Thursday, May 28, 2009

Rising Treasury yields

By John Authers, Investment Editor - Financial Times
Published: May 27 2009

There is an old market adage that you should not fight the Fed. The Federal Reserve has more bullets than anyone else.

However, maybe the Fed itself needs an adage not to fight the bond market. The yields paid on US treasuries provide the “risk-free” rates that undergird the world’s financial system. They are set by a ruthless and highly liquid market.

The US masterplan for revival is clear: cut interest rates and buy mortgage-backed bonds and treasuries in enough volume to force down their yields. This makes houses more affordable, so their prices go up, and the banks’ final losses from toxic mortgage bonds will be less.

The problem is the Fed must buy a lot of bonds to achieve this and the Treasury market is disposed to pick a fight.

After Wednesday’s auction of five-year bonds, yields soared. Mortgage rates, which had kept low thanks to tighter spreads over treasuries, capitulated.

By the end of New York trading, the 30-year Fannie Mae mortgage rate had leapt from 4.23 to 4.7 per cent, its highest since December and more than a percentage point above its low. A brief boom in mortgage refinancing was already tapering off, so this is bad news for the Fed (and many others).

The 10-year Treasury yield rose from 3.55 to 3.74 per cent; when the Fed unveiled its plans to buy bonds, it was 2.08 per cent.

Tellingly, the bond uproar turned a quiet day on the stock market into a very bad one. The S&P 500 fell 1.9 per cent.

The spread of 10-year over 2-year yields hit a new high of 2.78 percentage points. This lets banks make easy profits from short-term borrowing (from depositors) and longer-term lending. But it will not redress the damage higher rates could do to the toxic assets on their balance sheets.

Stocks are making a habit of turning south after midday bond auctions. That is a gauge of their profound importance.

Wednesday, May 27, 2009

Banks’ Balance Sheets Continue to Weaken

Following up on my previous report, banks’ balance sheets show no signs of improvements during the first Quarter of 2009. In fact, key ratios demonstrating bank weaknesses have increased—in some instances they have surpassed all-time highs. At the very least, until these figures reverse, all talk about “green shoots” and “economic recovery around the corner” must be taken with exceeding caution. This is what I found.

Net Loan Charge Offs-to-Total Loans at commercial banks increased to 1.75% as of 3/31/09, up from .96 reported during 4th Quarter 2008. The ratio has more than doubled year-over-year from .64 in 3/31/08. This figure is rapidly approaching the 1.81% peak reached 12/31/91 [see here].

Loan Loss Reserves-to-Total Loans ratio increased to 2.64% from 2.30% reported on 12/31/2008 [see here]. In particular to banks whose assets fall between $1 billion to $15 billion, the increase was from 1.89% to the current figure of 2.08% [see here]. For the biggest banks, that is those with assets in excess of $15 billion, the current figure stands at 2.96%, up from 2.53% reported the previous quarter [see here].

Considering Net Loan Losses-to-Average Total Loans, the most recent figure broke the all-time high of 1.6. Currently, the ratio stands at 2.02%, which is more than two times higher on a year-over-year basis [see here]. For banks with average assets of $1 billion to $15 billion, the ratio currently stands at 1.63%, up from 1.22% reported the prior period and getting closer to the peak amount of about 1.8 in 1991 [see here]. For institutions exceeding the $15 billion average assets threshold, the figures continue to be abysmal: The ratio currently stands at 2.35, which breaks the all-time high amount of 2.3 reported in 1990. During the last twelve months, this ratio has more than doubled, which indicates a worsening banking condition [see here]. The next key statistic to consider is Non-Performing Loans-to-Total Loans. You may recall that Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. The current figure stands at 2.19%, up from 1.70% reported the previous quarter and up from .78% reported on 3/31/08 [see here]. At its peak for all commercial banks, the ratio stood at 4.88%, so the trend is evident that the figures will continue to deteriorate. The same ominous gap is present for all banks exceeding $1 billion in average assets [see here, here, and here]

As I stated previously, banks’ balance sheets have deteriorated and will continue to get worse. The trend demonstrates that non-performing loans will continue to increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, are not sufficient to cover the potential losses: In fact, as the Wall Street Journal reported, ratio of reserves to noncurrent loans fell to 66.5% in the first quarter, down from 74.8% in the fourth quarter and the lowest level in 17 years [see here].

US Banks Report 1Q Profit,But Credit Problems Persist

By Michael R. Crittenden

U.S. banks were able to report a first-quarter profit, buoyed by revenues at a few larger companies, but overall the credit picture remained grim as the number of banks on the brink continued to rise and consumers and businesses increasingly fell behind on their loans.

The Federal Deposit Insurance Corp. said Wednesday that U.S. banks reported a net profit of $7.6 billion for the quarter ended March 31, down from the same quarter in 2008, but a sizable improvement from the $36.9 billion loss recorded by the industry in the fourth quarter of 2008.

Though banks were profitable, there were signs that the credit crisis continues to take its toll. The number of banks on the FDIC's "problem" list climbed to 305, the highest level since 1994, and the number of loans more than 90 days past due climbed across all major loan categories.

"The first quarter results are telling us that the banking industry still faces tremendous challenges," FDIC Chairman Sheila Bair said in prepared remarks. "And that going forward, asset quality remains a major concern."

Banks continued to aggressively add to their reserves during the quarter to prepare for expected losses. The FDIC said nearly two out of every three banks increased their loss provisions during the first quarter and that the industry set aside $60.9 billion in loan-loss provisions as a whole.

Despite those actions, banks are increasingly unable to build their reserves fast enough to keep up with noncurrent loans. The ratio of reserves to noncurrent loans fell to 66.5% in the first quarter, down from 74.8% in the fourth quarter and the lowest level in 17 years.

"Troubled loans continue to accumulate, and the costs associated with impaired assets are weighing heavily on the industry's performance," Bair said.

The FDIC said that banks responded to the rising amount of troubled loans by charging off $37.8 billion during the first three months of 2009, led by loans to commercial and industrial borrowers, credit cards and real estate construction loans.

The agency said the high-level of charge-offs did little to slow the rise in loans at least 90 days past due, which increased $59.2 billion during the quarter, as the percentage of loans and leases considered non-current hit the highest level since the second quarter of 1991. The problems were spread across all major categories, though the FDIC said that real estate loans accounted for 84% of the overall increase.

FDIC Chief Economist Richard Brown told reporters that regulators are seeing increasing issues with the commercial real estate market.

"That probably hasn't hit full-force yet," Brown said.

Additionally, the FDIC said the 21 bank failures during the first quarter was the highest quarterly total since the final three months of 1992, and it reduced the fund that protects consumers' deposits to $13 billion from $17.3 billion at the end of 2008.

The FDIC has already taken steps to address the declining fund, voting Friday to charge banks a special fee they project will raise $5.6 billion to replenish the fund. Bair, responding to a reporter's question, said the FDIC has no plans to access its $100 billion line of credit with the U.S. Treasury Department to help stabilize the fund.

"We really don't want to go to that step," she said. "For planning purposes we intend to continue to rely on our industry-funded reserves."

Saturday, May 23, 2009

Why Keynesianism Fails

The Economist is a relatively excellent periodical. They claim to promote “a sever contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress.” There are times where this is not displayed in full measure. Such is the case in a recent article exposing the errors of banks and what can be done about it.

