The Perils of Drahgi Addiction

Monetary policy makers keep peddling financial cocaine. How much longer will markets keep snorting it up?

John Maynard Keynes, the economist who told every government what they had always dreamed of hearing from an economist — “you know, you really should tax and spend more” — used to lament the “animal spirits”. This was the mysterious urge of investors, entrepreneurs, and consumers alike to suddenly go on a mass shopping spree that preceded every market crash, according to Keynes. But old John-Maynard never seemed to be able to explain why the animal spirits seized men’s minds at the particular times that they did.

A school of economists who initially described themselves as “causal-realists” — because they fancied themselves as being focused on the real causes of economic phenomena, but then adopted the moniker of “the Austrian school” because they were from — that’s right, you guessed it, Austria — just so they could rub it in the faces of their rivals, the German Historical school, who uttered the word “Austrian” with as much of a sneer as most Democrats today say “Russian” — had a different explanation.

According to the Austrians, it was an uptick in money creation by the central bank that sparked the investment and consumption boom. Entrepreneurs saw the increased availability of funds as a signal to invest in new long term, capital-intensive projects (like housing construction, for example), while at the same time consumers saw an opportunity to increase their demand for consumer goods. The capitalists hire workers with that newly printed money, and the workers want to spend a great deal of it on the good things of life.

“Animal spirits” can’t be satisfied without the available means provided by an expanded money stock, the Austrians have long explained repeatedly, ad infinitum. It’s like a line of cocaine. One snort and you think you can do just about anything.

“Mmmmmmm….snort up all that new money, baby. Yyyyeeeeaaaahhhh…let’s build a gazillion houses…Wage several foreign wars simultaneously…We can do anything we want now, baby…yyyyyyeeeeaaaahhhhhh…”

But no matter how much the supply of money is expanded by the central bank, there’s still such a thing as scarcity. That money can’t be sucked into both capital investment and consumption at the same time. Something’s got to give, sooner or later, one way or another. Consumption tends to win in that struggle, or the central bank that created all that new money in the first place gets skittish about possible hyperinflation and reduces the money supply by selling off some assets.

Hence, the bust. The capitalists end up having consumed a great deal of the capital stock on projects that, it turned out, were not really in demand after all, at least not for a sustainable period of time. There was only the illusion of increased demand that resulted from all that newly created liquidity.

Then everyone gets to saddle up on their high horse and blame capitalism for the results of the machinations of the central bank.

Nobody listens to the Austrians, at least nobody in any position of power among the monetary authorities. It was the Austrian School economists who predicted both the stock market crash of 1929 and the real estate market crash and financial system meltdown of 2008, and yet they remain the Rodney Dangerfields of economics. They get no respect.

America’s central bank, the Federal Reserve, reacted to the the Great Financial Sh*t Show of 2008 — a crisis that was created in the first place by the very cycle described above — by doing what it does best, which is — that’s right, you guessed it — making up a whole new batch of money out of nothing (aka “fiat money”, or “quantitative easing”, or “QE”), purchasing assets (such as the ever-reliable mortgage-backed securities and, at least for awhile, stakes in several major financial institutions), pushing interest rates downward to historic lows. By every conceivable metric, the overall supply of U.S. dollars expanded exponentially as a result. What is called the monetary base — the total amount of money in circulation and held in reserve by commercial banks in their vaults and in their accounts at the Fed, and upon which credit is created—increased from about $800 billion in September of 2008 to approximately $4 trillion by 2015.

In response to Europe’s considerable lack of economic growth, the European Central Bank (ECB) embarked on its own quantitative easing binge and spent €2.6 trillion ($2.86 trillion) on asset purchases. Global debt now totals $244 trillion and counting. That’s about three times the estimated value of the world’s entire economy.

In 2015, the Fed began to gradually “unwind” its balance sheet, that is, it sold off assets, resulting in a reduction of the monetary base to about $3.2 trillion and incremental hikes in interest rates. The base money supply still remains exponentially greater than it was during pre-crisis times, and the interest rates are still quite low, in spite of the Fed’s initial promise to return to its pre-crisis balance sheet once economic recovery appeared to be under way.

After the manufacture of all that liquidity, and even after the Fed implemented a .25% rate cut this past July, the Federal Reserve Bank of New York had to inject $53 billion of liquidity last month in response to an overwhelming spike in the borrowing costs of the overnight lending that commercial banks routinely engage in — “the repo market,” so named for the repurchase agreements that banks buy from one another with the promise of selling them right back — in order to keep the whole banking system afloat. It was the first Fed intervention of its kind in nearly a decade. The New York Fed subsequently offered $75 billion in cash to broader markets in exchange for U.S. Treasuries and those good ol’ reliable mortgage-backed securities as collateral.

"We think that the culprit is the scarcity of bank reserves, which are the only asset that provides banks with intraday liquidity," said TD Securities head of global rate strategy Priya Misra. "Reserves have been declining since 2014 and we expect them to decline further as Treasury's cash balance increases and currency in circulation grows."

Excuse us, Ms. Misra? Did you just say that $3.2 trillion is not enough for bank reserves? Once upon a time, $800 billion seemed serviceable enough, but now $3.2 trillion simply won’t cut it?

As the kids like to say, “WTF???”

“Ultimately, we believe the Fed needs to start growing the asset side of its balance sheet to prevent the decline in excess reserves,” he added. “ If the Fed views the repo spikes as a sign that reserves may have already become scarce (at least at a certain point), they may decide to begin buying Treasuries to keep pace with the growth of currency in circulation.”

There you go. The decade or so of manufactured liquidity seems to have finally resulted in a demand for some kind of return greater than the paltry interest rates that America’s central bank has pushed and cajoled and bullied onto the public, but if the Fed just draws more checks on itself, if it would only create some more funds out of the digital ether, that demand for yield would surely be satiated.

