Tuesday , 19 September 2017


Antal Fekete: The Fed Inadvertently Steering Economy on Road to Hell

My thesis is that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed to be a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears. Words: 2854

In further edited excerpts from the original article* Antal E. Fekete (www.professorfekete.com) goes on to say:

I have maintained over the years that with such bond speculation the economy would go into a recession and then morph into a depression. As I see it the immediate cause of such a depression is the destruction of capital and the ultimate cause is the monetary policy of open market operations. The chain of causation is as follows:

1. Open market operations (in effect, net purchases of T-bills) by the Fed invite bond speculators to take risk-free profits offered by this fact of their predictability.

2. Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, quantitative easing takes the risk out by making the odds that the normal yield curve will invert negligible.

3. The bond speculator faces the problem of having to roll forward the fast-expiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.

4. The upshot is that interest rates keep falling along the entire yield curve. Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.

Here we have the solution to the Greenspan-conundrum: the sky is the limit to the bond speculators’ appetite for Treasury paper. They are all right as long as they can sell T-bills against them. As the sky is the limit to the Fed’s appetite for T-bills, both flanks of the speculators are secure.

This is a vicious spiral: the more currency the Fed creates, the more risk-free profits bond speculators will reap, contributing to a further fall of interest rates.

The Squeeze is on to Bankrupt the Entire Economy
This outcome is the exact opposite of the one predicted by monetarism which predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however. The new money refuses to flow uphill to the commodity market. It will flow downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market? So grab the money, buy more bonds and sell the bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.

The Fed’s Fiat Currency Play is Nothing But a Ponzi Scheme
Some might object that the Fed could short-circuit the process and undercut the bond speculators’ lucrative business. All it has to do is to buy the short-dated paper directly from the Treasury. Inverting the yield curve will shake off the parasites but in my view there is no danger of this happening. The Treasury and the Fed know that bond-vigilantes watch what they are doing like a hawk. Any hanky-panky of direct sales of T-bills by the Treasury to the Fed would make them cry “foul play” as indeed it would be because direct sale of Treasury paper to the Fed would degrade the dollar from irredeemable currency to fiat currency. That is a subtle difference, realized only by a few.

Fiat currency is worse. Its arbitrary augmenting is decided behind closed doors. It does not need the endorsement of the open market. Fiat currencies have a short life-span as they readily succumb to the sudden-death syndrome. Irredeemable currencies are different from fiat in that they are created openly, using collateral purchased in the open market. They have a more respectable life-span. As long as the official check-kiting conspiracy between the Treasury and the Fed remains hidden from the general public, irredeemable currency may even prosper. Direct sale of T-bills by the Treasury to the Fed would tear down the curtain that hides the fact of check-kiting.

The mechanism of check-kiting is as follows: the Treasury issues debt which it has neither the intention nor the means ever to repay. This debt is used as “backing” for Federal Reserve notes and deposits, which the Fed has neither the intention nor the means ever to redeem. When the Treasury debt matures, it is paid in Federal Reserve credit issued on the collateral security of new Treasury debt. When Federal Reserve credit is presented for redemption, the Fed offers interest-bearing Treasury debt in exchange. This is a shell game and it exhausts the definition of check-kiting. Neither the Treasury debt, nor the Federal Reserve credit is issued in good faith. Neither is redeemable any more than Charles Ponzi’s tickets were. They are both issued in order to mesmerize a gullible public, much the same way as Ponzi did.

The Fed are Trying to Avoid a Crack-up Boom
Treasury and Fed officials know their history. They are familiar with the fate of the assignat, the mandat, the Reichsmark, not to mention the Continental. They know that no fiat money ever survived “the slings and arrows of an outrageous fortune”. Their only hope is that the fate of the irredeemable dollar, as predicted by Friedman, will be different. They will not embark upon an adventure in monetary policy involving direct sales of T-bills by the Treasury to the Fed because they know that if they did, surely this would be the end of their experiment. Foreigners as well as Americans would start dumping the dollar unceremoniously, and buy anything they can lay their hands on. This is variously known as flight into real goods, Flucht in die Sachwerte, crack-up boom, Katastrophenhausse. I purposely avoid using the term hyperinflation as it connotes with the Quantity Theory of Money, which is not really a theory. It is a linear model trying to explain non-linear phenomena.

Bond Speculators are “Scalping” the Fed
There is also a second method by means of which bond speculators are making risk-free profits. They “front-run” the Fed in the bill market. This means that, through inside information or otherwise, they divine when the Fed has to answer “nature’s call” and must make the next trip to the open market in order to buy the collateral without which it cannot issue more money. Bond speculators forestall the Fed by purchasing the bills beforehand, thus driving up the price. Then they turn around and dump the paper into the lap of the Fed at the enhanced price, making a risk-free profit. This process is called “scalping”, after the kindred activities of small-time speculators in tickets for the World Series and other popular sporting events.

