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.
Thursday, May 7, 2009
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 **
Source: http://www.atimes.com/
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.
***************************************
The mirage of recovery
By Hossein Askari and Noureddine Krichene **
Source: http://www.atimes.com/
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.
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: http://www.chartingstocks.net/wp-content/uploads/2009/02/cpi.png)
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.
Tuesday, April 28, 2009
Democrats Did Not Win 2008 Presidential Election
I wrote this article sometime in October 2008. In the spirit of "celebrating" Obama's first 100 days in office, I have re-posted it. Here is my salute to you, Mr. President!
*****************************************************************
The Republicrats will win the next U.S. election
The Republicrats are not an officially recognized party, yet for all intents and purposes, they might as well be. They represent, I believe, the symbiotic relationship between the Republicans and Democrats. In between the rhetorical maneuvers of “change” and displays of “patriotism”, lies a commonality that is evident to any impartial observer. This interaction would be quite comical if it were not for the fact that its consequence will prove grave for the entire nation. Sifting through the glib headlines and MSNBC/Fox News sound bites that have come to encompass the “issues”, the fact of the matter is that neither party proposes alternatives to treat the root causes of the problems that bedevil our nation. Hence the term Republicrats. I will take two issues to make my point.
The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or the tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.
On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.
The solution to these problems begins with individuals once again attaching importance to an aphorism from prior generations: never believe anyone who says, “I’m from the government and am here to help you.”
*****************************************************************
The Republicrats will win the next U.S. election
The Republicrats are not an officially recognized party, yet for all intents and purposes, they might as well be. They represent, I believe, the symbiotic relationship between the Republicans and Democrats. In between the rhetorical maneuvers of “change” and displays of “patriotism”, lies a commonality that is evident to any impartial observer. This interaction would be quite comical if it were not for the fact that its consequence will prove grave for the entire nation. Sifting through the glib headlines and MSNBC/Fox News sound bites that have come to encompass the “issues”, the fact of the matter is that neither party proposes alternatives to treat the root causes of the problems that bedevil our nation. Hence the term Republicrats. I will take two issues to make my point.
The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or the tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.
On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.
The solution to these problems begins with individuals once again attaching importance to an aphorism from prior generations: never believe anyone who says, “I’m from the government and am here to help you.”
Thursday, April 23, 2009
How Washington can prevent ‘zombie banks’ - My Critique
James Baker, Reagan and Bush’s former Chief of Staff and renown political advisor, recently wrote a column in the Financial Times proposing measures to stymie bank’s insolvency. I present a critique of his argument. Note that the italized sections of this missive represent Mr. Baker's words, while the bold sections represent my refutations.
***********************
Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.
A period of feeble economic performance called Japan’s “lost decade” resulted.Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.
But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade.
[This assumption is in fact wrong. We are headed into a prolonged decline. Complicating matters more, the U.S. is in a worse financial condition in comparison to Japan when undertaking the zombie operations.]
Evidence – a mountain of toxic assets, housing market declines, a sharp economic recession, rising unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital – strongly suggests that some American banks face a solvency problem and not merely a liquidity one.
[Agree. The majority of banks requiring government fund are de facto insolvent. If this were not the case, then they would not uphold themselves to onerous additional regulations simply to obtain cheaper funding.]
We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.
Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.
[I see no necessity to involve public funds in any rescue package, as this will perpetuate the moral hazard. Moreover, would anyone like to try to test the exclusivity of the too-big-to-fail idea? What if Citi of BoA would be the one dissolved? I doubt politicians would let the market take its adequate course.]
To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.
[For the most part, I agree. Bank runs in our time are a highly improbable event because it would mean everyone at the same time would eschew depositing currency in and removing deposits from financial institutions. A bank might fail from a run, but if that money is deposited in another bank, the system survives.]
This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.
[The trouble is that once an industry comes under the claw of government bureaucracy, it is challenging to undue it. And when they do de-nationalize, there is a tremendous risk that the process will be conducted politically. That is, the ripe fruits would go to those politically connected.]
