The Fed Is Out Of Ammunition

This title is not mine, but that of an article that appeared in The Wall Street Journal today (Nov 24), which closely mirrors my own assessment of where we are and what is likely coming next. In short, deflation is so unacceptable to a debt-based money system that it will be avoided at all costs. And I do mean all costs.

This was written by an equity strategist in Hong Kong; be sure to catch his startling conclusion at the end. Startling because of where it was printed – in the main circular of the high church of fiat money, a.k.a. the WSJ.

The whole thing is worth a read, and a ponder, but let’s review some of the more relevant bits.

The Fed Is Out of Ammunition

A discredited dollar is a likely outcome of the current crisis.

With an estimated $4 trillion in housing wealth and $9 trillion in stock-market wealth destroyed so far in the United States, there is little doubt that we are witnessing a classic debt-deflation bust at work, characterized by falling prices, frozen credit markets and plummeting asset values.

Those who want to understand the mechanism might ponder Irving Fisher's comment in 1933: When it comes to booms gone bust, "over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money."

My comment: Here he’s laying the groundwork – our current crisis is ultimately one of “too much borrowing.” Given this, one can easily be stumped by the current plan of having the US government borrow even more to give to already failed institutions. How does borrowing more solve a crisis rooted in “too much borrowing?”

It’s a great question, and one that you will be hard pressed to find discussed in the usual mainstream media outlets.

Why is the government so desperate to borrow our way out of this deflationary problem? Let’s continue.

The growing risk of falling prices raises a challenge for one of the conventional wisdoms of the modern economics profession, and indeed modern central banking: the belief that it is impossible to have deflation in a fiat paper-money system. Yet U.S. core CPI fell by 0.1% month-on-month in October, the first such decline since December 1982.

The origins of the modern conventional wisdom lies in the simplistic monetarist interpretation of the Great Depression popularized by Milton Friedman and taught to generations of economics students ever since. This argued that the Great Depression could have been avoided if the Federal Reserve had been more proactive about printing money. Yet the Japanese experience of the 1990s -- persistent deflationary malaise unresponsive to near zero-percent interest rates -- shows that it is not so easy to inflate one's way out of a debt bust.

My comment: The great fear of a deflationary spiral for central economic planners (like the former Soviet Union or the US central bank) is the loss of policy traction. That is, once the main levers break, the Federal Reserve rapidly loses both the ability to effect outcomes and credibility. Of the two, credibility is the most important feature in a faith-based economy. This is a large reason why such an outcome will be fought with every tool in chest. And also every dollar. Read on.

It is also true that under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

My Comment: This massive increase in total Fed assets and bank reserves will someday, possibly sooner than most expect, come flooding back out into the “real economy,” creating another boom. That’s the way these systems work. Presently, all that matters to the central planners is that the economy (meaning credit growth) returns to higher levels than before. That is what it requires, and that’s what they will seek. Unfortunately, this will only mean that we’ll have failed to learn our lessons from the past crisis and will have sown the seeds for an even larger, more disruptive crisis in the future. I will note that such crises are becoming both more frequent and larger with every passing rescue. [Next part: emphasis mine]

There are no easy policy answers to the current credit convulsion and intensifying financial panic -- not as long as politicians and central bankers are determined not to let financial institutions fail, and so prevent the market from correcting the excesses. This is why this writer has a certain sympathy for Treasury Secretary Henry Paulson, even if nobody else seems to. The securitized nature of this credit cycle, combined with the nightmare levels of leverage embedded in the products dreamt up by the quantitative geeks, means this is a horribly difficult issue to solve.

Virtually everybody blames Mr. Paulson for the decision to let Lehman Brothers go. But this decision should be applauded for precipitating the deflationary unwind that was going to come sooner or later anyway.

My Comment: Exactly so – as long as this crisis is prevented from fully resolving itself, which it would do all on its own, we can be sure that it will take longer and have a less restorative outcome than if allowed to progress more or less naturally. But the author is correct - this is a horribly difficult issue to “solve,” probably because it is more of a predicament than a problem (hat tip to Switters). Problems can have solutions, predicaments only have responses.

What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke's speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

My comment: And here’s the predicament in a nutshell: The only way to ‘solve’ a debt crisis in a debt-based money system is by adding more debt. Clearly, that cannot really work. I have long taken Bernanke at his word and assumed that he will use the power of the printing press to defeat deflation. I believe that is precisely why he was hired, and I believe it explains the more than one and a quarter trillion dollars (!) of money that he’s created out of thin air to buy distressed bank debts.

In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism -- and with it the fiat paper-money system in general -- as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the "barbarous relic" scorned by most modern central bankers, may well play a part.

