Goldenfreude? how about Bankenfreude

Cheer if you will Goldbug bashers, but I suspect if Gold starts another swan dive, it won't be alone.  There may even come a time when you wish Gold would rise.

"Triumphalism," Paul Krugman opined in a 1997 New Republic article, "presents its own problems." Under the, dare I suggest, ironic headline, Superiority Complex, Mr. Krugman completed his thought: " though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation." He closed the article with sage advice for his readers: "The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating."

Compassion, and a little less gloating might also help Mr. Krugman understand, rather than mock, Goldbugs- a label which, contra Krugman's caricature thereof, denotes a group exhibiting a very wide range of economic/investment views- while they are nursing their recently suffered monetary wounds. I imagine for every gold hoardin', gun totin', doomsday preppin' angry white male proclaiming the end of the world (they annoy me too),there's at least one confused, upset and perhaps unemployed person who's fed up with Wall Street's "head's I win, tails you lose" investment strategy, (or one, like myself, who believes structural reform-blocking rigidities in the developed world won't be overcome easily leaving only 2 eventual paths for excess liquidity, inflation or default). Those confused and unsettled Goldbugs, having witnessed a succession of bursting investment bubbles at home and more recently read about bank runs abroad might, not without justification, have decided to save in Gold, rather than a bank, or his mattress.

Mr. Krugman, alas, is not gloating alone over Goldbug's recent misfortunes. One clever soul coined the term Goldenfreude to describe his state of mind. Joe Weisenthal proclaims, EVERYONE Should Be Thrilled By The Gold Crash- a view echoed by Felix Salmon. Barry Ritholtz leavened his disdain for Goldbuggery with a sliver of compassion, I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold, he avers, has no fundamentals and those who buy are engaging in the ultimate greater fool trade.

While living in SE Asia during their late 90s crisis I witnessed first hand one of Gold's great virtues- when a nation's banking system, and almost always coincidentally, currency, comes under pressure Gold holds its value. The haircut recently forced on Cypriot savers was far less than that inflicted on Gold by the market. In other words, despite recent declines I'd rather be holding Gold in Cyprus than waiting in an ATM line to withdraw my daily allotment of currency.

America, the gloaters might retort, is not Cyprus. No, it isn't, and I (casting off one aspect of Krugman's Goldbug caricature) sincerely hope we don't find ourselves in their financial straits. My bet is that such can only be avoided by further monetization AND, in the absence of rapid real sector productivity gains which don't exacerbate income inequality induced domestic tensions (unlikely given right wing intransigence on welfare state expansion or a domestic Modest Proposal a la Swift), wage and price inflation.

"A ha," Krugman, beating his gloating compatriots to the punch, would likely argue, "you Goldbugs are always talking about runaway inflation. Didn't you read my recent article mocking your inflation worries thusly: "But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening."

I agree, and the absence of broad based inflation given the stimulus in an environment of limited structural reform outside the developing world is my concern. I suspect if Mr. Krugman would stop gloating, it might be his too (more on this below).  If the recent decline in Gold signals, as many gleefully hope, a decline in inflation expectations, might the US, and, I suspect, other mature industrial economies (Europe and Japan) be drawing ever nearer to a stall in growth followed by a liquidity crunch?

Consider this potential catalyst for the Gold crash. "Macroeconomic stimulus," said a US Treasury FX Report chiding Japan for the recent, now reversed, Yen slide, "...cannot be a substitute for structural reform that raises productivity and trend growth." We'll return to structural reform momentarily after a look at market reaction. The Yen's rapid recovery following this report's release was coincident with the Gold crash- perhaps both price adjustments represent market belief that inflation games (currency debasement either externally or internally) won't be tolerated.  With austerity the rage in European policy circles (we aren't far behind in that regard, thanks to the Republicans), competitive devaluation verboten and Gold signalling, to the cheers of many, declining inflation expectations, I'd be surprised if yet another liquidity crunch isn't around the corner.

Factors Behind the Forecast:  Structural Rigidities and Over-Leveraged Finance

Despite recent record profits, the US financial system, still dependent on a few highly leveraged (how else to achieve such profits in a low interest rate environment) TBTF banks, is far from stable. Many mortgaged home-owners are still looking up at the zero-equity line. Those cheering the absence of inflation simply, it seems to me, because such makes Goldbugs look stupid, might want to consider that in a highly leveraged economy, the cascading defaults of deflation- the "it" Bernanke assured us wouldn't happen here- always loom in the background.

Cheer if you will Goldbug bashers, but I suspect if Gold takes another swan dive, it won't be alone. As we've seen over the past few days, Gold price declines are mirrored to various degrees by oil, other commodities, and equities. Declining prices, if such becomes the trend, will lead to higher unemployment and, amplified by the former, declining house prices and rising foreclosures. In the teeth of such an event, some might be yearning for the days when Gold was rising and inflation was assumed. I'll admit, such a scenario favors the dollars-saved-in-a-mattress strategy rather than Gold ownership but both tactics are anti-investments ridiculed by Goldbug bashers.

The elephant in the room for the Goldenfreuders is the lack of structural reform in the developed world- an omission perhaps due to a focus on high frequency and exclusion of low frequency economic factors. Structural reform, for those unfamiliar, refers to changes in the capital structure (factories, transport systems, education programs, agricultural methods, etc.) that hope to produce more for less. China's rapid economic growth over recent decades is, in large part, an effect of these reforms such as the shift, in 1978, from communal to industrial farming.

