Can You Fake....a Capitalism?

 

We don't have a precise read on why this slower pace of growth is persisting. Ben Bernanke

Fed Chairman Ben Bernanke is confused.  Interest rates are low, liquidity is flowing freely and equity prices are up between 15-20% year-on-year.  Why then, Bernanke wonders, isn't the US economy growing as a capitalist economy should grow under such conditions?

Perhaps the US is just faking a Capitalism.

Most definitions of Capitalism include reference to private ownership of the means of production which exist on a "for profit" basis- i.e. survival of the fittest.

While worthy of discussion in their own right I'll only note in passing that ownership of the means of production is far from private in its early 20th Century sense and that existing on a "for profit" basis likely implies not existing (as opposed to being bailed out) if losses are excessive, hoping to draw your, and perhaps Mr. Bernanke's, attention to the graph below.

source: BEA

Stripped of econo-jargo, the graph above depicts changes over time of new capital (means of production like factories, tools, etc.) investment compared to annual national output or GDP.    As you can see, such investment has been generally declining for a decade.  We in the US are at a plateau like a weight lifter who won't add extra weight to his work-outs.  A more clever economist than I, Tyler Cowen, describes the US' condition as The Great Stagnation.

For all the official talk of stimulus, there is virtually no capital investment happening in America.  Is it any wonder unemployment remains high?

The " Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation," which, Karl Marx argued, "distinguish the bourgeois [Capitalist] epoch from all earlier ones" is not a current feature of American political-economy.

Can you fake a Capitalism?

I think we're doing about as good a job as Meg Ryan did above.  While some might wish "to have what she's having" I prefer the real thing and I suspect most Americans would too.

A few suggestions:

• let's focus on the real economy instead of the monetary quantifications thereof
• let's stop stimulating the economy and start investing in it
• let's stop being financialists and start being capitalists again

As JS Mill wrote: Capital, by persons wholly unused to reflect on the subject, is supposed to be synonymous with money. To expose this misapprehension, would be to repeat what has been said in the introductory chapter. Money is no more synonymous with capital than it is with wealth. Money cannot in itself perform any part of the office of capital, since it can afford no assistance to production. To do this, it must be exchanged for other things; and anything, which is susceptible of being exchanged for other things, is capable of contributing to production in the same degree. 

Paraphrasing Clinton (for Bernanke): It's the capital, stupid!

Bernanke and the Depression of Damocles

It's showtime for Ben Bernanke, Fed Chairman. The moment of truth, so skillfully postponed by months of swapping good money for toxic debt, is once again at hand.

He will either be the hero or a punch line in some future Fed Chairman's speech.

To wit, in Bernanke's own words:

The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. After the stock market crash of 1929, many thought a financial and economic crisis was necessary--even desirable--to wring out speculative excesses that had built up in the 1920s. Remarkably, despite the fact that the Federal Reserve had been founded to mitigate financial panics, the central bank made essentially no effort to prevent the wave of bank failures that paralyzed the financial system at the start of 1930s. Indeed, the Treasury Secretary at the time, Andrew Mellon, believed in the tonic effects of weeding out weak banks and famously advised President Herbert Hoover, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … It will purge the rottenness out of the system."

The Depression of Damocles hangs over his head while he deliberates long run strategies for managing the Fed's balance sheet- a hot topic at the Fed's meeting late last month.

The staff next gave a presentation on potential longer-run strategies for managing the SOMA. At previous meetings, Committee participants had expressed support for steps to reduce the size of the Federal Reserve's balance sheet over time and return the composition of the SOMA to only Treasury securities. The staff discussed the potential portfolio paths and macroeconomic consequences of a number of different strategies for accomplishing these objectives. To date, the Desk had been reinvesting the proceeds of all maturing Treasury securities in newly issued Treasury securities, but it had not been reinvesting principal and interest payments on maturing agency debt and agency MBS, nor had it been selling securities. One strategy considered in the staff presentation was a continuation of the current practice, which would normalize the balance sheet very gradually. In addition, the staff presented information on a number of other strategies that included sales of SOMA holdings of agency debt and MBS and under which the proceeds of maturing Treasury securities would not be reinvested; these strategies differed by the date and circumstances under which sales would be initiated, by the average pace of sales, and by the degree to which the timing and pace of such sales would be adjusted in response to financial and economic developments.

Ironically, the Fed is not debating whether to "liquidate" à la Andrew Mellon, toxic debt purchased from the banking sector, but rather the pace of liquidation.

The modern Fed, if it tries to drain liquidity by liquidating toxic assets, may well, like its counterpart in the early 1930s bury the economy under a mountain of unpayable debt in order to maintain a "strong dollar", which, as an aside, has risen roughly 20% so far this year in Forex markets.

Let's return to Ben's jab at Andrew Mellon, The first lesson--economic prosperity depends on financial stability--seems obvious, but this connection was not always well understood. Whether this first lesson is currently well understood at the Fed remains to be seen.

While there are many aspects of financial stability, one key feature is sufficient income to service liabilities, a task which gets most difficult the higher the ratio of liabilities to income.

The graph below depicts total US financial liabilities (source Fed's Flow of Funds data) divided by US national income (source BEA).

As you can see, current trends do not engender a sense of US financial stability. Income needs to rise to avoid a Mellon-esque liquidation. Financial stability, in my view, does not flow from support to financial institutions, which but buys time, but from a financially stable real sector. Right now, the last thing the US real sector needs is less liquidity and a strong dollar.

