How Quantitative Easing Destroys Jobs

November 19, 2010

On Wednesday Fed chair Ben Bernanke met with senators in a closed-door session. Bernanke said that he “remains absolutely committed to not letting inflation or inflationary expectations get out of control.” “Alabama Senator Richard Shelby, the senior Republican on the Banking Committee, said Bernanke cited an estimate that the program may help create 700,000 to 1 million jobs.”

Of course, if simply printing money could create jobs, without creating inflation, we would all be rich. Unfortunately, the Fed’s quantitative easing is likely to destroy jobs.

This morning Lands’ End sent me an e-mail announcement of their latest sale. One part of the sale caught my eye—spend $250 and receive $100 off with free shipping. This 40% off offer included any items already on sale.

Lands’ End can only dream of the good old days when their sales ran only at the end of the season. Winter clothes would not go on sale until January. And now, here we are the week before Thanksgiving, and everything is at least 40% off.

This is probably a pretty good harbinger of how consumer spending will go this holiday season. With that in mind, consider this Bloomberg News story from earlier this week:

Gap Inc., J.C. Penney Co. and other U.S. retailers may have to pay Chinese suppliers as much as 30 percent more for clothes as surging cotton prices boost costs.

“It’s a little terrifying to deal with cotton suppliers now,” said Vicky Wu, a sales manager at Suzhou Unitedtex Enterprise Ltd., a closely held, Jiangsu province-based clothes maker that counts Gap and J.C. Penney among its clients.

Cotton futures in China have surged more than 70 percent this year and were at a record earlier as the global economy emerged from recession, allowing people to spend more on clothes. Production of the fiber in China, the world’s biggest user and importer, is forecast to lag behind demand for a 12th year, cutting its stockpile to the smallest since 1995, according to the U.S. Department of Agriculture.

To be sure, there are wide differences of opinion about the impact of Fed policy; but most analysts believe that the rise in commodity prices this year is a new asset bubble created by anticipation of the Fed’s policy of quantitative easing. And the effect on Lands’ End is clear.

Do you think Lands’ End is going to be able to raise prices and pass along their increased costs? I don’t. If they had that pricing power they would not already be running 40% off sales. Instead their margins are going to get squeezed by rising commodity prices. Lands’ End will cut back in other ways—they may lay off staff and downsize.

Of course, I could be wrong. Commodity prices may crash from here. If so, we will hear news stories about the financial institutions and hedge funds that made incorrect bets. We will be told we need to bail them out for our own good. Or perhaps commodity prices will stay high; perhaps Lands’ End has pricing power that I’m not aware of. They could then increase prices of their clothing. In the face of declining real incomes, what will the average American household do? Will they decrease their spending still further, or will they increase their credit card balances to finance their clothing purchases? I would bet spending decreases. Then quantitative easing will have had the effect of chilling the economy.

Lands’ End will not be the only organization caught between understandably tightwad consumers and rising commodity prices.  If they are forced to lay off workers, they will not be the only firm to do so. Thanks to the Fed, for commodities traders and hedge funds specializing in commodities, 2010 may be a good year; for the average American, not so much.

Who Gets the Pie?

October 27, 2010

Suppose a family of four was setting down to desert after dinner; a pie is cut into eight equal pieces. Each member of the family received two slices. Now, suppose one member of the family said, “Let’s create eight additional slices and split the pie into sixteen equal pieces.” Clearly, if each member of the family received four slices there would be no practical reason (other than a smaller serving size) to create the additional slices. The amount of pie each family member received would be exactly the same.

Suppose that the pie cutting member of the family has an ulterior motive. He wants more pie at the expense of everyone else. So after slicing the pie sixteen ways, he gives everyone the same two slices they previously had and keeps the eight additional slices for himself. Someone in the family might remark, “My slice of pie is smaller and less filling.”  “No, you are mistaken,” he lies. “You are receiving the same amount of pie you always have.”

This little story gives us insights as to why the Federal Reserve inflates the supply of money. Have you been trying to make sense of the incessant claims by policymakers and some economists that in order to save the economy the Federal Reserve has to engage in a new round of quantitative easing? The Fed tells us that our inflation targets may be too low and may need to be increased. You might be asking yourself the obvious question—how would more inflation help the economy?

The answer is, it won’t. In the pie example, after cutting the pie in eight pieces, each of the four people expected two slices. If you cut the pie into sixteen slices and gave everybody four slices, increasing the number of pie slices will have no effect. But when people expect two slices, if the pie cutter increases the number of pie slices to sixteen, the pie cutter will have slices to keep for himself or to give to other favored pie eaters—increasing the number of pie slices has an effect. And that is exactly what the Federal Reserve does. When the Fed increases the supply of money and credit, the new money is not injected equally throughout the economy. For some, due to inflation, their slice of the pie shrinks; others get more.

Admittedly my pie analogy is simplistic. I use it to help cut through the idea that we should leave policy to the experts. But how can an expert like Ben Bernanke be so wrong? Some say he is an innocent Chauncey Gardner character; others believe he is simply a puppet whose strings are pulled by his banking masters. The more likely explanation is that Ben Bernanke is who he seems—a bright but limited man being guided by incorrect theories that have taught him that bright men can and should control the economy.  The end result of our hubris will be suffering on a larger scale than we can imagine. No, our is not a typo—it is our collective hubris that empowers Bernanke’s personal hubris.