After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.
The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.
To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.
[It is difficult to see politicians who rarely agree on anything substantive suddenly consent to engage in such a complicated operation.]
This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.
Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.
Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.
[But aren’t these some of the consequences of government manipulation in any sector? All government involvement in economic activity produces a winner and a loser. Both will lobby hard, given that they recognize rent seeking is the way to increase profits, not capital investment and productivity.]
Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.
[To use a bit of sarcasm to highlight the error in this statement consider your response to a doctor who will treat your symptoms without analyzing what caused it. That will not assist us in preparing the cure for our malady, correct? We need to finger-point the culprits, otherwise we may have a case where the lunatics are running the asylum.]
During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.
[A Biblical Proverb says that like a dog returns to its vomit, so a fools returns to his folly. Fools have been in charge in this country for quite a while. The same folks who never saw this crisis coming are the ones cheerleading when presumably “green shoots” are visible and are advising the end of the recession is nigh. Fortunately, reality cannot be mocked for too long. Or like Moses once utter, “be sure your sin will find you out.”]
***********************
Beginning in 1990, Japan suffered a collapse in real estate and stock market prices that pushed major banks into insolvency. Rather than follow America’s tough recommendation – and close or recapitalise these banks – Japan took an easier approach. It kept banks marginally functional through explicit or implicit guarantees and piecemeal government bail-outs. The resulting “zombie banks” – neither alive nor dead – could not support economic growth.
A period of feeble economic performance called Japan’s “lost decade” resulted.Unfortunately, the US may be repeating Japan’s mistake by viewing our current banking crisis as one of liquidity and not solvency. Most proposals advanced thus far assume that, once confidence in financial markets is restored, banks will recover.
But if their assumption is wrong, we risk perpetuating US zombie banks and suffering a lost American decade.
[This assumption is in fact wrong. We are headed into a prolonged decline. Complicating matters more, the U.S. is in a worse financial condition in comparison to Japan when undertaking the zombie operations.]
Evidence – a mountain of toxic assets, housing market declines, a sharp economic recession, rising unemployment and increasing taxpayer exposure through guarantees, loans, and infusion of capital – strongly suggests that some American banks face a solvency problem and not merely a liquidity one.
[Agree. The majority of banks requiring government fund are de facto insolvent. If this were not the case, then they would not uphold themselves to onerous additional regulations simply to obtain cheaper funding.]
We should act decisively. First, we need to understand the scope of the problem. The Treasury department – working with the Federal Reserve – must swiftly analyse the solvency of big US banks. Treasury secretary Timothy Geithner’s proposed “stress tests” may work. Any analyses, however, should include worst-case scenarios. We can hope for the best but should be prepared for the worst.
Next, we should divide the banks into three groups: the healthy, the hopeless and the needy. Leave the healthy alone and quickly close the hopeless. The needy should be reorganised and recapitalised, preferably through private investment or debt-to-equity swaps but, if necessary, through public funds. It is time for triage.
[I see no necessity to involve public funds in any rescue package, as this will perpetuate the moral hazard. Moreover, would anyone like to try to test the exclusivity of the too-big-to-fail idea? What if Citi of BoA would be the one dissolved? I doubt politicians would let the market take its adequate course.]
To prevent a bank run, all depositors of recapitalised banks should be fully guaranteed, even if their deposit exceeds the Federal Deposit Insurance Corporation maximum of $250,000 (€197,000, £175,000). But bank boards of directors and senior management should be replaced and, unfortunately, shareholders will lose their investment. Optimally, bondholders would be wiped out, too. But the risk of a crash in the bond market means that bondholders may receive only a haircut. All of this is harsh, but required if we are ultimately to return market discipline to our financial sector.
[For the most part, I agree. Bank runs in our time are a highly improbable event because it would mean everyone at the same time would eschew depositing currency in and removing deposits from financial institutions. A bank might fail from a run, but if that money is deposited in another bank, the system survives.]
