The deflation-inflation contraption for a fiat currency used as global reserve

I apologize for not having time to write a more detailed entry on this very interesting subject but Utterlycorrelated has a small readership, which I assume is already familiar with many of the strange ideas and opinions expressed here.

I will try to make my ramblings as as a collection of brief points.

First as it has been said quite a few times here on this blog, USD is a curious fiat construct based on self referenced debt since the Nixon Shock. There is absolutely no risk to have a long lasting and major deflationary event in US since the Bernank can summon the helicopters and print till the end of paper stocks. However the Fed has the ability to induce brief deflationary shocks which can have a devastating effect on the rest of the world which holds its reserves in USD, or in a proxy currency pegged directly or indirectly on USD.

These brief deflationary shocks can be very easy to induce due to three other factors:
1) USD is still overvalued since US us used as the largest consumer market and the importer of last resort.
2) US governmental debt and most of US private debt is denominated exclusively in USD (or in a proxy currency) which makes it an equivalent of domestic debt since it represents future liability on the US taxpayers.
3) Taking advantage of the 2008 Crisis the Fed has started the third piece of the scam by offering interest on excess reserves. Few people understand yet the power conferred by this relative obscure tool. By keeping both the interest paid on excess reserves and the discount window close to zero, the Fed has placed itself in a discontinuity monetary point which allows it to play with risk exactly as the Bernanke wants, without creating any inflationary or deflationary effects or by the contrary to generate inflationary or deflationary effects at will without modifying significantly the monetary aggregate. Basically the whole world is now kept hostage to the USD and the Fed and there is nothing they can do.

The game with interest paid on excess reserves is pretty simple: it hides risk. Let's say that Fed's discount window is 0.25% and the interest paid on reserves is also 0.25%. The Fed can lend to JPM $170 billion and JPM parks all this money back to the Fed as excess reserves. Cost for hiding JPM risk is zero for both the Fed and JPM and nonexistent virtual money with zero inflationary or deflationary effect is created out of nothing as a balance sheet artefact.

The interesting part is that the rate of growth of these unnatural and virtual excess reserves is a leading indicator of inflationary-deflationary events since it is dependent on the expectation of loses on bank capital. If we look at a chart of the EXCRENS evolution and at a inflation deflation indicator as the Finster Dollar Index the correlation is pretty clear. One may say that the double dip recession has already started in February-May 2008.

The problem is that this game of smoke an mirrors, makes the current definition of M1 money multiplier a joke. Officially it is well below 1. If we take out the virtual and illusory excess reserves out of the monetary base we obtain a corrected value which gives us a very interesting picture.

As it appears we are right now at the beggining of a new deflationary move, but only Bernanke knows how long he is going to hold it. Of course the first move is the flight to safety into PM, so we can see gold and silver shooting through the sky. The next step is deleveraging and covering position which in a deflationary event means selling the highly liquid PM( with a diving of gold and especially of silver) and we may see a crowding back to ... treasuries and we will see again the T yields flooring and LIBOR sky rocketing. This will burn again big time all the gold and silver bugs.

Currently the US Treasury paper is the international reserve currency not the USD (on which all T paper is referenced to). Let's say that there is a US Gov default and coupon payments are not made due to the bickering in the Clowngress.

In such situation we will have a major transient FX move with USD taking a dive. This will have a devastating effect on both China and EU which will see their currency soaring. If the yuan soars there will be game over for China because the Chinese export machine will collapse at the same time with the collapse of the real estate and development bubble.

EU will do slightly better in a first stage since a very high EUR will alleviate the pains of the PIIGS, which for a short would believe they have won the lottery. In the end it will hit the rich EU North which would be send in a huge trade deficit since their export will collapse (Germany, France and Netherlands will become the importers of last resort). The ECB by definition cannot call the helicopters to inflate.

The only problem is that it will be impossible for the ECB to generate enough debt, fast enough to allow for an orderly retreat of the international currency reserves from USD to EUR... The PIIGS are not big enough and unless the EU big players don't start running big deficits and gov debt, the EUR cannot replace USD.

My whole rambling is about the fact that in the case of a self referenced debt international reserve currency (such as the USD is) the whole notion of default is relative because of the Fx arbitrage, which keeps all creditors hostage to the Dollar (which is the index for T debt). If the show must go on US has to continue to run the so called "unsustainable deficits" in order to satisfy the appetite for reserve currency of the rest of the world otherwise the whole mechanism collapses.

If this appetite seems to vanish, the solution is simple: have the Fed engineer a deflationary shock in order to floor the Tsy yields even if USD in falling in Fx markets. I believe this is the perfect scam.

(I apologize for any spelling mistakes or poor grammar in writing this entry, but I an writing it on my laptop in a cab while rushing to a meeting. I have to stop editing now since I have just reached destination).