Archive for the ‘Federal Reserve’ Category

The “real economy” is still very messed up: a super weak and declining dollar, double digit unemployment, and a housing market saddled with inventory and foreclosures (and soon-to-be foreclosures). So why is the stock market rising? Does this make sense?

When in doubt, consider the possibility of a bubble. Goldman Sachs and Wall Street has been fueled with government money, both directly and through the AIG bailout which prevented any of the MBS bond-holders from taking a haircut on their bad investments. The Federal Reserve balance sheet has exploded, and its exposure to the housing market remains significant. It’s overall asset sheet (which translates into money in supply) is 2X what it was in August of 2008. Incidentally, I don’t believe they’ve taken their MBS assets and “marked them to market”; they’re valued at “coupon value,” which is an implicitly subsidy to the entire housing market.

This seems why we’re finally seeing reality hitting the banks; broke, unemployed people don’t pay their bills, don’t pay back their loans, get kicked out of their houses, and don’t make deposits with which banks can make loans. Citi declared a loss. BofA missed its earnings report. This is called a reality check.

The 10,000 Dow seems to show two things. One, that dollar deflation is masking the real decline in the Dow. And, two, this is an asset bubble driven by cheap, government-subsidized bailout money. Like the housing bubble, it’s all dependent ultimately on a projected robust real economy, investments in real businesses, and cash flows at the consumer level, all of which are in the dumps and will remain so for the foreseeable future.

The huge national deficit and the dubious Keynesian theories of Obama and company likely will slow down the recovery, create additional short-lived bubbles, and I am not encouraged by the good news that so excites the cheerleaders at CNBC.


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Bush said yesterday that the U.S. “will continue to act to resolve this crisis and restore stability to our markets.” John McCain–during his last “townhall” debate with Barack Obama–said, “But we all know, my friends, until we stabilize home values in America, we’re never going to start turning around and creating jobs and fixing our economy. And we’ve got to give some trust and confidence back to America.” Obama replied, ” Sen. McCain is right that we’ve got to stabilize housing prices.”

It all sounds good enough. Who wants “instability” after all? But it is the instability of falling prices that is absolutely necessary to an economic recovery. It is the necessary “creative destruction” on which all free market economic activity depends. Bad investments have been made. No one–other than politically less powerful first-time home buyers–was complaining much as housing prices were rising. People were getting rich just for living in their house. Now the former instability of artificial high prices must be followed by the instability of falling prices. Only when prices bottom out in housing, the stock market, and in general, can a recovery begin. And, while this painful process is most visible in the housing market, it’s true across the board.

Deceptive “par value” accounting of crummy assets, attempts to prop up overbuilt home prices, and various pockets of malinvestment will tie up assets, capital, and labor from more productive enterprises. Obviously, no one wants chaos. But an inordinate fear of a cleansing contraction is wasting money and dragging out this entire mess. By further weakening the dollar by increasing the national debt, it invites greater chaos in the future. Paulson’s $700B is going to be wiped out trying to bail out sinking ships, transferring money in various unforeseeable ways. What will we do in a few months when that $700B runs out and its supposed “investments” in byzantine financial instruments turn out to be worthless.

Murray Rothbard in his excellent book The Great Depression noted that various measures begun under President Hoover to induce artificial spending and “stabilize” wages prevented the necessary adjustments–in everything, including wages–needed for an economic recovery. Then, as now, politicians congratulated themselves on their commitment to stabilization. Far from being a heartless, laissez faire incompetent, President Hoover simply undertook New Deal style program, but with less panache and flair for public relations than his successor

President Hoover said–not so differently from McCain and Obama above:

I have instituted . . . systematic . . . cooperation with business . . . that wages and therefore earning power shall not be reduced and that a special effort shall be made to expand construction . . . a very large degree of individual suffering and unemployment has been prevented.

