Currency Wars: The Making of the Next Global Crisis (27 page)

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Authors: James Rickards

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As of April 2011, the Fed had a net worth of approximately $60 billion and assets approaching $3 trillion. If the Fed’s assets declined in value by 2 percent, a fairly small event in volatile markets, the 2 percent decline applied to $3 trillion in assets produces a $60 billion loss—enough to wipe out the Fed’s capital. The Fed would then be insolvent. Could this happen? It has happened already, but the Fed does not report it because it is not required to revalue its assets to market value. This situation will come to a head when it comes time to unwind the Fed’s quantitative easing program by selling bonds. The Fed may ignore mark-to-market losses in the short run, but when it sells the bonds, those losses will have to be shown on the books.
The Federal Reserve is well aware of this problem. In 2008, the Fed sent officials to meet with Congress to discuss the possibility of the Fed propping up its balance sheet by issuing its own bonds as the Treasury does now. In 2009, Janet Yellen, then president of the Federal Reserve Bank of San Francisco, went public with this request in a New York speech. Regarding the power to issue the new Fed Bonds, Yellen said, “I would feel happier having it now” and “It would certainly be a nice thing to have.” Yellen seemed eager to get the program under way, and with good reason. The Fed’s lurch toward insolvency was becoming more apparent by the day as it piled more leverage on its capital base. By getting permission from Congress to issue new Fed bonds, the Federal Reserve could unwind quantitative easing without having to sell the existing bonds on its books. Sales of the new Fed bonds would be substitutes for sales of the old Treasury bonds to reduce the money supply. By this substitution, the losses on the old Treasury bonds would stay hidden.
This bond scam was shot down on Capitol Hill, and once it failed, the Fed needed another solution quickly. It was running out of time before QE would need to be reversed. The solution was a deal arrived at between the Treasury and the Fed that did not require approval from Congress.
The Fed earns huge profits every year on the interest received on Treasury bonds the Fed owns. The Fed customarily pays these profits back to the Treasury. In 2010, the Fed and Treasury agreed that the Fed could suspend the repayments indefinitely. The Fed keeps the cash and the amount the Fed would normally pay to the Treasury is set up as a liability account—basically an IOU. This is unprecedented and is a sign of just how desperate the situation has become.
Now as losses on future bond sales arise, the Fed does not reduce capital, as would normally occur. Instead the Fed increases the amount of the IOU to the Treasury. In effect, the Fed is issuing private IOUs to the Treasury and using the cash to avoid appearing insolvent. As long as the Fed can keep issuing these IOUs, its capital will not be wiped out by losses on its bond positions. On paper the Fed’s capital problem is solved, but in reality the Fed is increasing its leverage and parking its losses at the Treasury. Corporate executives who played these kinds of accounting games would be sent to jail. It should not escape notice that the Treasury is a public institution while the Fed is a private institution owned by banks, so this accounting sham is another example of depriving the taxpayers of funds for the benefit of the banks.
The United States now has a system in which the Treasury runs nonsustainable deficits and sells bonds to keep from going broke. The Fed prints money to buy those bonds and incurs losses by owning them. Then the Treasury takes IOUs back from the Fed to keep the Fed from going broke. It is quite the high-wire act, and amazing to behold. The Treasury and the Fed resemble two drunks leaning on each other so neither one falls down. Today, with its 50-to-1 leverage and investment in volatile intermediate-term securities, the Fed looks more like a poorly run hedge fund than a central bank.
Ed Koch, the popular mayor of New York in the 1980s, was famous for walking around the city and asking passersby, in his distinctive New York accent, “How’m I doin’?” as a way to get feedback on his administration. If the Fed were to ask, “How’m I doin’?” the answer would be that since its formation in 1913 it has failed to maintain price stability, failed as a lender of last resort, failed to maintain full employment, failed as a bank regulator and failed to preserve the integrity of its balance sheet. The Fed’s one notable success has been that, under its custody, the Treasury’s gold hoard has increased in value from about $11 billion at the time of the Nixon Shock in 1971 to over $400 billion today. Of course, this increase in the value of gold is just the flip side of the Fed’s demolition of the dollar. On the whole, it is difficult to think of another government agency that has failed more consistently on more of its key missions than the Fed.
Monetarism
 
