The March of Folly

Good quote to remember:


Mankind, it seems, makes a poorer performance of government than of almost any other human activity…three outstanding attitudes–obliviousness to the growing disaffection of constituents, primacy of self-aggrandizement, illusion of invulnerable status–are persistent aspects of folly…all are independent of time and recurrent in governorship.

– Barbara Tuchman, The March of Folly

Gambling with Debt and Leverage


This article explains the simple problem with the modern world of banking and finance: too much debt leverage promoted by misguided tax and regulatory policies. The root cause of every financial crisis is excessive leverage funded by cheap credit. The solution is more equity on the part of shareholder owners through higher capital ratios. The essence here is RISK and the proper pricing of that risk. This means more skin in the game for those who control the financial risks. Then they can absorb the rewards or the failures of risk-taking, not the taxpayers. Of course, less leverage also means less bang for the buck, which implies banking should become the boring business it was meant to be.

From the NY Times:

We’re All Still Hostages to the Big Banks


NEARLY five years after the bankruptcy of Lehman Brothers touched off a global financial crisis, we are no safer. Huge, complex and opaque banks continue to take enormous risks that endanger the economy. From Washington to Berlin, banking lobbyists have blocked essential reforms at every turn. Their efforts at obfuscation and influence-buying are no surprise. What’s shameful is how easily our leaders have caved in, and how quickly the lessons of the crisis have been forgotten.

We will never have a safe and healthy global financial system until banks are forced to rely much more on money from their owners and shareholders to finance their loans and investments. Forget all the jargon, and just focus on this simple rule.

Mindful, perhaps, of the coming five-year anniversary, regulators have recently taken some actions along these lines. In June, a committee of global banking regulators based in Basel, Switzerland, proposed changes to how banks calculate their leverage ratios, a measure of how much borrowed money they can use to conduct their business.

Last month, federal regulators proposed going somewhat beyond the internationally agreed minimum known as Basel III, which is being phased in. Last Monday, President Obama scolded regulators for dragging their feet on implementing Dodd-Frank, the gargantuan 2010 law that was supposed to prevent another crisis but in fact punted on most of the tough decisions.

Don’t let the flurry of activity confuse you. The regulations being proposed offer little to celebrate.

From Wall Street to the City of London comes the same wailing: requiring banks to rely less on borrowing will hurt their ability to lend to companies and individuals. These bankers falsely imply that capital (unborrowed money) is idle cash set aside in a vault. In fact, they want to keep placing new bets at the poker table — while putting taxpayers at risk.

When we deposit money in a bank, we are making a loan. JPMorgan Chase, America’s largest bank, had $2.4 trillion in assets as of June 30, and debts of $2.2 trillion: $1.2 trillion in deposits and $1 trillion in other debt (owed to money market funds, other banks, bondholders and the like). It was notable for surviving the crisis, but no bank that is so heavily indebted can be considered truly safe.

The six largest American banks — the others are Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley — collectively owe about $8.7 trillion. Only a fraction of this is used to make loans. JPMorgan Chase used some excess deposits to trade complex derivatives in London — losing more than $6 billion last year in a notoriously bad bet.

Risk, taken properly, is essential for innovation and growth. But outside of banking, healthy corporations rarely carry debts totaling more than 70 percent of their assets. Many thriving corporations borrow very little.

Banks, by contrast, routinely have liabilities in excess of 90 percent of their assets. JPMorgan Chase’s $2.2 trillion in debt represented some 91 percent of its $2.4 trillion in assets. (Under accounting conventions used in Europe, the figure would be around 94 percent.)

Basel III would permit banks to borrow up to 97 percent of their assets. The proposed regulations in the United States — which Wall Street is fighting — would still allow even the largest bank holding companies to borrow up to 95 percent (though how to measure bank assets is often a matter of debate).

If equity (the bank’s own money) is only 5 percent of assets, even a tiny loss of 2 percent of its assets could prompt, in essence, a run on the bank. Creditors may refuse to renew their loans, causing the bank to stop lending or to sell assets in a hurry. If too many banks are distressed at once, a systemic crisis results.

Prudent banks would not lend to borrowers like themselves unless the risks were borne by someone else. But insured depositors, and creditors who expect to be paid by authorities if not by the bank, agree to lend to banks at attractive terms, allowing them to enjoy the upside of risks while others — you, the taxpayer — share the downside. [Heads we win, tails you lose.]

