Not Even Harry Browne Thought It Was Going To Be This Bad

[moda0306]

The fed owning bonds is not like some counterfeiter. It's part of the currency-issuing mechanism. Government bonds are fiat paper that are claims on fiat paper. They're not fundamentally different than dollars.

[MediumTex]

D1984,

I guess if interest rates started rising, inflation was low, gold started falling, stocks were doing well (but not TOO well) and t-bills weren't benefiting from interest rates rising TOO high, then for that period the PP might not do well.

I'm still not sure exactly why interest rates would keep rising, though.  I can see them rising a few hundred basis points as the economy strengthened, but then I would expect them to trade in a range and not just keep rising.  In other words, bonds might deliver a year or two of negative returns, but I wouldn't expect that to keep going for years and years (but I guess it could).  After you had absorbed the bond losses as interest rates reset to a higher level, though, you would then be able to enjoy higher interest payments as bonds found their new higher interest rate range.

[MediumTex]

For people who think what the Fed is doing will end in inflation sooner or later, how do you explain the Japan experiment, which is probably about ten years farther along than the Fed experiment and doesn't appear to have translated into dramatic inflation or weakening of the yen.

Why would similar policies in the U.S. lead to a different outcome here?

I also wonder about where the money would come from for U.S. consumers to pay higher prices if wages aren't rising because upward pressure on U.S. wages translates into more offshoring of jobs rather than an upward wage spiral that allows high inflation to gain traction and sustain itself.

[Libertarian666]

Here's a more accurate example:

1. You have an eccentric uncle who happens to be a very good counterfeiter.
2. You own a bond worth $1,000.
3. He asks to buy the bond from you.
4. You oblige; he prints $1,000 and takes your bond.
5. He burns the bond.
6. The $1,000 is such a good counterfeit that nobody ever notices. You proceed to use it to buy things; maybe even a new bond!

If your uncle sold the bond and used that money to buy ammo, then yes, you're right. But he doesn't. He always destroys the bonds that you sell him. What a weird guy.

So the Fed burns the bonds that they buy? That means someone has hacked the Fed website, which shows a GIGANTIC increase in their balance sheet over the last year:

http://www.federalreserve.gov/releases/ ... nt/h41.htm

Someone has to warn them!

[Gumby]

But here's the complete version:

1. You have an uncle who likes to spend more than he earns.
2. He asks you to lend him 4 quarters.
3. You lend him the 4 quarters, and he gives you an IOU.
4. You sell the IOU to me for a freshly printed dollar bill.
5. Your uncle spends the four quarters to buy ammo.

What is the result of all this? Yes, you have the same amount of money as before and I have the IOU, which I am keeping and not circulating.
But we are forgetting something: that the people that your uncle bought the ammo from have an additional $1 that never existed before I printed it. Thus, the total amount of money in circulation has been increased by $1.

Correct. However, what you're overlooking is that the IOU is an asset. The IOU is as good as cash (if not better). Therefore, your conversion of my uncle's IOU into cash did not increase the net financial assets in this story — the IOU did. In fact, you would not be able to perform the swap without the very existence of the newly created IOU asset in the first place.

Furthermore, his spending the 4 quarters to buy ammo provides 4 quarters that will eventually be lent back to him — which enables him to write another net IOU. If we keep repeating that, we see that it's really his IOUs that are increasing the net financial assets in this story — not your swaps. If the IOUs become unusable once they enter your possession, then all your swaps are doing is changing the liquidity of his IOUs.

[Pointedstick]

So the Fed burns the bonds that they buy? That means someone has hacked the Fed website, which shows a GIGANTIC increase in their balance sheet over the last year:

http://www.federalreserve.gov/releases/ ... nt/h41.htm

Someone has to warn them!

It's possible I'm not understanding the mechanics here as well as Gumby or Moda, but my sense is that once the Fed has the bonds, they're removed from the economy because the Fed is a government entity that does not use them to purchase anything, and remits all interest payments it receives on those bonds from the treasury ... right back to the treasury.

I guess the real question is whether you consider the Fed and the federal government to be market participants whose balance sheets affect the economy, or outside entities that manipulate the market and whose own balance sheets are not relevant; only their spending is.

[Libertarian666]

So the Fed burns the bonds that they buy? That means someone has hacked the Fed website, which shows a GIGANTIC increase in their balance sheet over the last year:

http://www.federalreserve.gov/releases/ ... nt/h41.htm

Someone has to warn them!

