Wednesday, December 28, 2011

Volatility Lurks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The European Union is putting its money where its mouth is. Never taking the slightest blame for euro woes, its New York employees are moving to new offices at 666 Third Avenue. The EU's United Nations delegation will "take about 45,000 square feet .... and pay about $60 a square foot annually for 15 years...." reported Bloomberg on December 23, 2011. Negotiations with its prospective new landlord, Tishman Speyer Properties L.P., are nearing completion. The real estate company should consider an anti-EU hedge at the moment the EU signs up.

Sixty Euro employees will occupy the space (per
Bloomberg). This works out to a 25-by-30 square-foot office for each. "Austerity" is imposed on the lower 99%, but not yet in Brussels, Strasbourg, or points west.

The potential break up of the European Union is more a consideration for a landlord holding a fifteen-year lease agreement than for the average investor. Yet, current havoc and future bedlam are clearly underpriced in all markets. European and U.S. mispricings will be discussed here.

The S&P 500 volatility index - the VIX - is a measurement of volatility expectations. It has fallen 50% since the (latest) agreement to save the euro was announced. From 30.59 on December 8, 2011, (the Eurocrats trumpeted their fiscal union pact on December 9, 2011) the VIX fell to a 20.72 close on December 23, 2011.

Whether or not fiscal continence is the route to euro salvation does not seem to matter. As discussed in
The Rotten Heart of Europe, the Euro establishment (Brussels, banks, and bond markets) vectored towards that conclusion. Having done so, the implied volatility of markets is a derivative of what negotiators accomplished on December 9th.

European Voice
, a Brussels-based, English-language newspaper "maintains an independent stance regarding the affairs of the European Union." So it claims. It is owned by the Economist Group. This disabuses the notion of neutrality. The Economist's heart, soul, liver, and spleen promote the European Union over national sovereignty.

Van Rompuy Sends European Leaders Draft of Fiscal Union Pact, published on December 14, 2011, distills the best efforts of euro fans to promote the fiscal union pact. We learn that Herman Van Romney, the president of the European Council, has (on December 14) sent a draft of an inter-governmental treaty that will seek to boost economic discipline in the eurozone. It will enter into force once nine of the 17 eurozone member states have ratified it. It contains tougher rules on economic discipline. [Underlined words to be explored - FJS]

Since the purpose of the pact is to convince skeptics of the euro's stability, Van Rompuy must be planning an early retirement. Maybe next week.

The "draft" will transmogrify into a treaty by March 2012. (This and what follows is gathered from
European Voice.) How many of the still (somewhat) sovereign states will sign is unknown. We do know that most countries "have shown interest." Whether any more is expected of countries is not clear: "If a eurozone country does not ratify it, it will not be bound by the new rules." That's the problem with the euro today.

However, an EU official told
European Voice that rejection by a country would "make life politically very uncomfortable for a non-ratifying member." Here is the mailed fist of the lifetime bureaucrat. The EU official continued: "It ["It' seems to mean the state's sovereignty - FJS] would not be durable for long." The second decade of the 18th, 19th, and 20th century were marked by continental European skirmishes. Four-in-a-row looks plausible.

European Voice
reports there are references in the treaty to "work jointly towards an economic policy fostering growth through enhanced convergence and competitiveness." Yet, these references - "remain vague." Please recall that markets, by and large, believe the Eurocrats will prevent a euro breakdown.

"Once adopted, the treaty will force countries to run a balanced budget and enshrine that rule in
their constitutions." This is the out-to-lunch attitude of the bureaucrat: expecting, by the beginning of March 2012, the parliaments of nine - or is it 17? - European countries to cede their parliamentary authority (and the opportunity to hand out vote-gathering favors) regarding respective national budgets, at a time voters are ready to lop off parliamentary heads.

Standards to enforce fiscal discipline were ignored in 2005 when "Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt stability pact..." (From:
The Rotten Heart of Europe.) That was during a time of relative prosperity. Actually, it was a time when all countries could borrow and spend with abandon, the very problem that has caused the euro's decline.

In any case, an
inter-government pact is unenforceable since "the European Commission cannot take member states to court when they breach budget rules." This is worth $60 a square foot?

Amidst this incoherence, gold and silver wallow. The VIX rose from a fat, dumb, and happy 17.56 on July 22, 2011 to 48.00 on August 8, 2011. It was during that time Standard & Poor's cut the credit rating of the U.S. government and the debt ceiling terrified the nation. Should another rating agency do so (Fitch has been making noises) one should expect volatility.
(Washington Post headline, December 27, 2011: "Obama to Ask for Increase in Debt Ceiling")

Jim Bianco
[], president and television star at Bianco Research, explained the potential problem in an interview with Kate Welling (Welling@Weeden). When a country loses its AAA-rating, Basel III capital requirements and central bank rules require banks to apply haircuts against the downgraded bonds. This would create a problem in repo markets, among others. Borrowers in the repo market (somewhere around $4 trillion for U.S. banks) would need to find additional collateral. (Here is the problem of falling standards of collateral leading to demands for more collateral, again.)

Bianco explained the potential rumpus: "Since [Moody's and Fitch] are still at triple-A, we can pretend S&P did nothing. The next downgrade, if Moody's or Fitch were to follow S&P's lead, would actually matter a lot.... The next one that issues a downgrade would make the U.S. a split-rated double-A-plus, which would change some of the rules."

If the VIX falls to 18, call options are worth considering.

Thursday, December 15, 2011

U.S. Exposure to Europe - Unknowns Unknowns

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - there are things we do not know we don't know. "

-Former United States Secretary of Defense Donald Rumsfeld, February 12, 2002

There were reasons to criticize Donald Rumsfeld's turn as Defense Secretary but this was not one of them, even though the media quoted and re-quoted this most sensible approach to uncertainty as proof of a retarded intellect.

As Eurocrats dissemble (see: The Rotten Heart of Europe), ratios that quantify U.S. financial system exposure to European insolvency are dated, even as they are published. Credit default swaps or loans may have been traded in the interim, may have been hedged, or may have slithered from For-Profit-or-Bailout Banks onto the Federal Reserve balance sheet (i.e., nuclear-waste securities). Aggregate bank balance-sheet figures may be gross or net (and we debate whether gross or net is the more consequential measure), may be the tip of an iceberg compared to submerged, off-balance-sheet liabilities, and ultimately, we do not know the timing of the Fed's $5 trillion academically certified money dump into the banking system.

These limitations have been compounded by a recently revealed "unknown unknown," at least to most of us. On December 7, 2011, Reuters published "MF Global and the Great Re-Hypothecation Scandal." Reuters' reporter Christopher Elias opened: "A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back." (Re-hypothecation will be described below.)

