Look at the photo of a dollar below:

See where it says “Federal Reserve Note” and where it says “This note is legal tender…”?   Dollars are notes or debts, that is, obligations of the Federal Reserve.  When the Federal Reserve buys US Treasury Bonds from the open market  and pays for them with dollars (a process some refer to as “monetization” or “printing money”), it and the marketplace has simply exchanged one form of debt for another.  The supply in the hands of the market of one kind of debt (dollars) increased while another (Treasury Bonds) decreased.   Long before the Federal Reserve got involved to exchange dollars for Treasury Bonds – when the Treasury bonds were first created and sold to the public – that’s when the notional value (that is, the proceeds) of those Treasury Bonds was attached to goods and services.  Increases in government debt, as well as increases in private debt (net), are inflationary.  But not the monetization of the debt by the Federal Reserve.

At present, we have a situation where private debt is being reduced faster than government debt is being increased so that, in aggregate, total debts are declining – this is deflationary.

Technically, the total supply of debt can increase in an amount equal to the amount which society saves each year without inflation.  Conversely, total debt (including new equity shares) must increase by the amount of savings each year, or… we will have deflation.

Gary shilling offers some reasons why he thinks the economy will not just “snap back”.

John Hussman makes two excellent points…whether you are a bull or a bear, you have to accept the cold facts and see the forest as well as the trees:

1. “So where does the money come from to buy [all] these new Treasury securities? Clearly, the sale of those securities must absorb the savings of someone in the economy whose savings have not already been claimed. Alternatively, the Fed can directly purchase those Treasury securities and literally print money. In practice, we have a third option. The Fed can acquire $1 trillion of commercial mortgage-backed securities and other assets from banks and create an equivalent amount of “reserves” (which is essentially printing money) at the same time that the Treasury issues the $1 trillion in new Treasury securities. In this case, which is in fact exactly what has happened, the banks that previously held $1 trillion in commercial debt securities can now use their newly acquired reserves to buy the $1 trillion in newly issued Treasuries. Having done this, they have no more money to lend than they had before. There is no more “liquidity” in the system than there was previously, except that the “quality” of the bank balance sheets has improved.”

2. “It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered.”

Zero Hedge ran a post this weekend revisiting Friedrich Hayek’s seminal Prices and Production,  in which the professor recognized that when total debt outstanding rises, whether through conventional banking or shadow banking, that increased credit has been used to bid up consumer goods and investment asset prices:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

…but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.”

In point 2, above, Hussman is emphasizing this point:  when debt is created, it is simultaneously “attached” to some consumer good or investment asset, it is not sitting “idle” on the sidelines in liquid form…waiting to be attached to (say) stocks.  To be attached to stocks, bonds, consumer goods or whatever it was previously attached to, must be sold down first.   In point 1, above Hussman, is emphasizing that the recent FED activities has provided no new credit to the banks…only the opportuntity to “swap” a toxic asset for a US Treasury security.  Currently,  if the banks decide to sell the Treasuries to raise cash to lend or to invest in stocks (like Goldman)…the price of Treasuries goes down and the yields go up.  If yields go up, the “recovery” is jeopardized.

From Tech Ticker (ht Rolfe Winkler)…

“…the whole concept of the economy finding its footing was “preposterous” to begin with, says Howard Davidowitz, chairman of Davidowitz & Associates.”
“We’re in a complete mess and the consumer is smart enough to know it,” says Davidowitz, whose firm does consulting for the retail industry. “If the consumer isn’t petrified, he or she is a damn fool.”

Davidowitz, who is nothing if not opinionated (and colorful), paints a very grim picture: “The worst is yet to come with consumers and banks,” he says. “This country is going into a 10-year decline. Living standards will never be the same.”


“The long-term deficit and debt that we have accumulated is unsustainable. We can’t keep on just borrowing from China or borrowing from other countries,” Obama told a town hall meeting event in New Mexico.

“What’s also true is at some point they’re just going to get tired of buying our debt,” he said.

“And when that happens, we will really have to raise interest rates to be able to borrow and that will raise interest rates for everybody.”

The key words here are “when that happens”.  So…we can 1. cut spending, 2. raise taxes, 3. monetize the debt, 4. sell the debt to US citizens instead of China, and others.  Of course it will be some combination of these 4, but how much will each be emphasized?  Swamp Report sees little political appetite for 1 and 2. Option 3 is already being used aggressively.  To utilize option 4 to absorb much of the debt, while continuing to use option 3, requires a resurgence of panic.

Phillip Moore’s article in Euromoney describes many investors and much money (from both UK and US investors) allocated to snapping up distressed commercial real estate debt.  What’s interesting to us is the indications in the article that it’s the banks that are unwilling to sell – that is preventing the investments – NOT a need for federal financing…

“There are three principal reasons explaining why, to date, so much of the cash that was earmarked for investment in commercial real estate debt remains “hors de combat”. The first is that in spite of the precipitous falls in values in the commercial property market over the past year, the general consensus appears to be that values still have further to drop.

Another reason explaining why there appears to be a disequilibrium between supply and demand in the commercial real estate debt market is that in spite of the bleak outlook for values, there is still a reluctance among European banks to offload their holdings, or even to acknowledge how distressed their exposure has become.

“There has been a widespread misconception that as commercial and investment banks looked to restructure their balance sheets they would start by marking their real estate books to a more realistic valuation and then look to sell significant volumes of those assets at those prices,” says Cairn Capital’s Henriques. “We have seen very little of that happening, largely because the markdowns the banks are being quoted on their debt valuations are such that they regard the benefits of selling them as somewhat ambiguous. The capital write-downs they would have to take from such a strategy are such that they would erode most if not all of the capital relief they would generate by selling. So while we are confident that there will be opportunities to acquire bank debt, it won’t be the avalanche that some people were expecting at the tail end of last year.”

We think the debt will not be available for the investors to “snap up” until the banks are willing to take what is offered. Granted, the Geithner plan makes overbidding easier, but to bridge the yawning gap that exists now, is going to make the plan very difficult to implement.