November 29, 2023

What Hank Knew

It’s the 159th anniversary – without fanfare – of the Sand Creek Massacre in southeastern Colorado.

Karen once accompanied me out to Lamar and up highway 385 to Chivington (named for the guy behind the massacre), and nine miles out a dirt road to the quiet site below a bluff.


10-year US Treasury chart, courtesy of the St Louis Federal Reserve bank,

That is true love. When you do something just because the other person wants to, well, that’s the definition.

I don’t know what we’ll call the end of the reserve-currency era.  I hope it won’t be the financial equivalent of a massacre.  “Yup, there’s where it happened. Across the creek and beyond those rocks.”

I’ve long said in private, right before everybody leaves the room and I’m by myself, that what in 2008 made Treasury Secretary Hank Paulson’s knees weak – paraphrasing what he said – was the fear that a Treasury auction would fail.

Over a weekend in September 2008, Lehman Brothers, a primary dealer for the Federal Reserve, went bankrupt. Instantly, Barclays, another primary dealer, absorbed chunks of it with help from the Federal Reserve.

The Treasury this week auctions about $485 billion of US government debt through primary dealers.  The auction for a seven-year tranche yesterday fell short of expectations and the stock market, beforehand up about 0.5%, reversed and turned negative.

Over the last four weeks, the Treasury has auctioned almost $1.6 trillion of debt. In the same period in 2019, the Treasury sold about $800 billion (counting reopened auctions the Wall Street Journal and other trackers incorrectly omit). Doubled in four years.

What if interest rates are up because the Treasury needs to get banks to make bids for this gushing financial effluvia? 

Quast. Everybody knows the Federal Reserve hiked rates to fight inflation.

Students of monetarism know that what follows inflation is deflation. Axiomatic. It’s Gresham’s Law.  Humans can’t fight inflation.  We can only promote inflation, and then deal with its consequences.

Because inflation does not happen by itself (like Covid, but I digress).  In fact, deflation is natural.  Prices in advancing societies should decline.

Karen and I were recently purging basement storage at our Denver house.  Don’t laugh, but I found the receipt for my flight to college in 1986.  My parents paid $127 to send me one-way on Frontier Airlines from Boise to Dallas through Denver.

Our currency is worth about 30% of what it was then.  Yet right now I can fly roundtrip on Frontier from Denver to Dallas for fifty-eight bucks.  Or the equivalent of about $17.

The Minneapolis Fed tracks the Consumer Price Index equivalent from 1800 to present.  Between 1800-1900, the price of consumer goods declined 55%.

Everything was like an airline ticket. 

Why are flights cheaper today than in 1986? Because air travel is ubiquitous.  Technology has improved. Flying is like taking a bus. Literally, an Airbus. 

Sure, service is crappy. But it’s the modern subway, in the air. Anybody can do it.  (Which pushes people wanting more from air travel to private jets or outfits like JSX.)

Improvements in technology and distribution should lower costs. When a currency is stable, it will be generally universal (there are always exceptions).  If purchasing power is diminishing, it will be uneven, manifesting in consumer goods – like air travel, TVs, shoes, clothes, etc.

But not in staples like houses, cars, refrigerators, etc. Productivity gains can’t lower the cost of CAPITAL goods. Because they require ever more money, even when other inputs like labor and materials fall.

Thus, the cost of jets has exploded while the price to fly has plunged.

The cause? Governments need money. There is never enough.  So they manufacture it (and have since the beginning). And since we’ll all thus need more of it, governments talk relentlessly about “growth” and “employment.”

And central banks cut interest rates because governments make money a commodity and they need people to spend it to drive “growth” and “employment.” And low rates mean retirement accounts need bigger and bigger piles of low-yield debt.

And governments create rules like the Basel Accords to require banks to have lots of reserves and capital, which depend in large part on assets called “debt.” Governments in effect mandate purchases of their debts. How debt is an asset is another story.

This works until it doesn’t. Stein’s Law: If something cannot last forever, it will stop.

The primary dealers – there are about 30 – must buy government debt.  Auctions depend on each primary dealer buying its portion (and selling it to Pimco and other bond managers for their clients’ retirement portfolios).

If just ONE primary dealer doesn’t show up, an auction can fail. It’s not yet happened. But we’ve been close. The government might not be able to raise the money it needs.  I think Hank Paulson feared it on Sept 14, 2008.

And interest rates would explode no matter the Federal Reserve’s policy.  The dollar would plunge. Inflation would surge.

This entire construct built on paper would implode. 

The way to avoid these troubles is simple. Don’t devalue the currency. Let rates set themselves. Live within your means. Stop trying to financially engineer “growth” and “employment.”

The odds that’ll happen? Less likely than failure. Other than that, everything is fine. 

Look, I’m not worried. I relish how humans will sort it out. Because we will. But not until after the effluvia hits the fan. The starting point, as in all solutions, is understanding the problem.

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