The panics of 1819, 1873, 1896, and 1907 are footnotes to American history, almost all over in a year. Yet in the “enlightened” age of government intervention and the Federal Reserve system, we witnessed the most massive depression in American history, which lasted over 10 years, as well as periodic recessions ever since. During the 1930s, as now, calls for government spending, loose money, “stability,” punitive measures against “speculators,” and various ill-advised schemes were pervasive. Then, as now, politicians, the media, and other elites pushed for consensus and for the government to “do something . . . anything.”

Would that we examined our history, where the instability and lack of government intervention in previous economic crises also allowed them to resolve themselves more quickly than those of the 20th Century.

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Steve Sailer has a very funny piece on WaMu’s advertising, which bragged about the company’s contempt for stodgy old bankers. Pretty obvious generational and ethnic subtext in this ad: WaMu positioned itself as a new kind of bank for the the age of diversity and free spirits.

Interesting piece from the Von Mises Institute on the Federal Reserve’s direct involvement in Mortgage-Backed Securities (MBS). I was under the impression almost all of the Fed’s assets were in Treasury Bills, a near equivalent of cash. Since its liquidity, stability, and the like are supremely important, I’m a bit disturbed to learn this was going on through the System Open Market Account (which is also the institution that holds the Bear Stearns bailout entity, Maiden Lane, LLC.) I have no idea how much direct MBS exposure the Fed has, and I’m surprised this has not been discussed by more commenters.  Does anyone know the scoop out there? I think from this chart it’s either the “other loans” or “other assets” portion of the Federal Reserve’s asset pool. In any case, this year’s expansion of the Fed’s asset pool should be worrisome; it usually portends an equally significant expansion of their liabilities, i.e., printing of money either directly or otherwise.

Apparently the bailout is a done deal. There is no significant change in concept from original Paulson proposal other than a bit more oversight. Still no word on pricing goal, i.e., lowest possible, above market (to create upward bidding), or something in between. I will make a rare series of predictions: a rally of stocks for 1-2 months with big days this week, i.e., the last of our inflationary bubbles. A few months from now, probably after Christmas, Paulson with lame duck President Bush will solemnly announce massive and continuing losses from first wave of MBS purchases and continued deleveraging by nonparticipating or ineligible entities. The losses will stem from overpricing of the Mortgage and Asset Backed Securities (ABS) Paulson bought for the US, the stagnation of third party securities, the impact of declining credit on our consumption-oriented economy (and trade partners), and the failure of the market to push prices upwards for debt-based assets because of continuing, excessive housing inventory. In other words, this debt is toxic for a reason, and its revival depends upon an upward-moving near-term housing market, which will not materialize.

On news of the failure of the first stage of the bailout, the market tanks. Bonds fail and numerous big, credit-dependent companies seek bankruptcy. Runs on banks become more common. Credit markets manifest serious breakdowns in everything from commercial paper to auto loans. Deleveraging by institutions continues having an additional negative effect on the immediate money supply. Foreign bond rating agencies downgrade Treasury Bills, but the US rating agencies stand firm for fear of retaliation.  This creates a crisis of confidence in all US-rated paper.  There is a swift shift away from dollars as a reserve currency overseas.  A severe and also inflationary recession starts January-February 2008.

The federal government will have blown the foreign creditors’ wads on the first stage bailout. But the more important FDIC bailout for commercial banks will become strained as nervous customers yank money from their longer-term accounts, just as unemployed depositers quit paying on their various loans. Instead of a sharp chastening lesson for Wall Street sorted out reasonably quickly in bankruptcy, the government will find that this bailout has strained its own ability to meet ex ante obligations to ordinary commercial banks. The banks who shifted their mortgage debt off the books to Fannie Mae, Freddie Mac, and other investors will now find the government’s bailouts of third-party holders of ABS and MBS left less money and weaker government credit available to fund the FDIC during the second-stage of the crisis (i.e., more WaMu-type failures and fire-sales).  Since money in checking accounts and saving accounts being wiped out is totally unacceptable politically,  the government begins monetizing the debt in short order.