Regardless of Bernanke’s motives the question remains: who is getting the new slices of pie? Here are some recent examples:

This week the New York Times reported that “the real wage and salary income of finance industry employees based in Manhattan rose nearly 20 percent in the first quarter of this year. That surge helped make Manhattan the fastest-growing county in the United States in terms of terms of year-over-year gains in income.”

This week when asked about receiving bags of cash from Iran, Afghanistan  President Hamid Karzai said “This is normal…The U.S. gives us large bundles of cash as well.”

Of course, asset bubbles form as new money is injected in explosive amounts. Grain prices and other commodities have increased sharply with wheat and corn both up over 50% this year. If firms try to pass on their higher costs through higher prices, family budgets feel the pressure of the increase. When firms are unable to raise prices due to market pressure, they feel increased pressure to reduce labor costs and unemployment increases.

Bloomberg reported yesterday on the Fed-induced  bubble in junk bonds: “The lowest-rated junk bonds are the most expensive corporate debt following a Federal Reserve- induced rally in high-risk assets, adding to concern fixed- income securities are overvalued.” No doubt after this bubble bursts, “for our own good,” we will be giving our pie to those who recklessly invested again.

Yet, we are told, if not for the heroic efforts of Ben Bernanke, we would have a terrible depression and no pie at all. Of course, a clear thinking child could see through the lies. A child might ask: “Has Ben Bernanke created even one new pie?” The answer, of course, is “no”—his policies have helped to redistribute the pie: Ordinary Americans who are not subsidized have given their share of the pie to the financial services industry, to contractors waging war in Afghanistan, to General Motors, to junk bond investors, and you name it.

This is an uncomfortable post to write. I have always taught that free market economies expand the supply of the proverbial pie. On a free market, there is no reason to see the world through win-lose eyes. Yet, we no longer have anything resembling a free market. For many Americans, their share of the pie is now contracting; a new round of quantitative easing will only reduce their share of the pie further.

As Bernanke Takes His Victory Lap

August 30, 2009

Conventional wisdom is nearly unanimous: Ben Bernanke has saved the world. Last week, bullish sentiment in stocks, as measured by the Daily Sentiment Index, exceeded 89%; the Intelligent Advisors survey found less than 20% bears.

Isn’t this great news for the economy? On the contrary, extreme sentiments usually coincide with major stock market reversals. The Daily Sentiment Index is higher than it was in October, 2007, when the stock market made its all time high—such an extreme reading now is an alarm signal.

How can so many people be so wrong? Conventional wisdom can be dangerously wrong. Professionals often go along with the crowd. Why? Professionals in any field have similar training, similar socialization, and similar views of the world. In time, when they are proven to have been wrong, they chant the big lie, “No one else saw this either.”

Think of other knuckleheaded expert advice you’ve heard recently. We are entering the flu season; more and more studies confirm that deficiencies of Vitamin D are associated with depressed immunological systems.  Still, many doctors advise sunscreen. (No, I’m not advising sunbathing. When the sun shines, get out for your normal activities.) Do you remember when experts assured us that housing prices could only go up? Weren’t we all told that ethanol was good for the environment? It was going to solve our energy problems, wasn’t it? Perhaps you grew up with “expert” nutritional advice to eat margarine with “healthy” hydrogenated vegetable oil and drink four glasses of artery-clogging milk a day.  This summer, were you impressed by the Food and Drug Administration (FDA) expert pronouncement that silver mercury fillings are safe, even for children and pregnant women? Did you think, “Oh, silly me for switching to composite fillings”?

Last week, as President Obama nominated Ben Bernanke for another term, he described Bernanke as approaching the crisis “with calm and wisdom, with bold action and out-of-the-box thinking.”

What is wisdom? In their book Sanity, Insanity and Common Sense Rick Suarez, Roger Mills, and Darlene Stewart write:

Wisdom is a level of intelligence, innate in every human being, which is deeper and more comprehensive than what we associate with an IQ score. Wisdom exists outside of individualized frames of reference, which is why it has not been more readily realized by a humanity that is wedded to fixed patterns of thinking and perceptions of reality. When wisdom is realized by an individual, it frees him from his own fixed views of life…

In short, we are not the source of wisdom; wisdom sets us free from our in-the-box thinking. The authors add:

Wisdom cannot be realized through mental struggle of the intellectual process of trying to figure out problems. The reason that wisdom is not more frequently recognized is that human beings have traditionally idolized intellectual and analytical reasoning, and wisdom does not come from these thought patterns.

Ben Bernanke may have a high IQ, but he is in-the-box. In-the-box thinkers see things in systemically distorted ways.  A wise person doesn’t pour unprecedented levels of credit on a problem caused by excessive credit.

Ben Bernanke is not wise. A wise man recognizes a problem and the false beliefs behind it. As late as 2006, Ben Bernanke didn’t recognize the housing bubble. A wise man—because he sees but doesn’t share delusions—offers the world the keys to a fresh start, if that is what people desire.

