The “Price” is Wrong

“Price is what you pay. Value is what you get.” – Warren Buffett

Quote from Grant Williams (full article here):

the United States TIPS curve is negative out to 20 years, and yet “investors” are still piling money into an asset that is clearly way overvalued. They are guaranteeing themselves a negative return for the best part of a generation because they are worried about generating any kind of return. That is most definitely the aim of the Federal Reserve’s ZIRP—drive savers farther out along the risk curve than they would ordinarily dare to edge in search of some kind of a return—but their policy ensures that, were this just one big game of The Price Is Right, contestants would have no chance of being able to correctly guess many of the prices in the world around them today.

Prices everywhere have been completely skewed by government intervention the world over. So much so that there is frequently no way to ascertain the correct price of many everyday commodities (and in that, I include financial commodities such as stocks and bonds).

I sat on a panel at Mines & Money in Sydney, and a gentleman in the audience asked me a very pertinent question that highlighted the major problem facing savers and investors. I shall paraphrase him here as the question was a little longer, but essentially he was asking this:

“How do I, as an investor, correctly assess the risk of a given investment in the current market environment? How do I invest my money when traditional valuation metrics no longer seem to be effective?”

Luckily, I have no need to paraphrase my answer:

You can’t, because the market is broken. Every day, we sit in the boardroom at Vulpes in Singapore and try to figure out where and how to invest the partners’ capital, and every day it gets harder and harder to do. Equity markets have thinned out to the point of emaciation. There is no volume going through in which to trade, and the interference in all markets (particularly those of sovereign debt) is so heinous as to hinder any form of price discovery. The trickle-down effect of this intervention on commodities and real assets is only just beginning as investors are finally coming to understand that what they must do is protect their wealth from confiscation by governments.

What are equally unpalatable are the clearly manipulated figures that are released by government agencies.

The Soviet Banking System—and Ours

The symbiosis between the Fed and the Treasury is unsustainable. (View graphic here.) Neither creates value, but they sure can destroy it. The financial sector is skimming its 3% or gambling house money on bigger payoffs, but eventually they will end up on the menu. Our policymakers are short-timers.

From the WSJ:

Capitalism depends on access to capital. It’s a sad development that banks have turned away from the noble task of directing financial seed corn and instead make bets on interest rates.


Many in America today fear that our nation is going the way of Europe—becoming more socialist and redistributionist as government grows ever larger. But the most disturbing trend may not be the fiscal enlargement of government through excessive spending, but rather the elevated role of monetary policy.

Our central bank, the Federal Reserve, uses its enormous influence over banking and financial institutions to channel funds back to government instead of directing them toward productive economic activity. For evaluating the damaging effects of this unhealthy symbiosis between banking and government, the more instructive model is the Soviet Union in its final years before economic collapse.

We can draw lessons from the fact that the Soviet Union went bankrupt even as its fiscal budget statements affirmed that government revenues and expenditures were perfectly balanced. Under Soviet accounting practices, the true gap between concurrent revenues generated by the economy and the expenditures needed to sustain the nation was obscured by a phantom “plug” figure that ostensibly reflected the working capital furnished by the Soviet central bank, Gosbank.

The problem for the Soviet government was that financing provided by the state-controlled bank was supporting an increasingly unproductive economy—bailing out unprofitable enterprises that had long since quit producing real economic gains that might have raised living standards. The extension of credit to these entities had little to do with merit or potential usefulness.

The Soviet central bank was making up for the difference between government revenues and government expenditures by creating empty credits to be disbursed by central-planning bureaucrats. By the time Mikhail Gorbachev came to power in 1985, vowing to address the disastrous financial situation of the Soviet Union through “perestroika,” or restructuring, the budget deficit being financed through the nation’s central bank amounted to more than 30% of total government expenditures.

Lenin had been wise about the uses of banks. Shortly before the October Revolution, he wrote: “Without big banks, socialism would be impossible. The big banks are the ‘state apparatus’ which we need to bring about socialism, and which we take ready-made from capitalism.”

Those big banks can be easily seen today in America: They’re the ones deemed too big to fail because their demise would threaten U.S. financial stability. As mandatory members of the Federal Reserve System, they are vital partners for conducting monetary policy through the purchase and sale of Treasury bonds orchestrated by our central bank, a process known as “federal open market operations.” Besides serving as conduits of Fed policy for expanding or contracting the money supply through Treasury debt transactions, commercial banks can also access short-term funding directly from the Fed through its “discount window.”