There are two solutions they propose: increase regulation and capital. The last is an absolute must because the events over the last year and half have exposed banks as extremely undercapitalized. The inappropriate marks of assets and liabilities led to the miscalculation of risk. Mathematical models underpriced risk and an undue qualitative judgment of the market environment compounded the problem. Concerning regulation, however, this solution is misaligned. Lack of regulation was the least of the causes that led to the bubble implosion. Subprime mortgage originations, for instance, increased in the earlier part of this decade like never before due to Fannie Mae and Freddie Mac’s interference in the market. These institutions would encourage banks to extend loans to less credit-worthy individuals by subsidizing some of the costs involved in the transaction.

But the most troubling part of enacting additional regulatory burdens as a means of preventing future crisis is the inherent assumption in this action. It requires an omniscient government. Make no mistake, regulation is an absolute must for any market to work efficiently. Nevertheless, more importantly there must be a sense of respect of the law. Regulators are responsible for ensuring market participants are adhering to them, and those that aren’t must be subjected to the appropriate punishments. This is critical and indispensable. Beyond a certain amount of regulatory measures, however, this process becomes burdensome and ineffective. Like any type of business, banking is best practiced under free-market competition. The “too big to fail” de facto policy must disappear. This simply distorts market incentives. Moreover, politicians are ripe to consider “campaign donations” from financial firms in order for the passage of favorable legislation. In other words, the corporate/state nexus would strengthen. As the article points out,
“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant of and bored by regulation. The more a financial system depends on the wisdom of regulators, the more likely it is to fail catastrophically.”

The article was written by a Keynesian supporter, which often without realizing it endorse contradictory statements. Whenever someone supports two views that counter one another, that individual suffers from schizophrenia; or said differently, he/she is confused. This is the core of Keynesianism and why it ultimately fails.

Thursday, May 21, 2009

A new global system is coming into existence

The following is an interesting article that was published in The Economist magazine. I present a critique of its argument in this post. Note that the italized sections of this missive represent The Economist's words, while the bold sections represent my refutations.


ALL monetary and economic systems are a struggle between borrowers, who favour inflation, and creditors, who are determined to maintain the purchasing power of the currency. In a democracy, this is a very fluid battle. The creditors have the money and therefore the ear of the political elite; the borrowers tend to have the votes.

[If an economic system is based on respect for the law in the form of property rights, sound money, and voluntary exchange there is no “struggle” to speak of. The “struggle” arises when perverse incentives get in the way by intervening in the market by government or a government-sponsored agency. ]

Creditors have periodically imposed monetary anchors in an attempt to defeat the borrowers’ lobby. These anchors are devised in prosperous times but run into difficulty during recessions. The gold standard failed to outlast the Depression. For nations with a shortage of gold, the “right” thing to do was to raise interest rates in an attempt to lure gold back; the austerity this imposed on the rest of the economy was politically unacceptable.

[One can write volumes expanding what the author has just claimed. Let’s speak in non-politically correct language. Creditors want sound money, borrowers do not. Creditors hate inflation, borrowers love inflation. The gold standard fomented sound money; as a consequence there was significant price stability. Given man’s unlimited wants, he will borrow if allowed without much hindrance. Too much borrowing always occurs. Borrowers can quickly gather to seek political favors: “I’ll give you my vote if you inflate.” The politician’s answer: “We need to get rid of the gold standard because it doesn’t permit me to inflate.” The borrower than says: “I’ll give you my vote if you inflate.” The politician then answers: “I will serve my constituents,”—which is another way of saying, “I want power.”]

The Bretton Woods era replaced a gold standard with a dollar standard (albeit with the American currency theoretically linked to bullion). The system worked well for more than two decades, helped by the post-war economic boom, particularly in Germany and Japan which began the period with undervalued exchange rates. It broke down because America refused to pay the domestic price for bearing the system’s weight.

[True. All empires extract some form of tribute from its territories. The American one did it in a peculiar manner. While previous empires levied tax money to flow from its conquered regions, the U.S. uses the inflation tax to get the same results. The U.S. dollar was inflated (i.e. print more than gold reserves allowed). The fact that the U.S. dollar is the world reserve currency gives the country special privileges (or as economist like to say, a free ride). The U.S. dollar free ride will continue until foreigners say “no mas.”]

When Bretton Woods failed, it was not immediately obvious what would replace it. European nations, in particular, maintained a hankering for fixed exchange rates. But floating rates eventually prevailed, particularly for the major currencies of the dollar, yen and D-mark.

The problem for creditors was that the floating-rate system was based on fiat (paper) money. What would keep the inflationary instincts of governments in check? The answer took a couple of decades (and recessions) to hammer out.

[Actually, what kept the inflationary instincts of governments in check was faith, or in economist-speak, managed expectations.]

Once it was accepted that the markets could set exchange rates, there was no real need for capital controls. And once capital could flow freely, ill-disciplined governments could be punished by higher bond yields. Politicians accordingly tried to reassure the markets by giving greater power to central banks, some of which set explicit inflation targets.

[During this time, the perception was given that central banks were “independent.” Of course, it was silly that market participants in fact believed this. There was never such a thing as central bank independence. Consider the Federal Reserve in its current standing: it does the dirty work of the Executive Office.]

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

[I would add the inclusion of formerly communist countries into the global financial system as a further supply shock. Moreover, financial innovation and technological improvement helped in this process too.]

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

[It is absolutely true that central banks engaged in loose monetary policy, however some of the “savings from developing markets” was actually money printed out of thin air. The fact that the risk-free rate was below the one that would exist in the absence of manipulation caused all forms of capital misallocation. The present crisis is the result of central banking.]

Now it seems to be recognised that inflation targeting is not enough. Given the explicit government guarantee behind the banking system, central banks need to monitor both financial stability and asset prices. At the same time, some central banks have adopted (via quantitative easing) a policy of creating money to boost markets that also has the convenient side-effect of funding budget deficits. That is just what opponents of fiat money feared would happen in the long run.

[As I said previously, the idea that there was ever such a thing as central bank independence was silly.]

The same old dilemma will eventually occur. Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger; ten-year Treasury bond yields are around a percentage point higher than they were at the start of the year.

[Translation: Defaults via mass inflation. In other words, this type of default on debt will occur by way of printing money (which already has been) out of thin air to pay back what is owed. There will be a heavy tax, but it will be in the form of high inflation.]

Creditor nations tend to set the rules and the new global monetary system will be unable to operate without the approval of China, a creditor country that has capital controls and a managed currency. It has been assumed that China will have to move towards the Western model. But why not the other way round? Western countries adopted free capital markets, as the British adopted free trade in the 19th century, because it suited them. Will China now be able to call the shots? Uncomfortable as it might be for the West, the next monetary order is more likely to be made in Beijing than in New Hampshire.

[China will loose a lot of wealth in the coming mass inflation. They will gladly incur the cost if it leads them to call the shots in shaping the new economic and financial world order which will emerge after the crisis.]

