Thursday, May 9, 2013

Menckenism: How The Federal Reserve Became History's Biggest Bad Bank

            by BILL FREZZA


            Every time a plane crashes, a team of engineers and aviation experts jump into action, methodically reconstructing the event to determine the cause�whether mechanical failure, bad design, pilot error, or poor aircraft maintenance. This painfully acquired knowledge is then immediately fed back into remediation programs for existing airplanes, while informing future aircraft designs. If negligent culpability is found, executives are cashiered and enormous damage claims are paid. The insurers that make these payouts then revise their policies, rates, and eligibility requirements. Airlines with consistently bad safety records disappear. As a result of this feedback, air travel is safer now that it has ever been in the history of aviation.



            Compare this to what happens every time a stock market, currency, or national economy crashes. Teams of bankers, economists, and technocrats are dispatched by those in power�to deny responsibility and affix blame on rival bankers, economists, and technocrats. Financial engineers who examine the wreckage rarely agree on what caused the problem, and even when they do politicians ignore their recommendations if they find them unpalatable. Painfully acquired knowledge is usually dismissed because �this time is different.�


            Culpable individuals rarely face consequences, and some even run for Congress or governor or get appointed Secretary of the Treasury. Failed banks that had implicit government backing are bailed out and given explicit backing. Congress passes massive regulatory bills that bear little or no relation to the actual cause of the problem. And after a few cursory mea culpas, everyone resumes business as usual, in a vicious circle that has left the global economy less stable after each crisis.


            As the Western Democracies expand their footprint across the world�s financial plumbing, the great money center banks increasingly eschew the boring world of commercial lending and dive ever deeper into the trading of derivative instruments so exotic that not one person in a thousand understands them, and certainly not the bureaucrats trying to regulate them. Each turn of the cycle brings tighter global connectivity and integration, everything riding on hair trigger algorithmic trading seeking to squeeze out the last drops of advantage. Many believe this interdependency has reduced the risk of catastrophic failure. These are the same people who tell us that �this time is different.� They are living under a cloud of willful denial about the fragile chains of counter-party risk upon which the whole edifice is propped, believing that the web of complex financial instruments they have woven will protect their own fortunes because their equations tell them so.


            Providing the liquidity for it all is an opaque and unaccountable ringmaster whose unique legal status confounds all efforts to audit it, much less bring it under control�the U.S. Federal Reserve. This banker to the banks, lender of last resort, and greatest money printer in history has embarked on a plan of indefinite monetary expansion as a magic tonic to cure unemployment, restore growth, and mitigate the political class� fiscal insanity. As the Fed presides over this plan-with-no-exit, it gets an assist from hordes of court economists and friendly media pundits who try to convince the rest of us that everything is under control.


            �Look at the stock market, it�s booming! Look at the housing market, it�s recovering! Look at consumer price inflation, it barely moves the needle! Look at gold, we have crushed it! Pay no attention to that debt behind the curtain! Forward!�


            Outsiders watch bewildered. What does it mean that hopelessly bankrupt nations like Spain can borrow money at less than 5 percent interest? What does it mean that 60 percent of home purchases in many U.S. metro markets are being made in cash, and that hedge funds and institutional investors are the largest buyers? What does it mean that the Dow and S&P 500 are hitting record highs while 47 million Americans are on food stamps? What does it mean that the official unemployment rate is going down while the number of people not working is going up? What does it mean that the Consumer Price Index is showing less than 2 percent inflation?


            I�ll tell you what it means. It means that this whole thing has become an insider�s game.


            The reason we are not seeing consumer price and wage inflation is precisely because quantitative easing�the Fed�s fancy term for flooding the economy with new cash�is failing, and everybody knows it. Businesses and consumers are not fooled by the illusory wealth effect. Despite the happy-days-are-here-again campaign, ordinary people and companies are not running out to borrow and spend, hire, or expand, because they are not stupid. Anyone with half a brain is hunkering down, knowing that when the next crisis comes, it�s going to be very, very ugly.


            The insiders don�t care because, as Keynes said, we are all dead in the long run. They are too busy making paper fortunes as they watch the tsunami of freshly printed money chase its own tail in ever tightening circles, all within the financial industry. The Fed, through its bond buying and interest rate manipulation, has destroyed the yield on safer assets, and thus driven investors into a desperate search for return. Predictably, bubbles are forming everywhere this money can be put to work. And behind it all, acting like a giant debt sponge, is the Federal Reserve, loading up on mortgages and sovereign bonds.


            Meanwhile, every other central banker on the planet must follow suit, lest they risk destroying their countries� export industries due to competitive devaluation. Mortgage debt and sovereign bonds, every bank stuffed to the gills, all �insured� by a chain of derivatives only as strong as its weakest counter-party link. But isn�t the souring of mis-priced debt exactly what caused the last catastrophe? Yep. So what is different this time? What is different this time is that when history�s biggest Bad Bank, the lender of last resort, the printer of the only global reserve currency runs out of gas, there will be no one left to bail it out.


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