Saturday, November 30, 2013

The Economist's Sell Signal

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 disintegration of central banking shifted to overdrive in November. The Senate Banking Committee's listless accreditation of Janet Yellen as next Fed chairman was not a surprise, but it was notable that vigorous critics of Chairman Bernanke, such as Senator Bob Corker, dozed through the hearing. When the bubble of all bubbles bursts, and the Senate and Congressional oversight committees fulminate at central bankers, it will be those politicians who should sit in the dock. They could have acted. Instead, the Senate is whisking Bernanke-Squared to the throne, as quickly and quietly as possible.

Yellen is very much the academic economist: in complete control of what cannot be known (macroeconomic silliness), setting world policy on such, and with no knowledge of the specific. She explained before the Committee, that stock prices are O.K. ("I don't see at this point, in major sectors of asset prices, misalignments.") She is not concerned about "bubble-like conditions, since "price-to-equity ratios" are benign. As distant observers of the stock market know, it is the "price-to-earnings ratio" she was supposed to memorize before the hearing.

The (Always) Brilliant Larry Summers, another macroeconomist who has never had an original thought in his life, blurted before the IMF on November 8, 2013, that conventional macroeconomic thinking leaves us in a very serious problem. It is not startling; though it would have been surprising at some point in the past, for this master cylinder of central planning, after admitting his generation of economists has failed, to not then offer his apologies and announce his permanent departure to Tierra del Fuego.

Instead, Summers continued: "The underlying problem may be there forever," which, in the world of Summers, Bernanke, Yellen, means the period until they are run out of town and sentenced to a prison cell, with their mouths taped, while Alan Greenspan sits on the other side of the iron bars, lamenting the decline of economists' prescriptions since his departure.

Summers (before the IMF) offered advice that is now conventional among conventional macroeconomists. He advises the bureaucratic class to impose a negative 2% or 3% interest rate on the 99% of Americans competing in the Hunger Games.

            It seems like yesterday when convention held that savers earned interest, and, no inflation (of prices) was the goal. This was the balance between savers being paid to lend their money, and borrowers paid interest to use the money. The rate paid was the meeting of minds among lenders and borrowers, a free forum of expression to which, someday, we shall return.

            For now, American university professors control markets. The route to the apathetic acceptance of redistribution and confiscation from the public has been laid by a careful and gradual brain washing.

            The Economist was neither careful nor gradual with a front-cover story in its November 9, 2013, issue: "The Perils of Falling Inflation." The lead story warns: "The biggest problem facing the rich world's central banks today is that inflation is too low." (This "rich world" foolishness will not be addressed here.)

            It is too low, for reasons not stated in the Economist. Inflation is too low, remember, for the "rich world's central banks," (not for us), because a financial economy needs larger quantities of money, credit, and accounting tomfoolery to prevent its collapse. The rich world's economy not only needs more finance, it demands an expanding base of finance, growing at an exponential rate, to remain whole. In 2000 and 2007, it was merely a slowing in the growth rate of credit creation that was followed by the plunge.

The various gimmicks are long in the tooth, so: "We need lower credit standards, a weaker banking system, and credit needs to be extended to the bankrupt to prevent liquidation of the Bank of England."

The Economist did not say that, though the statement is part-and-parcel to perfidious Albion's calls for the British people to spend and borrow themselves into penury. In the past three months, Bank of England Governor Mark Carney announced banks could cut their cash reserves "to support economic growth;" banks could now submit "any identifiable collateral" and it would be welcomed at the Bank of England; and the economic "recovery" is, quoting Carney, "still reliant on rising home prices and consumer demand." The result: interest-only mortgages: "borrowers, expecting to make the majority of the return from rising property prices" (Andy Lees, The Macro Strategy Partnership News Daily, November 19, 2013) is all that's left between the former Bank of Canada governor and a one-way ticket back to Banff. This is a desperate strategy by Carney.

Back to what the Economist did say; it was a whopper: "central banks' inflation target [is] 2%" and this has been "the cornerstone of central banking for decades." This is an attempt to erase history. Obliterating the past has been essential to the rise of Bernanke and Yellen. Their "2% inflation target victory" was described in the following links, written at the beginning of 2012, at the time the Fed asserted this new cornerstone of central banking: (see "Presidential Rivals: Drop the.....this was on January 12, 2012", "A Quartet of Fed Chairmen.... This was on January 20, 2012" and "Transparency has Landed..." January 29, 2012").

A year earlier, in December 2010, the Federal Reserve was handcuffed, since "an inflation target" of anything other than zero percent was still an absurd notion, other than among professors who had gone in for central planning. Bill King, in the December 14, 2010, "King Report" compared the past two communiqués by the Fed after their November 3, 2010, and the December 13, 2010, FOMC meetings. The December 13, 2010, communiqué claimed "measures of underlying inflation have tended downwards." This assertion was (in Bill King's words) to "deflect political and public outrage at QE 2.0." King went on: "If the Fed had to acknowledge there is inflation, their world is destroyed. QE would have to be scuttled." (The Fed and Bernanke go on about inflation "expectations" and try to ignore inflation but they are still faced with a public of 300 million that cares what it is paying today.)