Implicit guarantees of government support perversely encouraged banks to borrow, take risk and become “too big to fail.” Recent scandals — JPMorgan’s $6 billion London trading loss, an HSBC money laundering scandal that resulted in a $1.9 billion settlement, and inappropriate sales of credit-card protection insurance that resulted, on Thursday, in a $2 billion settlement by British banks — suggest that the largest banks are also too big to manage, control and regulate.

NOTHING suggests that banks couldn’t do what they do if they financed, for example, 30 percent of their assets with equity (unborrowed funds) — a level considered perfectly normal, or even low, for healthy corporations. Yet this simple idea is considered radical, even heretical, in the hermetic bubble of banking.

Bankers and regulators want us to believe that the banks’ high levels of borrowing are acceptable because banks are good at managing their risks and regulators know how to measure them. The failures of both were manifest in 2008, and yet regulators have ignored the lessons.

If banks could absorb much more of their losses, regulators would need to worry less about risk measurements, because banks would have better incentives to manage their risks and make appropriate investment decisions. That’s why raising equity requirements substantially is the single best step for making banking safer and healthier.

The transition to a better system could be managed quickly. Companies commonly rely on their profits to grow and invest, without needing to borrow. Banks should do the same.

Banks can also sell more shares to become stronger. If a bank cannot persuade investors to buy its shares at any price because its assets are too opaque, unsteady or overvalued, it fails a basic “stress test,” suggesting it may be too weak without subsidies.

Ben S. Bernanke, chairman of the Federal Reserve, has acknowledged that the “too big to fail” problem has not been solved, but the Fed counterproductively allows most large banks to make payouts to their shareholders, repeating some of the Fed’s most obvious mistakes in the run-up to the crisis. Its stress tests fail to consider the collateral damage of banks’ distress. They are a charade.

Dodd-Frank was supposed to spell the end to all bailouts. It gave the Federal Deposit Insurance Corporation “resolution authority” to seize and “wind down” banks, a kind of orderly liquidation — no more panics. Don’t count on it. The F.D.I.C. does not have authority in the scores of nations where global banks operate, and even the mere possibility that banks would go into this untested “resolution authority” would be disruptive to the markets.

The state of financial reform is grim in most other nations. Europe is in a particularly dire situation. Many of its banks have not recovered from the crisis. But if other countries foolishly allow their banks to be reckless, it does not follow that we must do the same.

Some warn that tight regulation would push activities into the “shadow banking system” of money market funds and other short-term lending vehicles. But past failures to make sure that banks could not hide risks using various tricks in opaque markets is hardly reason to give up on essential new regulations. We must face the challenge of drawing up appropriate rules and enforcing them, or pay dearly for failing to do so. The first rule is to make banks rely much more on equity, and much less on borrowing.

To Consume or Not to Consume?


THAT is the question. In fact, it is the defining question for an exchange economy. Let’s dissect exactly what it means. “To consume” seems fairly obvious, like the question you ask your kid at the dinner table, “Are you gonna eat that?” But “Not to Consume” offers all kinds of confusing options. To not consume means to save. Save for what? To invest? Invest for what? More stuff? Yes, more stuff to consume in the future. There’s really no other option: “Not to consume now” merely means to defer consumption to some indefinite future time period. (If you die before then, your heirs will consume whatever you saved.)

The implications of this simple insight are broad and deep for understanding the economy. How do we know how to choose whether to consume or save? If we go by the simple human weakness of instant gratification, who would save at all? Why put off until tomorrow the pleasures we can enjoy today? Since in many cases we do exactly that, there must be a good reason. Saving has two payoffs: one, it helps us reduce the risk of not having enough consumption goods to survive in the future (that would be eating our seed corn); and two, saving and investing in future production gives us more tomorrow than we give up today (that would be interest on the savings or profits on the investment).

There are two factors that influence how we choose to save and invest. First is our life-cycle needs – when we are young we consume a lot because we are growing and haven’t yet learned how to produce; in middle age we’ve learned to produce in excess of our needs, leading to saving for old-age when we are no longer producing but still need to consume. This is why societies are most productive if they have a demographic bubble in their middle years, as the US has had with the baby boom generation in the 1980s, 90s and 2000s.

The second factor is technology and the opportunities it offers to make a greater return by saving and investing for the future. The recent computer chip/Internet/social media revolution is a good example of this. If one put aside $100 back in the 1980s to buy shares of Microsoft or Apple, one would be a millionaire several times over today. Not a bad return for putting off one nice dinner.

The key that unlocks the economics of this choice between saving and consuming is the interest rate that signals whether the future may give us more consumption than the present consumption we sacrifice. When interest rates are high, we should consume less to save and invest, and when they are low we should consume more, (given all other things equal). So, the interest rate is crucial to making correct economic choices.

