They all ask some version of the same question, in any case. It’s the cocktail-hour question asked of every economist: What does the future hold and what should be done about it? The problem is that Bernanke doesn’t know more about the future than the markets know. Actually, looking at the transcripts of the 2006 FOMC meetings, the Fed knows much less than the markets know.

But at least we now know what Bernanke thinks he knows. A short summary of the flurry of news from the Fed yesterday: The economy is still in the tank, it will stay that way for years, interest rates will be held at zero and savers can go to hell.

That last part we can glean from the most-interesting question posed to Bernanke yesterday. Greg Robb of MarketWatch pointed out to him that he has some severe Republican critics. The Fed has been a major issue in the debates and on the campaign trail. Mr. Robb had a theory about why: Many Republican voters lived on fixed incomes that depend on some return on their money. For this crowd, zero interest rates are a disaster. Robbery, really.

Bernanke’s first response was to say that he was not going to involve himself in politics because he “has a job to do.” It is a credit to the press corp that they did not double over in laughter at the ridiculous claim that the Fed’s job has nothing whatever to do with politics! After 100 years of Fed service, it is pretty obvious that the Fed serves two clients: the big banks and the government. The Fed certainly doesn’t serve the class of people who save and invest.

So how did Bernanke deal with the second part of the question? This was interesting. He said that he was very sorry for savers and those who depend on interest income, but they need to understand that they too have a long-term interest in a healthy economy. If investment and productivity are rising, they create the conditions for growth down the line, and surely this is good for everyone.

That’s some crazy kind of circuitous reasoning going on there. It’s a bit like the thief who steals the silverware and then explains to the former owners that a wider distribution of beautiful tableware is surely good for everyone in the long run. Even if you buy the argument, it would be nicer if the owner had some choice in the matter.

And there’s another problem that is so incredibly obvious that no one at the press conference even dared point it out. The problem is that the zero-interest-rate policy has not worked to boost economic growth. What possible basis is there for thinking that two more years of this extermination of the saving class is going to do what the last three years have not done?

Of course, it depends on what you mean by “worked.”

Let’s say that the Fed wants to drive all investors away from government bonds and into riskier instruments in an attempt to artificially boost financial markets. Check.

Let’s say that the Fed wants to punish anyone who wants to sock away money for a rainy day and, instead, prod them into buying more plasma TVs, digital gizmos and summer homes. Check.

And let’s say that the Fed wants to artificially suppress the government’s own costs of borrowing in order to reduce pressure on the political class. Check.

In all these ways, abolishing interest rates works for the Fed and the political elites. But there are at least three downsides.

First, banks depend on interest payments for profitability, and low interest removes the financial incentive for banks to lend money in a normal way. This is why commercial bank loans remain low, with the latest data showing the volume at mid-2007 levels. One might suppose that this is contrary to the Fed’s aims, but it is a price that it is willing to pay.

Second, a low interest rate agenda requires that the Fed try to control not just the short-term rates over which it has the most influence, but also rates across the entire yield curve. This means removing risk premiums on longer-term loans by implicitly guaranteeing bailouts, just like those of 2008-10. This entrenches more moral hazard and drives a wedge between risk and result.

Third, this policy of low rates is similar to — but even worse than — the very policies that created the bubble of the 2000s that burst in 2008 and prompted the worst financial and economic calamity of many generations. The Fed has learned absolutely nothing from even its own most-recent history. If people can’t earn money through interest, financiers will find some other way to market risk, leading to crazy investments schemes and misallocated capital.

As David Malpass writes in The Wall Street Journal:

Near-zero interest rates penalize savers and channel artificially cheap capital to government, big corporations and foreign countries. One of the most fundamental principles of economics is that holding prices artificially low causes shortages. When something of value is free, it runs out fast and only the well-connected get any. Interest rates are the price for credit and shouldn’t be controlled at zero. It causes cheap credit for those with special access but shortages for those without — primarily new and small businesses and those seeking private-sector mortgages.

The big take-away from the Fed’s day in the news is its new policy benchmark of keeping inflation at 2%. This is sheer silliness. There is no such thing as a price level, as even recent CPI releases illustrate. Some prices went up (food, education, health), and some prices went down (oil, software, services). Mash them together and you get a single number that applies to absolutely nothing in particular.

In any case, the Fed can’t control prices in this way. It is always driving while looking in the rearview mirror. When the crash comes, there is nothing the Fed can do about it, despite Bernanke’s repeated promises to rescue the world from any bad effects of his policies.

As Bloomberg’s Caroline Baum says, it’s almost as if the Fed itself has completely forgotten the existence of the “long and variable lag” that separates its policies from their effects. She recalls Milton Friedman’s own analogy of the “fool in the shower” who keeps turning the water from all hot to all cold and wonders why he is either scalded or frozen.

Baum concludes that under Bernanke’s own plan, we would have “eight years of 0% interest rates. There will be a revolution in this country before then if the economy is lousy enough to warrant 0% interest rates for that long.”

Really? One would hope.

Regards,

Jeffrey Tucker

Zero Percent Uber Alles was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

All they can offer is a description of symptoms, such as with their favorite phrase: lack of “aggregate demand.” Which, if you think about it, doesn’t really explain anything. How come demand dropped? Why did it drop now and not at any other time? Whose demand dropped? (Hint: Mine didn’t.)

Sigmund Freud Meets Dr. Ruth

But hey, when faced with a lack of proper economic explanations, you can always fall back on some amateur psychology. Everything must be down to what goes on in people’s heads, right? People just get all mixed up. Too pessimistic. (Animal spirits, anybody?)

That’s why it is always up to those coolheaded guys and gals in government to use their policy tools to change expectations, change the psychology of people, cajole everybody into some elevated state of positive thinking and, hence, more economic activity. Save the masses from their own silly notions in their tiny heads, like saving and getting rid of debt. They all just clam up and save? Pitiful. But most importantly, why even worry about explaining the recession if you are confident, if you simply know, deep down in your heart, how to get out of it?

Most politicians don’t know any better. They certainly don’t know any economics. So the same toxic policy mix of Keynesian deficit spending and monetarist money printing has been implemented around the world since this crisis started four years ago. Just as in any other recession of the past 40 years, ever since Nixon cut the last link to gold and fulfilled every interventionist’s wildest fantasy: unlimited paper money under full control of the state! Yeah, baby, no more recessions!

