Thoughts on Listening to Peter Schiff

Peter Schiff spoke today at a conference I am attending. I have heard him before, and also have read his recent book, so it is not as though he said anything that startled me -- but he did get me thinking.

His main point was simple: the Fed has a tiger by the tail, and cannot let it loose without disastrous consequences for America and for the world. The Fed has reached this point because it unwisely chose, back in 2008, to use its power to print money out of thin air to prevent the collapse and bankruptcy of America's biggest financial institutions.

The Fed bailed out those institutions by purchasing their worthless mortgage-backed securities and other derivative instruments. This put worthless paper on the asset side of the Fed's balance sheet, but allowed the financial institutions to show actual Federal Reserve notes as assets in that paper's place. The Fed could withstand the deterioration of its balance sheet because it is the Fed -- with an unlimited checking account, it literally can never go broke, no matter how worthless are its assets.

From buying worthless paper to buying Treasury bills and notes was a simple next step, once the Government started spending more money on bailouts than it was taking in from taxpayers. The Fed's then President, Ben Bernanke, called this "quantitative easing", or "QE" for short, but in reality that was just a circumlocution for "printing money." When the Fed buys T-bills directly from the Treasury (instead of going through the usual bond brokers), for example, here's how it works.

Every week, the Treasury auctions off a mixture of bills, notes and bonds (bills are short-term, bonds are long-term, and notes are in between) to meet the cash flow needs of the U.S. government. Normally what the Treasury has to offer is picked up by the bond market and by foreign governments (central banks) wishing to acquire dollar reserves.

But when the government runs a huge deficit, as it has during the latter Bush years and all of Obama's first and second terms, the Fed can step into the bond market to buy up any bills, notes or bonds that are not sold to dealers or central banks. By doing so, the Fed ensures that interest rates on the Treasury's borrowings remain stable in accordance with their maturity dates. (If, for example, the Treasury could not find a buyer for all of its long-term bonds at its offered rate of interest, it would have to raise the interest rate to find more buyers. But if the Fed steps in and buys what's left first, the Treasury does not have to offer higher rates -- it just pays the Fed the same rate it pays all the other buyers).

When the Fed buys, say, bonds from the U.S. Treasury, it simply credits the Treasury with cash from its bottomless checking account, and takes possession of the bonds. When the Treasury later buys back those bonds at maturity, as it must for every bond it issues, it has to pay the face amount of the bond plus the interest at the bond's stated rate. And to do so, it needs the required amount of cash in its accounts.

Now, think a minute: if the Fed buys $1 billion worth of 30-year bonds at 3% (say) interest per year, the Treasury is credited with $1 billion when it first sells them. But then it is has to pay the Fed $30 million each year in interest, for 30 years -- or a total of $900 million (almost as much as it borrowed in the first place). And when the bonds mature, it has to come up with another $1 billion to pay off the principal.

So by selling $1 billion of bonds to the Fed, the Treasury commits its budget to come up with a total of $1.9 billion over the next thirty years. And so it goes, week after week. As Sen Everett Dirksen once famously noted: "A billion here, a billion there, and pretty soon you're talking real money."

Now, here's the wrinkle: all interest the Treasury pays to the Fed gets turned over, at the end of each year to: (you guessed it) the Treasury! (The Fed simply deducts what it needs to erect and maintain all of its splendid marble buildings, and to pay all of its officers and staff the very best salaries and benefits.)

So it is not quite a merry-go-round, because of the Fed's needs for money to operate. Out of the $1.9 billion the Treasury pays to the Fed in my example, $1 billion (the principal) is a wash, and the Treasury might net, say, $870 million out of its original $900 million paid in interest. The figures don't matter as much as the fact: the Treasury still, after everything is said and done, has to come up with new money in order to clear its books with the Fed.

By using "quantitative easing" to help out the Treasury, therefore, the Fed is really simply delaying the ultimate day of reckoning. For if the Treasury did not have the Fed buying those bonds from it, it would have had to come up with a full $1.9 billion to pay them at maturity, instead of being able to use what the Fed returns to it each year.

The same result occurs in the end, however. As long as anyone keeps buying bills, notes and bonds from the Treasury, the Treasury has to come up with more cash to pay back the principal plus the stated interest.

The Fed's QE to date has kept the interest rates the Treasury has to pay artificially low, because the Fed always buys whatever bonds are left without demanding higher rates. But how long can the game continue?

And that is just what Peter Schiff points out. The Fed has thus far "phased out" QE three times. Each time, it said (at first) that there would be no more QE, but then as interest rates began to threaten to rise, and the stock market threatened to panic, the Fed would step in again and announce "another round" of quantitative easing. Thus we have had QE#1, QE#2 and QE#3 so far. The Fed is now almost done with the process of phasing out QE#3, as it has been buying less and less bonds each passing month.

And how has the stock market taken this? Exactly as it always has -- with panic drops and uncertain swings because of the inability to predict how high interest rates will have to rise for the Treasury to sell all of its bonds without the Fed being the buyer of last resort. And if bond interest rates rise, the stock market will really plummet.

Moreover, if interest rates rise, the Treasury will have to come up with ever more and more cash to pay the interest on each new bill, note or bond it issues. Since it cannot print money itself, the Treasury has to go into the market to borrow that extra cash. And the more it has to borrow, the more the interest rates will rise -- it is a vicious cycle.

Mr. Schiff therefore predicts the Fed will soon be forced to announce QE#4. Most agree with him, because the alternative is to let the Government default on its debt, which would lead to institutional and commercial failures of all kinds, all around the world.

But QE#4 will at best be a temporary solution. How long will the Fed be able to continue to tell gullible markets that each new phase of quantitative easing will be only "temporary"? The fact is that, having started down the QE road, the Fed cannot reverse course permanently without disastrous consequences for everyone.

And once the Fed's game is seen to be what it is -- the repeated printing of paper money with nothing to back it except the promise to print more paper money as needed -- the notion of inflation will begin to get a toehold on the economy. Would you accept the promise to be paid in a year with paper that will be worth less than what you turn over to your borrower today? Not without demanding a suitably high rate of interest, you wouldn't. And so the Fed's policies inevitably will lead to a war between the demand for more interest to compensate for the shrinking value of paper money caused by the printing of ever more and more paper money to pay that interest.

This is all so simple, yet very few financial advisers are talking about it besides Peter Schiff. The process embarked upon by the Fed can lead to no good, no matter how things turn out. The government must stop borrowing what it can never pay back, or else it must either default on that debt (which will lead to massive deflation on a scale never before seen), or it must print so much worthless paper that hyperinflation ensues.

The choice between hyperinflation and super-deflation is truly a Hobson's choice, but that is where the government's policies, and the Fed's willingness to abet them, have led us. Of course, if a new world war breaks out, then all bets are off until after it is over -- but who wants the devastation of a world war just to postpone the inevitable devastation of hyperinflation or super-deflation?

This may not be original with him, but Peter Schiff has a striking analogy to portray what the Fed is now doing. "It's as though," he says, "a pilot were to take credit for successfully getting a plane from A to B without being able to land it. He has all sorts of excuses for why he can't land: the weather is bad, the airport isn't properly equipped, the plane's instruments aren't working right. But the truth is he does not know how to land the plane -- he just knows how to make excuses. And eventually the plane is going to run out of fuel -- and crash."

The Fed is that pilot, and we are all passengers on the plane. Better start praying for a miracle, because neither the Fed nor the current government has a clue as to how to get out of this predicament. They know only how to keep doing what got us to this point in the first place. And they keep doing it, and keep doing it ...

(Readers who would like more background as to how we got here may want to read the series of posts linked at this page.)