Bernanke's Federal Reserve System Doom LoopEconomics / Central Banks Jan 23, 2010 - 06:28 AM GMT
Two Bank of England economists have written one of the most perceptive and forthright papers in the history of central banking: "Banking on the State." Compared with any of the dozens of deadly dull, equation-filled, narrowly focused, recommendation-avoiding, career-enhancing, résumé-padding, utterly useless academic exercises published in the dozen regional Federal Reserve bank journals every month, this paper stands out like a diamond in an immense dung hill.
The authors offer a simple thesis: the modern nation-state has become the lender of last resort to the banks rather than the banks serving as the lenders of last resort to the state. The title reveals the thesis. The common phrase, "you can bank on it," describes the new reality. The big banks have banked on the intervention of the nation-state to protect them from economic forces that would threaten their solvency and therefore their survival. This constitutes a great reversal.
For the past two centuries, the tables have progressively turned. The state has instead become the last-resort financier of the banks. As with the state, banks' needs have typically been greatest at times of financial crisis. And like the state, last-resort financing has not always been repaid in full and on time. The Great Depression marked a regime-shift in state support to the banking system. The credit crisis of the past two years may well mark another (p. 1).
This initial reversal took place during the Napoleonic wars two centuries ago. They mention no cause.
There was a cause: the abolition of the domestic gold standard by Great Britain. British Treasury notes replaced gold as the basis of the reserves of the Bank of England. The domestic gold coin standard was restored in 1821.
The next great shift took place in the Great Depression. It has accelerated ever since. What took place in the Great Depression? The authors do not ask. England went off the gold standard in 1931. The United States went off the domestic gold standard in 1933. From that point on, only the United Stares agreed to exchange gold for dollars at a fixed price: $20/oz for the remainder of 1933, and $35/oz beginning in 1934. It made this agreement only with foreign governments and central banks. It was an agreement within a cartel.
The paper says that the banking system became far more leveraged in the 1970's. Again, it mentions no cause. There was one: the unilateral decision of Richard Nixon to cease honoring the American government's promise to redeem gold at $35 per ounce as of Sunday, August 15, 1971. He simultaneously floated the dollar: no more fixed exchange rates (government-imposed price controls on currencies). That two-fold broken contract – an agreement among an international cartel of central banks – released modern central banking from the last remaining contractual restraints on the expansion of central bank reserves.
The results were predictable. A tiny band of pro-gold economists and newsletter forecasters were the only ones who predicted these results. Governments ran huge deficits, central banks expanded their holdings of government debt, monetary inflation became widespread, and the boom-bust business cycle, explained by Ludwig von Mises as early as 1912, led to ever-greater banking crises around the world.
Keynesian economists in the mid-1960's hailed the end of major recessions. Major recessions in the United States in 1970–71, 1975, 1980, and 1981–2 were accompanied by price inflation, high unemployment, and financial losses. The Dow Jones Industrial Average peaked at 995 on February 9, 1966. It had risen above 1,000 for the first time earlier in the day. It bottomed at 777 on Friday, August 13, 1982, eleven years to the weekend after Nixon's announcement. In the meantime, the purchasing power of the dollar had fallen by over two-thirds. But I digress.
The authors do not identify national central banks as the sources of the expansion of domestic bank reserves. Such an admission would have constituted biting the hand that fed them. The paper was first delivered at a symposium sponsored by the Federal Reserve Bank of Chicago. Everyone in the audience was well aware of the relationship between central bank reserves, the legal reserve ratio, and commercial bank liquidity. The authors did not have to state the obvious.
Of course, this is not obvious to the general public. That, too, has long been part of the cartel's working arrangement with the national governments that have established the cartel, nation by nation.
HOW BAD IS IT?
The authors point out that government intervention to support the banks in 2008–9 in the UK, Euro zone, and USA was $14 trillion. This was the equivalent of a quarter of global GDP. This was the largest intervention in history. In some cases, the cost of insuring against default is higher for some G-7 nations than for McDonalds or Campbell Soup.
In the Middle Ages, as in the early modern period, the greatest risk to the banks was the default of the sovereign king who had borrowed the money for affairs of state. "Today, perhaps the biggest risk to the sovereign comes from the banks. Causality has reversed" (p. 2).
For over a century, every time the large banks have experienced a crisis, the state has extended a safety net. This safety net is never withdrawn. It only gets more bent out of shape, "like over-stretched elastic" (p. 2). With each extension of protection, the bankers assure the public that this is the last time. It never is. The paper explains why.
Today, there are reform proposals. The authors do not say that these cannot work. It is clear from their paper that reform has not worked before. Indeed, with each extension of protection and regulation, the bankers find ways to work around the law and make the system pay. The authors have a phrase for this: "gaming the state."
In the UK, from 1880–1970, bank balance sheets (loans) remained fairly stable: about 50% of GDP. In the early 1970's, this changed. By 2000, the ratio of balance sheets to annual GDP was 5-to-1 (p. 3). This was an increase in the ratio by a factor of ten: 50% to 500%. Something fundamental had changed.
From 1900 to 2000, capital ratios in the USA and UK fell by a factor of five. This means that the banks' capital supported five times the loan amount. Liquidity ratios – instantly marketable assets on hand – also declined by a factor of five. This happened in half a century (p. 3).
The banks started getting more bang for their bucks. But one year's profitable bang can become next year's explosion of losses. Leverage is a door that swings both ways.
Bank investors started cleaning up after 1970.
