Keywords

Quantitative easing; unemployment; unsolved political issues; bad investments; Treasury refinancing; QE3.5 releveraging; worst-case scenario; systemic risk

12.1 “Bernanke Should Show Humility at the Fed,” Says Senator Bob Corker

The advice Josef Stalin gave to Yuri Zhdanov, son of his one-time designated successor, worth writing in golden letters and having it displayed at the desk of every central bank governor, president, or chairman: “It is said that you spend plenty of time in politics, but believe me politics is a dirty business.”¹

It’s an expert’s opinion, coming directly from the horse’s mouth; that of a master of politics (and of terror). Politics is a combative sport, and few engaging in it really succeed. Playing politics and providing for currency stability are not at all the same thing. The banker’s most important duty is that of economics and financial stability while full employment (where, quite evidently, the word “full” is a lie) is the politicians’ job.

True enough, no two central banks (or reserve institutions) are alike in terms of their charter, mission the authority they exercise; as well as in terms of and their independence from the whims and priorities of their government. But if in the post-World War II years a general statement was to be made establishing what a central bank is supposed to do regarding its primary functions, then these would have fallen into four main classes:

Some reserve institutions also assumed other duties, the most important of them being bank regulation and supervision. This has been a subject leading to discussions and controversies, with critics saying that bank supervision distracts the central bankers from their topmost responsibility for monetary stability.

What the last couple of paragraphs mean is that, in practice, each central bank has its own specific objectives. An example is the Federal Reserve which, following an act of Congress dating back to the late 1970s, has the added responsibility to look after employment.³ That was a political mission which contradicted the Fed’s original and topmost duty of monetary policy independence from government goals and directives. Such a contradictory Fed mission led to loss of its independence. (We will see why later on in this chapter.)

Other western central banks have followed the same path. The Bank of England and ECB are examples. Indeed, the best kept secret among western central banks in the twenty-first century version of their duties is that what you hear is not what you get. Although QE, LTRO, OMT,⁴ and other unconventional central bank programs have arguably reduced tail risks to markets:

The fact that the Federal Reserve expanded its balance sheet from $800 billion in September 2008 to $3000 billion in September 2012 is evidence that politicians and central bankers have merged into one lot, and they are in no way eager to explain to the public what they are doing. Moreover, what they are doing is not necessarily the most rational in assuring a sound monetary policy which guarantees the value of the currency and with it the financial stability.

An often heard excuse is that economic developments have left behind old monetary policy and regulatory duties. Though no economist openly challenges the fact that monetary policy should be and remain a central bank’s basic assignment, pseudo-Keynesian and political voices add other obligations which distract the monetary institution’s attention and dwindle its independence.

Most of all, it is the change in central bankers’ personalities that damages most of their institutions’ standing.⁵ In an article, he published in the Financial Times under the title Bernanke should show some humility at the Fed, Bob Corker, a Republican senator from Tennessee and member of the US Senate Banking Committee, says that the blame cannot be solely debited to Congress:

It would be helpful to have a Fed chairman who acted with a greater sense of humility about what monetary policy can achieve. Mr. Bernanke’s … unwillingness to stand up and say that there are limits to what monetary policy can accomplish is disturbing, to say the least.⁶

Corker is right in his opinion that America needs a Federal Reserve that helps rather than hinders its economy’s transition; a Fed which pays attention to savers rather than being wholly reliant on leveraged consumers.⁷ The need the senator identifies is that of a central bank which serves as a utility to the US economy: “not an enabler of some perverse financial system addition.”

This is by no means a one-person’s opinion. In the campaign which led to the selection of the Republican challenger to president Barack Obama, Rick Perry, the governor of Texas, stated that it would be almost treasonous for the Federal Reserve to print money. Perry’s statement stirred up a debate and highlighted the political pressure surrounding Ben Bernanke. In the governor’s words:

If this guy (Bernanke) prints more money between now and the election … we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in history is almost treasonous, in my opinion.⁸

It takes people who stand by their opinion, and are not afraid to express it, to explain to the American public the risks embedded in the wrong-way monetary policy by the Fed (and other western central banks). It takes courage to explain why and from where these risks rise and what may be the most likely outcome when official pronouncements and the resulting numbers don’t add up.

Jan Tinbergen, a Nobel Prize winner, has become known for his rule that “for each policy objective, at least one instrument is needed.” In his testimony to a panel of the US House of Representatives in early 2012, Bernanke implicitly admitted that the Fed stepped over that rule. Though it more or less brought prices under control, it struggles with high unemployment. And as some economists put it:

Precisely because of the Fed’s easy money policies and the fact that, like other western central banks, it has compromised its independence by assuming a political position, discussions about reintroducing the gold standard have returned to mainstream US politics for the first time in three decades. In mid-2012, drafts of the Republican Party platform called for:

This proposal followed on the steps of the Gold Commission, created by president Ronald Reagan in 1981. While that commission ultimately supported the status quo, it did raise the issue that return to the gold standard is still an option, particularly when there is no other restraint to the money printing machines of the central bank working overtime.

