DIGITAL CURRENCY: Central Banking in the Twilight Zone

One has to believe that a bottom to the rabbit hole of negative interest rates that I wrote about in my last Patron Post will somehow be found, though no one knows where it is. It could come when people refuse to go further, such as by paying banks to hold their money in “savings” accounts or when the whole thing blows up all over the world.

For now, bond investors all over the world are riding negative rates ever lower to ever higher bond prices, which means tidy gains. From a speculator’s standpoint it makes sense. They are all betting yields on new bonds will keep going down so that the ones they are just buying will increase in value.

When (and it is WHEN not IF) the negative-interest debt Ponzi ceases to look like a speculative risk worth taking, people and institutions will prefer to zip their money inside of mattress covers or put it in wall safes or vaults, and the Ponzi will implode as all Ponzi schemes eventually do. That moment comes if negative rates ever stop going lower, taking away the reward for risk.

“I’m worried you become dependent on lower and lower rates,” said Mr Hoffman. “It feels like the bond market is suffering some kind of panic attack. But what happens when rates go up? It’s a dangerous game.”

Financial Times

In the US, we now see rates trying to go back up, which could put the “scheme” at risk. It could put it at risk globally because, the more yields rise in the US, the more those high yields make it hard for yields to go down everywhere else by making the US a more attractive option. Everyone needs to keep playing to keep the game fully secure. If the Fed had not leaped back on the QE bandwagon, yields in the US would likely be rising even faster due to the rapidly ballooning federal debt. That could be bad for the whole world.

It depends on how far up rates go. They might not go much further now that the Fed has rushed in to intervene with a massive return to quantitative easing. I’ve said many times that I don’t think QE4 will be as effective as prior rounds because it would be clear when QE4 began that it will have to be QE4ever because we’d know from experience that QE never can be unwound without crashing the economy that was built upon rounds 1-3. We’ve now seen that, and that is why the Fed is scrambling to assure everyone that the hundreds of billions it has committed to buy in US bonds is not QE this time.

QE faces a problem of diminishing returns, meaning larger and larger amounts are required. In part, that is because it loses its emotional impact on market that become less excited about it until it starts to go away and, then they go into withdrawal. In larger part, it is because QE builds up other problems in the system that make it harder and harder for the system, to function normally. The worst of those problems is negative interest, which I’ll explore below.

QE is the motor the Ponzi scheme. It keeps the merry-go-round spinning and the calliope playing so that all the riders remain happy. That leads me to ask what banks will jump to when QE stops working and the economy built from it either implodes spectacularly or just devolves into endless doldrums of global malaise. I cannot say I know wether the QE merry-go-round spins spectacularly off its axis (something I used to believe) or just grinds itself into a wobbly halt as the central banks try to keep it spinning.

Follow the money: it’s all about monetary control

I think there is something we can know in terms of what comes next. One of the hazardous side effects of negative interest is that banks don’t even want you to save your money any more. They can make more money charging you fees for the movement of your money. They’re looking for ways to get you to move your money into circulation where they make money. That means they need (or, at least, want) better control over money flow.

As bond interest goes negative, banks need to charge you interest on your savings (which they call negative interest) in order to maintain their own profit margins. As we’ve discussed already, they have to have a way to force your money to stay in banks if they are going to do that. So, as we now trudge further down the negative path, we have to look at monetary control as being a certain part of their plans when the present scheme falls apart. I am sure they must be as smart as we are to know that QE and negative rates cannot go on forever.

Not everyone wants to park money in banks where they are charged a storage fee. They will do so to some extent — and have for decades — in order to have money they can move electronically or by check to pay their bills because you cannot mail a gold chip to your local utility or drive some cash to Amazon’s headquarters for each purchase. We look to money for efficiency, and hard money and paper money is not always easy to use.

To manage the negative-interest stresses that are starting to build all over the world now and keep the merry-go-round spinning, central banks will inevitably need to move out of hard cash that you are able keep outside of a bank just to close off that option. Friends of your friendly central bank are already trying to tell the public banks shouldn’t move to digital currencies for that particular reason as if they wouldn’t just because they shouldn’t:

You can believe them if you want to. I think they are saying that in order to quell that fear; but the truth is they do have many other reasons they want to go to move to digital currency that they control.

The takeaways from the video above:

• CBs must create their own digital currency in order to eliminate currency arbitrage between all the various digital currencies that would exploit the little people or small businesses. (Not said is that this arbitrage diminishes the value of CB currencies. So, they want to avoid currency arbitrage that constantly forces them to manage the value of their currency against all the competitors. It is true that that is for the good of those who choose to keep using their currency, but it also becomes essential if others are going to keep using their currency.)
• Central banks can provide efficiencies and safety, which will make private currencies irrelevant. (Private currencies are unregulated and open to all kinds of corruption and mismanagement. It may not happen in all cases, but there isn’t a lot to prevent it from happening secretly. Central Banks are highly regulated and open to all kinds of corruption of mismanagement.)
• CBs shouldn’t go digital just for the sake of being digital or just to be able to drive down negative rates. (Of course not. They should do it for monetary control, which does not necessarily require negative rates. If banks can get people to move money without pushing them via negative interest on their money, I’m sure they would prefer to avoid the problems of negative interest, which are manifold; but how can they do that?)
• The central banks of China and Sweden are leading the move to central bank digital currencies (CBDCs ); so, others are pursuing this ahead of the Fed, showing the Fed is in no rush.
• The Fed is taking a more cautious, slower approach because this isn’t like a private-sector race where whoever gets their first wins. (It simply doesn’t have to be since each central bank has government-mandated monopoly over the currency of its region. Once the CBs figure out how they want to go digital, they will simply use their mandate to do so. The governments aren’t going to argue for reasons I’ll give below.)

Something I’d like to point out about how slow central banks are moving on digital currency compared to the private sector with things like Libra, Bitcoin, Etherium, etc. is that their slowness makes it evident to me that central banks have NOT had, as some conspiracists claim, a digital currency they are waiting to roll out. What they have is a plan to have one when the technology exists both on the issuer’s end and on the user’s end, and their monopolistic mandate gives them the security to let the private sector develop these currencies and means of exchange to see what emerges as the best and to let THEM experiment in discovering what the built-in risks are with their own systems — the hacks, etc.

After all, how would central bankers be more technologically advanced than the world’s biggest high-tech corporations? They are bankers, not techies, and they cannot hire technical help that doesn’t exist yet. So they are waiting for the hard scrabble of competition to invent the best hardware and software platform. By that path, acceptance will also grow more organically and sort itself out. As the messes emerge and losses occur, the central banks can step in as savior, being the ultimate managers of stable currencies that they are. And let’s give them that: overall the dollar has been pretty stable for a long time. So have some other currencies. Not perfect, but workably sound for decades.

There has not been some digital currency waiting in the wings of the Eccles Building (Fed HQ) since the Phoenix was talked about in the 1980s in The Economist.

When the right components evolve, the central banks can simply ride in to save the day with their own imprimatur, employing and modifying whatever technology rises to the top. For now, the Fed and other central banks are “activily looking at issues” that effect digital currencies. They’re not going to risk running out ahead because they don’t have to.

I think Adam Posen sees that negative interest rates are going to cause all kinds of other problems and believes central banks can find better ways of manipulating their currencies and their economies. So, he may be genuine in saying that CBs need to stop thinking of CBDCs from that perspective. Once the central banks have total control over your use of money, they may not even need negative rates in order to effect their monetary policies or their economic stimulus goals. (If they do, though, they will certainly have that power; and without that power, negative interest is just killing banks.)

Funny near the end of the video how Posen says the head of Libra is just “talking his book,” while Posen, himself, is talking his book as a longtime key advisor to central bankers and their governments. He’d naturally rather keep everything on the banking-government axis where he is a critical advisor.

And guess what? The bankers own the control panels. They own government because they fill all of its economic agencies and departments, so they sit feeling pretty secure in letting the high-tech companies like Facebook figure out the math and computer systems so they can harvest the results when it has evolved enough and has presented plenty of arguments for their astute oversight.

The CB pitch

What does this key advisor like about CBDCs?

• CBs are better positioned with payment-direct between consumers and businesses,
• direct deposits for government (of taxes and government payments),
• and of course the always lovely control of fees. (He speaks of being able to restrict fees, but that also means being able to have them and monopolize control over them to the advantage of the Fed’s member banks.)
• Central banks and governments controlling digital currencies can also protect citizens from abuse of their identities (or — not said — share all that indentify information with governments, such as law-enforcement and intelligence agencies and tax authorities). After all, we’ve seen from Facebook that our identity information cannot be trusted to corporations who process our financial transactions. (But have we seen any better from banks that also many times now had all our information stolen? Of course not; but somehow our central banks will do better. Rest assured.) All of that makes their argument before their government counterparts for their kind of continued pervasive control of the monetary systems of this world iron-clad.

