What is a bank? According to a helpful little essay on banks for students at ThinkQuest helpfully titled “What is a Bank?”, a bank is a financial organization in which people deposit their money. A bank is a business. According to the aforementioned essay, “each bank tries to make THEIR bank look better than all of the other banks by offering services that some other banks might not have.” That is to say, banks compete in a market. This is true, conceptually at least, and also true to some extent in reality, although numerous banking laws seriously alter the market and the competition. But it is the pure idea we are after here, and in the pure idea, a bank is a business that competes in a market.

I won’t analyze every “central bank” in the world. I don’t have to because their setup is more or less the same everywhere. I’ll use the Federal Reserve System (the Fed) to represent all of them.

Historically, the Fed and other “central banks” came to be called “central banks” for several reasons. First, they are financial organizations. Second, they hold deposits of other banks and governments. Third, their assets are largely financial assets. Fourth, they make advances or loans to other banks on collateral. Fifth, the government has made them to be at the heart or center of the banking industry and the monetary system. Sixth, government power is itself centralized or national. All of these statements are factual.

Now, this is an imposing array of reasons why “central banks” are called “central banks.” But the most important of these reasons is the fifth reason, which is that the government has used its power to make the “central bank” central. And because the government has used its power to create the “central bank” and make it central, we know that the “central bank” is not a free market institution.

This is the main ground upon which I challenge the notion that a “central bank” is a bank. The concept of “central bank” fails to distinguish a free market business and a bureau created by government power. The term “central bank” undermines this distinction between free market and government. Indeed, it erases it altogether.

The Fed is not a business. It has powers that no ordinary bank has. It has privileges that no ordinary banks have. It doesn’t compete with other banks. The government created the Fed. The government gave it power to create fiat money. The government can alter the Fed’s organization and powers at any time. The Fed’s so-called independence from the government is mythological. It is that of a dog on a long leash. The only independence the Fed has is from the public.

Let’s go back for a moment to the essay on banks that I just cited, because it displays this erasing of any distinction between the free market and government. After defining the term “bank,” it lists the kinds of banks. Quite suddenly, it introduces the term “central bank” in the same breath as ordinary banks that have national or state charters. It says, “There are different kinds of banks. There are national banks, state banks and central banks. The Federal Reserve Bank is the United States government’s central bank. The Bank of England is England’s central bank.”

Suddenly, what this essay told us earlier disappears. We were told that a bank was a business that competed with other banks. But now we are told that the Fed “decides how much money is in circulation” and that it “may tell the [ordinary] banks to charge more interest or keep more money in ‘reserve.’”

Obviously, if the “central bank” has such powers, it gets them from the government. Just as obviously, the “central bank” is not a business and not in competition with other banks if it exercises these and other powers over ordinary banks.

Furthermore, distinctions between monies that ordinary free market banks deal in and the fiat money that central banks produce are completely glossed over and erased.

This essay is representative of the usual thought in the field of economics. Banks are businesses. But then, all of a sudden, there is another so-called “bank” that has an array of powers that business banks do not have. This “bank” is actually a government bureau. Its fiat money is made into legal tender by the government. The government states that it stands behind this money. This “bank” has powers to control and organize the ordinary banks into a cartel.

The facts I’ve pointed out are widely recognized. There is a Wikipedia article titled “Central Bank” that confirms this:

“A central bank, reserve bank or monetary authority is a public institution that usually issues the currency, regulates the money supply and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation’s legal tender.”

This too makes it very clear that a “central bank” is not a bank, but a powerful Monetary Authority and Fiat Money Administration.

However, the same Wikipedia article almost immediately contradicts itself when it states: “Central banks in most developed nations are independent in that they operate under rules designed to render them free from political interference.”

How can a bureau that is established by the government and possesses extraordinary powers be independent and free from political interference? The “central bank” embodies political interference!

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And to the extent that a Monetary Authority such as the Fed has been granted powers that it can exercise free of political interference, how can such an institution be held accountable? How can it operate without being responsible to the government and, indirectly, to the people?

“Central bank” independence is to a large extent a myth, that is, in the essence of the institution and in those activities in which it is not mythical, it is an unaccountable power.

