Posts Tagged ‘Treasury Department’

Authored by Simon Black

 

Late yesterday afternoon the federal government of the United States announced that the national debt had finally breached the inevitable $20 trillion mark.

This was a long time coming. It should have happened back in March, except that a new debt ceiling was put in place, freezing the national debt.

For the last six months it was essentially illegal for the government to increase the debt.

This is pretty brutal for Uncle Sam. The US government hasn’t run a budget surplus in two decades; they depend on debt in order to keep everything running.

And without the ability to ‘officially’ borrow money, they’ve basically spent the last six months ‘unofficially’ borrowing money by plundering federal pension funds and resorting to what the Treasury Department itself calls “extraordinary measures” to keep the government running.

Late last week the debt ceiling crisis came to a temporary armistice as the government agreed once again to temporarily suspend the debt limit.

Overnight, the national debt soared hundreds of billions of dollars as months of ‘unofficial’ borrowing made its way on to the official books.

The national debt is now $20.1 trillion. That’s larger than the size of the entire US economy.

You’d think this would be front page news with warnings being shouted from the rooftops of America.

Yet curiously the story has scarcely been covered.

Today’s front page of the New York Times tells us about Hurricane Irma, North Korea, and alcoholism in Iran.

Even the Wall Street Journal’s front page has zero mention of this story.

In fairness, the number itself is irrelevant. $20 trillion is merely a big, round, psychologically significant number… but in reality no more important than $19.999 trillion.

The real story isn’t the number or the size of the debt itself. It’s the trend. And it’s not good.

Year after year after year, the US government spends far more money than it collects in tax revenue.

According to the Treasury Department’s own figures, the government’s budget deficit for the first 10 months of this fiscal year (i.e. October 2016 through July 2017) was $566 billion.

That’s larger than the entire GDP of Argentina.

Since the government has to borrow the difference, all of this overspending ultimately translates into a higher national debt.

Make no mistake, debt is an absolute killer.

History is full of examples of once-dominant civilizations crumbling under the weight of their rapidly-expanding debt, from the Ottoman Empire to the French monarchy in the 1700s.

Or as former US Treasury Secretary Larry Summers used to quip, “How long can the world’s biggest borrower remain the world’s biggest power?”

It’s hard to project strength around the world when you constantly have to borrow money from the Chinese… or have your central bank conjure paper money out of thin air.

And yet tackling the debt has become nearly an impossibility.

Just look at the top four line items in the US government’s budget: Social Security, Medicare, Military, and, sadly, interest on the debt.

Those four line items alone account for nearly NINETY PERCENT of all US government spending.

Cutting Social Security or Medicare entitlements is political suicide.

Not top mention, both of those programs are actually EXPANDING as 10,000 Baby Boomers join the ranks of Social Security recipients every single day.

Then there’s military spending, which hardly seems likely to fall significantly in an age of constant threats and warfare.

The current White House proposal, in fact, is a 10% increase in military spending for the next fiscal year.

And last there’s interest on the debt, which absolutely cannot be cut without risking the most severe global financial meltdown ever seen in modern history.

So that’s basically 90% of the federal budget that’s here to stay… meaning there’s almost no chance they’re going to be able to reduce the debt by cutting spending.

But perhaps it’s possible they can slash the national debt by growing tax revenue?

Possible. But unlikely.

Since the end of World War II, the US governments’ overall tax revenue has been VERY steady at roughly 17% of GDP.

You could think of this as the federal government’s ‘slice’ of the economic pie.

Tax rates go up and down. Presidents come and go. But the government’s slice of the pie almost always remains the same 17% of GDP, with very small variations.

With data this strong, it seems rather obvious that the solution is to allow the economy to grow unrestrained.

If the economy grows rapidly, tax revenue will increase. And the national debt, at least as a percentage of GDP, will start to fall.

Here’s the problem: the national debt is growing MUCH faster than the US economy. In Fiscal Year 2016, for example, the debt grew by 7.84%.

Yet even when including the ‘benefits’ of inflation, the US economy only grew by 2.4% over the same period.

