Destroying the Dollar For Something Logically Impossible

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The politics of economics has again risen in the wake of the stock market's recent haircut. Economists and experts from both the right and the left are now falling all over themselves to "do something". Why the stock market is the universal signal, the hunter's bugle call to action, is not yet known. After all, the economic and financial problems of August 2011 have been largely unchanged since August 2007, and indications of these unresolved imbalances have been, and continue to be, numerous.

What is troubling is this bipartisan political urge to "do something". In the space of a few days we have seen Paul Krugman on the left openly pine for "an all-out effort by the Federal Reserve to get the economy moving, with the deliberate goal of generating higher inflation to help alleviate debt problems" (in addition to his idea of faking an alien invasion). On the right, Ramesh Ponnuru, senior editor at the conservative magazine National Review, similarly argues for loose monetary policies.

Writing in Bloomberg, Ponnuru supposes that monetary policy has been effectively "tight", not loose. To this end, he advocates, like Krugman, a concerted monetary accommodation far above current efforts, openly conceding that inflation will come with it. The pay off for both Krugman and Ponnuru is believed to be beneficial economic activity that accompanies this new inflation.

These ideas are exactly the same as what has passed for monetary policy to date, but it seems now we are simply left to debate the size of intervention. Indeed, this line of thinking has been circulating for some time in the form of a kind of fiscal stimulus admission and regret: it would have worked had it been bigger.

Setting aside, for now, the potentially disastrous tax that would be on the most vulnerable segment of current society (which, as food stamp usage and labor force shrinkage indicate is a sizeable and still growing proportion), and whether it is appropriate to treat individual humans as if they were mathematical automatons by "enforcing" spending mandates through monetary machinations, there is just no possibility for this to operationally succeed. Why destroy the dollar and unleash inflation for something that is logistically impossible?

Neither Krugman nor Ponnuru seem to acknowledge the realities of the current banking environment. Even if the Federal Reserve created another $10 trillion in bank reserves (on top of the $1.65 trillion already there), there is no way to transmit that money to anyone outside the primary dealer network. Loan activity is not predicated on how much cash is available in a vault or on the Fed's books, it is entirely a function of individual bank balance sheet capacity and the wholesale funding market.

Unless an individual bank went directly to one of the emergency programs created during the last crisis (the banking equivalent of suicide), then there is no way for any bank outside the primary dealer network to directly connect to the monetary spigot. Instead, banks are left to fend for themselves in the interbank money markets. That means borrowing overnight or short-term through unsecured loans domestically at the Fed funds rate, or tapping the eurodollar market denoted by LIBOR rates. The only other alternative is going the secured route via repo (posting "high quality" liquid collateral net of a scheduled haircut).

I suppose it makes sense that these experts are unaware of the current turmoil engulfing the interbank money markets these days, especially since their own sense of urgency is dictated only by whether distress in these vital credit markets finally penetrates the narrow consciousness of stock investors. There is significant stress steadily progressing into a credit crunch that is currently wreaking havoc in the unsecured markets, in both the Fed funds and the eurodollar markets.

While the current crisis is centered on PIIGS exposure, this old game of guess-which-bank-is-actually-healthy creates a feedback loop where smaller banks are shut out simply because the primary dealer network (the banks with all the cash) has become universally risk averse. As is usual with Fed liquidity actions, such as both iterations of quantitative easing (QE), they can create liquidity but they can never guarantee its uniform availability. True systemic liquidity is dependent on how those primary dealer gatekeepers view their less-connected brethren.

So as more and more banks get shut out of the unsecured money markets they are herded into the secured markets via repos. The problem here is again QE itself. During both QE programs, the Federal Reserve created all that cash and pushed it to the primary dealers by purchasing bonds in their inventory - pulling out over $1 trillion in U.S. government debt securities from the wider marketplace (in addition to $1.25 trillion in mortgage securities). In the repo market, however, U.S. treasury securities are the one true interbank currency.

