The Virtue of the Republic

"The aggregate happiness of the society, which is best promoted by the practice of a virtuous policy, is, or ought to be, the end of all government..." (George Washington)

"Only a virtuous people are capable of freedom. As nations become more corrupt and vicious, they have more need of masters." (Benjamin Franklin)

Watching CNBC lately has been pretty amusing. Billionaire after billionaire comes on for an interview and expresses huge confusion about the credit markets. The emperor of debt himself, Donald Trump, expressed confusion a year ago that "money is cheap".....yet... "unavailable." Heck, cheap but unavailable seems to be the new mantra of the leveragati (think "literati" with more debt).

The answer to this "conundrum" is simple. The Federal Reserve is in the price-fixing business, and we all know that when you create a price ceiling, that supply shrivels up.

Similarly, interest rates are the price of money. When the Fed creates, in essence, a price ceiling on money, it won't be supplied by the private market, but only by idiots, or by the Fed (but I repeat myself).

So essentially, by artificially lowering the price of capital (interest rates) supply dries up, as it does in every market where price fixing is allowed. If you can't earn a decent return on your money, why would you take it out of your wallet? We then have an artificial "liquidity crisis" and the socialists come out of the woodwork and demand that the government "DO something" to assure that "this never happens again," this "problem" of recurring expansions and contractions.

I have a question for the Congress. If you don't let them lose so much money that they're fired from the banks, how do you prevent them from over-leveraging themselves in the future? And to the point of expansions and contractions, you can no more legislate them away then you can legislate away the tides of the ocean. Perhaps Congress believes it can make fear and greed illegal. Rather than go down a road of ever-complex, misguided regulation, remove leverage from the system with simple, yet strong regulation. Requiring 20% down on mortgages would be a start.

But what the government is doing is finding surrogates in order to spur lending at uneconomic rates. Fannie (FNM) and Freddie (FRE) are perfect examples. Their interest rates are too low and they will require more and more government funding due to this fact. They are essentially lending agents of the Treasury, not private actors engaged in lending at rational rates.

Congress misses the point when it complains to the Treasury and the Federal Reserve that banks are not lending. The very clear, but unstated policy of the Treasury and the Fed is the "money gift." As Wikipedia accurately describes,

In a liquidity trap, banks are unwilling to lend, so the central bank's newly-created liquidity is trapped behind unwilling lenders.

What is the solution? The "money gift." The U.S. government is gifting money to the banks in highly complex ways to make it appear more politically tenable to the populace. But make no mistake about it. It is a gift. Once the gifts exceed levels that the banks need to replenish their capital (either through the giving of dollars outright, or in the form of an artificially widened net interest margin due to low rates), then, perhaps, the money gift will "increase housing prices." Of course, it won't be a real price increase at all. It will merely be inflation.

The effect is to penalize the virtue of savers, who are caught in the double-whammy of the debasement of the currency and ridiculously low interest rates, thereby earning highly negative returns on their savings. This is not just China. These savers are ordinary Americans who do not over leverage and did all the right things. They are often the elderly on fixed incomes. This inflation is a taking (theft) from savers and a gift to all those who have borrowed money. Their debts are fixed, but the money they must repay in becomes steadily less valuable. It is yet another form of wealth transfer (theft) from those with virtue to those with vice.

And don't be naive. Homeowners are not the real targets of the money gift. Think AIG, Citigroup (C), Bank of America (BAC), et al. The bank lobby pulled off the greatest heist in the history of the world. And they got the government to sanction it.

But you may say, "sure these savers lose out, but we can increase employment with some inflationary increases in the money supply." This seeming "logic" is as widespread as it is wrong. Inflation kills demand in terms of the aggregate quantity of goods citizens can afford. It doesn't spur it.

For instance, for families with fixed budged constraints (a fancy term for incomes), if the price of Tide goes up by 20%, the family either buys 20% less quantity of Tide, or less of something else in order to still afford it. But their income is unchanged. They can afford less of everything. The economy is hurt, not helped. When citizens can afford less goods, businesses lay off even more workers. Less quantity of goods can be afforded, businesses earn less or go broke, more workers are laid off. It' a simple and vicious cycle.

