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Posts Tagged ‘Interest Rates’

Public Pension Funds Crisis Looming

Posted by Steve Markowitz on September 10, 2015

Defined benefit pension plans are a thing of the past for most private companies.  Those plans guarantee payments to retired employees based on years of service.  While a wonderful concept that was viable when American industry had little competition following World War II, these plans became untenable as worldwide competition increased.  As a result, most American businesses that offer pension plans have moved to 401(k) &plans whose funding requirements are more flexible and can be kept in line with a company’s economic realities.

In defined benefit pension plans, the real costs are hidden within complex actuarial tables that require assumptions on long-term returns.  Should the assumptions be overly optimistic, which they often are, what may look like a financially healthy company quickly become insolvent.

While most of the private sector has addressed its pension responsibilities, the public sector still offers many governmental employees defined benefit pension plans.  This has created a dangerous economic model for many municipal and state governments, which is being exasperated by decreasing returns for pension plan investments.

Timothy W. Martin’s recent article in the Wall Street Journal highlights the growing problem of public-sector pension plans.  The problem is being brought to a head as long-term plan assumptions by necessity are being decreased due to the long term economic downturn and low interest rates available on fixed income investments.

Historically, annual pension return assumptions have been set at 8%.  This assumption was used to calculate the rate of growth of pension fund investments.  This rate of return has not obtainable for some years.  However, the 8% return rate assumption was maintained by pension fund managers as a way of masking problems within their funds.  As a result, states and municipalities were able to underfund their plans and push liabilities off to a future time.  That time is rapidly approaching.

Martin points out that:

  • Over 60% of state retirement systems have cut their assumptions in the past seven years with the average now being just under 7.7%. This Blog proffers the view that even this lower assumption is overly optimistic.  In fact, it has been reported that for the first half of this year the average annual return for pension funds was less than 4%.
  • Last week one of the nation’s largest public pension funds, the New York State Common Retirement Fund, cut its return rate a half a point to 7%. Similarly, the San Diego County Employees Retirement Association cut its assumption quarter point to 7.5%.  The Oregon Public Employees Retirement System and Texas Municipal Retirement System have also lowered their forecasted return rate by a quarter point.
  • America’s largest public retirement fund, The California Public Employees’ Retirement System, is considering dropping its current return assumption rate from 8%.

While lowering the return assumptions by state and local governments is ultimately a positive step, forcing governments to adequately fund their pension obligations, there is significant pain associated with this action.  Increased taxpayer dollars will be required to fund the pension plans.   This will decrease funds available to support governmental services.  For example, Martin reports that Boulder, CO has eliminated 100 positions and cut services in order to add $1.7 million to its pension fund.

States and municipalities have increased their funding of pension programs by over $120 billion in the past 10 years.  That would pay for a lot of government services!


Pension problems for state and municipal governments will grow significantly since even the new lower assumptions are overly optimistic.  In the 1960s, for example, return assumptions were less than 4%.  Should pension fund returns approach those levels, the result would be catastrophic.  As Martin points out, every 1% decrease in a fund’s returns leads to a 12% increase in the pension’s liabilities.

While the looming public pension crisis was created by state and municipal governments using unrealistically high return assumptions and offering benefits that they could not afford, the problem has been exasperated by the low interest rate policies of the Federal Reserve that further depresses fund returns.  This is one example of the significant consequences of the Fed’s interventionist policy that has distorted expenses for some, cajoled investors into higher risk investments as they seek returns, and created bubbles including overpriced equity valuations. These problems are just now beginning to percolate.  When they boil over, books will be written on the fallacy of the Federal Reserve’s low interest rate policies.


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Fed’s Yellen Primes Pump, Feeds Bubbles

Posted by Steve Markowitz on February 24, 2015

YellenFederal Reserve Chairperson, Janet Yellen, today announced that Fed will continue its low interest rate policy for some time into the future. Many had expected Yellen to indicate that with the improving economy, the Fed would begin a slow rise in interest rates. Yellen’s commitment of more gin in the punch bowl had an immediate effect with the Dow Jones Industrial Average, S&P 500, and the UK’s flagship FTSE 100 all hitting record highs.

Generally, rising stock markets are positive signs if the rise is based on appropriate economic fundamentals.   The lengthy drive-up of equity values are instead being driven by the Fed’s low interest rates and Quantitative Easing. This is problematic at various levels. First, should there be an economic slowdown, as there inevitably will, the Fed would have no ammo left to juice up the economy. In addition, when interest rates eventually rise, overvalued equities will show a rapid decline in value causing significant economic pain.

Perhaps the most problematic aspect of the Federal Reserve’s low interest rate policies is who benefits from them. While some on mainstream benefit as equity values rise, especially in 401(k) plans, the greatest benefit goes to the highest income brackets, the people who have the most to invest. This has led to the large increase in the income disparity in the United States. The Fed’s continuation of its policies will further increase the disparity.

Finally, the Fed’s low interest rate policies have cajoled investors into higher risk investments in search of yield. This places further upward pressure on equity values as the bubble builds and guarantees that the next downturn will be exasperated by these interventionist policies.

