First of all, everyone should watch this video about money. No, it’s not about making your own, unless you own a bank:
‘Money as Debt’ explains how the little bank down the street conjures cash out of thin air. This video puts to rest widespread idea that banks ‘borrow’ money from other banks or the Federal Reserve in order to re- lend to you. Instead, banks create money as a balance sheet entry simply by writing a ‘bad check’ to the order of the borrower. The promise of the borrower to repay (with interest) is the only security for the loan. As the amounts of loans increase, central bank reserves are lent to the bank in order to provide security against ordinary risk such as withdrawal demand.
That the banks invent money on their own without the assistance of the government or a central bank clarifies the efforts of the government and the central banks – all of them – to assist ordinary bankers. Without banks, there would be no institution to create money. At the same time, since banks can lend increasing amounts almost without limit and by doing so create an ever enlarged money supply explains the necessity of taxes. If the government created money, there would be no reason for taxes as the government would simply invent the necessary funds to support operations and defray costs.
Instead, the government is obliged to tax funds that are lent into existence by the banks. Taxpayers are conduits that launder bank- created money for the benefit of the government.
The Treasury/Fed/Wall Street focus reflects institutional short- sightedness and a fixation on the continued creation of more and more funds without any apparent cost. This arrangement is ordinarily quite profitable for bankers who fiercely defend it. It is useful to the Treasury and gives the Fed great administrative power. At the same time, there is nothing inevitable or indispensable about the current banking regime. The ability to create ‘fiat’ money is an advantage which is outweighed by costs. The debt that is created alongside the funds can overhang the markets that are afforded by the funds to service the debt … as is occurring now. The bank creates the principal but doesn’t create the interest and loan repayment is not in under the control of the banker. All this must come from some ‘other’. By prejudice, the banker does not view banking as part of an integrated whole or ecology. The ability of borrowers to repay or service the loans is outside the concern of the banker.
Along this line there is a lot of discussion and confusion around the idea of the government and the central bank monetizing debt, either existing (bad) loans as well as debt instruments issued by the Treasury. This process is called ‘Printing money’, ‘running the printing press’ or fashionably, ‘QE‘ or ‘Quantitative Easing’ which means the Fed being a private bank invents money that it lends to you, collectively, the Treasury. The bond given to the Fed in return is an IOU.
Ordinarily the government borrows from individual citizens via brokerages or money funds, or from other treasuries and central banks. Currently, half of the money the Treasury borrows is lent by the Fed.
The concern is that these free- and- easy dollars will wind up in circulation and trigger inflation, or at least, a debasement of the dollar. After all, there are so many of them.
First of all, the dollar is so debased since the founding of the republic that any further debasement is rather like gilding a housefly; it’s a pointless exercise. That any discussion takes place at all illuminates the relative worthlessness of the other currencies which are traded for the dollar. After all, their purchasing power is debased just as much as ours is. All modern money is created the same way, all monies are fiat currencies lent into existence.
The only dollar relationship that matters is the dollar for oil. Since currency markets and the oil market have their own – and quite different – dynamics, there is a lot more risk than there would be if the primary concern existed with one market or the other. Since the markets are intertwined and vulnerable, a problem with dollar value could ramp up the price of oil to an oil- shock level.
Alternatively, a rise in Treasury rates reflecting the debt deluge would likely bring all sorts of ‘off balance- sheet’ bad loans looking for a buyer. The outcome would be a self- reinforcing deleveraging event.
Which leads to the second part; while general inflation isn’t likely because of the lack of demand/public participation, the influx of Federal Reserve liquidity into the asset markets generates inflation in those markets and nowhere else.
Andy Xie has written two timely essays describing the pitfalls:
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won’t it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don’t think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven’t done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don’t think so.
Here’s another take on the same problem, different country;
Japan’s stagnation has been linked to government handling of debt overhang in the corporate sector — mainly in the real estate, construction, and retail sectors, and left over from the bubble era. In the 1980s, especially after the Plaza Accord, Japan’s corporate sector accumulated a massive amount of debt for financial speculation. Total corporate debt more than doubled to about 900 trillion yen, or 200 percent of GDP, from 1984-’92. After land and stock prices collapsed, the net value of the corporate sector’s financial assets switched from about 30 percent of GDP to a minus 50 percent of GDP. If the change in land holding value is included, the corporate sector’s net worth may have fallen by 200 percent of GDP. As corporate profits are about 10 percent of GDP in a developed economy, Japan’s corporate sector would need two decades to earn its way back.
