Have the Fed Financing Bank fund the agencies with fixed rate amortizing term funding.

Have the FFB eat the convexity and allow prepayments of advances at par as mtgs pay down.

Have Congress set the FFB’s advance rate for the mtgs for public purpose.

Have fed member banks originate agency mtgs on
Congressionally dictated terms as agents for the agencies on a fee basis.

Have the agencies hold all these newly issues loans in portfolio.

Have the banks do the servicing for a fee.

This would lower mtg rates maybe 1%.

Have the agencies offer refi’s for existing agency loans at current rates without new appraisals or income statements.

Am i missing anything?

Feel free to distribute!

Excellent- an instant classic!

Modern Monetary Theory—A Primer on the Operational Realities of the Monetary System

By Scott Fulwiller

Karim writes:

Yes, contrary to my opinion. This about managing expectations. With falling inflation and unemployment this high it makes no sense that they would be holding back something that could make a material difference.

Agreed.

Again, if they did have anything that would substantially increase agg demand they’d have done it.

Yes, and, again, it’s doubtful lower credit spreads will do much for the macro economy but would shift a lot of credit risks to the Fed for very little gain.

FRB: Bernanke, The Economic Outlook and Monetary Policy

At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily.

That is not correct. Fiscal adjustment can sustain demand at any politically desired level.

For a sustained expansion to take hold, growth in private final demand–notably, consumer spending and business fixed investment–must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.

Agreed that hand off is slowly materializing and private sector debt expansion will then drive additional growth. But sustained expansion could come immediately from a fiscal adjustment as well.

However,although private final demand, output, and employment have indeed been growing for more than a year, the pace of that growth recently appears somewhat less vigorous than we expected.

Agreed.

Among the most notable results to emerge from the recent revision of the U.S. national income data is that, in recent quarters, household saving has been higher than we thought–averaging near 6 percent of disposable income rather than 4 percent, as the earlier data showed.

Non govt net savings of financial assets = govt deficit spending by identity, and with foreign sector savings relatively constant, the majority of the increase is in the domestic economy, either businesses or households.

That means in general household savings goes up with the deficit regardless of the level of consumer spending.

However, when household savings does start to fall, it’s due to household credit expansion, at which time, if the deficit is unchanged, the savings of financial assets is shifted to either the business or the foreign sector.

And, as growth accelerates, the automatic fiscal stabilizers- increased federal revenues and falling transfer payments- reduce the deficit and therefore reduce the growth in the total net savings of the other sectors.

So the hand off process is usually characterized by the federal deficit falling as private sector debt expands to ‘replace it.’

This continues until the private sector again necessarily gets over leveraged, ending the expansion.

3 On the one hand, this finding suggests that households, collectively, are even more cautious about the economic outlook and their own prospects than we previously believed.

At best his means that he thinks with this much savings households would start leveraging more.

But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

Yes, as I explained. He seems to understand the sequence of the data but doesn’t seem to be quite there on the causation.

Going forward, improved affordability–the result of lower house prices and record-low mortgage rates–should boost the demand for housing. However, the overhang of foreclosed-upon and vacant housing and the difficulties of many households in obtaining mortgage financing are likely to continue to weigh on the pace of residential investment for some time yet

Yes, which is a traditional source of private sector credit expansion, along with cars, that drives the process.

Generally speaking, large firms in good financial condition can obtain credit easily and on favorable terms; moreover, many large firms are holding exceptionally large amounts of cash on their balance sheets. For these firms, willingness to expand–and, in particular, to add permanent employees–depends primarily on expected increases in demand for their products, not on financing costs.

I couldn’t agree more!
Employment is primarily a function of sales as discussed in prior posts.

Bank-dependent smaller firms, by contrast, have faced significantly greater problems obtaining credit, according to surveys and anecdotes. The Federal Reserve, together with other regulators, has been engaged in significant efforts to improve the credit environment for small businesses. For example, through the provision of specific guidance and extensive examiner training, we are working to help banks strike a good balance between appropriate prudence and reasonable willingness to make loans to creditworthy borrowers. We have also engaged in extensive outreach efforts to banks and small businesses. There is some hopeful news on this front: For the most part, bank lending terms and conditions appear to be stabilizing and are even beginning to ease in some cases, and banks reportedly have become more proactive in seeking out creditworthy borrowers.

Another problem is that the regulators are forcing small banks to reduce what’s called ‘non core funding’ in a confused strategy to enhance small bank ‘deposit stability.’ Unfortunately, at the local level the regulators have interpreted the rules to mean, for example, it’s better for a small bank’s financial stability to fund, for example, a 3 year business loan with 1 year local deposits, vs funding it with a 5 year advance from the Federal Home loan bank. It’s also a fallacy of composition, as at the macro level there aren’t enough core deposits to fund local small businesses, as many larger corporations and individuals use money center banks and leave their deposits with them. The regulatory insistence on small banks using ‘core deposits’ rather than ‘wholesale funding’ recycled from the larger banks causes a shortage of local deposits and forces the small banks to pay substantially higher rates as they compete with each other for funding artificially limited by regulation.

In lieu of adding permanent workers, some firms have increased labor input by increasing workweeks, offering full-time work to part-time workers, and making extensive use of temporary workers.

Yes, and when you include this growth in employment the economy is doing better than most analysts seem to think.

Like others, we were surprised by the sharp deterioration in the U.S. trade balance in the second quarter. However, that deterioration seems to have reflected a number of temporary and special factors. Generally, the arithmetic contribution of net exports to growth in the gross domestic product tends to be much closer to zero, and that is likely to be the case in coming quarters.

Also, part of the hand off will be US consumers going into debt (reducing savings) to buy foreign goods and services, which increases foreign sector savings of financial assets.

Overall, the incoming data suggest that the recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most FOMC participants projected earlier this year. Much of the unexpected slowing is attributable to the household sector, where consumer spending and the demand for housing have both grown less quickly than was anticipated. Consumer spending may continue to grow relatively slowly in the near term as households focus on repairing their balance sheets. I expect the economy to continue to expand in the second half of this year, albeit at a relatively modest pace.

Agreed.

Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.

Agreed.

Monetary policy remains very accommodative,

Yes, for many borrowers, but the lower rates have also net reduced incomes. QE alone resulted in some $50 billion of ‘profits’ transfered to the Treasury from the Fed that would have been private sector income, for example.

and financial conditions have become more supportive of growth, in part because a concerted effort by policymakers in Europe has reduced fears related to sovereign debts and the banking system there.