Out-of-the-box thinkers do not become Fed chairs. Ben Bernanke is a man of his time. He is a manifestation of the collective delusion, held by the public, that it is possible to get something for nothing. If Ben Bernanke were not on the stage, does anyone doubt that many other functionaries would stand-in to play his part, ready to do the same in-the-box job?

In a few weeks, Ron Paul’s out-of-the-box book End the Fed will be published. Read the book for yourself; decide whether Paul or Bernanke is the wise man. Paul’s training was in medicine, and he practiced as a physician. As an avocation he studied economics. After all, does not a member of Congress have an obligation to be economically literate? The branch of economics Paul studies is the Austrian school—a branch of economics which long ago developed theories to explain how business cycles are distorted by central banks as they manipulate the money supply and interest rates.

Before this bear market is over, Ron Paul may be considered wise by many people; Ben Bernanke may be disgraced. My prediction implies a happy ending. Unfortunately, things are not that simple. A deep economic crisis produces wise men, but it also produces demagogues. People angry their dreams of something for nothing are not fulfilled will support demagogues. Those willing to change their “fixed patterns of thinking” will listen to solutions proposed by the wise. Our collective choice will determine the future of America.

Invasive Species

March 18, 2009

Lyn Gerner is a film maker who specializes in documentaries. Her short documentary Trouble in the Tropics: Invasive Lionfish is a visually beautiful and educational film.

No one is sure how the lionfish, “venomous and voracious, “was introduced to the Bahamas; but with no known natural predators, the lionfish has the potential to do grave damage to the ecosystem of the western Atlantic.

What to do is unclear. However, no one is proposing that the solution to too many lionfish is to introduce even more lionfish. No one is proposing introducing more lionfish, because everyone understands that would be absurd. If only our collective knowledge of economics was as high as our collective knowledge of the natural world.

Consider the powers of the Federal Reserve. Unlike the lionfish dilemma, many in the public believe that the solution to problems caused by the Fed is to give the Fed even more powers. The public accepts these expanded powers because they do not yet understand that, like the lionfish, the Federal Reserve is an invasive species.

Did the Fed evolve as part of the natural order of the market or, like the lionfish, was it unnaturally introduced into a stable “ecosystem”? Supporters of the Fed argue that it is an essential intervention designed to stabilize inherently unstable financial markets.  But is it? First, consider the origin of money as explained by Murray Rothbard in The Case Against the Fed:

It is impossible to understand money and how it functions, and therefore how the Fed functions, without looking at the logic of how money, banking, and Central Banking, developed. The reason is that money is unique in possessing a vital historical component. You can explain the needs and the demand for everything else: for bread, computers, concerts, airplanes, medical care, etc;  solely by how these goods and services are valued now by consumers. For all of these goods are valued and purchased for their own sake. But “money,” dollars, franks, lira, etc; is purchase and accepted in exchange not for any value the paper tickets have per se but because everyone expects that everyone else will accept these tickets in exchange. These expectations are pervasive, because the tickets have indeed been accepted in the immediate and more remote past…

Money, did not and can never could begin by some arbitrary social contract, or by some government agency decreeing that everyone has to accept the tickets it issues. Even coercion cannot force people and institutions to accept meaningless tickets that they had not heard of or that bore no relation to any other pre-existing money. Money arises on the free market, as individuals on the market try to facilitate the vital process of exchange.

Historically, gold and silver displaced other commodities—such as tobacco, sugar, copper, and tea—as the universal medium of exchange. The dollar, the pound—paper currencies—were paper tickets but they did signify a certain weight of gold or silver. In the United States until 1933, there was paper currency in the form of gold certificates that were redeemable in gold; and until 1964, there was paper currency in the form of silver certificates that were redeemable in silver. Now, all U.S. currency is fiat currency and cannot be redeemed for gold or silver; it has value only because the public continues to believe it has value.

In the past year, the Fed has rapidly expanded the supply of money in an attempt to add more credit into the market. As I have pointed out in many previous posts, the cure to correct a bursting credit bubble cannot be more credit. In his book Meltdown, Thomas Woods observes that, “The Fed has no real resources to inject into the economy. Credit has to derive from real, saved resources. Nothing can be lent that someone has not first saved.”

In other words, real growth occurs when savings increase. Yet, we are told by President Obama, Fed chair Bernanke, and Secretary Geithner that we need to spend rather than to save. I’m sure we will soon be told that savers are unpatriotic. Yet ignorance proclaimed behind the bully pulpit is still ignorance. As Woods puts it, “All the monetary manipulation in the world cannot defy the constraints mercilessly imposed by reality.”

Like lionfish multiplying in the western Atlantic, the Fed is multiplying paper in the economy—neither is native to their respective environments. The results will be equally catastrophic.

Sweet Are the Uses of Adversity

December 22, 2008

In Shakespeare’s As You Like It, Duke Senior, his throne usurped, has been exiled into the Forest of Arden. Even so, life is not all bad he allows, for “sweet are the uses of adversity.” Duke Senior does not say he’s glad for adversity, but he would prefer to use his adverse circumstances wisely rather than to sit around complaining.

