Friday, February 8, 2013

There's A New Bubble In Town

Here, Victoria McGrane and Jon Hilsenrath of the WSJ, write about about unintended perils of the Fed's zero-interest-rate regime (ZIRR) for the short end of the yield curve, and historically low interest rates for the long end. They write, 
Federal Reserve Board Governor Jeremy Stein said there isn't an imminent threat to the wider financial system (in an address Stein made in a symposium at the St. Louis Federal Reserve bank recently), but highlighted several markets—including junk bonds, mortgage real-estate investment trusts and commercial banks' securities holdings—as areas where potentially troubling developments are emerging, possibly as a result of the Fed's easy-money policies (a.k.a., quantitative easing).
In 2007 --- just before the credit bubble created by the Fed in the preceding seven years exploded --- Ben Bernanke had expressed his confidence that no imminent threat was at hand to the wider financial system, even though the housing market was CTD (circling the drain).  Right.  So, perhaps readers will forgive me if Fed Governor Stein's assurances now are less than comforting about the new credit bubble in town.

So what's going on?  Let's see if we can understand.

The Fed keeps interest rates historically low (in the basement, actually) by purchasing assets --- typically U.S. Treasuries --- in the open market.  If you understand how that works, great; if you don't, trust me, you can ask around; I'm not lying.  The Fed buys bonds with new money, which the Fed creates with key strokes on a computer.  No printing press needed; it's all done with computers these days.  What happens to the new money?

The new money gets deposited in the banks of whoever sold the U.S. Treasuries to the Fed.  If it was the U.S. Treasury itself (which usually isn't the case; the Fed does not like to be that transparent), the U.S. Treasury's bank account now has new money in it.  Of course, the U.S. Treasury spends the new money rather quickly. Sixty percent of the spending is to pay recipients of entitlement programs and recipients of other transfer payments.

If the seller of the federal debt wasn't the U.S. Treasury (say a bank, a private citizen, an investment company, an insurance company, a sovereign account, a business, or anyone who wanted money instead of the U.S. Treasury they sold to the Fed), the new money typically shows up in a demand deposit account (a.k.a., a checking account) of the seller.

Commercial banks (which is where most people set up a checking account) are in the business of acquiring money at a price lower than the price they can get by lending money or by purchasing a yield-bearing financial asset --- assets such as U.S. Treasuries, bonds, real estate --- you name it; whatever  banking regulations permit.

In fact, operating all together as a system, the banking system can purchase up to about 10 times as much as the new money that was injected by the Fed when the Fed bought U.S. Treasuries, kicking the whole money creation cycle off.

These days, the Fed pays banks about 75 basis points (three quarters of one percent per year) just to keep the new money on deposit with the bank's regional Federal Reserve Bank.  That's not a lot, but the spread between the price the bank pays to use the money, which on ordinary checking accounts is way less than 75 basis points, still provides a little profit for the bank.

Of course, banks would like a bigger spread to increase bank earnings, which is why banks will likely use the new money to make new loans or to purchase some other financial asset (like longer-term bonds, housing mortgages, and other securities allowed by banking regulations).

Any new money created by the Fed typically gets spent somehow, sooner or later.  In fact, the new money gets spent multiple times, not just once.  In fact, spending of the new money multiple times as it circulates through financial markets and real-goods markets is what creates credit bubbles,  asset-price-inflation, and ultimately, a continuously rising consumer price index.   

Banks are not usually content to keep the new money in a deposit account with the Fed that pays only 75 basis points.  Banks have lots of ways to spend (what banks call "investing") the new money, but all of those ways ultimately bid up the price of something.  During the seven-year run up to the Great Recession of 2008, that something was prices of residential housing, prices of commercial property, and prices of one or another financial instrument, such as mortgage backed securities, credit default swaps,  and other credit instruments created by the financial engineers of Wall Street.