Agreed.

Banks are improving their balance sheets and appear more willing to lend.

Agreed, though via a reduction in interest earned by savers that’s gone to increased net interest margins for banks.

Consumers are reducing their debt and building savings, returning household wealth-to-income ratios near to longer-term historical norms.

Yes, ‘funded’ by the federal deficit spending.

Stronger household finances, rising incomes, and some easing of credit conditions will provide the basis for more-rapid growth in household spending next year.

Yes, and that basis is credit expansion.

On the fiscal front, state and local governments continue to be under pressure; but with tax receipts showing signs of recovery, their spending should decline less rapidly than it has in the past few years. Federal fiscal stimulus seems set to continue to fade but likely not so quickly as to derail growth in coming quarters.

Yes, and traditionally matched or exceeded by private sector credit expansion as above.

Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives. At this juncture, the risk of either an undesirable rise in inflation or of significant further disinflation seems low. Of course, the Federal Reserve will monitor price developments closely.

The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate.

With the debate subsiding as more FOMC participants, but far from all of them, seem to be coming to understand the quantity of the reserves per se has no consequences.

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

This is evidence Bernanke himself has come around to the understanding that the quantity of reserves at the Fed per se is of no further economic consequence.

We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning.

Again, it shows the understanding that QE channel is price (interest rates) and not quantities.
This is a very constructive move from understanding indicated in prior statements.

Also, as I already noted, reinvestment in Treasury securities is more consistent with the Committee’s longer-term objective of a portfolio made up principally of Treasury securities. We do not rule out changing the reinvestment strategy if circumstances warrant, however.

In particular, the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists–namely, that the FOMC increase its inflation goals.

In my humble opinion those tools carry no risk and provide no reward to the macro economy.

The Fed should offer full transparency. These are the reasons the Fed gives for secrecy:

“The Fed argued that allowing disclosure could stigmatize banks, causing a loss of confidence that could lead to deposit runs, bank failures and damage to the economy.”

The fact that the Fed fears a liquidity crisis is evidence that it doesn’t understand banking.
With the FDIC offering deposit insurance for up to 100% of any bank’s liabilities, it should be clear to the Fed the liability side of banking is not the place for market discipline. Liquidity should not be an issue and it should be provided in unlimited quantities at all times, much like most of the rest of the world’s central banks have been doing for a long time.

All the Fed has to do is simply trade in the fed funds market and offer any bank unlimited funding at the Fed’s target interest rate, and turn all of their focus on regulating the asset side of banking where it belongs.

The Fed should be audited NOW, and get this issue behind them as soon as possible.

See this and the rest of my proposals, thanks.

Fed in emergency bid to put bailout ruling on hold

Aug 25 (Reuters) — The Federal Reserve asked a U.S. appeals court to delay implementing a ruling that would force the central bank to disclose details of its emergency lending programs to banks during the financial crisis.

Wednesday’s emergency request for a 90-day delay came after the U.S. Second Circuit Court of Appeals on August 20 denied a motion by the Fed to rehear the case, which had been brought by Bloomberg LP, the parent of Bloomberg News, and News Corp’s Fox News Network.

A stay would give the Fed and the Clearing House Association, a group of major U.S. and European banks, until November 18 to appeal the ruling to the U.S. Supreme Court.

The Fed programs were designed to shore up the financial markets, and more than doubled the central bank’s balance sheet to well over $2 trillion, especially after the September 2008 collapse of Lehman Brothers Holdings Inc.

In March, the Second Circuit ordered the Fed to disclose information, including the names of bailout recipients and amounts received, that the news media had requested under the federal Freedom of Information Act.

The Fed argued that allowing disclosure could stigmatize banks, causing a loss of confidence that could lead to deposit runs, bank failures and damage to the economy.

In its Wednesday filing, the Fed said denial of a stay would “force the government to let the cat out of the bag, without any effective way of recapturing it” if the Second Circuit ruling were later reversed.

“The public policy interest identified by the government will be irreversibly lost,” it added.

Fed spokesman David Skidmore said “the stay is necessary to permit the board to consult with the Department of Justice regarding an appeal to the Supreme Court.”

On Thu, Aug 19, 2010 at 11:40 AM, wrote:

Mr. Mosler,

I am an analyst in the Employment Projections Program at the Bureau of Labor Statistics and am currently working on a report on the future of the financial industry. My main focus is the impact of the Dodd-Frank regulatory bill, and I would like to know your assessment of it:

1) Proprietary trading by depository institutions is limited to 3% of a depository firm’s Tier 1 capital. Could you give me a sense of how significant this is? How much are firms like Citibank and JP Morgan putting into proprietary trading now and how much will it have to decrease?

Banks are public private partnerships, part of the public infrastructure, established to promote public purpose.

I’m not sure I see any public purpose in prop trading, which means there shouldn’t be any.

But to your question, I’d guess it won’t but a material limitation.

2) The overall sense on the derivatives exchange is that the effect will be largely distributional. Information on prevailing prices used to favor major firms like Goldman Sachs, and this exchange will take that away, but it will probably allow for a greater volume of derivatives trading. Do you agree with this take?

Yes, to some degree.

I developed a futures contract for libor swaps many years ago that was quashed by the dealers when the LIFE tried to get it approved.

Also, if the Treasury or Fed had an unlimited securities lending program for all tsy secs the tsy market would replace much of the swap market as we know it, eliminate netting issues, and provide total transparency.

3) Capital requirements and leverage caps are left to the discretion of regulators and will likely follow the standards set by an international agreement. Do you have a sense of that these figures will wind up being?

No, but they miss the purpose of capital requirements, which is all about the pricing of risk when making loans, and nothing about ‘protecting taxpayers money’ which is what they all think it’s about.

So when it’s all being conceptualized incorrectly the odds of getting it right dwindle.

4) What will be the most important effects of the Consumer Financial Protection Agency? How significant is the decision whether or not to appoint Elizabeth Warren as its chief?

Not a bad idea if it’s done right, but, again, there seems to be no understanding of what banking actually is, which reduces the odds of getting it right.

5) The financial industry has seen rapid growth relative to the rest of the economy since the 1990s. Do you see anything in this bill that will slow down that trend?

The strength of the financial sector is a function of the strength of the real economy, and not the other way around.

I see nothing that will change that, so I expect the financial sector to grow as its ‘food supply’- the real sectors- recover.