The question, in my mind, is why the Fed tolerates a "strong dollar". Will the words of men like Bob Rubin- "a strong dollar is in the US national interest"- become Mr. Bernanke's ironic epithet?

In time, economic historians may realize the only interests served by a strong dollar in recent times are those of the TBTF banks, who get a "free ride" on the exorbitant privilege of the US$'s role as main global reserve. Bernanke, to avoid being the goat, needs to solve Triffin's Paradox as Alexander the Great solved the Gordian Knot, by cutting it in half- and choosing to support the domestic (real) economy.

The real economy in the US needs a weak dollar and inflation or it will not be able to service its debt. How one can think finance needed the Fed's shock and awe in 2008-09 but the real sector doesn't, and can instead service its debt with a long and gradual decline in unemployment, escapes me.  The US needs some inflationary shock and awe.

"But," you might be thinking," hasn't the US been inflating?"

Yes and no. While the monetary base has tripled over the past decade, growing even faster than in the 70s, when it doubled, broader money stock measures are not responding in kind- M2 has roughly doubled during the past decade while it more than tripled during the 70s. Credit, more and more over the years, is flowing to the financial markets, (and overseas- some $300B of US currency is in foreign hands source: BEA) bypassing the US real sector.

Debates over the pace of Fed credit draining via toxic debt liquidation is ample proof. US monetary policy has been hijacked by international financial concerns who don't want the value of their dollar holdings inflated away (but don't seem to realize current income without inflation only invites default). 

Bernanke needs to make a choice. Supporting the TBTF banks and the "strong dollar" as basis of global reserves got us into this mess. More of the same won't get us out of it.

TBTF isn't just Bad Policy, it's a Scam

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal contraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income (NOI) for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

The streams here in the Northeast US today, following a solid 2 day rain, are akin to those of income enjoyed by US Banks- spilling over at record setting levels.

As promised yesterday when I detailed the obscene compensation of bank industry employees, today's musings will focus in more detail on US Banking sector incomes, expenses and the future of Too Big To Fail.

Banks always and everywhere make the bulk of their income from lending and the US sub-species is no exception to this rule. Bankus Americanus is, however, unique in a few regards. It is the only animal on the Endangered Species list whose dwindling numbers are a result of cannibalism. To wit, in just the past 15 years numbers have dropped from 12,604 to 8,012 but those that remain are fatter than ever. Additionally, (and somewhat more seriously) unlike most banks in history, in recent times non-interest income has risen to more than 50% of interest income, helped in part, by the termination of Glass Steagall restrictions.  Data: FDIC- all covered institutions, aggregated

Given the substantial compensation American Bankers receive one might expect the increased non-interest income to come via trading, investment banking or the recently allowed insurance and brokerage activities, but this is not the case. Service charges on deposit accounts earn US Banks more than trading, investment banking, insurance, or brokerage in every year for which I have data. The lowly paid back office workers, in other words, generate much more income than the highly paid traders.

Admittedly, as I learned at Chase, there are indirect benefits to having a trading desk (and other financial services). Trading, for example, requires a cash deposit which will not only generate its own set of fees but also increase lending by whatever multiple the bank deems prudent.

Regardless, in the aggregate, US bank trading profits (exclusive of employee expense) have never exceeded 10% of net interest income. And the banks haven't even begun to unwind their derivatives portfolios, an event which may well push the absolute value of trading income above that of interest income for a year or two. I suspect in the not too distant future the wisdom of bank trading will be seen as pure folly. The NIMBY (Not In My Back Yard) movement which drove, e.g. chemical processing, off to foreign lands will soon, I believe, drive trading from Banks.

Moving on to larger streams, the biggest line item in the FDIC's breakdown of non-interest income is obscurely titled "additional non-interest income." The FDIC defines this as:

 All non interest income of the bank not required to be reported elsewhere, including (but exclusive to): 

1. Income and fees from the rental of safe deposit boxes;
2. Income and fees from the sale of checks, money orders, cashiers' checks, and travelers' checks;
3. Income and fees from the use of the bank's ATMs;
4. Income from performing data processing services for others;
5. Earnings on or other increases in the value of the cash surrender value of bank-owned life insurance policies;
6. Rent and other income from Real Estate Owned.

Chalk up another win for the back office, and, better still, the electronic office. An inquiry with the FDIC informed me that ATMs (and related services) were some of the biggest earners at US Banks. How clever of Bankus Americanus. The advent of the computer and internet age led to price reductions in most industries, inspiring the then Banker in Chief Greenspan to proclaim a productivity miracle. Bankers, by contrast, increased their income.

Pause for a moment. Can you imagine the outrage if ATMs were outlawed and tipping a teller a few dollars each time one made a withdrawal became mandatory? Can you imagine how many people would suddenly get the urge to be a bank teller? Banks would then have no problem staying open 24 hours a day, just like the ATMs- and we might all enjoy a human voice saying, "Thank you for banking with us."

There's a lesson to be learned here. The aggregate data strongly suggests that bankers aren't smarter than they were 30 years ago, they are just more protected. Protection of the sector allowed a relatively small group of people to pay themselves huge salaries (and huger bonuses) while the bulk of bank income was derived not from their efforts but from normal bank services spared the ravages of tech sector cost cutting. The high priced guys are the one's who have generated the problems.

Returning to cash flows, income isn't generated for free. The network of ATMs required development (but shouldn't the patent protection for this have expired like those for pharmaceuticals?), installation, and continued service. Profits accrue only when incomes exceed expenses. Banks must borrow funds more cheaply then they lend them.