The simple insight of choosing between consuming or saving also illuminates the problems we have in the global economy when countries try to consume or save too much. China’s growth rate is falling because the savings rate is too high and its economy depends on selling too much of its product through exports to other countries, like the US, which is discovering in turn that its consumption is too high and savings too low (reflected in our excessive private and public debt). In other words, to sustain economic growth, the Chinese will have to consume more of their own product and Americans will have to produce more of what they hope to consume. Export-driven economic policies have been very popular in helping developing countries like the Asian tigers to grow rapidly – but we can see by this simple insight that the policy is not sustainable over the long run.

This simple question – To consume or not to consume? – is helpful to understanding many of the complex economic issues we face today, especially sustainability. You see, THAT is the real question, because life is certainly not all about consuming more stuff. The most important consumption good we can enjoy is more free time and leisure to enjoy the short lives we have on this earth.

(Read about this topic in greater depth in the book Common Cent$: A Citizens’ Survival Guide. Available at Amazon in eBook or print.)

Lies, Damn Lies, and Statistics


Quoted from this week’s Barrons:

It’s a good thing the federal government isn’t a public company. The way it accounts for its operations, it wouldn’t last a quarter on Wall Street.

Now, the Federal Accounting Standards Advisory Board, or Fasab, an obscure government agency, might formalize guidelines more than six years in the making that some say let the U.S. game its fiscal numbers—mainly by allowing it to leave institutions such as the Federal Reserve, Fannie Mae, and Freddie Mac off its consolidated financial statements.

The omission isn’t small, given the Fed’s expansion of its balance sheet to $3.3 trillion, and Fannie and Freddie’s $5.2 trillion in assets. And it adds to partisan rancor, since so much of the grappling over the budget and debt ceiling hinges on how much money there is to spend and how much Uncle Sam owes.

For example, if the rise for social programs like Medicare were included in the statements, they’d show that the U.S. outspent its revenue nearly 4 to 1 in the past 10 years, says money manager Joseph Marren, a former Wall Street banker who opposes the proposals. The White House contends that the overspending was just 32%.

Let’s see: the White House says we’ve overspent on the Federal budget by 32% and the data says 300%! Whose calculator are you going to believe?

Legalized Theft

Credit: William Waitzman for Barron's

Credit: William Waitzman for Barron’s

Do average Americans understand how their pockets have been picked clean by the big banks under the Federal Reserve actions of recent years? Here is the relevant point from this rather long and esoteric article:

The government’s motive, as the judge summarized Starr’s argument, was to use AIG and its assets to provide a “backdoor bailout” of such other financial institutions as Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan and UBS. …In other words, did the Fed … achieve a public-policy goal of making the Fed’s constituents, the banks, whole?

Let’s translate: Bernanke (together with NY Fed’s Geithner and Treasury Sec. Paulson ) led the charge to save the megabanks who had enormous losses from their trades with AIG. These banks received full payment for their reckless gambles on AIG swaps. Where did the money come from? Why, the shareholders of AIG and ultimately the good old U.S. taxpayer. So, our federal agencies are using their power to reward those same entities largely instrumental to the financial crisis. The “too big to fail” casino players made out like bandits and are now more powerful than ever. Good job fellas. I doubt this will go too far in the courts, but a little sunlight on these backroom deals will hopefully be eye-opening.

From the WSJ:

Ben Bernanke’s Anger and the AIG Case

The Federal Reserve took over the company and wiped out the shareholders. Was this legal? Or even constitutional?


Sometime in the next few weeks—if Judge Thomas Wheeler of the U.S. Court of Federal Claims gets his way—Federal Reserve Chairman Ben Bernanke will be forced to testify under oath about the Fed’s 2008 bailout of the insurance giant American International Group, better known as AIG.

The U.S. government has been fighting this deposition tooth and nail, warning of financial calamity if Mr. Bernanke is distracted from his duties at the central bank. But Judge Wheeler ruled last month that Mr. Bernanke could not duck his responsibility in a case involving enormous claims for damages. “The court cannot fathom having to decide this multibillion-dollar claim without the testimony of such a key government decision-maker,” the judge wrote.

The deposition could still be halted by an appeals court. If it does take place it would be unprecedented for a sitting Fed chairman. Such a deposition would be unlikely to be open to the public. But it could lead eventually to the public gaining a glimpse of what might be called Mr. Bernanke’s own moral hazard.

A moral hazard arises when someone takes a risk because the costs will be felt by someone else. It is exactly the kind of hazard Mr. Bernanke faced when, in a fit of anger that he acknowledged publicly only later, he engineered the AIG bailout—and takeover of the company—in September 2008.