Significant structural reforms are often resisted.  Consider the resistance some individuals display when asked to eat less, drink and smoke less, and exercise more.  Note, "when asked."  Change is much easier (but not guaranteed) when it's wanted.  Consider, for example, the rapid adoption of computers and cell phones.  I doubt even severe coercion could have done half as much in twice the time.  Fortunately the benefits of these new technologies were readily apparent and despite some resistance by, e.g., book store owners to Amazon, those individual losses were smaller than the aggregate productivity gain.  Those productivity gains created an environment where jobs were plentiful, further easing stress caused by the destruction economic creation usually entails- agriculturalists rarely coexist harmoniously with hunter gatherers but they produce more food per acre meaning, if the latter adapt to the new system, both groups can survive.

In cases when reform calls for the destruction of wealthy industries with government ties, substantial legal changes, or labor downtime and re-education for a significant portion of the work-force (especially in the absence of a decently funded welfare state), resistance can effectively block what would likely be widespread productivity gains.  Pre WWII rail transport in continental Europe seems a case on point.  International disagreements over railway standards and routes (an example of structural reform-blocking rigidities) kept the continent from reaping the productivity gains a fully connected rail system promised- and delivered, after a devastating war cleared away both dissent and, sadly, large chunks of the old rail system.  Expanding on von Clausewitz for the modern world (which finds the more apt term, political-economy, too archaic) war is not just politics by other means but economics by other means- the worst means, in my view.

Structural reform-blocking rigidities are, in a sense, other words for productivity sapping rent seeking- e.g. from a bottom up perspective, Luddites breaking machinery or US autoworkers striking to avoid being replaced thereby, and from a top down perspective, trade barriers (tariffs) or de jure monopolies (Britain's BBC prior to 1955).  Profits and Investments in rent seeking industries, particularly when higher productivity methods are known and feasible, tend to be misdirected from entrepreneurial activity (why make a better or cheaper widget when it's cheaper to bribe a competition stifling official?).  Bribery doesn't seem to me a very economically productive activity although it obviously benefits some while irking others.

For an example of a structural rigidity overcome consider recent changes in US law which reduced regulations on where and how (think fracking) petroleum products can be extracted.  Fracking has changed N. Dakota from a deficit to a surplus state and driven unemployment to near zero.  Before you send me a nasty-gram, I'm not arguing such is an unalloyed good- insufficient profits are likely flowing to those who have been and certainly will be negatively affected (this is no environmentally neutral practice).  I'm merely pointing out the positive economic benefits thereof.

To digress for a moment, first with an apology to the economically literate for the rudimentary and likely (to some) unsatisfactory treatment of these issues and second with further explanation thereof: the ideological (and physical) battle between communism and capitalism over the past two centuries is the battle between productivity and people.  In my view, productivity is most effectively and durably enhanced at an imaginary "sweet spot" between radical laissez faire (think Ayn Rand) and communal ownership (Marx).  Transfer payments, whether private (charity) or public (government welfare) are, in my view, necessary to ensure social cooperation within the capitalist framework.  Domestic dissent is a sign that transfer payments are, whether as a result of insufficient funds or inefficient distribution, not performing their function.  Labor dissent in many developed economies (Occupy and austerity protests in America and Europe respectively) suggest to me a hopefully solvable but currently intractable transfer payment crisis.  The pendulum has swung too far right which isn't meant to obviate calls therefrom for greater transfer payment efficiency.

Cheers for the Gold crash sound to my ears like cheers for austerity in Europe and further dismantling of the welfare state in the US. If Japan needs inflation now, don't we as well? Perhaps we too should join the Euro? and give up our right to buy time with inflation?

I'll close with a look at another structural reform-blocking rigidity whose removal might justify a moment of schadenfreude. The phrase "Too Big To Fail" speaks to a de jure monopoly of sorts for those protected banks.  Potential competitors were blocked from taking over business which would have looked elsewhere for financial services absent government support.  Competition was stifled and the public debt increased.  I believe, but for delusional faith in the virtues of these institutions (more below), a less costly, competition enhancing solution could have emerged from the crisis of 2008 and resolving that rigidity would have eased tensions between labor and capital. 

Consider: Would current budget negotiations in the US be so contentious in the absence of the recent bail-out and additional debt incurred?

Returning to the delusion, TBTF banks remind me of Alchemists wasting labor and resources trying to turn lead into gold, or, more accurately, trying to squeeze more profit out of trade than trade generates.  Finance, at best, facilitates trade. In practice it records, analyses, calculates and communicates. What Amazon did to the local book merchant a similar company (or 5 or 20) can do even more effectively to finance.  Surely networked computing should decrease the cost of finance for the rest of the economy. 

On the bright side, the presence of rigidities suggests greater future productivity upon their resolution, although it would be tragic if such resolution comes via violence rather than diplomacy.  I believe a new cooperation enhancing agreement between labor and capital is possible.  Given the European example, I believe American energy efficiency can be increased.   As noted above, I believe American financial efficiency can be greatly enhanced through the dissolution of TBTF. 