Any insights would be greatly appreciated.

See my proposals here.

This is the video of the forum I participated in with Senatorial Candidates John Mertens, Robb Simmons, and Peter Schiff.

Feel free to distribute!

Small banks, already penalized with a higher cost of funds than the large banks (link) have more recently been forced to contract due to ‘wholesale funding’ restrictions being imposed by the regulators.

Bank regulators distinguish between what they call ‘retail’ and ‘wholesale’ funding, and have set limits of small banks for ‘wholesale’ funding. This policy is meant to reduce the liquidity risk of a bank not being able to roll over its funding should depositors decide to take their dollars to another bank. The theory is that ‘retail’ deposits are ’sticky’ and less likely to move to another bank, while ‘wholesale’ deposits are more likely to move. And the ‘better’ the ‘account relationship’ the more likely the funds are to stay with the bank. Oddly, when I inquired if the maturity of the deposit is a consideration the regulators responded ‘no.’ So that means a 10 year CD obtained through a broker is considered a wholesale deposit, which must be limited, while money market deposits from local depositors that can leave the next day are the core retail deposits required by the regulators for ’stability.’

But apart from this obvious regulatory failure to recognize what’s more stable and what’s less stable for individual banks, there is also a highly problematic macro issue. In the banking system as a whole, loans create deposits, meaning that for each loan made by a bank (bank assets) there exists a bank deposit of the same amount originally created at the time of the loan as that bank’s liability. In short, for the banking system as a whole, loans equal deposits.

The problem is that money center banks attract more of these total deposits than the small banks in the normal course of business. That leaves the small banks short of deposits by an equal amount. This is easily resolved by the small banks needing funding borrowing the excess funds held by the large banks. And if the large banks decide to keep their excess funds at the Federal Reserve Bank the small banks can simply borrow from the Fed to cover their shortage. In any case the total funding of the banking system remains equal to the total loans outstanding, with the Fed acting as a ‘broker’ to facilitate system wide liquidity. However, when regulators restrict this ‘wholesale funding’ between banks, and also deem borrowings from the Fed ‘wholesale funding,’ they put powerful forces in place that force the small banks to either pay higher rates to attract deposits from the large banks, which is often impossible as large corporate customers can’t deal with small banks, or force the small banks to cut back on lending to reduce their dependence on wholesale funding.

The net result is a misguided regulatory policy that is both increasing the cost of funds to small banks and forcing small banks to cut back on lending.

The remedy is quite simple, have the Fed offer funding (fed funds) to all member banks at it’s target interest rate, which is the rate the Fed desires to in fact be the cost of funds for its banking system as a matter of public policy. In any case, bank borrowing and lending is rightly constrained by capital and other regulatory requirements, and not available funding, which is always attainable at a price. Using the liability side of banking for market discipline, as is currently the practice for small banks, is always evidence of a lack of understanding of banking fundamentals and counter to further public purpose.

Please distribute this to your favorite regulator, Congressman, and Fed official, thanks!

>   
>   (email exchange)
>   
>   On Mon, Jun 21, 2010 at 6:31 AM, wrote:
>   
>   Soros’s recipe, FYI
>   much about bubbles,
>   also about how bad can be deficit reductions at this time
>   

I usually don’t read or comment on Soros, but comments below this one time only for you.

:)

George Soros Speech

Institute of International Finance, Vienna, Austria
June 10, 2010

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals here.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ’supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Makes sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”

This describes the pro cyclical nature of the non govt sectors, which are necessarily pro cyclical. Only the currency issuer can be counter cyclical. Seems to me Minsky has the fuller explanation of all this.

Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

The spending power- or the desire to use it- fades.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak and a reversal precipitates false liquidation, depressing real estate values.

It all needs to be sustained by incomes. the Fed’s financial burdens ratios indicate when incomes are being stretched to their limits. The last cycle went beyond actual incomes as mortgage originators were sending borrowers to accountants who falsified income statements, and some lenders were willing to lend beyond income capabilities. But that didn’t last long and the bust followed by months.

The bubble that led to the current financial crisis is much more complicated. The collapse of the sub-prime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a super-bubble. It has developed over a longer period of time and it is composed of a number of simpler bubbles. What makes the super-bubble so interesting is the role that the smaller bubbles have played in its development.

Fraud was a major, exaggerating element in the latest go round, conspicuously absent from this analysis.

The prevailing trend in the super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the believe that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises its adoption led to a series of financial crises.

Again, a financial crisis doesn’t need to ’spread’ to the real economy. Fiscal policy can sustain full employment regardless of the state of the financial sector. Losses in the financial sector need not affect the real economy any more than losses in Las Vegas casinos.

Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever increasing credit and leverage and as long as they worked they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the super-bubble even further.

‘Monetary policy’ did nothing and probably works in reverse, as I’ve discussed elsewhere. Fiscal policy does not have to introduce moral hazard issues. It can be used to sustain incomes from the bottom up at desired levels, and not for top down bailouts of failed businesses. Sustaining incomes will not keep an overbought market from crashing, but it will sustain sales and employment in the real economy, with business competing successfully for consumer dollars surviving, and those that don’t failing. That’s all that’s fundamentally needed for prosperity, along with a govt that understands its role in supporting the public infrastructure.

It should be emphasized that my theories of bubbles cannot predict whether a test will be successful or not. This holds for ordinary bubbles as well as the super-bubble. For instance I thought the emerging market crisis of 1997-1998 would constitute the tipping point for the super-bubble, but I was wrong. The authorities managed to save the system and the super-bubble continued growing. That made the bust that eventually came in 2007-2008 all the more devastating.

No mention that the govt surpluses of the late 90’s drained net dollar financial assets from the non govt sectors, with growth coming from unsustainable growth in private sector credit fueling impossible dot com business plans, that far exceeded income growth. When it all came apart after y2k the immediate fiscal adjustment that could have sustained the real economy wasn’t even a consideration.

What are the implications of my theory for the regulation of the financial system?

First and foremost, since markets are bubble-prone, the financial authorities have to accept responsibility for preventing bubbles from growing too big. Alan Greenspan and other regulators have expressly refused to accept that responsibility. If markets can’t recognize bubbles, Greenspan argued, neither can regulators–and he was right. Nevertheless, the financial authorities have to accept the assignment, knowing full well that they will not be able to meet it without making mistakes. They will, however, have the benefit of receiving feedback from the markets, which will tell them whether they have done too much or too little. They can then correct their mistakes.