The consumer price index (CPI-U) rose 0.1% in November 2010; it had increased 1.1% over the past 12 months. The Fed nearly had to drop its money-printing, road-to-ruin because inflation was so high. "The cornerstone of central banking" was established over the next twelve months, culminating in the universally accepted practice of central banks' non-stop, money-printing and inflation of credit, stocks, corporate profits, buybacks, mergers, PIK bonds, rehypothecated collateral, and speculators' fortunes. Particularly piquant have been the booming auction-house, luxury-goods, and casino stocks.

The Economist's article was unbalanced, sloppy, and abandoned by the starting team: much like the world's markets. A suggestion for current asset allocation: where would you want your money today if you knew interest rates will rise by 4.0% tomorrow? 

Monday, November 25, 2013

The View from Madrid

My friend Fernando del Pino writes "Independent views on Spain, Europe and the big picture of politics and money," possibly the most coherent and perceptive dissection of the European carcass today. The fictional misrepresentations by the political and bureaucratic powers in Europe are extinguishing the peoples' trust. This is true on both sides of the Atlantic. In his November 13, 2013, essay, The Government Experiences a Financial Mirage, the corruption of finance and words in Spain reveals a degenerate incumbency sliding down the drain pipe with similar enthusiasm to hangover institutions in the United States. To read more of his essays, his website is FJS

The Government Experiences a Financial Mirage

Our government seems to be up in the crow's nest shouting land ahoy each time it sees, pretends to see or just imagines some grey mass on the horizon. Three years ago, the then ever-smiling-president Zapatero, mistaking the back of a whale for terra firma, shouted green shoots just moments before the whale submerged and the surface of this ocean of crisis turned flat again. Today, those currently in power think they see something and joyfully wave their arms about again.

 It is remarkable that so much attention is still paid to a president or finance minister, belonging to any political color or country, making comments on the prospects of the economy. They lack any superior prediction or analysis capabilities whatsoever, as shown by their dismal forecasting track record. If they truly had a crystal ball they would not have wasted their entire professional life going between the party HQ and the ministry but would have founded a hedge fund a long time ago, would have made a lot of money and would now be able to read the FT without an online translator. No: politicians simply sell their product, which is always aimed at getting elected or reelected by the people (or by the leader). This fact notwithstanding, the media remain blind to the overwhelming empirical evidence and keep on giving them an unfathomable amount of credibility. In Spain, this phenomenon of mystifying political power is particularly noteworthy, and extends beyond politics to the financial and big business ruling class, which is famous for never being independent or critical of the government. As an example, the Chairman of one of our largest banks predicted back in 2007 that the Spanish economy would keep "growing at high rates" in the future; in 2008 he said that the crisis would be over "soon", and today he states that we are living a "fantastic" moment. This part of the ruling class also sells its product, be it a bond issue, the price of its shares or a more favorable regulatory environment. Therefore, we should neither be impressed nor take these statements too seriously; instead, we should put them into context with some healthy skepticism and a grain of salt.

 Having said this, it seems that the situation in Spain is normalizing itself in the sense that the unemployment rate is stabilizing - alas at a very high level. This seems logical, because our 26% unemployment rate was already among the highest in the world. However, there is a purely financial phenomenon that is distorting the perception of what the true situation might be, and we may be taking for a solid comeback what remains a timid stabilization.

 In the summer of 2012, the markets, having been conveniently demonized by the politicians and the media, were "attacking" Spain and other periphery countries. Both the bond and equity markets were falling, effectively closing the door to the refinancing of our galloping debt. Those to blame for it all, we were told back then, were the damned speculators, that savage, heartless species that did not trust the numbers and the promises of politicians. How insolent! At that moment the European Central Bank came to the rescue and pledged to print as much as necessary in order to buy those assets that were unwanted by everyone - for good reason. Apparently tired of attacking after such long a siege, the speculators who despised our debt and that of other periphery countries suddenly changed. In the blink of an eye the were no longer damned, but blessed; actually they were no longer speculators (which in old Europe is an insult, nearly a crime), but serious investors. Exactly the same day the President of the ECB made his famous "whatever it takes" statement, the newborn investors started buying bonds and equities with both hands with the anxiety so typical of bullish hysterias, pushed by the money created out of thin air by central banks and backed by their fantastic promises. Since then, the prices of all assets of periphery countries have sharply and simultaneously increased: the Spanish equity index has jumped some 60%, and the Portuguese, Italian and Greek markets have followed suit increasing 45%, 55% and 100%, respectively. Also, the bond markets have turned bullish again bringing down interest rates and spreads. From that very day, the cost of 10 year bonds issued by the Spanish government has come down from 7.5% to 4%. Again, something similar has happened to the other countries: the Portuguese cost of debt has gone from 11% to less than 6%, the Italian from 6.5% to 4% and the Greek from 27% to 8%. As soon as the former speculators have started to do what politicians wanted them to do (lending a hand in their re-election), the fierce criticism has given way to a warm welcome and lots of praise. In Spain, this truce has drowned the government in a wave of self-complacency, to the extent that it no longer feels the need to pretend with more of its famous mini reforms. Surfing this wave of good luck, our government has shamelessly taken credit for the bull market as if it were a Spanish phenomenon wholly attributable to its own actions. But of course! What else would you expect from the incorrigible world of politics?

