Saturday, December 10, 2011

Why No Real Recovery Will Happen

Right now, major central banks are acting on your behalf. They are shoveling newly-created money into the coffers of their cronies at the major international banks. That money will largely go to finance governmental debt. Here is how it works.

First, a bank that has managed to get labeled 'too big to fail' approaches their former employees now running the local branch of the central bank, and says that he needs a 'loan' to survive. This loan is duly issued, as per policy. These loans come from the interbank or commercial loan operations. These operations have been established as 'lender of last resort' for some time now. When you hear the 'fed rate', this is the rate the banks will be charged. Not only is this rate well below the rate of inflation, both real and reported, it is well below the rate that the government pays for its debt.

That last bit is important, as most of this money, at last count $7.7 trillion in the US alone, is lent to governments because the bank will not hold cash. It doesn't make sense for the bank to use it to handle bad debts; they will simply swap those for US bonds from the fed anyway. This is another program the fed has. It provides swaps of government bonds to banks in exchange for the toxic assets the bank has. So, the banks can unload their toxic assets for bonds anyway, but must retain a 'reserve'. This reserve can be in any 'monetarized' asset, such as, for instance, government bonds. So, the bank tends to put its new loans from the fed into the bond market, one of the real reasons that the fed prints this money.

The bonds thus bought have a payment rate above the rate the money was borrowed at. For instance, the fed loans at, say. 1/4 % (0.25%), while federal bonds pay, say, 3%. This means that the bank is making 2.75% on borrowed money, 100% leveraged. For instance, it borrows $1 bn, buys bonds with it, pays $2.5 mn in interest to the fed (who, by the way, 'invests' that 'income' in, you guessed it, federal bonds), and sees the value of the bond increase on its way to maturity by 3% per year. That works out to $30 mn. This is $27.5 mn in profit. Remember, this is profit for no real investment.

This dodge is used primarily to provide profit for the banks, increasing bonus payouts (the money was free anyway), and provide support for US bond auctions, which might otherwise go no bid. This is very bad, as it would cause an increase in the cost of the bonds, in order to get bids, reducing the faith in the US government. As faith is what holds this system together, loss of faith can lead to the whole system falling apart.

These 'leaders' are really playing an end-game, and this end-game is known as a 'delaying tactic'. The idea is that if the thing is delayed long enough, the economy will recover, and the debts can be covered. There is one major problem with this: the delaying tactic is seriously distorting the economy.

Each time some bank pays bonuses to a banker for managing to suckle the teat of government, each time the government creates some new bureaucrat or boondoggle, each time money flows into some sort of production that nobody wants, the overall production pool of things people want shrinks.

We can use our hypothetical economy. With ten people in the economy, under normal conditions, one of them would be involved in government, say, and one in banking and financial services. When the government guy colludes with the banking guy, the government sector grows to, say, two people, and the banking sector grows to, say, two people. That's now four people. This results in a 25% reduction in the productive sector, from 8 to 6. However, as we've said before, the demand for goods remains the same. This drives the price up, as money was printed to purchase substantially less goods. The efficiency used to be 80% and is now 60%. The only way, of course, to continue keeping things as they are, is to print even more money, which leads to even greater public sector consumption, as well as more bankers with fat bonuses. As time progresses, the percentage producing drops. At the moment, some estimates put it around 50% in this country.

Ever wonder why they call it a 'gilded age'? The roaring twenties had a lot in common with this age; things are not as well built and they cost more. The only way to make a capital purchase, such as a car, is on credit because cheap credit has driven the price up by distorting the market. The only way to buy land or a house is on credit. Nobody can expect to save enough to buy anything because our real wages are continuously decreasing and available investment vehicles mostly lose money compared to inflation.

See, when the bank buys bonds with money borrowed at 1/4%, it drives the yield of the bond down. That means that someone playing with his own money will now make less. In our example above, it ends up being 3%, which is less than real inflation. Now, our investor will have to pay 40% tax on whatever he makes, so his real return is less than 2%, which means he is losing money.

One of the results of this kind of monetary shenanigans is the increasing price of insurance. When bond prices go down, insurance prices go up. This is because insurance companies are required by law to keep their money in highly liquid investments, meaning investments that can be easily and quickly traded for cash with little loss of principle. Bonds are commonly used. When bond yields go down, particularly when the bond yield is lower than the rate of inflation, the insurance company has to buy more bonds to meet his reserve obligations, meaning he has to raise rates in order to afford the bonds. This is certainly not the only reason for the rise in the cost of healthcare, but it is a major reason.

So, to recap, the average person cannot save because they lose money, cannot save anyway because their real income is falling, and thus must finance everything with cheap money, which leads to an increase in the cost of goods which drives price inflation. As a result, bankers get rich off of play money and the federal government gets to spend and spend and spend. And the best part? All of this is perfectly legal...