I hope I’m wrong.  Bonus question below.

Which recessions since the Great Depression have been inflationary?

Answer: Every single one of them.

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The meltdown of AIG, Merill Lynch, and Lehman Brothers in the last few days is remarkable. I’m nearly speechless at the scale of these failures and what they portend for the economy generally. I can’t pretend to fully understand their causes, likely consequences, and the desirability of particular regulations to avoid such failures in the future.

My first thought is that bailouts are a huge mistake. Risk has been made public, while the benefits of the last ten years have been notoriously private. Fed Chairman Bernanke has misdiagnosed these problems as a liquidity crisis rather than the predictable contraction of bad investments following an overheated expansion by the market responding to the combination of perverse incentives, cheap credit, and underregulation.

Speaking of regulation, conservatives should not necessarily oppose all of it. There is a big difference between price controls and regulations that address systems of private behavior with public consequences. For example, banking regulation to encourage transparency and solvency in the form of adequate reserves and sound investments is perfectly sensible, with or without the hook of banking insurance in the form of the FDIC, because banks operate as trustees of large amounts of private wealth deposited by relatively unsophisticated investors ill-equipped to oversee these institutions.

Unfortunately, central banking and deficit spending have made our government to some extent hostage to a handful of private investment banks that trade in government debt. The “liquidity crisis” is also a crisis of the government’s ability to deficit spend. Conservatives should not necessarily renounce some repudiation of that debt, if such a repudiation punished the enablers of mass government spending. Bad credit for the government would be a good thing for the public, making expensive endeavors like the Iraq War, farm subsidies, and prescription drug benefits a thing of the past. Regulation should aim above all at stability, transparency, and buffering of the economy as a whole from the actions of a small circle of risk-preferring speculators.

Government bailouts of entities on Wall Street, as well as large companies like AIG, would further entangle profit-motivated private businesses and the federal government, whose watchword should be fiscal restraint and immunity from the rise and fall of one sector of the economy. The Fed’s multiple bailouts of Bear Sterns, Fannie Mae and Freddie Mac, and now AIG invite the government to get more in bed with economic enterprises in order to control their decisions, in effect picking winners and losers. This would create a pretext for greater regulation of the content of economic activity–as opposed to the result-indifferent rules–in the name of protecting the government’s own interest in raising revenue.

A reckoning is on the way. There are something like $60T in underfunded “credit default swap” obligations out there. This is 6X the United States’ annual economic activity. The combination of parallel government debt, undersecuritized private debt, opaque securitized mortgage instruments, and the inevitable encroachment of these failures on ordinary financial institutions like banks and small business credit portends a sustained series of cascading failures. The market’s rally today is more like a death gasp.

Any conservative approach to economic regulation should first acknowledge what government does well and what it does poorly. Straightforward limits on certain volatile or fraud-laden economic activities–trading on margin, usury, risky bundling of subprime mortgages–should be distinguished from ill-advised price controls and government involvement in aggregate consumer preference for this or that product and service. Conservatives should also prefer the concentration of pain on the risk-takers rather than taxpayers. If Wall Street is bailed out–as it has now been on multiple occasions–it is unseemly and unsustainable to employ the rhetoric of obligation in relation to “upside down” homeowners and other under-water debtors. But this is exactly what recent events, including the giveaway to credit card companies several years ago and the taxpayer bailouts of companies like Fannie Mae and Freddie Mac and now AIG, mean.

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Market-oriented Republicans see the housing crisis and say, “The market is working, and will, if only we let it.”  Democrats see the temporary pain of the slowdown and say that we need a stimulus.  Missing from both accounts is any talk of monteary policy; today, monetary policy is out of the hands of the domestic market and in the hands of the Federal Reserve.  It is a government agency with a twist:  with worldwide currency markets, the Fed must act like other market players at least in regard to international markets or our currency will be rejected or devalued (as it has been in recent months).  More important, like players in any other competitive market, the Fed can make mistakes, particularly as it balances its contradictory mandates of stopping inflation and keeping full employment. 

