Friday, September 21, 2007
A Fed Panic and a Massive Bailout of
American Banks paid for by the entire world
"Manias, panics, and crashes are
the consequence of an economic environment that cultivates cupidity, chicanery,
and rapaciousness rather than a devout belief in the Golden Rule." –
Peter L. Bernstein, Foreword to Manias,
Panics, and Crashes (4th ed.) by C. P. Kindleberger
"In a crisis, discount and discount
heavily."
Walter Bagehot (1826-1877), British economist
"The
job of the Federal Reserve is to take away the punch bowl just when the party
starts getting interesting."
William McChesney Martin (1906-1998), Fed Chairman (1951-1970)
"The dysfunctional state of American politics does not give me
great confidence in the short run.''
Alan Greenspan, Fed Chairman (1987-2006)
The mismanagement
of money and credit has led to financial explosions over the centuries.
The causes, cures and consequences of such financial catastrophes are most
often repetitive. Indeed, such financial collapses are usually the result of
the unbridled greed and cupidity of financial operators and of the lack of
necessary supervision by public institutions designed to protect the public and
the common good. For example,
after the October/November 1907 financial crisis in the United States, the idea initially advanced by
banker Paul Warburg to establish a partially private and partially public Federal Reserve system of banking was finally adopted, in 1913. The Fed thus
became the lender of last resort
for banks that find themselves in an illiquid
position. It was
only after the stock market crash of 1929, however, that the Securities and Exchange
Commission (SEC) was established, in 1934.
But even with institutions and regulations in place,
when they are inoperative, corrupt or ill-adapted, financial crises can still
occur. And the current financial crisis is there to remind us of this fact.
On
September 18 (2007), the Fed showed some panic and announced a larger than
expected half percentage point cut in both the Federal funds rate and in the discount rate, and this after having slashed its
discount rate by a half point, on August 17, in order to facilitate borrowing
by America's largest banks and to facilitate the bailout of their affiliates
and other operators, such as hedge-funds, caught in the sub-prime loans
crisis. In so doing, the Bernanke Fed is following Bagehot's advice for aggressive discounting in a
situation of financial crisis. The only problem is that Bagehot's rule calls
for the central bank to lend copiously in times of critical credit stringency
... but at a high rate of interest. By lending to troubled lenders at reduced
preferential rates, the Fed is acting as their "government", i.e.
subsidizing their risky loans operations and taxing anybody else who holds
American dollars. It is not only attempting to make them more
"liquid", but also more "solvable" and less likely to fail.
This
raises three interesting questions. First, who pays for the bailout of U.S.
financial institutions; second, what are the longer-run consequences of the
massive bailout undertaken by the Fed; and third, why did the Fed let the
financial situation deteriorate to such an extent that an entire sector of the
economy is being clobbered and its collapse is threatening the whole economy.
First, we must consider that the U.S. dollar is still
a key reserve currency, although
losing ground to the euro, and it is still being held in
massive amounts by most central banks in their foreign reserves,
and also by private banks, commercial and economic entities and individuals
around the world. For example, in early 2007, foreign central banks alone held
some two and a quarter trillion in U.S. dollars reserves, which represented
about 66 percent of their total official foreign exchange reserves, with a bit
more than 25 percent being held in euros.
Since the dollar is losing its purchasing power, both
in absolute and relative terms, central banks and other foreign investors have
been "taxed" by the American Fed's policy of benign neglect regarding
the dollar. In real terms, the seigneurage tax on
foreign holders of the dollar can be measured by taking the difference between
the annual rate of depreciation of the dollar vis-à-vis major
convertible currencies and the short term rate of interest on these reserves.
For example, if the annual rate of depreciation of the dollar is five percent
and the short term rate of return on U.S. T-bills is four percent, central
banks are losing some $22.5 billion. Since private foreigners hold more than
two trillion in short term dollar denominated debt, the net annual loss of
foreign holders of U.S. dollars can easily reach $50 billion a year. The
conclusion is easy to see: Not only have foreigners been heavily financing the
large U.S. government's deficits over the last six years, but they are now
being called upon to help finance the generous bailout of American financial
institutions.
Investors
both abroad and in the U.S. know that official inflation figures
are tilted on the low side for many people, essentially because they are
designed to reduce the weight given in the indexes to goods and services whose
prices increase the fastest, but also because housing costs and asset prices
are only partly taken into consideration. This could explain why inflation
expectations are on the rise, even though official inflation figures do not
register an increase in inflation. Too much easy money as experienced over the
last few years at first fuels asset inflation, but sooner or later it shows its
ugly head in the prices of all commodities and in the prices of all goods and services.
With the current drop of the dollar, Americans can be expected to pay more for
a lot of items, such as fuel and food. This will translate to a lower standard
of living.
Already,
the price of gold, the price of oil and the prices of other commodities are on
their way up and can serve as inflation bell-weathers. The behavior of
long-term interest rates that incorporate inflation expectations is also a good
indicator of future inflation. With the Fed printing money and increasing the money supply on a high scale as if it was dropping money
from a helicopter, thus the nickname of Fed Chairman Ben "Helicopter"
Bernanke, short term interest rates will drop for a while, but long term
interest rates will be edging up, unless a deep recession steps in.
