Sunday, April 26, 2009

The Stress Test: Inspecting the Stable After the Horses Have Gone

[Thanks to for the photo.]

Even if it's too late, it's good to know that the US Treasury, other Government agencies, and the Federal Reserve are able to do what they were supposed to do all along, i.e. monitor the health of the US banking system. This Federal Reserve white paper amply demonstrates their know-how by detailing the accounting verification procedures they applied in their infamous "stress test" of 19 major US banks, the results of which they now hesitate to divulge to the public for fear of instigating another wave of panic.

This fear harks back to my growing list of examples of government running amuck through inappropriate intervention. Instead of intervening too late, they should have been minding the barn back when it might have turned up some loose beams and posts and kept the horses inside.

What makes this tragic situation worse is that since 2001 the BIS (Bank of International Settlements) has been discussing what to do about what central bank representatives had clearly identified as imbalances in international bank leveraging (e.g. assets vs. capital ratios) and as excessive fiat credit creation.

So where have our central bankers been? Why did it take so long?

Unfortunately, I have no answer to this question.

"[T]he Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the System, bank holding companies, international banking facilities in the United States, Edge Act and agreement corporations, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Board also sets margin requirements, which limit the use of credit for purchasing or carrying securities." [Source. See also this and this.]

Looks like the Fed has spent the last nine years sleeping on the job. Maybe we should start a class action suit for negligence? (Just joking, I think.)

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Sunday, April 19, 2009

Government Intervention Run Amuck No. 20: Bank Intervention

My list of examples of the unintended consequences of government intervention in the marketplace gets longer and longer. This time, I'm going to point out the latest irony: Investment banking's profitable last quarter.

[Thanks to for the photo.]

This would be wonderful news if it were genuine, but looking a little deeper reveals the truth. First, in one of Barron's feature articles by Andrew Bary, we learn about a little-discussed fact: Goldman Sachs has only been able to issue low-cost debt due to the backing of the FDIC through a program called the TLGP, or Temporary Liquidity Guarantee Program.

I suppose this program is no secret, but somehow it had escaped me that Goldman, JP Morgan, Morgan Stanley, and others are relying heavily on it to survive, at the same time as they are declaring profits and claiming that they want to return the TARP money in a show of strength. In fact, it's all show and no strength when you look at the facts.

Here's another thing that raises my cockles. Goldman has stated first quarter earnings as $1.8 billion. As Alan Abelson points out in his weekly Up & Down Wall Street column, Goldman's profit statement all but ignores results for December because of a fluke fiscal-year switch. "Goldman lost some $780 million in December," says Abelson. This brings the four-month profit down to $1.02 billion, which is still respectible; but somewhere else in Barron's (I can't find it now) we learn that Goldman made most of that profit through a risky bet on bond futures.

Isn't risky betting what got us into this mess? And aren't firms like Goldman now gambling with our tax dollars? Aren't we rewarding and encouraging the very behavior that helped get us where we are today? And is there any guarantee that they will make good bets (with our money) in the future? Shouldn't these people be market-dead?

Abelson conjectures, furthermore, along with his source Zero Hedge, that some of Goldman's $1.8 billion profit may have come from payments by AIG, who "'gifted the major bank counterparties with trades which were egregiously profitable to the banks.' This would largely explain, according to Zero Hedge, why a number of major banks actually, as they claimed, were profitable in January and February. But the profits, it is quick to point out, are of the one-shot variety, and ultimately, they entailed a transfer of money from taxpayers to banks, with AIG acting as intermediary."

My free-market instincts have always told me to hold onto my resentment of big bonuses and the new divide between the rich and the "middle class," as illustrated in the supplementary section to this weekend's Wall Street Times, with glossy pictures of dozens of fabulous mansions for sale around the country. And echoing my own sentiment, Gregory J. Millman chides me in his Barron's piece this weekend, "let's not go ape about fairness." He's right--or he would be, in a free-market society.

But Mr. Millman, this market isn't free and hasn't been for decades. How can we talk about free market when the banking barons are divvying up our hard-earned tax money, thanks to the largesse of those who didn't earn it, our legislative representatives? How can we talk about fair competition when the playing field is rigged in favor of the big boys, and the small businessmen and women just have to suck it up when they learn from their subsidized bank that they can't have any of the handouts? How can we talk about a deflationary correction, elimination of the unhealthy business models, and a return to saner plain-vanilla banking, when our legislators continue to reward foolhardy risk-taking?

