There has been a lot of talk about whether the Fed will discontinue Quantitative Easing (QE) and let the economy stand (or fall) on its own legs this summer. As we explore this question, it’s important to keep in mind the Fed will continue reinvesting principal payments from mortgage-backed securities and maturing Treasury holdings to keep the Fed’s balance sheet in excess of $2.5T. Before the 2008 crisis, the Federal Reserve maintained a portfolio of between $700 billion and $800 billion of Treasury securities—an amount largely determined by the volume of dollar currency that was in circulation. The increased size of the Fed’s balance sheet is an attempt to support the ever-growing debt held within both the public and private sectors. If you understand this in the context of the bigger picture, it will help you anticipate future Fed actions.
Sustaining our debt based currency requires constant and increasingly higher rates of credit creation. Factors converging right now are the enormous levels of debt in the system, a tapped-out consumer, loss of productive capacity (outsourced manufacturing), and the inability to grow exponentially due to resource scarcity.Cheap energy (oil) that provided the necessary growth over the past century is now becoming more expensive. We are getting less net energy at the same time we need to be increasing energy returns. The Mid-East crisis is only adding to the costs of energy while Japan’s disaster will add Treasury selling at a time we are in dire need of new buyers.
Although I have stated and continue to believe the Fed will resume QE in some fashion, we need to understand the consequences of no further QE to best prepare and protect ourselves for various possibilities.
Can the Economy Survive without QE?
The main reason the US economy cannot survive without life-support (QE) is that there is no ability to close the gap between available public resources and government spending. Nor is there the political or public will to push forward structural reforms in social welfare or unfunded liabilities, such as Social Security and Medicare. US debt has grown rapidly since the early 1980s when the US had under $1T in national debt. Today the US national debt stands at $14.3T, with annual deficits exceeding $1.5T. This is a pyramid/ponzi scheme that has only one ending, collapse. Following the 2008 insolvency crisis, millions of US citizens were left without a job and are now living on government handouts. Social welfare benefits increased by $514 billion over the last two years (TrimTabs) and now account for 35% of wages and salaries. Over 43 million Americans rely on Food Stamps to purchase groceries and we haven’t even gotten to the increasing population reliant on Social Security. All of this is occurring at the same time prices are rising for all necessities. Any cuts in social welfare or unfunded liabilities will result in massive discontent, populous uprising, and the eventual breakdown of the current system. Hunger is a great motivator.
Effects of Deflation
At this stage in a highly leveraged debt-based monetary system, deflation would result in massive defaults. Money (credit) would shrink, while prices, employment, borrowing, and tax revenues would fall. The US is already unable to meet funding requirements (as noted by the $1.5T deficit). Falling growth and declining tax revenue will only exacerbate the deficits, leading to a sovereign default.
Point of No Return
Beyond the social impact, if the Fed stops creating money to support the insolvency crisis (i.e., printing money to fill the funding gap), the sovereign bond market and western banking system will implode. The western (global) banking system is based on the continued functionality of its sovereign bonds markets, the underpinning of the monetary system. A major sovereign default will result in loss of international finance and loans. Borrowing costs in the form of higher interest rates will increase dramatically destroying derivative markets and the underlying currency.
Sovereign Debt Restructuring
There are many examples of sovereign defaults to explore that help explain how defaults impact borrowing costs and currency. One recent example is Russia’s 1998 default of $72B. Following the default, Russia’s entire banking system fell into chaos with many banks being closed, while others were taken over by the government. The ruble fell about 70% against the US dollar from August 1998 to July 1999 (84% consumer inflation rate in 1998). From 1992 to 2000, Russia’s annual inflation rate was 38%. Eventually Russia’s debts were restructured. Another example is the Argentinean default of $132B in 2001. Leading up to the default, Argentina suffered through hyperinflation – prices rose 5,000% in 1989. As with Russia, the Argentine debt was restructured.
Restructuring is not easy and often does not resolve the problems. For example, sovereign defaults: 1) must be consensual; 2) they pose risk of moral hazard; and 3) they require funding by increased taxation. Another problem is the introduction of hedge funds that hold distressed sovereign debt. The debt holders may sue for full payment, even after a restructuring has been arranged. Elliot Associates exemplified this when they purchased $20M of commercial loans guaranteed by Peru after they announced a Brady Bond restructuring. Elliot Associates sued for full payment and eventually won the case for $58M, which Peru paid in 2000.
Hold Your Gold
Much of the public and gold investors alike, are uninformed about the consequences of discontinuing QE and a subsequent sovereign debt default. What we are experiencing today is a global insolvency that has no possible outcome other than a devaluation and/or restructuring of western debt. Left with the choice of debt default through restructuring or monetization, the Fed will choose to delay as long as possible. Delaying the inevitable requires printing money and negative real interest rates to sustain debt financing. Entitlements will have to be cut at some point, taxes will increase, and public assets will be privatized. Unfortunately dragging this out leaves the poor and uninformed in the most vulnerable position. Given the astronomical levels of global debt, hyperinflation will occur if we don’t restructure, which is why you should hold physical gold. And if the Fed does decide to default, you should hold physical gold – currency devaluation, fraud, and corruption coincide with sovereign debt default.
Since this is a mental exercise in looking at the end of QE, I’ll touch on timing and sequence of events. The US may be able to keep bond markets functioning in the short-term following cessation of QE. This will result in falling GDP, a liquidity crunch, and temporarily rising US dollar. Timing depends on the willingness of foreign creditors and other external factors, but I do not expect US bond markets will be able to attract the necessary funding beyond 2012, without additional credit creation. If the US is able to prolong the collapse during this period, annual deficits will continue to grow, forcing the US Govt. to introduce new and fancy ways of hiding the growing debt. At that point the US will need to make a choice between default and resuming monetization of debt. In either case, the US dollar will fall and gold will rise. Just as both paths lead to higher gold prices, they eventually connect with a new monetary system. Nothing short of an asset backed currency will be accepted following the catastrophic collapse of the western (world’s) banking and monetary system that awaits.