RCM Reprint: Quantitative Easing by Karl Denninger

RCM Comment: We have been writing in this blog over the past few months about the inevitability of reaching the quantitative easing phase of this credit crisis. Well, here we are! The last Fed meeting ushered in an era of quantitative easing perhaps never seen before in history. In light of this sad fact we here at RCM feel it necessary to reprint this piece written by Karl Denninger of the blog The Market Ticker. Karl offers a comprehensive explanation of quantitative easing and how it works, or in this case, will not work.

Let's first talk about what "Quantitative Easing" IS.

That phrase applies to a central bank (in this case our Fed) lowering interest rates to zero. You can't lower rates below zero, so what comes next is to "quantitatively" ease money - that is, "in quantity" print up reserves and buy "assets", thereby throwing yet more money into the economy.

In theory, anyway. See, the economic theory is that when you lower interest rates people want to borrow more money, because it's cheaper to do so. Therefore, when you want the economy to expand (faster) you lower interest rates, which makes it more likely that people will borrow.
When people borrow they either spend or invest those funds, and both produce more GDP. If I buy a new flatscreen TV on credit that counts in the GDP of the economy, as does the farmer who borrows to buy seed and grows a crop of corn.

The problem is that the flatscreen TV purchase isn't really an increase in GDP; its a TIME SHIFT. Without borrowing the money, you see, I'd have to earn it first then buy the TV. By borrowing the money I am able to purchase the TV sooner than I would otherwise; ergo, I haven't actually changed demand in total, but instead have changed when the demand occurs.
Of course the downside of this little game is that the TV that I buy today is one I don't need to buy tomorrow. I'm robbing tomorrow's GDP to add to today's.

This is why I have maintained all along that the debt-to-GDP graph (which I know you are probably tired of seeing by now, but here it is again!) is so important:

Let's take GDP over a longer period of time - say, 10 years, and make a law that says there is no credit to be extended. That is, you pay cash or you don't buy. We add up all the output for the entire 10 year period and put it in a bucket.
That's the total output of the economy over the entire ten year period, along with all the productivity that enabled it. Now let's add credit to the system. What happens? Some people will immediately "pull from forward earnings" via credit. That is, they will purchase a TV they want today with earnings that they believe they will have tomorrow. This is the old "Wimpie" game from the Popeye cartoons - "I will gladly pay you Tuesday for a hamburger today!"

Now, here's the question - has the addition of credit actually added to GDP, or just shifted in time when the GDP is recorded? If - and only if - the credit extended is used for the purpose of producing additional output, then it is a net additive to GDP. If a farmer has 100 acres of land but only enough money to buy seed for 50 of those acres, his employment of credit to buy the other 50 acres worth of seed increases net GDP because he is using that credit line for the explicit purpose of increasing the net output of his labor. The credit extended to him is liquidated when the additional output is produced, but the output (less the cost of the credit) remains.
When credit is used in this fashion the debt-to-GDP ratio falls because the amount of debt outstanding remains the same or declines while the GDP increases. If you instead consume, however, you have only performed a time shift on demand, not added to actual demand. In fact due to interest cost you have shrunk the total (long-term) demand that exists in the economy because interest does not accrete to GDP.

We all recognize Wimpy from the Popeye Cartoons as a scam; why is it that we don't recognize that what Bernanke is attempting to do is precisely the same damn thing and demand that he stop it!
If you look at the GDP over a long enough period of time, this becomes obvious and indisputable - that which is demanded today isn't necessary tomorrow, and there is no long-term salutary impact on the economy.

The third condition is when debt-to-GDP expands dramatically, as it has been now for the last 30 years. In this case credit is being used to both pull forward demand and to pay the interest on previously-extended credit! This latter case is insanely destructive when maintained over a long period of time, because there is a natural limit beyond which credit cannot be expanded nor can demand be pulled forward. At some point the people have all the cars, IPods and flatscreen TVs they need, and their want for additional consumption becomes tempered by the pain of the debt service that came with "pulling forward" from an infinite future horizon. In short continuing demand becomes irrelevant because debt service chokes off available free cash flow.

"Quantitative Easing" into such an environment, which we are now in, is a complete and utter waste of time because it in fact requires that additional debt be taken on in the economy in order to do anything. That is, buying assets from banks and pumping reserves back into them so they can loan them out only boosts aggregate demand if there are in fact qualified borrowers who wish to take out a loan to buy something. Some so-called "economists" will argue that lowering borrowing costs acts as a stimulative effect in that interest costs come down. This is only true to the extent that there is unsatiated demand among unsaturated (by debt) consumers.

We have spent thirty years pulling forward demand at an ever-increasing rate. The graph above proves this. We have too many automobiles, flat-screen televisions and houses for the amount of aggregate demand that exists in the economy and the debt overhang has been left behind on consumer balance sheets - it has not been worked off. The "economics of more" have been pulled forward so far that there is nothing further to pull forward for those who have any hope of being able to pay the bill down the road. You can take me to the best restaurant in town but if I just ate my fill that $100-a-plate steak is going to sit and get cold in front of me. The paradox is that ever-increasing stimulus into such a condition will ultimately destroy the currency and economy where it is attempted.