But, the socialists will proclaim, incomes will rise as well, negating this effect. Go to your boss and ask for a raise. See what happens. Inflation kills economies. As Milton Friedman recollected of du Pont's famous adage "we do not have to be gracious at all to inconsistent logic or absurd reasoning. Bad logicians have committed more involuntary crimes than bad men have done intentionally." No society has ever prospered from inflation.

Contrary to popular belief, the sun will rise in the morning even if financial institutions fail. What we have done is to create affirmative action for the rich and stupid. The government has essentially asked, "Are you rich? Are you dumb? Did you invest in a bank? Are you a trader at one? Here's some money." Taking money from the populace and giving it to such sophisticates is lunacy. It is also gangsterism, not government.

Thomas Jefferson once opined that the foundation of a Republic is the virtue of its citizens. He wrote

When virtue is banished, ambition invades the minds of those who are disposed to receive it, and avarice possesses the whole community.

He might have been discussing the banking lobby.

The government cannot penalize virtue and reward vice and expect good results. I fear that we have lost the will to win as a nation. We have elected leaders who are not willing to endure short term pain for long term prosperity. The stimulus we are seeing is rather like crack to a drug addict. It may amp up GDP temporarily, but does damage to our economic system longer term.

When there is a cancer growing in a patient, the answer is to excise the tumor, not keep it alive, as we are with problem banks. The FDIC can easily seize the deposits of large institutions. They are not doing so, because of political pressure from the well-connected, which makes "saving" bad banks more politically tenable.

Placing formerly concentrated deposits with a myriad of healthy banks would place this capital in more capable hands and fix the probem of too big to fail in one swoop. These good banks would be much better able to direct rational lending in the future--they have done so in the recent past. Think banks like Hudson City (HCBK).

With all of our mathematical pretensions about business cycle theory and economics, it comes down to a very simple, very human phenomenon. We have contractions because people become too greedy when times are good, over-expand, and borrow too much money, and pay prices that are too high. We have expansions because during contractions, prices get too low when people panic and sell things for prices that are below what they are worth, and more rational people shrewdly buy and expand businesses, leading to recovery.

You can't banish fear and greed, intelligence and stupidity. They are as old as time itself. People of discernment recognize that you cannot legislate them out of existence, only try to educate people to immunize them as much as possible from following others like lemmings off of various economic cliffs. You also cannot reward vice and punish virtue. If government is the referee in the national morality play, every character must get what they deserve.

The 20th century ushered in a curious phenomenon to which we are all witness, in its ridiculous, irrational, myriads forms. Personal shortcomings are now seen as social problems. We can't perfect humans, but we think we can perfect society. In this fantasy world, personal greed is "market failure" and panic is a "liquidity crisis." Formerly wealthy institutions which might become poor are "too big to fail," rather than dumb. We need to start seeing things for what they are and to start calling them by their true names.

Perhaps Sir John Templeton said it best when he declared that

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.

The same might be said of nations.

Call me old-fashioned, but I have one message for policy-makers: charity is for poor people.

Disclosure: Harry Long does not own shares in any of the companies mentioned in this article, but he may in the future.

Comments

[paulsjj:]

Washington: "The House of Games"...The bail-out in all of its forms: "The Big Knockover" (Ref. Dashiel Hammet).

May 18 08:45 AM

[fireball:]

harry
good article, common sense is stretching pretty hard in the district of illogic and unreason. i am to complimentary here to d.c.. i think more likely we are in the hands of gangster/thug types and have been for a long time. it profits them to protect the interests of the "corptocracy" (borrowing an sa posters term). using expansion and contraction i wonder how much of the "missing" fed money has ended up in real property and tangible assets to enrich the hard to find fed stockholders.
we have a long painful road to go to restore constitutional government. i think we need a firehose to wash out the stable (you know the horse excrement) to get rid of by the lawyers, of the lawyers, for those that pay the lawyers government. we probably should make it illegal for lawyers to hold any public office. we have politicians. we need statesmen.
the mistake we make is assuming they are stupid rather than malicious.

May 18 08:56 AM

[antiquary:]

"So essentially, by artificially lowering the price of capital (interest rates) supply dries up, as it does in every market where price fixing is allowed. If you can't earn a decent return on your money, why would you take it out of your wallet?"