When that happens I'll suggest a new word- Bankenfreude- and might even indulge in some myself.  I'll swap my Gold for currency and put it back in the game.  Until then, I'll remain a Goldbug.

Full disclosure (if it wasn't obvious) I own gold.

S&P Downgrade: Be Afraid, Be Very Afraid

In boom times, credit rating agencies, like S&P, are thought to have the foresight of the Fates- figures of Greek (et al.) Mythology who spun, measured, and cut the threads of life.  As boom turns to bust, these credit rating agencies fall into the trap of spinning too much thread which is only measured and cut after credit death occurs. 

After getting caught looking in the rear view window a few too many times, our Fates of credit appear to be attempting an image rehab with Big Game- the long term credit rating of the United States.  Of course, as S&P is made up of real people, not mythical figures, they aren't as brave as Clotho, Lachesis and Atropos and thus are merely threatening to measure the life-span of US AAA credit (i.e. shifting the outlook to negative), rather than pronouncing a definite end.

For my money (and let's be clear, the debt under review is that upon which the $s in my pocket are valued) S&P's focus on the debt ceiling sideshow in Congress as catalyst for default is likely misguided.  Then again, I wouldn't be totally shocked to see the newbies in Congress force a default of a few bond payments just to make the Prez (who gets no more respect from me since his invasion of Libya) look bad and thus win more votes.  Yes it would be colossally stupid and therefore, not out of the question.  S&P puts the odds at 1 in 3.

Assuming Congress avoids the colossally stupid option and raises the debt ceiling, the "no risk of US default" views of Barry Ritholtz and Yves Smith et alios would seem to suffice.  The US issues the currency in which its debt is paid, in somewhat similar fashion to the Tech companies of the 90s.  So long as our foreign creditors continue buying US debt, default would be self inflicted.

If I was playing the role of the credit fate, Lachesis, who measures the thread, I wouldn't be watching the shenanigans in Congress but rather our creditors' perception of rising confusion and dissent in the US.  Our nation seems adrift in a self-inflicted sophisticated fog. 

We are promoters of freedom currently engaged in 3 colonial projects (Iraq, Afghanistan and now, Libya) which engenders great confusion.  We want control, but we don't want to be seen grabbing it coercively.  We are confused.  Colonies, as history attests, are difficult ventures when such policies are overt.  Covert colonialism seems to me a contradiction in terms.   

Congressional pissing matches over the debt ceiling are another sign of great confusion.  Those who cheer Tea Party "balance the budget" principles would, in the event the right flexes its muscles, discover the rapid reduction of government employment and spending in a highly leveraged economy creates most unpleasant effects. 

This isn't to argue against deficit reduction in general (I suspect terminating our covert colonial ventures and redirecting that labor force back home on infrastructure would go a long way towards solving many problems) just the method on offer.

Worse than our confusion, from the perspective of the single party Chinese, is the dissent, notably that from S&P.  While the Chinese ruling party has apparently learned to deal with US political kabuki, the notion of a US ratings agency downgrading its outlook on US debt must strike them as odd indeed.  Having invented paper money, the Chinese know it rests on faith- faith that is eroded by dissent, ergo their rigorous crackdowns on such. 

Eventually the Chinese, whose faith in US economic policy making was shaken during the debt crisis of 2008-09, will tire of the confused games in the US and force us to deal with them with real currency, not the funny money we call US Federal Reserve Notes.  Far worse for the US than default is enforced real currency dealings.  As with all sophisticated cultures, reality is a bitch.   

JPM Begins to Believe (in Gold) ...about time, eh?

Trinity (seeing Neo turn to face an Agent): What's he doing?
Morpheus: He's beginning to believe.





Today's Wall St. Journal reports, JPMorgan will accept Gold as a type of collateral:

Gold hasn't reinvented itself as a currency yet. But it is getting closer.

J.P. Morgan Chase & Co. (NYSE: JPM - News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.

By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes.
 
Alexander Bain famously (at least in my view) argued: Belief is often accompanied by strong emotion, yet emotion, as such, does not amount to believing. Fictitious narratives may stir the mind more strongly than real; we may disbelieve and yet tremble...... We are thus driven to the alternative query— Is, or is not, Belief essentially related to Action, that is, volition? I answer, it is. Preparedness to act upon what we affirm is admitted on all hands to be the sole, the genuine, the unmistakable criterion of belief. Columbus shewed his belief in the roundness of the earth, and in the existence of an unbroken ocean between Europe and the east coast of Asia, when he undertook his voyages. The Emotions and The Will

In other words- under this head- by adopting this policy, and acting upon it, JPM is demonstrating its belief in Gold as an asset class.

For their next trick I hear they plan on re-inventing the wheel.

Staying in Henny Youngman banker mode (Take my money--Please!) JPM just figured out that Gold might be as valuable as triple-A rated Treasuries (Take my money and give me your Gold-- Please!!).

The WSJ authors add (and the hits just keep on coming): In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.

But seriously folks, there's no liquidity in the Gold market, just Gold, on one side, and liquidity, on the other.  Prices in that market, which have risen by roughly 500% since 2001, explaining, perhaps JPM's policy shift, reflect participants belief in the relative values thereof (Gold vs. liquidity). 

Sadly, JPM might discover, as Neo did in the Matrix, that the "real world" of specie collateral is, for bankers, drab and gray compared to the exciting times of the Financial Matrix year 1999.

