Category Archives: Banking & Money

David McWilliams Explains Why Austerity Is Doomed In Europe

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A very interesting video by an Irish economist explaining how the current reduce government spending (“austerity”) approach to the Eurozone debt and currency crisis is doomed to fail. It is doomed because cutting government spending in a recession only makes the recession worse, which in turn, reduces tax collections which then makes the government deficits worse not better.  But not only is the austerity approach all wrong to solving the debt crisis, it carries very significant risk of social upheaval.  (hat tip to Philip Pilkington and New Economic Perspectives).

Now I’ll offer one pre-emptive comment.  Critics of the arguments McWilliams makes often claim that either government spending isn’t really effective, that somehow only private investment spending will stimulate an economy.  Or, the critics claim that any resources the government puts into use through spending actually detract from the economy by denying those resources to some supposedly better, privately chosen use. Both of these criticism fail.  We are clearly discussing a situation in which there are excess, unused economic resources in the economy.  In plain language:  there’s high unemployment and people are out of work.  The criticisms are all based on an idea called “crowding out”.  For crowding out to occur, the economy must be at full employment – the opposite of being in a recession.

More on The Fed Audit, “Secret Loans”, and Conflicts of Interest

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The last couple of days I’ve posted some thoughts on The Fed and the summer 2011 “audit” by the Government Accounting Office (GAO) here and here.  A long time reader and commenter, AZleader, apparently also wrote about The Fed audit.  I like his post a lot.  In particular, AZleader went beyond the press releases and news documents to read the actual report itself, something real historians do and journalists used to a long time ago.  He makes some good points (emphasis is mine):

Politicians and Press Releases

Shock of shocks! What you read in politician press releases doesn’t always jive with unbiased, objective truth. Politician press releases, as is true in the Sanders one, are often a mixture of fact and false implication crafted toward a political agenda.

It is not casual reading but ya gotta study the small print of the GAO’s very complex 253 page report that Sanders based his press release on to get to fundamental truths:

  1. The $16 trillion in “secret” Fed loans are not loans. They are MOSTLY innocuous financial services transactions provided by The Fed for which it was paid banking fees.
  2. There is nothing “secret” about the loans. According to the GAO Report all information it includes is in existing publicly available annual financial statements of the 12 federal reserve banks.
  3. The GAO audit isn’t “The first top-to-bottom audit of the Federal Reserve” as Sanders’ claims.  It isn’t even remotely close to that. Such an audit was proposed by Congressman Ron Paul and others but, as often happens in Congress, it got watered down in Dodd-Frank.
  4. The GAO audit is very limited in scope. It covers only temporary emergency loan programs between December 1, 2007 and July 21, 2010.

The main outcome of The Fed audit was to make recommendations on how The Fed can protect itself against exposure as the “lender of last resort” in emergencies.

Almost all the $16 trillion in transactions by The Fed are money swaps or very short-term 82 day or less collateralize loans to banks.

In other words, not only was The Fed not “out of control” as I noted, but it was instead actually doing what a central bank is supposed to do:  act as lender of last resort, facilitate transactions between banks, and facilitate international currency exchange — the precise things The Fed didn’t do so well in 1929-1933 and we paid for it with a Great Depression.

He also points out that while

…two CEOs were involved in conflict of interest situations. JP Morgan CEO, Jamie Dimon, and NY Fed Bank President, William Dudley, were both in positions of conflict of interest during the crisis.

The Fed was in a crisis mode and needed all the expertise it could get, even at the risk of having some conflict of interest.  I would agree that given the situation at the time, it was probably necessary to involve Dimon and Dudley.  However, what I fault The Fed for is for not having been prepared for such a situation.  The Fed has been too cozy with the banking executives for too long and too slow to move when changes in the industry or markets create a possible conflict of interest.

I agree with AZleader also in noting how the real scandal, the real damning information in the audit hasn’t gotten the attention it deserves.  Specifically:

….The vast majority of actual dollars spent by The Fed was in the “Agency Mortgage-Backed Securities Purchase Program“.

That isn’t even a loan program at all.

That program was created “to support the housing market and the broader economy”. It bought up all the toxic home mortgage loans approved by and backed up by Fannie Mae and Freddie Mac, the home mortgage lending giants.

The Fed had to buy all of Freddie and Fannie’s bad debt because it was required by law. Both companies are government sponsored enterprises (GSEs) created by the government. Those companies went into government receivership in September of 2008.

The total real dollar net purchases in that program was $1.25 trillion. Some of those assets have since been sold. There is still a $909 billion debt balance outstanding.

The Fed paid out about $80 billion in investment management fees to outside vendors, all of them American companies

Again, the problem here isn’t so much that they bought the Freddie and Fannie debt. Something had to be done to help “support the housing market”.  The problem is again a lack of foresight, planning, and consideration of alternatives.  In the reality, what The Fed did was prop up Freddie, Fannie, and the big banks involved in wholesaling mortgages and the MBS market.  The way it was done didn’t really address the fundamental issues in the housing and mortgage market, as evidenced by us being in the fourth year of a continued housing depression, declining house prices, and rising foreclosures.  Sick lenders were a symptom, not the disease in housing.  The Fed only addressed one symptom.  The Fed has also exposed itself to serious losses by taking on much of this mortgage debt.  What options The Fed might have considered is a topic for another discussion.

AZleader and I don’t always agree on a lot of things, but I think we’re close on The Fed audit.  Of course, how we fix The Fed is another topic….

Is The Fed Corrupt or Captured?

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Yesterday I responded to a reader who asked if “The Fed is out of control”.  In short, I said no, not in the sense that critics have charged them with “out of control printing of money” that could produce inflation.  But I left the post with an acknowledgement that the secrecy of The Fed carries some risks.  I said:

…it is unseemly for The Fed to be able to make large loans on favorable terms to banks, loans that save those banks’ managers from failure, without any sunshine or transparency.  It makes fertile ground for corruption.

