[FoRK] What it means...

Jeff Bone jbone at place.org
Sat Sep 26 09:02:34 PDT 2009


What follows is one man's opinion, not intended to be mistaken for a  
professional opinion or advice.

Re: the graph on zerohedge, first of all, a warning about zerohedge:   
don't believe everything (or necessarily anything) you read there.   
Caveat lector;  it's regarded by many as one of the more disreputable  
water coolers in the industry.  Still, even a broken clock gets it  
right twice a day --- and (like many of the contrarians and more  
tinfoil fora in the industry right now) they're perhaps getting some  
things right more frequently than usual lately.

The graph refers to all forms of securitization owned by the Fed.  It  
doesn't simply refer to bank equity --- it also refers to e.g.  
securitized mortgages, credit default swaps, other forms of  
securitized debt / government and corporate paper, and all sorts of  
other security instruments that the central bank has been purchasing  
through open market operations.  This is called "quantitative easing"  
and is the general policy that the Fed's been following for most of  
the year.

The biggest problem the Fed faces is massive deflation.  It's  
literally an existential risk for them.  Under a deflationary  
scenario, all debt actually *shrinks* in value rather than grows.   
While most previous Fed chairs in history have been well-known as  
almost paranoiac inflation-fighters, Bernanke's claim to fame is as a  
*deflation warrior* because, more viscerally than any previous person  
to hold the post, he recognized long ago that deflation could be the  
ultimate ruination of the Fed.  (Remember, it's a private corporation,  
with all the same profit motives etc. as any --- just a longer-term  
outlook and a much bigger balance sheet.)  Thus his infamous comments  
about "dropping money from helicopters."  It's no exaggeration to say  
that Bernanke might literally do *anything* in his power to prevent  
significant deflation;  from the Fed's perspective, the imperative is  
not to preserve the purchasing power of a unit of the currency;  it is  
to preserve the *value* of its balance sheet.

What the graph therefore shows is the activity presently being  
undertaken to do this, by providing an artificial buying bias for  
generally-undesirable assets in an effort to keep those asset prices  
up.  That's all "quantitative easing" is.  This is one key mechanism  
by which the Fed "prints money" --- simply creating it from thin air  
and using it to buy things, troubled assets in this case.  But all  
that money has to go somewhere --- remember, it's banks and financial  
institutions and so on that are "selling" these assets to the Fed.  So  
where does it go?  Into the equity markets generally.

Since I don't have my hands on the raw data, only a graph, I haven't  
performed the linear correlation analysis...  but it's quite clear  
that (assuming the figures are correct) the "bull market" rally as  
evidenced in the S&P 500 this year, which has puzzled so many folks,  
is merely an artifact and purely reflective of the injection of newly- 
created currency through the purchase of these assets.  A conspiracy  
theorist might want to link this with some political motivation ---  
i.e., we have to ensure that the market rallies in order to produce  
the illusion that the "recession is over" for political reasons ---  
however I am inclined to believe that this is coincidental, as the  
interests are merely coincidentally-aligned between the political  
powers du jour and e.g. the Fed and other financial institutions.

(The one thing I'm curious about:  the S&P price line is smoother than  
the security holdings line.  No opinion on that, but clearly it would  
tend to reduce the correlation coefficient.  It could be e.g.  
transient mark-to-market effects with respect to those securitized  
assets vs. the overall market, at any given point in time.)

I've been saying this for some time, but it ain't over yet.  Indeed, I  
believe the worst is yet to come.  We've got a weird and unprecedented  
confluence of factors going on right now:  naturally-occurring  
deflation due to loss of confidence in our currency, declining  
domestic productivity, natural slowing of the velocity of money,  
increasing savings rates coupled with massively reduced lending, and  
so on --- yet at the same time, more actual monetary inflation than at  
any previous similar period in history (as far as I can tell.)  This  
is just the prelude:  the Fed will do anything in its power to  
preserve the value --- not necessarily measured in dollars --- of its  
balance sheet.  It doesn't care what the value of a dollar is, really,  
so in effect massive devaluation of the dollar (i.e., implicit  
confiscation of wealth and purchasing power from private citizens and  
corporations, the "inflationary tax rate,") can go as high as  
necessary to achieve the Fed's ends, i.e. the maintenance of the value  
of its balance sheet and the quality of its credit / its ability to  
"print money" (which should really be stated as "print currency" ---  
not the same thing, clearly.)

So as the deflationary pressure increases, as it most certainly  
naturally will due to the sorry state of the real economy and the  
increasingly economically-irresponsible actions of our government, so  
will the monetary inflationary actions of the Fed massively  
accelerate.  It's a dynamic chaotic equilibrium, and the equity bubble  
we've seen over the last several months indicates how unstable it can  
be.  My own intuition on this runs counter to many of the standard  
economists' (both seawater and saltwater) predictions with standard  
monetary theory --- cf. Kling lately, he's also pondering some of the  
same things.  I think we could be looking at true hyperinflation  
within the next 24-36 months.  But that's perhaps a 15%-20% likelihood  
by my estimation, with a complete deflationary crash having almost but  
not quite the same likelihood.  So I'm hedging against both,  
personally, at about the same level.

Couple this with all the gross fiscal mismanagement and rampant  
economic innumeracy in Washington today *and* the ideological biases  
involved, and you've got a recipe for real economic disaster of a  
scale never seen before.  (One anecdotal data point:  recent CBO  
estimates re: Social Security, the most bearish of which that I'm  
aware of previously put deficit operations at least 10 years out, now  
say it could occur within the next two;  and that's SS, not to mention  
the pending insolvency of Medicare and Medicaid, the already-evident  
insolvency of the FDIC, and so on.  So the bill's coming due....  how  
do you think that will be handled?  Non-linearly increasing  deficit  
operations by the government, which also creates monetary inflation  
coupled with an acceleration in decline in demand for US government  
debt, and perhaps massive divestiture of same.  "You're soaking in  

$0.02, YMMV.


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