Second, in order to control asset bubbles it is not enough to control the money supply; you must also control the availability of credit.

Since the causation is ‘loans create deposits’ ‘controlling credit’ is the only way to alter total bank deposits.

This cannot be done by using only monetary tools;

Agreed, interest rates are not all that useful, and probably work in the opposite direction most believe.

you must also use credit controls. The best-known tools are margin requirements

Changing margin requirements can have immediate effects. But if the boom is coming for the likes of pension fund allocations to ‘passive commodity strategies’ driving up commodities prices, which has been a major, driving force for many years now, margin increases won’t stop the trend.

and minimum capital requirements.

I assume that means bank capital. If so, that alters the price of credit but not the quantity, as it alters spreads needed to provide market demanded risk adjusted returns for bank capital.

Currently they are fixed irrespective of the market’s mood, because markets are not supposed to have moods. Yet they do, and the financial authorities need to vary margin and minimum capital requirements in order to control asset bubbles.

Yes, man is naturally a gambler. you can’t stop him. and attempts at control have always been problematic at best.

One thing overlooked is the use of long term contracts vs relying on spot markets. Historically govts have used long term contracts, but for business to do so requires long term contracts on the sales side, which competitive markets don’t allow.

You can’t safely enter into a 20 year contract for plastic for cell phone manufacturing if you don’t know that the price and quantity of cell phones is locked in for 20 years as well, for example. And locking in building materials for housing for 20 years to stabilize prices means less flexibility to alter building methods, etc. But all this goes beyond this critique apart from indicating there’s a lot more to be considered.

Regulators may also have to invent new tools or revive others that have fallen into disuse. For instance, in my early days in finance, many years ago, central banks used to instruct commercial banks to limit their lending to a particular sector of the economy, such as real estate or consumer loans, because they felt that the sector was overheating. Market fundamentalists consider that kind of intervention unacceptable but they are wrong. When our central banks used to do it we had no financial crises to speak of.

True. What the govt creates it can regulate and/or take away. Public infrastructure is to serve further public purpose.

But both dynamic change and static patterns have value and trade offs.

The Chinese authorities do it today, and they have much better control over their banking system. The deposits that Chinese commercial banks have to maintain at the People’s Bank of China were increased seventeen times during the boom, and when the authorities reversed course the banks obeyed them with alacrity.

Yes, and always with something gained and something lost when lending is politicized.

Third, since markets are potentially unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks in the belief that they can always dispose of their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. They have to monitor the positions of participants in order to detect potential imbalances. That means that the positions of all major market participants, including hedge funds and sovereign wealth funds, need to be monitored. The drafters of the Basel Accords made a mistake when they gave securities held by banks substantially lower risk ratings than regular loans: they ignored the systemic risks attached to concentrated positions in securities. This was an important factor aggravating the crisis. It has to be corrected by raising the risk ratings of securities held by banks. That will probably discourage loans, which is not such a bad thing.

My proposals, here, limit much of that activity at the source, rather than trying to regulate it, leaving a lot less to be regulated making regulation that much more likely to succeed.

Fourth, derivatives and synthetic financial instruments perform many useful functions but they also carry hidden dangers. For instance, the securitization of mortgages was supposed to reduce risk thru geographical diversification. In fact it introduced a new risk by separating the interest of the agents from the interest of the owners. Regulators need to fully understand how these instruments work before they allow them to be used and they ought to impose restrictions guard against those hidden dangers. For instance, agents packaging mortgages into securities ought to be obliged to retain sufficient ownership to guard against the agency problem.

One of my proposals is that banks not be allowed to participate in any secondary markets, for example

Credit default swaps (CDS) are particularly dangerous they allow people to buy insurance on the survival of a company or a country while handing them a license to kill. CDS ought to be available to buyers only to the extent that they have a legitimate insurable interest. Generally speaking, derivatives ought to be registered with a regulatory agency just as regular securities have to be registered with the SEC or its equivalent. Derivatives traded on exchanges would be registered as a class; those traded over-the-counter would have to be registered individually. This would provide a powerful inducement to use exchange traded derivatives whenever possible.

There is no public purpose served by allowing banks to participate in CDS markets and therefore no reason to allow banks to own any CDS.

Finally, we must recognize that financial markets evolve in a one-directional, nonreversible manner. The financial authorities, in carrying out their duty of preventing the system from collapsing, have extended an implicit guarantee to all institutions that are “too big to fail.” Now they cannot credibly withdraw that guarantee. Therefore, they must impose regulations that will ensure that the guarantee will not be invoked. Too-big-to-fail banks must use less leverage and accept various restrictions on how they invest the depositors’ money. Deposits should not be used to finance proprietary trading. But regulators have to go even further. They must regulate the compensation packages of proprietary traders to ensure that risks and rewards are properly aligned. This may push proprietary traders out of banks into hedge funds where they properly belong. Just as oil tankers are compartmentalized in order to keep them stable, there ought to be firewalls between different markets. It is probably impractical to separate investment banking from commercial banking as the Glass-Steagall Act of 1933 did. But there have to be internal compartments keeping proprietary trading in various markets separate from each other. Some banks that have come to occupy quasi-monopolistic positions may have to be broken up.

Banks should be limited to public purpose as per my proposals, here.

While I have a high degree of conviction on these five points, there are many questions to which my theory does not provide an unequivocal answer. For instance, is a high degree of liquidity always desirable? To what extent should securities be marked to market? Many answers that followed automatically from the Efficient Market Hypothesis need to be reexamined.

Also in my proposals, here.

It is clear that the reforms currently under consideration do not fully satisfy the five points I have made but I want to emphasize that these five points apply only in the long run. As Mervyn King explained the authorities had to do in the short run the exact opposite of what was required in the long run. And as I said earlier the financial crisis is far from over. We have just ended Act Two. The euro has taken center stage and Germany has become the lead actor. The European authorities face a daunting task: they must help the countries that have fallen far behind the Maastricht criteria to regain their equilibrium while they must also correct the deficinies of the Maastricht Treaty which have allowed the imbalances to develop. The euro is in what I call a far-from-equilibrium situation. But I prefer to discuss this subject in Germany, which is the lead actor, and I plan to do so at the Humboldt University in Berlin on June 23rd. I hope you will forgive me if I avoid the subject until then.