As interest income is the bulk of bank income, you would expect that interest expense (i.e. cost of funds) is the bulk of bank expense. Up until the past few years, this was true. In 1994, interest expense was $145B (interest income was $321B) while employee compensation was $70B. In 2009, interest expense was $145B (interest income was $541B) while employee compensation was $163B. Amazingly, less than 2 million bankers (actually the problem is caused by the top 10%) paid themselves more than they paid the 100s of millions of depositors for the use of their funds. They even paid themselves more than they paid the bank owners.

If this (taking new equity capital to pay off previous investors and line their pockets) sounds like a Ponzi scheme that dwarfs that of Mr. Madoff, then I've made my point.

This brings us to the bottom line. If the Banks are truly TBTF and Bank employees truly indispensible, Capitalism is well and truly dead and Banking no longer a job, but a religion. In Capitalism, shareholders, not employees are the ultimate arbiters of business. Once net income goes to zero or below, the business, in its current form, is on borrowed time.

Free money from the Fed, and bail-outs from various governments allowed US Bank employees to pull off a marvelous trick, thereby freeing them from the normal constraints of Capitalism. They paid out more in dividends than they made in each of the past 3 years: by $8B in 2007, $41B in 2008 and $30B in 2009. Net operating income for the banks was $102B for 2007, $10B for 2008 and $17B for 2009. This is obviously unsustainable, and makes the crooks from the Tech Boom look like amateurs- while the Techies based their fraud on the greater fool theory, the Bankers simply paid off their owners, and gave themselves raises.

Yesterday Paul Volcker said TBTF was "moral hazard writ large". He was wrong. It's a hazard before it happens. This has been going on for 3 years.

As with the Tech Boom, something has to give. The real sector in the US isn't recovering, in part because credit is just circling round in the financial markets, as was the case in the early 90s, but on a much larger scale today. Real sector borrowing rates (adjusted for tighter credit conditions) are still too high. Thus the residential mortgage problem is not going away, and likely to worsen now that the Fed is out of the game (for the moment at least) and a commercial mortgage problem is looming.  Unlike the early 90s, there is no RTC set up to recover money for the banks, and there's that problem of who really owns the mortgages to be solved.

At current price levels it will be years before the banks are back to whatever constitutes normal these days, and I don't think we'll have that much time. Unlike the 90s, we have a government debt roll-over problem. If Banking sector NOI is roughly zero again this year, will shareholders be willing to accept zero dividends? I doubt it. Absent a sudden recovery in the real sector, US Banks, like the Irish Banks, will soon find they need more money.

Barring an unlikely substantial reduction in employee compensation (a solution I highly recommend, rolling salaries back to 1999 levels would free up roughly $70B A YEAR for loan loss provisions), the banks could dilute their own shares (but only for so long) or try to raise more overseas equity, but the amounts would be limited, in the case of foreign investment, to less than a controlling stake. I can't imagine the US population or government allowing China to hold a controlling interest in Citibank or any other big BHC.

A $ devaluation policy would alleviate the mortgage problem but the subsequent rise in interest rates would likely ignite another, much larger problem in the 200+ Trillion dollar derivatives portfolios, and our foreign creditors would be none too pleased. Sadly for them, the Germen option of forced liquidation is that least desired by the powers that be. Devaluation, I suspect, is the only option- it just has to appear to be an accident.

Regardless, we'll likely soon discover that TBTF isn't just bad policy, it's a scam- the Tech Boom on steroids.

A note on aggregation: Sometimes this process makes it easy to miss the trees for the forest-some banks might have profitable trading desks but they get lost. Goldman Sachs comes to mind. Yet, during the crisis of 2008, GS would have gone the way of LTCM (for the same reason) but for their transformation into a BHC and the bail-out of other institutions (notably AIG) which kept payments flowing.  GS isn't much of a bank in the usual sense but an investment house.  They should not, in my view, have gotten the protection of commercial banks. 

A note on trading: This essay might leave readers with the notion that I'm against trading. I'm not. I trade.  I simply believe that for trading to provide the promised price discovery benefits, they must stand on their own as private sector businesses.

Helping the Fed Solve the Problem of Excess Reserves

The key to the game is your capital reserves. You don't have enough, you can't pee in the tall weeds with the big dogs. - Gordon Gekko

Ben Bernanke and the brain trust at the Federal Reserve have been working overtime trying to solve the problem of excess reserves in the US banking system. "How," they wonder, "can we drain these reserves from the system without destabilizing the markets?" Their fears of destabilizing markets are, I believe, justified, which seems odd given that the Fed, in the past, has been able to drain reserves, although the quantity drained was admittedly much smaller.

To the extent there is no way to drain these reserves without upsetting the markets the solution to the problem might not be one of action, but of thought. As Norman Vincent Peale said, "Change your thoughts and you change your world." Instead of trying to drain the excess reserves let's admit that they are not, in fact, "excess", but rather, "prudent", or even, as I suspect, "insufficient."

How do we determine if reserve levels are prudent, excess or insufficient? The determination is a process of thought. If financial assumptions about the future are perfectly accurate, there is no need of reserves- correctly valued assets will, under that head, always generate income sufficient to pay liabilities.

Reserves, then, are a safety measure in the event assumptions about the future are inaccurate- if assets are, in fact, not correctly valued. The more inaccurate prior assumptions of future events prove to be the wiser it would have been to increase reserves before the inaccuracies come to light.

