Holiday Spending and the Fed

The veil of illusion that says the dollar has value is being torn away.


Last week’s “Saturday Night Live” had an actor playing President Obama giving a press conference with an actor playing China’s President Hu Jintao, who repeatedly reminded Obama that the US owes China a lot of money. At one point, Hu asks, “Do I look like Mrs. Obama?”, answering the question soon after with: “Then why you try to make sex with me like I was Mrs. Obama!”


Some things can be said in a joke that can’t be said with a straight face.

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Imagine telling someone back in 1989 that in twenty years China would be the world’s emerging power, and the US would be running to China to ask for more money to plug its enormous deficits, while reassuring China that its money is secure, and politely asking China to respect copyright rules and ensure free internet access (which China will politely ignore).


So where will we be in twenty years from now? The dollar will be discredited, a shell of its previous value, no longer a reserve asset. The world will want currencies backed with real assets, not fiat paper which can be printed at will with the touch of a keystroke.


In the US, anger is rising about the massive financial bailouts engineered by the Fed and the Treasury, which so far have not caused any reduction in unemployment or real economic stimulus. Perhaps this sentiment is why Rep. Ron Paul’s amendment to audit the Fed has passed a vote in committee and is gathering support in both houses of Congress. In a surprise move, Rep Barney Frank delayed a vote on the bill until after the Thanksgiving recess.


Why does the Fed oppose being audited so vociferously? Bernanke says he doesn’t want the Fed to be too influenced by short-term politics, but it’s hard to see how the current veil of secrecy prevents politics from entering into the Fed’s deliberations. The country ought to know what the Fed is doing (or was doing, as the bill calls for the release of information only with a 6 month lag).


Early reports on Black Friday, the largest single shopping day in the US, indicate a very small increase in spending over last year of 0.5%. Strangely enough, articles on Black Friday never seem to adjust sales figures for inflation. Given that the CPI rose 0.5% in the last two months, it’s more accurate to say that spending is flat or declining in real terms. We’ll have more details on the numbers in a few days, but the trend toward more frugal spending is still in force. Even if an increase is recorded, we have to keep in mind that retailers are offering massive discounts, which may pull sales to Black Friday at the expense of other days. We’d also do well to recall what products are being discounted: mostly electronics, which are rarely produced in the US. Increases in retail spending on imported goods puts the US economy in a deeper hole. We need to come to balance, and that won’t happen because of an unsustainable surge in retail spending, but rather will be due to growth in the productive sectors of the economy.

The 'Soft Budget Constraint' Hardens

The fate of the US empire depends on access to debt and the ability to service the existing debt burden at low rates. We could’ve chosen a different path. During the 2000 election, Al Gore spoke of paying down the entire public debt. Perhaps things may have gone a different way in the absence of the Bush/Cheney bloodless coup of 2000.

But now we seem to be committed to sky-high deficits, despite recent talk of health care being ‘deficit neutral’ and plans for reducing the deficit. Even the tough talk hints at the reality: we speak of reducing the deficit, not eliminating it, not running a surplus, not reducing the total debt outstanding. The only thing that qualifies as a plan is to increase the debt at a slightly slower rate than the economy expands, so that the debt burden becomes smaller in relative terms, while growing in absolute terms. The economist James K. Galbraith calls it a ‘soft budget constraint’. But how long can it remain soft?

The Fed has poured money into the US Treasury market, a practice called ‘monetizing debt’; this has made Treasury yields fall across the board. That makes the debt easier to service, but if taken too far, it makes US Treasurys unattractive relative to other investment-grade debt.

Fed chair Ben Bernanke criticizes China for having a ‘savings glut’. While they have been spending more, he warns them, don’t save too much! America, with the exception of government, is not following his advice. Americans have gone from being like the fabled grasshopper who fiddles all day long to the ant who works and saves. (If only finding steady work was that easy. There are now six job seekers for every available job.) A new culture of frugality is spreading to every corner of American society. Americans are planting vegetable gardens, learning to preserve food by home canning, even raising chickens. (Not that the average American is doing all this, but things spread from the leading edge to the center) Fashion designers are bringing out new looks inspired by the 1930s, as designers and artists embrace the new ‘rough luxe’ aesthetic, elevating old, vintage, weathered, used objects.