G20 Says Expansionary Fiscal Policy Not Sustainable

The G20 has dropped its support for fiscal expansion. The deficit hawks are prevailing. But why is that? We all either know or should know that operationally Federal spending is not constrained by revenues, as Chairman Bernanke stated last year, when asked on ’60 Minutes’ by Scott Pelley where the funds given to the banks came from :

“…we simply use the computer to mark up the size of the account that they have with the Fed.”

We know that when the Fed spends on behalf of the Treasury it simply credits a member bank or foreign government’s reserve account at the Fed.

We know that a US Treasury security is a credit balance in a securities account, also at the Fed.

We know that buying a Treasury security means US dollars (numbers on the Fed’s spreadsheet) shift from a Fed reserve account to a Fed securities account, which adds to the ‘national debt.’

We know that government deficits = ‘non government’ saving (net dollar financial assets) to the penny, as a matter of national income accounting.

And we know paying off the Treasury securities happens continuously when Treasury securities mature and the Fed simply shifts those US dollars from the securities account back to a Fed reserve account (including the interest).

So why should we care if US dollars are in a Fed reserve account or a Fed securities account?

We should not, yet most still do.

There are two featured sides to the argument, pro and con, deficit hawks and deficit doves. The deficit hawks aren’t the problem. They have no argument that makes any sense as a point of simple monetary operations. There is no such thing as the Federal Government running out of money, being dependent on foreigners or anyone else for funding to be able to spend, and the US is not the next Greece.

The problem is the deficit doves featured by the media don’t understand actual monetary operations and reserve accounting, and so they take the same ‘fundamentally wrong’ positions as the deficit hawks. The difference is nothing more than timing and degree. In effect, the media is showing only one side of the argument.

To be a credible media deficit dove, you agree deficits are ‘bad’ but in the long term, arguing that in the short term we need tax cuts or spending increases now, and deficit reduction later. You agree that deficits can be too high, but argue they have been higher, particularly in World War II, so current levels should be easily manageable, further agreeing there is a level that could not be manageable. You agree markets could be ‘unfriendly’ and a lack of confidence could translate into far higher interest rates, but argue that the current low rates for Treasury securities are the markets telling us that currently they do have confidence in the US and they are eager to fund current deficits. You agree that ‘bang for the buck’ matters and support tax cuts and spending increases based on higher ‘multipliers.’

The two ‘sides of the story’ are in fact on the same side, just with differing degrees. The media does not feature the true deficit dove story. Nor do any of the true doves have even a small piece of the administration’s ear, or the ear of anyone in Congress willing to speak out. There are maybe a hundred of them, including many senior economics professors. The nagging question is why this professional, highly educated, highly experienced collection of true doves, who happen to be correct and could get us back to full employment and prosperity in reasonably short order, does not get a fair hearing.

The answer may be credentials. My BA in Economics from the University of Connecticut in 1971 doesn’t cut it, nor the fact that the very large fund I managed was the highest rated firm for the time I ran it. And my net worth never getting anywhere near a billion hasn’t helped either. Seems billionaires get celebrity status and airtime for just about anything they want to say.

The same is true of the Economics professors who’ve got it right. Without being from and at the usual ‘top tier’ schools none can even get published in main stream economics journals, where submissions featuring obvious accounting realities are routinely rejected. In fact, any economist who states accounting identities and operational realities such as ‘deficits = savings’ or ‘loans create deposits’ or ‘Federal spending is not constrained by revenues’ is immediately labeled ‘heterodox’ and unworthy of serious mainstream consideration. Even the late Wynne Godley, who did have reasonable credentials as head of Cambridge Economics, and was the number one UK economics forecaster, was labeled ‘unorthodox’ because his mathematical models featured the deficits = savings accounting identity.

The breakthrough could happen at any time, in addition to economists at the ‘right schools’ or right financial sector firms, there are government officials with sufficient credentials to lead the breakthrough, including the head of the CBO and OMB, the Treasury Secretary and Fed Chairman, as well as former Fed officials, particularly from monetary operations.

Unfortunately Treasury Secretary Geithner, a potential hero due to the celebrity of his office, and the rest of the G20 are acting out the deficit hawk position, acting as if they do indeed believe the US has run out of money, is dependent on its creditors, and could be the next Greece. They speak as if they have no idea that the euro nations operate within a unique institutional structure that puts them in a ‘revenue constrained’ financial position similar to the US States, but with nothing equivalent to the US Treasury to run the countercyclical deficits for them. They speak as if they have no idea that the US, UK, Japan, and others with ‘normal’ central governments taxes function to regulate aggregate demand, and not to raise revenue per se. They act as if they don’t realize they can immediately make the fiscal adjustments- cut taxes and/or increase government spending- that will restore aggregate demand, employment, and output. In short, they act as if they were all still on the gold standard, an institutional arrangement where indeed government spending was constrained by revenues, and, as a consequence, the world witnessed repetitive, devastating deflationary depressions, far worse than what we’ve seen so far in this cycle.

The results of unnecessarily allowing a universal lack of aggregate demand to persist are already tragic, and if policy continues along the line of this weekend’s G20 results no relief is in sight, and it could all get a whole lot worse.

The end game is unfortunately unfolding as Spanish bank losses become Spanish govt losses.

Deposit insurance is only credible at the ‘Federal’ level, not the ‘State’ level.

If the ECB had to write the check the issue would be inflation, but not solvency.

The euro govts can no more fund bank losses than the US States could cover bank losses.

And the euro zone response of spending cuts and tax increases only makes matters worse.

From inception, the euro system has been exactly this kind of accident waiting to happen.

CajaSur Seizure Marks Change for Spain’s Ailing Banks

The euro remains under the cross currents of deflation driven further by the austerity measures that make it stronger.

And portfolio shifting out of euro mainly into dollars and gold out of fears of disintegration and restructuring that are making it weaker.

The latter is currently the stronger force as evidenced by the falling euro and rising price of gold, especially when priced in euro.

It may even be a case of allowing ‘insiders’ to get out and leave the public institutions like banks holding the bag at the point of restructuring at the expense of the remaining shareholders.

The deflation forces are evident in the falling commodity prices, declining equity values, and declining term structures of rates outside of the euro zone, where the politics of fiscal austerity also seem to be getting the upper hand as the world goes the way of Japan.

And each passing day provides more evidence that ultra low overnight rates from central banks are in fact deflationary, probably through the income and cost channels, which allows governments to have a much lower level of taxation for a given level of government spending (higher deficits) to sustain optimal levels of output and employment.

