Night of the Living Fed

Paul Krugman is writing about The Face-Slap Theory.

The scariest thing I’ve read recently is a speech given last week by Tim Geithner, the president of the Federal Reserve Bank of New York. Mr. Geithner came as close as a Fed official can to saying that we’re in the midst of a financial meltdown.

The Fed’s latest plan to break this vicious circle is — as the financial Web site interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

Drop In The Bucket

Several people have asked me recently if I have been changing my tune on a Fed bailout. The answer is no. I long ago predicted the Fed would try all sorts of things to stop a deflation threat. But I also have also said, these measures would not work and indeed they haven't. What is happening is the Zombification of Banks, that is exactly what happened to Japan as well.

See The Great Pretender and the '>Fed's New Role as Pawnbroker for more on the Zombification of Banks and the Fed turning the TAF (Term Auction Facility) into the PAF (Permanent Auction Facility).

From Krugman: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.

The Red Queen Race

On two prior occasions I have likened the liquidity efforts of Bernanke to The Red Queen Race. Here it is again.

In Lewis Carroll's Through the Looking-Glass there is an incident involving the Red Queen and Alice constantly running but remaining in the same spot. The scene is often referred to as The Red Queen's Race.

The Queen kept crying "Faster!" but Alice felt she could not go faster...

"Now! Now!" cried the Queen. "Faster! Faster!" And they went so fast that at last they seemed to skim through the air, hardly touching the ground with their feet, till suddenly, just as Alice was getting quite exhausted, they stopped, and she found herself sitting on the ground, breathless and giddy. The Queen propped her against a tree, and said kindly, "You may rest a little now."

Alice looked round her in great surprise. "Why, I do believe we've been under this tree all the time! Everything's just as it was!"



"Of course it is," said the Queen: "what would you have it?"

"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else -- if you ran very fast for a long time, as we've been doing."

"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"

The above image is thanks to the University of Virginia Library.

Bernanke, like the Red Queen and Alice, simply cannot run fast enough when it comes to bailing out this financial mess.

Why Measures Fail

Face Slapping, the TAF, the PAF, lowering interest rates etc. are measures that can only work if the problem is lack of liquidity. The problem is not one of liquidity. The problem is solvency. Massive amounts of credit was created out of thin air because fractional reserve lending allows it. Speculation in assets went through the roof when the Fed held interest rates too low too long.

Now with falling asset prices, margin calls are running rampant. Margin calls beget margin calls in an ever escalating chain reaction. Carlyle Capital, a once $32 billion fund, was Hit With Margin Calls And Default Notices. It may have to liquidate. If it does, most of that $32 billion will be wiped out because of the 32:1 leverage it was using.

For those who want a Seasonal Lenten Message here it is: Remember credit that thou art dust and to dust thou shall return.

Remarks by Timothy Geithner, President New York Fed

Let's now turn our attention to the speech that has Paul Krugman spooked: The Current Financial Challenges: Policy and Regulatory Implications. It's a long speech in which Geithner attempts to spread the blame around.

" The origins of this crisis lie in complex interaction of number of forces. Some were the product of market forces. Some were the product of market failures. Some were the result of incentives created by policy and regulation. Some of these were evident at the time, others are apparent only with the benefit of hindsight. Together they produced a substantial financial boom on a global scale. "

There were complex interactions for sure but blaming market forces is lame. The second sentence gets to the heart of the matter. I suggest these problems were entirely "the result of incentives created by policy and regulation".

Of course few see it that way. Many are blaming lack of regulation, specifically the unwinding of the Glass-Steagall Act for its role in this mess. Such blame is ill placed as discussed in Did Lack Of Regulation Cause This Mess?

Root Cause Of This Financial Crisis

• The Fed
• Fractional Reserve Lending
• Government sponsorship of the rating agencies (See Time To Break Up The Credit Rating Cartel)
• Government sponsorship and promotion of housing via GSEs, tax breaks, etc.

There is not a free market failure in the group, nor will there ever be.

Although Geithner fails to understand the cause, he does paint an accurate picture of the chain of events leading up to the crisis.

