The Future of the International Monetary System

The Future of the International Monetary System

By Jim Rickards

Triffin’s dilemma arose from the Bretton Woods system established in 1944. Under that system, the dollar was pegged to gold at $35.00 per ounce. Other major currencies were pegged to the dollar at fixed exchange rates. The architects of the system knew that these other exchange rates might have to be devalued from time to time, mostly because of trade deficits, but the devaluation process was designed to be slow and cumbersome.

A country that wanted to devalue (for example, the U.K. in 1967) first had to consult with the International Monetary Fund, IMF. The IMF would typically recommend structural changes, to fiscal policy, tax policy and other areas designed to cure the trade deficit.

The IMF also stood ready to offer bridge loans of hard currency to help the deficit-hit country withstand temporary stresses while the structural changes were implemented. Only if the structural changes failed and the trade deficits were persistent would the IMF allow devaluation.

That was the process for countries other than the U.S. As far as the U.S. was concerned, the link between gold and the dollar was fixed for all time and could never be changed. The dollar/gold link was the anchor of the entire system.

This fixed link between the dollar and gold made the dollar the most prized reserve currency in the world. That was the hidden agenda of Bretton Woods. With the dollar as the main reserve currency, U.K. pounds sterling, a competing reserve currency, would eventually fall by the wayside.

The U.K. relied on Imperial Preference among its trading partners in the British Commonwealth to gain trade surpluses, and also relied on the willingness of those Commonwealth partners to hold sterling in their reserves. The Bank of England assumed Commonwealth members would not ask to convert the sterling to gold. Imperial Preference came under attack by the General Agreement on Tariffs and Trade, the GATT, which was also part of Bretton Woods. (Today, GATT is known as the World Trade Organization, WTO.)

Bretton Woods was a one-two combination punch designed by the U.S. to destroy the British empire. GATT undermined Imperial Preference. The dollar-gold link undermined sterling. It worked. The U.K.’s trade deficits persisted, and the Commonwealth partners demanded their gold. Eventually, the pound sterling was devalued, and the empire dissolved. It was replaced by a new age of U.S. empire and King Dollar.

There was only one problem, and Robert Triffin pointed this out. If the dollar was the lead reserve currency, then the entire world needed dollars to finance world trade. In order to supply these dollars, the U.S. had to run trade deficits.

The U.S. sold a lot of goods abroad, but Americans quickly developed an appetite for Japanese electronics, German cars, French vacations and other foreign goods and services. Today, China has replaced Japan as the main source of exports to the U.S.; still, Americans have not lost their appetite for imports financed by printing dollars.

So the U.S. ran trade deficits, the world got dollars and global trade flourished. But if you run deficits long enough, you go broke. That was Triffin’s dilemma. Any system based on dollars would eventually cause the dollar to collapse because there would either be too many dollars or not enough gold at fixed prices to keep the game going. This paradox between dollar deficits and dollar confidence was unsustainable.

This system did break down in the 1970s. The solution then was to abolish the dollar-gold peg in 1971, and demonetize gold in 1974. But there was a third leg of the stool invented in 1969 -- the IMF’s Special Drawing Right, SDR.

The SDR was a new kind of world money printed by the IMF. The idea was that it could be used as a reserve currency side by side with the dollar. This meant that if the U.S. cured its trade deficit, and supplied fewer dollars to the world, any shortfall in reserves could be made up by printing SDRs.

In fact, SDRs were printed and handed out repeatedly during the dollar crisis from 1969–1980. But then a new King Dollar age was started by Paul Volcker and Ronald Reagan, with some help from Henry Kissinger, the king of Saudi Arabia and private bankers like my old boss Walter Wriston at Citibank.

Under the new King Dollar system, U.S. interest rates would be high enough to make the dollar an attractive reserve asset even without gold backing. Remember those 20% interest rates of the early 1980s?

Henry Kissinger also persuaded Saudi Arabia to keep pricing oil in dollars. This “petrodollar deal” meant that countries that wanted oil needed dollars to pay for it whether they liked the dollar or not.

The Arabs deposited the dollars they received in Citibank, Chase and the other big banks of the day. The bankers, led by Wriston at Citibank and David Rockefeller at Chase, then loaned the money to Asia, South America and Africa.