It's possible I'm not understanding the mechanics here as well as Gumby or Moda, but my sense is that once the Fed has the bonds, they're removed from the economy because the Fed is a government entity that does not use them to purchase anything, and remits all interest payments it receives on those bonds from the treasury ... right back to the treasury.

I guess the real question is whether you consider the Fed and the federal government to be market participants whose balance sheets affect the economy, or outside entities that manipulate the market and whose own balance sheets are not relevant; only their spending is.

I suppose one can take the position that it is the government's borrowing that creates money rather than the Fed's buying their bonds, and that the amount of bonds issued is irrelevant so long as the Fed buys (virtually) all of them. However, this does not solve the problem of what happens if the Fed ever stops buying the bonds (even if they never sell the ones they have). My position is that such an event would cause a stock and bond market crash, as if the Fed withdraws there is no one else to buy those bonds at anything resembling current interest rates. A 10% treasury rate would certainly add hundreds of billions to the deficit and would almost certainly drive the stock market down 50% or more.

Assuming that the Fed never stops, then we have another question, which is whether the government will ever reach a limit as to how much real wealth they can extract from the world economy. If there is no limit, then that would be the first time in history. My position is that there indeed is such a limit and that the limit is the point at which the dollar loses all its value.

My prediction is that they will never stop because they are more afraid of the first consequence above than of the second one. But one of these two outcomes will arrive one of these days. And I don't want to be holding either US debt or stocks when it does.

[Gumby]

So the Fed burns the bonds that they buy?

Not literally, of course. The point is that once the bonds are in the possession of the Fed, they have ZERO effect on the private sector's ability to spend. They might as well have been burned...or buried in a hole.

Think of it this way...

If you walked into a laundromat and stuck a $20 T-Bond into a change machine, and a whole bunch of quarters started pouring out everywhere, I suppose you might believe that you just hit the jackpot. Yippee! High-fives all around. Drinks on the house.

But, the fact of the matter is that despite all the quarters spilling onto the floor, all the people in the laundromat — including yourself — are no richer. And that T-Bond you stuck in the machine can no longer be used to barter for anything in the laundromat. For all practical purposes, the change machine might as well have burned the T-Bond. No inflation takes place within the laundromat.

Make sense?

Oh and the T-Bond you stuck in the machine no longer provides you with any future interest income. You just have a bunch of lousy quarters. Oh well.

[Gumby]

I suppose one can take the position that it is the government's borrowing that creates money rather than the Fed's buying their bonds

Excellent. Now we're making progress.

and that the amount of bonds issued is irrelevant so long as the Fed buys (virtually) all of them.

Nope. Completely unnecessary. The private sector always has the money to buy future bonds because every time the government issues a bond, it is also deficit-spending money into the private sector — and that government spending is used to buy future bonds. (If the spending is delayed, the Fed just provides a temporary loan until the reserves arrive). In other words, the Treasury bond auctions just act as reserve drains. Government spending swells excess reserves and the bond auctions drain those excess reserves. Easy peasy.

However, this does not solve the problem of what happens if the Fed ever stops buying the bonds

We already answered that.

http://pragcap.com/who-will-buy-the-bonds

...And we know he's correct because that's exactly what happened when QE2 ended. He nailed it and all the fear-mongerers were proven wrong.

[Libertarian666]

I suppose one can take the position that it is the government's borrowing that creates money rather than the Fed's buying their bonds,

That's how I look at it.

and that the amount of bonds issued is irrelevant so long as the Fed buys (virtually) all of them.

No.  These are bought by primary dealers.  See Gumby's post 71409 for a sample of auction results.  More recent results can be found here.

...another question, which is whether the government will ever reach a limit as to how much real wealth they can extract from the world economy.

Of course there is a limit.  But please do not confuse wealth with money.  The real wealth of the U.S. is its people, resources, and productive capacity.  If the government commandeers too much productive capacity, then of course this will be bad.

Also, if the relationship between money (too much) and production (not enough) gets out of whack, there will be inflation.  The more out of whack, the more inflation.  This is a real constraint.

But fiat dollars in and of themselves?  There is no inherent constraint.

The Fed is indeed buying almost all of the bonds. Yes, they buy them from dealers, but that is irrelevant. The dealers know the Fed is going to buy them, so they don't care what they pay.

"Treasury Scarcity to Grow as Fed Buys 90% of New Bonds"
http://www.bloomberg.com/news/2012-12-0 ... bonds.html

I am not confusing wealth with money. If there are too many dollars printed (whether by the Fed or the government does not matter), then no one will want to lend them, especially at a low interest rate, because they will expect them to lose value. Instead, they will buy gold or some other asset that cannot be created out of thin air. This is elementary economics. See Zimbabwe for a recent example.