For many months government publish statistics has shown a significantly improving economy. In addition, by the classical definition, the recession ended years ago. These two items seem in conflict with Janet Yellen’s announcement today that the economy is still fragile. Either the government’s published figures or Yellen’s comments of earlier today relating to the economy need to be questioned.

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Stock Market Bubble Created by Fed Policies

Posted by Steve Markowitz on July 31, 2014

The 2008 meltdown was largely created by Federal Reserve policies. Since the latter part of the 1990s, previous Fed Chairman Alan Greenspan turned on the spigot of easy money any time there was even minor economic downturns. Historically low interest rates were the favorite tool

The Fed policies damaged the moral hazard leading to irrational investment behavior, as well as poor business judgment especially by banks and other lending institutions. It also led to unsustainable increases in the housing values that created the mother of all bubbles. Not to miss a turn at the punch bowl, governments overspent due to increased tax revenues from the bubble economy.

The Fed doubled down on its easy money policies in response to the 2008 financial meltdown. The consequences are yet to fully play out, but have the potential to be huge.

In a nutshell, the 2008 financial meltdown was caused by excessive debt in the private sector. Through bank bailouts and other governmental interventions, a significant portion of the debt was moved to the public sector; i.e. sovereign debt. With central banks printing money and purchasing the debt, countries including the United States have been able to borrow money at artificially low interest rates creating the illusion of wealth.

There will be a cost and a day of reckoning for the reckless Fed policies. We saw a glimpse of a consequence today when the Dow Jones Industrial Average dropped more than 300 points, nearly 2%. Today’s drop was mainly the result of Argentina defaulting on its debt. Other countries face similar challenges.

Should the world’s financial markets continue to exhibit nervousness, it is predictable as to the Fed’s reaction. They will once again flood the market with more liquidity through quantitative easing. Governments will also have an excuse to expand their deficits with more spending.  This story has been told throughout history and it is never ended well.

Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, wrote an op-ed for the Wall Street Journal, Liberals Love the ‘One Percent’, that reviews some of the problems with the Federal Reserve’s policies:

  • While Fed Chairperson Janet Yellen indicated that its policies are designed “to help Main Street not Wall Street,” it has done the opposite. While the current recovery has been the slowest since World War II averaging only 2% annually for the past five years, this has been the most powerful stock market recovery during that same period increasing by 135%. A substantial portion of equity assets are owned by wealthier Americans, which has increased the wealth disparity in the United States.
  • The easy money Fed policies has fed an industry that creates financial instruments to make money on commodity trading and price variations. The best and brightest have learned that there is more money to be made in financial manipulation than inventing and building products.
  • Commodity prices have significantly increased since 2009. On average the increase is 40%, double the rate seen in commodity price increases in recoveries since World War II. In addition, price increases on staples such as food are significantly more problematic for the poor and poor countries, again increasing income disparity.
  • It is likely some commodities are in bubble territory. When they pop, while this will offer relief for those dependent on commodities for subsistence, it will likely lead to financial stress on the financial sector that will lead to a call for more bailouts.
  • Borrowing is often used to finance capital equipment purchases. The current artificially low borrowing costs offer incentives to companies to invest in capital equipment for efficiencies, rather than hire more labor, further depressing the employment.
  • Even some companies flush with cash are barring at the artificially low corporate bond rates and using the funds for less than productive purposes, such as mergers and acquisitions.

As Sharma insightfully concludes, “the Fed can print as much money as it wants, but it can’t control where it goes much of it is finding its way into financial assets”.  Central bankers throughout modern history have proven inept when it comes to proactive policies designed to fix economic distress.  Chairman Greenspan didn’t even see the housing bubble when had already actually popped.  Expecting them to have it right this time is little better than wishful thinking.

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Stephanie Pomboy on Ben Bernanke

Posted by Steve Markowitz on June 1, 2014

Well-known economist, Stephanie Pomboy, made a presentation at the Wine County Conference 2014 posted below. Pomboy reviews a series of charts that demonstrate the failure of Ben Bernanke’s easy money policies.

During the 2009 economic meltdown, the federal government and Fed used the crisis as a pretense for massive interventions. In the early months this included TARP, which bailed out banks that were at financial risk because of their own imprudent behavior. After the election Barack Obama and the Congress passed the massive Stimulus Program. While it is not possible to determine if these programs protected the economy from Armageddon, given the anemic recovery, the slowest since the Great Depression, it is evident that they did not aid long-term economic growth.

Ms. Pomboy specifically takes on the failed Fed easy money programs, mainly Quantitative Easing (QE) that in essence is printing money. The Fed purchased Treasury Bonds in an effort to keep interest rates artificially low under the theory that this helps stimulates economic growth. The slow recovery is one indicator that this effort’s benefit has been marginal.

Easy money policies typically lead to inflation. To date, however, QE has not generated broad-based inflation likely due to the competitive nature of globalization, excess production capacity and depressed demand. However, certain assets significantly inflated including energy, certain foods, and equities. One consequence has been the growing inequity between high net worth individuals and the greater population. Not only are wealthier individuals less impacted by food and energy cost increases, but they benefited more from the increases in equity values. In addition, as food prices increase, the poor in less developed countries go hungry. Some theorizeS&P 500 Interest that the Arab Spring was propelled more by hungry people than those seeking political reform.

