Something Doesn't Jive In This!

This doesn't make sense! If the economy is doing so well, why would central bankers need to artificially boost the markets and asset prices to bubble levels by more quantitative easing?

Manipulated Markets, Not Free Markets

Guess which one of these headlines has affected stock prices today. The Dow is currently up over 400 points. How can stocks be so bullish when today's economic data is so bearish? Central bankers, that's how! Today's markets are manipulated. They are no longer free markets!

Stock Valuations At Bubble Levels

The outcome of years of yield-seeking speculation induced by central banks is that investors across the globe have now locked in zero prospective total returns in virtually in every asset class for the coming decade... We actually view this period as the extended top-formation of the third speculative bubble in the past 16 years, not as a representative sample of things to come. -- Dr. John Hussman, PhD, August 15, 2016

Central Bank Delusions

"This is the market we have now: dominated by delusional, irrational central planners with unlimited powers to create money out of thin air to fund their manipulations.
The only rational response is to trade accordingly: anticipate constant manipulation, anticipate constant bombastic propaganda of the "whatever it takes" variety, and anticipate massive selling of volatility to maintain the ever-so-important illusion that global risks have been disappeared by central banks and central planners.
Until the central planning madness destroys markets' ability to discover price and allocate capital. Then you end up with Venezuela: a failed state and a broken economy that can no longer feed its people despite the nation's vast oil wealth.
Volatility has been chosen as a "signaling device" by central planners. A low VIX signals all is well and risk is non-existent, so central planners suppress VIX.
In a world roiled by staggeringly large risks, can VIX be suppressed forever? That's a difficult question in a market dominated by irrational central planners." -- Charles Hugh Smith, Of Two Minds blog. 

Read the rest here!

The Bubble Is Back!

The second chart shows the various central bank interventions since February 1st.

Central Banking and the Destruction of Free Markets

Submitted by Jeffrey Snider of Atlantic Capital Management
Volatility Is The Price Of Real Progress
As we all ponder what may come at us in 2012, the ongoing volatility in almost every corner of every marketplace is certainly concerning, as it should be.  This record volatility has enormous implications for any investor, but especially those in leveraged ETF’s.  Volatility is the anathema to these vehicles, as has been well discussed, but that does not diminish their targeted usefulness.
As a portfolio manager I use leveraged inverse ETF’s as hedges against the dramatic downside.  They have a very narrow window and only perform when the market more or less moves in a straight-line down – just as it did in early October 2008, May 2010 or July/August 2011.  Other than those sustained sell-offs, they are a drag on portfolio performance, a cost of doing business in this risk-on, risk-off “marketplace”. 
I willingly pay that cost because I have no concrete idea when another fit of sustained selling will actually take place, but I have more than an inkling that it will.  Instead, this massive and growing volatility, even though it is costing me some short-term performance, is a good sign that there is actually progress being made.  What we are witnessing is a titanic battle between the world as it really is and the one central banks need you to believe it might be (if only you would set aside your own perceptions and self-interest).  The fact that volatility has risen is a clear indication that the central bank-inspired anesthesia is no longer as effective as it was in 2009, or even in the QE 2.0 inspired insanity of 2010.  Reality, and the free market, is being imposed – and that means there is a place for even narrowly-useful hedging vehicles.
The current market battle is nothing more than the extreme measures of the rational expectations theory and a form of the fallacy of composition, combined with the political aspirations of a century-old theoretical notion of how the economic system should be ordered.  Mainstream economic “science” has developed in a relatively straight line since the Great Depression, starting with the idea that the economy must be governed in emergencies.  Executive Order 6102 and the subsequent devaluation of the dollar solidified the place for the entire field of economic management, marking perhaps the last time it would be challenged by mainstream thought.
Without the guiding hand of the educated economist, capitalist, free market economies are believed to be wrought with the danger of total collapse, unable to escape from their own emotional whimsies.  At the most primal level of modern economics is a deathly fear of deflation, a fear that is best summed up by Fisher’s paradox.
In 1933, Irving Fisher published a paper in the Federal Reserve’s Econometrica circular that amounted to a point-by-point logical deduction of the string of events that led to the unusual collapse of the economic and banking systems.  The scale and pace of the disaster confounded “experts” of the era (it seems experts have trouble with inflections in every era), so his deduction offered a highly plausible, well-reasoned and “logical” explanation. 
For Fisher, the combination of over-indebtedness and deflation was the toxic mix from which the calamity grew.  But within that mix lay a paradox that formed a trap by which no self-made recovery was possible:

“…if the over-indebtedness with which we started was great enough, the liquidations of debts cannot keep up with the fall of prices which it causes.  In that case, the liquidation defeats itself.  While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.  Then, the very effort of individuals to less their burden increases it, because the mass effect of the stampede to liquidate in swelling each dollar owed.  Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions:  the more the debtors pay, the more they owe.  The more the economic boat tips, the more it tends to tip.  It is not tending to right itself, but is capsizing.”