This is not a call for nationalisation but rather for a temporary injection of public funds to clean up problem banks and return them to private ownership as soon as possible. As president Ronald Reagan’s secretary of the Treasury, I abhor the idea of government ownership – either partial or full – even if only temporary. Unfortunately, we may have no choice. But we must be very careful. The government should hold equity no longer than necessary to restructure the banks, resume normal lending and recoup at least a portion of taxpayer investment.
[The trouble is that once an industry comes under the claw of government bureaucracy, it is challenging to undue it. And when they do de-nationalize, there is a tremendous risk that the process will be conducted politically. That is, the ripe fruits would go to those politically connected.]
After replacing bank management with new private managers, the government should have no say in banks’ day-to-day operations.
The FDIC can assist. Just this year, it has placed more than a dozen American banks – admittedly all small – into receivership. We might also consider setting up something akin to the Resolution Trust Corporation, created in 1989 to liquidate the assets of failed savings and loans. The RTC eventually disposed of almost $400bn in assets of more than 700 insolvent thrifts.
To avoid bank runs and contain market disruption, the Treasury should announce its decisions at one time. Washington will also need to co-ordinate its actions with other major capitals, especially in western Europe and east Asia. At best, this will encourage other countries to take similar steps with their own banking systems. At a minimum, other governments can prepare for the financial turmoil associated with the announcement.
[It is difficult to see politicians who rarely agree on anything substantive suddenly consent to engage in such a complicated operation.]
This approach is not pretty or easy. It will cost a lot of money, with the lion’s share coming from US taxpayers, at least in the short to medium term. But the alternative – a piecemeal pumping of more public money into insolvent banks in the vague hope that things will improve down the road – could truly be historic folly.
Eventually our banks and economy will start to recover. When they do, we would be wise to avoid another Japanese mistake – raising taxes. To counter mounting debt created by government stimulus packages, Japan increased taxes in 1997. Consumption dropped and the country’s economy collapsed.
Our ad hoc approach to the banking crisis has helped financial institutions conceal losses, favoured shareholders over taxpayers, and protected senior bank managers from the consequences of their mistakes. Worst of all, it has crippled our credit system just at a time when the US and the world need to see it healthy.
[But aren’t these some of the consequences of government manipulation in any sector? All government involvement in economic activity produces a winner and a loser. Both will lobby hard, given that they recognize rent seeking is the way to increase profits, not capital investment and productivity.]
Many are to blame for the current situation. But we have no time for finger-pointing or partisan posturing. This crisis demands a pragmatic, comprehensive plan. We simply cannot continue to muddle through it with a Band-Aid approach.
[To use a bit of sarcasm to highlight the error in this statement consider your response to a doctor who will treat your symptoms without analyzing what caused it. That will not assist us in preparing the cure for our malady, correct? We need to finger-point the culprits, otherwise we may have a case where the lunatics are running the asylum.]
During the 1990s, American officials routinely urged their Japanese counterparts to kill their zombie banks before they could do more damage to Japan’s economy. Today, it would be irresponsible if we did not heed our own advice.
[A Biblical Proverb says that like a dog returns to its vomit, so a fools returns to his folly. Fools have been in charge in this country for quite a while. The same folks who never saw this crisis coming are the ones cheerleading when presumably “green shoots” are visible and are advising the end of the recession is nigh. Fortunately, reality cannot be mocked for too long. Or like Moses once utter, “be sure your sin will find you out.”]
Tuesday, April 21, 2009
Why The Treasury Plan Will Fail
The recent economic plan endorsed by Treasury Secretary Geithner will not succeed for two reasons. I will not discuss the complexities of the proposal, but rather point to its inadequacy. The first pitfall of the plan is that it’s based on massive subsidies for economic agents participating in it. Subsidies by their very nature cause distortions in the price mechanism. So while the objective of the Treasury plan is to augment the price discovery process for opaque financial instruments, the government handouts will prevent this from taking place in full measure. Recognizing they have the support of the government (who presumably represent the taxpayers), bidding firms will overpay for the assets. Therefore the situation will create the environment where the latter will reap potentially unlimited rewards but cap its losses in a worst-case scenario. In essence, the government is writing an enormous call option for potential investors. Buyers and sellers will benefit. Assuming no additional regulatory burdens to investors arising for participating in the plan, the cost of the subsidies incurred by government will exceed the benefits for buyers and sellers—a characteristic of all subsidies. The notion that there is such a thing as an optimal subsidy concedes that a committee of economic advisors is superior to private parties interacting in an unhampered market.