Secondly,
a massive bailout as the Bernanke Fed has undertaken raises the question of moral hazard present in any massive central bank rescue
intervention, after it has failed to properly regulate the risky activities of
the banks it supervises. Indeed, by accepting mortgage-backed securities as
collateral for huge more or less longer term loans to American banks and
brokers, at reduced interest rates, the Fed is in effect rewarding the very
institutions which acted the most irresponsibly over the last four or five
years, while saving its own face for having failed in its regulatory mission.
The message is loud and clear: American financial institutions can indulge in
creating "innovative" risky artificial credit instruments, shifting
the risks to unsuspecting borrowers and investors while reaping juicy fees and
rewards, and when things turn sour, as can be expected, the Fed will come to
their rescue and bail them out with cheap and extended loans. That is a good
way to carelessly encourage greedy and out-of-control financial institutions to
create successive disorderly and disruptive financial crises.
Indeed,
the Bernanke Fed is presently taking the pain of the consequences away from
financial institutions that acted irresponsibly, and for some, as former Fed
Chairman Alan Greenspan has said, which have acted criminally. —This is a clear case of moral hazard.
If old
regulations are not implemented or if no new regulations are put into place,
such a massive bailout will insure that American financial institutions will
continue in the future to pursue the fast buck in creating risky artificial
capital, without due regard to the risks involved for small borrowers and small
savers, while the Fed will take responsibility for shifting losses partly on
itself but mainly to holders of American dollars. In effect, the Fed is
suspending market discipline for the big financial players it puts under its
protection, while letting market discipline crush small homeowners and small
investors who bought now foreclosed houses on shaky mortgages or who invested
their savings in fraudulent and risky collateralized debt
obligations (CDOs). That is the net result of applying Bagehot's rule only in part.
The third question is why both the
Greenspan and the Bernanke Fed did not remove the punch bowl of easy money and
easy credit sooner when things began getting ugly in the sub-prime mortgage market during the 2003-2007
period. Why did they appear paralyzed and do nothing? Former Fed Chairman Alan Greenspan has an easy and self-serving explanation. Before 2003, he
was afraid of an onset of deflation and that is why the Fed brought its key
lending rate to 1 percent (from June 2003 to June 2004) for only the second
time in history. He also says that there was too much "global
savings" around the world and that is what pushed interest rates down. This
is a slight of hands explanation, because if globalization and global savings
kept inflation low and long term interest down, short term interest rates and
money supply increases were under the Fed control at all times. The Fed had no
obligation, after 2003, to keep real short term interest rates so negative for
so long. Indeed, as the Bush administration was cutting tax rates to enhance
its 2004 reelection prospects and was spending money like a drunken sailor in
wars waged in remote lands, the Fed should have taken the contrary route to
counterbalance the fiscal impetus this created for the macro economy. In other
words, it should have taken the punch bowl away. —It did not.
As a consequence, mortgage debt as a
percentage of disposable income in the U.S. is at the highest level it has been
in seventy-five years, reaching 100 percent, while consumer debt has risen to
its highest level in history. All this makes the economy more vulnerable than
it has been since the 1929-39 depression. Another consequence of this binge of
easy money has been the frenzy of leveraged buy-outs and industrial
concentration that we have observed over the last few years.
Finally, let's put the cherry on the cake. Indeed, there is a most
disturbing piece in former Fed Chairman Alan Greenspan's recent Memoirs (The Age of Turbulence) and in the explanations he
gave in interviews granted to promote his book, and
it is his confession that while he was acting chairman of the Fed he actively
lobbied Vice President Dick Cheney for a U.S. attack on Iraq.
If this was the case, it was most inappropriate for a central banker to act
this way, especially when he had other things to do than lobbying in favor of
an illegal war. Does it mean that Mr. Greenspan was an active member of the pro-Israel Lobby
within the U.S. government and joined the
Wolfowitz-Feith-Abrams-Perle-Kissinger cabal? It would seem to me that such
behavior would call for an investigation.
Indeed, to what extent was the pro-Israel Lobby responsible for the Iraq
war and the deficits it generated? Already, polls indicate that forty percent of American
voters believe the pro-Israel
Lobby has been a key factor in going to war in Iraq and that it is now very
active in promoting a new war against Iran. This figure is bound to rise as
more and more people confront the facts behind this most disastrous and
ill-conceived war. Indeed, how many wars can this lobby be allowed to engineer
before being stopped? And, to what extent can the current financial turmoil in
U.S. and world markets be traced back to the influence of this most corrosive
lobby?
_______________________________________
Rodrigue Tremblay is a
Canadian economist who lives in Montreal; he can be reached at rodrigue.tremblay@yahoo.com
Visit his blog site at: www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check
Dr. Tremblay's coming book "The Code for Global Ethics"
at: www.TheCodeForGlobalEthics.com/
Posted,
Friday September 21, 2007, at 5:30 am
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