Some lessons here: First, if not for the money stolen from MF Global's customers, Reuters probably would not have set Elias on the trail to re-hypothecation. Second, it is when good credit is receding that such scandals come to light. (Madoff.) If not for the slide in European sovereign bond prices (the route by which MF Global's CEO leveraged and bet the solvency of his firm), MF Global would not have disappeared. Third, and very much related to the previous point, the world's good collateral shrinks by the hour. Fourth, the supposed bond "guarantees" that authorities bray about are a chimera. Quoting Elias: "Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow." The EFSF is backed by words, not assets. The more that governments and international bodies vote to back spiraling guarantees, the less their guarantees are worth. Thus: good collateral as a percentage of paper and paper promises shrinks. Fifth, and very much related to points two through five, it is only the spiraling of financial leverage that prevents the financial economy from collapsing.

Re-hypothecation is a revelation in financial leverage. Most readers understand "hypothecation," even if they never heard the word. Elias explains: "By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is 'hypothetically' controlled by the creditor, who has a right to seize possession if the borrower defaults." An example would be an investor who holds a margin account with a broker. If the value of the assets (shares of IBM) fall to a certain point, the broker requires that the investor put more money into the account. If the client does not put the required money into the account, the broker has the right to sell shares of IBM. The cash received in the sale restores the minimum level of equity required by the broker.

Elias explains the process as follows: "In the U.S., this legal right takes the form of a lien.... A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default."

Now we get to the scary part. Re-hypothecation, explains Elias: "occurs when a bank or broker re-uses collateral posted by clients... to back the broker's own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal." He quantifies the legal scam: "Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as 'churn'), the original collateral being used may have been as little as $1 trillion - a quarter of the financial footprint created through re-hypothecation.

ot off the press (dated December 2011) is an IMF report: The-Non-Bank-Bank Nexus and the Shadow Banking System. Authors Zoltan Pozsar and Manmohan Singh give an example of how re-hypothecation works (on page 11 of the paper). A dealer holds a Treasury security as collateral which "comes with the rights for the dealer to repledge it." The dealer uses this collateral as his (the dealer's) collateral with an asset manager. The asset manager "may re-use the Treasury security to post collateral with another dealer..." On it goes, each party in turn using the same Treasury security as collateral. The IMF authors proffer: "Since these transactions are underpinned by a single piece of collateral, such daisy-chains may be referred to as dynamic chains." They may also be referred to as an illusion of credit that nonetheless has inflated asset prices from Shanghai apartments to Apple common stock to European and U.S. Too-Levered-To-Die Banks. Pozsar and Singh write the traditional thinking of how banks fund themselves "ignores the significant funding that banks receive from the asset management complex" that permit "both individual banks and the banking system as a whole [to] quickly lever up."

Understanding this lends credibility to MF Global Chief Executive Officer Jon Corzine's statements before Congress that he does not know where his clients' money is. Pozsar and Singh write: "The securities that asset managers invest on behalf of households are seldom left lying around passively in portfolios. In order to capture their value as collateral, securities are routinely lent out for use in the shadow banking system, a fact few households, whose securities are ultimately being lent, are oblivious to." [My italics, should you have nodded off during all the IMF talk. - FJS]

It is generally believed that U.S. banks are in much better shape than European banks today. Of what value is this? Back to Pozsar & Singh: "The repeated use of... collateral facilitates system-lubrication [and] also the build-up of leverage-like collateral chains between banks and managers."

A down drift of collateral values, which should be expected since there is no value to the compounded layers, may be a reason European banks are in such dire straits. (European Central Bank President Mario Draghi to the European Parliament on Thursday, December 1, 2011: "We are aware of the scarcity of eligible collateral.")

reported on December 13, 2011: "EU Banks Selling 'Crown Jewels'..." The banks are selling some of their most profitable arms (lines of business) to raise cash. Is this the fire sale of the century? Probably not. Selling profitable lines at discounts to their fair value today drags down prices which may lead to another round of discount sales, at even lower prices tomorrow.

Distorted pricing of assets by a leveraged financial system with few real assets has led to some strange observations. Izabella Kaminska reports in the Financial Times (alphaville) that it is not regulators or authorities, but "the markets themselves... [that] are demanding a re-collateralization in all funding areas." She notes: "[T]he latest trend towards gold collateralized bank loans shows in some ways the market is demanding the recollateralization of credit with gold." Kaminska notes: "Gold is switching places with [U.S.] Treasuries as the ultimate form of security."

It is surprising U.S. Treasuries still hold that princely position. The FDIC is now guaranteeing $53 trillion (not billion, but: trillion) of Bank of America's (transferred from its Merrill Lynch subsidiary) credit default swaps. This maneuver was executed by the Federal Reserve. This is both reprehensible and meaningless. Assume a 25% default rate on the credits and that Bank of America also defaults. A $13 trillion tax on Americans to make good on our guarantee is meaningless, other than to induce an immediate credit downgrade to F-.

Speaking of the Fed, specifically of Federal Reserve Chairman Ben Bernanke, he told Congress on November 2, 2011, that MF Global had been approved as a primary dealer by the New York Federal Reserve, "but we are not the regulators of MF Global," nor is there any reason the Fed should be overseers or regulators to such a firm. Authors Poszar and Singh placed dealers at the heart of the re-hypothecation racket. Oh, Ben! Aggressively stupid to the end.

From the close on November 30, 2011, to December 12, 2011, (when Kaminska wrote), the spot gold price fell about $90, from $1,746 to $1,659. Kaminska explained why: Right now: "Banks don't need gold as much as they need cash." (This relative lack of need for gold is what she refers to below as "surplus gold.")

As has been written many times "gold is the ultimate form of payment," and so it is being lent by banks "for its use as a funding instrument: collateral." Gold now is being lent by banks (repoed) at a negative rate. "The more negative the rate, the higher the cost of funding using the collateral." Kaminska concludes: "With surplus gold being put into the system, the price of gold has no choice but to stall."

Maybe Kaminska should have considered another possibility: as the panic for collateral worsens, the price might continue to fall. In fact, over the past two days (December 12 to December 14), gold has fallen another $90, to $1,567 (as this is written). If Kaminska's analysis is correct, the price of gold could spring back up, with alacrity.

With the European banking system near collapse, we may soon find just how exposed is the U.S. banking system to continental credit, credit default swaps, and "repeated use of... collateral facilitates system-lubrication [and] the build-up of leverage-like collateral chains between banks and managers."

There is no question that, if it was within their power, the Eurocrats would have absorbed every last bond and bank loan on a bank balance sheet that is trading at a discount. "Oh," they must be wishing "if only we had the arrogated authority of Federal Reserve Chairman Ben Bernanke." They know that when (not if) the Federal Reserve chairman is in a similar position to theirs, he will beckon $5 trillion of funny money into existence. This would exceed his authority, but after members of a Congressional committee read him the riot act, they will thank him for saving the system, even as the inflation rate passes 30% during the hearing, and he will be Time magazine's Hero-of-the-Year again.