From there, the dollars were used to buy U.S. exports like aircraft, heavy equipment and agricultural produce. Suddenly, the game started up again, this time without gold. This new Age of King Dollar lasted from 1980–2010.

Still, it was all based on confidence in the dollar. Triffin’s dilemma never went away; it was just in the background waiting to re-emerge while the world binged on new dollar creation and forgot about gold. The U.S. ran persistent large trade deficits during this entire 30-year period as Triffin predicted. The world gorged on dollar reserves with China leading the way in the 1990s and early 2000s.

The new game ended in 2010 with the start of a currency war in the aftermath of the Panic of 2008. Trading partners are again jockeying for position as they did in the early 1970s. A new systemic collapse is waiting in the wings.

The weak dollar of 2011 was designed to stimulate U.S. growth and keep the world from sinking into a new depression. It worked in the short run, but now the tables are turned. Today, the dollar is strong, and the euro and yen have weakened. This gives Japan and Europe some relief, but it comes at the expense of the U.S., where growth has slowed down again.

The new dollar-yuan peg with China has also contributed to a slowdown in China. There’s just not enough global growth to go around. The major trading and finance powers are cannibalizing each other with weak currencies. Soon the U.S. and China may devalue relative to Europe and Japan, but that just moves the global weakness back to them.

Is there no way to escape the room? Is there no way out of Triffin’s dilemma?

A new gold standard might be one way to solve the problem, but it would require a gold price of $10,000 per ounce in order to be nondeflationary. No central banker in the world wants that, because it limits their ability to print money and be central economic planners.

Is there an alternative to gold? There is one other way out. That’s our old friend, the SDR. The brilliance of the SDR solution is that it solves Triffin’s dilemma.

Recall the paradox is that the reserve currency issuer has to run trade deficits, but if you run deficits long enough, you go broke. But SDRs are issued by the IMF. The IMF is not a country and does not have a trade deficit. In theory, the IMF can print SDRs forever and never go broke. The SDRs just go round and round among the IMF members in a closed circuit.

Individuals won’t have SDRs. Only countries will have them in their reserves. These countries have no desire to break the new SDR system, because they’re all in it together. The U.S. is no longer the boss. Instead, you have the “Five Families” consisting of China, Japan, the U.S., Europe and Russia operating through the IMF.

The only losers are the citizens of the IMF member countries -- people like you and I -- who will suffer local currency inflation. I’m preparing with gold and hard assets, but most people will be caught unaware, like the Greeks who lined up at empty ATMs last month.

This SDR system is so little understood that people won’t know where the inflation is coming from. Elected officials will blame the IMF, but the IMF is unaccountable. That’s the beauty of SDRs -- Triffin’s dilemma is solved, debt problems are inflated away and no one is accountable. That’s the global elite plan in a nutshell.

We never take our eye off the IMF and its plans to expand the use of SDRs. The IMF will include the Chinese yuan in the SDR basket over the next 12 months to make sure the Chinese are “on the bus” when the endgame begins. That’s an important step in the SDR process.

We plan to report on the IMF annual meeting in Lima, Peru, so you have a front-row seat for these developments. This story has longer to run, but the endgame is already in sight. Stay tuned...

Regards,

Jim Rickards

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

6 Major Flaws in the Fed’s Models

6 Major Flaws in the Fed’s Models
by James Rickards

For now, the U.S. dollar is the dominant global reserve currency. All markets, including stocks; bonds, commodities, and foreign exchange are affected by the value of the dollar. The value of the dollar, in effect, its “price”, is determined by interest rates. When the Federal Reserve manipulates interest rates, it is manipulating, and therefore distorting, every market in the world.

The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But, the lender of last resort function has morphed into an all-purpose bailout facility, and the liquidity function has morphed into massive manipulation of interest rates. 

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the “dual mandate” which allowed the Fed to consider employment as well as price stability in setting policy. 

The dual mandate allows the Fed to manage the U.S. jobs market and, by extension, the economy as a whole, instead of confining itself to straightforward liquidity operations. Janet Yellen, the Fed chairwoman, is a strong advocate of the dual mandate and has emphasized employment targets in the setting of Fed policy. Through the dual mandate and her embrace of it, and using the dollar’s unique role as leverage, she is a de facto central planner for the world. 