As each attempt at "Quantitative Easing" fails to raise demand a more intrusive and expansive one will be demanded. As the velocity of money dwindles toward zero confidence is lost - a non-circulating currency is very difficult to value! This is what has happened over the last year and a half. Bernanke has cut interest rates from over 5% to zero and yet aggregate demand has fallen in the economy because those who can borrow to consume are sated and those who are either over-leveraged or insecure in their ability to pay will not (or cannot) borrow irrespective of the cost of money. In addition the very act of Quantitative Easing puts a hard "bid" into government bonds. As their yields collapse toward zero up the curve prices for those bonds skyrocket and blow off in a parabolic fashion. This sounds great for the holders of those bonds (e.g. foreigners), except for one small problem - all bubbles burst, sophisticated investors know this, and in order to realize those paper gains you have to sell! Anyone who has seen one parabolic blow-off top on a chart knows what comes after the peak is reached. Eventually someone comes to the conclusion that "it's just not going to go any further" and sells. This begins the collapse in price (and skyrocketing yield) which places the central bank in an extraordinarily-difficult position - if they "take up" all of the supply to prevent the yield from shooting higher they are printing money of zero velocity which does nothing, and once all that supply has been taken up they're out of ammunition and holding the bag on bonds that are worth nowhere near what they paid for them!

Oops.
It is time to face the facts - "Quantitative Easing" cannot and will not stimulate demand and "reverse a deflation" if there is no capacity (or desire) to borrow irrespective of how cheap you make the money or how much of it you pump into the economy.
To explain all this in one sentence:
You can't solve a drunk's alcoholism with a bottle of whiskey.
Bernanke's thesis has been debunked and both his doctorate and position should be revoked.

News that Moves: Japan/U.S. Debt Forgiveness & India/Pakistan Unrest

RCM Comment: Two new developments on the international front that could significantly shape the investing climate in the new year. Both add to the appeal of gold as a safeguard of wealth.

Dec. 24 (Bloomberg) -- Japan should write-off its holdings of Treasuries because the U.S. government will struggle to finance increasing debt levels needed to dig the economy out of recession, said Akio Mikuni, president of credit ratings agency Mikuni & Co.
The dollar may lose as much as 40 percent of its value to 50 yen or 60 yen from the current spot rate of 90.40 today in Tokyo unless Japan takes “drastic measures” to help bail out the U.S. economy, Mikuni said. Treasury yields, which are near record lows, may fall further without debt relief, making it difficult for the U.S. to borrow elsewhere, Mikuni said.
“It’s difficult for the U.S. to borrow its way out of this problem,” Mikuni, 69, said in an interview with Bloomberg Television. RCM Comment: Can you imagine the response of other nations that hold a significant amount of U.S. debt? What will China's reaction be to U.S. debt forgiveness?

Pakistan moves troops toward Indian border - AP
AP reports Pakistan began moving thousands of troops away from the Afghan border toward India on Friday amid tensions following the Mumbai attacks, intelligence officials said. The move represents a sharp escalation in the standoff between the nuclear-armed neighbors and will hurt Pakistan's U.S.-backed campaign against al-Qaida and Taliban taking place near Afghanistan's border. Two intelligence officials said the army's 14th Division was being redeployed to Kasur and Sialkot, close to the Indian border. They said some 20,000 troops were on the move. Earlier Friday, a security official said that all troop leave had been canceled. The officials spoke on condition of anonymity because of the sensitivity of the situation... Prime Minister Manmohan Singh met Friday with the chiefs of the army, navy and air force to discuss "the prevailing security situation," according to an official statement.

News that Moves: China,Obama & the IMF, Commercial Property Woes, Meriwether

RCM Comment: The following three stories illustrate the desire for liquidity both here and abroad. And while billions of US$s & trillions of Yuan are created the IMF still feels this is not enough as they make their case for even more spending. As a reader of this blog you know that fiat currencies are easy to create. All you need is paper, ink and a printing press. I have highlighted in GOLD the sentences that hold a clue to the best investment vehicle during times of extreme currency printing. Can you guess which asset I am recommending?
China cuts rates, bank reserve ratio to boost economy - DJ
DJ reports China said it will lower deposit and lending rates as well as banks' reserve requirement ratio as part of continued efforts to boost liquidity and ease the country's economic woes. Analysts said more interest rate cuts are likely as China's government continues to worry about a sharp slowdown in the domestic economy, even after it recently launched a 4 trln yuan economic stimulus plan and eased restrictions on the development of the property market. The People's Bank of China said it will cut the one-year yuan lending rate to 5.31% from 5.58%, and the one-year yuan deposit rate to 2.25% from 2.52%, effective Tuesday. The PBOC said it is also cutting banks' reserve requirement ratio from Thursday by 50 basis points.