Today I want to look at the question of whether The Fed, as it is currently constituted, is corrupt.  The Fed has generated a lot of populist anger.  A quick Google search for “end the fed” turns up over 8 and 1/2 million results.  A lot of people seem to feel there’s something wrong here with The Fed, even if they can’t pinpoint what it is.  Typically the charge has been that The Fed has been guilty of creating (“printing”) money too fast and producing inflation.  We’ve seen that’s not true.  Inflation is not our problem and hasn’t been for 20-30 years. Nevertheless, many people feel there must be something wrong.

I tend to agree. First, let’s define corrupt.  From Webster’s online, we see two possible meanings for corrupt:

1…   b : characterized by improper conduct (as bribery or the selling of favors) <corrupt judges>…

3.  : adulterated or debased by change from an original or correct condition <a corrupt version of the text>

Going by this definition, The Fed is corrupt.  It’s characterized by improper conduct and it’s debased from a correct condition (although the original condition wasn’t much better).  Let’s take a closer look to understand problems better.

I’m not accusing The Fed or Fed officials of outright petty bribery.  I don’t think anybody has directly paid off Fed officials or promised personal gains in return for Fed decisions.  It’s more complex than that.  The Fed has become the subject of regulatory capture.  Regulatory capture occurs when an agency of the government is initially established to regulate or control the excessive behavior of some industry.  But then, over time, the industry captures the hearts, minds, and ideologies of the regulators.  The regulators come to function as the protectors and servants of the industry they were supposed to regulate.  Regulatory capture is common anytime the industry involved is complex and technical.  Experts have to be hired as regulators but the best source of experts on the industry is the industry itself.  The problem is made worse when the regulated industry is able to pay much higher salaries than the regulatory agency.  Wikipedia tells of a few examples from The Fed:

Federal Reserve Bank of New York (New York Fed)

The Federal Reserve Bank of New York is the most influential of the Federal Reserve Banking System. Part of the New York Fed’s responsibilities is the regulation of Wall Street, but its president is selected by and reports to a board dominated by the chief executives of some of the banks it oversees.[39] While the New York Fed has always had a closer relationship with Wall Street, during the years that Timothy Geithner was president, he became unusually close with the scions of Wall Street banks,[39] a time when banks and hedge funds were pursuing investment strategies that caused the 2008 financial crisis, which the Fed failed to stop.

In the wake of the financial meltdown, Geithner became the “bailout king” of a recovery plan that benefited Wall Street banks at the expense of U.S. taxpayers.[39] Geithner engineered the New York Fed’s purchase of $30 billion of credit default swaps from American International Group (AIG), which it had sold to Goldman Sachs, Merrill Lynch, Deutsche Bank and Société Générale. By purchasing these contracts, the banks received a “back-door bailout” of 100 cents on the dollar for the contracts.[40] Had the New York Fed allowed AIG to fail, the contracts would have been worth much less, resulting in much lower costs for any taxpayer-funded bailout.[40] Geithner defended his use[40] of unprecedented amounts of taxpayer funds to save the banks from their own mistakes,[39] saying the financial system would have been threatened. At the January 2010 congressional hearing into the AIG bailout, the New York Fed initially refused to identify the counterparties that benefited from AIG’s bailout, claiming the information would harm AIG.[40] When it became apparent this information would become public, a legal staffer at the New York Fed e-mailed colleagues to warn them, lamenting the difficulty of continuing to keep Congress in the dark.[40] Jim Rickards calls the bailout a crime and says “the regulatory system has become captive to the banks and the non-banks”.[41]

Regulatory capture isn’t limited to only the possibility that a regulators’ decisions might be influenced by their personal future employment prospects.  It also involves ideology and group think.  The regulators spend their time, both professional and personal, mixing with the regulated.  They come to think alike.  Professor Steven Davidoff writes at Deal Book:

Instead, we have ideological and social capture of the top regulators. This is an issue that trumps what can be a model regulator at the bottom where the line people are quite competent, able and uncaptured, but the message from the top skews their effectiveness….

For an example of social capture at the top, one need only look at the publicly available calendars of Treasury Secretary Timothy F. Geithner and his predecessor, Henry M. Paulson Jr. The people regulating the financial industry largely come from that industry or look to that industry for their social interactions. They play squash with them and dine with them, and these are the peers they look to when they have issues to discuss. Jo Becker and Gretchen Morgenson of The New York Times documented this ably in their April 2009article on Mr. Geithner’s social interactions during his time as head of the Federal Reserve Bank of New York.

Lawrence H. Summers may not be as social, but even he worked at a hedge fund in the year leading up to his current position in the White House.

Among these people, there is no evil or nefarious plot to regulate in favor of the banks. These men and women may believe they are doing their best, but their worldview is affected by the people they interact with. This is a problem that can be exacerbated by a revolving door between finance and regulators.

This social influence can be affected by an additional factor: ideological capture also at the top. This occurs when regulators are appointed who share the same beliefs and ideas as their industry. A prime example of this is Alan Greenspan, the former Federal Reserve chairman, who was a devotee of Ayn Rand and objectivism and a fierce devotee of free markets. He no doubt was acting in good faith and true belief; the financial industry benefited from the fact that he shared their ideology

James Kwak and Simon Johnson, the authors of the book 13 Bankers, have written extensively about the regulatory capture of The Fed and the resulting improper conduct and debased condition of the world’s largest central bank. The book is worth checking out, as is their blog The Baseline Scenario.  Bill Moyers interviewed them for PBS on these topics. You can watch the video or read the transcript here.

The evidence is extensive that The Fed has become captured by the very banks it is supposed to regulate.  The Fed now sees it’s mission as first and foremost as protecting Wall Street, the banks, and the financial system.  The audit of The Fed in July 2011 confirmed that problems existed with conflicts of interest:

The audit also found that the Fed mostly outsourced its lending operations to the very financial institutions which sparked the crisis to begin with, and that they delegated contracts largely on a no-bid basis. The GAO report recommends new policies that would eliminate such conflicts of interest, and suggests that in the future the Fed should keep better records of their emergency decision-making process.