The lessons of this paradox are interwoven into the fabric of modern/conventional economics, that whenever deflation might be present a recovery has to be forced since it cannot start on its own.  But it is extremely curious that only one half of the equation was chosen as an outcast:  deflation.  Over-indebtedness has, obviously, been warmly embraced in the decades since Fisher’s proposition.  The development of the mainstream of economics has led to the belief that intentional inflation can always defeat deflation, and therefore debt can assume a role, even a primary role, within the schematic of economic stewardship.
Fisher’s paradox survives in many forms, but among the most important was a logical derivation, namely the idea that economic participants can do what they believe is best for themselves, but in doing so harm themselves through systemic processes.  This is known as a fallacy of composition; that what is good for individuals is not necessarily best for the whole.  It overturned the traditional economic notion of an economy at its most basic level, from the time of Adam Smith describing individual self-fulfillment.  Sure, this idea had been around for awhile before Fisher’s paper, but the Great Depression “proved” that the fallacy was real and potentially cataclysmic.  Originally it was confined to the narrow interpretation of depression economics, and so the evolution of unquestioned economic management started from there.
The economics profession truly believes that there exists economic states where individual self-maximization no longer benefits the larger societal association of economic actions, so it “logically” follows that some process (or entity) has to step in and enforce conditions contrary to individual notions of self-maximization.  In other words, there are times when people must be forced to do what they perceive is against their own best interest.
In the context of depression avoidance this seems to be rather innocuous, but in the displacement of political thinking since the 1930’s, it was a slippery slope.  What Fisher’s paradox essentially required was a benevolent authority to administer and visit a kind of beneficial tyranny upon the economic population.  In the constant forward roll of history, though, the slippery slope of needed benevolence has been applied to a larger and larger cohort of economic circumstances – emergencies breed human desire for such authoritarianism.
It is important to remember that the Federal Reserve was a secondary institution for much of the post-Depression period.  After the monetary debacles of the Great Depression, especially the unnecessary reserve requirement hike in 1936 that initiated the depression-within-a-depression in 1937, the Fed was relegated to being simply a monetary check-writer.  The Treasury Dept. was the economic powerhouse, especially during a time in which the dollar was the primary tool of economic management.  The Fed was consigned to managing the money supply around treasury debt auctions to ensure the federal government’s uninterrupted ability to borrow (in some ways things never change).  When that borrowing exploded in 1965, the money supply went with it and the seeds of the Great Inflation were embedded.
Paul Volcker changed this with his “heroism” in defense of the dollar, a dramatic departure from the previous era of Treasury Dept. domination.  Conventional wisdom posits that it was Volcker’s Fed that vanquished the inflation dragon, in doing so he “created” another pillar of the fallacy of composition (high interest rates were not good for individuals, but seemed to be good for the larger system).  The chastened Fed of 1965 that allowed inflation to begin building was dropped for the activist Fed of 1980 that could apparently do no wrong (the monetary history of the 1970’s was completely and conveniently ignored).  The Fed’s reputation soared with the perceived economic success of the 1980’s, handing Alan Greenspan an amount of power unparalleled in human history. 
But how much economic success in the 1980’s was earned?  Again, conventional wisdom sees the Great Inflation ending in 1982, giving way to the Golden Age of Economic kingship – the Great Moderation.  What I see is simply a transformation of inflation from consumer prices to asset prices.  Instead of overwrought money creation circulating within the real economy in the form of wages and higher consumer prices, new credit production capabilities allowed a secondary circulation of credit money into assets, indirectly feeding into the real economy – first as interest income, second as debt – as the notorious “wealth effect”.  The economy in this age would transform from one based on earned income to one based on paper movements of created money, with the irony of the “wealth effect” being its tendency to incrementally create economic activity without actually creating productive wealth.  The global economy was increasingly reliant solely on money creation, a transformation that cannot be understated and a prime cause for re-evaluating the whole of the Great Moderation.
We see this quite clearly in the consumerism of the period.  In 1975, household spending was still largely a function of wage income.  If we adjust Disposable Personal Income by subtracting asset income (interest and dividends), we see a modest deficit in spending sources of about 3.5%.  Households spent more than they brought in from wages, benefits, government transfers (net of taxes) and rental income. Consumer/household spending needed asset income to make up that small funding shortfall (and to go beyond to generate a positive savings rate).  By the midpoint of the Great “Moderation” in 1990, the spending deficit was a chasm, 19.3%.  Without the $898 billion (nominal dollars) in asset income there was no way that consumer spending would have grown so far so fast.
That interest/asset income was a leftover effect of the Great Inflation when monetary creation found its way into growing stockpiles of “safe” financial assets for the household sector.  By 1990, US households had accumulated $5.1 trillion in deposits and credit market assets (largely US treasury bonds) against only $3.6 trillion in debt (including mortgages).  But that was a huge “problem” for the growing acumen of an activist Federal Reserve.  As the 1980’s progressed, interest rates were declining with consumer inflation (and providing a helping hand to asset prices running wild with credit now focused in that direction).  The mainstream of economics took this as a sign of success, but it was really just a marked decrease in monetary efficiency since new money was now circulating heavily in asset prices (the junk bond bubble and the new, great bull market in equities).
Concurrently, economic management had evolved in the 1980’s with the innovation of the “rational expectations” theory.  It was hailed as a huge advancement in monetary thinking coming out of the Great Inflation.  In many ways it was an adjunct to the fallacy of composition.  The rational expectations theory holds that the economic children of modern society can be fooled into undertaking activity that might be against their own best interest if some benevolent authority simply makes it look like everything will be better in the not-too-distant future.  If the Fed screws with the price and cost of money (for debt accumulation), manipulates the price of gold (for inflation expectations), or “nudges” stock or real estate prices in the “right” direction (the notorious wealth effect), the population will act today on those conjured expectations of good times tomorrow.
By the end of the 1980’s, the S&L crisis (a stark warning that economic management might not have been all that it was advertised to be, a warning that has largely been ignored) threatened to plunge the world back into depression.  The Fed and Alan Greenspan feared the consequences of a banking crisis and any attendant deflation.  The Fed funds rate was pushed from around 8.25% in April 1990 to a ridiculous 3.25% by July 1992 – staying at that low level well into 1994.  Alan Greenspan was trying to save the entire banking system from the S&L crisis by reducing the cost of funds so dramatically (hoping to see an increase in bank profits, leading to higher retained earnings and therefore equity capital upon which to pyramid more debt).  The pressure on household spending because of the collapse in interest rates necessitated a marginal change in spending, but not back toward earned income.  Instead we got the wealth effect and the myth of Greenspan’s genius.
Despite a persistently weak recovery (just ask George HW Bush) from a relatively mild recession, the Fed’s management of the economy into a “soft landing” was hailed as a new form of a New World Order.  The business cycle could be smoothed (or even eliminated) by the marginal attraction to debt and the wealth effect.  If expectations were properly managed, the public would suppress their base emotional instincts and dance to the tune set by the monetary kingship. 
It was hubris of the highest order, of course.  By the time the tech bubble finally burst (another warning of the dangers of an artificial economy) the Fed doubled down to save itself and its primacy.  The results have been disastrous as the marginal economy progressed further and further away from the fundamental foundation of wages and earned income.  The savings rate fell to zero by 2005.  Worse than that, US households added $10 TRILLION (+269%) in debt between 1990 and 2007, with $7 TRILLION coming after 2002 alone.  The household funding deficit reached a high of 24%!  Even worse than that, households had shifted preferences out of “safe” credit market assets or bank deposits and into much riskier price assets simply because the systemic cost of risk was intentionally held artificially low.
The economic foundation of the Great Moderation was an illusion, nothing more than asset prices and debt; wealth effect and rational expectations.  None of this describes a free market, capitalist economy.
Central banks and economists love to talk about economic potential, spending so much time trying to calculate it with their complex modeling capabilities and elegant mathematical equations.  But the hard truth of economic overlordship is rather simple.  The Federal Reserve, in cooperation with global central banks, Wall Street and the interbank wholesale money marketplace, simply substituted credit for earned income.  And the reason is also very simple, because debt accumulation is far more easily manipulated.  As long as households remained attached to earned income and “safe” savings assets, economic management was nearly impossible.  The rational expectations theory needs a system more attuned by asset prices and malleable debt levels.  And so marginal consumer spending shifted away from the solid foundation of jobs and wages right into the hands of the fallacy of composition and the rational expectations theory.
It is more than a little ironic that the Fed so willingly embraced indebtedness in light of their history with Fisher’s paradox.  But mathematical advances in modeling along with a growing commitment to steady inflation allowed the Fed to really believe it could stave off deflation.  So they made a deal with the debt devil to obtain the keys to the marginal economic castle and its grand artificial economy, and in the process dangerously surrendered to the over-indebted part of the Fisher’s paradox equation.  Thus the housing bubble to mediate the tech bubble since the tech bubble had some potentially deflationary consequences.  Even today, everything the Fed has done since 2007 can be seen in these terms:  the fallacy of composition, rational expectations and the preservation of the benevolent stewardship of the economic, academic masters. 
Somewhere in all this transition from Fisher’s paradox to Greenspan’s genius to debt-slavery, the system ceased to function as a free-market, capitalist system.  The free market values the bottom-up dispersal and divergence of billions and billions of free opinions, freely associating together as unfettered price discovery.  A central bank devoted to the fallacy of composition and rational expectations is a top-down system committed to manipulating price discovery to achieve ends that seem to be, and very often are, contrary to the perceptions of the vast majority of doltish economic participants.  The monetarist system is forced upon the population, no matter how much they resist. 
Indeed, the idea of an economic fallacy of composition is itself a logical fallacy.  I have no quarrel with the idea of a fallacy of composition or any logical fallacy for that matter, but logic holds no special place in social interactions.  There are no logical deductions from economics no matter how much math is applied.  It is, and will remain, a subjective interpretation of events.  Even the vaunted Fed and its accumulation of Ivy League PhD’s performs no leaps of logic.  Like anyone else with an opinion, whatever fallacy of composition it thinks it sees is still just subjective interpretation. 
And that is the real danger.  Cloaked in the apparent objectivity of math, the economic elite have gained unlimited economic power.  When you stop and think about it, you can create a fallacy of composition pretty much anywhere (and write and enforce rules based on it) – from the steep tax on savers with five-plus years of zero interest rates to mandating everyone has to purchase health insurance even if they don’t have the need for it.
The volatility of today is nothing more than a fight between the active perceptions of participants trying to maximize self-interest within the classical, traditional concept of a free economy, and the opposing forces of overlordship of the landed economic elite, trying to get the uninitiated to simply follow orders.  The elite really believes that if everyone would gladly pile on even more debt and spend with reckless abandon, the Great Moderation would once again be within reach.  Consumers should only stop thinking for and of themselves since common sense is dangerous to the controlled economic system.  To get more debt “flowing” requires active price manipulation to make the world seem like it will be better in the near future so that people will start acting like it.
Economic potential to the Fed is the level of economic activity of 2006.  To them, this is a cyclical recovery from a cyclical interruption in their normal smoothing of the business cycle.  Sure it veered way off into panic, but that was just more confirmation that human emotion needs to be managed.  But if we view the economy from the historical perspective, the lack of a cyclical recovery is not at all surprising.  The Fed spent decades building up so much monetary inefficiency, so many artificial monetary channels for indirectly “stimulating” economic activity, that it will simply take an enormous amount of new money to get it all moving in the “right” direction again (Ben Bernanke and Paul Krugman at least have that part right). 
The fact that resistance is growing, that investors are not drinking the economic Kool-Aid as much as 2009 or late 2010 is a sign of growing discord.  The efforts in the realm of rational expectations are simply not working.  That is the ultimate danger because the entire central bank gameplan is based on only that.  Without willing adherents (useful idiots?) to the central authority of economic management, everything falls back to the true potential – earned income and boring cash flow of un-manipulated dollars or euros.  With such a massive chasm between marginal economic activity and earned income sources of spending, it is not likely to be a shallow or short transition (this explains most of the inability of the economy to create jobs – so many jobs in the central planning era were based on money creation and financial “innovation”).
That is both the opportunity and danger of a system reaching its logical end.  Put another way, there is a growing realization that while free markets are messy and somewhat unstable, central planning is not really a cure for those symptoms.  In fact, it has created more harm ($13 trillion in debt is only US households) than good, more illusion than solid results.  Volatility means that the free market is at least attempting to impose itself at the expense of central planning’s soft financial repression and control.  By no means is such a beneficial outcome assured; rather the other half of all this volatility (the risk-on days) is the status quo desperately trying to hang on through any and all means (even those less than legal, like bailing out Europe through cheapened dollar swaps).
So the cost of using leveraged ETF’s as insurance against the failure of soft central planning necessarily rises, but that just may mean their ultimate usefulness is closer to being realized.  Unless you know exactly when this transition might reach its conclusion, it is, in my opinion, a cost worth bearing.