A politically motivated twenty-first century attitude by the reserve bank in sharp contrast to the 1956 decision by the Board of Governors of the Federal Reserve System that while relatively little is known about the safety margins in the finances of consumers who borrow on a short-term and intermediate term basis, the evidence of a trend over the past decades toward more liberal terms suggests that safety margins have shrank. This proved to be a prophetic statement because in the decades following 1956:

The shrinking of safety margins and explosion of public debt led to financial instability and heavily weighted on the economic downturn we are in. Made at the expense of longer term stability, short-term decisions upset the balances. Still the excuse that “other western central banks are doing the same” does not wash, particularly as what they are doing is to take over fiscal policy from the government.

What has been until two decades ago reliable monetary policies by central banks became the nearest thing to a Ponzi game. Monetary institutions are willing to lend against poorer quality assets and for longer periods of time. This involved them in financial intermediation characterized by political aims. Filled up with assets of ever lower quality, their balance sheets ballooned.

Since 2008, the Federal Reserve has monetized about 60 percent of the increased Treasury and government-sponsored enterprises paper. “This all serves to give the happy appearance of a borrower living comfortably within its budget constraint,” says a study by the Société Générale. “… governments have more tricks up their sleeves than the rest of us, like monopoly control of the seniorage industry. Since it jealously reserves for itself the right to supply the nation’s medium of exchange, (sovereigns have) recourse to the most splendid of all budget constraint-avoidance maneuvers: if tax revenues, or the trust of honest creditors, are insufficient the government can simply print any money it needs.”⁹ What this proves, in its way, is that both Senator Corker and Governor Perry have been right in what they said. But is anybody listening?

12.2 Employment and Unemployment Are Political Issues, Not the Central Bank’s Remit

In the short span between years 2000 and 2012, America has lost more than 5 million manufacturing jobs. By all evidence, these will never come back. Their loss has been a legacy of the Bush Jr. years, but both Clinton’s and Obama’s Administrations contributed to the delocalization of US jobs.

Neither is the loss of all these employment opportunities just a matter of delocalization, as some economists continue to maintain. The novelty which came up in the 2010–2013 period in the employment front is that many young people (55 percent in Spain and Greece and a great deal also in the United States) don’t find a job because they are not qualified for modern industrial effort. The skills even college graduates acquired are simply not in demand. This has been a terrible failure in career planning.

Another effect of professional misorientation which has shown up in the same time frame is that young people whose skills were in the borderline of what industry demands have become in the meantime long-term unemployed. They loafed while in unemployment, they did not keep up with their training, and what little they knew has become obsolete.

This professional misorientation is a deep political fault, not a matter of monetary policy as Bernanke likes to think. The Fed funds rate may stay historically low as long as the Fed chairman pleases and the share of the reserve institution’s Treasury holdings may be keep on being extended. These are monetary policy decisions having nothing to do with the roots of the unemployment problem in the United States, or anywhere else.

The evidence is that when by 2011 American manufacturing activity somewhat picked up, few new jobs have been created. Moreover, to compete in a globalized manufacturing environment, where every penny in cost counts, companies use automation as far as they can and cut out of their business bloodstream every superfluous cost dollar. Cutting costs with a sharp knife has replaced delocalization as senior management’s focal point, but it does not help in job creation.

At the end of 2012, there have been 23 million unemployed in the United States, representing a little less than 8 percent of the working population (official statistics talk of 7.5 percent). Unofficially, however, there is talk of 28 million unemployed which rises to nearly 40 million if part-time and precarious jobs are included. All the big money spent by the Fed with QE1, QE2, QE3, and QE3.5 has been for nothing—if one counts by obtained results.

The situation is not any better in the European Union with over 20 million unemployed, or 11.3 percent of the working population. This is an average number. For the young, the unemployment statistics stand at 26 percent in France, 53 percent in Spain¹⁰ and in Greece—despite all the money the ECB is spending with its LTRO, OMT, and other politically motivated anagrams.

Governments are still hiring workers and employees they don’t need,¹¹ adding to their budget deficits and the mountains of public debt. Companies are not hiring because the economic conditions are bleak despite the torrent of liquidity thrown to the four winds by the Fed, Bank of England, and ECB¹²—or because of it as its most pronounced effect is to greatly diminish confidence at both sides of the North Atlantic.

Projections up to 2018 by the US Bureau of Labor Statistics are hardly encouraging. They indicate that American manufacturing employment will witness virtually no growth while many industries will continue to experience technology-based employment losses.¹³ In the United States and Europe, unit labor costs are uncompetitive compared to those in developing countries, because they are also loaded with inordinate taxation relating to the social net: pensions and health care costs.

Ironically, as the US Bureau of Labor Statistics has it, half of the top 20 fastest growing occupations in America are health care related (see also Chapter 10 on health care costs). These are adding themselves to other costs to make factory produce even more uncompetitive in the global market. By 2018, two grades of health care workers:

are projected to grow to a level nearly matching today’s care manufacturing total tally. Notice, however, that these jobs pay roughly one-third as much as those in manufacturing. The Fed’s and ECB’s wild money printing operations don’t take such basic trends into account. But then they should not destabilize the currency and the financial market to play Heracles—because, by so doing, they feed rather than decapitate the mythical Hydra’s multiplying heads.