As our own nation’s budget deficit has grown substantially larger in recent years—with the shortfall between government receipts and government outlays widening to 34.9% in the enacted budget for fiscal year 2012—our central bank has aggressively stepped up its involvement in financing government spending in excess of revenues.

In 2011, the Fed purchased a stunning 61% of the total net Treasury issuance, thus absorbing a huge portion of the fiscal overhang. Meanwhile, the Fed has been making funds available to member banks at record-low interest rates, targeting zero to 0.25% in the federal funds market and charging less than 1% on primary loans through the discount window.

It’s a bad combination: The Fed, a government agency, not only conducts monetary policy through commercial banks using Treasury debt and by extending virtually cost-free lines of credit; it also regulates those same entities. Our nation’s depository institutions are at risk of becoming complicit instruments of the federal government rather than private credit-granting companies serving free enterprise.

Washington’s dire financial condition is distorting the very nature of banking and defeating the fundamental purpose of financial intermediation. Instead of taking on the risk of making loans to small-business owners, or to individuals wanting to purchase underpriced real estate with future potential, bank portfolio managers have every incentive to play it safe. Why do anything that might raise the eyebrow of the visiting banking examiner?

Even as community bankers feel the subtle pressure to avoid local lending, the distorted incentive structure resulting from the Fed’s behemoth presence in banking and finance has its greatest impact among the larger institutions. They can earn more profits by trading sophisticated financial derivative instruments and speculating in currency markets rather than engaging in the hard grind of evaluating individual proposals from entrepreneurs seeking investment capital.

According to the Bank for International Settlements, more than 75% of the $647 trillion in notional value of outstanding derivatives arises from such contracts linked to interest rates—an indication of the extent to which monetary policy dominates the world of big finance.

Capitalism depends on access to capital. It’s a sad development that banks have turned away from the noble task of directing financial seed corn to the most promising harvesters of productive endeavor. And that they are drawn instead to playing the Fed’s nuanced game of betting on government debt and arbitraging interest-related plays.

Recent suggestions that perhaps the solution is to involve our central bank even more in the lending decisions of banks—by having the Fed grant special funds to American banks for the express purpose of re-lending them to government-approved nonfinancial borrowers—highlight how alarmingly dirigiste the entire system has become. Can central planning be far away?

A Dangerous World

I’m not a gold bug, though I can appreciate it’s insurance value against bad government. Nevertheless, this Barron’s interview provides a good overview of what we face in the international economy.

Going for Gold in a Dangerous World


Eidesis Capital’s Simon Mikhailovich on why physical gold outside the world’s banking system is the safe place to be. Understanding the Philadelphia problem.

Simon Mikhailovich knows a thing or two about financial weapons of mass destruction. With a wealth of experience in structured credit, he co-founded Eidesis Capital in 1998 with Michael Sollott, after they completed a buyout of the collateralized-debt-obligation business of St. Paul Travelers.

The new firm focused on distressed CDO investing. Its latest such private equity-style fund, the $180 million Eidesis Special Opportunities III, had a net internal rate of return of 17% from July 2009 through June 2011, when it decided to lock in gains and return most of investors’ capital.

Mikhailovich, who emigrated to the U.S. from the Soviet Union in 1979 with just $100 in his pocket, issued early warnings in 2007 about the impending collapse of the derivatives market, and the coming financial crisis. Convinced the worst is yet to come, Eidesis, which also is managed by Jim Wang, now invests mostly in gold bullion in various locations around the world outside of the banking system. To understand why, read on.

Barron’s: What’s your view of the current macro picture?

Mikhailovich: The U.S. has so far succeeded in going slowly to allow an orderly deleveraging of financial assets. But the policy measures—essentially zero interest rates—are like antibiotics. The effectiveness wears off over time, you need to take more and more to achieve less and less, and eventually they stop working. Our concern is that excessive indebtedness around the world is driving governments to try to perpetuate a protracted deleveraging, because short-term deleveraging is very painful. But there are some natural limitations. Interconnectedness in markets—now higher than it has ever been—has been created by disruptive new technologies, which aren’t very well understood.

Try us.

One technology is securitization, such as CDOs, where high-risk debt is recharacterized into investment-grade securities. The other is over-the-counter credit derivatives, which are basically grossly under-reserved insurance. When you combine the government policies with the level of interconnectedness in markets, it creates a recipe for disaster.

