On August 26, the world’s investors were holding their breath before the Federal Reserve chairman ascended to the stage. They were anxiously looking to hear two words. Quantitative Easing. So there was a sign of relief when those words didn’t come out of Ben Bernanke’s mouth. As a matter of fact he proposed no new steps to boost the economy. But how can that be? With a ballooning federal debt and no sign of economic recovery, the federal government must surely be desperate. The debt ceiling has been raised to accommodate the increase of new federal debt, and the Central Bank has been assigned the responsibility to find the funding solution, but its name cannot be Quantitative Easing. And why is that? Because by now most of the people know that QE stands for newly created (out of thin air) money. The world’s investors know that expansion of the money supply leads to inflation and the debasement of the dollar. They also know that if we have to print more money we must not have our economic house in order.
A while back I wrote an article about one of the most important factors that could trigger hyperinflation without much warning to the American people. I describe how banks are currently holding over $1 trillion in excess reserves and why lending has contracted. If banks start lending out at their full potential – via the fractional reserve banking system – the money stock could be increased by a factor of six. Does a $18 per gallon of oil sound exciting to you? It is obvious it would be devastating to most Americans because the resulting massive inflation would erode people’s savings and drastically reduce the purchasing power and standard of living.
In normal circumstances the banks excess reserves would be at a few tens of billions. But the current high levels of $1.76 trillion are reflective of banks’ reluctance to lend and qualified borrowers unwilling to borrow. So the answer to the federal government budget deficit lies in these reserves, which are now significant in the success of the Federal Reserve’s new scheme. Remember why QE is not the desirable solution? Simply because just about everyone understands the perversity of such a program. So why not call it RRP (Reverse Repurchase or Reverse Repo)? After all, very few understand the repercussions of credit expansion and when you add fancy terms such as Reverse Repurchase the world can be fooled a little longer. Make no mistake, QE or RRP, the end result is still the same.
For just a moment pretend that I am in serious debt due to a lavishing lifestyle and I come to you asking for help. Because I am a person of known importance in my community my promises have become legal contracts. Simply put, I have the authority to create a financial asset (bond) out of my promises to repay. So, I offer to sell you my newly created financial assets today with an agreement that I will buy them back at a fixed price at a future date. Because you cannot provide the amount of money I need (to support my lifestyle) you borrow money from the bank. This sounds like a good deal to you as long as the interest that you receive from me is higher than the interest you pay to the bank. When time comes and I buy back from you the financial assets, I will pay you the initially agreed upon purchase price (possibly higher) plus interest at which time you should be able to repay the loan to the bank and make a nice profit. But the question is what happens if, in the near future, I become bankrupt and I cannot keep my promise? It is obvious that the financial assets that you hold will also become worthless so you most likely won’t be able to sell them to repay the bank loan.
Now hold this thought because in real life the seller of the financial assets (created out of thin air) is the federal government and the buyers are Fannie Mae, Goldman Sachs and the rest of the institutions from the NY Fed’s Reverse Repo Counterparties List. The banks are currently holding $1.76 trillion of excess reserves with the Federal Reserve for which are being guaranteed a yield of 25 basis points. Finally someone found the solution to put these funds to “good” use. All that is required for this program to work is the interest rate certainty, assurance that Bernanke already gave not long ago when he announced the rates would be kept close to zero for the next two years. Lending these reserves through the fractional reserve system is inflationary regardless whether it’s the private sector or the government that receives them. The scary thought however is the large appetite the federal government has and its unwillingness to tighten its belt, appetite that the already impoverished Americans and the future generations will have to feed.