If you consider the perversity of our current environment, Ms. Misra has a perfectly valid suggestion, of course. Especially if much of what economic growth we’ve had since 2008 is the result of the aforementioned cycle of liquidity-and-debt creation by the Fed, rather than by genuine savings on the part of capitalists and consumers. If rates spike, surely the bust phase of that cycle will be at hand. Just as in 2008, the biggest muckety-mucks who benefit the most from this rigged up financial system — the largest corporations, the largest financial institutions, and the world’s largest debtor, the U.S. government — would have to take some major doses of an always bitter medicine, frugality.

The powers that be simply cannot allow that. They need to keep the whole scheme going, or else all those paper riches can no longer be treated as if they had any corresponding relationship to reality. And as if in answer to the distressed lady’s call, the Fed, surely enough, instituted yet another .25% rate cut, barely two months after the preceding cut.

In an interesting coincidence of timing, ECB President Mario Draghi — whose term is over at the end of this month — barely a week before the New York Fed’s intervention into the repo market, announced the resumption of the ECB’s QE purchases, in an effort push the interest rate on European bank deposits down into the negative zone. -.5%, to be exact.

For the first time in recorded history, people will be expected to put up a sum of money today with the expectation of being repaid in a lesser sum tomorrow.

In light of all of the foregoing, could negative interest rates be coming to the U.S.? Former Fed chairman Alan Greenspan says that most likely they are, though he attributes them to an aging population rather than to central bank monetary policy. In any event, “the Maestro” appears to be priming Americans for the eventuality.

A negative interest rate of -.5% may not seem that steep at first blush. Many depositors may view such a rate as just an increase in banking fees. But if it’s just merely a dipping of the toes into the experimental waters, is -1%, -3%, -5% to follow? That’s when things would start to get really interesting.

Who would want to keep cash in the bank with such negative rates? Surely, a “run” on the banking system would have to ensue — that is, everyone would withdraw as much cash out of the banks as they could — with its complete collapse soon to follow. So it would be tinfoil hat time. The only way to compel people to keep money in the bank would be to enforce a cashless system — all payments could be legally made only electronically, digitally.

And all transactions would have to be tracked by government authorities, of course. The National Security Agency would most certainly be assigned that task. Then you’ll have to say goodbye to what’s left of your privacy.

But even if U.S. interest rates never go negative, the Fed would still keep them as low as possible, meaning ongoing periodic injections of that sweet fiat cocaine.

At this point, they have no choice. As mentioned above, the U.S. government is the world’s biggest debtor. The outstanding principal balance of Uncle Sam’s debt is now $23 trillion and counting. The interest expense on that debt currently stands at $574.5 billion, well on its way to topping the fiscal year-end 2018 total interest expense of $523 billion by nearly 10%. That implies a blended interest rate of about 2.50%. The interest rates for Treasuries are currently ranging about 1.62% for the one-year and 1.54% for the ten-year, with the thirty-year at about 2.16%.

Even though Uncle Sam is getting off pretty cheap with those rates, he’s still looking at well over a half-trillion-dollar expense on just the interest alone, because he simply cannot keep his spending habits under control. What happens if rates go up by, say, 1%? That interest cost could shoot up to about $800 billion, an increase of $275 billion. How about with a 2% increase?

Over one trillion dollars.

The U.S. government’s interest expense would be even greater than the sum total of all current defense-related spending. And, in fact, that’s what some people are already predicting will happen in the next several years based on just the rate of growth of the U.S. government’s deficit, with the possibility of interest rate hikes not even considered.

At what point do the holders of those U.S. Treasury bonds — about 40% of whom are foreign investors, including foreign governments — start selling off as many of those bonds as they can? At what point do they decide that Uncle Sugar-Daddy ain’t ever repaying any principal, that he’d rather choke on the borrowing costs first? Who else would buy those bonds but the Fed, in a mad, desperate effort to keep the whole racket going, whatever it takes, “monetizing” the debt if need be? If the Fed unwittingly prints enough money in its mad bond-purchasing frenzy to cause hyperinflation and a massive panic that roils markets throughout the world, that could mean a collapse of the U.S. dollar.

And then what? It’s anybody’s guess.

This is the pickle they have themselves, and us — we poor, unwitting, hapless suckers — trapped in. And it’s a helluva big juicy pickle, too.

So of course they have to do whatever they can to keep interest rates pushed down, ever downward, as low as possible — and now we’re starting to see the manifestation of that desperation: Mario Draghi’s negative interest rates.

“Ah, but we’re not cooperating, at least not willingly,” recently protested the repo market. “We need yield. We need some kind of return, dammitalltohell.” Repo market actors are surely not the only ones.

By now, dear reader, you may be wondering if I have a point to make of all of the foregoing, or am I going to just keep rambling on about this big juicy pickle that damns us if we bite off a chunk of it and swallow hard, and damns us if we don’t?

Well, in fact, I do have a point and it’s quite simple: TANSTAAFL, or, you can’t get something for nothing. Nobody, but nobody — from the lowliest working Joe or Jane to the wealthiest, most powerful elites — is entitled to an endless, bountiful supply of cheap credit that enables them to consume whatever they want, whenever the whim hits them. Whether you fancy you’d like a brand new house, a sporty new car, or you’d just like to take a shot at running the internal affairs of other countries on the other side of the world — by bombing and invading them, if necessary — you don’t have some God-given right to a cheap loan in order to achieve your heart’s desires.

But we humans — we deeply flawed, short-sighted humans, driven as we are by our passions and our illusions — just can’t help ourselves, can we?

Somtimes I write stuff.