WELCOME

Friends and Family, it is my pleasure to reveal the first installment of my monthly newsletter.  For some of you this will come out of left field whereas others may have seen this coming a mile away.  Paramount Times will be my outlet for channeling my obsession with economics and world affairs.             


The purpose of my writing will be to cut through the fat preached by the talking heads.  These so-called pundits are consistently shouting their opinions and using slander to appeal emotionally.  They want you to think with your heart instead of your brain.  Just remember, the mainstream media sells entertainment not facts. I hope my writing will sift through the entertainment, the news, and highlight the most critical issues.  With that said, I will not regurgitate articles or ideas.  I want to motivate you to think and build your own boat in this ocean of opinions. If I succeed in this journey then you will question stories that you hear and if I fail then you will just have another news source for economics and world affairs.

Paul Krugman (left) and Ben Bernanke (right) have many things in common besides their wisdom whiskers.  They have both been chairmen of Princeton University’s Department of Economics.  Paul Krugman is the current chairman and often writes for the NY Times.  Ben Bernanke was appointed chairmen of the Federal Reserve under Bush and Obama has kept him.  Both men are proponents of easy credit and stimulus packages to pull the economy out of recession.  They have even suggested dropping money from helicopters.  No joke.

Inflation, Deflation, China-Nation

What is inflation?  It is often defined as a general rise in consumer prices.  This is the new definition of inflation that people gravitate towards.  However, if you look up the definition of Inflation in a Merriam-Webster dictionary published before 1980 it will say:  Undue expansion or increase, from overissue of currency.   Inflation should be viewed as the expansion of the money supply.  Deflation, on the contrary is a contraction or decrease in the money supply.  Rising or falling prices are symptoms of money creation or destruction.

To understand our current financial crisis and potential solutions – one must understand monetary policy. 

Money can be created in numerous ways.  The fractional reserve banking system is the most traditional.  Whenever you deposit 100 dollars into a bank, only 10% must be held as reserves.  The other 90 dollars can be lent to somebody as a loan.   The person who receives that loan will likely deposit a large portion of that money into a bank as well.   Let’s say they deposit 2/3rds: 60 dollars is deposited into a bank.   Only 6 dollars needs to be held whereas the rest can be lent out.  As you can see: your 100 dollars has suddenly blossomed into 244 dollars (100+90+54). 

If you needed to withdraw your 100 dollars from the bank then the bank should have sufficient reserves to deliver.  However if 100,000 people wanted to withdraw a 100 dollars each then you may end up with a run on the bank.   The bank would become insolvent and default because it would not be able to honor all its customers.  This is exactly what happened during the Great Depression.  As thousands of banks went under, their assets and liabilities went with them.  The gigantic contraction of the money supply caused a deflationary spiral:

¨ People withdrawing their funds and/or stocks in fear of collapse

¨ Banks become insolvent and collapse

¨ Companies that lost capital from bank failures would go bankrupt

¨ Employees lost their job

¨ Less people could afford to buy goods or make deposits

¨ Repeat

Deflation-debt spirals are very troubling for all.  Backstops were put in place to prevent this from happening again – i.e. the FDIC.  Now a majority of banks are insured by the federal government.   However, insurance only works if subjects are independent of each other.   Unfortunately the US banking system is interconnected and too concentrated.   The four largest banks make up more than 80% of the banking sector (Bank of America, JPMorgan Chase, Citigroup, Wells-Fargo).   These entities have been deemed ‘Too Big to Fail’ which has given them a government safety net in the sake of protecting America’s prosperity. 

Since 2008’s meltdown, we have seen bank bailouts (TARP, 700B), Obama’s stimulus package (ARRA, 787B), Quantitative Easing 1 (QE1, 1.4T), Quantitative Easing 2 (QE2, 600B).   These four economic stimulus packages have totaled over $3.4 trillion and suggest that this time around they will err on the side of doing too much instead of too little. 

If the federal government and the Federal Reserve did nothing, we would certainly enter into a deflationary depression on par or worse than the Great Depression.  Both of these entities have done an adequate job of keeping us afloat but at the expense of the currency.  Since 2008, our money supply has more than doubled.   Interestingly we have not experienced much price increases domestically.  However, that is because most of the goods and resources that we buy come from abroad.  For example, when a Chinese product is sold in Walmart the revenue and profit dominated in US dollars is shipped back to China.  The Chinese banks then exchange the US dollars for Chinese currency (RMB or Yuan).   The Chinese banks can sit on the US dollars or they can exchange them for US treasuries in order to earn interest.  The Chinese have cash reserves and US treasuries totaling over $4 trillion.   For many years now, China has pegged their currency to the US dollar in order to keep exports strong.   In order to maintain the dollar-peg, the Chinese have had to print money in step with the US causing their inflation rate to rise to 10-12% (year over year).  The only way to combat this inflation problem will be to de-peg from the dollar and allow their currency to appreciate.  In doing so, the Chinese will shift from the world’s greatest exporter to the world’s greatest importer because their citizens will have a new found purchasing power.  Consequentially, the flood of US dollars into the markets will cause noticeable devaluation of the dollar.   This is known as the dollar trap because if they allow their currency to appreciate too quickly than they risk destroying the US dollar in which they are heavily invested.  At this point, our government and Federal Reserve System may have exhausted all options and appear to be at the mercy of our distant relatives: The Chinese.   

