Sunday, September 27, 2009

A Glimpse of the Monetary Policy (in Action)

So, what rules did Bernanke break when he tossed out the rule book?

Here is a story about the reduction in the Treasury’s Supplemental Financing Program that no one probably read because the few who understood it did not have to read it and the rest would not get it. According to Bloomberg:
The U.S. Treasury Department plans to cut back its borrowing on behalf of the Federal Reserve as it seeks to keep government debt under a legal limit ... The Treasury will reduce the outstanding borrowing in its Supplementary Financing program to $15 billion “in the coming weeks,” the department said in a statement in Washington. The Treasury has been keeping the account, set up last year to give the central bank more flexibility as it undertook unprecedented lending, at about $200 billion.
Note the critical phrase “on behalf” in the opening sentence – the Treasury is planning to cut back its borrowing on behalf of the Federal Reserve. That is an accurate characterization of the program, although the phrase does not appear in the Treasury communiqué that announced the inauguration of SFP. The dreary language of the announcement precludes the use of simple phrases such as “on behalf” and that is a good thing, because the phrase invites inquiry.

What does on behalf mean?

It means that the Treasury is borrowing money not for its own needs but at the instruction, and for the benefit of, the Federal Reserve.

As any loan officer would tell you, that cannot be done; you cannot borrow money on behalf of anyone. In this particular case, there are added complexities.

The Department of the Treasury represents – stands for – the U.S. government in financial markets. Only it, and no other entity, can borrow as, and on behalf of, the U.S. government. That is another way of saying that any borrowing by the U.S. Treasury is, per se, borrowing by the U.S. government, regardless of the intent and the use of funds. You can see this in the Bloomberg story. The Treasury is curtailing the program in order to reduce the U.S. government debt [which was reaching it legal limit of $12.1 trillion]. So the Treasuries issued “on behalf of the Fed” were clearly counted as part of the U.S. government's debt.

But why the need for this arrangement? Can't the Fed borrow money itself?

The answer is, No, it cannot. It is prohibited by law from doing so. Earlier this year it tried to change that law , but ran into opposition and a wall of technical complexities. Some insiders also did not like the idea of the Fed issuing its own debt, but I was enthusiastically for it. I wanted to see how this debt would be priced against the Treasuries.

The Fed, you see, cannot borrow as the U.S. government because it is not the U.S. government – or any part of it. It is not a part of the executive branch. It is not a part of legislative branch. And it most certainly is not a part of the judiciary.

The Fed was incorporated as an entity in 1913. It is comprised of private banks and follows an “independent" monetary policy – independent in the sense that it operates without regards to the economic policies of the government. That is another way of saying that it runs its business as it sees fit no matter who or what party is in charge.

The Fed’s business, among other things, is issuing Federal Reserve Notes, commonly known as money. If you take a bill from your pocket you will see that at top of the side which has the picture of a dead president, it says: Federal Reserve Note. The authority of issuing money and conducting “monetary policy” is vested in the Federal Reserve. The Treasury – that would be the U.S. government – has no say in it.

Why is an “incorporated entity” in charge of the nation’s money supply and monetary policy is a topic for another occasion. We were considering whether the Treasury could borrow money “on behalf” of a non-governmental entity and we saw that the answer was no. The U.S. government could guarantee a borrower – whether explicitly like Ex-Im bank credit lines or implicitly, like old Fannie Mae and Freddie Mac – but it cannot borrow under its name and turn over the funds for the use of others. Yet, as the Treasury secretary, Paulson agreed to this arrangement and Geithner continued with it. Bernanke was not the only one tossing out the rule book.

Why does the Fed which controls money and money supply need the Treasury Dept to arrange borrowing on its behalf?

The answer is that the purpose of the SFP is not so much getting money into the Fed as it is siphoning it out of the system.

Historically, the Fed had strict requirements for the so-called “Fed eligible” securities that the banks could pledge in return for cash. After Lehman, those rules were tossed out and the Fed began taking in junk synthetic securities as collateral that were trading as low as 22 cents on a dollar. However, it accepted them at much higher values than the market, at times close to par, because that is where the banks had financed the securities. If you had $5 and borrowed $95 to buy a $100 security whose price subsequently dropped to $40, you still owed $95. The market did not pay more than $40 for it, but you needed $95. The Fed came in and took your junk for $95. After all that talk, for more than 30 years, about the critical role of the markets in price discovery and fair pricing, the fair market value was likewise tossed out. That was the mother of all rule violations, a replay of the worst excesses of the most unscrupulous mortgage-brokers: valuing the underlying collateral higher than its market price.