It was evident before that.  I March 2010 I recounted how Nobel-prize winner Joseph Stiglitz accused The Fed of being corrupt and said if a developing nation had a central bank like The Fed, we’d pressure them to change.  So, yes, The Fed is corrupt because it has been captured.

 

Is The Fed Corrupt or Out of Control?

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The Federal Reserve System is an extremely controversial and largely misunderstood institution. Senators on both the right (Ron Paul) and the left (Bernie Sanders) are highly critical of The Fed.   I’ve shied away from commenting on The Fed because it’s  a pretty complex subject. Every time I think there’s a point to be made, I find it requires explaining some other point, which leads to yet another, and on and on.  It’s always seemed too daunting.  I could never figure out where to start.  But a reader asked last week for my thoughts about The Fed audit, so I’ll make an effort:

What’s the meaning of the audit of the Federal Reserve Bank that has just been completed? I am hearing from friends that the revelation of loans made to banks by the Fed is evidence that they “are out of control” and doing something corrupt or dishonest. I find that hard to believe.

At the risk that I’ll have a few “I’ll explain this later” points in this post, let’s talk about The Fed and whether it’s corrupt.  Let’s start with the results of the audit of The Fed which were released in July 2011 in response to a Congressional bill requiring a one-time public audit of The Fed..  The Raw Story summarizes the report for us and also has an embedded copy of the audit results for those interested:

The U.S. Federal Reserve gave out $16.1 trillion in emergency loans to U.S. and foreign financial institutions between Dec. 1, 2007 and July 21, 2010, according to figures produced by the government’s first-ever audit of the central bank.

Last year, the gross domestic product of the entire U.S. economy was $14.5 trillion.

Of the $16.1 trillion loaned out, $3.08 trillion went to financial institutions in the U.K., Germany, Switzerland, France and Belgium, the Government Accountability Office’s (GAO) analysis shows.

Additionally, asset swap arrangements were opened with banks in the U.K., Canada, Brazil, Japan, South Korea, Norway, Mexico, Singapore and Switzerland. Twelve of those arrangements are still ongoing, having been extended through August 2012.

Out of all borrowers, Citigroup received the most financial assistance from the Fed, at $2.5 trillion. Morgan Stanley came in second with $2.04 trillion, followed by Merrill Lynch at $1.9 trillion and Bank of America at $1.3 trillion.

The audit also found that the Fed mostly outsourced its lending operations to the very financial institutions which sparked the crisis to begin with, and that they delegated contracts largely on a no-bid basis. The GAO report recommends new policies that would eliminate such conflicts of interest, and suggests that in the future the Fed should keep better records of their emergency decision-making process.

The Fed agreed to “strongly consider” the recommendations, but as it is not a government-run institution it cannot be forced to do so by lawmakers. The seven-member board of governors and the Fed chairman are, however, appointed by the President of the United States and confirmed by the Senate.

The audit was conducted on a one-time basis, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year. Fed officials had strongly discouraged lawmakers from ordering the audit, claiming it may serve to undermine confidence in the monetary system.

The big news, judging by both Ron Paul’s and Bernie Sanders’ reactions is the three-fold fact that The Fed provided loans (or their equivalent in asset swaps) to large banks and governments to the tune of $14.5 trillion “in secret”.  The first concern is the size of the actions. The second concern seems to be that some of these banks and governments were foreign. And the third is that the loans were secret. I think the conflicts of interest and poor decision making processes are bigger issues uncovered by the audit. But I’ll get to that later in this post.

Before we can conclude The Fed is “out of control” or corrupt we need to look at what The Fed is supposed to do.  The Fed, being the central bank for the U.S., is responsible for:

  • maintaining the health of the U.S. banking and financial system and institutions.  It does this by regulation of those institutions and by being lender of last resort in a crisis.
  • conducting monetary policy. Legally, The Fed has a “dual mandate” on monetary policy. It is supposed to:
  1. maintain price stability (in other words, avoid inflation or deflation)
  2. maintain full employment

The critics from the right tend to be followers of Austrian economics (Ron Paul) or far-conservative and libertarian. These are the ones most likely to claim The Fed is “out of control”.  What they generally mean (a typical example is here) is they think The Fed has created too much money and is debasing the currency.  There’s very little The Fed can do that would satisfy most of these people other than to shut down and ask the government to return to a gold standard.  Their concerns about the $14 trillion in loans being inflationary and “newly printed money” reveal deep misunderstandings about the nature of money (a post yet to be written), the functioning of the financial system, and even the nature of inflation.  They make a big deal of the size of the loans by comparing them to real GDP.  That’s apples to oranges.  To figure out if the $14 trillion in loans was large, it should be compared to the total balance sheet of the banking system, not GDP.   Yes, the loans The Fed made were of record amount, but so was the crisis. The Fed has a duty to act as lender of last resort in a financial crisis.  It did that. And it largely avoided the scale of disaster that occurred in 1929-1933 when The Fed failed to act as lender of last resort and was complicit in creating The Great Depression, snuffing out thousands of banks in the U.S. and depositors’ savings with it.  So if “out of control” means The Fed is wildly “printing money”, creating inflation, and debasing the currency, then, no, The Fed is not out of control.

A second charge that both the right and left have leveled is that The Fed shouldn’t have made loans to foreign banks and governments.  In a pure-thought fantasy world of theoretical political economy, I suppose The Fed would be a nationalist institution.  Certainly we expect the central bank of any other nation to be dominated by solely by protecting their own nation’s interests. (in the case of the Eurozone, it would be a great improvement if the ECB gave a hoot about even it’s own).  But reality has to intrude.  The U.S. dollar is the world’s reserve currency. We wanted it that way. More than half of all U.S. money is outside the U.S.  The world’s trading and financial systems depend on the dollar. Given the scale and scope of the crisis in 2008, The Fed had little practical alternative to making loans to some large foreign banks and even some nations.  Nobody else could do it.  The alternatives were too nasty.  Should it be regular practice? No. Should it be encouraged? No. Should we second guess the middle of the crisis when nobody else was stepping up?  Probably not.  Should we think about how to handle it better in the future so we don’t have to rely on The Fed?  Yes.  Have we thought about it and changed? No.  So the second charge of being “out of control” as evidenced by making foreign loans doesn’t really hold up.

