What if the Fed Replaced all Debt with Cash?

Executive Summary – today I discuss the implications of the Fed’s money printing operations (QE), and what would happen if the Fed replaced all debt with cash, as outlined in a separate (linked) story. The net of it is that the Fed will have considered their activities a success if asset prices oscillate around, neither rising too much, or falling too much. Clearly, they want the economy to return to full employment, but that could just be beyond the reach of monetary policy.


* A great deal of uncertainty – with only two weeks before the upcoming elections, and a Fed meeting which the markets will be greatly anticipating only a day later, there is an amazing amount of optimism floating around the markets. Or put another way, as the Fed engineers even lower rates, money is being forced to go to other non-cash investments. By making and keeping interest rates low, the Fed is discouraging savings, at a time when there is still a great deal of debt outstanding, which should, or might be forced, to be paid down. In other words, the Fed is desperately trying to force investors to keep as much money as they can invested in the markets, even to the point of encouraging them to use leverage to keep asset prices as inflated as possible.


By simple supply and demand metrics, the more dollars that are created, the cheaper the dollar is supposed to get. The world is awash in dollars, and the Fed, the biggest money printing machine our planet has ever seen, is going to do what they need to, to keep the economy inflated to a certain level. At a very minimum, the government will print enough money to fill in the holes left behind by the losses of the credit collapse. For example, losses absorbed by banks going out of business are being borne by the FDIC, which in turn goes back to the government. This proud institution is at a $20 billion deficit, and has had to collect premium payments from the banking system, three years in advance, in order to have enough cash to shut down banks at the pace it is doing so.


The US treasury has absorbed over $200 billion of losses on FNMA and FHLMC so far, which in turn has been raised by the sale of debt, which was then bought by the Fed, which has printed money in order to buy that debt. I realize that the connection is not necessarily so direct, except for the fact that in the end, you CAN say that the Fed is printing money to pay for losses borne by the GSE’s. How will future losses get paid for by the government?


While FinReg suggests that private investors will bear the losses of a failed institution in the future, will the government have the chutzpah to let Citibank or B of A fail, as they almost did in 2009? What would be the repercussions to private investors if the public debt of a bank as big as Citibank is allowed to go bad? The popular press loves to talk about how bad it was when the government allowed Lehman to go out of business, while very little is said about the moral hazard the government has promoted by virtue of their rescuing AIG, Citibank, BofA, Bear Stearns, and many other institutions which should have been allowed to go out of business. Instead, the government has created an environment where the public distrusts big businesses by virtue of the fact that the government chose to let failing institutions stay in business, complete with a very large payroll.


The point I am making is whether you believe the government will let a large institution fail, and leave a swath of losses amongst investors, or not, there will be holes left behind after such an event. Will the government be able to fill in these holes if it is to stick to the presumption under FinReg that private investors need to bear the losses. If the government does stick to its guns, and losses are borne throughout the system, then what will the government need to do to resuscitate the economy which will now be reeling from absorbing those types of losses. This would be the deflationary depression sort of scenario.


My guess is that despite FinReg, the US government is going to find ways to absorb loan losses onto its own balance sheet, and income statement. By one means or another, the Fed will print money which will be required to assure the world that there will never be a liquidity problem in the US. What if Citibank goes down, as it almost did in 2009? Do you think anyone in any administration is up for the confusion which will result if tens of thousands of interest rate and credit derivatives, worth trillions of dollars, needs to be re-assigned, or torn up? The reason why the government never took over Citibank in 2009 was because the enterprise was too big and complex to successfully endure a change of control.


What makes me think that anything so remote as a Citibank failure could possibly occur? It would have happened in 2009 if not for the government. But haven’t the banks recapitalized themselves and can now withstand a future of turmoil? So the government wants you to believe. Of course, accounting for distressed assets on a mark to market basis has been thrown out the window, so who cares if the numbers the banks are reporting are inaccurate, just so long as your government is there to protect us.


Maybe future debt de-leveraging will come in the form of a sovereign debt crisis, with foreigners selling our treasury debt. If that is the case, the money printing mechanism is quite easy, as the Fed could just buy as much treasury debt as is needed to keep interest rates at a certain level. During James Bullard’s CNBC 3 hour interview on October 8th, he stated that there is no way that the Fed would ever buy up all the treasury debt there was. It is way too hypothetical to imagine what such a scenario might look like, and how the government would choose to respond. The government would certainly print money than let the threat of higher US interest rates derail the economy, as well as prevent the loss of confidence which concerns about our ability to repay our debts would engender.


How much money can the government print? As much as they need to is the answer, in my opinion. This leads me to an article which paints a hypothetical scenario, in which the US government prints as much money as is needed to replace the amount of debt in the US. Will it come down to tens of trillions of dollars, as this article suggests:


LINK`http`beforeitsnews.com/story/195/968/Ultimate_Bailout:_The_100_Trillion_Cram_Down.html`line-height: 1.2em; text-decoration: underline; color: rgb(0, 51, 153); outline-style: none; outline-width: initial; outline-color: initial; `LINK 


The punch-line is that the government might need to print many trillions of dollars of new cash to save the next “too big to fail” institution. This leaves me at the point where I debate the push and the pull between the deflationary headwinds of unwinding an over-leveraged debt burden throughout the world, and the response by the governments around the world, to fight the deflationary forces through re-flationary tactics.


Clearly the governments have been successful in combating deflation by pushing the burden (losses and assumption) of private debts onto the government’s balance sheet. At the same time, they have started printing money to help fill the holes as well. What I find most remarkable in the current environment, is that the Fed has continued this campaign, by engaging in a discussion ahead of plans for more QE. And of course it sounds allot more palatable for the Fed to say they are engaging in QE, rather than printing money.


As I have stated in previous blogs, I come out on the side of thinking that deflation will prevail, and asset prices collapse. However, this has been a losing strategy for the last 18 months, although it has been the correct strategy for the last 3 years. The best strategy would have been to switch from managing assets for a deflationary collapse for the first 18 months (Oct 2007 to March 2009), and to then position oneself for rising asset markets and prices.


The beauty about the “Before Its News” story, is that it suggests that the government should replace all debt with cash. Debt service would no longer be a problem to be reckoned with, and the world will be awash in dollars, albeit, many more of them. Clearly that is an extreme position too, which I consider unlikely, yet the reality is that something between a deflationary collapse and the printing of tens of trillions of new dollars, will likely occur. This will lead to a push me-pull you sort of outcome in the asset markets; up for a length of time, then down. And all throughout this, the inflation/deflation debate will continue. I am sure that the Fed would consider an oscillating asset market, as opposed to a sinking one, as a victory. While an inflation fueled rally in all asset prices would obviously mean that they have applied too much stimulus.  Clearly, they want the economy to return to full employment, but that is beyond the reach of monetary policy, in my opinion.


* CRE redux – last week I cited comments by a CRE (commercial real estate) professional who talked about “good” properties selling for a 5% cap rate (or return). I received a fair amount of resistance from a few readers that only the very best properties sell at such a low cap rate. The reality is that many other properties which are not considered in such high regard, sell at higher cap rates than 5%. It was suggested that some properties sell at a 15% rate, which I have been told could only happen if the expected return estimates did not make any allowance for losses. While we can debate the exact returns for less prominent pieces of CRE, the bottom line is that this market has returned from an abyss. Where the bloom has been taken off the rose for these markets has more to do with the economics of a particular piece of property, than the cap rates. If you own a strip mall in a location where many layoffs have occurred, then chances are that the value of your property is down considerably, as are your rents.