As a nation we can begin the process of using our adverse circumstances wisely. Government, at all levels, counts on the ignorance of the public in order to be able to continue their disastrous policies. Let us begin the process of remedying deficiencies in our own education. Monetary policy make headlines almost daily, and I urge everyone to read and study Murray Rothbard’s classic What Has Government Done to Our Money? This monograph is available online for a free download at the Ludwig von Mises Institute.

We are continually told the nonsense that the cure for the bursting of our credit bubble is an unprecedented flood of new money and credit. Can simply increasing the money supply cure our economic woes and restore prosperity? Common sense tells us that it cannot, and Murray Rothbard explains why:

When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future. The discovery of new, fertile land or natural resources also promises to add to living standards, present and future. But what about money? Does an addition to the money supply also benefit the public at large?…

Whereas new consumer or capital goods add to standards of living, new money only raises prices–i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value. Other goods have various “real” utilities, so than an increase in their supply satisfies more consumer wants. Money has only utility for prospective exchange; its utility lies in its exchange value, or “purchasing power.” Our law—that an increase in money does not confer a social benefit—stems from its unique use as a medium of exchange.

Yes, it is true that prices for most goods are not rising right now, but they are not falling as rapidly as they would otherwise be falling. Government who purports to be an advocate of affordable housing is desperately trying to stop housing prices from deflating and, in the process, is keeping housing out the hands of those who were prudent savers. Chrysler cars will sell at some price—that price may be 50% or more off—but why is Chrysler any different than your local clothing store where clothing is being marked-down 80%? Eventually, because of excess money creation, we may get the worst of all worlds—depression followed by hyperinflation.

So why is the Fed doing what it is doing? If new money is not a cure, why pump up the money supply at all? The key to understanding the Fed’s actions is the fact that the new money is not distributed equally to all of us; and those who do get it do not receive it at the same time. Despite Ben Bernanke’s nickname of “Helicopter Ben”—derived from a famous speech he gave that the Fed could spread money around through a helicopter drop—the Fed would never spread money around by a helicopter drop. New money always goes to benefit the Fed’s politically connected cronies, and it is not distributed equally.

Who are these cronies? Consider this report from Associated Press: “Banks that are getting taxpayer bailouts awarded their top executives nearly $1.6 billion in salaries, bonuses, and other benefits last year.” These banks have so far received $188 billion in taxpayer’s money. Among the other findings:

Lloyd Blankfein, president and chief executive officer of Goldman Sachs, took home nearly $54 million in compensation last year. John A. Thain, chief executive officer of Merrill Lynch, topped all corporate bank bosses with $83 million in earnings last year. J P Morgan Chase chairman James Dimon ran up a $211,182 private jet travel last year when his family lived in Chicago and he was commuting to New York. The company got $25 billion in bailout funds.

I could go on and on, but who is not getting the money? Probably those of us reading this blog post are not being bailed-out, but at least we have shelter and food. The LA Times recently reported on the growing homeless crisis in Los Angeles with poignant examples: “The father who pretends to work through the night at a computer at a 24-hour office supply center so his child can sleep safe and warm in a stroller…the mother who takes a baby to the emergency room at 11 p.m., knowing the odds are they won’t be called until morning and can pass the night in the waiting room.”

There are many more stories that appear every day, and they are heartbreaking. How can this be America? Trillions transferred from the middle class and poor to the incompetent, stupid, and criminal among the wealthy. I don’t believe in an Old Testament God that punishes nations and individuals for their misdeeds, but I do believe that individuals and nations that fall out of step with the principles of liberty suffer the natural consequences.

We all need to contribute in our own way to those who are suffering—direct contributions of food and clothing are important—but long-term, the only way out is education that corrects our mis-education. Please read What Has Government Done to Our Money?

What Really is Sustainable?

October 27, 2008

Today, the Bush administration announced that it has had talks with GM, Ford, and Chrysler about providing additional taxpayer money to the automakers beyond the $25 billion already announced.

Last week, Consumer Reports announced its annual automobile reliability rankings. The Chrysler Sebring was rated as Consumer Reports’ least reliable car and Chrysler’s offerings clustered at the bottom of Consumer Reports’ rankings. In contrast, Ford had almost caught up to Honda and Toyota in reliability.

Chrysler has made horrible cars for many years and would have failed long ago if the government had not bailed them out in 1979. That they are still in business takes away sales from Ford and GM and helps poison consumers’ views of the quality of American cars. Chrysler’s business model is simply not sustainable, nor is throwing more good money after bad.

The best thing for the American automobile industry would be reduced capacity and higher quality products. A bankruptcy at Chrysler would be a good first step. With GM angling to buy Chrysler and government bailouts on the horizon, of course, the inevitable will be postponed. In the meantime, the taxpayer will be bled some more.

Also today, the Fed announced that it will begin to buy commercial paper. Commercial paper is short-term debt that companies use to help finance their operations. The Fed said it will not cap the total amount it lends out; and at this point, who will be the recipients of more taxpayer handouts is unclear.