Like all central planners, she will fail. Yellen’s greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality. This approach is highlighted in two Yellen speeches. In June 2012 she described her “optimal control” model and in April 2013 she described her model of “communications policy.” The theory of optimal control says that conventional monetary rules, such as the Taylor Rule or a commodity price standard, should be abandoned in current conditions in favor of a policy that will keep rates lower, longer than otherwise.

Yellen favors use of communications policy to let individuals and markets know the Fed’s intentions under optimal control. The idea is that over time, individuals will “get the message” and begin to make borrowing, investment and spending decisions based on the promise of lower rates.

This will then lead to increased aggregate demand, higher employment and stronger economic growth. At that point, the Fed can begin to withdraw policy support in order to prevent an outbreak of inflation. The flaws in Yellen’s models are numerous. Here are a few:

1. Under Yellen’s own model, saying she will keep rates “lower, longer” is designed to improve the economy sooner than alternative policies.
   
   But if the economy improves sooner under her policy, she will raise rates sooner. So, the entire approach is a lie. Somehow people are supposed to play along with Yellen’s low rate promise even though they intuitively understand that if things get better the promise will be rescinded. This produces confusion.

2. People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen’s model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory. The resulting lack of investment and consumption is what is really hurting the economy. Economists call this “regime uncertainty” and it was a leading cause of the length, if not the origin, of the Great Depression of 1929–1941.

3. In order to make money under the Fed’s zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk. In an asset swap, a bank with weak collateral will “swap” that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank. In effect, a two party deal has been turned into a three-party deal with greater risk and credit exposure all around.

4. Yellen’s zero interest rate policy constitutes massive theft from savers. Applying a normalized interest rate of about 2% to the entire savings pool in the U.S. banking system compared to the actual rate of zero, reveals a $400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for six years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over $2 trillion. This hurts investment, penalizes savers and forces retirees into inappropriate risk investments such as the stock market. Yellen supports this bank subsidy and theft from savers.

5. The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis. Of course, the Fed carries these notes on its balance sheet “at cost” and does not mark to market, but if they did they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise. The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bailout of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed’s insolvency.

6. Market participants and policymakers rely on market prices to make decisions about economic policy. What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation and then you rely on the “price” to guide your policy going forward. This is the blind leading the blind. The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run.

But once you change the psychology, it is extremely difficult to change it back again. If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970’s. This means that instead of inflation leveling off at 3%, inflation may quickly jump to 7% or higher.

The Fed believes they can dial-down the thermostat if this happens, but they will discover that the psychology is not easy to reverse and inflation will run out of control. The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short-term liquidity provider. Central planning failed for Stalin and Mao Zedong and it will fail for Janet Yellen too.

Regards,
James Rickards

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

The Swiss’ Pearl Harbor Sneak Attack

The Swiss’ Pearl Harbor Sneak Attack
by James Rickards

The most dramatic battle yet in the currency wars took place last Thursday. It was the financial equivalent of a Pearl Harbor sneak attack…

“I find it a bit surprising that he did not contact me,” IMF Director Christine Lagarde told CNBC’s Steve Liesman that day, “but, you know, we’ll check on that.”

You can almost imagine the conversation afterwards between Mario Draghi of the European Central Bank (ECB) and Swiss National Bank (SNB) President Thomas Jordan…

Mario Draghi:“Did you tell Christine?”

Thomas Jordan:“I thought you were going to tell her…”

Mario Draghi: “Wait, I thought you were!”

Switzerland had just abandoned its peg of the Swiss Franc to the Euro. The result was mayhem with an immediate 30% drop in the value of the Euro against the Franc, and billions of dollars of trading losses by banks and investors around the world.

Several foreign exchange brokers went bankrupt because their customers could not settle their losing trades. The Swiss operated in total secrecy.

Currency wars resemble real wars in the sense that they do not involve continuous fighting all the time. At certain times, there are intense battles, followed by lulls, followed by more intense battles.

But there is nothing new about the Swiss National Bank’s move. It’s the latest salvo in the currency war that President Obama started in 2010 and it won’t be the last. It was in 2010 that the president announced his National Export Initiative designed to double U.S. exports in five years.

