Liberty Forged

the State has no money of its own, so it has no power of its own. ` Nock

Harking back to the beginning of the economic “crisis”

Posted by Jesse on November 27, 2008

[Ben Bernanke: “The U.S. government has a technology, called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost.”]

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(An artificial conversation with a few authors….my comments are in bold text and my guests’ are italic.)

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Did you hear about Bear Stearns Mr Whitney ?

·The New York Times summed it up like this in Saturday’s edition:

“If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system.”

What? There’s a financial crisis because of one company?!

That’s the question that will be addressed in the next couple weeks and people are not going to like the answer. For the last decade or so the markets have been reconfigured according to a new “structured finance” model which has transformed the interactions between institutions and investors.

Derivatives trading which, according to the Bank of International Settlements, now exceeds $500 trillion, has sewn together the various lending and investment institutions in a way that one failure can set the derivatives dominoes in motion and bring down the entire financial scaffolding in a heap. That’s why the Fed got involved and (I believe) approached Congress in a closed-door session (which was supposed to be about FISA legislation) to inform lawmakers about the growing possibility of a major economic meltdown if conditions in the credit markets were not stabilized quickly.

Hmm. Sounds like a big big mess. How the heck would one handle a situation like that?

Washington mandarins and financial heavyweights had to decide whether to sit back and let one small investment bank take down the whole equities market in an afternoon or stealthily buy a few futures and live to fight another day? Tough choice, eh?

Heh. That makes sense. So what can we expect then?

The ongoing massacre in real estate has left the structured investment market frozen, which means that the foundation blocks (i.e., mortgage-backed securities) upon which all this excessive leveraging rests; is starting to crumble. It’s a real mess.

The CDS market is roughly $45 trillion, whereas, the aggregate value of the US mortgage market is only $11 trillion; four times smaller. That’s a lot of leverage and it can have a snowball effect when the CDS trades begin to unwind.

Now, in capitalism’s extreme crisis Bernanke, acting beyond his mandate, invokes a law that hasn’t been used since the 1960s so the Fed can become the creditor for an institution that attempted to enrich itself through wild speculative bets on dubious toxic investments which are now utterly worthless.

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(I wonder what the Doc has to say about this?)

What’s the Fed’s role and policy regarding the economy in the 1st decade of the new millenium Dr Paul?

Mr. Bernanke views our system of fiat currency as a tool for creating wealth out of thin air by producing more dollars, whether paper or electronic.

How does this affect the holders of dollars?

It’s called monetary inflation, which destroys the value of the dollar and punishes those who save and invest. The money supply, as measured by the Fed’s own M3 figure, has increased about 5 times since 1980.

Inflation is not in check, as anyone who examines the cost of housing, energy, medical care, school tuition, and other basics can attest. In one sense the remarkable rise in housing prices over the last decade really just represents a drop in the value of the dollar. The artificial boom in the 1990s equity markets, engineered by Mr. Greenspan’s relentless monetary expansion and interest rate cutting, ended badly for millions of Americans holding overinflated stocks. What will happen when the same thing happens with housing?

Right. How about Bear Stearns and what we see in the news today?

The current market crisis began because of Federal Reserve monetary policy during the early 2000s in which the Fed lowered the interest rate to a below-market rate. The artificially low rates led to overinvestment in housing and other malinvestments. When the first indications of market trouble began back in August of 2007, instead of holding back and allowing bad decision-makers to suffer the consequences of their actions, the Federal Reserve took aggressive, inflationary action to ensure that large Wall Street firms would not lose money. It began by lowering the discount rates, the rates of interest charged to banks who borrow directly from the Fed, and lengthening the terms of such loans. This eliminated much of the stigma from discount window borrowing and enabled troubled banks to come to the Fed directly for funding, pay only a slightly higher interest rate but also secure these loans for a period longer than just overnight.

So how bad is it? Is there a way to stem the negative effects?

After the massive increase in discount window lending proved to be ineffective, the Fed became more and more creative with its funding arrangements. It has since created the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). The upshot of all of these new programs is that through auctions of securities or through deposits of collateral, the Fed is pushing hundreds of billions of dollars of funding into the financial system in a misguided attempt to shore up the stability of the system.

Do they recognize the fault in their attempts?