Obama expands goals of stimulus - Financial Times
Financial Times reports Barack Obama has expanded the goals of his proposed economic stimulus, with a plan to create or save an additional 500,000 jobs. The president-elect raised his jobs target over the next two years to 3 mln -- up from the 2.5 mln goal set last month -- after US unemployment hit its highest level for 15 years in November. Transition officials said Mr Obama had agreed the outlines of a $675 bln - $775 bln two-year recovery plan last week. But the price tag is likely to rise above $800 bln as Congress makes its own demands during the legislative process. The moves come amid a warning on Sunday, from the International Monetary Fund, that governments must act more aggressively to prevent a deeper slump. Dominique Strauss-Kahn, IMF managing director, told BBC radio that inadequate stimulus measures risked making the slowdown worse than expected next year. "I'm specially concerned by the fact that our forecast, already very dark.. will be even darker if not enough fiscal stimulus is implemented," he said.

IMF head worried about lack of fiscal stimulus - Reuters.com
Reuters.com reports International Monetary Fund chief Dominique Strauss-Kahn said a lack of fiscal stimulus by governments to tackle the global slowdown may make a bad 2009 even worse, according to an interview. Strauss-Kahn told BBC radio that the IMF may need to cut its next economic growth forecasts, due in January, referring to "2009 as really being a bad year." "I'm specially concerned by the fact that our forecast, already very dark ... will be even darker if not enough fiscal stimulus is implemented," he said in an interview. "The question of having social unrest has been highlighted by journalists and I can understand that, but it's only part of the problem," he said. "The problem is that all the whole society is going to suffer."

RCM Comment: I spent time at an investment conference recently and had the good fortune to meet some quality people involved in the commercial property market. This market had held up well vs other real estate assets until October at which point business froze seemingly over night. The key take away from this conference was the high likelihood that the commercial property market would be the next "shoe to drop" in this snowball of a financial crisis.
Times of London discusses commercial property sector pleas for help from Washington
Times of London reports America's commercial property industry got out the begging bowl yesterday as the credit crisis tightened its grip on the world's biggest economy. Amid grave warnings that thousands of office blocks, hotels and shopping centers are braced for bankruptcy, representatives of the industry went cap-in-hand to Washington. Henry Paulson, the US Treasury Secretary, managed to secure $700 billion of taxpayer funds in October to help to bail out Wall Street banks. It emerged yesterday that representatives of America's real estate bodies have written to Mr Paulson, who has only a month left in office before he is succeeded by Tim Geithner, requesting federal assistance. In a letter sent to Mr Paulson, signatories representing a dozen property trade groups, wrote: "We believe there is insufficient systemic capacity to refinance expiring, performing commercial real estate loans. For many borrowers, [credit] is not available."... In recent weeks, executives from the US commercial property market have been engaged in talks with the Treasury, Harry Reid (the Senate Majority Leader), the Federal Deposit Insurance Corporation and members of Barack Obama's transition team. As a result of those talks, it is understood that both the Treasury and the US Federal Reserve have agreed to consider assisting the commercial property market with loans. However, such a measure would not come into effect until February at the earliest.

Developers ask U.S. for bailout as massive debt looms - WSJ
... $530 bln of commercial mortgages will be coming due for refinancing in the next three years -- with about $160 bln maturing in the next year. To head off some of the impending pain, the industry is asking to be included in a new $200 bln loan program initially created by the government to salvage the market for car loans, student loans and credit-card debt. This money is intended to go directly to help investors finance purchases of securities backed by these assets. If commercial real estate is included, banks might have an incentive to make more loans to developers since they'd be able to repackage and sell them more easily to investors with the assurance of government backing. As part of their lobbying efforts, some industry representatives have asked lawmakers to explore the idea of setting up a separate program aimed at boosting lending to commercial real estate only.

RCM Comment: Will people never learn? From the Madoff case to Meriwether I find it amazing that investors willingly overlook major red flags in their quest for returns. Clearly the sickness of greed clouds judgement.
Meriwether Fund to cut staff over losses - WSJ
WSJ reports JWM Partners, a hedge fund set up by John Meriwether in 1999, told investors it will lose four partners and cut staff after the performance of its flagship fund plummeted this year. JWM Partners was founded by Mr. Meriwether after his previous hedge fund, Long-Term Capital Management, had to accept a $3.6 billion bailout by U.S. banks in 1998 after it ran aground with highly leveraged trading strategies. Connecticut-based JWM Partners said in its November letter to investors, seen by DJ, that its flagship fund, the Relative Value Opportunity Portfolio, fell 42.78% in the year to the end of November, to reach a net asset value of $554.8 million. Many investors have their funds locked into the company because of a system that allows one-eighth of the cash to be pulled out of the relative value vehicle at each quarterly redemption date, according to one investor in the fund.