The Nightmare After Christmas

By Detlev Schlichter of The Cobden Center

The pathetic state of the global financial system was again on display this week. Stocks around the world go up when a major central bank pumps money into the financial system. They go down when the flow of money slows and when the intoxicating influence of the latest money injection wears off. Can anybody really take this seriously?
On Tuesday, the prospect of another gigantic cash infusion from the ECB’s printing press into Europe’s banking sector, which is in large part terminally ill but institutionally protected from dying, was enough to trigger the established Pavlovian reflexes among portfolio managers and traders.
None of this has anything to do with capitalism properly understood. None of this has anything to do with efficient capital allocation, with channelling savings into productive capital, or with evaluating entrepreneurship and rewarding innovation. This is the make-believe, get-rich-quick (or, increasingly, pretend-you-are-still-rich) world of state-managed fiat-money-socialism. The free market is dead. We just pretend it is still alive.
There are, of course those who are still under the illusion that this can go on forever. Or even that what we need is some shock-and-awe Über-money injection that will finally put an end to all that unhelpful worrying about excessive debt levels and overstretched balance sheets. Let’s print ourselves a merry little recovery.
How did Mr. Bernanke, the United States’ money-printer-in-chief put it in 2002? “Under a paper-money system, a determined government can always generate higher spending…” (Italics mine.)
Well, I think governments and central banks will get even more determined in 2012. And it is going to end in a proper disaster.
Lender of all resorts
Last week in one of their articles on the euro-mess, the Wall Street Journal Europe repeated a widely shared myth about the ECB: “With Germany’s backing, the ECB has so far refused to become a lender of last resort, …” This is, of course, nonsense. Even the laziest of 2011 year-end reviews will show that the ECB is precisely that: A committed funder of states and banks. Like all other central banks, the ECB has one overriding objective: to create a constant flow of new fiat money and thus cheap credit to an overstretched banking sector and an out-of-control welfare state that can no longer be funded by the private sector. That is what the ECB’s role is. The ECB is lender of last resort, first resort, and soon every resort.
Let’s look at the facts. The ECB started 2011 with record low policy rates. In the spring it thought it appropriate to consider an exit strategy. The ECB conducted a number of moderate rate hikes that have by now all been reversed. By the beginning of 2012 the ECB’s policy rates are again where they were at the beginning of 2011, at record low levels.
So why was the springtime attempt at “rate normalization” aborted? Because of deflationary risks? Hardly. Inflation is at 3 percent and thus not only higher than at the start of the year but also above the ECB’s official target.
The reason was simply this: states and banks needed a lender of last resort. The private market had lost confidence in the ability (willingness?) of certain euro-zone governments to ever repay their massive and constantly growing debt load. Certain states were thus cut off from cheap funding. The resulting re-pricing of sovereign bonds hit the banks and made it more challenging for them to finance their excessive balance sheets with money from their usual sources, not least U.S. money market funds.
So, in true lender-of-last resort fashion, the ECB had to conduct a U-turn and put those printing presses into high gear to fund states and banks at more convenient rates. While in a free market, lending rates are the result of the bargaining between lenders and borrowers, in the state-managed fiat money system, politicians and bureaucrats define what constitutes “sustainable” and “appropriate” interest rates for states and banks. The central bank has to deliver.
The ECB has not only helped with lower rates. Its balance sheet has expanded over the year by at least €490 billion, and is thus 24% larger than at the start of the year. This does not even include this week’s cash binge. The ECB is funding ever more European banks and is accepting weaker collateral against its loans. Many of these banks would be bust by now were it not for the constant subsidy of cheap and unlimited ECB credit. If that does not define a lender of last resort, what does?
And as I pointed out recently, the ECB’s self-imposed limit of €20 billion in weekly government bond purchases (an exercise in market manipulation and subsidization of spendthrift governments but shamelessly masked as an operation to allow for smooth transmission of monetary policy) is hardly a severe restriction. It would allow the ECB to expand its balance sheet by another €1 trillion a year. (The ECB is presently keeping its bond purchases well below €20 billion per week.)
Deflation? What deflation?
It is noteworthy that there still seems to be a widespread belief that all this money-printing will not lead to higher inflation because of the offsetting deflationary forces emanating from private bank deleveraging and fiscal austerity.
This is an argument I came across a lot when I had the chance in recent weeks to present the ideas behind my book to investors and hedge fund managers in London, Edinburgh and Milan. Indeed, even some of the people who share my outlook about the endgame of the fiat money system do believe that we could go through a period of falling prices first, at least for certain financial assets and real estate, before central bankers open the flood-gates completely and implement the type of no holds barred policy I mentioned above. Then, and only then will we see a dramatic rise in inflation expectations, a rise in money velocity and a sharp rise in official inflation readings.
Maybe. But I don’t think so. I consider it more likely that we go straight to higher inflation.
The deleveraging in the banking sector is the equivalent of austerity in the public sector: it is an idea. A promise. The reflationary policy of the central bank is a fact. And that policy actively works against private bank deleveraging and public sector debt reduction.
Consider this: The present credit crisis started in 2007. Yet, none of the major economies registered deflation. All are experiencing inflation, often above target levels and often rising. In the euro-area, over the past twelve months, the official inflation rate increased from 2 percent to 3 percent.
From the start of 2011 to the beginning of this month, the U.S. Federal Reserve boosted the monetary base by USD 560 billion, or 27 percent. So far this year, M1 increased by 17.5 percent and M2 by 9.5 percent.
Below is the so-called “true money supply” for the U.S. calculated by the Mises Institute.

As the Mises-Institute’s Doug French pointed out, total assets held by the six biggest banks in the U.S. increased by 39% over the past 5 years. Maybe this is not surprising given that in our brave new world of limitless fiat money, credit contraction is strictly verboten.
In the UK the official inflation reading is at around 5 percent, but nevertheless in October the Bank of England embarked on another round of “quantitative easing”. It has so far expanded its balance sheet by another £50 billion in not even three months, which constitutes balance sheet growth of about 20 percent.
What we have experienced in the UK in 2011 provides a good forecast in my view for the entire Western world for 2012: rising unemployment, weak or no growth, failure of the government to rein in spending, growing public debt, further expansion of the central bank’s balance sheet, rising inflation.
Death of a safe haven
And what about Switzerland? Here the central bank expanded its balance sheet by 40 percent over just the first three quarters of the year, and almost tripled the monetary base over the same period of time. Most of this even occurred before the 6^th of September, the day on which Mr. Hildebrand, the President of the Swiss National Bank, told the world and his fellow Swiss countrymen and women that the whole safe-haven idea was rubbish and that Switzerland was now joining the global fiat money race to the bottom.
Deflation has become the bogeyman of the policy establishment. It must be avoided at all cost! Of course for most of us regular folks deflation would simply mean a tendency toward lower prices. It would mean that the capacity of the capitalist economy to increase the productivity of labour through the accumulation of capital and to thus make things more affordable over time (a true measure of rising general wealth) would accurately be reflected in falling nominal prices. The purchasing power of money would increase over time. This, however, would require a form of hard and apolitical money. Instead we are constantly told that our economy needs never-ending monetary debasement in order to function properly. We are constantly told to fear nothing more than deflation, which can only be averted by a determined government and a determined central bank. And the never-ending supply of new fiat money.
Appropriately, there is no talk of exit strategies any longer.
Given the size of the already accumulated imbalances I think a stop to this madness of fiat money creation would be painful at first but hugely beneficial in the long run. I am the last to say that no risk of a very painful deflationary correction exists. But a correction is now unavoidable in any case, and every other policy option will make the endgame only worse. Even if I am wrong on the near-term outlook on inflation and even if all this money-printing does not lead to higher inflation readings imminently, it will still be a hugely disruptive policy. Money injections obstruct the dissolution of imbalances and invariably add new imbalances to the economy, including new debt and capital misallocations, that will make even more aggressive money printing necessary in the future.
The nationalization of money and credit
Herein lies a fundamental contradiction in our present system: The desire for constant inflation and constant credit expansion requires that the banks be shielded from the effects of their own business errors. Allowing capitalism’s most efficient regulators, profit and loss, to do the regulating, would mean that banks could face the risk of bankruptcy – this is, of course, the ultimate disciplinary force in capitalism. This could then lead to balance sheet correction and thus periods of deflation. Ergo, banks cannot be capitalist enterprises at full risk of bankruptcy as long as constant credit growth and inflation are the overriding policy goals. The constant growth of the banking sector must be guaranteed by the state through the unlimited provision of bank reserves from a lender-of-last resort central bank.
That banks get ever bigger, that they routinely hand out multi-million dollar bonuses, and that they frequently get bailed out, is not a result of the greed of the bankers – a stupid explanation anyway, only satisfactory to the intellectually challenged and perennially envious – but is integral to the fiat money system.
Banking under state protection ultimately means banking under state control. In the end it means state banking. And this is where we are going.
Last week the Federal Reserve and the Bank of England announced plans to tighten the control over the balance sheet management and the risk-taking of private banks. This is just the beginning, believe me. The nationalization of money and credit will intensify in 2012 and beyond. More regulation, more restriction, more control. Not only in defence of the bankrupt banks but also the bankrupt state. We will see curbs on trading, short-selling restrictions and various forms of capital controls.
A system of state fiat money is incompatible with capitalism. As the end of the present fiat money system is fast approaching the political class and the policy bureaucracy will try and defend it with everything at their disposal. For the foreseeable future, capitalism will, sadly, be the loser.
The conclusion from everything we have seen in 2011 is unquestionably that the global monetary system is on thin ice. Whether the house of cards will come tumbling down in 2012 nobody can say. When concerns about the fundability of the state and the soundness of fiat money, fully justified albeit still strangely subdued, finally lead to demands for higher risk premiums, upward pressure on interest rates will build. This will threaten the overextended credit edifice and will probably be countered with more aggressive central bank intervention. That is when it will get really interesting.
We live in dangerous times. Stay safe and enjoy the holidays.
In the meantime, the debasement of paper money continues.

