Why the Fed Will Not Stop Deflation

Editor's note: Robert Prechter's Latest Elliott Wave Theorist was released three weeks early, and is one of his best ever. He does not mince words and cuts straight to the bone on what the Fed is and is not willing to do to stave off a financial crisis. It is fascinating reading. I have arranged to make this brief excerpt available.

Excerpted from The Latest Elliott Wave Theorist
August 26, 2007 | Robert Prechter
Reprinted with permission

We hear it every day: "What about the Fed?" The vast majority of investors and commentators seem confident that the Fed's machinations make a stock market collapse impossible. Every hour or so one can read or hear another comment along these lines: "the Fed will provide liquidity," "the Fed is injecting money into the system," "the Fed will be forced to bail out homeowners, homebuilders, mortgage companies and banks," "the Fed has no choice but to inflate," "the government cannot allow deflation," "the Fed will print money to stave off deflation" and any number of like statements.

None of them is true.

The Fed is not forced to do anything; the Fed has not been injecting money; the Fed does have choices; the government does not control deflationary forces; and the Fed will not print money unless and until it changes its long-standing policies and decides to destroy itself.

A perfect example of one of these fallacies recently exposed is the widespread report in August that the Fed had "injected" billions of dollars worth of "money" into the "system" by "buying" "sub-prime mortgages."

In fact, all it did was offer to stave off the immediate illegality of many banks' operations by lending money against the collateral of guaranteed mortgages, but only temporarily under contracts that oblige the banks to buy them back within 1 to 30 days. The typical duration is 3 days. Observe three important things:

  1. The Fed did not give out money; it offered a temporary, collateralized loan.
  2. The Fed did not inject liquidity; it offered it.
  3. The Fed did not lend against worthless sub-prime mortgages; it lent against valuable mortgages issued by Fannie Mae (the Federal National Mortgage Association), Ginnie Mae (the Government National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). The New York Fed is also accepting "investment quality" commercial paper, which means highly liquid, valuable IOUs, not junk

As a result:

  1. The Fed took almost no risk in the transactions.
  2. The net liquidity it provided -- after the repo agreements close -- is zero.
  3. The financial system is still choking on bad loans.
  4. Banks and other lending institutions must sell other assets to raise cash to buy back their mortgages from the Fed.

These points are crucial to a proper understanding of the situation. The Fed is doing nothing akin to what most of the media claims; like McDonald's, it is selling not so much sustenance as time, in this case time for banks to divest themselves of some assets. But in the Fed's case, that's all it's selling; you don't get any food in the bargain.

As I have said before, the Fed is a bank. It has private owners. The owners do not want to see their enterprise destroyed. Although Bernanke probably received distress calls from mortgage lenders, he probably also got calls from the Fed's owners saying, "Don't you dare buy any of that crap and put it in our long-term portfolio." The Fed's owners are smart. They exploit the banking system without taking on any of the risks. They let member banks make mortgages and lend to consumers, but they don't do so themselves.

In the early 1930s, as markets fell and the economy collapsed, the Fed offered loans only on the most pristine debt. Its standards have fallen a bit, but not by much. Today it will still lend only on highly reliable IOUs, not junk. And it doesn't even want to own most of those; it takes them on only temporarily as part of a short-term repurchase agreement.

The Fed's power derives from the value of its holdings, which are primarily Treasury bonds, which provide backing for the value of the Fed's notes. What would a Federal Reserve Note be worth if it were backed by sub-prime mortgages? The real value of U.S. Treasury debt is precarious enough as it is, but at least it has the taxing power of the government behind it. But if the Fed bought up the entire supply of sub-prime mortgages, its notes would lose value accordingly. So will the Fed bail out mortgage companies, as the optimists seem to think? No, it won't. Those who think the Fed will buy up junk with cash delivered by helicopter are dreaming.

Ironically, of course, the Federal Reserve System and the federal government-both directly and via creations such as privileged mortgage companies and the FDIC-have fostered all the lending and the junk debt that resulted. But these entities want only to benefit from the process, not suffer from it. As we will see throughout the bear market and into the depression, the Fed is self-interested and will not brook losses in its portfolio. Those who own the bad loans, and perhaps some foolish government entities that try to "save" them, will take losses, but the Fed won't. ...

What must the banks do with their "grace period" of a few days that the Fed's repo agreements provide? They have to raise the cash to buy back the IOUs that the Fed agreed to hold for them. How does a bank raise money? By selling assets. Thus begins the downward spiral: Contracting credit causes asset sales, which cause collateral values to fall, which causes lenders to curtail lending, thus contracting overall credit, which causes assets sales, and so it goes. Thus, the Fed is not staving off deflation; at best, it may have helped -- momentarily -- to make it more orderly. But the selling of assets has begun regardless.