All they have to worry about is the possibility of the people pressuring their governments in another direction if the people become unhappy with their central banks. So, as those protections are talked about in the video, notice all the slurs toward privately owned digital currencies to sow concerns among the proletariat against private sector digital currencies and preference for CBDCs (Central Bank Digital Currencies, a term CBs now throw around as if they already expect everyone is familiar with it). The seeds are already being planted so people will be quick to those fears. “We knew this would happen; we were warned this would happen; we demand the government step in and protect us.” On the other hand, one could just say those are things we do need to worry about. They WILL happen. It’s the built in risk of digital currencies. They are hackable, and people can lose everything. So, they will be hacked. Some will.

Notice, also, what is not being said there: There is not any thought or hope or desire for preserving real cash (paper or coin) expressed in any of this. Now that we have the technology of digital wallets at last widely spread, it’s not necessary. We don’t even need small-time vendors to have the little card readers that attach to their phone or tablet for smalltime transactions. You can just link phones with Bluetooth or wifi — tap their little heads together.

But here is the biggest argument that absolutely assures central banks security in the digital space: governments need them. With their massive sovereign debts, governments are dependent upon their central bank’s stable source of financing. They need them for salvation. They know what happened in 2008, and they know that central banks, not governments, saved the day with lightning intervention. Nobel economist Nuriel Rubini commented on this in a discussion with several digital currency founders as being weakness private digital currencies and the superiority of central banks:

Roubini noted that as an analyst of financial crises, he is “not a defender of the traditional financial system.” He nonetheless forcefully argued that central banks’ responses to 2008 — such as coordinated monetary policy and the Fed assuming the role of “lender of last resort” — had worked and prevented the Great Recession from becoming “a Great Depression 2.0.”

Zero Hedge

While I could argue for years — and have — against the approach central banks took because of its unavoidable eventual doom, it is a fact that they bailed us all out from having to feel the full force of the Great Depression by bailing out banks. It was the wrong solution, but it saved society the pain — pain it needed to go through if it was going to find a true path to build a sustainable and equitable economy.

The public will never willingly accept that pain. Politicians will never accept what the public will not accept. So, within that framework, central banks are essential. Bitcoin and its competitors are not … and never will be. They couldn’t save the economy or even pretend to or save long-profligate governments if they were hell-bent on doing so. So, CBs know their position is secure, but it doesn’t hurt to secure it with the people, too, in videos like the one above.

As I noted in another article to private digital currency enthusiasts, digital currencies may be exciting to speculate on, but that is actually the biggest strikes against them. They can soar in value. Wow! The counterpart to that is always that anything that speculative can also crash in value. You don’t get huge speculative gains without huge risks. We’ve seen the rollercoaster ride in market values for all of these currencies. While their proponents talk about their soaring value like it is a badge, it is actually what makes them worthless as true currencies.

You see, in a currency, the last thing you want is speculative value. What you want is rock-solid stability as a store of value you can bank on. You want to know with certainty you can make your mortgage payment or rent payment next week with the paycheck you got this week. Central banks have by in large proven themselves to be masters at that — keeping their currencies on a slow path of constant inflation. Much as we hate inflation, central banks regard that planned inflation as an insurance fee — worth the price for predictability, and we like our currency to be predictable. Other digital currencies are all far from that.

Why it won’t be about going negative

The argument that CBs would go digital as a way to force negative interest on to consumers caught my eye along the path of this year’s discussion, but I think Brainerd and Posen are seeing it right when they try to clear that argument away. After all, why are negative rates currently necessary? They are an effect of the central bank’s efforts to finance their governments by monetizing debts and to stimulate economies with lots of new money; but they are clearly not creating much stimulus because the economies that are the most negative are in worse and worse shape. So, they are starting to lose that reason for being, except that, once there is a lot of debt resting on them, you become pressed to maintain them. Negative rates are not inherently desirable to banks, which are still figuring out how to work with them. Banks have struggled under them and do better when there is a good positive interest spread that they understand.

Consider the downsides to negative rates that can be avoided if digital currencies give banks the ability to manipulate monetary policy without creating negative rates:

The Japanification of the world is now essentially complete with most central banks on a path of easing forever. The Ponzi scheme that will blow up if negative rates normalize is unbearable. From the banks’ standpoint, that may be seen as both an argument for keeping them out of necessity now that they are so prevalent but also for getting off this path before it becomes worse.