In this way, between the summer of ‘07 and January ‘09, the balance sheet of the Fed increased from just above $700 billion to over $2 trillion. The quality of its assets moved in the opposite direction.

The flooding of markets with so much money, above and beyond the value of securities “in play”, risked inflation. To counter that, the SFP was created to take the money out of the system. The Treasury Dept sold Treasuries to take in the money that the Fed had provided to the market in return for junk collateral. Presumably, the monetary policy gurus at the Fed thought that that would be the end of the cycle. But capital is a thing in motion. There is no end point in its circulation. The financial institutions which bought the Treasuries pledged them again with their counterparts for the cash. And the Fed, in order to keep interest rates low and the money flow going, began “quantitative easing”, a code for buying the Treasuries! So, here is the full cycle: giving money away, siphoning it out of the system through the sale of the Treasuries and then introducing it to the system by buying the Treasuries! That is the monetary policy for you.

According to the official statement, the termination of the SFP would have no adverse effects on the Fed actions. The Fed officials stated that that they have other policy levers at their disposal.

I bet they do.

Tuesday, September 15, 2009

Looking Back in Incomprehension

It is the anniversary of Lehman’s demise and everyone is looking back for “lessons learned”. The passage of time has not helped. The usual nonsense about greed, bad management, etc. is being regurgitated, with a new spin making the rounds: that Lehman’s demise prevented even bigger collapses. Goldman’s Blankfein was first to float this nonsense.
“A bailout of Lehman Brothers might have provoked a public backlash, causing the government “to let the next institution fail” instead, Blankfein said ... “It might have been a much bigger one with much more dire consequences.”
Joe Nocera of the New York Times picked up the same theme in a front page article claiming that if Lehman had been saved, a much bigger firm such as Merrill might have collapsed.

The claim can be neither proved nor refuted. It is an idle conjecture. Nocera’s Merrill example shows how little he knows about the markets. Merrill was bigger in terms of assets. But Lehman was a far more “connected” – systemically important, if you will – firm. It was one of the largest issuers of commercial paper. It was the freezing of the CP market, after Lehman had filed for bankruptcy, that triggered the crisis.

The spin tries to make the boys who let Lehman down look less bad. Nice try, gentlemen.

The how of Lehman’s collapse is a technical matter involving the business model of a highly leveraged broker-dealer. I described it in detail in the Credit Woes series, especially parts 9 and 10.

The why of Lehman collapse – why Geithner, Paulson and Bernanke allowed it to happen – cannot be known without a full confession from the said individuals. But I doubt that malice, in the sense of involving calculations and plot, played any role. That would be giving these men credit for what had to be a complicated chess move.

The truth is more banal. I think I came close to it when I described why Lehman was allowed to fail. Read it here and judge for yourself.

Looking back, I also think that I grasped the significance of the event better than others. Read it and judge for yourself.

Sunday, September 13, 2009

Functionaries (passed off) as Revolutionaries

I was at the start of my vacation when Bernanke was reappointed. In terms of newsworthiness, then, the story is a tad dated. But this is not a news site, and there are important points about the reappointment that I would like to write about.

Ben Shalom Bernanke secured a second term as the chairman of the Board of the Federal Reserve because he played ball in his first term. He played ball obediently and unquestioningly.

In the ceremony announcing the reappointment, President Obama said that Bernanke’s “bold action and out-of-the-box thinking” helped save the economy from free fall. That was the agreed-upon line on Bernanke that the media had been promoting for over a year: a bold and unconventional thinker and doer – a veritable revolutionary, in other words, of the kind that these crisis times demanded. Google “Bernanke + rule book” and see how many sources, from the New York Times to the National Public Radio, approvingly talk of Bernanke “throwing out” or “tossing out” the rule book – the rule book being the policies of the Federal Reserve.

Rule books spell out the details and boundaries of actions in organizations. They are written to be followed. Anyone who has ever worked in an organization knows that ignoring the rules, to say nothing of tossing them out altogether, would be committing career suicide. In many cases, it would be a criminal offense. Imagine a pilot violating the rules of aviation. Or an accountant ignoring generally accepted accounting principles. Or a bank compliance officer not reporting suspicious transactions. Such conduct is so predictably ruinous that if willful and intentional, must to be pathological.