Unprecedented Coordinated Central Bank Interventions Stoke Stock Rally

Whisper rumors in the financial markets suggest that a major European bank was on the verge of collapse while we in the US were asleep last night. This was a massive coordinated intervention today by the central banks of China, Japan, Europe, Switzerland, and the United States. 37 major global banks' debt was downgraded yesterday by S&P shortly after the market closed.

Congressman Ron Paul released this statement this morning. I think he is absolutely correct in this. I couldn't have said it better if I was divinely inspired:


"Rather than calming markets, these arrangements should indicate just how frightened governments around the world are about the European financial crisis. Central banks are grasping at straws, hoping that flooding the world with money created out of thin air will somehow resolve a crisis caused by uncontrolled government spending and irresponsible debt issuance. Congress should not permit this type of open-ended commitment on the part of the Fed, a commitment which could easily run into the trillions of dollars. These dollar swaps are purely inflationary and will harm American consumers as much as any form of quantitative easing." -- Congressman Ron Paul
The Dow is up 400 points at this moment. Folks, do NOT misunderstand. This huge stock market rally today is a bet on INFLATION, not prosperity! This is an unprecedented intervention in the global financial markets by the central criminals -- also known as bankers -- as a panic move to stop what could be an imminent global banking meltdown.

This stock market rally is not due to expectations of renewed recovery. It is an oversized bet on massive inflation that will be the natural consequence of the excessive money creation and debt monetization that is being created.

Central banking and other monetary policy authorities are desperately trying to prevent what they see as certain calamity without such broad, coordinated, and extreme measures. What they fail to see in this short-sighted strategy is that with each succeeding threat of catastrophe, the magnitude and impact of it increases. They are just kicking the can down the road, with a bigger and more leaden can reappearing each time they do it. Don't be surprised if we see runs on banks before this crisis is resolved. They are already seeing bank runs (I've seen the photos) in parts of Europe right now just like the ones in the classic Jimmy Stewart movie, It's a Wonderful Life!

Market? What Free Market?

from Zero Hedge:

Anyone just waking up and noticing futures trading just barely below the closing print may get the impression that things are fine. They are not. Here is what has happened overnight as the global central planning cartel does everything in its power to prevent the global market rout, which has so far wiped out $7.8 trillion in market value around the world, from morphing into the catalyst that ends the status quo. To wit: ECB resumes buying Italian and Spanish bonds (UniCredit says the bank is losing a “game of chicken” with lawmakers by not holding out for budget cuts and higher taxes, and may eventually need to print money), the G-20 is prepared to take joint measures to stem a global crisis, Brazilian Finance Minister Guido Mantega said. Greece’s securities regulator banned all short-selling on the Athens exchange for two months starting today. Taiwan’s government bought stocks yesterday and this morning through four funds it controls. South Korea’s regulator asked pension funds, brokerages and asset-management companies to step up efforts to stabilize the market. South Korea also bans short selling for three months starting August 10. And lastly, rumors of an emergency Fed announcement are ripe. So... after all this global cartel intervention, is it any wonder that futures staged a near vertical move up overnight?

Why IMF Meetings Failed

Here's an excellent article by Michael Hudson. Michael Hudson is President of The Institute for the Study of Long-Term Economic Trends (ISLET), a Wall Street Financial Analyst, Distinguished Research Professor of Economics at the University of Missouri, Kansas City and author of Super-Imperialism: The Economic Strategy of American Empire (1968 & 2003), Trade, Development and Foreign Debt (1992 & 2009) and of The Myth of Aid (1971). Read more here. - Ilene

