Treasury Bond Avalanche

Illusions pile up… They’re sure to come down sooner or later.

Like snow at high altitudes, the central banks’ new money is piling up. As reported last week, all the world’s major central banks have turned on their snow machines. The U.S. Federal Reserve has been authorized to “print” $1.75 trillion worth of new money in order to buy Treasury bonds. The Bank of England has its own program — worth 75 billion pounds, so far. Even Switzerland has been printing money — so much that its money supply, as measured by M2, is growing at 30% per year. And two weeks ago, the European Central Bank announced that it too would begin creating money in order to buy corporate bonds.

“Quantitative easing” it is called. As a refresher for readers with real lives and better things to do, QE is how central banks describe what is essentially an act of counterfeiting. They buy bonds with money created — electronically — specifically for that purpose. Abracadabra — “money” comes into being.

The feds aim to provide liquidity for the cities and farms. But so far, only a trickle is coming down. Instead, chilly weather in the upper reaches of the financial sector holds it frozen in place. Hundreds of billions come down from central banks, but there it stays…waiting for spring.

Today, here on the back page, we ask ourselves a simple question: What will happen to it?

The feds’ counterfeit money does such a good imitation of the real thing, you can’t tell them apart. But the problem with all money is that it is as fickle and unreliable as a bad girlfriend. One minute she goes along with the flow. The next minute she turns silly and bubbly. And then, she gives you the cold shoulder.

According to theory, an increase in the supply of something leads directly to a decrease in the price of it… That is, if other things remain constant. Despite the credit crunch, the banking freeze-up, and the economic recession, the money supply in the U.S. as measured by M1 is actually rising at 14% per year. Yet consumer prices are not keeping pace. The latest report shows them actually going down slightly over the last 60 days.

Turns out, causing inflation is not as easy as it looked; controlling it probably will be even harder. It’s not enough to manage the quantity of money; you also need to be able to control its behavior. Money can be a solid, a liquid, or a gas depending upon the temperature of the economy. At normal temperatures, money runs freely, watering the economy. And when things really get hot, it vaporizes, creating gaseous bubbles such as those of the late Bubble Period. But when the temperature falls, money shivers in wallets and bank accounts — reluctant to go out into the cold.

Economists refer to the “velocity of money” to describe the magnifying effects of motion. When the same dollar bill appears in three different places in the same day, it is as if the money supply has been multiplied threefold. In a freeze, on the other hand, it comes to a dead stop.

When the thaw will come we don’t know. But the authorities are ready for it. When consumer prices begin to rise, they’ll stop adding to the money supply. Then, they’ll withdraw liquidity, as need be, to keep it under control.

They know that runaway inflation would cause problems — the collapse of the dollar…and the U.S. Treasury bond market, for example. So at the first signs of inflation, they will move quickly to remove excess liquidity from the system. How? Their emergency plan is simple enough. Now they are buying bonds. When their inflation targets are met, they will begin selling them.

We thought the Bubble Epoch was the peak in claptrap and illusions. But we were only in the foothills. The feds now pretend to bail out the economy by giving money to companies that pretend to be concerned, run by people who pretend to know what they are doing. And when they run short of money, they create more of it, pretend it is real…and pretend they can tell it what to do.

What is likely is that money will have a mind of its own. First, the markets will react…and the authorities will not. They will remember their own critiques of Japanese and Roosevelt-era monetary policy. In both cases, they believe central banks removed the punch bowl too early — before the party really got rolling. In both cases, the recovery was cut off.

Then, while they are hesitating, money will turn on them. Inflation rates will rise further. The velocity of money will pick up. And investors — including foreign governments — will become eager sellers of government debt. Suddenly, it will be too late. In order to remove the monetary inflation they previously added, central banks will have to sell bonds, instead of buying them, trying to reabsorb money from the economy. The extra cash will then disappear back into the central banks. But in order to bring inflation under control, the biggest bond buyers in the world must turn into the world’s biggest sellers. Bond prices, already falling as investors fear the worst, will collapse immediately. An avalanche of dollars will fall upon the world markets — as dollar holders all over the world become desperate to get rid of them.

We don’t know what day it will happen. But we have a good idea as to what time of day central bankers will realize that they are doomed. About 4 AM is our guess. That is the moment when Ben Bernanke and other central bankers begin to feel like members of the Donner Party. That is, like imbeciles.

Regards,
Bill Bonner

May 29, 2009