Wednesday, May 20, 2009

A View of Modern Society

Amidst the claptrap of government bailouts of Wall Street, Democrats vs. Republicans, liberal vs. conservative, globalization vs. protectionism, etc. there is an underlying theme that seemingly connects disparate groups. Few give it adequate attention. And those who do have their voice silenced or obliterated into oblivion. There is a profound battle occurring in our society today which does not have to do with weapons of mass destruction, guns, grenades, tanks, or any other typical army armament. For armed insurrections and rebellions, once successful in their attempts, lay the foundation to further insurrections and rebellions. The battle I am referring to is nothing of the sort. I am talking about the struggle to salvage the last remaining philosophical tenets that allowed our society to function and flourish. One just simply needs to scan daily newspaper headlines and have a genuine desire to seek the truth amidst the sheer amount of toxic information to “see” what I am speaking about. Failed states, failed policies, failing institutions. In other words, a society that seems to be falling apart at the seams. If I were to take a point in time, say ten years ago, the amount of change that has transpired is tremendous. The same can be said going back fifteen years. Yet, if I had taken inventory of this change on a yearly basis, it would have been so miniscule that the sheer exercise of it might have been futile. But this just merely exhibits the effects of compounding interest: that is, for example, a 2% change after one year is 2%, after two years the value is 4.04%, after three years it is 6.12%…after 10 years it is 21.89%. The point is that change adds up exponentially, sometimes for better or for worse. In our society today, it is the latter.

If you think my proposition is an exaggeration, let me give you four names: Harold Berman, Jacques Berzun, Robert Nisbet, and Martin Van Creveld. You probably have not heard of them. Let me give you a hint: They are not New York Times (or any newspaper) reporters, or journalists who work in some office of CNBC or Fox News (or any other TV personality)—many who pass on opinions as facts. They are academic luminaries who never forsook their profession’s seriousness into the inquiries of their disciplines and of society. By now I hope you have considered their qualifications and background to know they are far from obscure “gentlemen and scholars”. On the contrary, they have a remarkable authority to speak about their subject matter. All of them separately conclude of the tectonic shifts that have occurred during the last generation or two, which consequently has led to the abandonment of the pillars that sustain our modern society.

In his book, "Law and Revolution", Harold Berman makes the following observation:

“The two generations since the outbreak of the Russian Revolution have witnessed-- not only in the Soviet Union and the West—a substantial break with the individualism of traditional law, a break with its emphasis on private property and freedom of contract, its limitation on liability for harm caused by entrepreneurial activity, its strong moral attitude towards crime, and many of its other basic postulates. Conversely, they have turned to collectivism in the law, towards emphasis on state and social property, regulation of contractual freedom in the interest of society, expansion of liability for harm caused by entrepreneurial activity, a utilitarian rather than a moral attitude toward crime, and many other new basic postulates.” (pg. 36-37).

That is, administrative law as a means of market efficiency has been on a constant rise for almost a century. The belief that increased legislative measures alone will alleviate hardships is at least foolish to accept at face value and a half-truth at best. Indeed, laws and its concomitant respect are a prerequisite for any society to prosper. However, the underlying motives and reasons for enacting such laws is what Berman is considering. Laws are the agglomeration of what society considers relevant. The “bailout” mentality, for example, is not a new phenomenon, but one that has been bred for quite a while. Consider recently when Congress forced the Financial Accounting Standard Board (FASB) to change its accounting methodology at the risk of backlash if the former did not comply. These days financial institutions do not have to fend for themselves, given that politicians admonished the FASB that they would use administrative law to get its cooperation. FASB ultimately caved in to political pressure. This is clearly evidence of disrespect for private property rights. They were eschewed on some nebulous premise of market stability.

In Jacques Berzun’s From Dawn to Decadence, we learn that

“the 20th century has gone the 16th century one better in making the absurd a sign of righteousness, of surefire appeal. Any doctrine or program that claims the merit of going against the common sense has presumption in its favor—a major discovery is at hand. Where earlier the proponent was declared a charlatan, now he is the bearer of the desirable new and enlightened” (pg. 757-758).

Having just recently finishing my graduate degree from Columbia University, I can first-hand acknowledge the veracity of Berzun when it comes to assessing the current environment in academia—particularly in Economics. For example, the ideas of J.M. Keynes, which were discredited in the 1970s, have been re-packaged and dispensed in a new format to the entire student body. How about society in general, as Berzun points out,

“Western nations spend billions on public schooling for all, urged along by public cries for Excellence. At the same time society pounces on any show of superiority as elitism. The same nations deplore violence and sexual promiscuity among the young, but pornography and violence in films and books, shops and clubs, on television and the Internet, and in the lyrics of pop music cannot be suppressed, in the interest of ‘free market of idea’” (pg. 758).

One can go on and on to expose the rampant contradictions many live by. Few give it any passing thought about this absurdity. Perhaps this obvious cognitive dissonance—to borrow a phrase from social psychologists—is the effect of a structural cause of a society. Perhaps it has something to do with our idea of what progress constitutes, as Robert Nisbet claims. In “History of the Idea of Progress”, he states that

“everything now suggests, however, that Western faith in the dogma of progress is waning rapidly at all levels and spheres in this final part of the twentieth century. The reasons…have much less to do with the unprecedented world wars, the totalitarianism, the economic depression, and other major political, military, and economic afflictions which are peculiar to the twentieth century than they do with the fateful if less dramatic erosion of all the fundamental intellectual and spiritual premises upon which the idea of progress has rested throughout its long history” (pg. 9).

This encapsulates the very core of our identity as a society. Nisbet seems to say that we have entered a dark-age period.

In “The State: Its Rise and Decline”, Martin Van Creveld goes a step further and makes the assertion that the modern state is in its period of decline, which began somewhere between 1945-1975. The “global character of the changes indicates that they were produced by anonymous forces over which scarcely anybody could exercise any control. And in relation to which, indeed, the entire question of morality becomes almost irrelevant.” The decline is characterized by nuclear weapons proliferation, breakdown of the welfare state, and globalization. The product has been strife and continued disintegration in social structures.

Harold Berman, Jacques Berzun, Robert Nisbet, and Martin Van Creveld, albeit coming from different perspectives, all agree that something radically different is evident in our society. If what they claim is true (which, given my own research, I happen to believe they are right), unless a radical shift occurs, I cannot be absolutely sanguine about the future.

Tuesday, May 19, 2009

Stock Market Fraud?

According to Daniel Shaffer, CEO of Shaffer Asset Management, the recent upswing in the stock market has been the result of market manipulation. This is the transcript of his statement made on Fox Business Channel on May 14, 2009.

"“Something strange happened during the last 7 or 8 weeks. Doreen you probably can concur on this -- there was a power underneath the market that kept holding it up and trading the futures. I watch the futures every day and every tick, and a tremendous amount of volume came in a several points during the last few weeks, when the market was just about ready to break, and it shot right up again. Usually toward the end of the day – it happened a week ago Friday, at 7 minutes to 4 o’clock, almost 100,000 S&P futures contracts were traded, and then in the last 5 minutes, up to 4 o’clock, another 100,000 contracts were traded, and lifted the Dow from being down 18 to up over 44 or 50 points in 7 minutes. That is 10 to 20 billion dollars to be able to move the market in such a way. Who has that kind of money to move this market?
On top of that, the market has rallied up during the stress test uncertainty and moved the bank stocks up, and the bank stocks issued secondaries – they issues stock – they raised capital into this rally. It was perfect text book setup of controlling the markets – now that the stock has been issued…” (Transcripts courtesy of

This is the video where Mr. Shaffer made his statement. Pay particular attention on the 2 minutes and 30 second mark...

Monday, May 18, 2009

The Deflation Myth

Expanding on my last post, the decline in the CPI has sparked once again the fear of a deflationary spiral. The debate between “inflation” and “deflation” still continues to get media coverage, but adequate explanations are far from satisfactory. In this missive I will clarify why deflation is merely smoke and mirrors concealing the true menace: price inflation.

