ICangles Investment Post…
Major central banks of the world have set in motion a chain of events likely to result in their own decline and the eventual demise of fiat money. Of late there has been growing concerns about the risk of bankruptcy to central banks, due to the trillions of dollars in debt instruments being carried on the balance sheets of the Federal Reserve, European Central Bank, Bank of Japan and Bank of England. Recently the chairman of the Federal Reserve for the United States had to answer a growing number of questions about how he could exit these immense positions, which are poised to grow beyond four trillion dollars on the Fed’s balance sheet alone. Ben Bernanke’s responses should give no one comfort. Yet focusing on the risk of bankruptcy to central banks, actually ignores the real risks around the demise of the world’s fiat money system. Nor are market observers appreciating how the current central banking conundrum is likely to eventually give rise to a return to hard money.
The Central Bankers’ Road to Ruin
The major central banks around the world are engaged in one of the boldest experiments in monetary policy history. Although their so-called quantitative easing policies are very similar, for the purposes of this post I will focus on the Federal Reserve of the United States. Traditional tools the Fed uses to manage the economy include setting interest rates that banks can borrow money from the Fed at and dictating reserve requirements, or how much money banks are allowed to lend out of the total amount they hold. These tools allow the Fed to influence how much money enters the economy, thereby encouraging or discouraging lending and economic growth. Yet, the current economic environment after the housing bubble burst has been characterized by nominal interest rates near zero and banks inclined to hold onto reserves rather than lend them out. This liquidity trap renders the Fed’s typical tools largely ineffective.
Having dug itself into this proverbial hole by injecting too much money into the economy and creating the dotcom and real estate bubbles in the first place, a common sense approach might have been at this point to stop digging. The Fed’s response instead was to abandon the shovel for an industrial strength excavator, and embrace what they have called quantitative easing and others have called printing money. The Fed began purchasing U.S. government debt and expanded its purchasing program from short-term maturities to longer-term ones, as well as mortgage debt obligations. Today, it owns over three trillion dollars of such debt instruments over a wide range of maturities from thirty days to thirty years.
The economic effects of quantitative easing on economic growth are debatable, but other impacts are not. The Fed has increased the money supply by trillions of dollars, although when banks don’t lend, much of that money doesn’t enter the economy. Interest rates have also been artificially suppressed and the Fed has become the biggest buyer of government debt, allowing the federal government to borrow and spend more money than might otherwise be the case. So, there certainly has been more money entering the economy via government spending, although at present interest rates there is also less of an incentive for investors to lend money. Lastly, the balance sheet of the Fed has been substantially leveraged with both its assets and liability columns growing to levels previously unimaginable. If the value of the bonds the Fed holds in its asset column were to decrease below what the central bank paid for them in its liability column the Fed could face insolvency.
The Central Banking Conundrum
The risk to the Fed is inflation, and it is a risk the Fed has itself created by expanding the money supply by trillions of dollars through quantitative easing. Interest rates could rise if investors start pushing that money into the economy, thereby lowering the value of money as more of it becomes available. Investors could also begin demanding higher interest rates to compensate for risks, such as default risk, or the Fed by its own actions could drive rates higher by no longer suppressing rates, when it eventually stops aggressively buying government debt to force rates down. Such a scenario could make it much more difficult for governments to service their immense debts. Since money is global, default risks, such as around Japan’s mountain of debt, or even the end of China’s property bubble, which is soaking up excess liquidity, should also be perceived as potential monetary dangers. Lastly, an exogenous supply shock, such as experienced with the Arab oil embargoes in the latter twentieth century, also poses risk. However a rise in rates were to happen, the value of the Fed’s bond portfolio would slip below what was paid. At that point on a mark-to-market basis (valuing those bonds at their present market value) the Fed would be insolvent.
Should the risk of the Fed going broke on a mark-to-market basis worry us? According to the Fed it should not. In recent testimony about how the Fed could exit its quantitative easing program and unwind its debt positions, without throwing the economy into chaos and the Fed into insolvency, Bernanke had a simple response. The Fed might simply hold onto its trillions of dollars in bonds until maturity and value them not at market value, but at what was originally paid for them. In this way the Fed would not technically go broke and all those trillions of dollars would be gradually withdrawn from the economy. Under this fairytale scenario the federal government would pay the Fed the money owed for each bond, and then either stop borrowing money or find new investors willing to lend it money at an interest rate affordable to the government. Some have even suggested an even better fairytale, where the debt is monetized, or the Fed simply forgives the federal government’s debt and avoids insolvency through a different accounting gimmick.