When I say so in my lectures I am asked how this “feeding” is done. The answer is straightforward: through uncertainty about future economic conditions created by the western central banks’ unlimited paper money printing. The top 10 problems cited in a survey by the National Federation of Independent Business (NFIB), a small-business lobby in the United States, include:

Other issues contributing a great deal to western unemployment have to do with working culture, which deteriorated greatly during the last three decades and continues doing so. Nearly everybody waits that a job is served to him or her on a silver platter. There is also a phrase coined in socialist France: “The right to work.” There is no “right to work,” but there is an obligation:

Has the reader heard of Sidney Weinberg? Seeking employment while still in his teens (back in 1907) he went to the top of a 25-floor building (which at that time was the tallest in New York) and asked every company at every floor if it was looking for a worker. He got 23 refusals, but he did not give up.

At the second floor was a, then, relatively small investment bank: Goldman Sachs. Weinberg asked the same question, if work was available, and the chief clerk hired him to assist the porter at $3 a week.¹⁵ The teenager got the job. He worked during the day and studied in the night and weekends. He stayed for sixty-two years with the firm rising to become chairman and CEO for the last four decades of his employment at the firm.

Any young fellow or young lady who waits for the government to “find him or her a job” should read the life of Weinberg, as well as of Andrew Carnegie (who also started at $3 the week and became the king of steel and a well-known philanthropist); of Captain James Cook who left school at 12 to work and became one of the best-known explorers and cartographers; of Konosuke Matsushita who also had to leave school at a very young age but early on in his life made one of the giant firms in electrical engineering and electronics.

What Bernanke thinks that he accomplished in the US unemployment front by flooding the market with liquidity and destabilizing the currency? Does he believe that it is enough to keep the presses working overtime? Is he prompting the young to do their damnedest to get a job and work hard at it? Or is he only throwing newly minted money at the problem so that they remain unemployed forever?

Unfortunately, most unfortunately, in our western society, the search for a job and its diligent maintenance lies low in their list of priorities. By contrast, rent-seeking is near the top. Rent-seeking is the way economists describe all efforts on the part of special interests to benefit by influencing political decisions, asking for money without doing any work.

At the root of the trouble is a combination of entitlements and other benefits indiscriminately offered by the welfare state. The result is one of social distortion and of lower ethics. The irony is that this often happens in the name of “free enterprise.” Profits are often determined by way of:

In conclusion, unemployment is too deep and complex an issue for central banks to solve by operating at the money end of the problem. Bernanke should have known that much. Presumably he does not. The issue is nearly 100 percent political. If the western economies are unable, unwilling, or both to touch the gilt-edged welfare benefits that strangle them, then high unemployment is here to stay. If on the home-front governments cannot cut social costs, which hurt their companies’ competitiveness and jeopardize society’s longer term well-being, then it is not realistic to expect that the Fed or any other central bank would solve the problem for them.

12.3 Money Is Always Invested, but There May Be Bad Investments

Except for money hidden in mattresses, there is no such thing as cash in the sidelines. Money is always invested in something: bonds, equities, commodities, real estate, and deposits paying an interest rates. Other things equal, when investments in one sector(s) of the economy grow rapidly, this means that in another sector they are going down. And when interest rates are kept rock-bottom for too long, in their search for yield, investors assume inordinate risk of which quite often they are unaware.

This is not only characteristic of individual investors but, as well, of institutional: pension funds, insurance companies, university endowments, and more. It therefore came as bad news when at its January 26, 2012 meeting, the FOMC¹⁶ decided that low interest rates will stay till end of 2014, which meant for 3 more years. Worse yet, as 2012 neared its end, a new Fed decision has been that near zero interest rates will stay till end of 2015; once again another 3 years.

Prior to the first of these statements which pointed to a longer accommodative policy, the market expected a first rate hike in early 2014. Following it, investors adjusted their plans to reflect the FOMC’s new language. As longer date Treasury yields reflect expected short-term yields sometime in the future, the 10-year Treasury yield fell by 14 basis points to 1.91 percent after the announcement, then it rebounded to around 2 percent.

That policy even deceived the market’s expectation, and there was a second deception. Many analysts thought that the Fed was so focused on inflation that it would tighten as soon as it topped 2 percent, no matter how high unemployment was. Bernanke dispelled that notion by emphasizing the Fed’s attention to unemployment without any reference to the impact a rising inflation may have on Fed policies.

This wrong-way priority in central bank decisions started at end of 2008, and it became unstoppable. After so many years of fed funds rate at about zero, four quantitative easing programs and an extended operation Twist, the resulting ballooning of the Federal Reserve’s balance sheet (Section 12.1) is a precursor to another bubble.

Critics say that most damage will be from a mixture of politics and arrogance which dominates current monetary decisions. This damage will have much to do with the fact that balance sheets at monetary authorities are likely to stay bloated for some time. The way Robert Parker, a former senior banker at Crédit Suisse, put it in an article in the Financial Times:

Over a period when banks are deleveraging, when consumers are increasing their savings and reducing their borrowings, when companies are running historically high levels of excess liquidity and when fiscal policy is having a negative impact on GDP growth, it is difficult for monetary policy to be effective except as a backstop.¹⁷

The way other economists look at the problem, while inflation fears have moved back into the economic landscape, a polarized policy at the Federal Reserve is unlikely to provide further monetary stimulus in 2013. For instance, nothing happens in economic growth or US competitiveness by additional Treasury purchases by the Fed, on top of its current pace of buying mortgage-backed securities (MBSs). Other western central banks which, quite likely, also engage in more monetary policy stimulus on top of the considerable expansion of their balance sheet they have already done, can expect the same minimal to zero results.

