Bernanke, the Federal Reserve Bank, and economic treason

Last week's announcement by the Federal Reserve that it plans to 'buy $600 billion of U.S. government bonds over the next eight months to drive down interest rates and encourage more borrowing and growth' is nothing more or less than economic treason against the United States.

Strong words? Sure, they are - but they're also accurate. Let me explain, beginning with a brief primer (for those not familiar with the subject) about currencies and bonds.

In the old days, a nation's currency was based upon hard assets. Initially, those assets were themselves the currency. A nation would mint gold or silver coins, each a given weight of metal, fixed at a value corresponding to that weight. From time to time, venal rulers would attempt to cheat by reducing the weight of metal, or using an alloy of precious and non-precious metals rather than pure gold or silver. Inevitably, the 'market' soon realized what was going on, and the value of the debased currency declined accordingly. That decline was, of course, measured in commodity prices. If a slave would normally cost (say) one gold coin, that slave's price would go up to one gold and one silver coin, to make up for the lower value of the coins themselves.

As time passed, nations began to use bearer currency in place of actual coins - i.e. paper money. The banknotes were, in effect, negotiable instruments, promissory notes that guaranteed the bearer, on demand, the equivalent value to the banknote's denomination in precious metals. There were frequent abuses of the system, where a country would not maintain sufficient reserves of precious metals to redeem its paper currency, but whenever this was found out by the market, the value of its currency declined (sometimes precipitously). This tended to keep the system reasonably honest, not printing too much money . . . as long as there was an underlying commodity of value to support the currency. Until the last few decades, this was known as the 'gold standard'. It came to an end in 1971.

Since 1971, nations have issued what's known as 'fiat currency' - in other words, their money is worth only as much as they say it is (or the market says it is - the two don't always coincide). Its value is not related to that of any physical commodity such as gold. The US dollar, the Euro, and most modern monetary units are all fiat currencies.

The problem with fiat currencies is that their value is determined by what the market thinks they're worth. Let me pretend that I'm a nation. My currency is called the 'widget'. The market will value my widgets as a function of the overall health and strength of my economy. If I decide, arbitrarily, to print double the number of widgets, without any growth in the underlying value of my national economy, the markets will take note. Traders in another country will say something like: "Hmm. You had a million widgets in circulation, and we valued each of them at one of our currency, the whatsit. You now have two million in circulation - without any added value to justify them. We, on the other hand, still have only a million whatsits in circulation. That means that the value of your widgets has declined relative to our whatsits. Each widget is now worth only half a whatsit." I may protest, and claim that the value of my currency is unchanged, but the markets won't buy it - literally. If I try to buy something from another country, using my widgets, they'll now demand twice as many widgets as before to buy their product.

This is why the value of the dollar has been declining on overseas markets for some time now - because the Federal Reserve has been printing dollars hand-over-fist to pump liquidity into the US economy. There's been no rise in economic output, no increase in economic activity, to justify the increased number of dollars in circulation; so the value of each dollar, expressed as a representation of the underlying value of the US economy, has dropped in relation to other currencies and commodities. Glenn Beck illustrates the growth in money supply very accurately in this short video clip.

I don't particularly like Glenn Beck, regarding him as a bit of a rabble-rouser; but I have to admit, in terms of economics, he knows his stuff. That video clip was absolutely accurate.

What this means is that we have to spend more to buy the things we need. If a barrel of oil cost $50 a few years ago, and we've doubled the number of dollars in circulation, we shouldn't be surprised to see the price of that barrel of oil double to $100. It's an invisible tax on every one of us. Our own incomes haven't doubled; but what we pay for goods and services from abroad has doubled, so we - all of us - have to spend more on necessities. We have less left over for discretionary spending.

Ben Bernanke, Chairman of the Federal Reserve, has been conducting what is known as 'quantitative easing', or QE, by issuing Federal bonds, and paying for them by printing dollars (fiat currency, remember, with no underlying assets to justify the increase in the number of dollars in circulation). Effectively, he's been treating the Government's own bonds as assets, and buying those assets with newly-printed dollars. He prints one piece of paper, pays for it with several billion other newly-printed pieces of paper, and then classifies the first piece of paper as an asset on the books of the US Government!

The first round of QE hasn't had the desired effect on the US economy. Indeed, it's merely weakened the US dollar to a dangerous extent on overseas markets. Bernanke now proposes to undertake another round of quantitative easing, known as QE2, to print and purchase a further $600 billion in bonds. There's no guarantee whatsoever that this round will have any greater success than the first. On the contrary, it's likely to have catastrophic consequences for our economy in the short term.