For Bernanke, this pathology was presented as heroic and as the evidence of his courage. The trick worked thanks to the perversion of the social frames of reference, of the kind that Shakespeare said make foul fair, black white, wrong right, base noble and coward valiant.

Let us begin with the “tossing out” part, that not-playing-by-the-rules shtick that is invoked to conjure up the go-it-alone ways of the heroes the Western movies. Hollywood was instrumental in creating the link between such “mavericks” and the frontiersmen who built the U.S. In the American psyche, patriotism and individualism – the latter connoting non-conformity – are thus linked.

The American individualism, however, always had a commercial base, even when it took the form of exploring the nature. The “enterprising” men and women could go off the well traveled paths and take whatever risks they chose, as long as their goal remained pursuit of money, which the Founding Fathers somewhat defensively called “the pursuit of Happiness”. That kind of individualism was encouraged, promoted and admired because it was in line with the guiding principles of the country.

Individualism, if it involved questioning the guiding principles which were codified in law, was strictly discouraged because the “common good” was supposed to trump individual interest. Those who went against these principles, whether for personal gains or out of concern for others, were branded outlaws and dealt with accordingly.

With the rise of speculative capital, the balance between the individual and the common good – between the narrow and general interests – was shaken in favor of the narrow interest. Speculative capital is an expansionary force. Expansion is the condition for its preservation. Constant expansion naturally brings it into conflict with the myriad of laws and regulations which inhibit its growth. So it strives to eliminate them. In Vol. 1, I wrote at length on the dialectical relation of speculative capital to law and regulation, which produced, starting with the Carter presidency up to current times, the longest running orgy of deregulation in the history.
Speculative capital abhors regulation. Regulations interfere with the cross-market arbitrage that is its lifeline. If speculative capital cannot freely operate, it cannot generate profits and must cease to exist. The opposition of speculative capital to regulation is thus not a matter of some technical or tactical disagreement but a question of life and death.

The attack of speculative capital on regulation is not indiscriminate. Though generally suspicious of regulation, speculative capital singles out only those regulations which directly or indirectly hinder its free flow across the markets. The same speculative capital, meanwhile, supports and pushes for the passage of sweeping laws. In so opposing the regulation and supporting the law, speculative capital distinguishes between the two in ways few philosophers of law could.
But how could the idea of dismantling laws that protected the common interests be sold to the public? The trick was in framing the issue “properly”, which is to say, emotionally, by personalizing it. Whilst originally the “common good” trumped individual interests, now the concern for the individuals was used as the pretext for discarding the rules for the common good.

Focusing on the individual is the secret and foundation of storytelling in which Hollywood excelled. So beginning in the early ‘70s, parallel to the rise of speculative capital, we see the appearance of Clint Eastwood as “Dirty Harry”, a sadistic and criminal cop who shot and tortured suspects but the audience was made to cheer for him because his actions were in defending the “rights” of the victims. A torrent of vigilante movies and “tough but fair” cops followed, all with a similar theme but progressively more violent and more lawless characters. The culmination of that trend is the current TV show “24” where torture is sold as advisable and even normal.

To what extent this indoctrination – now supported and reinforced by the radio talk shows, newspaper columns and the TV commentaries – has succeeded in making foul fair can be seen from the comments of Antonin Scalia, the justice of the Supreme Court of the United States about the fictional character of “24”.
Senior judges from North America and Europe were in the midst of a panel discussion about torture and terrorism law, when a Canadian judge’s passing remark—“Thankfully, security agencies in all our countries do not subscribe to the mantra ‘What would Jack Bauer do?’ ”—got the legal bulldog in Judge Scalia barking.

The conservative jurist stuck up for Agent Bauer, arguing that fictional or not, federal agents require latitude in times of great crisis. “Jack Bauer saved Los Angeles. … He saved hundreds of thousands of lives”...

The real genius, the judge said, is that this is primarily done with mental leverage. “There’s a great scene where he told a guy that he was going to have his family killed,” Judge Scalia said. “They had it on closed circuit television—and it was all staged. … They really didn’t kill the family.”
Jack Bauer saved Los Angeles. He saved hundreds of thousands of lives!

These words about a fictional TV character from someone charged with interpreting the U.S. Constitution.

(Read the last paragraph again and pay attention to the tone, narrative, the use of “great scene” and the way Scalia articulates what he has seen on TV: “There’s a great scene where he told a guy that he was going to have his family killed. They had it on closed circuit television—and it was all staged. … They really didn’t kill the family.” If this quote is accurate, the man’s mental capacity can be no more than that of a 7-year old.)

