For some nine years I have been predicting that the
economy is going to a recession morphing into a depression, using a purely
theoretical argument. The essence of my argument is that the open market
operations of the Fed cause a protracted decline in interest rates which is
responsible for the hard-to-detect capital destruction affecting the
financial sector no less than the productive sector. The immediate cause of
the depression is the destruction of capital. The ultimate cause is the
monetary policy of open market operations. The chain of causation is as
Open market operations (in effect, net purchases of T-bills) by the Fed are
predictable. They invite bond speculators to take risk-free profits offered
by this fact of predictability.
Bond speculators buy the long-dated Treasurys and
sell the short-dated ones, to pocket the difference in yields. These
straddles represent borrowing short and lending long. As such, they are
inherently risky. However, Quantitative Easing takes the risk out by making
the odds, that the normal yield curve will invert, negligible.
The bond speculator faces the problem of having to roll forward the
fast-expiring short leg of his straddle by selling T-bills. The extraordinary
funding and refunding requirements the Treasury is facing, and the
extraordinary pressure on the Fed to increase the money supply combine to
make it ultra-easy for the bond speculator to move both the short and the
long leg of his straddles as he sees fit.
The upshot is that interest rates keep falling along the entire yield curve.
Regardless how many long-dated issues the Treasury offers, bond speculators
snap them up even before the ink is dry on them.
Here we have the solution to the Greenspan-conundrum: the sky is the limit to
the bond speculators’ appetite for Treasury paper. They are all right
as long as they can sell T-bills against them. But as the sky is the limit to
the Fed’s appetite for T-bills, both flanks of the speculators are
other writings I have explained how a prolonged fall in interest rates along
the yield curve brings about depression through the indiscriminate
destruction of capital in the productive as well as financial sector.
There is a vicious spiral: the more currency the Fed creates, the more
risk-free profits bond speculators will reap, contributing to a further fall
of interest rates.
This outcome is the exact opposite of the one predicted by monetarism. The
latter predicts that the new money created by the Fed will flow to the
commodity market bidding up prices there, to nip depression in the bud.
Bernanke & Co. fully expects this to happen. This is not what is
happening, however. The new money refuses to flow uphill to the commodity market.
It flows downhill to the bond market where the fun is. Why take risks in the
commodity market, the speculators ask, when you can gamble risk free in the
bond market? So grab the money, buy more bonds and sell an equal amount of
bills. As a consequence of bullish bond speculation interest rates fall,
prices fall, employment falls, firms fall. The
squeeze is on, bankrupting the entire economy.
Some might object that the Fed could short-circuit the process and undercut
the bond speculators’ lucrative business. All it has to do is to buy
the short-dated paper directly from the Treasury. Inverting the yield curve
will shake off the parasites. My answer is that there is no
danger of this happening. The Treasury and the Fed know that bond-vigilantes
watch what they are doing like a hawk. Any hanky-panky of direct sales of
T-bills by the Treasury to the Fed would make them cry “foul play!”
As indeed it would be: direct sale of Treasury paper to the Fed would degrade
the dollar from irredeemable currency to fiat currency. There is a subtle
difference, realized only by the few.
Fiat currency is worse. Its arbitrary augmenting is decided behind closed
doors. It does not need the endorsement of the open market. Fiat currencies
have a short life-span as they readily succumb to the sudden-death syndrome.
Irredeemable currencies are different from fiat in that they are created
openly, using collateral purchased in the open market. They have a more
respectable life-span. As long as the official check-kiting conspiracy
between the Treasury and the Fed remains hidden from the general public,
irredeemable currency may even prosper. Direct sale of T-bills by the
Treasury to the Fed would tear down the curtain that hides the fact of
mechanism of check-kiting is as follows. The Treasury issues debt which it
has neither the intention nor the means ever to repay. This debt is used as
“backing” for Federal Reserve notes and deposits, which the Fed
has neither the intention nor the means ever to redeem. When the Treasury
debt matures, it is paid in Federal Reserve credit issued on the collateral
security of new Treasury debt. When Federal Reserve credit is presented for
redemption, the Fed offers interest-bearing Treasury debt in exchange. This
is a shell game and it exhausts the definition of check-kiting. Neither the
Treasury debt, nor the Federal Reserve credit is issued in good faith.