Strategist Alex Merk sees it as follows:

Federal Reserve policies have put the US dollar [at] the risk of crashing, which will hammer consumers through higher prices, strategist Axel Merk told CNBC.

Investors should brace for a much weaker dollar by diversifying out of the greenback and into currencies of other countries, said Merk, chairman and chief investment officer of Merk Investments, of Portland, Maine.

Merk spoke the day after the Fed said it will be embarking on a program to buy $600 billion in Treasurys in an effort to pump up the economy by increasing liquidity. Critics say the program, also known as quantitative easing, will further devalue the dollar and ultimately create inflation.

"It's with the best of intentions but I think it's a very, very wrong policy," Merk said in an interview.

Consumers should prepare for another turn of events like the spring of 2008, when oil prices soared to $147 a barrel and gas at the pump was more than $4 a gallon, he said.

"One of the key things here is a weaker dollar has traditionally not been inflationary because Asian exporters like to absorb the higher cost of doing business," Merk said. "There comes a breaking point when Asian exporters can no longer absorb that higher cost of doing business. They'll raise prices and guess what? They will stick.

"So we will have a cost-push inflation. We're going to get inflation but not where Bernanke wants to have it. We're not going to get wages to go up. We'll get the price at the gas pump to go up instead."

There's more at the link.

The inimitable Karl Denninger puts it like this:

The purpose of issuing bonds into the market is to provide a putative check and balance on Treasury overspending. That is, at some point the continued issuance causes the bond market to revolt and refuse to buy, driving rates much higher. That in turn causes the interest expense to go to the moon.

. . .

The problem with removal of this device of restraint is that fiscal discipline is in fact the only way one avoids imposing taxes on the public. Taxes come either in the form of a literal tax that must be paid or they are financed by causing an increase in the price of things denominated in a currency as a result of debasement.

Taxes inhibit business profits by diverting income from the business and to government. Therefore, in the general sense, the lower the tax rate the more business prospers. Of course taxes cannot be zero, because the government must have funding to perform its essential functions - we merely argue over what those essential functions are and how to pay for them.

QE is effectively naked emission of currency into the economy by government spending. It thus always results in shifting the price equilibrium on commodities in that currency to the right - that is, higher. At the same time since input costs are effectively a tax on production pressure downward is increased on wages. This in turn means that while cost pressures go upward, wages go downward.

Thus QE cannot spur employment. It in fact does the opposite by imposing an effective tax on business operations and consumers, which tends to drive down

Ben Bernanke claims that QE is intended to "spur investment" by increasing the "wealth effect." But any such effect is in fact transitory, as one cannot support higher stock valuations while margins are being pressured. You need margin expansion to be able to support higher valuations over time, and that means you need either lower input costs, higher employee after-tax earnings or both.

Bernanke's policies are in fact pushing both of these factors the wrong direction.

But worse, consider the certain "death spiral" scenario on the path we are now traveling:

after-tax compensation of employees.

1. QE is an implicit tax on the population. Input costs go up. This is an effective tax increase on everyone in the country. A dollar increase in the price of gasoline is an effective $140 billion dollars a year in additional tax, as just part of the impact. Basic staples are already up about 10% annualized, despite Bernanke's claim of "no inflation." Note that the "tax on the rich" everyone is talking about is a mere $70 billion a year by comparison.
2. This in turn means lower disposable income for consumers. That in turn hits discretionary spending. And that, in turn, means companies don't need to hire people to provide discretionary goods and services. This is what Bernanke did with QE1. He in fact destroyed job creation, which is a big part of why we still have 10% unemployment! Bernanke CAUSED that unemployment by creating a price ramp in the commodity space!
3. This, in turn, means more demand for social programs. More unemployment. More Medicaid. More food stamps. More government spending of all sorts. But there is no tax revenue increase coming in to pay for these increased demands (it's all going to the commodity producers) so the government once again turns to the bond market and issues debt to fund this increased spending demand.
4. Left alone, the bond market will react to this "never-ending" deficit spending cycle by increasing rates in an attempt to cut it off. This in turn provokes The Fed into even more QE to "spur employment and increase asset prices".

See the problem? The more QE you do, the more jobs you destroy because you continue to trash margins through the imposition of an effective tax on the entire economic system.

Eventually The Fed ends up being, for all intents and purposes, the entire government bond market.