The third charge, the question of “secrecy” in the loans is more difficult.  On the one side, it is unseemly for The Fed to be able to make large loans on favorable terms to banks, loans that save those banks’ managers from failure, without any sunshine or transparency.  It makes fertile ground for corruption.  On the other hand, banking is a confidence game. Publicizing loans to banks, even when part of the normal course of affairs, can be misinterpreted by the public, fund managers, or other banks.  It alone could spark a run on a bank. The run then creates the very crisis the loan was intended to avert, turning temporary liquidity crisis into permanent bank failure.

Some fear of the secrecy of these loans is driven by a misunderstanding of what The Fed loans and where it comes from.  Again, this arises from common misunderstandings of what money really is or where it comes from.  Many fear the “money” The Fed lends is money that had to come from somewhere (they suspect taxpayers) or diverted from some other useful purpose.  Not so.  The Fed doesn’t actually lend “money” in the sense that you and I have “money” to spend.  The Fed creates new bank reserves out of thin air.  It’s not spending money and it’s not scarce. The Fed can as easily remove these reserves later in the future.

So, is The Fed “out of control”?  I don’t think so in the way that many critics make the accusation.  Just because I don’t think The Fed is some “out of control money printing machine” doesn’t mean I think The Fed is innocent or doesn’t need to be changed.  The audit revealed other issues regarding decision-making and transparency that I find much more troubling.  They reveal that The Fed has fallen into a kind of “group think” that doesn’t serve the nation well.  I think The Fed is both misguided and poorly structured.  But I’ll deal with that in tomorrow’s post.

The Fed is a Rorschach test.

The Quantity Theory of Money and Fears of Inflation Are Nonsense

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We rarely get to conduct scientific experiments in economics, but for the last 3+ years The Federal Reserve has unintentionally conducted a test of an economic theory called the “Quantity Theory of Money” (QTM). QTM makes some very specific predictions – predictions that Ron Paul, conservatives on Wall Street, and others have been repeating a lot.  Unfortunately for them, QTM has failed the test.

First, some background on the theory. The QTM is and has been one of the foundations of both monetarist thought and Austrian economic thought.  In it’s base form, it’s based on an accounting identity that must, by definition, be true.  The notation sometimes varies, but the quantity theory of money is based on a definition called the equation of exchange.  This equation goes like this:

M times V = P times Q
where:
M: Money supply
V:  velocity of money, or the number of times the average dollar changes hands and is spent during the same time period as Q is measured.
P:    price level
Q:   real GDP (sometimes real National Income, Y, is used – same thing essentially)

So what does the equation say?  If you look at the left hand, M x V, you get a representation of the total spending in the economy.  It’s how much money was in circulation times the number of times that money was spent.  The right side, P x Q, gives us the value of nominal GDP.  It’s the value of all the real stuff we bought (Q, real GDP) times the Price level P which translates it into today’s prices.  Put the two sides together and you’ve got total nominal spending in money terms must be the same as the total value of the things we bought.  Duh.  Of course it is.  It’s an identity.   It’s the macro equivalent of saying that if I spend $5 each time (M) on 7 trips to the grocery (V) to buy 70 apples (Q) at $0.50 each (P), then I will spend $35 on $35 worth of stuff.

As an identity definition it’s not really very interesting.  It’s when economists begin to use it as a model of future outcomes that problems arise.

The typical way QTM is used, and the simple way folks like Ron Paul and a lot of folks who are upset at Federal Reserve efforts to stimulate the economy, is by thinking of what happens when M, the money supply, is suddenly increased.  The thinking is that an increase in M must result in an increase in P in order to keep the equation balanced.  This is the foundation of modern inflationary fears in the last  few years.  Typically folks using the QTM this way don’t say things like “an increase in M must lead to an increase in P”.  They say things like “The Fed is printing money like mad and that’s going to lead to inflation”  since an increase in the price level, P, is how we measure inflation.

But there’s actually four terms in this equation.  Any of them can change.  That’s where assumptions come in.  The advocates of QTM, whom I’ll call “inflation-phobes” for the moment since they’re always fearful of inflation, make some strong assumptions.  They assume three big things.  First, they assume that the velocity, V, is constant.  In other words, according to them, you and I always spend our money at exactly the same rate. Suppose I spend my whole paycheck every two weeks now.  They assume that I’ll always spend my whole paycheck every two weeks no matter how big or small that check is or whether I’m suddenly fearful of losing my job next month.  The evidence for the constant velocity assumption is weak.  You be the judge using the St.Louis Fed data:

To me, that doesn’t look constant.  If V is constant, then any increase in M also increases spending, MxV.  But if V isn’t constant, then an increase in M can be offset by simultaneous slowdown in velocity.

The next assumption is that real GDP is always at capacity.  In other words, there is no unused capacity in the economy such as unemployed workers or empty office buildings or factories running only 1 shift when they can run 2.  This is assumption is essential to the inflation-phobes because it means that Q can’t be increased.  This is necessary to their desired outcome because it would imply that the only way for PxQ to rise to meet an increase in MxV is by having P increase.  I won’t go to the trouble of showing data and graph to prove that Q isn’t at capacity.  If you have doubts, see last week’s update on employment and GDP.