As for the Eurocrats, they will find a way to do the same. They must: otherwise the pampered satraps in Brussels will have to move home and pay taxes.

But could this "known known" (speaking of both the U.S. and Europe) be a miscalculation? That is to say, could the parties mentioned miscalculate and not act in time to pump up the sinking structure of leveraged ether?

Possibly so. There is precedence. Benjamin Anderson, economist at the Chase Bank from 1920 to 1939, wrote about two such misjudgments in the 1930s, in his highly recommended book, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946.

On May 12, 1931, "there came an unexpected run on Oesterreichische-Credit-Anstalt," a large Austrian bank. To be noted: (1) Oesterreichische-Credit-Anstalt was forced into a merger with a weaker bank in 1929. This might be analogous to Bank of America's acquisition of Countrywide Financial, and, (2) quoting Anderson: "The Austrian government guaranteed certain of the investments." (Oh, those government guarantees again!), but "the merged bank had been inadequately financed... the big merged institution was still insolvent." Just as in Europe today: how good is the credit (collateral) of the guarantor? The bulk of a sovereign state's collateral is future tax revenues. From Greece to the United States, this does not inspire confidence today.

On May 14, 1931, the Bank for International Settlements coordinated support by central banks. "This made a great show of international cooperation... but the effect was bad when eleven central banks were providing among them only $5.6 million. Creditors grew more frightened, rather than less. If the thing were to be done at all, it should have been done adequately. The first principal of bank loans in a crisis is that if the borrower needs $100,000 to save him, you give him $100,000 or you give him nothing at all. You don't give him $20,000."

Here, as described above, is where the U.S. (today) can hyper-inflate at will, while Europe is encumbered. Back to Anderson and 1931: "Panics are not dealt with effectively through delay, through public discussion, and through fighting for position. A loan of $25 million made promptly at the first sign of panic would probably have stopped it. There came a time when $100 million would not stop it. By the time the Austrian government on May 29, [1931], voted the guarantee of $150 million, the credit of the Austrian government was so shaken that no one cared about the pledge. When on June 6, 1931, the Bank for International Settlements arranged to give a... 100 million shilling credit [$14 million - FJS] to Austria, the Austrian financial disaster was very little helped thereby."

German banks endured a run on June 1, 1930. "In the beginning of the run on Germany, again the effort of international banking cooperation was made. Again $100 million promptly provided by concerted action of British, American, and French banks, publicly announced and instantly made available, could have stopped the crisis. A month later $500 million would not have been sufficient."

There were squabbles: It is "in the French character and the French tradition that immediate acceptance of a contract proposed by another party is out of the question.... France delayed, and France delayed to long.... The German people, as well as foreign creditors, were engaged in the run on German banks." France was not the only culprit. Anderson criticizes New York bankers for being too timid and too late.

This was not the end for German banks. Publicized meetings among government authorities and official proclamations dragged into 1932: the Euro summits of the day. Hope sprang eternal that a reconstruction of German debts (and war repatriations) could be managed, but it was not to be. Anderson observed (literally: he was confidant to participants) that "governments move slowly and politicians look to the next election." He concluded: "If the governments had acted that winter, Hitler would never have come to power, and we should have saved the democratic regime of Germany." This was an unknown unknown.

Thursday, December 8, 2011

The Rotten Heart of Europe

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

To Americans, European problems may seem as remote as they did in 1939. There is a good chance, though, that the crumbling financial structure will not be "contained" or "ring-fenced": the latter being the common description of how Europe had isolated itself from Italy's difficulties. That lasted a week or so. We may soon discover the extent of American exposure to European financial insolvency.

The catalyst for this coming weekend's European Union meeting is the failure of Europe's daisy-chain finance. On Monday, December 5, 2011, Bill King (The King Report) wrote of the latest: "European solons are proposing another Daisy Chain Bailout scheme - bankrupt and near-bankrupt European nations will inject money that they must borrow from the IMF so they can in turn borrow the money that they borrowed and then lend to themselves." Wendy's toes are curled around the end of Captain Hook's gangplank.

The creditworthiness of the fractured institutions is not trusted: the commercial banks, the national central banks, the ECB, the EFSF, and most importantly, the Bundesbank. On November 23, 2011, the Bundesbank attempted to auction €6 billion of 10-year German government bonds. It received bids for €3.8, or 61% of the total. Neil Jones at Mizuho Corporate Bank Ltd. in London told Bloomberg: "If investors do not wish to buy bunds, they do not wish to buy Europe." Right-ho.

The purpose of this dispatch is to dispel rumors that current front-page treaty talks have any economic meaning. The European and U.S. stock markets react with a 3% or 4% gain after vague announcements, but we are getting closer to a day when the false prophets are stripped bare.

The euro cannot survive in its current form. To understand this, we will return to its introduction. Some dates: The 1992 Maastricht Treaty formally established the intent of a single currency. The euro acquired electronic legitimacy on January 1, 1999. For instance, it was henceforth used in electronic bank transfers. The national currencies were locked at a specific rate to the euro on that date. On January 1, 2002, euro coins and bills became legal tender.

The euro was introduced after the finances of 10 (or 11, we'll skip over this) countries had "converged," meeting such criteria as national budget deficits less than 3% of GDP and a debt ratio less than 60% of GDP. It is now the currency of 17 European countries. Most, if not all, played games to meet these requirements. This was not a secret.

The preferred method of cheating has been to fabricate or ignore. On June 5, 2000, when Greece was admitted into the not very exclusive euro club, Austrian Finance Minister Karl-Heinz Grasser told reporters: "Greece will become a member for sure. It meets all the requirements for membership." A leading requirement was to not tell reporters the truth. French Finance Minster Laurent Fabius offered a more discreet assessment, as would be expected from a graduate of the École Nationale d'Administration (the training ground for advanced French bureaucrats): "Greece has made a huge improvement."

The euro, and more generally, the European Union, has been a bureaucratic racket from the beginning. Brussels protects its own interests first. It does not weigh the success of its ventures by how the masses subject to its mandates fare. The euro had its flaws, but the paper pushers never answer for mistakes. Like the Federal Reserve or the Gang of Four, they are unaccountable. (The latter offers some hope.) Human tissue is Play-Doh in their hands to be molded into what Superior Persons call their "European Project.

When trouble loomed, the Eurocrats looked the other way: "
Except for being told by the EU and ECB to get its financial house in order, Greece was not punished for cheating. In 2005, Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt "stability pact," despite knowing that Greece had been above the 3% threshold for the previous three years." (Gold Alert, May 27, 2011)

The great flaw was already evident: countries could spend and tax as they wished (or didn't wish) while issuing bonds as if they were as creditworthy as the Bundesbank. It is only natural that Italy shoveled out bonds, borrowing and spending, until its debt grew to be the third largest sovereign bond market in the world, without a chance now of repayment at par.