My Comment: And finally, the interesting conclusion. Any mention of the gold standard, let alone postulating its return, is a remarkable thing to see in the WSJ. In any crisis, the solutions are usually fashioned from whatever happens to be lying around at the moment. The gold standard is well understood, and would undoubtedly have prevented the various monetary and trade imbalances from having grown to their current dangerously large proportions. Because it is a possible solution that 'happens to be lying around,' it stands a chance of being seriously considered. So this conclusion is interesting, in part because of where it was printed (the WSJ), and in part because such thinking is creeping into more and more articles, indicating that it’s once again being considered by more and more people.

However, the possible return of some form of the gold standard is more speculative than his other assessment that the present crisis will end up discrediting the dollar itself, leading foreign investors to flee the dollar. This is something that I fully expect to happen at some point in the future and is something that everyone should consider.

How likely is it, and what will be the impact to you if it does?

This is a companion discussion topic for the original entry at https://peakprosperity.com/the-fed-is-out-of-ammunition-2/

If there is a return to the gold standard, what does that do to the likelihood of gold confiscation?

[quote=c1oudfire]If there is a return to the gold standard, what does that do to the likelihood of gold confiscation?
[/quote]

One would assume very likely!

I made such a prediction to Mish, and he responded by chastising me for being so dollar centric in my thinking. His point being that although we are surely trashing the dollar, all currencies are being trashed by just about everyone else…so the dollar may survive on relative terms…with the world still believing in the power of America to pull through.

I raised this concern because I have a bet against the long bond…expecting interest rates to rise as the dollar is eventually shunned.

He is clearly of the view that deflation is the great worry…I have a foot in each camp, just wanting to survive.

I thought the concept of a gold standard was based on the idea that a unit of currency was redeemable for a certain amount of gold, and/or silver. When I was a kid they still had gold and silver certificates…which I think could be traded for bullion.

Why would gold be confiscated if one could trade metal for paper? I would appreciate a full discussion of how such a system might be put in place…if the idea were to be played out.

 

Uh,

 

Anyone have a good answer to Chris’s parting question?

 

Inflation, Zimbabwe-style?

 

SG

I don’t think the "govmint" will confiscate gold. They can tax it heavily if they so choose.

I’m not sure what’s going to happen and the truth is that nobody is either. I like Mish and I think he’s super smart, but as Chris has mentioned elsewhere he has a strong belief about deflation. In times like these, it’s probably best to keep an open mind and consider all possibilities.

There is more than a zero percent chance that the dollar will collapse, so it makes sense to hedge against that possibility. There is also a chance that the dollar will perform well in relation to other fiat currencies, as Mish suspects. So one should be hedged against that possibility as well.

What does that look like? Probably owning both dollars and gold. However, it could be argued that since gold could perform well in both deflation with a relatively strong dollar and inflation with a weak dollar, that one might want to weight their portfolio more towards gold than towards any fiat currency. That’s what I’ve done. Gold and silver.

dcary:
http://www.wellsfargonevadagold.com/confiscation-order.pdf
In 1933 FDR needed to fill the "Feds" safe with gold. The U.S. citizens used gold coins then, and the U.S. was, as a result, flush in gold. FDR yanked the gold from them and handed it over to the "Fed."
It gets better. Gold was "purchased" by the govt. for $20.67 an ounce with paper money, then it was re-valued at $35.00 an ounce.
Basically if you held gold you got screwed out of 70% of your hard earned investment - overnight. Like selling your shares in an IPO like Google the day before Google went public.
Or, another way of looking at things is, the dollar which they paid you in for "your" gold now was worth 70% less than the day they "bought" your gold. Inflation. (And I use the word loosely.)
Now, to answer the rest of your question: Other countries could trade paper for gold, but U.S. citizens could not.
And trade it they did. I pictured that they smelted the coins into bullion bars. Reading up on this I found out that they didn’t. Most coins then were less than .99999% gold, if I recall about .96% pure. So what they did is do face dollar value on the coin. So on a million dollar trade of gold for dollars they screwed the foreign country out of $40,000.00 by paying them in gold coins at face not melt value.
Nixon declared BK or force majeure (performance of contract not possible due to reasons out of your control) and took the U.S. off the gold standard 15 August, 1971. At the time de Gaulle called the bluff suspecting that the U.S. was printing too much "funny" money. They were. Johnson didn’t like the bread or bullets ultimatum, he wanted his cake and he wanted to eat it to, so it was print baby print. Almost like today. Almost.
In 1974 U.S. citizens could own gold again.
So, my take on Chris’s question? Own gold and have relatives you trust implicitly who live overseas with it? Don’t know. Do know, or suspect that our dollar will be as SG/capeSurvvor says Inflation, Zimbabwe-style? (worthless) Switters has a valid merit about silver, they didn’t take that before, and they don’t seem all to creative these days. You won’t get as much bang for your buck with silver though…
I do recall also reading that you couldn’t open a safe deposit box at a bank without an IRS agent standing there after this law went into effect.
Somewhere I have a 25 page pdf done by a Brooklyn prof. on the Constitunality of this. His take - ot wasn’t Constitutional.