The apparently resolved crisis in Greece seems a case in point (as, it seems to me, was the US crisis of 2008). The Greeks didn't simply decide, out of the blue, to borrow an additional 50 or 100 billion Euros, they, at certain levels of government, knew their fiscal position. Why then the crisis?

Simple. They made poor assumptions about either the value of their assets relative to liabilities (what economists call the primary fiscal balance) or the duration of the deceit which, in part, allowed them to borrow in sufficient quantities at favorable rates. In their case the latter seems more of an issue, as tends to be the case when crises "suddenly" manifest.

Like the homeowner who lied about his income to get a home or the Ponzi schemer who claims to own more than he does, the Greeks had been living on borrowed time. The question in that case about a crisis is not if but when.

Deceit, of course, is a loaded term as it connotes intent. Bernie Madoff is in jail because he admitted to such. In other instances a more appropriate phrase would be willfully ignorant. Those in charge hope for an outcome more objective, but equally educated persons deem unlikely, or impossible. Traders call this, talking your book.

Regardless of intent, the effects are the same. Reserves bridge the gap between projected and actual income relative to liabilities whether the gap is a function of deceit or ignorance (willful or otherwise). Sufficiently higher levels of reserves (other things equal) would have kept Mr. Madoff out of jail and obviated the Greek crisis.

Gordon Gekko had it right.

Returning to the issue du jour- the proper level of reserves in the US banking system- the difficulty of imagining a plausible future scenario with the reserves drained strongly suggests to me that current levels are minimally prudent. That is, if draining reserves would cause rates to rise, decrease real sector activity, or some combination thereof such that bank incomes wouldn't cover required payments then they shouldn't be drained.

Why then does the Fed seem so intent on draining? Perhaps they aren't as intent on draining them as some might think. Perhaps their intent is simply to maintain the illusion that the reserves are considered excess. If they told the world the level of reserves was considered prudent this would likely send a message that the financial state of US banks is not as healthy as otherwise advertised. This, in turn, might exacerbate future gaps between bank income and outflow, requiring even higher levels of reserves than currently exist, or, as was the case in Greece and with Mr. Madoff, precipitate a crisis.

Perhaps the only way to keep the real sector operating such that bank assets perform is to increasingly dilute the currency (since any increase in reserves would most likely be "borrowed" from the Fed as happened during the last crisis). Perhaps Mr. Kinsley's nightmare scenario of impending substantial inflation and even hyper-inflation is much nearer that truth than the Fed or Mr. Krugman would have us believe.  Perhaps the classification of reserves as excess has more to do with what the Fed wishes others (i.e. those who lend money to the US) to assume than what they assume, which edges ever closer to Greek deceit.

The Fed could, of course, prove me wrong by draining the reserves deemed to be in excess without precipitating a crisis.

I won't, however, be holding my breath.

The Kins(l)ey Report (on Inflation)

One could, in a debate of US inflation prospects, discuss the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not (in this essay) a reasoned debate but a notice of the lack thereof.


If, like me, you're an official member of the pajama wearing blogger corps, you might be familiar with the recent debate over US inflation prospects between Michael Kinsley and Paul Krugman, et. al. If not, here's Kinsley's initial article, Krugman's rebuttal, Kinsley's retort, and Krugman's rebuttal of the retort.

Krugman's second rebuttal dripped with condescension, or so it seemed to me, recalling memories of school yard bullies. Those memories tempted me to begin this article with a quip about Krugman needing to pick on someone his own size......, but I'll use a different metaphor.

"Ouch!," you might be thinking, "that's a bit cruel."

True.

So's this line from Krugman to Kinsley: "I’m tempted to get into an argument about whether it’s “bullying” to suggest that if you’re going to write about an economic issue, you might want to study it first. But what I really want to do is..."

Don't you love the artful use of the non-statement statement?

Aside from my belief that future events are more likely to follow some variation of Kinsley's nightmare scenario than Krugman's Japan model (about which, more here), the element of the exchange that inspired this post was Krugman's nasty dismissal of an apparently serious inquiry from one who apparently admires his views.

Kinsley's initial article contains statements like: "am I crazy?", "Every economist I admire, from Paul Krugman and Larry Summers on down, is convinced that inflation will remain low for as long as we can predict", "I can’t help feeling that the gold bugs are right", and "My fear is not the result of economic analysis. It’s more from the realm of psychology."

These are the words of a humble student searching for wisdom to quell his fears.

The wise Professor Krugman begins his rebuttal with: "Mike Kinsley has an odd piece in the Atlantic in which he confesses himself terrified about future inflation, even though there’s no hint of that problem in the real world."

You can almost see the sneering Professor holding up the student's paper in front of the class as you read the words (at least I could).

Using the tried and true nasty Professor trick of tossing about a bit of relevant jargon and a counter-example, Krugman expects Kinsley to slink back into his seat.

To his credit, Kinsley doesn't flinch.... much. He almost falls for the Professorial misdirection (debating whether a sudden 100% inflation shock is better than a Weimar hyper-inflation is like debating whether losing both legs is better than getting killed- I see your point, but I'll take none of the above) but then gets back on point, telling the Prof (in effect), "you didn't answer my question."

Why not inflation?

As Kinsley argued, the 70s demonstrated the US is not immune to inflation and Gold has risen from $275 to over $1000 during the past decade. Perhaps Kinsley's main confusion lies in his focus on the future tense, instead of seeing it as an ongoing issue.