In other words, the debt is growing over THREE TIMES FASTER than the economy. This is the opposite of what needs to be happening.

What’s even more disturbing is that this pedestrian economic growth is happening at a time of record low interest rates.

Economists tell us that low interest rates are supposed to jumpstart GDP growth. But that’s not happening.

If GDP growth is this low now, what will happen if they continue to raise rates?

(And by the way, raising interest rates also has the side effect of increasing the government’s interest expense, essentially accelerating the debt problem.)

Look– It’s great to be optimistic and hope for the best. But this problem isn’t going away, and it would be ludicrous to continue believing this massive debt is consequence-free.

There’s no reason to panic or be alarmist.

But it’s clearly time for rational people to consider this obvious data… and start thinking about a Plan B.

Do you have a Plan B?

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For the self-described “most transparent administration ever” it appears keeping the lies straight is becoming harder and harder. Having slammed the press, Donald Trump, and anyone who dare mention the “lack of logic” in paying a $400 million ransom for 4 Iran hostages, WSJ reports that Treasury officials have confirmed that Obama lied and in fact, the tightly scripted exchange of cash was specifically timed to the release of several American prisoners held in Iran. Trump was right again.

As a reminder, The Hill reported that, President Obama chastised the press for their coverage of the payment, noting that the deal with Iran was announced months ago as part of a larger diplomatic settlement.

 “This wasn’t some nefarious deal,” Obama said.

“It’s been interesting to watch this story surface,” the president said. “Some of you may recall, we announced these payments in January. Many months ago. There wasn’t a secret, we announced them to all of you.”

“What we have is the manufacturing of outrage on a story that we disclosed in January,” he added later.

“The notion that we would somehow start now in this high-profile way, and announce it to the world, even as we’re looking in the faces of other families whose loved ones are being held hostage and say to them, ‘we don’t pay ransom,’ defies logic,” Obama said.

Defies logic indeed – because having slammed the press for suggesting this was a “ransom payment,” we discover that is exactly what The Justice Department warned

In his remarks, the president didn’t mention the objections raised by his own appointees within the Justice Department, where, according to people familiar with the discussions, many officials raised alarms that the timing of the cash payment would look like ransom. (via WSJ)

  The head of the national security division at the Justice Department was among the agency’s senior officials who objected to paying Iran hundreds of millions of dollars in cash at the same time that Tehran was releasing American prisoners, according to people familiar with the discussions. John Carlin, a Senate-confirmed administration appointee, raised concerns when the State Department notified Justice officials of its plan to deliver to Iran a planeful of cash, saying it would be viewed as a ransom payment, these people said. A number of other high-ranking Justice officials voiced similar concerns as the negotiations proceeded, they said.

The U.S. paid Iran $400 million in cash on Jan. 17 as part of a larger $1.7 billion settlement of a failed 1979 arms deal between the U.S. and Iran that was announced that day. Also on that day, Iran released four detained Americans in exchange for the U.S.’s releasing from prison—or dropping charges against—Iranians charged with violating sanctions laws. U.S. officials have said the swap was agreed upon in separate talks.

The objection of senior Justice Department officials was that Iranian officials were likely to view the $400 million payment as ransom, thereby undercutting a longstanding U.S. policy that the government doesn’t pay ransom for American hostages, these people said. The policy is based on a concern that paying ransom could encourage more Americans to become targets for hostage-takers.

Of course, the denials kept on coming from The White House. However, as The Wall Street Journal now reports, new details of the $400 million U.S. payment to Iran earlier this year depict a tightly scripted exchange specifically timed to the release of several American prisoners held in Iran, based on accounts from U.S. officials and others briefed on the operation

 U.S. officials wouldn’t let Iranians take control of the money until a Swiss Air Force plane carrying three freed Americans departed from Tehran on Jan. 17, the officials said.

Once that happened, an Iranian cargo plane was allowed to bring the cash back from a Geneva airport that day, according to the accounts.

President Barack Obama and other U.S. officials have said the payment didn’t amount to ransom, because the money was owed by the U.S. to Iran as part of a longstanding dispute linked to a failed arms deal from the 1970s. U.S. officials have said that the prisoner release and cash transfer took place through two separate diplomatic channels.

But the handling of the payment and its connection to the release of the Americans have raised questions among lawmakers and administration critics.

One of the Americans released in January as part of the prisoner exchange, a Catholic pastor named Saeed Abedini, said he and other American prisoners were kept waiting at Mehrabad airport for more than 20 hours from Jan. 16 to the morning of Jan. 17.

He said in an interview that he was told by a senior Iranian intelligence official at the time that their departure was contingent upon the movements of a second airplane.

Just as Trump had suggested (before oddly retracting his suggestion), the exchange did take place and as the BBC reported. a video did indeed exist of the events, referring to a documentary called “The Rules of the Game” which was broadcast on Iranian state TV in February. In the clip, one can see shots of an airport are accompanied by commentary which references 17 January in Tehran’s Mehrabad Airport.

Specifically, the video shows a loaded crate, partially blurred out, which allegedly shows the money in question.

 

And another version:

“Early hours of 17 January 2016, Mehrabad Airport (Tehran), $400m cash was transported to Iran by an airplane.

“A little bit later, part of the interest money was also paid to Iran, and the US government made a commitment to pay the rest of Iran’s money.”

While it is not clear if this is intended to be a literal description or whether the shots are just general views of the airport.

The video is shown below, and the pettets of cash appear at the 11:00 mark.

 It is unclear where Donald Trump might have caught the clip of the video, and whether or not the cash disclosed is what Iran claims it is (in light of the WSJ revelations it is very likely that this is indeed the alleged payment in question) but the footage was widely discussed several months ago when the hostages were released.  The Iranian TV ran it with a title “The Rules of The Game.” It was released on BBC TV during a segment discussing the release of the prisoners.In other words, it did exist.  

*  *  *

So to summarize – Obama lied; the administration did indeed make a $400 million in exchange for the release of four hostages (if it walks like a ransom, and talks like a ransom, it is a ransom), and Trump was right.

Finally, this is far from over, as The Wall Street Journal concludes, Republican lawmakers have charged that the $400 million payment equated to a ransom paid by the White House to gain the release of the Americans.

 Republican leaders said they are preparing to hold hearings on the $400 million transfer once Congress returns from its summer break in September. Rep. Sean Duffy (R., Wis.), chairman of a House investigative body, sent letters to the Justice and Treasury Departments, as well as the Federal Reserve, on Aug. 10 requesting all records related to the Iran exchange.

Mr. Duffy asked Attorney General Loretta Lynch to identify all “persons within the Department authorizing or otherwise taking steps to carry out the payment.”

Obama administration officials have confirmed that they have paid the remaining $1.3 billion to Iran as part of the settlement reached in January on the failed arms deal. This marked the interest accrued over the past 37 years on the original $400 million paid by Iran. U.S. officials, however, have refused to disclose how the Obama administration made this additional payment. Lawmakers are seeking to determine whether this money was also paid in cash or if the Treasury Department was able to wire it electronically.

You are about to see undeniable evidence that the U.S. economy has been slowing down for quite some time.  And it is vital that we focus on the facts, because all over the Internet you are going to find lots and lots of people that have opinions about what is going on with the economy.  And of course the mainstream media is always trying to spin things to make Barack Obama and Hillary Clinton look good, because those that work in the mainstream media are far more liberal than the American population as a whole.  It is true that I also have my own opinions, but as an attorney I learned that opinions are not any good unless you have facts to back them up.  So please allow me a few moments to share with you evidence that clearly demonstrates that we have already entered a major economic slowdown.  The following are 15 facts about the imploding U.S. economy that the mainstream media doesn’t want you to see…

1. Industrial production has now declined for nine months in a row.  We have never seen this happen outside of a recession in all of U.S. history.

2. U.S. commercial bankruptcies have risen on a year over year basis for seven months in a row and are now up 51 percent since September.

