Something Wicked This Way Comes

Today I paid $4.15 to put some gas in the tank of my car. Ben Bernanke refuses to accept that the Fed has anything to do with commodity inflation and refuses to view it as anything other than “transitory” according to remarks on April 5th.  Before putting the lie to such nonsense, it will be instructive to review what exactly the Fed is trying to accomplish by purchasing well over half of the debt being issued by the Federal Government and in the process creating excess reserves in the banking system.  Ostensibly their purpose is that specified by Congress in the 1970s, to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.  But for a variety of reasons the country has become saddled with so much debt that it is effectively drowning.  A nice sip of water is invigorating when running but if you drink too much, you can no longer run.

A fairly facile assessment of why this has happened would put together the move to a fiat currency system in the early 1970s together with a profound and predictable lack of discipline by Congresses who let no palm go ungreased and no economic rent go uncollected with a final piece which was the move toward a freer global trading system (laudable on its own terms but in conjunction with the other two preconditions, disastrous for the level of domestic wages and hence for our Gini Coefficient which will matter when it matters).  The result has been the rise of a current account deficit of staggering proportions and a world awash with dollars in the hands of mercantilist economies needing to park such dollars – in US Treasuries and other US assets primarily.  The other result has been a move to source labor, the highest proportion of the cost of doing business, to overseas markets where labor was orders of magnitude cheaper.  This of course placed downward pressure on labor prices here in the US, but with the tradeoff that the cost of goods to be bought with remaining wages would also be lower.  It turns out that the stagnation in wages has left the majority of people worse off even considering the availability of cheap goods, resulting in downward pressure on the standard of living.  A temporary cure was found for that problem.  Interest rates were low due to the recycling of dollars into Treasuries and together with official urging, produced a massive inflation in the prices of real estate which allowed people to borrow against the collateral to maintain their standard of living…until the music stopped.

And stop it did in 2007 when enough people who had been given loans they could not really afford to service stopped servicing them in size.  Note that there were two kinds of people and two kinds of institutions – those who exercised some restraint and who did not leverage themselves to the hilt by buying more than they could afford, and those who pushed to the limit.  Once a sufficient number of people stopped paying their loans, the virtuous circle reversed as prices of real estate began to fall, ensnaring more and more people in positions of negative equity and removing the crutch that had allowed everyone to maintain their living standards.  It also threatened the balance sheets of financial institutions to the extent that their capital vanished and they were insolvent.  An insolvent financial institution has to raise liquidity to forestall liquidation, first by selling assets.  This impaired collateral across the economy and the recursive downward shift was on until in September 2008 Lehman collapsed and all transactions were grinding to a halt as banks would not lend funds to anyone for any length of time and companies could not roll over operating loans.

At this point a choice had to be made.  Let the markets clear – which implied a painful reduction of asset prices, which, while it would punish those institutions that had made poor choices as their equity and debt was wiped out, would also punish innocents alike as the value of collateral was impaired.  Or prop everything up to save the innocents, while letting the bad actors off the hook – the so-called moral hazard of bailouts which serves to privatize gains while socializing losses, ie, putting them to the taxpayers.  The compassionate conservatives of the Bush administration in conjunction  with the wild-eyed liberals of the 111th Congress, who could be counted on to help out anyone down on their luck, especially as they had been so helpful with campaign donations, chose the course of moral hazard.  The clearest example of this mindset was the early program to help underwater mortgagees which prompted the Rick Santelli rant that precipitated the formation of the “Tea Parties” and which was haughtily dismissed by Robert Gibbs for the White House as he urged Santelli to actually read the plan, which he claimed did not help those who did not deserve it at the expense of everyone else (I did read the plan – it did help those who acted irresponsibly at the expense of everyone else, the White House lied).  Bernanke even chimed in.  His reasoning was that if the bad people were punished by the market, it would also result in punishment for the good people and we wouldn’t want that would we?  That was very telling as to the mindset of the man in charge of the Fed and the conception of the relationship between the institutions of governance and those governed in the minds of liberals everywhere.

A parent has to decide whether to interject when their child is in peril as a result of their own actions to protect them or to stand aside and let the child learn from the experience, absent some threat of irreparable harm.  This is the pattern in mind for liberals.  But note that this is appropriate when the relationship is that between Parent and Child.  In other words the relationship assumed by liberals and progressives is one of paternalism.  But such a pattern is not appropriate when the relationship is between two adults.  In that case, the adult takes their medicine and better luck next time (of course this assumes that true bankruptcy is available to people, a fresh start – this was removed during the Bush administration at the urging, inter alia, of our current Vice President Joe Biden).