Alas, it is not working, is it?

Rates were cut, and the state not only spent money it didn’t have…as usual, it spent much more money it didn’t have. But the economy did not recover. So more of this policy was implemented. And then, more again. In fact, by any standard, never before in modern times has the economy been “stimulated” more through Keynesian and monetarist government intervention than over the past four years.

Balance sheets of major central banks have tripled. Banks have been receiving limitless funds for free and will continue to do so forever, and governments are running deficits the likes of which mankind has only ever seen at the height of major wars, and which are increasingly funded by the printing press.

It is still not working.

You would probably guess that the interventionists of Keynesian and other ilk would be a bit more humble by now. Maybe check a few of those premises in their models? Or maybe start thinking again about those elusive explanations for what’s wrong with the economy in the first place? Are we really suffering from a lack of paper money and government spending? Maybe it is not simply down to all of us being too depressed, morose and in need of some policy Prozac. Maybe something else is broken.

Alas, no. The academically trained Keynesian economist is too committed to his or her beliefs to let the facts get in the way. Why has policy not worked? Because we have been too timid. We need the same policy. We just need more of it. A lot more.

More monetary madness

In her recent op-ed piece in The New York Times, High Priestess of Keynesianism Christina Romer suggests a radical policy “change” at the Federal Reserve: toward more money printing.

Rather astutely, she calls for Helicopter-Ben to embrace a Volcker-moment. Maybe by quoting the poster boy of the Reaganites and the hard-money crowd, she hoped to reach a new audience for her tiring and dreary, old policy recipe of more and bolder interventionism. She almost had me fooled.

Wait a minute, I thought. Volcker? He is the guy who abruptly stopped the printing press and allowed high real market rates to cleanse the system of the dislocations of previous booms, and to squeeze inflation out of the system, thus, giving the paper dollar another lease of life — albeit one that is quickly running out.

I thought, has Christina finally seen the light? Has she begun to realize how massively disruptive a constantly expanding supply of fiat money is for an economy? Is she calling, as I do, for an end to this monetary madness of zero policy rates and quantitative easing?

Well, no, she isn’t. She wants the Fed to print more money, much more. She wants the Fed to adopt a nominal GDP target. This will allow the Fed to become even more aggressive in its monetary policy and to communicate this aggressiveness better. Make people trust in that aggressiveness. And this communication is important for Romer.

As we have seen, for the good Keynesian, the policy was never wrong. The policy was just not ambitious enough. All it needs is a more-ambitious goal and better communication. People just have these bad thoughts and wrong expectations. The public is just not playing ball, not going along with this enlightened economic program. Well, says the Keynesian, we’ll teach them.

The Volcker analogy works like this for Romer: In 1979, inflation was too high, and small rate hikes didn’t work. So Volcker implemented a much tighter policy and crushed inflation. And it worked, because people believed him. Today, unemployment is too high. Gradual policy easing (not sure what planet Christina is on, but from where she is sitting, monetary policy in the U.S. must have appeared to be gradual) is not working, either.

So Bernanke needs to become more aggressive, and publicly so. Because people believe that if you stick to your policy, which — please remember — was, of course, the right policy to begin with, then the policy will really begin to work. You just need to drill it into those blockheads.

Every first-semester economics student, not only those at Berkeley — where Romer is economics professor — should be able to tear this apart with ease. The analogy with Volcker is silly. Volcker used monetary policy to fix a monetary problem: inflation. Stopping inflation by not printing money anymore is pretty straightforward. The link is kind of direct.

To be honest, it doesn’t even matter what the public believes or not. If you stop printing money, inflation will drop. Period. The link is that direct. You don’t need the accompanying belief system.

Was there full employment in Weimar Germany?

However, unemployment or the level of ‘aggregate demand’ is decidedly not a monetary phenomenon. Only in the airy-fairy dreamland of macroeconomic models is there a direct link.

To assume that we can simply and straightforwardly establish whatever nominal growth rate and level of employment we desire by means of the printing press is precisely the type of naive “building block economics” that got us into this mess in the first place. According to this worldview, the economy is just a machine, and all we need to do is to pull the right levers. Or it is like a cooking recipe, in which we need to simply change the ingredients a bit and — voila! The souffle will rise!

It is precisely because (a certain type of) economists have been telling us…that we can have more growth and high employment by constantly debasing money. This is how we created this highly levered economy over the past four decades. One that is so thoroughly addicted to ever larger fixes of cheap credit and that is now choking on excessive debt and weak banks.

By printing money and artificially lowering interest rates we have, again and again, bought near-term economic growth at the expense of long-term economic imbalances. That this was bad economics everybody is now learning the hard way. Everybody, that is, except Christina Romer. Her simple worldview is unshaken.

It is this weird combination of childlike belief in the simplicity of the problem (aggregate demand, lack of optimism) and the striking arrogance of the notion that the government can and should control the economy by simply pulling at the right strings hard enough that makes Romer’s article such an illustrative example of the intellectual dead end that is mainstream economics today.

Romer has apparently no notion of relative prices and of the importance, in particular, of interest rates for coordinating saving with investment. She cannot see that lowering interest rates administratively and injecting new money into the financial system will have many additional effects, other than lifting some statistical measure of aggregate economic activity. Easy money will always change resource use and capital allocation. Cheap credit encourages borrowing and debt accumulation, and will cause additional problems for the economy later.

Romer cannot perceive of these complexities. In her ivory tower, the world is one of simple statistical aggregates and large wholes that you can direct and mend to your liking. You just add the desired real growth rate (2.5%) and the acceptable inflation rate (2%) and stir it nicely to come up with the nominal growth rate (4.5%). How hard can it be?

We have some indication that Bernanke is not very sympathetic to this proposal at present. It doesn’t look like this will become official policy anytime soon. But who knows? A lot of what is now accepted monetary and fiscal policy in major countries and debated dispassionately by financial market economists would only a few years ago have been the mark of the economic crank, or the populist policy program of some economic backwater just before it was put under IMF surveillance.

But what is striking is this: Such rubbish emanates from the highest echelons of academic economics in America. Christina Romer is economics professor in Berkeley, Calif., and I fear that a lot of very bright young people burden themselves and their families with student loans and waste valuable time absorbing such drivel. If Romer is all that economics in Berkeley has to offer, why not emulate the late Steve Jobs and drop out?