What are the short-term chances that we see a meltdown comparable to 2008?

Chances are high. Although there’s faith in the U.S. and its ability to help Europe navigate this situation financially, the U.S. itself has a big pending problem of the debt ceiling, of automatic tax increases, of the presidential election. There’s tremendous uncertainty. Many things have to go right in the short term to delay the eventual resolution, if you will. Based on recent precedent, it’s clear the politicians have no incentive to act unless they are faced with some sort of existential threat. A compromise will only delay the problem, because it’s a problem of excessive indebtedness and you can’t solve a balance-sheet problem without solving it, except by delaying it.

So the risks are greater than 2008?

Yes. The disruptive technologies and government policies have created an extremely highly correlated environment with all financial markets and all financial institutions. The risks were manifest in 2008, but rather than defuse them, government policies have since increased the interconnectedness. Too big to fail is now too bigger to fail. Northern European countries have been trying to figure out how to bail out Southern European countries, which increases their interdependence. The Federal Reserve is opening credit lines to the European Central Bank, and essentially supporting the ECB and providing liquidity to the European banks. Rather than enable a quick but extremely painful deleveraging, Western governments are trying to delay it by borrowing significant amounts to supplement economic activity. Debt increases the risks by increasing the interconnectedness of financial institutions and governments. Correlation is a measure of risk. That poses threats that have never existed before to the stewards of capital.

What can the government do?

My approach is what investors should do to protect themselves from the consequences. Investors need to examine old ideas about diversification, and to realize that both bonds and stocks have become much more highly correlated than ever. Investors should look for alternative sources of uncorrelated assets or assets whose value is less correlated, as opposed to simply looking at the price of those assets. The hidden cost of deleveraging proceeding without a blowup is that it transfers value from savers to debtors. It creates perverse incentives because it breaks the price mechanism, which is the most important signal in a free-market economy. We don’t know the real cost of misallocation of capital. Meanwhile, people are making valuation decisions based on these bad signals.

Where do you allot assets if you are concerned about correlated risk?

There are two roles of uncorrelated sources of returns, or reserves, in a central banking sense. Reserves are essentially hedges or protections, they’re monies or some value that is sitting on the sidelines that can be pressed into service if something happens and you need to rely on these stores of value, for two reasons. One is to protect the value of part of the portfolio, and the other is to have access to liquidity during market disruptions when you can profit by being able to buy when others do not have access to liquidity. We concluded such an asset is physical gold bullion—not paper or derivative instruments—held securely outside the financial system, which is potentially subject to a disruption like we saw in 2008, and geographically diversified to provide access to various markets, where the hope is that at least one or some of them would be liquid. That is a very intelligent way to allocate part of your portfolio to this sort of reserves.

Central banks all have gold reserves, and they’ve been increasing them. Recently, the Swiss National Bank announced that it holds its reserves in diverse locations around the globe. A spokesman explained that the main reason is to protect against a crisis scenario.

They aren’t comfortable storing their assets in their own country?

A cardinal rule of risk management is, don’t put all your eggs in one basket. If anybody is an expert in safe-haven assets, it is the Swiss National Bank. The U.S., for example, holds its gold reserves outside the financial system, at Fort Knox and at West Point.

We came up with a vehicle that enables investors to do the same thing. Our specialty is structured credit, and credit derivatives are mispriced because the rates are at zero and are subject to potential significant disruptions. We have just seen an example of that. Despite the fact that JPMorgan Chase was lauded as the most capable risk-management institution, it is facing potentially very large losses. Their trade wasn’t a hedge. It was a very specific bet on a very specific set of outcomes that is not panning out.

Can you imagine another Lehman event?

It’s just a matter of time. This financial system is completely unsustainable. The level of interconnectedness, the level of misapplied incentives is again unprecedented in history. If you were offered a game of chance where when you win, you win, and when you lose, you are given another chance to throw the dice, then, of course, everybody would play that game and essentially that is where the financial system is. That isn’t capitalism. That creates distortions, misallocation of capital, and mismanagement of risk, and we are seeing it time and time again.

Should the U.S. break up the big banks?

