When Counterfeiting is Legal

11/22/11 Laguna Beach, California ? If I told you that I had $1.6 trillion on deposit at a local bank, you?d think I was not merely a member of the ?1%,? but a member of the ?1%? of the ?1%.? (Can?t you just imagine the bitter jealousy the other 99% of the 1% would feel?)

But if I then mentioned that ? oh by the way ? I also owed $1.6 trillion to a bunch of people, you?d realize that I probably belonged to the lowest cohorts of the 99%, rather than the very highest echelon of the 1%. In other words, you?d realize that I wasn?t ?ber-rich; but ?ber-poor.

But if I then told you, ?Hey, don?t pity me. I can print as much money as I want. In fact, all of the $1.6 trillion I have in the bank is money I printed for myself.?

At that point, you wouldn?t know whether I belong to the 1% or the 99%, but you?d be pretty sure that I belonged in jail. And you?d be right?until you realized that even though counterfeiting is always criminal, it is not always illegal.

When the counterfeiters wear pinstriped suits, hold advanced degrees from Ivy League institutions, draw government paychecks and conduct their counterfeiting operations in government-sanctioned facilities like the Philadelphia mint, counterfeiting is not merely legal, it is financially sophisticated?or so we?re told.

The process is called ?quantitative easing? (QE)?and it is not new news. Almost every investor on the planet has heard of this process by now and understands ? more or less ? what it is. It is counterfeiting, more or less. The Federal Reserve prints dollars and uses those dollars to buy mortgage-backed securities and/or Treasury bonds. At last count, the Fed owned more than $1.6 trillion worth of Treasurys.

Since late 2008, the Federal Reserve has been buying mortgage-backed securities and Treasuries with dollars it prints expressly for this purpose. Although the numbers are a bit murky, the Fed admits to having purchased at least $1.2 trillion worth of bonds under its publicly announced QE programs. Somewhat inexplicably, however, the Fed?s balance sheet has expanded by $2.2 trillion during the three-year QE operations, as this chart from the Cleveland Fed?s website clearly shows.

So is it $1.2 trillion or $2.2 trillion? Who cares? What?s an extra trillion dollars here or there?

Despite this overt and well-publicized counterfeiting operation, the Federal Reserve still manages to retain a semblance of legitimacy. Even more mystifyingly, the US dollar still manages to retain some semblance of strength and respectability.

For example, the dollar has not lost any value relative to the euro during the last three years. But that?s probably only because the dollar and the euro are both losing value at about the same pace. When compared to gold or most other non-governmental forms of money, the dollar has indeed been losing value during the last three years?lots of value.

Nevertheless, there is no palpable ?dollar crisis,? like there is a very palpable euro crisis. But give it time, dear reader. The chart below presents a trend that should be worrisome to everyone who expects the dollar to hold its value over the long term.

?Over the past year,? CNSNews.com reports, ?as the Federal Reserve massively increased its holdings of US Treasury securities ? and entities in China marginally decreased theirs ? the Fed surpassed the Chinese as the top owner of publicly held US government debt??

Thanks to quantitative easing, the Fed?s holdings of Treasury securities have soared to $1.66 trillion, which is well above the $1.15 trillion of Treasurys held by the Chinese.

?At the end of September 2010,? CNSNews explains, ?the Chinese owned about $340 billion more in US Treasury securities than the Fed owned at that time. But by the end of September 2011, the Fed owned about $517 billion more in US Treasury securities than the Chinese owned.?

The whole-hog purchases of Treasurys by the Fed do not necessarily portend any impending doom for the US dollar, but they do at least suggest eventual doom. Large-scale counterfeiting does not enhance a currency?s value.

The Fed?s Treasury purchases may look and feel identical to China?s Treasury purchases?just like a counterfeit dollar may look and feel like the real thing. But they could not be more different.

The Chinese buy Treasuries with dollars they earn from commerce. The Fed buys Treasurys with dollars they create from paper and ink. Over the long term, commerce is a much more valuable source of capital than a printing press. Commerce, generally speaking, nurtures wealth creation. A printing press, generally speaking, nurtures wealth destruction.

Nevertheless, the temptation to print money is absolutely irresistible for a government in distress. It is so easy?and so ?painless.? Ben Bernanke conjured $1.2 trillion (at least) into existence during the last three years without even breaking a sweat. Contrast that process with the ?Super Committee?s? strenuous failure to raise $1.2 trillion of deficit reductions through the difficult, old-fashion processes of spending cuts and tax increases.

Counterfeiting is easier than austerity?just like fraud is easier than punching a time-clock. But since the Chairmen of the Federal Reserve and the other dirigistes of the US economy have little appetite for the austerity and time-clock-punching that builds national wealth, they have embraced expedient short-cuts to ?prosperity.?

Eric Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial?s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling. ?Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research ? ?institutional research products dedicated to international investment opportunities and short selling.?

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry ?supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning.?Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts. ?His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

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