The Trillion-Dollar Day

December 28, 2007

What happens when governments create $1 trillion out of thin air? Nothing good, according to Serrapere.
 

Mr. Mosler is a seasoned Fed watcher and principal of Valance Co, Inc. Mr. Mosler originated the "mortgage swap" in 1986. He orchestrated the largest futures delivery to date (over $20 billion notional) in Japan in 1996. He also created the current euro swap futures contract. Mr. Mosler also is a Senior Associate Fellow at the Cambridge Center for Economic and Public Policy, Downing College, Cambridge, U.K., and an Associate Fellow at The University of Newcastle, Australia.

Mr. Mosler responded to my take on The Trillion Dollar Day, which references financial dealing during a 24-hour period on December 18 to 19, 2007. You can also find this information at www.mosler-economics.net.

I am not an expert on the Fed or central banking. In fairness to readers, it is best to examine Mr. Mosler's views. I would also appreciate the views of others, so please post them.

Our Federal Reserve Bank has always evoked strong emotions and varied opinions. Henry Ford Sr. expressed the public’s confusion and fears over Fed dealings when during the Great Depression he said:

“It is well enough that the people of the nation do not understand our banking system, for if they did, I believe there would be a revolution before tomorrow morning.”

Yesterday, $1.048 trillion was printed out of thin air, which gave the globe its first trillion-dollar day. $506 billion was injected by the ECB into European banks, $518 billion was earmarked as an add-on to U.S. federal spending for 2008, and $24 billion was taken by banks from other central banks to shore up reserves. Most importantly, 3-month Libor and Euro Dollar rates declined by only 15 – 20 basis points. The markets expected these rates to decline more as a sign of greater liquidity. The European and U.S. markets sold off overnight and this morning in reaction to stubbornly high short-term rates.

EVERY DAY ALL GOVT. SPENDING IS 'PRINTED OUT OF THIN AIR' AND ALL PAYMENTS TO GOVT. 'VANISH INTO THIN AIR.' HOWEVER, THERE WERE NO NET PAYMENTS YESTERDAY FOR ALL PRACTICAL PURPOSES.

THE UNINFORMED LANGUAGE CONTINUES WITH 'INJECTED' IMPLYING NET FUNDS 'FORCED IN' SOMEHOW. ALL THAT HAPPENED WAS THE ECB OFFERED FUNDS AT A LOWER INTEREST RATE TO REPLACE FUNDS AVAILABLE FROM THE ECB AT HIGHER INTEREST RATES. THIS HAS NO EFFECT ON AGG DEMAND.

FEDERAL DEFICIT SPENDING DOES INCREASE NET FINANCIAL ASSETS OF THE 'NON-GOVT.' SECTORS. THAT IS MORE PROPERLY CALLED 'INJECTING' FUNDS, AS GOVT. EXCHANGES CREDIT BALANCES FOR REAL GOODS AND SERVICES (BUYS THINGS), THEREBY ADDING TO AGGREGATE DEMAND.

NOT WHAT HAPPENED. IT WAS ALL ABOUT SUBSTITUTING ONE MATURITY FOR ANOTHER.

WHEN THE CBs FULLY UNDERSTAND THEIR OWN RESERVE ACCOUNTING AND MONETARY OPERATIONS, THEY WILL OFFER UNLIMITED FUNDS AT OR JUST OVER THEIR TARGET RATES AND MATURITIES, AND ALSO HAVE A BID FOR FUNDS AT OR JUST UNDER THEIR TARGET.

An anonymous person from the ECB told Bloomberg this morning that the $518 billion was the single greatest injection of emergency lending in central bank history and that it was a climatic effort to free up interbank lending.

Here is my take on ECB efforts as I have discussed with members of our firm: Some bank(s) and/or investment bank(s) most likely have sustained huge market-to-market losses that they must bring onto their balance sheets soon, which are causing them and others who fear losses from counterparties in our $500 trillion-plus derivatives market. My suspicion is that these losses include derivative losses that are not directly related to subprime.

OK. POINT?

I also think that the Fed and Central Banks have suspected the above since August 2007, which caused them to reverse course from fighting inflation to supplying liquidity to save the banking and financial system. I also do not have much faith in central banks and government authorities' ability to manage a widespread financial crisis because they created this crisis with their loose money and lax regulatory practices that have been rampant since 2002.

SEEMS TO BE THE MAINSTREAM VIEW RIGHT NOW. POINT?

There is also evidence that U.S. government spending and deficits are much larger than actually reported since 2002. I have found reports from numerous ex-GAO officials and current GAO staff that have come clean with our budget. Former government officials are now reporting that Treasury Secretary O’Neill was fired because he wanted to right the ship at GAO and report true numbers in his reports to Congress and the American public.