To illustrate why this is insanity, let’s take the examples of three retailers: Circuit City, Crutchfield, and Costco. Circuit City is an electronics retailer with a web presence. Crutchfield is a large electronics retailer who sells exclusively online. Costco is an upscale warehouse chain that sells electronics too, among other things. Circuit City will likely go bankrupt while Crutchfield and Costco are likely to survive and even thrive in the coming depression.

In 2007, Circuit City became famous for firing 3400 “overpaid” sales clerks. Now, who did Circuit City consider overpaid? They were sales clerks earning an average of $12-$15 an hour. Of course, Circuit City’s already poor service became even worse. All well and good, as long as consumers were spending their home-equity lines of credit and buying new, big-screen sets. As long as the economy was good, consumers were all too willing to add to their purchase an overpriced, extended warranty and fancy, high-profit connecting cables. Like subprime mortgages, this was an unsustainable business model. Like the subprime industry, Circuit City deserves to go out of business, without the Fed hindering this process.

Contrast Circuit City with Crutchfield. Here is what the CEO of Crutchfield recently had to say:

For many years, I have been concerned about the growing credit bubble. It was obvious to me that it was unsustainable and that an inevitable day of reckoning would come. To protect our customers, our employees, and my family from the disastrous consequences of a financial meltdown, I positioned Crutchfield to withstand the worst. We became very frugal with how we spent money. We did not pay outlandish executive salaries and bonuses. We did not build fancy facilities. We did not expand our retail store operations. And we did not buy other companies. Instead, we worked extremely hard to improve how we serve our customers, while we managed every aspect of our business with excellence. Furthermore, we paid off all of our debt and accumulated cash reserves.

Or, contrast Circuit City with Costco. Here is what the CEO of Costco, Jim Sinegal, recently had to say in response to why Costco pays their workers on average $17 an hour and covers 90% of the health care costs:

You have to recognize — and I don’t mean this in an acrimonious sense — that the people in that business are trying to make money between now and next Thursday. We’re trying to build a company that’s going to be here 50 and 60 years from now. We owe that to the communities where we do business. We owe that to our employees, that they can count on us for security. We have 140,000 employees and their families; that’s a significant number of people who count on us. We owe it to our suppliers. Think about the people who produce products for us — you could probably multiply our family of employees by three or four times. And we owe it to our customers to continue to offer good prices. Our presence in a community makes pricing better throughout that community because when you have a tough competitor in the marketplace, prices come down.

Crutchfield and Costco have sustainable business models—Circuit City does not. Sustainability has become a new, business buzz word. Bailouts hinder—rather than promote—sustainable business models.

Two Cheers and a Jeer

October 23, 2008

First the jeer: Congressman Barney Frank’s ignorance of the basic laws of economics is hard to beat and he is a “superstar” among the ignorant. Recently on CNBC he said:

I think at this point, there needs to be a focus on an immediate increase in spending and I think this is a time when deficit fear has to take a second seat. I do think this is a time for a kind of very important dose of Keynesianism. I believe later on there should be tax increases. Speaking personally, I think there are a lot of very rich people out there whom we can tax at a point down the road and recover some of this money.

Many, of very modest means, are going to be surprised in coming years when they are considered “rich.”

Andrew Lahde is a hedge fund manager who made an 866% gain last year by betting on the subprime mortgage collapse before shutting down his fund. In his farewell letter to his investors he contemptuously explains who was on the other side of his trades:

I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

Lahde is also giving us an explanation why many have been so viscerally opposed to the bailout. One function of the market is to separate those, including the rich and stupid, from their money when they make bad investments that damage the economy. Government’s role is not to bailout them out at the expense of everyone else. Until this year, America never had an aristocracy.

In his Wall Street Journal essay “The Confidence Game” James Grant explores among other things the “conceit” of central bankers who thought they could manage the economy. Grant writes:

But it wasn’t the vigilance of monetary policy that facilitated the construction of the tree house of leverage that is falling down on our heads today. On the contrary: Artificially low interest rates, imposed by the Federal Reserve itself, were one cause of the trouble. America’s privileged place in the monetary world was — oddly enough — another. No gold standard checked the emission of new dollar bills during the quarter-century on which the central bankers so pride themselves. And partly because there was no external check on monetary expansion, debt grew much faster than the income with which to service it. Since 1983, debt has expanded by 8.9% a year, GDP by 5.9%. The disparity in growth rates may not look like much, but it generated a powerful result over time. Over the 25 years, total debt — private and public, financial and non-financial — has risen by $45.1 trillion, GDP by only $10.9 trillion. You can almost infer the size of the gulf by the lopsided prosperity of the purveyors of debt. In 1983, banks, brokerage houses and other financial businesses contributed 15.8% to domestic corporate profits. It’s double that today.

Grant rightfully brings up the gold standard. When bringing back the gold standard is part of mainstream conversation, we may be close to the end of this crisis. That day is at least years, if not decades, away.

It’s The End of the World As We Know It

September 21, 2008

There can be no prosperity without freedom. For now, and perhaps for decades to come, America’s best days are behind us.