A return to the fundamental view of central banking in line with its historical origins is not yet in the books, even if it has become evident that focus is on just one objective: kicking up the economy deprives the western economies of the basic services to a monetary institution. There are as well, other mishappenings.

Audits made at central banks come up with negative findings for their governors. An example is the audit conducted in the Fed by the Government Accountability Office (GAO) of the US Congress. GAO found problems with Federal Reserve loans which were not covered by appropriate collateral. Neither is this a one-tantum case. An Italian banker characterized the collateral in the vaults of ECB as being more garbage than that found in the streets of Naples.¹⁸

The western public is not particularly thrilled by the central banks stance on economic policy and the stability of the currency. A widely held view in the United States is: “All the Fed has done is to help Wall Street.” Common citizens and managers of small to medium enterprises object to the fact that there is a growing gap in central bank support for Wall Street and for Main Street.

For their part, many economists hope that monetary policy will become more supportive of financial stability. The market, too, thinks in this way but some of the projections being made over the last few years turned out to be wrong, for instance, that the Fed will refrain from QE3 because, contrary to QE1 the QE2 results were minimal and investors did not believe in the wisdom of QE3. Bernanke, however, continued to flood the market with liquidity.

Analysts looked at the Fed chairman’s August 31, 2012 speech, kicking off the Jackson Hole Conference of the Federal Reserve Bank of Kansas City, as an opportunity to explain what mechanisms the Fed would use in the near- to medium-term future. The more general expectation was that he lays out a path of moderate easing able to address the transmission mechanism of monetary policy rather than simply providing additional liquidity to the market.

Others believed that Bernanke’s Jackson Hole speech will provide the inspiration for a Fed program through which credit institutions would be rewarded for meeting targets related to their business behavior:¹⁹

It did not turn out that way. Instead, on September 2, 2012 Fed officials set out their views on a third round of quantitative easing, with Bernanke hinting at more action along that path. James Bullard, president of the St. Louis Fed, said “middling” economic data meant that the Fed could afford to wait, stating that: “The most reasonable expectation is still that the economy will improve in the second half of the year and that it will improve further in 2013.”²⁰

In a paper presented to the world’s assembled central bankers at Jackson Hole, Professor Michael Woodford of Columbia University implied that the Fed was going about easing policy the wrong way. The way newly minted money was invested was not the best possible. Woodford argued that:

Woodford also stated that forecasting low interest rates for a long time without making a commitment to them could have a perverse effect, because people could reasonably assume the central bank was deeply pessimistic about the outlook for growth in the American economy.²¹

Indirectly, Bernanke allegedly admitted that QE1 and QE2 created just 2 million jobs. This was less than a fifth, the then prevailing unemployment, and it was small game compared to the destabilization of the currency. As for the unexciting speech the Fed chairman gave at the Jackson Hole Conference of 2012, it was interpreted as meaning that his personal wish was to proceed with QE3 (which he did anyway).

To the opinion of financial analysts, Bernanke does not want higher end yields, and this not only because an increase in the cost of financing will impact negatively on business activity. The more important reason is that the $16.4 trillion of public debt will weigh heavily on the interest the Obama Administration has to pay, and therefore on the government’s budget deficit.

A quick look at the behaviour of dollar interest rates suggests that this is a plausible hypothesis. In June 2011, the Fed completed QE3 as the yield on 10-year Treasury bonds stood at 3.1 percent, following a spring decline below 3 percent. At that time, Washington debated raising the debt ceiling, and this issue led to partisan politics.

The debt ceiling was raised in August 2011, near the deadline. By then, the interest rate on 10-year Treasuries had fallen just north of 2.1 percent. A month later, the Fed announced Operation Twist and the 10-year yield dropped to 1.70 percent, after the Fed committed itself to keeping rates rock-bottom until mid-2013. By July 2012, the interest on 10-year Treasuries dipped below 1.40 percent, but the market turned around and interest rate rose to nearly 2 percent.

To assure that interest rates on 10-year Treasuries stay low, in December 2012, the Fed chairman announced an open-ended QE with outright Treasury purchases replacing Operation Twist (more on this so-called operation QE3.5 in described in Section 12.4). Throughout these milestones, “unemployment” has been used as the weeping boy. The true reason for throwing so much liquidity to the market lies in the maintenance of an accomodative economic policy.

With the exception of Neo-Keynesian economists, others said that such a tandem of QEs was not the solution, and therefore, the law of diminishing returns hit a policy stuck in the search for elusive full employment. Critics compared QE3 to “monetary heroin,” with several Fed governors wanting to prevent that from happening. Allegedly, the central bank’s chairman acknowledged it is uncharted waters, but saw no other way to follow. His tool box has only one tool, printing money, said one of the critics.

12.4 Twisting the Treasury’s Refinancing and QE3.5 Releveraging

With the so-called Operation Twist which started in September 2011 and finished at end of December 2012, the Fed got itself into the public debt controversy and the US Treasury’s refinancing operations, particularly their term structure. This term structure is disquieting in the short term when, reportedly, it is due the majority of US debt. As the majority of US debt on the market falls due within the next 3 years:

Each one of these consequences is affected not only by national economic factors but as well by international ones, the two most important being the continuing willingness of Asian countries (Japan, China) to keep on buying US debt and Euroland’s crisis exemplified by the state debt showdown by Greece, Portugal, Italy, Spain, Cyprus, Slovenia, and eventually France. (Mario Draghi’s policies at ECB did not provide a solution to these outstanding debt problems. It only temporarily calmed the market.)