The big question that has to be asked when one considers the possibility of the dollar going to hell in a handcart is where is the money going to flow. I mean there aren’t stronger currencies lining up, are there?

The US has tremendous financial mobility, great access to cheaper labour south of the border, amazing inventive skills and much more.

 

How likely is it and what will be the impact to you if it does?

I defy anyone to say they really understand economics… So, having admitted I don’t, (at least none of it makes any sense to ME) would not the return to a gold standard imply that the entire wealth of the world, at least, would need to be covered by gold? Would that not mean, then, that as a gold is just as finite a resource as oil, and less and less of it is being discovered and mined, that the price of gold would have to go through the roof (into orbit!)…? I mean like millions of dollars an ounce?

Starting to wish maybe I had bought some now!

"Why is the government so desperate to borrow our way out of this
deflationary problem? Let’s continue."

Becuase they are clutching at straws? Because they don’t understand economics any better than I do?

A guy on "talk of the nation" today on npr said that the gold standard doesn’t make sense for a global economy because there just isn’t enough gold in the world to cover the amount of amassed wealth in the world. Is this simply because it has to keep growing because of the debt based fiat currency or what?

Is it worth considering the likelyhood of some ‘semi gold standard’…something like OPEC demanding payment in gold.

[quote=Floyd]I don’t think the "govmint" will confiscate gold. They can tax it heavily if they so choose.
[/quote]

You must not be aware of what Roosevelt did.

[quote=Juvysen]A guy on "talk of the nation" today on npr said that the gold standard doesn’t make sense for a global economy because there just isn’t enough gold in the world to cover the amount of amassed wealth in the world. Is this simply because it has to keep growing because of the debt based fiat currency or what?
[/quote]

 

All they would have to do is to increase the value of gold and print more money. Remember, if the central banks convince us to go to a gold standard…so that we never have these boom and bust cycles again then they can set the price of gold as high as they want. Since they own something like three quarters of all the above ground gold, they will profit greatly.

 

 

All they would have to do is to increase the value of gold and print more money. Remember, if the central banks convince us to go to a gold standard…so that we never have these boom and bust cycles again then they can set the price of gold as high as they want. Since they own something like three quarters of all the above ground gold, they will profit greatly.

 

[/quote]

Well, that’s what I was thinking… but why did they not do that instead of removing the gold standard, then, back in the 70’s?

Roosevelt wanted to devalue the dollar and couldn’t with legal tender gold floating outside the system. We aren’t in that situation now so I doubt that the same conclusions can be drawn. The chance of gold becoming legal tender again is zero.
The argument that there is not enough gold to go around is fallacious and has been addressed on several economic sites. http://www.Mises.org is a good one to start looking through for more info. As I said, though, it isn’t going to happen although some sort of a Bretton Woods like pseudo gold standard might arise.
I agree with Mish on deflation over the short to intermediate term but even Robert Prechter, the "uber deflationist", admits that at some point the Fed printing will swamp the the system and then the dollar will be in deep weeds. If the Fed starts buying Treasuries, we will be very close. Gold will be what you want to own.
I will end with a quote from Ludwig von Mises:
"The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
Ludwig Von Mises, Human Action, 3rd Revised Edition, pg 572

A guy on "talk of the nation" today on npr said that the gold standard doesn't make sense for a global economy because there just isn't enough gold in the world to cover the amount of amassed wealth in the world. Is this simply because it has to keep growing because of the debt based fiat currency or what?
That's a standard inflationists argument. There is always a price at which there is enough gold. Money mouth

I really think the U.S. will fight the gold standard tooth and nail. Our military is global. Unless the U.S. wound up with all the gold, that would stop. The Roman empire fell, so I’m not saying it can’t happen, I’m just saying they will fight it all the way.

The govt. loves inflation. (and I’m using that definition loosely). More taxes, it could wipe out the 73 trillion debt and keep entitlements if there were hyperinflation. People could pay off their debt and would be ready to suck down more debt after the dollar was re-denominated. Gold would screw that up for them.

Not to say that PMs won’t become the dafacto standard until this is sorted out. I have NO doubt that Ben the mad printer will chart this course, and if they can him I’m certain the next guy/gal will be even worse.

Oh, woostock46,

I think they are buying, I’m seeing signs of Quantitative easing now.