For Americans who are economically literate, the events of this week are as significant as those of 9/11. The proverbial tanks have rolled in America this week in a bloodless coup. This is the end of America as we have known it. This country was built on the supremacy of rule of law, on the sanctity of contracts and property rights, on individual liberty, and on trust that most people will keep their word. For now, that America has ended.

I have told my students for years that when fears of economic troubles increase, politicians will be ready to exploit those fears. The public and the media seem collectively ready to justify the end of America that we have known; they are hypnotizing themselves with the mantra “it would have been so much worse if the Bernanke and Paulson had done nothing.”

A public that has lost touch with the principles that promote liberty and prosperity will always trade away freedom for the illusion of security. And they will wind up with neither freedom nor economic security. That day of reckoning has arrived.

Let’s make a few things very clear. The failure of the housing market, AIG, Fannie Mae, Lehman etc. is not what is damaging the economy; the damage to the economy occurred during the boom. The artificially cheap credit policy pursued by the Fed under Greenspan and Bernanke did the invisible (during the boom) damage. The failures we are experiencing today are the consequences of the distortions created in the boom.

Too many houses were built, mortgages were issued to those unqualified to receive them, housing prices were driven to unattainable levels, and Wall Street and the banks bought and sold these mortgages. Wall Street and the banks acted as if housing prices would go up forever and bailout them out of their mistakes. Cheap credit allowed Ford, GM, and Chrysler to sell enough cars to be complacent—complacent enough to not truly innovate and be competitive.

I could go on, but you get the picture. What we are now experiencing is the liquidation of damages that have already occurred—we are in the credit contraction part of the cycle. Again—the problem is not housing foreclosures, Lehman Brothers, etc. These are symptoms of what the Fed, fractional reserve banking, and out of control Congressional spending had already wrought.

The analogy of an alcohol or drug addict is helpful. The damage to the addict occurs when he is taking cocaine, heroin, or alcohol. When he is off his high he is recovering form the previous damage. No matter how much he screams for more drugs or alcohol, no reputable treatment center would supply him with more.

Those who have benefited by the past excesses are now screaming for more drugs in the form of cheap credit and bailouts. The amount of bailouts that our essentially bankrupt government is promising is staggering—it will easily run over a trillion of dollars. The productive sectors of the economy will be forced to foot the bill—we’ll be forced to throw good money after bad.

Again, let’s be clear. These bailouts will not save us from the terrible times ahead. The damage to the economy has already been done, and we are now transferring the good money of productive taxpayers into the hands of those who wrecked the economy. As Lila Rajiva, coauthor of the excellent Mobs, Messiahs and Markets, colorfully wrote, the attempt to portray the interests of Wall Street and Main Street as exactly the same is false:

We, of course, need to do nothing. There is no we here. This is a Wall Street crisis. And the usual suspects on Wall Street need to line up, bend over and get caned for their misdeeds. Barring that, they need to take the market’s medicine like men.

Instead, they were out in full therapeutic mode, pouting and whining for a change of their soggy diapers by dear Nanny Washington.

Andrew Jeffrey writing in Minyanville colorfully explains why the failures on Wall Street need to be liquidated and not subsidized:

When government invades free markets to the extent it has – specifically in the last 24 hours — the system ensuring capital gets where it needs to be breaks down. Money is instead doled out to the firms well connected enough in Washington to lobby for handouts.

Beltway bureaucrats have been trying to rewrite this country’s economic rules and protect Wall Street from its own mistakes for over a year. Still, the free market prevailed, punishing the firms that made the most egregious bets during the housing boom: Countrywide, Bear Stearns, IndyMac, Merrill Lynch (MER), AIG (AIG), Lehman Brothers, National City (NCC), Washington Mutual (WM) and Wachovia (WB).

According to our once-free market, these firms needed to be wiped out, gobbled up and liquidated, so real economic growth could take hold from a stronger foundation.

The bailouts of the incompetent and corrupt may work for a while—read “a while” as in weeks or months—but then the inevitable will begin again.

When the stock market decline resumes, the ban on short selling will cause prices to fall even more than they would have otherwise. (More on short selling in another post.) Welcome to a no growth, capital starved economy of shrinking opportunity.

Jeffrey Tucker in his excellent essay The Rich He Hath Sent Away explains why the current reprieve will be short lived:

Market conditions change. A dramatic change can blow away a company with billions in assets in a matter of days. With communication technology moving information at lightning speed every second of every day all over the world, there is nothing anyone can do to stop this from happening. The secretary of the Treasury, the heads of the Fortune 500, and the governors of the Federal Reserve can meet in rooms and hammer out deals all they want. But they are powerless to stop a market that has turned.

Mostly what the powerful attempt to do is provide more of what started this mess to begin with: floods of paper money. What is the effect of that? It can postpone the day of reckoning sometimes. But at what cost? Every dollar that the Federal Reserve prints waters down the value of the existing dollar, which means one thing: inflation. Actually, it means one more thing: distorted market signals.

Even then, the market winds blow ever stronger. The injections of credit in the past didn’t stop the present crisis; it only worsened them by creating the illusion that life could go on as usual.

