The Biggest Bank Run in History

Posted on 17/03/2011 by

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Image via Run Red Hot.

As more information comes out of Japan, it is becoming increasingly clear the country has a very serious emergency on its hands. At time of writing, many nuclear reactors are in the process melting down, with two apparently undergoing uncontrollable melt-downs. This is on top of the wider destruction wreaked by the series of earthquakes and resultant tsunami which devastated Japan in recent days.

It isn’t perhaps the most obvious of connections, but the physical destruction in Japan is going to be a financial catastrophe for the United States-specifically, for the US dollar. Stick with me as I take a little trip into the wacky world of international central bank financing.

Even a cursory glance at the damage in Japan will back up the statement, “rebuilding will be wildly expensive”. So expensive, in fact, that Japan Inc. (aka Japan) is going to have to dig deep indeed. For example, the Bank of Japan has already pumped about 15 trillion yen (~US$183.8 billion) into the economy at time of writing, with almost certainly more to follow.

But money printing is a dangerous game to play in normal times, and Japan is presently anything but normal. Japan will want to avoid creating any further stresses on the country’s economy and currency. So rather than creating money, the government will move to sell off assets, in order to raise necessary funds for major infrastructure projects, disaster clean-up and relief; as well as avoid fears of excessive money-printing.

In the same vein as defending the currency and economy, the Japanese will not sell of any domestic debt or corporate paper. To do so would harm already stressed corporations, which is the last thing Japan would want to do. Therefore, only foreign holdings will be sold off, because selling those present the lowest threat to the stability of Japanese markets.

Rhetorical question alert: what is a fully liquid, world-recognised asset which every bank in the world has, and will be accepted at any major financial institution?

That asset is US Treasury debt, also known as T-Bills. It is the single most fungible financial instrument in the world, after gold. According to the US Treasury, Japanese banks held about $883 billion in T-Bills in December 2010. Add into that an uncertain — but very large — amount of other US securities (ie government agency debt such as Fannie Mae, Freddie Mac, et cetera; and simple stocks) we can easily say that the Japanese can liquidate over $1 trillion of US securities in very short order. Call it $1.5 trillion as a nice, round-ish number. $1.5 trillion won’t rebuild everything in Japan, but it’s a good start.

Now, the US Gross Domestic Product (GDP) as of 2009 was around $14 trillion; let’s call it $15 trillion for convenience. The effect of selling off $1.5 trillion — ~10% of total GDP — would be beyond a mere crisis. It would probably bring the entire US economy and financial to a screeching halt in a matter of seconds: the price of those securities would collapse so quickly on the open market that the Japanese would have little hope of recovering the face value of the paper. Indeed, the open market would itself collapse!

That is assuming the Japanese would move to raise cash as quickly as possible, which I think is the most likely scenario. So, in order to protect their investments, the Japanese would prefer some other, non-traditional buyer to step up; a buyer with very deep pockets.

Enter at this point the Federal Reserve. They are interested in avoiding a serious economic problem, such as a dump of $1.5 trillion in US securities on the open market; perfectly willing to print up digital money [search for ‘helicopter’]; and looking to expand their balance sheet via quantitative easing. It would seem to be a match made in heaven: a seller — Japan — looking for cash, and a buyer — the Federal Reserve — looking to print money.

All this can take place behind closed doors, so it will take some time to know whether I am correct or not. However, if it does in fact happen, the Federal Reserve will literally have to create money in order to purchase the securities which Japan is selling; the Fed is the only organ which can absorb that amount of purchases in a short amount of time. In essence, the disaster in Japan is going to become the biggest bank run in history, and the Federal Reserve is that bank.

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Posted in: Analysis