3. The delinquency rate on commercial and industrial loans has been rising since January 2015.

 4. Total business sales in the United States have been steadily dropping since the middle of 2014.  No, I did not say 2015.  Total business sales have been in decline for nearly two years now, and we just found out that they dropped again
 Total business sales in the US did in April what they’ve been doing since July 2014: they dropped: -2.9% from a year ago, to $1.28 trillion (not adjusted for seasonal differences and price changes), the Censuses Bureau reported on Tuesday. That’s where sales had been in April 2013!

5. U.S. factory orders have been dropping for 18 months in a row.

6. The Cass Shipping Index has been falling on a year over year basis for 14 consecutive months.

7. U.S. coal production has dropped to the lowest level in 35 years.

8. Goldman Sachs has its own internal tracker of the U.S. economy, and it has fallen to the lowest level since the last recession.

9. JPMorgan’s “recession indicators” have risen to the highest level that we have seen since the last recession.

10. Federal tax receipts and state tax receipts usually both start to fall as we enter a new recession, and that is precisely what is taking place right now.

11. The Federal Reserve’s Labor Market Conditions Index has been falling for five months in a row.

12. The employment numbers that the government released for last month were the worst that we have seen in six years.

13. According to Challenger, Gray & Christmas, layoff announcements at major firms are running 24 percent higher this year than they were at this time last year.

14. Online job postings on the business networking site LinkedIn have been declining steadily since February after 73 months in a row of growth.

15. The number of temporary workers in the United States peaked and started falling precipitously before the recession of 2001 even started.  The exact same thing happened just prior to the beginning of the 2008 recession.  So would it surprise you to learn that the number of temporary workers in the United States peaked in December and has fallen dramatically since then?

Earlier today, we learned that two of our biggest corporations will be laying off even more workers.  Bank of America, which is holding more of our money than any other bank in the country, has announced that it is going to be cutting about 8,000 more workers

 Bank of America is expected to reduce staffing in its consumer banking division by as many as 8,000 more jobs.

The nation’s largest retail bank by deposits has already reduced the staffing in its consumer division from more than 100,000 in 2009 to about 68,400 as of the end of the first quarter of 2016, said Thong Nguyen, Bank of America’s president of retail banking and co-head of consumer banking at the Morgan Stanley Financials Conference Tuesday.

And Wal-Mart has announced that it is going to be eliminating “back-office accounting jobs” at approximately 500 locations

 Walmart is going to cut some back-office accounting jobs at about 500 stores in a bid to become more efficient.

The job cuts will occur mostly at stores mostly in the West and involve accounting and invoicing workers, says spokesman Kory Lundberg. Instead, bookkeeping functions will be switched to Walmart’s home office in Bentonville, Ark. Cash at the stores will be counted by machine.

Day after day we are hearing about more layoffs like this.  So why would this be happening if the U.S. economy truly was in “recovery mode”?

Even with how manipulated the GDP numbers are these days, Barack Obama is on course to be the only president in all of U.S. history to never have a single year when the economy grew by at least 3 percent.  The truth is that our economy has been stuck in the mud ever since the end of the last recession, and now a major new downturn has clearly already begun.

And you want to know who else realizes this?

Foreign investors do.

Last month, foreign investors dumped U.S. debt at the fastest pace ever recorded

 Foreign investors sold a record amount of U.S. Treasury bonds and notes for the month of April, according to U.S. Treasury Department data on Wednesday, as investors priced in a few more rate increases by the Federal Reserve this year.

Foreigners sold $74.6 billion in U.S. Treasury debt in the month, after purchases of $23.6 billion in March. April’s outflow was the largest since the U.S. Treasury Department started recording Treasury debt transactions in January 1978.

There is no debate any longer – the next economic crisis is already here.  This is so abundantly obvious at this point that even George Soros has been feverishly dumping stocks and buying gold.

We can argue about whether the U.S. economy started turning down in late 2015, early 2015 or late 2014, and it is good to have those debates.

But at the end of the day, what is far more important is what is ahead.  Fortunately, our downturn has been fairly gradual so far, and let us hope that it stays that way for as long as possible.

