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Bernanke Inserts Gun In Mouth

Karl Denninger
Market Ticker
Mar 20, 2009

I'm not at all sure I believed what I read today. (my comments in italics, indented)

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

The economy is screwed, and although we have made statements for the last year that our actions would solve the problem, we've been wrong. Exponents (that is, compound interest) are a bitch and its unfortunate that you were too stupid to call us on this two years ago.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The economy is deflating. We can see the deflation in the CPI and PPI numbers, not to mention home prices. The data we have that we're not publishing is even worse. This is a major problem because we have literally run our playbook that should have prevented this according to our thesis, but it didn't.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

We've got over a trillion in trash on our balance sheet now, which we promised would fix the problem but it didn't do jack. That's because nobody in their right mind will borrow money when the economy is in the tank and debt levels are above sustainable maximums. The only borrowers are people who are deadbeats, and that doesn't help. Instead of clearing this out by forcing the bankrupt to take their medicine our "solution" is to attempt to devalue the currency by explicit monetization. We have little choice in this matter because the most-recent TIC data that has been published, along with what hasn't been published (yet) but which we have, shows that foreigners have given us the finger in buying any more of our agency, corporate and sovereign debt. In short, we're screwed - within months - and we know it.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

We've all stuck guns in our mouths and are now threatening to blow our brains out. Oh, and each of us is holding a dead-man's switch to a thermonuclear weapon, strategically placed somewhere in the United States economy. If one goes, we all go, and so do you - this is a murder-suicide pact, and you're the potential homicide victim. Have a nice day.

Folks, this is the most frightening statement I've read from the FOMC - ever.

Notice what's missing - the statement just a few days ago from Ben Bernanke in which he said that the economy would recover in early 2010, and the recession would end in late 2009.

If this was the base case the FOMC believed, there would be no reason for the actions taken today. Monetary policy has a six month (or thereabouts) leadtime, which means that should Ben believe what he spewed on 60 Minutes then his actions to date were sufficient to fix the problem, needing only the fullness of time to flow through the system and restart credit creation.

I believe Ben knows what he said on 60 minutes was a lie.

But this action also tells us a few other things about the short term:

  • The banks aren't in as much trouble as we've been led to believe. That is, imminent business failure is not going to happen; this action had a dramatic and instantaneous impact in flattening the yield curve, which means the banks earn less in net interest margin. In the short term this means that the risk of upside surprises in earnings for next quarter are very real, even if those earnings are "cooked". Short take-away: beware if you're short banks.

  • Bernanke and pals have in their possession enough non-public information on the credit markets (likely TIC data - that is, foreign investment flows) that they have been effectively forced into doing this, lest something even worse happen immediately. Has China (along with others) finally woken up and said "no mas"? The sabre-rattling makes one wonder, especially in conjunction with this action yesterday.

Now $300 billion in purchases out the curve, to be sure, isn't all that much. In fact its about half of the issue expected over the next three months - significant to be sure, but not huge. More important to the market is the GSE ("agency") debt and coupon being purchased; a program that has been underway for some time, but has now been more than doubled in size. This program would appear to be low risk but really isn't, as Fannie and Freddie (where this paper is mostly coming from) are both bleeding money like crazy, and as such one has to wonder whether these notes being bought are really "money good" or not. The answer is almost certainly "not", which in turn strongly implies that there are monstrous hidden embedded losses that will appear down the road.

The problem with the direct Treasury purchase is the potential precedent.

See, Ben will effectively "overpay" for these bonds. As we saw in England with their buy this results in an immediate "sold to you!" response. Their "bid to cover" was insane, showing that essentially everyone and their brother was attempting to unload these bonds into the Bank of England - knowing full well that once this policy starts it always ends badly, and when you are given the opportunity to sell at higher than actual market value you take it.

The danger is that in trying to suppress the long end of the curve is that it can fail. That is, the move we had today (which was massive) can be fleeting - and then reverse. This of course would force Ben to do it again, and again, and again. Ultimately he could wind up owning the entire long end of the curve or even worse, the entire $6 trillion public Treasury float.

This is the "economic collapse" scenario, because further government spending in such a situation requires the dilution of all existing money in the system by the same amount spent. This is a circle jerk - you're not actually able to spend that money and get the goods and services you want as a government, since you are creating and consuming at the same time. As such the operations cancel each other in effect and the government finds it cannot fund its internal operations with Treasury issuance any more, being forced back onto whatever tax base it has left (which won't be much at that point!)

Here is the problem, graphically illustrated:


Note the breakdown. We are anticipating at least a $1 trillion shortfall this year, and frankly, that's unreasonably "good"; the real shortfall is likely closer to $2 trillion.

So what happens if half of that $2 trillion is no longer "money" from foreigners - it is a circle-jerk from The Fed and Treasury? You can basically remove it, that's what.

Now look at that chart - you can't remove the "net interest" (about $250 billion), because that has to be paid. "Other spending", that is, other than defense, interest, and social programs, is about $700 billion. Defense is also about $700 billion.

