Financial topics

[vincecate]

[*] QE money will flow into banks, and from there into "hot" investment opportunities. This will create new asset bubbles, but not inflation.

[*] The choice of bubbles is a matter of fashion. The real estate bubble was highly fashionable five years ago, but now it's passé. Today's hot bubble are commodities and stocks, and investors are as oblivious to the dangers of commodity investing today as they were to real estate investing five years ago.

China and everywhere else that the money is flowing is already seeing inflation. So that is wrong. Also, when commodities all go up (oil, iron, copper, food, etc) it is only a matter of time before inflation flows everywhere. If USA is buying stuff from China and China has inflation, the US will get inflation in a bit.

The big bubble now is bonds. They may have started the "pop" phase.
When the bonds pop the dollar will pop also. Commodities are just protection against the bond/dollar pop. Commodities will not pop.

The only real chance that electronic dollars go away is EMP, and if that is going on you don't want paper dollars either. At that point it is guns, food, barb wire, and maybe gold/silver. If someone is launching nuclear bombs at the Fed, you can be sure the dollar is no longer the world reserve currency.
So the only thing holding the dollar up will be gone.

[Higgenbotham]

So if we put together your concepts and my concepts, we see the
following scenario:

• QE money will flow into banks, and from there into "hot" investment
  opportunities. This will create new asset bubbles, but not inflation.
• The choice of bubbles is a matter of fashion. The real estate
  bubble was highly fashionable five years ago, but now it's passé.
  Today's hot bubble are commodities and stocks, and investors are as
  oblivious to the dangers of commodity investing today as they were to
  real estate investing five years ago.
• What's really changed today, versus previous centuries, is that
  bubbles are being created with "electronic money," rather than
  physical money.
• There's already a multi-tier stratification of securities, with
  companies like Moody's serving as arbiter.
• Some event will cause a panic, leading people to lose faith in
  electronic money. This is a new concept that I've never seen
  discussed before.
• The multi-tier stratification of securities will be extended
  to "cash." Presumably physical money will be considered the safest,
  while various other forms of electronic money will be rated as
  safe or unsafe in some way.
• This panic will immediately reduce the money supply by anywhere
  from 10% to 50%, causing an enormous deflationary shock. People won't
  receive paychecks, landlords won't receive rents, creditors won't
  receive monthly payments.
• Initially, whatever commerce occurs will be only through physical
  money. As time goes on, faith in some forms of electronic money
  will be rebuilt from backup disks and paper records.
• One possible government response at this time will be to
  make a lot more paper money available, thus returning to the original
  meaning of "printing money." At that point, the huge deflationary
  shock may be offset by some inflation, but the net will still be
  deep deflation.

One thing that always keeps nagging at me is the hundreds of trillions
of dollars (nominal value) of structured securities, including
credit default swaps and interest rates swaps.

These are almost never discussed by the popular financial pundits,
but this continues to appear to me to be a huge mega-mountain of risk.

Right now, we see bond yields increasing in America and Europe. This
could easily reverberate in the interest rate swap market. And with
some $300 trillion outstanding, even a tiny 5% collapse leads to an
enormous $15 trillion less money in the world. That alone would be a
huge deflationary shock.

John

The Fed and the banks are using electronic money and the exchanges to create inflation. The commodity bubbles will create artificial inflation of exchange traded items that gets passed through into the real economy. The bubbles are in all exchange traded items because that is the avenue for the money flow. Since the real economy can't support the higher prices without growth, there will be a second stage of collapse if GDP can't move higher. To generate the inflation, the Fed and the US government have narrowed the door through which money can flow to safety. In the first collapse back in 2008, the market deemed all forms of US government sanctioned or US government issued dollars to be safe, from Federal Reserve Notes up to 30 year bonds. Since then, a larger number of US government sanctioned and issued dollars have been created (including Federal Reserve Notes). In addition, a large excess of electronic base money has been created that did not exist in 2008. The electronic base money was not sanctioned or issued by the US government directly. The electronic base money is liquidity in possibly insolvent institutions with the whole banking system probably tipping toward insolvency. In such an environment, in a second stage of collapse, the market will probably, I would say almost certainly, try to sniff out differences in the relative safety of various forms of government sanctioned or government issued dollars, just as the market sniffed out differences in the relative safety of dollars (money markets for example) back in 2008. In Rome, a denarius was a denarius. It was all debased equally. In Weimar, a mark was a mark. It was all printed the same. Any stratification won't be formally extended to cash through the rating system. The market will do it as it did with the money markets in September 2008 out of necessity. The Fed will try to come in and backstop it with electronic dollars but if the market is in the process of rejecting electronic dollars then it is a meaningless backstop. It will happen as quickly as the morning the Reserve Fund broke the buck with no feasible means to backstop. The electronic dollars can sit there all they want but they will be radioactive or jammed as I said before because they are not real dollars, just as the Reserve Fund was not real dollars (and subprime mortgages were not real securities). This is not anything different than mann and I have been saying since this forum opened up. Only the words are different and of course the situation has now evolved. The rejection of phony forms of the dollar is not inflationary when other forms are available and required in the marketplace. The government can try to prevent bank runs through the FDIC and so on, and that can help hold the depositors at bay but it cannot prevent the marketplace from refusing to accept checks drawn on insolvent banks. As far as the Fed printing more Federal Reserve Notes, the electronic base money can be converted in theory if the public demands it but try to go to any bank today and get Federal Reserve Notes. It'll be complete panic, complete chaos, and very few Federal Reserve Notes to be found. The conversion can't happen as quickly as the panic and, so far as I know, the notes cannot be collateralized with existing MBS on the Fed balance sheet (notice the Fed roll MBS into Treasuries). This is only one scenario I am discussing. There are many that can accomplish the same thing.

I posted the below on July 1 as a summary of the reasons why deflation is probable. The above paragraph is only one aspect of two subjects below:
Multiple forms of dollar (currency notes, commercial paper, derivatives, etc.)
Market preferences for various forms of dollars

These are the issues we've discussed in this forum that Bernanke does not address in his speech (all of these issues have a bearing on the question of whether he can generate inflation through the creation of electronic dollars):

Effects of Fed actions on profitability and tax collections

Potential for resulting international trade lockups

International political realities

Dual nature of dollar (simultaneously debt and extinguisher of debt)

Multiple terms of dollar debt instruments and changing yield curves

Quality of debt instruments and changing credit spreads

Multiple forms of dollar (currency notes, commercial paper, derivatives, etc.)

Market preferences for various forms of dollars

Exogenous events (BP, terrorism, etc.)

Wage deflation and employment rates

Demographics

Generational dynamics realities with an emphasis on attitudes toward debt

Money velocity

[vincecate]

The electronic dollars can sit there all they want but they will be radioactive or jammed as I said before because they are not real dollars, just as the Reserve Fund was not real dollars (and subprime mortgages were not real securities).

The electronic dollars are backed 1 for 1 with paper dollars. So far any bank that has had a reserve account at the Fed has always been able to take out as many paper dollars from their electronic reserve account as they wanted. For "faith" in electronic dollars to fall there would have to be something huge keeping the Fed from giving out paper dollars for electronic dollars. Something like a Nuke doing an EMP over each Fed computer. However, these guys probably took EMP into account when designing their disaster recovery plan. Remember, the Fed can honestly say, "money is no object".

Now the Fed has not printed all the paper dollars to "back" all the electronic dollars ahead of time. Up till now printing enough to keep a small stockpile has always been fine. But given the trouble they had recently printing 1 billion $100 bills, I could easily imagine that if people tried to take out $1 trillion in paper $100 bills that the Fed would not be able to make enough for a long enough time that people would treat paper dollars different from electronic dollars. It is sort of a "run on the Fed" where even though they can print money they don't have enough on hand.

When central banks have run into this type of problem in the past they just make larger bills. So expect a $1,000 bill if they ever have trouble printing enough $100 bills to cover all the electronic dollars they made. And if they still have trouble, then a $10,000 bill will be made. Etc.

All previous central banks were always able to back their electronic money with their real paper money. Short of Nukes, I am confident the Fed will too.

The Fed had their backup system tested when a water pipe broke above their mainframe. Here is a 1991 paper about that:

http://www.minneapolisfed.org/publicati ... fm?id=3772

My guess is that by now the Fed has worked out something really good. EMT shielding is not that hard. A backup in a metal safe in an underground bunker should be very safe. Only a fraction of a millimeter of metal is needed for shielding. People with far less than "the fate of the world" or $3 trillion dollars at stake have computers in underground bunkers. My guess is the Fed would not lose the data and be in operation very quickly.