What is “deflation” and why it is bad?

When you hear economists mention the word deflation, they generally mean a fall in consumer prices. More specifically, it is the sustained fall in consumer prices. On the surface, declining prices are not pernicious in and of itself because buyers can purchase more goods with their money. In other words, their wealth increases. However, for society at large this outcome may not be optimal because the wealth-gain for some could be offset by wealth-loss for others. This is particularly the case in a debt-laden society. Economists refer to this as the theory of debt deflation: lower prices increases the true cost of debt, causing spending to decline, which leads to shrinking demand and consequently higher unemployment. High unemployment means higher risk of defaults. Thus we have the beginning of a spiral taking place.
Deflationists—which include the likes of Ben Bernanke—point to the period between 1929 and 1933 when prices (as defined by the CPI) declined approximately 27% as proof of their heightened concern. As a result, the current crisis has been treated by an extraordinary surge in liquidity by the Federal Reserve. In particular, the Fed’s balance sheet has more than double since September 2008.

Yet, in context their fear is misplaced. During the early years of the Great Depression, prices declined primarily for three reasons: 1) The money supply decreased between 1929-1931, which caused a sharp contraction in economic activity.

The subsequent increase in the monetary base had no effect since production was declining and 2) there were approximately 9,000 bank failures between 1929-1933. This caused the money multiplication effect, which is the byproduct of a fractional reserve banking system, to be nullified. The FDIC was nonexistent in those days; so when a bank would fail, depositors lost their money. In this instance, the supply of money simply “disappeared” from the economy. But most importantly, 3) the U.S. operated under a domestic gold-standard as its monetary system. In addition and in contrast to today, gold coin freely circulated as money in those days.

This last point is crucial to reiterate because deflation cannot occur outside of a commodity-linked currency. Said differently, it is impossible to have price deflation (i.e. a sustained decrease in prices) under a fiat monetary system, except only when productivity outpaces money supply. Critics will point to Japan as an example of the consequences of deflation. However, Japan’s economic malice is the result of government intervention (see here and here for a detail analysis on this country).

As demonstrated by the following chart, prices declined in the U.S. from 1928-1933 and subsequently increased thereafter. (Insert Chart).

It is of utmost importance to highlight that on April 5, 1933, President FDR criminalized the private holding of gold and forbade the usage of gold coins as money to settle transactions. There is no coincidence that prices began to increase post-1933.

Why prices decline under commodity-linked money and not under a fiat?

Inflation and deflation is always a monetary phenomenon. When the safety and soundness of banks during the Great Depression was suspect, the population’s demand for gold coins increased. People subsequently withdrew their bank deposits and converted them to physical gold. This resulted in a run on banks, their failures, and an overall decrease of the money supply—all which aggravated the economic conditions of the country. Under a domestic gold standard, monetary policy is very limited. And while the FED did inflate the money supply beginning in late 1931, it had no effect on the general tendencies of prices until FDR’s intervention.

Under a fiat monetary system, however, monetary policy is amplified and thus has more power. Price might decline from time to time, but a sustained fall is impossible because money (unlike the one backed by gold) has no anchor which to hold on to. Deflation proponents under a fiat monetary regime must answer the following facts: 1) most of the currency is held in the banking system, which is part of the monetary base, 2) this currency is part of bank deposits, which get multiplied in the fractional reserve banking system, 3) the FDIC main objective is to prevent banks to disappear, thus maintaining the money multiplier effect operative, 4) despite the high debt load by the U.S., there will always be somebody willing to borrow (e.g. the Federal government needs about $4 trillion this year alone to cover its expenses), and 5) monetary policy is without limitations, in contrast to the gold-standard era.
As can be noted, there are significant differences between the Great Depression period of deflation and our own time. Ignoring these facts has led policymakers and the population in general to “reason correctly from an erroneous premise”. If there is something else to salvage from my analysis is that once governments change the rules of the game, intertemporal comparisons become an evaluation between apples and oranges. Inflation continues to be the primary risk today.

Saturday, May 16, 2009

Explaining the Fall in CPI

The most recent Bureau of Labor Statistics’ report demonstrates that the urban consumer price index (CPI) decline 0.7% from April ‘08 to April ‘09—the biggest fall since 1995. Excluding food and energy, or commonly known as core prices, have increased 1.9%. Policymakers use core prices as a proxy to manage inflation because they perceive they do not have “control” of the excluded items. This policy approach is a distortion because food and energy prices are legitimate costs bear by all consumers. I will explain why prices have decline momentarily.

But there is a deeper issue concerning the CPI that warrants further explanation—that is, the nature of indexation. Indices in many instances, the CPI included, are inadequate indicators to value a desired activity. First, the CPI is made up of a basket of goods and services set in a particular base year—this mean that the basket does not change from year to year. The problem is that consumer preferences change over time and hence their consumption habits. Indeed, the basket of goods and services can be altered at some point; however, the CPI is far from being a real-time indicator of preferences. What matters are relative price changes, not changes in the CPI. Second, “nonmarket goods” (e.g. recycling, clean environment) are not counted as part of the CPI basket of goods. Third, each individual imputes value to goods, which in many instances will deviate from their price. As such, the CPI’s basket of goods and services is far from static in terms of individual consumption: some people will consume more or less of what this basket constitutes. Fourth, outliers easily distort averages; that is, one large data point can skew the distribution. Therefore, it is more reasonable to use the median CPI as a rough proxy.

Having said that, the primary reason the fall in the CPI has to do with a massive fall in private inventories, which declined at an annual rate of 2.79% in 1Q’09 (see table 1.1.2). In comparison, for the years of 2007 and 2008 inventories declined .40% and .26% respectively. Except for 3Q’08, private inventories have fallen each quarter of 2008 and 2009. On a greater scope, they have fallen steeply since 2006. Private inventories consist of the following:

“purchases of fixed assets (equipment, software, and structures) by private businesses that contribute to production and have a useful life of more than one year, of purchases of homes by households, and of private business investment in inventories. Inventory investment, which is shown as “change in private inventories,” includes the value of goods produced during a period but not sold, less sales of goods from inventories that were produced in previous periods” [see page 8 here].

These figures (and the St. Louis Fed chart) tell us that firms are producing less (hence the fall in capacity utilization) and are selling-off their excess inventory in greater measure. The steep fall reveal that firms built an extraordinary amount of inventories during the bubble years. The recent fall in prices merely represent the law of demand and supply at work.

The trend of the annualized median CPI over the last several months, however, demonstrates a small decline in prices, but not as extreme as reported by the urban CPI. In November 2008, the 12-month percent change was 3%, 0.4% higher than the figure reported as of April 2009.

In conclusion, prices are declining because of excess quantities supplied and inventoried over the last expansionary economic cycle. The median CPI, an imperfect yet rough proxy of consumer spending habits, continues to demonstrate price inflation.

Wednesday, May 13, 2009

Decision-making Under Uncertainty: A Word of Caution

“What chiefly distinguishes the empirical research on decision making and problem solving from the prescriptive approaches derived from SEU [subjected expected utility] theory is the attention that the former gives to the limits on human rationality. These limits are imposed by the complexity of the world in which we live, the incompleteness and inadequacy of human knowledge, the inconsistencies of individual preference and belief, the conflicts of value among people and groups of people, and the inadequacy of the computations we can carry out, even with the aid of the most powerful computers. The real world of human decisions is not a world of ideal gases, frictionless planes, or vacuums. To bring it within the scope of human thinking powers, we must simplify our problem formulations drastically, even leaving out much or most of what is potentially relevant.”

