Excess Reserves

Recently, there has been an intense debate in Europe on the TARGET2 system (Trans-European Automated Real-time Gross Settlement Express Transfer System 2), which is the joint gross clearing system of the eurozone the interpretation of this system and its balances has provoked divergent opinions. Some economists, most prominently Hans-Werner Sinn, have argued that TARGET2 amounts to a bailout system. Others have vehemently denied that. Philipp Bagus adresses the question of whether this 'mysterious' system, that we have been so vociferously discussing, simply amounts to an undercover bailout system for unsustainable living standards in the periphery? Concluding by comparing TARGET2, Eurobonds, and the ESM, he notes that all three 'devices' serve as a bailout system and form a tranfer union but governments prefer to hide the losses on taxpayers as long as possible and prefer the ECB to aliment deficits in the meantime.

Not like it should come as any surprise that the bank that first among peers "discovered" that flow, not stock matters, implying the Fed may literally never be able to stop monetizing, is expecting the FOMC to "ease monetary policy on June 20", but nonetheless here is the full just released Q&A from Goldman's Jan Hatzius, who just happens to be a Pound and Pence drinking buddy of former Goldmanite Bill Dudley, who just happens to run the New York Fed. Connects the dots. Implicit is that a big dollop of Large Scale Asset Purchases is imminent. That said, if the Fed does disappoint on June 20, and merely extends the maturity of bonds that it will sell as part of a Twist extension from 3 to 4 years, as the bond market appears to be implying (as first warned by Zero Hedge), then all bets are truly off. On the other hand, note where Goldman says: "However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month." If that happens, gold is going to $2000, $3000, hell, $10,000 very soon, as it means the Fed will not stop printing ever again. Period.

"Private Debt Doesn't Matter" Because "Banks Can't Create Money Out of Thin Air"

As Many Have Predicted for Years

From early October of last year (Grand Plan and Global CB intervention) until the start of the LTRO program in Europe, Gold and Stocks (and Treasuries and the USD) all traded in sync with one another. Since the LTRO program, the equity market has generally been on its own in terms of belief. While growth hope, Europe's recovery, and the Bernanke Put (as well as a short-squeeze of epic proportions) were at play, it seems to us that the Fed's Twist program has been ignored by the money-printing crowd (since Twist was sterilized and did not expand the monetary base (excess reserves) - which gold reacts to; but did provide flow - helping stocks - as the Fed's DV01 increased; implicitly devaluing the currency even though Fed's efforts to dissuade have worked) while the ECB's LTRO provided a liquidity overhang that at-first-glance removed one short-term structural risk from US markets (the Europe contagion). Since we made clear that LTRO is in fact an encumbrance and not 'clean' debt monetization (which fits with gold not moving as much), equity markets in Europe have retraced all of those gains - leaving US still elevated. The last few days, gold and stocks have surged together as hope for LTRO3 (seemingly gone now) and Fed QE3/4 (not sterilized; with ES -7.75% from its highs?) has become imminent. However, Gold and stocks remain very far apart in the medium-term and Rick Bensignor sees trendline support and DeMark TD Setups providing an excellent risk-reward for a Short Stocks, Long Gold trade from here.

Deflation has effectively been abolished by central banking. But is it sustainable? The endless post-Keynesian outgrowth of debt suggests not. In fact, what is ultimately suggested is that the abolition of small-scale deflationary liquidations has just primed the system for a much, much larger liquidation later on. Central bankers have shirked the historical growth cycle consisting both of periods of growth and expansion, as well as periods of contraction and liquidation. They have certainly had a good run. Those warning of impending hyperinflation following 2008 were proven wrong; deflationary forces offset the inflationary impact of bailouts and monetary expansion, even as food prices hit records, and revolutions spread throughout emerging markets. And Japan — the prototypical unliquidated zombie economy — has been stuck in a depressive rut for most of the last twenty years. These interventions, it seems, have pernicious negative side-effects. Those twin delusions central bankers have sought to cater to — for creditors, that debt is wealth and should never be liquidated, and for debtors that debt is an easy or free lunch — have been smashed by the juggernaut of history many times before. While we cannot know exactly when, or exactly how — and in spite of the best efforts of central bankers — we think they will soon be smashed again.

All is (once again) failing. What to do? Much more of the same of course. Only this time whip out the nuclear option: the Helicopter Money Drop. This is the logical next step that Citigroup's Willen Buiter sees as "Central Banks should also engage in 'helicopter money drops' to stimulate effective demand" - temporary tax cuts, increases in transfer payments, or boosts to exhaustive public spending - all financed directly by the willing central bank accomplice in the monetization gambit. In his words: "This will always be effective if it is implemented on a sufficient scale." It is not difficult to implement, would likely be politically popular (nom, nom, nom, more iPads), and in his mind need not become inflationary. He does come down to earth a little though from this likely-endgame scenario noting that "helicopter money is not [however] a solution to fiscal unsustainability." It is just a means of providing a temporary fiscal stimulus without adding to the stock of interest-bearing, redeemable public debt. Any attempt to permanently finance even rather small (permanent) general government deficits (as a share of GDP) by creating additional base money would soon – once inflation expectations adjust to this extreme fiscal dominance regime - give rise to unacceptably high rates of inflation and even hyperinflation. His estimate of the size of this one-off helicopter drop - beyond which these inflation fears may appear - is around 2% of GDP - hardly the stuff of Keynes-/Koo-ian wet dreams. The fact that this is being discussed as a possibility (and was likely always the end-game) by a somewhat mainstream economist should be shocking as perhaps this surreality is nearer than many would like to imagine.