• Real short-term interest rates were reduced around the world.
• Global savings appeared to rise faster than did perceived real investment opportunities.
• Emerging market economies built up very large levels of official reserves to hold the value of their currencies stable against the dollar.
• The exchange rate policies in those economies made overall global financial conditions more accommodative.
• Expected and realized volatility in both debt and equity markets dropped. Term premiums declined and remained low.
• Credit spreads across a wide range of asset classes fell to levels that assumed unusually low levels of future losses.
• Many households, including those previously lacking access to credit or with access only to expensive credit, found they could borrow on a significant scale to finance the purchase of a home and other expenses.
• Prices rose across a range of real and financial assets, most notably the prices of homes.
• This constellation of broad economic and financial conditions was accompanied by rapid innovation in financial instruments that made credit risk easier to trade and, in principle at least, to hedge.
• Issuance of asset-backed securities [ABS], collateralized debt obligations [CDOs)]and collateralized loan obligations [CLOs], as well as credit default swaps [CDS], expanded on a dramatic scale.
• The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity.
• A sizable fraction of long-term assets—assets with exposure to different forms of credit risk—ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.

Self Reinforcing Action

Continuing the discussion from Geithner:

The self-reinforcing dynamic within financial markets has intensified the downside risks to growth for an economy that is already confronting a very substantial adjustment in housing and the possibility of a significant rise in household savings.

The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets. The damage to confidence—confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk—will prolong the process of adjustment in markets. This process carries with it risks to the broader economy.

For more on self reinforcing action, please see the excellent discussion on Daisy Chain Reactions by Professor Bennet Sedacca in Changing the Benchmark.

Fed Has No Confidence In Monetary Policy

"We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time."

There you have it. That is an explicit comment from a Fed Governor that they have no idea with any confidence they know what they are doing.

I Have 100% Confidence

On the other hand, I have 100% confidence they have no idea what they are doing. They can no more accurately fix the interest rate than they can fix the price of orange juice. Heck, in actual practice, the latter would be far easier.

Fed Attempts To Wash Hands

Sadly Geithner sticks to the myth that this was not preventable.

"Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks."

Of course it was preventable. Two simple measures would have prevented 80% of this mess: Elimination of the Fed, and elimination of fractional reserve lending.

Three Part Solution

Geithner's speech goes on and on and on. Still, it is probably one of the most important speeches ever by a Fed governor in admitting what the problems are. I recommend reading it in entirety. And while the Fed (at least Geithner) admits it has no idea what to do, I offer this 3 part solution.

• Abolish the Fed
• Eliminate fractional reserve lending
• Implement a sound monetary policy based on hard assets such as gold as opposed to price fixing by government sponsored clowns

Comments

[flow5:]

Stop the bullshit:

There are increasing numbers of advocates for the adoption of some form of gold standard. Gold standards of whatever type, gold coin, bullion or some modification of the gold bullion standard, all require that the unit of account be defined in terms of gold of a certain fineness, e.g., one dollar equals 25 grains, 9/10 fine, thus establishing the mint price. The other sine-qua-non requires the government, acting directly or through the agency of a central bank, to stand ready at all times to buy or sell gold at the mint price.

An operating old standard creates, or is associated with, many advantages: 1) stable foreign exchange rates; 2) free multilateral clearing of currencies among nations; 3) the maximization of multilateral foreign trade; and, 4) relatively stable price levels e.g., no chronic inflation.

All that is required to achieve this economic utopia is a 1) world free of major wars, depressions and cartels (OPECs); 2) markets with downward price flexibility, that is , true price competition; 3) creditor nations which impose no significant restraints on imports; 4) monetary authorities who abide by the “rules of the game”, i.e., the central banks expand credit (create commercial bank legal reserves) when gold stocks expand, and vice versa; 5) monetary authorities who restrict the expansion an d contraction of central bank credit within a very narrow range, thus preventing the commercial banks from creating an unsupportable volume of credit money (transaction deposits); and, finally, 6) a world where the reserve currency countries (those countries whose currency serves as a store and standard of value as well as a transactions currency) never operate with chronic deficits in their balance of payments.

Note: deficits or surpluses refer to changes in a country’s gold stocks and net short-term claims (transaction deposits, CDs, commercial paper, etc. – the “balancing items” in the balance of payments.) deficits result from gold exports and/or a decrease in short-term claims against foreigners relative to the short-term claims held by foreigners. The reverse is true for surpluses.

From 1816-1914 there conditions were achieved under the aegis of the Bank of England to an extent sufficient to provide international trade, and the British domestic economy, with all the advantages of a free gold standard. This period marked the heyday of the gold standard. The British pound sterling was the reserve and transactions currency of the world. International transactions were financed largely by transfers on the books of the “big five” London banks, thus minimizing the necessity to transport gold. So great was the faith in the convertibility of the pound sterling, that the Bank of England could, and did, operate with relatively small gold reserves. A change in the central bank’s discount rate, or a small change in the buying price of gold (not a devaluation or a revaluation, but simply a change in the price sufficient to offset implicit interest and shipping costs) usually was enough to prevent significant or unnecessary outflows of gold.