As Morpheus might put it, you've been living in a dream world JPMorgan. Welcome to the credit desert of the real (money, that is).

To wax explicit (and make this essay actionable), if JPM has finally gotten around to seeing the virtues of Gold collateral based trading, it will be in their interest to see it holds its value.  If you haven't gotten on the Gold train yet, you might want to consider it.

Remember, it ain't a bubble until the big banks get involved.


Full Disclosure: Long Gold, no position in JPM

Are We There Yet?

With the US$ sinking and Gold setting new highs every few days those, like me, who have been waiting for the final collapse of the current $ based international financial system have one question on our minds- “are we there yet?”

“Not yet.  But we’re getting very close.”

This past week the US electorate, in a fit of justified pique over Democratic failure to fix the broken (at least from the perspective of the majority of US citizens) economy, put Republicans back in charge of the House of Representatives.  Big Finance must have viewed election results with glee.  Gridlock, as we Americans lovingly refer to government divided and thus incapable of passing radical legislation, means the Volcker Rules (or other meaningful financial reforms) have an even slimmer chance of becoming law. 

Coincidentally, the Federal Reserve announced plans to buy, during the next 9 months, $600B of long dated US Treasuries- a policy they refer to as “quantitative easing”.  I prefer “monetizing debt” to avoid confusion.   

While Big Finance in the US celebrated the return of Gridlock and the gift from the Fed, our foreign financiers most likely took a less sanguine view of the policy changes.  US banks will soon be free to take even bigger risks while the Fed actively drives the value of the US$- the ultimate “asset” our financiers are promised- ever lower. 

The wonderfully apt, in this case,  phrase, “thick face,” no doubt crossed many Chinese minds as they pondered US Treasury Secretary Geithner’s proposed current account targets to “accelerate global rebalancing” in the context of US debt monetization and ever more impotent regulation of the big banks who have led the world to the current impasse. 

To wit-  Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday, “We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”

    

It seems to me a sign of the times that Mr. Geithner didn’t respond to current concerns over the declining $ as Nixon’s Treasury Secretary, John Connally once did, i.e. the US$ “is our currency, but your problem.”  The swagger of US policy makers evident in decades past is now shrouded in sophisticated euphemism- but the effects will be similar.

“But, are we there yet?”

“Not yet.”

There is, in my view, one last road sign before we reach our destination.  When the US Bond Market begins to “fight the Fed”- a strategy normally as wise as spitting into the wind- we will begin the end stage of our journey to a new system of international finance.  When US Bond prices fall despite Fed intervention (better yet, when bond prices fall on news of increased intervention) the excrement will be about to hit the fan in international finance. 

We must, however, be getting close.  I noticed the Fed established the Office of Financial Stability and Research this past Thursday.  Talk about closing the barn door after the horses have all escaped.

Finding the Right Safe Haven For This Crisis

"Is it safe?"

That question still brings shivers up my spine as I recall the 1976 movie, Marathon Man, starring Dustin Hoffman, Roy Scheider, and Laurence Olivier. If you haven't seen the film, here's the scene in question on YouTube.

Terrifying.

That question, no doubt, is running through the mind of many an investor at the moment as they search for a safe haven. Like Dustin Hoffman's character in the movie, many financial advisors may well be telling clients this or that investment is "very safe, so safe you wouldn't believe it." Also like Hoffman's character, they may not know what they're talking about because, I suspect, experience isn't much of a guide these days.

You don't know if I do either, so I'll just lay out my arguments and you can decide if they make sense.

I believe the world is in the final stages of what has been the longest unanchored credit expansion (by which I mean a period of undefined monetary units) in modern history. Previous credit expansions ended, after a manic phase, with prices quickly finding some equilibrium in relation to the monetary anchor's price. In modern history that anchor has been gold and/or silver.

"Oh no," you might be thinking, "it's another lecture from a gold bug."

Yes and no.

I think the past 39 years has demonstrated the potential for an unanchored monetary system. In "The Fed Vs. Gold" I charted the US$/Gold price for each of the post 70s crisis Fed Chairmen, and prior to Mr. Bernanke's tenure (and the end of Greenspan's), even though the US$ was not convertible to gold at a fixed rate, the price behaved, more or less, as if it was.

The point being, convertibility isn't the key, rather, however one measures monetary stability, Central Bankers need to shoot at a target and the market needs to have some sense of what that target is.  No commodity or inflation target, no bond vigilantes.

The target now, apparently, is to ensure that the world's big banks don't go bust, ergo the size and direction (to the banks and not the people, infrastructure projects, etc.) of "rescue" flows each time the increasingly frequent crises erupts. 

The effect of this policy was readily apparent today, as it was during the last few months of 2008- nobody knows what anything is really worth. Traders, on their own or, more often, guided by computer models, act on "asset" price cues and sling around huge volume orders in markets suddenly thinned of price makers. 

I sometimes wonder if, in part, the substantial increase in computer driven trading has kept this game going far longer than it otherwise would.  After a while, you'd think, humans would begin to wonder what things are actually worth, instead of simply reacting to price cues.  Of course, the answers to those questions might not be favorable to the big banks, or governments.

It's not safe.