There is a lot of talk about recovery, but state unemployment figures for September indicate that payroll unemployment declined in 43 states. Pressure is beginning to mount on the Fed to raise rates. A recent Barron’s cover story argues that the Fed should raise the interbank lending rate from 0% to 2%. If the Fed does raise rates, we’ll see how strong the recovery truly is. If that rate increase takes place while states continue to trim spending, residential foreclosures continue to escalate, followed by increases in commercial foreclosures, that looks like the making of the return of the credit crunch of 2008, and the double-dip recession of 2010.

Is Inflation Coming Soon?

Most economists will tell you that there’s a tradeoff between inflation and unemployment (called the Phillips Curve), making it unlikely that a high unemployment economy generates unemployment. Well, expect to see the unlikely happen soon.

Here’s a chart of monthly inflation, as measured by the Consumer Price Index, since 2007:

The Federal Reserve is waging war against deflation, funnelling trillions of new dollars into the financial system in an attempt to defeat deflation.

The Fed will win; in fact, they’re already winning. Inflation has simply been channeled into the stock market. Oil has doubled in price. Gold has recovered from its low of the fall of 2008, when it dipped below $700, and is currently pushing $950. These are early signs of inflation.

An interesting feature of the CPI is that it’s not designed to measure changes in the cost of living. It’s designed to provide a measure of how much money it takes to maintain a constant level of satisfaction. That means the Bureau of Labor Statistics must do a very difficult thing: instead of merely measuring prices, they must measure our satisfaction. They do this by imputing value to technological changes, and by using sophisticated averaging techniques which attempt to measure how consumers make substitutions between products in response to price changes. The outcome of this fancy guessing-game is the most widely-quoted measure of inflation in the US, but CPI has little to do with what most think the CPI measures.

My guess is that we’re already seeing the kind of inflation that the Fed so fears: consumer price inflation. Prices ought to fall during a recession, and some have. But I think prices have not fallen as much as they should, given the extreme weakness in consumer demand. If the effect of money creation is the prevention of falling prices, that’s inflation, it just doesn’t look like it when we look at the CPI.

It’s clear that the Federal government would prefer inflation to deflation. With the ten-year deficit now officially projected to add $9 tril to the public debt (which would bring it above $20 tril), some inflation sure makes the interest easier to pay in depreciated dollars. I wonder if the American consumer will go along for this ride. Sure, inflation will probably kill your real wages, but it can also zap the value of your debts. Perhaps the average American won’t complain too much if inflation begins to roar. Much depends of what happens to the unemployment numbers as we move forward.

As Gold Continues to Slide, Treasuries Crater, World Openly Debates the Fate of the Dollar

{I wrote this on 6/8, but didn't get around to publishing it until 6/11, which was after the WSJ wrote a cover story on the rising 10-year Treasury!]

The yield on the 10-year US Treasury note is up to 3.88%, [now it's gone up to 3.93%, then slid back to 3.86% today] as prices for the note continue to crater. (Recall that as bond prices fall, yields rise) The battle continues. Since this yield is tied to so many other interest rates, the hazard is that the rising yield will soon become higher interest rates for mortgages, car loans, credit cards, etc. The bigger problem perhaps is, are there borrowers?

It's an economic distortion that interest rates should fall when the economy moves into recession and credit tightens after being loose for so long. What's being revealed is that the risk of default is much, much higher than was previously thought. Naturally, interest rates should rise to compensate for the increased risk. But instead, the Fed tries to go against the market and lower interest rates.

