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For some nine
years I have been predicting that the economy is going to arecession
morphing into a depression, using a purely theoretical argument. Theessence of my argument is that the open market
operations of the Fed cause aprotracted decline in
interest rates which is responsible for the hard-to-detectcapital
destruction affecting the financial sector no less than the productivesector. The immediate cause of the depression
is the destruction of capital. Theultimate cause is
the monetary policy of open market operations. The chain ofcausation
is as follows.
(1) Open
market operations (in effect,net
purchases of T-bills) by the Fed are predictable. They invite bondspeculators to take risk-free profits offered by this
fact ofpredictability.
(2) 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.
(3) 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.
(4) 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
secure.
In
my 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.
Official check-kiting
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
check-kiting.
The
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 Ponzi did.
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.
Falsecarding by the Fed
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.
The
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
may backfire.
The
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 Vegas
My voice has remained a cry in the wilderness. Nobody paid attention to the
mumblings of this armchair economist.
My
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 bond market.
“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
occurrence.
“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 system
The 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
own counsel.
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
To 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 U.S. 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. government.
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 lethargic clientele.
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 Good Intentions
The 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 inevitable.
Calendar
of Events
Seminar at the Martineum
Academy, Szombathely, Hungary, March 25-29, 2010
Is the Global Financial Crisis Over?
Sponsored by the Gold Standard Institute, with the
participation of Sandeep Jaitly,
Peter van Coppenolle, Rudy Fritsch, Darryl Schoon, Nathan Narusis,
Professor Fekete, and others. Among other topics, there will be a
presentation of the latest research
on the gold basis, the world’s pension woes, and an exclusive business idea
turning the
ridiculously undervalued “legal tender gold coins” to your advantage.
For further details, see: www.professorfekete.com
Antal E. Fekete
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright © 2002-2008 by Antal
E. Fekete - All rights reserved
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