Neither is redeemable any more than Charles Ponzi’s tickets were. They
are both issued in order to mesmerize a gullible public, much the same way as
Treasury and Fed officials know their history. They are familiar with the
fate of the assignat, the mandat,
the Reichsmark, not to mention the Continental.
They know that no fiat money ever survived “the slings and arrows of an
outrageous fortune”. Their only hope is that the fate of the
irredeemable dollar, as predicted by Friedman, would be different. They would
not embark upon an adventure in monetary policy involving direct sales of
T-bills by the Treasury to the Fed. If they did, surely this would be the end
of their experiment. Foreigners as well as Americans would start dumping the
dollar unceremoniously, and buy anything they can lay their hands on. This is
variously known as flight into real goods, Flucht
in die Sachwerte, crack-up boom, Katastrophenhausse. I purposely avoid using the term
hyperinflation as it connotes with the Quantity Theory of Money, which is not
really a theory. It is a linear model trying to explain non-linear phenomena.
There is also a second method by means of which bond speculators are making
risk-free profits. They “front-run” the Fed in the bill market.
This means that, through inside information or otherwise, they divine when
the Fed has to answer “nature’s call” and must make the
next trip to the open market in order to buy the collateral without which it
cannot issue more money.
Bond speculators forestall the Fed by purchasing the bills beforehand, thus
driving up the price. Then they turn around and dump the paper into the lap
of the Fed at the enhanced price, making a risk-free profit. This process is
called “scalping”, after the kindred activities of small-time
speculators in tickets for the World Series and other popular sporting events.
objection that the Fed knows how to throw bond speculators off scent by
various stratagems ― for example, through falsecarding,
say, by selling when speculators would expect it to buy ― can be safely
dismissed. There is no question that every year the Fed is a big buyer of
bills on a net basis. If it sells, it has to buy that much more later on.
Fiddling means that the Fed may miss its target. Falsecarding
speculators are a smart lot, thanks to “natural selection”
culling the rank and file. They risk their own capital, which they stand to
lose if they place the wrong bet. Once their capital is gone they are out,
and smarter guys will take over. Hired hands at the Fed are no match for them
as far as brightness and adroitness is concerned. The latter work for
salaries. If they make the wrong bet, losses will be replenished by dipping
into the public purse. Think of the losses the Bank of England suffered at
the hand of a lonely bond speculator, one George Soros. The British public
was forced to swallow the loss, and Soros was allowed to run with the loot
and boast in his book that he has busted the Bank of England single-handedly.
Recently Soros said in Davos that he is bearish on gold. In his opinion gold
is in a bubble. Of course. He knows that he couldn’t bust the Bank of
England again, once it is back on the gold standard!
Cheating in Las
My voice has remained a cry in the wilderness. Nobody paid attention to the
mumblings of this armchair economist.
idle theorizing got an unexpected boost from the website Jesse’s
Café Américain (http://jessescrossroadscafe.blogspot.com).
On January 22, 2010, Jesse posted a story with the title Front-Running the
Fed in the Treasury Market from which the following quotation is taken.
Attached is some information from a
reader. I cannot assess its validity, not being in the bond trading business.
But it does sound like someone has tapped into the Fed’s buying plans
to monetize the public debt and is front-running those purchases, essentially
‘stealing’ money from the public. It’s what they call a
‘sure thing’. To try and figure out who might be doing it, I
would look for some big player who is showing extraordinary returns on their
trading, with consistent profit that is not statistically ‘normal’,
but is consistently ‘too good’. The problem with cheaters is that
they sometimes get greedy and call attention to themselves. In Las
Vegas the bigger cheats at the casino were often taken
to the desert for further questioning and final disposal. On Wall Street they
are more arrogant and persistent, defying resolution with that ultimate
defiance, “We’ll just have to figure out other ways to cheat, and
come back again”.
Time for a trip to the desert?
Here are my reader’s observations from the
“I used to work for a BB on a prop desk until
the financial crisis took hold and they fired the less senior guys. I now
trade US Treasurys for a small prop firm in xxxxx, to scalp basis trades in most on-the-run securities.
Occasionally, I will also take position in the repo markets for off-the-runs
if I see something ‘mispriced’. Your recent article piqued my
interest because we, too, have noticed ‘shenanigans’ of a sort in
the Quantitative Easing program involving US Treasurys.