Now Starr International is in court, on behalf of itself and other owners of AIG stock, with a $55 billion claim against the United States. Starr was the largest shareholder in AIG when the insurer ran into a liquidity crisis that triggered the bailout. Starr is headed by Maurice “Hank” Greenberg, who built AIG before he came under attack by the then-New York state attorney general, Eliot Spitzer, for accounting irregularities, and stepped aside. The new management took most of the gambles at the heart of AIG’s collapse.

Starr contends that the bailout wiped out shareholder equity in a way that amounted to a government “taking” that is unconstitutional absent the due process and just compensation guaranteed by the Fifth Amendment. Starr filed suit in 2011. As the case was later summarized by Judge Wheeler, Starr alleged that rather than providing liquidity support like the government did to “comparable financial institutions” such as Citigroup and the Hartford Financial Services Group, the government “exploited AIG’s vulnerable financial position by becoming a controlling lender and controlling shareholder of AIG.”

The government’s motive, as the judge summarized Starr’s argument, was to use AIG and its assets to provide a “backdoor bailout” of such other financial institutions as Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P. Morgan and UBS. In pursuit of that end, Starr alleges, the government seized AIG’s property, including 562,868,096 shares of its common stock.

Starr alleges that when the Fed made its loan to AIG in 2008, it took 79.9% of its stock and put it in what Starr characterizes as a “sham Trust”—a sham because it existed solely as a vehicle to get around the Fed’s lack of authority under the law to own stock in private companies.

Starr also makes an issue of the Fed’s denial of a shareholder vote on the dilution of AIG shareholders in 2009. The company initiated a reverse stock split to accommodate the government’s demand for 80% of the company’s stock. In other words, did the Fed use a forbidden ownership in a private corporation to achieve a public-policy goal of making the Fed’s constituents, the banks, whole?

“The basic terms of these transactions amounted to an attempt to ‘steal the business,’ ” Starr claims, quoting what it says a banker hired to represent the interests of the New York Federal Reserve Bank remarked at the time of the bailout.

The government disputes this, arguing in a court filing that to the extent AIG “exchanged any property” with the New York Fed, “it agreed to do so for consideration” and was rescued from the consequences of its own actions. “That exchange was not a taking.”

Government officials, though, were plenty nervous about what they were doing. The Treasury secretary at the time, Henry Paulson, has written of a meeting with Mr. Bernanke and a group of congressional leaders in September 2008. Mr. Paulson reports that then-Sen. Christopher Dodd (D., Conn.) twice asked “how the Fed had the authority to lend to an insurance company and seize control of it.”

According to Mr. Paulson, Mr. Bernanke explained that the Federal Reserve Act “allowed the central bank to take such actions under ‘unusual and exigent circumstances.'” Eventually, in Mr. Paulson’s account, Sen. Harry Reid (D., Nev.) announced: “You’ve heard what people have to say. I want to be absolutely clear that Congress has not given you formal approval to take action. This is your responsibility and your decision.”

The meeting was so tense, according to Mr. Paulson’s account, that the Treasury secretary at one point ducked behind a pillar in the Capitol and went into dry heaves. The following year, when Mr. Bernanke was being questioned by the Senate, he confessed in reference to AIG’s behavior and the need for a bailout, “If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG.”

Could it have been an anger management issue that explains the Fed running past redlines in the statute and the Constitution? Mr. Greenberg, in his own book, “The AIG Story,” insists that the statute did not authorize the Fed to seize control of private property. He argues that the constitutionality of any such provision would be doubtful.

On top of which, Starr argues, the seizure of AIG’s equity was part of punitive measures imposed on no other recipient of a government bailout. Mr. Bernanke himself has said that the Fed imposed significant costs and constraints on AIG’s owners in order to mitigate concerns that the bailout of AIG would “exacerbate moral hazard” and “encourage inappropriate risk taking.”

No wonder Judge Wheeler seems bound and determined that Mr. Bernanke becomes the first Fed governor to sit for a deposition. The only question is why do it in private?

There’s a lot the public deserves to know, starting with the question of whether Mr. Bernanke, who normally seems unflappable, got so angry at AIG that he lost his own sense of the very moral hazard he was claiming to be acting to prevent.

In Praise of Humility


Counting on monetary policy to secure full employment is like attempting vascular surgery with a dull ax. … Running what amounts to a hedge fund on steroids is more glamorous and exciting than managing a regulatory bureaucracy. Perhaps the most important qualification for the next Fed leader is one all too rare in Washington: humility.

