James Pethokoukis

I recently rediscovered my optimism ………

Since Obama was elected, I had held out hope on some real long shots to hold on to my optimism, things like the “birthers” but when I discovered one simple inevitable truth ,”[B]markets don’t lie”[/B]………………… I discovered an ocean of new optimism and I am smiling like never before.

To explain my new found optimism , the reader will have to bare with me while I lay its foundation.

Why do Governments and very large corporations overwhelming “raise” money via bonds?

What is the difference between borrowing money via Bonds vs. a Bank loan?

Why does it make a difference?

The average individual that wants/needs a loan goes to a bank. Why don’t the many American Governments and Large corporations just go to a bank? Or better yet just buy a few banks? Or better yet why doesn’t the Federal Government just print the money ? Or do they?

Well, the answers are may not be simple but the pieces fit together so nicely for the future. So do some thinking on your own and consider the following. (The following two examples are simplified for the sake of brevity)

A loan form a Bank: A man walks in to a bank and asks to borrow $10,000.00 , if the bank approves the loan “according to the rules as a member of the Federal Reserve” and if the bank has at least $1,250.00 in “cash assets”, they have permission from the Federal Reserve to credit that mans account with $10,000.00 dollars. The Bank accounts for the money in this way, they move the $1,250.00 “cash assets” to $1,250.00 in “cash reserves”and the balance $8750.00 is placed on their balance sheet as a debt. This debt is held by the “Federal Reserve system” which all banks are a member, so the “debt or deposit” however you want to look at it, is recognized by all banks. So, this money will most likely never be printed, it only need be printed if the person, withdraws the money from the bank and puts it under his mattress at home. So the $8750.00 debt is money that has been created by fiat (out of thin air), as an entry in a log by the Federal Reserve system as a debt. ……………. If this type of transaction is kept under control via various tools of the Federal Reserve , you will have a good growing economy with low to no inflation because you will have a supply of Money growing at a manageable rate. And when the supply is growing then the demand is growing at close to the same rate.

A loan to a Government via a Bond/note/bill: A person withdraws 10,000.00 dollars from his bank account, he buys a Bond/bill or note from a Government or large cooperation and the person is given a piece of paper, a Bond guaranteed by the seller. The seller of the Bond deposits the money in a bank. The transaction is complete and no money was created………………. This type of transaction has a modest deflationary impact on the economy as the money generally used by the governments is not used productively.

The differences between the two above examples can not be overstated. As the Loan from a member bank of the Federal Reserve creates money out of thin air and a bond/ note / bill does not create any new money, this difference is profound and incalculably a positive effect on the American economy and our standard of living going forward.

Why?

Because, State, Federal, local government borrowing is always done by selling bonds, bills or notes, (at least for now) and this type of borrowing in itself is not inflationary. Which is very good news. And very large business’s also fund themselves with Bonds, which is another aspect of this which is extremely interesting in this changing world. Take the auto makers bankruptcy. The auto makers/unions stuck it to the bond holders, at the insistence of the Federal Government, boy that is going to come back and haunt the Federal Government! If you are a buyer of bonds, I think you might be a little bit wary of any big government or big business in the future. As you may get what the Bond holders in the auto makers got, nothing! If Obama will insist on not paying bond holders because of the union support of him, how much more will he resist paying Federal Government bond holders the money they are due?

Inflation occurs with large growths in Money supply and then the subsequent borrowing of that money. Both have to happen to get inflation, supply and demand. If the money supply increases and the borrowing doesn’t, no inflation. That exact scenario happened just a few months back.