It may seem as if I am splitting hairs, but what I see is that the common explanations of central banking confuse banking as might occur in free markets with so-called banking as executed by a “central bank” that is empowered by government. They are two entirely different kinds of operations. A thoughtful or questioning reader is bound to feel a degree of discomfort when he encounters these explanations that blur important distinctions.

A “central bank” is a government department. It is a government bureau. It is the government’s fiat money bureau. The “central bank” is the government’s money-printing machinery or money-printing organization or money-printing bureau or money-printing agency. As contrasted with monies produced in a free market, the Fed’s money is state-produced “money.” In the sense of comparing the Fed’s money to free-market money, it is counterfeit. It is held up by the force of government law and power. It is imposed on the public.

A more accurate term for the Fed might be the “Fiat Money Administration.” Perhaps the term “Monetary Authority” would be more accurate. It would be more accurate if the latter were the official name. In the U.S. Constitution, at least, it is clear that there is no power to create a Monetary Authority, and if there were such a power, it could not possibly be delegated in such a way as to make that Monetary Authority independent.

The “central bank” is not a real bank. Everything about it is permeated with government power. At the heart of the financial and monetary system of a nation that is supposed to be an exemplar of free markets is a government money-bureau.

Regards,

Michael S. Rozeff

Michael S. Rozeff is a retired professor of finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire: Liberty vs. Domination and the free e-book The U.S. Constitution and Money: Corruption and Decline.

Central Banks Aren’t Banks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Apart from the stark self-contradiction in this quote from The New York Times, you have to love the fatuous ‘it’s all good’ self-assurance where global banking is concerned. No problemo y’all! A mere overdraft incident, a cash-flow hiccup… and yet “the main fear” [among whom?] is that investors [where and in what? Like, everywhere?] could flee risky markets all at once in search of safer havens for their money [WTF?]. Gosh, well, as long as they don’t flee the New York Stock Exchange, the Hang Seng, the FTSE…. And, hey, do you suppose anybody bought any credit default swap “insurance” on the deals that financed scores and scores of super-giant condominium skyscrapers and hotels amounting to the greatest spec construction folly in the history of the world?

Snapshots of the stupid ****ing work-in-progress have been circulating around the Internet for five years, the disbelief was so monumental. I confess, when I first saw the Palm Island I was impressed at what a superb air strike target it presented. And then, when the real estate assemblage of artificial islands arranged like a map-of-the-world came along, I could only imagine the megalomaniacal glee rising in the throat of a jet bomber pilot (nationality unspecified) as he closed in on it.

Whom the gods would punish, they first make completely crazy. That includes us, here in the USA, by the way, but pound-for-pound Dubai is the current champeen. The monstrosity they built in their waterless convection-oven of a city-state makes Las Vegas look like a mere strip mall in comparison. Throw in a few other affronts to nature, such as an indoor ski “mountain,” a beach cooled by an under-the-sand refrigerated pipe network, golf courses that have to be hosed down with acre-feet of desalinated sea-water, and forget about “the gods” — one begins to see the monotheistic hand of “Old Scratch” himself working the levers of the construction cranes out there.

Frankly, I have no idea whether the Dubai fiasco will send seismic ripples thundering through a global banking establishment that is already crippled in more ways than you can count. But it does remind those in thrall to the dazzlement of “green shoots” that debt comes a’creeping, and runs so far, deep, and wide through the broken system of mutual assurances constituting international finance, that Ben Bernanke and his counterparts in central banks ’round the world could drop helicopter loads of paper cash on every rooftop, intersection, parking lot, field, forest, and camel raceway and never make a dent in the fatal web of false obligations we have woven for ourselves.

But you do wonder what was going through their minds as this ridiculous organism took shape on the horn of the Persian Gulf, just as one wonders at loathsome aspirations that Las Vegas presents in our own so-called culture — essentially a wickedness that exceeds the wildest fantasies of the most demented clergymen, be they closeted sado-masochistic Southern Baptist teleministers, Vatican-approved child molesters, or mullahs dispatching suicide bombers to the marketplaces frequented by housewives and their children.