The most dramatic battle yet in the currency wars took place last Thursday.

The only way to do that was with a cheaper dollar, so the president’s policy amounted to a declaration to the world that the U.S. wanted other countries to let their currencies go up so the dollar could go down. Ten months later, the Brazilian Finance Minister, Guido Mantega, shocked global financial elites by publicly proclaiming what everyone knew, but no one would say — that the world was in a new currency war.

The problem with currency wars is they last a long time; sometimes even fifteen or twenty years. The reason is they have no logical conclusion, just back-and-forth devaluations and revaluations as countries retaliate against each other.

We have seen this seesaw pattern re-emerge. The weak dollar of 2011 has turned into the strong dollar of 2015. Countries that complained the weak dollar was hurting their exports in 2011 now complain that the strong dollar is hurting their capital markets in 2015.

That’s the other problem with currency wars — no one wins and everyone loses. Currency wars don’t create growth; they just steal; growth temporarily from trading partners until the trading partners steal it back with their own devaluations.

The surprise revaluation of the Swiss Franc on Jan. 15 will not be the last such surprise. There are many important pegs left in the international monetary system they are vulnerable to being broken. Right now the Hong Kong dollar and the major Arab currencies are all tightly pegged to the U.S. dollar.

The Chinese Yuan is loosely pegged to the U.S. dollar, too. If the U.S. raises interest rates this year as the Fed has warned, the stronger dollar may force those countries to break the peg because their own currencies become too strong and hurt their exports.

If the Fed does not raise interest rates, the result could be a violent reversal of current trends and a weaker dollar as the “risk on” mantra causes capital to flow out of the U.S. and back to the emerging markets. Either way, volatility is the one certainty.

The other problem with the currency wars is what the IMF calls “spillover” effects, also known as financial contagion. Many mortgages in Poland, Hungary, and other parts of Central and Eastern Europe are made not in local currency but in Swiss Francs. The stronger Swiss Franc means those borrowers need more local currency to pay off their mortgages.

This could lead to a wave of mortgage defaults and a mortgage market meltdown similar to what the U.S. experienced in 2007. This shows how a decision made in Zurich can wipe out a homeowner in Budapest. Financial contagion works just like Ebola. Once an outbreak begins, it can be difficult to contain. It may not be long before the Swiss Franc sneak attack infects investor portfolios in the U.S.

We’ll be monitoring the danger on your behalf. Financial contagion can also be a two-way street. It not only creates dangers, it creates opportunities for investors who can connect the dots in the currency wars. The easiest conclusion you can draw and act on is this simple truth: Do not believe government and central bank lies.

This maxim is not without historical precedent. You’ve probably heard about Franklin Roosevelt’s own sneak currency attack. In 1933, President Roosevelt devised a plan to increase the price of gold in dollars, effectively a dollar devaluation. But he had a problem. If he increased the price of gold while Americans owned it, the profit would go to the citizens, not the U.S. Treasury. He knew that he had to lie to the American people about his intentions in order to pull off the theft of the century.

So Roosevelt issued an emergency executive order confiscating the gold at about $20.00 per ounce, and then revalued it to $35.00 per ounce, with the Treasury getting the profits.

On Thursday, the Swiss National Bank pulled a similar stunt. Last November, the Swiss citizens voted on a referendum to require an informal link of the Swiss Franc to gold. The Swiss National Bank argued against the referendum on the ground that it would cause them to break the peg of the Swiss Franc to the Euro.

The people believed them and voted “no” on the referendum. But now the Swiss National Bank has broken the peg anyway. The price of gold is spiking as a result, but the Swiss citizens have lost the benefit of that because the referendum is now a dead letter. The Swiss National Bank lied to the Swiss people about their intentions with regard to the peg.

The lesson of history is that citizens should own some gold, store it safely, and don’t believe government and central bank lies. In fact, we could see more investors fleeing to the safety of gold in the coming months as trust in central bankers wanes.

Regards,

Jim Rickards

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

The Currency Wars of the 20th Century

The Currency Wars of the 20th Century
by Addison Wiggin

Jim Rickards is no ordinary hedge fund manager. Lots of guys can boast 35-year careers on Wall Street.