Ms. Pomboy refers to a various charts that indicate some of the negative impacts to the economy resulting from Ben Bernanke’s (Fed’s) QE policies. One charts posted shows the benefit large corporations have obtained from artificially low interest rates.  This has increased profits that further propelling equities’ valuations. That Corp Profits Vrs GDPbenefit has flattened more recently and will inhibit these gains and possibly equity values going forward.

Also plotted are corporate profits as a percentage of GDP. This has reached new heights that are unsustainable. The two previous periods that this ratio peaked was before the Dotcom meltdown in 1999 and before the stock market crash of 2008.

Perhaps the most significant chart presented by Pomboy is the one showing the source of funds from which the U.S. Treasury borrows to fund our deficits. Since Quantitative Easing started, the willingness of other countries to buy America’s debt has dropped S&P 500 Interestsignificantly. This trend is unlikely to change with the artificially low interest rates being paid on US Treasuries. There are two likely outcomes to this trend. Either: 1) the United States will have to pay significantly higher interest rates on future borrowings that will force the government to significantly cut spending, or 2) the Fed will have to increase QE to fund the country’s deficits. The second outcome, which Ms. Pomboy predicts, will create significant inflation and place at risk the US dollar’s unique position as the world trading currency. The ramifications of this latter item are quite destabilizing for the American economy.

Ms. Pomboy theorizes, somewhat sarcastically, that Ben Bernanke retired from the Federal Reserve because of his understanding of the dilemma resulting from foreign buyers losing their appetite for US treasuries. Printing money is voodoo economics that has been tried in the past by failed economic models. It is never resolved a country’s long-term problems. The question is not whether there will be consequences, only what they will be.

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US Fed Policies Creates Economic Problems in India

Posted by Steve Markowitz on August 28, 2013

The US government and Federal Reserve have intervened with ever increasing frequency in the economy during the past two decades.  In the 1990’s the US economy had various hick-ups that included the dot.com and telecom bubbles’ and their meltdowns.  Immediately following the 2001 9/11 tragedy a steep drop in economic activity occurred.  In earlier years the Federal Reserve and government would have allowed the law of supply and demand to rebalance the economy.  While painful, such rebalancing is necessary to ensure the proper amounts of goods and services be produced for the available demand.   The interventions, mainly through low interest rate policies and printing money, stopped rebalancing and this ultimately led to the largest bubble of all; the housing bubble.

Five years since the housing bubble popped we continue to see the negative effects of the interventions.  Perhaps the best example is the slowest increase in job growth of any recovery of modern times.

The Fed understands the risks of continuing the low interest rate policy.  It understands that pulling the plug on this “free lunch” is akin to making a drug addict go cold turkey.  In an effort to set the stage for changing the policy, in spring the Fed announced that it is considering lessening its purchase of U.S. Treasury bonds.  That made investors nervous with US equity values gyrating since.  The Fed’s easy money policy is the major reason that US equity prices have inflated during the past two years, not economic growth.  Pull the plug on the easy money and equity values will drop.  It is only question of how far.

The unintended consequences of the Fed’s easy money policies are not limited to the United States.  The Wall Street Journal reported that developing economies are showing significant stress as a result of fears that the Fed will stop buying US Treasury bonds.

  • The Indian stock market lost approximately 5% in value over a two-day period and its currency has dropped significantly versus the US dollar.
  • Thailand has seen its equity markets’ value drop significantly.
  • The Indonesian currency has dropped to a four-year low versus the US dollar and its share prices were down 10% in one week.
  • Malaysia’s currency value has dropped significantly.

The fear is that as interest rates rise investors will pull capital from developing countries and move it to more developed and less risky markets.  As these countries’ currency values drop, their cost of imported commodities such as oil and fertilizer increase.  Inflation in India is currently at an annual rate of about 10%.  Inflation, especially in developing countries, is devastating on the poor who spend most of their money on staples including food.

When the Fed and the US government embarked on the major interventionist policies during the 2008 meltdown that included bailouts, they justified the radical actions by saying they were required to protect us from economic Armageddon.  It is not possible to determine if these policies actually protected us from a more catastrophic meltdown.  However, there are significant consequences to their “free lunch” policies.  We are beginning to see these consequences play out.  People will go hungry.

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The Federal Reserve’s Risky Policies

Posted by Steve Markowitz on December 17, 2012

Last week Federal Reserve Chairman Ben Bernanke made two significant announcements concerning additional aggressive Federal Reserve (Fed) actions.  First, the Fed will continue to keep interest rates at near zero until the US unemployment goes below the targeted rate of 6.5%.  In addition, the Fed will increase its quantitative easing (QA) to $85 billion per month, nearly double the current rate.  With QA the central bank buys America’s debt in an effort to drive down interest rates and stimulate economic activity.

If history is a reasonable judge, the recent steps by the Fed are doomed to fail.  A super-low interest rate policy has been in place for four years.  Given the policy’s failure to stimulate the economy during this lengthy period makes it unreasonable to expect much benefit from it going forward.

While low-interest rates can stimulate the economy, this will not occur when the problem is liquidity based.  The ongoing economic downturn was caused by excess debt that needs to be de-leveraged before real economic growth can begin.  As a result, much of the low-interest loans are not being invested in areas that lead to economic growth, but instead are being taken by corporations as a source of low-cost long-term funding.