The fact that neither the American nor the European economy got going with all the liquidity their central banks threw to the market and its players, is disquieting. As a result, it highlighted an important way in which western economies appeared to have changed, while central banks continue to administer the old remedy of trying to be market-friendly.

Through Operation Twist,²² the Fed decided to combat slowing growth by buying long-term Treasuries while selling shorter duration debt. Twist reminded investors that the central bank is ready to turn to provide accommodation. The Fed:

This practically means the Federal Reserve decided to replace $400 billion of short-term debt in its portfolio with longer term debt, while aiming to reduce borrowing costs for the government (Section 12.3) as well as banks and other entities. It did so by exerting slight upward pressure on short-term rates while keeping long-term rates low. The result on the long end of the curve, however, is only tentative because there exist several factors that put pressure on yields. The three most important are:

Operation Twist was said to be a monetary policy tool that does not necessarily involve money creation as such, and rightly or wrongly it is thought of as neutral for the currency. Both assumptions are wrong, even if they can be found in the background of the Fed’s decision.

The target of Twist has been to lower the yield of risky assets by lowering the yield on risk-free Treasury bonds well into very long maturities. With this, Bernanke aimed to deter private savings and to encourage spending and investment. With 71 percent of the money greasing the wheels of the American economy coming from consumers, higher spending and investments have a positive impact on growth. But, they are also bad for the currency because they contribute to widening the US trade deficit.

In addition, lower yields over the whole yield curve reduce the incentive to buy US bonds by investors, including foreign investors. This means that the Fed will need to intervene in the Treasury bond market even more than at the present time.

According to other economists, Operation Twist should be seen not as a standalone event but as part of a global process affecting interest rates. For example, US 10-year yields fell back to 2 percent after an early December 2011 press conference by the ECB, while the EU “summit” held that same month also disappointed investors who were hoping that either:

Critics expected Operation Twist to have a rather limited impact on asset classes even if the central bank extended the average maturity of its US Treasuries portfolio. Moreover, the FOMC announced that it would rollover maturing securitized US government agency debt. Indeed, QE3 targeted MBSs aiming to support the mortgage market by way of exercising downward pressure on mortgage yields.

On December 12, 2012 Bernanke announced his 3.5 round of quantitative easing to take the place of Twist which was expired at end of 2012. QE3.5 consisted of throwing to the market an extra $45 billion per month of newly minted money primarily directed to the purchase of MBSs. Together with the $40 billion of QE3, the Fed was flooding the market with $85 billion of new liquidity per month—or 1020 billion per year, roughly the US government’s deficit.

The deeper result of this decision is that Bernanke used the central bank as substitute to the Obama Administration’s fiscal policy, probably foreseeing that investors and foreign governments will buy less and less US Treasuries at about zero interest rate. “It’s zero rate forever,” said an economist, since 15 out of 19 members of the FOMC voted to keep it that way till 2015.

Many economists were looking in the Fed announcement for a limit to the zero rates, but in this regard, the wording has been very vague. It set as a barrier US unemployment falling below 6.5 percent committing itself to zero interest rates till then as well as to continuing buying of MBSs. In his speech, which followed the December 12, 2012 announcement, Bernanke looked at the $45 billion of extra liquidity as the best possible way. In contrast, several economists and financial analysts suggested that:

Apart from other negatives, an evident downside is that the Federal Reserve’s balance sheet gets bigger and bigger, becoming a bubble. “The market will force the Fed to exit,” said a financial analyst interviewed by CNBC. One of the interviewed economists put his thoughts in this way: “Prior to this policy, a person retiring with $1 million could expect an income of $40,000 per year. With zero interest rate he gets nothing. This depresses savers and hurts their living standard.” To the opinion of still another expert: “Zero interest rates over seven years are going to change the American economy forever.”²⁴

Looking at Twist and QE3.5 from a currency perspective, economists point out several aspects which, in sum, are more negative than positive for the US dollar. They are chipping away its armory which consists of an impressive 86 percent of all foreign exchange transactions still being made in American dollars.

This 86 percent figure is under attack by Federal Reserve actions such as Twist and QE. By contrast, one aspect of Twist that should be positive for the currency is that the government (and real-estate lenders) were to lengthen the duration of existing debt, therefore being able to better confront changes if inflation expectations change or other economic stress shows up.

This may be handy at a time the US dollar loses ground as the world’s reserve currency. Not long ago, the then Chinese prime minister Wen Jiabao and Japanese Prime Minister Yoshihiko Noda promoted the use of their own currencies in bilateral trade, rather than using the US dollar as intermediary. China already has similar agreements with some of its trading partners like Brazil.

Japan and China, Asia’s two main industrial powers, hold so much American public debt that if bilateral agreements in local currencies become a trend, this would impact US interest rates at some stage. Quantitatively speaking, among themselves, Japan and China own a whopping $2.1 trillion of US Treasuries which represents a cool 13 percent of total US debt, larger than the Federal Reserve’s US debt holdings.