Returning to the main thread of the story, the collapse of the system threatened the banks over whom the Fed IS the protector.  It also threatened pension plans.  This is an underreported aspect of the crisis.  As the Baby Boom generation prepares to retire it would be most inconvenient for them if their 401ks had become seriously impaired.  This in turn would threaten the government who would be looked to to DO something about it.  it also threatened debtors everywhere as deflation INCREASES the real value of debts to be paid as the dollars to be repaid have GREATER purchasing power than the ones borrowed, and in a massively leveraged economy that would result in a lot of bankruptcy and insolvency for everyone including the government.  And especially the government as the debts of the nation were massively increased both because liberals acting in the name of Keynes (rolling in his grave) decided to spend like drunk sailors (also underreported, how many of those tens of billions went straight into the pockets of political supporters in various states) and also as tax receipts plummeted from reduced economic activity.

Enter the saviors.  The cooing could be heard getting louder as the doves at the Fed flew in first, and appropriately, to stem the liquidity crisis resulting from the collapse and then, inappropriately, to continue flooding the system with liquidity indefinitely by facilitating massive further borrowing, making the insolvent even more insolvent.  This of course is the whole idea of pushing on a string in a liquidity trap.  The idea that you give a runner who is choking on water MORE water and keep pouring in more water as if that will help rather than hurt.  The problem with insolvency is too much debt.  And adding more debt is not only NOT going to help solve the problem of too much debt but is going to make it worse.  At first the runner may run some more as the parched condition is better, but eventually he will collapse.

Aside from that though there is the question of who is helped and who is hurt as the Fed monetizes the debt and holds rates at negative real levels.  The Fed Funds target rate has been at 0-25 basis points for nearly two and a half years at this point, even though the recession officially ended something like 21 months ago.  The thing about the zero lower bound is that real people do not necessarily care what real rates are when the nominal return on their savings is zero.  One large class of people hurt, as stated for example by Michael Steinhardt in an interview yesterday on CNBC, are savers.  From a cultural standpoint, it is considered a virtue to save, right?  Except that it is the official policy of the government that savers not get a nominal return on their savings.  What is the message you suppose will be learned?  On the other hand, in a bid to have banks rebuild their balance sheets, zero rates on the short end, where banks can borrow for funding, with an explicit guarantee that the shape of the yield curve will remain stably positive for “an extended period” so that banks can earn the spread between what they pay to borrow (0%) and what they lend it out for to the government (1% or more), works wonders – at the expense of savers.  So Prince Alwaleed of Saudi Arabia, a major holder of Citibank, is made whole on his investment, a person who is a billionaire merely because he was born into a family on a plot of land occupied by people whose religious institutions (with funding by the ruling family) exhort them to kill us and who will not let women go outdoors unless they are with their husband or brother, while ordinary Americans trying to do the right things and play by the rules are screwed.  The message there?  It is better to cheat than to play by the rules.  There is therefore a moral rottenness suffusing the whole enterprise that also is rarely talked about but that represents a real long-term cost to our society.

The official policy of the organs of the US Government is that cheaters prosper and prudent people are screwed or quaintly naive (after all our Senate Majority Leader even said so when the Cornhusker Kickback scandal brewed – “You are not doing your job if you DON’T cheat” was his message -and he was reelected shortly thereafter!!!).  And this doesn’t even take account of the actual TARP bailout that was a direct injection of capital to existing banks.  Is it a surprise then that people were a little bit upset that with our tax dollars and foregone savings flowing into the balance sheets of banks as an official policy of our government, the bankers then turned around and paid themselves huge bonuses out of those guaranteed profits for doing “God’s Work”?

