It was borrowed into existence – at absurdly low rates -- rather than earned.
Dublin, Ireland - “I think it is unlikely that the next policy rate move will be a hike,” said Jerome Powell. But why? US inflation is running about 100% above the Fed’s supposed target. Why cut rates rather than raise them? Herewith, we propose a hypothesis.
Last week, colleague Tom Dyson gave us a simple way to connect the dots. We are near the end of the biggest financial experiment in history, he says. Condensing the following 700 words to just five: central bankers cannot resist temptation. In 1971, guided by Milton Friedman, the US did something extraordinary. It changed the whole world’s money system. And few people even noticed.
At issue was whether the US dollar system could be managed better by professionals — Ph.Ds with more discretion over interest rates and other banking policies - so as to improve capitalism. The gold-backed dollar wasn’t easily managed at all. You can’t just ‘print’ gold. You had to mine it. And ship it. And store it. And in the end, you were lucky if the supply of new gold-backed money kept even with supplies of other goods and services in the real economy.
Not a bad thing. The dollar was fairly stable... and hard to diddle. In 1913 - when the Fed was created - a dollar was worth almost exactly as much as it had been 100 years before. But the system limited the amount that US policymakers could spend.
Temptation too much: The new system changed that. Gold was out. The Fed could create money on demand. In 2002, Ben Bernanke explained: “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” But could ordinary humans be trusted to resist the temptation to print too much? The answer, now in, is ‘no.’
This experiment was not new. ‘Paper’ or ‘monopoly’ money systems have come, and gone, many times. The coming was always fun - people had more to spend. It was the ‘going’ that was painful - often ending in depression, war or revolution.
After WWI, Germany was faced with huge war debts. It switched to paper money with no gold backing. By 1923, it took 4,210,500,000,000 marks to buy one dollar.
France in 1960, after years of excess money printing, had to replace the old franc with a new one, at 100 to 1. China... Yugoslavia... Argentina... Zimbabwe... Lebanon - all were social, political and financial catastrophes.
Inflation in Germany led to such widespread discontent that gangs battled it out in the streets; Adolf Hitler’s national socialists won those street brawls and took over the country. Russia’s financial instability led to the Bolshevik Revolution in 1917. Chinese inflation in the 1940s brought Mao Tse-tung to power.
On August 15, 1971, in the US, came the Nixon Shock. The new dollar looked just like the old one. But it no longer represented an asset - a dollar backed by gold; now it was essentially an IOU, a ‘federal reserve note,’ issued by a federal reserve bank. Most economists nodded in approval. The public nodded off.
It’s now 2024 - 53 years later. In 1971, US debt reached $400 billion. Even nine years later, it was still only $800 billion. At that level, the Fed’s last honest chief, Paul Volcker, could still fight inflation with extraordinarily high interest rates. His top Fed rate — 20% in June of 1981 — caused the worst downturn since the Great Depression. That is what it took to wring inflation out of the system. It was a heroic move. Politicians and economists squealed. Volcker was widely despised. He was burned in effigy on the Capitol steps and denounced by thousands of economists.
And today? A 20% Fed Funds rate would be impossible. Here’s why. After Volcker’s save, cheaper and cheaper credit made it profitable to borrow and speculate like never before. Consumers, businesses, investors, and the government all went deeper and deeper into debt. They bought bigger houses, better cars, more fighter jets and aircraft carriers... mergers and acquisitions... dotcoms... cryptos — whee!
A subtle corruption infected the whole financial system. The new money was a credit from the banks, not an asset. It was borrowed into existence – at absurdly low rates - rather than earned. Who could borrow it most cheaply? Big, credit-worthy institutions — big banks, big business, and big government. That’s how firms like BlackRock were able to outbid families and buy up thousands of homes; they could borrow at lower interest rates.
At 10%... debt payments would quickly absorb all income tax receipts. At 20%, all Hell would break loose immediately.
What this means is that the Fed can no longer ‘save the system.’ It can’t afford to. There’s too much debt. Floating on a tide of ultra-low interest rates, debt seemed almost weightless. But the farther out to sea it floated, the harder it was to get back onto dry land. Today, even a 10% fed funds rate - half the level of 1981 - would be so devastating the Fed wouldn’t dare to try it.
Today, there is $34.6 trillion in federal debt, rising by more than $120 billion per month. And the Treasury, trying to keep its debt payments down, is choosing shorter- and shorter-term debt - 2-year notes, rather than 10- year bonds, for example. The result is that more of the total debt gets ‘marked to market’ each year. And the whole lot of it becomes more sensitive to interest rates.
Instead, its real goal is not to eliminate inflation, but to manage it... to ‘monetize the debt’ - reducing its real value with sustained price increases. But to do so, inflation must be higher than the rate of new debt creation. US debt is galloping along at nearly 7% of GDP per year. The inflation reading needs to get up to that level... and stay there. That’s the real reason the Fed is talking about cutting interest rates rather than increasing them. But watch out. Trying to manage inflation is like trying to control a block party in a bad neighborhood. The bullets could fly at any moment. Stay tuned..."
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