There’s one more unstated assumption by the inflation-phobes.  They assume that any increase in base money, which is primarily the bank reserves The Fed makes available to commercial banks, will necessarily translate into M1, money in circulation among the public.  This too is a bad assumption.  There times, like the last 3 years, when commercial banks don’t want to or can’t lend.  In times like this bank reserves just sit there on the books safely tucked away from any kind of productive economic activity or spending.  The Fed can push reserves onto the banks’ books, but it can’t turn those reserves into loans or spending by customers. Another weakness in this assumption is the idea that even if the money ends up in private hands it will be used for spending on goods and services. Instead, what we’ve seen is that much of what little lending the big banks have been doing has been to finance financial market trading and speculation – things like oil futures.  Speculating in oil futures isn’t the same thing as actually refining and selling oil.  The speculation doesn’t create jobs and isn’t part of the circular flow. Production is.

So we’re back to the question of testing the QTM theory.  The QTM theory of money as inflation-phobes express it, says that increases in base money (M) necessarily must result in inflation (increases in P) at some time in the near future.

In 2008 and 2009 The Federal Reserve expanded bank reserves greatly.  It expanded the monetary base dramatically.  The Fed invented a variety of new names and methods for doing it, although almost all of them involved The Fed buying some kind of bond, security or financial asset.  If the QTM theory and the hard-money inflation-phobes are right, there should have been a dramatic increase in inflation.  They predicted it.  Again and again.  It simply hasn’t happened.  Paul Krugman put together an nice little graph showing the failure of the QTM theory:

The thing is, of course, that the past three years — the post-Lehman era during which the Fed presided over a tripling of the monetary base — have been an excellent test of that model, which has failed with flying colors. Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t):

A couple of notes: for the commodity prices it matters which month you start, because they dropped sharply between August and September 2008. I use the IMF index for convenience– easy to download. (Thomson Reuters I use when I just want to snatch a picture from Bloomberg). But none of this should matter: when you triple the monetary base, the resulting inflation shouldn’t be something that depends on the fine details — unless the model is completely wrong.

So, we’ve had a test, a pretty substantial test of the Quantity Theory of Money and the assumption that any increase in monetary base must lead inevitably to an increase in prices and inflation.  The theory has failed.  It should be put to rest.  Milton Friedman, a man as responsible as any other for pusing QTM, once famously claimed that “inflation is anywhere and everywhere always a monetary phenomenon”.  He was clearly wrong, there’s more involved than just base money growth.

Rhetoric Is A Powerful Tool To Advance Moneyed Interests

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Money is essential to a successful economy.  But it’s money in circulation that’s useful.  Money that’s locked up in storage in vaults and savings doesn’t help.  The early economists understood this well and often used the analogy of money-is-to-economy as blood-is-to-human-body.  Circulating money, money that is used to buy things is as important to the economy as the blood in your arteries and veins.  The analogy works.  It leads us to realize that money, and more of it, can and usually is a good thing.

The analogy, however, doesn’t work for those economists and policy-makers who want are more interested in enabling the top 1% or so to profit at no risk by earning income on holding money.  Theoretically, the rich, the top 1%, could earn income from their large stores of wealth by investing it in production.  But the profit-by-investment-in-production method requires risk. It’s hard. It requires work to find and exploit good investment opportunities. From the perspective of the really wealthy, it can be more desirable to make money by simply owning money.  To do that, it’s necessary to that there be no inflation. They actually prefer deflation because then their cash wealth gets more valuable without being risked or used productively at all. The other approach to making money without risk by simply owning money is to lend it. Instead of starting, owning, and building a business, investing in equity, you make loans. Ideally you use your wealth and influence to get politicians to guarantee your loans – heads you win and tails somebody else loses. These approaches to making money by simply owning money require that money be scarce and hard to get.  It’s directly counter to the money in circulation paradigm.  A circulatory system deprived of money is good thing those who make money from money instead of labor.

But to persuade the mass of people, the 99%, the ones earning money from labor, it’s necessary to change the metaphor.  That’s been rather effectively in the second half of the 20th century.  It’s been done by extending a different metaphor.  Economists have long used the word liquidity for the idea of how easy it is to convert an asset into cash and therefore spent. For example, real estate (particularly in this market) is very illiquid.  I could own a $1 million house but be unable to buy a Coke from the 7-11 store because I lack any cash.  That’s an extreme example of illiquidity.  In contrast, a liquid asset is one that is either actually cash or easily turned into cash so it can be spent.  There’s a whole range of assets in between with varying degrees of liquidity.

This idea of liquidity and it’s association with cash has been used to push a metaphor that suggests the problem is too much money in the economy.  We’re peppered with phrases like “drowning in debt” or a house mortgage that is “underwater”.  It makes us feel that the liquid stuff is undesirable.  So we get  a central bank that’s reluctant to create and inject money into the economy because critics claim that will create too much liquidity and they falsely claim that it’s inflationary.  When the central bank does increase inject liquidity into the economy, it does it by getting the money to precisely the people who keep it from circulating.  We get a government that refuses to use it’s ability to directly inject money into the economy and get it into circulation.

Government ultimately is the source of all money.  Only government can define and create money.  It has two ways to do it. It can simply create (“print” or “mint” if you will, but it’s not that way anymore) money and spend it.  That puts money immediately into circulation in the circular flow of goods and services.  Or, the government could create money reserves for the banks, a riskier strategy.  The banks then can lend using a fractional reserve logic.  If the banks lend out the reserves, then money is created.  If the borrowers from the banks spend the borrowed money, then it’s in circulation.  If the borrowers use the money to simply buy other financial assets, then it’s not in circulation and is sterile.

In our modern system, the government (in the U.S. and many other nations) has delegated the responsibility for creating money and putting it into circulation to quasi-private central banks such as The Federal Reserve Bank.  In today’s workings of the financial system, these central banks have further delegated the responsibility and decision-making on money-creation to private commercial banks by providing reserves for whatever level of loans they choose.  When those banks choose not to create money or choose not to create and provide money in a way that puts it into circulation, the system suffers. We suffer from too little liquidity.

