Money for Nothin’ Writing Checks for Free
It was Milton Friedman, not Ben Bernanke, who first made reference
to dropping money from helicopters in order to prevent deflation.
Bernanke’s now famous “helicopter speech” in 2002, however, was no less
enthusiastically supportive of the concept. In it, he boldly previewed
the almost unimaginable policy solutions that would follow the black
swan financial meltdown in 2008: policy rates at zero for an extended
period of time; expanding the menu of assets that the Fed buys beyond
Treasuries; and of course quantitative easing purchases of an almost
unlimited amount should they be needed. These weren’t Bernanke
innovations – nor was the term QE. Many of them had been applied by
policy authorities in the late 1930s and ‘40s as well as Japan in recent
years. Yet the then Fed Governor’s rather blatant support of monetary
policy to come should have been a signal to investors that he would be
willing to pilot a helicopter should the takeoff be necessary. “Like
gold,” he said, “U.S. dollars have value only to the extent that they
are strictly limited in supply. But the U.S. government has a
technology, called a printing press (or, today, its electronic
equivalent), that allows it to produce as many U.S. dollars as it wishes
at essentially no cost.”
Mr. Bernanke never provided additional clarity as to what he meant by “no cost.”
Perhaps he was referring to zero-bound interest rates, although at the
time in 2002, 10-year Treasuries were at 4%. Or perhaps he knew
something that American citizens, their political representatives, and
almost all investors still don’t know: that quantitative easing – the purchase of Treasury and Agency mortgage obligations from the private sector – IS
essentially costless in a number of ways. That might strike almost all
of us as rather incredible – writing checks for free – but that in
effect is what a central bank does. Yet if ordinary citizens and
corporations can’t overdraft their accounts without criminal liability,
how can the Fed or the European Central Bank or any central bank get
away with printing “electronic money” and distributing it via helicopter
flyovers in the trillions and trillions of dollars?
Well, the answer is sort of complicated but then it’s sort of
simple: They just make it up. When the Fed now writes $85 billion of
checks to buy Treasuries and mortgages every month, they really have
nothing in the “bank” to back them. Supposedly they own a few billion
dollars of “gold certificates” that represent a fairy-tale claim on Ft.
Knox’s secret stash, but there’s essentially nothing there but trust.
When a primary dealer such as J.P. Morgan or Bank of America sells its
Treasuries to the Fed, it gets a “credit” in its account with the Fed,
known as “reserves.” It can spend those reserves for something else, but
then another bank gets a credit for its reserves and so on and so on.
The Fed has told its member banks “Trust me, we will always honor your
reserves,” and so the banks do, and corporations and ordinary citizens
trust the banks, and “the beat goes on,” as Sonny and Cher sang. $54
trillion of credit in the U.S. financial system based upon trusting a
central bank with nothing in the vault to back it up. Amazing!
But the story doesn’t end here. What I have just described is a
rather routine textbook explanation of how central and fractional
reserve banking works its productive yet potentially destructive magic. What
Governor Bernanke may have been referring to with his “essentially
free” comment was the fact that the Fed and other central banks such as
the Bank of England (BOE) actually rebate the
interest they earn on the Treasuries and Gilts that they buy. They
give the interest back to the government, and in so doing, the Treasury
issues debt for free. Theoretically it’s the profits of the Fed that are returned to the Treasury, but the profits are
the interest on the $2.5 trillion worth of Treasuries and mortgages
that they have purchased from the market. The current annual remit
amounts to nearly $100 billion, an amount that permits the Treasury to
reduce its deficit by a like amount. When the Fed buys $1
trillion worth of Treasuries and mortgages annually, as it is now doing,
it effectively is financing 80% of the deficit for free.
The BOE and other central banks work in a similar fashion. British
Chancellor of the Exchequer (equivalent to our Treasury Secretary)
George Osborne wrote a letter to Mervyn King, Governor of the BOE
(equivalent to our Fed Chairman) in November. “Transferring the net
income from the APF [Asset Purchase Facility – Britain’s QE] will allow
the Government to manage its cash more efficiently, and should lead to
debt interest savings to central government in the short-term.” Savings
indeed! The Exchequer issues gilts, the BOE’s QE program buys them and
then remits the interest back to the Exchequer. As shown in Chart 1,
the world’s six largest central banks have collectively issued six
trillion dollars’ worth of checks since the beginning of 2009 in order
to stem private sector delevering. Treasury credit is being backed with
central bank credit with the interest then remitted to its issuer.