In much of the rest of the world, things are already in full-blown panic mode.  For instance, Venezuela was once the wealthiest nation in South America, but now people are literally hunting cats and dogs for food.

Absent a major “black swan event” of some sort, we won’t see that happening in the United States for at least a while yet, but without a doubt we are steamrolling toward a major economic depression.

Unfortunately for all of us, there isn’t anything that any of our politicians are going to be able to do to stop it.

 

Are we better off with “QE”, the ultra-accommodative monetary policy pursued by major central banks around the world? Is it “mission accomplished” or are we facing a “ticking time bomb”? Are extreme characterizations even warranted to describe the unconventional monetary policy of recent years, and what are implications for investors?

The Good

When interest rates are at or near zero and central bankers want to provide more “monetary accommodation,” it is not clear that negative interest rates are the answer.  The term “quantitative easing” or “QE” was coined to describe the purchases by of government bonds by central banks. It was combined with “forward guidance” which signaled rates would stay low for an extended period; in our assessment the key goal of both policies was to lower long-term rates (historically, central banks control short-term rates, but leave longer term rates up to the market to determine). Doing so, so the logic goes, would provide the desired “accommodation.” There is an index that tries to create a Fed Funds rate incorporating QE:

 Note that this index suggests that we have had substantial tightening take place since the ‘end’ of QE.

Did I just write “the end of QE”? Last time I checked, the Fed has stopped increasing to its arsenal of bonds, but has continued to reinvest proceeds from maturing securities on its balance sheet. The Fed owns these bonds; that is, they sit on the asset side of the Fed’s balance sheet. This is not the place to pass judgment on the methodology of the index, but want to show how at least some economists look at QE.

It’s our understanding that central bankers never want to appear out of ammunition. As such, QE gives them a tool that they believe does the equivalent of ‘lowering’ rates at any time should, in their assessment, that be warranted.

 

The Bad

While the Fed’s measures may have prevented more firms, possibly even the financial system as a whole, from imploding in the aftermath of the 2008 financial crisis, the economy has hardly fired from all cylinders ever since. Historically, a sharp contraction is usually followed by a steep recovery; this time, however, the recovery has been rather lackluster.  Amongst the reasons for the lackluster recovery may be:

