14 Oct 2009

The $850 Billion Question

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You know how a few months after you first get a GPS system in your car, you no longer can find your way to the grocery store on your own? Well that’s what Robert Wenzel’s site EPJ has done to me, in terms of staying abreast of the government’s financial shenanigans.

In this post Wenzel reproduces some very scary quotes from the Federal Open Market Committee, and how they are making it a “top priority” to develop “tools” to withdraw the excess liquidity from the financial system before all hell breaks loose (I’m paraphrasing). Let’s remind ourselves what all the fuss is about:

Right now, the banks have the legal ability (i.e. they can still satisfy their reserve requirements) to lend out some $850 billion in new loans in step one. But then remember we are in a fractional reserve system, so as that initial burst of lending gets deposited back, a second (and smaller) wave of new lending could occur. Using a back-of-the-envelope 10% multiplier, there are enough excess reserves in the system to support a total of $8.5 trillion in new loans.

In practice that is too much; let’s be conservative and call it a mere 5 trillion new US dollars in the wallets and checking account balances of the public. How much is that? Well right now M1 (basically cash held by the public, checking accounts, travelers’ checks, and other really liquid assets) is about $1.65 trillion. So an injection of an additional $5 trillion would mean a quadrupling of the narrow “money supply” held by the public. So if gas costs $2.50 a gallon right now, it would cost $10 a gallon when everything settled down.

Ah, but this assumes the worldwide demand to hold dollars stays constant, which it surely would not in such an environment. I emailed back and forth with Jeff Hummel a few months back, and we came to the (very rough) conclusion that if the worldwide demand to hold dollars fell in half, that would be akin to a 30% increase in the domestic money stock (using the current levels, not the uber-inflated one). So let’s round it off to $11 / gallon gasoline.

The thing is, it doesn’t matter what Bernanke et al.’s plans are to make interest on reserves. If and when price inflation starts getting out of control, the banks aren’t going to sit idly by while the dollar crashes. It’s no good to have $850 billion in reserves on deposit with the Fed–rolling over at 0.25% APR–if CPI is rising at 3% per month and yields on 10-year Treasurys have risen to double-digits. Sure, Bernanke could jack up the interest he pays on reserves, but that just makes the problem grow exponentially. At some point, even Wall Street analysts will have to realize that the only point to having a stockpile of US dollars is that you spend (at least some of) them.

Of course, the real question for investors is the timing. Is Bernanke’s delicate balancing act going to keep up for several years, or will it come crashing down before Christmas? A few months ago, I thought the collapse was imminent. I couldn’t believe that investors worldwide would continue to buy the US Treasury’s garbage (literally) at such high prices for much longer.

But I must confess I have been surprised by the relatively tame CPI reports. It’s true, price inflation is positive, even though people keep repeating the mantra that we’re in a deflationary black hole. But the big spikes in M1 and M2 in late 2008 have basically been tamed by Bernanke holding them constant since then.

So for me, I’m very curious to see tomorrow’s scheduled CPI release (for the August–>September price hikes). If it’s relatively tame, then I think Bernanke will have successfully tamed the domestic inertia in prices. But if it’s a big “unexpected” spurt, then I will still maintain that things are slipping out of control for our overlords in DC very quickly.

Finally, I reiterate my view that at any time, the dollar could crash against other currencies based on some slip of the tongue by a foreign central banker. In that scenario, oil shoots up to $175 or higher in a day, and those of you who bought gold and silver coins based on this blog will owe me a Christmas card. (And yes I recognize that my overall views here are strikingly similar to those I earlier mocked when voiced by Robert Wenzel.)

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