Regards,

Detlev Schlichter

Christina Romer’s Toxic Cookbook was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Case in point: The July 13, 2011 exchange between the Austrian-schooled Republican who “gets it” Whiskey bar favorite Congressman Ron Paul and the Fed chairman.

What strikes me is not Bernanke’s struggle to explain the monetary function of gold, but something else. It’s something that scares the living bejesus out of me whenever I hear Bernanke testify.

Before I say what it is, let me stress that I don’t much like the widespread demonization of the Fed chairman. I think he was sincere when he said that he never cared about the management or the shareholders of the Wall Street firms he invariably bailed out and is generously subsidizing. He really believes that what he is doing is helping the U.S. economy and the U.S. people.

The problem is not that he is evil or dumb – I think he is neither – the problem is much bigger. You can deal with people who are evil and dumb. Deeply-convinced do-gooders in positions of almost unchecked power, those are the ones we should worry about. The good intentioned can suffer from tunnel-vision, incurably in awe of their own theories and are incapable of even grasping how what they are doing could make things worse.

Market manipulations — keeping rates artificially low and bank reserves expanding – are creating momentous dislocations, vast problems with as-yet incalculable consequences – even if they do not generate instant hyperinflation or intolerable expansion in the wider monetary aggregates.  This only looks deceptively harmless through Bernanke’s narrow prism of national account statistics.

Mr. Bernanke suffers from a blind side: He can’t see that ‘elastic’ money is always destabilizing. In my forthcoming book, Paper Money Collapse, I show how any expansion in the money supply (including bank reserves) distorts relative prices, always and everywhere. Even if some fortuitous rise in money demand cushions some inflationary impact and if inflation measures therefore remain contained.

Every money injection disrupts the market’s setting of interest rates, thus disorienting the process of coordination between true savings and investment and capital formation.

Bottom line: Interest rates are market prices, Mr. Bernanke, and you interfere with them at your peril!

I didn’t discover this, of course. I owe much to Ludwig von Mises and the young F.A. von Hayek. Ron Paul understands them, Bernanke doesn’t.

Bernanke: Man on a Mission – To the Wrong End

Bernanke upholds the original mission of the Federal Reserve: to avert credit contraction and debt deflation at all costs. During the Q&A, he reminded the laissez-faire Congressman Paul of the bank runs of the 19th century. Instability in banking — and in the wider economy as a result of banking — should come as no surprise to anybody who understands the practice of fractional-reserve banking.

Today, banks are money-producers. But here’s the problem: whenever the economy slows, the nervous public ditches deposit money for ‘real’ money. In fact, we want money that is not somebody else’s liability, such as gold or, even, state paper tickets. The banks then have to contract the supply of deposit money — shrinking the supply of what is used as money in the economy — thus exacerbating the recessionary forces in the economy.

The Fed Reserve wanted to avoid recessions — or shorten them –and avoid credit contraction. What they thought was needed is some form of elastic money so that in economically challenging times the banks do not have to contract the supply of credit.

It is almost comical how Mr. Bernanke seems to say, why are you criticizing me? I am spending all this money, but it doesn’t add to the federal deficit. I am printing this myself. I just press a button. Money printing is costless. And I can help the economy.

The Austrians know that such a powerful threat to the banks is brought about by the banks themselves! The lowering of reserve ratios and the creation of deposit money leads to a credit boom which always creates imbalances — in the saving-investment equation — and thus must end in bust.

What the Fed is trying to do is destined to fail. It cannot solve the problem. It must exacerbate the problem. Bernanke believes that with his all-powerful printing press he can always buy another recovery. For him his job appears to require an astute balancing act between the two things his macro-tunnel vision allows him to see: the trade-off between growth and inflation, both — so he believes — neatly observable with macro-statistics (the fetish of the economics profession). He cannot grasp the distortions in prices he creates, the misallocations in capital he furthers, and the accumulation of debt he encourages. None of them register on his statistical radar.

The debt-ceiling debate in the U.S. is trivial. What matters is this: as long as there is a Federal Reserve and as long as it is run by men like Mr. Bernanke — dedicated, smart but hopelessly committed to a flawed belief system — the economy will not be a capitalist one, benefiting fully from saving, entrepreneurship and true capital accumulation but will always be addicted to easy money, cheap credit and propped up asset markets.

What Will Happen Next?

Like a little hamster in his hamster wheel, Mr. Bernanke will only run faster and faster. Next, the interest rates that banks get on their deposits at the Fed will be cut to encourage more lending. The Fed will conduct QE3, and then QE4, and so forth. Maybe they will not call it that, but in effect that is what the Fed chairman’s own belief system will force him to do.

The size of the accumulated dislocations is already too gigantic today to allow any politically acceptable correction. Nobody had the stomach for it during Lehman. Nobody has the stomach for it today. In the monetary environment the Fed maintains, deleveraging will never be accomplished. Mr. Bernanke digs himself deeper into a hole that he won’t get out of when the market demands higher interest rates to maintain confidence in the paper dollar.

Paper money systems collapse — and they have all collapsed, throughout history and without exception — not because the money printers don’t understand inflation. They simply always reach a point when they fear the immediate impact of turning off the monetary tab more than the further printing of money. Of course, the disaster in the end is only bigger.

Bernanke is no James Bond villain out for world domination or even a big Wall Street payout. He is more the mad  professor in some sci-fi B-movie, unwittingly in cahoots with the forces of destruction not out of mean-spiritedness but out of intellectual hubris and infatuation with his own theories and technical wizardry.

Utterly convinced that he has worked out all the effects of his manipulation of the money supply and of interest rates, Bernanke can’t see why anybody would not want him to go on manipulating. In the meantime, debasement of paper money continues…

Regards,

Detlev Schlichter

The Bernanke Blind Side was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Bernanke spooked investors in New York when he fronted a group of empty headed Senators in Washington and told them that the future of the U.S. economy was “unusually uncertain.” But in a real boon to those of us looking forward to the inflationary effects of trillions of dollars more in quantitative easing, Bernanke assured the Senators that, “We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.”

Can this sort of nonsense really be taken seriously? Unfortunately, we have to take it seriously because it has serious investment consequences.