“What we have noticed, especially in smaller issues like the 7 Year
Cash, is that before a Fed buy-back would be announced, the price would pop
significantly as if buyers would run through all the offers on the two major
electronic exchanges (BGC Espeed and ICAP Broker
Tec). This has occurred more than several times as the 7 Year Cash would be
overvalued both by its BNOC, by as much as 20-30 ticks, as well as by its
value relative to similar off-the-runs. These buyers would lift every offer
they could, driving the price substantially above
its ‘value’, sometimes for as long as a week at a time. After
this buying occurred, the Fed would announce the purchase of that security,
sometimes a handle above its approximate value. This ‘luck’ has
occurred not just in the on-the-run 7 Year sector, but also in the 30 Year
Cash, 3 Year Cash, and in several other off-the-runs. Again, it was
especially prevalent in the less liquid Treasury products. Often the
‘appetite’ for these securities would begin two weeks before the
official Fed announcement. The buying was well-orchestrated and done in such
a way as to throw it out of kilter with the like cash Treasurys
and the CME Ten Year Contract. If you examine the charts of some of the
selected buy-backs before the official announcement, you will see a similar
“While I haven’t broken this down into a paper to prove it (and I
see nothing positive coming out of contacting the ESS-EEE-SFE about this
issue), I can assure you that it was occurring on a consistent basis across
the entire curve. A certain issue would be bid up substantially above market
value (as determined by several metrics), only to be gobbled up later by the
Fed at an unreasonably high price. These players must have substantial
pockets as we, the small guys (but with a decent capital base) would take the
other side of what seemed to be an obvious fade. While this did not occur in
every issue of the Quantitative Easing program, it occurred often enough to
be obvious to any knowledgeable observer.
While I am not sure that this can be attributed to a purposeful Fed policy or
someone at the Fed talking to his pals, I am certain that it transpired.”
Congenital disease of the monetary
anonymous correspondent of Jesse is looking for an answer in the wrong
direction. Cheating is not necessarily involved. What he has observed need
not be a purposeful, if veiled, Fed policy, nor is it necessarily someone at
the Fed tipping off his brother-in-law at a brokerage house (however valuable
the tip may be).
What we face here is a congenital disease of the irredeemable dollar. Open-market operations is the tool for the purpose of
increasing the money supply through monetizing government debt as needed. It should
be recalled that open-market operations by the Fed were illegal according to
the Federal Reserve Act of 1913. The original Act looked at the monetization
of government debt as an anathema. Illegal open-market operations started in the early
1920’s. They were legalized ex post facto in 1935 by an amendment to the Act, after the gold
standard was destroyed by the proclamation of president Roosevelt in 1933.
Those who sponsored the amendment were ignorant of what effect open market
operations would have on bond speculation. Economists in and out of
government and academia were equally ignorant. The financial press also
failed to criticize the hare-brained scheme of open market operations making,
as it did, profits from bond speculation risk free.
There is no need to look for a conspiracy in the bond market. It is quite
possible that a large number of smart speculators, acting spontaneously and
independently of one another, have come to realize that there is a bonanza,
perfectly legal, in ripping off the public purse. Of course, they kept their
If anybody is responsible for this colossal blunder of economics releasing
the genie of risk-free speculation out of the bottle, the names that come to
mind are those of Keynes and Friedman, resp. They invented, resp.,
‘improved’, the system of floating exchange rates assuming a goldless currency that has to be arbitrarily augmented
from time-to-time through the monetization of government debt (that,
incidentally, proliferated profusely after the politicians deliberately
unbalanced the budget upon the explicit advice of Keynes). The rest, as they
say, is history.
As long as budget deficits were ‘modest’, the activity of
speculators making risk-free profits in the bond market escaped public
attention. With the advent of ‘Quantitative Easing’ and
mega-deficits, everybody sitting at a bond-trading desk can see it. The
figures literally jump off the screen, as explained by Jesse’s blog.
Recruiting a corps of shills
be fair to Jesse’s anonymous correspondent I must admit that his
conjecture, that in risk-free bond speculation we may be looking at
deliberate Fed policy, is plausible. It is not impossible that the rot in the
monetary system has already spread so far that in a truly free and unrigged
bond market no bidders would turn up. Time is long since past when Treasurys were eagerly sought after by the most
conservative segment of the investing public, such as guardians of widows and
orphans, trust funds, eleemosynary institutions. Typically, they held the
bonds to maturity. Treasurys, second only to gold,
were the most trusted instruments of wealth-preservation.