Over the past few years the number of safe havens have been shrinking, and, in one key respect shifting. For the first time in many years, gold rose as traders looked to shed risk. This, to me, is a most interesting development. Historically, gold has been the premier safe haven, the ultimate store of value in times of financial confusion. I expect this to continue.

As I noted a few days ago (the timing was more fortuitous than a result of expertise), credit conditions are tightening and should continue to tighten. The authorities, most likely, will try to inflate their way out of the tightness.  The Fed, as the supplier of global reserve currency liquidity will have to act as lender of last resort at a time when Fed Funds are already near zero.

They key, in my view, the last peg to the US$ standard, is the US bond market. Had bond prices fallen sharply today I would have qualified today as the terminal stage of the credit expansion, but prices rose.  Prior to the 1987 crash, a substantial equity market decline would have, as today, led to thoughts of more liquidity and, unlike today, higher inflation.

If the argument laid out above is correct, at some point in the not too distant future, US bond prices will fall sharply along with equity markets, major currencies will slide against key industrial commodities, and gold will rally sharply. 

When people don't know what money is worth, and have no faith in its stability, how can they know what anything else is worth in terms thereof?

At times when nobody knows what anything is really worth there is one answer historically to the question, "is it safe?"

It's safe, if it's gold.

An interesting observation:  I spent the day playing golf and none of the televisions in the club house were tuned in to CNBC.  That would not have been the case in 2000.

Full Disclosure: Long lots of Gold (thank you, Morgan Stanley, for those 1998 Golden Eagles at $275)

Collapse of Occult Economics and US$ Based World

I see bad libor rising
I see trouble on the way
I see market crashes and (near) defaults
I see bad times today

Don't go 'round tonight
For it's bound to take your cash
There's a bad libor on the rise

Ex-Fed Chairman Greenspan has been accused of occulting (hiding from people's view) dissent from the Fed's panglossian housing market forecasts in 2004. While I'd love for that to be true, I'm with Felix Salmon, who, after reading the whole transcript (always a good idea before jumping to an opinion) discerned the offensive quote (see below) referred to debate over Fed transparency and not the housing market.

We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.  Fed Transcript

To my mind, a more interesting quote can be found in Ms. Minehan's discussion of US economic growth at the same meeting: And like everybody else, I don’t know why the pace of hiring has been as slow as it has been or whether it will get slower or speed up more quickly than we expect.

There's an admission worth noting, she, like everyone else at the table didn't know why the pace of hiring had been as slow as it had been (perhaps because Fed liquidity had gone more to overseas markets than at home would be my guess). In other words, the only occulting that occurred at Fed meetings was the far less sinister, but much more ominous blind leading the blind.

I think the same phenomenon lies behind TPM's discovery of occult practices at the US Treasury in their dealings with Congress (Ms. Pelosi has recently reported the meeting to first request funds came at her, not the Treasury's, request) prior to the request for TARP funds. It isn't sinister, it's just a case of enforced ignorance, as in, let's try whistling past the graveyard, it might work.

Neither Greenspan, nor Rubin, nor Summers (whose financial prescience was shown to be flawed at Harvard) nor Blankfein nor any other of the financial big wigs knows what's going to happen in the financial world because they believe this time is different. (If they did know they would have run for the hills long ago) They have thrown away the only tool that allows economic forecasting, the assumption that the rules of economics always operate (qualifying the proper conditions as they relate to the past being the tricky part of the game, whether I've done so accurately this time remains to be seen).

The collapse of occult economics to which I refer is the apocalypse (Greek for unveiling) of the US$ based system as operating under the same rules of finance that have always operated, specifically the fact that true provision of global liquidity can only come (in a US$ based trading system) through increased US$ supply, a.k.a. Triffin's Dilemma.

As I've previously discussed, Robert Triffin noted the dilemma at the heart of the US$ based global trading system- in order for the world to get the liquidity it wants US$ balances overseas will have to grow, thus eventually weakening the US$ such that it could no longer serve as global reserve currency.

Two events are conspiring to unveil Triffin's Dilemma to the world, the coming economic slowdown in China as a result of previous credit over-extension and current tightening and the current emerging crisis in the Euro periphery- the "G"-less PIGS (Portugal, Italy, Greece (who've gotten their bail-out), and Spain). The "G"-less PIGS must have felt a bit left out of the liquidity party for Greece this past weekend and are now clamoring for their own rescue package.

As an aside, I'm only partially facetious when I suggest a most profitable Hedge Fund theme, find liquidity deprived countries to invest in a fund that will blow out your spreads (CDS and swaps) and create the need for a bail-out. As an added bonus, the rescue deal will likely include a fully funded financial rescue package.

As always there are options available to policy makers. They could allow defaults to occur but that is the "it" (being deflation) Bernanke promised wouldn't happen here (in the US, and by extension, the world), and that option too would likely lead to the end of the US$ based trading system. The other option, the option that has become the rule is more liquidity, and in this case, barring a significant decline in the Euro and RMB vs. the US$, the Fed will have to supply that liquidity at a time when they would prefer to begin unloading some of the toxic securities they bought from the TBTF banks.

Unlike the 2008, 2000-2001 and 1997-1998 crises, however, Fed Funds are already near zero. Quantitative easing, in the form of continued declines in acceptable collateral for Central Bank discounting will be the tool- monetization of poor credit, in large amounts.

At that point, I suspect, Gold will begin to soar against all currencies, and the search for a new global international reserve will being in earnest.