The objection that the Fed knows how to throw bond speculators off scent by various stratagems ― for example, through falsecarding, say, by selling when speculators would expect it to buy ― can be safely dismissed. There is no question that every year the Fed is a big buyer of bills on a net basis. If it sells, it has to buy that much more later on. Fiddling means that the Fed may miss its target. Falsecarding may back-fire.

The speculators are a smart lot, thanks to “natural selection” culling the rank and file. They risk their own capital which they stand to lose if they place the wrong bet. Once their capital is gone they are out, and smarter guys will take over their place. Hired hands at the Fed are no match for them as far as brightness and adroitness is concerned. The latter work for salaries. If they make the wrong bet, losses will be replenished by dipping into the public purse.

Cheating in Las Vegas
My voice has remained a cry in the wilderness. Nobody pays attention to the mumblings of this armchair economist. Interestingly, however, a website called Jesse’s Café Américain (http://jessescrossroadscafe.blogspot.com), recently posted a story entitled “Front-Running the Fed in the Treasury Market” suggesting that someone has tapped into the Fed’s buying plans to monetize the public debt and is front-running those purchases, essentially ‘stealing’ money from the public. It’s what they call a ‘sure thing’. To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically ‘normal’, but is consistently ‘too good’. The problem with cheaters is that they sometimes get greedy and call attention to themselves. In Las Vegas the bigger cheats at the casino were often taken to the desert for further questioning and final disposal. On Wall Street they are more arrogant and persistent, defying resolution with that ultimate defiance, “We’ll just have to figure out other ways to cheat, and come back again”. Time for a trip to the desert?

Congenital Disease of the Irredeemable Dollar
While the above may, indeed, be occuring cheating is not necessarily involved. What is happening may not be a purposeful, if veiled, Fed policy, nor is it necessarily someone at the Fed tipping off his brother-in-law at a brokerage house (however valuable the tip may be). Instead, what we may be facing here is a congenital disease of the irredeemable dollar.

There is no need to look for a conspiracy in the bond market. It is quite possible that a large number of smart speculators, acting spontaneously and independently of one another, have come to realize that there is a bonanza, perfectly legal, in ripping off the public purse. Of course, they have kept their own counsel.

If anybody is responsible for this colossal blunder of economics releasing the genie of risk-free speculation out of the bottle, the names that come to mind are those of Keynes and Friedman, respectively. They invented the ‘improved’ system of floating exchange rates assuming a goldless currency that has to be arbitrarily augmented from time-to-time through the monetization of government debt (that, incidentally, proliferated profusely after the politicians deliberately unbalanced the budget upon the explicit advice of Keynes). The rest, as they say, is history.

As long as budget deficits were ‘modest’, the activity of speculators making risk-free profits in the bond market escaped public attention. With the advent of ‘quantitative easing’ and mega-deficits, everybody sitting at a bond-trading desk can see it. The figures literally jump off the screen, as explained by Jesse’s blog.

The Fed’s has Encouraged Bond Speculation
To be fair to Jesse’s anonymous correspondent I must admit that his conjecture, that in risk-free bond speculation we may be looking at deliberate Fed policy, is plausible. It is not impossible that the rot in the U.S. monetary system has already spread so far that in a truly free and unrigged bond market no bidders would turn up. Time is long since past when Treasurys were eagerly sought after by the most conservative segment of the investing public, such as the guardians of widows and orphans, trust funds, eleemosynary institutions.

Typically, they held the bonds to maturity. Treasuries, second only to gold, were the most trusted instruments of wealth-preservation. Under the regime of the irredeemable dollar no investor in his right mind would buy a Treasury bond and hold it until maturity. Treasuries lose value as ice melts in the sunshine. They have become a plaything in the hands of speculators for their value in turning a fast buck. Under the gold standard there was no bond speculation, just as there was no foreign exchange speculation. Interest rates were stable and so were bond prices. Speculators would shun bonds. Of course, all this changed when president Nixon defaulted on the short-term gold obligation of the Treasury to foreigners in 1971, and gold was finally removed from the international monetary system at the behest of the U.S. government.

For a decade speculators were happy with the trading profits they could make in the bond market. As the monetary system kept deteriorating, however, they started abandoning bonds, transferring their activities to the commodity market. By 1981 demand for bonds practically evaporated. As this spelled the end of the regime of the irredeemable dollar, the Fed had to do something to prop up the bond market by enticing bond speculators back. As such, it is quite possible that a decision was made at the highest level to offer the enticement of risk-free profits to bond speculators. It certainly cannot be denied that bond speculators have been making obscene profits in the course of the 30-year bull market in bonds that is still ongoing. These profits are unprecedented in the history of speculation, both on account of their magnitude and their regularity. They were made at the expense of productive enterprise, the capital of which has been surreptitiously siphoned off by the falling interest-rate structure.