If we find ourselves unable to sell debt to actual investors with actual money, and are circle-jerking ourselves; to balance this budget we would need to contact spending to roughly $1.0-1.5 trillion in total.

Since the interest payments are inviolate, that leaves us $1.25 trillion for everything else. Assume we can cut half of the defense budget, and we've got $800 billion left. Cutting "other spending" (that is, all other programs) by 50% would leave us with about $500 billion net-net for social programs - forcing a reduction of about sixty percent in Social Security, Medicare and Medicaid - all at once.

In short this would wind up costing us roughly a 50% across-the-board cut in every program within government on an immediate basis. That in turn would force further reductions in GDP, which would further shrink tax revenues.

You can see where this leads, I'm sure, and it's not pretty.

Ben Bernanke may think he can extricate The Fed from this outcome before it happens. But I must ask - exactly why would anyone believe that? He hasn't been able to extricate himself from anything he's tried thus far.

The danger here is that this really is "the last bullet in the gun." If it fails, our currency and political system would appear to many who read this to go down the toilet in a hyperinflationary detonation.

Not so fast grasshopper.

See, if he fails, it won't be simply a United States phenomena. Quite to the contrary. That failure will in fact be global - Bernanke has guaranteed it by tying The Fed to every other major central bank in the world via his "unlimited swap lines." We may be a cheap $5 hooker in the bar, but of the hookers, we've got crabs and everyone else has AIDS!

The error in the hyperinflationist scenario is that without being able to couple price increases back into wages they are unsustainable - price increases instead collapse demand. If gasoline goes to $20/gallon you will buy less of it - a lot less - not because you want to, but because you simply don't have the money. This in turn destroys the gasoline retailer and oil company's operating cash flow, which in turn causes them to lay off more people. In a debt-laden economy the debt percentage (of GDP) continues to rise even as spending drops and a mad dash to try to redeem what debt can be repaid soaks up all available money.

The nightmare scenario that is staring us in the face, right here, right now isn't hyperinflation. It is in fact a collapse of monetary systems driving demand for dollars through the roof in a crescendo of attempted redemptions into collapsed ("no bid") asset prices - a demand that Ben will not be able to meet, as the collateral backing those dollars will have all been exchanged for toilet paper. Whether Bernanke holds all this trash on his balance sheet or manages to scam Treasury into exchanging it for T-bills, the result is the same - there is no collateral behind Bucky and as employment collapses no production to replace it with either.

The mad scramble will be on, and as it happens trade will be choked off by not a collapsing dollar but other currencies collapsing around the world.

Paradoxically, the DX, or dollar index, will skyrocket - not go through the floor - as this plays out.

Unfortunately this shuts down virtually all exports - at a time when we desperately need them, as we cannot borrow to consume any more. he economy collapses, along with government funding and our currency - but not through hyperinflation. The mad dash to redeem and sell anything and everything instead collapses pricing (that is, it becomes out-of-control deflation in an exponentially-increasing fashion) irrespective of Ben's attempt to halt it.

The "death spiral" ends in the destruction of our monetary base - not due to hyperinflation but due to the inability to borrow any more funds, the reduction of the currency's base to a giant circle jerk, asset fire sales in a mad liquidation dash and ultimately, the collapse of both the monetary and political systems in the United States as tax revenues collapse to very close to zero.

This is a national security emergency that quite literally can take down our government and way of life within months or even days, and I'm willing to bet that not one person in Congress understands the seriousness of the matter.

By refusing to confront the bankrupt nature of institutions under Bernanke's supervision and by choosing instead to continue to bail them out and take their trash onto his (our) balance sheet, Bernanke is risking something much worse than a Depression.

He is literally risking the end of America as a political and economic power.

Watch for a bond market dislocation very carefully.

I will be, and hopefully I will detect it in time to warn people if Ben's "last bullet" gambit ends up blowing up in his face.

In the meantime, for however long this rally in the market lasts (and it might be a while if the sheeple misdiagnose what's coming - if the newsletters I've seen thus far this evening are any clue, most people have) use it to raise cash and be prepared for some really tough times.

I have been singing this song - raise cash now - for quite some time. Let me be succinct - it has been my considered belief that you need enough in liquid cash - not credit access in the form of credit card available balances or anything similar - for at least six to twelve months. I'm upping that here and now to twelve to twenty-four months - that's right - one to two full years of "minimum necessary to make it" expenses. Figure out right here and now what your minimum "monthly nut" is, and raise 12-24 months of that much in safe, liquid funds.

That's a minimum; if you can in fact have enough available to be able to execute a "bug out" plan where you are able to become effectively self-sufficient on short notice (a couple of months maximum) if necessary, that's even better. Yes, we're talking chickens, goats, enough arable land to grow what you need to survive (bartering for what you don't have with what you do) and the means to defend it. If you live in a big city consider carefully what you intend to do if unemployment goes north of 20% and the city effectively goes feral - if you're interested in "how bad can it get" go drive through major parts of Detroit - bring an armored vehicle for your tour and/or at least semi-automatic weapons.

There's an ill-wind blowing and while this storm has not yet reached the shore, I'm putting up the plywood.

Mar 19, 2009
Karl Denninger

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