Clipping Coins in the 21st Century

November 13, 2006 – In 1787 Russian general Grigori Potemkin constructed facades of buildings along the banks of the Dnieper River to fool Catherine the Great during her visit to the Crimea. These facades have since been called “Potemkin villages”. I think the US Treasury with the help of the Federal Reserve is playing a similar trick today, but these partners in deception are not constructing the shells of villages. Rather, they are creating Potemkin dollars, an apt name because these dollars have appearance but no substance.

The US Treasury is issuing a modern form of Bills of Exchange, which was the name given to the rapidly depreciating fiat currency that plagued economic activity during North America’s colonial days. In other words, the Treasury is ‘printing’ currency in order to pay its expenses – like the Confederation of States did with the Continental currency during the War of Independence, and like Zimbabwe is doing with its currency today. The only difference is the way the US Treasury is doing it. The technocrats at the Treasury have come up with a new, modern form of debasement.

US coins cannot be debased any further because they are already completely base (and in fact, even the base metal content is approaching the face value of the coin). In any case, coinage is not an important form of currency in the modern economy. Nor is paper currency a significant factor in today’s economy; it was only about 7% of M3 when the Federal Reserve stopped reporting M3. It is deposit currency – the dollars on deposit in banks – that is important today, and my conclusion is that the Treasury is debasing deposit currency.

The effect though is no different than if the Treasury were ‘clipping coins’. In other words, debasement cheapens a currency, which means its purchasing power is eroded in the process we call inflation. But in the modern economy, governments do not steal the old fashioned way by ‘clipping coins’. They need new ways to debase the currency, and Potemkin dollars gives them a way to do that.

The article by John Crudele I reference below provides some evidence that extraordinary measures are indeed being taken by the feds to keep the dollar monetary system and the US economy from collapsing. Crudele’s article I think though only paints part of the picture.

It is an important article in its own right, but I found it to be particularly valuable because it filled in the gaps in some of my own research and thinking. Namely, I suspect that the feds are using secret, unreported Special Purpose Vehicles (SPVs) to create off-balance sheet what I call “Potemkin dollars”. (www.nypost.com)

U.S. Treasury is quietly doing the Fed’s work

November 7, 2006 — FOR the past few years the U.S. Treasury has been quietly involved in what the financial markets call “repo” agreements and this near-secret operation could explain why the nation’s money supply seems to be confoundingly large. It might also explain why Washington decided earlier this year to stop publishing M3 money supply figures, the broadest and most popular measure of money in circulation…“

A basic premise of central banking is that central bankers only tell you what they want you to hear. Given that their reason for no longer reporting M3 is ludicrous on the face of it, the basic premise of central banking tells us that some other factors (the ones they didn’t tell us about when they made their M3 announcement) are obviously at work.

The logical conclusion is simple I think. What they didn’t tell us about was that the feds want to keep interest rates from rising, which would have been happening this year given the drop in demand for the dollar by central banks and others (with its therefore concomitant drop in the demand for US government debt instruments).

In summary, I think the feds have learned a lesson from what they think went wrong in Weimar Germany. Namely, don’t disclose what you are doing to the money supply, while at the same time focus your efforts on controlling inflationary expectations.

The feds seem to be following economist Phillip Cagan’s theory that expectations about inflation are more important than actual changes in the quantity of money itself, but the feds aren’t taking any chances. Just in case Cagan’s theories are not reliable, they are no longer reporting M3. Maybe the feds think enough people will believe them when they say so ‘sincerely’ that inflation is under control, and that they are ‘diligently’ watching to make sure it doesn’t get out of control.

Are the feds really creating “Potemkin dollars”? Only they know for sure at this point, but the markets just do not add up, which has led me to the inevitable conclusion (even before reading Crudele’s article) that some extraordinary steps are indeed being taken.

Debt growth in the US at all levels continues, meaning more dollars are being created, while at the same time central banks (among others) are reducing their dollar balances. Consequently, dollar supply is up, and dollar demand is down. So why has the dollar index been going sideways for months, while real interest rates are zero (or more likely negative when you look at the true rate of inflation)?

Potemkin dollars help me to partly explain this puzzle. The feds are creating their own artificial demand for the dollar through SPVs. The SPV creates new dollars, which inherently debases the dollar, but offsetting this debasement – so the feds think – is the Federal Reserve’s attempt to control inflationary expectations. The SPV then feeds these newly created dollars to the US Treasury for spending by the federal government.

This process is like an invisible printing press. But there is more needed to explain the puzzle why the markets are doing what they are doing, and here is where Crudele’s article filled in for me a critical missing link that I could not get my hands around.

Remember back in the late 1970’s when the dollar’s exchange rate was crashing and Jimmy Carter needed to borrow Deutschemarks to save the dollar? The SPVs need foreign currency – euros, pounds, yen etc. – to keep the dollar from collapsing. Here’s why.

Let’s assume the Chinese Central Bank (CCB) is selling T-Bills. The SPV buys them and gives the CCB the dollar proceeds from the sale. What do the Chinese do with the dollars?

Well, they buy some commodities and maybe some shares, but they will be unable to exchange all of their dollars for something of value. There are just too many dollars. So they sell their dollars for euros. Now, because the dollar is not falling against the euro, and has in fact been going sideways for over six months, the dollar has all the earmarks of being artificially supported. That means the excess dollars being dumped by central banks are being mopped up. To mop up these dollars the SPV needs foreign currency.

Rather than borrowing foreign currency like Carter did, I assume the SPVs are creating them. It’s much cheaper to issue currency than it is to borrow the currency on the open market.

Can the SPV issue euros or pounds or yen? Why not? What’s to stop it? The only thing to stop it is the rule of law, but we all know that the rule of law has been thrown out the window and has been missing for some time. From a practical point of view, there is nothing to stop the SPV from issuing currency (deposit currency, not cash currency) and/or carrying foreign currency liabilities. It is just a simple matter of accounting – as they say, “creating money out of thin air”, in this case that money being foreign currency.

So the SPV balance sheet has US government debt instruments as assets with newly created foreign currencies as their liabilities. These foreign currencies are then being used to mop up excess dollars, which are then in turn being put back into circulation through Treasury repos as John Crudele explains.

To accomplish this nefarious outcome, the US Treasury is likely working with one or two banks who have been informed of the scheme. The liabilities of the SPV (both dollar denominated and foreign currency denominated) are owed to these couple of banks purposefully selected to participate in this diabolical scheme, which no doubt is going to end badly.

Now, I will be the first to admit that much of the above is built upon supposition, anecdotal evidence and assumptions. I therefore cannot vouch for its accuracy, and even though it is consistent with the premises of John Crudele’s article, there is no way of knowing whether my interpretation of the Treasury’s actions is on the mark.

Nevertheless, Potemkin dollars go a long way toward explaining how the dollar is managing to defy gravity. If I’ve missed some details of the scheme or misinterpreted it, the underlying premises of my analysis I believe are correct. Namely, the dollar is not defying gravity because it is sound money that is much in demand by people for their money needs. Rather, it is a sick currency, the usefulness of which is continuously being eroded by its mismanagement, which is the inevitable result of all fiat currency.

What’s more, the secrecy under which central banks are allowed to operate opens up the opportunity for all manner of abuse, including the creation of Potemkin dollars or even worse. The best way to protect yourself from that abuse is to minimize your holdings of dollars, and instead hold money that is safe, like gold and silver.