Saturday, February 21, 2009

The Circle of Lies

Circular Money(TM): at least that's the PG-version of what several correspondents are calling it and we'll explain later. But first a little background. Quite a few folks have expressed concern about the Fed "printing" massive amounts of dollars and putting them into the economy, which will trigger inflation. This is certainly a reasonable fear given the numbers being thrown around and the rhetoric coming out of the Treasury and the Fed. However, we do not believe that the fear is well-founded and our evidence come from the Fed itself. Consider the latest report on reserve balances.

The total balance sheet has expanded by an alarming $1 trillion or 110% in 12 months - very disturbing. But the key question would be is any of this actually printed into existence? To determine this, look at the other side of the balance sheet - the liabilities and capital. Liabilities have expanded by $1,032 billion and capital by $3 billion. Liabilities mean the the assets are funded by borrowing. Real printing would go straight to capital since it creates no offsetting liability. The minuscule increase in capital is easily accounted for by interest on the Fed's bond portfolio so we may safely conclude that little or no actual printing is taking place - much less the monstrous quantities that some would suggest. So the money is being borrowed; now let's look at the liability details to see from where the incremental money is being borrowed.
  • $78 billion worth of Federal Reserve Notes has been issued - increasing the amount in circulation by 10%. This is a function of demand for cash, not Fed policy. Increasing distrust of banks naturally leads to an increased preference for cash instead of deposits.
  • $32 billion of reverse repos - that is the Fed borrowing from other financial institutions using its Treasury holdings as collateral
  • $917 billion of "deposits" - now a deposit is a loan so this is the Fed borrowing once again. Let's break this down further:
  • $216 billion is borrowed from the US Treasury - through the general and supplemental accounts
  • $699 billion is from "depositary institutions" - i.e. banks.
This last one really should get your attention. You might say "I thought the Fed was lending money to the banks!?!" and you'd be right. Then the banks are turning right around and lending that money back to the Fed. It would be as if George "lent" money to Bob and then Bob turned around and "lent" that money right back to George. If the "loans" were for $1, they each now have an asset (the loan) and a liability (obligation to repay) of $1. But that is a sham transaction, whether for $1 or $1 billion. They have both expanded their balance sheet, but how much actual lending took place there? In reality, nothing changed except a meaningless book entry and the same is true with the Fed and the banks. George and Bob could exchange "loans" of $1 billion dollars and it would be just as ineffective as what the Fed has done. This is what we have dubbed Circular Money(TM).

Keep in mind, this is Circular Money(TM) only to the extent to which the entries offset and that is not a perfect match but very close. TAF loans increased by $388 billion and "other loans" (the rest of the alphabet soup) by $139 billion for a total of $527 billion vs $599 billion the banks lent to the Fed. The remainder comes from assets the banks sold to the Fed to raise cash. Clearly a large portion of the $34 billion in agency bonds and $65 billion in mortgage-backed securities (MBS) also was sold by banks. The money comes from the Fed and goes right back to them. Here again we see the Fed's actions in light of their attempts to maintain the deception. They started to pay interest to the commercial banks on required and excess reserves in October 2008. They are currently paying the banks 25 basis points (0.25%) on all reserves deposited with the Fed. Note that the Effective Fed Funds rate is a nearly identical 22-24 basis points. The ability to pay interest on the reserves was critical to offset the interest cost of borrowing. This way the imaginary accounting entries can be maintained nearly indefinitely with interest paid neatly offsetting interest received as well. The interest differential on huge sums of non-existent money would have unmasked the deception fairly quickly otherwise.

The Big Con
This game has no effect in reality, so what is the purpose of the Circular Money(TM) deception? It is yet another con game by the Fed to convince people that dead banks aren't really dead because Ben Bernanke says so. As long as a critical mass of people continue to buy the party line, the zombie banks will continue to lurch about spastically. We have long contended that the Federal Reserve is a very weak entity in reality and it's greatest power is that people THINK it is powerful. They announce things intended to influence the behavior of those under this illusion. They threaten to "print" in order to stoke fear of inflation and get people to act accordingly - they seem to be hoping to restart financial speculation by scaring people into draining their savings or taking on debt. But if the Fed could actually induce inflation, then we should already have it already as they've been taking radical action now for over 18 months. When the current threats fail to become reality, the already damaged credibility of the Fed will be severely compromised.

The concerns about inflation would be very serious if any actual printing were taking place but that would destroy the banking system - which is the last thing they want. As things stand, the money exists only in theory and cannot be lent outside the banking system since it doesn't really exist. In order for it to exist outside this circle of lies, the Fed would have to find a large funding source beyond the banks themselves to replace any funds the banks lend out to the economy rather than back to the Fed. They would have to compete for that funding with the Treasury who needs to borrow over $1 trillion in short order. Now do you see why the Fed prefers this deception to going to the market and trying to get that funding? If they tried and failed, it would reveal the Great Oz as the helpless little man behind the curtain that he really is.


Russ Wong said...

Where does this initial money that is lent to banks coming from?

dataSlave said...

If the money is immediately re-deposited with the Fed it never needs to exist at all. Both the Fed and the bank make an accounting entry. This is why I used the example of two guys exchanging IOUs.

In cases where the funds are not immediately sent back to the Fed, it must come from the couple hundred billion the Fed borrowed from the Treasury, which issued special T-bills to raise the money.
-- dS

CLN said...

I think you are right about the circular money, and the interest on reserves plays an essential role.

Definitely there was very little pure printing and most of the Fed game has been so far in neutral sterilization operations.

That rises the question if the Fed has been really interested in easing the credit crunch or it just pretended to expand credit up to the sky when in fact was it allowed the deflation take it's course and let the unsupported financial institutions (banks, hedgefunds, insurers) go belly up.

This may be a huge operation for clearing the field not very different with what the Fed did during the great depression. These days there is a quote from Andrew Mellon which is quite popular: "In a depression assets return to their rightful owners."

A couple of nice charts:

and one showing clearly the Circular Money game:

Lcruiser said...

Thanks Sushi... :)

Lcruiser @

Greenie said...

Excellent post !! You are a very smart guy. Watch out - Fed is going to catch you for disclosing their secret :)

I added your blog to my recommended links.



raptor said...

What about the 9T off balance sheet , that was mentioned on the hearing of the Fed oversee ?
And what what about the 300B they anonced to spend until the end of the year for buying the long-term ty's ?

How those play in this game ?

Eleua said...

Thanks for this explanation. I've been telling my circle of associates pretty much the same thing (there is no "printing"), but they refuse to believe.

Your blog is one of the best. Thanks for your insight.

Eleua said...

One easy refutation of the "inflationary" thesis is as follows:

Why would the bankers, who own Congress and seem to get everything they want, go through all this trouble to get out of their bad trades, get all the money, and stick us with the debt, only to allow "inflation" which destroys their money and gets us out of our debt?

They wouldn't. We are getting deflation.

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