Economists say that bilateral currency deals can start a ball rolling. In addition, the more the assets are issued in Chinese currency, the deeper becomes China’s financial market. Another negative for the dollar has been that holdings of US Treasuries by foreign central banks had fallen by a record amount of $69 billion over the 4 weeks prior to January 2012. (If Bank of Japan had not bought Treasuries to weaken the yen against the dollar, the statistics would have looked worse.)

Globalization promoted free capital mobility elevating it to “fundamental right.” It should not be forgotten, however, that Bretton Woods restricted financial speculation and attacks on currencies, which today have become a second religion. Indeed, John Maynard Keynes considered as the most important achievement of the conference the establishment of the right of governments to restrict capital movements. It is curious that the self-proclaimed Neo-Keynesians refrain from making reference to this and other important policies of Keynes. They only spouse deficit spending.

In conclusion, Twist and its successor QE3.5 have been more politically oriented than a monetary policy might warrant. Not only the so-called unconventional tools provided massive liquidity to the financial system, beyond reasonable needs and limits, but also bought unprecedented amounts of government bonds hurting the currency without really helping the recovery or reducing unemployment. This has its own risks. As an article in the Economist commented: “More power of central bankers means less for politicians. Hardly surprising, them, that a backlash is starting.”²⁵

12.5 An Unwarranted Worst-Case Scenario

According to Strategas Research, a think tank, total US government debt has risen 42 percent over just 3 years: 2009, 2010, and 2011. Weak growth and inflation have played a part but Fed largesse, both realized and expected, accounts for a large chunk of it. The central bank is walking the thinnest of tightropes with plain disregard to the Copernican thesis, expounded in 1526 by King Sigismund of Poland: “Money loses its value when it has too much multiplied.”

Printing paper money without limits is like becoming drug addict. It’s an unwarranted practice getting its users over many difficult moments, but it is fatal to those who persist. Only the analphabets of economic conditions and currency behavior are unable to grasp that age-long truth; whether we talk of people or of the economy, drugs kill.

This drug addiction allegory is bad news for the US economy and for the West at large because, quite unfortunately, it has become a more general trend in western economies. The desire to repay debts and repair balance sheets is easier to find among companies and households than among sovereigns. The approach most usually adopted by governments is that of always:

This is ludicrous. The problem lies precisely in the role central banks play as deus ex machina, which has been totally unhealthy. The money supply is growing more prodigiously than ever. The Fed’s policy to flood the market with liquidity and keep the cost of money rock-bottom over a long stretch of time has damaged the free market as well as Bernanke’s reputation as scholar of the First Great Depression:

There is a delirium in ballooning the monetary base by turning the handle of the printing press, merrily but unconsciously of its disastrous aftereffect. This is done by central banks accepting no connection between printing money and its depreciation. In turn, this means that they are not in control of the country’s monetary stability. That’s the typical socialist practice.

Socialists, Winston Churchill has said, are like Christopher Columbus. When they start their voyage they don’t know where they go, and when they arrive they don’t know where they are. Margaret Thatcher had an even better definition: Socialism lasts as long as other peoples’ money is lasting. When the central bank is part of the socialists’ game and it keeps on minting paper dollars, other peoples’ money would not last for long. Then comes the day of reckoning.

The socialist state has already established itself in western democracies and ruined the sovereign budgets through unsustainable entitlements. Nowadays, it set for itself a second objective: pressing into the shortest time frame of fallacies and errors regarding currency stability. This has been Lenin’s strategy for conquering the western democracies, which he expressed in a short sentence: “If you wish to destroy a nation you must corrupt its currency.”

Bernanke is no Benjamin Stark, Marrinner Eccles, Arthur Burns, or Paul Volcker. He is a theorist with a transparent socialist inclination who is not made out of central bankers stuff. The policy he is following at the Fed is indeed a losing battle because the US debt-to-GDP level is so high that America’s credit has been downgraded by US-based independent rating agencies. Printing lots of paper money, over and above that, evidently makes matters worse.

Since some time, a growing number of economists have been suggesting that the United States is living beyond its means and that with so much paper money minted overnight without real assets to back it up, the dollar’s dominance is threatened. Financial markets are also uneasy about the longer term, as with its spending programs the Obama Administration is playing with fire.

The argument that the Federal Reserve, as well as Bank of England and ECB have plenty of time to absorb the huge liquidity they threw and continue throwing to the market lacks conviction. According to well-informed opinions, monetary policy decision makers have been looking to exit quantitative easing since its inception in 2009, but political reasons don’t allow doing so.

Each time central banks look for the exit, the government bond market sells off and they are forced to do more of the same. As the paper money piles up, there is no reason to expect that “next time” it will be different. It is more likely that a worst-case scenario will resemble hyperinflation in the Weimar Republic. According to Adam Fergusson, by early 1924, hyperinflation in Germany was rising so rapidly that legal tender billion mark bills became obsolete by the time they were printed. The Reichsbank stocked them in 300 railroad cargo wagons.²⁶

This is what happens when a nation’s money is looked upon by the market, investors, and common citizens as a joke. At the center of the hurricane were the sovereign German politicians, Allied reparations, and Reichsbank—the monetary institution. This crisis started in 1920 with an elusive economic revival, and kept on building up over the following couple of years.

