The Aleph Blog » Blog Archive » Entering the Endgame for Monetary Policy, Part II

Entering the Endgame for Monetary Policy, Part II

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.  Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.  That’s an estimate on my part.  Why does balance sheet quality at the Fed matter?  If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.  Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

Credit: The Economist

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”  I know Tyler and de Tocqueville said something like that as well.  At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.  In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?  This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.  As in the Great Depression, there was too much debt financing of assets.  The debt was more liquid than the assets, as well.  Borrow short, lend long.  Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).  Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.  That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

  • Inflation when the Fed monetizes the debt,
  • Depression from vastly increased taxes,
  • Debt repudiation (whether internal, external, or both), or
  • Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)  No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.  Trouble is, we don’t internally fund our debts.  At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.  Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.  Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.  Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.  There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.  My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”  The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.  I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.  Yeah, the pain’s gotta go someplace

Bonds, Currencies, Fed Policy, Insurance, Macroeconomics, Pensions, Portfolio Management, Real Estate and Mortgages, Speculation, Stocks, Structured Products and Derivatives, Value Investing | RSS 2.0 |

2 Responses to Entering the Endgame for Monetary Policy, Part II

  1. I think it was a simple attribution mistake at Seeking Alpha. Thanks for letting me know. I have sent them a polite note; they are my friends all.


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email

Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin