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.

Fed's Strong Correlation to Rising Prices

This week's Stock World Weekly is called "Balancing Act." Here's the Week Ahead section, click here for the full newsletter. - Ilene

Excerpt (Week Ahead Section):
The S&P 500 failed to hold the critical level of 1,333 on Friday and this market is feeling a bit toppy. If the Fed allows QE2 to end in June as planned, the perpetual market prop-up may face some headwinds.
On Saturday, April 9, Phil posted “Investing for Income - Part One.” The article discusses constructing a conservative, low-maintenance portfolio designed to produce consistent income while preserving capital. Our intention is to test- drive a virtual portfolio of $500,000 and see how it performs over time, with the goal of generating $4,000/month income. Of course, part of the challenge is not only to produce income, but also to offset inflationary effects and prevent the erosion of the value of the original investment. Part two will follow in about two weeks.
Inflation and stagflation have been important topics of debate, particularly since the Fed announced the QE2 program last fall, and even more so as prices of commodities have been rising unabated. While Fed apologists make academic arguments that QE shouldn’t cause inflation, many financial commentators disagree. Jason Kaspar, of GoldShark.com, discussed the subject with SWW editor Ilene in email correspondence. Jason wrote, “The real definition of inflation is an increase in the money supply, and according to me, that includes credit as well. The real definition of deflation, conversely, is a decrease in the money supply.
“Logic presupposes that when the money supply increases, the prices of goods will increase. This is generally true. However, the reverse is not always true. An increase in the price of goods does not necessarily mean there has been an increase in the money supply.
“For example, during the collapse of 2008, a tremendous amount of money was vaporized through de-leveraging (among other things). We saw much of this occur in the mortgage market with innumerable foreclosures. When the Treasury instituted its stimulus spending and the Fed helped facilitate this spending through quantitative easing in 2009, the stimulus served only to replace the money that was lost. The Fed bought mortgage backed securities (in QE1) and treasuries from the banks, but instead of lending that money out to individuals, the banks allowed it to build in reserves at the Fed (which renders it useless) or have been investing that money in assets, like food, equities, gold, etc.
“Therefore, even though there is no overall increase in the money supply (M3 has started contracting again recently), some of the QE money has been shifted into specific assets, which are enjoying nominally large price increases. This is the difference between money supply inflation, and price inflation.”
Russ Winter, at Wall Street Examiner, and author of Winter Watch writes, “The following chart says it all (below). The Fed’s aggressive Treasury monetization has been the causa proxima (90-percent correlation) to the pedal-to- the-metal Minsky Meltup in commodities. I suspected this would be the effect but confess I did not believe the Fed and government could be so irrational and stupid as to attempt it, especially with the blowback evident by year end. Though I am one of the most persistent critics of Fed rabble, this exceeded even my worst fears and nightmares. This is what Bernanke refers to as ‘temporary’ inflation. Nor did I anticipate the markets ignoring such clear and present danger either. The transmission of this inflation disease appears to take about six months, which corresponds to the MIT price survey I have been using. It, too, now shows that inflation is in full swing.”
“If the Fed continues its purchases, we can calculate that each new $100 billion of Treasury purchased will add about 5 percent to the commodity index and $7 to oil. It takes four weeks for the Fed to purchase $100 billion in Treasuries. What a game of chicken being played out and right before our eyes! You can sense the collision, flying glass, blood and bones at almost any moment. If the Fed desists or scales down its Treasury buying, the stark trillion dollar question becomes who will buy them?” (The Game Of Chicken: Collision, Blood and Bones, originally posted on the Winter Economic and Market Watch blog, and Russ’s premium service, Russ Winter’s Actionable.)
Lee Adler, editor and publisher of Wall Street Examiner presents another perspective: “The evidence shows that banks are again out of the Treasury buying game. It also shows that they lost money in the first quarter, which is insane considering that their cost of funds is zero. It’s an indication of just how dire the circumstances are. Banks continue to accumulate cash at a frantic rate in their accounts at the Fed. The last time reserves rose this fast was in the midst of the crisis in 2008.
“Although the banks did buy some Treasuries in mid March, they have again stopped buying and reduced their holdings, opting to hold cash at the Fed instead. The banks are pulling cash out of the system and depositing it in their reserve accounts even faster than the Fed is printing it, lately 60% faster. We have to wonder what has them so spooked.
“At the same time, FCBs [foreign central banks] purchases of Treasuries are also backsliding, and are well below the threshold where they need to be to keep the markets stable. These elements essentially neutralize the Fed’s pumping. It may not be enough to send the
markets lower, and in the absence of new Treasury supply, Fed buying should be enough to keep the field tilted in favor of higher prices. April’s bias should be to the upside, but the background drag will be there. Things will get tougher in May when Treasury supply increases, and really tough this summer when the Fed presumably will stop pumping.” (Fed Gets To Skate On Thin Ice In April)
The S&P 500 is near the level where we might be more bullish on a technical basis. However, the low volumes that have characterized this rally, and the artificiality of it, leave us skeptical and cautious going into next week.
Read more: Balancing Act.
Stock World Weekly archives here >

Worthless Pieces of Paper

We now live in a world where governments print worthless pieces of paper to buy other worthless pieces of paper that combined with worthless derivatives, finance assets whose values are totally dependent on all these worthless debt instruments.  Thus most of these assets are also worth-less. -- Egon von Greyerz, Matterhorn Asset Management

"...there are only two kinds of paper money - those which are already worthless and those which are going to be worthless"

"Before it can be exchanged, wealth must be created. Wealth cannot be created out of thin air. By definition, an economic good is “scarce”. If it were not, there would be no such thing as economics or exchange. Neither would be necessary because no effort or choice in the face of alternatives would be required in order to provide the GOODS which further our lives. Before we can talk about money and the VITAL role it performs, we must stress this point. Money is NOT wealth, it is the means by which wealth is exchanged amongst those who produce it. Paper money is not suited to this function...