Only Rickards is also a lawyer who was the chief negotiator during the 1998 rescue of Long-Term Capital Management — in which 14 of the world’s biggest banks ponied up $3.6 billion to prevent a global financial meltdown. And only Rickards is a consultant to the Pentagon who walked senior military planners through their first-ever “financial war game.”

His best-selling book Currency Wars opens with a two-chapter account of this war game — held at the Warfare Analysis Laboratory in Laurel, Maryland — a strategy room whose website boasts “14 plasma displays for defense exercises” and “3-D scenario modeling and visualization.”

The financial war game was made more intense by the fact it took place amid the market panic in late 2008 and early ’09. We won’t give too much away here; suffice it to say Team Russia announced it would accept only gold in exchange for its oil and gas — no dollars. Then Team China made its own move to “tighten the noose around the U.S. dollar’s neck.”

As it happened, on the second and final day of the war game, Russia’s Vladimir Putin declared of the dollar, “The one reserve currency has become a danger to the world economy: that is now obvious to everybody.”

Rickards believes the real currency war presaged by Putin began in early 2010. He labels it Currency War III.

“Currency wars,” Rickards writes, “are fought globally in all major financial centers at once, 24 hours per day, by bankers, traders, politicians and automated systems — and the fate of economies and their affected citizens hang in the balance.”

Both previous currency wars both took place within the last century. Currency War I erupted from the ashes of World War I in 1921 when Germany began its epic devaluation of the mark — the one memorialized in pictures of wheelbarrows full of paper money that weren’t enough to buy a loaf of bread.

Thus did the rest of the world race to devalue their own currencies to remain “competitive.” France leaped first in 1925, devaluing the franc. Britain abandoned the gold standard in 1931. The United States infamously devalued the dollar against gold in 1933 — from $20.67 an ounce to $35. France and England devalued again.

Rickards believes the real currency war presaged by Putin began in early 2010

“In round after round of devaluation and default,” Rickards writes, “the major economies of the world raced to the bottom, causing massive trade disruption, lost output and wealth destruction along the way.”

Currency War I ended in a whimper in 1936 with a three-way deal between the United States, Britain and France. Germany by that time was goose-stepping to its own drummer, and a shooting war followed three years later.

Currency War II blew up in 1967 when Great Britain devalued the pound against the dollar. Soon the dollar itself was under pressure — a matter complicated by the fact the dollar was still tied to gold in international trade.

The rest is monetary history: France turned in scads of dollars for America’s gold, nor were the French alone. The Treasury’s gold supply dwindled from 20,000 metric tons in 1950 to barely 9,000 when President Nixon “closed the gold window” in 1971. The entire world was now on a floating fiat currency standard.

The dollar sank throughout the ’70s, but soared in the early ’80s under Federal Reserve Chairman Paul Volcker. The world’s other principal currencies, the Japanese yen and West German mark, went on a roller-coast ride the whole way. Exhaustion set in. The Plaza Accord of 1985 set the dollar on another downward trajectory, and the Louvre Accord of 1987 resulted in equilibrium — more or less.

“There was relative peace in international monetary matters,” Rickards writes, “yet this peace rested on nothing more substantial than faith in the dollar as a store of value based on a growing U.S. economy and stable monetary policy by the Fed.”

That faith finally broke in early 2010.

On Jan. 27, 2010, President Obama fired the first volley of Currency War III in his State of the Union speech. He announced the National Export Initiative. Its aim — to double U.S. exports in five years.

“The traditional and fastest way to increase exports had always been to cheapen the currency,” Rickards writes in Currency Wars. And everyone around the world knew it.

Later in 2010, the Federal Reserve stepped in with a second round of “QE,” or money printing. “By using quantitative easing to generate inflation abroad, the United States was increasing the cost structure of almost every major exporting nation and fast-growing emerging economy in the world all at once.”

And so began another race to the bottom, a new round of competitive devaluations. “We’re in the midst of an international currency war,” declared Brazil’s finance minister Guido Mantega in September of 2010, “a general weakening of currency.”

No one will be left untouched by Currency War III, but Rickards says it will take place in three major theaters. In two of the theaters, the combatants have mutual aims. The third is the most likely source of outright conflict.