Unfortunately they firmly believe the opposite and continue with their deflationary, overly tight fiscal policies.

And talk coming out of China about ‘monetary easing’ tells me they see reason to be very concerned about their growth as well.

So it looks like the two external threats to the US economy, the euro zone and China, are indeed happening as feared.

Last, on a reread and after discussion, the new Fed swap lines look to be both unsecured and containing rollover language that reads as the foreign central banks being able to roll over their loans in perpetuity meaning they are not loans but one way fiscal transfers from the US to foreign central banks, as repayment is strictly voluntary.

EU Daily

Zapatero Said Sarkozy Threatened to Leave Euro, El Pais Says
ECB’s Trichet Dismisses Inflation Fears
ECB’s Tumpel Says Inflation to Be Fought ‘Without Compromise’
Volcker Sees Euro ‘Disintegration’ Risk From Greece
Trichet Says ECB Plans Time Deposits to Sterilize Buys
ECB Will Give ‘Sterilization’ Details Next Week
Quaden Says Market Reaction to Greece Was Excessive
German Cities’ Deficits to Hit Record in 2010, Rundschau Says
ECB Pares Spanish, Italian Bond Purchases, AFME Says
Constancio Says ECB Will Give Details on Sterilization Soon
Spain’s Core Inflation Turns Negative for First Time

>   
>   (email exchange)
>   
>   On Tue, May 11, 2010 at 6:05 PM, Bernar wrote:
>   
>   Warren ecb is hardly punishing speculators . They’re removing bad collateral
>   from the banks portfolios under the guise of protecting the sovereigns.
>   

Who would have thought?

Glad the banks aren’t letting their insiders get their funds out before declaring insolvency and turning it over to their national govt.

That would be very bad form…

>   
>   The actions are scary the associated rhetoric is comical at best.
>   

Greece CAN Go it Alone
Yesterday at 5:00pm
By Marshall Auerback and Warren Mosler

Greece can successfully issue and place new debt at low interest rates. The trick is to insert a provision stating that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are ‘money good’ and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes. This would not only allow Greece to fund itself at low interest rates, but it would also serve as an example for the rest of the euro zone, and thereby ease the funding pressures on the entire region.

We recognize, of course, that this proposal would also introduce a ‘moral hazard’ issue. This newly found funding freedom, if abused, could be highly inflationary and further weaken the euro. In fact, the reason the ECB is prohibited from buying national government debt is to allow ‘market discipline’ to limit member nation fiscal expansion by the threat of default. When that threat is removed, bad behavior is rewarded, as the country that deficit spends the most wins, in an accelerating and inflationary race to the bottom.
It is comparable to a situation where a nation like the US, for example, did not have national insurance regulation. In this kind of circumstance, the individual states got into a race to the bottom, where the state with the laxest standards stood to attract the most insurance companies, forcing each State to either lower standards or see its tax base flee. And it tends to end badly with AIG style collapses.

Additionally, the ECB or the Economic Council of Finance Ministers (ECOFIN) effectively loses the means to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.

What Europe’s policy makers would like to do is find a way to isolate Greece and mitigate the contagion effect, while maintaining the market discipline that comes from the member nations being the credit sensitive entities they are today; hence, the mooted “shock and awe” proposals now being leaked, which did engender an 8% jump in the Greek stock market on Thursday.

But these proposals don’t really get to the nub of the problem. Any major package weakens the others who have to fund it in the market place, because the other member nations are also revenue dependent, credit sensitive entities. Much like the US States, they do not control central bank operations, and must have good funds in their accounts or their checks will bounce.

The euro zone nations are all still in a bind, and their mandated austerity measures mean they don’t keep up with a world recovery. And Greek financial restructuring that reduces outstanding debt reduces outstanding euro financial assets, strengthening the euro, and further weakening output and employment, while at the same time the legitimization of restructuring risk weakens the credit worthiness of all the member nations.

It does not appear that the markets have fully discounted the ramifications of a Greek default. If you use a Chapter 11 bankruptcy analogy, large parts of the country would be shut down and the “company” (i.e. Greece Inc) could spend only its tax revenues. But the implied spending cuts represent a further substantial cut in aggregate demand and decreased revenues, in a most un-virtuous spiral that ends only with an increase in exports or privation driven revolt.

The ability of Greece to use the funds from the rescue package as a means to extinguish Greek state liabilities would improve their financial ratios and stave off financial collapse, at least on a short term basis, with the side effect of a downward spiral in output and employment, while the sovereign risk concerns are concurrently transmitted to Spain, Portugal, Ireland, Italy, and beyond. Those sovereign difficulties also morph into a full-scale private banking crisis which can quickly extend to bank runs at the branch level.

Our suggestion will rescue Greece and the entire euro zone from the dangers of national government insolvencies, and turn the euro zone policy maker’s attention 180 degrees, back to their traditional role of containing the potential moral hazard issue of excessive deficit spending by the national governments through the Stability and Growth Pact. If the member states ultimately decide that the Stability and Growth Pact ratios need to be changed, that’s their decision. But the SGP represents the euro zone’s “national budget”, precisely designed to prevent the hyperinflationary outcome that the “race to the bottom” could potentially create. At the very least, our proposal will mitigate the deflationary impact of markets disciplining credit sensitive national governments and halting the potential spread of global financial contagion, without being inflationary.

>   
>   (email exchange)
>   
>   On Wed, Apr 28, 2010 at 8:23 AM, wrote:
>   
>   Given this view warren, do you think Natl Bk of Greece goes to zero here?
>   Or do you think Europe will do a “shock an awe” 100b package that makes
>   greek banks a buying opportunity?
>   

Wish I knew!

They might like to, but they still don’t have an answer to the moral hazard issue or popular support for a ‘bailout’

What’ they’d like to do is figure out a way to isolate Greece, hence the presumed proposals from yesterday, but those aren’t satisfying either.

And any major package weakens the others who have to fund it in the market place.

Nor do they have a way to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.

They are still in a bind, and their austerity measures mean they don’t keep up with a world recovery

Also, a Greek restructure that reduces outstanding debt is a force that strengthens the euro as it reduces outstanding euro financial assets.

The negative is that it further reduces euro ’savings desires’ and drives more portfolios to shift away from euro.

And domestic taxes are still payable in euro, so there is that fundamental support .

Again, could go either way from here.

Sometimes that’s how it is!