The paper money “price” of Gold will last as long as the attempt to make paper money “work” lasts. In the end, Gold will no longer have a “price” because it has reverted to its role as MONEY. Whenever and wherever that happens, that nation can return to the production of wealth - rather than “money”.

 -- Bill Buckler

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.

Quotes: Gold (the only real money) vs. fiat money

"Bulls of 1929 - like their 1990s counterparts - had their eyes glued on improving profits and stock valuations. Not a thought was given to the fact that the rising tide of money deluging the stock market came from financial leverage and not from savings."
- Dr. Kurt Richebacher

"...resources have been misallocated because of the cheapness of credit in both stock and credit markets. So, you're not going to solve the problem by making money cheaper again."
- Al Friedberg, Welling@Weeden, March 23, 2001

"Every mania in financial history has been liquidity driven. You can go back to the South Sea Bubble or tulips in Holland. As long as the money is coming in, everything is fine. "
- Raymond DeVoe, Dec. 11, 1995

"The length and severity of depressions depend partly on the magnitude of the 'real' maladjustments, which developed during the preceding boom and partly on the aggravating monetary and credit conditions."
- Gotfried Haberler, Prosperity and Depression, 1937

"The aggressive mindset of the world's economic powerhouse may need to be replaced with the humility appropriate for the world's biggest debtor nation."
- Berry Riley, Financial Times, April 2001

"Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

"Fortunately, nearly all of our public and private debt is denominated in U.S. dollars and we claim one-third of the world’s gold supply. And, we are the only super-power and have the largest economy in the world. In short, if we declare a new monetary regime disciplined by gold, the world has to accept it.

"In summary, because of the unique position of the U.S., perhaps running the printing presses to destroy excess financial claims through monetary inflation and then creating a new gold based monetary regime might be the most beneficial course of action for the interests of the U.S.

"But, again, unless they had just taken a vow of poverty, it would be unsettling to the owners of financial assets.

"As in the past, do we still hold the value of the U.S. dollar sacred?"

Remarks by Chairman Alan Greenspan Before the Economic Club of New York, New York City, December 19, 2002

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
--John Maynard Keynes

“The plot is easy to read. The Fed has read it all along. The plot is as follows – American consumers MUST AT ALL COSTS CONTINUE TO CONSUME.”
– Richard Russell, April 16, 2003

“We have reached the point where there is no turning off the Credit excess, no turning off the GSEs, no turning off the Mortgage Finance Bubble, no turning off the destabilizing world of derivative trading, and no turning off the rampant financial speculation and its increasingly destabilizing effects. It is truly one massive Bubble running out of control. And let’s not ignore the reality that these frightening financial convulsions are symptomatic of an extremely sick system. One of these days there will be a life-threatening seizure. What we have here is an historic circumstance of a dysfunctional monetary regime and a central bank that will defend it at all costs." -Doug Noland

“By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation” “Deflation: Making Sure ‘It’ Doesn't Happen Here,” Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., November 21, 2002

"…the U.S. is heading for maybe the greatest financial mess in world history. The U.S. is far too extended financially, militarily and socially in the way of entitlements that we can't afford." Richard Russell, Quoted by Mark Hulbert, “Russell Celebrates by Selling Bonds,” CBS Marketwatch, July18, 2003. Richard Russell, considered the dean of Investment Newsletters, publishes the Dow Theory Letters, the oldest and most successful investment newsletter in the world. His stock-market timing record is in first place on a risk-adjusted basis among all market-timing newsletters the Hulbert Financial Digest has tracked over the past 23 years.

"It was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, has allowed a persistent over issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess." – Fed Chairman Alan Greenspan Before the Economic Club of New York, New York City December 19, 2002 "Issues for Monetary Policy"

President Woodrow Wilson, who signed the Federal Reserve Act in 1913 was quoted just three years later as saying, “I have unwittingly ruined my country. The growth of the nation, and therefore all of our activities, are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world” (Quoted in “National Economy and the Banking System," Senate Documents Co. 3, No. 23, 76th Congress, 1st session, 1939.)

Wall Street spends so much of its intellectual and financial resources trying to figure out how to hedge every kind of risk it can imagine. But the one kind of risk that repeatedly brings down markets and the biggest and boldest players in those markets is liquidity risk. The only true hedge against liquidity risk would be to cut out man's greed gland. You can't hedge human nature. Michael Lewitt

“High inflation countries almost always have high money growth and low inflation countries have relatively low money growth.” Federal Reserve Chairman Ben Bernanke

George Bernard Shaw:

“You have to choose [as a voter] between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect for these gentlemen, I advise you, as long as the Capitalist system lasts, to vote for gold.”

Voltaire (1694-1778)

“Paper money eventually returns to its intrinsic value ---- zero.”

Daniel Webster, speech in the U.S. Senate, 1833

“We are in danger of being overwhelmed with irredeemable paper, mere paper, representing not gold nor silver; no sir, representing nothing but broken promises, bad faith, bankrupt corporations, cheated creditors and a ruined people.”

Thomas Jefferson to John Taylor, 1816

“I sincerely believe ... that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.”

Daniel Webster "Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money."

St. Louis Federal Reserve Bank,
Review, Nov. 1975, p.22 "The decrease in purchasing power incurred by holders of money due to inflation imparts gains to the issuers of money--."++

Andrew Jackson, in his will, indicated that the epitaph on his gravestone was to read, "I killed the bank". He considered his cancellation of the 2nd National Bank to be his greatest accomplishment not only of his Presidency, but of his life!