Herbert Simon expressed these words in a 1986 briefing panel concerning decision-making and problem-solving. His statement admonishes us of the non-linearity of life in such process. We never possess complete information or perfect foresight. Yet, this does not hinder us from making decisions and expressing our beliefs. However, it is imperative we recognize our limitations.

One reason why, relatively-speaking, only a handful of people ever saw the financial crisis occurring relates to the mischaracterization of reality. In my view, I don’t believe there was ever a full understanding of what actually constitute risk and how that’s different from uncertainty. Risk is uncertainty that can be quantified. One measure of it might be “standard deviation”. Uncertainty, on the other hand, cannot be quantified. I think of this like a “black swan” or “fat tail” events. In many instances of business activity, it is the “unquantifiable” that poses the major risk. How can one quantify gov’t policy or geopolitical factors that are inherently non-numeric? Very difficult. Even if one could estimate it, chances are the prognosis may not be entirely accurate.

Business and financial models use parameters, which in many instances, “leave out much or most of what is potentially relevant.” This continues to be true today. This applies to me too. That is why I add that my predictions could be worse than I propose. The alternative—a better than expected scenario—is highly unlikely because I have already accounted what I believe is potentially relevant.

Tuesday, May 12, 2009

An Unexpected Cashflow for Banks: "Bear" This in Mind

The government manipulation of the banks’ stress tests reveals another nefarious aspect market participants should be aware. Things are shaping up such that 2nd quarter earnings from banks will be equal to or “better” than those reported 1Q. The Financial Times reported today some banks would reap financial benefit by providing assistance in capital raising efforts for weaker institutions. In particular, approximately “450 million in underwriting fees.” If you add to this amount the fees generated from expected divestitures, such as the $7.3 billion deal recently completed by Bank of America, these non-recurring fees could be a welcome addition to the coffers of some financial institutions. Given that there is no economic recovery in sight but rather continued deterioration, 3Q09 results have the high probability of being disappointing. The recent market run-up has been driven on the backs of bank stocks. The trend will reverse once investors realize that nothing but hot air has been pumping it.

I keep coming back to the theme that from September through December I expect the same dynamics that played out last year to repeat this year—perhaps to a greater degree. However, the macroeconomic and geopolitical landscape is covered by traps, which could bring a market collapse quite suddenly and before September. But these sorts of events are difficult to predict, since they are what Nassim Taleb categorizes as “black swans”. One such event is the tumbling of the U.S. Dollar, which could conceivably arise from the excessive public debt. The U.S. Federal Government for example will need to raise about $2 trillion to finance its deficit and at the same time needs an additional $2 trillion to roll-over some of its debt. These are staggering figures.

As always, be aware of your environment.

Monday, May 11, 2009

No Stress Over Stress Tests - Part II

Over the weekend, the Wall Street Journal reported what heretofore had been a premonition: backroom wheeling and dealing between the Federales and the banksters on stress-test results. There were some handsome winners out from this negotiation. Consider Bank of America: the Feds first assessed the bank needed "more than $50 billion," but ultimately settled for $34 billion. Citigroup, for example, was deemed to need $35 billion, but they brought the figure down to $5.5 billion. Not even with the exaggerated help from the government in the form of less than rigorous testing parameters were the banks able to pass the results. Make no mistake, every bank that needed capital funding failed the test. Caveat emptor if you purchase bank stocks. Below you will find the Journal's full article.


Banks Won Concessions on Tests Fed Cut Billions Off Some Initial Capital-Shortfall Estimates; Tempers Flare at Wells

The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation's biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.

In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.

The overall reaction to the stress tests, announced Thursday, has been generally positive. But the haggling between the government and the banks shows the sometimes-tense nature of the negotiations that occurred before the final results were made public.

Government officials defended their handling of the stress tests, saying they were responsive to industry feedback while maintaining the tests' rigor.

When the Fed last month informed banks of its preliminary stress-test findings, executives at corporations including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. were furious with what they viewed as the Fed's exaggerated capital holes. A senior executive at one bank fumed that the Fed's initial estimate was "mind-numbingly" large. Bank of America was "shocked" when it saw its initial figure, which was more than $50 billion, according to a person familiar with the negotiations.

At least half of the banks pushed back, according to people with direct knowledge of the process. Some argued the Fed was underestimating the banks' ability to cover anticipated losses with revenue growth and aggressive cost-cutting. Others urged regulators to give them more credit for pending transactions that would thicken their capital cushions.

At times, frustrations boiled over. Negotiations with Wells Fargo, where Chairman Richard Kovacevich had publicly derided the stress tests as "asinine," were particularly heated, according to people familiar with the matter. Government officials worried San Francisco-based Wells might file a lawsuit contesting the Fed's findings.

The Fed ultimately accepted some of the banks' pleas, but rejected others. Shortly before the test results were unveiled Thursday, the capital shortfalls at some banks shrank, in some cases dramatically, according to people familiar with the matter.

Bank of America's final gap was $33.9 billion, down from an earlier estimate of more than $50 billion, according to a person familiar with the negotiations.

A Bank of America spokesman wouldn't comment on how much the previous gap was reduced, though he said it resulted from an adjustment for first-quarter results and errors made by regulators in their analysis. "It wasn't lobbying," he said.

Wells Fargo's capital hole shrank to $13.7 billion, according to people familiar with the matter. Before adjusting for first-quarter results and other factors, the figure was $17.3 billion, according to a federal document.

"In the end we agreed with the number. We didn't necessarily like the number," said Wells Fargo Chief Financial Officer Howard Atkins. He said the company was particularly unhappy with the Fed's assumptions about Wells Fargo's revenue outlook.

At Fifth Third Bancorp, the Fed was preparing to tell the Cincinnati-based bank to find $2.6 billion in capital, but the final tally dropped to $1.1 billion. Fifth Third said the decline stemmed in part from regulators giving it credit for selling a part of a business line.

Citigroup's capital shortfall was initially pegged at roughly $35 billion, according to people familiar with the matter. The ultimate number was $5.5 billion. Executives persuaded the Fed to include the future capital-boosting impacts of pending transactions.

SunTrust Banks Inc. also persuaded the Fed to significantly reduce the size of its estimated capital gap to $2.2 billion, after identifying mathematical errors in the Fed's earlier calculations, according to a person familiar with the matter.

PNC Financial Services Group Inc., saw a capital hole materialize at the last minute. As recently as Wednesday, PNC executives were under the impression they wouldn't need to find any new capital, according to people familiar with the matter. Thursday morning, the Fed informed PNC that it had a $600 million shortfall.

Regulators said other banks also were told they needed more capital than initially projected.

The Fed's findings were less severe than some experts had been bracing for. A weeklong rally in bank stocks continued Friday, with the KBW Bank Stocks index surging 10%. Investors were especially relieved by the relatively small capital holes at regional banks. Shares of Fifth Third soared 59%, while Regions Financial Corp.'s $2.5 billion deficit led to a 25% leap in its stock.

With the stress tests, government officials were walking a fine line. If the regulators were too tough on banks, they risked angering their constituents and spooking markets. But if they were too soft, the tests could have lost credibility, defeating their basic confidence-building purpose.