When/if word gets out that depositors can lose, that contagion spreads across the euro zone with a general run on the banking system to actual cash, gold, and other currencies, which doesn’t create a cash shortage but drives the euro down further, and further weakens the credit worthiness of all the national govts.

As previously suggested, the endgame is a shut down of the payments system and a reorganization of the entire system with credible deposit insurance and central funding.

My proposal still seems the only one I’ve seen that makes any sense at all, and it’s still not even a consideration.

Europe-wide carnage we saw today.

This is not just about sovereign debt. This is about a concern about the banking system.

The word from S&P is that Greek debt holders will take a major haircut on their holdings, and that means serious problems for banks. (See the full list of victims here)

The surging CDS of Portuguese and Spanish banks is a major red flag.

From CMA Datavision:

Too big to fail should not mean restricted liquidity.

Hopefully they don’t use the liability side of banking for market discipline.

But as they don’t even know what a bank is and are in this way over their heads they might!

>   
>   (email exchange)
>   
>   On Tue, Apr 27, 2010 at 8:09 AM, Jason wrote:
>   
>   Possibly if the legislation succeeds in removing risk for those determining the setting…
>   
>   But one of the primary goals is to remove the lending subsidy provided by the TBTF
>   moniker
>   
>   If they firmly establish banks as no longer too big to fail, their short term credit ratings
>   could fall as far as tier 2 in some cases.
>   
>   Thus the average LIBOR setting may move higher just as their CP rates move higher.
>   
>   Also if they lose their ability to lend at lowest rates some of their businesses fall into
>   jeopardy (bank letters of credit, liquidity facilities for VRDNs etc)
>   

Yes, his causation is off on the less important point of the central bank eliminating opportunity costs when in fact market forces eliminate opportunity cost as they express indifference levels to central bank rate policies.

But apart from that it’s very well stated and what we’ve been saying all along, thanks!!! The highlighted part is especially on message and hopefully becomes common knowledge.

Jaime Caruana, General Manager of the BIS says ‘unconventional
measures’ do not increase lending, nor are inflationary:

In fact, bank lending is determined by banks’ willingness to grant
loans, based on perceived risk-return trade-offs, and by the demand
for those loans. An expansion of reserves over and above the level
demanded for precautionary purposes, and/or to satisfy any reserve
requirement, need not give banks more resources to expand lending.
Financing the change in the asset side of the central bank balance
sheet through reserves rather than some other short-term instrument
like central bank or Treasury bills only alters the composition of the
liquid assets of the banking system. As noted, the two are very close
substitutes. As a result, the impact of variations in this composition
on bank behaviour may not be substantial.

This can be seen another way. Recall that in order to finance balance
sheet policy through an expansion of reserves the central bank has to
eliminate the opportunity cost of holding them. In other words, it
must either pay interest on reserves at the positive overnight rate
that it wishes to target, or the overnight rate must fall to the
deposit facility floor (or zero). In effect, the central bank has to
make bank reserves sufficiently attractive compared with other liquid
assets. This makes them almost perfect substitutes, in particular for
other short-term government paper. Reserves become just another type
of liquid asset among many. And because they earn the market return,
reserves represent resources that are no more idle than holdings of
Treasury bills.

(…) What about the concern that large expansions in bank reserves
will lead to inflation – the second issue? No doubt more accommodative
financial conditions resulting from central bank lending and asset
purchases, insofar as they stimulate aggregate demand, can generate
inflationary pressures. But the point I would like to make here is
that there is no additional inflationary effect coming from an
increase in reserves per se. When bank reserves are expanded as part
of balance sheet policies, they should be viewed as simply another
form of liquid asset that is comparable to short-term government
paper. Thus funding balance sheet policies with reserves should be no
more inflationary than, for instance, the issuance of short-term
central bank bills.

(…) Ultimately, any inflationary concerns associated with
monetisation should be mainly attributed to the monetary authorities’
accommodating fiscal deficits by refraining from raising rates. In
other words, it is not so much the financing of government spending
per se – be it in the form of bank reserves or short-term sovereign
paper – that is inflationary, but its accommodation at inappropriately
low interest rates for too long a time. Critically, these two aspects
are generally lumped together in policy debates because the prevailing
paradigm has failed to distinguish changes in interest rate from
changes in the amount of bank reserves in the system. One is seen as
the dual of the other: more reserves imply lower interest rates. As I
explained earlier, this is not the case. While both the central bank’s
balance sheet size and the level of reserves will reflect an
accommodating policy, neither serves as a summary measure of the
stance of policy.

How to fight back against Wall Street

Much like we killed the buffalo to defeat the American Indians, we can work to tame Wall Street by working to reduce its food supply. And a large part of that food supply is the US pension system. Created and sustained by the innocent fraud that savings funds investment in a ‘loans create deposits’ world, the powerful attraction of being able to accumulate ‘savings’ on a pre-tax basis has generated nearly $20 trillion in US pension assets in thousands of scattered plans, from the giant State retirement funds to the small corporate pension funds, to the various smaller individual retirement funds.

Before I get to the way we can eliminate these bloated whales being eaten alive by the sharks, let me first suggest a few ways to whales from becoming shark food. The first is to get back to ‘narrow investing’ and public purpose by creating a list of investments deemed legal for any government supported pension funds. And ‘government supported’ would include any funds that are in any way tax advantaged. Legal investments would be investments that are in line with further public purpose. Not a lot comes to mind. If the public purpose is safety for the investors government securities would be appropriate, as government securities are functionally government guaranteed annuities. New issue equities might make sense if portfolio managers were required to be sufficiently educated and tested to make sure they are up for the responsibility of deciding where new real investment is best directed. But that’s a major and impractical undertaking. And there is no public purpose in simply trading new issues for relatively short term gain with no longer term stake in the merits of the underlying business. Nor is there any public purpose to investing in the secondary equity markets. In fact, with the rules and corporate governance stacked against shareholders, there is public purpose to not investing in those markets. Nor are these my first choice for the institutions I’d want investing in corporate bonds. It makes more sense to utilize the 8,000 regulated and supervised Fed member banks, all of which already specialize in credit analysis. If there is public purpose to buying corporate bonds, better the banks perform that function and not the pension funds.

So it looks like the only investments that make sense are government securities. The problem there, however, is I’m also advocating the government stop issuing securities. So that would mean the only investments for pension funds that make sense from a public purpose point of view are insured, overnight bank deposits. And that would go a long way towards taking away Wall Street’s food supply, thereby greatly reducing the troubling kinds of activities that we’ve been witnessing. This drastic reduction in financial sector activity would make regulation and supervision of what’s left a lot less complex and far more effective, and at the same time work to stabilize the financial aspects of the real economy.