The signs of impending crisis are already manifesting: 1) global stock markets are rolling over 2) credit default swap prices for the "G"-less PIGS are rising rapidly 3) the pace of decline in US$ swap rates has eased.

In the not too distant future, if stock markets continue to weaken, US$ swaps rates will rise. US$ liquidity will, once again, be in short supply and the Fed will be called on to rescue the world.

Let the unveiling commence.

p.s. the primary rule of economics that, in my view, has been occulted from view, because it is so distasteful (to some) is the no free lunch rule...just my, rapidly depreciating, two cents

p.p.s yes, I'm way out on a limb on this one, but what the heck, I'm just a pajama-wearing blogger

Full Disclosure: Long lots of Gold

Breaking Up Is Hard To Do: TBTF, the Euro and Gold

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

Recent news about Greece's financial travails reminded me of a conversation I had with Helmut Schlesinger as the Asian Crisis was unfolding in 1997. Over a few drinks at the Long Bar in Singapore's Raffles Hotel, Mr. Schlesinger regaled me with his views on inflation, monetary integration and "realignments" (devaluations).  I don't know whether it was the drinks, the ambiance of the historic Long Bar, or the impending realignment of Asian currencies to the US$, but Mr. Schlesinger was in a mood to talk, and I, to listen.

As President of the Bundesbank from 1991-93 Mr. Schlesinger had a wealth of experience on monetary integration (with East Germany), realignment within the ERM (European Exchange Rate Mechanism), and disintegration (as Britain left the ERM). On the side of the "economists" in the debates over EMU, he argued, presciently, as the Greek situation demonstrates, that the "monetarists'" view- monetary integration prior to complete political integration wouldn't be a problem- was not historically grounded. Nor was he sanguine about the German reunification of East with West- 13 years hence East Germany continues to lag the West.

For Mr. Schlesinger, "flexibility" was a key component of economic integration. Adjustments in the terms of trade between economic parts, he told me, would always be necessary. Thus integration which didn't maintain some potential for flexibility-which assumed the combined parts would always thereafter be a unified whole- risked disaster. Perhaps this explains, to some extent, his comments about potentially necessary ERM realignments in 1992 that acted as catalyst to the GBP (British Pound) and ITL (Italian Lira) devaluations, and withdrawal of the GBP from the ERM.

There seems to me a lesson to be learned from both the recent EU and TBTF problems on either side of the Atlantic- breaking up, in the sense of making necessary adjustments in the terms of trade (a phrase that usually refers to the relation between import and export prices between nations, but can more broadly refer to the agreed upon bases of exchanges (prices, credit access, etc.) between and amongst any and all economic units), is hard to do. Flexibility has been lost in the pursuit of economic monolithism (if you will).

Previously, situations like Greece, or the TBTF banks in the US, would have begged a period of disintegration and adjustment in the terms of trade, either via devaluation in the case of Greece, or disintegration (perhaps bankruptcy) of certain units of the TBTF banks, in the case of the US.

To wit, US financial sector reform, in my view, needs to, inter alia, restrict discount window borrowing privileges to commercial banking (i.e. adjust the terms of trade within finance), leaving derivatives and proprietary trading to stand or fall on their own merits.  This is virtually impossible within the current system of financial monolithism.

The cost of the new approach of economic monolithism, is increasing bailouts- dilution of the common currency- which distributes the losses system wide, and slows the necessary adjustments in the terms of trade.

It is not surprising to me that the Germans, where fears of a Weimar style inflation remain strong, are loathe to dilute the Euro to bail-out Greece. After Greece, who else will need a bail-out?

Perhaps what the EU needs is a divorce (perhaps temporary separation, might be more apt) clause- a means to make the necessary terms of trade adjustments. This, in a sense, is that US financial reform seeks- a procedure to disintegrate (temporarily, or permanently) the financial sector to make equally necessary terms of trade adjustments.

The issues noted above, Greece and the TBTF banks, combined with the broader issue of relations between sovereign states and the international whole suggest that the world has, for the time being at least, reached a point of diminishing returns on economic integration. We may need more currencies, and certainly greater economic flexibility between the parts than currently exists.

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

China, TBTF, and dancin' with the gal that brung ya'

QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.

MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010

Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.

As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.

Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?

These days, the mother of all "max pain" trades would be an RMB decline.  How likely might such an event be?

Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).

However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension.  In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).

For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing.  I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.

My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.

Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.  

China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail.  We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.

In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.

In times of crisis, ya' gotta dance with the gal that brung ya'.

China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).

In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.

I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.

To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.

And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us.  I'm not, at the moment, arguing for a rethink of this policy, just observing.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

Financial Regulation: Then and Now (Busting TBTF)

Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here and "restraint of trade" the lever. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.

Simon Johnson and James Kwak of 13 Bankers and The Baseline Scenario, urge President Obama, in a recent Washington Post Op-Ed, to channel Teddy Roosevelt’s defiance of Wall Street, exemplified by the break-up of Northern Securities in 1904 in order to clean up the US financial system.

I agree with Johnson and Kwak’s call to arms, and am sure their views are far more nuanced than a space limited op-ed can relate, however, my examination of the Progressive period in US history, of which the chapter on US financial regulation is but a part, suggests that repetition of that period is most unlikely, and hopefully unnecessary. While there are many similarities between then and now, both the context and issues of concern are, in certain key respects, different.