 We might be mistaking a financial bubble (yet another one) for a solid economic recovery. Because, what has really changed in these last twelve months? I do not see the ingredients for a healthy, sustainable recovery. In the very first place, have we reduced our overall indebtedness? Has the financial sector turned robust or is it functioning normally again? Do we suddenly possess a favorable framework that promotes entrepreneurship and wealth and employment creation? Do we have lower taxes? Has the vast ocean of despotic legislation and regulation been reduced? Are we abruptly a country famous for its rule of law? Have we confronted the vast problem of the size of the public sector or the regional monster administrations? Thus, are we about to grow as if by magic? Have our problems disappeared in a puff of smoke?

 The liquidity created out of thin air by central banks of the whole world is generating new bubbles everywhere. However, in nearly all countries, little or nothing of this vast experiment is improving the real economy. In fact, a growing number of alarmed voices on both sides of the Atlantic are questioning such a monetary policy that bears no fruit while exponentially increasing the fragility of the system.

 We still have tough times ahead and, wickedly, the crisis will last longer because of the burst of the latest bubble created by the damned central bankers.

 Near the end of the 18th century-Dickens wrote in Tale of Two Cities - France "rolled with exceeding smoothness downhill, making paper money and spending it". The British writer was describing the huge economic crisis which preceded (may I say caused) the bloody French Revolution of 1789, a crisis that was disguised for a while with the usual monetary trick. Plus ça change, plus c'est la même chose. Two centuries have passed, and not only France, but Spain, Europe and most of the West are rolling with exceeding smoothness downhill, printing money and spending it. For a while, nothing seems to happen, and the treatment looks efficient and harmless. But then, inevitably, all hell breaks loose.
Fernando del Pino Calvo-Sotelo

Friday, November 22, 2013

The Federal Reserve's Expanding Omniscience

Following is an expanded version of a speech delivered for With Integrity Financial: "Securities and Advisory Services offered through Commonwealth Financial Network, a Member FINRA/SIPC, a Registered Investment Adviser."

The Federal Reserve's Expanding Omniscience

 Speech Delivered November 13, 2013, Plymouth, MA.

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 Federal Reserve System is approaching its one hundredth anniversary, a period often dubbed the American Century. The Fed played its part in making it so, which has been characterized by expansion and inflation. The inflation has not been solely in money. We might consider if monetary inflation followed the inflated tendencies of Americans.

I will start with the origin of the idea of the Federal Reserve. "Civilized" countries had a central bank. The United States, it was said, demonstrated its primitiveness during the financial Panic of 1907. It was left to commercial bankers to halt the panic and restore solvency to America's financial system.

That year, the financial system shook, and bankers convened nightly at J.P. Morgan's library desk. Morgan had a "bunch of young men with nice green eyeshades and who know how to read a balance sheet," in the words of David Stockman. The young men examined the balance sheets of financial houses at night, "and when the morning hour arose, they concluded if you were solvent or insolvent."

Those banks and trust companies deemed solvent were told by the banks and clearinghouse of banks that financed their salvation: "We will make you a loan but "all you officers and the board of directors - all of you are gone. We are putting new people in the bank when it opens at 9:00 this morning."

That was quite unlike 2008, a bailout of a financial system that preserved failure, of institutions and their bank officers. The saviors of 1907 could not print money. In 2008, TARP and other alphabet soup windows of reincarnation acted as a black hole of impenetrability to the Fed, the U.S. Treasury, the bankers, and the public, alike. "Policy makers" - they love to call themselves that - took two routes both unavailable and anti-ethical to the bankers in 1907. They printed an astonishing increment of new money: electronic credits to the banking system, in modern parlance. They terrorized the people and Congress into craven submission, instead of calming Americans. This used to be the mark of leadership.

A second difference: The House of Morgan had to contend with a real money-market: a market-clearing, borrowing rate - one that shot to 80%. In 2007 and 2008, the Fed cut the borrowing rate - on its way to zero. Later, I will discuss the same tactic used by the Fed in 1930 - to no avail.

A third difference was the source of the money lent. It was the banker's own, in a time when bank shareholders were subject to double liability. Thus, the no-nonsense dispersal of failed bankers.