There are negative consequences for economic growth from the low interest rates, particularly for people on fixed incomes including the elderly who have seen their incomes drop significantly.  In addition, pension funds’ returns are artificially low requiring companies and municipal governments to fund them in lieu of spending funds on productive projects that could lead to long-term economic growth.

When the Fed’s low-interest rate policies began in the latter part of 2008 the concern was whether the Fed would be able to withdraw the funds from the economy quick enough to avoid rampant inflation.  Many economists at the time suggested that this would need to occur within a 16 month period.  As the chart shows, now four years later, the Fed’s priming the pump continues with no end in sight.

As serious as the failure of the Fed’s policy is, the real danger for the economy is that it may someday succeed.  When the employment rate approaches the 6.5% target, the fear will be that the Fed will start increasing interest rates.  This will suppress economic activity, especially for an economy that for years has gotten his direction based on Fed interest rate policies.

Another concern is that the Fed’s policy will lead to investors making imprudent investment decisions leading to significant asset bubble creation.  As with all bubbles, they ultimately must pop leading to widespread economic crises.  Less than five years after the pop of the housing bubble that was in part caused by the Federal Reserve’s earlier low interest policies, it is evident that the Fed has learned little from that painful lesson.

Fed Balance Sheet

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Fed Continues Same Failed Policies

Posted by Steve Markowitz on June 21, 2012

The Federal Reserve announced a relatively small increase in what has been called “Operation Twist“.  Through this program the Fed will buy an additional $270 billion long-term Treasury securities.

The theory behind Operation Twist is that it helps bring down long-term borrowing costs including as mortgages.  Economists estimate that previous purchases under Operation Twist have reduce these rates by a trivial 0.15 to 0.20%.  Given this meager drop it is easy to understand why the program has had such little positive effect on the economy.

Since the economic meltdown of 2008, Fed and governmental policies have been stimulative to the max.  This includes keeping short-term interest rates near zero and promising to maintain the low rate until at least 2014.  The Fed has also purchased more than $2.5 trillion in Treasuries and other government securities.  None of these efforts have even caused a dent in the overall problem, excess debt.

After making the announcement, Chairman Bernanke said that the Fed is “prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”  This statement guarantees further Fed action given its history of failed policies.  Sooner or later these knuckleheads will succeed in creating inflation. However, once that genie is out of the bottle, their ability to control it will be limited.

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Fannie Mae / Freddie Mac Debacle Prove Democrat Hypocrisy

Posted by Steve Markowitz on May 25, 2012

On February 9, 2012 this Blog posted Housing Market Damaged by Ongoing Governmental Interventions concerning Fannie Mae and Freddie Mac and their roles in creating the housing market crash that led to 2008 global economic meltdown that is still ongoing.  The ongoing housing downturn is the worst in since the Great Depression.  United States government actions and interventions played a significant role in creating this mess.

In the 1934 the US government created the Federal Housing Authority.  The FHA was a backstop for mortgages that led to lower borrowing costs, governmental subsidy to promote homeownership.  The government’s actions were based the mistaken belief that home prices always increased making them a good investment for all Americans.  The meltdown of 2008 proved this to be ridiculous thesis.

Like all governmental agencies, the FHA’s reach and authority increased with time.  In 1977 Congress passed the Community Reinvestment Act promoting homeownership to lower income groups who could not afford mortgages.  Then, in the 1990’s Congress pressured Fannie Mae and Freddie Mac to offer loans to even higher risk buyers to further promote home ownership.  While the interventions were made for supposed noble reasons, their benefits mainly benefited the home building and real estate industries.  In addition, the policies led to inflated home prices making them bad investments especially for those that purchased homes in more recent years, the very group the governmental actions were suppose you help.

Finally, the government under the Bush and Obama Administrations pursued a dangerous low interest rate policy to further increase demand and consumption of all types of goods, including housing.  Like an addiction, this drug no longer offers a high and the economic downturn continues irrespective of additional interventions.

Those who believe in and promote(d) the government’s interventions are culpable for the mess we face today.  Progressives understand this and therefore deflect by creating the false narrative that the macroeconomic malady is merely the result of greedy capitalists.  The video submitted below by Blog reader John helps show the Left’s complicity in creating the housing bubble and subjecting taxpayers to huge losses at Freddie Mae and Fannie Mac.  It also shows that in opposite of the Left’s narrative, it was they who stop the Republicans from further regulating Freddie and Fannie.  Excerpts from our congressmen include:

  • Richard Baker, Rep. Louisiana – He predicted Fannie and Freddie failure in 2004 and called calls for more regulations on them.
  • Maxine Waters, Dem. California – She said that no problems existed at Fannie Mae and Freddie Mac under “outstanding leadership” of Mr. Franklin Raines and accused regulators of trying to fix something that wasn’t broke.  Waters then praised Raines for exceeding GSE Performance and further attacks regulator for impeding affordable housing mission.
  • Gregory Meeks, Dem. New York – Watch his irrational rant attacking a regulator trying to control Fannie and Freddie.
  • Ed Royce, Rep. California – He pleads for more regulations on Fannie and Freddie.
  • Lacy Clay, Dem. Missouri – “This hearing is about the political lynching of Franklin Raines”  No problem with Freddie and Fannie soundness.
  • Christopher Shays, Rep. Connecticut – Points out that that Fannie and Freddie were incredibly exempted from Sarbanes-Oxley act.
  • Artur Davis, Dem. Alabama – Beats up on a regulator who attempted to put controls on Fannie and Freddie.
  • Barney Frank, Dem. Mass. – Defended Freddie and Fannie incredibly stating that there were not issues with their “safety and soundness”.
  • Don Manzullo, Rep. IL – Attacks Fannie and Freddie for skirting the rules so that they could pay huge bonuses to their executives.