Bottom line, the Fed created a credit bubble, which created an asset-price bubble, as only the Fed can.  Borrowers spent the new money the Fed created to purchase other kinds of assets, real and financial, which bid up their prices.  A bubble is nothing more than prices of particular assets getting bid higher and higher in a tail-chasing exuberance of people who want to hit it big.  That can't and doesn't happen without a central bank (or a collection of colluding banks acting like a central bank).

People who pay attention to financial news understand that the Fed has pumped a bit north of $1 trillion dollars of new money into financial markets since 2008, with tens of billions more coming with each passing month at present (QE3).  What Fed Governor Stein is at least a tad bit worried about is that all that new money may be pumping a new bubble.  Do you think?  So where is the bubble this time?

A big part of the bubble is in the prices of U.S. Treasuries themselves.  The U.S. Treasury just keeps on-a-borrowing.  So far, Congress has raised the debt ceiling as needed every few months to keep that borrowing possible.  All the pumping by the Fed is the only thing keeping prices of U.S. Treasuries high enough to keep government borrowing costs historically low.  In effect, the Fed has purchased about 25% of the Treasury's new debt since 2008. 

Another part of the bubble is evidently showing up in junk bonds, real estate investment trusts, and bank security portfolios, according to Mr. Stein.  By the way, what do you suppose is fueling the rising prices of farm land in the Midwest?  Why do you think the price of gold rose from about $800 per ounce in 2008 to more than $1,600 today?

The new bubble in town isn't quite as concentrated as the housing bubble was from 2000 to 2007.  But that's the thing about bubbles.  They sneak up on us.  Lots of folks, including the Fed, never really see them as bubbles --- until they explode.

Can the Fed let the air out of the new bubble in town just in time to avert an explosion?  Ben Bernanke evidently thinks so.  The Fed's track record for stabilizing financial markets certainly isn't promising.  Why will the new bubble in town be any less destructive of all that fake wealth than the housing bubble was?  After all, the bubble has to explode, if for no other reason than to wipe out all those pretenders to wealth, people who have produced no real goods or valuable services to earn their paper wealth.

I like to sum it all up this way.  You can't really borrow what hasn't already been produced and saved, even if the Fed says you can.  But there I go again, repeating my old refrain. 


Fiddlinmike said...

Is a bubble in US Treasries the same as a bubble in the printed dollar (as most folks view a dollar)? In other words, during the dollar bubble, people around the world attribute more value to a dollar than they should. Eventually the bubble will be pricked and the value of the dollar will sharply decline.

Many folks run to gold, for example, as a better store of value than dollars. And if that's the cause of increasing prices for gold, maybe it's a different type of "bubble" for gold - maybe not a bubble at all. It seems to me that rising gold prices demonstrate the anticipation of a Treasuries bubble. Provided the world remains inclined to see gold as a store of value and possible means of exchange, a gold bubble won't prick like a housing bubble and will actually benefit when the Treasury bubble is pricked. Is that right?


DLK said...

Hi Mike,

You are correct, in my opinion. The rising price of gold isn't a bubble.

Bubbles are the result of irrational bidding up of the price of some category of asset. I see nothing irrational about the rising price of gold at all. Neither does Peter Schiff (

Gold is not a productive asset, as a stock might be or as real, physical plant and equipment might be. In fact, gold has a built-in negative rate of return, because it has to be stored and protected. People don't hold gold because they believe the "earnings" of gold are going up, up, up. People hold gold when they are worried that fiat money will lose its command over real goods and services rapidly.

Price inflation occurs unevenly throughout the economy when the central bank pumps the monetary base. Often enough, some categories of assets lead the way as people spend excess money they do not want to hold in their portfolios. Gold is an ancient favorite.

Soros and Paulson have recently increased their holdings of gold (in the form of SPDR gold trust --- GLD). Paulson is up to 44% of his assets under management in GLD. Soros (whose politics I abhor) may be a political elitist, but he's not a financial moron.