Monetarism is an economic theory most closely associated with Milton Friedman, winner of the Nobel Prize in economics in 1976. Its basic tenet is that changes in the money supply are the most important cause of changes in GDP. These GDP changes, when measured in dollars, can be broken into two components: a “real” component, which produces actual gains, and an “inflationary” component, which is illusory. The real plus the inflationary equals the nominal increase, measured in total dollars.
Friedman’s contribution was to show that increasing the money supply in order to increase output would work only up to a certain point; beyond that, any nominal gains would be inflationary and not real. In effect, the Fed could print money to get nominal growth, but there would be a limit to how much real growth could result. Friedman also surmised that the inflationary effects of increasing the money supply might occur with a lag, so that in the short run printing money might increase real GDP but inflation would show up later to offset the initial gains.
Friedman’s idea was encapsulated in an equation known as the quantity theory of money. The variables are M = money supply, V = velocity of money, P = price level and y = real GDP, expressed as:
MV = Py
 
This is stated as: money supply (M) times velocity (V) equals nominal GDP, which can be broken into its components of price changes (P) and real growth (y).
Money supply (M) is controlled by the Fed. The Fed increases money supply by purchasing government bonds with printed money and decreases money supply by selling the bonds for money that then disappears. Velocity (V) is just the measure of how quickly money turns over. If someone spends a dollar and the recipient also spends it, that dollar has a velocity of two because it was spent twice. If instead the dollar is put in the bank, that dollar has a velocity of zero because it was not spent at all. On the other side of the equation, nominal GDP growth has its real component (y) and its inflation component (P).
For decades one of the most important questions to flow from this equation was, is there a natural limit to the amount that the real economy can expand before inflation takes over? Real growth in the economy is limited by the amount of labor and the productivity of that labor. Population grows in the United States at about 1.5 percent per year. Productivity increases vary, but 2 percent to 2.5 percent per year is a reasonable estimate. The combination of people and productivity means that the U.S. economy can grow about 3.5 percent to 4.0 percent per year in real terms. That is the upper limit on the long-term growth of real output, or y in the equation.
A monetarist attempting to fine-tune Fed monetary policy would say that if y can grow at only 4 percent, then an ideal policy would be one in which money supply grows at 4 percent, velocity is constant and the price level is constant. This would be a world of near maximum real growth and near zero inflation.
If increasing the money supply in modest increments were all there was to it, Fed monetary policy would be the easiest job in the world. In fact, Milton Friedman once suggested that a properly programmed computer could adjust the money supply with no need for a Federal Reserve. Start with a good estimate of the natural real growth rate for the economy, dial up the money supply by the same target rate and watch the economy grow without inflation. It might need a little tweaking for timing lags and changes in the growth estimate due to productivity, but it is all fairly simple as long as the velocity of money is constant.
But what if velocity is not constant?
It turns out that money velocity is the great joker in the deck, the factor that no one can control, the variable that cannot be fine-tuned. Velocity is psychological: it all depends on how an individual feels about her economic prospects or about how all consumers in the aggregate feel. Velocity cannot be controlled by the Fed’s printing press or advancements in productivity. It is a behavioral phenomenon, and a powerful one.
Think of the economy as a ten-speed bicycle with money supply as the gears, velocity as the brakes and the bicycle rider as the consumer. By shifting gears up or down, the Fed can help the rider accelerate or climb hills. Yet if the rider puts on the brakes hard enough, the bike slows down no matter what gear the bike is in. If the bike is going too fast and the rider puts on the brakes hard, the bike can skid or crash.
