Everyone thinks they know the cause and effect of the Federal Reserve’s response to crises such as 2008 and 2020. The Fed prints money to buy assets. This increases the quantity of money. And this causes prices to rise. The Fed wants this, because it thinks that inflation eases the burden on debtors. The mainstream wants this, because they have been brainwashed into thinking that inflation causes good effects such as employment. The critics decry this, because they see inflation as a tax.
This view is not even wrong.
The dollar is not money. It is just credit. And it’s not printed. It’s borrowed. An increase in the quantity of it does not necessarily cause commodity and consumer prices to rise. Just look at not one, but two drops in the price of oil. And not small drops, but epic collapses. Starting in June 2014, the price began to fall from $108. By January 2016, it had dropped to $26, a crash of 76%. Then it rose for a while, hitting $77 by October 2018. It has been downward since then, to $66 this January, or -14%. It’s now $25, which is a further loss of 62%. This is not counting the brief plunge to -$38 on April 20—yes, those who had oil were obliged to pay someone to take it off their hands (thus debunking the notion that oil is like gold).
In other words, this not-even-wrong theory predicts a didn’t-even-happen price hike.
When a bank, pension fund, or investor sells a bond to the Fed, they do not go out and buy consumer goods. They buy another asset. This is why the result is not rising consumer prices, but rising asset prices.
Another way of looking at this is that the Net Present Value of an asset is determined by adding up all future earnings. But the catch is that earnings in future years have to be discounted to calculate their present value. The discount rate is the market rate of interest. A lower interest rate (which the Fed drives by buying bonds) means a lower discount rate for assets. Which means higher asset prices.
We have written previously that the process of rising asset prices is a process of conversion of one person’s capital into another’s income, to be consumed. Today we want to look at this from a different angle, one germane to the lockdown in response to the coronavirus.
The root of the problem is that the government has locked down the economy. Real estate that was previously generating revenue (i.e. rent) is now unable to generate anything. Revenues may be zero, but of course expenses are not. Assets based on this real estate (e.g. mortgage backed securities, bonds, and REITs) are therefore impaired or worthless.
In an inflationary system, a decline in asset values is deadly. This is because assets are generally owned with borrowed money. When an asset drops in value, of course the debt that financed it does not. If the drop is big enough, then the borrower is bankrupt. He must give the asset to the creditor. But the creditor is also leveraged. So the creditor is bankrupt, and must give the asset to its creditor. And so on.
And when we say inflationary, we don’t mean the grammar school understanding of rising quantity of money and rising consumer prices. Or maybe we should say medieval, as this is an understanding of how the monetary system works the way the Ptolemaic geocentric model is an understanding of how the universe works.
When we say inflation, we refer to the counterfeiting of credit. That is credit where one or more of the following statements is false: (1) the lender knows he is lending, (2) the lender is willing to lend, (3) the borrower has the means to repay, and (4) the borrower has the intent to repay.
Do you know anyone who refuses to own government bonds, because he does not want to lend to the government—but who holds a sizeable cash balance? Then you observe proof that the lender in our system does not even know he is lending. If you tried to explain to him that the bank takes the cash he deposited and buys a Treasury bond with it, he would object. The lender is often not willing to lend, even if he is aware at all.
The means to repay refers to the borrower’s income, which must be enough not merely to service the debt but to amortize the principal as well. The government debt is now well over $25 trillion. We estimate that is about $250,000 for everyone working in the productive sector. Can even a socialist claim that the government can amortize this, with a straight face? Of course not, which is why they’ve become more pugnacious. They now promote Cargo Cult economics, aka Modern Monetary Theory, which asserts (among other things) that the debt need not be paid back at all.
Intent refers to all of the things a legitimate borrower does, starting with borrowing to finance the purchase or development of productive assets. The lack of intent is betrayed by borrowing to spend on such thing as welfare programs.
We must emphasize that lack of intent is also shown by President Roosevelt’s move to make the dollar irredeemable to Americans, and Nixon’s follow-on move to make it irredeemable to foreign government creditors.
In an irredeemable currency, there is no mechanism to extinguish debt, on net. Sure, one debtor can pay off his mortgage. But in aggregate, debtors cannot do this. So debt must increase every year by at least the accrued interest (it’s more than that, actually, as what is really necessary is that the marginal debtor get enough cash to service his debt), and more if you want what passes for growth.
We have written many times about the perversity of someone buying a house for $100,000 then selling it to someone else for $200,000 who sells it for $300,000, etc. Each time, the buyer borrows the cash to buy the house (and each time, the seller has a gain, which he can spend, which is to say consume the capital of the buyer, or more precisely, the capital provided by the buyer’s bank, which is the savings of the bank’s clients).
Today, we just want to focus on the fact that as onetime-$100,000 house may be worth $1,000,000 today. And there is a $1,000,000 debt to match it. This debt is someone else’s asset (a bank, most likely). And the bank borrowed this sum, itself. So the bank has a liability (e.g. a deposits, or bonds) which is someone else’s asset. And so on.