IF THEY WERE LARGER THAN REPORTED AND ADDED MORE AGG DEMAND THAN APPEARS ON THE SURFACE, THEY ARE THEN RESPONSIBLE FOR SUSTAINING GROWTH AND EMPLOYMENT.

Below is a take on this from John Williams. John also publishes the CPI using pre-1982 methods that show annualized CPI running 3-4% higher than reported under current methods.

RECALL THAT DEBATE AND THE RESULTS SEEMED VERY REASONABLE AT THE TIME. CAN'T REMEMBER ALL THE DETAILS NOW.

Here are adjusted budget numbers for 2006-2007.

The results summarized in the following table show that the GAAP-based deficit, including the annual change in the net present value of unfunded liabilities for Social Security and Medicare narrowed to $1.2 trillion in 2007 from $4.6 trillion in 2006. The reported reduction in the deficit, however, was due to a one-time legislative-related accounting change in Medicare Part B that likely will be reversed, and, in any event, needs to be viewed on a consistent year-to-year accounting basis.

On a consistent basis, year-to-year, I estimate the 2007 deficit at $5.6 trillion, or worse, based on the government's explanation of the process and cost estimates.

WHAT MATTERS FROM THE MACRO LEVEL IS THE FISCAL BALANCE THAT ADD/SUBTRACTS FROM CURRENT-YEAR AGG DEMAND. THIS WAS LEARNED THE HARD WAY IN 1937 WHEN, IF I RECALL CORRECTLY, TAX REVENUE FROM THE NEW SOCIAL SECURITY PROGRAM WAS PUT IN A TRUST FUND AND NOT COUNTED AS FEDERAL REVENUE FOR PURPOSES OF REPORTING THE FISCAL BALANCE, AND FUNDS AVAILABLE FOR FEDERAL SPENDING. THE RESULT WAS A FISCAL SHOCK/DROP IN DEMAND THAT UPPED UNEMPLOYMENT TO 19% AFTER HAVING COME DOWN CLOSE TO 10%.

From Note 22 of the financial statements, under "SMI Part B Physician Update Factor":

"The projected Part B expenditure growth reflected in the accompanying 2007 Statement of Social Insurance is significantly reduced as a result of the structure of physician payment updates under current law. In the absence of legislation, this structure would result in multiple years of significant reductions in physician payments, totaling an estimated 41 percent over the next 9 years. Reductions of this magnitude are not feasible and are very unlikely to occur fully in practice. For example, Congress has overridden scheduled negative updates for each of the last 5 years in practice. However, since these reductions are required in the future under the current-law payment system, they are reflected in the accompanying 2007 State of Social Insurance as required under GAAP. Consequently, the projected actuarial present values of Part B expenditure shown in the accompanying 2007 Statement of Social Insurance is likely understated [my emphasis]."

Since this was handled differently in last year's accounting, the change reduced the reported relative deficit. The difference would be $4.4 trillion, per the government, if physician payment updates were set at zero. I used that estimate, tentatively, for the estimates of consistent year-to-year reporting, but such likely will be updated in the full analysis that follows in the December SGS.

With Social Security and Medicare liabilities ignored, the GAAP deficits for 2007 and 2006 were $275.5 billion and $449.5 billion, respectively. Those numbers contrast with the otherwise formal and accounting-gimmicked cash-based deficits of $168.8 billion (2007) and $248.2 billion (2006).

-------------------------------------------------------------------------------------
U.S. Government - Alternate Fiscal Deficit and Debt
Reported by U.S. Treasury
Dollars are either billions or trillions, as indicated.
Sources: U.S. Treasury, Shadow Government Statistics.

Fiscal
Year*
Formal
Cash-
Based
Deficit
GAAP
Ex-SS
Etc.
Deficit
GAAP
With SS
Etc.
Deficit
GAAP
Federal
Negative
Net Worth
Gross
Federal
Debt
Total
Federal
Obligations
(GAAP)
  ($Bil) ($Bil) ($Bil) ($Bil) ($Bil) ($Bil)
2007 $162.8

$275.5

$ 1.2** $54.3** $9.0 $55.8**
2006 248.2 449.5 4.6 53.1 8.5 54.6
2005 318.5 760.2r 3.5 48.5 7.9 50.0
2004 412.3

615.6

11.0*** 45.0 7.4 46.4
2003 374.8

667.6

3.0 34.0 6.8 36.2
2002 157.8 364.5 1.5 31.0 6.2 32.7
*Fiscal year ended September 30.
**Estimated minimal $5.6 trillion deficit, negative net worth of $58.7
trillion, obligations of $60.4 trillion, excluding one-time legislative
issues and accounting for same tied to Medicare Part B (see link below).
***Estimated at $3.4 trillion, excluding one-time unfunded setup
costs of the Medicare Prescription Drug, Improvement, and
Modernization Act of 2003 (enacted December 2003).
r - Revised prior-period data as shown in the 2007 report.