Anyway, we are going over the same ground again and again. I'm not going to convince you, and you certainly aren't going to convince me. We will see soon enough who is right; until then, I don't see any reason to continue a fruitless discussion.

[MediumTex]

I suppose one can take the position that it is the government's borrowing that creates money rather than the Fed's buying their bonds, and that the amount of bonds issued is irrelevant so long as the Fed buys (virtually) all of them. However, this does not solve the problem of what happens if the Fed ever stops buying the bonds (even if they never sell the ones they have). My position is that such an event would cause a stock and bond market crash, as if the Fed withdraws there is no one else to buy those bonds at anything resembling current interest rates.

Here are the current rates on the 10 year and 30 year bond in the following countries:

U.S.: 2.63% / 3.64%

U.K.: 2.43% / 3.61%

Germany: 1.65% / 2.45%

Japan: .86% / 1.86%

Do you notice something about those figures?  Interest rates are low all over the world in major developed economies.  It's not just the U.S.

It's true that central banks in these countries are probably doing everything they can to keep rates low, but it seems odd to me that they are all succeeding so spectacularly if rates would be much higher but for their intervention.

An alternative explanation is that maybe there are a set of powerful deflationary economic forces at work in the form of demographic changes in these countries when combined with the credit contraction associated with the aftermath of a financial crisis.

In my opinion, interest rates might be 100-200 basis points higher without central bank meddling, but probably not much more.

This is just my take on things, but I think that people often assume that it's only the U.S. that is experiencing ridiculously low interest rates without realizing that of the four countries above the U.S. is the one with the highest rates as you get farther out on the yield curve.

I believe that rates on treasuries are more likely to head down from current levels than up.

[Pointedstick]

Anyway, we are going over the same ground again and again. I'm not going to convince you, and you certainly aren't going to convince me. We will see soon enough who is right; until then, I don't see any reason to continue a fruitless discussion.

Well, with an attitude like that, what's the point of even engaging? If you enter a discussion with the presumption that you're right and your position needs to be defended at all costs, there's not really any point in having it.

Why not keep an open mind?

[moda0306]

The fact that the fed has to engage the member banks the way they do is a relic of the gold standard system. Simply by stating they want the rate to be something they could probably make it happen.

The unanswered question still seems to be... Why does a currency issuer need to issue bonds?  What is fundamentally different about a private sector that holds a few hundred billion in nominal confetti issued by government vs a few hundred billion in interest-bearing nominal confetti issued by government?

Tech, you seem to want to avoid answering questions that lead to thoughts that don't fit how you've been informed to think about money.

God I wish the federal government would just draft a law making treasury bonds actual legal tender so we could just collectively shrug and move on to whether grains are toxic.

[MediumTex]

Anyway, we are going over the same ground again and again. I'm not going to convince you, and you certainly aren't going to convince me. We will see soon enough who is right; until then, I don't see any reason to continue a fruitless discussion.

Well, with an attitude like that, what's the point of even engaging? If you enter a discussion with the presumption that you're right and your position needs to be defended at all costs, there's not really any point in having it.

Why not keep an open mind?

Many of us here started where Libertarian666 is at now and our thinking just sort of evolved as the discussion progressed.

I am completely sympathetic to Libertarian666's views having once held them myself.  I would urge him to continue discussing these topics with the rest of us.  The worst thing that can happen is that he will get a more nuanced understanding of his own beliefs and at best he might learn something that he doesn't currently know.

We've had this same discussion many times and it never gets old. 

I hope he will re-engage, but if he thinks it's a waste of his time that's cool as well.  We're all friends here.

[moda0306]

Most of us were deficit hawks at one time.

Most of us saw the fed printing money as a huge market distortion that's bound to cause inflation at one time.

This does doesn't seem to make sense until it does.  And then it makes perfect sense. Not that everyone converts, but most do.

We're so utterly trained to look at this from the standpoint of a currency user with a counterfeiting machine.  It's healthy to have a skepticism of government "cheating."  However, it's all much closer to a bank-dominated chartalist system that dances a lot like a fractional gold reserve standard system that we have to completely rewire our thinking to understand it.

[moda0306]

I'll add, the government being in the monopoly business of money, as a sovereign individual with half a brain, is one of the easiest things to get around.  Far easier than taxes, war, police, etc.