The Treasury Department has recently proposed that the Federal Reserve, which was responsible for the housing bubble and subprime crisis in the first place, be rewarded for all its intervention by being turned into a super-regulator. The Treasury foresees the Fed as the guarantor of market stability, with oversight over any financial institution that could pose a threat to the financial system. Rewarding poor-performing financial institutions is bad enough, but rewarding the institution that enabled the current economic crisis is unconscionable.

I hear that. Thanx Dr Paul

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But what about all the deregulation?. How does all that play into such a highly regulated atmosphere? Prof. Rozeff, would you enlighten us please?

Deregulation was part of a general movement during the 1990s, approved by piecemeal government regulations and deregulations, that allowed both investment banks and banks to become universal banks.

The Gramm-Leach-Bliley Act of 1999, or the Financial Services Modernization Act, loosened control over banking while leaving the rest of the regulated system intact. This heightened the moral hazard. Banks then extended many more questionable loans and entered into complex financial agreements that they never should have been allowed to make. All of this was to our detriment.

So the free market is to blame?

The system we have is the furthest thing from lawful free markets. It is not “financial capitalism,” as France’s President Sarkozy would have it.

There is no excuse for regulators to allow such banks to write inordinate mounts of insurance via credit default swaps, or to extend inordinate amounts of loan guarantees that are another form of insurance. There is no excuse for government to have encouraged home loans to people who could not afford them. There is no excuse for government to encourage people to take on excessive amounts of debt, period. Insured banks shouldn’t have had large obligations hidden away in off-balance-sheet subsidiaries. These banks shouldn’t be so highly levered. Government is fully responsible, not only for the welter of regulation but also for the inept deregulation and the resulting financial tragedy that has unfolded.

So you agree with Congressman Paul when he mentioned moral hazard. Government is both responsible for the regulations they have imposed and for the deregulation they allowed.

(In) depository institutions with insured deposits, the depositors (who are the creditors of the bank) have no incentive to control the moral hazard. It is left up to the government. Whether or not it was recognized at the time, there is good reason why the New Deal put in bank regulation that separated banks from investment banks at the same time that it put in deposit insurance. It helped to control moral hazard by ruling certain activities as off limits for insured banks.

When the government deregulates bank lending without simultaneously removing deposit insurance, the moral hazard increases exponentially. The “too big to fail” doctrine amplifies the moral hazard even more. Uninsured deposits then become quasi-insured, and managers are less likely to lose their jobs. Raising deposit insurance limits and extending them to all types of deposits increase the moral hazard still more. These are steps Congress recently took.

Great.

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Let’s ask Robert Blumen over at Mises.org….

What investments are necessary in-so-far as the US gov’t is concerned

The economic meaning of investment is the employment of real resources toward the construction of more productive capital yielding more consumption goods in the future. Treasury debt is fundamentally different from private savings in that it is simply a claim on the taxing power of the government that issued it with no productive capital behind it. The money that was borrowed upon the issue of the bond has already been spent to fund government consumption for its favored welfare and warfare programs, while the taxpayers were burdened with the obligation to repay.

While the problems with central banks holding Treasury debt are bad enough, the problems with these institutions going into the market for private sector equity are even greater.

So not only is it a matter of moral hazard, but pure economic reasoning proves it’s foolishness.

As Mises showed in his famous critique of central planning, only private owners of capital allocate it in an economically rational way. Prices are only economically meaningful when they are the outcome of individuals risking their own wealth to purchase the asset in competition with other private owners of wealth.

Ownership of capital ultimately requires control over its use in order to realize its economic value. Once government entities hold private sector equities, there can be no doubt that rent-seeking leeches would start to lobby for the politicization of corporate decision making.

So what can be done?

The only exit from this process is a renunciation of monetary interventionism itself: the dissolution of central banks and a return to sound money.

As long as the policy of interventionism is pursued, new “solutions” are required in order to solve the problems caused by the prior interventions. If not stopped, the end of this progression is a system of total central planning.

Sources:

Fractional Reserve Banking Murray Rothbard

More of the Same at the Federal Reserve Ron Paul [Nov 29, 2005]

Bailing out Banks Ron Paul [Apr 16, 2008]

Deregulation Blunders and Moral Hazard Michael Rozeff [Nov 2008]

Bearly Alive Mike Whitney [Mar 2008]

Will Bankers Become Central Planners? Robert Blumen [Jul 2007]

Essential Reading:

The Bailout Reader, The Depression Reader, Understanding the Crisis, So Much for Diversity, The Dollar Crisis, Bernanke: He’s Reviewing the Situation

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