The most important thing for the government to do is admit the truth: that we have all participated in overspending through various means and that our standard of living exceeds our ability to pay for it. As with any emergency, this requires a tremendous amount of leadership. Before you can solve the problem, you have to admit you have a problem. And it is critically important to restore the confidence of the population in the fact that the system is not rigged.

It’s absolutely disgraceful that 2008’s consequences haven’t been the same as, let’s say, savings and loans in the 1990s. Unquestionably, things were done that were illegal in many cases, certainly grossly negligent. By various fiduciary and criminal standards, we should have seen a tremendous number of prosecutions and successful lawsuits. The U.S. system was built on a very simple premise: if you take a chance and succeed, you reap the rewards of your success. If you take a chance and fail, you have to take the consequences of your failure. When you disconnect greed and fear, greed runs rampant.

What’s the endgame for the euro?

I don’t know; nobody knows. If we step back from everything that is going on in the U.S., and in Greece and Europe, one can say that the endgame ultimately is devaluation of financial assets. It is almost as if these disruptive financial technologies enabled overproduction of financial assets. They increased productivity and they created oversupply, and that excess supply needs to be liquidated. But the liquidation is what governments don’t want to allow. So they are trying to support the prices of goods and services that have been overproduced, which are financials. That is the endgame. Greece has overproduced credit…. There is a huge vulnerability. What about Spain? What about Portugal? What about Ireland? These are irreconcilable issues, and the only way they can be reconciled is by printing more money for the moment. The ability of governments to sustain the unsustainable ultimately rests on their ability to maintain faith in their creditworthiness, and faith is something that takes a long time to crumble. But once it goes, it can go very quickly. Here is the paradox: Governments are borrowing more and more, and the spreads of government securities are getting tighter and tighter. So the creditworthiness is getting worse and the cost of funding is getting better.

How do you explain it?

Very simple. It is faith. It is muscle memory. It’s normalcy bias, a psychological phenomenon that prevents people from seeing unconventional threats. People overestimate their previous experience and they underestimate future experience…. But there may come a moment when it doesn’t work, and then what’s a safe haven? lt is gold. It’s silver, diamonds, Rembrandts, Picassos, real estate. It’s agricultural land. It’s the means of production.

But you have to consider the Philadelphia problem. In the movie Trading Places, the hero is trying to sell his very expensive Swiss watch at a pawn shop in Philadelphia, and he is told that in Philadelphia it’s worth 50 bucks. The benefit of land and of paintings and other stores of value is that they are not financial assets and they do preserve value over an extended period. But they are not liquid during times of disruption. You can’t get a fair price; they’re unique, whereas gold is ubiquitous. It’s divisible. It’s measurable. It’s testable. There is a global market for it. So you will never have the Philadelphia problem. You may not like the price, but it is never going to be a rip-off.

So, gold is going to rise over time.

The price of gold never rises. It is the value of financial assets that declines. Gold is a store of value. Gold is not an investment. However, in the current environment, gold can produce tremendous real returns because it’s an asset that doesn’t produce any cash flow. Its valuation is driven exclusively by supply and demand. In the 10 years through 2010, a study has shown, 80% of physical demand for gold came from emerging markets and only 20% from the developed world, and half of that was for jewelry. Developed markets that are the repositories of most of global financial wealth have had de minimis demand for physical gold. If this devaluation of financial assets proceeds apace and the moment of clarity comes for many investors in the West who realize they need to diversify into assets that can protect against devaluation, demand for physical gold has the potential to rise dramatically.

What about commodities?

It is very difficult to own commodities physically, and therefore you are subject to market disruptions and counterparty risk. MF Global’s clients thought they owned commodities. They even thought they owned U.S. Treasuries, and they ended up being paid 70 cents on the dollar for their Treasury holdings. Lehman clients couldn’t get full value for assets they didn’t think were at risk. They thought they were simply in custody of Lehman Brothers. That raises another problem with financial technology—re-hypothecation—where banks make money by lending out collateral. Every asset and every dollar that is in custody in a bank, unless specific legal arrangements are made, is re-lent, and as we saw with MF Global and with Lehman, ultimately it is the customer or the investor who bears the counterparty risk.

Do you have any of your money in a bank?

Of course. But I try to diversify. This isn’t about the end of the world. Armageddon is a physical end of the world, financial disruption is financial disruption. Many countries have gone through financial disruptions and had their currencies devalued and had all sorts of economic problems, even in the last 20 years. Russia, Argentina, Brazil—it didn’t extinguish life in those countries.

