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What Happens When QE Ends?
“The United States can pay any debt it has because it can always print money to do that.” Former Federal Reserve Chairman Alan Greenspan responding to a question as to whether United States Treasuries were safe to invest in.
From a (kinda) Gold Standard to Petro Dollars to the Printing Press
Since the end of World War II the United States dollar has traditionally been a strong currency in relation to other currencies. The Bretton Woods Agreements of 1944 established, among other things, that the United States dollar would be the world’s reserve currency. According to this agreement the dollar could be exchanged by other countries’ central banks into gold upon request. This “gold standard” coupled with the United States’ preeminent military and economic position, gave the world confidence that the dollar was as good as gold.
By the late 1960’s after a decade of massive U.S. spending relating to: the space race (resulting in landing a man on the moon in 1969); the cold war with Russian; the Vietnam War and; new and expanding social welfare programs associated with Lyndon Johnson’s Great Society it became clear that the United States was spending far in excess of any gold reserves it might have to back the dollar.
France’s President Charles DeGaulle recognized the potential and actual monetary abuse by the United States under the Bretton Woods agreement in this 1965 speech:
By early 1971 Switzerland and France increased their requests to have their dollars redeemed in gold. Concern over a run on the United States’ gold led President Richard Nixon to issue an executive order on August 15, 1971 that “suspended” the convertibility of the United State dollar into gold.
Following Nixon’s closing of the gold window, the United States worked out agreements with Saudi Arabia and eventually with the Organization of the Petroleum Exporting Countries (OPEC) that only United State Dollars could be used to purchase oil. This created the “petro dollar” and reestablished a demand for dollars and dollar denominated securities like U.S. Treasuries.
Despite these agreements (which are still in place today), the United States in the 1970’s experienced high rates of inflation and low growth that remained until the early 1980’s when then Federal Reserve Chairman Paul Volker instituted a series interest rate increases that finally brought inflation under control and ushered in the economic growth of the 1980’s.
The petro dollar arrangement allows the United States to continue to spend without experiencing hyperinflation as it can export its inflation by spreading the dollars across the globe and maintaining their demand.
From 1944-1971, or about 40 years, the strength of and demand for the dollar came from its convertibility of the dollar into gold by central banks in accordance with the Bretton Woods Agreement. In 1970 if a country like France did not like the way the U.S. was conducting its finances and no longer wished to hold dollars it could redeem them for gold. Today if a country does not like the way the U.S. is conducting its finances and is concerned about the value of the dollars they hold in reserves or in U.S. Treasuries, they can’t redeem them into gold.
Forty years seems to be limit under which the rest of the world is willing to tolerate a one sided monetary arrangement that allows the United States to print money at will.
Since the early 70’s until today, or another 40 years, the continued demand for the dollar has come from the Petro dollar arrangement that requires large scale holdings of dollars (usually held in the form of U.S. Treasuries) by any entity that purchases oil. The U.S. dollar’s hegemony increased after 1971 not because the underlying finances of the United States got better, but because dollars were required to conduct most international trade due to the petro dollar arrangement. As the economies of countries like China have grown over the past 40 years, so have their dollar holdings giving them a vested interest in the value of the dollar. Thus, countries today hold dollars and continued to hold more dollars as their economies grow (mainly by selling their goods to the United States in exchange for dollars).
The Bretton Woods and Petro Dollar agreements allowed the United State to enjoy flexibility in spending money it didn’t have initially by a promise to redeem dollars into gold and later by the requirement that dollars be used in international trade.
After the financial crisis of 2008, the Federal Reserve hit upon an idea to revive the economy that involved more than just lowering interest rates. They concocted the quantitative easing program (QE) that allowed the Fed to monetize debt-or in other words: to print money in order to buy U.S. Treasuries and mortgage backed securities (MBS’s).
A natural reaction to anyone holding dollars concerned about their value would be that such a move would devalue their holdings. The value of the dollar did fall in the early rounds of quantitative easing but has since recovered. The value of U.S. Treasuries since QE, until recently, rose as Treasuries carried with them the perceived safety of the backing of the U.S. Treasury AND the Federal Reserve.
Generally rising interest rates are a sign of an improving economy and also a sign that central banks are serious about defending the value of their currencies- witness Paul Volker’s monetary tightening in the early 1980’s.
This time is different- all financial bubbles are alike and it’s never different, but all monetary crises are different in their own set of causes and circumstances. Rising interest rates today do not mean the economy is getting better, but rather that the Fed is talking about no longer buying U.S. Treasuries to keep interest rates down. Indeed, the Fed wants lower interest rates and intends to keep the Fed Funds rate low for a long time (and not to unwind its balance sheet) but no longer wants to buy U.S. Treasuries and MBS’s to keep rates low. Good luck with that! We have seen rates rise nearly 80% since May at the mere talk of the Fed “tapering” its purchases of U.S. Treasuries and MBS’s.
Rising rates due to the Fed threatening to taper its purchases of U.S. Treasuries or actually doing so will not translate into a stronger dollar.
The willingness of the Fed to back U.S. Treasuries by printing dollars has given some a sense that the U.S. dollar may not be as good as gold but that the United States, as Alan Greenspan noted, is “good for it.”
The Printing Press is the New Gold Standard
The value of U.S. Treasuries has been maintained by the Fed’s willingness to print dollars to buy more Treasuries thus creating a non market $45 billion a month demand for such securities. Remove that demand and the price of Treasuries drops and yields rise.
Thus, the value of U.S. Treasuries AND the dollar have been backed by the Fed’s willingness to print dollars to support the dollar because if the U.S. Treasury market collapses, so does the value of the dollar.
If the Fed doesn’t buy the newly issued U.S. Treasuries, who will?
The United States is so deep in debt it can’t fund its annual deficit spending or its unfunded social security and medicare expenses via taxation so it has relied on foreign borrowing and the Federal Reserve’s QE bond buying program to help fund them. Foreign holdings of U.S. Treasuries remain at near record levels but new purchases are slowing.
Indeed, without continued and increased borrowing the United States is in no better position to meet its unfunded liabilities than is Detroit- except for one difference – its ability, in the words of the Maestro Alan Greenspan, to print money to pay any debt.
That understanding is what is holding the dollar and U.S. Treasuries afloat.
Certainly central banks and large entities holding dollars and dollar denominated U.S. Treasuries have figured out that the United States owes too much money to ever pay it back. They continue, however, to hold dollars and treasuries to meet their international financial obligations (and because the sovereign debt of other nations is not in many instances a much better bet) because they know the Fed has been standing by for nearly five years buying U.S. Treasuries.
If and when the Fed tapers and ceases its QE program interest rates will rise and the dollar will be undermined.
Ron Paul has noted that at some point the Fed will lose control of interest rates.
It seems the Fed gained control over interest rates through its QE program and stabilized the dollar. They are now poised to lose control over rates and the value of the dollar when they stop QE.
Since the dollar’s value is in part tied to the level of U.S. debt and the willingness of the Fed to monetize that debt via QE, a cessation of QE would undermine the value of the dollar. With a decline in the dollar, values of hard assets like gold and silver that are not dependent on third party actions (like Fed intervention in the bond market) and with no counter party risks (like the creditworthiness of the United States) should rise.
Alternatively, if the Fed continues with QE for a longer period of time, eventually confidence in the dollar will be lost and hard assets like gold and silver will rise. Thus the Fed’s no exit dilemma. The Fed has already created massive economic damage through their QE program (for a part time recovery) for which the economic consequences will be paid if they continue QE or if they stop it.
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