S The False Economy; R-Star Estimates Bleak

When the Fed speaks, it is like that insurance company telling you that your car will not be replaced if totaled in the fine print. The fine print reads, blah blah blah blah blah blah blah. Well, the Fed, the BOJ and central banks everywhere are getting us to ignore the fine print, expecting us to really believe they will fix things. Unless radical solutions are found, they won't fix things.

Donald Trump, who is not my favorite politician (come to think of it, I don't have any favorite politicians anymore), has kindled a potentially useful discussion that could one day be helpful to the real economy. The odds are that it probably won't be helpful, so I am not trying to get anyone's hopes up. As I show later R* (R-Star) predictions are very bleak.

But more people need to understand the argument for getting money from the financial economy into the real economy, and more people need to demand something be done. I will tell you upfront that if Harvard professor Jeremy Stein can't solve the problem of building up the real economy through changes to the financial economy, I am not sure who could.

Trump is correct that the economy is a false economy, in that it is powerful within the financial system but not so potent on MainStreet, and that interest rates must rise. However, he is short on details about how to make that happen. And it is unlikely that any president could establish a fix for our massive decline in bond yields, as the chart below shows, that reflects their massive demand as collateral. This demand drives yields down, and it doesn't look like that will change.

Hillary Clinton toes the traditional line saying that presidents or presidential candidates speaking out about Fed policy move markets. Well, it didn't happen. The 10 year UST is yielding under 1.60 after Trump's comments.

The discussion about the Fed policy is significant if only to illustrate that raising rates at the low end has had little effect on the long bond due to Greenspan's "conundrum" which he knows is really not a conundrum. It is expected behavior for the 10-year bond, due to the structured finance bond hoarding that Alan Greenspan himself help put in place to push risk off banks and onto counterparties.

It would not hurt if American citizens were all familiar with the conundrum, which is that raising rates on the low end does nothing to push rates up on the long end. It would be good for citizens to be familiar with the Fed's limited ability to raise interest rates in the face of a massive derivatives market that has pushed demand for the long bond way, way up and yields way, way down.

It would be good for the masses of American citizens to know that the Fed cannot allow a booming economy because it cannot raise rates like it could before the derivatives markets took the world over. There is a solution given as you read on. But it would require a change of rules that is unlikely to occur.

Don't get me wrong, I wish that the Donald could fix this problem. But in order for it to be fixed, at least two things would have to happen.

1. Treasury bonds would have to be banned from the derivatives markets for use as collateral. That would require moving heaven and earth in the financial world. Without suitable substitutes, it would be almost impossible to replace treasuries with other financial assets.

2. Asset-based securities and corporate bonds would have to replace those treasury bonds. Asset-based securities, privately originated, like MBSes, are riskier than treasury bonds, which are gold to the derivatives markets.

It could be necessary to use more commodities, like gold and copper, as collateral, but their price fluctuates even more than treasury bonds. They would cost more to use, and corporate bonds as well. Haircuts to the value of that collateral would prove to be very expensive and could drive derivatives trading into the shadows and away from the clearing houses. That didn't work so well leading up to the Great Recession.

An article discussing the natural rate, R*, and that it is predicted to decline to 1 percent in the next 10 years.That prediction does not bode well for the real economy. Michael Ashton on Talkmarkets has pointed out that John Williams of the SF Fed has stated that a savings glut has caused the slow down in economic activity.

Well, the savings glut, as Ashton has pointed out, was caused by the Fed flooding the bank with excess reserves that just sit there. 2.4 trillion dollars of reserves or so are just sitting collecting interest for the banks.

This Fed president blaming a glut of savings for the slow economy is like those who blame guns when people misuse them. It is simply a warped view of things and defers the real blame off of where it belongs.

To reformulate the saying, "guns don't kill people, people do", we could say:

A glut of savings doesn't weaken growth in the economy, the Fed placing this glut with TBTF banks weakens growth in the economy. 

So, the idea Trump puts forward is sound, but getting the glut to flow into the real economy is a function of the Fed, not of fiscal spending. All fiscal government deficits will do is to increase the UST's available to Wall Street, without helping the economy in a sustained way. Only the Fed can help the economy in a sustained way.

That isn't to say spending on roads is a bad idea. It isn't. It is a good idea. But big deficits are not needed, since the economy is not doing so well and the deficits may increase anyway, without any additional spending. Taxing the wealthy, many of whom readily want to be taxed, would help our pitiful and needy roads.

But if the Fed, Williams in particular, has to resort to blaming a savings glut for the woes of the real economy in America, we have not budged off square one. We are getting nowhere.

In May, Donald Trump said he was for continuing low-interest rates in order for the dollar not to strengthen, hurting trade. It is not unusual for him to take both sides of a political or economic position. He is also for higher and lower wages. So, for now, he is as confused as most real economists are, and as the Fed economists are, who have frozen up like Ice Age the movie. 

We need a Jedi to blow up the R-Star, but Trump has only started the conversation. He isn't the guy who will blow it up. In order the blow it up, something will have to take the place of treasury bonds in the derivatives markets.

Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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