Perhaps the worst character this sordid matter is Franklin Raines who headed Fannie Mae until being forced to retire in late 2004 after the SEC began investigating accounting irregularities.  Raines, who received total salaries exceeding $90 million at Fannie is quoted: “These assets (houses) are so riskless, that their capital for holding them should be under 2%”.  This incredible example of stupidity did not stop Barack Obama from looking to Raines for advice on the housing market.

For those who would question the Left’s culpability in creating the mortgage meltdown, the video concludes with Bill Clinton clearly stating that both he and the Democrats in Congress must accept responsibility in that they resisted any Republican efforts to tighten up of on Freddie Mac and Fannie Mae.

This story is one of stupidity, greed, and the failure of government.  It has been buried by a mainstream media that no longer does any investigative journalism, especially if it may place Progressive policies at risk.  The Leftist politicians who manipulated the housing market are just as guilty as the mortgage brokers and bankers who took advantage of their ill-conceived policies.

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Federal Reserve’s Failings

Posted by Steve Markowitz on April 28, 2012

Politicians on both sides of the political aisle are quick to blame the other side for ongoing economic malaise that has continued since the 2007 meltdown.  Such proponents blame the other side in an effort to obtain political gain.  However, no Democrat and a very few Republicans in Washington address the underlying causes of the worldwide economic crisis.

The frontal issues of the economic challenges are easy to see: the creation of and popping of bubbles and the growing inequity between the haves and the have-nots.  However, the underlying causes not only take a deeper understanding of economics, but involve messages that lessen the likelihood of reelection.

The Federal Reserve’s manipulation of interest rates and other markets and their relationship to bubbles and other market imbalances is rarely discussed by politicos in Washington.  The subjects are too complex for the sound-bites required for reelection.  However, there are those who not interested in public office and who have a deep understanding of the Federal Reserve and monetary policy that are speaking.  One is Jim Grant who recently made a speech to New York Federal Reserve.  The speech is posted in full below with this Blog’s only edition being the underlying and bolding of key sentences.

While some blame Barack Obama for the ongoing economic challenges, and he certainly deserves some, he is merely carrying out the Progressive policies initiated with the creation and morphing of the Federal Reserve.

A Piece Of My Mind, By Jim Grant

My friends and neighbors, I thank you for this opportunity.  You know, we are friends and neighbors.  Grant’s makes its offices on Wall Street, overlooking Broadway, a 10-minute stroll from your imposing headquarters.  For a spectacular vantage point on the next ticker-tape parade up Broadway, please drop by.  We’ll have the windows washed.

You say you would like to hear my complaints, and, on the one hand, I do have a few, while on the other, I can’t help but feel slightly hypocritical in dressing you down.  What passes for sound doctrine in 21st-century central banking – so-called financial repression, interest-rate manipulation, stock-price levitation and money printing under the frosted-glass term “quantitative easing” – presents us at Grant’s with a nearly endless supply of good copy.  Our symbiotic relationship with the Fed resembles that of Fox News with the Obama administration, or-in an earlier era-that of the Chicago Tribune with the Purple Gang. Grant’s needs the Fed even if the Fed doesn’t need Grant’s.

In the not quite 100 years since the founding of your institution, America has exchanged central banking for a kind of central planning and the gold standard for what I will call the Ph.D. standard.  I regret the changes and will propose reforms, or, I suppose, re-reforms, as my program is very much in accord with that of the founders of this institution.  Have you ever read the Federal Reserve Act?  The authorizing legislation projected a body “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States, and for other purposes.”  By now can we identify the operative phrase?  Of course: “for other purposes.”

You are lucky, if I may say so, that I’m the one who’s standing here and not the ghost of Sen. Carter Glass.  One hesitates to speak for the dead, but I am reasonably sure that the Virginia Democrat, who regarded himself as the father of the Fed, would skewer you.  He had an abhorrence of paper money and government debt.  He didn’t like Wall Street, either, and I’m going to guess that he wouldn’t much care for the Fed raising up stock prices under the theory of the “portfolio balance channel.”

It enflamed him that during congressional debate over the Federal Reserve Act, Elihu Root, Republican senator from New York, impugned the anticipated Federal Reserve notes as “fiat” currency. Fiat, indeed!  Glass snorted.  The nation was on the gold standard.  It would remain on the gold standard, Glass had no reason to doubt.  The projected notes of the Federal Reserve would-of course-be convertible into gold on demand at the fixed statutory rate of $20.67 per ounce.  But more stood behind the notes than gold.  They would be collateralized, as well, by sound commercial assets, by the issuing member bank and-a point to which I will return- by the so-called double liability of the issuing bank’s stockholders.