As a sovereign individual, all I have to do to protect myself against debasement is to hold just enough cash in my account to pay bills, don't engage in any long-term fixed nominal income profit ventures, borrow with long-term debt to buy useful hard assets and real estate, hold some gold, maybe invest in any one of many foreign currency options that I have or bitcoin, etc.

This isn't rocket surgery in 2013.  It's quite easy to not only avoid debasement and artificially low interest rates, but even put yourself in a position to benefit from it.

The problem is, when you realize that rates are naturally low, bonds are practically money and we're not being debased, doing all I mentioned could actually lose you a lot of money.  That's why I really DON'T want to be wrong about this. 

I care more about keeping my money than winning political debates.  Trust me, I wish you were right in some greedy ways.  If I knew an inflationary collapse was coming, since it's obvious as hell the market doesn't think it's going to happen, I could stand to make an absolute f*ckload in real terms just by poising myself right. I don't take that opportunity lightly.

[Gumby]

The Fed is indeed buying almost all of the bonds. Yes, they buy them from dealers, but that is irrelevant. The dealers know the Fed is going to buy them, so they don't care what they pay.

What you are missing is that there is a tremendous demand for a Treasury Bond. They are the world's safest paper. If the private credit market is $57 trillion, and there only exists about $16 trillion in interest bearing T-Bonds, then you can bet that savers will want to hold those T-Bonds.

It makes no difference if the Fed buys the bonds or not. The Primary Dealers would rather hold on to interest-bearing T-Bonds than cash. Savers would rather hold on to T-Bonds than cash. Cash stinks unless you need immediate liquidity.

You keep wondering who will buy the bonds if the Fed does not purchase them. We already answered that...

http://pragcap.com/who-will-buy-the-bonds

Anyone who owns a savings account will be a T-Bond buyer whether they know it or not. When the government spends, it swells savings accounts. And those savings accounts are used to buy T-Bonds whether the holders realize it or not. Unlike Euro nations — whose bonds compete against each other — US T-Bonds have no other dollar-denominated competition. They are the only choice for dollar-denominated saving. So, every auction is a slam dunk...every time.

There is never a risk of T-Bond auctions failing so long as people want to hold savings accounts. It makes no difference if the Fed buys the bonds or not. We know this because demand for T-Bonds only increased after the Fed stopped buying T-Bonds when QE2 ended. The fear mongerers were proven wrong.

[Gumby]

Many of us here started where Libertarian666 is at now and our thinking just sort of evolved as the discussion progressed.

I am completely sympathetic to Libertarian666's views having once held them myself.

Yes, I agree. At one time I too used to believe that the government could run out of money and that bond auctions could fail. But when I took the time to walk through the operational steps of how our monetary system works, it became painfully obvious that our debt-based fiat monetary system was set up in such a way that it could not fail from an operational standpoint. They made the bond auctions like shooting fish in a barrel. (Austrians miss this entirely because their textbooks are all based on a gold standard, which no longer exists).

The auctions are essentially rigged, for all practical purposes. And the market knows it (while the media is still using pre-fiat logic).

While I totally understand why someone like Libertarian666 mistrusts our government (he raises some good points there), at the same time I'm surprised that he is unwilling to see that the very game that keeps our government in power has already been rigged to keep them in power indefinitely. I mean, I hope he doesn't believe that the government willingly allows itself to risk its own ability to govern every time it has a bond auction. That would be pretty dumb.

No, the government essentially sets up the bond auctions so that they always go off without a hitch — whether the Fed is a participant or not — and the politicians never have to worry about losing their power.

See? You don't have to be a government-trusting liberal to understand how the system works.

[moda0306]

I really think if Austrians didn't have such a deep moral/political fight that they want to fight, they would have a much easier time seeing the light.

They are literally being blinded by their moral plight.  I mean if you've gone your whole life thinking you're essentially a slave to the fed and have been thieveried from as a responsible saver, it can be hard to look at the system as something that has at many points rewarded savers with very lucrative real returns without having to take any nominal risk.

Admitting MR is correct would mean that an Austrian's plight was mostly a myth.  People don't like to concede that kind of "wrongness," especially if we've held these views for a long time. 

I'm not saying there aren't still some huge moral issues with the current system, but it becomes a lot more of a nuanced discussion rather than "95% of my savings have been stolen from government via inflation since 1913" or whatever the common wisdom is.