Kinsley's search for the truth on inflation reminds me of Alfred Kinsey's search for truth on human sexual habits, which led to the publication of two books on human sexuality known collectively as the Kinsey Reports. Like Kinsley (or so it seems to me) Kinsey's search for truth battled with popular conceptions of what should (in some views) be, but wasn't.

In a sense Kinsey reported on what everyone (collectively) knew, but was afraid to say. The fear (perhaps, with the benefit of hindsight, somewhat justified) among then current opinion shapers was, in part, that open discussion would release the genie from the bottle. Hugh Hefner, of Playboy fame, credits Kinsey with opening his eyes to human sexual experience.

Krugman, in my view, is too smart an economist to dismiss outright the possibility of another significant inflation episode in the US, which may or may not be followed by hyper-inflation.

To use his phrasing, for those dismissing prediction of substantial US inflation, what is it about the US now that looks different to you from Thailand, Korea and Indonesia in say, 1997 (or Russia in 1998, or Iceland just recently)? Substantial public and private sector debt? Check. Huge expansion in the monetary base? Check. Large external debts and ongoing external deficits? Check. Increasing difficulties rolling over ever shorter term debt? Check. And yet each of those countries suffered, not multi-year hyperinflation, admittedly, but a sudden substantial (50-100% or more) inflation shock.

There are, admittedly, differences. As I wrote, I was using his phrasing and argument form. One could debate the virtues of issuing the currency in which your debt is denominated, and the ability of US political leadership to enact tough change counter-balanced, I think, by the magnitude of the debt in question relative to world GDP, and the actual history of US political leadership to enact tough change. But my aim is not a reasoned debate but a notice of the lack thereof.

Mr. Krugman might snidely respond to my snidely put question that the issue was hyper-inflation. I lived in Asia during their crisis and such shocks are worth worrying about even if hyper-inflation is avoided (besides, his use of Japan- a nation which self-finances, which seems to me a critical distinction- as counter-point suggests even moderate inflation is unlikely). Moreover, as Kinsley notes, who knows what policy makers will opt to do when the next crisis erupts. The history of the Bernanke Fed is not one of monetary restraint in a time of crisis.

I suspect that Krugman, not the economist, but the opinion shaper is, like those Kinsey battled, trying to keep the genie in the bottle- thus the Professorial dismissal instead of reasoned discussion of the issue. Inflation has both psychological and real world causes- when the two unite, the fireworks begin.

Perhaps, in a limited fashion, the Kinsley Report on Inflation will have a similar effect as Kinsey's, (then again maybe both should be seen as catalyst instead of cause) by bringing the debate into the open.

I wonder who the Hugh Hefner of Inflation will prove to be- perhaps Bill Murphy of GATA?

My advice to Kinsley is to have the courage of his convictions and buy some Gold, the price of which may have been as suppressed as reasoned open debate on US inflation prospects appears to be- both actions aim at the same effect.  I did (at $275 for Krugman's information) and I'm still holding.

Whistling past the Depression

Ben Bernanke – for it was he, of course – has found himself in an even more privileged position to learn such lessons. As chairman of the Fed, his record already deserves more plaudits than those prematurely heaped upon his predecessor. How lucky for us that a Great Depression buff was running the Fed when a second Great Crash came along! For this time the contractionary forces have not been intensified, in the name of sound money. Instead, an active monetary policy has pursued a strategy of easing credit restraints on the real economy, and the threat of inflation has been rightly dismissed as a purely notional danger under present circumstances. FT

The Fed, according to a scan of the financial news, is currently debating the timing and method of an "exit strategy" from the zero-interest-rate-policy (ZIRP), which, according to the above view, saved the US from a repeat of the Depression. This may well prove to be true, and if so, would be, in my view, an example of the myopia inducing effects of unproved assumptions.

The assumption, in this case, is the belief that a good deal of the pain of the Great Depression could have been avoided by policies enacted after the Crash of '29.

This was Milton Freidman's assumption and, judging by Mr. Bernanke's academic work and recent speeches, his as well. Depressions, they think, can be "cured".  Most people have not studied the Great Depression but in many cases seem more than willing to whistle past the the idea of a Depression- uneasily perhaps, but unwilling to change course while, knowingly or not, willing to put their faith in conclusions similar to those in the opening paragraph.

Conclusions drawn from a study of any historic event will necessarily be colored by prejudice. Open minded people, without an axe to grind, might quickly lose those prejudices that seem inconsistent with the facts and theoretical bent, if any, while the less open minded, for whatever reason, will come away with their main prejudices confirmed.

Perhaps because I've studied the Depression without hopes of being an economist with a future at the Fed or of writing any policy-effecting book on the topic (I'm lucky to get 1000 page views on this site) but rather as a husband and father who merely wishes to muddle through without calamity, my read of that (and the preceding) period in US history is that there is no "cure". Perhaps in the event that Plato's Philosopher-Kings ran the world, Depressions might be avoided- although this would involve a system of political economy very different from ours- but never cured.

The reasoning behind this view is as follows. Depressions, in contrast to the more common financial or inventory overheated recessions, are caused by many years of what Austrian Economists call mal-investment- investment, and by consequence, education and employment patterns predicated on a view of the future radically inconsistent with the economic conditions that actually unfold.

Depressions are not, in my view, caused by the financial crises that tend to precede them.  Rather the financial crisis is the moment when the mal-investment is first revealed to the unsuspecting, usually without changing too many minds.