All the back-and-forth is typical of the way regulators traditionally wrap up their examinations of banks: Regulators often present preliminary findings to lenders and then give them time to respond. The process can result in changes to the regulators' initial conclusions. Some of the stress-test revisions, for instance, were made to account for the beneficial impact of the industry's strong first-quarter profits.

On Friday, some analysts questioned the yardstick, known as Tier 1 common capital, that regulators chose to assess capital levels. Many experts had assumed the Fed would use a better-known metric called tangible common equity.

According to Gerard Cassidy, an analyst with RBC Capital Markets, the 19 banks' cumulative shortfall would have been more than $68 billion deeper if the government had used the latter metric, which accounts for unrealized losses.

Federal officials said their projections reflected the most comprehensive analysis ever conducted of the industry. The test results showed that the 19 banks faced a total of $599 billion in losses over the next two years under the government's worst-case, Depression-like scenario. The Fed directed 10 banks to add a total of nearly $75 billion to their capital buffers to insulate themselves from potential losses.

Banks pressed ahead on Friday with plans to fill their capital holes by tapping public markets. Wells Fargo raised $7.5 billion in stock through a public offering. The bank originally planned to raise $6 billion, but expanded the offering, which was valued at $22 a share, due to robust demand. Shares of Wells Fargo rallied $3.42, or 14% to $28.18.

Morgan Stanley, which is facing a $1.8 billion capital hole, raised $4 billion by selling stock. Shares of Morgan rose $1.06, or 4%, to $28.20.

Saturday, May 9, 2009

No Stress Over Stress Tests

The recent government-enacted “stress tests” of banks reveal some serious flaws. One of the errors was pointed out by the Financial Times, which reported that,
“During the tests, policymakers made adjustments after first-quarter operating revenues were stronger than forecast, reducing demands for equity by nearly $20bn compared with original estimates based on data for the end of 2008.”

This tells us that if year-end 2008 operating results would have been used, the required capital needed to be raised should be approximately $95 Billion. Yet, the mirage of 1Q09 results further highlights the extent the government authorities went to ensure banks recorded a profit. For a detail discussion of the shenanigans that led to the “stellar” reported bank revenues, see my post here. Moreover, the original estimate to use 2008 data is even more questionable because 1) some banks will not continue to benefit from assets which most likely will be sold in the near future (e.g. Citi), 2) it is unlikely that what had become traditional sources of income for banks (e.g. CDO issuance, securitizations) will continue in the future. Regulators could have used another year, say, 2003, when the use of leverage by banks was less. Of course, this was not going to happen because capital needs would have easily risen to triple digits.

Take a closer look at Citi, for example. The Federales estimated earnings (ex-provisions) for this year and next to total $49 billion, which is approximately the yearly average going back to 1999 (excluding 2008). If the government used this average as guidance, it is deficient because it is not a forward-looking estimate. A reasonable earning parameter “stress test” would have been to use, for example, 50% of aforementioned figure.

All considered, what the public has received are cooked books and cooked results, and if one does not take adequate precaution, somebody is going to get cooked. The stock market has not considered any of this. If it had, it would not have climbed higher the day after the “stress test” results were released.

Paul Krugman’s La La Land

Mr. Krugman, like a typical Keynesian, holds onto distorted views. About a year ago he posted the following in his blog to express his belief of malevolent vs. benign inflation. Of course, Keynesians adore price inflation because it is the only way that the real value of wages would decline, which is a required proposition to keep employment high in light of expansionary fiscal and monetary policies they endorse during recessions. That being said, while I don’t fully agree with the likes of Milton Friedman, he was right to point that price inflation is always and everywhere a monetary phenomena. Mr. Krugman cites the following example to promote his view:
"Imagine that there are two entrepreneurs, Harry and Louise, both of whom change prices only at fairly long intervals — say, once a year. Other things equal, Harry want his average price over the next year to be about the same as Louise’s; Louise wants her average price to be about the same as Harry’s. But their price setting takes place on different dates...In this situation, inflation can feed on itself: Harry raises his price above Louise’s, because he expects her to raise her price in the future, and she does the same thing when it’s her turn."

In Mr. Krugman’s example of Harry and Louise, the former can raise prices all he wants—irrespective his motives. What Mr. Krugman fails to note is who will do the bidding and how will the transaction be settled? The customer, of course, but with what money? If an economy (assume produce only one good) has a money stock of, say, $100, and the asking price of the good by Harry is $200, it is impossible for price inflation to occur beyond $100. However, if the central bank increases the money supply to $500, someone will offer to buy at the $200 asking price. Someone will come along, however, and bid $300. Hence an economy experiences price inflation.

The same logic applies to the so call wage-price spiral. That is, higher wages cause price increases. This is a fallacy. Wage demand can increase but if there is no commensurate increase in the money supply, all things being equal, it is impossible prices to increase without demand-side increases.

Keynesians avoid confronting and openly challenging this fact. That is why they rarely mention it in their publications. With this backdrop, it is silly to presume the Federal Reserve balance sheet expansion from $800 billion last August to nearly $2.4 trillion currently will not be inflationary. Any kind of “expectations” management not rooted on fundamental truth will eventually unravel, which will lead to sharp increases in the CPI—although rest assure the government will massage the statistics to deflate them. When that will happen is anyone’s guess? But it’s practically a foregone conclusion that mass inflation (anything above 15-20% annual price increases) is on its way.

Thursday, May 7, 2009

Banking Swindles, Public Relations, and Other Government Follies

On the afternoon of Thursday, May 07, 2009, the U.S. government will make public the results of the so-call stress tests of the largest 19 banks. This entire process is nothing more than a public relations stunt to give the appearance to investors that all is ‘honky dory’ with the banks. But as I pointed out on a recent post, the balance sheet problems of banks are very significant. The government’s market interference is merely postponing the day of reckoning by conscientiously manipulating and concealing the actual shape of the largest financial institutions. Given the propensity of human nature to reap the benefits of the proverbial ‘free lunch,’ market participants have been practically cheerleading and applauding government efforts. This concealment cannot continue for a prolonged period of time. I expect by September this house of cards will start crumbling. In the meantime, illusions will be given that we have or are “turning the corner.” Don’t believe it. It is coming from politicians (and those who benefit from their actions) who have nonexistent credibility.

These are some of the steps the government has de facto legalized extortion—otherwise known as assisting the banks.

1. The Federal Reserve System exorbitant expansion of its balance sheet is aimed at “helping” the banks by taking on dodgy assets from the banks’ books and replacing them with less risk ones (like Treasurys). This has lessened the write-downs and write-offs financial institutions must undertake. Even with this manipulation, the IMF reckons that approximately $550 billion more in write-downs are on the way.

2. The low interest rate environment, which is a direct result of monetary policy by the Federal Reserve, has allowed banks to practically execute the carry trade of borrowing short and lending long. Banks borrow and pay almost nothing on interest, and subsequently lend the proceeds long-term. In other words, banks pay, say 1% on the borrow funds, and lend the money at, say, 4.5%. Given that consumer credit is tumbling, most of the fees earned by banks has come from refinancing. This is not continuous cashflows. These non-recurring fees may carry through the 2nd quarter reporting season, but not much more after that.

3. Balance sheet manipulations led by the “politization” of the Financial Accounting Board. Mark-to-market rules, which is the mechanism by which a bank’s trading book is adjusted to reflect its most recent valuation, were in effect suspended. This allowed financial institutions to disguise problem assets. This fact alone should have sent shivers to the market, but it simply brushed it off. Furthermore, it is almost impossible given this directive to assess the true value of bank assets.