Why the IMF Meetings Failed

And the Coming Capital Controls
Courtesy of Michael Hudson

“Coming events cast their shadows forward.” – Goethe

What is to stop U.S. banks and their customers from creating $1 trillion, $10 trillion or even $50 trillion on their computer keyboards to buy up all the bonds and stocks in the world, along with all the land and other assets for sale, in the hope of making capital gains and pocketing the arbitrage spreads by debt leveraging at less than 1% interest cost? This is the game that is being played today.
The outflow of dollar credit into foreign markets in pursuit of this financial strategy has bid up asset prices and foreign currencies, enabling speculators to pay off their U.S. positions in cheaper dollars, keeping the currency shift as well as the arbitrage interest-rate margin for themselves.
Finance has become the new form of warfare – without the expense of military overhead and an occupation against unwilling hosts. It is a competition in credit creation to buy foreign real estate and natural resources, infrastructure, bonds and corporate stock ownership.
Who needs an army when you can obtain monetary wealth and asset appropriation simply by financial means? Victory promises to go to the economy whose banking system can create the most credit, using an army of computer keyboards to appropriate the world’s resources.
U.S. officials demonize countries suffering these dollar inflows as aggressive ‘currency manipulators’ for what Treasury Secretary Tim Geithner calls “‘Competitive nonappreciation,’ in which countries block their currencies from rising in value.”[1A] Oscar Wilde would have struggled to find a more convoluted term for other countries protecting themselves from raiders trying to force up their currencies to make enormous predatory fortunes.
Competitive nonappreciation’ sounds like ‘conspiratorial non-suicide.’ These countries simply are trying to protect their currencies from arbitrageurs and speculators flooding their financial markets with dollars, sweeping their currencies up and down to extract billions of dollars from their central banks.
Their central banks are being forced to choose between passively letting these inflows push up their exchange rates – thereby pricing their exports out of foreign markets – or recycling these inflows into U.S. Treasury bills yielding only 1% with declining exchange value. (Longer-term bonds risk a price decline if U.S interest rates should rise.)
U.S. officials demonize foreign countries as aggressive “currency manipulators” for keeping their currencies weak. But these countries simply are trying to protect their currencies from arbitrageurs and speculators flooding their financial markets with dollars. Foreign central banks must choose between passively letting these inflows push up their exchange rates – thereby pricing their exports out of global markets – or recycling these inflows into U.S. Treasury bills yielding only 1% and whose exchange value is declining. (Longer-term bonds risk a domestic dollar-price decline if U.S interest rates should rise.)
The euphemism for flooding economies with credit is “quantitative easing.” The Federal Reserve is pumping liquidity and reserves into the financial system to reduce interest rates, ostensibly to enable banks to “earn their way” out of negative equity resulting from the bad loans made during the real estate bubble. This liquidity is spilling over to foreign economies, increasing their exchange rates. Joseph Stiglitz recently acknowledged that instead of helping the global recovery, the “flood of liquidity” from the Fed and the European Central Bank is causing “chaos” in foreign exchange markets. “The irony is that the Fed is creating all this liquidity with the hope that it will revive the American economy. … It’s doing nothing for the American economy, but it’s causing chaos over the rest of the world.”[1]
What U.S. quantitative easing is achieving is to drive the dollar down and other currencies up, much to the applause of currency speculators enjoying quick and easy gains. Yet it is to defend this system that U.S. diplomats and bank lobbyists are threatening to derail the international financial system and plunge world trade into anarchy if other countries do not agree to a replay of the 1985 Plaza Accord “as a possible framework for engineering an orderly decline in the dollar and avoiding potentially destabilizing trade fights.”[2]
The Plaza Accord derailed Japan’s economy by raising its exchange rate while lowering interest rates, flooding its economy with enough credit to inflate a real estate bubble. IMF managing director Dominique Strauss-Kahn was more realistic. “I’m not sure the mood is to have a new Plaza or Louvre accord,” he said at a press briefing on the eve of the IMF meetings in Washington. “We are in a different time today.” Acknowledging the need for “some element of capital controls [to] be put in place,” he added that in view of U.S. insistence on open, unprotected capital markets, “The idea that there is an absolute need in a globalised world to work together may lose some steam.”[3]
At issue is how long nations will succumb to the speculative dollar glut. The world is being forced to choose between subordination to U.S. economic nationalism or an interim of financial anarchy. Nations are responding by seeking to create an alternative international financial system, risking an anarchic transition period in order to create a fairer world economy.
Re-inflating the financial bubble rather than writing down debts
The global financial system already has seen one long and unsuccessful experiment in quantitative easing in Japan’s carry trade. After its financial and property bubble burst in 1990, the Bank of Japan sought to enable its banks to “earn their way out of negative equity” by supplying them with low-interest credit for them to lend out. Japan’s recession left little demand at home, so its banks developed the carry trade: lending at a low interest rate to arbitrageurs to buy higher-yielding securities. Iceland, for example, was paying 15%. So yen were borrowed to convert into dollars, euros, Icelandic kroner and Chinese renminbi to buy government bonds, private-sector bonds, stocks, currency options and other financial intermediation. Not much of this funding was used to finance new capital formation. It was purely financial in character – extractive, not productive.
By 2006 the United States and Europe were experiencing a financial and real estate bubble of its own. And after it burst in 2008, they did what Japan’s banks did after 1990. Seeking to help U.S. banks work their way out of negative equity, the Federal Reserve flooded the economy with credit. The aim was to provide more liquidity, in the hope that banks would lend more to domestic borrowers. The economy would “borrow its way out of debt,” re-inflating asset prices for real estate, stocks and bonds so as to deter home foreclosures and the ensuing wipeout of collateral on bank balance sheets.
Quantitative easing subsidizes U.S. capital flight, pushing up non-dollar currency exchange rates
Quantitative easing may not have set out to disrupt the global trade and financial system or start a round of currency speculation, but that is the result of the Fed’s decision in 2008 to keep unpayably high debts from defaulting by re-inflating U.S. real estate and financial markets. The aim is to pull home ownership out of negative equity, rescuing the banking system’s balance sheets and thus saving the government from having to indulge in a TARP II, which looks politically impossible given the mood of most Americans.
The announced objective is not materializing. Instead of increasing their loans against U.S. real estate, consumers or businesses, banks are still reducing their exposure. This is why the U.S. savings rate is jumping. The “saving” that is reported (up from zero to 3% of GDP) is taking the form of paying down debts taken out in the past, not building up liquid funds. Just as hoarding diverts revenue away from being spent on goods and services, so debt repayment shrinks spendable income. Why then would banks lend more under conditions where a third of U.S. homes already are in negative equity and the economy is shrinking as a result of debt deflation?
Mr. Bernanke proposes to solve this problem by injecting another $1 trillion of liquidity over the coming year, on top of the $2 trillion in new Federal Reserve credit already created during 2009-10. This quantitative easing has been sent abroad, mainly to the BRIC countries: Brazil, Russia, India and China. “Recent research at the International Monetary Fund has shown conclusively that G4 monetary easing has in the past transferred itself almost completely to the emerging economies … since 1995, the stance of monetary policy in Asia has been almost entirely determined by the monetary stance of the G4 – the US, eurozone, Japan and China – led by the Fed.” According to the IMF, “equity prices in Asia and Latin America generally rise when excess liquidity is transferred from the G4 to the emerging economies.”[4]
This is what has led gold prices to surge and investors to move out of the dollar since early September, prompting other nations to protect their economies.
Speculative credit from U.S., Japanese and British banks to buy bonds, stocks and currencies in the BRIC and Third World countries is a self-feeding expansion, pushing up their currencies as well as their asset prices. Their central banks end up with these dollars, whose value falls as measured in their own local currencies. U.S. officials say that this is all part of the free market. “It is not good for the world for the burden of solving this broader problem … to rest on the shoulders of the United States,”[5] insisted Treasury Secretary Tim Geithner on Wednesday, as if the spillover from U.S. quantitative easing and deregulation was not promoting the speculative dollar glut.
So other countries are obliged to solve the problem on their own. Japan is holding down its exchange rate by selling yen and buying U.S. Treasury bonds in the face of its carry trade being unwound as arbitrageurs pay back the yen they earlier borrowed to buy higher-yielding but increasingly risky sovereign debt from countries such as Greece. These paybacks have pushed up the yen’s exchange rate by 12% against the dollar so far during 2010, prompting Bank of Japan governor Masaaki Shirakawa to announce on Tuesday, October 5, that Japan had “no choice” but to “spend 5 trillion yen ($60 billion) to buy government bonds, corporate IOUs, real-estate investment trust funds and exchange-traded funds – the latter two a departure from past practice.”[6]
This “sterilization” of unwanted inflows is what the United States has criticized China for doing. China has tried more normal ways to recycle its trade surplus, by seeking out U.S. companies to buy. But Congress would not let CNOOC buy into U.S. oil refinery capacity a few years ago, and the Canadian government is now being urged to block China’s attempt to purchase its potash resources. Such protectionism leaves little option for China and other countries except to hold their currencies stable by purchasing U.S. and European government bonds.
The problem for all countries today is that as presently structured, the global financial system rewards speculation and makes it difficult for central banks to maintain stability without recycling dollar inflows to the U.S. Government, which enjoys a near monopoly in providing the world’s central bank reserves by running budget and balance-of-payments deficits. As noted earlier, arbitrageurs obtain a twofold gain: the margin between Brazil’s nearly 12% yield on its long-term government bonds and the cost of U.S. credit (1%), plus the foreign-exchange gain resulting from the fact that the outflow from dollars into reals has pushed up the real’s exchange rate some 30% – from R$2.50 at the start of 2009 to $1.75 last week. Taking into account the ability to leverage $1 million of one’s own equity investment to buy $100 million of foreign securities, the rate of return is 3000% since January 2009.
Brazil has been more a victim than a beneficiary of what is euphemized as a “capital inflow.” The inflow of foreign money has pushed up the real by 4% in just over a month (from September 1 through early October), and the past year’s run-up has eroded the competitiveness of Brazilian exports. To deter the currency’s rise, the government imposed a 4% tax on foreign purchases of its bonds on October 4.
“It’s not only a currency war,” Finance Minister Guido Mantega explained. “It tends to become a trade war and this is our concern.”[7] Thailand’s central bank director Wongwatoo Potirat warned that his country was considering similar taxes and currency trade restrictions to stem the baht’s rise. Subir Gokarn, deputy governor of the Reserve Bank of India, announced that his country also was reviewing defenses against the “potential threat” of inward capital flows.”[8]
Such inflows do not provide capital for tangible investment. They are predatory, and cause currency fluctuation that disrupts trade patterns while creating enormous trading profits for large financial institutions and their customers. Yet most discussions treat the balance of payments and exchange rates as if they were determined purely by commodity trade and “purchasing power parity,” not by the financial flows and military spending that actually dominate the balance of payments. The reality is that today’s financial interregnum – anarchic “free” markets prior to countries hurriedly putting up their own monetary defenses – provides the arbitrage opportunity of the century. This is what bank lobbyists have been pressing for. It has little to do with the welfare of workers in their own country.
The potentially largest speculative prize promises to be an upward revaluation of China’s renminbi. The House Ways and Means Committee is demanding that China raise its exchange rate by the 20 percent that the Treasury and Federal Reserve are suggesting. Revaluation of this magnitude would enable speculators to put down 1% equity – say, $1 million to borrow $99 million – and buy Chinese renminbi forward. The revaluation being demanded would produce a 2000% profit of $20 million by turning the $100 million bet (and just $1 million “serious money”) into $120 million. Banks can trade on much larger, nearly infinitely leveraged margins, much like drawing up CDO swaps and other derivative plays.
This kind of money has been made by speculating on Brazilian, Indian and Chinese securities and those of other countries whose exchange rates have been forced up by credit-flight out of the dollar, which has fallen by 7% against a basket of currencies since early September when the Federal Reserve floated the prospect of quantitative easing. During the week leading up to the IMF meetings in Washington, the Thai baht and Indian rupee soared in anticipation that the United States and Britain would block any attempts by foreign countries to change the financial system and curb disruptive currency gambling.
This capital outflow from the United States has indeed helped domestic banks rebuild their balance sheets, as the Fed intended. But in the process the international financial system has been victimized as collateral damage. This prompted Chinese officials to counter U.S. attempts to blame it for running a trade surplus by retorting that U.S. financial aggression “risked bringing mutual destruction upon the great economic powers.”[9]
From the gold-exchange standard to the Treasury-bill standard to “free credit” anarchy
Indeed, the standoff between the United States and other countries at the IMF meetings in Washington this weekend threatens to cause the most serious rupture since the breakdown of the London Monetary Conference in 1933. The global financial system threatens once again to break apart, deranging the world’s trade and investment relationships – or to take a new form that will leave the United States isolated in the face of its structural long-term balance-of-payments deficit.
This crisis provides an opportunity – indeed, a need – to step back and review the longue durée of international financial evolution to see where past trends are leading and what paths need to be re-tracked. For many centuries prior to 1971, nations settled their balance of payments in gold or silver. This “money of the world,” as Sir James Steuart called gold in 1767, formed the basis of domestic currency as well. Until 1971 each U.S. Federal Reserve note was backed 25% by gold, valued at $35 an ounce. Countries had to obtain gold by running trade and payments surpluses in order to increase their money supply to facilitate general economic expansion. And when they ran trade deficits or undertook military campaigns, central banks restricted the supply of domestic credit to raise interest rates and attract foreign financial inflows.
As long as this behavioral condition remained in place, the international financial system operated fairly smoothly under checks and balances, albeit under “stop-go” policies when business expansions led to trade and payments deficits. Countries running such deficits raised their interest rates to attract foreign capital, while slashing government spending, raising taxes on consumers and slowing the domestic economy so as to reduce the purchase of imports.
What destabilized this system was war spending. War-related transactions spanning World Wars I and II enabled the United States to accumulate some 80% of the world’s monetary gold by 1950. This made the dollar a virtual proxy for gold. But after the Korean War broke out, U.S. overseas military spending accounted for the entire payments deficit during the 1950s and ‘60s and early ‘70s, while private-sector trade and investment were exactly in balance.
By August 1971, war spending in Vietnam and other foreign countries forced the United States to suspend gold convertibility of the dollar through sales via the London Gold Pool. But largely by inertia, central banks continued to settle their payments balances in U.S. Treasury securities. After all, there was no other asset in sufficient supply to form the basis for central bank monetary reserves.
But replacing gold – a pure asset – with dollar-denominated U.S. Treasury debt transformed the global financial system. It became debt-based, not asset-based. And geopolitically, the Treasury-bill standard made the United States immune from the traditional balance-of-payments and financial constraints, enabling its capital markets to become more highly debt-leveraged and “innovative.”
It also enabled the U.S. Government to wage foreign policy and military campaigns without much regard for the balance of payments.
The problem is that the supply of dollar credit has become potentially infinite. The “dollar glut” has grown in proportion to the U.S. payments deficit. Growth in central bank reserves and sovereign-country funds has taken the form of recycling of dollar inflows into new purchases of U.S. Treasury securities – thereby making foreign central banks (and taxpayers) responsible for financing most of the U.S. federal budget deficit. The fact that this deficit is largely military in nature – for purposes that many foreign voters oppose – makes this lock-in particularly galling. So it hardly is surprising that foreign countries are seeking an alternative.
Contrary to most public media posturing, the U.S. payments deficit – and hence, other countries’ payments surpluses – is not primarily a trade deficit. Foreign military spending has accelerated despite the Cold War ending with dissolution of the Soviet Union in 1991. Even more important has been rising capital outflows from the United States. Banks lent to foreign governments from Third World countries to other deficit countries to cover their national payments deficits, to private borrowers to buy the foreign infrastructure being privatized or to buy foreign stocks and bonds, and to arbitrageurs to borrow at a low interest rate to buy higher-yielding securities abroad.
The corollary is that other countries’ balance-of-payments surpluses do not stem primarily from trade relations, but from financial speculation and a spillover of U.S. global military spending. Under these conditions the maneuvering for quick returns by banks and their arbitrage customers is distorting exchange rates for international trade. U.S. “quantitative easing” is coming to be perceived as a euphemism for a predatory financial attack on the rest of the world. Trade and currency stability are part of the “collateral damage” caused by the Federal Reserve and Treasury flooding the economy with liquidity to re-inflate U.S. asset prices. Faced with this quantitative easing flooding the economy with reserves to “save the banks” from negative equity, all countries are obliged to act as “currency manipulators.” So much money is made by purely financial speculation that “real” economies are being destroyed.
The coming capital controls
The global financial system is being broken up as U.S. monetary officials change the rules they laid down half a century ago. Prior to the United States going off gold in 1971, nobody dreamed that an economy could create unlimited credit on computer keyboards and not see its currency plunge. But that is what happens under the global Treasury-bill standard. Foreign countries can prevent their currencies from rising against the dollar (which prices their labor and exports out of foreign markets) only by (1) recycling dollar inflows into U.S. Treasury securities, (2) by imposing capital controls, or (3) by avoiding use of the dollar or other currencies used by financial speculators in economies promoting “quantitative easing.”
Malaysia used capital controls during the 1997 Asian Crisis to prevent short-sellers from covering their bets. This confronted speculators with a short squeeze that George Soros says made him lose money on the attempted raid. Other countries are now reviewing how to impose capital controls to protect themselves from the tsunami of credit flowing into their currencies and buying up their assets – along with gold and other commodities that are turning into vehicles for speculation rather than actual use in production. Brazil took a modest step along this path by using tax policy rather than outright capital controls when it taxed foreign buyers of its bonds last week.
If other nations take this route, it will reverse the policy of open and unprotected capital markets adopted after World War II. This trend threatens to lead to the kind of international monetary practice found from the 1930s into the ‘50s: dual exchange rates, one for financial movements and another for trade. It probably would mean replacing the IMF, World Bank and WTO with a new set of institutions, isolating U.S., British and eurozone representation.
To defend itself, the IMF is proposing to act as a “central bank” creating what was called “paper gold” in the late 1960s – artificial credit in the form of Special Drawing Rights (SDRs). However, other countries already have complained that voting control remains dominated by the major promoters of arbitrage speculation – the United States, Britain and the eurozone. And the IMF’s Articles of Agreement prevent countries from protecting themselves, characterizing this as “interfering” with “open capital markets.” So the impasse reached this weekend appears to be permanent. As one report summarized matters: “‘There is only one obstacle, which is the agreement of the members,’ said a frustrated Mr Strauss Kahn.”[10] He added: “The language is ineffective.”[11]
Paul Martin, the former Canadian prime minister who helped create the G20 after the 1997-1998 Asian financial crisis, noted that “the big powers were largely immune to being named and shamed.” And in a Financial Times interview, Mohamed El-Erian, a former senior IMF official and now chief executive of Pimco, said: “You have a burst pipe behind the wall and the water is coming out. You have to fix the pipe, not just patch the wall.”[12]
The BRIC countries are simply creating their own parallel system. In September, China supported a Russian proposal to start direct trading between the yuan and the ruble. It has brokered a similar deal with Brazil. And on the eve of the IMF meetings in Washington on Friday, October 8, Premier Wen stopped off in Istanbul to reach agreement with Turkish Prime Minister Erdogan to use their own currencies in tripling Turkish-Chinese trade to $50 billion over the next five years, effectively excluding the U.S. dollar. “We are forming an economic strategic partnership … In all of our relations, we have agreed to use the lira and yuan,” Mr. Erdogan said.[13]
On the deepest economic plane today’s global financial breakdown is part of the price to be paid for the Federal Reserve and U.S. Treasury refusing to accept a prime axiom of banking: Debts that cannot be paid, won’t be. They tried to “save” the banking system from debt write-downs in 2008 by keeping the debt overhead in place while re-inflating asset prices. In the face of the repayment burden shrinking the U.S. economy, the Fed’s idea of helping the banks “earn their way out of negative equity” is to provide opportunities for predatory finance, leading to a flood of financial speculation. Economies targeted by global speculators understandably are seeking alternative arrangements. It does not look like these can be achieved via the IMF or other international forums in ways that U.S. financial strategists will willingly accept.
Footnotes