Left unattended, as the Weimar Republic’s government could only make ends meet by the Reichsbank’s benevolence to print more and more money—which somehow resembles the western world today—hyperinflation became, so to speak, institutionalized. The German government’s income was a mere 30 percent of its expenditures. In the United States today, the government’s income is 70 percent of its expenditures (Section 12.1) and as expenses for endowments continue rising Weimar comes in many peoples’ mind.

We are not yet there. But who can say so in a few years? Phillip Cagan defined hyperinflation as beginning in the moment price rises first exceed 50 percent per month.²⁷ That’s where we may be heading, unless politically difficult decisions are now made, at long last, to bring the budgetary deficit and start paying back the debt. Paul Ryan, House Budget Committee chairman, is right when he asks for a “big down payment on the debt crisis” and for focus on fiscal deadlines.

Moreover, as the case of Weimar Republic documents, a tragedy parallel to hyperinflation would be its effect on ethics. Speculators and profiteers will spring all over the globalized financial market, causing an increase in uncertainty and unbearable pain to common people. No economic discussions will pacify the anxiety of citizens because they know from experience that such discussions lead to nothing that is concrete.

Pretending that the debt issue could be solved without downsizing entitlements and increasing taxes is as childish as insisting that the current unfunded liabilities of sovereigns would fade away on their own will or as a result of unstoppable high-speed printing of paper money. If anything, the Bernanke model has been faulty as it worsens an already bad situation.

The more the Fed buys Treasuries the more money the government has to spend, while at the same time it tries to raise the statutory debt limit. On May 12, 2011 when a major jump in statutory debt limit was in discussion (Chapter 11), the Fed chairman warned that using the national debt limit as bargaining chip may lead to a Lehman-type meltdown of the US economy.²⁸

Critics answered that what the Federal Reserve Chairman forgot to say is that such a meltdown is promoted by his policies of flooding the US and global market with newly minted dollars in a desperate effort to face single handed the huge US government deficits which continue to grow.

“I am very much concerned about the fiscal cliff,” said Alan Greenspan in an interview he gave to CNBC on October 23, 2012. “Each of the two political parties has its position and the parties do not really talk to each other. They need to talk to reach a compromise.” A month and a half later, Greenspan was quoted by Bloomberg News as having said that: “There is no painless solution to the US debt problem.”²⁹

Congress, the White House, and the central bank are the three parties with topmost responsibility to fix the debt, rather than doing matters worse by delaying the big down payment on the debt crisis Ryan asked for. The American economy, which has espoused socialism à la Française, can no more afford the State Supermarket (into which has been the outgrowth of nanny state) and its voracious appetite for money. Even less sustainable are the increases in “benefits” contemplated by Obama.

This does not mean that there should be no tax increases. Having balanced the budget through the downsizing of expenditures, the new tax money should be strictly used to pay down the colossal public debt of $16,400 billion. There is plenty of room for doing so by adopting a top tax bracket which prevails in other developed countries. For example:

In America, the current top level tax rate is 39 percent, and an increase will probably leave it below that of other western countries.³⁰ A precondition however is that the Federal Reserve is part of the deal and stops sailing very close to the wind, often to the wrong side of it. This means that it:

In May 2011, Charlie Rose interviewed Singapore’s founding prime minister and elder statesman who criticized those central banks ready to flood the market will newly printed money. Lee Kuan Yew³¹ said that the US dollar still holds a global position because all important commodities are dollar denominated, but it is losing value against other currencies. To his opinion, if the United States continues along the current path, it will become a deeply indebted country and the huge amount of currency floating around will create a great deal of inflation.

Singapore’s elder statesman might have added that when the currency is destroyed, the nation’s resources would be shot away to nothing, as it has happened with the Weimar Republic. Given the way we are going, the question is not “if” but “when” the bill will be presented. This issue of unsustainable indebtedness will linger in the public’s mind,³² just as that of uncovered banknotes will haunt central bankers and sovereigns for years to come.

12.6 Financial Stability and Systemic Risk

The focal point of financial stability is that of providing assurance that there is not another crisis or another bubble, and if one is building up it will be taken care of without delay. Too much liquidity, way above what the market needs, is a way bubbles build up. Financial stability and the avoidance of systemic risk correlate. Systemic risk is the risk that the failure of a very large financial entity, or an accumulation of failures, can tear the fabric apart and lead to a domino effect with the one economy pulling another into the abyss.

When leveraged deals go right, the result may be spectacular. When they go wrong, they may wipe out plenty of capital and goodwill. New financial instruments as well as unconventional monetary policy measures magnify the danger of systemic risk, because of several reasons compounding upon one another:

Derivatives are not the only source of possible inordinate exposure. Quantitative easing by central banks provides another example of going way out on one leg. And there is always the tendency to confuse team playing with the urge to avoid the expression of contrarian opinion, which condemns decision makers to one-way thinking.

“It is not an easy thing to vote against the President’s wishes,” said Henry Wallich (a fed governor in the Carter years). “But what are we appointed for? Why are we given these long terms in office? Presumably, it is that not only the present but the past and the future have some weight in our decisions. In the end, it may be helpful to remind the President that it is not only his present concerns that matter.”³³

On the surface, the origin of systemic risk is simple; it gets complex as the globalization of banking and financial markets ties the players together so effectively that shocks in one place can have severe implications in other far-away places which till then seemed untouchable. Speaking at the eighth International Banking Event on May 7, 1996 in Frankfurt, the then Federal Reserve Chairman Dr. Alan Greenspan pointed to the likelihood of significant market disruptions and the potential for systemic risk. This, he said, had become a worry in the mind of every banker.