The second issue relates to the continued distress banks’ balance sheet will experience, in particular to loan deterioration. The current crisis has dealt primarily with the trading side of financial institutions. The next phase will take place in the so-call banking book, which makes up the non-tradable assets (e.g. loans). Consider the ratio of Net Loan Charge Offs-to-Total Loans at commercial banks: It has climbed significantly since 2006, where it stood just below .2 to the current figure of .95. This same pattern is exhibited for all data series presented in this missive since the aforementioned period. But during the late 1980s/early 1990s, the ratio peaked at around 1.8 (see here). Another key statistic is the Loan Loss Reserves-to-Total Loans ratio, which is lower today (2.30) in comparison to where its peak in 1993 (2.75). But this hides the fact that for commercial banks with assets whose assets fall between $1 billion to $15 billion the gap is much larger. The ratio currently stands at 1.89, significantly lower than its peak of 2.90 registered in 1992 (see here). Those banks with average assets exceeding $15 billion, the ratio is currently 2.53 vis-à-vis approximately 4.70 in 1987 (see here). As can be expected given the severity of the economic crisis, these ratios will increase.
Considering Net Loan Losses-to-Average Total Loans for banks resemble the same behavior. For all banks, the ratio currently reported is of 1.33 compared to its peak of approximately 1.6. For banks with average assets of $1 billion to $15 billion, the ratio currently stands just below 1.2, much lower than the peak amount of about 1.8 in 1991 (see here). For institutions exceeding the $15 billion average assets threshold, the figures are equally abysmal: The ratio currently stands at 1.5, which is much lower than the amount of 2.3 reported in 1990 (see here). But what evidently demonstrates that more difficulty awaits the banking industry, consider the ratio of Non-Performing Loans-to-Total Loans. Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. At its peak for all commercial banks, the ratio stood at 4.88, which is much higher than the current figure of 1.70 (see here). The same ominous gap is present for all banks exceeding $1 billion in average assets (see here, here, and here).
Therefore, we can assess that banks’ balance sheets will continue to get worse. Non-performing loans will increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, is not sufficient to cover the potential losses. Banks starving for capital will be forced to increase this amount and reduce lending to risky borrowers. All this points to more bailouts and failures ahead. The Treasury plan does not address any of these looming troubles.
The second issue relates to the continued distress banks’ balance sheet will experience, in particular to loan deterioration. The current crisis has dealt primarily with the trading side of financial institutions. The next phase will take place in the so-call banking book, which makes up the non-tradable assets (e.g. loans). Consider the ratio of Net Loan Charge Offs-to-Total Loans at commercial banks: It has climbed significantly since 2006, where it stood just below .2 to the current figure of .95. This same pattern is exhibited for all data series presented in this missive since the aforementioned period. But during the late 1980s/early 1990s, the ratio peaked at around 1.8 (see here). Another key statistic is the Loan Loss Reserves-to-Total Loans ratio, which is lower today (2.30) in comparison to where its peak in 1993 (2.75). But this hides the fact that for commercial banks with assets whose assets fall between $1 billion to $15 billion the gap is much larger. The ratio currently stands at 1.89, significantly lower than its peak of 2.90 registered in 1992 (see here). Those banks with average assets exceeding $15 billion, the ratio is currently 2.53 vis-à-vis approximately 4.70 in 1987 (see here). As can be expected given the severity of the economic crisis, these ratios will increase.