From the NYT:

Wanted: A Boring Leader for the Fed


THE debate over who should succeed Ben S. Bernanke, the chairman of the Federal Reserve, has been exceptionally personality-driven. Supporters and opponents of the two leading contenders — Lawrence H. Summers, a former Treasury secretary and adviser to President Obama, and Janet L. Yellen, a Clinton administration veteran like Mr. Summers, and now the Fed’s vice chairwoman — have been feuding in public. Mr. Obama has called the decision, which is expected soon, one of the most important of his presidency.

What all sides seem to misunderstand, however, is the proper nature of the central bank’s role in the economy. Instead of casting about for a new maestro, we need to return the Fed to dullness and its chairman to obscurity.

The Fed has become anything but boring. Under Mr. Bernanke and his predecessor, Alan Greenspan, it didn’t foresee the housing bubble, much less try to pop it. Even if the Fed could identify bubbles, Mr. Bernanke once said, “monetary policy is too blunt a tool for effective use against them.”

Yet for more than four years, the Fed has used this blunt instrument on an unprecedented scale. It is currently buying $85 billion in Treasury securities every month, the third round of a strategy, known as quantitative easing, that aims to stimulate the economy by keeping interest rates low.

Mr. Bernanke’s supporters say he has done his best with monetary policy while a do-nothing Congress has offered no help through fiscal policy. But quantitative easing has amounted to an audacious experiment in trickle-down economics. Among other things, it has artificially boosted the stock market in the hope that enriching a few — the top 1 percent of American households owned 42 percent of the nation’s financial assets in 2010 — will help the many. Meanwhile, retirees who don’t dare buy stocks have seen their modest bank deposits stagnate with interest rates near zero (despite a recent significant increase in Treasury yields).

Economists hate to admit it, but the profession is as much faith as science. “If we speak frankly,” John Maynard Keynes once wrote, “we have to admit that our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.” Even in medicine, where double-blind experiments with control groups are de rigueur, the evidence of efficacy is far from ironclad; for economic policy, it is even less so.

Supporters say Mr. Bernanke has made up for his lack of prescience before the Great Recession through his bold emergency rescue actions, coordinated with President George W. Bush and then President Obama, and his willingness to do “whatever it takes” to get the economy moving, despite the potential risks of inflation down the road.

But wittingly or not, the mild-mannered Mr. Bernanke has made his job even more prominent than it was under Mr. Greenspan’s 19-year tenure. Such concentration of power within the Federal Reserve Board in Washington is precisely what Congress did not intend when it created the central bank in 1913.

The Fed’s chairmen in recent decades have been eminently qualified individuals of undisputed probity. But they are humans, too, whose blind spots, egos and potential conflicts of interest — Mr. Greenspan has had a lucrative post-Fed career giving speeches and advice — raise real concerns about hubris, even bias. The solution is not to subject the Fed to the whims of a dysfunctional Congress but rather to scale back what we can expect of it.

Counting on monetary policy to secure full employment is like attempting vascular surgery with a dull ax. Diversity and dynamism are vital features of our economy. As home building in Nevada collapsed, fracking in North Dakota boomed. Facebook and Apple surged while AOL and Yahoo stumbled. Across-the-board interest-rate suppression is just as likely to pump up already surging sectors as it is to revive slumping ones. Property prices have soared in Manhattan, while Detroit is in a death spiral.

Commanding the Fed to eliminate price fluctuations is also asking too much. The prices of bananas can fluctuate even across neighboring supermarkets. Each of us has our own consumption basket and inflation rate. The overall inflation rate is important — as Mr. Greenspan’s predecessor, Paul A. Volcker, demonstrated in the early 1980s when he crushed inflation at the cost of painful, back-to-back recessions — but only at the extremes.

Where the Fed must be held more accountable is for its oversight of banks. It is banks, not the government, that effectively create most of the money we use, by extending credit where it is most needed. As we’ve painfully learned, banks can over-lend and even set off an economic collapse.

Before the crisis the Fed seemingly lost all capacity for the painstaking, boots-on-the-ground supervision of the banks under its purview. And, effective or not, top-down monetary interventions remain attractive to the Fed’s top brass. Running what amounts to a hedge fund on steroids is more glamorous and exciting than managing a regulatory bureaucracy. Perhaps the most important qualification for the next Fed leader is one all too rare in Washington: humility.

