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Friday, January 17, 2014

Yes Virginia there is such a thing as a free lunch…Or at least that is what economists want you to believe

The adage that “there is no such thing as a free lunch” has been a staple in the school of economic thought for, well forever. It seems that were supposed to believe that the laws of the physical universe have been altered by the great omnipotent and omnipresent Federal Reserve (FED). Everywhere you look in the media there is one economist or another pontificating on how the FED’s Quantitative Easing (QE) program has no impact on inflation because it is a “neutral” policy. They point to the fact that the FED’s balance sheet is currently north of $3.8T, yes, "T" for trillion yet; at least by heavily manipulated CPI statistics we have no inflation.

 First, we should point out that inflation is a monetary event and that rising prices are a symptom not a cause. It is no different than patient with diabetes that continually abuses sugar and ends up with foot problems but says the foot is causing the diabetes. The notion of “sterilized” QE is a wonderful invention of the Bernanke FED but the reality is that truly sterilized QE will only work on smaller scales for short periods of time. 

Dear reader, think of when you were a kid at the beach and built a sand castle at low tide. I am sure you labored diligently shaping the castle building a moat and then a wall around it to protect it from the incoming tide. We have all experienced what happens to the castle as the walls can no longer resist the on rushing tide; they become overwhelmed collapse and the castle gets wiped out. Now Imagine QE is that on rushing tide and the banking system and economy are behind that sand wall, at some point it will get overwhelmed. At the moment the vastness and complexity of the US economy along with the fact that the US Dollar is the world’s reserve currency has given us a “bye” if you will, but this will not last forever. Do I know when the QE tide overwhelms the system? As Yogi Berra once said “Predictions are very difficult especially regarding the future”. Is that a cop out? Perhaps. It seems that every mile marker event is taking 5 to 10 miles to get to, or much longer than one can imagine. Rest assured that it will happen.

 But they are tapering you forget! While it is true that the FED for whatever reason decided that they were able to safely cut $120B from the QE program, but they are still monetizing $900B a year. While the mainstream media (MSM) and sell side economists continually cheer-lead every positive data point and downplay reality,eventually reality catches up; remember the years of 2nd half recovery and “Green Shoots”. For example, there was much made over this past quarter’s GDP report clocking in at 4% growth, however, some 2.5% of that figure was inventory growth. Now given the latest UPS report and retailer reports (think Best Buy) are pointing to sluggish sales and given the US economy is 70% consumer driven this does not paint a picture of an expanding economy. Even today the rise in inventories, which is usually a harbinger of recession, is being spun as a positive see the article “US business inventories rise, will support Q4 GDP".

At some point in the not too distant future the economy will slip again and the FED will be forced to tuck their tail between their legs and up QE at least to previous levels, which will probably sacrifice whatever credibility they have left. History is replete with examples of schemes where countries tried to manipulate their way out of a bad economy yet none of them succeeded. The current situation reminds me of the French Assignat period and the reason I believe the FED will have to continue QE is as demonstrated in that period. You see, dear reader, in the late 1700’s the French economy was struggling so they started on a QE program of their own and each time they printed money the economy seemed better, then they would stop and things would revert back until they printed even more money. This money printing went on in greater quantities until things just finally collapsed ushering in Napoleon who promised sound money. 

So today we have a twist on the money printing AKA QE. The idea behind QE is that the Federal Reserve uses freshly printed money and buys bonds from Member Banks (JPM, GS, MS etc..) only then these banks deposit the proceeds (or about 80% of them) as excess reserves to be held on account at the FED. The FED entices this behavior by paying interest on the excess reserves there by allowing the banks to “risklessly” re-liquify their balance sheets and keeping the excess money out of the fractional reserve system, which would stoke inflation and create more potential bubbles. In some respects this idea is quite clever, but it is still monetization regardless. So now the member banks would rather collect interest at the FED than loan to a business that may have some risk associated with it so the bank makes money as the economy is choked off of credit. This situation is a catch 22. In order to get out of the current environment the economy needs to grow and firm which would benefit the banks, instead we have the banks on the FED’s iron lung while the body economy atrophies and shrivels. 

We are told over and over that this QE scheme is not inflationary and is the “ultimate free lunch” but the reality that while the FED has succeeded in lowering rates and keeping them down by crowding out buyers of Treasuries and Mortgage Backed Securities they have in essence become the bond market. Currently they admit to buying $75B a month but we suspect that they are buying much more utilizing various entities (like the exchange stabilization fund etc..) probably on the order of double or even triple the reported figures, of course we will never know as no audits are allowed. The reality is that QE is a direct monetization of US Debt made to appear indirect and while the FED’s dollars go to the member banks the government has to keep selling debt and someone has to keep buying it. This means that while we have seen foreigners pull back from buying our debt someone is stepping up to the plate in a large manner. There is really only one player that would be able or willing to do this and that is the FED itself. The best blatant example of this hypothesis harkens back to June when Zero Hedge questioned who was the buyer of last resort as depicted in this graph. (Click link for full size)
Regardless, of whether the FED is buying the treasuries out right or via an intermediary makes little difference. The fact remains that the FED is pumping money in to the government and that will be ultimately inflationary.

