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Saturday, October 25, 2014

How it all works

From a talk by Peter Schiff, summarized by Anglican Curmudgeon:
Every week, the Treasury auctions off a mixture of bills, notes and bonds (bills are short-term, bonds are long-term, and notes are in between) to meet the cash flow needs of the U.S. government. Normally what the Treasury has to offer is picked up by the bond market and by foreign governments (central banks) wishing to acquire dollar reserves.

But when the government runs a huge deficit, as it has during the latter Bush years and all of Obama's first and second terms, the Fed can step into the bond market to buy up any bills, notes or bonds that are not sold to dealers or central banks. By doing so, the Fed ensures that interest rates on the Treasury's borrowings remain stable in accordance with their maturity dates. (If, for example, the Treasury could not find a buyer for all of its long-term bonds at its offered rate of interest, it would have to raise the interest rate to find more buyers. But if the Fed steps in and buys what's left first, the Treasury does not have to offer higher rates -- it just pays the Fed the same rate it pays all the other buyers).

When the Fed buys, say, bonds from the U.S. Treasury, it simply credits the Treasury with cash from its bottomless checking account, and takes possession of the bonds. When the Treasury later buys back those bonds at maturity, as it must for every bond it issues, it has to pay the face amount of the bond plus the interest at the bond's stated rate. And to do so, it needs the required amount of cash in its accounts.

Now, think a minute: if the Fed buys $1 billion worth of 30-year bonds at 3% (say) interest per year, the Treasury is credited with $1 billion when it first sells them. But then it is has to pay the Fed $30 million each year in interest, for 30 years -- or a total of $900 million (almost as much as it borrowed in the first place). And when the bonds mature, it has to come up with another $1 billion to pay off the principal.

So by selling $1 billion of bonds to the Fed, the Treasury commits its budget to come up with a total of $1.9 billion over the next thirty years. And so it goes, week after week. As Sen Everett Dirksen once famously noted: "A billion here, a billion there, and pretty soon you're talking real money."

Now, here's the wrinkle: all interest the Treasury pays to the Fed gets turned over, at the end of each year to: (you guessed it) the Treasury! (The Fed simply deducts what it needs to erect and maintain all of its splendid marble buildings, and to pay all of its officers and staff the very best salaries and benefits.)

So it is not quite a merry-go-round, because of the Fed's needs for money to operate. Out of the $1.9 billion the Treasury pays to the Fed in my example, $1 billion (the principal) is a wash, and the Treasury might net, say, $870 million out of its original $900 million paid in interest. The figures don't matter as much as the fact: the Treasury still, after everything is said and done, has to come up with new money in order to clear its books with the Fed.

By using "quantitative easing" to help out the Treasury, therefore, the Fed is really simply delaying the ultimate day of reckoning. For if the Treasury did not have the Fed buying those bonds from it, it would have had to come up with a full $1.9 billion to pay them at maturity, instead of being able to use what the Fed returns to it each year.

The same result occurs in the end, however. As long as anyone keeps buying bills, notes and bonds from the Treasury, the Treasury has to come up with more cash to pay back the principal plus the stated interest.

The Fed's QE to date has kept the interest rates the Treasury has to pay artificially low, because the Fed always buys whatever bonds are left without demanding higher rates. But how long can the game continue?

And that is just what Peter Schiff points out. The Fed has thus far "phased out" QE three times. Each time, it said (at first) that there would be no more QE, but then as interest rates began to threaten to rise, and the stock market threatened to panic, the Fed would step in again and announce "another round" of quantitative easing. Thus we have had QE#1, QE#2 and QE#3 so far. The Fed is now almost done with the process of phasing out QE#3, as it has been buying less and less bonds each passing month.

And how has the stock market taken this? Exactly as it always has -- with panic drops and uncertain swings because of the inability to predict how high interest rates will have to rise for the Treasury to sell all of its bonds without the Fed being the buyer of last resort. And if bond interest rates rise, the stock market will really plummet.