If Glass had the stronger argument, Root had the clearer vision.  One can think of the original Federal Reserve note as a kind of derivative.  It derived its value chiefly from gold, into which it was lawfully exchangeable.  Now that the Federal Reserve note is exchangeable into nothing except small change, it is a derivative without an underlier.  Or, at a stretch, one might say it is a derivative that secures its value from the wisdom of Congress and the foresight and judgment of the monetary scholars at the Federal Reserve.  Either way, we would seem to be in dangerous, uncharted waters.

As you prepare to mark the Fed’s centenary, may I urge you to reflect on just how far you have wandered from the intentions of the founders?  The institution they envisioned would operate passively, through the discount window.  It would not create credit but rather liquefy the existing stock of credit by turning good-quality commercial bills into cash-temporarily.  This it would do according to the demands of the seasons and the cycle.  The Fed would respond to the community, not try to anticipate or lead it.  It would not override the price mechanism-as today’s Fed seems to do at every available opportunity-but yield to it.

My favorite exposition of the sound, original doctrines is a book entitled, “The Theory and Practice of Central Banking,” by H. Parker Willis, first secretary of the Federal Reserve Board and Glass’s right-hand man in the House of Representatives.

Writing in the mid-1930s, Willis pointed out that the Fed fell into sin almost immediately after it opened for business in 1914.  In 1917, after the United States entered the Great War, the Fed set about monetizing the Treasury’s debt and suppressing the Treasury’s borrowing costs.  In the 1920s, after the recovery from the short but ugly depression of 1920-21, the Fed started to implement open-market operations to sterilize gold flows and steer a desired macroeconomic course.

“Central banks,” wrote Willis, glaring at the innovators, “…will do wisely to lay aside their inexpert ventures in half-baked monetary theory, meretricious statistical measures of trade, and hasty grinding of the axes of speculative interests with their suggestion that by doing so they are achieving some sort of vague ‘stabilization’ that will, in the long run, be for the greater good.”

Willis, who died in 1937, perhaps of a broken heart, would be no happier with you today than Glass would be-or I am.  The search for “some sort of vague stabilization” in the 1930s has become a Federal Reserve obsession at the millennium.

Ladies and gentlemen, such stability as might be imposed on a dynamic capitalist economy is the kind that eventually comes around to bite the stabilizer.

“Price stability” is a case in point.  It is your mandate, or half of your mandate, I realize, but it does grievous harm, as defined.  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.

The economist Hyman Minsky laid down the paradox that stability is itself destabilizing.  I say that the pledge of a stable funds rate through the fourth quarter of 2014 is hugely destabilizing.  Interest rates are prices.  They convey information, or ought to.  But the only information conveyed in a manipulated yield curve is what the Fed wants.  Opportunists don’t have to be told twice how to respond.  They buy oil or gold or foreign exchange, not incidentally pushing the price of a gallon of gasoline at the pump to $4 and beyond.  Another set of opportunists borrow short and lend long in the credit markets.  Not especially caring about the risk of inflation over the long run, this speculative cohort will fund mortgages, junk bonds, Treasurys, what-have-you at zero percent in the short run.  The opportunists, a.k.a. the 1 percent, will do fine. But what about the uncomprehending others?

I commend to the Federal Reserve Bank of New York Financial History Book Club (if it doesn’t exist, please organize it at once) a volume by the British scholar and central banker, Charles Goodhart.  Its title is “The New York Money Market and the Finance of Trade, 1900-1913.”  In the pre-Fed days with which the history deals, the call money rate dove and soared.  There was no stability-and a good thing, Goodhart reasons.  In a society predisposed to speculate, as America was and is, he writes, unpredictable spikes in borrowing rates kept the players more or less honest.  “On the basis of its record,” he writes of the Second Federal Reserve District before there was a Federal Reserve, “the financial system as constituted in the years 1900-1913 must be considered successful to an extent rarely equaled in the United States.”  And that not withstanding the Panic of 1907.

My reading of history accords with Goodhart’s, though not with that of the Fed’s front office.  If Chairman Bernanke were in the room, I would respectfully ask him why this persistent harking back to the Great Depression?  It is one cyclical episode, but there are many others.  I myself draw more instruction from the depression of 1920-21, a slump as ugly and steep in its way as that of 1929-33, but with the simple and interesting difference that it ended.  Top to bottom, spring 1920 to summer 1921, nominal GDP fell by 23.9%, wholesale prices by 40.8% and the CPI by 8.3%.  Unemployment, as it was inexactly measured, topped out at about 14% from a pre-bust low of as little as 2%.  And how did the administration of Warren G. Harding meet this macroeconomic calamity?  Why, it balanced the budget, the president declaring in 1921, as the economy seemed to be falling apart, “There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures.”  And the fledgling Fed, face to face with its first big slump, what did it do?  Why, it tightened, pushing up short rates in mid-depression to as high as 8.13% from a business cycle peak of 6%.  It was the one and only time in the history of this institution that money rates at the trough of a cycle were higher than rates at the peak, according to Allan Meltzer.