The Keynesian logic is straightforward: because credit is tending to tighten, money destruction ensues through the action of the fractional reserve banking system. However, that destruction of money results in far less aggregate demand. The solution: create money through the central bank (the Fed) equal or greater to the money destruction, lowering interest rates, encouraging firms and consumers to borrow, and stimulating the economy when it most needs it.

Unfortunately, what this Keynesian story overlooks is that the economy has a hangover. The best cure isn't a couple of (trillion) shots of booze, it's a reorganization, a re-thinking of priorities and activities.

The economy has binged on unproductive economic activity: a frenzy of finance, retail, advertising, lawyering and lawmaking. Corporations have turned their attention away from productive investment (the kind that is designed to produce better things) and toward unproductive investment, designed to capture an ever-larger piece of the economic surplus. But since efforts to capture a bigger piece of pie don't actually grow the pie, only so much of US capitalism can be engaged in such endeavors.

Meanwhile, the International Monetary Fund, seeking to retain some kind of relevance, jumps in to say that the world could potentially use a different reserve currency than the US dollar. Of course, their solution is the bogus Standard Drawing Right, administered by an impartial, international central banking organization. I wonder who that would be. Of course, they call for "liquidity", a silly central banking code word which means "fake money". It's obvious that the IMF does not have in mind the creation of a currency backed by an item of real tangible value, such as gold. After all, Keynes called gold a "barbarous relic".

Of course the IMF thinks we're years away from such a "revolutionary" move. Only slowly can we change the global monetary order.

Right.

The world has a way of changing faster than you think. The dollar is already dead. Each country in the world is simply trying to figure out how to edge away from the dollar's corpse before every other country in the world does so. Gold has tripled in price since the year 2000. The technology of producing gold hasn't changed much.

The world faces a choice: either we descend into a morass of distrust, reversing the tide of globalization, retreating behind border walls and tariffs, or we create a new global monetary order that no country, no individual, no corporation can game. That order simply must be based on an item of real value, that no government can manipulate, that holds its value over time, that cannot be destroyed through the printing press. We need the gold standard of money. What could that be?

I'll Be Off For the Rest of the Week

Treasuries are up today, pushing the yield back down to 3.55%. Still too high. With the ten year US Treasury note at that yield, a lot of other interest rates are going to be higher. Still a lot of volatility in this market; today's swing was 2.55%. A lot of movement for any market in one day.

How can the Fed possibly re-inflate this impossibly flaccid credit bubble with high rates?

Commodities took a pause; gold is back under $970, oil retrenched to $66, copper's down to $2.22. A bit of backfilling is in order. I wonder when the next big move up will happen. Next week?

Meanwhile, banks are doing their best to resist honesty and transparency. Here's a piece about their off-balance sheet assets. Isn't it a bit absurd that a corporation would have off-balance sheet assets? What possible rationale could there be for keeping an asset off the books besides lying about its true value?

I'll be traveling for the rest of the week. Have a great weekend!

Now Treasuries Recover!

This is getting exciting.

After a massive sell-off that sent the yield on the bellwether 10-year Treasury note skyrocketing to an intraday high of 3.75%, investors snapped up the debt Friday, sending the yield back down to close at 3.465%. That is one wild ride.

Remember that the Fed would like to see the yield below 3%. A rapid increase in the yield is the market's way of rejecting the Fed's monetary stimulus.

It's interesting that the market had such a rapid snap-back. No doubt some investors were seeking bargains. Was one of those investors the Fed?

The dollar is coming apart. Was this a warning shot or the beginning of the final conflict?

Stay tuned...

Krugman: Don't Worry About Inflation

Paul Krugman is at it again. (Here's a picture of him with former President Bush) 

This time, he reassures us of two ideas: 1) all that money the Fed is creating won't push up prices, and 2) the US would never default on its debt obligations by inflating away the debt.

So, for Krugman's first assertion, while he is correct that the contraction in bank lending has counteracted the increase in money created by the Fed, it flies in the face of logic to think that the Fed can create trillions of dollars out of nothing and that this will have zero effect on prices. Doesn't it seem more likely that certain prices are being prevented from falling to their equilibrium level by the Fed's monetary mischief, thus distorting the price mechanism? 