From today, for how long will life go on as usual? Clearly the time between each crisis and each “solution” is shrinking, and this rally, if it continues, will soon be rudely interrupted. One day the government will run out of funds that they can confiscate from the healthy sectors of the economy, or the new drugs administered will not work at all—the economy will simply seize up just as a young drug addict sometimes dies prematurely from a heart attack.

At that point, the Fed and the Treasury department will have a choice. They will have thrown way so much good money bailing out bad assets that either they will have to allow a full-blown deflationary depression to proceed, or they will have to print so much money as to generate hyperinflation.

The political pressure by demagogues to choose hyperinflation will be enormous; we can only hope for a deflationary depression. Why? Our economy is extraordinary resilient, but only if we allow it to be. Without government intervention, the market will dismantle our failed financial institutions and transfer the remaining assets to those who are better able to manage them. A deflationary depression, if it is allowed to proceed, can end relatively quickly; and prosperity can begin again. Many of us who played no part in creating the problem will suffer greatly, but the alternative is far worse.

Let us hope we don’t choose the more dangerous path of hyperinflation. A hyperinflation, such as Zimbabwe is experiencing today or Germany did in the 20s, will essentially destroy the market economy and it will threaten the survival of the country as we currently know it.

I fear for the future of this country, and I’m not just speaking in economic terms. There are many Americans who will lose everything in the coming years. No doubt future political demagogues will feed on their anger, and far more ruthless and despotic elements than we see today will likely rise to the top.

Fannie Mae and Freddie Mac: Too Big To Continue

July 16, 2008

If the public was unaware of Fannie Mae and Freddie Mac, they have received a quick education in the past few days. Unfortunately, the education that they are receiving can be summed up by the hypnotic mantra that has been repeated ad nauseam by politicians and financial commentators alike: Fannie Mae and Freddie Mac are too big to fail.

These comments by Mark Zandi, chief economist at Moody’s, are fairly typical:

If the government hadn’t moved and Fannie and Freddie failed, the cost to taxpayers and the overall economy would be enormous. If Fannie and Freddie were unable to play their huge roles in financing new mortgages, the housing market would only suffer more, not to mention the turmoil for the financial institutions around the world that invest in Fannie and Freddie’s debt securities.

Zandi’s comments are exactly the opposite of the truth—if the government continues to bailout those who made bad bets on the housing market, the cost to the taxpayers and economy will be catastrophic, not just enormous.

Fannie Mae and Freddie Mac have engaged in fraud, have helped to corrupt the political process, and have helped to raise the price of housing. Their debt holders should not be made immune from the same sharp decline in the value of their securities that their shareholders have already suffered.

First, the fraud and corruption issue: In May 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), released a “Report of the Special Examination of Fannie Mae.” The report covered the years from 1998-2004 and found that top management at Fannie Mae were engaging in fraud: “By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders.”

Fannie Mae is a prolific giver of campaign money to candidates of both political parties. Instead of responding to the serious accusations in the OFHEO report, they had the temerity, according to Bryon York, to lobby “Congress to cut OFHEO’s funds unless it got rid of the top official in charge of investigating Fannie Mae.” Further, they continue to spend much money lobbying Congress. In the first quarter of 2008 alone, Fannie Mae and Freddie Mac spent about $3.5 million on lobbying and hired 42 outside firms in this effort.

And how have they pushed up housing prices? Mish Shedlock looked at the mission of Fannie Mae: “We are a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.” Mish pointed out:

Fannie Mae exists to expand affordable housing. Clearly Fannie Mae has failed its core mission. All government sponsored corporations fail their mission. The very nature of promoting housing makes prices go up, until the final blowoff top which we are now on the backside of, having reached Peak Credit.

And who is really being protected? London’s Financial Times reported that “Bill Gross, whose Pimco Total Return fund is the world’s largest bond mutual fund, has tripled his bet on mortgage debt, which now comprises about 61 percent of the fund’s assets. ” Gross commented, “Government policy is moving to sanctify the status of the government-sponsored agencies. It became a question of which institutions would be sheltered by the government umbrella.”

In other words, the taxpayer is bailing out the investors in Gross’s bond fund and others who bought securities issued by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are in trouble because they helped finance too many low quality mortgages; and in so doing, they pushed housing prices up to unsustainable levels. Matt Kibbe, president of FreedomWorks, commented, “The prospectus for every GSE (Government Sponsored Enterprise) bond clearly states that it is not backed by the United States government. That’s why investors holding agency bonds already receive a significant risk premium over Treasuries.”

Thus as Harry Long points out: Any bailout of the GSEs would not be about homeowners. It would be about charity to financial institutions and investors who have not behaved logically and stand to lose terribly due to sloppy decision making. I like to call it affirmative action for the rich and stupid.“ Bill Gross makes more in a year than most taxpayers will make in a lifetime—it is hardly in the interest of taxpayers that they subsidize him.

There are a few politicians in Congress who understand all of this. Just yesterday, during Senate testimony by Ben Bernanke, Senator and Hall of Fame pitcher, Jim Bunning said,

The Fed is asking for more power. But the Fed has proven they cannot be trusted with the power they have. They get it wrong, do not use it, or stretch it further than it was ever supposed to go. As I said a moment ago, their monetary policy is a leading cause of the mess we are in…

Now the Fed wants to be the systemic risk regulator. But the Fed is the systemic risk. Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that and will use all my powers as a Senator to stop any new powers going to the Fed.