But then something wonderful happened: Markets cleared, and a vibrant recovery began.  There were plenty of bankruptcies and no few brickbats launched in the direction of the governor of the New York Fed, Benjamin Strong, for the deflation that cut an especially wide and devastating swath through the American farm economy.  But in 1922, the first full year of recovery, the Fed’s index of industrial production leapt by 27.3%.  By 1923, the unemployment rate was back to 3.2%.  The 1920s began to roar.

And do you know that the biggest nationally chartered bank to fail during this deflationary collapse was the First National Bank of Cleburne, Texas, with not quite $2.8 million of deposits?  Even the forerunner to today’s Citigroup remained solvent (though for Citi, even then it was a close-run thing, on account of an oversize exposure to deflating Cuban sugar values).  No TARP, no starving the savers with zero-percent interest rates, no QE, no jimmying up the stock market, no federal “stimulus” of any kind.  Yet-I repeat-the depression ended.  To those today who demand ever more intervention to cure what ails us, I ask: Why did the depression of 1920-21 ever end?  Given the policies with which the authorities treated it, why are we still not ensnared?

If you object to using the template of 1920-21 as a guide to 21st-century policy because, well, 1920 was a long time ago, I reply that 1929 was a long time ago, too.  And if you persist in objecting because the lessons to be derived from the Harding depression are unthinkably at odds with the lessons so familiarly mined from the Hoover and Roosevelt depression, I reply that Harding’s approach worked.  The price mechanism is truer and enterprise hardier than the promoters of radical 21st-century intervention seem prepared to acknowledge.

In notable contrast to the Harding method, today’s policies seem not to be working.  We legislate and regulate and intervene, but still the patient languishes.  It’s a worldwide failure of the institutions of money and credit.  I see in the papers that Banca Monte dei Paschi di Siena is in the toils of a debt crisis.  For the first time in over 500 years, the foundation that controls this ancient Italian institution may be forced to sell shares.  We’ve all heard of hundred-year floods.  We seem to be in a kind of 500-year debt flood.

Many now call for more regulation-more such institutions as the Treasury’s brand-new Office of Financial Research, for instance.  In the March 8 Financial Times, the columnist Gillian Tett appealed for more resources for the overwhelmed regulators.  Inundated with information, she lamented, they can’t keep up with the institutions they are supposed to be safeguarding.  To me, the trouble is not that the regulators are ignorant.  It’s rather that the owners and managers are unaccountable.

Once upon a time-specifically, between the National Banking Act of 1863 and the Banking Act of 1935-the impairment or bankruptcy of a nationally chartered bank triggered a capital call.  Not on the taxpayers, but on the stockholders.  It was their bank, after all.  Individual accountability in banking was the rule in the advanced economies.  Hartley Withers, the editor of The Economist in the early 20th century, shook his head at the micromanagement of American banks by the Office of the Comptroller of the Currency-25% of their deposits had to be kept in cash, i.e., gold or money lawfully convertible into gold.  The rules held.  Yet New York had panics, London had none.  Adjured Withers: “Good banking is produced not by good laws but by good bankers.”

Well said, Withers!  And what makes a good banker is more than skill.  It is also the fear of God, or, more specifically, accountability for the solvency of the institution that he or she owns or manages.  To stay out of trouble, the general partners of Brown Brothers Harriman, Wall Street’s oldest surviving general partnership, need no regulatory pep talk.  Each partner is liable for the debts of the firm to the full extent of his or her net worth.  My colleague Paul Isaac, who is with me today-he doubles as my food and beverage taster-has an intriguing suggestion for instilling the credit culture more deeply in our semi-socialized banking institutions.

We can’t turn limited liability corporations into general partnerships.  Nor could we easily reinstate the so-called double liability law on bank stockholders.  But what we could and should do, Paul urges, is to claw back that portion of the compensation paid out by a failed bank in excess of 10 times the average wage in manufacturing for the seven full calendar years before the ruined bank hit the wall.  Such a clawback would not be subject to averaging or offset one year to the next.  And it would be payable in cash.

The idea, Paul explains, is twofold . First, to remove the government from the business of determining what is, or is not, risky-really, the government doesn’t know.  Second, to increase the personal risk of failure for senior management, but stopping short of the sword of Damocles of unlimited personal liability.  If bankers are venal, why not harness that venality in the public interest?  For the better part of 100 years, and especially in the past five, we have socialized the risks of high finance.  All too often, the bankers who take risks don’t themselves bear them.  By all means, let the capitalists keep the upside.  But let them bear their full share of the downside.

In March 2009, the Financial Times published a letter to the editor concerning the then novel subject of QE.  “I can now understand the term ‘quantitative easing,’ wrote Gerald B. Hill of Stourbridge, West Midlands, “but . . . realize I can no longer understand the meaning of the word ‘money.'”

There isn’t time, in these brief remarks, to persuade you of the necessity of a return to the classical gold standard.  I would need another 10 minutes, at least.  But I anticipate some skepticism.  Very well then, consider this fact: On March 27, 1973, not quite 39 years ago, the forerunner to today’s G-20 solemnly agreed that the special drawing right, a.k.a. SDR, “will become the principal reserve asset and the role of gold and reserve currencies will be reduced.”  That was the establishment- i.e., you-talking.  If a worldwide accord on the efficacy of the SDR is possible, all things are possible, including a return to the least imperfect international monetary standard that has ever worked.