The Fed has Recruited a Corps of Shills
Another way of describing this scenario (assuming it is correct) is that in 1981 the Fed, unknown to the public, decided to recruit a corps of shills to prop up a moribund bond market. The shills hired by the casinos of Las Vegas bet big and win big at the gaming tables in full view of the gamblers who are unaware that they are being treated to a show. The sight of these big payoffs will then perk up the gambling spirit of a lethargic clientele.

The shills recruited by the Fed are the bond speculators, and their remuneration is in the form of risk-free profits they are allowed to make (and keep). The scheme was a roaring success. Not only did it save the bond market from extinction; it also saved the dollar from ignominy, and was instrumental in making possible a whole string of bubbles, each bigger than the previous one, during the past decade.

The Road to Hell Is Paved with Good Intentions
The problem is far more serious than it may at first appear. Risk-free speculation is like a computer-virus that has no antidote and threatens to wipe out the Internet. It short-circuits normal economic processes and gobbles up the world economy.

I would welcome a public debate of my thesis that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed as a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears.

Here is the Problem
The prevailing orthodoxy is the unholy alliance between Keynesianism and monetarism inspired by Friedman (defying the pretence that these two are antagonistic theories). The idea that an artificial increase in the money supply must raise commodity prices dies hard but as my theory suggests, and as events have repeatedly shown (first during the Great Depression of the 1930’s, and again, during the present crisis), the presence of risk-free speculation renders the increase in the money supply counter-productive. It causes prices to fall rather than rise.

Giving them the toy of risk-free profits, speculators vacate the commodity market where risks are too high, and they congregate in the bond market where risks are non-existent. The speculator who in the absence of risk-free profits might resist falling prices in the commodity market, will decline the honor of helping the Keynesian agenda if given the choice of risk-free profits in bonds. This is basic human reaction that cannot be criticized, still less rectified, by official brow-beating. Keynesians should have thought about the consequences of their master-plan more thoroughly before they put open-market operations into effect.

The intentions of policy-makers at the Fed are praiseworthy. They want to prevent prices and employment from collapsing but they are prisoners of their orthodoxy, and their good intentions make them steer the economy on the road to hell.

A catastrophe is confronting the Titanic, but the captain, just confirmed in his position in spite of a most serious public challenge, will not change course. A head-on collision with the iceberg straight ahead, otherwise known as the debt-tower, now appears inevitable.

*http://www.professorfekete.com/articles%5CAEFFrontRunningTheFedInTheTreasuryMarket.pdf

Editor’s Note:
– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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One comment

  1. Professor Fekete sent me the article below from Gary North (http://www.garynorth.com/public/6092.cfm) that is a stern and unkind rebuttal of what he had to say in the article above. It shows you how confident Fekete is in what he asserts on one hand and how thick skinned he is on the other.

    Antal in Wonderland: Antal Fekete’s Theory of Monetary Hyperinflation That Creates a Boom in Bonds and a Falling CPI

    Antal Fekete’s article may confuse you so let me de-confuse you.

    First, he is a deflationist. This is the central fact. He thinks there will be two money supplies, and the dominant one is deflationary. If you think this sounds nutty, wait until you read what he says about the bond market.

    He begins with a summary of a nine-year forecast that has not come true. This, I must admit, is a unique way to begin an article that once again forecasts the same non-event. But this is what deflationists do.

    “For some nine years I have been predicting that the economy is going to a recession morphing into a depression, using a purely theoretical argument”.

    He summarizes his argument: “the Federal Reserve’s policy of buying assets with fiat money causes a decline in interest rates. This decline destroys capital”.

    Odd; falling bond rates raise the market value of bonds. But he says this destroys capital. Our journey into Wonderland begins. Everything is backward in Wonderland.

    “The immediate cause of the depression is the destruction of capital.” But why do falling long-term interest rates destroy capital? That is the issue he must deal with. Let me show you how he deals with it.

    The FED lowers interest rates for the assets it buys with fiat money. But as long as the money is not sterilized by banks that refuse to lend — which the FED can force to lend by charging a fee on excess reserves — the money raises prices.

    At that point, there will be an added rate of interest tacked onto all long-term loans. Lenders want protection against a depreciating currency unit. They charge higher interest rates. This is discussed by Murray Rothbard, who called this factor an inflation premium. Rothbard wrote:

    “Thus, if someone grants a loan at five percent for one year, and there is seven percent inflation for that year, the creditor loses, not gains. He loses two percent, since he gets paid back in dollars that are now worth seven percent less in purchasing power. Correspondingly, the debtor gains by inflation. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay it. Hence, in the long-run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums. Therefore, a Fed tightening will now tend to dampen inflationary expectations and lower interest rates; a Fed expansion will whip up those expectations again and raise them.”

