Greg Marmalard: But Delta’s already on probation.
Dean Vernon Wormer: They are? Well, as of this moment, they’re on DOUBLE SECRET PROBATION!
– Animal House, 1978

Thank you, once again, for the outpouring of response to the “Government Motors” piece. As usual, your replies have provided a great deal of food for thought. We’ll continue to discuss these vital issues and keep an eye on the Washington-Wall Street nexus.

We won’t wade too deep into the feedback today, but I do want to share this note:

Your article on Government Motors is pretty close. I was a GM dealer for 36+ years, 1949 to 1985. I watched their demise closely and it started even before the 1980’s as you mentioned. I attended a 6 week GM dealer’s school in Detroit in 1969 and already the “governmental” signs were showing. Our class instructors were mostly mid-level department heads from Chevrolet. They openly expressed their frustration with the decision making of the top level executives, and how it took forever to make a change in car design or innovation. Their motto even then was “don’t make waves, our dealers must sell whatever we make, and we don’t make mistakes.”
– TD Reader/ VIP Inner Circle Member Bob D.

Yep. Classic government mentality, through and through. And by the way, have you ever noticed how these pompous bureaucrat types tend to lack a sense of humor? Rigid regimes and sourpuss faces go together like eggs and bacon… and heaven forbid you challenge their righteous authority.

That’s probably why humor can prove so powerful in the right context. Suppressing truth and oppressing the human spirit is a distinctly unfunny business. The ability to crack wise, then, is a sort of extended middle finger in the frowning face of tyranny.

In his first official visit to China since becoming Treasury Secretary, Mr Geithner told politicians and academics in Beijing that he still supports a strong US dollar, and insisted that the trillions of dollars of Chinese investments would not be unduly damaged by the economic crisis. Speaking at Peking University, Mr Geithner said: “Chinese assets are very safe.”

The comment provoked loud laughter from the audience of students.

Ah well. Practice makes perfect, eh? America should probably get used to seeing its monetary policy as the punch line of a joke. And the big spenders in Washington might want to heed a word from Dean Wormer of 1978 Animal House fame: “Fat, drunk and stupid is no way to go through life, son.”

Why the Dean Is Pissed

The Animal House analogy feels timely, given the tough rhetoric coming from the Fed this week. Ben Bernanke (the Chairman of the Fed) did his best Dean Wormer impression, in an effort to impose order on an increasingly rowdy marketplace.

“We cannot allow ourselves to be in a situation where the debt continues to rise,” Bernanke said. “That means more and more interest payments, which swell the deficit, which leads to an unsustainable situation.”

Would that someone could send Mr. Bernanke a postcard with John “Bluto” Belushi’s face on it, fists jammed into cheeks, as a giant mouthful of cottage cheese spews at the camera.

On the back, a simple note:

Dear Ben:

Look! I’m inflation! Get it?

Love,

Delta House (a.k.a. Congress)

See, here’s the thing. Lots of folks think the Federal Reserve is in control of the money supply. That simply ain’t true – not by a long shot. The main thing the Fed controls is the mix of assets, i.e., the mix of treasuries versus dollars.

If there are too many dollars floating around, the Fed can absorb those dollars by selling treasuries (and thus soaking up the dollars). If there is too much government debt weighing down bond prices (and pushing up interest rates), the Fed can buy those bonds with paper dollars.

The thing that really pisses off Dean Wormer, I mean, er, Fed Chairman Bernanke, is this. The more debt that Congress issues, the harder the Fed’s job gets. If you think of the total accumulation of government debt and paper dollars in circulation as a pie, the Fed does not control the size of that pie. And when Congress spends money it doesn’t have, the pie gets bigger.

When Congress decides to drop a cool $100 billion worth of debt on the markets in the space of a week, for example – something that happened recently – that extra $100 billion becomes the Fed’s headache. It becomes part of the “mix,” out there in the marketplace as new supply.

As long as there are willing purchasers for all the new debt Congress issues, everything is hunky-dory. But if the buyers don’t show up at the auction, all hell can break loose, as Latvia recently discovered. (The Latvian treasury tried to sell $100 million worth of sovereign debt this week, and nobody felt like buying. Fiscal hilarity ensued.)

So, the risk is that the drunken party animals in Congress issue so much new debt on their free-spending bar tab that China, Japan, and the other various central bank bag holders of the world finally say “You know what? Enough is enough… we’re on a buyer’s strike. We ain’t buying your dopey debt no more.”

If that happens – or rather I should say when it happens – it will largely be the fault of Congress and the Obama administration, as they are the ones ushering forth a tsunami of debt too big for the world to swallow… but it will be the Fed Chairman who sees his job become a nightmare, as it is the Fed’s job to manage America’s collective finances.