At that point the issuance of credit money is no longer backed by anything at all - it is simply emitted raw, and for every dollar emitted in this fashion you have both a 100% transmission into prices and a premium applied on your threat to do more of it.

That's Weimar Germany folks - it is exactly what happened there, and exactly what will happen here unless Bernanke stops this crap. Since he won't stop on his own volition it is up to Congress and the people to stop him.

Metals will not save you if this spiral occurs. Nothing will save you, other than not being in the nation that this happens to. Government will, in its last gasps of trying to prevent itself from being unable to pay the military, Congress, and of course Ben, find ways to literally confiscate everything in a futile attempt to increase the asset base upon which it issues its increasingly-worthless currency.

There is no exit that can come from a "growing" economy when you are continually increasing the implicit tax rates in the general economic system as your response to each previous tax increase. That is, when your tax increase results in more unemployment and you respond by further increasing taxes, you are simply tightening the noose around your own neck.

The implied tax that has been imposed on the economy thus far since QE1 was put in place is a stunning $250 billion annually due to oil's price increase alone, or nearly four times the so-called "Bush Tax Cuts" for the rich. QE2 will add another $1/gallon (roughly) to gasoline which is another $140 billion, for a total of almost $400 billion each and every year.

And that's just in oil prices - then you have to add in all the other input cost-push problems, from corn to wheat to oats to cotton to wood pulp. The total effective tax increase from QE2 is in fact the entire $600 billion QE package, plus whatever the market anticipates Ben will do as a follow-on!

What is being done here, if it is not stopped by Congress and/or the people, will destroy the economy.

There's more at the link. Bold and italic print are Mr. Denninger's emphasis. (I should add that I agree entirely with his analysis of the situation.)

Remember Glenn Beck's video above? Mr. Bernanke now proposes to add a further $600 billion to the eruption in currency in circulation that's already happened on his watch. That's on top of the growth shown in the video - it'll take Mr. Beck's line right off the chart! I absolutely cannot see anything positive coming from such a step. On the contrary - it's likely to do a great deal of harm. Even some of Mr. Bernanke's colleagues agree:

Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, who described the move before the meeting as a "bargain with the devil," was the lone dissenter in a 10-1 vote of the Fed's policy committee. He said the risks of additional government bond purchases outweighed the benefits.

Consider the situation of countries which have invested in US treasury bonds. Let's say that a nation has bought $100 billion worth of them. The US dollar's value will decline relative to other currencies, because there are going to be far more of them in circulation without any increase in the underlying valuation of the US economy. Therefore, one dollar will be worth less against other currencies. That nation's $100 billion dollar investment in US bonds will now be worth only the reduced value of that number of dollars. It's going to be rightly angry with the US for devaluing the investment it made in our economy . . . and it's going to do anything and everything it can to recover its lost money. That might mean revaluing its own currency, or refusing to support the US economy any further, or turning to other nations to get a better return on its investments elsewhere in order to make up what it's lost on its investments with and in the USA.

This is already happening. Since Bernanke announced his intentions, China, Brazil and Germany - all among our largest trading partners - have protested vigorously (click on each link to see their views), and indicated that they may pursue countermeasures to protect their own interests. The backlash appears to be growing.

Some governments worry the tactic, which will lower interest rates and is known as quantitative easing, might send money flooding into their markets seeking higher returns. That could push up exchange rates, hurting exports by making their goods more expensive.

The conflict might hamper efforts to fix strains in the global economy at next week's Group of 20 summit in Seoul. Leaders from the United States, Japan, Germany, China and other governments that account for 85 percent of the global economy hope to make progress on reducing trade and current account gaps. Some nations such as the U.S. buy far more than they sell to the rest of world while many developing countries including China run vast surpluses.

"If the domestic policy is optimal policy for the United States alone, but at the same time it is not an optimal policy for the world, it may bring a lot of negative impact to the world. There is a spillover," said Zhou Xiaochuan, governor of the People's Bank of China, speaking at a business conference.

Again, there's more at the link.

Let me close with another Glenn Beck video. Please skip forward to the 4.00-minute mark, and begin watching from there. Mr. Beck shows how increased commodity prices are going to hit all of us in the pocket-book, just like a tax increase, because of Bernanke's 'quantitative easing'.

Again, I endorse everything Mr. Beck has to say. He speaks the truth.

Brace yourselves, folks . . . and let's hope and pray that the new Republican Congress can - and will - do something to stop this folly before it's too late. If they don't . . . we're screwed.

Peter