[1A] Sewell Chan, ‘Currency Rift With China Exposes Shifting Clout,’ The New York Times, October 11, 2010.

[1] Fed, ECB throwing world into chaos: Stiglitz, Walter Brandimarte, via Reuters, Oct. 5, 2010, reporting on a talk by Prof. Stiglitz at Columbia University. Dirk Bezemer and Geoffrey Gardiner, “Quantitative Easing is Pushing on a String” (paper prepared for the Boeckler Conference, Berlin, October 29-30, 2010), make clear that “QE provides bank customers, not banks, with loanable funds. Central Banks can supply commercial banks with liquidity that facilitates interbank payments and payments by customers and banks to the government, but what banks lend is their own debt, not that of the central bank. Whether the funds are lent for useful purposes will depend, not on the adequacy of the supply of fund, but on whether the environment is encouraging to real investment.” (p.c., G. Gardiner)

[2] Tom Lauricella, “Dollar’s Fall Roils World: As Global Leaders Meet, Strains Rise Among Nations Competing to Save Exports,” Wall Street Journal, October 8, 2010, quoting Edwin Truman, a former U.S. Treasury official now a senior fellow at the Peterson Institute for International Economics.

[3] Alan Beattie Chris Giles and Michiyo Nakamoto, “Currency war fears dominate IMF talks,” Financial Times, October 9, 2010, and Alex Frangos, “Easy Money Churns Emerging Markets,” Wall Street Journal, October 8, 2010.

[4] Gavyn Davies, “The global implications of QE2,” Financial Times, October 5, 2010.

[5] Alan Beattie, “Global economy: Going head to head,” Financial Times, October 8, 2010.

[6] Megumi Fujikawa and David Wessel, “Central Banks Open Spigot,” Wall Street Journal, October 6, 2010.

[7] Jonathan Wheatley, “Investors calm over Brazil tax rise,” Financial Times, October 6, 2010.

[8] Alan Beattie, Joshua Chaffin and Kevin Brown, “Wen warns against renminbi pressure,” Financial Times, October 7, 2010.

[9] Alan Beattie, “Global economy: Going head to head,” Financial Times, October 8, 2010.

[10] Chris Giles and Alan Beattie, “Leaders pledge cooperation on currencies,” Financial Times, October 9, 2010.

[11] Chris Giles and Alan Beattie, “Global clash over economy,” Financial Times, October 10, 2010.

[12] Alan Beattie and Chris Giles, “IMF meeting dashes hopes for co-operation,” Financial Times, October 10, 2010.

[13] Joe Parkinson, “Turkey, China Shun the Dollar in Conducting Trade,” Wall Street Journal, October 8, 2010.

ECB Initiates New Program of Quantitative Easing (Monetization of Eurozone Debt)

If the Eurozone Central Bank is so "confident" of growth as they say, then why would this be necessary at all? These are not the actions of confidence, but of desperation!

from EuroIntelligence.com:

So much for phasing out the bond purchasing programme. The latest weekly ECB data suggest that the ECB bought €237m worth sovereign bonds last week, the highest since the middle of August, according to the FT. Still small in absolute size, the paper notes, it is a sign of continuing problems in eurozone bond markets. Irish traders last week reported that the ECB had been in the market to support Irish bonds, whose yield spread to German bunds rose to new record levels. The article suggested that the ECB was also buying Greek and Portuguese bonds.

About that ECB’s exit strategy

Ralph Atkins and David Oakley have an excellent analysis in the FT about the change in the ECB’s exit strategy. While a year ago it was the conventional wisdom inside the ECB that the banking support policy would have to be phased out, and only then could interest rates rise. That is no longer so. As banks have become dependent on generous ECB liquidity support, it is possible that the monetary tightening occurs while the liquidity policies are still in place.