World War I ended all this. Attempts to restore the gold standard in the 1920’s were swallowed up in the Great Depression. For most of the period from the end of World War I to 1968, the world was on a U.S. dollar standard, but never a free gold standard. World War I transformed the U.S. into a creditor nation, left our industrial capacity expanded and intact, and set in motion forces which made our economy the safest haven for foreign capital seeking escape from foreign nationalization. World War II and the Great Depression accentuated these trends. But the U.S. tended to ignore its responsibilities as the world’s principal creditor nation and reserve currency custodian. We severely restricted imports through sky-high tariffs (Hawley-Smoot, 1931, for example), customs red tape, commodity classifications and other devices. The volume of Federal Reserve Bank credit was determined more by domestic considerations than by gold flows. In April, 1933 we nationalized gold, made the dollar inconvertible and by administrative fiat capriciously raised the dollar price of gold in a series of steps from $20.67 to $35 per ounce. All of this was done even though were a creditor nation and had a chronic surplus in our b balance of payments. In January, 1934 the Congress codified these administrative actions into law. Under this modified gold b bullion standard, the dollar was convertible on foreign, but not domestic account at $35 per ounce.

Before we commit ourselves to the naïve proposition that a successful gold standard requires only an Act of Congress, we should examine the reasons for the abandonment of gold convertibility in March, 1968. That was the month and year the U.S. Treasury ceased to sell gold on the open market. No longer could foreigners buy gold and the London or any other exchange at $35 per once.

The U.S. Treasury held approximately two thirds of the world’s monetary fold stocks in 1949. They resulted from years of surpluses in our balance of trade and “flights” from foreign currencies. In 1949, the U.S. dollar was not only as “good as gold”, but it was also preferred over gold. There were not enough dollars to finance the legitimate needs of the world economy.

With the outbreak of the Korean War in 1950 surpluses turned to deficits. With the sole exception of 1957, these deficits (usually of increasing magnitude) have characterized our balance of payments in every year since. For the first few years, the deficits were beneficial. But a good thing can be over done and we did it. In our efforts to police the world, we overcommitted ourselves. This zealotry finally leg to the escalation of the Vietnam War in 1965 and the subsequent demise of the dollar as the reserve currency of the world.

Note: Until 1971, the private sector always operated with a surplus. These surpluses were more than offset by the excessive unilateral foreign transfers by the Federal Government (our foreign military bases, personnel, and war expenditures). Since 1971, the private sector can share the blame. U.S. industry has become less competitive, but the principal villain (since 1973) has been OPEC.

By the mid 1960’s foreigners found themselves in possession of excessive dollar balances, excessive in terms of the needs of trade. Some of these excess dollars come to be used as “prudential” reserves in the formation and growth of the Euro-dollar banking system. Other excess dollars were used to buy our under priced gold (under priced as a consequence of chronic inflation). Our gold stocks, which were about 700 million ounces in 1949, had fallen to about 260 million ounces by March, 1968. Had the Treasury not abandoned its effects to maintain the equality of the market price with the mint price, our entire monetary gold stocks probably would have been depleted by the end of 1968.

Paradoxically, the Euro-dollar System, (now a foreign-dollar prudential reserve banking system) which was established both because the dollar was in excess supply and the reserve currency of the world, is now one of the principal factors militating against any attempt to reestablish the convertibility of the dollar into gold’s at a fixed price. We are not even willing to give the Fed the degree of control over our own domestic money creating institutions.

Regardless of whether or not our objective is establishing a gold standard, the situation requires measures be taken which well reverse the deterioration of the dollar’s integrity. What is required is no less than an end to the chronic liquidity deficits in our balance of payments, and a halt to the excessive creation of U.S. and Euro-credit dollars. But the alternative is, at some point in time, a flight from the U.S. dollar and, therefore, the Euro-dollar. This will generate hyperinflation in terms of U.S. and Euro/Yen/Yaun/Petro/-d... etc., and an international financial crisis of unprecedented proportions.

2008 Mar 14 12:46 PM

[REBEL:]

The history of ALL GOVERNMENTS' creation of fiat money, (fiat money: that money created by governments - out of thin air - by legal decree), boils down to one thing: ALL GOVERNMENTS will carry out any evil, corrupt and foul act(s) to keep from having a money STANDARD to which the GOVERNMENT must adhere. How would GOVERNMENTS maintain their control over the serfs, (who toil to put food in their own mouths)? Therefore, a continuous war on ANY STANDARD which can't be readily manipulated, (e.g. paper money),
is waged by ALL GOVERNMENTS. To ALL GOVERNMENTS, the GOLD STANDARD must be eradicated from planet Earth.

2008 Mar 14 03:03 PM