- - - -

More follows for subscribers. The complete issue totals nine pages, including:

  • The Fed Is Not Smart Enough to Stop Deflation, Even If It Could
  • A Deflationary Spiral
  • The Home Investment Illusion
  • Economic Contraction Approaching
  • A Profit in Losses

Learn more about this issue here.



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the stranger's picture

Gold and Silver are cash;

Gold and Silver are cash; cold hard cash. Federal Reserve Notes are pseudo cash; counterfeit. They are counterfeit because, by definition, they were designed to look like the real thing. The Federal Reserve Note was designed to look like a United States Note; a gold or silver certificate. The later was backed by gold and silver, the former gradually nothing but debt. Same with the coins; gold and silver coins could be shaved on the side; clipped essentially. This is what the reeds along the edge of the coin are there to prevent. Coppers quarters have these as well – and they are silver plated. Why? So they looked like the real thing. That is what a counterfeit does; it looks like the real thing. You want to stay in cash? …then stay in cash. But understand what is. This is what the Liberty Dollar is all about.

Federal Reserve Notes are the common cause of the unconstitutional theft and redistribution of wealth; the consolidation of power, the financing of wars, and the impoverishment of the middle class with the resulting destruction of family. Finally, FRNs destroy the Republic itself. You want to call FRNs cash? Go ahead; the devil's on the line, says you’re doing just fine.

Depressions are real. Prechter may have the large wave right; call me when the world ends. Regarding gold and cash, Conquer the Crash had contradictory statements as dose Prechter’s interviews. Conquer the Crash also had useful, practical advice.

Like many others, I have used Austrian Economics and other elements of history to try and make sense of what is unfolding. I am convinced that the interest rate on gold should be governed by the propensity to save. I’m convinced that the discount rate on Real Bills should be governed by the propensity to spend.

I’m also convinced that Deflation (monetary deflation) belongs to aspect monetary science that deals with real things; not fiat money. The rules of ‘supply and demand’ are secondary to the ‘force and faith’ elements of the fiat process. Deflation and Depression are not synonymous. For the fiat process specifically, I think deflation is a myth to keep you in cash while wheat goes through the roof.

When the Inflation process stops, the system seizes (pdf). You will not buy more supplies with less FRNs, because the system that makes and moves provisions will cease to function in many ways. I think Russell was close with his infamous ‘inflate or die’ – but ‘inflate then die’ might be more accurate.

Of course, I could be wrong…

Deflation

The article indicates that the Fed loans must all be paid back therefore the net money supply change from the bailouts will be zero. Well, please show me a single loan ever made by the Fed that didn't need to be paid back. By that logic, the money supply today would be identical to that of 1913. Clearly the money supply has grown tremendously. This is because the Fed can always loan increasing quantities of money. If it find's no takers, it offers it at a lower interest rate. Plus, the government is always willing to borrow stupendous quantities to fund welfare and warfare.

This article has far too many errors for me to even begin to refute them all. For example, "The Fed's power derives from the value of its holdings, which are primarily Treasury bonds, which provide backing for the value of the Fed's notes." Well, this is simply wrong. For a currency to be "backed" means that is it "redeemable". Just try to redeem your FRN's at the counter for anything. The reason dollars are in use today is because they USED to be redeemable in gold. Try setting up a brand new fiat currency without redemption in something of value. (Mises regression theorem).

It is clear to me that Robert Prechter does not understand what money is. As the crunch deepens, the Fed will print, and this fiat currency will end up like every other fiat currency: worthless.

http://www.mises.org/rothbard/rothmoney.pdf

redeemable in oil

Agreed, you can't redeem a government note.
But, hey, you can buy mid-east oil with FRN's
So, they are sorta redeemable for oil
So, our FRN is backed by oil!?!?!
LOL
And when they start selling oil for euro's we're finished!

Just say Yes to Dr No

Inflation/deflation

I should probably just stick to writing songs, but I have a lot, for me, invested and I stay up a little late too many nights trying to figure out what I'm doing. And I really want to know. Especially lately! Prechter and Brady Willett got me into this stuff back in the late 90s and I've sure never been the same since! Prechter's time to be right approaches ever faster, but...

