Monetizing Debt: The Grandest of Larcenies
“Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation,” said Ben Bernanke in response to a question posed by a member of Congress. Then, he added…
“The Federal Reserve will not monetize the debt.”
That last sentence has a ring to it. It reminds us of Richard Nixon’s “I am not a crook.” Surely, it is destined to make its way into the history books, alongside Bill Clinton’s “I did not have sex with that woman” and the builder of the Titanic’s “even God himself couldn’t sink this ship.”
Monetizing the debt is precisely what the Fed will do. But it will not do so precisely. Instead, it will act clumsily…reluctantly…incompetently…accidentally…and finally, catastrophically.
That’s our prediction, here at The Daily Reckoning. Prove us wrong!
In today’s reckoning we describe why you don’t have to be an astrologer or an economist (the two are similar…except the astrologers have more professional credibility) to see what is coming.
First, a look at the market. Yesterday, investors seemed to think it over and change their minds. Their first reaction – on Wednesday – to Geithner’s reassurances to the Chinese and Bernanke’s reassurances to Americans was positive.
“Maybe these guys are on the level, after all,” they said to themselves. “Maybe the dollar won’t fall apart.”
But after 24 hours of deep reflection and heavy drinking they came to their senses: “What was I thinking? Of course they’re going to undermine the dollar…what else can they do?”
So yesterday they were back at it – buying assets that are priced in dollars but that move in the opposite direction. The euro went right back to where it was at the beginning of the week, at $1.41. Gold, which had lost $18 on Wednesday, recovered $16 on Thursday. Oil had slipped $2 after Bernanke’s comments; yesterday, it gained $2.
Stocks rose too – with the Dow up 79 points.
A friend sent a recent report from analysts with Barclays Bank. Barclays is advising private clients that the “bear market is probably over.”
Anything is possible, of course. But for the many reasons we’ve described in these reckonings we doubt that we’ve seen the last of this bear. Or the last of this recession. What we’ve seen so far is merely a classic post-crash bounce. Nothing more.
Which is WHY the Fed will eventually monetize the debt. “Monetizing” debt, by the way, is larceny on the grandest scale. Rather than honestly repaying what it has borrowed, a government merely prints up extra currency and uses it to pay its loans. The debt is “monetized”…transformed into an increase in the money supply, thereby lowering the purchasing power of everybody’s savings.
Of course, the Fed will not want to do such a dastardly deed; but it will do it anyway. Even good people do bad things when they get in a jamb. The feds are already in pretty deep…and they’re going a lot deeper.
The European Central Bank came out yesterday and said that its forecasts for the recession were on the low side. Instead of putting total output back 3.5% this year – as it had estimated in March – it now thinks the setback will be between 4% and 5% of GDP.
Unlike Japan’s slump of the ’90s and ’00s, this depression is worldwide. Americans aren’t buying like they used to. So, foreigners aren’t selling. Everyone gets poorer as expected income and profits disappear…and turn into losses.
Meanwhile, in America, today’s jobs report shows that unemployment is still on the rise. People without jobs can’t buy stuff – neither the kind of stuff you get at the grocery store…nor the kind of stuff you get from real estate agents. Since they don’t buy stuff, manufacturers don’t make stuff. And since they don’t make stuff, they don’t need the stuff that stuff is made of, nor the employees who turn the raw stuff into the finished stuff.
Result: the stuffing gets knocked out of the economy.
Also, while Tim and Ben reassure investors, long bond yields go up. The Chinese have shifted from buying long bonds to buying short bills. This causes the return on bills to go down, but it pushes up yields on the 30-year bond…to which long-term fixed-rate mortgages are calibrated.
Last week, according to Freddie Mac, the average 30-year mortgage had a fixed rate of 4.9%. This week it’s 5.27%. At the margin – which is where most people live – this extra cost of financing pinches would-be homeowners. Either they buy a smaller house…or they pay less for it.
It also pinches anyone who needs to refinance – which includes not only sub-prime borrowers, but many others too. MSN Money reports:
“The next group of Americans to lose their homes seemed to have good credit and affordable loans. But those families have been walloped by the recession.
“In the housing market, a lot of prime mortgages are becoming subprime as a new wave of foreclosures begins to hit. Mainstream homeowners – those previously ‘safe’ borrowers with sound credit who have conservative, fixed-rate mortgages – are getting into trouble at an alarming rate.
“In the first quarter, the percentage of these borrowers who were behind on their mortgages or in foreclosure had doubled from a year earlier, to nearly 6%. For the first time in the housing crisis, these homeowners accounted for the largest share of new foreclosures.
“Job losses are a major reason once-safe borrowers are falling into trouble. With unemployment likely to rise, the problem will only get worse. So the core challenge at the heart of our economic crunch – a poor housing market that infects banks and the whole credit system – is not going away soon. That’s bad news for the stock market and the economy in general.
“‘A couple of months ago, a lot of people had hoped that the housing collapse was about over,’ says money manager and forecaster Gary Shilling, a well-known bear who called the housing problems early in the cycle. ‘But it was more hope than reality.’
“Economists call rising delinquencies and foreclosures among prime borrowers the third wave of trouble. The first two waves were housing speculators going bust and subprime borrowers – those with poor credit histories and some version of no-down or low-down adjustable-rate mortgages – getting into trouble.
“Mark Zandi, the chief economist for Moody’s Economy.com, calls the third wave a ‘significant threat’ to the economy. ‘“It is gathering momentum,’ he says. ‘The problem is now well beyond subprime and deep into prime.’”
Following this article was a series of comments. One, filed on Wednesday, was particularly interesting:
“This is my world crashing down on me. I own apartments and I rent to poor people. I more than most know what people are experiencing. While my properties are struggling, the income they generate has not dropped significantly to threaten the payment of any loan. Unfortunately, my loans are due this year and I am simply unable to borrow money to replace the loans I am currently servicing successfully. What can I do? All my capital reserves are gone, but effectively, I am losing my job because the banking system and market will not allow me to borrow money. If you bought my property today at the current market rate, your cash on cash return would be over 15%. This type of return in the Atlanta Real Estate market has not been seen in decades. When employment growth rises in Atlanta in 12 to 24 months, the cash on cash return will be over 20%. I probably will not survive. I will lose everything, my house, my business and my savings. I will have to start all over…”
Now, dear reader, we ask you a question: Is a politician from either party willing to stand in front of this man and tell him that interest rates are going up? Or how about telling him that Congress is raising his taxes? Even if the goal were only to balance the budget ten years from now, it would take a permanent, across-the-board tax increase of 60% to do so. (See below…) Would any politician in his right mind vote for such an increase? Ben Bernanke talks about cuts in spending and tax increases. But Bernanke is not up for election. Besides, practically every economist in the country in telling Congress it needs to spend MORE money, not less. Cut spending and increase taxes in a recession? Are you kidding?
We are in a serious, multi-year depression. No increase in taxes and no decrease in spending will be seriously considered until we are out of it. But if it follows the patterns of the past, then genuine, durable healthy growth will probably not return for many years…maybe 5…maybe 10…maybe 20. Long before then the US will have too much debt to carry…let alone pay back. It will have no choice but to “monetize” this debt by means of inflation.
We’ll tell you more of the HOW…on Monday.