Two weeks ago, I explained to Capitol Hill Daily readers what America might look like after a government collapse. 

And I ended on a note about the Federal Reserve.

Today, I’m going to begin with a radical statement:

The purpose of the Federal Reserve is to benefit its shareholders… not America.

This statement is confusing to most people, because they assume the Federal Reserve is an agency of the government. It’s not.

In fact, it’s a private entity. Only the shareholders aren’t private investors. They’re the major “too big to fail” banks of America.

The next thing you must understand is that the Fed was given (by Congress) the most lucrative monopoly on Earth… total control over the creation of money. So it can print money,legally. 

What a business!

Now, don’t get me wrong – there is some regulation. What Congress gives, it can also take away.

The problem is that when you can literally create money, you have lots of cash to influence the system.

Indeed, when it comes to the economy, the Fed is even more powerful than the president. Only Congress and the president, working in unison, can check the power of the Federal Reserve.

And considering that such cooperation isn’t exactly the norm in D.C., the Fed is using its insane amount of power to rob you blind.

Here’s how…

Too Big to Fail

Simply put, the supply of money should only grow at about the same rate as the economy. It creates a solid equilibrium between goods in the economy and the money supply.

But when the supply of money grows too quickly, it shatters equilibrium and leads to inflation (i.e. – too many dollars chasing too few goods).

And right now, we have too many dollars.

Of course, we can thank the economic crisis in 2008 for that. As you know, when the banking crisis erupted, the Fed was fearful that its shareholders were going belly up. So the former CEO of Goldman Sachs (GS), Hank Paulson, arranged for billions of dollars to be transferred from the government to these private banks through the Troubled Asset Relief Program (TARP).

Keep in mind, I believe that allowing banks to go bankrupt would’ve been the best solution for America. We have over 200 years of bankruptcy court precedent, and the courts should’ve overseen the liquidation of these mismanaged banks. It ultimately would’ve punished the guilty parties.

But that didn’t happen. Instead, the Federal Reserve kicked into action. It created over $1 trillion that was lent to these same banks to keep them from collapsing.

Now, with so much money floating around, bank deposit owners are worried that the supply of dollars will outstrip demand. This could drive the price of the dollar down. In fact, I believe we could even see a flash crash of the dollar.

And that’s precisely how the Fed is stealing from you. It’s knowingly devaluing the dollar, so your money can buy fewer goods.

And no one is safe.

Say you’re happily employed – perhaps you even got a raise recently. Unfortunately, inflation can devalue your dollars so fast that you end up with less buying power than you began with.

As long as the Fed continues on its current path, we’ll continue holding a currency that’s worth less and less every day.

How Can We Protect Ourselves?

On Friday, you’ll receive news regarding a very specific action to take.

Please check your inbox.

In the time being, just know this…

We’ll all likely get poorer unless we take serious steps to hedge ourselves.

Buying gold, stocks, real estate and other hard assets is the best hedge. When the dollar crash comes, these assets will likely bounce back from inflation, even if their prices decline at first.

Bonds, CDs and cash are the assets I encourage everyone to avoid. They’ll be crushed by inflation.

Once again, this is just a small part in the ongoing quest to see what America will look like after a government collapse.

Along the way, I want to explain what’s happening behind the scenes in Washington and give you as much actionable advice as possible.

Until next time, I remain…

Your eyes on the Hill,

Once upon a time the government had a vast scrap yard in the middle of a desert.

Congress said, “Someone may steal from it at night.”

So they created a night watchman position and hired a person for the job.

Then Congress said, “How does the watchman do his job without instruction?”

So they created a planning department and hired two people, one person to write the instructions, and one person to do time studies.

Then Congress said, “How will we know the night watchman is doing the tasks correctly?”

So they created a Quality Control department and hired two people. One was to do the studies and one was to write the reports.

Then Congress said, “How are these people going to get paid?”

So they created two positions: a time keeper and a payroll officer then hired two people.

Then Congress said, “Who will be accountable for all of these people?”

So they created an administrative section and hired three people, an Administrative Officer, Assistant Administrative Officer, and a Legal Secretary.

Then Congress said, “We have had this command in operation for one year and we are $918,000 over budget, we must cut back.”

So they laid-off the night watchman.

NOW slowly, let it sink in.

Quietly, we go like sheep to slaughter.

Does anybody remember the reason our government gave for the establishment of the DEPARTMENT OF ENERGY during the Carter administration?

Anybody?

Anything?

No?

Didn’t think so!

Bottom line is, we’ve spent several hundred billion dollars in support of an agency, the reason for which very few people who read this can remember!

Are ya ready for the rationale offered by our government??

