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January 8, 2024 | Sometime during the summer of 2016, the worst of the post 2008 asset price deflation arguably bottomed out. During that summer, Cumberland Advisors chief-investment officer David Kotok approached us during lunch on the shores of the Big Lake in Downeast Maine.
“Write the book,” said Kotok. He had a glass of white wine in one hand and a large chain pickerel on a stringer in the other. “Write the book.” Kotok then turned and went off to consult with Ray Sockabasin about the steaming of the pickerel.
Source: Missouri Department of Conservation
After returning from Maine, we next heard from the folks at John Wiley & Sons. “We hear you are writing a book,” they exclaimed. We said yes. Soon a contract appeared. We then realized that a book need be written. And it was.
In the intervening 15 years, we have discovered an awful lot more about the financial history of the US that makes us think about reissuing "Inflated," especially now that the US public debt has reached $35 trillion. In 2010, the US public debt was under $15 trillion, but today post-COVID we are at just shy of $35 trillion and counting.
Notice in the chart below showing the national debt that the relative increase in debt accumulation during COVID was minor, but the baseline of increase in indebtedness has been steady. Growing fiscal deficits reflect a national flight from reality that has occurred during and after the 2008 financial crisis. Nobody in Washington or on Wall Street seems to know or care. The growth in debt suggests that the psychic damage caused by 2008 may be more enduring than the COVID lockdown event.
Source: US Treasury
In the book "Inflated," we argued that understanding the development of the US financial evolution since colonial times is about layers of leverage. In the earliest days, Americans used gold and silver coins, and obligations drawn upon UK and Dutch banks. Later state chartered banks added to the money stock, issuing private paper IOUs against vault cash measured in precious metals. Money in those days was metal.
By the Civil War, the government of Abraham Lincoln borrowed all of the available gold coin and then turned to issuing unbacked paper greenbacks to finance the war to end slavery. The creation of national banks to buy Lincoln’s debt was a major addition of leverage in the American system and one that remained even after the Civil War era greenbacks were redeemed. The legal and financial expedients used to finance the civil war enshrined the special role of the dollar in the US economy.
The creation of the Federal Reserve System on the eve of WWI represented yet another new layer of leverage, this to feed the demand for financing during and after the war. The Fed took the ball from JPMorgan and other US banks to finance the wartime trade needs of the Allied governments. After the 1929 market collapse a decade later, market capitalism in the US truly died.
More publicly-backed parastatal entities led by the Reconstruction Finance Corporation and the Federal Deposit Insurance Corporation were created by Washington to restructure and finance housing, banks and many other parts of the economy. We wrote in "Inflated" in 2010:
"It is often overlooked by popular accounts of the Great Depression that President Hoover, and not FDR, created the Reconstruction Finance Corporation (RFC) and the Federal Home Loan Banks, two of the most significant and interventionist initiatives ever taken by Washington up to that time. The RFC, operating under Jesse Jones, was empowered to make loans to banks, insurers, and industrial companies almost without limit. The RFC was initially set up with the idea of repaying the government and then some on its investment, and would serve as an important part of the government’s response to the Depression during the 1930s."
In the 1970s Ginnie Mae and then the GSEs became issuers of securities, adding yet another layer of leverage. Nonbank finance blossomed in the 1990s, driving decades of economic growth despite the best efforts of prudential regulators to kill this key American phenomenon. In the most recent Fed proposal in Basel III Endgame (see our comments here), the regulatory attack on residential mortgage finance has reached a hysterical frenzy.
Last week we reminded our readers on X to read a couple of important research papers coming from the economic community talking about the true reasons behind the Fed’s open market operations in 2008 and 2020. In both cases, the narrative tells us that the central bank rode to the rescue of the US economy. In fact, the Federal Reserve Board rescued the US Treasury and, indirectly, the national Congress.
Menand and Younger (2023) state in their excellent paper, “Money and the Public Debt: Treasury Market Liquidity as a Legal et Liquidity as a Legal Phenomenon.”
“This Article… argues that American public finance has long been closely intertwined with the American monetary framework and that deep and liquid Treasury markets are, in large part, a legal phenomenon. Treasury market liquidity, in other words, did not arise organically as a product primarily of private ordering. Instead, it was actively constructed by government officials. The high degree of convertibility between Treasury securities and cash—the market’s “liquidity”—depends upon entities that can create new, money-like claims to buy Treasuries. Sometimes the government’s central bank has issued these claims directly, as in March 2020; other times these claims were issued by central bank-backed instrumentalities, such as banks and select broker-dealers. Either way, it has taken extensible, money-financed balance sheet capacity to give Treasuries their cash-like properties.”
