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March 2013

The Fed’s Exit

Lee Quaintance & Paul Brodsky



The markets have begun to wonder whether the Fed (and other central banks) will ever be able to exit from its Quantitative Easing policy. We believe there is only one reasonable exit the Fed can take. Rather than sell its portfolio of bonds or allow them to mature naturally, we believe the Fed’s only practical exit will be to increase the size of all other balance sheets in relation to its own.


This “exit” will be part of a larger three-part strategy for resetting the over-leveraged global economy, already underway. The first stage is policy-administered monetary inflationQE in which the Fed is de-leveraging bank balance sheets by adding bank reserves. The second phase will be policy-induced price inflation hyper-inflating the general price level enough to diminish the burden of debt repayment and gain public support for monetary system change. (Imagine today the Fed proclaims all one dollar bills are ten dollar bills. Goods and service prices would increase 10x, more or less, as would wages, asset prices, revenues, costs, etc. The only item on the balance sheet that would not increase 10x would be the notional amount of systemic debt owed.) We believe the third phase of the strategy will be a monetary reset that recaptures popular confidence following the hyper-inflation.


Below, we list a progression of facts and reason supporting these conclusions:


As the Fed monetizes Treasury debt (or, as it claims, temporarily adds Treasuries and MBS to its balance sheet prior to selling them or letting them mature sometime in the future, thereby draining reserves), the obligations of the US Treasury (i.e., obligations of US taxpayers) to the US banking system are increasing dollar for dollar.


The US banking system is: 1) the largest American creditor to the Treasury; 2) the largest warehouse of US taxpayer wealth (via deposits); 3) the largest (infinitely capitalized) intermediary for public US capital markets, and; 4) the monopoly issuer of US dollars and USD-denominated credit. In short, the US banking system is the issuer of the world’s reserve currency and supports conditions to maintain USD hegemony.


Thus, it seems reasonable to assume that the interests of maintaining a healthy US banking system rise above or are at least equal to the economic interests of Americans, and to a large extent their government.


Significantly higher US interest rates would implicitly harm the Fed’s balance sheet (which is not marked to market) and explicitly harm the loan books (assets) of private bank balance sheets (marked to market), potentially placing bank capital ratios in jeopardy and undermining confidence. (While significantly higher interest rates would ostensibly increase the value of adjustable rate bank loans not near their cap levels, they would also decrease the creditworthiness of borrowers’ loan collateral values, lowering lending activity.)


The Fed’s balance sheet is infinite and the Fed creates the currency with which its balance sheet may grow. The Fed will always have more money at its disposal with which to buy bonds and set benchmark interest rates than the quantity of bonds for sale, sine qua non.


Thus, it seems reasonable to assume that there will not be a sudden rise in US market interest rates unless the Fed wants such a rise. Nominal economic growth or even price inflation will not
necessarily act as a trigger for higher Treasury yields (but it may be reasonable to fear higher
yields within tertiary bond markets in which the Fed/banks do not have significant exposure).


The relevant issue for Treasury investors is not the risk of capital loss from bond price
depreciation, but rather the risk of capital loss in real termsnegative real returns as coupon
interest and principal repayment do not keep pace with price inflation (i.e., the loss of future purchasing power of Treasury P&I vis-à-vis consumer goods, services and equity assets).


The mix of economic growth (leading to higher tax receipts) and/or government austerity
needed to reverse ongoing debt growth over time is mathematically impossible to achieve
within the context of a stable social environment. The US public sector and US households are in
a compounding debt trap in which there is no exit. Thus, debt is growing and being shifted
presently, not being extinguished, and this portends the likeliest future path.


Real output growth from current debt/leverage levels cannot be generated from a coincident
increase in more systemic credit/debt. So, the policy solution cannot be issuing new credit and transferring debt with the goal of generating increasing demand and nominal output growth.
(And we further argue that wealth concentration that results directly from asset price inflation is a very relevant and direct constraint on real economic growth.)


The US economy (and all indebted advanced economies) is shrinking in real terms presently and
fiscal measures are incapable of providing a sustainable remedy. This is precisely the catalyst
forcing today’s aggressive monetary policy action.


The only solution is true systemic de-leveraging (banks, households and governments). Banks are already in the process of being de-levered through QE in the form of bank reserve creation.


