The Gold Standard Institute International, Author at The Gold Standard Institute International

The Trillion Dollar Coin

January 18, 2013 by The Gold Standard Institute International

http://keithweiner.posterous.com

There has been much buzz in the past few days about a truly horrible idea. Instead of having to negotiate with Congress to raise the debt ceiling so the Treasury Department can sell more bonds to pay for more spending, why not just mint a trillion-dollar platinum coin? This coin would contain one ounce of platinum, worth about $1,500 in reality. By law, it would be magically assigned a value of one trillion dollars. Even at first glance, this is just a bad idea.

In this paper, I first present some conventional analysis. Following that I offer my own insight which I hope attacks this notion from a different angle.

Seigniorage has existed for millennia. Through seigniorage, the government can declare by fiat that the value of a coin is greater than the value of its metal content. In the case of the trillion-dollar one-ounce platinum coin, the metal content is de minimis and the fiat value is $1,000,000,000,000. This would be counterfeiting on a monstrous scale.

None other than Paul Krugman supports this idea, he of the “broken window theory” (yes, he really did rewrite the old broken window fallacy debunked by Frederic Bastiat into a “theory”: http://www.acting-man.com/?p=19668). Krugman asserts that the trillion dollar coin will do no harm at all (http://krugman.blogs.nytimes.com/2013/01/07/be-ready-to-mint-that-coin/), thus proving the adage that it takes a PhD to truly unlearn what one knew at age 6!

Looking deeper, one gets an uneasy sense that this could be a game changer. We currently have the second-worst kind of monetary system, in which an irredeemable currency is borrowed into existence under the central planning of a central bank. The only system which would be worse is one in which politicians can outright create money at will.

I have been a staunch opponent of the various hyperinflationary predictions, which are mostly based on the quantity theory of money and its specious logic that prices rise in proportion to an increase in the (debt-based) “money supply”. But this trillion-dollar coin is not borrowed into existence. Indeed, that’s the whole point. It is simply minted by the Treasury at will.

Like the power of the One Ring in JRR Tolkien’s classic fantasy trilogy, the power to print money will be too tempting to resist. Unlimited printing (or minting with seigniorage) would be a very different process from the present scheme of borrowing. It could lead to the hyperinflation of the US dollar and its derivatives like the euro, pound, etc. This could be a process of overloading the remaining incentives for production in what’s left of our markets, such that while more and more people and assets are rendered unproductive, they are outright gifted with more and more counterfeit “money” with which to buy dwindling supplies of goods especially food and energy. This process could run away.

Now let’s look at the impact to the credit markets. Today, credit drives everything. And the transition from borrowing to coin “printing” would have a large impact.

In the short term, there could be chaos as Treasury bonds stop flowing to the market. Would interest rates drop as the remaining dwindling supply of Treasury bonds are bid up further? Many institutions have a mandate by law and/or charter to buy Treasury bonds. This is one reason why the rate of interest is not set by inflation expectations. Japan’s debt problem is far worse than that of the US, and their interest rate is about half.

Would the Fed end “Quantitative Easing” and stop buying Treasury bonds? That could have some huge and possibly surprising results. It may very well be that interest rates continue to fall, despite no Fed purchases of bonds. An irredeemable paper currency is a closed-loop system. The dollars have to go somewhere, and if you buy a tangible good such as gold then the seller of the gold now has the dollars. What will he do with them? Deposit them in a bank, most likely. What will the bank do? Likely it will buy Treasury bonds. If not Treasury bonds, what else can a bank buy to earn a predictable spread above the rate they paid to the depositor?

If the Fed does not stop buying Treasurys, it could be even worse. The Fed would own more and more of the total issuance of bonds, especially since they are focused on the long end of the curve. What would be the consequences if the Fed owned substantially all Treasury bonds outstanding? I can think of several things:

The average duration of the Treasury debt held by the public would continue its fall to zero—this is concerning because a 30-year bond is not currency, but a 30-day bill is very close to currency
The interest rate would likely fall sharply
The banks’ game of borrowing short from the Fed to lend long to the Treasury would end and banks would be deprived of a source of cash flow—what can they do to replace it?
Treasury bonds are used as collateral, ceteris paribus credit would be harder to obtain
The marginal debtor would be forced into default (deflation: http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit)
Treasury bonds are used in many arbitrages, which would bedrastically affected

Let’s look at item #6. Consider the following set of transactions that are executed simultaneously:

borrow dollars
buy a gold bar
sell a gold future

This trade will occur so long as this is true:

gold basis > funding cost

The gold basis = Future(bid) - Spot(ask). This is because to buy gold in the spot market, you must pay the ask, and to sell it in the futures market you must accept the bid. The gold basis is normally a positive number and it moves around like every other price in the markets.

