E-piphany

After my last post, two readers asked me what I thought about this article at Zerohedge, and about some of its claims. The answer was going to be very long, so I decided to make it a separate post. Since there is not much economic data due today, this may be my Monday post. Below are three questions/statements made by the article in one way or the other (and there are other sub-questions answered within), and my responses. Afterwards, I have a couple of remarks about the current situation.

1.      QE was meant to stimulate the economy by provoking banks to make loans.

I know that this was the stated goal, but I don’t think there is much evidence that this is really the case. If the Fed wanted to actually get money into the hands of domestic consumers (rather than saying that it was pursuing QE to help the economy, which after all is the only statement that would fly politically), it would not have offered to pay banks to continue to hold them as excess reserves. The caption I like to have on the chart below is “Pay For Excess Reserves, Get Excess Reserves.” If the Fed wanted that money to flow into the transactional money supply, they would not only not pay Interest On Excess Reserves (IOER) but would instead charge a penaltyrate on excess reserves. That would flush the money into the system within days. Of course, that would cause other (big) problems, but it isn’t like there’s a big mystery about how to get the quantitative easing money to actually become transactional money.

Pay for reserves, get reserves.

2.      The Fed was trying to prop up foreign banks, which received the bulk of its largesse.

If the Fed was not flooding the banks with money to stimulate the economy, which it evidently was not, then what was it doing? Clearly, a big part of what it was doing was trying to help the banks re-liquify. But there is no evidence to me that they were targeting foreign banks. The primary dealers, many of which are banks based overseas, all got to participate in the programs such as the Primary Dealer Credit Facility. The Fed cannot, unless it wants to dismantle the primary dealer system, discriminate among those dealers. As it is, there are few advantages to being a primary dealer, and large costs (for example, you must bid on every auction, and you must win some bonds with reasonable frequency whether you want them or not). So BNP gets to participate just as much as Jefferies.

And once the banks have the money, how could you prevent them from using the capital to shore up the home office? After all, capital is fungible. I worked at a domestic branch of a foreign bank (not one of the primary dealers) during the crisis, and in our case the capital usually flowed the other way – from home office to domestic branch – and usually at the last moment and at usurious interest rates. Banks go to where the cheapest capital is available, and transfer the capital between units. They do this all the time. And this is a key point: delivering cheap capital to where it is most needed is in fact one of the critical functions of the banking system!

The Fed wasn’t bailing out foreign banks. They released nearly-free capital in order to shore up the weakest banks. The money, as it turns out, flowed to the weakest banks – they just happen to be mostly in Europe. Surprise, surprise (although John Mauldin’s recent piece presented evidence from the BIS that U.S. banks may be heavily exposed to the European sovereign debt crisis as sellers of credit default swaps. That will be a kick in the pants, if after thinking our banks were relatively free of this particular morass it turns out they managed to find their way into it).

Now, in the ‘old days’ the Fed would have been working very hard to make sure that the major central banks were all on the same page so that one central bank wasn’t providing all of the liquidity. During the crisis, that worked. They had all of the major central banks running with spigots wide open. Right now, though, the ECB is seemingly trying to drain liquidity while the Fed is providing it, so it isn’t surprising to see money flowing from U.S. to Europe. But if I were the Chairman of the Fed, I would be burning up the phone lines to Trichet and suggesting that perhaps instead of poking more holes in the bottom of the boat he could help bail.

But while we’re on the subject of helping foreign banks, let’s ask “why not?” I think it should be fairly obvious why the Fed is okay with helping Barclays and Deutsche and Nomura survive even though those banks are the primary responsibilities of the BOE, the ECB, and the BOJ respectively. They are also institutions that are far more integrated in the global financial system than was, say, Lehman Brothers. They are truly global banks that operate in virtually all markets. If there are any banks that are too big to fail, it is the main primary dealers.

The Fed’s plan since the beginning has clearly been to extend the game as long as possible, keep the yield curve as steep as possible, and hope that global economic growth would re-capitalize these banks before the piper was called. For a while it looked like they would be able to do so. Now, not so much and I am frankly terrified at the prospect of what happens next.