That’s why Bernanke put Congress on Double Secret Probation this week with his “cool it on the damn deficit” talk. He knows he’s got the buffoon treatment coming, thanks to Congress’ antics… and he is none too happy about it.

Greenspan as Otter

It’s only a matter of time, really, given the trillions upon trillions in new debt that Washington plans to issue, before the Fed is forced to “monetize” the debt.

The process of debt monetization is fairly straightforward. If the government holds a debt auction and nobody shows up, the government simply writes itself a check to buy whatever didn’t get sold.

In America’s case, the check writer is the Federal Reserve – thus making the Fed a “buyer of last resort,” paying for whatever debt is issued with paper dollars created from thin air. And thus said debt is literally “monetized”… turned into paper money.

Dean Wor – dangit, I mean Fed Chairman Bernanke – says this will never happen. The Fed “will not monetize” the debt, Bernanke told Congress on Wednesday.

Yeah, right.

If the members of Congress were half as bright as Tim Geithner’s audience of Beijing University students, they would have laughed in Bernanke’s face too. The Fed’s promise not to monetize will go down in history with other such wonderfully emphatic statements as “GM will never go bankrupt,” “mission accomplished,” “the state of the economy is strong,” and so on. 

Why? Because the Fed/frat house connection has deep and storied roots…

William McChesney Martin was one of the true grand old men of the Fed. He was the ninth and longest-serving Chairman, holding court under five separate Presidents between April 1951 and January 1970.

It was McChesney Martin who famously quipped that the Fed’s job is “to take away the punch bowl just as the party gets going.” McChesney Martin understood that Congress and Wall Street were populated by a bunch of frat boys… and that when blitzed freshmen start climbing onto the roof with bras on their heads, someone responsible has to play the “Dean” role and tell the kids to shut it down.

But Alan Greenspan, Ben Bernanke’s predecessor, never wanted to be the sober dean. He desperately wanted to be one of the cool kids instead. In his heart of hearts, Greenspan never saw himself as Dean Wormer… instead he dreamed of being Eric “Otter” Stratton, a lovable cut-up at the center of the action.

And so, instead of “taking away the punch bowl” as the party ramped up earlier this decade, Greenspan poured straight-up vodka into it. Then he stood by with a big cheese-eating grin, high-fiving every inebriated i-banker and mortgage originator in sight as they stumbled back for more.

That pretty much sums up the legacy that Fed Chairman Bernanke inherited, and even quietly endorsed until this week… and that’s why the Fed’s hand-wringing calls for sobriety are seen as such a joke. The entire financial superstructure has been propped up by drunken revelry for so long, a genuine attempt at sobriety now would simply lead to full-on systemic collapse.

Locked In

Bottom line: What Washington refuses to admit, and cunningly pretends not to see, is that we are now locked in on a super-inflationary trajectory. Temporary flights of fancy aside, there will be no swerving from the debt monetization path. The tough talk is designed to hide or otherwise mask this reality for as long as possible.

In stating flat out that the Fed will not monetize the debt, and in voicing sharp concerns about deficit spending and long-run fiscal discipline, Mr. Bernanke has taken public relations lessons from the savvy denizens of the White House. There is something very seductive in a politician’s ability to candidly address a concern with words, while in actions ignoring that concern completely.

“We are out of money now,” President Obama admitted most refreshingly and disarmingly, in a May 23rd C-SPAN interview. “We are operating in deep deficits…”

And yet, for a country out of money, we are preparing to spend with greater abandon than ever. For instance, America’s president has declared healthcare reform, of the mind-blowingly expensive variety, to be a “make or break” priority this year. With all due respect, sir, how can this new boondoggle be “make or break” if we are already broke?

And then, too, there’s the little matter of the banks, which are still far from out of the woods… and still deeply exposed to the as-yet-unexploded time bombs of commercial real estate, consumer credit card debt, and prime mortgage resets. As Niels Jensen of Absolute Return Partners observes, “The poorest two thirds of US households are effectively bankrupt and the wealthiest one third are facing substantial tax hikes. This combination is lethal for US consumer spending.” (Would now be a bad time to mention that consumer spending counts for 70% of U.S. economic output?)

Have no doubt – Washington will spend and the debt will roll down. (And down, and down…) The Fed, in turn, may protest this profligacy loudly, and even hotly deny the unavoidable reality of debt monetization (while Turbo Timmy goes around making university students laugh).

But in the end, before all is said and done, Ben Bernanke’s reputation is likely to be even more thoroughly discredited and destroyed than that of Arthur Burns – the Nixon-tainted Fed Chairman who presided over the grand inflationary epoch of 1970-1978.

After all… don’t all these wacky frat house movies end in pretty much the same way?