But how long will it be before most people understand that the Fed, the regulators, and the monetary authorities have no credibility when it comes to: a) understanding what is going on, b) fixing it, c) confessing to their culpability in causing the misallocation of capital and the zombification of large chunks of the global banking sector and generally forcing all of us contemplate their moronic and opaque pablum?

These people really are vandals and thieves. We are encouraged to take them seriously and cede micromanagement of the economy and public life to people who don’t have an entrepreneurial bone in their body. What a big con.

In any event, don’t be fooled by the results of the stress test. Those so-called stress tests for European banks are just as much a whitewash of the real capital inadequacy issues as were the American stress tests. In fact, the whole exercise is perfect pretext for another round of central bank quantitative easing/outright support of asset prices.

After all, American and European banks are stuffed full of housing-backed securities and sovereign debt. The credit boom manifested itself in many assets. Much of the fiscal and monetary policy since 2000 has been designed to keep those assets from deflating. It can’t work.

We reckon this latest and largest round of quantitative easing will come sooner than most people are expecting and be a lot less effective than some people are hoping. It’s time to get ready for it now. Crank up the fan…here comes the merde.

Meanwhile, a minor merde storm is brewing between Australian banks. Nothing sexier than watching the banks go at it over lending practices. Commonwealth Bank of Australia hard man Ralph Norris delivered a rhetorical smash to the nose of NAB’s Mark Joiner. According to the Australian, Joiner said last month that some banks in Australia were making “super profits” by expanding their mortgage lending to the detriment of small business lending.

“Kapow!” says Mr. Norris. Well, not literally. Rather, he said, “I think the real issue is that we have a bank (NAB) that has performed poorly for many years and missed out on an opportunity when the mortgage market opened up… The market [for small business lending] grew by 0.5 per cent and we grew by 9 per cent…I don’t know where that rubbish is coming from, because the facts certainly don’t support it.”

Never having been a banker, we are inclined to sit back and watch the slap fight. But the stakes are high. CBA’s loan book is 60% in residential mortgages. Under Basel II, the bank has to hold less capital against a home loan than it does against a ‘riskier’ business loan. So, you could argue that expansion of the mortgage lending book, even at the expense of business lending, is a safer move for the bank and delivers bigger profits to shareholders. It also keeps the rivers of credit flowing into Australian property.

You could argue that. But it’s not the argument we would make. We would instead make a high-handed, ivory tower, abstract kind of comment that the people of a nation can’t all get rich by buying and selling houses from one another. For one, it’s a singularly unambitious national goal. But that’s not the biggest argument against it.

Creating a profit is hard. In some ways, it’s unnatural. Profit is surplus value. Human beings improve their living standards by increasing productivity and efficiency through innovation and constant adaptation. The free market is a great mechanism for producing surplus, as long as risk taker and small businesspeople and crack pot inventors and dreamers and builders have access to capital. Of course the banks are under no obligation to take bad risks (unless you’re talking about U.S. banks compelled to make loans to bad credit risks during the American housing boom.)

As for the aforementioned impending (we believe) quantitative easing round two, how should you prepare? Well, in the fashion that you find most fit naturally. But we’d suggest that asset markets are going to cop it good and hard in the second half of this year. We’re expecting a one-two combination of big falls in stock markets and then wild, irresponsible, unprecedented and unconventional attempts to reflate by central banks.

Regards,

Dan Denning,
The Daily Reckoning Australia

P.S. In the meantime don’t forget: the people backing an emissions trading scheme the most usually have a vested interest in the exchanges that will be set up to trade said emissions. It’s like a potential casino owner telling you we should all be compelled to gamble. The government’s interest in the matter is self-evident: mo’ money. And the bureaucrats who are backing it presumably thrive, in some small-minded and mean-spirited but satisfying way, on simply telling people what to do.

Resist them all! And as the great thinker, champion of liberty, and emancipated American slave Frederick Douglass advised, “Agitate! Agitate! Agitate!”

Fed Up with the Fed and the Welfare State was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“The reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention…”

So said Henry Paulson, U.S. Treasury secretary and ex-Goldman Sachs chief, in Shanghai on March 7, 2007. Hank was lecturing Chinese officials (who this week allowed short-selling on their domestic equity markets for the first time) at the so-called China-U.S. Strategic Dialogue summit.

Of course, Paulson bent their ear before Bear Stearns “Enhanced Leverage” mortgage-bond hedge funds blew up in June ‘07. The following month, Ben Bernanke, chairman of the Fed, made his first guesstimate of total bank losses — “in the order of between $50 billion and $100 billion” — to come from the subprime collapse.

Now the terrified trio of Bush, Bernanke and Hank want $700 billion just to refinance the U.S. investment banks and their foreign landfill sites, let alone home-buyers, mortgage lenders and house builders.

Yet five U.K. banks alone hold $175 billion of qualifying junk — fully one quarter of the sum requested. So no wonder Bill Gross — boss of Pimco, the world’s biggest bond fund, and a cheerleader for governmental intervention ever since Bear Stearns’ hedge funds went “hiccup!” — says the “troubled auction recovery program” will need another $500 billion on top, just for starters.

Paulson’s ideological grandstanding in Shanghai last year preceded a few other events that may have forced his Damascene conversion.

All this while, of course, the developed world’s central banks were pouring cash into the credit market, trying to fix the first big problem, the first of five “big freeze” spikes in world money market interest rates.

It just keeps coming back, however. Because the people who know best the liquidity and solvency of major banks — the other banks — refuse to lend whatever money they get, hoarding it instead for fear of a run at their own branches.

“British banks have squirreled away nearly £6 billion [$11 billion] with the Bank of England rather than lend it to each other for more than a few days,” reports the Financial Times, “using its safe but low-interest deposit standing facility is a sign of the fear gripping money markets.”

Little surprise that inter-bank lending rates are holding near an eight-month high for U.S. dollars — despite the Fed now offering more than $290 billion to foreign authorities for their own domestic money markets — while the banks’ price for borrowing euros has reached a record high for the single currency, launched in 1999.

And all this while as well, of course, the Federal Reserve has been busy slashing U.S. interest rates…finally joined by the U.K., Aussie and New Zealand authorities in making debt cheaper even as the free market — both the interbank market and the commercial market of home-loans, overdrafts and corporate lending — pushed in the other direction.