The Federal Reserve was voted into existence on December 23, 1913. It started operations in 1914. It was an institution of high ideals. A champion was Irving Fisher, Professor of Economics at Yale, famous beyond what that position may sound. He was an expert on everything and not hesitant to splay his omniscience on all. Fisher summed up the founders' vision in 1907:

"The world consists of two classes-the educated and the ignorant-and it is essential for progress that the former should be allowed to dominate the latter. But once we admit that it is proper for the instructed classes to give tuition to the uninstructed, we begin to see an almost boundless vista for possible human betterment."

Not everyone was so beguiled by human nature - dominators or dominated. The December 23, 2013, vote by the Senate was 43 "ayes" and 26 "nays". Elihu Root, senator from New York, stood firmly against the formation of a Federal Reserve Bank. In the 1913 debate, he warned:

"[W]ith the exhaustless reservoir of the government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. Bankers are not free of it. They are human...when credit exceeds the legitimate demands of the currency and the currency becomes suspected and gold leaves the is the United States that is discredited by the inflation of its demand obligations which it cannot pay."

Benjamin Strong, who was one of the young men with the green eye shades during the Panic of 1907, helped prepare Elihu Root's speech.

Such warnings were overwhelmed by the progressive camp. The Wall Street Journal proclaimed on September 13, 1913: "Some attention is devoted in the pending currency bill to the question of improving the examination of national banks. It is by no means a minor detail in the general perfection of our banking system."
 Note the inflated opinion of ourselves. Specifically, the godlinessof those who would administer improvement upon lesser beings, known colloquially today as the "99%":
 "Progress" "Boundless vista" "Human Betterment" "Perfection" - of a banking system?
             Here, I will jump to the end. The Federal Reserve was to be a non-inflationary central bank. In fact, all central banks were non-inflationary (over periods of time) in 1913. "Price stability" did not need to be defined. Our ancestors of 1913 would not have been able to comprehend a banker, an economist, a public servant: that is, serving the public, who would announce "price stability" means 2% inflation. Nor comprehend that, when, 2% is no help "we'll-make it-4%-then-8%-then-12%." Adam Posen, formerly at the Bank of England rolled out the 12% possibility.  
The original legislation is worth time to understand. It so contrasts to the Brunhilde that developed.  
            The structure was anything but central. It was a system. It is still called the "Federal Reserve System," but it is not. There were and are 12 regional Federal Reserve banks. Each of the 12 originally operated with a high degree of autonomy. This structure recognized the seasonal flows of finance. The country was still, to a large degree, agrarian. It was not until 1920 that a U.S. census showed more than 50% of the American people lived in towns and cities with a population of greater than 3,000. Every year, rural - agricultural areas of the country - needed to finance the autumn harvest. The country banks called upon the New York banks, which held the reserves necessary for the rest of the year. This notable difference between New York - Chicago, Boston, and Philadelphia also fit the bill - and much of the rest of the country, was a reason for establishing regional districts. 
Each of the twelve regions set its own discount rate to meet its character - and veer towards the "perfection" of banking, as the Wall Street Journal anticipated. It is notable that the Federal Reserve governors in Washington were a backwater for Federal Reserve policy until the1930s.  
The original legislation was a world apart from what we see today. The Fed was intended to function according to the "real-bills" doctrine. I think this is worth taking a few minutes to explain. Very important, in my opinion, the "real bills" firmament is instructive in how finance expanded or contracted according to the needs of business. Not to the desires of finance: the "Main Street" and "Wall Street" distinction so often discussed today. 
First, "real bills" handcuffed Federal Reserve operations to a narrow mandate. The original legislation was written to prevent serendipitous expansion of the money supply and credit by the Fed. Second, it shows how much more closely banking - and money in existence - was tied to real business.  
Two of the founding fathers should be recognized. Carter Glass, senator from Virginia, understood banking better than any other senator.

H. Parker Willis was the nuts-and-bolts man who coordinated the design of the Federal Reserve System. Willis was a professor of economics (Washington & Lee, Columbia University) fully versed in the English banking school, including the "real bills" monetary doctrine. The Federal Reserve Act authorized the Federal Reserve System to accept "real bills" from banks. Government securities were not acceptable.

That was non-inflationary. The credit extended from the Federal Reserve to a commercial bank was backed by payments owed to the commercial business. The business, had likely borrowed against a 30-day receivable that was used as collateral to obtain a loan: A shoe manufacturer had sold shoes to a store, that must pay the bill within 30 days. This was fairly simple. At least, it made sense. Central bankers were not witch doctors, spawning $85 billion a month of electronic credits - which is not "money" in any real sense - off a keyboard.

In December 1915, after the first year of Fed operations, Willis wrote: "Under the provisions of the Federal Reserve Act it is required that loans be made upon paper protected by warehouse receipts, and such provisions have been made by the Board in the circular relating to commodity paper (Circular No. 17, Series of 1915)." In other words, a bank borrowing from its regional Federal Reserve Bank must present a "real bill": a bill payable to the commercial customer of the commercial bank. Again, U.S. government securities were not acceptable. Governments had a history of not paying off their loans. They still do.

