"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Tuesday, November 30, 2010

Fiat Evolution Part III

In Part I, I discussed the emerging US Fiat Model, and in Part II, I described the emerging EU Fiat Model.  But as the current Euro crisis plays out, we may see the EU following in the footsteps of Ben Bernanke - that process is unfolding right now.  The overall theme of this series of posts is that we have entered a new era.  An era of fiction, an era of success without failure, of backstops and bandages.  It is an era of suspended disbelief; of delaying a cruel and unavoidable reckoning of reality.

Things will look as they always have.  Most people will sense something is amiss, but will never fully appreciate the sea change that is occurring.  Policymakers will temporarily succeed in creating an atmosphere of business as usual; that things are OK and we'll get through it.  They will temporarily succeed, but long term, their failure is certain.

The Sovereign Bond Markets are Dead; Long Live the Sovereign Bond Markets!

Historically, sovereign bond markets have been a source of funding for government activities.  This remains true for the individual EU member states, but not for the US Federal Government.  Unlike the EU member states, the US issues its own free floating currency and denominates its debt in its own currency.  So if the US needs money, it prints it, or in modern times, a keyboard stroke credits an account.

But the US maintains a bond market to control the amount of money and influence the cost of money in the global financial system.  By having the world reserve currency, the US must continually create money to keep up with the growing world economy.  This has been described as the "exorbitant privilege," that is, to a degree, the US can export its inflation and get a free lunch in the process.  Other countries can not do this.

The Primary Dealers which are the Commercial Banks (which ares also shareholders in the Federal Reserve System) always make sure that US Government debt is purchased.  They pick up any slack, so to speak.  Thus, and I want to make this clear, there will never be a failed US Government auction!  So not only does the debt not finance US Government spending, but the system is created so that the debt is always sold.  Always.

As I mentioned in Part I of this series, QE2 is really a replacement of a normal, healthy, functioning private banking sector and a normal, healthy, functioning sovereign bond market.  The US never really relied on foreign bondholders such as China to finance it's debt. (See my post Part I)  Furthermore, the interest the Federal Reserve now accumulates from Treasury purchases is mostly returned to the government.  The US government is essentially receiving an interest free "loan."  This is turn affects all interest rates, so in a way, yes there is a free lunch.  But that too will end. I will explain below.

The EU, on the other hand, is in shackles.  Each country needs to go to the sovereign bond market as a begger.  And if the sovereign bond market doesn't like the way the government is managing its budget, the interest rates soar.  And so, we have seen Greece and Ireland backstopped by the IMF, EU, and ECB.  There will be more.  Portugal is likely next, and Spain isn't too far behind.

Thus, the Sovereign Bond Market in the Western World at least, is dead, but it is also still "functioning."  It is a walking zombie, or a comatose patient on life support.  It is dead in the US because without the Federal Reserve buying up Treasuries from the Primary Dealers, there would be a failed auction.  The Federal Reserve is now the largest holder of US debt.  Fiat money in the US has now evolved into a complete fiction.  The housing industry, and soon to be state budgets, will all be supported by a fictional monetary system controlled by the Fed.  Price discovery?  Please....  There is no such thing.  Jim Rickards recently addressed this:

The Sovereign Bond Market is just about dead in the EU, because without the IMF, EU, and ECB, there would be a flood of government insolvencies and European-wide Banking collapses.  The ECB has been actively trying to keep rates low by buying up government debt by, you guessed it, creating money out of thin air.

And so, Sovereign Bond Markets are a fiction.  They are on artificial life support and will remain so until the system collapses.  And no one is admitting this!!!  Here's an example of a typical politician/economist's rhetoric :  Greek Finance Minister George Papconstantinou recently said that the extension of the repayment period of IMF/EU loan funding would allow Greece to go to the international markets for funding next year.  What is he smoking?!!!  Greece's debt to GDP percentage will be much WORSE next year.  Does he believe that Greece will get an interest rate below 9%?  And I'm being optimistic with the 9% figure.

If your GDP grows less than the interest on your debt, you are INSOLVENT, or soon to be.  Think about it.  If your debt is growing at 6% (if you're lucky), but your GDP is growing at 2% (if your're lucky) how do you think that story will end?  Do these economists own calculators?  Do they understand the laws of mathematics?  But this isn't a Greek thing, it affects Ireland, Portugal, and soon Spain, and maybe even France.

The US and Modern Monetary Theory - Avoiding the Laws of Thermodynamics

There are many out there that smugly preach that the US will never have a failed auction, and thus, things are just peachy. Many describe themselves as Modern Monetary Theorists (MMT'ers) They have a right to be smug because they are some of the few people that understand how the US system actually works. Most others are clueless. Many have been right about this crisis, but for the wrong reasons.

But what the MMT'ers ignore are the geopolitical consequences of basing your monetary system on a "free lunch" paradigm. They also ignore the convenient fact that the US has the world's reserve currency - for now. I mention this because MMT'ers think in a sterile, economic environment. By ignoring the geopolitical consequences of such a monetary system, they ignore the ultimate end game. That's why I like to focus this blog on the " interwoven fields of geopolitics, economics, and monetary theory" as I write in the intro to my blog. Because that's how the real world works.

So what do I mean by the geopolitical constraints of a monetary system? Well, let's forget how money is created for a moment. Let's look at why we have money. Money is used to allocate the world's resources - who gets what and why. Money is used to build armies and fight wars. Money is used to control others. So the more money you can create, the more you can consume and control, compared to others.

Guess what? China and Russia know about the US's dirty little secret. They understand that having the world's reserve currency gives the US an economic advantage over them. They also understand that QE2 is the next phase of the evolution of Fiat Money that gives the US the ability to continue business as usual despite skyrocketing budget deficits and a national debt that will never be manageable.

And what is China and Russia doing about it? They are increasingly ignoring the US dollar. They are entering into non-dollar denominated bilateral agreements. They are openly challenging US economic hegemony. They are calling for the end of the US economic free ride. I write about this in more detail in my post: The Next Largest Nuclear Powers, China and Russia, Openly Challenge US Economic Supremacy.

Thus, the US debt-based paper dollar will likely meet its end through geopolitics, not a failed government auction, as most believe. MMT'ers completely ignore this variable in their analysis.  My belief is that things will get extremely complicated within the next two years.  Current geopolitical bullying evidenced thru the North/South Korean confrontation and the closer ties between Russia and Germany, and Russia and China, tell me that the process to a new monetary system is accelerating.

The EU is an Utter Clusterfuck - The Two Roads to Hell

(sorry due to time constraints, to be continued tomorrow!)


Dave Narby said...

Ooo, good cliffhanger title for part ii!

"If a country could simply buy its own debt with zero downside, I say we should have been doing this all along."

- Greg Hunter, USAWatchdog.com

Misthos said...

Good one Dave. The monetary system is definitely a fiction that benefits an elite few, that's why Ben Bernanke or Geithner never bring this up... reminds me of something Henry Ford once said:

"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."