Big banks pay nearly zero interest to borrow today. For a variety of reasons outside the scope of this paper, the short-term interest rate is generally (but in a paper monetary system not always!) below the interest rate on a long-term bond. If the interest rate on long Treasury bonds is forced downward, that would likely push down the short-term funding costs. This would push down the gold basis, because the trade will continue until the basis is just above the funding cost. This drives gold closer to, if not outright into, permanent backwardation (http://keithweiner.posterous.com/when-gold-backwardation-becomes-permanent).

A drop in the interest rate available on deposits would further harm savers, people who live on a fixed income, discourage savings, and encourage risk-taking in order to find a little yield somewhere. Maybe this could fuel another subprime mortgage fiasco, or give Greece the money to continue for a few more years.

If the gold lease rate < Treasury bond interest then two more legs would be added to this arbitrage:

lease the gold out
buy a Treasury bond

The term “gold lease” is slightly misleading. What happens is that one swaps one’s gold for dollars. One must pay additional dollars in the form of interest at maturity.

As the Treasury rate falls, it could have the effect of pushing down the gold lease rate. Or it could have another effect: discouraging the marginal carrier of gold (steps 2 and 3 comprise a gold carry). This would let the basis rise, though not because the monetary system is healing. This would be a case of widening spreads signaling decreasing economic coordination (discussed under “distortion” in section 2.1 in: http://keithweiner.posterous.com/a-free-market-for-goods-services-and-money).

There are other arbitrages involving Treasury bonds and gold.

And of course there are many arbitrages involving Treasury bonds without gold. A simple one (which I think is a mistake) is: short Treasury / long dividend-yielding stock. Every arbitrageur has his own notion of what the spread between a dividend yield and the Treasury should be.

Treasury bonds are also used in sale and repurchase agreements, which are like loans with the Treasury used as collateral. What would happen if Treasury bonds were less available because the Fed is now minting dollars rather than borrowing them into existance? We would speculate that it would make it more difficult for market participants to obtain credit. This would manifest in the economy as a slowing of the rate of credit expansion (inflation). This author contends that in an irredeemable currency, credit must always be expanding. Because there is no extinguisher of debt, debtors must, in aggregate, borrow the money to pay the net interest. This newly borrowed money carries interest, which must be borrowed, and so on,, in and endless cycle of borrowing more at an exponentially rising rate.

There is, additionally, an arbitrage between Treasury bonds and corporate bonds. This means that as the Treasury rate falls, the corporate rate falls. This causes both government and corporate debtors to experience a destruction of capital (http://keithweiner.posterous.com/a-falling-interest-rate-destroys-capital). This will drive them to default eventually (deflation).

There are numerous arbitrages that depend on the Treasury bond. Each of them is impacted by a change in the rate of interest. Analysis of any one of them is non-trivial, as should be clear from the survey above. A comprehensive market forecast based on this would be a monumental undertaking. My goal in this paper is to introduce some of the factors to consider and a few of the first-order consequences of a transition from borrowing to printing. While we cannot predict everything that would happen, we can clearly see that printing a trillion dollars would have a number of very destructive effects.

Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

Congress Passes Fiscal Cliff Deal

January 18, 2013 by The Gold Standard Institute International

http://keithweiner.posterous.com

We now see who are “millionaires and billionaires” in practice. They are individuals with income over $400,000 or married couples with income over $450,000. Their top tax bracket rises from 35% to 39.6%, an increase of 13%.

The capital gains tax rate goes from 15% to 20%, an increase of 33%.

The temporarily reduced payroll tax rate of 4.2% reverts back to 6.2%, an increase of 48% on all wages up to around $110,000.

The spending problem was not addressed.

There was one positive. The threshold to be forced into the “Alternative Minimum Tax” was set in 1993 and never adjusted for inflation. Incomes and prices have risen since then, so today much of the middle class would be ensnared in this regime that disallows most deductions including state income tax. Every year, Congress provided a temporary fix, and now they have finally made it permanent.

An increase in the tax on high incomes may not have a large immediate effect. Most high earners do not consume all of their income. They spend what they need to maintain their lifestyle and invest the remainder, though some may cut their consumption budget to keep a fixed ratio of their income. The damage done by this tax hike will be felt in future years, as it makes capital harder to accumulate. Our economy (and job creation) depends on capital accumulation. This tax hike in effect transfers capital out of the hands of those who may save it prudently into the hands of the government to be consumed.