4. A number of banks, most notoriously Citigroup, engaged in an accounting trick call “credit value adjustment.” The “adjustment” allows firms to record as a profit the amount of the decline in value of its issued debt. For example, if at the beginning of the quarter Citigroup’s debt traded at $100, but it is currently trading at $75, Citigroup records a $25 profit. The assumption is that the company can purchase its own debt at the discounted price. Of course, the bank does not do this because it does not have the money; but for accounting purposes, this is legitimate. Instead of the actual term used, this should be call “creative value enhancement.”
5. Goldman Sachs, the master of deception, switched from reporting earning results on a fiscal year basis ending in November. It will now report on a calendar year basis. The result of this switch: Not accounting a huge loss in December 2008 in their most recent quarterly earning report. On that month alone, the firm lost about $780 million. This would have cut into the $1.8 billion “profit” reported.

As previously mentioned, these manipulations have occurred under the watchful eye and in some instances endorsed by government manipulators, who purport to act for the benefit of the “people”. There is a cliché that says that if you have friends like these who need enemies. One can sweep trash under the rug and hope no one notices. Soon enough, however, people will notice. When that happens, you have better be out of the stock market or be shorting it.

Wednesday, May 6, 2009

The Mirage of Recovery

Occasionally there are excellent articles that truly encapsulate what is currently happening in the U.S. economy. There has been a marked and sustained upward movement in financial markets over the six weeks, based on presumptions that "green shoots" of recovery are evident. However, this is nothing more than a sham. By year-end 2009, the stock market will be a lot lower than the level we see right now--possibly the Dow falling below 6,000. In order to understand our current economic status, one must adequately assess the historical background and the effects of the policies enacted. All leads to an unhappy ending. While lengthy, it is certainly a good investment of time to read it. It can save you A LOT of money if you act accordingly.


The mirage of recovery
By Hossein Askari and Noureddine Krichene **

Over recent days, observing a sudden increase in car sales and record profits of "bankrupt" banks, Federal Reserve chairman Ben Bernanke has announced that recovery of the US economy was under way. Treasury Secretary Timothy Geithner echoed the same message and even "globalized" his prediction of a recovery for the world economy. President Barack Obama saw "glimmers of hope". While these three top US policymakers were rushing to announce recovery, economist Paul Krugman exuded skepticism, saying "do not count your recoveries before they are hatched".

US policymakers' optimism seems to be founded on their grandiose reflationary programs. Obama has launched an unprecedented stimulus package at US$787 billion, followed by the largest US fiscal deficit ever, at $1.85 trillion, or 13% of gross domestic product (GDP). Underlying the stimulus package and the fiscal deficit was a Harvard income multiplier of 1.5, implying an increase in the US real GDP by about $4 trillion, or a record 30% per year. The basic economics advocated by the Obama team were simple: trillions of dollars in stimulus package and government expenditures would boost real aggregate demand for consumption and investment and automatically lead to economic recovery and full employment. Their mechanical multiplier model provided a strong reason for Obama to announce a premature economic recovery.

Bernanke's optimism is the result of the aggressive monetary policy that he forced under the George W Bush administration and has continued to expound under Obama, irrespective of the devastation it has caused to the banking sector and subsequent fiscal bailouts. Bernanke has gained the reputation of the doctor of the "Great Depression" and proponent of monetary anarchy. For him and his school of thought, inflation seems to be of little concern. His aggressive monetary policy has sent the US economy, and with it the world economy, into financial collapse and recession.

Yet, doctor Bernanke kept strong faith in his aggressive anti-Great Depression medicine. Besides forcing interest rates to zero, never seen in the monetary history of the US, he decided to unleash money supply by expanding the credit of the Federal Reserve from $700 billion prior to August 2007 to $2.3 trillion by end April 2009. Doctor Bernanke's reasoning was simple: zero interest rates combined with unlimited credit to the sub-prime markets ought to hike up aggregate demand in such a powerful way that it blasts away recession and secures fast growth and full employment.

The recent cheers for Geithner were based on similar reasoning, however, transplanted at the world economic level. A Group of 20 stimulus package of $5 trillion, on the top of a commitment by the G-20 countries to undertake the most expansionary fiscal and monetary policy, combined with free lending to any country in any amount, that would in their view guarantee a fast and strong world economic recovery.

Neither G-20 policymakers nor the US seem to recognize that the current recession was the product of overly expansionary fiscal and monetary policies during the past decade. Obviously, these policies yielded a temporary high demand-led economic growth during the 2002-2007 period accompanied by the highest commodity price inflation in recent memory; however, they also triggered a food and energy crisis, general bankruptcies in form of meltdown of sub-prime loans, an economic recession and trillion of dollars of bailouts in the US and Europe that socialized financial losses. These bailouts will weigh on economic growth for a long time in the future.

These same policies are now being replayed around the world. The supporters of these policies claim to be innovative as if for the first time in history they were implementing voluminous fiscal expansion and the free printing of money. Yet these policies were used time and again in the past with startling examples such as the German hyperinflation in 1920-23, Latin American hyperinflations in 1950-1985, and the more recent Mobutu and Mugabe hyperinflations.
In all cases where these policies were tried, there was devastating inflation, a substantial decline in real income and a considerable impoverishment and social malaise. Notwithstanding historical evidence against rapid monetary and fiscal expansionism, G-20 policymakers and the US now believe in success of super inflationary policies.

US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the large external deficits that reached about 6% of GDP in recent years and negative national savings. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration's war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.

Bernanke blamed the financial crisis on China and on oil exporters who invested their balance of payments surplus in the US, leading to low interest rates and a credit boom in the US, thus denying Fed influence on interest rates and credit creation. Certainly, Bernanke did not understand that China and oil exporters do not decide the US current account deficit.

Often, Bernanke has noted that the Fed's mandate from the Congress was to promote maximum sustainable employment and stable prices. The failure of the Fed to achieve either or both objectives has been quite recurrent over the past decades. Bernanke's aggressive policy since August 2007 has even triggered stagflation: rising unemployment and inflation. It would be more natural to have a central bank with one single mandate - to preserve the value of money.

Bernanke has simply dismissed traditional central banking and decided, based on his own Great Depression doctrine, to go beyond the twin mandates that were prescribed by the Congress and to create high-risk instruments that go beyond traditional government bonds held by a central bank for open market operations. No central bank has the mandate to lend directly to non-depository banks or to the private sector. That would constitute a violation of standard central banking practice. No government in the world would allow its central bank to violate its mandate and hold assets other than government bonds and member banks' discounts. The arbitrary and overly discretionary power of Bernanke can be illustrated by the following passage from Bernanke:

"More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. ... Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool - namely, buying securities in the open market. The FOMC [Federal Open Market Committee] has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5%, the lowest level since the 1940s." (Speech delivered at Morehouse College, Atlanta, Georgia, on April 14, 2009.)

Bernanke does not seem to understand the nature of credit. A bank lends deposits it receives from its depositors and from repayments of loans. When borrowers do not pay back, the bank no longer has the capital to lend. Bernanke interpreted the credit freeze as a liquidity problem and had little idea about the extent of frozen portfolios. His massive liquidity injection translated into a mountainous buildup of banks' holding of excess reserves that reached $862 billion as of end-April 2009 against less than $2 billion prior to September 2008.