What is particularly startling, Greenspan stated, is how large the expansion in cross-border finance has become relative to the trade it finances. The discrepancy between the real and the virtual economy—the goods being traded and financial aggregates—is not necessarily the result of out-of-control financial speculation. It is a consequence of the change in the nature of output that has become progressively more conceptual and less physical.

In a startling change from past generations, a much smaller proportion of the measured real GDP currently constitutes the classical physical bulk. This is an expression of a trend toward “physical downsizing,” while the rising “virtual content” of output has become a major factor in financial exchanges. At the same time, the more virtual is the economy, the more it depends on confidence.

“There is no doubt in my mind,” writes Volcker “that the two big devaluations of the 1930s – Britain in 1931 and the United States in 1933 – did place large pressures on their trading partners, deliberately or not, and set off further rounds of instability.”³⁴ Deliberately or not, confidence was lost and this led to what became known as beggar-thy-neighbor policy considered to be one of the key reasons leading to World War II.

At global scale, loss of confidence can turn at no time into a systemic political crisis. In a similar manner, a systemic financial crisis is the result of loss of confidence in the banking industry at large, including the central bank(s). Theoretically, but only theoretically, bank liabilities are meant to be riskless allowing customers to assume they can get back 100 cents on the dollar on request. If anybody in the modern economy still believes so, he or she is living in a past world.

True enough, in the eighteenth³⁵ and nineteenth centuries bank liabilities consisted of privately issued notes convertible on demand to gold or silver (specie). But with the advent of paper money, in the case of panics the banking system did not have enough specie to meet all the redemption requests.

The abandonment of the gold standard after World War I made the specie issue irrelevant, at least for private citizens. To the contrary, the Bretton Woods agreement preserved specie for the central banks. They could ask for the conversion of paper money to gold, if they so choose. In terms of their monetary policy, this kept the reserve institutions in their line of duty. Since 1971, however, Bretton Woods belongs to history.

Bringing the amassed paper money back to its issuer and asking for gold was a great disciplinary tool. The unwanted consequence of its cancellation has been a flood of newly minted paper money. “Looking back, the performance of the world economy in the first twenty-five years of Breton Woods was exceptional,” says Volcker. “… convertibility of currencies was restored, exchange controls in Europe were relaxed, exchange rate changes among industrialized countries were limited in number and, by prewar standards, relatively small.”³⁶

Monetary discipline made the difference as Bretton Woods turned from symbol to substance, but with the end of the agreement this discipline was lost. Tremendous changes have taken place over the following four decades, but only after the economic and banking crisis which started in 2007 we began to appreciate their deeper implications. One of them is that the nature of the systemic risk has changed; another that the tools which we were using in the past have become substandard but we hardly know the aftermath of so-called unconventional tools newly added to the central banks’ arsenals, particularly when:

Bernanke’s Federal Reserve started with quantitative easing, as an experimental tool, in late 2008, at a time when the dollar was rising sharply because of being regarded as “safe haven” currency. Investors rush to the US dollar when they are worried about the outlook for the global economy.

The increase in the size of the central bank’s balance sheet significantly expanded the monetary base as the Fed bought assets from the financial system and credited the account of the counterparty from which it bought the asset by an equivalent amount of central bank money which did not exist prior to this transaction.³⁸

The reasons for QEs in 2008 and in 2013 are not the same. The target in 2013 is to keep from rising the longer term dollar interest rates. As already brought to the reader’s attention, if they do rise (which they will eventually do), the federal budget will be devastated. As Masaaki Shiraka-wa, governor of the Bank of Japan, told the Diet regarding his country’s huge public debt: long-term yields could rise and that would be a problem for public finances.

We are living at the end of an epoch characterized by the dollar as global reserve currency, unit of money for transactions, and credit card whose balance is never to be repaid. The Fed is using the paper money weapon to fill the gap in Obama’s budget, but this can work out only as long as there are counterparties accepting it. The way to bet is that the wider acceptance which dates back to Bretton Woods would not last long.

In retrospect, Bernanke chose the wrong policy in playing the eternal financier of US government deficits and protector of its mountain of public debt. “We have substituted central bank credit for the fiscal deficit of countries,” said Greenspan in an interview he gave to CNBC on October 23, 2012. As the understanding of this substitution sips down business, industry, and foreign governments,³⁹ the level of confidence drops while systemic risk rises.

At the level commercial and investment banking, systemic crises are largely about obtaining cash. Much depends on the bank’s ability to fund itself in the financial market, and this has much to do with its creditworthiness. Since the beginning of this century, such as constraint has been relieved through sovereign action, government uses taxpayer money to pull up from under banks “too big to fail.” Big government and big banks merged their interests. Yet, there is an interesting reference in Adam Smith’s Wealth of Nations, capitalism’s bible, warning of the dangers of leaving the management of banking entirely to the self-interest of bankers.

It’s all part of the socialization of America and of Europe. In his book Mémoires, David Rockefeller writes that when in 1964 he visited the Kremlin with his daughter Neva, Nikita Khroutchev told them that they would end up by living under a communist regime in the United States.⁴⁰ The extent and length of economic and social uncertainty we are now confronting tends to suggest that old man Nikita might, after all, have been right.

End Notes