In the case of the Great Depression of the 30s, the view upon which mal-investments were based was that there would always be willing and able consumers to buy whatever the US manufacturing machine was capable of producing at a profit to their costs. In the event, US manufacturers discovered they had grossly over-estimated the willingness and ability of the world's consumers to buy their goods. Had the emergence of World War II not provided insatiable consumers, and provided a crisis-induced mental reboot of the population, if you will, I suspect the 40s would have been far grimmer in economic terms than it proved to be.

In our current situation, the mal-investment is, in a sense, reversed. Instead of believing that consumers are infinitely willing and capable of buying their goods, the US believes that suppliers are infinitely willing to accept US$s in exchange for goods, regardless of US official policy towards their currency. Instead of people trained to work in factories, and an infrastructure geared to manufacturing, people are trained to work in Dilbert style cubicles, and our infrastructure is geared for an endless supply of cheap oil.

In both cases, strong lobbies resist change. Manufacturers had their thumb on government for much of the 20th Century, only to find their position usurped by Finance, which it still retains. Long standing beliefs as to the virtues of such influence will be slow to change, as will the beliefs of many people who, in my view, are educating and training themselves for a world that won't manifest.

World War II, as earlier noted, provided a crisis that engendered a period when one could look at the world with fresh eyes. In the US families of farmers and laborers were able to dream of sending their children to college to become engineers, scientists, doctors and lawyers, or even to do this themselves.

I don't yet see such a catalysts for a mental reboot in the present period, although perhaps a US$ currency crisis might prove sufficient (and hopefully a war won't be necessary).

The thrust of my view is, to the extent I've correctly identified some of the causes of the Depression, the required mental changes in a good deal of the population, not to mention the manifestations thereof in education, training and investment will take years to unfold. If the US will no longer be able to set the terms of trade more or less unilaterally, we have a long way yet before our economy is ready to compete.  At a minimum the US population must accept that they will have to produce much more to enjoy the same standard of living, or deal with less.

In 2007, Fed Chairman Bernanke argued: Economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. He then went on to highlight the crucial supporting role that financial factors play in the economy. I think he continues to place too much emphasis on the latter and not enough on the former in his views and the policies which emerge therefrom (on second thought he hasn't done a great job in getting finance to help the real sector either- leveraged bets on bond market capital appreciation doesn't seem like a cure for anything).

He, and many others may think they can whistle past a Depression as easily as they whistle past a graveyard, but in the case of a Depression, the Bogeyman is real.

It's Not The Size Of The Banks, Comrade Bernanke, It's...

Mr. Bernanke, speaking at a Federal Reserve Bank of Boston meeting Friday on Cape Cod, said [in response to question about "too big to fail"] he would prefer “a more subtle approach without losing the economic benefit of multi-function, international (financial) firms." WSJ

The players are laying their cards on the table at the Big Casino debates over regulation. On one side of the table we have Paul Volcker, and Alan Greenspan, Mervyn King et alios, who think that banks should be broken up (although with some difference between them on how that might be done). On the other side of the table we have current Fed Chairman (who obviously knows whom he speaks for ) Ben Bernanke who thinks that Bigger is still Better when it comes to banking.

To wit, in that Friday speech, Mr. Bernanke argued: First, recent experience confirms the value of supervision of financial holding companies--especially the largest, most complex, and systemically critical institutions--on a consolidated basis, supplementing the supervision that takes place at the level of the holding company's subsidiaries.

Leaving aside the rather obvious (to anyone but Big Bank CEOs and Ben Bernanke, it seems) point that recent experience only proves that that the value of supervision of financial holding companies was roughly nil, let's examine his argument more fully.

He continues: Second, our supervisory approach should better reflect our mission, as a central bank, to promote financial stability. The extraordinary pressure on financial firms last fall underscored how profoundly interconnected firms and markets are in our complex, global financial system. Thus, any effort to address systemic risks will require a more systemwide, or macroprudential, approach to the supervision of systemically critical firms. More generally, supervisors must go beyond their traditional focus on individual firms and markets to try to identify possible channels of financial contagion and other risks to the system as a whole.

A ha. In other words, Big Banks mean Big Regulations. According to Comrade Bernanke, it's the job of the Fed (or another even Bigger Brother) to to promote financial stability, whatever that might mean.

The thin edge of the wedge has pretty much split the log of Capitalism here. The Fed's job, at least before Humphrey Hawkins slid into obscurity, is to maintain price stability and foster as full an employment situation as is consistent with the first directive. Financial stability, under that head, is only important to the extent it impairs one of those directives.

If "Financial Stability" of Comrade Bernanke refers to the casino-derivative markets never being short of liquidity, that is a fool's dream- Big Finance will keep leveraging until they ex(im)plode. It also strikes me as anti-Capitalist. Bankruptcies, liquidity shortages, defaults and currency crises are part of the game- a self-correcting game if failure is allowed to extract its price.

Paul Volcker's "middle of the road" approach, echoed by Mervyn King, to "financial stability" is to separate the casino (he, being more genteel used, speculative) elements of finance from the utility elements. In other words, instead of "financial stability" we should aim for "commercial stability" and retain the "survival of the fittest" aspect of capitalism in the big stakes arena.

In that way, Comrade Bernanke might even get his way, although I suspect the virtues of economies of scale to which he refers are offset by the vices of complacency that flow from lack of competition. As olive branch perhaps we can separate the commercial banking departments of the Big 5 from the speculative elements and roll them into one or two big firms with some Banking Czar, like Comrade Bernanke, in charge. Not that I'll be banking there, I'm going to stick with my local bank.  Then we can see if the proprietary traders at the big banks are really worth the bucks without risking the commerical financial system in the process.