To obtain repo financing in U.S. dollars without huge haircuts or significant hits to bank capital reserves requires the use of a U.S. treasury security, particularly shorter-term bills. As the unsecured markets have fallen off (in addition to the mass migration away from European sovereigns as repo collateral), the demand for treasuries as repo alternatives has proportionally risen. The supply of those securities was artificially and severely diminished by QE. As hard as it is to believe in this age of massive government borrowing, U.S. treasuries, especially the bills, are in desperately short supply. That is why we have seen negative nominal rates in t-bills and other indications, including general collateral and special collateral rates.

As long as this imbalance remains, creating new cash is actually extremely harmful to the interbank system in its present state. If the Fed were to follow Krugman's advice, for instance, and roll out a massive QE 3.0, it would be disastrous for the interbank markets. T-bill rates would drop significantly, deepening the negative nominal rates and beginning a large cascade of voluntary capital destruction. Banks outside the primary dealer network would be forced to lose money on a short-term treasury bill just to maintain operational liquidity.

At that point, these operational liquidity demands would give rise to asset selling across the board. Banking institutions would not be able to persist with voluntary capital destruction, so they would seek to purge liquid assets (say global stock futures and high-yield credit from early to mid-August) to raise a sufficient enough cash cushion to avoid the unfavorable interbank conditions - a credit freeze akin to 2008. This might be counterintuitive, but a new liquidity program by the Fed would actually lead to greater banking system illiquidity. All that intervention and intentional instability has again left us in the same exact place as we started.

As ridiculous as this sounds, we have arrived at the point in time where cash actually creates a liquidity crisis. As much as economists love to theorize about policies and their efficacies, they never seem to fully grasp the mechanical finance involved (the classroom exercise of theory vs. the practice of making those theories fit and work within the real world). The Federal Reserve knows this and has already taken baby steps to alleviate the treasury security shortage. Beginning Monday (August 15), the Fed began a program of reverse repos - where they take cash out of the banking system and replace it with treasury bonds and (more likely) bills. While this program is advertised as "small" in comparison to the overall level of bank reserves, that could still be a large number.

Indeed, examining the Fed's balance sheet we see that the "normal" level of reverse repos has been stepped up only very recently. From March 31 through July 29 this year, the aggregate level of outstanding reverse repos held steady at about $65 billion. Through the first two weeks of August (through August 11), the exact time the liquidity crisis and the treasury security shortage hit, the Fed increased reverse repo aggregates by 14% to $74 billion - and that was before the latest program announcement. Cash is now a problem, not a solution.

As long as instability reigns in the interbank markets, and ongoing turmoil in Europe will make sure that it does, there is no operational method for turning Federal Reserve cash into monetary flow outside of primary dealers. As much as these reverse repos will alleviate some of the repo market/treasury collateral strain, it will not be enough should the tempo of the crisis change unexpectedly (economists' models, including those at the Fed, only forecast in straight lines). The other constant about the Fed is its propensity to underestimate crises while responding very slowly to them. After all, their record of prediction will not suddenly improve since they have the same theoretical flaws imbedded in the same models they started with in 2007.

As much as Mssrs. Krugman and Ponnuru form the basis for a bipartisan program of taxing the American public further into the inflationary abyss, their hoped for revival of economic activity is stuck in the realities of the 21st century banking system (of which they seem completely unaware). Essentially, another program of monetary easing would have exactly the same effects as the first two - destroying the dollar further, driving the prices of necessities even higher, while creating exactly zero beneficial economic flow. Worse yet, the new cash would open up a cycle of voluntary capital destruction that would (and is) reverse the asset price increases that were engineered to pioneer the original, and also completely ineffective, intentions of a "wealth effect".

Even if central banks could somehow solve these persistent banking uncertainties plaguing the interbank money markets, there is still the lack of balance sheet capacity. The banking system is not constrained by a lack of liquidity in making loans, it is constrained, according to Basel rules, by its capital ratios. In other words, the upper limit of loan capacity is dictated by the amount of equity capital each bank has on its books, a level completely and totally unrelated to the amount of cash in existence.

