Click here to read this article in pdf format:Â December 2 2012
The intention today was to do a revision of what I had expected in 2012, what happened and what I think will happen. However, we may have to put this aside one more time, given the feedback received on the last post, titled â€œAnatomy of the End Gameâ€. I seem to have been misinterpreted and to clarify this very important topic, I present a second part to make absolutely clear that:
a)Â Â Â Â Â It is misguided to believe that the end game should be blamed on the shadow banking system. Should regulators succeed in leaving regulated banks the role of funding the commodities and futures markets, the end game wouldÂ notÂ be avoided and its violence would be even greater,
b)Â Â Â Â Â Fiscal austerity in theUS, if my assumptions (clearly laid out in the previous post) apply, would be irrelevant unless it produces a sizable fiscal surplus,
c)Â Â Â Â Â The approach taken by policy makers addressing this logical outcome (which they mistakenly call tail risk â€“the tail risk is the reverse: That the game does not end-) is wrong.
The End Game in a world without shadow banking
There are continuous attempts at further regulating money market funds and central counterparties (i.e. clearinghouses), based on the belief that their operations entail risk of a systemic nature. But the systemic nature of the risk is simply due to the leverage built upon the collateral that these players use to provide funding. There is nothing particularly intrinsic to either the players, the markets that use that collateral or the collateral (i.e. sovereign debt, mortgages, etc.) itself, to make them â€œsystemicâ€. To coerce these players to increase their capitalization or to prevent them from freely disposing of their liquidity as risk varies only increases costs and volatility.
Letâ€™s assume the extreme case where the â€œshadow bankingâ€ sector disappears and banks become the sole providers of funding in the repo market. The figure below describes the situation. In stage 1, we can see the consolidated balance sheets of the financial institutions, traders, and non-financial institutions (private sector). Traders have US Treasuries as assets, which in stage 2, they sell to source cash. This cash is expressed as deposits (in stage 2), which are liability of the financial institutions. Deposits then, are backed by US Treasuries. When these are repudiated (our main assumption) the sustainability of the financial institutions is challenged, precisely at the same time that traders may be suffering a short squeeze on short commodities positions and margins are called. This short squeeze would also affect the commodities and futures marketsâ€™ clearinghouses (not shown in the figure). From stage 3, it is easy to see that depositors (non-financial institutions) who are not part of the aggregate â€œtradersâ€ class are the ones who are most at risk. The faith in the US dollar system is lost and a run on the banks is triggered.
We must clarify that the US dollar zone/system is not bound by geographical or jurisdictional borders. A Hong Kong or Brazil based bank that relied on US dollar funding to generate relevant net interest income would be equally affected by the liquidity squeeze, as so many European banks learned in 2008 and 2011.
Under this scenario, and unlike the case where the shadow banking system funds the repo market, the Fed would not have the luxury of choosing whether or not to intervene. It would simply be their duty to do so, and they may believe that they have the option to purchase the US Treasuries from the banks with or without sterilization. But in the end, it would not matterâ€¦sadly. Letâ€™s go through the process:
a)Â Â Â Â Â Â The Fed purchases US treasuries without sterilization
This is the easiest option to understand. As the figure shows below, the Fed purchases US Treasuries from the financial institutions and their reserves grow. As the whole context in which this would occur is not positive for economic growth, to say the least, and the private sector delevers: Loans outstanding, on a net basis, decrease. Deposits decrease and the non-financial private sector increases cash on hand. The equity of the financial sector, naturally, suffers. This cash on hand will keep rising as long as the US debt remains repudiated and US Treasuries need to be monetized by the Fed. Eventually, in the absence of alternative investments (as in the current context, with zero to negative interest rates), the cash is simply spent on consumption. In an environment of financial repression, where companies use whatever liquidity preferably to distribute back to owners via share buybacks or dividends (as we expected back inÂ March), the higher consumption facing lower production ends up driving prices higher.
b)Â Â Â Â Â Â The Fed purchases US treasuries with sterilization
If the Fed decided to sterilize the purchase of US Treasuries being repudiated, the market would immediately begin to discriminate between those banks who get the benefit of carrying Fed debt and those who donâ€™t. This is similar to what we see in the Eurozone: Deposits flee banks which are seen at risk of being caught on the wrong side of the tracks, should a break up of the Euro zone occur, to banks in the core of the Euro zone (i.e. banks with continuous access to liquidity lines of the European Central Bank). This arbitrage (why carry cash, which pays no interest, rather than Fed debt?) would drive all banks to buy distressed US Treasuries to make a difference exchanging them for Fed debt. This would be a very perverse process, because banks would drive deposit rates higher to maximize the sourcing of US Treasuries.
At this point, I am aware you may be confused: ItÂ doesn’tÂ seem to make sense to first assume that Treasuries are being repudiated and later say that banks seek to raise deposits to purchase them.Â But this makes perfect sense, when we realize that in this context, the market for US Treasuries would be simply broken, segmented.Â Only banks with the privilege of access to the Fedâ€™s window would be interested in US Treasuries, because only they would have access to the interest-paying debt of the Fed.Â The US Treasuries, effectively, would be marked to model by the Fed and as the private sector gets crowded out and deposits drop, the need for liquidity and profitability of the financial institutions would demand that higher interest be paid by the Fed on its debt.