There are only two ways to de-lever balance sheets: 1) letting debt deteriorate naturally, which
would cause a 1930s style deflationary depression, and/or; 2) creating new base money in the
form of bank reserves (first) and circulated currency (second). Both reduce leverage ratios
(unreserved credit-to-money available with which to repay systemic debts).


The only two ways for the US government to de-lever without creating a deflationary depression
would be: 1) Treasury sells assets (e.g. land, resources, shipping lanes etc.) and uses the
proceeds for debt repayment, and/or 2) Treasury has the Fed devalue (inflate) the US dollar
against a monetary asset on its balance sheet. The former would threaten US sovereignty and
the latter would threaten the purchasing power of US dollars (i.e., the perceived current savings of US dollar holders).


To gain US public and geopolitical support for policy-administered deleveraging through
devaluation and a fundamental shift in the world’s monetary system, confidence in the current
regime would have to be lost. The most effective tool for achieving this broadly would be price
inflation.


Over the last forty years, the rate of price inflation has been about 2% per year (about a 125%
compounded growth rate), which has diminished the purchasing power of the USD by about 55%. In other words, one dollar in 1972 is worth about forty-six cents today.


Policy-administered US dollar devaluation would apply the same principle, but the inflation would occur suddenly and, discretely. Following a hyper-inflationary episode, the public would be conditioned for another resetting of the global monetary system (its fifth in one hundred years).


Central banks, led by the Fed, would have to re-price and monetize an equity asset rather than debt assets. The only monetize-able equity asset on official balance sheets is gold (which may explain why central banks of emerging economies are voracious buyers presently).


Re-monetizing gold would be popular within indebted advanced economies and therefore politically expedient. While net savers of US dollars would be harmed from the devaluation, net debtors would be helped. (The burden of repaying existing debts would be greatly diminished vis-à-vis inflated wages and asset prices.) Thus, those holding cash and bonds would suffer and those with mortgage, school, auto, and consumer debt would benefit. On balance, a policy-administered USD devaluation would be greatly welcomed within advanced economies. It would position politicians and central banks as economic saviors.


For the first time in memory all global currencies are baseless, including the lone reserve currency, and there is no other scarce currency that provides an alternative for global savers seeking a better store of future purchasing power. This implies that the Fed, with or without the encouragement of the BIS Global Economic Committee of thirty global central bankers, may unilaterally and effectively expedite a global currency devaluation. A policy-administered USD devaluation would force all other fiat currencies to respond in kind or to adopt the US dollar as its currency (maintaining USD hegemony).


The global system would revert to the gold/dollar exchange standard used between 1945 and 1971 (i.e., Bretton Woods). Currency devaluation against precious metals has long precedent (including the USD in 1933).


As we have discussed in the past, the mechanics for currency devaluation are straightforward and would be simple to exercise.1


Global banks, having already been de-levered and finding the quality of their loan books to be pristine following the devaluation, would be eager to lend again. (The fractional reserve banking system would not be altered.) The devaluation would be economically stimulative.


In our view, public arguments by Fed members and observers of future balance sheet reduction using normal asset sales or amortization seem specious. The most visible, politically expedient and most likely path seems to be the path usually taken: inflation. In the case of the Fed and other central banks, we assert the magnitude of the systemic leverage problem will be met with equal inflationary force.



1 From “Locked & LoadedFebruary 2013: “Today, the Federal Reserve System announces a program of gold monetization in which the Fed offers to tender for any and all gold in qualifying forms at a price of US $20,000 per troy ounce. The program will be conducted through participating U.S. chartered banks, which will be instructed to properly assay gold and exchange it for U.S. dollars to be placed in customer bank accounts as deposits. Deposit holders will be entitled to make withdrawals in the form of dollars or gold at the fixed exchange rate.


By establishing the fixed exchange rate substantially above past market prices for spot gold, the Board of Governors believes enough gold will be tendered to produce a supply of new base money sufficient to adequately reserve the stock of U.S. dollar-denominated deposits in the global banking system. The Fed will monitor the tender process to ensure the soundness of the exchange rate and the ongoing viability of the US dollar.”




March 13, 2013 6:51 pm
 
Beware monetary experimentation
 
 
 
 
Suffering from persistently weak economies, governments and central banks are experimenting with ever more aggressive – some say dangerousmonetary treatments. Countries are being enrolled, like it or not, in the economic equivalent of clinical trials.