It was very simple… and at the time, everybody thought it very
appropriate.

The Department of Energy was instituted on 8/04/1977, TO LESSEN AMERICA’S DEPENDENCE ON FOREIGN OIL.

Hey, pretty efficient, huh???

AND NOW IT’S 2012 — 35 YEARS LATER — AND THE BUDGET FOR THIS “NECESSARY” DEPARTMENT IS AT $24.2 BILLION A YEAR. IT HAS 16,000 FEDERAL EMPLOYEES AND APPROXIMATELY 100,000 CONTRACT EMPLOYEES; AND LOOK AT THE JOB IT HAS DONE!

(THIS IS WHERE YOU SLAP YOUR FOREHEAD AND SAY, “WHAT WERE THEY THINKING?”)

34 years ago 30% of our oil consumption was from foreign imports. Today 70% of our oil consumption is from foreign imports.

Ah, yes — good old Federal bureaucracy.

NOW, WE HAVE TURNED OVER THE BANKING SYSTEM, HEALTH CARE, AND THE AUTO INDUSTRY TO THE SAME GOVERNMENT?

Hello!! Anybody Home?

Signed…. The Night Watchman

The point of this Outlook is that even IF QEs and near zero-bound yields are able to refloat global economies and generate a semblance of old normal real growth, they will do so utilizing historically tried and true “haircuts” that rather surreptitiously “trim” an asset holder’s money without them really knowing they had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor’s purchasing power as manipulated interest rates lag inflation. In the process, governments and their central banks theoretically reduce real debt levels as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”

Let’s examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name to delineate their severity.

(1) Negative Real Interest Rates – “Trimming the Bangs”

During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates, which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions.

Today, central banks are doing the same thing with near zero-bound yields and effective caps on higher rates via quantitative easing. The Treasury’s average cost of money is steadily grinding lower than 2%. If current policies continue to be enforced in future years it will eventually be less than 1% because of the inclusion of T-bill and short maturity financing. The government’s gain, however, is the saver’s loss. Investors are being haircutted by at least 200 basis points judged by historical standards, which in the past offered no QE and priced Fed Funds close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim they will be implicitly defaulted on or haircutted via negative real interest rates.

Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and
(-2%) real rate haircuts are not a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.” But at the cut’s conclusion, there’s a lot of hair left on the floor.

(2) Inflation / Currency Devaluation – the “Don Draper”

Inflation’s sort of like your everyday “Mad Men – Don Draper” type of haircut. It’s been around for a long time and we don’t really give it a second thought except when it’s on top of a handsome head like Jon Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s just like breathing air … you just gotta have it for a modern-day levered economy to survive. Sometimes, though, it gets out of control, and when it is unexpected, a decent size hit to your bond and stock portfolio is a possibility. If our TV idol Don Draper lives another decade or so on the airwaves, he’ll find out in the inflationary 70s. Such was the example as well in the Weimar Republic in the 1920s and in modern day Zimbabwe with its One Hundred Trillion Dollar bill. As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way – historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be “good as the money” you might be banking on.

(3) Capital Controls – the “Uncle Sam Cut”

Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the U.S. can latch on to your money or capital. Back in the 1930s, FDR instituted a rather blatant form of expropriation. All private ownership of gold was forbidden (and subject to a $10,000 fine and 10 years in prison!) if it wasn’t turned into the government. Today we have less obvious but similar forms of capital controls – currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargos of bank deposits (Cyprus). Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax. Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you’re not careful.

(4) Outright Default – the “Dobbins”

Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in honor of this 5-year bond issued in the 1920s with a beautiful gold seal and payable, in dollars or machine guns! Bond holders got neither and so it represents the historical example of the ultimate haircut – the buzz, the shaved head, the “Dobbins.” As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die. That is half figurative and half literal, because central banks are typically limited from purchasing bonds payable in machine guns or subprime mortgages (there have been exceptions and Bloomberg reported that nearly 25% of global central banks are now buying stocks believe it or not)! But by purchasing Treasuries and Agency mortgages they have rather successfully incented the private sector to do their bidding. This behavior reflects the admission that modern-day developed economies are asset-priced supported. Unless prices can continuously be floated upward, defaults and debt deflation may emerge. Don’t buy a Dobbins bond or a Dobbins-like asset or a bond from a country whose central bank is buying stocks. They probably aren’t “good as money!”

Investment Strategy

So it seems as if the barber has you cornered, doesn’t it?

Let’s acknowledge that possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets. If so, the rather mixed metaphor of “money’s goodness” and “avoiding haircuts” is still the question of our modern investment age. The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.

The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sounds a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing, and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.