  

Debt Ceiling Debate: A Case of Irrelevant Theatrics

If one second is one dollar then a million dollars is 11.5 days and our national debt is 457,000 years.   So does it matter if we raise the debt ceiling?

We have already indirectly defaulted.   The question now is do we want a hard landing or a soft landing?

Back on May 16^th, 2011 we officially hit the debt ceiling limit of $14.294 Trillion.  Our treasury secretary, Timothy Geithner, bought us some time until August 2^nd by raiding retirement funds.  But don’t worry too much; he replaced the cash with IOUs or US treasury bonds.  Interestingly the news outlets and rating agencies have saved the fireworks for now. 

The drama that you see unfolding between the blue and red teams may be irrelevant at this point.  The real meat of the matter can be found in the major players: the Federal Reserve and China.

The government is currently spending between 4 and 5 billion dollars a day and about 40-50 cents on every dollar is borrowed.  In the past decade, China and Japan have been our largest creditors.  However, since 2008 they have greatly reduced their purchases of long term treasuries.  Recently, the Federal Reserve has passed China as the largest holder of US treasuries.   This is no surprise with the Fed purchasing roughly 80% of the long term US treasuries every month since 2009.  The Fed’s purchasing plan has allowed China and Japan to reduce their holdings making the Federal Reserve the new, most powerful creditor on the block. 

A hard landing may occur if a debt limit deal is not reached by August 2^nd.  It would result in selling and panic in the markets and subsequently a deflationary scare like we saw in the latter part of 2008.  The good news is this will not happen.  As the largest US-debt holder and creditor of the US government, the Federal Reserve has the greatest incentives to keep the markets confident in US assets.  The key metric: bond yield, has been unfazed by the debt drama. 

At this point the most logical solution is the most unpopular one: Spending cuts accompanied with tax increases.  If we don’t generate some income to balance out our expenses then we will continue to add to the already blooming debt.  The deeper we climb into debt, the less likely there will be willing purchasers of our bonds.   As the demand for bonds fall, the federal funds rate (interest rate) will need to rise in order to attract new customers.   If interest rates climbed to 6%, interest payments on the debt would skyrocket– adding another 5 trillion dollars to our national debt.  

This time it may be different because we have the Fed willing to purchase as many treasuries as it needs to in order to keep a low-interest environment.  In exchange for US government treasuries the Fed gives the government freshly printed dollar bills to spend at its will.  With politicians accelerating spending to combat the recession and deliver on promises, it won’t be long before the markets are flooded with too many dollars.  A regimen of money printing and loose credit will delay the pain for the time being but eventually hyperinflation could set in. 

The truth of that matter is that we can keep getting drunk on the Government’s punch or we can sober up and face reality.   The hangover will come inevitably. 

Quote of the Month

"Treasury investors are going to get cooked like frogs in an increasingly hot pot of water.” –Bill Gross


If you throw frogs into a pot of boiling water—they will jump out.  However, if you place frogs in room temperature water and then bring it to boiling– the will get cooked.   You also may need to be cold-blooded to be investing in US treasuries.

For those who have never heard of Bill Gross, he is one of the few people that can move markets when he speaks.  Bill Gross is the founder and fund manager of the world’s largest bond company: PIMCO or Pacific Investment Management Company.   PIMCO has been the largest private holder of US treasuries until recently.  Bill Gross has been outspokenly critical of Ben Bernanke and the Federal Reserve’s Quantitative Easing programs.  With QE1, the Federal Reserve exchanged bad bank debt and toxic mortgage backed securities for $1.4 trillion in newly printed cash.  After QE1 ended the economy started to slump again.  The Federal Reserve intervened with QE2 which exchanged $600 billion in cash for long term US bonds. Since the introduction of QE2 the Federal Reserve has been purchasing around 80% of new long term treasuries (i.e. 10 yr and 30 yr treasuries).   Now that QE2 has expired, who should we expected to pick up that 80 percent? 

Our once great creditors: China. Japan, and Saudi Arabia have been greatly reducing their long-term US debt exposure.   Why would anyone want to own long term treasuries when the Fed is purposely employing inflationary tactics to stimulate the economy?  It makes little sense to hold a 10 year treasury that yields 3% when the country’s inflation rate is at 3.6% (The government’s own CPI number). Unless, you enjoy to losing money on purpose. 

Interest rates need to rise in order for more foreign and domestic investors to become attracted to US treasuries.  Unfortunately, we have an economy that has been addicted to 0% interest rates for 27 straight months so any rise could be catastrophic for the housing market and the ‘Too Big to Fail’ banks.

Welcome.

Soon to come.