The Federal Government during the Gilded Age bore little resemblance to that existing today. As a financial entity, in the main, the government collected customs’ duties, which were more than half its receipts, paid interest on the debt, the bulk of which was incurred during the Civil War, and fought the Native Americans and Spain (wars were much cheaper then, additional Army and Navy costs for the 1898 Spanish American War came to $190M).

The malefactors of great wealth, as the industrial and financial titans of the day were known, controlled commerce and finance. They mined iron and made steel, connected the nation via railroads, telegraphs and telephones, and controlled the banks. They set prices and controlled the supply of money, credit and raw materials, which gave them the power to “shake down” people and firms of which they didn’t approve, competitors and frauds alike.

Unlike today, the leading banks which emerged at the end of the Gilded Age weren’t Too Big To Fail, they were Too Solvent To Fail. They owned much of the US gold stock, then the basis of money, and were seemingly immune from the Panics which shook the rest of the nation every decade or so, more often than not, it was claimed, at their instigation.

I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago.  There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility.  Thus, some believe we need more regulatory officials rather than better ones.

When the government was running dangerously short of gold reserves, in 1895, they went to Wall Street for help- call it a reverse bail-out- and had the Treasury supply replenished. A very small group of unelected men, in effect, owned the government.

This small group of men directed the transformation of America from a disconnected agrarian to a connected soon to be industrial society- from the states united to the United States. In the process, however, they paved the ground for the Progressives to use the power, not of money, but of public opinion, via the ballot box, to usurp their control.

The government that almost died in 1895, was reborn in 1901, when the assassination, by an anarchist (love the irony), of President McKinley, made Teddy Roosevelt President.

Teddy Roosevelt’s Trust Busting kicked off a vigorous 20 year period for the new government. Progressives, who had pushed potentially transformative legislation through Congress from 1885-1900 finally had an executive willing to use it, and his big stick, for change. The Rough Rider took the de jure power of the Interstate Commerce and Sherman Anti-Trust legislation, which had hitherto been used against labor, and prepared to make it de facto, against big business.

The Federal Government, as we know it today, was born. It was a small child about to battle grown men. US Federal Government receipts totaled $670M in 1900 (JP Morgan bought the Carnegie Steel Company around that time for $487M). In 1904, Northern Securities, a railroad trust owned by JP Morgan, JD Rockefeller et alios, was ordered to break up. The precedent, after appeal, was set and many other trusts followed. In 1911, after more than a decade of court battles, the Supreme Court dissolved Standard Oil, making JD Rockefeller, according to some, the richest man in the world, in cash.

He and the other Titans got rich, but lost control of their businesses.  Like the Titans of Greek Mythology, they are, for good or ill, only going to appear once.

The child was growing quickly. In 1913, the Federal Reserve was created and the 16th Amendment, which made income taxes Constitutional, was ratified. Four years hence, the US entered World War I. At war’s end, the child had given way to the man. By 1920, receipts had grown to $23B. The Federal Government was now the biggest guy in town.

On one level, this growth of government is like that of Gilded Age business-built on the destruction of competition. There are, however, two key differences: 1) government didn’t “swallow” competitors, they dissolved them into smaller pieces, diluting their control 2) Gilded Age businesses were dynastic and decision-making was concentrated into few hands, government officials were (and are) popularly elected, operate within a system of checks and balances, and change more frequently.

The context in which Progressives operated was, as I’ve hopefully made clear, very different from today. The Federal Government then was, at least in a critical mass of minds, like a Deus ex machina, come to save the day. It didn’t tax the average citizen, but was likely to tax the wealthy and promised to not only break up the trusts, but also to open the credit spigot much wider.   One hundred years hence, the bloom is off the Federal Government's rose.  Increased taxation to fund another government expansion seems most unlikely.

Back then, the “money question”, as the debate between those who favored deflation or inflation was called, was one which brought people to the ballot box (I can’t imagine President Obama giving a Cross of Gold type speech). Elastic money seems to me the deciding factor which cemented Woodrow Wilson’s support of the Fed’s take-over of financial regulation.

Before turning to the present period, a few words about the Fed’s creation. There were two competing visions for the proposed central banking system, the Aldrich plan, which kept bankers in control, but allowed banks, at their discretion, access to government created liquidity (thus the need, under either vision, for the government, as financial entity, to grow, via increased taxes), The Bryan plan wanted government totally in control of a Central Bank which regulated the banks, and, at its sole discretion, could also supply liquidity.

The creature, as some call it, which emerged, was a compromise: government top down control of some key board members, banker control of others, the controlling board would be in D.C., thus demoting NY bankers, banks had access to liquidity, but the national liquidity level was at the board’s discretion.

Fortunately, unlike Johnson and Kwak, I’ve had the luxury of virtually unlimited internet space to flesh out the history. Unfortunately, I’ve probably lost most readers in this exercise of pedantry.

For those few that remain, let’s soldier on.

A Progressive solution, for our era, would involve for the creation of an empowered, taxing, global government with its own central bank, empowered with regulating all banks. This is, in a sense, the Nietzsche solution, fight monsters by creating bigger monsters. The United Nations (which replaced the earlier League of Nations) could be seen, in a Progressive dream, as the US Federal Government during the Gilded Age, an institution that, under direction of charismatic individuals, should become the biggest monster on the block, and maintain world order.