What happens if the market value of the house goes down to the original $100,000 that it was when Andrew bought it?
It wipes away all of those assets. The bank’s, the depositors’, the bondholders’, their creditors, etc. The loss of nominal value goes up the credit chain, toppling everyone.
So the Fed is supposed to stop this. By buying Treasury bonds (and now also: mortgage bonds, corporate bonds, and we have even read of municipal bond buying though we are not sure if this has started yet) it seeks to hold up asset prices. Note that the Fed cannot fix the problem of restaurant and retailer inability to pay rent. But it can attempt to compensate by trying to set a firm bid in the market for such assets.
Those who own bonds do so for one reason. They need to obtain income from their ownership. The Fed has long ago sucked out most of the yield. But asset owners can at least hope for capital gains. A capital gain is a surrogate for yield, the way cocaine is a surrogate for sleep.
The point being that if investors can get the yield they seek, then there is no reason to sell. If they don’t sell, then asset prices do not crash. If asset prices do not crash, then creditors are not ruined, and there is no cascade of toppling financial intermediaries like dominoes. And GDP can go on rising. So all is good, right?
Not quite. Where is this yield coming from? As we said, the restaurants and retailers have closed up shop, or those who remain open are surely renegotiating a new rent amount that is sustainable for them based on their much-reduced revenues post-virus. The landlords have no choice but to renegotiate their monthly payment to their creditors. There is no choice to keep paying the same, like there is no choice to keep the same elevation when pushed off the edge of a cliff. Payments for debt service must drop. Which would ordinarily mean the market value of this debt (which is the asset of the bank or pension fund) must drop commensurately.
Which is what the Fed cannot allow.
So how does the Fed prop up asset prices? It borrows to buy them. How much does it have to borrow? As much as it takes to show the market that the Fed is boss, and there is now a firm bid to support the market. The “Fed Put”, it’s been called. Also a “bazooka”.
From whom does the Fed borrow? To understand the answer, first consider that the Fed has a magic power. All banks are granted a legal privilege to borrow short-term and lend long-term with impunity. But the Fed has the unlimited right to monetize debt, that is to issue currency to pay for long-term bonds such as 30-year Treasuries (and now 30-year corporates). Banks are subject to regulation—and outright government supervision—which puts a limit on what they can do, but the Fed is not.
The Fed’s credit paper is deemed by law to be currency. That is, it is a current asset. It can be used to service debts and every creditor must accept it as payment in full.
Think about that for a minute. If you own a 30-year bond, you cannot use it to pay your debts when due. You must sell the bond, to raise the cash—the Fed’s credit note—to pay your creditors. If the bond market has no bid at that moment, you will be forced into bankruptcy. But the Fed isn’t you. The Fed can buy as many 30-year bonds as it pleases, and emit currency. The Fed seemingly turns long bonds into money, the way a magician seemingly turns a dove into a rabbit.
The Fed borrows from anyone who needs the liquidity or wants the uptick in price. From every investor who decides to increase his cash cushion in case business drops. From every investor who seeks a capital gain on his Treasury bonds. To hold a money balance is really to hold a balance of the Fed’s liability, its credit note. It is to be a lender to the Fed. It is to be an enabler of the Fed to buy every asset it feels like buying.
Many market participants trade good assets for the Fed’s credit-note money. The way that bonds backed by retail real estate occupied by nonpaying restaurants are perfectly good. And the way the irredeemable credit notes of a central bank are money.
These people and institutions who desperately crave what has been legally deemed to be money, crave the Fed’s credit notes.
They are not only giving up impaired assets, but also productive capital assets too. This is the source of the capital that’s fed into the Fed’s sausage grinder, which spits out if not a yield, at least capital gains for asset owners.
If the Fed owned only bad assets, then this scheme would not work, the way the body would not work if someone consumed only alcohol with no food. The Fed must bury the bad assets among assets that, even if they aren’t good, are at least paying the interest.
So long as the Fed can keep doling out gains for asset owners, the system can continue, asset owners can continue to lever up to bid up asset prices to give sellers capital to consume. Everything works, the way electrical appliances work in a house where the fuse that kept burning out is replaced with a copper penny.
And the above is a necessary feature, not a bug. If the Fed does not take the action we describe, then asset prices collapse and with them all financial intermediaries. Savers and investors will be wiped out. The unwind will be that big.
We believe that it’s important for people to clearly understand the nature of the beast (and give a little more color on why we pay interest on gold, to make it profitable to invest in the gold standard—because the gold standard does not allow for a central bank to convert all the capital into income, and dole it out to prop up an ever-increasing pile of counterfeit credit). Evil regimes do not end, merely because they wreak destruction. Venezuela is the latest example of this principle. They end when enough people regard them as evil.
And we want to clarify one thing. This essay should not be taken as a prediction that the Fed will succeed in driving up asset prices. That remains to be seen. We make no prediction of market prices, but seek only to explain the theory and practice of central banking in a crisis.
© 2020 Monetary Metals