Republicans should take notice that markets have always been vulnerable to force and fraud and do not work well when those threats are undetected and unpunished.  This is why we have laws.  This is why in the “internal market” of a corporation people are fired or rewarded for making money for the company.  Mortgage markets are vulnerable to fraud where obligations travel up a chain from buyer, to broker, to bank, and finally to some mortgage backed security holder.  The broker gets paid up front even though the real risk holder bears the cost of default down the line.  This is cause for external regulatory reform and also internal business structure reform.  For example, wouldn’t banks and brokers be more careful if they had to return some of their commission (or otherwise be penalized) if whatever they sold had to be refunded if it defaulted within, say, five years?  Alternately, they could be paid partially by a stake in the mortgage backed securities holding their notes.  Bundles of mortgages could be valued based on a particular bank, broker, zip code, or some other combination of common, information-bearing factors.  Brokers, banks, and anyone who gathers information from lendees ideally should have “skin in the game.”  

These mortgage backed security holders should not be bailed out, of course, as this conflict of interest between lender and note holder should have been apparent to anyone purchasing these instruments.  Spreading risk may still be valuable, however, and would be more so in a proper environment of incnetives, including targeted regulation.  (We should also consider how much of this craziness was a function of the rates themselves, which drove a “flip this house” culture and shook up banks’ otherwise conservative culture.  Higher rates might do much of the work of bringing banks down to earth as any specific regulation or structural reform.)

The problem today is not a lack of stimulus or demand in the economy.  Rather, we are in a classic “supply shock” correction featuring simultaneous inflation and a reduction in output.  It’s sad that the NY Times editorial on the recent slowdown is largely silent about the causes and, in particular, ignores the fact that we are reaping the rewards of an early “stimulus” policy in the form of extraordinarily cheap money from 2001-2004.  They write, in Pavlovian fashion:

The best place to start is by rethinking economic stimulus. When Congress passed the existing stimulus package, gasoline was around $3 a gallon. By the time the rebate checks start going out in May, gasoline is likely to be well on its way to $4 a gallon. At that price, much of the $100 billion or so in rebates will go to fill Americans’ tanks, a bigger boost to nations that sell oil to the United States than to the United States itself.

The next round of stimulus, which Congress should be considering now, must accomplish what the first round neglected. It must focus on bolstered unemployment compensation and bolstered food stamps, ensuring that taxpayer dollars are spent on the neediest and on programs that are proven to spur the most economic activity for every dollar provided. The nation cannot afford more misguided giveaways.

The Carter administration faced the same problem in the late 1970s.  Bound by Keynesian analysis, they simply couldn’t make sense of the simultaneous reduction in demand and inflation that signalled the supply shocks rolling in from OPEC and elsewhere.  Stimulus packages may win a vote or two, but this kind of response is simply the fiscal equivalent of the loose money policy that Treasury Secretary Paulson and Fed Chairman Bernake continue to embrace in response to the current financial crisis.  Neither the NY Times, nor Bernake and Paulson, care to acknowledge that the earlier Fed-driven inflation and the fiscal stimulus of Bush’s deficit spending are largely the reason we are where we are now. 

As the old saying goes, when you’re in a hole, the first thing you’ve got to do is stop digging.

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There is a shocking triumph of common sense in the world, at least among some observers:

Fences work to protect borders.

Markets work better than government regulators to sort out misallocated resources.

Anti-war movies work to lose Hollywood money.

Trendy websites, i.e., “what white people like,” that do not tread upon any multicultural sensibilities work to obtain book deals

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One of my thoughts on the financial crisis is that the cause of disagreement among experts on how to prevent a disaster from the mortgage correction is rooted chiefly in theories of the causes of the Great Depression and the cause of the business cycle in general.