  • Rates aren’t so low. While nominal rates are low, inflation is also low. More so, as the chart above suggests, there might have been substantial tightening since the ‘end of QE’ was announced. In Europe, ECB chief Draghi suggests real interest rates (nominal rates net of inflation) are higher now than twenty years ago. It’s beyond the scope of the analysis here to comment on this argument.
  • Constrained banks.  Policy makers wanted banks to take less risk. That may be a good policy goal, but it comes at a price: in a credit-driven society, when those providing credit are constrained, one ought to expect lower growth. We agree with this argument in principle, but would like to point out that it’s been lack of demand for credit, not the lack of supply that’s been key to holding back economic growth. One can lead a horse to water, but you can’t make it drink; similarly, central banks can make credit cheap, but can’t force consumers and businesses to borrow.
  • Headwinds imposed by taxes and regulation. There is an argument to be made, and I sympathize with it, that we’ve had a tremendous increase in regulations, making it less attractive to invest. The counter-argument to this is that there’s a political camp that has “always” complained about too much regulation and that there’s nothing new here. I beg to differ and concur with the camp that suggests this may well be the biggest impediment to growth, but note that it is most unfortunate that this debate turns political.
  • Lackluster global growth / the strong dollar. I group those two into one not because they are identical, but because they both reflect what may be a global attitude that it’s others that should fix their problems to help us. I beg to differ: while there may be headwinds caused by global factors, we can foremost control domestic ones. Our policy makers may be well served to focus on what they can control rather than blame others. Having said that, I allege that it is a defining symptom of the environment we are in that policy makers increasingly seek to blame others (this is a non-partisan jab at policy makers globally, not merely U.S. elections).
  • Demographics. As society ages, there may be less economic growth because labor force growth slows or even declines. I agree that demographics may be under-estimated, but the U.S. fares far better than many other advanced economies, yet the U.S. is plagued by a declining labor force participation rate as well. That said, U.S. elderly Americans are working (they don’t have enough savings to retire); it’s folks in their prime years that are dropping out of the work force that, in my assessment, is a bigger problem. Part of the challenge is an increasing number of Americans on disability. Just recently, I spoke with someone who lamented that he is sitting at home bored, but couldn’t go back to work, as he would lose his disability benefits. The increase in disability benefits has held growth back.
  • Technology. A tune that I increasingly hear is that “everything worth inventing has been invented.” Similarly pessimistic reasons make it to the headlines every couple of decades. I don’t buy it. Quantum computing could provide an exponential boost to our computing power. Technology could solve challenge posed by climate change Without a doubt in my mind, there can be lots of improvements in healthcare. Â
  • Globalization. In my view, globalization doesn’t hold growth back, but it provides a more level playing field. However, that’s bad news for those who had in the past demanded top dollars for their services, when there are a billion others offering to provide the same service at a lower price. Technology, in some ways, provides the same challenge, as ever more complex tasks can be outsourced to machines. Those are challenges, and in my view, policy makers on both the left and the right of the political spectrum have done a poor job helping society keep pace and adjust.
  • Lack of vision. At the peak of the Eurozone debt crisis, Eurogroup head Dijsselbloem pointed out that one cannot expect investors to buy bonds of peripheral Eurozone countries if policy makers don’t provide a vision of where they should be in ten years. I believe such criticism is well warranted not just for the Eurozone, but for much of the developed world, both with regard to fiscal and monetary policy. In our assessment, the lack of clarity on future policy is a headwind to growth.
  • Low productivity. In a speech in 2005, Janet Yellen, then President of the St. Francisco Fed, argued low productivity warrants higher rates. Now as Fed Chair, we believe she argues the opposite. The apparent contradiction may be found in the fact the low productivity is the result of other policies, not a variable that can be manipulated, even if some economists may be tempted to do so. At a debate amongst the living (current and former) Fed Chairs at the International House on April 7, former Fed Chair Alan Greenspan argued an economy that’s close to full employment must be boosted by facilitating greater productivity, which, according to him, is facilitated by making it more attractive for businesses to invest. This is in contrast to former Fed Chair Bernanke, who joins what we see as a growing chorus of people that seemingly argue for greater fiscal spending. Greenspan disagrees, arguing greater fiscal spending may only lead to a temporary boost in growth, but will lead to both higher deficits and wage pressures (given that we are near full employment).
  • Low rates. In contrast to the first bullet point, low rates themselves may be part of the problem. In my assessment, monetary policy has facilitated unproductive businesses to stick around when many of them should have failed. Had they been allowed to fail, the downturn would have been more severe, but it would have allowed a market based re-allocation of resources to more productive businesses. Differently said, in my humble opinion, central banks are guilty of disrupting the creative destruction mechanism capitalism relies on; we are paying the price for this, amongst others, through lower productivity and lower growth. More broadly speaking, we allege that capital misallocation is fostered by rates that may be too low, also leading to subpar growth.
  • Why did I just list a laundry list of possible impediments to growth? With the exception of the first and the last, they have little, if anything to do with monetary policy. Yet, we believe today’s breed of central bankers often feels responsible to do whatever they can to help out the economy, even if monetary policy cannot fix the problems at hand. QE might just be too tempting a tool; one, however, that cannot necessarily provide the cure that’s needed.

    The Ugly

    The ugly part comes in when thinking about how to exit QE, if at all. The Fed ought to be focused on inflation & maximum sustainable growth, yet, the Fed to us appears to be increasingly focused on financial markets. Why should the Fed care about how the markets react? A former Fed official told me that the Fed may only need to be concerned about market reaction if it had created an asset bubble. He left it at that without saying that the Fed indeed created an asset bubble.