World War I disrupted this arrangement. The Great War also deranged the world's financial system when it was found necessary to decapitate the International Gold Standard. In 1913, none of the world's central banks were inflation-producing operations. Since 1914, central banks have done little else.

The fledgling Federal Reserve did what everyone else did in time of war. It followed orders. The Fed's Annual Report of 1918 noted the institution's "duty to cooperate unreservedly with the government [i.e., the Treasury] to provide funds needed for the war." Duty bound, the Fed was a full-fledged participant in the U.S. Treasury war-bond market. The 1919 Federal Reserve Annual Report excused the excesses: "an incident of the general credit expansion" and "occasioned by crop-moving and other seasonal needs." This was less than the truth and there was no turning back, either from fibbing or as purchaser of the federal deficit.

The Federal Reserve initiated open-market operations in the 1920s. Open-market operations are the conduit through which the Fed fills the banking system with newly created dollars. The Fed could now manipulate the money-market rate and boost the supply of money in the economy.

The Fed, through money-market operations, also decreases the money supply at times. In that instance, the Fed sells bonds from its portfolios to banks. Banks purchase the bonds. The dollars, now departed from the commercial bank to the Fed, have also departed the banking system - thus, from the machinery of the economy. Banks can not make as many loans.

I can say with a high degree of confidence the Fed is institutionally incapable of decreasing - contracting - the money supply ever again. It's all one way from here.

It was not immediately clear the Fed would avail itself of the flexibility open-market operations that were permitted, post-war.

Benjamin Strong was president of the New York Fed. Power had been sucked from the eleven other regions into New York, and into the hands of Strong. In 1923, he was a staunch foe of the Fed meddling either with the money-market rate or the money supply. Strong wrote:

"What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing" - please note that - "price fixing" - "to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal."

Unless Strong is referring to "miscalculation" in that final sentence, he does not even mention: "the power ceded to a bunch of old men who may have no idea what they are doing." Yet, it would have been inconceivable to Strong this super-government would - "progress," I'm sure they believe - to a bunch of college professors.

As one of J.P. Morgan's around-the-clock, green-eyeshade saviors of the financial system in 1907, Strong knew the calamity that can follow a period of irresponsible lending. In 1913, he helped Elihu Root compose the senator's warning about the shortcomings of human nature.

Possibly, though I suppose it is unlikely, Strong decided to prove Root correct: that the United States should never have created the Federal Reserve System.

He authorized open-market issuance of dollars three times in the 1920s. The most consequential watering of the dollar stock was in 1927. Many have concluded this was a most unnecessary and fatal injection, causing the stock market crash of 1929. Few have stated the consequence more forcefully than Adolph Miller, a member of the Federal Reserve Board, from 1914 and through Strong's tenure. He issued a summary of the New York Fed's inflationary intrusion: "[I]t was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years. I am inclined to think that a different policy would have left us with a different condition at this time." (Miller was speaking in 1931. Strong died in 1928.)

The Federal Reserve System has never been held accountable for Strong's miscalculation. Today's Federal Reserve Chairman Ben S. Bernanke, revered for his scholarship of the Great Depression, recites a tale taught by his professors to enhance the power of the Fed and of his professors. He - they - ignore the 1920s and claim the Fed's mistake was that it did not act after the stock market crash.

Forgetting about Ben Bernanke's ignorance or suppression of the 1920s, it is not even true the Fed did not act. It acted immediately in response to the stock market crash. In addition to ignoring the 1920s, they ignore 1930.

On December 27, 1930, the Wall Street Journal reported the Federal Reserve's latest rate cut - from 2.5% to 2.0%. In an editorial, the Journal noted this was the seventh rate cut by the New York Fed since November 1929. The editorial writer explained that each cut was hailed as a hopeful market factor, but they have had little effect so far.

This was disappointing. We know the feeling.

However, the Journal was hopeful. We know that feeling too. There were reasons to believe this latest cut might be - now quoting the Journal - "the turning point of the whole economic situation." The Journal went on: The psychological effect is likely to be far reaching; for one thing, it "affords assurance that the whole credit and banking structure in this country is sound." It also indicated the Fed is likely to maintain very easy money in the coming months: "Unless all signs fail, the stage has now been reached ... when large supplies of available cheap credit must produce the traditional effect of stimulating new enterprise and ... expansion ... [T]here is every reason to feel that a turning point cannot be far away."

The opposite happened. In 1931, the economy and markets caved in. "Every reason to feel that a turning point cannot be far away," ignored tremendous imbalances left by the 1920s. To name just one - considerable liquidation of inventory and the consequent credit write-offs had barely begun.

What the Fed really did in 1930 remains unknown to Federal Reserve Chairman Ben Bernanke, the "expert on the Great Depression."