Bernanke was fooling the public by saying he wanted to free up the flow of credit to households and small business, forgetting that most of outstanding loans to households and small business were simply lost and written down. He forgot the bailouts he extended under the Troubled Asset Relief Program to banks in replacement of lost portfolio. He was oblivious about the nature of credit.

Banks accord credit to borrowers from the savings of their depositors. The Fed does not receive deposits from households; it is not intermediating between savings and lending and therefore cannot be considered to be freeing up credit. It is purely creating money out of thin air. As such, the Fed has become a taxing authority that confiscates wealth and redistributes it to lucky borrowers. The new mandate for taxation and redistribution has been self-attributed by Bernanke. Other new mandates were insuring the highest car sales and highest credit card, student, and small business loans. Bernanke has also extended his role to the housing market, with the aim of preventing a downward adjustment of housing prices and pushing down interest rates. Bernanke wanted to renew the speculative euphoria that characterized the housing market under his predecessor Alan Greenspan.

Bernanke does not believe in any regulation of the financial system. By pushing trillion of dollars in liquidity to the sub-prime market, he is likely to bankrupt the Fed within a few short years. Loans pushed on borrowers will never be repaid. Moreover, consumer loans by definition finance consumption. Contrary to investment loans that generate income for their repayment, consumer loans generate no income and cannot be repaid. A stress test applied to the Fed itself would surely predict a huge lost portfolio.

While banks have already been bankrupted and are no longer ready to play out in the hands of Bernanke again, he has decided to go on his own, turning a central bank into an all-encompassing institution, showering free money to consumers and reaching out once again to ninja's - no income, no job, no asset, borrowers. The injection of over $1.25 trillion in mortgages is already setting off another speculative wave, with speculators surging everywhere after high commissions and profits and enticing borrowers into cheap loans that are secured by Bernanke's Fed.

Bernanke considered the rise in car sales as a sign of economic recovery. When Bernanke has become himself the car dealer of the US, handing out luxury cars for free, could this rise in car sales be considered as a sign of recovery? Certainly, the rise in car sales did not reflect savings and growth in the economy. It only reflected Bernanke's overly cheap monetary policy. Bernanke's successor will be saddled with trillions of dollars in bad loans and faced with uncontrollable inflation. A Fed saddled by a mountain of bad debt should be the cause of serious concern for Obama.

Most astonishing of Bernanke's magic tricks is to turn bailout banks into record-profit-making banks in such a record time, while Geithner is still setting up his toxic asset banks. The TARP money served to pay bonuses to managers. Why not use some for paying bonuses to stockholders? Moreover, the Fed is paying an interest on excess reserves held by banks following massive liquidity injection. That interest could be considered as another subsidy to banks that contributes to create illusory profits and the mirage of economic recovery. Banks' profits are not rising from real economic activity and are pure bailout money and subsidies from the state.

How much credibility could be accorded to the soothsayers Bernanke and Geithner? It would be safer to talk about recovery when it really has occurred and strengthened over a period of a few quarters, not through distorted indicators such as those manipulated by Bernanke, but through real GDP growth and a pick up in general employment. If durable growth occurs in such incredible fiscal and monetary chaos, then the disastrous experience of countries that undertook these policies would be baffling. Namely, Zimbabwe should not have experienced four digit inflation and its employment and real income should have grown at highest possible rates.

High US inflation, while not admitted by US policy makers, has eroded real income, had reduced dramatically food consumption, and has certainly caused rising unemployment. The more an economy is inflated, the more its real activity is deflated and the more unemployment rises. The creation of money out of thin air could lead to starvation. Others have called it counterfeiting. Counterfeiters could bring as much stimulus and confiscation as does Bernanke's money creation.

Paul Volcker applied prudent central banking soon after his appointment as Fed chairman in 1979 and achieved a durable recovery in a financial environment of strong and healthy banks by tightening monetary policy and allowing the federal funds rate to remain at 19% for several quarters. He did not invent tricks. Bernanke had caused financial disorder by pushing his theory of anti-Great Depression ever since he was appointed as a governor in 2002 and later as a chair of the Fed in 2006.

He announced recovery with zero interest rates, bankrupted financial system, unorthodox central banking, and most expansionary money creation in the US history. He has kept on inventing tricks and showing genius and innovation. Certainly there is a huge dichotomy between Volcker's plain-vanilla prudent banking and Bernanke's advanced and dangerous financial engineering. But it can be easily solved when we recognize that all roads lead to Rome.
While the Volcker recovery proved to be real, the Bernanke pick-up has so far been a mirage. Bernanke has announced that the Fed credit is to expand to $4 trillion by end-2009. Besides the effects of a breakout of the swine flu, over the coming months and years we also have the results of the Bernanke credit breakout to look forward to.

**Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.

Tuesday, May 5, 2009

The Real Case for a Gold Standard

There are many perceptions concerning the usage of gold as money, many of which are either misplaced or misunderstood. A recent article in the Financial Times is a clear example of the couple of widely accepted, yet simply wrong, comments that circulate popular press. In this post I will highlight these and provide reasons that should give more clarity on the issue.

The article claims that “it is effectively impossible for gold to replace the dollar” as an international reserve currency. While this a true statement, it does not provide an explanation supporting this argument. Since time immemorial gold has served as money. This fact alone precluded governments from absolutely controlling the means of production in an economy without using outright force. This means individuals have the liberty to pursue their own affairs as they deem fit, without much interference from a central authority. Therefore, gold as an international reserve currency in effect creates a ceiling in terms of the activities governments want to perform. From about 1870 until 1913, the world operated on money fully-backed by gold. It is of no coincidence that during this time world production boon on the back of foreign investment. Monetary stability reduces risk premia, thus stimulating capital mobility. Under the gold standard all governments must surrender central bank policy tools, since overt interference in the market by printing more currency than allowed by gold deposits would lead to its sharp sell-off. Ambitious governments, i.e. those that have pursuits that extend beyond domestic borders, detest the idea of a gold standard. The gold standard was discontinued due to the advent of WWI because governments did not have the sufficient money backed by gold to pay for the human slaughterhouse (aka war); therefore they abandoned it and turned to simply printing money.

The article further claims “the logistical issues with replacing the dollar with gold as means of payment are hard to overcome.” This is an outright exaggeration and unfounded. If this were true, how could the gold standard have lasted uninterrupted between 1870-1913? The logistics of gold settlement for international transactions are not at all different than the process to clear checks between international banks. Central Banks could simply perform an accounting entry in their books to the foreign bank’s book transferring ownership of the commodity. Dollars, Yuans, Yens, Pesos, etc. would not disappear. On the contrary they would represent different names (currencies) for the same money everywhere (gold). As a result, there is no need of “actually shipping it from one continent to another, the shipping security, etc.” If a country were to print currency without the appropriate gold backing, other countries would present the first with the excess printed money for redemption. Since 1971 the world desisted from operating under a gold standard. This continues to be true today.

Mainstream economists, including the so-call “free-market” economists from the Chicago School, disdain gold as money. They claim that it is inherently unstable in terms of prices. Yet, empirically this perception is false. Take a look at the following chart. The data are obtained from the Minneapolis Federal Reserve. You will notice that the CPI is anything but stable particularly post-1971.

(Note: Chart was obtained from:

The solution to the current financial and economic crisis reveals that the foundation of the present monetary infrastructure has lacked sound footing. In effect, this represents an extraordinarily large Ponzi (or Madoff?) scheme, which eventually will come to an end. This already has begun.