January 11, 2012

My Favorite Economic Factoid

I apologize in advance for bringing this topic up so often, but I just really can't get enough of it. I think it's because it absolutely encapsulates and epitomizes the fundamentally fake nature of the modern American economy.

To wit: the Federal Reserve has just reported that it has remitted $76 billion to the Treasury Department of the Fed's earnings on its $2.9 trillion portfolio of Treasuries, mortgage-backed securities, and other trash. Relative to this number, the Fed maintains a very low overhead (on the order of 1/2 billion), so the Fed's gross earnings essentially equal its net. The Fed is a lean, mean, phony-money-generating machine.

I think what I love more than anything is the learned discourse about this topic among all the major economic thinkers: Ben Bernanke, Paul Krugman, Brad DeLong, Larry Summers, Tim Geithner, Brian Sack of the New York Federal Reserve, as they ponder this awesome contribution to American solvency. They honestly take all this shit seriously, the "money" the Fed is paying into the Treasury, the money the Fed uses to "purchase" Treasuries on the "open market" from the In Crowd Primary Dealers, the "Quantitative Easing" programs that enabled the Fed to take all that dodgy mortgage paper off the hands of its troublesome children in the banking community in the first place. They consult graphs and charts, talk about the "expectations for inflation," note with satisfaction that the U.S. Treasury market remains saturated with offers for the Treasury's promises to pay money in the future on the paper it sells today, and at such a low cost! The Treasury barely pays anything for the privilege of accepting over a trillion dollars a year in new issuance.

Of course, the Federal Reserve is itself the largest holder in the world of Treasury bonds, which it purchased on the open market, as noted above. The Primary Dealers participated in auctions, bought Treasury bonds, then held most of this paper for a few weeks before flipping it to the Fed. The Fed thus avoided violating the rule which prohibits the Fed from simply buying the bonds directly from the Treasury at the original auction. You see, if the Fed did that, it would be directly "monetizing the debt," and the Fed would never do that. Instead, the Fed waits until someone else, a big bank or broker-dealer, first purchases the Treasury bonds; then the Fed conjures money out of thin air with a few keystrokes on its computer, takes possession of the bonds, and credits the reserve account of the Primary Dealer with a few billion, on which the PD earns a quarter of a percent in interest.

The Fed isn't really operating a Quantitative Easing ruse right now; it's running "Operation Twist," whereby as bonds in its portfolio mature, they are exchanged for bonds with longer duration. Thus, 2-year bonds become 5-year bonds, 5-year bonds become 10-year bonds, and so forth. Bernanke wants to lock in the super-low rates on which the Treasury is "obligated" to the Fed for as long as possible, because the Fed's big stash of Treasuries achieves a dampening effect on bond rates in general.

It's quite a high-wire act, the business of running a phony economy. Bernanke knows that he is engaged in a titration problem, analogous to the swimming pool metaphor I used a few posts back. I mean after all, if the Fed can really support the Treasury not only by purchasing bonds with conjured money, but can push the issue by then reporting "earnings" on these bonds and remitting them back to the Treasury to the tune of $76 billion per annum, then why not a reductio ad absurdum whereby the Fed simply buys all of the Treasury's issuance? And why not eliminate all taxation and support the Federal government entirely with Treasury issuance, all of which is purchased by the Fed with conjured money? But no need to stop there. Why not simply put the entire Gross Domestic Product on the government's payroll, all $15 trillion of it, and finance it all with keystrokes from the Fed's corner office computer?

Well, of course now I'm simply being ridiculous. However, in my ironic defense I would say this: if the logic of a proposition can be extended to encompass the absurd conclusion of the reduction in question, then the logic of the actual reality is also absurd. It is only a question of degree. Bernanke has gotten away with it so far because he tries to keep it down to a roar. He asks himself, when considering yet more "quantitative easing:" will this be the pillar, when I yank it out, that finally brings the entire temple down on my head?

I note with grim amusement that Russia, China, Iran and other countries are now actively seeking ways to work around the dollar-dominated system for settling oil deals and other commodity purchases. It's not hard to see why this would happen. Russia is selling real stuff, oil and natural gas, in exchange for paper originating on the computer in Bernanke's corner office. When China and Russia reinvest the dollars they receive from commodities, they must "repatriate" this money in America in exchange for Treasury promises that pay virtually nothing, with a negative return, in fact, when inflation is factored in. And the paper they buy is with actual money earned from selling real stuff, whereas Bernanke can buy his Treasury paper, with precisely the same value and return, simply by tapping in numbers.

Thus, at some point the foreign buyers will be gone. They won't need dollars anymore because they will find another way to settle their accounts. Not this year perhaps, not next, but soon, and for the rest of America's life. The American government will continue to run its massive deficits, of course, and with our savings rate effectively locked in at zero, it will be up to the Primary Dealers to buy it all, every piece of dubious paper emitted by the Treasury. To attract the foreign buyers, the recipients of all that money we use to buy all the stuff we used to make, or can't produce ourselves (such as most of the oil we use), we would have to pay them a real rate of return. But as the national debt hits $20 trillion and beyond, a rise in interest rates will be disastrous, and it's doubtful that the world's remaining producers of essential commodities (oil, most specifically) are going to be interested in American funny money anyway.

It is all very much like the myth of Narcissus. American leaders feel trapped by the expectations of the electorate; despite all evidence to the contrary, no one who values his favored position in American politics can afford to admit the awful truth, that this whole system is phony, made up out of thin air, fumes if you will, and we are running on those fumes and nothing more. We are transfixed by our own image, by our beauty and self-regard, and we cannot tear ourselves away from the reflecting pool. And one day we will take a header.

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