His professors and Ben consorted to:
First - they have ignored the Federal Reserve's inflation of credit and assets in the 1920s,
Second - they have misrepresented the Federal Reserve's reaction to the stock market crash,
Third - they do not know - or, pretend not to know - the Fed, after the stock-market crash and into 1930, responded just as Bernanke said it did not respond - but should have. This neglectful scholarship paved the way for Bernanke's money printing and zero-interest rate policy - also known as "ZIRP"

In 2006 and 2007, after permitting the credit bubble to grow and pop, Bernanke repeated exactly what had failed in 1930 and 1931. His expert scholarship missed the fact that in 1930:

First - Bank reserves increased during 1930 from $3.178 billion to $ 3.316 billion.
Second - Companies issued more long-term bonds in 1930 ($2.8 billion) than in 1929  ($2.4  billion).
Third - Corporate bond prices rose in 1930.
Fourth - Corporate profits fell but, in the aggregate, were at the same level as 1926 and 1927.

            Such "facts" need to be reviewed in context and in comparison. There were worrying developments. However, Ben Bernanke does not question the orthodox party line in his Essays on the Great Depression: the depression would not have been "Great" if the Fed had opened the levies in 1930. And, of course, you'd rather drop an atomic bomb on the country than live through price deflation.           

Now, dispensing with the Great Depression, we will turn to the depressing career of Alan Greenspan. Rather than talk much about him, I will discuss how the United States has changed over the course of his so-called professional career. I hope you will keep in the back of your mind through this, the discarding of the "real bills" doctrine by the Fed, and the "boundless vistas" opened to the Fed after it was discarded. From World War I on, open-market operations have worked to separate money - and credit extended by the banks - from business. Wall Street has benefited from ZIRP while Main Street is filled with nail salons.

Alan Greenspan understood how the Fed compromised its mandate. In 1959 - Greenspan was a 33-year-old consulting economist at the time - he was interviewed by Fortune magazine. Greenspan explained that before World War I, "prices could not get too far out of line with real values because the supply of credit was automatically constricted by a limited money supply."

Since 1914, "[w]ith one eye necessarily cocked on politics, the Fed has always maintained a more than adequate money supply even when speculative booms threaten."

The "automatic constriction of the money supply" that Greenspan refers to is the restriction on Fed credit creation, and, the pre-World War I gold standard. Note, by prefacing his statement, "Since 1914," he dismisses the derivative gold standards. First, the interwar experiment that failed. It never really got off the ground. Second, and notably, the Bretton Woods agreement, signed in 1944, that was moving slowly towards its 1971 demise when Greenspan spoke.

One measure of how the structure of the United States has changed is who has made the money. In 1950, 59% of corporate profits were in manufacturing, 9% were from financial activities. During the period from 2000 to 2008, 18 percent of profits were from manufacturing and 34 percent were from finance. The latter is much higher if financial activities of non-financial companies are included.

We can see in our daily lives that greater quantity produces lower quality. As the volume of credit expanded, quality deteriorated.

Among the past century's downgrades, a significant development was the borrower's promise that stands behind a "security," a word that once credibly described a paper contract backed by appropriate collateral.

An important change in quality was the product of President Richard Nixon's decision to default on the United States' promise to pay $35 for an ounce of gold on August 15, 1971. This severed the attachment of dollars (thus, credit) from redemption. Until that date, when it was still possible for the French or Germans to demand gold for their dollars, a link between commercial needs and credit still existed. But after August 1971, everyone was on their own. If a French treasury clerk showed up at the U.S. Treasury with $35, the U.S. Treasury clerk would hand over $35, quite possibly produced for that purpose by the Arthur Burns, chairman of the Federal Reserve.

In Debt and Delusion, author 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 in power generation by publicly owned corporations."

Most everyone here remembers the price inflation during the 1970s. There were four years of double-digit inflation, reaching an apex in 1980: when the Consumer Price Index was calculated at 13.5%.

There were other consequences, after the creation of dollars had been de-linked. This is not solely because of Nixon's decision to drop gold. There were a lot of changes in their air. One could debate cause and effect.

Long-term investment collapsed. Inflation reduces long-term investment. Planning is more difficult since the change in prices - goods, wages, profits - are not predictable. Long-term investment is very good for a company: It produces barriers to competition that are hard to hurdle.

At the same time, Americans were becoming more impatient. The middle-class profile that was shifting from saver to spender was due to inflation and also to ourselves: The Federal Reserve has not evolved in a vacuum.

Alan Greenspan saw no good in all this. In 1979, interviewed in the New York Times, he warned the "[e]xpansion of manufacturing capacity has fallen short of the pattern in earlier business cycles." He thought, "more ominous", was the "shift in research and development budgets towards quick-payoff 'development' projects."

Greenspan was right on the money. By the way, that means Greenspan's gripe was common chatter. He would never stray from the favor of those who pay his rent. That's how he's made the big bucks. Our boy was in nauseating form last week when, up popped a Bloomberg headline: "Yellen Gets Big Vote of Confidence from Greenspan." He had made the gutsy call: "I forecast she'll get confirmed."