European Commission optimistic about eurozone

The European Commission published its autumn forecast and, as ever, the news coverage is taking a national angle on this. El Pais is worrying about increasing growth divergences in the eurozone, with Spain falling far behind Germany with its 3.4% growth rate. The Portuguese newspaper Negocios didn’t even bother to report about any other country but Portugal, reporting that the European Commission said that Portugal has “an opportunity to recover” but that it must “intensify consolidation”.    For the eurozone as a whole GDP is forecasted to rise 1.7% this year (rather than  a previously projected 0.9%). La Repubblica picks on the Commission’s warning that labour market dynamics are still fragile.

Gold Continues to Edge Lower for 3 of 4 Days on Central Banking Selling

from the WSJ:
Central banks are pawning their gold to the Bank for International Settlements at a record rate, taking advantage of the precious metal's historically high value to raise cash.
A little-noticed data point at the back of a 216-page report released last week by the BIS shows the international agency has taken 349 metric tons of gold since December—allowing central banks to raise a record $14 billion.
The number surprised the market, which had assumed most central banks had retained their holdings of gold. Instead, the BIS data show that they have been entering these gold swaps—exchanging their gold with the ...

How the Monetary Shell Game Works

from the Chris Martenson blog:

Executive Summary

• The Federal Reserve and the federal government are attempting to "plug the gap" caused by a slowdown of private credit/debt creation.
• Non-US demand for the dollar must remain high, or the dollar will fall.
• Demand for US assets is in negative territory for 2009
• The TIC report and Federal Reserve Custody Account are reviewed and compared
• The Federal Reserve has effectively been monetizing US government debt by cleverly enabling foreign central banks to swap their Agency debt for Treasury debt.
• The shell game that the Fed is currently playing obscures the fact that money is being printed out of thin air and used to buy US government debt.

The Federal Reserve is monetizing US Treasury debt and is doing so openly, both through its $300 billion commitment to buy Treasuries and by engaging in a sleight of hand maneuver that would make a street hustler from Brooklyn blush.
This report will wade through some technical details in order to illuminate a complicated issue, but you should take the time to learn about this because it is essential to understanding what the future may hold.
One of the most important questions of the day concerns how the dollar will fare in the coming months and years. If you are working for a wage, it is essential to know whether you should save or spend that money.  If you have assets to protect, where you place those monies is vitally important and could make the difference between a relatively pleasant future and a difficult one.  If you have any interest at all in where interest rates are headed, you'll want to understand this story.
There are three major tripwires strung across our landscape, any of which could rather suddenly change the game, if triggered.  One is a sudden rush into material goods and commodities, that might occur if (or when) the truly wealthy ever catch on that paper wealth is a doomed concept.  A second would occur if (or when) the largest and most dangerous bubble of them all, government debt, finally bursts.  And the third concerns the dollar itself.
In this report, we will explore the relationship between those last two tripwires, government debt and the dollar.

 

Replacing private credit with public credit

Our entire monetary system, and by extension our economy, is a Ponzi economy in the sense that it really only operates well when in expansion mode.  Even a slight regression triggers massive panics and disruptions that seem wholly inconsistent with the relative change, unless one understands that expansion is more or less a requirement of our type of monetary and economic system.  Without expansion, the system first labors and then destroys wealth far our of proportion to the decline itself.
What fuels expansion in a debt-based money system?  Why, new debt (or credit), of course!   So one of the things we keep a very close eye on over here at Martenson Central, as they do at the Federal Reserve, is the rate of debt creation.
One of the big themes in the current credit bubble collapse is the extent to which private credit has been collapsing and the corresponding degree to which the Federal Reserve has been purchasing debt and the federal government has stepped up its borrowing.  In essence, public debt purchases and new borrowing has attempted to plug the gap left by a shortfall in private debt purchases and borrowing.
That's the scheme right now - the Federal Reserve is creating new money out of thin air to buy debt, while the US government is creating new debt at the most fantastic pace ever seen.  The attempt here is to keep aggregate debt growing fast enough to prevent the system from completely seizing up.
How are they doing?

The debt gap

One of the great perks of living in a relatively open society is that we generally get access to pretty good information. The Federal Reserve routinely publishes a document called "Monetary Trends," where they collapse all their points of interest into a nice, tidy collection, and then make it available for all to see.
Here's what caught my eye in the most recent one:

What we see here is federal debt (bottom chart) exploding at a nearly 30% yr/yr rate of change in response to a collapse in corporate and consumer borrowing (top charts).
This raises a most interesting question:  "Who is lending the money to accommodate all that federal borrowing?"
Here's where the story gets interesting.

Treasury International Capital (TIC) flows

Lately, a number of observers have made note of a troubling decline in foreign demand for US paper assets, notably bonds.  Worse, it's even turned into outright selling which will ultimately translate into dollar weakness.
The relative demand for the dollar "out there" in the international Foreign Exchange (or "Forex") market directly impacts the dollar's strength.  If there are more sellers then its value will fall; if there are more buyers, then its value will rise.  One way to assess this delicate balance is to ask, "In total, are foreigners buying or selling US assets and what are they doing with those proceeds?"
Luckily for us, the exact answer to this very question is released in a monthly report put out by the Treasury Department, called the Treasury International Capital Flows report, or TIC report for short.
The recent TIC reports have been quite alarming, because they not only reveal the most sudden deceleration in flows in history, but also that they have been negative for some time now. This chart is from the Federal Reserve:

What we see here is that from the early 1990's onward until 2007, foreigners bought progressively more and more US assets and did so by bringing their money to the US and leaving it there.  It is only over the past seven months, out of decades, where that process has reversed and become negative.  This is a significant event, to say the least.
On the surface, the above chart hints at a potential disaster for a country that is embarking on the largest-ever federal debt binge in history.
After all, if US assets are being shunned by foreigners, how will we find enough buyers? And what will happen to the dollar?
The answers are:  "We won't" and "Nothing good."

Digging in

If we dig into deeper into the detail of the report, we find something even more interesting. While the overall flows have been negative, there is an enormous difference between the behaviors of foreign central banks and private investors.  Fortunately the TIC report distinguishes between these two broad classes of buyers.
Since the start of 2009 and continuing through the month of May, private investors sold $364 billion dollars worth of US assets, while central banks purchased  $50 billion dollars worth (source is a .csv file available here from the Treasury).  Added up, some $314 billion dollars of foreign money has left the country since the start of the year.
What this demonstrates is the utter reliance of the entire house of cards upon the continued purchase of US financial assets by foreign central banks. Without the continued cooperation of the foreign central banks in accumulating US assets, suffice it to say that the dollar will fall a lot lower than it already has.

The dollar

Not surprisingly, the dollar recently put in a new closing low for the year (YTD 2009) and is approaching a major area of support and resistance. If it breaks through, we could be looking at a rapid game-changer here.

Of course, I've said all this before, and every time we seem to get close, there's been an upside surprise in store.  The forces aligned to prevent a dollar collapse are numerous.
But the same risk remains, and the fundamental picture concerning the dollar has not changed since I first became wary of its fortunes in 2002.  In fact, it's grown worse.  Federal deficits are higher than I ever imagined possible (13% of GDP!), and now the TIC flows are negative.  The only somewhat bright(er) spot is that the trade deficit has shrunk quite a bit.  However, it, too, remains solidly in negative territory, meaning it continues to apply pressure to the value of the dollar by increasing the total number of dollars that need to find a quiet resting place outside of the country.

Treasury auctions

During this past business week (July 27^th - 31^st, 2009), the US Treasury auctioned off more than $243 billion worth of various Treasury bills and bonds. "Indirect bidders," assumed to be mainly central banks, took an astonishing 39% of the total, or nearly $95 billion worth.

With the exception of the 5-year auction, which mysteriously stank up the joint with a worrisome bid-to-cover ratio well below 2.0 (the bond market behaved poorly upon the release of that news item), the story here is that foreign central banks are buying up vast quantities of Treasury offerings.
Wait a minute, hold on there…I thought we just talked about how the TIC report said that foreign central banks have only bought $50 billion in total US paper assets through May - and now they are said to be buying $95 billion during a single week in July alone?
Something is not adding up here.
To understand what, and to get to the essence of the shell game, we need to visit one more source of information - something called the Federal Reserve Custody Account.

The Federal Reserve Custody Account

It turns out that when China's central bank (or any other foreign central bank) decides to buy either US agency or Treasury bonds, they do not walk up to some window somewhere, hand over a pile of cash, and then take some nice looking bonds home with them in a suitcase.
Instead, what happens is that the Federal Reserve actually holds the bonds (or rather an electronic entry representing the bonds) in a special account for these various central banks.  This is called the "Custody Account" and it holds US debt 'in custody' for various central banks. Think of it as a magnificently vast brokerage/checking account, run by the Federal Reserve for central banks, and you'll have the right image.
Although the TIC report shows flows of capital into and out of the country, it does not show you what is going on with those funds that are already in the country.  If you look again at the first chart in this report, and behold the vast flows of money that came into the US between 1995 and 2008, you can get a sense of how much money got sent to the US and mostly remains parked there.
The custody account currently stands at $2.787 trillion (with a "t") dollars.  It has increased by over $430 billion the past 12 months and by more than $275 billion in 2009 alone (through July 29).  These are truly shocking numbers, and they tell us that foreign central banks have been accumulating US debt instruments throughout the crisis.
As we can see in the chart below, there has been absolutely no deflection in the growth of the custody account as a consequence of the financial crisis, bottoming trade, or the local needs of the countries involved.  It's almost as if the custody account is completely disconnected from the world around it.  If you can spot the credit bubble crisis on this chart, you have sharper eyes than me.