Picking Your Pocket

Credit: William Waitzman for Barron's

Credit: William Waitzman for Barron’s

The Fed is merely encouraging herd behavior and money illusion. Herd behavior as speculators chase higher asset prices and money illusion from the wealth effect that higher 401ks and house prices will encourage people to spend more. Even though their incomes are flat, unemployment is still high, and food and energy prices are rising.

From the WSJ:

The Games the Fed Plays With Your Investments

Judging the value of your portfolio is a lot more work these days than opening your account statement.


Federal Reserve Chairman Ben Bernanke is playing games with your investments. The Fed’s quantitative-easing program and near-zero interest rate policy is explicitly aimed at (among other things) raising asset prices to create a “wealth effect” that will bring about more confidence and spending, which will support the economy and, in turn, the market.

The Fed’s game isn’t that easy to win, however. Since everyone knows what the Fed is doing, its actions are highly anticipated and “discounted” by the market, to the extent that when they actually occur they may have no effect on prices at all. Worse, they may have the opposite of the intended effect. This can happen if an “accommodative” move is judged to be a tad less so than was expected, sending the market down rather than up.

The Fed, of course, must take this possibility into account, since its whole wealth-effect strategy depends on market reaction. It may therefore have to make the move a little more accommodative, lest it disappoint.

But the market understands this also, and may have anticipated this second-order adjustment, a possibility that the Fed in turn must assess in deciding whether to make it. Mind you, “the market” isn’t one person, but a very large number of different actors, each trying to anticipate how all the others will behave.

The process can at some point turn powerfully negative, if the monetary stimulus stops, or is expected to stop, or becomes ineffective—which it will if it is expected to become ineffective, because it is only effective based on what the market expects.

If your head is spinning by now, join the club. The conditions are those of a classic “game” in the language of game theorists. The job of that profession (which includes several Nobel Prize winners) is to predict and if possible handicap the possible outcomes of such games. You don’t have to be much of a theorist to see that the number and volatility of outcomes increases geometrically with each new player, especially one as powerful and manipulative as the Fed.

And you don’t need a theory at all to notice that the market has been regularly moving in the “wrong” direction: Bad news is good news, and vice versa, because it isn’t the news itself that matters, but how the Fed will react to it—or, more accurately, how the market thinks it will react.

Price and value have a weak relationship at best on Wall Street, and the Fed seems intent on bringing about a complete divorce, by manipulating and generally inflating price, and by simultaneously undermining value.

Value, to make any sense for investment assets, must make some reference to why we hold the assets. Generally speaking, it isn’t for the ability to convert them to cash, in bulk and on short notice, but to generate a cash flow, or income stream, that continues reliably over some lengthy if not indefinite period and preserves its purchasing power. Value for this purpose would be the size of such a cash flow that the assets can support.

The Fed’s aggressive suppression of interest rates, while raising the price of bonds, has correspondingly destroyed their value. A 10-year Treasury bought today at a 2% yield would pay 1.2% net of tax (current top federal rate only), for an annual loss of .8% against the 2% rate of inflation that the Fed is aiming for. The loss would be greater against the higher rate that the Fed says it may tolerate, and greater still against the rate that many investors think they are really facing in their expenses.

Stocks have a better record of supporting lifestyles over long periods, but that ability also depends on their price level at the starting point. You might think that a draw of, say, 3% from a diversified equity portfolio would produce a cash flow that sustained its purchasing power over time. Yet looking at all 10- or 15-year, quarter-to-quarter periods since the start of the S&P index in 1926, this was true only about 60% of the time. Unless it is justified by real profit growth, higher price just means lower sustainable draw.

Higher prices logically mean lower value (more money having to be paid for the same thing), but they tend to correct themselves for just that reason: Wanting better value, people stop paying the higher price.

The rules are different in the game the Fed is playing. If the price of investment assets is going up, not because of improved economic conditions—creditworthiness of debtors, profitability of companies, real demand for commodities—but rather because the Fed has decreed that they shall go up, the natural, corrective effect is subverted, at least for as long as the Fed has credibility. In this respect there is no difference between prices on the stock market and in other markets: Engineered inflation is self-feeding rather than self-correcting, until it isn’t. We saw this play out to disastrous effect in the housing market as low mortgage rates pushed home prices ever higher until they collapsed in 2007-08.

All in all, judging the value of your investment portfolio is a lot more work these days than opening your account statement. The more people do that work, of course, the less stimulated they will feel about spending, and the more futile will be Fed policy and its supposed “wealth effect.”

Meanwhile, painful as it is to hold cash, it might pay to keep some handy as the game plays out. The Fed is a powerful but uncertain player. When it steps away, the turmoil may be more painful still, but will set the stage for a return of true value determined by market forces.

