Liberty Forged

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

Posts Tagged ‘credit’

The Fed is saving the Economy?

Posted by Jesse on March 19, 2008

The Fed’s New Tricks Are Creating Disaster

The Federal Reserve is trying a range of new tricks to push new forms of lending as a means of preventing what they fear may otherwise be a major collapse in financial markets. What all these strategies have in common is an unwillingness to come to terms with the reality that the crisis is based on real factors and can’t be merely papered over without grave consequence to economic health.
The Case Against the Feda-personal-view.png
[Mises and Austrian Economics: A Personal View.mp3]

Thus, last Tuesday (March 11), in response to the looming troubles with the Bear Stearns investment bank, the US central bank said that it would offer primary dealers up to $200 billion in Treasury securities for 28 days in exchange for triple A rated mortgage backed securities (MBS) as collateral. As the problems with Bear Stearns intensified and clients started to pull out cash the Fed announced that it was ready to do much more.

Last Sunday, March 16, the Fed announced it would provide direct loans to investment banks through the discount window for the first time since the Great Depression. The Fed has agreed to lend investment banks against a large variety of paper securities including a big chunk of difficult-to-trade securities.

This move by the Fed came in response to Bear Stearns’s cash holdings dropping from $17 billion on March 11 to $2 billion on March 14.

The fact that Bear Stearns was rapidly losing cash posed a serious threat to the repo market. In this market, banks and securities firms extend and receive short-term loans that are backed by securities. Fed officials feared that Bear Stearns’s dwindled cash situation posed a risk that it would not be able to honor its indebtedness. This in turn could undermine the confidence in the large $4.5 trillion repo market and further damage the credit market.

In the end, Fed officials orchestrated the selling of the Bear Stearns to JP Morgan Chase Co for $2 a share, or $236 million. Note that on December 20, 2007, Bear shares closed at $91.42. The main reason given for this deal was to prevent further uncertainty that was poised to destabilize financial markets.

Most commentators have endlessly praised the innovative methods that Bernanke and his colleagues are introducing to counter the financial crisis. Bernanke, who has written a lot about the causes of the Great Depression, is regarded as the ultimate expert on how to counter the current economic crisis. In short, most commentators are of the view that the man knows what he is doing and he will be able to fix the current financial problems.

Bernanke is of the view that by means of aggressive monetary policy the credit markets can be normalized. Once credit markets are brought back to normalcy, this will play an important role in preventing serious economic crisis. Remember Bernanke’s financial accelerator model: a minor shock in the financial sector could result in large damage to the real economy.

In short, Bernanke, by means of his so-called “innovative” policy of fixing the symptoms of the disease, believes he can cure the disease.

What is the source of the disease and why are investment banks so heavily infected by it? The root of the problem is the Fed’s very loose interest rate policy and strong monetary pumping from January 2001 to June 2004. The federal funds rate target was lowered from 6.5% to 1%. It is this that has given rise to various malinvestments, which we label here as bubble activities.

We define a bubble as the outcome of activities that have emerged on the back of loose monetary policy of the central bank. In the absence of monetary pumping, these activities would not have emerged. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real saving is left for real wealth-generators, which in turn undermines real wealth formation. (Monetary pumping gives rise to misallocation of resources, which as a rule manifests itself through a relative increase in nonproductive activities against productive activities.)

When new money is created out of thin air, its effect is not felt instantaneously across all the market sectors. The effect moves from one individual to another individual and thus from one market to another market. Monetary pumping then generates bubble activities across all markets as time goes by.

As with any other business, participants in financial markets like investment banks are trying to “make money.” It is this that gives rise to the creation of various products like collateralized debt obligations (CDO) and mortgage-backed securities (MBS) in order to secure as big a slice as possible of the pool of newly created money. (Financial entrepreneurs are basically trying to exploit opportunities created by the Fed’s loose monetary stance and get as much as possible out of the expanded pool of money.)

As long as the Fed kept pushing money into the system to support the low interest rate target, various activities that sprang up on the back of the loose stance appeared to be for real. When money is plentiful and interest rates are extremely low, investment in various relatively high-yielding assets like CDO’s and MBS’s that masquerade as top-notch grade investment becomes very attractive. The prompt payment of interest and a very low rate of defaults further reinforce the attractiveness of financially engineered investment products. However, once the central bank tightens its monetary stance — i.e., reduces monetary pumping — this undermines various bubble activities.

The damage from the loose monetary policies of the Fed from January 2001 to June 2004 cannot be undone by trying to fix symptoms. Various activities or financial bubbles that sprang up on the back of loose monetary policies have weakened the bottom line of the economy. This fact cannot be undone by another dosage of policies that attempt to suppress the symptoms. If anything, such policies are likely only to weaken the bottom line further.