This double-edged sword allowed banks to accumulate massive leverage through the use of AAA-rated securities since those securities were intentionally assigned a much lower risk weighting. That meant banks were afforded the opportunity to add far more mortgage bonds per unit of equity capital. Once the mortgage bond risk weightings proved desperately inadequate, balance sheet capacity became dangerously constrained. So TARP was created and then changed into a systemic bank investment program - rebuilding equity capital ratios throughout the system.

Unfortunately, the new balance sheet capacity created by TARP was quickly absorbed by all the old loans made during the housing bubble. Whether it was ongoing losses (income statement losses erode bank capital by reducing retained earnings) or FAS 166 & 167 (accounting changes proposed in 2009 that forced banks to repatriate securitization structures in 2010, including nearly every outstanding master credit card trust), balance sheet capacity has been continuously strained by the legacy of the old regime. A sizable expansion of new loans to the public (i.e., higher risk-weighted obligors) is impossible in this environment.

Instead, banks are forced to rebuild their Tier 1 capital through earnings harvested from exclusively investing in sovereign debt. Sovereign obligors are risk-weighted to zero, meaning there is no equity capital "reserve" requirement. The reason banks have loaded up on government debts, especially PIIGS, is because that is the only option for their limited balance sheet capacity.

No matter how much cash the Fed or ECB creates, it will not flow to private borrowers without more systemic bank equity. I seriously doubt another TARP is even remotely possible. And in this uncertain stock environment, especially for bank stocks, it is hard to see them going to market now with massive equity offerings. That means banks will only be lending to governments for the still foreseeable future.

The problem of credit flow is the banking system itself, and that includes the Federal Reserve and other central banks. The amount of leverage and illusory risk weightings has proven to be too much of a burden to systemic capacity. Now, four full years after the crisis erupted, we are still dealing with the banking legacy of the housing bubble. It is still being systemically weakened by loans made more than a half decade ago, including losses that have yet to be charged off. Since that battle is not yet finished, there is no way for the banking system to embark on another sustained period of new credit expansion.

So much of this uncertainty locking up the interbank market today is the direct descendant of central bank policies designed to save the banking system and get credit flowing. In its rush to save each and every financial firm, the Fed and the ECB both allowed losses to remain hidden, fomenting this persistent mistrust. At the same time they (especially the Federal Reserve) mistakenly believed a system awash in cash would remain insulated from another panic. Unfortunately, market interventions, especially the massive distortions that central banks applied in response to 2008, create all manner of unintended consequences that are often just as harmful as the original problem.

There is a definite quality of absurdity to all this intervention. Besides the fact that every method of intervention or monetary "solution" guarantees ongoing crisis and instability, what else has to be said about a condition where increasing cash for the banking system actually creates a liquidity crisis. Whatever rabbit hole exists for central banks and economic experts, they have widened and deepened it, inviting the rest of the world to follow them down it.

Until the banking system is actually cleared of hidden losses (not just PIIGS but also commercial real estate), uncertainty will remain - the Japanification of the system. That means there will not be any direct credit flow from the Fed or ECB to the wider economy, outside of corporate bonds. That is one area that Mssrs. Krugman and Ponnuru seem to ignore - that credit to large, especially multinational, corporations is very robust. Corporate bond issuance has been at record levels, yet all that new money has not led to the robust hiring which continues that monetary flow to households. At least that beneficial flow has not happened domestically.

Instead, as I have referenced so many times before, corporations flush with debt-financed cash invest in overseas operations (thank you dollar destruction) and repurchase their own stock (thank you short-term investment incentives). Rather than focus on creating more money and intentionally creating more instability and dollar devaluation, perhaps experts should contemplate the issue of broken economic flow here, as empirically shown by large American corporate businesses. More money does not equal more flow.

As much as it can never succeed with a broken banking system, the corporate cash issue conclusively demonstrates that the quantity of money is not the solution; it is the problem. Perhaps policies that enhance dollar stability and favor long-term domestic investment would be far more productive than shoveling more money at a banking system broken by constant monetary "remedies". Clear the regulatory path, remove these costly and absurd interventions, and give companies a reason to invest CAPITAL domestically, and they will.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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