The problem, to which I alluded in the title, is not the size of the banks. It's Big Finance's use of key commercial banking aspects to shield them from speculative losses that would have sent any other not protected firm into bankruptcy. Even LTCM got wound down.  Trading is supposed to be about managing risk (at least if the intent is to allocate capital wisely), and if you can't go bust, there isn't much of that.

Of course, mine is but a lone opinion from the woods of Upstate NY. I'm eager to see how the battle progresses, assuming the debate doesn't become moot due to another crisis.

The Fed vs. Gold

In August, 1971, the US began a unique experiment in modern finance- with, I must add, after a very bumpy start, astonishing success, until recently. This was an experiment in "fiat money." The trick was to make the US$, without any fixed exchange rate to Gold, a store of value that wouldn't drive people back into the yellow metal.

I've put together a few graphs, the first of which depicts the relative value of an investment in Gold and in Fed Funds (I also ran a few simulations with Bonds and found that the 10 year has an even better relative return, thanks to the timely reset in 1981, although even there Gold is beginning to outperform) assuming that the Gold was purchased when Nixon closed the Gold window and held for the duration of the simulation while the coincident Fed Funds investment was reinvested daily (I used average monthly rates, which should be close enough).

As you can see, despite the very bumpy start, US$s invested in Fed Funds became as "good as (the) Gold" purchased at the beginning of the experiment by 1998 or so.

The second graph examines the Volcker Fed era, with a much higher starting Gold price.

His policy of very high rates early and stubborn (according to Greider's Secret's of the Temple) refusal to ease, made the US$s earning Fed Funds a better investment than Gold.

The third graph examines the Greenspan era.

Surprisingly, to me at least, the Greenspan era also was a better time to own US$s earning Fed Funds than Gold (although how this was done is a matter of some debate (see GATA)). Certainly by 2000, Gold once again began to shine as the relative return this century is 2.16.

The final graph examines the Bernanke Fed era.

Under Chairman Bernanke, Gold has been a much better investment than US$s, invested anywhere in the curve. While the relative performance during his Chairmanship is not yet as poor as that under Arthur Burns, Nixon's man at the Fed, with US yields so low he just might catch up (or down as the case may be).

Ultimately, as Ben Graham taught; in the short run, the market is like a voting machine--tallying up which securities are popular and unpopular. But in the long run, the market is like a weighing machine.

Since 2000, the scale is tipping, increasingly, towards Gold.

It's a Bad Time for Bad Money

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

Come January in upstate NY, when the snow flies and temperatures drop below 0F, it's a bad time to drive without a shovel. Likewise, when the financial system of an economy misprices assets and liabilities, it's a bad time for bad money.

To the extent one believes, as I do, that men, from time to time, as Charles Mackay wrote, think and go mad in herds, especially with regard to money, it seems a wise idea to have some sort of monetary standard to attenuate the degree of inevitable error. The more out of whack the mispricing the more difficult the path of recovery will prove to be, and the more likely will the anti-money crowd find open ears. A few more years like the last one here in the US and the Marxists will start coming out of the woodwork. The greater the disconnect between the real and financial sectors of the economy, the louder will the anti-money/anti-finance crowd scream- with even those usually in favor of Capitalism crying foul.

To wit; Naked Capitalism recently ran a piece entitled, Does Banking Contribute to the Good of Society, which opens with:

Quelle horreur, some smart people are starting to question whether banking serves a redeeming social function.

Of course, in the abstract, it does. Banking (or more accurately, extending credit) is essential for commerce. But any essential support function, if it overpriced in relationship to its true value, becomes a drag on the productive economy. And our modern system is extracting a very large toll relative to its actual worth.

That article was sourced from one similarly titled in UK's Telegraph. It argues:

The whole of economic life is a mixture of creative and distributive activities. Some of what we "earn" derives from what is created out of nothing and adds to the total available for all to enjoy; but some of it merely takes what would otherwise be available to others and therefore comes at their expense.......

Much of what goes on in financial markets belongs right at the purely distributive end. The gains to one party reflect the losses to another, and the vast fees and charges racked up in the process end up being paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through the costs and charges that he pays for goods and services.

Even what the great investors do belongs at the distributive end of the spectrum.

On the same theme I found How the Servant Became a Predator: Finance’s Five Fatal Flaws, which begins:

The financial sector is a tool to help those that make real tools, not an end in itself. But five fatal flaws in the financial sector’s current structure have created a monster that drains the real economy, promotes fraud and corruption, threatens democracy, and causes recurrent, intensifying crises.

While I agree, in part, with many of the underlying views behind the articles, and, from time to time, have used radical rhetoric myself, it's during crisis phases that proper articulation is key. Radical anarchic/revolutionary rhetoric in the late 19th Century inflamed populations sufficiently to inspire a rash of assassinations, including William McKinley here in the US. I've personally witnessed successful and attempted revolutions in Indonesia and Jamaica respectively, and they're no picnic.  During crisis phases, the risk of throwing the baby out with the bathwater rises sharply.

Back to the articles. Finance doesn't have a socially redeeming function in the abstract, it puts savings to real use, when well functioning the investments provide wonderful benefits for many. That there are more people living on the planet than, according to my understanding of history and anthropology, at any other time, speaks to these benefits.

