How long before we fall victim too?
By
Bill Bonner Dec 04, 2009
Print this article
Early this week, the world's largest central bank, the Federal Reserve, announced plans to exit its monetary stimulus efforts. It unveiled a new tool – reverse repos – to hasten the work.
The term "unintended consequences" was probably invented to describe such tools. Give the Feds a saw and they will cut off their fingers. Give them a pistol and they will blow off their toes. Give them quantitative easing and there will soon be nothing left of them.
The private-sector debt crisis of 2008-2009 will almost certainly lead to a public-sector debt crisis sometime between now and eternity, if not sooner. In the standard narrative, governments create more money to stimulate their economies out of the slump. Leading economists propose it, then defend it... and then, when it doesn't work, they call for more of it.
Now those economists are claiming victory – many are calling on the Fed to withdraw its monetary stimulus before the money shows up as consumer price inflation. Increases in the supply of money, beyond increases in output, usually lead to inflation. They're hoping the Fed can head it off by sopping up the surplus liquidity before it is too late.
Optimists expect mild inflation in a decent recovery. Pessimists fear the Feds may have waited too long and think they see higher rates of inflation coming. Here on the back page we see nothing at all – no recovery, nor any inflation. At least, not yet. But we wouldn't rule out a collapse of the public-debt market.
There is always a wide gap between the Feds' reach into the economy and their grasp of what they are really doing. When the Federal Reserve increased reserves in the banking system, the idea was simple enough: more reserves would allow the banks to lend more; in turn, more credit would allow consumers to spend more. Ergo, the recession would soon be over.
But the more reserves the Fed pumped into the banking system, the more reserves the bankers didn't lend out. In two years, excess reserves (beyond what was needed for loans) expanded 500 times from the level they had been at for the previous three decades.
If the banks chose to lend these reserves they could multiply them into another $10trn to add to the money supply. Instead, in the third quarter, the US suffered a record contraction of bank lending, according to the Federal Deposit Insurance Corporation. Lending to households and business is in a steep decline. Nothing like it has happened since World War II. Total credit outstanding is falling too. The banks are barely even lending to the US government – from which they got the money in the first place.
"Banks, in aggregate, just absorbed the additional reserves by allowing their ratio of reserves-to-deposits to balloon," reports Charles Goodhart in the Financial Times, "so the multiplier collapsed to zero." Why?
The feds can't use a screwdriver without endangering a vital limb. Quantitative easing turned out to be a chainsaw. In effect, bankers competed for yield with the deepest pockets in the monetary universe – the central bank itself. When the Feds bought Treasury bills they drove yields down to such skimpy levels that the incentive for risky private loans was nearly lost altogether. Better to leave the money on deposit at the Fed.
No loans, no multiplier. No multiplier, no recovery. Instead, the Feds take $1 worth of supposedly 'idle' resources (actually, savings that people hoped to spend or invest later) out of the private economy, squander it on bribes, bailouts or boondoggles, and get 90 cents' worth of 'recovery'. Then, when a real recovery doesn't come, they spend $2.
Where will this end up? Most observers expect rising rates of inflation – this is what is driving the bull market in gold, which hit the $1,200-an-ounce mark this week. But the multiplier is out of action and consumer price inflation seems far away. And the Feds can't do anything about it.
What? What about more government spending? Or dropping hundred-dollar bills from airplanes? But those tools have self-mutilating effects too – they jeopardise governments' access to deficit financing.
"Britain risks becoming the first country in the G10 bloc of major economies to risk capital flight and a full-blown debt crisis over coming months," says an article in Tuesday's Daily Telegraph.
First, lenders grow worried about excess spending, inflation and the risk of default. They demand higher interest rates. Treasury bond yields rise, in real terms, even in a deflationary world. These higher rates affect public finances like a cold draft on a pneumonia patient.
As governments pay more to borrow, their condition deteriorates. The odds of default increase. Some, like Dubai World, are forced to postpone payments. Others just shake and shiver. The slow-motion depression continues. If we are lucky – and nothing else goes wrong.
• To read Bill's daily thoughts, sign up for The Daily Reckoning free email at Morefrombill.co.uk.
Published in
Economics
| More
articles
by
Bill Bonner
Related articles
-
By John Stepek, Feb 11, 2012
-
By Tim Price, Feb 10, 2012
-
By Merryn Somerset Webb, Feb 07, 2012
-
By Bill Bonner, Feb 07, 2012
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.