Deficit Terrorism and Quantitative Easing: Two sides of the same strategy?

[Jehu Eaves]

According to James Rickards, the Federal Reserve Bank likely has no way to exit from its money printing effort known as quantitative easing:

Disasters sometimes sneak up in small steps, each of which appears unthreatening at the time but which cumulatively spell collapse. The Fed is leading the United States to ruin in ways that are claimed to be well intentioned and benign viewed in isolation but which take us finally into a locked room reminiscent of the Sartre play “No Exit.”

He takes us through the steps of the process by which the Federal Reserve has already found itself in a quagmire, and insists on pushing deeper into it:

How does the Fed print money? It’s easy; they simply buy bonds from the market and credit the seller’s bank account with electronic cash that comes out of thin air. When they want to reduce the money supply, they do the opposite; that is, they sell bonds and the buyer’s bank account is reduced by the sale price and that money disappears. So, printing money is just a massive program of bond purchases. The Fed intends to concentrate the current bond buying program in the intermediate sector of 5 to 10-year maturities.

A massive program of bond purchases, yes. But, more important, a program of swapping fictitious assets for fictitious money in a series of fictitious transactions that superficially resemble real transactions but result in the exchange of no real economic values. There are, for instance, the utterly worthless purchases of mortgage backed securities and various junk from the failed financial sector. The intricacies of this garbage need not be understood in order to understand Rickards' point: it is all junk, worthless, pieces of paper that have not an iota of value, and which will never be worth anything ever into the distant future beyond the point where the planet itself is no longer habitable.

The point is, none of this crap will ever be sold again for more than a fraction of its face value. It is toxic. You could back a truckload of it up to a recycling plant and walk away with no more than a week's worth of groceries. And, the Fed has so much of this crap on its books, if it actually had to state its market value, the bank's balance sheet would implode:

As a result, the Fed is coming to resemble a highly leveraged hedge fund with an inverted pyramid of risky, volatile and junk debt balanced on a slim layer of capital. Recall the Fed owns the Maiden Lane portfolio of junk from Bear Stearns and $1.4 trillion of mortgages whose value is in serious doubt because of strategic defaults, lost notes and halted foreclosures. Treasury notes may be of good credit quality if you don’t mind getting paid back in debased dollars but even Treasury notes have market risk. If interest rates go up, the value of Treasury notes goes down; it’s that simple. The Fed is taking both credit risk and market risk on its balance sheet in unprecedented amounts.

Under QE2, the Federal Reserve hopes to double down by adding Washington debt to its mix of toxic sludge. And, this is where the game gets really interesting.

To buy Washington's debt, and force down interest rates, the Federal Reserve essentially has to outbid all other players in the public debt market. It can do this simply by entering the required digits at a computer terminal -- and keep entering them until every other bid is taken out. At the end of the day, the Fed has pushed everyone else out of the market by paying more for Washington's debt than anyone else in their right mind would be willing to pay.

When people say the action of the Federal Reserve is nuts -- because the Fed is deliberately paying more for the debt than it is worth, and because the Fed is inundating the economy with worthless currency -- the Fed has two responses:

When critics raise the issue of mark-to market losses, the Fed has a simple answer, which is that they will hold to maturity. The Fed does not have to mark to market; they can simply hold the assets to maturity and collect the full proceeds from the Treasury or other issuers. Just ignore for the moment the fact that some of the junkier assets and mortgages will not pay off, ever. That’s years away; for now, let’s just give the Fed the benefit of the doubt and say that mark-to-market losses don’t matter because they don’t have to sell.

Critics also raise the issue that this much money printing will result in inflation at best and maybe hyperinflation if velocity takes off due to behavioral shifts. The Fed is also very reassuring on this point. They say not to worry because at the first signs of sustained and rising inflation they will reverse course and reduce the money supply by selling bonds and nip inflation in the bud. But also note that the world in which the Fed wants to sell the bonds is also a world of rising inflation and therefore rising interest rates. This is the world of huge mark to market losses on the bonds themselves.

To the first concern the Fed says, "Oh, sure we're paying too much for this debt, but we will just hold onto it until we can sell it without taking a loss."

To the second concern the Fed says. "Oh, sure this will cause inflation, but we can fix that by selling this debt and soaking up the excess money."

Rickards isn't buying this. If the Fed is successful and inflation takes hold, he points out, interest rates will be rising -- and if interest rates are rising, the price of Washington's debt will be collapsing. The Fed will suffer massive losses if it tries to sell the debt to siphon off the excess money in the economy that is driving up prices:

The Fed is saying don’t worry about mark to market losses because we will hold the bonds. The Fed is saying don’t worry about inflation because we will sell the bonds. Both of those statements cannot be true at the same time. You can hold bonds and you can sell bonds but you can’t do both at once. You will want to sell when rates are going up but that’s when losses will be the greatest. So the time when you most want to sell is the time when you will most want to hold. The Fed may say they can finesse this by selling shorter maturities only to reduce money supply and holding onto longer maturities. But that just further degrades the quality of the Fed’s balance sheet and turns it into a one-way roach motel for highly volatile and junk assets.

Monetary policy is dead -- stick a fork in it -- and so is the Fed:

So, here’s the bottom line on money printing, or QE if you prefer. If nothing happens, the whole thing was a waste of time. If inflation takes off, the Fed will have to choose between holding bonds and letting inflation get worse or selling bonds and going bankrupt in the process. Since no entity goes down without a fight, the Fed will naturally hold the bonds and let inflation take off. Do not ask about the exit strategy from QE; there is no exit.

End of story, right?

No! Not by a long shot. We're just getting to the really really interesting part -- the part where you and all working families get royally screwed.

You see, even if the Fed cannot exit from its quantitative easing program, there is still all this fictitious money sloshing around the economy, driving up prices, and bidding up everything that isn't locked down. The Fed may be effectively frozen, but there is still a way to drain the economy of all that excess money.

Washington simply takes it from you. Your elected officials down in Washington can perform a type of monetary policy to drain all the excess liquidity from the system by raising your taxes and cutting the programs you rely on. According to Billy Mitchell, a prolific modern monetary economist who writes at Billy's blog:

It is a good practice to think of taxes as just draining liquidity from the non-government sector reflecting the Government’s desire for that sector to have less spending capacity.

Now, you know why Washington is debating deficit reduction in the middle of the worst recession since the Great Depression: if the Federal Reserve is able to get the debt creation process moving again, and the economy starts to expand, they intend to withdraw the excess liquidity in the economy by taking it from you.

You will pay more taxes.

You will pay higher prices for everything.

You will retire when you are dead.

The bottom line for you: you will be forced to work longer hours for less pay just to keep the same standard of living, because inflation will be rampant, and your after tax income will be plummeting.

They assume that, if you figure this out, it will already be too late for you to do anything about it.

If Washington gets its way, working families are going to suffer a massive wage income collapse.