Lately, the much-repeated aphorism has circulated around the Web that civilizations build their most extreme monuments at the very moment of collapse. If this is true — and it is hard to argue with the historical record — then it’s time to organize a new Third Party for the 2012 election with Jared Diamond and Cormac McCarthy heading the national ticket (and Roland Emmerich for EPA chief). By then, if we don’t stop lying to ourselves about the destruction we have induced, every other suit-and-tie wearing authority figure in America, from the county clerk to Barack Obama, will take on the aura of the archetypal Evil Clown from a Stephen King yarn. Imagine living in a country where absolutely nobody in a leadership position is credible. This is the kind of country we’re becoming and it will not keep running that way for long.

The markets have begun digesting the Dubai news in earnest, making for a holiday season of possibly momentous thrills-and-chills. The big debate going into Thanksgiving was whether the dollar would continue its downward trajectory, leading to some kind of currency failure, hyper-inflation, take your pick… or turn briskly around as investors bailed out of risk vehicles for the conventional safe-haven paper parking lot of US Treasuries. This debate between the inflationists and deflationists has defied resolution all year. Personally, I side with the deflationistas these days, though I believe our ultimate destination, in a year or so, is destruction of the dollar.

In keeping with the wickedness theme, isn’t it interesting that our society now vests all its hopes and wishes for thriving — indeed survival! — on a yearly ceremony we have come to call Black Friday. I was raised in a religion-free household, but I confess the signs are just everywhere that we’ve taken some turn to the Dark Side. I’m a little surprised that “consumers” were not caught on video wringing the necks of chickens in the Wal-Mart parking lots the other day in the hopes of winning supernatural favor for that race down the aisle to the flat-screen TV loss leaders. The cinemas are full of blood-sucking teenagers. Grown men swarm in the unemployment offices wearing sideways hats and butt-crack trousers. Why not just tattoo a message on your forehead that says: “Moron for Hire”?

Regards,
James Howard Kunstler

December 2, 2009

Dubai Malinvestment Outdoes U.S. was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Predictably, we’re likely going to see the addition of another big bureaucracy in reaction to a crisis partially caused by a poorly structured banking system and toothless enforcement of existing regulations. The answer to the sloppiness of bureaucratic regulators is, apparently, another layer of bureaucratic regulators. Regulatory reform will not be effective if its architects incorrectly diagnose how the system blew up under the existing system of oversight.

The popular narrative is that that the financial crisis was a failure of the free market, but this narrative glosses over the fact that banking is far, far from a free market. Those who describe the banking business as a wild, woolly free market simply do not understand how banks operate — especially how, with government subsidies and backstops giving them the confidence to make insane loans, banks had grown large enough to blow up the entire global economy.

Last year was less of a failure of free markets than it was the failure of the “shadow” banking system built on a weak foundation: bankers’ lack of connection with the risks they underwrote, government guarantees and tax incentives for mortgages, and misapplication of statistics to exotic fixed income securities, to name just a few things. The shadow banking system could not have grown as large and dangerous as it did without banks’ subsidies from taxpayers and the Fed’s manipulation of the price of money. The Fed’s interest rate targeting creates illusions about default and liquidity risks and distorts the natural relationship between savings and capital investment.

The banking system shares much in common with the federal government, especially in their common isolation from the discipline of the free market; Free market discipline refers to the fact that if you make mistakes, your customers will let you know about it by leaving, and if you don’t reform and improve your product or service, you’re out of business. By promoting competition, free market discipline imposed on business has done more for “the little guy” than any government handout by spurring advances in productivity and living standards.

The banking system hasn’t been subject to free market discipline for decades, and it’s still not. Case in point: Bank bondholders and shareholders were bailed out — at taxpayer expense — from the consequences of their poor lending and investing decisions.

Unlike most businesses, banks don’t earn their profits by serving customers, but mostly by extracting huge economic rents from savers and borrowers. Otherwise, the financial system couldn’t have grown to be such a large percentage of GDP.

Banks are supposed to be intermediaries between savers and borrowers, allocating credit in a manner at prices (interest rates) in line with default risk. But they largely failed in this role. Most banks — especially the “too big to fail” banks — did a horrifically poor job of pricing credit risk at the peak of the credit bubble. Credit spreads were ultra low in early 2007, when it was one of the riskiest times in history to be making loans.