Daniel Becker at Angry Bear made this point very well in a long post there in June 2011.  He points out that we should really talk about “dehydrating in debt”, not “drowing in debt”.  The dehydration metaphor leads us directly to the solution – more money in circulation.  I from the conclusion to his post:

Got that? Let’s summarize: The share of income to the 99% of people declined from 1976 onward. At the same time the means of making money changed from labor production to money manipulation (producer economy to finanicialized economy) adding to the reduction in share of income. We also changed the ideology to one from relying on the vast population (as represented by the individual and We the People) to relying on a small portion of the population to distribute what money was created. We did this for 33 years. By 1996, people were borrowing as a means to sustain their standard of living (not increase it). If the people are not spending to increase their standard of living, then is the economy really growing? By 2006 people were no longer able to make the payments and consumption was declining.  Then gas hit $4/gal and winter heating was looking like another $4000 to $6000 would be needed.

To date, nothing has been done to address this. Nothing at all. And, by “this” I mean, the income inequality that has resulted in an an economy where a very small group of people (top 1%) are taking money out of the system (that is money that would fuel the engine) faster than the engine can make it which results in an ever faster declining share to the rest of the people. Instead, we have refined new fuel and dumped it right into the top 1%’s hands and wonder why the engine is still sputtering?

One other issue I have with framing and the words used today: Under water.

People are not under water. They are not drowning in debt. On the contrary, people are dehydrating. They are starving for water. Do you know what the symptoms are of dehydration? You get thirsty and then urinate less to conserve water. (debt spending) Then you stop making tears and stop sweating. (can’t borrow) Eventually your muscles cramp, the heart palpitates and you get dizzy. (close to bankruptcy, voting against your interest) Let it go long enough and you get confused, weak and your coping mechanisms fail. (Tea Party, etc) In the end, your systems fail and you die. (recession)

People are dehydrating and Washington is doing nothing about it because they believe it is drowning.  They are throwing out life boats to people in a desert.  That is the chart Ken linked to.

The Economy Has Caused Riots Before – In the Great Depression

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Washington’s Blog reminds us that things got ugly during the last prolonged depression in the United States.  This interesting historical footage from the Great Depression shows what happens when large numbers of people are unemployed for years at a time, get desperate, and perceive that the game is rigged to the benefit of Wall Street.

This depression isn’t as deep or severe as the Great Depression – the bank bailouts and the 2009 Obama stimulus spending/tax cut bill (ARRA) made sure of that.  But as this week’s GDP numbers show, we simply aren’t growing enough to fully recover.  For workers, the nightmare is real.  With the #OccupyWallStreet movement (#OWS) growing stronger, spreading, and continuing now for well over 6 weeks, perhaps the Wall Street banks are having nightmares of their own about such scenarios as what happened in the video.  Could that be why JP Morgan Chase bank is making such large payoffs donations to the New York City Police department?  Yves Smith at Naked Capitalism fills us in:

Is JP Morgan Getting a Good Return on $4.6 Million “Gift” to NYC Police? (Like Special Protection from OccupyWallStreet?)

No matter how you look at this development, it does not smell right. From JP Morgan’s website, hat tip Lisa Epstein:

JPMorgan Chase recently donated an unprecedented $4.6 million to the New York City Police Foundation. The gift was the largest in the history of the foundation and will enable the New York City Police Department to strengthen security in the Big Apple. The money will pay for 1,000 new patrol car laptops, as well as security monitoring software in the NYPD’s main data center.

New York City Police Commissioner Raymond Kelly sent CEO and Chairman Jamie Dimon a note expressing “profound gratitude” for the company’s donation.

“These officers put their lives on the line every day to keep us safe,” Dimon said. “We’re incredibly proud to help them build this program and let them know how much we value their hard work.”

…

But what, pray tell, is this about? The JPM money is going directly from the foundation to the NYPD proper, not to, say, cops injured in the course of duty or police widows and orphans…

And look at the magnitude of the JP Morgan “gift”. The Foundation has been in existence for 40 years. If you assume that the $100 million it has received over that time is likely to mean “not much over $100 million” this contribution could easily be 3-4% of the total the Foundation have ever received.

Now readers can point out that this gift is bupkis relative to the budget of the police department, which is close to $4 billion. But looking at it on a mathematical basis likely misses the incentives at work. Dimon is one of the most powerful and connected corporate leaders in Gotham City. If he thinks the police donation was worthwhile, he might encourage other bank and big company CEOs to make large donations.

And what sort of benefits might JPM get? It is unlikely that there would be anything as crass as an explicit quid pro quo. But it certainly is useful to be confident that the police are on your side, say if an executive or worse an entire desk is caught in a sex or drugs scandal. Recall that Charles Ferguson in Inside Job alleged that the use of hookers is pervasive on Wall Street (duh) and is invoiced to the banks.

Or the police might be extra protective of your interests. Today, [Oct 5] OccupyWallStreet decided to march across the Brooklyn Bridge (a proud New York tradition) to Chase Manhattan Plaza in Brooklyn. Reports in the media indicate that the police at first seemed to be encouraging the protestors not only to cross the bridge, but were walking in front of the crowd, seemingly escorting them across…

The wee problem is that the police are in the street, and part of the crowd is also on the street (others are on a pedestrian walkway that is above street level). That puts them in violation of NYC rules that against interfering with traffic. Note the protest were aware fo the rules; they were careful to stay on the sidewalk on the way to the bridge.

…some (many?) the protestors who used the walkway and got across the bridge were also corralled and not permitted to proceed to the Chase plaza. Greg Basta, deputy director of the New York Communities for Change, told me by phone, based on multiple reports from people who participated in the march, that as soon as protestors got to the Brooklyn side of the bridge, they were kettled. Greg was under the impression that there were construction barricades at the foot of the bridge which made it impossible for the marchers not to walk on the street. Because the focus has been on the what happened on the bridge, the coverage of what happened to the rest of crowd is sparse.

Some confirmation in passing comes from MsExPat at Corrente (apparently some of the very first off the bridge were permitted to proceed):

My friends and I made it to the Brooklyn side okay–we ended up with about 350 other marchers in Cadman Plaza, a lovely 19th century park. What I didn’t find out until later is that several hundred people behind me also got kettled and barred from going all the way to Brooklyn. So I was among the lucky marchers in the middle.