What are the classic signs of an asset bubble? People piling into an asset class to such an extent that it becomes unprofitable to do so. Treasury bonds are so overbought that they are now producing negative real yields (yield minus inflation). And so America’s creditors are now getting slapped quite heavily in the mouth by the Fed’s easy money inflationist policies. John Aziz proposes (much to the consternation of the monetarist-Keynesian “print money and watch your problems evaporate” establishment) that this is a very, very, very dangerous position. And that those economists who are calling for even greater inflation are playing with dynamite. See, while the establishment seems to largely believe that the negative return on treasuries will juice up the American economy — in other words that “hoarders” will stop hoarding and start spending — we believe that negative side-effects from these policies may cause severe harm. Do we really want to risk the inflationary impact of continuing to print money to monetise debt (and hiding the money in excess reserves, thereby temporarily hiding the inflation). As John wrote recently - "So, does the accumulation of excess reserves lead to inflation? Only so much as the frequentation of brothels leads to chlamydia and syphilis." We’d call that playing dice with the devil.

While Krugman does not by any means endorse the level of centralism that Diocletian introduced, his defence of bailouts, his insistence on the planning of interest rates and inflation, and (most frighteningly) his insistence that war can be an economic stimulus (in reality, war is a capital destroyer) all put him firmly in Diocletian’s economic planning camp. So how did Diocletian’s economic program work out? Well, I think it is fair to say even without modern data that — just as Krugman desires — Diocletian’s measures boosted aggregate demand through public works and — just as Krugman desires — it introduced inflation. And certainly Rome lived for almost 150 years after Diocletian. However the long term effects of Diocletian’s economic program were dire. Have the 2008 bailouts done the same thing, cementing a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite? Only time will tell.

Forget Competing Theories … What Do the Facts Say about Quantitative Easing?

Throughout the postwar period, banks have almost always lent out all the way up to the reserve requirement. So, does the accumulation of excess reserves lead to inflation? Only so much as the frequentation of brothels leads to chlamydia and syphilis. Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection. But eventually — so long as you do it enough — the condom will break. As soon as banks start to lend beyond the economy’s inherent productivity (which lest we forget is around the same level as ten years ago) there will be inflation.

At first we were going to comment on this "response" by the high priest of Keynesian shamanic tautology to Mark Spitznagel's latest WSJ opinion piece, but then we just started laughing, and kept on laughing, and kept on laughing...

"In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability!" is how PIMCO's El-Erian introduces the game-theoretic catastrophe that is potentially occurring around us. In a lecture to the St.Louis Fed, the moustachioed maestro of monetary munificence states "let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden" and "it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances." It appears that we have reached the legitimate point of – and the need for – much greater debate on whether the benefits of such unusual central bank activism sufficiently justify the costs and risks. This is not an issue of central banks’ desire to do good in a world facing an “unusually uncertain” outlook. Rather, it relates to questions about diminishing returns and the eroding potency of the current policy stances. The question is will investors remain "numb and sedated…. by the money sloshing around the system?" or will "the welfare of millions in the United States, if not billions of people around the world, will have suffered greatly if central banks end up in the unpleasant position of having to clean up after a parade of advanced nations that headed straight into a global recession and a disorderly debt deflation." Of course, it is a rhetorical question.

In advance of ever louder demands for more, more, more NEWER QE-LTROs (as BofA's Michael Hanson says "If our forecast of a one-handle on H2 growth is realized, then we would expect the Fed to step in with additional easing, in the form of QE3") , it is an opportune time to demonstrate just what the traditional monetary "plumbing" mechanisms at the discretion of the Fed are, and more importantly, just how completely plugged they are. So without any further ado...

This chart tells millions of stories. That’s right: since 1984 (surely an appropriate year) while the elderly have grown their wealth in nominal terms, the young are much worse off both in inflation-adjusted terms, as well as nominal terms (pretty hard to believe given that the money supply has expanded eightfold in the intervening years). So why are the elderly doing over fifty times better than the young when they were only doing ten times better before? There is enough money to keep the economy flowing so long as there are opportunities for people to make themselves useful in a way that pays. With the crushing burden of overregulation and the problem of barriers to entry, these opportunities are often restricted to large corporations. These issues of youth unemployment and growing inequality between the generations are critically important. Unemployed and poor swathes of youth have a habit of creating volatility in response to restricted economic opportunity.