Remember that nonproductive activities are not self funded. Their existence is made possible by the diversion of real funding from wealth-generating activities. The diversion of real funding in turn was made possible by loose monetary policy. Hence the tightening in monetary stance from June 2004 to September 2007 is what is currently undermining various false activities.

Monetary policy manifests itself through the prices of various goods and assets. A price of a good is the number of dollars per unit of a good. When the growth momentum of money supply strengthens, this lifts the number of dollars paid per unit of a good generated by a particular activity — i.e., prices go up. Conversely a tighter monetary stance that slows the flow of money puts downward pressure on the prices of assets, or the prices of the goods of various activities.

A tighter monetary stance generates two things. It weakens the supply of real savings to nonproductive activities and weakens the flow of money to these activities. (Remember that real savings are diverted to bubble activities from wealth-generating activities by means of loose monetary policy.)

A diminished flow of real savings starts to undermine the existence of false activities and their solvency becomes questionable. A fall in the flow of money in turn puts downward pressure on the prices of goods of these activities. In fact, prices of goods that emanate from false activities have a tendency to fall sharply during the economic bust. This in turn reduces the flow of investors’ money to these activities. As a result the prices of the stocks of bubble activities also tends to fall sharply, which puts more pressure on these activities. (With the value of their assets falling, misdirected investments can now only secure less funding from lenders.)

In contrast, wealth-generating activities that do not need an expansion of money for their existence actually start to gain strength. A fall in the prices of their goods is likely to be less severe than that seen in the prices of the goods of bubble activities. In fact their prices may not fall at all. Remember that wealth generators are engaged in the production of goods and services that are on the highest priority list of consumers. In contrast, bubble investments are engaged in the production of goods and services that are on the low priority list of consumers.

As consumers’ real incomes fall because of the damaging effect from loose monetary policy, goods and services produced by various bubble investments may not feature at all on consumers’ priority list.

We suspect that at the moment a tighter stance from June 2004 to September 2007 is dominating the current economic scene. So-called economic growth is always assessed in terms of GDP, which is the amount of money spent on final goods and services. The pace of monetary pumping sets the rate of growth of GDP. A stronger money rate of growth tends to be followed by a stronger GDP rate of growth, while a weakening in the money rate of growth is followed by a weakening in the growth momentum of GDP.

The engine of economic growth is not money, however, but real savings. If the pool of real saving is declining or stagnating, then the economy — also in terms of GDP — will follow suit, irrespective of what the Fed is doing.

How a particular sector responds to a tighter monetary stance depends on the extent to which that sector has been infected by bubble investments. The larger the percentage of bubble activities vis-à-vis all activities in a particular sector, the more severe the effect of a tighter stance.

If the pool of real savings is still expanding, then it means that bubble investments in general do not dominate the economic scene. (They can still be dominant in a particular sector or sectors.) This means that commercial bank expansion of credit is not going to collapse and the growth momentum of money is likely to hold its ground.

However, if the pool of real savings is falling or stagnating, this could mean that bubble activities are dominating the scene, which in turn raises the likelihood that the commercial banks’ expansion of credit will come to a halt. Obviously one can always argue that the Fed could open the money spigots in a big way and flood the economy with money. There is no doubt that the Fed could do it. This does not mean, however, that banks will embark on an expansion of credit if the pool of real savings is falling.

Obviously, then, if the pool of real saving is still healthy, Bernanke’s policies might “work.” In short, after a time lag, financial markets might start zooming ahead and the real economy will follow suit. We suggest that if this were to happen, the recovery shouldn’t be attributed to Bernanke’s policies but, rather, understood to have happened despite his policies.

In the alternative scenario, to which we assign a fairly high likelihood, the pool of real savings is actually falling or stagnating. In the framework of the alternative scenario, Bernanke’s policies will only do further damage to the stock of savings and sound capital investment, and plunge the economy into a severe and prolonged crisis.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.

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Outstanding Statement to Bernanke

Posted by Jesse on February 27, 2008

This is what a leader is supposed to do.
A leader is not supposed to micromanage every aspect of human life.
A leader is supposed to lend guidance. Set examples and preach principle.
This is what Ron Paul does.

Below is Ron Paul’s opening statement

Ron Paul is right! Bernanke concede the point!

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A roofer gives some insight regarding the Fed and recession

Posted by Jesse on February 6, 2008

Mark R. Crovelli writes:

What Caused The Boom In The First Place?

As was noted above, the idea that has been most responsible for the widespread complacency among business owners and construction workers with regard to the housing recession is that the whole housing crisis can be rectified through some action or another by the Fed. This idea is totally mistaken. The root of this mistaken idea lies in the failure of construction workers and business owners to grasp the root causes of the housing bubble in the first place. When the cause of the housing bubble is investigated, however, it becomes clear that the Fed itself was responsible for the creation of the bubble and it is now impotent to forestall a severe housing recession for long.