3.      What do you make of the dollars being accumulated by overseas banks?

I don’t worry about it. Dollars being held as dollars are an interest-free loan that institution has extended to the U.S. government. That’s terrific! And the dollars after all will return to the economy – a dollar can only buy dollar-denominated assets, goods, or services, or be exchanged for another currency in which case the buyer of the dollars can only buy dollar-denominated assets, goods, or services.

And that means that if (not when) the Fed ever chooses to sop up those dollars, they will be able to. The author of that Zerohedge post seems to think that the dollars being accumulated by overseas banks must somehow remain dollars. Of course not. Euros will do just as well. If the Fed starts to suck the dollars back out of the market by selling off its bond portfolio, it means dollar-based capital will become more dear. Banks will simply exchange dollars for Euros because there will be a bid for the dollars from folks who want to buy those bonds. It can’t really happen any other way – it isn’t like when the Fed sells some of its bonds, and has sucked up all the cash except for the money in Europe, we’ll all be walking around with nothing in our pockets. No, when that happens we’ll go to the ATM and pull out more U.S. currency, and the bank will deliver some of its dollars and replace them with cheaper capital from somewhere else.

The fungibility of currency works both ways. Don’t worry about it.

Now, what this means is that if the Fed starts to drain in earnest it will tend to increase the value of the dollar. No question about it. Given the crisis in Europe, the only reason the dollar is so weak in the first place is that there are so darn many of them. If they become scarcer relative to Euros, they will become more expensive. That’s how the FX market works!

***

Bad times are coming, as they usually do when Europe is at war. It is an economic war, to be sure, but it is a war. Germany’s parliament on Friday declared that more funds for Greece should only be disbursed if debt holders agree to roll/extend the debt (and thus shoulder ‘part of the costs’). But the ECB has declared that it will absolutely not do so. This is a throw-down, friends. If the ECB refuses to roll its debt, then Germany will not back a rescue and that means, no rescue. If the ECB does agree to roll its debt, then it will constitute a default, the ECB and many banks will be insolvent, and Greece will eventually default anyway.

I don’t see any path that does not lead to Greece defaulting, eventually leaving the Euro, and another major banking crisis. Frankly, I haven’t ever seen a path that didn’t lead that way, but as we get closer to a resolution it is beginning to dawn on more and more people that … hey, it isn’t that we couldn’t see the way forward, it’s that there isn’t a way forward.

In this circumstance, it is a fair question to ask what the Fed could do differently or could have done differently to avert this sorry pass. As I made clear in my book, I think the answer goes back to the last Fed. The answer is similar to the answer to the question of what we could do if we suddenly discovered an asteroid on a collision course with Earth. What can we do about it? If given sufficient warning, say 10 years, then steps can be taken to avert disaster. After some point, however, there is nothing that can be done because the collision is too close. If we find the rock bearing down on us only one month before the impact, all we can do is prepare for it and hope it doesn’t hit us directly. I am not suggesting that the developing sovereign/banking crisis will end life on the planet as we know it, but unless something miraculous happens it’s going to happen and it’s not going to be pretty. And I think, given the fact of global financial interconnectedness, the hope that it will somehow pass us by is going to be dashed.

The central banks are doing everything they can to delay the day of reckoning, and they’ve managed to do it so far. It is very hard to figure out exactly how long the game can be extended, and as I’ve written many times in the past the institutional survival meme is very strong – it is hard to bet on calamity because everyone has an incentive to avoid calamity. Despite all of the predictions that the 1980s would end in a nuclear holocaust, it didn’t happen, and that’s a hopeful note. I worry about the fact that the issue is being framed as “big banks versus the little guy,” because that tends to divide us whereas in the 1960s-80s we all knew we were in the same boat with respect to the exchange of nuclear weapons. The current circumstance is not unlike “the big ship versus the passenger.” Like it or not, we little people depend on the financial infrastructure that the big banks are a part of. We need to restructure so that the system rests on smaller banks, but we can’t do that by cheering for the failure of the big banks and pontificating about greed and other easy targets.

What do I like as an investment in this situation? My models are still heavily into commodity indices as the best of a poor set of choices: commodities and cash in preference to inflation-linked bonds and equities. I think that’s probably right, although I do worry about a knee-jerk correction to commodities on a growth scare that confuses real variables and nominal variables (that is, oil drops because consumption of it is expected to decline, but if the real value of the currency halves then the price of oil should rise regardless).