But notice even then that the procession to Chase Manhattan Plaza [correction, Cadman Plaza} was effectively barred. [Note JPM may have operations nearby, Bear Stearns had much of its back office there, and if the leases were cheap, JPM may have kept the space].

We simply don’t know whether the police would have behaved one iota differently in the absence of the JP Morgan donation. But it raises the troubling perspective that they might have. …

So far, the JP Morgan donation is an isolated example. But the high odds of continuing deep budget cuts at the state and local level open up the opportunity for corporate funding of preferred services, and with it, much greater private sector influence on the apparatus of government. This is a worrisome enough possibility to warrant a high degree of vigilance by all of us.

Banks Want to Do To Student Loans What They Did to Mortgages

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On the heels of yesterday’s post about student loans and their growth.  I want you to know that Wall Street is hot on the problem.  They’ve made a quiet proposal to the “supercommittee” that’s supposedly addressing government deficits to have the government subsidize the banks via fees without creating any more student loans or taking on any risk.  The essence of the whole proposal is to leave the government on the hook for student loans but to use accounting tricks to “take them off the books”.  It’s similar to the ways the big banks prior to the crisis would take debt and obligations they had and hide them in “special purpose entities” so they wouldn’t have to show them on their books.  There’s no benefit to investors, students, or the government from the proposal. Only the banks benefit.  But maybe that’s why they aren’t talking about the proposal in public but instead try to get it passed quietly through lobbyists.

Jason Delisle of New America Foundation’s Higher Ed Watch explains (bold emphases are mine):

The investment banking industry – and its friends in Congress – have cooked up a scheme they are pitching to the “supercommittee” that they say would reduce the federal debt and cut federal spending. Supposedly, the plan would take the government’s $555 billion direct student loan holdings off of its books. In reality, the plan, which would allow the bankers to earn fees on a $555 billion deal, plus $100 billion more every year, would not reduce the debt or cut spending. But that hasn’t stopped Wall Street from trying.

A proposal that could only have been be cooked up by investment bankers is circulating on Capitol Hill. It would refinance the $555 billion direct student loan portfolio with new debt backed 100 percent by the federal government. But this new debt would not be called U.S. Treasury debt, despite the 100 percent guarantee, and therefore not counted as part of the national debt. In other words, the new debt would be used to pay off the old debt (Treasury bonds) that the government issues to finance direct student loans. To be sure, the mechanics of the proposal are more complicated than that, but the effect of the proposal would be to move all outstanding and future student loans from bonds backed 100 percent by taxpayers to another set of bonds backed 100 percent by taxpayers but not counted as part of the national debt. …

The proposal would increase federal spending because the new securities the government would issue to finance direct loans would have higher interest costs than the Treasury bonds they would replace, effectively increasing the cost of every direct loan. Investors would view the new securities as slightly less desirable than Treasuries (even though they still carry a 100 percent guarantee from the federal government) because they will not be as liquid (easily bought and sold among investors). The new securities would also be subject to prepayment risk…Then there are the fees that the government would have to pay to investment banks (the “syndicate of underwriters”) to put the new securities on the market each year. Those fees could cost taxpayers tens or even hundreds of millions of dollars every year.

Apparently the supporters of the proposal claim that it would “diversify funding sources”.  In other words, if someday, somehow, some investors wouldn’t want to buy U.S. Treasury bonds (something is emphatically NOT happening now since interest rates are at record lows), then maybe they might be interested in something that’s backed by the U.S. but isn’t called a Treasury bond.  In other words, there’s a slight chance that pigs might someday fly away from the farm so let’s have a bunch of hogs that well call “pink cows”.  Jason speaking again:

Some members of Congress – particularly Republicans – would simply feel better if the direct loan program were funded with “private capital” rather than U.S. Treasury bonds….[but] the securities would be sold in the same markets as Treasury bonds and the capital raised to finance direct student loans would be no more or less “private” than it was before.

If the Wall Street proposal to refinance direct student loans doesn’t actually reduce the debt, increases the federal budget deficit, and doesn’t make the program’s financing any more dependent on the private market than it already is, what does it do? It effectively addresses what some see as the direct loan program’s biggest shortcoming; it doesn’t allow Wall Street to make a ton of money off of it.

So Wall Street wants to do to student loans what it’s done to home mortgage finance.  Have somebody else, such as the federal government, guarantee that they cannot lose any money.  Then, they want to bundle them and re-sell them solely for the purposes of making more fees – just like they did with mortgage-backed securities and credit default swaps and other derivatives.  If I recall correctly, that didn’t really work out too well now did it?  Well it worked out for the banks, but not for the rest of us.

Warning: More Bank Bailouts Possible

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One area I haven’t commented on much is the ongoing European “debt crisis”.  The Greek debt crisis is a part of it, but it’s only the tip of the iceberg.  The roots are much deeper.  One reason I haven’t commented is because it’s fairly complex and requires a lot of background explanation which I haven’t had time to write.  Nonetheless, it’s something worth mentioning.  In particular because it’s likely to mean more big bank bailouts.

In short, the crisis involves the way the Euro currency zone is constructed.  Countries that use the Euro have surrendered their sovereignty on monetary policy – that’s now the purview of the European Central Bank (ECB).  This means that government debt levels do matter for countries in the Euro.  They can default because they don’t have control over their own currency.  The U.S., Japan, UK, Canada, Australia, and others can’t default because they control their own central bank and currency.  But Euro countries can.  In the case of Greece and Ireland this means a high likelihood of default.  When the global economy crashed three years ago, it sent the economies of most countries down.  This raised the debt-to-GDP level by reducing the denominator, the GDP number.  But a country in a recession needs to increase government spending and deficits to stimulate growth.  Instead, the construction of the Euro agreement and pressures from the ECB forced these countries to pursue an austerity-based policy of cutting government programs.  But the cutting of government spending has only worsened the recession and shrunk their GDP even more, reducing tax collections.  It’s made default more likely.