(The Illusion of) The Perpetual Money Machine


This is an excerpt from an excellent paper by Didier Sornette and Peter Cauwels on the state of our world financial economy. Your can download a pdf of the entire paper here. It’s worth a read. The layman’s version can be found here.

There is no use trying,” said Alice. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
 – Lewis Carroll

Chasing fantasies is not the exclusive pastime of little girls in fairy tales. History is speckled with colorful stories of distinguished scientists and highly motivated inventors pursuing the holy grail of technology: the construction of a perpetual motion machine. These are stories of eccentric boys with flashy toys, dreaming of the fame and wealth that would reward the invention of the ultimate gizmo, a machine that can operate without depleting any power source, thereby solving forever our energy problems. In the mid-1800s, thermodynamics provided the formal basis on what common sense informs us: it is not possible to create energy out of nothing. It can be extracted from wood, gas, oil or even human work as was done for most of human history, but there are no inexhaustible sources.

What about wealth? Can it be created out of thin air? Surely, a central bank can print crispy banknotes and, by means of the modern electronic equivalent, easily add another zero to its balance sheet. But what is the deeper meaning of this money creation? Does it create real value? Common sense and Austrian economists in particular would argue that money creation outpacing real demand is a recipe for inflation. In this piece, we show that the question is much more subtle and interesting, especially for understanding the extraordinary developments since 2007. While it is true that, like energy, wealth cannot be created out of thin air, there is a fundamental difference: whereas the belief of some marginal scientists in a perpetual motion machine had essentially no impact, its financial equivalent has been the hidden cause behind the current economic impasse.

The Czech economist Tomáš Sedlácek argues that, while we can understand old economic thinking from ancient myths, we can also learn a lot about contemporary myths from modern economic thinking. A case in point is the myth, developed in the last thirty years, of an eternal economic growth, based in financial innovations, rather than on real productivity gains strongly rooted in better management, improved design, and fueled by innovation and creativity. This has created an illusion that value can be extracted out of nothing; the mythical story of the perpetual money machine, dreamed up before breakfast.

To put things in perspective, we have to go back to the post-WWII era. It was characterized by 25 years of reconstruction and a third industrial revolution, which introduced computers, robots and the Internet. New infrastructure, innovation and technology led to a continuous increase in productivity. In that period, the financial sphere grew in balance with the real economy. In the 1970s, when the Bretton Woods system was terminated and the oil and inflation shocks hit the markets, business productivity stalled and economic growth became essentially dependent on consumption. Since the 1980s, consumption became increasingly funded by smaller savings, booming financial profits, wealth extracted from house prices appreciation and explosive debt. This was further supported by a climate of deregulation and a massive growth in financial derivatives designed to spread and diversify the risks globally.

The result was a succession of bubbles and crashes: the worldwide stock market bubble and great crash of 19 October 1987, the savings and loans crisis of the 1980s, the burst in 1991 of the enormous Japanese real estate and stock market bubbles and its ensuing “lost decades”, the emerging markets bubbles and crashes in 1994 and 1997, the LTCM crisis of 1998, the dotcom bubble bursting in 2000, the recent house price bubble, the financialization bubble via special investment vehicles, speckled with acronyms like CDO, RMBS,  CDS, … the stock market bubble, the commodity and oil bubbles and the debt bubbles, all developing jointly and feeding on each other, until the climax of 2008, which brought our financial system close to collapse.

Each excess was felt to be “solved” by measures that in fact fueled following excesses; each crash was fought by an accommodative monetary policy, sowing the seeds for new bubbles and future crashes. Not only are crashes not any more mysterious, but the present crisis and stalling economy, also called the Great Recession, have clear origins, namely in the delusionary belief in the merits of policies based on a “perpetual money machine” type of thinking.

“The problems that we have created cannot be solved at the level of thinking we were at when we created them.” This quote attributed to Albert Einstein resonates with the universally accepted solution of paradoxes encountered in the field of mathematical logic, when the framework has to be enlarged to get out of undecidable statements or fallacies. But, the policies implemented since 2008, with ultra-low interest rates, quantitative easing and other financial alchemical gesticulations, are essentially following the pattern of the last thirty years, namely the financialization of real problems plaguing the real economy. Rather than still hoping that real wealth will come out of money creation, an illusion also found in the current management of the on-going European sovereign and banking crises, we need fundamentally new ways of thinking.

A graph of the Perpetual Money Machine can be viewed here. Some of those new ways of thinking can be found here.

The Effect of Monetary Policy on the Real Economy or Who Moved (Stole?) My Cheese???