This privilege, allowing central banks to set the price of money whenever it thinks the economy needs tweaking, might seem to jar with Paulson’s tidbit from Shanghai.

But shepherding the free market is why central banks, regulators and government itself exist today. And as they’ve proven so adept at this task, guiding the lambs of Wall Street to the slaughter of Florida and California condos, it would surely make sense to extend their powers — and shepherd the free market a little more closely — from here.

Right?

“We thought Resolution was just suspended, not delisted,” said a spokeswoman for City watchdog the Financial Services Authority last Friday.

You’d think they might know. But no, Resolution, a U.K. insurer, was delisted in London after being bought out in May. Yet it still found its name on the banned list of 29 “no shorting” stocks proscribed by the FSA.

“It will be removed,” said the all-powerful watchdog. “A revised list will be up on our website later today.”

Meantime in New York — where Hank Paulson’s “open, competitive, and liberalized financial market” is also taking a break — the Securities & Exchange Commission (SEC) has banned short-selling of GLG, the giant London-based hedge fund, along with 798 other financial stocks and 100 or more stray sheep like GE, GM and Ford.

Funny, but GLG itself paid a $3.2 million fine in June ‘07 for “multiple violations” of the SEC code, after shorting some 14 public offerings in the U.S. and making $2.2m over two years in “illegal” profits.

Still, there is more rejoicing in heaven over one lost sheep found, eh?

“Markets are usually right,” says Anatole Kaletsky in the London Times, “but sometimes they are dangerously wrong — and they need to be managed with decisive and competent government intervention.”

Ignore Polly-Ana’s morality if you can; fact is, markets often get dangerous. Whether they’re right or wrong doesn’t matter much if you’re buying high and then forced to sell cheaper.

Here and now, the market — right or wrong — is pricing toxic debt and derivatives at zero or worse. U.S. subprime mortgage bonds, if marked-to-market — rather than against the apparent “final redemption value” used to help pay $66 billion to Wall Street staff in 2007 — are also worth zilch. That’s why there’s no danger of anyone buying them, no one outside Washington, that is. And there’s the true danger today.

The dangerous market has been and gone. It popped when Florida condos stopped selling to buy-and-flip wannabes without a red cent of cash but one million in debt. Only government meddling — just like Hank Paulson said — risks further danger; the danger that U.S. taxpayers will pay through the nose (and through inflation) for $700 billion of utterly worthless “investments.”

Hell, he did run Goldman Sachs, after all. What did you expect! But is there any danger of letting the free market do what needs doing?

Regards,
Adrian Ash
September 29, 2008
BullionVault

Government Regulation and Financial Bailout was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

He did that to get your attention.

Fed chairs rarely ever say that word, for reasons that Greenspan learned on his first days in office back in 1987 — the same reasons that CEOs rarely comment on their stock’s valuation.

Bernanke’s original remarks came before Friday’s unemployment report rained on Wall Street.

But just in case anyone thought the weak report might have softened his stance over the weekend, on Monday, he repeated his determination to tackle increases in long-term inflation expectations, and to fix the dollar. The rhetoric helped boost the currency and splashed cold water on gold’s recovery.

I say “helped” because the Saudis did most of the work by announcing an output hike (500,000 bpd).

Let me tell you right out of the gate that, as a rule, the Fed talks tougher than it is capable of acting, especially with a new administration around the corner. Bernanke has nothing more in mind than taking away the interest rate stimulus, as Greenspan did after 2004 — gradually and marginally…if that!

What’s more, the consensus doesn’t expect any action near term. Even more crucially, ultimately, his resolve rests on the correctness of his premise that the risks to economic growth have abated.

The Fed is not ideologically equipped to tackle the duality of rising unemployment and rising prices. Do you really think it is going to hike rates while stocks are reeling?

No. It just assumes that won’t be happening at the same time that prices are generally still rising.

But what is most important to understand is the factor that stirred the hawkish rejoinder.

For it is obvious that the Fed is reacting to market sentiments. And those sentiments are what I want to bring to your attention.

Is This the Crackup?

Back in March, oil prices were just breaking through $100, and the Fed hinted that it was probably finished cutting interest rates. Investors started looking for a big commodity and oil price correction.

It wasn’t to be.

Oil continued charging higher, egged on by bullish calls from America’s biggest investment dealers.

It is now backing off a high of about $139 in the nearest futures contract. That’s up 40 percent in three months, 100 percent in 12 months and nearly 200 percent in fewer than two years. It’s up more than 1,000 percent over the past 10 years. The moves in crude have been nothing short of spectacular.

On May 21, when the front month was breaking through $130, I got a call from a friend of mine — an oil analyst who runs his own investment service out of New Jersey. Like me, he’s been bullish since the turn of the millennium, but neither of us expected anything like this. Is this the crackup, he asked?

That’s the first time someone asked me if this was it…you know, “it.”

The crackup is a stage of the inflationary boom that occurs late in the cycle — when the market gets the idea that money grows on trees…and it finally abandons the idea that “prices will one day drop.”

Fear marks this final stage — in particular, of the erosion in monetary values.

It is born of a revelation, according to its author: “Finally, the masses wake up” to the fact that “inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears.”

However, it is the final stage of the boom. It is relatively short. It could last days, weeks, maybe even months, but the author (Mises) did not have much more in mind than that.

It is literally the death of that particular money.

Importantly, Ludwig von Mises concludes, “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds.”

The laws of supply and demand determine money’s value, as with anything else. And if the supply of something is unlimited, it’s not usually worth much. So the Fed likes to downplay the fact that it can or will print money “beyond all bounds.”

I doubt we are seeing the crackup.

But we are seeing some of the things that characterize the onset of the late stages of a long-in-the-tooth inflationary cycle — in which prices rise because people expect them to rise, and the demand for money drops as confidence in the economy and the world’s common medium of exchange erodes.

As Market Focus Shifts to Money Relation…

Bernanke senses that the market is making a dangerous transition.

If I could point to one catalyst, it would be that the commodity markets are making moves that make the situation difficult to explain in terms of regular supply-and-demand fundamentals. That is, people are finally asking questions like how could the total demand for oil have doubled in just 12 months?