How did the banking system make such colossal errors in judgment about credit risk? I described a few critical weaknesses in the banking system in a September 2007 Whiskey & Gunpowder article (see link here). It wasn’t rocket science to figure out how interest rates were sending a distorted signal about credit risk; all you needed to do was follow the new credit back to its ultimate source and ask the right questions about the connections (or lack thereof) between saver and borrower. One would think thousands upon thousands of federal banking regulators — and those responsible for designing our financial regulations — would have the resources at their disposal to identify the structural weaknesses in our financial system.

Unfortunately, instead of providing a road map to designing a system that connects savers with borrowers in a more sane, responsible manner, it looks like the proposed banking reforms will give us more of the same. Such economic power concentrated in the hands of banks not subject to enough free market discipline is a problem, and the real economy will likely suffer from it.

Regards,
Dan Amoss

June 23, 2009

Banking, the Federal Government and the Free Market was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

These three banks were following Wall Street like a shadow, and lending money to buy stocks and real estate.  While the US stock market was doubling, the Icelandic stock market went up 900%.  By 2006, Reykjavik real estate prices doubled, and the average Icelandic family was three times as wealthy as it was in 2003.  All this supposed ‘wealth’ was tied to the investment banking industry.  Sound familiar?  Naturally, the whole thing collapsed with a huge thud, when the three investment banks went bust last October.

Fishermen quit fishing, and the craze was to buy and sell stocks and real estate.  For the past few years, many Icelanders engaged themselves in speculation, and seeming to be successful, they did what Americans and the rest of the world did.  They bought things they couldn’t afford…on time.  Since interest on their krona was 15.5%, why not buy euros or yen at a 3% interest rate and clean up?  So they made huge loans of euros and yen.  Then their krona collapsed, and they still owe for the euros and yen they bought.  They now own $500,000 houses on which they owe $1.5 million, and $35,000 Range Rovers, on which they owe $100,000.    There have been lots of fires in Iceland recently, to pay the bills of course.  Lucky insurance companies.  It will happen here, and already has to a small degree.

Iceland has lots of wonderful glass and steel office towers and apartment buildings, which are unfinished and empty, with gobs of money owed on them.  Sort of like the rest of the world, I suspect, but it happened in Iceland far quicker.  The bomb went off in Iceland quickly, because it is so small, and its speculation went to such extreme heights.  Walking around Manhattan, the empty stores, streets, and taxis are quite evident I hear, and the same thing is obvious in big cities and small towns everywhere.  The bomb will explode later in these places outside of Iceland, but beware:  Iceland might be the prototype.

Icelanders discovered that trading bits of paper isn’t a productive enterprise.  A handful of guys, who fancied themselves as financial experts, were taking out tens of billions of dollars in short term loans from abroad.  They were then re-lending this money to themselves and their friends to buy assets, such as soccer teams, cars, homes, etc.  Since the entire world’s assets were rising; thanks to people of like mentality paying crazy prices for everything, the Icelanders appeared to be making money.  One non-Icelandic fund manager said that its like, “You have a dog and I have a cat. We agree that they are each worth a billion dollars.  You sell me the dog for a billion, and I sell you the cat for a billion.  Now, we are no longer pet owners, but Icelandic banks with a billion dollars in new assets.  They created fake capital by trading assets amongst themselves at inflated values.”  DOESN’T THAT SOUND LIKE THE REST OF THE WORLD’S FINANCIAL GENIUSES?

Iceland was and is, simply the extreme of what’s going on in the rest of the world, and it came home to roost in Iceland first.  When traders got a whiff of what was going to happen in Iceland, guess what they did?  They went short and made a lot of money.  Do we think that insiders at AIG, Citibank, and the rest of the bankruptcies, knew in advance of what troubles loomed ahead?  Of course they did!  Can we possibly imagine that they shorted their own companies in advance of the collapses and made tons of money?  And that such bonanzas are carefully guarded in the sacrosanct walnut-paneled boardrooms of these holies of holies?  I think there’s no doubt about it.

Iceland looked so good to the rest of the world…for a time anyway…just like Madoff. That they “invested” heavily in Iceland, with its 15.5% interest.  Germans banks put $21 billion into Iceland banks.  The Netherlands gave them $305 million. Sweden kicked in $400 million.  U.K. investors forked over $300 billion from various pension funds, hospitals, universities, and other public institutions.  Oxford University lost $30 million.  It’s all so sad that 99% of the world believes things to be true, which couldn’t possibly be true.  That “experts” can do no wrong, and are to be trusted with wealth and surplus assets.  A few years ago, and not in the current time frame at all, a local retired electrical contractor and his wife, who had bought gold eagles from me @ $301, and silver eagles @ $7.50, were lured by a fast talking Madoff type into “investing” $100,000 in his scheme with the promise of a ten percent annual return.  They tried to get me involved and even introduced him to me.  I said NO, and tried to tell them that it would cost them their $100,000.  It did.