It is within this environment that Bernanke’s throwing out the rule book “to save the financial system” was sold to the public as a heroic, albeit slightly unconventional, act – in the manner of Jack Bauer saving Los Angeles from a nuclear attack. The president had little choice. They had him on the run with the same rhetoric and a not-so-subtle threat, in case he did not get the hints:
A top White House official said Mr. Obama had decided to keep Mr. Bernanke at the helm of the Fed because he had been bold and brilliant in his attempts to combat the financial crisis and the deep recession ... Some analysts caution that the economy is still so fragile that financial markets would react badly if President Obama decided to install new leadership at the Fed anytime soon.

“He’s the best person for the job,” John Makin, a senior fellow at the American Enterprise Institute, said of Mr. Bernanke. “Why would anyone want to change the Fed chairman now?”
Why, indeed. That would be like changing Superman just when General Zod had broken into Daily Planet.

Three questions remain. One concerns Bernanke’s boldness. One of the main criticisms directed at Ibsen’s feminist manifesto, A Doll’s House , is Nora’s quantum psychological leap that takes her from being a “silly bird” of a housewife to a woman able to leave her husband – all within the span of 48 hours. The criticism is a valid one. In real life, people who have been meek all their lives would not disturb a comfortable status quo to face uncertainty and danger. How, then, did a meek academic, whom the New York Times described as “a quiet and often unprepossessing person” – and was installed at his position because of those qualities – become so bold so as to throw out the Federal Reserve rule book?

The second question is, how did he know what he was doing, after he had tossed out the rule book, was the right thing to do?

Finally, who was behind Bernanke? Who promoted and passed him off as a bold and revolutionary thinker and doer?

The answer to all three questions is: speculative capital.

Among the official press, the New York Times alone sensed the need to explain the source of Bernanke's uncharacteristic courage; it implied it came from the firm conviction of knowing the right way, itself the result of first-rate scholarship.
Mr. Bernanke was a leading scholar of the Depression who had broken important ground on the links between financial crises and the real economy. In his work on what he called the “financial accelerator,” Mr. Bernanke argued that a run on banks or other disruptions in financial markets could turn a relatively mild downturn into a severe one.
In truth, the quality of Bernanke's academic work is on par with his academic peers: overdone on technical details, dreadfully shallow, almost childish in depth. Here is a single, albeit telling, line from one of his main speeches just before the onset of the financial collapse that shows his grasp of finance.
As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems.
The central function of banks is to screen and monitor borrowers – this according the “information-theoretic approach to finance”, which he approvingly quotes.

The same year that he spoke of this central function, the U.S. banks sent 5 billions credit card offerings to about 112 million U.S. households – roughly about one credit card per week per household. That is screening borrowers for you.

Bernanke knows finance no more than Scalia knows law – or the reality.

So, no, it was not Bernanke’s knowledge that showed him the way and the strength to act. It was the demand of speculative capital.

Speculative capital is constantly in motion. Whether in expansion during “economic growth” or in retraction during crisis, it naturally finds the most profitable path for itself. Because the public at large has been made to see the events from the viewpoint of speculative capital, the path that speculative capital chooses appears as the only viable, logical option. Alternative options, if they are noticed at all, seem non-workable, irrelevant or radical.

In this way, the course of action becomes preordained and if the rules stand in the way, so much the worse for the rules.

In this environment, functionaries rise to fame. By virtue of unquestioningly executing the diktat of speculative capital, they are thrust upon the center stage as bold thinkers and doers – bold because they discard the existing rules. In doing so, they become the instrument of the destruction of the old system and the creation of a new one in which speculative capital holds sway even more extensively.

But speculative capital is self destructive. It destroys itself and the environment in which it operates, only that each phase of destruction is more intense and violent.

That is where we stand now. The “financial markers” seem to be gradually stabilizing but the Federal Reserve, in circumvention of all the laws and regulation that created it and defined its operations, is saddled with over $2 trillion of junk securities.

When a pilot deviates from the aviation rules or an accountant violates the accounting principles, the consequences are immediately clear. The consequences of the Federal Reserve issuing U.S. treasuries for junk is not immediately transparent. I will return to this topic in later entries and in Vol. 4.

In the mean time, Bernanke’s children and grandchildren will tell tall tales about how Grandpa Ben singlehandedly saved the world from the brink.