Ben Bernanke, whose work as a Professor at Princeton prior to joining the Federal Reserve Board of Governors in 2002 supposedly makes him an expert on the Great Depression, probably thinks he is doing “God’s Work” too.  Because he views the relationship between the government and the governed as a paternalistic one, he thinks he is protecting us.  But his policy is in fact creating commodity inflation.  The official measures of inflation include housing as 40% of the measure or so.  Housing is in a depression and is deflating.  So official inflation measures look tame.  But the very people who can least afford commodity inflation are the ones getting hammered by it as they pay substantially more for food and energy and these represent a relatively high portion of their discretionary income.  So not only do they not get paid to save, but they are paying out more to live.  At some point anger will erupt here as it has erupted in North Africa and the Middle East if Bernanke does not change course.  Fortunately for everyone, most of the 25-30% of the unemployed young adults and probably some of the 9-14% of unemployed older adults are busy enough playing Wii or Playstation that they are not out rioting.  But that only works while they can somehow afford to get enough calories from cheap foods at McDonalds and Wal-Mart to stave off hunger. Wal-Mart and McDonalds have both come out recently and said price rises are on their way.  With 44 Million people on food stamps the government is doing all it can to keep them in their living rooms in front of their TVs.  How long can that last?

And to top it all off, from a capital markets standpoint, the Fed has interjected itself into the markets to such a degree that our markets, especially the stock market, and every other market which depends on the value of the dollar, can no longer be said to be free markets.  Price discovery? For chumps. A reliable signal of value for long term investment? Whoever heard of such a thing? The Fed Chairman as much as said that the Fed would make the stock market rise in the shocking editorial he wrote in the Washington Post in the days after the QE2 announcement in November 2010.  For years, people had speculated about a “Plunge Protection Team” at the New York Fed but they were derided as fringe conspiracy whack jobs.  Here was the Fed Chairman stating openly that there would be a “Plunge Protection Team” of sorts to  greatly enhance the now openly spoken Greenspan/Bernanke Put under the market.  Amazing.  No wonder the equity indexes have surged with the Fed pumping billions of dollars a day into primary dealers and other banks (and not always at the best prices.  See zero hedge for plenty of instances where the bonds monetized were not the cheapest to deliver). The misallocation of capital continues apace which represents a long term diminution of aggregate wealth.

Finally I cannot end this discussion without mentioning the outright lies to Congress stated by Bernanke in the latest Humphrey Hawkins testimony.  In it, when a Senator talked about the Fed monetizing US Treasury Debt, Bernanke was quick to correct him that they were not monetizing the debt.  Well technically that is true.  They are not buying the debt directly from the Treasury.  Instead it is worse.  They let the primary dealers buy it from the treasury and then a week or two later they buy it from the primary dealers.  And you can bet the primary dealers are getting paid for the privilege of holding the debt for a week or so.  The level of dissembling has gotten to the point that people are not buying it any more.  When William Dudley, the President of the New York Fed and a former Goldman Sachs Chief Economist, was speaking to a group in Queens a week or two ago, he was trying to explain to them how because people were getting higher quality goods like iPads which are more powerful for the same price, that was actually an offset to inflation.  The audience guffawed at that and someone said “I cannot eat an  iPad”.  The Fed is getting out of touch when it is getting caught saying “Let them eat cake”.  Again this will not matter until it matters, but at some point it will matter and when it matters, it will matter painfully.

And another thing. The US Attorney in some district or other just put a man behind bars for what they described as the most heinous act of domestic terrorism, that of creating a currency that competes with that of the US Dollar, because it represents a threat to our currency. Well who do you suppose represents a clear and present danger to our currency? Really? Well, duh, maybe the guys who are debasing it by virtue of keeping real rates of interest negative indefinitely. And yet because they are vested with the imprimatur of authority, somehow they get away with it. Take a look at the chart of the Dollar Index below. Notice anything? Since Ben Bernanke became a member of the Federal Reserve the dollar has accelerated straight down. And this with the blessing of two successive Administrations. Who should be in jail?

Helicopter Genocide Zimbabwe Ben Bernanke’s term as Fed Chairman does not end until January 2014, which is really far away.  Maobama will, by all accounts today, be reelected in 2012 and so may even reappoint Bernanke to another term.  Either our taxes will be raised therefore in a desperate attempt to stave off default, reducing our standard of living even further, or Zimbabwe Ben will have to print until we risk a catastrophic loss of confidence in our currency and interest rates skyrocket and we default anyway.  While I hope we can drastically cut expenditures, after which a modest rise in taxes would be palatable from a morale standpoint, and that the debt can then be worked off without a collapse, the odds of threading that needle do not look high.  The charts below illustrate why the Fed Chairman doth protest too much when he abjures responsibility for the current commodity inflation.  There are many more such examples.  Ben Bernanke’s famous Helicopter speech can be found here.  A timeline of Quantitative easing events can be found here.  The chart on Real Rates of interest can be found here.


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