Former European Central Bank Chief Economist Otmar Issing was quoted by Bloomberg on May 26, 2011: "Greece cheated to get in, and it's difficult to know how we should deal with cheaters." In fact, this is a matter of character, not law: "The grand plan outlined by France and Germany on Monday for European Treaty change breaks no new ground in terms of ideas - all the proposals already exist in various legal acts, the only problem is they have never been observed in practice." (Reuters - December 5, 2011)

The Eurocrats are meeting this weekend to discuss a treaty that will - do nothing, even in today's frantic quest to sign a scrap of paper that will satisfy potential bond buyers. A carrot was dangled, but quickly withdrawn. From Ambrose Evan-Pritchard in the Daily Telegraph: "[German Chancellor Angela] Merkel seems to have backed off on demands that budget breaches will be justifiable before the European court, so the Treaty chatter is mostly Quatsch, betises, and eyewash.

By the way, the effectiveness or necessity of rules is not discussed nearly as much as whether they are breached. The rules seem to be an end in themselves. The real problem, of divergent national economies operating in a single financial system, while countries spend and tax with very different priorities, has not changed. It remains - just talk.

Recall that the catalyst is disintegrating finance. Aside from the Bundesbank auction, an unknown number of banks cannot borrow from each other, so are drawing on the European Central Bank, which, itself, is highly leveraged, is holding Greek and Italian bonds at par, and is cheating on its constitutional restriction that it cannot bail out nations. Europe has begged around the globe for capital investment, to no avail. Portugal carried its tin cup to Angola, a former colony. The Angolans responded "nyet." Thwarted by its African sidekick, Lisbon officials validated Angola's wariness by confiscating €5.6 billion from Portuguese pension funds to fill its budget gap. Isn't technology wonderful? Tanks and troops slogging across continents warned of such heists in the past. Americans beware.

Of importance: the financial woes are REAL; the advertised solution is pretense. There is no financial "solution" as the loungers and idlers at European Union cocktail parties would define solution. They want a "fix" under the assumption the European Project could not possibly suffer from a design flaw. They designed it.

The Belgian bureaucrats expect the ECB to deploy enormous monetary firepower (€2 to €5 trillion) to relieve them of all this financial talk. To do so would break the law, not a consideration eurocrats or eurocratic periodicals mention. Bernard Connolly, in The Rotten Heart of Europe: The Dirty War for Europe's Money (1995), wrote that monetary union "is not only inefficient but undemocratic. A danger not only to our wealth but also our freedoms, and ultimately, our peace. The villains of the story... are bureaucrats and self-aggrandizing politicians." Monetary union "is a mechanism for subordinating the economic welfare, democratic rights, and national freedom of the European countries to the political and bureaucratic elites whose power-lust, cynicism, and delusions underlie the actions of the vast majority of those who now strive to create a European superstate."

Connolly is now an economic consultant (Connolly Insight) who wrote this book after his eye-opening experience inside the Eurocracy. There is a single copy available on Abebooks, for $1443.52.

It was 97 years ago when German Chancellor von Bethmann-Hollweg asked the British ambassador in Berlin, Sir Edward Goschen, why England would defend Belgium's neutrality. His Majesty's Government had signed a treaty to do so, in 1839. Bethmann-Hollweg replied this was a "scrap of paper."

It has been a deplorable century for the law, agreements, and treaties since that confrontation in 1914, the same year the International Gold Standard unraveled. Now, the stellar leadership mentioned above and in the United States are worming their way to a poetic conclusion. Currencies will not be worth the money they are printed on.

Thursday, December 1, 2011

The SEC's Day in Court

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Mists gather over dubious government practices. The collapse of MF Global should have scared the wits out of U.S. investors. If you haven't panicked yet, there is still time. Since public discussion of its demise lasted about 45 minutes, we are left to speculate. A possible, but sketchy summary might run: a securities firm, run by the former senior partner at Goldman Sachs, took a leveraged position in speculative bonds that caused the eighth largest bankruptcy in U.S. history. Thousands of brokerage customers, who believed their accounts were segregated from MF Global's account, are left to conclude (given the silence of government agencies), that their money is gone. And, MF Global may have done nothing illegal (protected within the boundaries of CFTC Rule 1.29).

Now, the good news: a government employee - a judge - who is fighting for the common man.

Judge Jed S. Rakoff of the United States District Courts of the Southern District of New York struck a blow against the Securities and Exchange Commission and in support of the "public interest." The Securities and Exchange Commission had asked the Court to approve a Consent Judgment between Citigroup and the S.E.C. Judge Rakoff (cutting to the chase) wrote he could not do so: "An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts - cold, hard solid facts, established either by admissions or by trials - it serves no lawful or moral purpose and is simply an engine of oppression."

Judge Rakoff summarized the lawsuit of
U.S. Securities and Exchange Commission vs. Citigroup Global Markets: "According to the S.E.C.'s complaint, after Citigroup realized in early 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as "Class V Funding III") that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup's misrepresenting that the Fund's assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negatively projected assets and had then taken a short position in those very assets it helped select." There is more, but this gives a sense of Citigroup's conduct.

The settlement required Citigroup to disgorge its ill-gotten profits and to pay the S.E.C. a $95 million civil penalty. This is pocket change for a bank that makes or loses $10 billion a quarter. Judge Rakoff said as much: "If the allegations are true, this is a very good deal for Citigroup; and, even if they are not true, it is a mild and modest cost of doing business."

Judge Rakoff's rejection of the Consent Judgment is in contradiction to past and current practices: the securities firm under investigation (all of the big ones, all of the time) engages in a questionable practice; the SEC investigates; the parties agree to a settlement, the defendant neither "admitting nor denying the allegations of the complaint..." (All quotations are from Judge Rakoff's Opinion and Order, unless otherwise noted.) The November 29, 2011,
Financial Times addressed the context: "Citigroup did not admit or deny wrongdoing - a standard practice for four decades in SEC settlements."

These side deals are rubber-stamped by the Court even though it "has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.... [T]he court has become a mere handmaiden to a settlement privately negotiated on the basis of unknown facts."

Judge Rakoff hints such agreements are privately negotiated within the White Shoe Club: "Although [the charges against Citigroup] would appear to be tantamount to an allegation of knowing and fraudulent intent... the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence...."

This "deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation, in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence... but also cannot derive any collateral estoppel assistance from Citigroup's non-admission/non-denial of the S.E.C.'s allegations." ["Collateral estoppel assistance": The S.E.C. structured the settlement so that private litigants cannot use any admissions/statements Citigroup made during this S.E.C. action.]

This helps explain why every bank CEO and director sat in front of post-meltdown, Congressional committees and pleaded idiocy. They "never saw it coming." That was negligent, which cannot be litigated. The dumbbells have escaped (at least, until now) charges of "knowing and fraudulent intent" since it was beyond their comprehension that mortgages on which the buyer never made a single payment (common by early 2007) should not be bundled and sold to the public. It was quite a sight to watch Bob Rubin, former partner (and certified genius) at Goldman Sachs, testify he was denser than Wall Street shoe shine boys.