    This is simple. Fekete does not address this obvious issue.

    Fekete argues that the FED’s purchase of T-bills will lower short-term rates. Agreed. This will create a carry trade. Maybe. Banks will borrow the money and buy bonds. This will lower bond rates: increased demand.

    He writes:
    “(2) Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, Quantitative Easing takes the risk out by making the odds, that the normal yield curve will invert, negligible”.

    A yellow light should go on. You should be thinking: “I am about to get rolled, intellectually speaking.”

    Can you spot the error? Probably not, unless you are a well-read Austrian economist or a professional investor.

    Fekete limits his discussion to T-bonds. He never mentions corporate bonds.

    This is the pea under the shell. “Keep your eye on T-bonds. Don’t look at corporate bonds.”

    The corporate bond market is the 800-pound gorilla in the world of finance. It is where companies raise capital. In the first quarter of 2009, the U.S. corporate bond market amounted to $6.7 trillion.

    Fekete goes on to say:
    “(3) The bond speculator faces the problem of having to roll forward the fast-expiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.”

    I have warned readers not to short T-bonds, for just this reason. It is not a free market. I have said that shorting corporate bonds is a legitimate crap-shoot. It is risky, but it is a relatively free market. Rising price inflation will raise corporate bond rates. The bonds will fall in value. Why? Because the existing bonds locked in a lower rate. That rate is now a money-loser.

    Fekete never mentions municipal bonds, either.

    Corporations can be wiped out by inflation. Capital costs rise. Labor costs rise. The risk of corporate default rises. So, corporate bond rates are hit by a second factor, beyond the inflation premium: the risk premium. Companies may default.

    Fekete ignores this. He goes on:
    “(4) The upshot is that interest rates keep falling along the entire yield curve. Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.”

    See the trick? He says “bond speculators.” But he is talking only about Treasury bond speculators.

    Can he be this blind? Yes. He is a deflationist.

    In my other writings I have explained how a prolonged fall in interest rates along the yield curve brings about depression through the indiscriminate destruction of capital in the productive as well as financial sector.

    A fall in the yield curve — the Treasury’s yield curve — that results from mass inflation of money brings an economic boom, rising gold and silver prices, and asset bubbles. The money flows into the economy, creating a boom. See Mises, Human Action, chapter XX. Fekete is wrong again — in theory and in terms of economic history.

    When Fekete says, “There is a vicious spiral: the more currency the Fed creates, the more risk-free profits bond speculators will reap, contributing to a further fall of interest rates” he is talking about T-bond speculators, not corporate bond speculators.

    He then says:
    “This outcome is the exact opposite of the one predicted by monetarism. The latter predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however.”

    Is he blind? This is exactly what has happened! The recession was reversed by massive FED spending that saved the housing market: over $1 trillion.

    And goes on to say:
    “The new money refuses to flow uphill to the commodity market. It flows downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market?”

    Remember: he has not yet discussed corporate bonds. He never does.

    And then says:
    “The corporate bond market fell for 34 years, 1947 to 1981, because of Federal Reserve inflation. It reversed only after Volcker’s policies tightened money. Bond rates came down after 1982.

    In October of 1946, Truman removed the wartime price and wage controls. So, 1947 was the first year of a free market since World War II began. In 1947, AAA corporate bonds paid 2.57% at the beginning of the year. In September 1981, at the peak of 34 years of price inflation, they paid 15.49%. The data are here, courtesy of Economagic.

    Bond prices move inversely to bond rates/yields. This was the longest bear market in corporate bonds in U.S. history. Anyone who bought and held AAA corporate bonds got killed financially.”

    Fekete wants us to believe that monetary inflation will not raise bond rates. On the contrary, it will lower bond rates, he insists. To make his case, he limits his discussion to T-bonds. This is simply intellectual trickery. This is putting the shuck on the rubes.

    An honest mistake is one thing. But this is a mistake so inconceivably huge that it calls into question the man’s ability to deal with reality. At the heart of his argument is an error that destroys his argument.

    He concludes:
    “So grab the money, buy more bonds and sell an equal amount of bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.”

    This is Antal in Wonderland.

    This sort of thing passes for serious analysis: bad theory, deliberate deception (or huge ignorance), and a refusal to look at the historical data.

    For background on Fekete’s theories, begin here:

    http://www.lewrockwell.com/blumen/blumen9.html
    http://blog.mises.org/archives/003869.asp
    http://blog.mises.org/archives/004196.asp