See, gold and silver don’t require “trust” and expertise to own.  No degrees or licenses from experts are required to decide to buy gold and silver, which after all, are historic money throughout the ages.  They’re simply a way of protecting assets from the criminal inflating of the world’s currencies.  The dollar is not alone.  Don’t be fooled by the “strength” of the dollar.  It is strong only in comparison to other pieces of paper, which are all being printed with merry abandon by the world’s governments.  People who brag about their CD making 4% rather than 2% are essentially bragging that their boat has a smaller leak in it than their neighbor’s, and is sinking more slowly.

Hope you went to a Tea Party!  I went to two, and it was a blast.  We sang the National Anthem, God Bless America, America the Beautiful, My Country Tis of Thee, saluted the flag, and had a grand time. In this town of 17,000 we had over 400 at one of them.  People were driving by honking their horns and waving.  It made tears run down my face.  Sorry, I am a hopeless romantic, and I love America.  It’s the current government I hate, and both parties.  If the Republicans would listen to our music and pay attention, they could take both houses at the next election, but it’s doubtful they’ll wise up and think straight.  How sad!

Regards,
Don Stott
Colorado Gold

April 17, 2009

Iceland: Harbinger of Worldwide Collapse was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

My guess is that the disorder in agriculture will be pretty severe this year, especially since some of the world’s most productive places — California, northern China, Argentina, the Australian grain belt — are caught in extremes of drought on top of capital shortages. If the US government is going to try to make remedial policy for anything, it better start with agriculture, to promote local, smaller-scaled farming using methods that are much less dependent on oil byproducts and capital injections.
     
This will, of course, require a re-allocation of lands suitable for growing food. Our real estate market mechanisms could conceivably enable this to happen, but not without a coherent consensus that it is imperative to do so. If agri-business as currently practiced doesn’t founder on capital shortages, it will surely collapse on disruptions in the oil markets. President Obama at least made a start in the right direction by proposing to eliminate further subsidies to farmers above the $250,000 level. But the situation is really more acute. Surely the US Department of Agriculture already knows about it, but the public may not be interested until the shelves in the Piggly-Wiggly are bare — and then, of course, they’ll go apeshit.
    
The recent huge drop in oil prices has left the public once again convinced that the world is drowning in oil — if only the scoundrelly oil companies were forced to deliver it at reasonable prices. The public has been consistently deluded about this for decades. What’s missing so far is for the president of the US to lay out the reality of the situation in a dedicated TV address. I know a lot of you think that Jimmy Carter already tried this and failed to make an impression (and ruined his presidency in the process). I guarantee you that Mr. Obama will have to do this sometime in the next few years whether he likes or not, and he’d be well-advised to get it done sooner rather than later. And by this I don’t mean just vague allusions to “energy independence” or “renewables” in speeches devoted to many other issues. I mean telling the public the plain truth that we’ll never offset oil depletion and the intelligent response is to do everything possible to transition to walkable towns and public transit, not to sustain the unsustainable.
     
The alternatives — i.e. what we’re trying now — is to further delude ourselves into thinking that we can run WalMart and the suburbs by some other means than oil. Despite all our investments in these things, we won’t be able to run them by other means, and the news about this had better get out before enormous disappointment turns into titanic rage. If Americans think they’ve been grifted by Goldman Sachs and Bernie Madoff, wait until they find out what a swindle the so-called “American Dream” of suburban life turns out to be.
    
On this blizzardy Monday in the power centers of America, attention is fixed on the never-ending fiasco of AIG — a company whose main product turned out to be credit default swaps, and is now choking on them. Kibitzers on the sidelines of finance are forecasting a king-hell bear market suckers’ rally in the stock markets followed by a belly flop to Dow 4000 or lower. I myself called for Dow 4000 two years ago — and was obviously a bit off on my timing. All this is surely trouble enough. But while your attention is focused on Rick Santelli in the Chicago trader’s pit, or Larry Kudlow desperately seeking “mustard seeds” of new growth in financials, try to let one eye stray to the horizon where these other complex systems are working out their next moves. Farming. The oil markets. These are the coming theaters of alarm and distress.