See, the thing is, the US is approaching this psychological level, where the debt of the Federal government approaches 100% of GDP. This is only important because people often fail to see that the two can't be compared directly - GDP is a flow, like your yearly income, and debt is a stock, like the value of your stock portfolio (except in reverse!). So just as a person who makes $50,000 a year could owe $75,000, so it is possible that the US debt exceeds GDP, and nothing really changes from debt being 90% of GDP to debt being 100% or more. However, GDP is a good reference point for understanding the level of debt, because it shows our capability for paying back the debt, and also gives us a yardstick which adjusts for changes in the price level and economic growth.

Now there's this thing called denial. When a lot of people say "you don't need to worry about that," they're often saying, "I get why you're worried about that - you should be". Krugman's denial of inflation is similar to his denial of debt default. There's no way the US would default on its debt, he shouts. No way in hell! 

In other words, it's extremely likely. All signs point toward default: escalation in borrowing, continued current account deficits, falling dollar, rising yields.

Paul Krugman, I salute you. You're a great economist. You've made important contributions to the theory of international trade. You were right about the war in Iraq. But you're wrong on this: the US will default on its debt, and the method we'll choose is inflation. I'd suppose you have 5 or 10 years before you have to admit your mistake. 

I'll be waiting!

Treasuries Crumple!

The price of the bellwether 10-year US Treasury note cratered yesterday, sending the yield skyrocketing.

This chart (^TNX) shows the yield of the 10 year US Treasury note. (As the price of a bond falls, the yield rises)

Look at the pattern of the last few days. The yield is up rather sharply. Keep in mind that this 10 year Treasury yield drives a lot of other interest rates, including mortgages. People often think that it's the Fed that controls interest rates. Not really. The Fed influences interest rates, and has been struggling to influence the yield on the 10 year US Treasury note, but the Fed is only one player in a big and very complex game. Sure, the Fed is one of the few players that can (semi) credibly print money at will, which is what they do when they want to push the 10 year Treasury yield down. They print money, then spend it buying Treasuries, which pushes prices up and yields down.

The Fed is losing a massive, behind-the-scenes battle. The Fed must keep this yield under control. But it must do it quietly. If investors get to thinking the Fed is the only buyer of Treasuries, they will sell, sending the price down even further. Also, it looks as though foreign central banks, which hold a lot of US Treasury debt, are starting to quietly edge toward the exit, and see the Fed's buying sprees as a good opportunity to sell off some of their holdings. The more money the Fed creates to manipulate markets, the more precarious becomes the state of the dollar, because it becomes more and more obvious that the plan is to inflate away the debt.

About the size of this market: check out the Treasury direct website. The total US Federal government debt is about $11.3 trillion. The US stock market, by comparison, is about $9.3 tril, as measured by the Wilshire 5000.

If money really begins to flee the US Treasury market, where will it go? Keep in mind that when someone sells a US Treasury note, they are paid in dollars. If the idea is to avoid the depreciation of the dollar, then the money must go into another currency or asset that is outside the ability of the Fed to depreciate. The obvious candidate is gold, but I expect we'll see continued movement into the Euro (note that the Euro is up strongly against the dollar recently, which tells us that many investors don't buy the rally. If the worst was over, why would the dollar be falling against the Euro?)

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Ron Paul Grills Bernanke

Here's a good video of Ron Paul giving Fed chair Ben Bernanke the business.

Much has been said about how Ron Paul sounds crazy, conspiratorial, etc., but at least he's up there questioning the economic guru of the day.

Ben Bernanke firmly believes that the reason the Great Depression happened was that the Fed did not act aggressively enough, and allowed monetary policy to tighten, worsening the Depression. In fact, the Fed was quite aggressive. Consider that the Fed flooded the banking system with liquidity, raising the money supply by 10% in a single week. However, this was counteracted by the contraction in bank lending, because banks were in the process of deleveraging.