But you’re talking about a greater correlation between the financial system and these financial weapons of mass destruction.

They destroy money, not lives. Human history ultimately is the history of ebbs and flows of wealth, and the ability to preserve wealth over time requires a very proactive approach. Secular changes that disrupt technologies are traditionally very, very difficult, and many will lose. But some people will win. Tremendous wealth was created during the Great Depression. The idea is to position oneself to survive financially and potentially enhance one’s position.

How to Model “Money” in Economics

Article worth reading. One comment I would make is that Murphy does not consider the most difficult policy hurdle in defining money in the first place. The shadow-banking system “creates” money by creating credit. This is what the Fed could not manage. Now it struggles to manage the contraction of that “money” as everyone de-leverages their debt.

Robert P. Murphy. “Modeling Money.” June 4, 2012. Library of Economics and Liberty [Online] available from; accessed 4 June 2012; Internet.

Murphy points out that even at this late stage in economic thought, economists fit money in their model rather awkwardly. He considers the pros and cons of two ways of “modeling” money.

Democracy and the Euro or “The Greek Stand-off”

Hold on folks, it looks like Greece may turn out to be the Lehman Bros. of public debt. Moral hazard on a national scale. No wonder markets are nervous.

Greeks have to face the consequences of their own political choices.

One way to look at this week’s events in Greece is as George Papandreou’s revenge. As Prime Minister last November, he proposed that Greeks vote on whether they could live with the conditions the EU and IMF were imposing in return for a bailout. The idea sent markets into a tizzy, Mr. Papandreou lost his job, and the referendum never occurred.

But Greek voters are having their say anyway. On Tuesday Greek President Karolos Papoulias called a new election for next month, after no party could put together a majority following this month’s splintered election.

The far-left Syriza coalition, which finished second in the voting, is rejecting the bailout terms and demanding an end to fiscal restraint and economic reform. Presumably the Greeks will now have a no-holds-barred debate about the consequences of their policy choices, including possible ouster from the euro zone.

The rest of Europe may find this inconvenient, but this strikes us as progress and in any event was inevitable. That was the wisdom behind Mr. Papandreou’s stillborn idea. Like every other country in the EU, Greece is still a democracy. Greek voters reserve the right to say no to Brussels, or even to elect those willing to abrogate agreements made in their names by former governments.

For decades, the European conceit has been that voters would gladly cede their national right to democratic accountability in return for Continental peace and prosperity. This worked as long as there was prosperity. But now that pan-European governance includes painful policy choices imposed from afar, the national publics want their franchise to mean something.

Angela Merkel may want to enshrine fiscal rectitude for all time in a fiscal pact. The German Chancellor may even be right as a policy matter to want to do that given that her taxpayers will otherwise have to pay. But the fatal flaw in her vision is that she can’t control the course of democratic events outside Germany’s borders. All the more so when she has become arguably the main issue in Greek politics, complete with demagogic posters of her in Nazi garb.

In a sense the Greeks are using their elections as a way to renegotiate the terms of their most recent €130 billion bailout by the rest of Europe. They assume that if they refuse to go along, the Germans and the European Central Bank will give in and ease the terms of fiscal retrenchment and reform.

The belief, at least on the Greek left, is that the country will be able both to stay in the euro and keep its generous welfare state, albeit with some mild adjustment. Syriza leader Alexis Tsipras is even proposing to hire 100,000 more public employees.

European leaders will be doing everyone a favor if they make clear that there is no such easy way out. If Greeks want to continue being rescued by the rest of Europe, they must meet European terms. If Greeks can’t manage that, then Athens will get no more bailout cash and will have to find the money to pay its own bills.

And if Athens fails to do so, then default and ouster from the euro zone are likely, with all of the predictably terrible consequences for Greek living standards following the return of the drachma and devaluation. Instead of staying as part of modern Europe, Greece will slide toward a Third World future.

European leaders need to deliver this message not as a threat, but as the reality of what Greeks are risking if they reject reform. At least this is a choice Greeks will be making for themselves. The lesson will not be lost on voters elsewhere in the euro zone.

Europe’s leaders can’t repeal democracy on the Continent, and therefore they can’t ask countries in the euro zone for more than their politicians can deliver or their populations can take. This means admitting that the bailout model that Europe adopted for Greece two years ago has failed and is increasing political polarization across Europe, and not only in Greece.