This shift has been disastrous for America. Greenspan also hit the bull's eye in 1980 when, again writing in the New York Times, he waxed nostalgic for the "halcyon days of the 1950's and 1960's" when "business investment decisions seemed appropriately focused on longer-term payoffs." But now, "it is not surprising that in recent years business capital investments have become increasingly concentrated in assets with quick cash payoffs."

In 2003, Greenspan was Fed chairman. There was concern about the decline in American manufacturing. It was "all finance, all the time." Greenspan turned his wise advice from two decades before inside out. He concluded it no longer mattered if we made anything at all.
The inflationary seventies had enlightened Alan Greenspan as to human adaptability. In 1980, again, in the New York Times, he demonstrated a knowledge that a house-trading public might come in handy. He explained to the New York Times "that the translation of home-ownership equity into cash available for consumer spending is perhaps the most significant reason why the economy in 1975 to 1978 was consistently stronger than expected."

Now we will contrast. There was one Federal Reserve governor who sized up Greenspan during the mid-1990s. That was Larry Lindsey. He did not tire of lecturing the FOMC at every meeting between 1993 and 1996. He could see that, following recovery after the early-1990s recession, the United Stated was floating on a sea of finance. This had restructured the economy.

Lindsey gave several presentations to the FOMC on a single theme: the "1%" and the "99%." Those were his words. Simply stated, the middle class was not recovering from the recession of the early 1990s, but it was still spending. The public relied on more credit and gains from financial markets, since cash payment for work was slipping. Quoting Lindsey: "Among the "bottom 99 percent.... [w]e're seeing a big change in the functional distribution of income away from wages." He compared the period from 1983 to 1988 when "56% of all the personal income was paid in the form of wages." .... to 1993 - when that fell to 38%."

In Lindsey's conclusion, "the non-rich, non-old live paycheck to paycheck, quite literally. That's where all their income comes from. Remember, virtually none of the capital income or business income goes to them. They have to live on their wages and that wage share is also declining."

Of course, Lindsey got nowhere with that bunch and left the Board of Governors.

Looking at the imbalances that grew between 1950 and the Lindsey Lectures:

Inflation of prices never stopped.
Asset inflation was now beginning its assent.
Individuals were borrowing more and saving less, even though they were living:"paycheck to paycheck"
The traditional path of savings, towards long-term investment, had fallen.
The economy was tending more towards finance than towards industry.

At FOMC meetings, Alan Greenspan rarely responded to Lindsey's lectures, but he did offer an opinion at the May 1995 FOMC meeting. "[T]urnover" - he's speaking of existing house sales - "has induced large realized capital gains that have been financed in the mortgage market. Those funds are going disproportionately into the financing of consumer durables."

Greenspan consistently kept interest rates too low. This propelled the house-trading market, and, the ancillary corridors of the GDP such as durable goods, construction jobs, and mortgage lending.

In 1995 - the year in which Chairman Greenspan was just quoted - home mortgage debt increased $153 billion. At a 2002 FOMC meeting, Greenspan concluded a fairly long monologue on house-trading, with the comment: "Previously, consumers were not able to extract cash easily from the rising value of their houses, but they can now, and that source of funds has been a strong sustaining force for spending through the recession."

In 2005, Americans increased their mortgage debt by $1.1 trillion, by which time, 42% of homebuyers were putting no money down. The manufacturing capacity of the U.S. economy had been hollowed out.

As we know, the finance-driven economy collapsed in 2007 and 2008. Ben Bernanke's Fed resurrected Wall Street, by methods opposite to J.P. Morgan's green-eyeshade decisions that wiped the slate clean in 1907.

Insolvencies were papered over. To this day, "the insolvencies are called
"liquidity problems."
The officers of banks were untouched.
The U.S. has swerved even more fatally towards a credit-driven economy.
Assets are more concentrated in the five largest banks than before.
Five years of ZIRP has left Americans with a lower median income than in 2007.

To add to our misery, on January 25, 2012, the Bernanke Fed notified the American public that the FOMC - the monetary, decision -making body of the Fed - "judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." The excuse for this truly New Era inflation target is the incineration of Americans if we were to suffer - price deflation! There, I said it. The unmentionable.

Alternatively, Bernanke could have said: "The FOMC will hereby confiscate 22% of American savings over the next 10 years."

That is: if the Fed hits its mark.

I will finish with this. The mandarins asserted and repeat the U.S. would have suffered a calamity worse than the Great Depression if not for the Fed's heroic, gutsy credit handout in 2008. If you are so told, I suggest you ask: "Why?"

You may not receive much of a response. The assertion is not one to question. Why, for instance wouldn't 2008 turn into a depression like the one in 1920-1921, when real GDP fell 4.4% in 1920 and by 8.7% in 1921? The wholesale price index fell 37%. What was the result of that deflation? This possibility of deflation today resonates with terror from the lips of central bankers and the media. In 1922, the GDP rose by 15.8% and in 1923, by 12.1%, and the twenties roared. 