In the Greek case, default appears inevitable.  The question is how much of a loss do bondholders take and when.  Therein lies a problem.  The people who own the Greek debt are largely big French and German banks. These banks themselves aren’t exactly robust.   If Greece defaults at a level that will actually help Greece find it’s way out instead of simply delaying the crisis, then these banks will likely take very heavy losses.  The losses are large enough to jeopardize the solvency of the banks themselves.  So Greek default also means figuring out how to recapitalize these big banks.  These are so-called “too big to fail banks”.

Currently there are negotiations going on about how to structure a  Greek default, simultaneously prop up the Euro banks, and stop a possible contagion effect from spreading to Ireland, Portugal, Spain, Italy, and Belgium.  But there have been negotiations over this crisis for nearly two years now with much successs.  The German and French leaders have promised a comprehensive solution later this week. It was supposed to be today, but it’s been delayed to mid-week.

What does that have to do with the U.S.?  Nobody really knows.  The devil is in the details.  At first pass, big U.S. banks aren’t supposed to have much exposure to Greek debt, so they shouldn’t be endangered by a large Greek default.  But, the big U.S. banks like Citi, JP Morgan Chase, BofA, and Goldman Sachs have large stakes in the big Euro banks.  A failed Euro bank could have repercussions.  Of greater concern are derivatives, particularly Credit Default Swaps. The U.S. banks, particularly Goldman are known to have been active in selling these derivatives.  Since the derivative markets and positions are largely secret and non-transparent (a failure of the Dodd-Frank Financial Reform bill), we don’t know if a Greek default will trigger significant liabilities for these banks.

In separate news, Bank of America, is on a death-watch by some analysts.  Yves Smith at Naked Capitalism clues us in:

If you have any doubt that Bank of America is in trouble, this development should settle it. I’m late to this important story broken this morning by Bob Ivry of Bloomberg, but both Bill Black (who I interviewed just now) and I see this as a desperate (or at the very best, remarkably inept) move by Bank of America’s management.

The short form via Bloomberg:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation…

Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

Now you would expect this move to be driven by adverse selection, that it, that BofA would move its WORST derivatives, that is, the ones that were riskiest or otherwise had high collateral posting requirements, to the sub. Bill Black confirmed that even though the details were sketchy, this is precisely what took place.

Part of BofA’s problems, well, actually a very large part of it’s problems stem from the loose and possibly illegal banking practices at Countrywide Mortgage which it took over in 2008.  Yves updates us on this here.

Bottom-line on all this:  expect more big bank bailouts of some kind in coming months.  It might only be big Euro banks.  It might only involve Bank of America.  But there’s significant,if less than probable, chance that we’ll have to see another round of bank bailouts.

Too Big to Fail Should Be Too Big to Exist

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Against Monopoly has a great graphic that shows a big part of the problem with our financial sector and our economy.

How the Too Big to Fail Banks Got So Big

How the Too Big To Fail Banks Got So Big

The four banks shown above are the four largest banks in the U.S.: JP Morgan Chase, Citi, BofA, and Wells Fargo.  Together they dominate the financial industry. If you add in Goldman Sachs and Morgan Stanley, the domination is near complete.  They all received large bailouts in the 2008-09 crisis.  Today they are much larger than when we entered the crisis. As the graph shows, none of these banks grew so large by “natural” or “organic” means.  They didn’t grow because they offered better or more efficient services to customers.  They didn’t “win in the marketplace” by competing better.  They simply bought the competition.  It’s domination by merger.  The U.S. banking system which at one time was very competitive and decentralized with literally thousands of very competitive banks is now dominated by a few.  We call it oligopoly on the way to monopoly.

When very, very large banks get too big, they become “Too Big To Fail”.  That means, if the banks were allowed to fail because of bad decisions, bad management, or bad investments, it would set off a domino effect throughout the economy and financial system.  That would punish all of us and not just the bank’s owners.  This, of course, is what happened in 2008 when Lehman Brothers was allowed to fail.  It set off a financial panic where banks wouldn’t / couldn’t loan to each other (or anyone else).  Result:  big bailouts of big banks.

But it doesn’t have to be this way.  Yes, once we have a “too big to fail” bank and it fails, then there’s pretty much no choice but to bail them out.  There are choices about the structure of the bailout. We could have set up the bailouts in a way that the economy wins and the failed managers and bank owners suffered.  We didn’t.  The Federal Reserve, the Bush administration, and then the Obama administration made it a priority to keep the bank managers and bank owners whole.  The economy has suffered from a slow recovery partly as a result.

But bailouts shouldn’t be necessary because we shouldn’t allow the banks to become this big in the first place.  Again, we have a choice.  We could have prevented some or all of these mergers.  The laws are on the books to do it.  Washington, following the failed anti- antitrust philosophy of the Chicago school since the 1980′s simply doesn’t challenge many mergers these days.  It’s bad for campaign contributions.  Besides we’re supposed to believe that a market fairy will make it all right.  Instead of challenging and stopping some of these mergers, both the government and The Federal Reserve have actually facilitated and acted as match-maker for many of the mergers.  In March 2008, when Bear Stearns failed, The Federal Reserve offered a deal to JP Morgan Chase.  If Chase would buy Bear Stearns, The Fed would reimburse Chase for any losses over a set amount.  Heads Chase wins. Tails Chase wins.  Nice deal.

We have other choices as well.  In other industries historically when the private competition in the market led to monopoly or near-monopoly outcomes, the government chose to regulate the industry as a public utility.  We did it in the 1920′s and 1930′s with the electrical industry.  Your local electrical company wasn’t always a regulated utility.  At one time it was ravenous and rapacious private monopoly just like these banks are becoming.  When Standard Oil became a monopoly over a hundred years ago, we sued and broke it up into a bunch of other companies.

This complicity in allowing the big banks to become Too Big To Fail is among the types of policies that the protesters of #OccupyWallStreet want changed.  Me, too.