Regards,
James Howard Kunstler

March 3, 2009

Peak Oil, Credit and the Collapse of Complex Systems: What Next? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“THE ECONOMY HAS BEEN HIT BY TWO shocks,” said Andrew Sentance, a Bank of England policymaker, in a speech last Tuesday night.

He was talking specifically about the British economy, but these two shocks have smacked policy wonks square in the face across the developed world.

The two ugly fists — both with “hate” tattooed on the knuckles — are “financial market turbulence and a sharp rise in oil and some other commodity prices.”

“[They] are operating in opposing directions in terms of their impact on inflation,” says the Bank of England’s man. “So judging the appropriate monetary policy response will not be easy.”

But who needs to judge the right response when you’ve got a printing press and an unlimited line of credit from taxpayers?

Growth in the European money supply hit a 28-year record in October, the central bank reported last week.

The broad M3 money supply — “which the ECB uses as a gauge of future inflation,” as Bloomberg notes — rose 12.3% from October last year, the fastest rate of growth since July 1979. But this monetary inflation can only rise faster when November’s numbers come out late in December.

Last week alone, the European Central Bank promised to supply the money markets with an extra €30 billion ($44.27 billion) in short-term funds, “another indication that the credit crisis is far from over,” as Sean O’Grady reports for The Independent in London.

So far, however, no cigar. On Wednesday this week, the ECB made its biggest loan of three-month money since April 2001, as the global credit crunch pushed the interbank lending rate up to 4.74%.

The ECB’s current target rate for eurozone interest rates is 4%, and these short-term loans are designed to help ease upward pressure on the free-market rate by making easy with central bank cash.

But even after last week’s record auction of €50 billion ($73.7 billion) “We didn’t see any effect on markets,” one money-market trader told Reuters.

“The amount [that private banks are] needing is a lot more than the ECB is allotting.”

Resolving tensions in the financial markets is only one half of a central banker’s task, however. His other key responsibility — and central bankers are almost without fail always male, if not men — is defending “price stability.” In other words, inflation must not be allowed to rise above some target or other, decided over tea and biscuits in the hushed conference suites where politicians and central bank wonks chew the cud.

The inflation target is currently set at 2% in both Europe and the United Kingdom. On Tuesday last week, however, the Federal Statistics Office of Germany announced that consumer price inflation in the world’s third-largest economy will rise by 3% in November — the highest rate of price increases since February 1994.

“A sense of impending inflation is currently influencing German consumers,” warns the highly regarded GfK consultancy. “The positive factors currently evident, such as the sustained improvement on the job market and rising incomes, seem unable to prevent the evaporation of optimism.”

“Solid anchoring of inflation expectations is all the more important in a period of turbulences associated with this market correction,” as Jean-Claude Trichet, president of the European Central Bank, said in a speech on Monday this week.

That neatly sums up the head-scratcher now costing central bankers their hair the world over. You either bail out the money markets with a flood of liquidity…or you keep a lid on inflation.

You can’t do both, not according to history. And every so often — not least when you’re bruised and beaten by a fearful credit crunch on one side and a hateful oil-price shock on the other — it seems you can’t achieve either.

Just ask Andrew Sentance at the Bank of England. In Tuesday night’s speech, he ‘fessed up to an inflationary mess that looks a little like this…

The U.S. Federal Reserve, meanwhile, is also presumed to be targeting 2% annual growth in its consumer prices.

But just like the ECB too, it’s also pumping money into the New York credit market at a record clip.

Can central bankers really have it both ways?

The U.S. Fed is forever making short-term loans to the money markets. Adding liquidity is nothing unusual.

The Fed offers money to the big New York banks in exchange for good-quality securities — securities such as, say, U.S. Treasury bonds or government agency debt. And it will lend money for anything between one day and two weeks or more.

On any one day, you might find the New York Fed making two, three or more of these loans via auction. And between the start of 2001 and the end of last month, the average sum lent in each of these auctions was $6.01 billion.

