White Knight of Zombieland

SUBHEAD: The Fed's effort now suggests that the harsh effects of Peak Oil are to be felt imminently. Our waste-based economy is a zombie.

By Steve Ludlum on 5 November 2010 in Economic Undertow - 
Image above: Bust of zombie version of superhero Colonel America. From (http://www.gametrailers.com/users/bobafett300/gamepad/?action=viewblog&id=99236).  

Now the furor over Quantitative Easing (QE) and whatnot has been swept into the past. The question now is what happens after QE proves to be a failure? The cliche is 'QE 5 - 6 - 7' but this is unlikely. Why? The failure of this iteration of QE will be the end of the Federal Reserve. In this real world, not the zombie world of phantom central banks and imaginary wealth, failure has consequences. Bernanke's bet is a tremendous gamble. There is nothing short of desperate necessity would compel him to take it; and this speaks to our clear and present dangers.

The Fed has a relevance problem which orbits around the dollar price of crude oil and the current $13.5 trillion US budget deficit. Since this latter is ongoing with no possibility of retirement in sight, it is the certain the Fed will continue monetizing (printing money). Since the crisis began servicing this debt has created difficulties requiring the shuffling of funds between primary dealers and overseas central banks.

The massive credit overhang and the effect deflation has on currency value increases both the risks and dangers of a failed Treasury auction. The solution is direct monetization but this has adverse effects on the credit market which is ... uh, useful to actually price credit risks.

The Fed argues that its goal is to reduce lending rates and increase employment but this is a lie. The Fed risks crowding out the Treasury market so as to guarantee a bid and funds for Treasury operations. Because of a relative shortage of 5- 10 year Treasury securities the Fed will also likely buy mortgage-backed bonds and protect the flailing mortgage business from the consequences of its own criminality.

By monetizing the Fed creates extraordinary risks that are then priced into debt in place of the demand for credit that is ordinarily priced into it. These 'other' risks are ones the Fed does not want to think about. By monetizing, the Fed becomes both the lender and borrower of first and last resorts.

Once begun, the Fed must monetize until the end, when circumstances will not allow it anymore. This is the kind of risk that the markets will price into Treasury issues. By attempting to solve one problem the Fed creates greater downstream problems. What the Fed buys is time but the cost is very high. Part of this new risk is showing up in 30 year Treasuries.

Part is the mechanics of the trade, the rest is this default risk. What the Fed also buys at great expense is the admission that it has no clue as to what is behind our wasting, zombie economy. Fortunately for the Fed, it and the Treasury have been monetizing US debt since the Vietnam War era. Countries that choose to monetize can do so for very long time periods, witness Japan since 1990. At the same time, doing so does not address any underlying structural issues.

Since monetizing is a compounding exponential function at some level the process accelerates then breaks down. After that point borrowing to service debt is not possible. The problem the Fed cannot hope to solve is our broken energy balance sheet, not the finance version. Servicing debts by monetizing them or burning- excommunicating- or exorcising them will not solve the structural energy waste problems that propel the current economic malaise.

Nevertheless, Bernanke is playing a clever game. He can create a distraction and hope someone else shows up with an energy solution. He also realizes if he goes too far and monetizes too much he risks being 'outed' as irrelevant. He has to monetize enough to attract attention but not enough to suggest that what is doing is failing. At the same time he cannot possibly succeed as his actions have no relationship to the real problems.

Bernanke is a rodeo clown with a beard. All he can do to keep the bucked rodeo cowboy - the US economy - from being trampled is to distract the enraged bull. I almost feel sorry for the dude! That bull is going to be trampling until the end of time. With the Treasury absent from policy and the will to legislate more fiscal funding evaporated the only support for 'Recovery Lite' is Bernanke and his con game.

 The finance nincompoops that decry the vanishing dollar and incipient inflation are playing Barnyard Ben's game. Perhaps he's hired them! Without this chorus of Zero Hedge ignoramuses Bernanke would have no traction in the real world. When Marc Faber and the central bankers of China and Germany get up and squeal that QE is ruining things they are giving BB credibility that he cannot possibly earn by himself.