Judge Rakoff chastised the S.E.C. for abusing the public interest: "[I]n any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world propaganda reigns, and truth is confined to secretive fearful whispers." If Heaven were on Earth, the Bureau of Labor Statistics would face off against Judge Rakoff and defend its unemployment, inflation, and G.D.P. propaganda.

Like other failing, doddering, American bureaucracies, the S.E.C.'s counter-argument hurt more than it helped: "[T]he S.E.C. suggests that, if the public interest must be taken into account, the S.E.C. is the sole determinant of what is in the public interest..." This shows an organization that is so accustomed to reigning outside the law that it could only muster a nonsensical, circular, self-aggrandizing argument in front of a judge who is determined that the S.E.C. must operate according to the laws of the United States: "[T]he S.E.C.,
of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges.... [T]his court must not... grant judicial enforcement to the agency's contrivances." [My italics - FJS]

If only the bankrupt customers of MF Global can find such an advocate.

Wednesday, November 23, 2011

Ted Forstmann

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

In a world where evidence often shows the bad do well, memories of a good, rich man may lift the spirits of the disillusioned.

Ted Forstmann died of brain cancer on Sunday, November 20, 2011. He was 71. Obituaries and tributes that describe his life are accessible in newspapers and elsewhere.

We met at Michael's in New York after the publication of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession. "I really enjoyed your book," were his first words. This was gratifying, since the number who have read the book is probably in double-digits.

Ted was a former friend of Alan Greenspan's, so, it was especially nice to hear, "You were very fair to him." I told him this was not difficult since Greenspan's own words condemned his Federal Reserve chairmanship. Recording his life and statements before 1987 (the year he became Fed chairman) was evidence enough that he lacked personal character to a sufficient degree for the Wise Men to satisfactorily conclude Alan Greenspan would act as expected. I went out of my way to suggest higher motivations for Greenspan's blemishes, allowing the reader to decide in which direction the evidence fell.

In Ted's opinion: "His own words showed how confused he was."

Ted thought my chapters about the 1980s were accurate. This was received with some relief. Few played a more central role than Ted, during the period I proposed (in Panderer to Power) as the sharp break in American finance. In particular, 1984 to 1986 was the time when Wall Street corruption was institutionalized. Alan Greenspan's participation in the S&L swindle (in 1984 and 1985) was akin to a Triple-A, minor-league, first baseman batting .360: the consulting economist was major-league material.

(From a letter written by New York Senator Daniel Patrick Moynihan on August 15, 1990: "Consider the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) more commonly known as the 'S&L bailout bill.' Has there ever been an equivalent phantasmagoria of evasion, avoidance, incompetence, muddle, and panic, all with the nice overlay of swindle? From a Treasury Department once handled by Alexander Hamilton! The largest scandal in the history of the national government; for which no one is responsible. That being the first sign of a government whose true energies and talents are directed elsewhere.")

There were more pages in Panderer to Power about the 1980s than some wished. Yet, the times and the man were Siamese twins. A grounding in that period is a foundation to understanding the final and accelerating finish of venerated U.S. institutions today: financial, academic, media, and government.

Without saying it should be so (to the best of my recollection), Ted supported my conclusion that Too-Big-To-Fail banks should be shut. He didn't know his banker anymore: "I don't know what a bank is. I've been doing this for 30 years. I went for a loan for one of my companies recently. The room was filled and I couldn't figure out if there was a person, a banker, who decided [whether I would get] the loan. None of them knew who I was."

Ted did not think derivatives should exist "except to hedge gold, crops [or similar physical materials]."

I had not known, until reading the New York Times obituary, that Ted Forstmann "coined, if inadvertently, a phrase that set the public image of the leveraged buyout industry. While he was golfing in the late 1980s with Richard L. Gelb, then the chairman of Bristol Myers, the discussion turned to a surge in takeovers by buyout firms. 'What does it all mean?' Mr. Gelb asked Mr. Forstmann. 'It means the barbarians are at the gate,' Mr. Forstmann replied. 'And they'll be coming for you next.'"

The obituary quoted from a Wall Street Journal column that Ted wrote in 1988: "Watching these deals get done is like watching a herd of drunk drivers take to the highway on New Year's Eve."

I graduated from business school in 1985 and played a bit part in the leveraged buyout spectacle. As a bit player though, with investment bankers grasping for every company's business (even to the unlikely degree of wooing a very junior analyst), I knew the gossip. Ted Forstmann was in the thick of deal-making at that point (Forstmann, Little), but his name was above reproach.

Ted thought younger people today combine a strange mix of materiality and immateriality. People he talked to in their 30s or 40s wanted to make money. They didn't really care about producing or making something.

Ted thought Alan Greenspan, via the Federal Reserve, was the central spigot of our current plight. In Ted's words: "They print the money. When they print too much, it goes into activities that aren't economic. When the interest rate is too low, people aren't careful. Borrowers can pay back in depreciated dollars. They barely need to put any of their own money into a project. If interest rates are 7%, they need to calculate its potential profitability."

Ted recommended Nicole Gelinas's book: After the Fall: Saving Capitalism from Washington and Wall Street. He thought she successfully made the case we did not need a slew of new financial regulations. If the Federal Reserve and other regulators had enforced the rules then in place, there would not have been a financial crisis. These are wise conclusions that could never penetrate the interests in Washington, Wall Street, academia, and the media. For each of these parties, such an acknowledgement would reveal their failure to halt the obvious beforehand. (See Moynihan, 1990, above.)

I presumed Ted did not think Federal Reserve Chairman Ben Bernanke was an improvement. Whenever his name was mentioned, Ted either winced as if he had bitten into a lemon or exhaled a low moan.

Ted was disappointed, but maybe not surprised, that I saw no other solution than to let prices, including assets and incomes, settle at a lower level, at which point the U.S. will be competitive again. This may have been a reason he simply could not speak at the mention of Ben Bernanke's name.

Ted Forstmann was a sterling example in a tarnished field.

Wednesday, November 2, 2011

Gold Stocks

A compelling argument to steer clear of gold and silver miners is their poor management. "Those companies are run by a bunch of miners. They don't know how to manage a company." Most often this criticism refers to gold miners' seemingly insatiable desire to issue new shares. By issuing new shares, a company reduces the value of shares already in the hands of the public. For instance, a company has issued 10 million shares of common stock. Now, it sells another 10 million shares. The profit-per-share to current shareholders (before the new issue) is cut by one-half.

This argument sometimes stops here. By not looking further, the necessity to raise more capital over the past decade is not addressed. During the 'oughts, the price of gold was too low for many of the miners to continue prospecting - without receiving more funding. To this, the complaint often goes: "If miners weren't such a bunch of miners!, they would have stopped prospecting, and let the price of gold rise to a profitable level."