The posit you take as granted is that the ceiling set by the Fed is below a decent return. This is not necessarily true; what a "decent return" is will depend on what the alternatives are in the current economy. The general level of paranoia is not a legitimate factor. I think the way you get banks to lend is by showing them that they're being outcompeted by other people or entities who are lending, even if that has to be the Federal government for a time to prime the pump.

May 18 10:39 AM

[ain't no fo...:]

"the mistake we make is assuming they are stupid rather than malicious."

and machiavellian to the extreme

as the market explodes higher as the banksters recommend each other and bid up each others' shares, led by GS of course with their oh so timely reco of BAC

jail and firing squads for all of them

May 18 10:47 AM

[waf76:]

common sense is not so common. government has been and always will be about controlling the masses. what better way to control them then to have them do it willingly? Patriot act?...the players in the game get a do over when they screw up. privatize the profits and social the risk. at the end of the day there has to be a winner and a loser and these guys are not going down without a fight and society is too busy to meticulously follow what is going on...people have to work to pay their mortgage or rent, feed their kids, pay the utilities, etc...we're distracted so we outsource these decisions to them and thats what we get for not following attentively...instead we're watching the yankees, the mets, the nfl, reality shows, or whatever else is on the 1000's of channels...who's gonna watch cspan and see what our leaders our deciding for us? not me...and thats why we are where we are...

May 18 11:24 AM

[Perry B:]

One bright spot last week is Obama starting to change the anti trust laws. A fact that has to happen before any change can be realized. Even criminal punishment. I believe and hope he is successful in turning around the laws that have gotton us into this mess. As is; by law Obama's hands are legally tied to just going along with doling out cash.
However we as citizens need to educate ourselves along with our leaders, to the law.
We need a media source that will bring these virtuous deeds to the front page until they are resolved.
A media source that sheds light on the truth of the many good efforts by our President, and those in Washington who are taking these virtuose, first steps to correct these wrongs. Screw waterboarding and other communist yellow journalism tactics to get our mind off the truth.
There are many good peope that are trying to right a wrong that has been long in the making. Hold the media to a higher standard of journalism. We need a good internet new paper armed with the truth. that digs and reports the truth. Good article good quotes and good sentiment.

May 18 11:56 AM

[henarl:]

excellent article. Superb rhetoric and unassailable logic.

May 18 12:21 PM

[Harry Long:]

Thank you, henarl. Very kind words.

May 18 12:23 PM

[Leftfield:]

Of course, the inflation statistics of the government show a substitute of a cheaper brand over Tide to be an equal trade, not a cut. Same with hamburger substituted for steak. Wall St. and DC are ginning up bad statistics more than ever now to "solve" the crisis. Marking to magic. Stepping up the fogbank is not a good way to reassure investors that they are seeing good value.
US and Detroit offer some examples and comparisons. Hedonic prices as calculated in inflation statistics are also famous for imputing astronomical values to computers as they advance over previous, less-capable models. What fun! If they had started that when the Model T ruled, they would have imputed $millions in value to each car purchased today and we would have shown zero inflation for the last century.
Detroit automakers were once so rich, powerful and full of hubris they were commonly labeled "dinosaurs." They have nearly completed that whole analogy now. How similar to the US who still commands great power in the world as the basis for it decays and shrinks. Aiding failures is only hastening national bankruptcy. Keeping the same leaders is suicidal.

May 18 01:15 PM

[fireball:]

wpdragon
i understand and sympathize but i want them to have trials or grand jury hearings. for our sake not theirs. i imagine you like me try to obey the law (sometimes i like to drive to fast but that is the idiot kid in me). i want to be sure that there is always a fair trial for us so i have to want the same for them.
it is kind of like censorship. i don't want religion or porno censored because i don't want to be censored. besides free speech is a two-edged sword.

May 18 02:30 PM

[Econ 101:]

If you trust BHO, I have a bridge for sale

Support HR 1207, an Audit of the Federal Reserve. And the companion bill in the senate S604,

www.house.gov/htbin/bl...

May 18 03:12 PM

[djc:]

Excellent article. Perfectly framed sentiment.

Jefferson was my hero.