What economists fail to see is that if the FED is buying all or most of the USTs whether directly or via member banks it is directly monetizing. At one point there were reports that the FED was purchasing 80% of treasuries but since 2012 no figures have been available, however, I get reports daily of FED purchases and they run between 20-50% of what is offered on a given day. 

Yes, dear reader, this money is making it in to the economy in the form of government spending, it could be in a defense contract , EBT card, Social Security check, Welfare Check, Government worker salary, the list is virtually endless. So those that argue the money supply is not growing are incorrect, it is and it is being spent driving costs of items like food. Moreover, that money is now in circulation not being drawn back and destroyed as far as we can tell. The reason inflation is not out of control is simply because of the transmission mechanism for this freshly printed money. We have inflation and in some areas strong inflation but since the banks are not in the act the freshly printed money is not being "fractionalized". So instead of the money going thru the fractional reserve system and having a multiplier effect of 9 – 10 times it is passing as is and resulting in much slower velocity. Said another way it takes much longer to overflow a glass filling it only using the drip of a faucet rather than turning the faucet on. 

We don’t believe that the FED will be able to taper long term as there is no fiscal restraint in Washington as every budget deal or debt ceiling raise either puts off any cuts that will be wiped out by a future congress or uses bogus math for justification. For example last year we were told the deficit was ONLY $681B and there was much chest thumping as strutting about like male peacocks but it’s a deception in itself. Instead we prefer to look at the numbers directly from the US Treasury website. Dear Reader, we are sure you can recall the shutdown of 2013 as it was in your face 24 x 7 in the MSM until it concluded on the evening of 10/16/2013. Well the evening of the end the shutdown vote the debt stood at $16,747,478,675,335.10 but the day the government reopened and the debt was tabulated that evening it had jumped to $17,075,590,107,963.50 an increase of $328,111,432,628.40. The true debt for last year was more like $900B if you factor in that the FY ended on 9/30 yet this figure is thru 10/17. The $681B number is derived by only factoring from 9/30/2012 to 9/30/2013 and during the last few months of that period the debt was being altered by extraordinary measures taken by Jack Lew at the US Treasury to avoid running out of money. It was simply amazing that the US could stay consistently $25B under the debt limit while all of this Kabuki Theater was taking place. Worse yet as part of the agreement that reopened the government there is no debt limit in force at until February when Congress votes on it and as a result the debt has gone from the above 10/16 figure to $17,286,874,322,095.90 as of last night or an increase of $539,395,646.760.80. This means that in 100 days since the government has reopened it spent just under $5.4B per day or an annualized rate of $1.97T. Even if one were to give the government a pass and start from the 10/17 figure you have a deficit of 211, 284,214132.40 or 2.1B per day which tallies to $771B annualized. What is not made clear is how much of the debt between 9/30 and the 10/17 jump is a result of FY 2013. Yet we are told about fiscal restraint and budget deals, but the real numbers do not bear this out. There is no way we can grow or tax enough to finance this or even half this pace and why we believe the FED is outright monetizing at a much higher level than we are being told and probably keeping it off balance sheet. 

Is it any wonder that countries like China and Russia are striking trade deals left and right, snapping up every available ounce of gold all while calling for the abandonment of the Dollar system. Countries outside the US have dealt with currency debacles in their recent histories while the US has been fortunate that in generational memory there have been no currency disasters here; so as part of a conditioning very few believe it could happen here. We believe they are wrong just because something has not happened does not mean it cannot happen. For example, by this logic one can acknowledge that a huge meteor destroyed the dinosaurs 65 million years ago but because a huge meteor has not struck the Earth since then it cannot happen. 

The bottom line is we believe that the FED can only taper so long before the addicted patient will need its fix again and that numbers reported by the FED and government are suspect at this point. No one wants the party to end and will do whatever it takes to keep it going even if it means crushing savers and much larger problems down the road as confidence in the US Dollar and by extension the US Treasuries are eroded, which will be a tipping point. No Fiat currency has gone the distance eventually they all end up in trouble and the dust bin of history. In fact Zero Hedge had a great  article featuring the chart below of  of prior reserve currencies since the 1400’s.

 So dear reader, the idea that QE is a free lunch with no repercussions is a true economic fallacy.

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