Such fairytales assume moderate to low inflation, where the Fed is so brilliant that it has bought just the right amount of bonds, as to withdraw them at maturity to shrink the money supply, but withdraw them at just enough lower value to grow the supply at the right amount to support sustainable economic growth. Such an expectation for muted inflation might even seem a fair assumption nowadays, since it characterizes the current environment and seems likely to continue for a while longer. But when I look at all this leveraged debt on the balance sheet of the Fed, I am reminded of my business partner’s words that all market bubbles are characterized by leverage, while I am also reminded of Keynes’ famous saying, “markets can remain irrational longer than you can remain solvent.” Although I’m not willing to bet on rising interest rates now, no matter how irrational I might think the current rate environment, I am willing to bet rates will rise significantly at some point in our future. And the real risk to the global monetary system is if inflation and interest rates rise faster than expected.
Although the Fed has set forth what it may do, when everything goes exactly to plan, i.e. allow its bond portfolio to mature over time. The Fed is short on answers as to what it can do if inflation rears its ugly head and threatens the economy, with rising rates and a decline in the real value of money. At that point debating whether the Fed is bankrupt won’t be the issue. Neither will debating whether the Fed monetized government debt or if the Fed printed all the excess money helping to drive inflation, although I would argue that if the Fed is unable to withdraw money from the economy at its real value then yes the Fed did print money. What will be the issue is: how can the Fed lower inflation, reduce the money supply and withdraw some of the trillions of dollars previously injected before this money adds to inflationary pressures?
The conundrum the Fed will face is how to get rid of the trillions it injected into the economy via quantitative easing, when the bonds it holds are worth less than paid. It’s the classic problem leveraged investors face when an asset bubble implodes. Leveraged exposure to real estate threatened the banking sector in the last recession. In the next cycle, leveraged exposure to mostly government debt may be what threatens central bankers and their ability to manage the global monetary system. In such a scenario if the Fed just sits on the sidelines and doesn’t sell bonds for less than it bought them it may not technically go broke, but it won’t do anything to reduce the money supply. If it does sell bonds for less than purchased, as rising interest rates reduce their value, it will not be able to reduce the money supply by the amount grown through its original bond purchases. In addition such sales would create serious problems for the federal government now having to compete with the Fed to find buyers of its debt. And for obvious reasons the possibility of the federal government recapitalizing the Fed is ludicrous on its face.
The Hard Money Answer to the Gordian Knot
So, what can the Fed due to solve this conundrum of withdrawing money from the economy to counter inflation, when the value of the securities it owns are now less than the amount it needs to withdraw? Likely, the Fed will try to leverage whatever credibility it has left to assure market participants everything is under control and not to drive interest rates higher. The smart money will likely use that period to head for the exit doors. Because this isn’t just a problem of the Fed, but all of the major central banks there will also be talk of coordinated actions and great attention paid to every scheme envisioned. The current generation of central bankers have also shown themselves to be very creative if not wise in their use of available policy tools. We can for instance expect some creative uses of reserve requirements. If history is a guide we have seen in Nixon a Republican President embrace price controls and a Democratic administration during the Great Depression confiscate gold holdings of private citizens. Recently in the Eurozone consideration was given to seizing portions of private banking accounts in Cypress. So, there is a potential for some volatility to say the least.
Of course this isn’t a problem just for the Fed. Other major central banks have also created commensurate amounts of excess liquidity and will likely compound future problems. There is also the potential for the United States to feel disadvantages from being the world’s reserve currency. For example China would need to sell assets on its central bank’s balance sheet, like U.S. Treasury securities, convert those sales into its own currency and then erase that currency from existence (decreasing its balance sheet liability), in order to decrease its own money supply. Like the Fed, all central banks, whether selling Treasuries or other debt instruments, would face the problem of how to do so without depressing the price in the process. Such a scenario would not be easy for anyone to navigate. Commodities could face downward price pressure from any decline in economic activity, especially if Chinese activity declines. Those who think gold is a safe haven should be leery of its price buildup and the potential for in times of distress investors and central banks to sell an item in gold likely to still have good liquidity.