The euro zone was conceived as a currency union among countries adhering to certain basic fiscal rules. Had it stuck to that vision in this crisis—rather than turn it into a fiscal or debt union—and let Greece face the consequences of its economic mismanagement from the beginning, Greece might have defaulted and stayed within the euro.

Now so much damage has been done that it’s hard to see such an outcome. Trying to turn the euro into a larger political union has put the entire euro zone in jeopardy.

The Fed and Deflation

Another good quote from Jim Grant’s speech at the NY Fed.

From a speech by James Grant to the New York Federal Reserve Bank, March 12:

For reasons you never exactly spell out, you pledge to resist “deflation.” You won’t put up with it, you keep on saying—something about Japan’s lost decade or the Great Depression. But you never say what deflation really is. Let me attempt a definition. Deflation is a derangement of debt, a symptom of which is falling prices. In a credit crisis, when inventories become unfinanceable, merchandise is thrown on the market and prices fall. That’s deflation.

What deflation is not is a drop in prices caused by a technology-enhanced decline in the costs of production. That’s called progress. Between 1875 and 1896, according to Milton Friedman and Anna Schwartz, the American price level subsided at the average rate of 1.7% a year. And why not? As technology was advancing, costs were tumbling.

Long before Joseph Schumpeter coined the phrase “creative destruction,” the American economist David A. Wells, writing in 1889, was explaining the consequences of disruptive innovation. “In the last analysis,” Wells proposes, “it will appear that there is no such thing as fixed capital; there is nothing useful that is very old except the precious metals, and life consists in the conversion of forces. The only capital which is of permanent value is immaterial—the experience of generations and the development of science.”

Much the same sentiments, and much the same circumstances, apply today, but with a difference. Digital technology and a globalized labor force have brought down production costs. But, the central bankers declare, prices must not fall. On the contrary, they must rise by 2% a year. To engineer this up-creep, the Bernankes, the Kings, the Draghis—and yes, sadly, even the Dudleys—of the world monetize assets and push down interest rates. They do this to conquer deflation.

But note, please, that the suppression of interest rates and the conjuring of liquidity set in motion waves of speculative lending and borrowing. This artificially induced activity serves to lift the prices of a favored class of asset—houses, for instance, or Mitt Romney’s portfolio of leveraged companies.

And when the central bank-financed bubble bursts, credit contracts, leveraged businesses teeter, inventories are liquidated and prices weaken. In short, a process is set in motion resembling a real deflation, which then calls forth a new bout of monetary intervention. By trying to forestall an imagined deflation, the Federal Reserve comes perilously close to instigating the real thing.

How the Fed Favors The 1%

Wake up, folks – you’ve been ZIRPed! (Zero Interest Rate Policy)

“…an increase in money supply is beneficial to those who get it first and is detrimental to those who get it last…”

From the WSJ:

The Fed doesn’t expand the money supply by dropping cash from helicopters. It does so through capital transfers to the largest banks.


A major issue in this year’s presidential campaign is the growing disparity between rich and poor, the 1% versus the 99%. While the president’s solutions differ from those of his likely Republican opponent, they both ignore a principal source of this growing disparity.

The source is not runaway entrepreneurial capitalism, which rewards those who best serve the consumer in product and price. (Would we really want it any other way?) There is another force that has turned a natural divide into a chasm: the Federal Reserve. The relentless expansion of credit by the Fed creates artificial disparities based on political privilege and economic power.

David Hume, the 18th-century Scottish philosopher, pointed out that when money is inserted into the economy (from a government printing press or, as in Hume’s time, the importation of gold and silver), it is not distributed evenly but “confined to the coffers of a few persons, who immediately seek to employ it to advantage.”

In the 20th century, the economists of the Austrian school built upon this fact as their central monetary tenet. Ludwig von Mises and his students demonstrated how an increase in money supply is beneficial to those who get it first and is detrimental to those who get it last. Monetary inflation is a process, not a static effect. To think of it only in terms of aggregate price levels (which is all Fed Chairman Ben Bernanke seems capable of) is to ignore this pernicious process and the imbalance and economic dislocation that it creates.