The Atlantic theater is the balance between the United States and the eurozone. “The euro and dollar,” writes Rickards,” are best understood as two passengers on the same ship… moving at the same speed, heading for the same destination.”

The euro topped at $1.59 in July 2008 and bottomed at $1.10 in June 2010. As we go to press, it’s at $1.29 — essentially where it was in early 2007, and again in early 2011.

That relative stability is no accident: Washington aims to prop up the euro to the point of the Fed engineering a secret bailout of European banks in 2008 — $3.08 trillion in loans that became public only in 2011.

The Eurasian theater of the war, meanwhile, is the balance between Europe and China. “China has a vital interest in a strong euro,” Rickards writes — not least because the European Union is China’s largest trading partner, larger even than the U.S.

Bottom line: “Europe, China and the United States are united in their efforts to avoid a euro collapse despite their mixed motives and adversarial postures in other arenas.”

Which brings us to the Pacific Theater — the big show.

The U.S. trade deficit with China was less than $50 billion in 1997. By 2006, it swelled to $234 billion. Politicians grandstanded about American jobs “lost forever to China” and Chinese leaders “manipulating” their currency.

Never mind that the evidence linking currency value to jobs is, er, slim at best. Even if the yuan doubled in value, Rickards points out a Chinese furniture maker would be making $236 a month — and a furniture maker in North Carolina still wouldn’t be competitive.

If we still had a gold standard — or even the Bretton Woods system in place between 1944-71, such yawning trade gaps would be impossible. The flows of gold between creditor and debtor nations — consider our example at the start of the issue — would, naturally, maintain an equilibrium.

Meanwhile, manipulation is a two-way street: “China’s policy of pegging the yuan to the dollar,” Rickards writes, “was based on the mistaken belief and misplaced hope that the Fed would not abuse its money printing privileges.”

Fool me once…

“Given the choice,” Rickards writes, “between uncontrolled inflation with unforeseen consequences and a controlled revaluation of the yuan, the Chinese moved steadily in the direction of revaluation beginning in June 2010, increasing dramatically by mid-2011.”

You can see the result in the chart nearby. Through mid-2010, it took 6.8 yuan to equal one U.S. dollar. But with the conscious decision to strengthen the Chinese currency, it now takes barely 6.1 yuan to equal a dollar.

Thus, “the United States had won round one of the currency wars.” There will be more to come.
“Everything’s a cross rate,” Jim says. “There’s a dollar euro cross rate. There’s a dollar yen cross rate. There’s a dollar Chinese yuan cross rate, Swiss francs and so on. And it’s dynamic. The dollar could be going up against the Euro, which it has been lately but going down against the Chinese yuan.

“Is the dollar going up or down? Well, the answer is compared to what? And this is what we do in currency wars. We look at this. We understand these dynamics. We understand that any two currencies are a zero sum game.”

Regards,

Addison Wiggin

Source: Daily Reckoning

Follow us on Twitter: @blacklioncm

6 Major Flaws in the Fed's Economic Model

The U.S. dollar is the dominant global reserve currency. All markets, including stocks, bonds, commodities, and foreign exchange are affected by the value of the dollar.

The value of the dollar, in effect, its “price” is determined by interest rates. When the Federal Reserve manipulates interest rates, it is manipulating, and therefore distorting, every market in the world.

The Fed may have some legitimate role as an emergency lender of last resort and as a force to use liquidity to maintain price stability. But, the lender of last resort function has morphed into an all-purpose bailout facility, and the liquidity function has morphed into massive manipulation of interest rates.

The original sin with regard to Fed powers was the Humphrey-Hawkins Full Employment Act of 1978 signed by President Carter. This created the “dual mandate” which allowed the Fed to consider employment as well as price stability in setting policy. The dual mandate allows the Fed to manage the U.S. jobs market and, by extension, the economy as a whole, instead of confining itself to straightforward liquidity operations.

Janet Yellen, the Fed chairwoman, is a strong advocate of the dual mandate and has emphasized employment targets in the setting of Fed policy. Through the dual mandate and her embrace of it, and using the dollar’s unique role as leverage, she is a de facto central planner for the world.