Long-time shareholders also lament that miners too willingly issue shares. Common stock is only one way to meet accounts payable. The managers of mining companies can, and have, borrowed from banks, from the bond market, and from private investors. They have sold mining rights, and used other means to get money.

The tendency of gold-mining managers to behave like diggers rather than owners is less important today. Thus, the reasons stated above to not own miners is less compelling. "Gold and Silver Stocks" discussed some reasons why this is so.

Several miners have announced they will pay or increase dividend distributions to shareholders. Implicit in this trend is the recent profitability of gold mining.

Many miners are now able to finance their capital expenditures from cash flow. Where this is so, the digger-managers are less likely to act in contradiction to interests of the common shareholders. The Gold Stock Analyst has discussed companies that are now able to meet capital needs from cash: Goldcorp, Yamana, Newmont, and New Gold (funded by Goldcorp) are a few.

Not by any means are all gold and silver miners in this position. Nor should they be. Miners that issue shares in the future should not be summarily dismissed by shareholders. The companies are in different stages of the prospecting-to-production cycle and hold different opinions about internal growth or growth by acquisition. But all in all, gold and silver miners are in a much better financial position than during the Evil 'Oughts. If Simple Ben runs the Fed just awhile longer, $10,000 gold will solve all financing questions.

Monday, October 24, 2011

What They Are Doing

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The Euro and You described a fundamental problem of world finance. The quantity of debt grows as the quality recedes. The problem of bad loans is no longer just the pre-2008 mortgages, CDOs, and LBOs. Debt issued after the bust is defaulting, such as Greek sovereign bonds, issued in June 2010. Some securities are born to part investors from their money, but it's remarkable the extent and variety of such instruments issued in 2011. The world choked on similar bonds and derivatives only three years ago, many of which are still held at false prices on financial institutions' books.

Of all the past century's downgrades, none has been greater than the borrower's promise that stands behind a "security," a word that once credibly described a paper contract backed by appropriate collateral. In Debt and Delusion, Peter Warburtin wrote: "It is easy to forget that, as recently as in the 1960s, the government budgets of the OECD countries were in approximate balance and that net issues of debt were comparatively rare. The outstanding stock of debt in public hands was a meager $800 billion at the end of 1970. At that time debt issue was typically reserved for the financing of large construction projects or investment by power generation companies by publicly owned companies." Today, PIMCO's Bill Gross manages $244 billion in a single bond fund.

The starting pistol was sounded on August 15, 1971, 40 years ago. On that date, the United States broke its long-standing promise to pay one ounce of gold to a foreign government that redeemed $35 for the same. (The ability of American citizens to redeem dollars for gold with the U.S. government was modified during World War I and ceased after the War.) As a prelude to the loosy-goosy financial contracts today, it is worth reviewing the wording of the contractual relationship between the United States government and the holder of its currency before and after. (A book should be written on the parallels between the century-long degradation of language, the American legal system, money, credit, debt, and the American people.)

The face of a $20 bill, a gold certificate, issued in 1882, stated: "This certifies that there have been deposited in the Treasury of the United States, twenty dollars in gold coin, repayable to the bearer on demand." The bearer of $20.67 received one ounce of gold in exchange. This is a simple legal contract. It is easy to understand. There was no theory. No economists were employed to interpret what did not require interpretation.

A 2011 Federal Reserve Note states: "This note is legal tender for all debts, public and private." As contracts go, this makes no sense. Nor does it make sense to a three-year-old. My extensive survey of three-year-olds did not uncover a single child, who, in exchange for a $20 bill, preferred another $20 bill rather than receive a one-ounce gold coin. (The current value of the one-ounce coin versus that of the $20 bill is not germane to this survey.)

The abstraction of money is related to the manner in which securities today are often backed by abstract or non-existent collateral. Contradictory theories employ at least 100,000 economists (probably multiples of this figure), among whom, there may not be a handful who ever write or think about money. Read (if you must) the theoretical papers or newspaper columns of these imposters. They retreated into a soothing bubble bath of differential calculus generations ago.

Many of the malignant securities issued in 2010 and 2011 have fallen into disfavor. Credit markets have suffered loss of liquidity, momentary or protracted. These issues, collateralized by hope and imagination, are on the books though, often at institutions that already hold wads of securities still valued at wishful prices (for purposes of accounting, capital requirements, and falsifying the institutions' dubious solvency). We should expect that when Federal Reserve Chairman Ben Bernanke revs up his money machine, more will flow.

It is a safe bet that Ben is preparing to welcome more unmentionable securities on the Fed's balance sheet. ("Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities to boost the ailing economy...." - Wall Street Journal, October 21, 2011.)

Guessing at why the Fed will splurge is a chicken-or-egg game. Is the Fed preparing for a downdraft in the stock market with its tried-and-false response: by creating more money? Or, is it preparing to transmit (by electronic keystroke) more dollars to absorb securities held at banks, insurance companies, money-market funds, and mutual funds that should be carried at a much lower value?

The Fed washed its hands of credit analysis on January 6, 2011, when it issued its weekly H.4.1 "Factors Affecting Reserve Balances." The federal agency that vaunts its "transparency" (i.e.: the Fed) implanted a note that transferred all capital losses to the taxpayer. The January 6, 2011, "Factors Affecting Reserve Balances" stated that beginning on January 1, 2011, all capital losses in the Federal Reserve's mangy and non-transparent portfolio would henceforth be transferred to the Treasury Department. In a sense, this is only an accounting frivolity, since the taxpayer ultimately pays for the New York Fed's reckless mismanagement of its highly leveraged portfolio (103:1); that could soon, absent the January 6 sleight-of-hand, mirror Enron's jambalaya.

After the 2008 credit meltdown, the Fed, led by Simple Ben, fought for greater regulatory control of the banking system. The cranks who warned against Federal Reserve regulatory authority have been vindicated, on a comically inflated scale.

Wild-and-wooly securities that cratered after the credit cycle turned (circa 2007) are back, for instance: low doc, cov lite, payment-in-kind toggle notes, the proceeds of which pay private-equity firms up-front dividends. Century bonds (Mexico, the University of Southern California) sold swiftly, never a good sign. "Synthetic junk bonds" warned the Financial Times" resemble transactions linked to U.S. mortgages, which proliferated before the crisis" and "staple deals" counseled the Wall Street Journal "came under sharp criticism during the buyout boom for causing a number of conflicts of interest" have been structured by the banks that Ben Bernanke regulates. This highlights the greatest conflict of interest: the false claim that the Federal Reserve regulates the banks.

One security in the pipeline (possibly on hold during the current market mayhem) is a "synthetic deutsche mark," that would "create shadow trading in legacy currencies in a synthetic market." Paul Volcker said somewhere the only financial advancement of the past 30 years is the ATM card. Comparing the collateral behind Peter Warburtin's bond market to the absence of such behind the synthetic deutsche mark (a currency that ceased to exist over a decade ago) outlines the enormous waste of capital, human ingenuity, and savings over the past 40 years. With nothing learned, this will continue, until uncollateralized paper spawns a New Era in post-fiat origami.