Finance, in my view, is not necessarily a "distributive" activity. George Westinghouse's investment in Tesla's alternating current generation powers the computer on which you read this essay, and the pump that brings water in to your house, and allows sewage removal- a key point now that winter sets in as outhouses are quite cold places.

Yet, these financial polemics have a point. Big Finance, currently, is a large drag on the public sector, and by extension, the public, due to, I believe, a conflation.

Sadly, it was the titans of finance who fomented the current confusion over the virtues of finance when restrictions separating investment from commercial banking were dropped. As I recently argued, echoing Paul Volcker: Instead of designating certain financial institutions as "too big to fail" the US, he [Volcker] argued, needs to separate the aspects of finance which are too important to fail- broadly, commercial banking functions- from the more speculative practices- hedge and private equity funds and, more generally, proprietary trading. finance (intentional small "f"), i.e. commercial banking is key. Finance, i.e. investment banking, has its benefits as well, but only, I believe, when it is willing to accept the rules of Capitalism full bore- survival of the fittest.

What a bunch of wussies the current generation of uber-Capitalists have become. In search of capital to bet they bought the assets of commercial banking, in effect turning those deposits into a "trust" of yesteryear. Then, with a copy of Atlas Shrugged on their bookshelves they run to the government for a bail-out when their investments don't pan out, hiding behind the recently purchased, socially vital commercial banking departments they wouldn't have deigned to join when job hunting.

I wonder if the currently in production sequel to Wall Street will have Gordon Gekko almost losing it all in derivatives and then getting bailed out by the Feds to retire in comfort.

But where, you might be wondering, do the monetary standards you noted come into play?

Thanks for the reboot, I sometimes go off on a rant.

I opened with the idea that monetary standards act sometimes as a policy tool itself but minimally as a measuring tool of sorts. If a specie standard is chosen the drain (or excessive gain) thereof sends a sign that policy needs to change. If some monetarist standard is chosen there will be limits on the amount of liquidity prudently considered available to "buy time." There are other standards one can use but all act as a limiting factor- an anchor to some sense of reality, or measure of the divergence between the real and imaginary.

French Philosopher Baudrillard (about whose views I've opined here) reflected on the NYC Billboard depicting the growth of the public debt: The disappearance of the referential universe is a brand new phenomenon. When one looks at the billboard on Broadway, with its flying figures, one has the impression that the debt takes off to reach the stratosphere.

In other words, by bad money I mean unreal money, anchorless money. There is, apparently, no accepted measure by which one might judge a currency as failed- Baudrillard's hyperreallity. In plain language our money has been so bad for so long many assume it to be normal.

Consider. The British Pound was the currency of choice for a good portion of international trade in the latter half of the 19th and early 20th Centuries. It cost a bit more than 4 Pounds to buy an ounce of Gold. Over time it lost its utility as both a medium of international trade and standard of value from WWI through the eventual loss of most of its colonies in the 60s. During this time the value of the Pound declined from that 4+ Pounds per oz. of Gold to 14.5 Pounds per oz.- roughly 72 pence off each pound.

Few in the 40s, 50s, and 60s would have argued that such a devaluation was not a disaster. The US$ has lost a similar amount vs. Gold in the past nine years and yet there is heated debate to the effect that the demise of the US$ is exaggerated.

Some, like the FT's Martin Wolf, in rather stark contrast to his usual astute views, argues that Gold's price is a dubious indicator of inflation risks: its previous peak [just north of $800] was in January 1980, just before inflation was crushed.

This argument strikes me as silly. Yes, Gold did fall from $800, settling during the almost 2 decades of relatively stable commodity prices from 1980 to 1999 at $350. But that $350 was a 10-fold increase from the Gold Standard rate of $35. In my view, Gold was a wonderful inflation barometer during the 70s, and, barring the overshoot inspired by the Iranian Revolution and Russian invasion of Afghanistan, inter alia, remained a good barometer during the 2 decades of price stability- and obviously since (or perhaps not so obviously).

If you prefer a monetarist perspective; the Greenspan Fed's decision, followed more vigorously by Bernanke's Fed, to allow the monetary base to expand by leaps and bounds every time investment banking got in trouble seems ominous, the warning signs are clear.

Pick a standard and the message is the same, the US$ as international medium of exchange and on the margin choice of international store of value, is not just dying, it is dead. But as John McCain once quipped about Greenspan, the authorities are simply doing a Weekend at Bernie's- propping up the corpse of the US$ and declaring everything fine.

If we had some monetary standard I believe the monetary authorities would long ago have decided that investment banking needs to be cut loose to sink or swim on its merits, which are not small, if the manager is competent (I don't see George Soros begging for hand-outs) instead of dragging the US medium of exchange into the toilet and risking social discord on a scale not seen in many decades.  Instead the disconnect between the real and financial economies will simply be allowed to widen further.

Imagine how angry the common man will be if the DJIA hits 15K with gas at $5 and unemployment at 20% (as so accurately measured by the BLS).  It seems to me time to choose between letting the big investment banks go bust or (if you happen to have some assets left) living in walled off communities, hoping a revolutionary spark won't ignite.  I wonder if some have forgotten that there are other reasons besides gaining wealth that economists began tracking economic growth, income equality and other such statistics- societies are not inherently stable, reason and wisdom do not always prevail. 

Do you know where the tipping point is?   

Russia and China are just now recovering from a few decades of the effects of throwing the baby out with the bathwater.  These things happen.

Yes, it's a bad time to have bad money.

Full Disclosure: I'm long Gold and Silver