If that doesn't sound familiar, it ought to.

The very same thing happened in the Fall of 2008. The money supply actually tightened, despite the Fed creating massive amounts of money and injecting it into the system. This is because the money supply is not controlled directly by the Fed, but rather it's a product of the fractional reserve system. If banks lend less, the money supply falls, perhaps as much as $10 for every $1 fall in lending. That's the magic of the fractional reserve system. Banks create and destroy money, and the process is not under the direct control of the Fed.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

FASB Suspends Mark-to-market Accounting Rules

And the market loves it! The Dow is up 270 points as I write this. (Here's a link to a WSJ article on this development.)

Well, we should have known that with the steady drumbeat of analysis (examples here, here, and here) blaming the financial crisis on mark-to-market accounting that this would eventually happen.

Unbelievable. It is absolutely absurd to blame the financial crisis on mark-to-market accounting. What causes banks to suddenly realize that they have solvency problems is that they are insolvent every single day of every year; it's only that a dip in asset prices causes them to worry about it for the first time. Modern banks run on the fractional reserve system. During a credit boom, market competition pushes banks to decrease their reserve ratios, for this is key to higher profits. The Fed tends to look the other way as banks move assets around to avoid mandatory reserve requirements (either 10% or 3% depending on the size of the bank.) According to Fed data, aggregate bank reserves fell to 0.74% of bank deposits, showing that banks are adept at getting around mandated reserve ratios. (Reserves have exploded since the fall of 2008, showing the fear that has struck the banks.)

Allowing corporations more flexibility to value their assets (i.e. facilitating wishful thinking or outright deception) will not make this crisis go away, it will prolong it. The crisis will be over when markets clear. That requires accurate information, not opacity.

Fed "Quarterbacking"

If you want something that will turn you against the study of monetary economics forever, read a series of experts debating what the Fed should've done and how what they did affected the economy. For example, The Wall Street Journal's recent symposium, Did Alan Greenspan Cause the Housing Bubble?

What a tiresome parade of simplistic reasoning and confusion, with the exception of Judy Shelton's piece, "Loose Money and the Derivative Bubble." (She has another great article published on 2/11 called Capitalism Needs a Sound-Money Foundation. (Ms. Shelton is the author of Money Meltdown, which I confess I have not yet read.)

To blame the Chair of the Fed for supposedly disastrous Fed policies is "quarterbacking", as in, how might have that game played out if the quarterback had acted differently? A speculative exercise at best, quarterbacking ignores the interconnected nature of events, supposing that we could go back in time and change one thing, leaving all other things unchanged.

The other problem with Fed quarterbacking is that the Fed is in an impossible position. The Fed's stated mission is to maintain price stability, full employment, and financial stability. Each of these is a sham. Price stability? The Fed issues a fiat currency, and has recently increased the number of Federal Reserve Notes (aka dollars) by several trillion (most of it in electronic form). The Fed is the primary engine of inflation, not price stability.

That the Fed can use wise monetary stimulus to ensure full employment is Keynesian dogma, and it's more or less true during the credit-fueled boom. But when that boom ends, as it must, the Fed becomes ineffective, for the contraction in bank lending tends to counteract the Fed's lowering of the interbank lending rate. This is where we are now, and the Fed's efforts to re-inflate the bubble are likely to create inflation, which will surely interfere with the economic adjustments necessary to begin recovery.

As for financial stability, the Fed presides over a fractional reserve banking system, which is inherently unstable. Like building on a river delta, a flood will periodically come and wash out the banking system, causing banking failures and bank runs, which the system cannot endure.

The housing bubble isn't Alan Greenspan's fault. But it is the fault of the Fed system, which generates credit bubbles which must inevitably pop. Greenspan should've known better. He has long advocated the gold standard. But he just did what everyone wanted him to do: he spiked the punch so we could all get drunk at a decades-long party. Now we're sobering up and cursing the man who sold us the drinks we demanded.

