pyramiding scheme the world has ever seen - or ever will see again."

This is likely true, but Einstein once said that only two things were infinite, the universe and human stupidity; but he wasn't sure about the former.

IQ 145's picture

 I've been telling people this exact statement for thirty years, but I had to quit; because people look at me like I was just let off by an alien spaceship.

Oracle of Kypseli's picture

Yes. But, it takes too long to travel to infinity. Too far.

dearth vader's picture

Imagine, you're part of infinity already.

It's all in the mind, dear.

Spalding_Smailes's picture

Warnings Aplenty From the 'Father' of Securitization

In his first television interview ever, Lew Ranieri did not disappoint. In a candid interview, the "father" of the mortgage-backed security offered important insights on the state of the housing market and the market for securitized commercial mortgages, while also proving willing to accept criticism of the industry he helped to create.

(Lew Ranieri is known as the "father of securitization" because he helped invent the securitized mortgage in 1977 while working for Salomon Brothers. He's even been credited with inventing the word "securitization.")

http://www.cnbc.com/id/41740606/

TruthInSunshine's picture

The collapse of the Shadow Banking is not resulting in the degree of asset deflation you might expect because the assets deflating are what has been referred to as toxic debt. The underlying basis for these instruments is real estate which is correspondingly being stopped from collapsing by the halting of Mark-to Market and other Fed sanctioned accounting gimmickry. Meanwhile the offsetting Money creation by the Fed is flowing into equities and bonds. This is creating the asset inflation that the Fed wants and needs. A major problem for the Fed is not just being able to generate the amount required to offset the Shadow Banking System erosion, but also the rate at which the it can realistically make this happen. The Fed needs to buy more time. Unfortunately there are other major problems that are boxing them in.

 

 

Great, great selection of analysis - there.

 

We're NO WHERE near done deleveraging. Aside from losing a good chunk of its middle class in this rip-your-face-off downturn, the other problem that the nation as a whole faces is that whatever potential for planting the seeds of any recovery there are, government is colluding with the elite in alleged 'private' enterprise to ensure those seeds never grow on U.S. soil - these are now saplings in Mexico & China, soon to be mighty oaks.

We're back in a bubble mentality where people think Apple, Groupon and Facebook will save us, when Apple has 90 employees in China for every 4 they have in the U.S., and companies like Groupon and Facebook aren't and will never be large scale employers, never mind that Groupon and Facebook have shaky business models and they lack proprietary underpinnings (so they're not even guaranteed a long life).

 

DrStrangelove's picture

the population growth chart might not have been expected to look like that in 1000A.D.

dearth vader's picture

Nevertheless, they were in overshoot, even in those days.

Lack of energy from fossil fuels!

plocequ1's picture

Who cares. I always hated money anyway. Its dirty

Jean Lazard de Rotschild's picture

then money laundering would come in handy for you... lol

mynhair's picture

But it has copious quantities of Sheen residue....

Bearster's picture

If I were as confused as Gordon T. Long, I would not be writing about economics but frantically studying it remedially.

 

"...the US dollar is a Federal Reserve note. It is an IOU to the Federal Reserve."

It is a liability of the Fed, not an asset of the Fed.  The possessor of the FRN does not owe anything to the Fed; the Fed owes him something.

The FRN is irredeemable, but still one should be clear on this distinction (and many other erroneous notions in this article)!

TruthInSunshine's picture

The FRN is an asset of the holder, and a liability of the taxpayer, if one wished to be technical.

But I won't mention that in reality, due to the incredible distortions of Modern Money Mechanics (the playbook for both the London Central Bank & Federal Reserve Bank), what we count as an asset (the FRN) is really not what we intuitively believe it is - because to do so would be to digress.

Bearster's picture

Actually ... to be technical, the Treasury Bond is the liability of the taxpayer.  The Fed is, by a convenient fiction everyone pretends to believe in, a separate entity with a separate balance sheet.  That way the mutual check kiting scheme (aka "69") between the Fed and the Treasury does not appear to be mere masturbation, but something more...