We're headed in the wrong direction. More limited government is the answer, not bail-outs of bankers who should be dead by any Darwinian-Schumpeter standard; not Treasury-instigated bank "stress tests" that will soon go bang in the night, raining multiple unintended consequences; not back-room cronyism in the name of "saving the system."

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Monday, April 13, 2009

Taylor's (and Friedman's) Error

In a book review by Clive Crook in todays Financial Times, we read about the new work Getting Off Track by John Taylor, creator of the "Taylor Rule" for monetary policy. According to Taylor, if the Federal Reserve had followed his famous Rule instead of their own discretion over the last decade, we wouldn't be in the mess we're in today.

Taylor's Rule gives a mathematical formula for the calculation of monetary policy. As Crook describes it:

"The rule says central banks should set the short-term interest rate equal to one-and-a-half times the inflation rate; plus half of the gap between actual and trend gross domestic product; plus one. For example, if the inflation rate is 5 per cent and the output gap 3 per cent, the Taylor rule says make the interest rate 10 per cent: one-and-a-half times 5, plus a half of 3, plus 1."

His idea is similar to the formula of Milton Friedman, which at one point economists called the "k-percent rule." Friedman would have had the Fed increase the money supply annually by a fixed percentage. He is essentially Taylor's precursor.

Both economists advocated a fixed, formulaic determination of the expansion of money supply because they were wary of a discretionary monetary policy open to the whims of central bankers and the politicians who appoint them.

Where both these illustrious gentlemen err is in their naive belief that any political appointee(s) would be capable of limiting themselves to a non-discretionary monetary policy once they have the power not to.

In a July 2006 e-mail exchange with the Wall Street Journal's Tunku Varadarajan, Friedman wrote: "There are certainly occasions in which discretionary changes in policy guided by a wise and talented manager of monetary policy would do better than the fixed rate, but they would be rare." WSJ Archives.

Rare indeed. Didn't he realize that "rare" is in the eyes of the rate-setter?

Friedman's incongruous naivety is at odds with his skeptic personality. In his own book Capitalism and Freedom, he says:

"As matters now stand, while this rule [the k-percent rule] would drastically curtail the discretionary power of the monetary authorities, it would still leave an undesirable amount of discretion in the hands of Federal Reserve and Treasury authorities with respect to how to achieve the specified rate of growth in the money stock, debt management, banking supervision, and the like."

So why does he even bother with the k-percent rule in the first place?

Both Friedman and Taylor seem to be aware of the fallibility of agency intervention into the supply of money; and yet, inexplicably, both seem in the end to take for granted that the agency in question will be willing to renounce discretion when push comes to shove.

This is equivalent to sitting two-year-old Dick and Jane in a room with a big box of chocolates, telling them they can have only one each, then leaving the room. It just won't work.

[Thanks to, the Univ. of Delaware Library, and The New Fun with Dick and Jane, Chicago: Scott, Foresman and Co., 1956.]

And it's not Dick or Jane's fault. Dick and Jane are only two years old. Monetary policymakers are just humans. Humans are control freaks. They are tinkerers. It is a rare economist who, once appointed to the position of Federal Reserve Board Member, can look deep down inside existing economic science and declare the truth of what he finds, i.e. that no one knows how to control monetary policy, with or without a formula.

For one illustration of the mindset of our FRB Members, read this speech by Governor Mishkin. It's an eye-opener, revealing just what the more rational economists like Taylor and Friedman are up against. These Governors see themselves as monetary artists, not scientists.

For a second example of Federal Reserve mindset, take a look at this astonishingly self-serving article by Alan Greenspan in the Wall Street Journal last month. We perceive between the lines that there's a nasty feud going on between Taylor and Greenspan, and rightfully so. Taylor is Jane's older brother (he's six) and Greenspan is little Dicky.

Now children: I guess we'll just have to take that box of chocolates away, now won't we? (Gold standard and sound commercial banking, anyone?)

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Monday, April 06, 2009

The PPIP Drip

Another version of my April 4th cartoon, suggested by a friend. Which one do you prefer? (Click on the image for a larger version.)

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Saturday, April 04, 2009

PPIP: The Right Medicine?

These tense times need comic relief. (Click on the image for a larger version.)

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