Tuesday, October 18, 2011

Harrisburg Fails to Get the Word

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Municipal bondholders have something else to worry about. If Occupy Wall Street has legs, and, if labor unions handcuff the protestors' agenda ("Major Unions Join Occupy Wall Street Protest" - New York Times, October 5, 2011), will that effectively downgrade general obligation (G.O.) bonds another notch? That is unlikely. In fact, trends over the past few months have shown states and municipalities are more inclined to meet general obligation bond payments as long as they possibly can. Union workers who press municipalities into bankruptcy (the Harrisburg, Pennsylvania bankruptcy might be interpreted as such) should take heed.

States and municipalities are averse to filing for bankruptcy. If they wobble, the courts remind them of their priorities. The State of Minnesota could not reach a budget agreement this past fiscal year (ending June 30, 2011). In advance, a June 29, 2011, District Court expressed its opinion: "Only minimal levels of staff and operating expenses that are necessary" should continue. "All others are recommended to close." Of "activities recommended to continue" number one on the list (although it is not stated if the sequence is in order of priority) was "bond payments and related activities."

Minnesota political alliances belie such a full-throated bondholder decree. The attorney general petitioned the District Court for an Opinion; the governor opposed the attorney general's Petition, arguing executive and legislative authority over budget priorities are not judiciable. In private, the political actors agreed that payments to bondholders were more important than paying a single salary. (The impasse, during which bondholders were paid and non-critical state employees were idled, lasted until July 20, 2011, when an agreement was reached.) Such a cordial behind-the-scenes concord can be expected in other states and municipalities. The consequence of not paying bondholders includes the assumption they will be unable to issue general obligation bonds for several years and, even then, at higher interest rates.

A second reason to remain current is to retain control. When a municipality enters bankruptcy, the court can exert enormous control over the legislative bodies. The court will decide who gets paid in the case of Harrisburg, leaving aside for the moment the Commonwealth of Pennsylvania's legislative and legal attempts to thwart the bankruptcy filing, as well as the mayor of Harrisburg's legal action against the city counsel's decision to file. (Note: this discourse addresses situations when it is not necessary to default. There will be many situations when there is no choice.)

This "clearing of the decks" allows us to suppose the court adapts the "Municipal Financial Recovery Act Recovery Plan [for the] City of Harrisburg" submitted (by several concurring organizations) on June 13, 2011. Since Harrisburg's finances are no better than four months ago (at best), the court may save itself some time by reviewing this 422-page, 11-megabyte plan.

Among its conclusions, the Plan states: "[T]he City must [note: "must"]... outsource [its] commercial sanitation collection; eliminate [its] Park Ranger program; combine Park Maintenance in the Department of Public Works..." These are only a few of many structural changes. Henry Kravis has a bigger heart.

The Plan does not shrink from expressing its disgust at backroom City deals by certain politicians: "The City must contain fast growing employee compensation by immediately challenging the extensions made by the previous Mayor immediately prior to his leaving office that increased compensation for employees despite the looming financial crisis..."

The nexus between previously negotiated employee compensation - particularly by unions - and the dwindling revenues to fulfill their legally negotiated pay and benefits (both parties signed), will be a battle royale. Although the Plan does not state a specific reduction, it is unambiguous in regard to which is Peter and which is Paul: "[T]he city is forced to reduce its existing operating budget by a minimum of $2.5 million to pay debt service and compensate for lost revenue...."

Although not generally mentioned, both the municipalities and the unions understand which comes first. The unions know it is better to press their demands up to the point before default and (possibly) bankruptcy. This puts them in accord with the politicians' top priority: to make bond payments. A central figure in the mid-1970s, New-York-City negotiations recalls: "Union leaders need to look as tough as they can. When they have to back down, they vilify the city's negotiators. It's a macho thing."

Why, then, did Harrisburg file for bankruptcy, given that many parties did not think it was necessary? This is a big country and not everyone gets the word. Mistakes will be made. That's why they are where they are.

Thursday, October 13, 2011

The 8% Solution

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The terminal stage of Dr. Frankenstein-style central banking is disgorging ridiculous claims of authority motivated by reckless efforts to retain control. One such pincer attack is the Federal Reserve's purported 2% inflation target. Behind our very eyes, this fictional mandate is being raised, all the more reason that savers need to speculate, not a welcome prospect with both inflationary and deflationary influences expanding and bound to burst.

A certainty of this age (post-Western-Civilization) is the ease with which libertine policies escalate to fantastic proportions even as they are failing. The Federal Reserve mumbles its 2% inflation target while the "economic literature" has sown the garden for an 8% inflation rate, in the name of "price stability."

To be more precise, "inflation" to the Federal Reserve is conveniently defined as the consumer price index - without including food and energy. This 2% or 8% target should be understood as a negative interest rate. The Federal Reserve will (through its current policy, although this will boomerang at some point) hold Treasury yields at zero-percent. It will target inflation at 2% to 20%.

In The Beginning, at least in this short narrative, a Harvard economist told a Senate committee the United States must accept a 2% inflation rate as the cost of prosperity. That was in 1957, a very good year to wrap such a career-advancing declaration inside a Cold War mandate. "Growth" would defeat the Soviet Union.

Federal Reserve Chairman William McChesney Martin did not agree. On August 13, 1957, Martin warned that recent inflationary pressures had risen from a period of strong economic growth fostered by "'imbalances in the economy' in which 'rising costs and prices mutually interact upon each other over time with a spiral effect.' . . . The person most likely to be injured in the inflationary cycle was the 'hardworking and thrifty...little man' on fixed income who could protect neither his income nor the value of his savings."

Martin was doomed to lose this battle and the media misunderstood hemorrhaging inflationary tendencies. Inflation was National Worry #1 when the business editor of the New York Times calmed his readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as it has happened recently in other countries." That was in 1966.

President Richard Nixon held a farewell gala for Martin in 1970. The soon-to-be ex-Federal Reserve chairman sobered up the tipsy revelers when he removed the punch bowl during his valedictory speech: "I wish I could turn the bank over to Arthur Burns [the next Fed Chairman] as I would have liked. But we are in deep trouble. We are in the wildest inflation since the Civil War."

Moving ahead, Professor Ben S. Bernanke wrote a book that was well received in the right circles: Inflation Targeting: Lessons from the International Experience (2001). One of his co-authors was Frederic Mishkin. Those in the know understand the implications of Mishkin's cooperation. The book propagated the awful euphemisms ("the zero-bound" and "inflation targeting") used to disguise their mandate to inflate. Rather, they could have simply stated: "Let's ruin the dollar."