TruthInSunshine's picture

While I agree with you, I hasten to add that both each FRN and Treasury Bonds are liabilities.

I agree that it's only through collusion between the Fed and the Treasury that our system can now operate.

Sean7k's picture

The FRN is not a liability of the FED, it is a liability of the Treasury department and by extension the taxpayer. Treasury issues bonds and notes and in return, receives FRN's and credit notations. 

FRN's are a monetary instrument, being a liability and an asset, depending on how you are using it. For those holding the bonds, it is an asset. For the taxpayer, it is a liability, thus the national debt interest payments.

 

benbushiii's picture

It is a liability of the Fed, not an asset of the Fed.  The possessor of the FRN does not owe anything to the Fed; the Fed owes him something.

 

Actually, this is where the problem with the Bernank becomes evident.  The note is indeed a liability of the Fed, but the Bernank can honor that liability by printing more liabilities.  There is nothing  backing the under-lying liability owed by the Fed.  All of the QEs only perpetuate the myth.

mynhair's picture

Just put a wooden stake into the TBTF already!  This is getting tiresome.

Big whoop if Soros winds up eating mud pies.

spinone's picture

Lets stick with the concept of the currency being debt saturated for a minute.

When a debt based fiat currency is debt saturated, game over. 

We do not have the capacity at this time to grow the economy and pay off the debts.

Either the debts are defaulted, or the currency remains broken.

The debts wont be defaulted because they debts are the TBTF assets, and they get mark to market.  The system that keeps the US middle class in debt slavery, and the currency broken, is supported by the system because it is TBTF. 

How long can this go on?  Until a crisis puts it over the edge.  Keep your eyes on Japan ripple effects for the next month.

Meme Iamfurst's picture

THAT  (Japan) is just the tip of the ice berg.  There will be no place untouched by world events unfolding, Japan is just the headline.

The Forth Turning, five planets in Aries, with Uranus sitting there until 2019...the collective world has no idea what is going to happen, but the status quo is ended.

 

Creed's picture

if ASSTROLOGY makes you so omniscient...

why don't you use it to trade the stock market, get uber rich, then come back here and tell us how it's done?

 

then I'll give you props

LibertyIn2010's picture

"But, I see the tip of the iceberg and I worry about you."

RUSH - Distant Early Warning

http://www.youtube.com/watch?v=rC0u9MdHA98

If ZH had a theme song...this is it.

 

chump666's picture

On wires now!

*Japan radiation from plant could exceed Chernobyl

*Forum companies evacuating staff

*Tokyo airport gridlocked

mynhair's picture

Wires.  Let me guess:  AP?

TruthInSunshine's picture

Well, like I've been saying, there will be a series of crises between now and 8:45 tomorrow morning, and all hope will be restored just in time for market open.

Glow in the dark airline passengers from Japan notwithstanding.

Meme Iamfurst's picture

can't you just smell the rubber hitting the road?

Murphy's law, it ain't just for you anymore.

decklap's picture

Is the sky ever *not* falling on this blog?  Seems like you guys can't look out the window without getting the shit smaked out of you with a chunk of wild blue yonder

mynhair's picture

My 'wild blue yonder'  is populated by Algore's aged (for Libs:  pronounced age-ed)  G-II.

anony's picture

"A Zebra can't change its spots".   (an original Al-Gore-Rhythm)

TruthInSunshine's picture

Take the blue pill.

Or are you prepared to make a case for 'green shoots?'

Jendrzejczyk's picture

Unvarnished reality takes a bit of getting used to.

RockyRacoon's picture

Truth.  Yep, it's a bitch.

Cynthia's picture

But unvarnished reality is too painful to handle without being Comfortably Numb:

http://www.youtube.com/watch?v=0wtiNzci1Wc

StychoKiller's picture

The snow has finally started melting -- enough for us to get most of the XMas decorations taken down.  Soon, the frogs will be peeping in the lake behind our property -- the World WILL continue to spin on its axis, whether Humans still exist to perceive it, or not.