Considering Net Loan Losses-to-Average Total Loans for banks resemble the same behavior. For all banks, the ratio currently reported is of 1.33 compared to its peak of approximately 1.6. For banks with average assets of $1 billion to $15 billion, the ratio currently stands just below 1.2, much lower than the peak amount of about 1.8 in 1991 (see here). For institutions exceeding the $15 billion average assets threshold, the figures are equally abysmal: The ratio currently stands at 1.5, which is much lower than the amount of 2.3 reported in 1990 (see here). But what evidently demonstrates that more difficulty awaits the banking industry, consider the ratio of Non-Performing Loans-to-Total Loans. Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. At its peak for all commercial banks, the ratio stood at 4.88, which is much higher than the current figure of 1.70 (see here). The same ominous gap is present for all banks exceeding $1 billion in average assets (see here, here, and here).
Therefore, we can assess that banks’ balance sheets will continue to get worse. Non-performing loans will increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, is not sufficient to cover the potential losses. Banks starving for capital will be forced to increase this amount and reduce lending to risky borrowers. All this points to more bailouts and failures ahead. The Treasury plan does not address any of these looming troubles.
Monday, October 6, 2008
The Republicrats will win the next U.S. election
The Republicrats are not an officially recognized party, yet for all intents and purposes, they might as well be. They represent, I believe, the symbiotic relationship between the Republicans and Democrats. In between the rhetorical maneuvers of “change” and displays of “patriotism”, lies a commonality that is evident to any impartial observer. This interaction would be quite comical if it were not for the fact that its consequence will prove grave for the entire nation. Sifting through the glib headlines and MSNBC/Fox News sound bites that have come to encompass the “issues”, the fact of the matter is that neither party proposes alternatives to treat the root causes of the problems that bedevil our nation. Hence the term Republicrats. I will take two issues to make my point.
The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.
On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.
The U.S. currently finds itself with a public debt of about $9.6 trillion; this does not even count the $5.4 trillion liability resulting from the de facto nationalization of Fannie Mae and Freddie Mac or tens of trillions in other unfounded government liabilities. Since the Reagan administration, Republicans have become intoxicated with spending. Hinging on their interpretation of supply-side economics, they believed that lowering taxes would increase government receipts (this is the famous Laffer Curve), thus giving them the ability to spend without little constraint. They have “reasoned correctly from this erroneous premise.” Democrats, on the other hand, have had an equally nefarious record. They will quickly point out and say, "hey, at least Bill Clinton reduce the budget deficit." Unfortunately, however, that's not entirely true. In fact, public debt increased during Clinton’s Presidency. According to Treasury Direct, an agency of the U.S. Bureau of Public Debt, Mr. Clinton’s administration added about $1.5 trillion public debt. Currently, our nation needs to borrow $2.5 billion dollars, primarily from foreign sources, on a daily basis to meet its bills. Making matters worst is the fact that the dollars backing the debt have been printed out of thin air—thanks to the U.S. Treasury Dept. and the Federal Reserve System. The excessive supply of dollars has not translated into higher prices in the U.S. because foreign governments have had an insatiable appetite to acquire them. If one assumes that the foreigners will always crave dollars, then the U.S. will continue to get a free ride. If one assumes the contrary, more unpalatable consequences are surely to come. Despite this ominous forecast, neither party has candidly addressed this issue. Instead they talk about more spending, giving more money away to other nations, and continuing to use government credit to bail out corporations.
On the foreign policy front, the theme repeats itself. Neither party has relinquished its imperial ambitions to embrace peaceful multilateral relations—an absolute must in order to foster international trade. Democrats offer “no imperialism without representation”; that is, a continued belligerent foreign policy, as long as there is world consensus. Republicans, well, it goes without saying that they are the party of “perpetual war for perpetual peace”. The U.S. Constitution gives authority to declare war only to Congress. Yet, hearing presumptive presidential and vice-presidential candidates these days one wouldn’t think that. In fact, rarely anyone mentions that Congress never declared war on Iraq; a resolution was passed but never a declaration. I can only come to the conclusion that continued breach of U.S. law will prevail. So as a net result, one party wants to take the U.S. citizen out to McDonalds while the other one proposes Berger King.
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