[moda0306]

Culture and morality intertwine.  The Austrian culture is one that enjoys their co-complaining and scheming of how to avoid their plight of government tyranny.  Their moral superiority creates a culture that is very strong.  Their culture creates a groupthink as well that reinforces their moral plight.

But I think it is a moral position first and foremost.  "Live and let live... No questions asked" is a very appealing and wonderfully simple moral structure and it would be easy to get behind it militantly (verbally, not literally).  Of course, pure freedom is complicated by us having been plopped on a big island with limited natural resources to share.

The food stuff is different, except where it's not.  I think vegans have, in part, a very tight moral plight with their hatred of factory farming.  However, they allow this to color their views on whether meat is healthy for humans. They're allowing their moral stance, reinforced by culture, to affect their interpretation of the science of nutrition.

[Libertarian666]

So it is okay on this forum to imply that Austrians are mentally unbalanced or emotionally immature? I guess that tells me all I need to know about the "civility" that we are supposed to engage in here.

[Gumby]

So it is okay on this forum to imply that Austrians are mentally unbalanced or emotionally immature? I guess that tells me all I need to know about the "civility" that we are supposed to engage in here.

Uh no. Nobody ever said or implied those things.

Surely you can have a high-level conversation about these concepts without taking everything so personally? (Your name isn't 'Ludwig von Mises' is it?) So, I assume you have the ability to objectively examine your own beliefs — as we all have done before. We didn't all used to believe these concepts. We examined them and our thinking evolved.

The fact of the matter is that the Austrians look at our currency as if it has a reserve constraint — as if it were still tied to a gold standard. They didn't update their dusty old textbooks once the currency lost its ties to gold, despite the fact that the currency became free-floating and operated differently after 1972. To add to the confusion. many of the legacy gold-standard laws were never updated by Congress (such as bond auctions). So, this only confused the Austrians even more as the Fed and Treasury unpegged the currency and stuck to the letter of the legacy laws.

This isn't a criticism of the Austrians so much as its a criticism of their outdated textbooks.

So, no, Austrians are not "mentally unbalanced" or "emotionally immature". Nobody here would ever say that. And you really shouldn't claim that we implied it. We didn't. Nobody did.

[systemskeptic]

Can you elaborate on why you think they are dangerous?

Is there an economic condition that the PP doesn't cover?

I doubt there are any examples that I can provide that would be new to you, so it's not really a question of new information but rather existing.  As an example, your response to D1984.

You seem to be holding the view, if I may summarize: "I have covered all the bases, so nothing can possibly go wrong"  again, fundamentally I think this is very dangerous.

Like you, I have an asset allocation that matches my view of the world and where it is going, and I feel is greatly diversified.  One difference I see in our perspectives is I accept that there are still many scenarios that could unfold that would result in poor performance, even devastating performance, over 5, 10, 20, 30 year periods.

To address your second point: in the view of many on this board, a US PP performs in "all economic conditions" yet to my view it only performs in two:  US prosperity and geopolitical/currency crisis.  The short of it is the world (and all it's invest-able assets) is far too big of a place for any investment to be as risk-free as you seem to believe. 

Again, just an opinion and an observation.

[Libertarian666]

Ok, so then this would be an acceptable post? If you say so.

-------------------
I really think if "monetary realists" didn't have such a deep reluctance to admit the tail risks they are ignoring, they would have a much easier time seeing the light.

They are literally being blinded by their inability to admit that their portfolio could be demolished by a freeze-up of the US financial system.  I mean if you've gone your whole life thinking you're essentially safe in believing that the US empire is different from every other one in history, it can be hard to look at the system as one that could collapse without warning and leave your "safe portfolio" in ruins.

Admitting Austrian economics is correct would mean that a "monetary realist's" belief in the stability of the financial system was mostly a myth.  People don't like to concede that kind of "wrongness," especially if we've held these views for a long time. 

I'm not saying there isn't some life left in the current system, but it becomes a lot more of a nuanced discussion rather than "tail risks in the current system can be safely ignored" or whatever the common wisdom is.

[MediumTex]

So it is okay on this forum to imply that Austrians are mentally unbalanced or emotionally immature? I guess that tells me all I need to know about the "civility" that we are supposed to engage in here.

Just to clarify, I think that Ludwig von Mises was one of the deepest and most insightful thinkers in the entire field of economics.

He was as close to a true economic philosopher as you are ever likely to find.

I just think that there has been a paradigm shift in monetary arrangements that has rendered some of von Mises' conclusions obsolete, but it takes nothing away from the fact that he was an outstanding thinker.