    I would like to take it a step further, though. What happens to all the bonds that central banks have purchased? We hear an increasing number of both economists and pundits suggest that this is good news because it effectively reduces government debt, now that the debt has moved from private holders to the central bank. Indeed, we have seen reports that Japan may soon have one of the lowest government debt levels as a percentage of Gross Domestic Product (GDP) given that the Bank of Japan (BoJ) owns an ever-increasing share of Japanese Government Bonds (JGBs). If true, this would be the best free lunch ever served in financial history. Sadly, I very much doubt that this free lunch is digestible. Let me give you two arguments:

    First, for purposes of analyzing the impact on an economy, we believe the balance sheet of central banks should be consolidated with that of their government. When the Fed, BoJ or other central banks buys bonds, all they really do is replace long-term obligations (buying bonds) with short-term obligations (cash); that is, they reduce the duration of outstanding government debt. So while the Treasury Department in recent years has diligently tried to take advantage of low rates by extending the average duration of U.S. debt, the Fed has (more than) neutralized their efforts by gobbling up bonds. Think about having a homeowner switch their long-term fixed-rate mortgage to an adjustable rate mortgage. This may work well as long as rates are low, but can cause havoc should rates rise. Importantly, since the central bank sets the rates, it provides an incentive to keep rates lower for longer, potentially causing unintended consequences.

    Second, and we have eluded to it, when a central bank buys bonds, it not only increases the assets on its balance sheet, but double entry accounting requires that something also increases on the liability side of the central bank’s balance sheet. What increases are reserves, notably excess reserves held by banks. That is, banks are sitting on a pile of cash that can be used to support bank lending (as a result of fractional reserve money creation). If there were sufficient demand in the economy, this may provide substantial inflationary fuel. This is one of the reasons we are in ‘unchartered’ territory. The Fed suggests it can conduct monetary policy through what it calls reverse repurchase agreements, notably by engaging in short-term market operations to reduce liquidity. Our concern is not with the mechanism itself, but foremost the potential political fallout, as they amount to the Fed paying potentially tens, if not hundreds of billions to financial institutions to incentivize them not to use their reserves to provide loans: an increase in interest rates by the Fed directly translates to the Fed paying, well, interest on its liabilities.

    The more sustainable approach, in our assessment, would be to unwind QE, i.e. to let the Fed’s bond portfolio roll off or possibly sell its bond portfolio. The Fed could also extricate itself by swapping its bond portfolio with the Treasury department for cash or short-term Treasuries, to allow it to return to more traditional monetary policy faster. Selling bonds on a large-scale may well put downward pressure on bond prices, increasing bond yields, i.e. the cost of borrowing for the government, corporations and consumers alike.  And that, in turn, might make government debt levels appear less sustainable, as it would signal a sharp reversal from the seemingly ever lower borrowing costs despite higher absolute levels of government debt.

    How it will all end?

    Higher borrowing costs are a problem if you have too much debt relative to your income. Governments have a couple of choices, including:

    • Cutting expenditures
    • Raising revenue
    • Economic growth that lowers the debt as a percentage of GDP

    Cutting expenditures may include things like:

    • Reducing entitlement benefits
    • Reducing military spending
    • Restructuring (defaulting on) debt

    We believe different countries will address these challenges differently; some in potentially increasingly creative or convoluted ways to provide the appearance of legitimacy. In practice, the tough decisions may well need to be imposed by the market, whereas policy makers may increasingly focus on hoping that fiscal spending will get us out of the lackluster growth. Unfortunately I can’t help but think of how the Great Depression ended: it was a boost of fiscal spending, all right: the financing of a war. I’m not suggesting any one country will necessarily start a war, but do note that increasing military expenditures in the name of national defense may be more easily passed through the legislature in countries without strong majorities than infrastructure spending. Add to that a rise in populist politicians throughout the world, and we have a mix that suggests to me history may well repeat to those unwilling to learn from it.

    I leave it up to the reader to decide whether the Fed and other central banks are part of the problem or the solution. However, I would like to caution that investors may not want to rely on the Fed or the government to take care of their financial well being; they have their own problems cut out for them, as a government in debt may well have their own priorities that run counter to investor interests.