Author : John E. Charalambakis
Date : September 18, 2013
Our Federal Reserve Bank, the ECB, and other central banks of developed nations face a paradox: the same institution that is supposed to hold the ultimate reserves of the commercial banks has a duty of lending those reserves to the banks that are in trouble and which are lacking those reserves that were supposed to have deposited with the central bank. Welcome to quantitative easing (creating reserves out of thin air), where the central bank not only lends those newly created reserves but also monetizes the debt of the government, while sustaining an environment of financial repression (i.e. keeping interest rates extremely low). Someone may call it the art of central banking, while someone else may call it the art of staying sane in this insane environment. My fear is that the system may be able to sustain itself for a few more years if tapering takes place and interest rates rise, however the explosion of the reserves (in cosmological terms the dark energy) has already planted the seeds of the system’s implosion (dark matter) in a new kind of a Minsky moment. If that is the case then, who can blame Chairman Bernanke wanting to exit his position?
David Ricardo once observed “…neither a State nor a bank ever has had the unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control, and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or in bullion”.
These days we are recalling the awful facts of five years ago when the collapse of asset values froze credit and brought the global economy on the verge of a depression. While we have written before about the causes of that collapse, we have not discussed in detail the role of cash plus reserves as a fraction of banks’ financial assets as the vehicle of crises. The fact is – as Minsky showed in his work – that when that percentage declines, a crisis is brewing. This fact shines new light into central banks’ focus (up to now) to create enough reserves in the system to avoid total collapse.
However, those reserves need to be classified into non-borrowed (banks’ own reserves) and borrowed reserves. The central banks objective then in the next phase is to let borrowed reserves be converted into loans so that through the deposit creation mechanism of the fractional reserve system more non-borrowed reserves to be created. Here we enter one of the reasons for optimism regarding equity markets (with the reservation of a needed correction in the next few weeks). As borrowed reserves are being converted into money supply through loans, the velocity of money should increase, and the provided liquidity will uplift the stakes of corporations and of the economy in general.
As liquidity and loans increase, asset prices rise too and that allows the banks to relax a little bit the lending standards. Therefore, for a period of another two-four years the system can retain a momentum. The problem arises due to the fact that the ratio of borrowed (from the central banks) over non-borrowed reserves is way out of historical norms, which restraints free cash flow in the economy, especially when interest rates are rising. Banks once again will revert to a variety of position-making instruments in order to be able to function with such low ratios of cash and non-borrowed reserves to total assets (despite the deleveraging that they attempted). Those position-making instruments have to accommodate the need for total assets to increase relative to the non-borrowed reserve deposits and vault cash, which in turn will push the banks to develop reserve-economizing types of liabilities, such as swaps, and borrowing from foreign banks (Eurodollars) to make a position.
As credit expands (generated by borrowed reserves), the inverted debt pyramid – founded on fiat money – will stand on very thin ice, and “asset” holders will start realizing that their “assets” are nothing but third-party liabilities that cannot be honored, and hence my prediction that as the central banks attempt tapering we may be entering the last phase of what we know as paper money.
We built a system that taught us that money is neutral. What a delusion! Money never was and never will be neutral. Circulated borrowed reserves cannot be the fertilizer of new economic activity that creates real capital and collateral sufficient enough to resolve the mess that derivatives created.
Precious metals may still portray a downward trend, but have no counter-party liability. The time will come in the near future when they will be attractive again for accumulation.