The Fed can’t do much to grow the economy and create wealth, but it can do an awful lot to screw it all up. Remember the iron-clad rule: a healthy economy must have 2-4% real positive interest rates. Currently ours are at zero or in negative territory.

The following excerpt is a repost from Charles Hugh Smith’s blog Of Two Minds.

Innovation and the Fed

Innovation is often a meaningless buzzword (think “financial innovation”), but it is also the key driver of wealth creation in the real economy.

The Federal Reserve could be shut down and all its asset bubbles could pop, and innovations in energy, agriculture, transportation, education, media, medicine, etc. would continue to impact the availability and abundance of what really matters in the real world:  energy, knowledge, water, food, and opportunity, to name a few off the top of a long list.

It is rather striking, isn’t it? The supposedly omnipotent Fed has virtually no positive role in the key driver of wealth creation.  On the contrary, the Fed’s policies have had an actively negative influence, as its monetary manipulations have distorted the investment landscape so drastically that capital pours into unproductive speculative bubbles rather than into productive innovation because the return on Fed-backed speculation is higher and the risk is lower (recall the Fed’s $16 trillion bailout of banks; including guarantees, the total aid extended by the Fed exceeded $23 trillion; the landscape looks different when the Fed has your back).

Profits from speculative gambling in malinvestments are yours to keep, while losses are either transferred to the public or buried in the Fed’s balance sheet. Why bother seeking real-world returns earned from real innovations?

Apologists within the Fed Cargo Cult’s gloomy hut (repetitive chanting can be heard through the thin walls—humba, humba, aggregate demand!) claim that the Fed’s financial repression of interest rates boosts innovation by making money cheap for innovators to borrow.

But this is precisely backward: cheap money fuels unproductive speculative bubbles and siphons resources away from innovation, while high interest rates reward innovation and punish malinvestments and financial gambling.

Two thought experiments illustrate the dynamics:

The Free Lunch

Let’s say J.Q. Public has the opportunity to borrow $1 billion at 0% interest rate from the Federal Reserve.  It costs absolutely nothing to keep the $1 billion. How careful will J.Q. be with the $1 billion? There’s a casino open; why not bet a few thousand dollars at roulette? Actually, why not bet a couple of million? If J.Q. loses the entire $1 billion, there’s no recourse for the lender, while J.Q. gets to keep the winnings (if any).

With essentially free money, there is little incentive to seek out long-term real-world investments that might pay off in the future, and every incentive to seek financial carry trades that generate short-term profits with little risk. In other words, if you can borrow money at 1%, then shifting the funds around the world to lend at 4% generates a 3% return with modest risk.  Since 3% guaranteed return beats the uncertain return of investing in innovative real-world companies, the carry trade is the compellingly superior choice.

The Square Meal

If we can only borrow money at an annual rate of 10%, there aren’t many carry trades available, and those that are available are very high-risk. At 10%, we have to sharpen our pencils and select the very best investments that offer the highest returns for the risk.

Let’s say you’re an entrepreneur and it costs 10% per annum to borrow money to pursue a business opportunity. The only investments that make sense at this rate are the ones with outstanding risk-return characteristics.

In other words, cheap money doesn’t incentivize risky investments in high-return innovation; it incentivizes carry trades and financial speculation, which actively siphon off talent and capital that could have been applied to real-world enterprises.  High real interest rates force entrepreneurs to choose the best investments, a process that favors high-risk, high-return innovations. [Casino Cap note: remember the rule.]

Avoiding the Bill

The Fed isn’t supporting innovation in the real economy; rather, it is actively widening the moat that protects the banking sector from disruptive innovation.

Thanks to innovations in technology, it is now possible to bypass borrowing entirely and raise money for innovative ventures with crowdsourcing. It doesn’t take much insight to look ahead and see that the crowdsourcing model could expand to the point that the economy no longer needs Too Big to Fail Banks at all: Virtually all lending, from commercial paper to home mortgages, could be crowdsourced, managed, and exchanged online.

This sort of real financial innovation is anathema to the Federal Reserve, of course, as its primary task (beneath the PR about maintaining stable prices and employment) is enriching and empowering the banks.

There are only two ways to deal with innovation: either dig a wider regulatory moat to protect your cartel, monopoly, or fiefdom from disruptive innovation, or get on the right side of innovation and evolve amidst the inevitable disruption.

Unfortunately for centralized institutions like the Fed, innovation always jumps the moat and disrupts the Status Quo, despite its frantic efforts to protect the perquisites of those skimming cartel-rentier profits as a droit de seigneur.