An example from my own construction experience is perhaps the best way to initially illustrate the Fed’s responsibility in creating the housing bubble. When I was a graduate student at San Diego State University a few years ago, I worked in a number of construction-related capacities in southern California at the peak of the housing boom. One of the most memorable jobs I undertook involved the remodeling of a horse barn for a doctor in the Temecula valley. This doctor had recently acquired a great deal of cash by means of a massive home equity loan, and he was willing to pay me and a good friend $17,000 of this newly acquired money to rebuild a part of his horse barn because he thought it a somewhat unsightly view from his swimming pool. (Interestingly, the good doctor did not, and still does not own horses). At the time, this sort of construction project was being repeated all over southern California, to the point where it would have been more profitable for me to remain a construction worker than it would have been to pursue a job with my graduate degree. Virtually all of the construction projects across southern California (and elsewhere), were financed with either gigantic home loans with ridiculously low interest rates, or, like the good doctor, with home equity loans with ridiculously low interest rates. What few people in southern California seemed to be asking either then or now, however, was where the banks got this massive amount of money to loan out in the first place? How, in other words, did the banks in southern California manage to miraculously come up with billions of dollars to loan out to homeowners who wanted to remodel their horse barns?

The answer is that the Federal Reserve under Greenspan the Magnificent created this money literally out of thin air. The Fed lowered interest rates through various devices (e.g., FOMC purchases of assets with money created out of thin air) to unbelievably low levels, and this action allowed the banks all across America to loan out massive amounts of newly created dollars. This new credit drove up price of real estate to stupendous levels, drove up the wages of construction workers to absurd levels, and dramatically increased the number of people working in the building industries. (It also, incidentally, spurred illegal immigration, as Mexican laborers found it profitable to risk crossing the border to earn artificially high wages from gringo jefes who couldn’t find enough workers to keep pace with the feverish demand for their building services.

The result of this flood of mortgages and home equity loans was, as we now know, an unsustainable and staggering boom in the building industries. The ultimate responsibility for this unsustainable boom, moreover, was, as was just seen, the Fed and its reckless and unnecessary increase in the money supply which allowed banks to loan out massive amounts of new cash which was subsequently spent on construction. The boom was thus not an expression of increased consumer demand for homes and $40,000 roofs. On the contrary, the boom represented an artificial and destructive bubble that could have been and should have been avoided with sound money (i.e., gold) and 100% reserve banking.

It also should be clear, moreover, that in order to continue this massive boom in construction the Fed would have to continue to artificially increase the money supply in the credit markets. This the Fed could indeed accomplish (and the Fed is in fact moving in this direction with its series of recent interest rate cuts), but the effects of propping up the unsustainable boom would be more damaging than letting the housing recession simply run its course. This is true, in the first place, because if the Fed floods the economy with more and more paper money and credit, this will merely postpone the inevitable recession and massively increase price inflation. Moreover (as I’ve written before), this price inflation will eventually make its way into the credit markets anyway, as banks tack on inflation premiums to their loans to deal with rising inflation. These inflation premiums will reduce the amount of credit available on their own (since businesses and homeowners will have to pay much higher rates of interest), because higher interest rates will, ceteris paribus, reduce demand for credit. In the second place, were the Fed to continue to inflate the housing bubble, this would temporarily induce even more people to move into the building industries, when, as was also seen above, a major part of the problem with the building industries is that there are already too many people working in construction.

….The final advice I have for everyone associated with the building industries is to support the candidacy of Dr. Ron Paul for president. As was seen above, the source of our impending misery is the Federal Reserve System, and the destructive boom-bust cycle which the Fed inevitably creates. Dr. Ron Paul is the only politician in the past fifty years who understands what the Fed has done to the U.S. dollar, interest rates, and the housing market, and he alone has vowed to return stability to the American economy through peace, sound money and radically lower taxes.

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The Political and Economic Agenda for a Real Gold Standard

Posted by Jesse on January 17, 2008

by Ron Paul

This paper was originally delivered at the Mises Institute’s 1985 conference on the gold standard. It later appeared as the final chapter in The Gold Standard: Perspectives in the Austrian School.
Read the full transcription here
The Case for Gold

“One of the basic insights of the great Austrian economists, both Carl Menger and Ludwig von Mises, is that money emerged by evolution from the market process. It was not invented by governments. There are basic economic forces today that are contributing to the further evolution of the monetary system, and there is a political strategy that I believe will make it possible to liberate those forces and restore the monetary role for gold. Because of the current economic and political climate, it is important to understand what we can do — and what we cannot hope to do in the short run.”
…………
“In The Theory of Money and Credit, Mises wrote, “The first step must be a radical and unconditional abandonment of any further inflation.”[2] Although I strongly support this objective, I do not believe it would ever be possible to achieve such a requirement if we place it as “the first step.”