Link to 2007 report: http://fms.treas.gov/fr/07frusg/07frusg.pdf

Current numbers derived from document page 3 (Table 1, with Social Insurance
Exposures, Closed Group, added in as liabilities on the balance sheet, and
pages 102, 103 [note on SMI Part B Physician Update Factor]).

YES, NET GOVT. SPENDING MAY INCREASE OVER TIME, AND MAY LEAD TO HIGHER RATES OF REPORTED INFLATION, BUT SOLVENCY IS NOT THE ISSUE.

THESE 'DEFICIT TERRORISTS' TOTALLY MISS THIS POINT, FOR IF THEY DID 'GET IT,' THEY WOULD BE DOING THE WORK AND PROJECTING FUTURE INFLATION RATES, NOT JUST DEFICIT LEVELS.

FURTHERMORE, THEY IGNORE THE DEMAND DRAINS, LIKE PENSION FUND CONTRIBUTIONS, IRAs, INSURANCE RESERVES, CORP. RESERVES, ETC., THAT ALSO GROW GEOMETRICALLY AND HELP 'EXPLAIN' HOW GOVT. CAN DEFICIT SPEND AS MUCH AS IT DOES WITHOUT EXCESS DEMAND DRIVING NOMINAL GROWTH TO HYPERINFLATIONARY LEVELS.

--

Addendum By John Serraperre
The Ted Spread: A Harbinger of Financial Stress

The Ted Spread (TED) is the yield differential between 3-month Euro Dollar Bank Deposits (Euro) and the 3-month USA Treasury (T) Bill or Ted = Euro-T-bill. The TED Ratio is the TED divided by the T-bill yield, which tells us the degree of stress relative to nominal yields. At the end of the trading on December 12 and 24, 2007, the ratio was 85% and 56% versus 50% on August 16, 2007. This confirms that European savers are extremely fearful of a major default by a bank or financial institution, which is causing them to hold most of their cash in T-bills. It shows that three Fed rate cuts have done zero to dispel heightened fears of default.

Ratios above 50% are very rare, having occurred in only 271 days out of 9,082 trading days from January 4, 1971, trough August 16, 2007. Since August 16, 2007, the ratio has been above 50% for 35 days out of 88 days, which is 40% of the time. Since November 15, 2007, the TED/T-bill ratio has remained above 50% for 27 consecutive days. This is the longest streak since August 6, 1974, when the streak was 33 days. The all-time streak for the stress ratio ended on October 8, 1971, at 36 days.

The table below shows the daily readings of Euro deposits minus the T-bill yield (Ted) and the TED/T-bill ratio readings from January 4, 1971, through December 11, 2007. The current TED at 1.8% is 56% of the T-bill yield. It shows that the major holders of capital are scared, although less so than earlier in the month.

Historically, extreme ratios have preceded major financial defaults. The central banks smell a rat! On December 12, 2007, the Euro Zone Bank, Great Britain, Canada and Switzerland joined the Fed in providing emergency funds to almost any financial institution.

Even those with the weakest of collateral get tidy sums to hold them over for a little while. These are temporary fixes; mere Band-Aids on a ruptured artery. After their announcement, stocks rallied almost 3%, and sold off 2% while Euro Dollar rates barely budged. They failed miserably to effect commercial lending rates. Why? She’s come undone, as the song goes. The debt bubble, she’s a bursting. She's fat. She’s singing and for Fed Chairman Bernanke, she is farting all over his emergency plan. It stinks!

Currently, 3-month Euro Dollar deposits and Libor rates are at 5.10% and 4.82%, respectively. Libor yields have also not fallen very much since the Fed started to cut the Fed Funds rate. Since 1995, most American businesses and consumers have had their loans pegged to some rate over Libor. The Fed is impotent. Their recent rates cuts have not dispelled fear and have not reduced domestic borrowing costs for those who can still get prime credit.

Here is proof that we are likely in the early stages of the Mother of all Credit Crunches since 1971.

When you add the above signs to many other warnings such as a peak in U.S. earnings, slower economic growth, higher inflation, a housing bust, weak consumer spending and a lame technical picture for domestic equities, one has to conclude that The Bear is here or near.




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