The next question is if any of the regular banks would still have working computers or if communication networks were up. That could be the real thing that makes electronic money unusable.

http://www.doh.wa.gov/ehp/rp/factsheets ... ecpuls.htm

[Higgenbotham]

The electronic dollars can sit there all they want but they will be radioactive or jammed as I said before because they are not real dollars, just as the Reserve Fund was not real dollars (and subprime mortgages were not real securities).

The electronic dollars are backed 1 for 1 with paper dollars. So far any bank that has had a reserve account at the Fed has always been able to take out as many paper dollars from their electronic reserve account as they wanted. For "faith" in electronic dollars to fall there would have to be something huge keeping the Fed from giving out paper dollars for electronic dollars.

This is not necessarily true as things stand now. The Federal Reserve Act allows the Fed to take in certain kinds of collateral in exchange for liquidity during a financial crisis as provided in Section 13 of the Federal Reserve Act:

3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any participant in any program or facility with broad-based eligibility, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange, the Federal reserve bank shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions. All such discounts for any participant in any program or facility with broad-based eligibility shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

And there's much more to it. However, the restrictions on what the Fed can take in exchange for the electronic dollar reserves are not the same as the restrictions on what the Fed can post to the local Federal Reserve agent as collateral for Federal Reserve Notes. From Section 16 of the Federal Reserve Act:

2. Application for Notes by Federal Reserve Banks
Any Federal Reserve bank may make application to the local Federal Reserve agent for such amount of the Federal Reserve notes hereinbefore provided for as it may require. Such application shall be accompanied with a tender to the local Federal Reserve agent of collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application. The collateral security thus offered shall be notes, drafts, bills of exchange, or acceptances acquired under section 10A, 10B, 13, or 13A of this Act, or bills of exchange endorsed by a member bank of any Federal Reserve district and purchased under the provisions of section 14 of this Act, or bankers' acceptances purchased under the provisions of said section 14, or gold certificates, or Special Drawing Right certificates, or any obligations which are direct obligations of, or are fully guaranteed as to principal and interest by, the United States or any agency thereof, or assets that Federal Reserve banks may purchase or hold under section 14 of this Act or any other asset of a Federal reserve bank. In no event shall such collateral security be less than the amount of Federal Reserve notes applied for. The Federal Reserve agent shall each day notify the Board of Governors of the Federal Reserve System of all issues and withdrawals of Federal Reserve notes to and by the Federal Reserve bank to which he is accredited. The said Board of Governors of the Federal Reserve System may at any time call upon a Federal Reserve bank for additional security to protect the Federal Reserve notes issued to it. Collateral shall not be required for Federal Reserve notes which are held in the vaults of, or are otherwise held by or on behalf of, Federal Reserve banks.

While the MBS were taken in under the emergency provisions of Section 13 of the Federal Reserve Act, they do not constitute acceptable collateral for Federal Reserve Notes as specified in Section 16 of the Federal Reserve Act (the collateral security thus offered shall be notes, drafts, bills of exchange, or acceptances acquired under section 10A, 10B, 13, or 13A of this Act...).

Prior to the initiation of the MBS rollover into treasuries, I think it was pretty much assumed that the economy would get better and the MBS would be jettisoned by offering money markets and open market operations to move the MBS off of the Fed's balance sheet. I was reading that earlier in the year. Since then, I've seen no indication anywhere that any local Federal Reserve agent would allow MBS to be posted as collateral for Federal Reserve Notes. If not, then the electronic dollar reserves offset by the MBS are not convertible to Federal Reserve Notes.

As far as the discussion about EMP, you can spend years trying to figure out whether the Chinese can or can not shut down or jam the Fed's electronic printing press and never know for sure. The Chinese have great incentive to lock up the Fed's electronic printing press and there are many ways to do so besides EMP. They don't have to do a direct hit on the Fed's computers to accomplish that. So far, the Chinese have successfully driven Google out of China and they have stolen reams of government and private files and technology from supposedly secure computers. The entire Silicon Valley office of the FBI is devoted to technology theft. In no way can I be sure whether they can or can't successfully lock up the Fed's electronic printing press any more than someone could have been sure that the US could or could not build a nuclear device to end WWII. The Chinese will respond to what Bernanke is doing. I have no doubt that the team that is formulating and coordinating the Chinese response has a collective IQ, experience level, and information sources in these matters orders of magnitude higher than that of this forum. Economic war simulations coming out of Washington are saying that the Chinese are going to win this fight.

[Higgenbotham]

This is the role that computer sabotage might play according to this article about an economic war simulation conducted by the Pentagon.