May 18 04:50 PM

[RWCMom:]

Yes, 20% down on mortgages (& car loans) is good but the bankers were too greedy to live with that so they come up with zero down, ARMs and anything else to part uneducated folks from their money. Perhaps if they would lend some of that money at 10% to credit card holders instead of 20%, the other 10% could be spent on real goods made by real Americans instead of lining the pockets of VISA. Quit making the Feds to be the bad guys; bankers do this to themselves and I am tired of hearing them cry wolf.

May 18 06:01 PM

[derryl:]

Superb article.

Harry quoted Jefferson, "When virtue is banished, ambition invades the minds of those who are disposed to receive it, and avarice possesses the whole community."

Whether we like it or not, leaders 'lead'. When ordinary people see the leaders (or their neighbors) getting fabulously wealthy they want to get in on the action, regardless of the immorality of the means. 'Avarice possesses the whole community.'

In the post-war era people saw their leaders and neighbors getting ahead by being productive workers and this created a virtuous cycle. Now we're in the vicious cycle of getting ahead by entitlements and bailouts; by getting money we haven't earned with no concern for who we're robbing. This is the kleptocracy phase of a society and I don't know how to get out of it. Hopefully there is the beginning of a bottom-up realization that basic reality has not changed: we need to earn our living producing real things of real value to each other. Maybe a nation of honest earners will refuse to accept a cabal of kleptocrats ruling them.

May 18 06:55 PM

[Missing_Link:]

Brilliant article!

> The 20th century ushered in a curious phenomenon to which we
> are all witness, in its ridiculous, irrational, myriads forms.
> Personal shortcomings are now seen as social problems. We
> can't perfect humans, but we think we can perfect society. In this
> fantasy world, personal greed is "market failure" and panic is a
> "liquidity crisis." Formerly wealthy institutions which might
> become poor are "too big to fail," rather than dumb. We need to
> start seeing things for what they are and to start calling them by
> their true names.

Truer words were never spoken!

May 18 10:32 PM

[ain't no fo...:]

You're correct fireball, I even speed once in awhile, and I agree they need fair and impartial trials. WE ARE still a nation of laws (I hope) for all citizens.

But sweeping what they did under the rug, and allowing them and their institutions, shareholders and debt holders to profit from the vast amounts of money we are throwing their way in order to prevent a systemic meltdown just emboldens them all, and in the end run what have they learned from this mess they caused? Nothing... while millions of Americans have lost their retirements, and many who played by the rules will nevertheless lose their homes, their jobs, their health benefits... and who is bailing THEM out?

How much of this money are they recycling out as loans and how much is simply going to trading these markets? Close to one third of the program trades executing in the markets these days are being done by GS, and they have all been using this money to prop up each others' stock prices. Their balance sheets are still rotten to the core, they haven't marked their junk assets down anywhere near adequately (and they never even marked it down BEFORE the mark to market rule was rescinded), and if jobs continue to stay weak as the next rounds of foreclosures and Option ARM and Alt-A resets go thru, they will STILL be looking for hundreds of billions more in taxpayer money to stem the NEXT systemic risk scenario they know damn well is coming.

I was born in 1950. The America I experienced in the 50's is not the America I recognize today. And for that I mourn.


On May 18 02:30 PM fireball wrote:

> wpdragon
> i understand and sympathize but i want them to have trials or grand
> jury hearings. for our sake not theirs. i imagine you like me try
> to obey the law (sometimes i like to drive to fast but that is the
> idiot kid in me). i want to be sure that there is always a fair trial
> for us so i have to want the same for them.
> it is kind of like censorship. i don't want religion or porno censored
> because i don't want to be censored. besides free speech is a two-edged
> sword.

May 18 10:35 PM

[100%:]

Nice article. I am afraid reading it from a brutally practical perspective leads to the conclusion, "buy bank stocks!", and I don't think I disagree with that either.

May 18 11:08 PM

[wcinvest:]

A few good ideas in this article but their is no need to demonize the banks that have already been scapegoated.