The actions rather than the words suggest that the wheels are in the process of falling off business as usual. Bernanke's actions inform us that the recovery is a sham. He promotes inflation: adding more money to reserves guarantees there will be no inflation even as the recently rising oil prices also guarantee there will be no inflation.

 First of all, inflation is not that are prices rising but an increases in the supply of money. More money stuffed into reserves creates an increasing incentive to keep these reserve funds from leaking into circulation. Inflation - or in this case, hyperinflation - only takes place when funds are in circulation and transacting more frequently, which is the 'velocity' of money. As more reserves are swept into traps the increase itself represents potential inflation. That is, there would be inflation if the funds in the traps were circulated.

Since releasing funds into circulation would reduce their value, they are kept in the traps at all costs. The more reserves the Fed creates the tighter the traps are that hold them. Increased reserves guarantees that more of these reserves will be liquidated when the traps finally implode. Liquidity/currency traps are places where money goes to die. The killer is the massive overhang of unrecognized debt exposure that is on the balance sheets of the traps themselves. The amounts of the debts are far greater than the currency in the traps. Even gold is a currency trap as it is pledged as margin collateral elsewhere.

Most funds in currency traps are forms of collateral for debts on the traps' balance sheets. They aren't called traps for nothing. When the gold bubble- liquidity trap collapses, gold speculators will get hammered. Getting into a trap is easy, getting out when everyone else is trying to do the same thing is fatal. If cash in accounts is trapped within insolvent banks the accounts will be frozen and rendered inaccessible. Real estate is the worst kind of currency trap.

When the danger appears there will be no buyers for real estate and cash spent on it will evaporate. In hyper- inflationary China, cash speculative purchases of apartments are likely to return nothing as the buildings themselves will revert to state ownership leaving the speculators empty handed. Lenders will be repaid in yuan that has near- zero value. These ruined lenders will ruin others in turn returning pledged collateral to the state which holds the underlying leasehold value of the land upon which the buildings themselves are erected. The Fed cannot solve the dollar price of crude.

A Fed- generated price bubble in crude can only crash when the price reaches an unsupportable level. Afterward, the price will recover from crash lows and reestablish the equilibrium price at the upper bound where any further increase destroys demand. This is the 'value- peg' of dollars priced in crude. Here, the dollar has real value.

Currently, there is no 'scarcity premium' to ubiquitous dollars which is a world- wide benefit of the dollar as reserve currency. Since dollars have this non- money value relative to other, scarcer commodity currencies it is almost impossible for the US dollar to be 'destroyed' by reducing is F/X value. The dollar at any exchange rate by the size of its float stabilizes fuel prices ... to a point.

 If the Fed was to somehow succeed and destroy the value of the dollar by widespread dollar revulsion overseas, some other currency would become pegged in value to crude in the dollar's place. Once that happens, the US and other buyers would have to either buy that currency - at a great disadvantage to the US - or buy fuels with dollars at a discount to the pegged currency. Buying a second currency with dollars would be extraordinarily expensive. Why?

Because any other currency would be scarce in circulation relative to the dollar and this scarcity would cause its value to be bid up. If the US was to bleed liquidity traps and start circulating more dollars to afford this price the effect would indeed be hyper- inflation and fuel would quickly become unaffordable. It's price would rise in dollars faster than dollars could be circulated. The inevitable crash might not reduce the price of fuel because the post- crash dollars would not be competitive overseas versus the 'other' currency which would be held by creditor nations such as China, India, Germany and the south Asian countries.

These countries have large F/X reserves and which would certainly avoid the crash outcome that dollar inflation would wreak on the US itself. For all extents and purposes the 'death' of the dollar would effectively put the US out of business as an industrialized nation.