Should interest rates rise and losses accrue to the Fed’s portfolio,
they record it as an accounting liability owed to the Treasury, which
need never be paid back. This is about as good as it can get folks.
Money for nothing. Debt for free.
Investors and ordinary citizens might wonder then, why
the fuss over the fiscal cliff and the increasing amount of debt/GDP
that current deficits portend? Why the austerity push in the U.K., and
why the possibly exaggerated concern by U.S. Republicans over spending
and entitlements? If a country can issue debt, have its central bank buy
it, and then return the interest, what’s to worry? Alfred E. Neuman for President (or House Speaker!).
Well ultimately government financing schemes such as today’s QE’s or England’s early 1700s South Sea Bubble end badly.
At the time Sir Isaac Newton was asked about the apparent success of
the government’s plan and he responded by saying that “I can calculate
the movement of the stars but not the madness of men.” The madness he
referred to was the rather blatant acceptance by government and its
citizen investors, that they had discovered the key to perpetual
prosperity: “essentially costless” debt financing. The plan’s
originator, Scotsman John Law, could not have conceived of helicopters
like Ben Bernanke did 300 years later, but the concept was the same:
writing checks for free.
Yet the common sense of John Law – and likewise that of Ben Bernanke
– must have known that only air comes for free and is “essentially
costless.” The future price tag of printing six trillion
dollars’ worth of checks comes in the form of inflation and devaluation
of currencies either relative to each other, or to commodities in less
limitless supply such as oil or gold. To date, central banks
have been willing to accept that cost – nay – have even encouraged it.
The Fed is now comfortable with 2.5% inflation for at least 1–2 years
and the Bank of Japan seems willing to up their targeted objective to
something above as opposed to below ground zero. But in the process,
zero-bound yields and their QE check writing may have distorted market
prices, and in the process the flow as well as the existing stock of credit. Capital
vs. labor; bonds/stocks vs. cash; lenders vs. borrowers; surplus vs.
deficit nations; rich vs. the poor: these are the secular anomalies and
mismatches perpetuated by unlimited check writing that now threaten
future stability.
Ben Bernanke has publically acknowledged these growing disparities.
“We are quite aware,” he said in November 2011, “that very low interest
rates, particularly for a protracted period, do have costs for a lot
of people… I think the response is, though, that there is a greater
good here, which is the health and recovery of the U.S. economy... I
mean, ultimately, if you want to earn money on your investments, you
have to invest in an economy which is growing.”
That growth now is to be measured each and every employment Friday
via an unemployment rate thermostat set at 6.5%. We at PIMCO would not
argue with that objective. Yet we would caution, as Bernanke himself
has cautioned, that there are negative consequences and that when
central banks enter the cave of quantitative easing and “essentially
costless” electronic printing of money, there may be dragons.
Investment conclusions
Investors should be alert to the longterm inflationary thrust of such check writing. While
they are not likely to breathe fire in 2013, the inflationary dragons
lurk in the “out” years towards which long-term bond yields are
measured. You should avoid them and confine your maturities and bond
durations to short/intermediate targets supported by Fed policies.
In addition, be aware of PIMCO’s continued concerns about the
increasing ineffectiveness of quantitative easing with regards to the
real economy. Zero-bound interest rates, QE maneuvering, and
“essentially costless” check writing destroy financial business models
and stunt investment decisions which offer increasingly lower ROIs and
ROEs. Purchases of “paper” shares as opposed to investments in tangible
productive investment assets become the likely preferred corporate
choice. Those purchases may be initially supportive of stock prices but
ultimately constraining of true wealth creation and real economic
growth. At some future point, risk assets – stocks, corporate and high
yield bonds – must recognize the difference. Bernanke’s dreams of
economic revival, which would then lead to the day that investors can
earn higher returns, may be an unattainable theoretical hope, in
contrast to a future reality. Japan we are not, nor is Euroland or the
U.K. – just yet. But “costless” check writing does indeed have a cost
and checks cannot perpetually be written for free.
William H. Gross
Managing Director