"No reputable economic forecaster is predicting a depression"

Says Edward Leamer, Director of the UCLA Anderson Forecast, on Marketplace. He sees no depression in the near future:

We've frightened consumers to the point where they imagine there is a good prospect of a Great Depression. That certainly is not the prospect. No reputable forecaster is producing anything like a Great Depression. So it's still OK if you spend a little bit. You do not have to put all your money into a mattress.

Dr. Leamer also sees the economy in a "healing cycle" by the second half of 2009, without "significant growth", but with fewer of the "large negatives" we've seen so far.

We shall see. I do not think that the errors and excesses of the boom years will be corrected by then. My guess is that the inflationary recession will continue for a period of years rather than quarters, particularly since government policy seems driven to prevent markets from reaching equilibrium, and the Fed is producing monumental amounts of new money, much of it secretively, off its balance sheet. Estimates of Fed off-balance sheet money creation are in the trillions of dollars.

Here are a few analyses of the magnitude of these Fed activities: ritholtz.com/blog, nowandfutures.com (this site also has a reconstruction of M3, the broad monetary aggregate that was discontinued by the Fed in 2006.)

What Caused the Housing Crash?

“Problems started at the household level, with poorly-designed mortgage products”, claims Elizabeth Warren, professor of law and member of the newly-formed Financial Products Safety Commission. According to this view, the US housing bubble, where prices of homes increased 125% from 2000 to 2006, was the result of shoddy products sold to an unsuspecting public. Like the general claim of ‘predatory lending’ such a view assumes that people need a government agency to protect them from making bad decisions.
The fall in home prices, which began in 2006 and continues, has so far wiped out perhaps $10 trillion in value. If only there had been some government agency providing oversight, all of this may have been averted, Warren suggests. But there was. It’s called the Federal Reserve. But the Fed did nothing to avert the housing bubble—in fact, former Fed Chair Alan Greenspan made public statements urging people to buy homes with adjustable rate mortgages. What a spectacle: the nation’s foremost economist urging people to commit financial hari-kari.
Sure, there were ‘toxic mortgages’, to use a recently-coined term which seems to have caught on. Mortgage brokers aggressively sold them to people. People were encouraged to lie about their income and assets and they did so eagerly, to get their piece of the American dream: their own home. Fraud and deception proliferate in an atmosphere of denial. Home prices will always go up; you’ll be able to re-finance later at low rates, an army of mortgage brokers said.
But to say the current crisis is the result of bad mortgages is to employ a circular logic. Why did these mortgage products spread and gain dominance? Why did they displace the traditional banker’s strategy of lending conservatively to qualified borrowers? The reason is that the creation of toxic mortgages is the result of the same force that produced the rapid growth in hedge funds, credit-default swaps and other financial derivatives, and massive increases in trading volumes: money creation. Money created out of thin air always creates inflation. But when the price being inflated is a home, it seems to cause a special kind of madness that does not result from the inflation of other prices, like food, gasoline, or medical care.
Money creation is itself the product of two forces: the fractional reserve banking system, and the desire of the government to run large, continuing deficits, which are partly financed by slowly depreciating the currency through inflation. The change in bank policy which made toxic mortgages possible was a relatively new practice of moving money into new categories (such as repos, Eurodollars, collateralized debt obligations, and others) which allowed banks to circumvent the Fed’s required reserve ratio (which ranges from 10% for larger banks to 3% for smaller ones). As the result of this shell game, the actual reserve ratio in US banks fell to an incredible 0.74% at its trough—that’s $0.74 for each $100 deposited (this ratio has since risen, as banks are now in panic mode).
The Fed, which, after all keeps the statistics on bank deposits and lending, certainly must have known, but opted to look the other way. The rewards to financial ‘innovation’ of this kind were great, and the riskier banks bought those who employed more traditional strategies. Mortgage lending became so profitable that banks specialized in it, eschewing deposits altogether, instead obtaining funding by selling the mortgages as securities and making more loans, always more loans.
Given that the housing bubble was caused by money creation, it would be simply silly to think that some commission assigned to prevent bad mortgage products will have an impact. The solution to future asset bubbles is clear: abolish fractional reserve banking.