Meanwhile, the dollar/crude peg is aggressively deflationary. Being exchangeable on demand for a valuable physical good the dollar does now and will have increased value. This is the inevitable outcome of physical shortage. 'Barnyard Ben' Bernanke's foray into experimental monetary policy is tragic and romantic ... as well as irrelevant. Regardless of his efforts the dollar/crude peg will reestablish itself at some level with dollar recognized as a defacto hard currency.

At that point the deadly arbitrage between the dollar and other currencies will begin and the world's economic activity will shrivel into little other than buying and selling money in order to obtain increasingly valuable oil. This is the exact same thing that took place during the early 1930's and resulted in mass bank failures in the US and elsewhere and only ended when the peg between paper money and gold was broken. As was the case then, the only escape from money- value generated deflation will be for economies to 'go off' oil and break the peg. There is no other way!

Reductions in the use of crude oil will be by necessity be of the order of 80- 90% of current levels of usage - the level at which the US can become a sustainable multi- year net exporter of crude oil! The great recessions of 1973 and the early 1980's were caused by supply reductions in the US of 10% or less. Cuba's regression in the post-Soviet period were the outcome of import constraints on the order of <20 href="http://www.nydailynews.com/archives/news/1999/03/01/1999-03-01_richard_whitney_the_harder_t.html">The tragedy of Richard Whitney who saved the stock market on Black Thursday:
Whitney had been a legend since Black Thursday 1929, when, amid the din of the roaring calamities that were wiping out fortunes, he strode onto the exchange floor and boomed: "205 for Steel!" With this one bold offer - U.S. Steel had plummeted to well below 205, but Whitney was a Morgan man, and thus it followed that America should be no less confident than the House of Morgan - the worst panic in 50 years briefly subsided. "HEROIC ACTION RALLIES MARKET", the papers clamored, and Whitney was Wall Street's white knight from that moment forward. In May 1930, he was elected exchange president, marshal of 1,357 member brokers - and now, as the economy reeled, the nation's most vocal defender of their traditional interests. As securities values continued to decline, as suspicions mounted that slick traders were responsible, as New York Congressman Fiorello LaGuardia introduced a bill requiring securities to be registered with the government, Whitney appeared many times before the Senate Banking and Finance Committee, crusading to keep the market free, denouncing his inquisitors as know-nothings. It was not the professionals who had brought on the crash, he argued, it was the greed-maddened public, the seamstresses and the bootblacks and the rest of the ignoramuses and nuisances who pumped their nickels and dimes into a marketplace best left to the better classes. Control was not to be removed from the descendants of the men who had in 1825 begun gathering at the old Wall St. buttonwood tree to transact their affairs. It would not do. But the arrival of Roosevelt's New Deal brought still louder calls for government intervention, and increasingly Whitney was cast as the villain in the public's great war on big business, the living embodiment of the frostily conservative old-guard financial barons who controlled the nation's money. Finally, nothing could prevent the creation of the bristling New Deal watchdog called the Securities and Exchange Commission. By March 1935, even Whitney's allies agreed he had to step down from the exchange presidency to ward off any further federal incursions. There was no appeasement. Late in November 1937, SEC Chairman William O. Douglas made it plain that the stock exchange was going to be a regulated public institution. The stage was now set for epic combat between the old millionaires and FDR's Depression-stricken America. At this precise moment, disturbing matters were coming to the attention of the stock exchange's board of governors. There seemed to be irregularities in Richard Whitney's private affairs. It, well, appeared that the eminent Richard Whitney was a crook.
All so sickeningly familiar. Whitney's Black Thursday rescue was followed the next week by Black Monday and Black Tuesday, then a whole calendar of black days. The lights in America were not to be re-lit until the New Deal and then for almost twenty years when in 1948 the US used the Marshall Plan to recapitalize its economy by rebuilding Europe and Japan. Now comes the latest version of Richard Whitney with his order of "205 For Steel!" He rides a pale horse like Death himself as he streaks across a sky empty of stars. He is Ben Bernanke the White Knight of Zombieland. .

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