Since the start of this month, in contrast, each of the Fed’s short-term liquidity auctions has averaged $10.17 billion.

But let’s put quantity to one side for a moment, even if it does seem to be driving a sharp rise in German consumer price inflation. The quality of the collateral that the Fed is accepting when it makes these loans has changed dramatically, too:

The Fed has always been happy to accept mortgage-backed bonds as security for the short-term cash injections it makes.

If the New York interbank lending rate needs a little shot in the arm to cool it down, AAA-rated mortgage-backed securities are just fine. But as you can see, the big banks stepping up to the Fed’s auctions have always been keen to use more mortgage-backed securities (MBS) as collateral than the Fed would accept.

Indeed, the ratio of MBS submitted to MBS accepted averaged only 0.55 between November 2000 and the end of July 2007. More times than not, the Fed said “no” to home loan-backed bonds and demanded U.S. Treasury notes or agency debt as collateral instead.

Since the credit crunch first bit at the start of August, however, the New York Fed has relented somewhat. The ratio of MBS submitted to MBS accepted when bidding for the Fed’s cash has risen to 0.85.

And while the size of the Fed’s injections — as well as the volume of mortgage-backed bonds held against them — have both grown substantially, the frequency of those injections has also soared. There were 29 temporary Fed injections in the first 28 days of November alone.

Over the preceding seven years, the New York Fed averaged fewer than 25 injections per calendar month.

But it’s not only the Fed that’s supporting the local housing market by accepting mortgage-backed bonds as collateral for new loans. Last week, Australia’s central bank lent Aus. $500 million — some U.S. $435 million — in a series of repurchase agreements based on mortgage-backed bonds. On Thursday alone it bought Aus. $100 million of home loan debt, set to mature in just over three months.

“This is the first high-volume activity ever in this market and may encourage further investor participation,” reckons Warren Mellor, an analyst at National Australia Bank in Sydney, talking to Bloomberg. It might just encourage Australia’s financial firms to park as much of their home loan inventory at the reserve bank, too.

Sales of Australian mortgage-backed bonds sank by 94% between July-September, the newswire adds, down to a meager Aus. $1.8 billion — a five-year low.

Can the Reserve Bank of Australia reverse this slump? It claims to love mortgage-backed bonds so much right now, it’s willing to lend hard cash against them at a bargain rate of interest.

Sydney’s interbank lending rate for three-month loans ended last week at 7.165%, just shy of an 11-year high. The RBA, however, was happy to lend for 0.24% below that market rate.

Or put another way, the flood of money trying to wash away the current slump in world credit markets is truly global.

Think this will help ease inflation in your cost of living?

Regards,
Adrian Ash

December 3, 2007

Two Shocks, One Solution was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“IF YOU UNDERSTOOD a business perfectly and the future of the business, you would need very little in the way of a margin of safety,” said Warren Buffett at Berkshire Hathaway’s annual meeting in 1997.

He had first issued his famous dictum 20 years earlier. Buffett referred to it again in 2005.

“We [only] borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand,” he told his shareholders…and the BRK faithful just loved it.

Understanding where you’re putting your money — knowing how it will be used and knowing the likelihood of getting it back — reduces your risk, in short. If you don’t understand an investment, then the “unknown unknowns” threaten to eat you alive.

Appears sound in theory, right? But does anyone outside of Gorat’s Steak House today even begin to care if it’s true?

“Although the dislocations, especially to short-term funding markets, have been large and in some cases unexpected,” the International Monetary Fund just reported, “the event [of the world credit crunch] hit during a period of above-average global growth.”

Moreover, added Rodrigo de Rato, the IMF’s managing director, in a Moscow press conference Tuesday, “the evolution of recent days is moving toward normalization.”

“The most important financial institutions have enough capital to withstand the shock,” de Rato explained. And amid the crisis in confidence and “state of turbulence” hitting the financial sector, “We welcome the actions of central banks to maximize liquidity,” he announced.

Trouble is, maximizing liquidity — the availability of money — is what created this mess in the first place. Failing to understand this plain fact is what led the United Kingdom, the world’s fourth largest economy, to suffer its first genuine banking run in more than a century. Here in London, all progress in finance since 1878 just got wiped out.