What Caused the Stock Market Crash of 2008-2009?

[Written for the Borsen-Kurier]
What caused the US stock market to spectacularly crash in 2008 is intimately connected to what caused the market to boom from 1980 to 2007. In broad terms, the long market boom, which took the Dow from 875 to over 14,000 at its peak in the fall of 2007, was the result of two interconnected forces: money creation and redistribution.
Economically, the great puzzle to solve is not why the market crashed, but why it performed so far above the rate of economic growth for so long. Why should the stock market, which is composed of nothing more than a broad section of corporations, on average perform any better than the overall rate of economic growth, upon which it surely rests?
Consider the following graph of the stock market and M3, the Federal Reserve’s broadest measure of money creation (M3 was discontinued in 2006, but the series is kept up by several different private economists). Notice that the performance of the stock market (as measured by the Dow) is far above the rate of productivity growth or the rate of real economic growth.

The fractional reserve nature of most modern banking systems means that money creation takes place in a decentralized manner; during this period, much of that money found its way into financial markets, in the form of leveraged buyouts, stock buybacks, and the effects of increasing leverage on the part of investment banks and the explosive growth of the highly-leveraged hedge fund industry. Much of this borrowing went to purchase equities, bidding up prices dramatically.
At the same time, the shifting balance of power between labor and capital made it possible for corporations to hold down wage growth, resulting in an unprecedented 20 year period of falling real wages in the US. This caused corporate profits to increase, along with share prices, as stockholders re-evaluated the new distribution of income between labor and capital.
The problem, of course, is that neither of these forces are sustainable. The share of income going to labor can fall, allowing the share that goes to profits to rise, but labor’s share cannot fall far without producing resistance. In the US, that resistance was weak, in part because of a new innovation: leverage for consumers. Unfortunately, the new kinds of consumer credit that were invented and eagerly used by US consumers were rarely used for any kind of investment, so debts mounted without an increase in income to pay them back.
As for money creation, it must eventually lead to inflation. No one can truly create wealth out of thin air, so when money is created far in excess of economic growth it must cause rising prices somewhere. If it causes rising consumer prices, we notice it and demand a solution, but if it causes rising stock prices, we celebrate it. But the money is not real, and the prices cannot last. At this point, it seems likely that the Dow will fall to 5500, which would give the Dow a traditional bear market dividend yield of 6%. Given the extent of money creation thus far, a strong possibility is that the Dow shows strong growth, perhaps rising above 10,000, or even above its record heights. While this may reassure investors, such an outcome would simply be the first manifestation of inflation that will not be confined to financial markets this time around.

Solving the US Banking Crisis

[Written for the Borsen-Kurier]

Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).

Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.

The catch? It will involve some short-term economic pain.

The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.

Here’s the plan, in two parts.

Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.

Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).

The sacrifice would begin when all imported goods immediately rise in price dramatically (an imported good that costs $1 may rise to $25). International trade flows would change as markets reach equilibrium. This would certainly cause some dislocation. But we’d skip the lasting pain of a sequel to the Great Depression because the main damage to the economy would be avoided. The money supply would not contract due to banks rational fear of collapsing during the financial crisis. Banks would be on a solid basis, and they could immediately begin lending (from savings accounts only; these would have to be set aside specifically for investment purposes, and would no longer be available on demand).

Sacrifices would continue as the US could no longer maintain a current account deficit without draining US gold reserves. The federal government would not be able to borrow billions or trillions to finance deficit spending. The depreciation of the dollar would mean foreign bond holders would immediately lose money, and large-scale selling of bonds would ensue. While it is unfortunate to break the trust of those who bought US bonds, it is simply unavoidable. The US has too much debt to pay it back. The US government will repudiate its debt, either simply and honestly, as in this plan, or covertly, through inflation.

Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.

The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.