Like all central planners, she will fail. Yellen’s greatest deficiency is that she does not use practical rules. Instead she uses esoteric economic models that do not correspond to reality. This approach is highlighted in two Yellen speeches. In June 2012 she described her “optimal control” model and in April 2013 she described her model of “communications policy.”

The theory of optimal control says that conventional monetary rules, such as the Taylor Rule or a commodity price standard, should be abandoned in current conditions in favor of a policy that will keep rates lower, longer than otherwise. Yellen favors use of communications policy to let individuals and markets know the Fed’s intentions under optimal control.

The idea is that over time, individuals will “get the message” and begin to make borrowing, investment and spending decisions based on the promise of lower rates. This will then lead to increased aggregate demand, higher employment and stronger economic growth. At that point, the Fed can begin to withdraw policy support in order to prevent an outbreak of inflation.

The flaws in Yellen’s models are numerous. Here are a few:

1) Under Yellen’s own model, saying she will keep rates “lower, longer” is designed to improve the economy sooner than alternative policies. But if the economy improves sooner under her policy, she will raise rates sooner. So, the entire approach is a lie. Somehow people are supposed to play along with Yellen’s low rate promise even though they intuitively understand that if things get better the promise will be rescinded. This produces confusion.

2) People are not automatons who mindlessly do what Yellen wants. In the face of the embedded contradictions of Yellen’s model, people prefer to hoard cash, stay on the sidelines and not get suckered by the bait-and-switch promise of optimal control theory. The resulting lack of investment and consumption is what is really hurting the economy. Economists call this “regime uncertainty” and it was a leading cause of the length, if not the origin, of the Great Depression of 1929-1941.

3) In order to make money under the Fed’s zero interest rate policy, banks are engaging in hidden off-balance sheet transactions, including asset swaps, which substantially increase systemic risk. In an asset swap, a bank with weak collateral will “swap” that for good collateral with an institutional investor in a transaction that will be reversed at some point. The bank then takes the good collateral and uses it for margin in another swap with another bank. In effect, a two-party deal has been turned into a three-party deal with greater risk and credit exposure all around.

4) Yellen’s zero interest rate policy constitutes massive theft from savers. Applying a normalized interest rate of about 2% to the entire savings pool in the U.S. banking system compared to the actual rate of zero, reveals a $400 billion per year wealth transfer from savers to the banks from the zero rates. This has continued for five years, so the cumulative subsidy to the banking system at the expense of everyday Americans is now over $2 trillion. This hurts investment, penalizes savers and forces retirees into inappropriate risk investments such as the stock market. Yellen supports this bank subsidy and theft from savers.

5) The Fed is now insolvent. By buying highly volatile long-term Treasury notes instead of safe short-term treasury bills, the Fed has wiped out its capital on a mark-to-market basis. Of course, the Fed carries these notes on its balance sheet “at cost” and does not mark to market, but if they did they would be broke. This fact will be more difficult to hide as interest rates are allowed to rise. The insolvency of the Fed will become a major political issue in the years ahead and may necessitate a financial bail-out of the Fed by taxpayers. Yellen is a leading advocate of the policies that have resulted in the Fed’s insolvency.

6) Market participants and policymakers rely on market prices to make decisions about economic policy. What happens when the price signals upon which policymakers rely are themselves distorted by prior policy manipulation? First you distort the price signal by market manipulation, then you rely on the “price” to guide your policy going forward. This is the blind leading the blind.

The Fed is trying to tip the psychology of the consumer toward spending through its communication policy and low rates. This is extremely difficult to do in the short run. But once you change the psychology, it is extremely difficult to change it back again.

If the Fed succeeds in raising inflationary expectations, those expectations may quickly get out of control as they did in the 1970’s. This means that instead of inflation leveling off at 3%, inflation may quickly jump to 7% or higher. The Fed believes they can dial-down the thermostat if this happens, but they will discover that the psychology is not easy to reverse and inflation will run out of control.

The solution is for Congress to repeal the dual mandate and return the Fed to its original purpose as lender of last resort and short-term liquidity provider. Central planning failed for Stalin and Mao Zedong and it will fail for Janet Yellen too.

Regards,

Jim Rickards
for The Daily Reckoning

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Source: The Daily Reckoning