Notice, I do not say the perfect monetary system or best monetary system ever dreamt up by a theoretical economist.  The classical gold standard, 1879-1914, “with all its anomalies and exceptions . . . ‘worked.'”  The quoted words I draw from a book entitled, “The Rules of the Game: Reform and Evolution in the International Monetary System,” by Kenneth W. Dam, a law professor and former provost of the University of Chicago.  Dam’s was a grudging admiration, a little like that of the New York Fed’s own Arthur Bloomfield, whose 1959 monograph, “Monetary Policy under the International Gold Standard,” was published by yourselves.  No, Bloomfield points out, as does Dam, the classical gold standard was not quite automatic.  But it was synchronous, it was self-correcting and it did deliver both national solvency and, over the long run, uncanny price stability.  The banks were solvent, too, even the central banks, which, as Bloomfield noted, monetized no government debt.

The visible hallmark of the classical gold standard was, of course, gold-to every currency holder was given the option of exchanging metal for paper, or paper for metal, at a fixed, statutory rate.  Exchange rates were fixed, and I mean fixed.  “It is quite remarkable,” Dam writes, “that from 1879 to 1914, in a period considerably longer than from 1945 to the demise of Bretton Woods in 1971, there were no changes of parities between the United States, Britain, France, Germany-not to speak of a number of smaller European countries. ” The fruits of this fixedness were many and sweet.  Among them, again to quote Dam, “a flow of private foreign investment on a scale the world had never seen, and, relative to other economic aggregates, was never to see again.”

Incidentally, the source of my purchased copy of “Rules of the Game” was the library of the Federal Reserve Bank of Atlanta.  Apparently, President Lockhart isn’t preparing, as I am-as, may I suggest, as you should be-for the coming of classical gold standard, Part II. By way of preparation, I commend to you a new book by my friend Lew Lehrman, “The True Gold Standard: A Monetary Reform Plan without Official Reserve Currencies: How We Get from Here to There.”

It’s a little rich, my extolling gold to an institution that sits on 216 million troy ounces of the stuff.  Valued at $42.222 per ounce, the hoard in your basement is worth $9.1 billion.  Incidentally, the official price was quoted in SDRs, $35 to the ounce-now there’s a quixotic choice for you.  In 2008, when your in-house publication, “The Key to the Gold Vault,” was published, the market value was $194 billion.  Today, the market value is $359 billion, which is encouraging only if you personally happen to be long gold bullion.  Otherwise, it strikes me as a pretty severe condemnation of modern central banking.

And what would I do if, following the inauguration of Ron Paul, I were sitting in the chairman’s office?  I would do what I could to begin the normalization of interest rates.  I would invite the Wall Street Journal’s Jon Hilsenrath to lunch to let him know that the Fed is now well over its deflation phobia and has put aside its Atlas complex. “It’s capitalism for us, Jon,” I would say.  Next I would call President Dudley. “Bill,” I would say, pleasantly, “we’re not exactly leading from the front in the regulatory drive to reduce the ratio of assets to equity at the big American financial institutions.  Do you have to be leveraged 89:1?”  Finally, I would redirect the efforts of the brainiacs at the Federal Reserve Board research division.  “Ladies and gentlemen,” I would say, “enough with ‘Bayesian Analysis of Stochastic Volatility Models with Levy Jumps: Application to Risk Analysis.’  How much better it would please me if you wrote to the subject, ‘Command and Control  No More: A Gold Standard for the 21st Century.'”  Finally, my pièce de résistance, I would commission, staff and ceremonially open the Fed’s first Office of Unintended Consequences.

Let me thank you once more for the honor that your invitation does me.  Concerning little Grant’s and the big Fed, I will quote in parting the opening sentences of an editorial that appeared in a provincial Irish newspaper in the fateful year 1914. It read: “We give this solemn warning to Kaiser Wilhelm: The Skibbereen Eagle has its eye on you.”

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Standard & Poor’s Downgrades Spanish Debt

Posted by Steve Markowitz on April 26, 2012

The Wall Street Journal reported after the markets closed that Standard & Poor’s (S&P) downgraded Spain’s bonds two notches from A to BBB+.  This will likely lead to increased borrowing cost for Spain, a country that cannot afford to pay back its loans even before any increase in interest costs.

Before the 2008economic downturn hit, Spain had the highest debt rating of AAA.  Its continually sliding bond ratings is a similar theme that has hit many Western countries, including one downgrade the United States’ debt.

Spain and other highly indebted countries will not be able to repay a significant portion of their sovereign debt.  European governments are attempting to forestall this reality by printing money and bailouts.  However, as they kick the can down the road, each sovereign debt crisis is increasing in significance.  While Greece was a canary in the mine for sovereign debt problems, there are bigger one still to come.

Under more typical economic times, equity and bond markets worldwide would be reacting quite negatively to the sovereign debt problems.  However, the moral hazard has been broken with the myriad of government interventions worldwide in recent years.  As a result, equity markets are back to pre-meltdown levels and are likely becoming a new bubble that when popped, will cause other unintended consequences.

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