As Dr. Benn Steil, an economist at the Council on Foreign Relations, on May 20 stated:

“If you want to explain this terrifying apparent shortage of food that we now have in the world, I don’t think you could possibly explain it based upon enormous growth in the world’s appetite for food over the past three quarters. It just can’t be done.”

Indeed, although it was completely unrelated to this speech, the question of crack-up came the day after Steil’s speech to the Committee on Homeland Security, in which he pinned the commodity bull market almost entirely on fiat money inflation, and drew attention to gold’s relative stability as money:

“Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold — gold having been the foundation of the world’s monetary system until 1971. It is, therefore, reasonable to conclude not that we are  experiencing a commodities bubble, but, rather, the end of what might usefully be termed a ‘currency bubble.’”

George Soros’ subsequent comments last week regarding doubts about the dollar’s reserve status were like a beacon to the Fed. Undoubtedly, they provoked Bernanke’s rebuttal. For they reflect sentiments the Fed would rather discourage, as they are difficult to “control.”

For the past eight years, the big money has explained the commodity bull market in terms of events like Sept. 11, growth in Asia and other developing frontiers, previous underinvestment or the finiteness of commodities. The Fed has succeeded in discouraging the market from pointing its invisible finger at it.

But the commodity bull market is about to take on a whole new form…

Regards,
Ed Bugos
June 18, 2008

P.S.: With gold still readying itself for another historic run, there has never been a better time to begin investing in the miners that bring this gold to market. Readers of my Gold & Options Trader service have already heard the word on a new miner that has a new take on the process of mining itself.

Inflation and Commodity Prices was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg
May 15, 2008

The Danger of Stagflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

Greenspan was vexed: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of [banks without knowledge of LTCM’s positions] is just mind-boggling.” So boggled was the man that the Greenspan (and Bernanke) Fed allowed the banks to lever as never before and write $400 trillion worth of derivatives between then and 2008 — without so much as a dollar bill of reserves: Nor a peep that maybe these off-balance-sheet liabilities might bear closer attention.

A staff member described what he had learned on his field trip to LTCM. On Aug. 31, the hedge fund had a $125 billion balance sheet. It also had $1.4 trillion of off-balance-sheet assets. On Sept. 21, when it appears (from the transcript) the Fed first saw LTCM’s balance sheet, its leverage was 55-to-1 and the “off-balance-sheet leverage was 100-to-1 or 200-to-1 — I don’t know how to calculate it.” He wasn’t alone. Greenspan’s “first line of regulatory defense” didn’t know if LTCM was trading interest rate swaps or stolen cars. The models of LTCM’s “counterparty supervision” were so “complex and sophisticated” that the hedge fund’s portfolio had been translated into a Greek salad — gammas, thetas, and epsilons.

For practical purposes, LTCM had no capital by Sept. 29. It was not able to meet margin calls. The hedge fund had not been required to post margin, but was required to post collateral worth 100 percent of the assets it borrowed. Even this looked amateurish. Greenspan, a former director of J.P. Morgan, shared his view: “If I am a bank lender and I lend $200 million to a hedge find, ordinarily, I would be overcollateralized. I would hold more than $200 billion in, say, U.S. Treasury bills.” Greenspan asked if the collateral was U.S. Treasuries. A staffer replied: “U.S. Treasuries, Danish government bonds, BBB credits — you name it.” Beanie Babies were next on the list. The value of LTCM’s collateral was falling. The balance sheets of the banks LTCM traded with were sinking.

A staffer explained the risk: “I’m going to say this in plain English. If markets keep moving away from [LTCM] in the wrong direction, their future exposure could be large and they might not have the collateral at that point in time to cover the exposure.” McDonough had described the house of cards earlier: “The firm’s position in a variety of instruments was very large. What my contacts were talking about was the effect that the failure of the firm would have on world markets if all these positions had to be dumped on the markets. People who thought they had an offsetting position with [LTCM] would suddenly find that they did not have one. They would suddenly find themselves with big open positions…” Globalization might end in a financial meltdown.

A Fed staffer thought the banks “were saying the right things in terms of the kinds of risk management processes they had in place” but “the question is how effectively the banks were actually implementing them…” The Fed staff had not taken the initiative to check. Greenspan was told the Federal Reserve had not examined the banks since December 1997. In Greenspan’s remaining decade at the helm, his bureaucrats produced masterful studies on counterparty risk, but permitted the banks’ risk models to optimize executive bonus compensation.

This is interesting, but not of great utility in 2008. The 1998 Fed weaknesses are important because the molehill grew into a mountain. Greenspan and Bernanke chaired the most egregious administrative failure in financial history. Paulson’s proposal is on a par with Caligula’s decision to name his horse consul.

In March 1999, Greenspan gave a speech on derivatives. He might have wandered onto the podium from Mars. Derivatives “are an increasingly important vehicle for unbundling risk.” He doused the post-LTCM movement toward a better form of regulation: “Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk schemes. In my view, this would be a major mistake.” The regulators’ risk models “are much less accurate than banks’ risk measurement models.” The Federal Reserve is not the institution to lead the much-needed bank regulation.

The nominal value of derivative contracts held by U.S. commercial banks (those over which the Fed has direct regulatory authority) leapt from $33 trillion at the end of 1998 to $101 trillion at the end of 2005, about the time Greenspan left office. We mustn’t ignore Greenspan’s successor: By the second quarter of 2007, 18 months later, these banks held $153 trillion in derivatives. The collapsing financial system is in the early stage of unwinding. Ben Bernanke has had time as Fed chairman to do something — anything — to slow the production of bad debt. Instead, the rate of financial claims in the economy accelerated.

The virtues of derivatives (their ability to diversify risk away from the banking system) received full approval from Greenspan and, more to the point, from his audiences. Bernanke is considered a monetary genius. Will we ever learn? Someday, we might ridicule, rather than praise, the Fed. On that day, it should be disbanded.