Reviewing the sweep of monetary history, an end to the current monetary system and the beginning of a new one is exactly what we should expect. The last two secular bear markets saw the demise of previous systems and sowed the seeds for the birth of new ones. In 1933 Franklin Roosevelt took the United States off a true gold standard, during the Great Depression, and at the early stages of the subsequent secular bull market in 1946, a new hybrid monetary system around the Bretton Woods Conference came into being where foreign governments could sell U.S. dollars to the Treasury for a fixed amount of gold. During the next secular bear market President Nixon ended such gold transactions, and in an informal arrangement named Bretton Woods II, which came into existence in the ninety eighties at the start of the following secular bull market, the world embraced the current fiat money system, where central bankers issue paper money to whatever degree they believed prudent.
In the cycle of market history the next logical move after going from hard money, backed by gold, to a hybrid system and today a fiat money system, would be a return to hard money. It would also be a simple answer to the conundrum central bankers face if there credibility has largely been destroyed after years of turbulence. It is said that when Alexander the Great was faced with the question of how to untie the Gordian Knot, which was so hopelessly intertwined together that no one could untie it, he simply cut it in half with his sword. Rather than giving up their power and freedom of action, central bankers will certainly first try every means imaginable to untie the knot they have created and restore the current fiat money system whole. However, if inflation rears its head this particular knot won’t be unraveled. On the other hand, if the current system, which asks investors to put their faith in the prudence of central bankers, was eschewed for one where hard money stands for something, inflation could be contained and faith in the global monetary system restored. If a cycle of inflation gets going this might eventually be the best option for the Fed and one that may becomes increasingly popular.
Embracing hard money would in some ways be a simple solution to the central banker balance sheet conundrum akin to Alexander cutting the Gordian Knot in half. But assuming this is the future there are still important questions to ponder. Keeping in mind that the period from the fall of previous monetary systems and embracement of new ones unfolded over years, while a new secular bull market began before a new monetary system was embraced, what kind of transition period might we be looking at? Will the worries over the implosion of the current monetary system help create a once-in-a-lifetime contrarian stock market buying opportunity? What kind of hard money system might we embrace? Will there be a return to some form of a gold standard or a commodity basket? Will there be an international arrangement, as the major economic powers, facing the same dilemma, try to forge a shared solution? Or will there be a private solution, and as people lose faith in government money will the Internet help enable a return to money issued by non-governmental entities?
The End isn’t Nigh
Central bankers using tremendous leverage to purchase trillions in dollars of debt instruments will likely lead to their own decline and the demise of fiat money. Although too many see such a scenario as heralding an economic Apocalypse, looking back on market history would suggest this to be a natural, albeit volatile, characteristic of the transition from a secular bear to a secular bull market. It is unlikely the developed world will follow Zimbabwe down the path of hyperinflation and economic ruin. Unfortunately, it is also unlikely that this time the Fed will turn out to be prescient and successful in its attempts to manage the economy. Simply put, based on our current predicament, as well as market history, transitioning into a new monetary system after years of instability is the most likely eventual outcome.
When analyzing systemic risk to the current monetary system it is easy to understate the strength of the current system, overestimate the destabilizing risks and misgauge the time periods involved. A key point here is that central banks around the world have put themselves in a poor position to be able to manage inflation. But this should not be mistaken for a prediction that the end of the current monetary system is imminent. One possible scenario is that the end of quantitative easing by central banks could help trigger a new downturn, as well as higher borrowing rates, forcing more austerity on governments. Resulting instability could raise the risk of exogenous supply shocks. However, the real risk to the monetary system might be the start of a secular bull market with stronger economic growth and a rising velocity of money. As was the case previously in history it could be several years down the road after the actual end of a secular bear market when pressures for change on the monetary system finally become irresistible.
In all likelihood the world is facing significant volatility over many years. Although embracement of a system where all money is directly backed by gold is ludicrous, it would not surprise me at all to eventually see a system of linking the supply of the major currencies to a commodity basket for instance. Yet, to get there from here is likely to unfold over years and give plenty of opportunity for re-evaluation. The more important investment question revolves around the risks posed by any change in monetary conditions causing a downturn and a bear market. In my view those risks are significant. Yet, there is also a good chance such a downturn might see the start of another secular bull market amidst an unstable monetary environment, as has happened previously in history. Therefore, rather than listening to Ben Bernanke’s assurances everything will work out according to plan, I would put more credence in that famous line uttered by Bette Davis. “Fasten your seatbelts. It’s going to be a bumpy ride.”