The biggest beneficiaries of government fund that won't be paid back are the 2 GSEs and AIG. None of these companies are banks! I do think AIG should have been handled differently but if they failed, it could have led to other failures of insurance companies and that may have been a disaster that led to the complete collapse of the financial system. Slowly over the next 5-8 years, the GSEs should be split up if necessary and become private companies without an 'implicit guarantee'.

Most of the companies that behaved most irresponsible have either failed or suffered massive dilution. And yes, lower interest rates does help the banks in a recession but the rates were lowered to help the economy much more then to help the banks... When rates are raised, it's not too punish the banks but simply to curb inflation and make sure the economy doesn't spin out of control.

May 19 03:03 AM

[fireball:]

wp dragon
1954---agreement.

May 19 12:20 PM

[Harry Long:]

Antiquary, with all due respect, if it was not below a decent level of return, why didn't interest rates get to the current level without government intervention?


On May 18 10:39 AM antiquary wrote:

> "So essentially, by artificially lowering the price of capital (interest
> rates) supply dries up, as it does in every market where price fixing
> is allowed. If you can't earn a decent return on your money, why
> would you take it out of your wallet?"
>
> The posit you take as granted is that the ceiling set by the Fed
> is below a decent return. This is not necessarily true; what a "decent
> return" is will depend on what the alternatives are in the current
> economy. The general level of paranoia is not a legitimate factor.
> I think the way you get banks to lend is by showing them that they're
> being outcompeted by other people or entities who are lending, even
> if that has to be the Federal government for a time to prime the
> pump.

May 20 05:54 PM

[Harry Long:]

Wcinvest, to your point about AIG's counterpaties:

To those who would argue that derivative counterparties would have been "unfairly" penalized by AIG's (AIG) collapse, let us be clear—we are not talking about innocents, we are talking about highly sophisticated (but clearly not very bright) players in the derivatives markets.

Traditional theory in Economics of the Law posits that it is most efficient for actors best able to exercise a prudent standard of care to bear the liability of loss. Simply put, it costs less money for derivative counterparties to examine a company's balance sheet and refuse to do business with any companies they deem imprudently run than to bail out the derivative counterparties later. If they do choose to do business with companies that are badly run [such as AIG], they should bear the full risk of loss, without any government "affirmative action" for such sophisticates.

seekingalpha.com/artic...


On May 19 03:03 AM wcinvest wrote:

> A few good ideas in this article but their is no need to demonize
> the banks that have already been scapegoated.
>
> The biggest beneficiaries of government fund that won't be paid back
> are the 2 GSEs and AIG. None of these companies are banks! I do think
> AIG should have been handled differently but if they failed, it could
> have led to other failures of insurance companies and that may have
> been a disaster that led to the complete collapse of the financial
> system. Slowly over the next 5-8 years, the GSEs should be split
> up if necessary and become private companies without an 'implicit
> guarantee'.
>
> Most of the companies that behaved most irresponsible have either
> failed or suffered massive dilution. And yes, lower interest rates
> does help the banks in a recession but the rates were lowered to
> help the economy much more then to help the banks... When rates are
> raised, it's not too punish the banks but simply to curb inflation
> and make sure the economy doesn't spin out of control.
>
>

May 20 05:58 PM

[Harry Long:]

Deryl, so true. I am always touched that so many still honor our principles as a nation.


On May 18 06:55 PM derryl wrote:

> Superb article.
>
> Harry quoted Jefferson, "When virtue is banished, ambition invades
> the minds of those who are disposed to receive it, and avarice possesses
> the whole community."
>
> Whether we like it or not, leaders 'lead'. When ordinary people see
> the leaders (or their neighbors) getting fabulously wealthy they
> want to get in on the action, regardless of the immorality of the
> means. 'Avarice possesses the whole community.'
>
> In the post-war era people saw their leaders and neighbors getting
> ahead by being productive workers and this created a virtuous cycle.
> Now we're in the vicious cycle of getting ahead by entitlements and
> bailouts; by getting money we haven't earned with no concern for
> who we're robbing. This is the kleptocracy phase of a society and
> I don't know how to get out of it. Hopefully there is the beginning
> of a bottom-up realization that basic reality has not changed: we
> need to earn our living producing real things of real value to each
> other. Maybe a nation of honest earners will refuse to accept a cabal
> of kleptocrats ruling them.

May 20 06:04 PM