Banishing inflation is, in fact, the ultimate objective we expect to achieve by creating a new gold standard. The US government has moved so far in the direction of fiscal irresponsibility that the reform of our basic monetary and financial institutions has become much more complex. For political reasons, ending inflation cannot be the “first” step. We must subdivide it into many smaller preparatory steps even to approach the task.”
………………..
“One of the points on which Mises was adamant is the role of the Federal Reserve System: “It is essential for the reform suggested that the Federal Reserve System should be kept out of its way.”[4] Mises advocated the creation of a “Conversion Agency” that would be responsible for issuing gold coins and bullion to the public, and redeeming excess quantities of gold in circulation if the public should choose to exchange gold for paper. The Federal Reserve would continue to have some responsibility under his plan, as a fiscal agent for the Treasury in managing the national debt, but the Conversion Agency would maintain the domestic and international exchange value of the dollar.

This is one of the most distinctive differences between Mises and other advocates of the gold standard, who want the Federal Reserve to buy and sell gold at a fixed conversion for dollars. The government’s fiscal agent necessarily performs a banking function as it collects and disburses tax money. It would have to be separate from a conversion agency that would function more like an office of the National Bureau of Standards than like a bank. Mises’s analysis of financial institutions and the market process led him to favor free, decentralized banking.[5] He was thus a consistent advocate of a separation of powers.

Ludwig von Mises understood that the problem with monetary institutions is first of all a political problem. By proposing this separation of powers between the central bank and a conversion agency, he was an early proponent of an institutionalized competition in currency. Even the government of a constitutional republic like the United States could not be trusted with discretionary monetary power:

The President, Congress, and the Supreme Court have clearly proved their inability or unwillingness to protect the common man, the voter, from being victimized by inflationary machinations. The function of securing a sound currency must pass into new hands, into those of the whole nation.[6]
………………..
“The choice for advocates of a gold-coin monetary system, therefore, is straightforward: either we move ahead with a program for US gold coins denominated by weight, with no face value in terms of dollars — thereby starting the transition period immediately — or we sit on our hands, perhaps for decades, debating the fine points of banking theory, until the paper money system collapses around us. Even then, it is not obvious that the collapse of the paper money system would bring about the political pressure necessary to restore a gold standard. We might end up with controls on wages, prices, credit, and exchange controls instead of a gold-coin standard.”
…………..
The genius of Ludwig von Mises was his profound insight into the free-market process, the science of catallactics. The most important thing I have learned from his work is that the achievement of a new gold standard in our society will have to come from the free market itself. This is why I believe the first step must be a new troy-ounce gold coinage, even without any legal tender qualities or special tax treatment. As we have found in recent banking deregulation, the market develops new procedures and techniques in the monetary and financial system, and Congress follows with repeal of old, restrictive laws. This is the political and economic dynamic process that we also can harness to restore gold to its proper monetary role.”
……………….
“Restoring a gold coinage is also the highest duty we now face, as citizens of this country. We no longer live in a world where the free market is taken for granted. On the contrary, most people assume government must control and guide the economic system for the benefit of all. Ludwig von Mises suffered during most of his career because he understood too well the stakes of this ideological conflict:

“Cynics dispose of the advocacy of the restitution of the gold standard by calling it Utopian. Yet we have only the choice between two Utopias: the Utopia of a market economy, not paralysed by government sabotage, on the one hand, and the Utopia of totalitarian all-round planning on the other hand. The choice of the first alternative implies the decision in favour of the gold standard.”[14]

I believe the goal of a market economy, not paralyzed by government sabotage on behalf of vested interests and pressure groups is an ideal worth fighting for. This is why I first ran for Congress, and it is the only reason I believe justifies political action.”

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Posted by Jesse on January 15, 2008

If this had been a mere subprime crisis, it would now be over. But it is not, and nor will it be over soon. The reason is that several other pockets of the credit market are also vulnerable. Credit cards are one such segment, similar in size to the subprime market. Another is credit default swaps, relatively modern financial instruments that allow bondholders to insure against default. Those who such sell such protection receive a quarterly premium, based on a percentage of the amount insured.

The CDS market is worth about $45,000bn (£23,000bn). This is not an easy figure to imagine. It is more than three times the annual gross domestic product of the US. Economically, credit default swaps are insurance.

read the rest here:This is not merely a subprime crisis [Financial Times, Wolfgang Munchau]

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