Before embarking on a new course of treatment, the doctors ought to inspect the patients in the wards next door. I found myself last month visiting two countries following diametrically opposite courses of treatment: Portugal, perhaps the least demonstrative sufferer on the eurozone periphery; and Argentina, which has long injected economic drugs not registered elsewhere. Both are instructive – and discouraging.


Portugal belongs to a strong currency bloc – its money functions as a real store of value, and convertibility is not in question. But the place is stony broke, and these advantages, so dear in the abstract to business people, have little appeal to residents with no money at all. The new roads built with EU funds are deserted, since they carry a toll; traffic has been displaced on to the roads they were designed to relieve. People prefer double-parking their ageing cars in the narrow streets to paying a euro or two at the shiny new car park. The receptionist in the empty hotel arrives, after a long wait, to serve you a drink in the bar; he later turns up as a waiter in the restaurant. Though they have the gentlest manners in Europe, the Portuguese have begun to express their frustration in a frank and vivid style of graffiti. Everything is on sale and no one is buying.


So poor Patient Fado, placed on an austerity-plus regime, is semi-comatose. The state spends as little as it can, and tries to extract ever more from its citizens, who seem to spend most of their time working out how to avoid paying. Fado’s ratios of indebtedness remain stubbornly high but the expensive foreign doctors believe a higher dose of the present medicine will, in the end, prove to be the right answer.


In Argentina, by contrast, the currency is on a managed slide. There is plenty of it, though, and since it is fast losing its internal value – the government says inflation is at roughly 10 per cent a year; everyone else tells you it is more than 25 per centpeople are in a hurry to spend it. It is rather like Britain in the 1970s: you can buy air tickets and holiday packages in your own currency at the official exchange rate but you have no foreign currency to use once you arrive abroad. There are no new money flows coming into the country (though companies reinvest the profits they make there), Argentina has few external assets earning foreign currency, and it has no access to the credit markets, following a default still fuelling lawsuits 10 years later.


So minor fluctuations in the trade account, which the government is obliged to micromanage, are all-determining. Banks are required to lend a substantial proportion of their deposit base at 15 per cent for “productive investment”: no pussy-footing about with persuasion here.


Patient Tango receives repeated stimulation. She is economically hyperactive, rushing to get her constantly increasing wages in the hospital shop (she is rarely allowed to go out). Her doctors say her ratios are wonderfully improved since her debt restructuring. Rather like Britain’s Patient Morrisnow in a seedy hospital after a spell in the casualty department – she had been living way beyond her means.


In the eurozone, Fado has been forced to stop and seems barely to be living at all. Tango has tried a different response, deciding those to whom she owes money are vultures, and it would be outrageous to pay them back, which has done wonders for her debt-to-gross domestic product number. They, in turn, do not seem that keen to pay for her treatment.


Morris has been for many years a patient under Dr King, an old-fashioned GP who used to tell him he was in fair health while warning him not to eat and drink so much. Now, after his heart attack, Dr King says he had been urging him to lose weight for years. Dr King is retiring and Dr Carney, new to the practice, is considering electroconvulsive therapy. He believes patients feel better if they are told they will be flat on their back for a long time. From time to time the saturnine registrar, a Mr Osborne, drops in and discusses amputation.


Dear old Morris was put on a version of Fado’s regime, but with a much lower dose. Unlike Fado, he is not in a near-comatose state but he is not getting much stronger either. The temptation to switch to something more like Tango therapy, though without the un-British excess of default, is clearly growing.


In Portugal, the quantity and velocity of money in circulation are both down; in Argentina, both are rising rapidly. Neither presents an attractive example. In Britain the Bank of England has prevented the quantity from falling too far, but seems unable to get the money moving. A little well-targeted fiscal relaxation feels less risky at this stage than more monetary experimentation. Doctors are enjoined, above all, to do no harm.


The writer is a former chief executive of Barclays

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Copyright The Financial Times Limited 2013.


Commodities on the Rise

Dambisa Moyo

13 March 2013

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SEOULThe commodity super-cycle – in which commodity prices reach ever-higher highs, and fall only to higher lows – is not over. Despite the euphoria around shale gas – indeed, despite weak global growthcommodity prices have risen by as much as 150% in the aftermath of the financial crisis. In the medium term, this trend will continue to pose an inflation risk and undermine living standards worldwide.
 