The Fed is not the only institution getting bigger bats—Fannie Mae and Freddie Mac are too, and they are destructive bullies. Giving the bullies bigger weapons will only ensure that the once great American economy will continue to be destroyed.

The “Night of the Living Dead” Economy

July 9, 2008

Yesterday Ben Bernanke announced that the Fed is “considering” allowing Wall Street firms more time to draw emergency loans. The unprecedented loans to Wall Street began in March when the Fed loaned money to JPMorgan in order to bailout Bear Stearns. On Monday, the Senate advanced a $300 billion dollar housing bailout bill. On Sunday, my family and I hiked our first high peak of the summer season.

Am I mixing my blog posts? What could my hike possibly have to do with the Fed’s loans and housing bailouts?

I have been hiking the White Mountains of New Hampshire for well over 20 years. The peak we hiked this past weekend, Mt. Tecumseh, is one I have hiked perhaps 7 or 8 times. The first time I hiked Tecumseh I was a much younger man; I was literally twice as fast as I was this past weekend. As so often is the case, my physical prowess peaked long before my emotional maturity did. With hiking, emotional maturity means that you understand your limits, you plan appropriate hikes that stretch you safely beyond your current limits, and you have the discipline to commit to the training that is needed to accomplish your goals. With my emotional maturity still growing, I have been able to accomplish hiking goals that I never even thought of when I was younger and much stronger.

On Sunday, at the half-way point, I noticed how comparatively “slow” my wife and I had become. I was at a choice point, I could allow my ego to concoct a story about my declining abilities. I could get lost in my thinking and ruminating about the days when I was faster. Of course, doing so would take me from the present moment, slow me still more, and ruin the enjoyment of the day.

It is easy for the ego to rail against what is; but wisdom lies not in the voice of the ego but in the intelligence that is beyond. I can panic and as a consequence overtrain and risk injury, or I can exercise in prudent ways that will maximize my years on the trails. I can go to the doctor and demand some miracle drug or injection, or I can take time to maintain a healthy lifestyle and a healthy diet. I can overlook my current abilities and plan risky hikes that put me and my family in danger, or I can continue to enjoy the mountains commensurate with my abilities for many years to come. No matter what I do, the stark truth of life is that no measure I take will produce any guarantee.

So what does any of this has to do with the economy? Plenty. Collectively as a society we are like aging hikers who demand that the doctor shoot us up with inappropriate remedies to maintain our youth. When an athlete’s body is artificially maintained, the inevitable decline is even worse. Similarly, when we demand to be bailed out of any losses, which are normally produced by a vibrant free-market economy, we guarantee that we will no longer enjoy the benefits of freedom. And the more we try to stave off loss through artificial means, both the severity and the length of the resulting decline will increase.

Is this hyperbole? Consider the sad case of Argentina. In 1900, Argentina was one of the wealthiest countries in the world; it ranked 12th in the world in GDP per capita. In little over a century, Argentina has fallen all the way to 72nd. What happened? The collective will of Argentines turned away from principles that promote prosperity and instead embraced an ongoing series of fascist and socialistic dictators who promised to deliver what is undeliverable—namely, a centrally planned economy that never suffers from declines.

Is Argentina on the road to recovery? Hardly! The current president of Argentina, Cristina Kirchner, recently increased effective taxes on farmers to 75% and limited farm exports. Since a third of the Argentina’s work force is employed in agriculture and half of Argentina’s exports are agricultural, the country is certain to suffer from further devastating declines.

An economy that never suffers from declines is no more possible than a human being that never suffers from a bad mood. In a dualistic world, bad moods and economic declines are inevitable. Both, however, can be “treated” gracefully; and mental and economic health can quickly return. We can learn to recognize thinking patterns that are generated by the ego; we can learn to drop our resulting problematical thinking. This does not require elaborate interventions; it just requires a willingness to do so.

Human beings, due to periodic episodes of collective excessive optimism and misdirected signals caused by Fed policies, create economic cycles. Markets have a self-correcting mechanism, but only if they are allowed to operate. Instead, we are spending enormous amounts of money trying to maintain that which has failed us. In doing so, we postpone our economic recovery and create conditions for even greater declines.

If we demand that we never have bad moods, or that we hike at the same speed in our 50s as we hiked in our 30s, or that we never suffer economic losses, we will choose what is counterproductive. David Whyte in his book The Heart Aroused observes:

It takes tremendous energy to keep up a luminescent front when the interior surface is fading into darkness. In some ways we are constantly preventing our own rebirth into new cycles and greater lives, and instead work twenty-four hours a day keeping a wraithlike image of our former selves alive long after its time has past. This “night of the living dead “syndrome is just as true of an organization as it is of a person.

I know I don’t want to be a “night of the living dead” hiker—a hiker who can no longer enjoy the mountains because he demands that he always gets stronger. But I am afraid we are choosing to have a “night of the living dead” economy—an economy where all failures are outlawed, and as a result, success is nowhere to be found.


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