Moreover, if interest rates rise, the Treasury will have to come up with ever more and more cash to pay the interest on each new bill, note or bond it issues. Since it cannot print money itself, the Treasury has to go into the market to borrow that extra cash. And the more it has to borrow, the more the interest rates will rise -- it is a vicious cycle.

Mr. Schiff therefore predicts the Fed will soon be forced to announce QE#4. Most agree with him, because the alternative is to let the Government default on its debt, which would lead to institutional and commercial failures of all kinds, all around the world.

But QE#4 will at best be a temporary solution. How long will the Fed be able to continue to tell gullible markets that each new phase of quantitative easing will be only "temporary"? The fact is that, having started down the QE road, the Fed cannot reverse course permanently without disastrous consequences for everyone.

And once the Fed's game is seen to be what it is -- the repeated printing of paper money with nothing to back it except the promise to print more paper money as needed -- the notion of inflation will begin to get a toehold on the economy. Would you accept the promise to be paid in a year with paper that will be worth less than what you turn over to your borrower today? Not without demanding a suitably high rate of interest, you wouldn't. And so the Fed's policies inevitably will lead to a war between the demand for more interest to compensate for the shrinking value of paper money caused by the printing of ever more and more paper money to pay that interest.
This is a great summary with one cavil: the dollar is not actually "unbacked." Rather, it is backed by all the goods and services which dollars can buy. And that, dear readers, is the explanation for nearly everything. If we are going to print ever more dollars to service ever more debt, we must grow ever more and ever larger markets. Therefore,
* The US must prop up multi-lateral organizations such as the UN, NATO and the OECD to maintain open channels for global trade. US imports must necessarily be paid by US exports, which requires overseas markets for our goods, services and financial instruments.

* The US domestic market must grow and grow and grow to sop up the never-ending stream of new dollars entering the economy. The stodgy, extant K-selected population can't do it, so we must import r-selected peoples to provide eyeballs to Facebook, subscribers to Comcast and debtors to Titlemax (pawn-title loans are now bundled and securitized, I am informed by someone well up the food chain in that sector).

* Open borders require the US to invade the homelands of imported Americans to nip threats in the bud, whether due to militant Islam or the Ebola virus, because there is no question that we are going to let everybody in.

Of course it's an economic Mobius strip: the US dollar is backed by all the goods and services exhangeable for US dollars. This is why we must be perennially going back to step 1 and repeat.

As I put it, if you could just print money and buy your own debt with it, the US would not exist; we'd all be loyal subjects of Caesar in Rome. But at the same time, there are real goods and services that can be purchased by dollars, so the dollar remains a marketable commodity and, due to the size of our market, the most marketable commodity.

This game of economic musical chairs ends when the US can no longer uphold its end of the balance sheet: the US military is no longer able to assure global hegemony; the US populace is no longer adding value; US markets no longer supply or demand products with long, sophisticated production chains.

It will end when it ends. And it will end.

1 comment:

Your Kakistocracy said...

US domestic market must grow and grow and grow to sop up the never-ending stream of new dollars entering the economy. The stodgy, extant K-selected population can't do it, so we must import r-selected peoples to provide eyeballs to Facebook, subscribers to Comcast..,

This has long been a key point of misdiagnosis on the right. That imports are for cheap labor. Certainly they are, but that is an ancillary role. They are here primarily for growth. To consume. And what is so sobering, if one digests the implications of the quarterly growth impetus, is that this is a perpetual dynamic. If today's revenue base is 100 and tomorrow's 200, no board simply tells their executives "Nice job, keep her steady from here." Revenues must then increase to 400.

This process doesn't end.

And so if you are in the home building industry, for instance, how do you turn revenues of 100 into 400? By massive domestic population increase. More people, more houses, more growth, more environmental despoliation, more silent liberals.

There's your picture of the future for as long as America lasts. An immigrant driving nails into the roof of a cheap tract house...forever.