I'm a Richard Russell junkie. I wait patiently... well, not often patiently, to read his daily comments. He believes the markets are telling us we are now about to experience the greatest boom -titanic global boom that the world has ever seen. I guess in other words, Inflation, before the grand Deflation # 10 on the Prechter scale. He makes a great case for the stock market now in it's early 3rd mania stage. He thinks the bear mkt. of early 2000 was the divider between the 2nd and this last greatest stage now beginning. Russell's years of experience at this racket are most persuasive and compelling. He does allow that should the markets show a different story, he will tell us. I guess that means, for now, it is a ripe time buy and get in at the early grand mania blow off stage of the boom. It's all so hard to believe what is going on around us.

I wish I'd stayed in cash that I got into in the spring and would be in cash at this point as Michael suggests in a reply. I'd have more to work with now. But I didn't. I was able to buy a bit at near the bottom this time around. Well, if it was the bottom. :-) We will surely see.

Even thinking and writing about Dr. Paul can't keep me from worring about this stuff at times like these.

SD

Michael Nystrom's picture

Love Richard Russell

Steve -

I am a big Richard Russell fan as well, and read his remarks every night! I find it fascinating that he is diametrically opposed, in many ways, to what Prechter believes. Russell says inflation before deflation, while Prechter says deflation first, then a likely hyper inflation. Russell believes that the bull market in stocks - in everything - will continue.

Which one will be right? It is impossible to say, as Russell himself will admit. (He's got a little more humility than Prechter). The key to the continued bull market is that the Fed has to be able to entice everyone into borrowing and spending more and more. It looks like everyone is tapped out now, but it looked like that back in 2000, also, so it is hard to say how things will turn out.

He's the man.

Truly fascinating...

Another amazing character I listen to with strict attention is Jim Puplava. He has this thing going with Prechter about who's got the corner on -I guess you have to call it guessing. Or well educated guessing in their case. It's fun listening to them together.

Prechter should be the right one. Which is almost a good enough reason to say he won't be the way things go in our world. Sounds absolutely ridiculous.

I wonder what Harry Shultz is telling us. I just can't subscribe to everyone all the time.

Wonder which would be a better of the ...ations for Ron Paul to work from during the final year before his election. :-)

SD

I disagree with some of this but the end result is the same.

Robert is correct, the Fed does not have our best interests in mind but PLEASE, US Treasury debt as a quality investment? Treasurys are dollar based. A dollar that has "already" been printed into oblivion and grugingly held by our trading partners in a huge game of musical chairs. (they can't dump them because it's value would fall further) Who knows how long this game can go on, into hyper inflation? Maybe but probably not, because then the bankers would get paid off with even more worthless dollars. The BIS, Bank for International Settlements, The central bankers central bank released a statement a couple weeks ago indicating that they will not be left holding the bag should the Fed move in the wrong direction.
Sooner or later it all ends with a grand deflationary debt collapse the likes of which the world has never seen.
I've been following Ron Paul's writings on hard money for many years and totally agree with him. Thats why I'm surprised Ron does not tell his many supporters to protect themselves by getting out of debt and buying and holding physical gold and silver more often and more forcefully. As a side benefit it might actually hasten the demise of the wicked central banks. After all, if there is to be a collapse, we want it to happen before he gets elected not after so he does not get the blame. It will take a true miracle to avert the economic judgment day we have coming to us.

Washington doesn't need more lawyers.
It needs a doctor!
Dr. Ron Paul *** RX for Freedom

exactly right.

And please note he did say something about gold-price manipulation in that debate where everyone focused on Rudy's false allegations about Dr. Paul. The media just did not deign to notice more than one thing at once. Again.
JMR

Small investors

Michael, what do you feel is the safest avenue for the small investor to pursue at the current time?

Michael Nystrom's picture

Believe it or not, CASH

AOXOMOXOA -

First - no one knows what the future holds. Most market watchers believe that we are headed towards ever increasing inflation. I believe that will happen as well, but we will first have a severe bout of deflation, as the article above indicates. One of the best books out there on the subject, IMHO is called Conquer the Crash, by the same author as the above piece. It is about 3-4 years old now, so you should be able to get a used copy on Amazon for pretty cheap.

The basic summary is this: Everything today - from a cup of coffee at Starbucks to the house next door is inflated due to all the cheap and easy credit that has been flooding the market over the last 25-30 years. We have had a severe case of inflation. However, unlike other hyperinflationary episodes in history, this one is based on an increase in credit, not in actual physical cash.

Credit can be created and destroyed. When a bank makes a loan, credit is created. When the borrower pays it back, that money exits the system. Likewise, if a borrower defaults, that money is also destroyed.