You don’t want to blow all that up, but you don’t want it to turn into a bigger debt monster either. Blowing it up will hurt banks in incalculable ways since they own a lot of that debt, central banks included. It’d be a mess for everyone — a mess Japan pioneered and the Fed popularized, though the Fed didn’t take things that low in the US … yet; but the policies it advocated around the world during the Great Recession certainly did.

Some argue that the banks want to blow up all the world’s economies so they can repossess everythingl; but what will they do with it if they do blow it up? In bankruptcy, everything sells at firesale prices. We already saw in the last crisis that the banks could not begin to foreclose on everything that was behind in payments because they were crashing the value of their own collateral and making their own problems worse by doing so, and they were having to write down their asset loans.

Banks actually slammed the brakes on their foreclosure rates to try to keep from crashing real-estate values further because such a crash not only puts all their remaining loans underwater by plunging values of all the other homes they hold loans on, but it leaves properties unoccupied and going derelict, which leaves the banks responsible to maintain them and to maintain their taxes or lose even more value. Much lower prices mean much smaller loans when new loans finally are made. It means more broke people with less money in the bank and less reason to use a bank for financing. It means hardly anyone wants to take out loans or run up credit-card balances. I fail to see how the banks benefit by turning the entire world into a derelict slum just so they can say they own it. To me, that is an argument that is not well thought through.

I see a different situation. We are now caught all over the world in a negative feedback loop where the main reasons investors buy this debt is to reap gains when the next round takes interest even lower. That is how so many nations have found so many ever-ready buyers in order to go so negative so quickly. Everyone knows those buyers will all stop buying the second the next round stops going lower in yield (which means higher in price/vale) because that is the sucker round in the upside-down Ponzi scheme.

That is why it is a trap that must go endlessly downward because no one truly wants to buy AND HOLD negative-yielding debt to maturity. The more negative it goes, the less they want to buy and hold to maturity. The more negative it goes, the more the players get fearful that they could be ones left standing without a chair when the music stops. NO ONE will buy any of this debt as soon as debt stops going deeper down that drain. Like any Ponzi it blows apart immediately when the final round of takers is found. Like any Ponzi, no one knows where the final round of suckers lies.

The US holds odd company with the UK and Italy as the last positive yielders of note in the government bond market. That’s an odd situation. When factoring in currency hedging costs, even most US debt is negative for most foreign investors. I’m not an astute enough bond/FX person to know what affect that might be having in the current Repo crisis, but there is no doubt it is creating huge distortions throughout the bond universe and could have contributed to the Repo crisis. Maybe we are nearing the last round of suckers.

JPMorgan stated last summer,

There is little doubt that negative yields are causing a distortion in the pricing of duration and credit risk as pension funds and insurance companies are forced to move further up the maturity and credit curve to avoid negative yields. Government yield curves and credit spread curves are losing their information content…. The fact that the 3m10y or 2y10y UST spreads have inverted is less of a reflection of US recession risks and more of a reflection of the desperation for yield by foreign investors flocking into USD denominated bonds as bond yields turned more negative in Europe and Japan.

Zero Hedge

Loss of information content in pricing doesn’t really sound to me like anyone understands this wormhole. How can you understand anything properly when information is lost?

This developing lack of information in pricing and yield curves reminds me of the lack of information in the deeply buried tranches of the mortgage-backed securities world and other derivatives that caused the Great Recession. Even though it is a different arena with different unknowns, buried information leads to sloppy decisions, which lead to disasters over time as the sloppiness and mistakes in understanding build up debris and trouble like the tinder of underbrush built up in the woodlands and brush lands of California.

If JPMorgan sees a loss of information in pricing and related yield curves, then I suspect central bankers see it, too. When JP talks, central bankers listen. This is all the detritus of their bad plans — the unintended consequences. There is buried trouble smoldering here, and it could go up in flames quickly. JP is not exactly and alarmist kind of company, and they saw this as potentially turning into a devastating situation.