Indeed, back in 1999, the Chinese literally wrote the book on how to use economic asymmetries as a blunt instrument, entitled "Unrestricted Warfare."

It draws no meaningful distinction between military, economic and political force (including using cyberspace) as means to defeat an enemy. Instead, it shows how a nation can dominate its opponents not with planes, ships and soldiers, but with foreign exchange rates, trade embargoes and armies of computer hackers.

Suppose that in retaliation for some slight China decides to stop buying Treasury bonds, forcing our debt to cost us even more. A furious US Congress hits back with trade sanctions. China then responds by driving up the price of the dollar, crippling US exports -- or, alternately, it crashes the dollar by dumping its foreign reserves, even as Chinese computer hackers slow down our banks' ability to respond to the crisis.

No one will call this a war. But it will certainly fit the classic definition of war as politics by other means. And the Pentagon knows it.

Last March, the Pentagon held its first-ever economic-warfare war game, with China as the putative opponent and with economists and bankers (including from UBS) helping out.

Details of what unfolded are still classified. However, sources told Fox Business News that the scenario played out as planned. That was the good news.

The bad news is that China won.

Read more: http://www.nypost.com/p/news/opinion/op ... z18LPbfFgU

[vincecate]

The electronic dollars can sit there all they want but they will be radioactive or jammed as I said before because they are not real dollars, just as the Reserve Fund was not real dollars (and subprime mortgages were not real securities).

The electronic dollars are backed 1 for 1 with paper dollars. So far any bank that has had a reserve account at the Fed has always been able to take out as many paper dollars from their electronic reserve account as they wanted. For "faith" in electronic dollars to fall there would have to be something huge keeping the Fed from giving out paper dollars for electronic dollars.

This is not necessarily true as things stand now. The Federal Reserve Act allows the Fed to take in certain kinds of collateral in exchange for liquidity during a financial crisis as provided in Section 13 of the Federal Reserve Act:

The Federal Reserve Act governs what "real bills" are acceptable as collateral for issuing new Federal Reserve Notes. The intent is that any assets the Fed accepts for FRNs are of sufficient quality that they could later be sold to take the FRNs back out of circulation. So the Fed would always have an "exit strategy". The rules are meant to keep the Fed from doing stupid things like "buying toxic assets". The rules are also meant to limit corruption. Right now Goldmen Saches might bribe a few guys a million dollars each and then get $200 billion for $100 billion worth of "toxic assets". The Fed operated in such secrecy that they could (up till very recently) do such things without anyone knowing. Since the Fed ignored the rules, they can not in fact sell the assets they recently bought for as much as they paid for them. So they can not withdraw all the money they issued. They can not unwind the inflation of the currency.

But the Federal Reserve Act of 1913 does not talk about "electronic dollars" vs "paper dollars". My word "backed" is not the best way to say it. I now think it is better to say "electronic dollars are pegged at 1:1 to paper dollars". So far the Fed has always maintained that peg. If you give them one paper dollar they will credit you one electronic dollar. If you give them one electronic dollar they will give you one paper dollar. So it is like a 1:1 peg.

We are contemplating situations where they might not be able to keep that peg in effect. Like if there was a long bank holiday or EMP. It is an interesting question.

The Chinese will respond to what Bernanke is doing. I have no doubt that the team that is formulating and coordinating the Chinese response has a collective IQ, experience level, and information sources in these matters orders of magnitude higher than that of this forum. Economic war simulations coming out of Washington are saying that the Chinese are going to win this fight.

Yes. To me it is clear China will win because they produce and export more than they import, while the US is importing much more than they export.

US debt is dropping in value as interest rates go up. I think rates are going to go up for some time now. The longer China holds their US debt the more they will lose. I think it is in China's best interest to sell their US debt before others sell theirs. If China were to aggressively sell their debt, it would show that they have lost faith in the dollar. The selling, and also the world learning that China has lost faith in the dollar, would sink the dollar. People/countries all over would want to rush and sell their US debt and dollars before it dropped more. Panic selling and crash would follow.

At that point China can still buy oil, copper, iron, cement, food, etc. just fine. But the US will have a really really hard time buying any of the world commodities if the world does not want dollars. By "purchasing power parity" type measures China would suddenly be much richer and the US much poorer. The US will lose this fight big time.

China does NOT need nukes to destroy the dollar and the US. The Fed has already gutted the dollar. Also, the Fed/government "easy money" policy has gutted the US economy. If China sneezes they could kill the dollar.