We are currently at a stage where lots of people won't be able to pay back their loans - on credit cards, houses, cars, etc. As people default, banks take back the property and it loses value. People put things on the market at firesale prices in an attempt to raise cash to pay back their loans. As a result, the value of cash increases, while the value of most things (houses, stocks, bonds, cars, and yes even for a time, gold) decreases.

This is not an immediately intuitive argument, but it is the one that makes the most sense to me. As a result, the safest place to be for now is in cash - i.e. money in a safe bank.

Gold and silver are, no question, no doubt, money. You should have some. But I wouldn't put all my money into gold & silver just now. As people become desperate for cash to pay off their loans, they will sell anything to avoid bankruptcy. This includes gold and silver. At the end of the day, you can't make your mortgage payment, or meet a margin call with gold.

Just my humble opinion. Hope it helps.

Michael Nystrom

He's the man.

When a borrower defaults,

When a borrower defaults, money is not destroyed. It has been spent already, so how can the bank destroy it? It is in the hands (or bank accounts) of home builders, carpenters, lumber companies - or maybe they spent it already too. Defaults are inflationary. At least that's the way it would seem to me. Show me where I'm wrong.

Ĵīɣȩ Ɖåđşŏń

"Fully half the quotations found on the internet are either mis-attributed, or outright fabrications." - Abraham Lincoln

Yes, it does help.

I'm no economist but I've been thinking for a while now that holding onto cash is a good idea. My stocks took a hit the other day and that really got me thinking that it was time to cash out on a good bit of them. The last two days have been a bit of a recovery, but I've been worried about deflation for over a year now. A good friend of mine who follows the market closely says I'm worrying needlessly, but then again, he thinks we were attacked on 9/11 because "they hate our freedom".

They said that about the NAZ in 2000, too.

NASDAQ is still only half of what it was then. In this environment, Michael's advice is sound. Preservation is the name of the game now. He hits the nail on the head: this is the result of a CREDIT bubble~we are seeing the worst case scenerio, IMHO. Real estate collapse, consumer led recession. The world is losing faith that we Americans will continue to borrow and spend, our Gov is losing faith in their tax base~us! I understand what Roth was saying about FED/$, but I believe the world would always loan to us as long as the consumer remained a strong tax base~that faith is being rocked right now. Many young people here have not lived through a consumer led recession or real estate crash I've never lived through what I forsee. My grandparents did, though. Michael, credit via IPO's, etc. dried-up for Corps. during our little 2001-on recession (and biz bankruptcy), but the consumer spending/borrowing barely dipped, and the Fed slashing rates (worldover) just kicked everything back into high gear. We'll just have to see how it goes, up-down, up-down for a while longer, but the liquidation has already started and continues from what I can see. This will take a long time to unwind, because they fight the fall. When all hope is lost, then the final crash. Ron Paul's holdings are public knowledge and available on his Congressional site and FEC.

I don't know what Michael thinks but...

.
Both of my financial friends are telling me (privately) that precious metals, such as gold and silver coins are the safest place to put investments.

Buying some silver coins, which are fairly inexpensive, is a good hedge!

Why, if I had any money, I would buy them myself.

You Have Enough Now!

Zenpiper,

You can invest in gold and silver NOW with what little money you have NOW. Buy Liberty Dollars! Also, if you join the organization, they'll discount the dollars to you. It's not the same as buying raw gold and silver, but it will provide you protection none the less.

Also, you don't have to have them shipped - there is probably a retailer close by you that has them and is using them in place of greenbacks.

Good advice. And some Jokes !

.
Thanks, Shade. I didn't know about Liberty Dollars. I will certainly look into it. But if you were any kind of friend, you would just send me some.

Ha ha.

Sorry, I am in a jokey mood today.

Flubber Thompson was walking through the Tennessee State Fair carrying a pig. A farmer said, "Hey! Where'd you get him?" And the pig said, "I won him at a bingo game!"

* * * * *

What's the difference between John McCain and the Titanic?
The Titanic had a band.

* * * * *

Hillary Clinton and her entourage were at Sea World looking at a tank of great white sharks. Suddenly the scaffolding gave way and Hillary and her party tumbled into the tank. Within seconds the sharks ripped the humans to shreds and the water turned bloody. Hillary, however, was not touched. "We all know each other," she smiled.

* * * * *

Rudy Giuliani was asked what motivated him to take part in the New York talent shows. "It's like ths," he said. "I normally don't do stuff like that, but when I went to meet the promoters, I noticed one of the guys was wearing lipstick. And when I saw him, I thought, hey...!"