Under the regime of the irredeemable dollar no investor in his right mind
would buy a Treasury bond and hold it till maturity. Treasurys
lose value as ice melts in the sunshine. They have become a plaything in the
hands of speculators for their value in turning a fast buck. Under the gold
standard there was no bond speculation, just as there was no foreign exchange
speculation. Interest rates were stable and so were bond prices. Speculators
would shun bonds. Of course, all this changed when president Nixon defaulted
on the short-term gold obligation of the Treasury to foreigners in 1971, and
gold was finally removed from the international monetary system at the behest
of the U.S.
For a decade speculators were happy with the trading profits they could make
in the bond market. But as the monetary system kept deteriorating, they
started abandoning bonds, transferring their activities to the commodity
market. By 1981 demand for bonds practically evaporated. As this spelled the
end of the regime of the irredeemable dollar, the Fed had to do something to
prop up the bond market by enticing bond speculators back.
Thus, then, it is quite possible that a decision was made at the highest
level to offer the enticement of risk-free profits to bond speculators. It
certainly cannot be denied that bond speculators have been making obscene
profits in the course of the 30-year bull market in bonds that is still
ongoing. These profits are unprecedented in the history of speculation, both
on account of their magnitude and their regularity. They were made at the
expense of productive enterprise, the capital of which has been
surreptitiously siphoned off by the falling interest-rate structure.
Another way of describing this scenario (assuming it is correct) is that in
1981 the Fed, unknown to the public, decided to recruit a corps of shills to
prop up a moribund bond market. The shills hired by the casinos of Las
Vegas bet big and win big at the gaming tables in full
view of the gamblers who are unaware that they are being treated to a show.
The sight of these big payoffs will then perk up the gambling spirit of a
The shills recruited by the Fed are the bond speculators, and their
remuneration is in the form of risk-free profits they are allowed to make
(and keep). The scheme was a roaring success. Not only did it save the bond
market from extinction; it also saved the dollar from ignominy, and was
instrumental in making possible a whole string of bubbles, each bigger than
the previous one.
The Road to Hell Is Paved with
problem is far more serious than it may at first appear. Risk-free
speculation is like a computer-virus that has no antidote and threatens to
wipe out the Internet. It short-circuits normal economic processes and
gobbles up the world economy.
I would welcome a public debate of my thesis that risk-free bond speculation
suppresses the rate of interest and destroys capital in the process. I have
challenged neo-classical economists who still consider the open-market
operations of the Fed as a ‘refined tool to manage the national
economy’. I want them, instead, to see in open-market operations the
cancer of the economy responsible for the withering of the world’s prosperity.
So far my challenge has fallen upon deaf ears.
Here is the problem. The prevailing orthodoxy is the unholy alliance between
Keynesianism and monetarism inspired by Friedman (defying the pretence that these two are antagonistic theories). The
idea that an artificial increase in the money supply must raise commodity
prices dies hard. But as my theory suggests, and as events have repeatedly
shown (first during the Great Depression of the 1930’s, and again,
during the present crisis), the presence of risk-free speculation renders the
increase in the money supply counter-productive. It causes prices to fall rather than rise.
Giving them the toy of risk-free profits makes speculators vacate the
commodity market where risks are too high. They will then congregate in the
bond market where risks are non-existent. The speculator who in the absence
of risk-free profits might resist falling prices in the commodity market,
will decline the honor of pushing the Keynesian agenda if given the choice of
risk-free profits in bonds. This is basic human reaction that cannot be
criticized, still less rectified, by official brow-beating. Keynesians should
have thought about the consequences of their master-plan more thoroughly
before they put open-market operations into effect.
The intentions of policy-makers at the Fed are praiseworthy. They want to
prevent prices and employment from collapsing. But they are prisoners of
their orthodoxy, and their good intentions make them steer the economy to the
road to hell. A catastrophe is confronting the Titanic, but the captain, just
confirmed in his position in spite of a most serious public challenge, will
not change his course.
A head-on collision with the
iceberg straight ahead, otherwise known as the debt-tower, now appears