As Mises protégé Murray Rothbard explained, monetary inflation is akin to counterfeiting, which necessitates that some benefit and others don’t. After all, if everyone counterfeited in proportion to their wealth, there would be no real economic benefit to anyone. Similarly, the expansion of credit is uneven in the economy, which results in wealth redistribution. To borrow a visual from another Mises student, Friedrich von Hayek, the Fed’s money creation does not flow evenly like water into a tank, but rather oozes like honey into a saucer, dolloping one area first and only then very slowly dribbling to the rest.

The Fed doesn’t expand the money supply by uniformly dropping cash from helicopters over the hapless masses. Rather, it directs capital transfers to the largest banks (whether by overpaying them for their financial assets or by lending to them on the cheap), minimizes their borrowing costs, and lowers their reserve requirements. All of these actions result in immediate handouts to the financial elite first, with the hope that they will subsequently unleash this fresh capital onto the unsuspecting markets, raising demand and prices wherever they do.

The Fed, having gone on an unprecedented credit expansion spree, has benefited the recipients who were first in line at the trough: banks (imagine borrowing for free and then buying up assets that you know the Fed is aggressively buying with you) and those favored entities and individuals deemed most creditworthy. Flush with capital, these recipients have proceeded to bid up the prices of assets and resources, while everyone else has watched their purchasing power decline.

At some point, of course, the honey flow stops—but not before much malinvestment. Such malinvestment is precisely what we saw in the historic 1990s equity and subsequent real-estate bubbles (and what we’re likely seeing again today in overheated credit and equity markets), culminating in painful liquidation.

The Fed is transferring immense wealth from the middle class to the most affluent, from the least privileged to the most privileged. This coercive redistribution has been a far more egregious source of disparity than the president’s presumption of tax unfairness (if there is anything unfair about approximately half of a population paying zero income taxes) or deregulation.

Pitting economic classes against each other is a divisive tactic that benefits no one. Yet if there is any upside, it is perhaps a closer examination of the true causes of the problem. Before we start down the path of arguing about the merits of redistributing wealth to benefit the many, why not first stop redistributing it to the most privileged?

A World Awash in Money

A monetary Wizard of Oz? From today’s WSJ editorials:

Central bank stimulus can’t last forever.

If you want to know who rules the world economy these days, Wednesday was instructive. In Europe, central bank chief Mario Draghi waved his hand and lent European banks another few hundred billion euros at 1%. (See below.) And in Washington, Federal Reserve Chairman Ben Bernanke roiled markets in Treasurys, stocks, commodities, etc., when he told Congress . . . well, no one seems sure of what he really said, or at least what he meant.

So it goes when central bankers take it upon themselves to save the world economy.

And, man, are they ever trying. The most important economic news in recent weeks has been the global flood of monetary easing. Wall Street economist Ed Hyman sends out a useful daily summary of world economic news, and his top headline on Monday was “Massive Global ‘QE’,” as in quantitative easing.

In addition to the European Central Bank’s liquidity burst, China is easing its reserve requirements to stimulate more bank lending. The Bank of England has been all-in for some time, and the Bank of Japan recently joined the party. Lesser central banks have been following suit, as the world takes its cues from the grandest monetary maestro, Mr. Bernanke, who has announced that the Fed will keep interest rates at near-zero for another three years.

The Fed’s policy is intended to reassure business and investors about monetary stability, but you wouldn’t know it from the response to Mr. Bernanke’s testimony yesterday on Capitol Hill. The economy has been doing better of late and fourth-quarter growth was revised upward yesterday to 3%, but Mr. Bernanke was downbeat and seemed to suggest unemployment won’t keep falling. Rising oil prices are a problem, he added, but any burst of inflation will be “temporary.”

Would he rule out another round of bond purchases, a QE3? No, but he didn’t foresee another round anytime soon either.

What this means for policy, who knows? But the dollar promptly rose, gold plunged $90 an ounce, silver took a bath, stocks fell despite other good economic news, and Treasury yields rose.

It seems that some investors had been hoping for even more monetary stimulus, and so they had to cover their long bets on riskier assets like gold when Mr. Bernanke disappointed them. Stocks, which have also been riding the liquidity wave, respond as much to monetary portents these days as they do to news about the economy.

The larger point is the inherent instability of growth rooted in easy money. For a time, and especially in a crisis or recession, monetary policy can supply vital liquidity and arrest a collapse of confidence. But sooner or later as growth recovers, the easing has to stop before it begins to produce even more instability.