You may ask why should the Fed be forced to pay higher rates, when the private sector would seem to be out of investment alternatives. First, we must remember that in this context, commodity prices would be rising and the nominal rate of return in gold would be a benchmark, just like simply holding US dollars in the â€˜80s was a benchmark shaping inflation expectations in Latin America. Secondly, the Fed would be forced to pay higher rates to keep deposits from dropping in a context of decreasing trust in the solvency of the banking system. Those living today in the periphery of the Euro zone understand this. Why should deposits not drop? Because if they do, more currency will be circulating and available to buy real assets (i.e. gold) and the outstanding stocks of US Treasuries being repudiated would not be cleared from the market into the balance sheet of the Fed. Their increasing yield (as the price drops) would be a price signal to the market that the Fed would have every reason to kill.
However, if the value of the US Treasuries falls and the interest the Fed has to pay to sterilize their purchase rises, the Fed will face a net interest loss. The Fed may chose to keep accumulating these losses or may also decide to simply convert its debt in legal tender, to end the arbitrage between currency (not paying interest) and its interest-paying debt. In the first case, we end up with a plain monetization of US Treasuries, which we just analyzed above. The second case (enforcing Fed debt as legal tender) would truly mark the end of the game in terms that would make historians of the 21stÂ century would devote entire volumesâ€¦
Why fiscal austerity would be irrelevant without a surplus
A logical outcome, which I think is clear from the two scenarios above, is that no matter how far the spending cuts go, the only way to compensate for the monetization of EXISTING INVENTORY of US Treasuries, is to reach a fiscal SURPLUS. Being only frugal wonâ€™t cut it!
In order to avoid being dragged to double digit inflation, there will have to be a fiscal surplus to offset the quasi fiscal deficit of the Fed. However, the implementation of austerity measures (i.e. spending cuts), will necessarily lead to a decrease in activity which would only be temporary if the same are accompanied by a widespread liberalization of markets. It is possible but unlikely, for reasons beyond the scope of this post. All sorts of negative feedback mechanisms could be triggered in this situation, only enhancing the repudiation of the US sovereign debt and the resolve of the Fed to monetize it (For instance, the so called Olivera-Tanzi effect postulates that as inflation rises, access to working capital is restricted and firms delay their tax payments, to get them devalued by inflation. The government therefore receives depreciated tax revenue while its operating costs increase, facing deficits that need to be further monetized, therebyÂ fuelingÂ even higher inflation).
In Argentina, this negative feedback was always resolved with the plain confiscation of citizensâ€™ assets: Savings accounts in 1989, chequing accounts in 2001, pension funds in 2008, etc. (I canâ€™t stress enough how important it is for anyone in the financial markets today to study the monetary developments in Argentina between 1972 and 1991)
Policy makers look the wrong way
The natural reaction from policy makers, so far, has not surprised me. Rather than addressing the source of the problem, they have and continue to attack the symptoms.Â The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free.
This problem truly brings western civilization back to the time of Plato, when there was nothingÂ â€œâ€¦worthy to be called knowledge that could be derived from the sensesâ€¦â€ and whenÂ â€œâ€¦the only real knowledge had to do with conceptsâ€¦â€.Â Â In the view of policy makers, Â the statement â€œthe probability of US sovereign default is zeroâ€ is genuine knowledge, but a statement such as â€œThe US government needs to issue about $100 billion per month to finance its fiscal deficitâ€ is so full of ambiguity and uncertainty that it cannot find a place in their universe of truthsâ€¦(Note: I am paraphrasing Bertrand Russell here. I am certainly not erudite)â€¦and just like since the beginning of the 17thÂ century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21stÂ century, we too will have to begin attacking anything supporting the belief that the issuer of the worldâ€™s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs. The following paragraph, from a speech by Paul Tucker (currently Deputy Governor at the Bank of England) says it all:
â€œâ€¦Two strategies come to mind which I am airing for debate. The first would be â€˜recapitalizingâ€™ the CCP (i.e. central clearing counterparty) so that it can carry on.Â The second would be to aim to bring off a more or less smooth unwinding of the CCPâ€™s book of transactionsâ€¦â€ Â P. Tucker, Bank of England, â€œClearing houses as system risk managersâ€, June 2011
Policy makers then believe in recapitalization and coercive smooth unwinds. With regards to recapitalization, I will just say that we are not facing a â€œstockâ€, but a â€œflowâ€ problem. US Treasuries would be repudiated because of fiscal deficits, which are flows. No matter how capitalized a clearinghouse is, once the repudiation starts, the break-up of the repo market and the short squeeze would unfold and develop. Whether there is or not a capital buffer is irrelevant to the problem. In fact, in my view, it would be better that thereÂ wasn’t: Why would you want to add more resources to a lost cause?
With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be Â anything but violent, like any other lie that is exposed by truth. Establishing restrictions to delay the unmasking would only make the unwinds even more violent and self-fulfilling. But these considerations, again, are foreign theÂ metaphysicsÂ of policy making in the 21stÂ century.