Regards,
Fred Sheehan
April 14, 2008

Mistakes at the Federal Reserve was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Better still, imagine they spell out the words “your savings” instead. Here’s goes…

“We need concerted action by governments, central banks and market participants to help stop this wave [of liquidations]…”

— Josef Ackerman, head of Deutsche Bank, speaking in Frankfurt on March 17

“The government is prepared to do what it takes to maintain the stability of our financial system…”

— U.S. Treasury Secretary Hank Paulson to Fox News, March 16

“In every country in 2008, every government has one aim — to maintain stability through the world economic slowdown. Britain with its central role in the world’s financial system is no exception…”

— U.K. Finance Minister Alistair Darling, in his Budget speech of March 12

Not quite with it yet? Check these examples, already done for you…

“The U.S. tax-payer last week agreed to help J.P.Morgan acquire Bear Stearns after a run on Bear, once the second-biggest underwriter of US mortgage bonds. In an effort to shore up Wall Street’s other firms, you also agreed to become lender of last resort to all 20 primary dealers in Treasury notes…” (Bloomberg)

“U.S. leveraged institutions, which include banks, brokers-dealers, hedge funds and tax-sponsored enterprises, will suffer roughly $460 billion in credit losses after loan loss provisions, Goldman Sachs economists wrote in a research note released late on Monday…” (Reuters)

“The [investment] banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the tax payer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks…” (Paul Krugman in the NY Times)

With it now? Great fun, isn’t it! Just cut to the chase about bailouts and financial aid by remembering what the state’s big generous hand-outs are made from — your tax payments, both current and future, plus the spending power of your savings, ripe for inflating away by elected officials and their unelected agents and staff.

This game beats playing “Spoof” any day, we reckon…which is funny again when you come to think about it.

Because Spoof — played in pubs and bars across the world to decide who buys the next round of drinks — is a game without winners, only a loser. Exactly like this game, then.

Fancy another cocktail before playing (and paying) again?

“We need a continuing message from tax payers and cash savers around the world that they will do what it takes to support economic growth. That will not be easy. It may necessitate taking some risks with inflation. But the message has to be unambiguous…”

So said John Varley — or as near as damn it — in a long open letter to government, published by The Banker magazine at the start of this month.

Varley is group chief of Barclays bank here in London. According to the annual report released on Thursday, he took home £2.4 million last year ($4.8m), just down from his 2006 payout of £2.5m after annual group profits fell 1% to £7.08 billion “due to the global financial turmoil” as the BBC puts it.

Don’t get me wrong here; I have no problems — moral or otherwise — with the concept of multi-million-dollar salaries. Executive pay merely puts flesh on those inequities which life itself thrives upon. The profit motive in finance is precisely what created the joint-stock company, mortgage lending, the safety-net of insurance, credit cards, overdrafts and all the other monetary tools developed by Homo economicus in the last five hundred years.

But what sticks in the craw and makes us choke on our martini-olives, however, is the “privatization of profit [and] the socialization of loss” as Martin Wolf calls it in the Financial Times. Every time the bankers screw up, your money steps in to patch up the losses. Letting the crisis wear on is simply not possible, because no one has dared to try it before. “The authorities feel compelled to intervene,” writes Charles Kindleberger in his history of Manias, Panics & Crashes. “The dominant argument against the view that panics can be cured by being left alone is that they almost never are left alone.”

Hence the pleading from Wall Street and Washington alike.

“Tax-payers need to continue to supply liquidity,” Varley’s article in The Banker very nearly goes on, “and they can help the restarting of the residential mortgage-backed security and commercial mortgage-backed securities markets by being prepared to accept this paper as collateral.”

More than that, “it would have a significantly (and disproportionately) positive impact if your cash savings were to buy commercial paper.”

Ain’t you brave, gentle reader, stepping into the breach so gamely like this! And so modest, too. Thanks to you covering Wall Street’s losses with your tax-dollars, “we’re going to have maybe a mild recession, but we’re going to avoid anything worse,” reckons Jeremy Siegel, professor of economics at Wharton.

Yet the plaudits will go to somebody else, with nary a murmur from you, reckons Siegel. “[Ben] Bernanke may very well easily turn out to be a hero here,” he explains.

Which I guess was precisely your aim in putting money aside to provide for your future.

“Systemically important institutions must pay for any official protection they receive,” Martin Wolf continues for the Financial Times. “Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted.

“This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidized, casino will not allocate resources well.”

This quid pro quo — the “this for that” stated so bluntly by Varley at Barclays and Ackerman at Deutsche Bank — is fast-becoming the surest financial consensus in history. If we bail out the banks to stop their stupidity creating a second Great Depression, they must accept far tighter regulation by those governments and bureaucrats who step in to save the day. No redemption without legislation.

Thing is, of course, we’ve all been before. Across the world, hundreds of times. New regulations come in to stall the last crash…and a new complex system of finance sprouts up, thriving on excessive risk, which ends up needing your money — your tax receipts and your savings – to mop up the mess when it explodes in turn.

From Barnard’s Act of 1734 — which sought “to prevent the infamous practice of stock-jobbing” that had already peaked and exploded with the South Sea Bubble 14 years earlier — through to Sarbanes-Oxley in 2002, which tried to stop Enron and Worldcom once they had crashed, new standards come in after it matters. Financial risk-taking, meantime, simply moves on to find new ways to gear up, using the latest regulations to pin-point those loopholes that will, in due course, be closed up when it no longer counts.

“After the collapse of Equitable Life in 2000,” notes a letter to The Times of London today, “the Financial Services Authority [U.K. watchdog] set up a review team on the regulation of the assurance society. Among the important ‘lessons to be learnt,’ identified in 2001 were — and I quote verbatim — that ‘the FSA management take steps to ensure that the supervisory team is properly constituted with persons with the necessary expertise and knowledge’…

“[Yet] from the recent internal audit by the FSA on its regulation of Northern Rock [the top five mortgage lender which blew up in Sept. 2007] we learn that the bank ‘was monitored by supervisors with expertise in insurance, not banking’…”

More than that, the FSA failed to conduct a proper review of Northern Rock’s operations for the entire 18-month period leading up to its collapse. Even then, prior to that last full review of Feb. 2006 — and “contrary to standard practice” as this week’s official report into the scandal revealed — “formal records of key meetings were not prepared.”

Thus the quid pro quo of bailouts for new rules becomes, in the end, a straight swap of excessive risk for incompetence. Underpinning this long-run historical fact you’ll find the assumption that “if one cannot control expansion of credit in boom, one should at least try to halt contraction of credit in crisis,” as Charles Kindleberger concludes.

For you, the taxpayer and saver, all that means is you get to pay twice — first in higher deductions and then through inflation.