The current moment of “massive global QE” is helping stocks, which boosts confidence, but it is also lifting commodity prices, which undermines consumer spending and business confidence. Far from increasing stability, Mr. Bernanke’s extraordinary monetary efforts are keeping everyone guessing about his next move. An economy that hangs on the words of a monetary Wizard of Oz is not one that is, to borrow a phrase, “built to last.”


The Federal Reserve’s Covert Bailout of Europe

More monetary machinations behind the scenes…

When is a loan between central banks not a loan? When it is a dollars-for-euros currency swap.


America’s central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.

The Fed is using what is termed a “temporary U.S. dollar liquidity swap arrangement” with the European Central Bank (ECB). There are similar arrangements with the central banks of Canada, England, Switzerland and Japan. Simply put, the Fed trades or “swaps” dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one-half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

Why are the Fed and the ECB doing this? The Fed could, after all, lend directly to U.S. branches of foreign banks. It did a great deal of lending to foreign banks under various special credit facilities in the aftermath of Lehman’s collapse in the fall of 2008. Or, the ECB could lend euros to banks and they could purchase dollars in foreign-exchange markets. The world is, after all, awash in dollars.

The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan.

The ECB is entangled in an even bigger legal and political mess. What the heads of many European governments want is for the ECB to bail them out. The central bank and some European governments say that it cannot constitutionally do that. The ECB would also prefer not to create boatloads of new euros, since it wants to keep its reputation as an inflation-fighter intact. To mitigate its euro lending, it borrows dollars to lend them to its banks. That keeps the supply of new euros down. This lending replaces dollar funding from U.S. banks and money-market institutions that are curtailing their lending to European banks—which need the dollars to finance trade, among other activities. Meanwhile, European governments pressure the banks to purchase still more sovereign debt.

The Fed’s support is in addition to the ECB’s €489 billion ($638 billion) low-interest loans to 523 euro-zone banks last week. And if 2008 is any guide, the dollar swaps will again balloon to supplement the ECB’s euro lending.

This Byzantine financial arrangement could hardly be better designed to confuse observers, and it has largely succeeded on this side of the Atlantic, where press coverage has been light. Reporting in Europe is on the mark. On Dec. 21 the Frankfurter Allgemeine Zeitung noted on its website that European banks took three-month credits worth $33 billion, which was financed by a swap between the ECB and the Fed. When it first came out in 2009 that the Greek government was much more heavily indebted than previously known, currency swaps reportedly arranged by Goldman Sachs were one subterfuge employed to hide its debts.

The Fed had more than $600 billion of currency swaps on its books in the fall of 2008. Those draws were largely paid down by January 2010. As recently as a few weeks ago, the amount under the swap renewal agreement announced last summer was $2.4 billion. For the week ending Dec. 14, however, the amount jumped to $54 billion. For the week ending Dec. 21, the total went up by a little more than $8 billion. The aforementioned $33 billion three-month loan was not picked up because it was only booked by the ECB on Dec. 22, falling outside the Fed’s reporting week. Notably, the Bank of Japan drew almost $5 billion in the most recent week. Could a bailout of Japanese banks be afoot? (All data come from the Federal Reserve Board H.4.1. release, the New York Fed’s Swap Operations report, and the ECB website.)

No matter the legalistic interpretation, the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments. It is difficult to count the number of things wrong with this arrangement.

First, the Fed has no authority for a bailout of Europe. My source for that judgment? Fed Chairman Ben Bernanke met with Republican senators on Dec. 14 to brief them on the European situation. After the meeting, Sen. Lindsey Graham told reporters that Mr. Bernanke himself said the Fed did not have “the intention or the authority” to bail out Europe. The week Mr. Bernanke promised no bailout, however, the size of the swap lines to the ECB ballooned by around $52 billion.

Second, these Federal Reserve swap arrangements foster the moral hazards and distortions that government credit allocation entails. Allowing the ECB to do the initial credit allocation—to favored banks and then, some hope, through further lending to spendthrift EU governments—does not make the problem better.

Third, the nontransparency of the swap arrangements is troublesome in a democracy. To his credit, Mr. Bernanke has promised more openness and better communication of the Fed’s monetary policy goals. The swap arrangements are at odds with his promise. It is time for the Fed chairman to provide an honest accounting to Congress of what is going on.

Mr. O’Driscoll, a senior fellow at the Cato Institute, was vice president at the Federal Reserve Bank of Dallas and later at Citigroup.