 
For starters, there is the convergence argument. As China grows, its increasing size, wealth, and urbanization will continue to stoke demand for energy, grains, minerals, and other resources.

 
For example, the US consumes more than nine times as much oil as China on a per capita basis. As more of China’s population converges to Western standards of consumption, demand for commodities – and thus their prices – will remain on an upward trajectory.
 
 
Of course, not all commodities are equal. For example, although the case for copper seems straightforward, given that it is a key input for wiring, electronics, and indoor plumbing, a strong bid for iron is not as obvious, given the Chinese infrastructure boom that already has occurred in the last two decades.
 
 
Worst-case estimates have China’s real GDP growing at around 7% per year over the next decade. Meanwhile, the supply of most commodities is forecast to grow by no more than 2% annually in real terms. All else being equal, unless China’s commodity intensity, defined as the amount of a commodity consumed to generate a unit of output, falls dramatically, its demand for commodities will be greater this year than it was last year.
 
 
As long as China’s commodity demand grows at a higher rate than global supply, prices will rise. And the rapid economic growth that China’s leaders must sustain in order to lift enormous numbers of people out of poverty – and thus prevent a crisis of legitimacy places a floor under global food, energy, and mineral prices.
 
 
To be sure, intensity of use has fallen for some commodities, like gold and nuclear energy; but for others, such as aluminum and coal, it has risen since 2000 or, as is the case for copper and oil, declines have slowed markedly or stalled at high levels. As the composition of China’s economy continues to shift from investment to consumption, demand for commodity-intensive consumer durables cars, mobile phones, indoor plumbing, computers, and televisions – will rise.
 
 
There is also the issue of the so-called reserve price (the highest price a buyer is willing to pay for a good or service). The reserve price places a cap on how high commodity prices will go, as it is the price at which demand destruction occurs (consumers are no longer willing or able to purchase the good or service).
 
 
For many commodities, such as oil, the reserve price is higher in emerging countries than in developed economies. One explanation for the difference is accelerating wage growth across developing regions, which is raising commodity demand, whereas stagnating wages in developed markets are causing the reserve price to decline. By implication, if nothing else, global energy, food, and mineral prices will continue to be buoyed by seemingly insatiable emerging-market demand, which commands much higher reserve prices.
 
 
Ultimately, emerging economies’ absolute size and rate of growth both matter in charting commodity demand and the future trajectory of global commodity prices, with per capita income clearly linked to consumers’ wealth. If people feel rich and enjoy growing wages and appreciating assets, they are less inclined to cannibalize other spending when commodity consumption becomes more expensive. They just pay more and carry on.
 
 
Of course, upward pressure on commodity prices also stems from supply-side challenges. It is not just that global supplies of resources are increasingly scarce, but also that supplies are increasingly falling into inefficient hands.
 
 
Around the world, governments are taking greater control of resources and imposing policies that hamper global production and ultimately force prices higher. (Following the recent fracas surrounding Argentina’s nationalization of Yacimientos Petrolíferos Fiscales (YPF), Australia’s 2012 mining tax on iron and coal companies is a stark reminder that such tendencies are not limited to emerging-market politicians.)
 
 
Such price increases can prove particularly inflationary in countries that import commodities. And they can be disastrous to exporting economies, which risk rapid currency appreciation and thus a loss of competitiveness.
 
 
Of course, technological advances, like hydraulic fracturing (“fracking”) in the shale-gas industry, could increase supply and therefore lower prices. But mounting environmental challenges, and the limited availability of commodity substitutes, suggest that a reprieve on commodity prices is not near.
 
 
There is a perennial temptation to focus on – even to overemphasize – the short-term, tactical drivers of commodity-price movements, at the expense of giving longer-term, structural factors their due.
 
 
While short-term factors – for example, political instability, weather-related disruptions, and speculative activity – are important determinants of prices, they tell only part of the story.
 
 
The economic fundamentals of supply and demand remain the key factors in driving the direction of commodity prices and determining whether the commodity super-cycle will persist. In practical terms, this means that oil prices, for example, are more likely to hover near $120 per barrel over the next decade, rather than $50; and we are unlikely to see a $20 barrel of oil ever again.
 
 
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Dambisa Moyo is the author, most recently, of Winner Take All: China’s Race for Resources and What it Means for the World.    .

Copyright Project Syndicate - www.project-syndicate.org