[Higgenbotham]

Section 16 of the Federal Reserve Act specifies, among other things, the types of assets that may be used to back Federal Reserve notes. Before 1999, only discount window loans extended under section 13 of the Federal Reserve Act were available to back Federal Reserve notes. Now, under section 16, loans extended under the authority of section 10B (also sections 10A and 13A) may be used to back the currency. This change was implemented partly to address the potential for large volumes of discount window lending associated with the century date change. But the change is equally important for the consideration of discount window alternatives in this study because—at least under current law—any plan for replacing a significant volume of Treasury securities in the System Open Market Account must identify alternative assets that could be used to back Federal Reserve notes.

http://www.federalreserve.gov/boarddocs ... trmnts.pdf

[Higgenbotham]

We are contemplating situations where they might not be able to keep that peg in effect. Like if there was a long bank holiday or EMP. It is an interesting question.

That's another way of putting it. If the Fed didn't properly discount the MBS to begin with, as we know is likely, then they have issued too many electronic dollars into the reserve accounts. Secondly, the MBS are deteriorating as real estate prices have continued to fall in the past 4-6 months. The Fed is doing some rollover of MBS into treasuries and effectively calling that part of QE2. Now if they want to try to post MBS as collateral for Federal Reserve notes under Section 16, first of all, the way I understand the Federal Reserve Act, I don't think they can do it. But even if they can, then in order to meet the requirements of the Federal Reserve Act, the MBS will have to be heavily discounted and a haircut or writedown in some sense will occur at that point. Effectively what happens then is the banks have now taken a loss on their MBS as 1 electronic dollar gets converted to a fraction of a Federal Reserve note. So the Fed is in a real bind. If they make a conversion under Section 16, they know they may be put in a position where they will need to post more collateral. I think Bernanke is scared now and doesn't want to risk it. Also, Congress has caught onto this and the new Republican Congress will be watching like a hawk. They've already made modifications to Section 13(3) under the reform bill which indicate they are aware that the Fed did not follow proper procedures. My opinion is that the Fed will or is being blocked from doing any MBS conversions under Section 16. As I stated weeks ago, I think things are being set up to reverse this mess and put the banks into receivership.

[vincecate]

Congress easily passes tax cuts and jobless aid, which Obama will sign.
http://www.foxnews.com/politics/2010/12 ... bless-aid/

There is no real reason to think they will cut spending. If people stop lending them money at crazy low interest rates (which seems to be starting) then they will be reduced to borrowing freshly made money from the central bank. Historically this causes hyperinflation.

[vincecate]

Now if they want to try to post MBS as collateral for Federal Reserve notes under Section 16, first of all, the way I understand the Federal Reserve Act, I don't think they can do it. But even if they can, then in order to meet the requirements of the Federal Reserve Act, the MBS will have to be heavily discounted and a haircut or writedown in some sense will occur at that point. Effectively what happens then is the banks have now taken a loss on their MBS as 1 electronic dollar gets converted to a fraction of a Federal Reserve note.

When the Fed got these MBS two years ago they created more dollars then. They should have "marked to market" then and never paid more than they were worth.

Now if they bought the MBS I don't see how they can today make the banks take a haircut.

If the MBS were collateral for a loan, and the banks pay back the loan and get their MBS back, maybe. But I don't think it was done that way.

The other option is to go after the fraud the banks did when they were doing "liers loans" and passing them on as good.

I don't think the Fed will try to say that the electronic dollars that particular banks have are not worth a full paper dollar. This probably breaks legal contracts the Fed has with the banks to treat the electronic dollars the same as paper dollars. Also, it is such arbitrary power that could be used to abuse Chinese or anyone else that doing this would cause a loss of faith in the Fed and the dollar.

Another part of the "real bills" theory of central banks issuing paper money is that they should only ever accept short term debt as collateral, like 3 month or less. The reason is that long term debt can go up and down in value, so might not be worth as much as they paid for it when they needed to use it. Imagine that the Fed buys a 30 year bond when interest rates are 4% and then rates go up to 9%, the bond will be worth only about 48% of what they paid for it. If they then try to buy back the FRNs they issued they can only buy back 48%. The central bank has lost control of the other 52% of the FRNs. So when the Fed bought MBS they broke this "only high quality short term debt" rule big time.

Anyway, I really doubt the Fed can restore their balance sheet given the full situation.