In a nutshell, this is the exact dynamic that has characterized the U.S. economy for over ten years. After peaking at 2.12 in 1997, velocity has been declining precipitously ever since. The drop in velocity accelerated as a result of the Panic of 2008, falling from 1.80 in 2008 to 1.67 in 2009—a 7 percent drop in one year. This is an example of the consumer slamming on the brakes. More recently, in 2010 velocity has leveled off at 1.71. When consumers pay down debt and increase savings instead of spending, velocity drops as does GDP, unless the Fed increases the money supply. So the Fed has been furiously printing money just to maintain nominal GDP in the face of declining velocity.
The Fed has another problem in addition to the behavioral and not easily controlled nature of velocity. The money supply that the Fed controls by printing, called the monetary base, is only a small part of the total money supply, about 20 percent, according to recent data. The other 80 percent is created by banks when they make loans or support other forms of asset creation such as money market funds and commercial paper. While the monetary base increased 242 percent from January 2008 to January 2011, the broader money supply increased only 34 percent. This is because banks are reluctant to make new loans and are struggling with the toxic loans still on their books. Furthermore, consumers and businesses are afraid to borrow from the banks either because they are overleveraged to begin with or because of uncertainties about the economy and doubts about their ability to repay. The transmission mechanism from base money to total money supply has broken down.
The MV = Py equation is critical to an understanding of the dynamic forces at play in the economy. If the money (M) expansion mechanism is broken because banks will not lend and velocity (V) is flat or declining because of consumer fears, then it is difficult to see how the economy (Py) can expand.
This brings us to the crux. The factors that the Fed can control, such as base money, are not working fast enough to revive the economy and decrease unemployment. The factors that the Fed needs to accelerate are bank lending and velocity, which result in more spending and investment. Spending, however, is driven by the psychology of lenders, borrowers and consumers, essentially a behavioral phenomenon. Therefore, to revive the economy, the Fed needs to change mass behavior, which inevitably involves the arts of deception, manipulation and propaganda.
To increase velocity, the Fed must instill in the public either euphoria from the wealth effect or fear of inflation. The idea of the wealth effect is that consumers will spend more freely if they feel more prosperous. The favored route to a wealth effect is an increase in asset values. For this purpose, the Fed’s preferred asset classes are stock prices and home prices, because they are widely known and closely watched. After falling sharply from a peak in mid-2006, home prices stabilized during late 2009 and rose slightly in early 2010 due to the policy intervention of the first-time home buyer’s tax credit. By late 2010, that program was discontinued and home prices began to decline again. By early 2011, home prices nationwide had returned to the levels of mid-2003 and seemed headed for further declines. It appeared there would be no wealth effect from housing this time around.
The Fed did have greater success in propping up the stock market. The Dow Jones Industrial Average increased almost 90 percent from March 2009 through April 2011. The Fed’s zero interest rate policy left investors with few places to go if they wanted returns above zero. Yet the stock rally also failed to produce the desired wealth effects. Some investors made money, but many more stayed away from stocks because they had lost confidence in the market after 2008.
Faced with its inability to generate a wealth effect, the Fed turned to its only other behavioral tool—instilling fear of inflation in consumers. To do this in a way that increased borrowing and velocity, the Fed had to manipulate three things at once: nominal rates, real rates and inflation expectations. The idea was to keep nominal rates low and inflation expectations high. The object was to create negative real rates—the difference between nominal rates minus the expected rate of inflation. For example, if inflation expectations are 4 percent and nominal interest rates are 2 percent, then real interest rates are negative 2 percent. When real rates are negative, borrowing becomes attractive and both spending and investment grow. According to the monetarists’ formula, this potent combination of more borrowing, which expands the money supply, and more spending, which increases velocity, would grow the economy. This policy of negative real rates and fear of inflation was the Fed’s last, best hope to generate a self-sustaining recovery.

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