But if Money supply and borrowing both increase, inflation is likely but not guaranteed. If your interested in the money supply figures you can look at them at www federalreserve.gov/releases/h6/current/

So, Is monetization of the National debt a likely scenario ?
Monetizing the debt, meaning making the national debt smaller by making the currency worth less. For “America” to monetize its debt, it really takes two participants. The Federal Reserve to keep interest rates low and for “American’s” to qualify and then borrow money at a rate that money supply grows rapidly, say 10 to 20 percent per year for a few years, I don’t see it happening. I don’t even see the Federal Reserve participation …….. Keep in mind three things regarding Federal Reserve Corp., 1: it is a private corporation. 2: their assets are 99 percent in Cash, so they don’t like high inflation . 3: While the Federal Government puts enormous pressure on the Fed to do their Bidding, the Fed has its own self interest and even if they did exactly what the Federal Government wants them to do, it still takes two to tango and unless the American People start to borrow the money that the Fed is making cheap you will still not have inflation and have you tried to get a loan lately?

The good news…………… Many Governments are coming to the ends of their ropes. Bonds are getting harder and harder to sell. And as they get harder to sell, they are having to pay more interest and soon it will be obvious, to all the investors in bonds, that these out of control governments will not even be able to cover the interest payments on these large debts. Soon your patriotism will be challenged if you don’t “invest” in the debt of the Federal Government. As these same governments struggle to find any and every excuse to raise taxes , which they know will produce only less revenue(goggle Laffer curve) and they will be in a even worse position. At that point they are going to be out of control. And when they finally come to the realization that they can no longer get investors to invest in their Ponzi scheme, that they have been running for 50 years or so??? They may literally go out of their minds.

So where will the big holders of Dollars like China put their dollars? I believe they will put them in Real estate , directly with purchase’s and via real estate mortgages and that has a double good effect ……. it will help keep Mortgage rates low, for those of us who pay our bills, and the dollars will stay out of the hands of the Governments and big business’s (GM) who don’t pay their bills. Markets don’t lie

The fools in the Congress, like Mr. Frank and Mr. Dodd, who passed the laws that enabled people who could not afford these overpriced homes, to go ahead and to buy them anyway. Homes they could not afford. that ended up destroying these same peoples credit ………………. and now that they could afford these homes, because of the collapsed housing market, they can’t buy them as their credit is in the toilet . And because Millions of people can not qualify to borrow money, it furthers the unlikely hood of inflation in the foreseeable future. So, Mr Frank and Mr Dodd get hoisted on their own petard, as the economy at this point will not produce the inflation they want and the economy won’t produce the revenue they are Jonesing for! Markets don’t lie

In this day and age we like to think of ourselves as an advanced culture , sophisticated in the ways of technology and we know all things ……….. but the truth is far from the way we think of ourselves. The fact is monetary systems are still not fully understood. Just like the scientist doesn’t know what “light” is or what “Gravity” is , they just know how to describe them. Bankers don’t fully understand monetary systems and all the possible interactions. From my observations, not until the early 1980′s did the Federal Reserve even have a clue as to what they were doing. Now with the advent of communications and computers, the Federal Reserve can do a much better but not a perfect job. Today, 2009, I can, with a stroke of a keyboard, check and see how much the money supply grew at last month. Just 30 years ago, the Chairman of the Federal Reserve did not have that information that quickly. With the countless interactions of a population of 300 million people buying and selling, not to mention the interactions with the worlds other economies, controlling the money supply, looks to me, to be as complicated as the weather here on earth. But with each passing recession the Federal Reserve learns more and I believe will do a better job as time goes on. And I think they generally do a good job.

I am very optimistic. The States and the Federal Government are going to wake up very soon and not be able to borrow any money. And as most people thought in the past, including me, that the Federal Government would just monetize the debt, will not and cannot happen, in a world economy and with an independent Federal Reserve and with China investing in things like Home Mortgages. Monetizing is not likely. My proof , the spread between what I can borrow money at and the Federal Government can borrow at, is less then 1 percent more per annum. That is incredible! Soon I may well be a more attractive risk to a lender, then the Federal Government! I think as of today , I am a better risk then the State of California!

- Treasury Bills mature in one year or less.
- Treasury Notes mature in two to ten years.
- Treasury Bonds have maturities greater than ten years.

James:

I don’t think banks are out of the wood yet! With a slow economy the next waive of default will be coming from commercial mortgages.
We started seeing more defaults. I think Banks will suffer more loses this year.

We hope for the best.

Eddie Fadel