Notice in the above passage that the market for Treasury debt was created by government and, of course, sold by private dealers. In 2008, as we’ve noted in The IRA over the years, the primary dealer community was annihilated. The Fed forced many independent primary dealers to merge with or become commercial banks. Becoming banks destroyed the nonbank ecosystem for marketing US Treasury debt. This evolution took us backward to the period before WWII when large banks controlled US finance.
Why is the decline of the nonbank dealer community important? The public debt is rising during a time when the functioning of the Treasury market is deteriorating. The Dodd-Frank legislation enshrined the Volcker Rule, for example, reducing liquidity in the bond markets. Independent primary dealers that once made markets in Treasury paper have been replaced with hedge funds running basis trades funded with credit lines provided by bank prime desks.
Treasury Secretary Janet Yellen and others in the establishment fuss about the need for central clearing in the market for US government debt. Yet do these luminaries that populate the Biden Administration understand that limiting market liquidity via regulations like Basel III, the Volcker Rule and now centralized clearing of Treasury debt, actually hurts market function? These last remaining nonbank buyers of Treasury debt are seen as a problem by regulators, but they could not be more wrong.
Ponder the bid-to-cover ratio of the 10-year Treasury note below. Notice that the ratio has steadily declined as the size of the auctions has increased.
Source: Bloomberg
The steady increase in calls for the Fed to end its balance sheet runoff (aka “QT” in Fed newspeak) is really not about interest rates or the economy, but all about poor execution in the US Treasury market. Dallas Fed President Lori “Repo” Logan, the intellectual author of the Fed's various liquidity facilities, has been among those officials saying that the Fed should maybe end its balance sheet contraction soon. That’s a hint.
Notice in the chart above that the Fed's reverse repurchase agreement (RRP) facility has shrunk as money market funds moved into T-bills. Yet the overall system open market account (SOMA) is still over $7 trillion. That $2.5 trillion in low-coupon mortgage-backed securities is not moving at all. Those Fannie, Freddie and Ginnie Mae MBS with sub 4% coupons might as well be 15-year Treasury bonds in terms of effective maturity.
The Fed’s balance sheet is still enormous, but the public debt is growing rapidly, the more important fact. Like most Fed officials, Logan never actually talks about the budget deficit. We never talk about why the Fed needed to erect all of these new liquidity facilities and repo programs in the process of keeping the Treasury market open. Here is an excerpt from Logan’s comments from November 2023.
“In recent decades, central banks around the world have been shifting toward floor systems for monetary policy implementation. That shift has been motivated by the actions central banks had to take in response to the Global Financial Crisis (GFC) and subsequent stress episodes; by a growing appreciation of the benefits of floor systems across a wide range of economic and financial environments; and by post-GFC changes in bank regulations and banks’ own risk management, which increased the demand for liquidity and the costs of interbank transactions.”
Logan, like most Fed officials, is able to deliver speeches rivaling the oratorial duration of Fidel Castro but say absolutely nothing. Logan describes a “liability driven floor” system for reserves as the US policy choice going forward, yet she neglects to tell us why the Fed needed to defend the zero bound at all. The Fed’s actions in Q1 2020 to catch the collapsing market for Treasury debt created huge market disruptions for banks and money-market funds. The Bank Term Funding Program then became necessary when the Fed shifted to “fighting inflation.”
Notice at the end of her speech that Logan continues the idiotic messaging by Fed officials asking commercial banks to make regular use of the discount window. Not going to happen. Calls by Fed officials for banks to use the discount window for regular liquidity needs is revealing of the childlike naïveté that operates inside the central bank. Banks that are seen using the Fed discount window are presumed to be distressed and at risk of imminent failure. No amount of happy talk from President Logan or other Fed officials will change this perception. Fed officials would do well to come up with a new name for the bank liquidity facility.
The effective nationalization of the US bond markets and banks is the unspoken truth that President Logan and Fed Chairman Jerome Powell will never address publicly. Since the FOMC began targeting fed funds as a policy mechanism decades ago, the short-term interest rate market has become a function of FOMC policy and ever more frequent open market operations. Equity market investors do not seem to understand what this creeping nationalization of the heretofore private credit markets implies. As the public debt of the US grows, after all, the implicit claim of the Treasury on all private US assets also expands apace.
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