Tuesday, November 12, 2013

Insolvent Thinking

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)

            It is possible neither Janet Yellen nor another pretender will fill Bernanke's shoes in January. The odds of such a surprise may be once-in-a-history-of-the-universe, but those keep coming at a faster rate the longer we splurge. Simple Ben has been walking both his bank and the world's financial institutions closer to the cliff. Here, we will look at the precarious position of the Federal Reserve and the far-out financial securities entering the pipeline at an increasing rate.

The machinery of state demands exponential buying by banks, insurance companies, and pension funds. The purchasers risk insolvency by doing so. Chairman Bernanke would be the last to recognize this problem, unaware as he remains of his own institution's balance-sheet woes, and not understanding the financial calamity in 2007.

Central banking insolvency does not matter at the moment. The Emperor's New Clothes is preferred by Wall Street and the media alike.

            The Federal Reserve's balance sheet is a mystery, but not that much of a mystery. John Hussman wrote in his November 4, 2013, letter to clients in ("Leash the Dogma"): "A brief update on the bloated condition of the Federal Reserve's balance sheet. At present, the Fed holds $3.84 trillion in assets, with capital of just $54.86 billion, putting the Fed at 70-to-1 leverage against its stated capital. Given the relatively long maturity of Fed asset holdings, even a 20 basis point increase in interest rates effectively wipes out the Fed's capital. With the present 10-year Treasury yield already above the weighted average yield at which the Fed established its holdings, this is not a negligible consideration."

The 10-year yield has risen from 1.40% on July 27, 2012, to 2.6% or so today. Thus, the Fed is insolvent six times over. Life goes on.

There have been no sightings of central bankers jumping from windows yet. Of course, it's not their money; it isn't money at all, so we pretend. Since the Fed governors are academics, their financial knowledge is wanting. A practical reason for reducing quantitative easing (q.e.); actually, a practical reason for never getting started; is the reduction in top-rung collateral. Banks and other financial outfits borrow and lend in the trillions every day. Treasury securities that have disappeared onto the Fed's balance sheet are no longer available for collateral.

The Fed can lower standards of collateral. It has in the past, but it cannot make a bank accept Bit Coin receivables. This was central to the insolvency of Bear Stearns and onward in 2008. J.P. Morgan and Goldman Sachs were not going to repo (lend overnight) with an institution that might be shut the next morning.

This sinkhole of miscalculations was up for discussion on October 18, 2008, when the Wall Street Journal published an interview with Anna Schwartz. The article opened: "On Aug. 9, 2007, central banks around the world first intervened to stanch what has become a massive credit crunch. Since then [note: over one year later - FJS], the Federal Reserve and the Treasury have taken a series of increasingly drastic emergency actions to get lending flowing again. The central bank has lent out hundreds of billions of dollars, accepted collateral that in the past it would never have touched, and opened direct lending to institutions that have never had that privilege. [The Fed will do anything, so watch your wallet. - FJS] The Treasury has deployed billions more. And yet, 'Nothing,' Anna Schwartz says, 'seems to have quieted the fears of either the investors in the securities markets or the lenders and would-be borrowers in the credit market.'"

            Anna Schwartz was co-author with Milton Freidman of A Monetary History of the United States, 1867-1960. She went on to tell the Journal: "[T]he Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is [uncertainty] that the balance sheets of financial firms are credible." This was true although Simple Ben and aligned interests still refer to the "liquidity crisis," not the "insolvencies" in 2007 and 2008. The title of the Journal's interview was "Bernanke is Fighting the Last War."

And now, Fed Chairman Bernanke has led the Fed itself into insolvency. You can be sure there have been high level meetings at the largest financial institutions, pondering what to do if a fellow Too-Big-to-Fail Bank steps away from repo loans between itself and the Fed.

The Fed has introduced a slew of other problems attributable to its q.e. and to ZIRP (Zero-Interest Rate Policy). U.S. money-market funds break even by purchasing lower-rated European bank debt. Reuters, on September 25, 2013, reported: "Life insurance is becoming an unviable business in Europe as low interest rates reduce insurers' profits, forcing many to compensate with higher-risk investments or move overseas, according to an industry survey." A Bloomberg headline from September 26, 2013: "Pension Funds Need to Buy Higher-Yielding Assets, Allianz Unit Says." Also from Reuters: "U.K. Pension Funds Take on Leveraged Loans in Search of Yield."

The longer investors find themselves buying while holding their noses, the worse are the securities offered. Corruption is one result. The Financial Times reported on November 10, 2010: "[T]he credit rating agencies are using 'deluded' processes to calculate the risks of asset-backed securities (ABS).... 'Here is a situation where you keep putting more untenable risks into the system,'" declared William Harrington, who "spearheaded analysis on derivatives between 1999 and 2010 at Moody's Investors Services."

"However," the Financial Times goes on, "institutional investors such as pension funds and insurers have begun to increase their exposure to ABS once again, as low interest rates force them to search for alternative sources for yield."