Some economists took exception. Lee Hoskins, president of the Federal Reserve Bank of Cleveland from 1987 to 1991, wrote: "Pundits, economists, and some Fed officials often talk about the fight against inflation or the battle against it or the need to contain it as if it is some preternatural event. The Fed does not have to battle or contain inflation, it creates inflation.... So when a Fed official says the goal for inflation should be 2 percent, he is explicitly choosing to create that rate of inflation." ("Zero Inflation: Goal and Target," 2005) Hoskins is not a regular on CNBC's short list. (See "The Education Gap.")

Federal Reserve policy of 2% inflation is a product of failure and verbal repetition. Bernanke's Fed needs room to maneuver ("infinite bound"), and a wide fairway to compound its broadening failure, while not losing credibility. Thus, this fictional authority is repeated over and over. Current Federal Reserve Governor Janet Yellen: "This increase in core inflation was below the 2 percent rate that I and most of my fellow Fed policymakers on the Federal Open Market Committee (FOMC) consider an appropriate long-term price stability objective."

Note the structure of Yellen's statement. She hides the arbitrary ("consider an appropriate") under legal cover ("price stability"). The Fed and its accomplices in the professorate train the public mind through such repetition.

Even with 2% inflation touted as a mark of price stability, higher figures are working their way into the public conscience. N. Gregory Mankiw, a Harvard economics professor who consistently establishes new lows in personal integrity, wrote a column in the April 19, 2009, New York Times: "It May Be Time to go Negative."

It should be remembered that Mankiw made his proposal because Federal Reserve Chairman Ben S. Bernanke's grand theory was failing. In October 2011, we know it has failed. Bernanke's foolish interpretation of the Great Depression has done nothing to halt the housing bust. It is far worse today than in 2009, and probably about to take another tumble. This was an inevitable consequence of the credit binge, of which Bernanke's Fed has no understanding. We have paid a heavy price for this ignorance. Investment continues its drift towards short-term trading gains and not into industries that need long-term investment to prosper. The result: a country with an inflation-adjusted median income that is 6.7% below that of June 2009.

In his 2009 column, Mankiw wrote: "[T]here is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates - interest rates measured in purchasing power - could become negative. Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation...." That's enough. Mankiw consistently makes Eddie Haskell's syrupy conversations with Ward Cleaver sound like General Patton's misadventure with the hospitalized soldier.

Note that Mankiw was behind the times. He needed to justifying negative interest rates even though such a course is inconsistent with the Fed's mandated goal of "price stability." No insufferably pliant economist would make that mistake today - note Yellen, above.

It is obvious that Mankiw is vying to head the Fed, with such maneuvers as his recently announced post as Presidential candidate Mitt Romney's economic adviser. Romney has stated he will jettison Bernanke. (Romney's other adviser is Glenn Hubbard - See: Inside Job) The resourceful Bill Black, author (The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry) and currently professor of Economics and Law at the University of Missouri - Kansas City recently quoted from a paper written by Mankiw in 1993: "[I]t would be irrational for operators of the savings and loans not to loot."

Harvard economics professor Kenneth Rogoff, author of This Time is Different: Eight Centuries of Financial Folly, told Bloomberg News on May 19, 2009: "I'm advocating 6 percent inflation for at least a couple of years." Rogoff has not changed course, recently advocating 6% inflation in the Financial Times.

Mankiw was quoted in the same article as declining to "put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that." The "model" trick is the mental ghetto that permits fourth-rate economists to become Federal Reserve chairmen.

But Mankiw is on to something. Why pin yourself to a rate, when triple-digit inflation may be required to really ruin the country?

The following sequence is a lesson in how bureaucracies insinuate their failures into accepted policy.

Stanley Fischer, current Governor of the Bank of Israel, doctoral Ph.D. thesis adviser to Ben S. Bernanke and to Greg Mankiw (at MIT), with stops at every institution of impeccable prestige among the anointed (chief economist at the World Bank, vice chairman of Citigroup) professed in 1997 that: "The fundamental task of a central bank is to preserve the value of the currency." That is the first sentence in "Maintaining Price Stability," a paper published when Fischer was First Deputy Managing Director of the International Monetary Fund. Five paragraphs later (wasting no time) Fischer wrote: "Barro (1995) and Sarel (1996) do not find a clear negative relationship below 8 percent inflation..." That is, as long as it remains at 8 percent or below, inflation is not a burden to economic growth.

We can be sure the conclusion rested on the result of some computer model. Barro (1995) and Sarel (1996) cited as their authority Fischer (1993), which is noted later in Fischer (1997).

In 2001, IMF economic researchers Mohsin S. Khan and Abdelhak S. Senhadji wrote a staff paper "Threshold Effects in the Relationship between Inflation and Growth." The authors declare "[F]irst identified by Fischer (1993)" [addressing inflation below an 8 percent rate], "inflation does not have a significant effect on growth, or it may even show a slightly positive effect." Note the change from the (1997) model Fischer from whom they quote: from "do not find clear negative relationship below 8 percent inflation," to "it [8% inflation] may even show a slightly positive effect." This sequence was arranged by Sheehan (2011)

In 1978, Federal Reserve Governor Henry C. Wallich spoke before the graduating seniors at Fordham University. His topic was inflation. Wallich explained the loser is labor. "Inflation becomes a means of exploiting labor's money illusion."

His speech is interesting in a contemporary context. The Wall Street protestors, who are probably building igloos in front of the Nome, Alaska city hall by now, are on to something; or, it seems, some things; but they are diffusing their influence. One of the protestors' tendencies leans towards a government solution. This is a barren tangent. A supersized government uses supersized banks to remain supersized.

Wallich told the Fordham students, that government is one of the winners in an inflation. From this Federal Reserve official: "It [inflation] allows the politician to make promises that cannot be met in real terms, because, as the government overspends trying to keep those promises, the value of those benefits shrinks." This creates a "diminishing ability of households to provide privately for the future.... One may ask whether it is not an essential attribute of a civilized society to be able to make that kind of provision for the future."

Wallich went on to emphasize "the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government." If alive today, he would not be surprised the protestors are looking to the government for help. Wallich (1914-1988) grew up in Berlin and lived through what he warned against (1978).

Wallich added that inflation "creates a vacuum in the private sector into which the government moves." He worried that the consequences of the inflation would be "a shift into the third dimension, away from democracy and toward authoritarianism."

In Wallich's Germany, Joseph Goebbels (1897-1945) spoke at Nuremberg (1934):

"It is no sign of wise leadership to acquaint the nation with hard facts over night. Crises must be prepared for not only politically and economically, but also psychologically. Here propaganda has its place. It must prepare the way actively and educationally. Its task is to prepare the way for practical actions. It must follow these actions step by step, never losing sight of them. In a manner of speaking, it provides the background music. Such propaganda in the end miraculously makes the unpopular popular, enabling even a government's most difficult decisions to secure the resolute support of the people. A government that uses it properly can do what is necessary without running the risk of losing the masses."