What does such a chart imply?  We might wonder what sorts of distortions are created by having such a massive monetary spigot aimed from several central banks towards a single country.  We also might question just how sustainable such an arrangement really is.  It is a complete mystery how such a chart can display nary a wiggle, despite all that has recently transpired.
This next table showing the yearly changes in the custody account actually surprises me quite a bit.

Despite everything that's been going on, the custody account is on track to grow by the largest dollar amount on record this year, nearly $500 billion dollars (if the current pace continues).  Where is all this money coming from and for how much longer?

Understanding the gap between the TIC and the Custody numbers

One thing you might have noticed is that the TIC report only shows $50 billion in foreign bank inflows for 2009, while the custody account grew by $277 billion.
How is it possible for the TIC report to show smaller inflows than growth in the custody account?  We can see that clearly in this table, which compares the two.  (Note: These are 12 monthly yr/yr changes, so the numbers will be different than the YTD numbers I just cited):

One explanation is that the custody account, at some $2.7 trillion dollars, is accumulating a lot of interest. If those interest payments are not "sent home" and remain in the account, then the account will grow by enough to more or less explain the difference. For example, the $135 billion difference shown above could be generated by a 5% return to the custody account, which is not an unthinkable rate of interest for that account.

International check kiting

Some people view the custody account as nothing more than an elaborate version of check kiting, played at the central banking level.

Check kiting
An illegal scheme whereby a false line of credit is established by the exchanging of worthless checks between two banks. For instance, a "check kiter" might have empty checking accounts at two different banks, A and B. The kiter writes a check for $50,000 on the Bank A account and deposits it in the Bank B account. If the kiter has good credit at Bank B, he will be able to draw funds against the deposited check before it clears, i.e., is forwarded to Bank A for payment and paid by Bank A. Since the clearing process usually takes a few days, the kiter can use the $50,000 for a few days, and then deposit it in the Bank A account before the $50,000 check drawn on that account clears.

In this game, Central Bank A prints up a bunch of money and buys the debt of Country B. Then the central bank of Country B prints up a bunch of money and buys the debt of Country A.
Both enjoy the appearance of strong demand for their debt, both governments get money to use, and nobody is the wiser.  Except that the world's total stock of central bank reserves keep on growing and growing and growing, as reflected in the custody account, which will someday result in thoroughly unserviceable amounts of debt, an unmanageable flood of money, or both.
If this strikes you as a scam, congratulations; you get it.
If that was all there was to the story, then it would be far less interesting than it actually is. When we dig into the custody account data, we find that the total picture is hiding something quite extraordinary. Even as the total custody account has been growing steadily and faithfully, the composition of that account has been changing dramatically.

Here we note that agency bonds peaked in October of 2008 at nearly a trillion dollars but have declined by $178 billion since then.  Treasuries, on the other hand, have increased by over $500 billion over that same span of time.  A half a trillion dollars!  If you were wondering how the US bond auctions have managed to go so smoothly, here's part of your answer.
What is going on here?  How is it possible that central banks are buying so many Treasury bonds, at the fastest rate of accumulation on record?
It would appear that foreign central banks have been swapping agency bonds for Treasury bonds, but that's not how the markets work.  First, they would have to sell those bonds, before they could use the proceeds to buy government debt. So to whom did they sell those Agency bonds in order to afford the Treasury bonds?
Here we might recall that the Federal Reserve has been buying agency bonds by the hundreds of billions.

The shell game

Have you ever seen a sidewalk magician run the shell game, where a pea under a shell is magically shuffled around - now you see it under this shell, now you see it under that shell, now it disappears completely - or does it?  The more it moves around, the more confused you get.  If you can only figure out which shell the pea is hidden under, you win!   But where is the pea?  The point of the game, from the perspective of the street hustler, is to use complexity of motion to confuse the mark.
These are the three critical points to remember as you read further:

1. The US government has record amounts of Treasuries to sell.
2. Foreign central banks, which have a big pile of agency bonds in their custody account, would like to help but want to keep things somewhat under the radar to avoid scaring the debt markets.
3. The Federal Reserve does not want to be seen directly buying US government debt at auctions (and in fact is not permitted to, but many rules have been 'bent' worse during this crisis), because that could upset the whole illusion that there is unlimited demand for US government paper, but it also desperately wants to avoid a failed auction.

For various reasons, the Federal Reserve cannot just up and start buying all the Treasury paper that becomes available in record amounts, week after week, month after month.
Instead, it uses this three-step shell game to hide what it is doing under a layer of complexity:

Shell #1:  Foreign central banks sell agency debt out of the custody account.
Shell #2:  The Federal Reserve buys those agency bonds with money created out of thin air.
Shell #3:  Foreign central banks use that very same money to buy Treasuries at the next government auction.

Shuffle, shuffle, shuffle, shuffle, shuffle, SHUFFLE, shuffle! Confused yet?
Don't be.  If we remove the extraneous motion from this strange act, we find that the Federal Reserve is effectively buying government debt at auction.  This is exactly, precisely what Zimbabwe did, but with one more step involved, introducing just enough complexity to keep the entire game mostly, but not completely, hidden from sight.  They can scramble the shells all they want, but the pea is still there somewhere - the pea being the fact that the Fed is creating money to fund the purchase of US debt.

At the time, the Federal Reserve program to purchase agency bonds was described like this:

Fed to Pump $1.2 Trillion Into Markets
Greatly Expanded Purchases Are Designed to Lower Interest Rates, Stimulate Borrowing
The Federal Reserve yesterday escalated its massive campaign to stabilize the economy, saying it would flood the financial system with an additional $1.2 trillion.
In its statement yesterday, the Fed said it will increase its purchases of mortgage-backed securities by $750 billion, on top of $500 billion previously announced, and double, to $200 billion, its purchases of [Agency] debt in housing-finance firms such as Fannie Mae and Freddie Mac.

While "stimulating borrowing," "stabilizing the economy," and "lowering interest rates" are laudable goals, the primary goal of the program seems to have been something else entirely - to assure plentiful funds for the massive US Treasury auctions coming due.  I saw nothing in any article I read about this program that even suggested that one of the goals was to allow foreign central banks to effectively swap their agency debt for US government debt using money printed from thin air.  But that's clearly one of the outcomes.
The Federal Reserve, for its part, has been quite open about these purchases of Agency debt. It even provides an excellent website with nice graphics, allowing us to track the purchase program.

(Source)
However, this openness only extends to the amounts themselves, not the source(s) of those Agency bonds.  This is, in my mind, yet another reason the Fed desperately wishes to avoid an audit. The results would expose the game for what it is.
As we can see in the above chart, the Fed has purchased more than $640 billion of Agency bonds, and has promised to buy more in the near future.
As we now know, at least some of that money has been recycled into US government debt, where "indirect bidders" have been snapping up an unusually high proportion of the recent offerings.  (Note: The way Indirect bidders  are calculated has recently changed, and I am not entirely clear on how much this influences the numbers we now see….I'm working on it).
A fair question to ask here is, "If there are green shoots everywhere and the stock market is racing off to new yearly highs, why is the Fed continuing to pump money into the system at these mind-boggling rates?"  One answer could be, "Because things might not be as rosy as they seem."

Conclusion

The Federal Reserve has effectively been monetizing far more US government debt than has openly been revealed, by cleverly enabling foreign central banks to swap their agency debt for Treasury debt.  This is not a sign of strength and reveals a pattern of trading temporary relief for future difficulties.
This is very nearly the same path that Zimbabwe took, resulting in the complete abandonment of the Zimbabwe dollar as a unit of currency.  The difference is in the complexity of the game being played, not the substance of the actions themselves.
When the full scope of this program is more widely recognized, ever more pressure will fall upon the dollar, as more and more private investors shun the dollar and all dollar-denominated instruments as stores of value and wealth. This will further burden the efforts of the various central banks around the world as they endeavor to meet the vast borrowing desires of the US government.
One possible result of the abandonment of these efforts is a wholesale flight out of the dollar and into other assets.  To US residents, this will be experienced as rapidly rising import costs and increasing costs for all internationally-traded basic commodities, especially food items.  For the rest of the world, the results will range from discomforting to disastrous, depending on their degree of dollar linkage.
Under these circumstances, "inflation vs. deflation" is not the right frame of reference for understanding the potential impacts.  For example, it would be possible for most of the world to experience falling prices, even as the US experiences rapidly rising prices (and hikes in interest rates) as a consequence of a falling dollar.  Is this inflation or deflation?  Both, or neither?  Instead, we might properly view it as a currency crisis, with prices along for the ride.
Further, all efforts to supplant private debt creation with public debts should be met with skepticism, because gigantic programs are no substitute for the collective decisions of tens of millions of individuals and cannot realistically meet millions of individual needs in a timely or appropriate manner.
The shell game that the Fed is currently playing does not change the basic equation: Money is being printed out of thin air so that it can be used to buy US government debt.
My advice is to keep these potential issues and insights in sharp focus, make what moves you can to diversify out of dollars, and be ready to move rapidly with the rest.  This game is far from over.

Your faithful information scout,
Chris Martenson
Original article.