Bet you’re glad Ben Bernanke will get all the thanks.

Cheers!
Adrian Ash
BullionVault
April 4, 2008

Who Pays for the Bailout was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Today, with progressive calls for action in the face of crisis, the Fed’s tentacles are potentially reaching directly into the credit and securities markets. This week alone, the headlines are rife with news of its “sweeping” new powers under Treasury Secretary Hank Paulson’s “plan.”

The Federal Reserve is in the midst of another historic interest rate-cutting campaign. Its official policy stance is that it recognizes the inflation risks, but worries more about growth, so it will inflate to sustain “growth.”

Its message has been, more or less, that money grows on trees, which is why Ben Bernanke’s moniker, “Helicopter” Ben, is catching on with the press. Gold bugs could not be more thrilled. Just recently, I wrote that we are seeing the best of all worlds for gold to shoot straight up a few hundred points.

But wait! “It’s not such a sure thing.” At least that’s what I thought I heard…from a voice in the wilderness. “What do you mean it’s not a sure thing? Look at ‘em flood the markets with liquidity. $100 billion here, a few hundred there.”

As I was about to sign off, the voice continued: “No, they are not inflating. They’re just creating confidence in the credit markets. Look at the ‘money’ numbers,” said the voice. “Forget credit. Look at the level of bank reserves and the adjusted monetary base. They haven’t grown since August. The Bernanke Fed is just pretending to inflate!”

Perhaps I already knew what the voice was telling me. Like the title character in Tolstoy’s classic novel, The Death of Ivan Ilych, I was doing some soul searching and discovering hidden truths buried deep beneath the surface. The voice was my own, and it was telling me something I had yet to consider.

It has not escaped my attention that the narrow constituents of money supply are not expanding. I’ve written about it.

This disinflation was first apparent as far back as 2005, under Alan Greenspan’s tenure, when M1 growth hit zero percent on a year-over-year basis. He set it in motion through the rate hike campaign. The total value for U.S. M1 has not changed in three years. But our “voice” insists that Bernanke is running a different, more deflationary policy than Greenspan — even though under Bernanke’s reign, since 2005-06, the broad credit aggregates have reaccelerated and the tightening campaign abandoned, and reversed.

Clearly, the Bernanke Fed is running a different policy.

But it is difficult to call it a more deflationary one:

Okay, so it has kept M1 flat, and slowed the growth in the monetary base a wee bit further (which has no doubt contributed to the crisis). And since August, the Fed has not expanded bank reserves overall, even though it has slashed its policy-setting interest rate by 300 basis points, has taken other measures to ensure short-term liquidity and talks as if it is ready to underwrite almost any insolvency.

We may point out that if the Fed wanted deflation, it would have already arrived.

If, for example, Bernanke actually did nothing, the monetary base would have probably shrunk.

At a minimum, the Fed is inflating just enough to replenish erosion in bank reserves and the market’s confidence. The thrust of all of its actions has been to cheapen money and credit and inflate.

That is not to say there aren’t any deflationary forces in the system — just not ones produced by the actions of the Federal Reserve System so far. If there is deflation in the system, stable money proves the Fed is inflating. If it were pursuing a deflationary policy, you’d have seen a few more Bear Stearns by now — and it is unlikely that the broader credit aggregates like M3 and money with zero maturity (MZM) would be expanding so furiously.

Sure, there is a run on risk, and this risk aversion is causing some asset deflation, which in turn is producing a lot of short-term liquidity. So the Fed hasn’t had to create a lot of net new notes to push rates down, yet. Consequently, so far, it is merely underwriting a lot of the market’s current confidence, rather than monetizing it. But it does not necessarily follow from stable money supplies that the Fed is deliberating a deflationary policy.

The Deflation Equation Doesn’t Add Up

So deflation has not set in yet, but our normally credible source is still convinced that Bernanke is secretly pursuing a policy of deflation while pretending to inflate. But from the central bank’s point of view, the costs of such a policy are prohibitive. So why am I still listening to this “voice”?

Because it believes the Fed wants to hijack the gold market… In other words, the Fed is trying to quell the rise in the gold price.

A central bank’s general incentive to dampen gold fever is a given, but why would it want to so bad that it would be willing to risk political suicide? Our voice explains that some of the large bullion banks still hold massive derivative short positions in gold, which they borrowed from the central banks to sell into the market in the ‘90s. We have not heard any of them report large losses on those positions yet.

They are potentially huge.

But are they huge enough to motivate the Federal Reserve to orchestrate a deflation policy in order to save these banks from ruin?

The last genuine deflation in the U.S. (1929-33) wiped out almost all the banks. Are you telling me that the gold shorts held by a few select bullion banks can cause more total pain than a deflation policy?

I doubt it, especially since the central banks are so forgiving on the terms of the gold loans.

This voice is right that the Fed is not expanding narrow money.

It is wrong about the Fed targeting deflation.

So Is the Fed Targeting Gold?

It should be. Bernanke may well be trying to keep the monetary base stable to discourage speculation in the gold and oil markets, while at the same time boosting confidence in dollar-denominated assets.

This kind of a balancing act (or “sterilized” inflation) is not foreign to the Fed’s modus operandi.

In fact, it was well accomplished by Bernanke’s predecessor.

While the idea that the Fed is deliberating deflation in order to undermine gold makes little sense, the fact that the monetary base is not growing is relevant and deserves further monitoring. Regardless of the explanation, when the central bank is not inflating, it is not bullish for gold. I say this even though, empirically, the relationship between money (i.e., M1) growth rates and gold prices is not cut and dry.

If you bought and sold gold based on the requisite changes in M1 growth rates, you’d be on the wrong side of the trade most of the time, at least since the ‘80s. You’d have turned bearish after 2004, missing the last $400 rally. It is important to monitor. But we live in a global world today. The effects of inflation produced by China’s central bank are felt in America, and vice versa.

It’s especially a bad idea to short gold. But it is a good time to pick away at values created by the “Chicken Littles” on the way up to $2,000 — if you believe that the Fed is inflating.

I’m not going to tell you that gold is going to go up whether we have deflation or more inflation. I don’t believe that. I believe gold prices would fall in a monetary deflation. But I don’t expect one soon.

Regards,
Ed Bugos
April 3, 2008

How the Fed Effects Gold was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.