Longer term, with the recognition that we don’t need savings to have money for investment, we can change the tax laws that are fostering these problematic pools of savings, and let them wind down over time.

Racing to the bottom

Government is about public infrastructure for further public purpose. That includes the usual suspects such as the military and the legal system, but Federal public infrastructure also includes regulation to stop what are called ‘races to the bottom,’ which usually involve what are known as ‘fallacies of composition.’ The textbook example is the football game, where if one person stands up he can see better, but if all stand up not only is nothing is gained, and no one gets to sit and watch. Allowing anyone to stand to see better is what creates that race to the bottom, where all become worse off. A ‘no standing’ rule would be a regulation that supports the public purpose of preventing this race to the bottom.

Another example is pollution control. With no Federal regulation, the States find themselves in a race to the bottom where the State that allows the most pollution gets the most business. The need to attract business drives all the States to continuously lower their pollution standards resulting in minimal regulation and unthinkable national pollution. Again, Federal regulation that sets national minimum standards is what it takes to prevent this race to the bottom.

Insurance regulation has been at the State level, which was deemed too lax only after the failure of AIG, which was the end result of a race to the bottom the Federal Government should have addressed long ago. Discussion has now begun regarding national insurance regulatory standards.

On Thu, Apr 15, 2010 at 12:08 PM, wrote:
Hi Warren,

I must admit that your writing and thoughts have had a significant impact upon me. Interestingly—at least from where I sit—your Soft Currency Economics paper, which I have now read 5 or 6 times, has provided me with an odd peace of mind…not sure if that is a GOOD thing or not. :)

thanks!

KNOWING that—so long as trust and confidence in our fiat system remains—we are always able to mitigate, at least in some manner, the impact of global financial crises through the changing of numbers ‘upward’ in the accounts of men and of institutions, is somewhat akin, I’d imagine, to an alcoholic knowing that, no matter what, an endless supply of Johnny Walker Black always exists in his basement stash.

Actually, as long as we can enforce tax collections the currency will have value.

Problem is the currency can’t be eaten or drunk, so if the crops fail it won’t help much.
All we can insure is enough currency to pay people to work, not enough things to buy

OK, so maybe the analogy is a tad morose…but hence my funny feeling about my peace of mind.

So, my question of the week revolves around the U.S.’s apparent choice to monetize (again, if you will) the IMF coffers. I point to the following from Zerohedge:

“…As we reported a few days ago, the IMF massively expanded its last resort bailout facility (NAB) by half a trillion dollars, in which the US was given the lead role in bailing out every country that has recourse to IMF funding.

We buy SDR’s with dollars which the IMF then loans, so yes.

Yesterday, Ron Paul grilled Bernanke precisely on the nature of the expansion of the US role to the NAB: “The IMF has announced that they are going to open up the NAB which coincides with the crisis in Greece and Europe and how they are going to bailed out. The irony of this promise is that in the new arrangement Greece is going to put in $2.5 billion in. I think only a fiat monetary system worldwide can come up and have Greece help bail out Greece and be prepared to bail out even other countries.

Greece needs euros, so the IMF will sell SDR’s to the euro nations to fund Greece, not the US.

SDR’s are only bought with local currency.

But we are going from $10 to $105 billion… We are committing $105 billion to bailing out the various countries of the world, this does two thing I want to get your comments on one why does it coincide with Greece,

Coincidental.

what are they anticipating, why do they need $560 billion, do we have a lot more trouble, and when it comes to that time when we have to make this commitment, who pays for this, where does it come from?

Seems they anticipate more nations will be borrowing dollars from the IMF?

We buy them by crediting the IMF’s account at the Fed. If and when the IMF lends dollars we move those dollars from the IMF’s account to the account at the Fed for the borrowing nation.

Will this all come out of the printing press once again, as we are expected to bail out the world?

Short answer, yes. long answer above.

Are you in favor of this increase in the IMF funding and our additional commitment to $105 billion?”

No.

Bernanke, of course, washes his hands of any imminent dollar devaluation – it is all someone else’s responsibility to bail out life, the universe and everything else. Bernanke pushes on “I think in general having the IMF available to try to avoid crises is a good idea.”

2 problems. First the borrowers would probably be better off using local currency solutions rather than dollars, and second the IMF terms and conditions can and often do make things worse for the borrower.

Yet Paul pushes on “Where will this money come from? We are bankrupt too.” Indeed we are, but nobody cares – that is simply some other poor shumck’s problem…”

He’s flat out wrong about the US being bankrupt but that’s another story.

best,
warren

Warren, this strikes me as problematic. YES, we can add zeros to the end of accounts and thus ‘create’ more liquidity in the global economy. HOWEVER, at what point does the world choose not to believe that those numbers in those accounts have true value?

As long as we enforce dollar taxes the dollar will have value.

warren

With this vote along party lines Dems will look very bad if they don’t win it.

>   
>   (email exchange)
>   
>   On Mon, Apr 19, 2010 at 2:37 PM, wrote:
>   
>   the vote was close but I’m not sure it changes much. However the political angle
>   in light of the Administration’s efforts at financial reform cannot be avoided.
>   Government leverage vs. bank leverage…
>   

SEC Said to Vote 3-2 to Sue Goldman Sachs Over CDO Disclosures

By Jesse Westbrook

April 19 (Bloomberg) — The U.S. Securities and Exchange
Commission split 3-2 along party lines to approve an enforcement
case against Goldman Sachs Group Inc., according to two people
with knowledge of the vote.

SEC Chairman Mary Schapiro sided with Democrats Luis
Aguilar and Elisse Walter to approve the case, said the people,
who declined to be identified because the vote wasn’t public.
Republican commissioners Kathleen Casey and Troy Paredes voted
against suing, the person said.

The SEC on April 16 accused Goldman Sachs, the most
profitable company in Wall Street history, of creating and
selling collateralized debt obligations in 2007 tied to subprime
mortgages without disclosing that hedge fund Paulson & Co.
helped pick the underlying securities. Goldman Sachs also didn’t
disclose to investors that Paulson was betting against the
securities, the SEC said.

SEC spokesmen John Nester and Myron Marlin didn’t
immediately return a phone call and e-mail seeking comment.