A Termite-Riddled House: Treasury Bonds

  
When termites eat your house, you don’t notice a thing. You don’t hear a thing, you don’t see a thing—you’re house stands there, silent and staid, while you and your family happily go about your days, without a care in the world—
  
—until your house crashes on top of your head.
  
Right now, we are at a stage where Treasury bonds are as weakened as a termite-riddled house. They look fine: Nice glossy coat of paint, pretty shingles, bright clear windows, sturdy-looking plankings on the open-aired porch. 
  
But Treasuries are well on their way to a complete collapse. Why? Because of the way they have been mishandled and mistreated by the Federal Reserve Board, and the U.S. Treasury. Whether by incompetence or by design, U.S. Treasury bonds have become the New & Improved Toxic Asset. The question is no longer if they will collapse—it’s when. 
  
Let me explain why. 
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Hyperinflation, Part II: What It Will Look Like

I usually don’t do follow-up pieces to any of my posts. But my recent longish piece, describing how hyperinflation might happen in the United States, clearly struck a nerve. 

It was a long, boring, snowy piece of macro-economic policy speculation, discussing Treasury yields, Federal Reserve Board monetary reaction, and the difference between inflation and hyperinflation—but considering the traffic it generated, I might as well been discussing relative breast size in the porn industry. With pictures. 

Essentially, I argued that Treasury bonds are the New and Improved Toxic Assets. I argued that, if there was a run on Treasuries, the Federal Reserve—in its anti-deflationary zeal, and its efforts to prop up bond market prices—would over-react, and set off a run on commodities. This, I argued, would trigger hyperinflation. 

 

The disproportionate attention my post garnered is indicative of people’s current fears. As I’ve said before, people aren’t blind or stupid, even if they often act that way. People are worried—they’re worried about the current state of affairs: Massive quantitative easing, toxic assets replaced by the full faith and credit of the U.S. government in the shape of Treasuries, fiscal debt which cannot possibly be repaid, a second leg down in the Global Depression that seems endless and only getting worse—people are scared. Many readers gave me quite a bit of useful feedback, critiques, suggestions and comments on the piece—clearly, what I was discussing touched on a deeply felt concern. 

However, there were two issues that many readers had a hard time wrapping their minds around, with regards to a hyperinflationary event: 
 
The first was, Where does all the money come from, for hyperinflation to happen? The question wasn’t put as baldly as that—it was wrapped up in sophisticated discussions about M1, M2 and M3 money supply, as well as clever talk about the velocity of money—the acceleration of money—the anti-lock brakes on money. There were even equations thrown around, for good measure. 

But stripped of all the high-falutin’ language, the question was, “Where’s all the dough gonna come from?” After all, as we know from our history books, hyperinflation involves people hoisting bundles and bundles of high-denomination bills which aren’t worth a damn, and tossing them into the chimney—’cause the bundles of cash are cheaper than firewood. If the dollar were to crash, where would all these bundles of $100 bills come from?
 
The second question was, Why will commodities rise, while equities, real estate and other assets fall? In other words, if there is an old fashioned run on a currency—in this case, the dollar, the world’s reserve currency—why would people get out of the dollar into commodities only, rather than into equities and real estate and other assets? 
  
In this post, I’m going to address both of these issues.

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How Hyperinflation Will Happen

Right now, we are in the middle of deflation. The Global Depression we are experiencing has squeezed both aggregate demand levels and aggregate asset prices as never before. Since the credit crunch of September 2008, the U.S. and world economies have been slowly circling the deflationary drain. 

To counter this, the U.S. government has been running massive deficits, as it seeks to prop up aggregate demand levels by way of fiscal “stimulus” spending—the classic Keynesian move, the same old prescription since donkey’s ears.

But the stimulus, apart from being slow and inefficient, has simply not been enough to offset the fall in consumer spending. 

For its part, the Federal Reserve has been busy propping up all assets—including Treasuries—by way of “quantitative easing”.

The Fed is terrified of the U.S. economy falling into a deflationary death-spiral: Lack of liquidity, leading to lower prices, leading to unemployment, leading to lower consumption, leading to still lower prices, the entire economy grinding down to a halt. So the Fed has bought up assets of all kinds, in order to inject liquidity into the system, and bouy asset price levels so as to prevent this deflationary deep-freeze—and will continue to do so. After all, when your only tool is a hammer, every problem looks like a nail.

But this Fed policy—call it “money-printing”, call it “liquidity injections”, call it “asset price stabilization”—has been overwhelmed by the credit contraction. Just as the Federal government has been unable to fill in the fall in aggregate demand by way of stimulus, the Fed has expanded its balance sheet from some $900 billion in the Fall of ’08, to about $2.3 trillion today—but that additional $1.4 trillion has been no match for the loss of credit. At best, the Fed has been able to alleviate the worst effects of the deflation—it certainly has not turned the deflationary environment into anything resembling inflation.

Yields are low, unemployment up, CPI numbers are down (and under some metrics, negative)—in short, everything screams “deflation”. 

Therefore, the notion of talking about hyperinflation now, in this current macro-economic environment, would seem . . . well . . . crazy. Right?

Wrong: I would argue that the next step down in this world-historical Global Depression which we are experiencing will be hyperinflation. 

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QE2 Will Sink Us

See Update I, below.

Ben Bernanke and the Federal Reserve are preparing for QE2—a second round of Quantitative Easing.

The rationale is that the United States’ economy is circling the deflationary drain—something Bernanke and the Fed are absolutely terrified of. Certainly deflation is hitting the U.S. economy full bore, but it’s yet to be proven that this deflationary trough has twisted itself into a self-reinforcing vicious cycle. I would argue that the chances of the U.S. economy twisting into a deflationary death spiral has yet to be made. But be that as it may, it doesn’t matter if the economy is in a deflationary death spiral—Bernanke and Co. think that that’s the imminent danger. And they're the ones with their finger on The Big Red Money-Making Button.

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Fuck The Deficit (Or Will The Deficit End Up Fucking Us?)

Currently, the United States is conducting one of the most remarkable experiments in fiscal finances in world history.

The American economy is in a severe recession. Coupled with that—as both partial cause and partial effect of the recession—the United States' banking system crashed in the Fall of '08, a crash which in many ways is still ongoing as I write this, nearly two years later.

What the recession and the concomitant banking crisis have caused are, essentially, a fall in aggregate demand levels, as well as a fall in aggregate asset value. In other words, the population is spending less, and asset values have deteriorated, both nominally and as compared to any basket of hard commodities.

These are the two metrics which the two principal camps of current American macroeconomic thought consider vital. “Saltwater” economists look to aggregate demand levels, while “freshwater” economists look to aggregate asset value—each of these camps view their fetish-object as the cornerstone for economic growth, development and prosperity. Naturally, when either of these camps see their juju slide, they freak out. They declare the economy to be “in crisis”—and further declare that “something must be done”.

Something has been done: It's called The Deficit.

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