Fed Chairman, Ben Bernanke, and certain monetarists view the depression as rooted in a liquidity crisis. If that crisis could have been avoided, then a cascading series of confidence failures could also have been avoided. The theory is that the central bankers of the 1930s pursued an austerity policy at the wrong time, leading to runs on banks, hoarding of hard assets like gold, leading in turn to the inability of functional businesses to get capital in what should have been a prime, deflationary environment with which to attract labor and purchase capital assets.

The Austrians and I view the depression and the business cycle in general as a phenomenon of inflationary monetary policy and the distorted economic cycles caused by central banking and fiat currency. Central bank artificial inflation allows artificially long and non-correcting cycles of inflation. In the older regime of private banks, hard currency, and the “bank run,” any one bank’s over-extension would represent an arbitrage opportunity for other banks, so the cycle was often self-correcting, just as in private markets of other kinds, such as international currency exchanges.  It was unlikely and unusual for too many players to make the same kind of error at the same time, but such “errors” are built into the system of central banking monetary policy because, at least in the short run, betting on speculative bubbles makes sense in today’s environment.

Further, central banks make these errors repeatedly not only because they are big, but because they are subject to various political pressures, such as the current pressure to avoid a recession at all costs. This relatively unregulated (in the short term) central bank inflationary policy leads to incorrect signals and speculative bubbles.  When the market’s investors realize that they have diverted real savings into bad investments, the price of these investments drop, assets must be liquidated, and businesses fail.

Efforts to “prime the pump” and get the economy moving again lead to additional inflation and frantic activity, until rising interest rates are imposed out of the absolute necessity to cover rising prices from inflation and to attract foreign investors who have stronger currencies to invest in bank debt.

The Austrians note that the “supply shock” crises of the 19th Century–before the era of central banking or fiat currency–were over very quickly in contrast to the frequent, repeated, inflationary, and drawn out recessions of the 20th.

The third view, the Keynesian view, is that demand-side fluctuations call for government austerity (in times of inflation) and increased spending (during a slow down).  These maneuvers are supposed to counterbalance inflation or increase demand respectively. These proposals rely a great deal on the multiplier effects of spending, but the Keynesian theory does not take adequate account of the “crowding out effect” of government debt spending and the historical unlikelihood of the government practicing austerity during boom times.  The money comes from somewhere, and it would otherwise go to private bonds, private equities, and other productive uses.

Neither Bernanke, nor his Austrian critics, really endorses this view. But Bush does implicitly in his stupid stimulus package. It should be obvious why the Keynesian big government theory has been popular with government officials since its origination in the 1930s. It lets them spend money they don’t have, as if this were some courageous and far-sighted measure, rather than a demagogue’s natural instinct. Needless to say, the 1937 downturn should put to bed the Keynesians’ hoary view that the CCC and other public works projects of the New Deal pulled us out of the Great Depression.  In fact, they made it worse.

But here we are again. We have the benefit of what should be the clear inflationary lessons from the 1920s, but Greenspan inflated the money supply like crazy after 2000, and Bernanke is undertaking another doomed effort to inflate our way out of an inflationary-speculative bubble.

A downturn of any kind is like pulling off a band-aid. The quicker we liquidate the bad investments, homes, nonperforming commercial paper, and upside-down businesses, the better off we’ll all be, and the quicker we’ll move onto the next cycle of growth.  As Secretary of Treasury Andrew Mellon infamously said, “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” Indeed.

It’s not like anyone is going to debtor’s prison. Moreover, the more people “hurt” by seeking bankruptcy protection, the less stigma there will be to folks who are otherwise good risks. Protecting speculators, improvident banks, overly leveraged hedge funds, and over-extended mortgage holders from the consequences of their actions will only drag out the pain and delay a recovery.

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