The Japanese government did choose to let the corporate sector earn its way back, first by preventing bankruptcies and second by stimulating demand. To achieve the first goal, the government kept interest rates near zero and Japanese banks did not pursue mark-to-market accounting in assessing borrower solvency. With a big chunk of the corporate sector zombie-like, the economy, of course, was always facing downward pressure. The government had to run large fiscal deficits to prop up the economy. After the bubble, Japan’s economic equilibrium stagnated and the fiscal deficit swelled.
This strategy was flawed in three aspects. First, even as the corporate sector earns profits to pay down debt, the government’s debt is rising. At best, it is shifting corporate debt to government debt. In reality, government debt has been rising faster than private sector debt has been falling.
Second, economic efficiencies don’t increase in such equilibrium. Existing resources in the zombie sector are essentially unproductive. Bankruptcies improve efficiency by shifting resources from failing to succeeding companies. When rules are changed to stop bankruptcies, efficiency is sacrificed. Worse, incremental resources are sucked up to pay fiscal deficits used to prop up zombie industries. Japan is thus trapped in equilibrium of low productivity.
It seems that actual production is obsolete, even in the most industrialized of countries. Why? Greed is always a good answer, but the effect of high energy prices handicaps production in ways that are not relevant to speculation and finance. High enough oil prices and even China production is too expensive. High enough oil prices makes oil speculators rich.
Both articles are worth a read, Xie and David Rosenberg always have something credible and important to say.
One consideration is to look at the US monetizing (and bubble making) is to consider central bank to be a sort of massive ‘Option Arm’ mortgage where the recast period is … well, never!
An option arm mortgage product allows the borrower to pay an ‘option’ percentage of interest on the loan and defer paying principle. The balance of the monthly interest payment is added to the principal. After a term – usually five years, or should the combined principal and deferred interest reach 125% of the original loan amount – the loan is ‘recast to a fixed rate, 30 year loan’ and the monthly payment adjusted to reflect the new interest and principal due.
Consider the Fed doing the same thing, but with whatever bank loans it takes custody of. Just for fun, let’s say the Fed swaps some ‘QE’ for all the US bank’s and the government’s bad debts – all $45 trillion of them – and then just sits on them, collecting and paying this and that interest and adding any remaining interest balance to the principal amount. The Fed, of course, has no intention of paying any principal. The sum of bad loans and accumulating interest just grows and grows.
This would make the Fed a gigantic, insolvent bank. At what point would its liabilities bring it to ruin? Theoretically, there is no limit to what the Fed can lend or swap; since the funds simply shift from (private) custody to (Fed) custody, there would be no effect on the greater economy. The theoretical limit is the demand to service the loans that the Fed holds. Interest expense would increase exponentially. At some point, the service costs would be greater than the principal amount of the loans. In our example, any accumulated service difference would be added to the Fed’s principal … which would never be repaid. Eventually there would be enough currency debasement to destroy the truly bad debt; the rest repaid with inflated dollars. The Fed would outlive its creditors, in other words. Even if the Fed’s balance sheet expanded to $45 trillion plus deferred interest, the Fed would still be able to gin up more ‘QE’ just by lending more cash to the Treasury.
The exponential growth of debt service cost bearing down on the Treasury has a different effect. Unlike the bad- boy Fed, the Treasury is the ‘good guy’. It’s a part of the US government and has to pay interest. It relies on the Fed to keep the yield down with various manipulations … such as ‘QE’ and other meddling in the bond market. The debt service cost imposes a theoretical limit to government borrowing, although that cost is a manageable amount, now. At some point, interest cost of servicing the sovereign borrowing could/will be greater than the total annual budget. Currently low interest rates prevent service expense from being a crisis. The taxpayers can pay the debt service. Tomorrow?
What happens to the banks freed of bad loans and also free to lend again?
The answer of course is to run out and make more bad loans. With the energy backdrop, all loans going forward are likely to turn out bad. There is less and less energy available to propel commercial activity profitably and allow the interest to be repaid.
… and a new productive paradigm does not exist.