Don’t fear the 15 trillion debt

December 8, 2008

It is interesting how the boogie man of the econalypse keeps changing.  First it was subprime loans, then CDOs and SIVs, then CDSs and other derivatives.  These days Schiff, Taleb and others are warning that the worse is yet to come, in the form of a devalued currency and hyperinflation as the Fed and Treasury keep throwing money at the problem.  As much as I applaud them for forecasting the current storm, I think they’re wrong this time.

Now that the whole derivative legalized gambling scheme has unraveled we are going through a shocking de-leveraging process where every party is unwinding positions, returning to sensible reserve ratios and reassessing risk on every asset.  Hedge funds and SIVs that used to invest at reserves of 40 to 1 are borrowing much less (or closing altogether), either because of the higher risk, or because they can’t find anyone to lend them money.

The cummulative effect is that the multiplier ratio, and the money supply (M3), are dropping at a precipitous rate.  Unchecked, the lowered money flow will result in economic slowdown, or deflation, or both (and both are obviously undesired).

The government’s response has been clear: Pump more money into the system.  The Treasury has done this by injecting money directly into banks through TARP in exchange for equity.  The Fed relaxed their standards and has been buying inferior-quality paper from member banks.

So the argument goes, the Fed (therefore us taxpayers) is going to be saddled with all these toxic paper losses, and, the Treasury (again us) is going to print so many T-Bills we’ll end up owing our shirts to the Chinese.  All these losses and borrowing will erode confidence in the Dollar, which will no longer be used as reserve currency and eventually be dumped and lose its value.

I don’t believe this is the case.

First, let’s not forget that the Fed can print as much money as it wants.  Usually it creates only as much as needed and no more in order to control the money supply and therefore keep inflation in check while stimulating growth.  It’s a perennial tightrope and it is the basis of our monetary policy.  But given the current extraordinary de-leveraging and reduction in the velocity of money (since banks aren’t lending to each other) taking place, aggressively expanding the monetary base is exactly what is needed to keep the M3 supply stable.  The trick of course is to time this right, otherwise we’ll end up with a nasty case of inflation.

Secondly, a large chunk of the treasuries that will be issued will be bought by the Fed to create bank reserves, not so much by China since our imports (and the current account deficit) are slowing down.  This makes a big difference because the Fed, unlike all other creditors, returns all interest paid to the treasury.   When growth resumes they will slowly find their way back to the Treasury.   I wouldn’t be surprised if the Fed ends up with up to 4 trillion of treasuries in their balance sheet before the storm starts dying down.

Third, more treasuries give the Fed more room to grow reserves and expand the base without having to take in lower-grade paper and even toxic loans.

Lastly, because of the worldwide flight-to-safety these days yields are lower than ever, so there has never been a better time in our history to ‘take out a loan’.  We should be very very thankful for this.


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