As banks moved up the risk spectrum, the return required by shareholders has predictably increased. Between 1920 and 1970, the return on UK banks' equity averaged below 10% per annum, with low volatility of around 2% per year. This was roughly in line with risks and returns in the non-financial economy. The 1970s signalled a sea-change. Since then returns on UK banks' equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to higher return is higher risk. And so it was, with the volatility of UK banks' returns having trebled over the past forty years (pp. 3–4).
I think of the punch line of a children's poem. "When she was good, she was very, very good, but when she was bad, she was horrid." In 2008, the banks' returns became horrid.
In response, the Bank of England since 2007 has increased the base money supply by a factor of four. The last time this happened was in 1825, during a major crisis.
Then there were asset swaps. They were gracious enough not to describe these as toxic assets. There were also guarantees of liabilities. They did not mention the Treasury's guarantee of Fannie Mae and Freddie Mac bonds. Together, the swaps and the guarantees in the UK, Euro region, and the USA ranged between 10% and 40% of GDP (p. 5).
Here is the problem. "This is a repeated game. State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximize expected profits. So it was in the run-up to the present crisis" (p. 8). There are five areas where this is accomplished:
1. Higher leverage (lower capital ratios)
2. Higher trading assets (mark-to-market)
3. Business line diversification (similar portfolios)
4. High-default assets (e.g., subprime loans)
5. Out-of-the-money options (e.g., credit default swaps)
Because bankers know the government will bail them out, they increase their risks. When times are good, they get rich. When the market moves against them, they get bailed out. This is what economists call an asymmetric relationship.
Beginning in the nineteenth century, economists and critics of the schemes of bank protection by the state named this phenomenon: moral hazard. The phrase became common. This is just about the only example of economists' showing any concern about morality in economic analysis.
The authors offer a far better description: doom loop.
THE DOOM LOOP
There are two general gaming strategies that produce high profits for banks. The authors name them: (1) doom loop; (2) St. Petersburg paradox.
These five strategies are the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, it poses a dilemma. Ex-ante [beforehand – G.N.], they may well say "never again." But the ex-post [hangover – G.N.] costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of "never again" announcements. This is a doom loop.
The "St Petersburg paradox" explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak. Clearer practical examples of a policy time-consistency problem are unlikely to exist (p. 11).
The authors suggest several possible reforms, none of which is likely. One is to introduce leverage limits on banks. This is easy, they say. Is it? They say that leverage limits operate in Canada and the USA. But what good have they done? "We have sleepwalked into a world in which leverage of 20 or 30 times capital is the rule rather than the exception" (p. 12).
Here is the problem, which they do not mention: the Austrian theory of the business cycle. The financial system was bailed out in 2008 and 2009 by means of gigantic increases in the monetary bases. This expansion awaits only a decrease in excess reserves to double the money supply in the USA. In the UK, it will quadruple.
Governments are on the hook for huge liabilities. These are tied to the most leveraged market of all: residential real estate. In the USA and the UK, these markets will fall if the support is removed. Bernanke says the FED will end the purchases of Fannie/Freddie bonds on April 1, 2010. Then what?
The authors refer to the Basel accords: rules limiting the loan/capital ratio. These have proven unenforced and unenforceable. They are nothing but suggestions. These suggestions are never taken seriously when the crisis hits. Basel is dead. Every central banker knows this.
The governments could revoke limited liability protection for banks, they say. Allow creditors to collect from all bank investors. Yeah, right – remove the #1 protection of entrepreneurs from the banks that have run the West's economies for a century. This is just silly. Who would buy bank stocks on that basis? The banks would have debt/capital ratios close to infinity within days. "Sell!"
Get rid of "too big to fail." How?
We need a "well-articulated framework for the banking system." We also need manna from heaven. We are 300 years into central banking. No such framework exists. We are now in the transition phase: either to depression and monetary deflation (no government intervention, no FDIC, no FED bailouts) or mass inflation by the FED to head off the former.
They believe in a third way: the middle way. Right! We will muddle through in terms of the nationalized mortgage market, trillion-dollar annual Federal deficits, unemployment at 10% or higher, and the bankruptcy of Social Security and Medicare, both of which are in negative pay-out mode.
The authors conclude with a summary of the shift in the state/banks relationship.
Over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises. But for at least the past century the pendulum has swung back, with the state often needing to dig deep to keep crisis-prone banks afloat.
We are now deep into the doom loop that was created when the world adopted central banking early in the twentieth century, mimicking the Bank of England. Step by step, war by war, crisis by crisis, all governments threw off the shackles of free market interest rates and the gold standard. The commercial bankers, to quote the legendary George Washington Plunkett of Tammany Hall, seen their opportunities and took 'em.
Now what? The authors spin pipe dreams of effective reform.
Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing. Reversing direction will not be easy. It is likely to require a financial sector reform effort every bit as radical as followed the Great Depression. It is an open question whether reform efforts to date, while slowing the swing, can bring about that change of direction.
It may be an open question for these two economists. It is not open for anyone who understands American politics and Austrian economics. There will be no reform that undercuts the ability of big banks to game the state. The system was designed by their predecessors so that the state could be gamed.
Bernanke is trapped. He and his central banking peers have pushed the world deeper into the doom loop. There is nothing on the horizon or in the pipeline that suggests that the system is going to be reformed in any way that will change the system while allowing the world to escape the effects of massive expansion of central bank balance sheets.
The problem has never been the balance sheets of commercial banks. The problem has been the balance sheets of central banks, which supply the banking system with reserves.
Much as I hate Goldman Sachs – the bank we love to hate – the problem did not originate with Goldman Sachs. It originated with the Federal Reserve System.
There is only one way out of the doom loop. End the FED.
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