Yes, the City and its regulators have swapped whiskery chops and black stovepipe hats for ShockWave hair gel and pink gingham shirts. But they’re no more “sophisticated” than were their Victorian forebears. And as the IMF report proves, it’s not only London that’s failed to grasp the risks facing global finance today.

The run on Northern Rock came thanks to the very “liquidity” that de Rato says he’s glad to see pouring out of central banks once again. NRK was a top-five mortgage lender that gathered £24 billion in saving deposits but lent out £113 billion. It raised the difference by borrowing short-term funds in the money markets.

Did anyone inside Northern Rock understand the risks inherent in “maximizing liquidity” so aggressively? Didn’t the Bank of England or Financial Services Authority grasp the dangers this high-profile bank was storing up on its balance sheet? Evidently not — and why would it?

By the end of June, NRK’s total exposure to subprime U.S. home loans represented only 0.24% of its total assets. Hot on the heels of the Bear Stearns’ hedge fund collapse at the start of the summer, this meant NRK was deemed safe from the chaos of failing mortgage-backed bonds relying on low-income U.S. homebuyers for repayment.

Not that London’s financial leaders were alone in their error. The mass of British investors also mistook NRK’s tiny subprime exposure for evidence that it was safe. NRK was one of the five most popular shares bought by private U.K. investors in the last week of August. Since then, however, NRK’s stock has sunk by 75%.

Pictures of anxious savers queuing outside NRK’s branches on the High Street also destroyed confidence in the Bank of England and the Financial Services Authority — the government-mandated watchdogs supposed to understand, monitor, and cap its risky behavior. The media’s panic, shocked at the very idea that a financial firm might ever go under, then forced London’s government of amateur financial idiots to guarantee all savings for all savers wherever they bank.

Risk has been abolished, in short — a concept even the TV news anchors can grasp. So who cares that it’s not true?

“Whatever system is put in place to safeguard deposits following the run on Northern Rock,” says a letter to the Financial Times, “it is important that it is understandable to savers. I wonder how many savers understood the workings of the Financial Services Compensation Scheme before its recent coverage in the press?”

The British equivalent of the FDIC, this Compensation Scheme — it was revealed Tuesday — now holds funds of just £4.4 million. Total U.K. bank deposits, on the other hand, total some £1.6 trillion. It doesn’t matter that, in the wholly unlikely event of a total collapse in British banking, the fund could offer only 0.0002% in compensation. Forget the fact, too, that the U.S. insurance scheme, by comparison, holds 500 times as much cash for a population only five times the size.

The point is that the FSCS in London was allowed to promise insurance worth £31,700 to each of Britain’s cash savers (just less than $64,000) — and to continue making this promise — without anyone bothering to even imagine that the policy might ever be needed.

The United Kingdom also has the Banking Code, a 36-page document setting out standards of behavior agreed upon by the vast majority of retail banks and building societies. But the state-owned monopoly post office has yet to sign up to the Code. And the Code itself does not mention the word “risk” once. Nor does it talk about “safety.” The sole preoccupation, as with today’s bubble-friendly banking regulations everywhere, is with honesty in marketing.

Honesty about the raw fact of banking deposits — that your money is at risk the moment you let someone else lend it out for a profit — just doesn’t figure.

In the United States, too, the very concept of “risk” has been long forgotten as a warning. Indeed, for Bank of America’s current marketeers, it’s now just a tool…a branding technique to prop up tired advertising execs when they’re all out of ideas. The biggest bank in the U.S. currently offers what it calls the “Risk Free CD.” Never paying less than 4.75% during its 11-month term, the Risk Free cash deposit actually comes with no more, or less, risk than any other U.S. savings account. Its only claim to safety is that you can “count on the security of FDIC insurance up to $100,000 on your accounts,” says the marketing blurb.

Yes, that’s it! Beyond the FDIC promise, the risks to your money are no different than the risks incurred by holding your cash anywhere else. The “risk free” sticker on BoA’s Risk Free CD is simply there to make 4.75% interest sound unique, intriguing, perhaps even attractive.

But who outside Wall Street, the City, Frankfurt’s glass towers, or Tokyo’s Kabutocho district can understand that? Who on the inside even cares?

Regards,

Adrian Ash
October 3, 2007

Buffett’s Dictum & Your Margin of Safety was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.