The Fed's Turn to Fail
Those projecting a replay of the 1970s in US financial markets should bear in mind that today's bond market is not only many times larger than it was then, there are now more than $100 trillion in contracts that derive their value from it. This is a vast and skittish crowd that will not sit idly by should Dr Bernanke begin to debase the value of their holdings through willy-nilly debt monetization. They will sell, driving interest rates higher and causing interest charges to outrun debt growth. Marginal debtors, unable to service their debt, will be forced to liquidate. Without a liquidity buffer in the form of savings or a current account surplus, the transition to cascading cross-defaults would be seamless. As a result of the reaction of bondholders, Dr Bernanke's prescribed medicine for preventing a collapse of history's most extreme debt bubble is tantamount to monetary system euthanasia.
Leaving the Fed to
Dr Bernanke stands ready to facilitate this new borrowing. He is eager to create new dollar entries in the Fed's balance sheet and swap these for new Treasury debt, in what would amount to a transfer of purchasing power away from existing bondholders. The effect is akin to the dilution suffered by existing shareholders when a company carries out a new stock offering to raise capital. Foreigners, who own half of all outstanding Treasuries, could not be coerced into accepting the uncompensated losses that such a scheme implies. Their exit from the Treasury market would make borrowing prohibitively expensive, putting the government in a position where it can neither tax nor borrow effectively. At this point, the Fed's usefulness would be in serious doubt and confidence in the notes backed by its balance sheet in tatters.
Alan Greenspan and others with an appreciation of monetary tradition might assume that falling confidence in FRNs would be arrested at some point by the Fed's 9,000 ton gold holding. Wishful thinking. Not only is it uncertain how much gold remains since it has not been audited for some 40 years, it is actually owned by the Treasury, not the Fed. With the Fed unable to adequately finance the Treasury, the government may rescind the Fed's authority over the US gold reserve, thereby removing the final prop supporting confidence in its notes. A discredited Fed, with Dr Bernanke at its head, would provide the required receptacle to place the blame for the failure of the monetary system and clear the way for the issuance of a new currency. While those with unquestioned faith in modern central banking may find this outrageous, history reminds us that it is an all too familiar story, even in the US, where the Fed itself was preceded by two failed central banks, both called the Bank of the United States. If we learn anything from history, it is that we do not learn from history.