Raising the capital gains tax rate strikes a blow directly at the entrepreneur and the investor. Fewer new businesses make sense to start or finance. Investments in new businesses are risky, and most are total losses to the investor. The few winners must earn enough to pay for all the losers. A higher tax on gains raises the bar that an investment must get over. There may be a long delay so that most will not see the connection. In addition, it is difficult to imagine the products that are not in the market but which would have been under a friendlier regime. One thing is clear, mature businesses are managed to reduce cost, which often means layoffs. Job creation is in new businesses. Higher taxes on capital gains may only hurt a few people directly. The indirect impact will be felt by everyone in the job market, along with every retail store, restaurant, and manufacturer of consumer goods.

The payroll tax affects the wage earner. I think it is safe to say that most of this reduction in take-home pay will translate into a reduction in consumer spending and the remainder will reduce the personal savings rate.

Taxes damage the economy in another way. They cause distortion. People are not stupid. They react to the incentives offered to them by the market or forced on them by the government. How much has demand increased for accountants and lawyers and decreased for fitness instructors? There is no way to calculate this, but we can say one thing with certainty. The distortion increases with the tax rate.

The problem is that the economy has become addicted to government spending. Withdrawal of this powerful drug will be painful. Right now there is approximately zero political will to make any cuts at all. For now, the government can get away with it. Just as in Greece, the government depends on the bond market. Whatever it cannot collect in taxes, it can make up by selling bonds, including the interest on outstanding bonds.

And just like Greece, the game ends when the bond market goes “no bid”. This is not imminent in the US. But it is inevitable.

Fiscal Deniers

January 18, 2013 by The Gold Standard Institute International

http://keithweiner.posterous.com

Everyone today is talking about the “Fiscal Cliff”. It is a small decrease in spending combined with a significant tax increase. Let’s put this in perspective. The budget for fiscal year 2012 was $3.8 trillion and the deficit (shortfall which had to borrowed) was $1.1 billion. If no deal is reached, and we go “over the cliff”, then spending will be automatically cut by $110B. This is less than 3% of the total budget and 10% of the deficit.

Let that sink in. The government would still borrow about a trillion dollars a year. The debt would rise to $20 trillion by 2016. This is not much of a solution.

To make the math easier, think of it in terms of a family budget. The total salary of the parents is $38,000 but spending is $49,000; the family borrows $11,000 every year. Now they propose to address the problem by spending $47,900, a reduction of $1,100. The kids would probably be screaming about cuts to their allowance.

In addition to a small cut in spending, if we go over “the cliff”, there will be increases in many taxes, some of them not so small. The income threshold for a taxpayer to be forced into the Alternative Minimum Tax falls back down to the 2000 level. Under AMT rules, most deductions are not allowed. Even without an increase in tax rates, there can be a large increase in the tax bill.

One tax rate increase is that the capital gains tax rises by 33%. Many supporters don’t realize that investors have a choice whether or not to take risk, especially in startup companies. Most startup investments are a total loss to investors. The few that produce big gains must pay for all of the others plus enough profit to make it worthwhile. The higher the tax, the fewer startups justify an investment and the more investors will ignore startups altogether.

How did we get to the point where a token effort to slow the rate of ascent of the skyrocketing public debt is regarded as falling off a cliff? Why do so many people want to increase taxes on investors and entrepreneurs, and ignore that this will hurt the economy, reduce jobs, and hit their pension fund or 401k?

A very large part of the economy exists only because of government spending. This is not just food stamps, corporate subsidies, and bailouts for big banks. It also includes government-guaranteed loans for students and homebuyers. It includes Social Security and pensions that are provided or guaranteed by the government. And it includes many other things; from Medicare and other healthcare (even pre-Obamacare) to bridges and roads, to water, sewer, and power. It would be hard to think of many sectors of the economy that did not have any government subsidies.

To some people, every problem has a simple answer: more government spending. To others, the government must cut “waste”, but not “vital programs”. It is obvious what they mean by “vital”—programs from which they benefit. While most people seem to agree on cutting spending, they cannot agree on any actual, specific cuts.

They are Fiscal Deniers. They deny two facts. First, they deny that the economy has become dependent on government spending. Business would fail and people would lose their jobs if the government stopped spending.

Second, they deny that government spending has become dependent on borrowing. If the government could only spend its tax revenues, it would have to drastically cut spending.

Fiscal Deniers prefer not to acknowledge these two facts. But reality will have its final revenge. If we don’t cut spending voluntarily now, then sooner or later the US will run into a brick wall. To paraphrase Margaret Thatcher, we will run out of other peoples’ money. When that happens, it will be a nightmare that makes the “fiscal cliff” look like a pleasant dream.