For countries that have gone deeply negative, the results have been perverse compared to what was hoped for:

• Going negative resulted in slowed — almost frozen — money markets, causing overnight funding to coagulate, just as I pondered above with respect to the US repo crisis. Of equal concern, the nearly frozen money markets did not thaw when the ECB temporarily ended its QE. The side effects of the medicine did not go away when the medicine was discontinued. International interbank lending also decreased, resulting in international repo disruptions. Banks in some countries appeared afraid to reach out to banks in others. Yet, some found incentive in other countries because of the differences in negativity. In short, interbank markets became more fragmented across national borders.
• Banks became less profitable, not more profitable. (Doesn’t seem like a desired CB outcome to me, but more like the disastrous unintended consequences of their deeply flawed recover plans.) This happened, in part, because banks were unable to pass negative rates on to their customers, which is that argument talked about above in favor of digital currency. (Not a dead argument, just a questionable one because having negative rates in the first place is so undesirable to banks that a better answer would be getting out of this entirely; but maybe CBs are just truly trapped and know it.) Banks in non-negative nations have fared much better.
• Pension funds became less profitable even where rates were just lowered; but in a negative environment, they really suffered and were pressed to take greater risks to escape negative rates that would eat away at the fund. That is building a major crises for the future because we are steeling stimulus now from the future because those who will be retiring will have far less buying power.
• Greater income inequality resulted because those dependent on pensions are hit the hardest while those who can benefit from higher-risk equities benefitted more under QE than without it.
• Reduced credit creation in the real economy came as a surprise. If the goal is stimulus, it backfired. As one might expect, credit creation increased when nations first dipped into the negative zone; but that effect didn’t proceed any further and even reversed as these nations went more negative (which they seem forced to do once entering the gravity below the zero bound in order not to implode the Ponzi). Maybe that is because too many people become afraid to enter this wobbly credit area.
• In Denmark, it has resulted in mortgages that pay you money to service them to maturity. The bank didn’t pay interest in those situations. Rather, it collected monthly payments from the debtors, BUT wrote down more on their principal each month than what they paid in! In most cases, negativity hasn’t flowed on to mortgages because it makes no sense. (In that scenario, why not take out an infinite mortgage and get rich if you can get the mortgage? Do mortgages that pay the debtor also trickle down into landlord’s paying tenants rent just to keep them from running out to get a mortgage and make money? You can see how trying to price anything becomes insane in this black hole.)
• Another bizarre result was that negative rates resulted in higher stores of savings, not in less as people thought would happen. No one knows why. It just did.

Witness the confusion in savings:

Maybe that was just because the rates could be passed through to the depositors.

All of that is why smarter people have always called this the zero bound, because thar be monsters beyond it that no one knows.

So, what are central banks to do now that it is QE4ever or bust? I don’t think they have a plan any more than they had a plan for the unwinding of QE1-3 that worked;. So, I suspect it ends with the implosion of this behemoth global debt monster before central banks find their technological answer, and that will catapult the nations of this world into acceptance of a digital currency; but I also think we’re going digital whether that happens or not.

Negative interest heightens the risk of policy errors in a universe where bankers don’t even know how to function efficiently. Things don’t seem to move in the direction you intend to send them by your actions in the negative universe. Yet, a return to normality will blow it all up by sending interest on this massive accumulation of debt soaring and causing the value of bonds in bond funds (especially heavily loaded in retirement accounts) and bank collateral to plummet.

I think the stifling effect on banks and repos comes from the fact that banks fear operating in this dark, unknown space as much as you and I do. They are drifting in a twilight zone but do not know how to get out any more than they knew how to exit QE, something they promised they would do but clearly and relatively quickly found out they never can without causing a catastrophe. As banks grow more afraid in this bizarre zone that even the Fed has re-entered, expect more funding seizures, and expect them to come as much by surprise as they did in September and on greater scales as negativity takes us deeper into the twilight.

Inefficient companies that would have died over time without this abundant profitable debt (zombie corporations) will die in a great herd extinction if rates go back up. In the negative realm, debt is an asset. So, normalization means their assets become debts again. It’s an utterly dependent world where the negativity must be sustained forever once begun. Yet going further down this hole means only that the crash becomes worse should that negative sustenance cease.

Now, you see why the Fed RUSHED back to QE.

What I don’t see is that a massive disruption of everything is necessary for acceptance of digital currency. I think banks have created a disaster that will certainly be disruptive throughout the world, but I don’t think they are doing it by intention in order to repossess the world, nor do I see that it is necessary to get the world to go digital. Some Scandinavian countries have already started accepting CBDCs. Younger generations that have grown up digitally are likely to prefer them anyway as they tap their iPhones together at Starbucks. So, you don’t have to crash the world to get them accepted either. I do think, though, a global crisis will push us to a global answer that will be digital simply because that is the way the whole world is now running. We’ll be looking for a technological solution, and we won’t be looking for one that leaves global trade more fractured.

For those who want to believe in the conspiracy theories, fine. I cannot say you are wrong; but let me put it this way: If you don’t believe in them at all, you will still get to same conclusion about where we are headed.