In my view, such a solution would but buy time in the same way that, 100 years from the empowering of the US government, many of the old problems remain. Ideas and conviction, not power, seem to me the missing elements. Further, the newly empowered Federal Government of a century ago was battling individuals, not national governments with armies, which would be the objects to be brought under control of any world government. If national governments begin to collapse, or fail to restrain growth of their internal monsters, however, I wouldn’t be surprised to see this “solution” emerge.

Supporters of continued US sovereignty within our borders, and the big bankers themselves, who might win the battle against US regulation only to risk eventually losing the war to world regulators (as the NY banks won the battle against state regulator but lost the war to the Feds) should take note. Men like Rockefeller and Carnegie, who ultimately submitted to government restraint, financed legacy institutions like the Trilateral Commission and its ilk to lay the basis for these bigger monsters. For a preview, consider: The IMF and the EU are currently battling for control in Greece, which seems willing to trade sovereignty rather than restrain its appetites via default.

Today, as then, the issue of size is key in one sense. Our regulators were seduced by “economies of scale” arguments and allowed a few financial institutions to grow beyond the ability of an indebted government to restrain. The 1895 analog is striking and, in that sense, Johnson and Kwak’s call to channel Roosevelt seems right on the mark. Terms like charisma and force of personality are often used to explain Teddy Roosevelt’s ability to bend people, ostensibly possessed of more power, to his will.

In the event, it took more than Roosevelt’s charisma to beat Morgan and his crew (or his charisma, and fear of popular backlash, was such that he bent a critical mass of the Supreme Court, to his will). US vs. Northern Securities was decided 5-4, with Chief Justice Fuller and Justices White, Peckham and Holmes dissenting. From a financial perspective, David, in the form of the US Government, had slain Goliath, a Trust whose capitalization was almost 2/3 of US revenues.

The basis of the decision, which, after appeal, and modification, became unanimous, however, was not bigness, but restraint of trade, via the stifling of competition. As Justice Holmes wrote in his dissent, “Size has nothing to do with the matter.”

Justice Harlan, writing in the affirmative: The Government charges that, if the combination was held not to be in violation of the act of Congress, then all efforts of the National Government to preserve to the people the benefits of free competition among carriers engaged in interstate commerce will be wholly unavailing, and all transcontinental lines, indeed the entire railway systems of the country, may be absorbed, merged and consolidated, thus placing the public at the absolute mercy of the holding corporation.

Adding: it need not be shown that the combination, in fact, results or will result in a total suppression of trade or in a complete monopoly, but it is only essential to show that, by its necessary operation, it tends to restrain interstate or international trade or commerce or tends to create a monopoly in such trade or commerce and to deprive the public of the advantages that flow from free competition;

Having read both sides, I understand the dissenting view; until trade is restrained, monopoly, per se, isn’t a crime, and might even lead to reduced consumer costs. Should there always be at least two rail options for every possible route? I assume, however, that the objects sought by President Roosevelt were a precedent, and distributed control and profits, not a strict reading enforcement.

I dwell on the decision to suggest a legal challenge to the current concentration of financial control into very few hands. Contrary to the above, financial concentration has already restrained trade, and imposed additional costs to all. Financial support (and even the expectation thereof) of TBTF firms also restrains trade in that potential (and actual) competitors who avoided (or even profited by) the declines in certain asset markets were restrained in gaining increased market share. Surely one of the benefits of competition is the weeding out of the short-sighted.

Fortunately, I don’t think we need new legislation, we just need to enforce what’s already on the books.

Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.

The need for redundancy would become more apparent if we held as self-evident the belief that there is no magic cure for financial overextension (bubbles) and their dissolution (busts) in a fractional reserve banking system. It will happen, again and again. Mitigation, as should now be clear, is not just an issue of additional liquidity but also a financial industry comprised of smaller, and more numerous, competing firms. It might also help to examine the books of any firm (including the Fed) which promotes the notion that “this time is different.”

I hold no illusions about being the sharpest knife in the drawer, as the Brits say, and thus assume others have considered similar legal arguments against financial concentration. Given the obvious trade restraining effects of TBTF, why isn’t the Supreme Court hearing arguments?

Like the Federal Government in 1895, ours too needs a bail-out. While the big financial firms can no longer provide such support, they can keep the Feds afloat by selling bonds as Primary Dealers, and, if needed, increase their own holdings thereof (particularly after the Fed has graciously relieved them of toxic mortgage, et alia, assets). If the Federal Government is ever to restrain finance, they need to break this dependency, and prepare to take their lumps, so to write, for poor fiscal management. If they were crafty they would blame the firms they were about to break up…just a thought.

This will require either skillful diplomacy or a good deal of charisma from some in power, and a good deal of conviction that this problem cannot be fixed without radical solutions, and will only worsen if left to fester. The "break-up" strategy from the early trust busting days may well prove effective today, and increase the number of balance sheet managers in the bargain.  It will also, I suspect, require inflation ($ debasement) as a self-administered bail-out. President Obama might need to channel William Jennings Bryan, as well as Teddy Roosevelt to get the US out of this mess.

Perhaps President Obama can deliver a Cross of TBTF speech at the next Democratic convention.