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Banks Must Be Restrained And Financial System Reformed, Before There Can Be Any Sustained Economic Recovery

Stock-Markets / Credit Crisis 2011 Mar 18, 2011 - 06:24 AM GMT

By: PhilStockWorld


Best Financial Markets Analysis ArticleI have long been a fan of Jesse's Café Américain. Jesse is a brilliant writer and a deep thinker who uniquely transcends politics, easily seeing through lies and disinformation. He has a great feel for what really matters, and the courage to speak out about it.  Jesse and I have spoken before about the economy, markets and politics, and being at a crossroads once again, it was a perfect time to catch up. 

Ilene: Hi Jesse, since our last interview, I would guess that we'd both would agree that nothing has been done to clean up the financial system - the banks and government interconnectedness, conflicts of interest, and out-and-out fraudulent activities.  Are things better or worse, or in line, with what you were expecting over a year ago?

Jesse: I think things are progressing in line with what I had expected, with the Fed and the government trying to prop up an unsustainable status quo by monetizing debt.  I am still a little shocked by the brazen manner in which the financial markets are being conducted and regulated, and the news is reported in the US. It is one thing to hold a theory that says something will happen, but it quite another to see it actually happening, and so blatantly, almost without a word of protest.

Ilene: How do you view our financial system and the global financial system now, with no progress towards any kind of reform?

Jesse: The US is now being run by an oligarchy, with lip service being paid to the electorate in allowing the people to vote for the candidates that the parties and the powers will put forward.  There will be no recovery for the middle class until they assert themselves. I know I have stated this often in my tag phrase, “The banks must be restrained…” But it is the case.

There are areas of resistance to this trend on what one might call ‘the fringes of Empire,’ those client states which have been ruled by powerful cliques with the support and the protection of the US.  Although certainly not a great analogy, it does remind one of the freedom movements in the former Soviet satellite countries as that empire faltered.  The walls are coming down.

Ilene: You wrote an excellent article "Modern Monetary Theory: The Sophistry of the US Dollar" in which you countered points made by Pragcap (Cullen) who maintains that the Fed is not "printing money" and not causing inflation.  He makes an academic argument which I can't understand, and couldn't intelligently challenge, except that we see inflation in prices of necessities everywhere.  And other countries are revolting and overthrowing their governments, at least in part spurred by severe increases in food prices.  When theory (good as it may sound) is in conflict with what you see in front of you, it's hard to stick with the theory.  I thought your counterpoints were compelling and addressed the real situation rather than theory.  On this topic, which has been confusing me for months, here are some questions that might hopefully help non-economic types understand the mechanism of the Fed's QE2 program as it applies to the real world.

The Fed may not be really "printing" money, but it is monetizing debt, isn't it? Creating more debt, and more liquidity in the market based on debt. Can you elaborate?

Jesse: There are three basic ways that ‘money’ is created in this fiat system. The Treasury issues debt to support government expenditures and the markets accept that debt through the Primary Dealers and the Federal Reserve System. The second major manner is money expansion based on fractional reserve lending, in which the banks and other financial institutions can essentially expand the available money supply through using their credit facilities. And the third method is for the Fed to expand its balance sheet and monetize existing debt.  That is pure ‘hairy-knuckled’ money creation.  

The Fed does not issue debt per se, as it leaves that to the Treasury and to the financial sector.  But it legitimizes and regulates that money creation, and in extremis, will become the ‘lender of last resort’ and the money creation mechanism when the system falters. The Fed in a sense is always presiding over the money creation process in the US – that is what they do! But there are times when they must fall back on their own balance sheet to expand the money supply as the private sector has faltered, and is not able to support the credit creation process by the Treasury and the financial sector. 

I am not surprised when some people in the manner of talented amateurs distort the bookkeeping aspects of the banking system or the markets to promote theories that are not correct, to paint a picture that is false in support of policies that are hare-brained. But I am a little disappointed when professional people, especially responsible people in banking or the Fed, do this same thing promoting things like ‘the efficient markets hypothesis’ or some neo-monetary theory. 

No matter how one handles the accounts, the limits of the power of an economy to create money are the acceptance, the valuations if you will, of their bonds and currency, which these days are just bonds of zero duration, in a free market and holders exogenous to that particular economy.  If you want to know how an economy is doing, look to the sentiment amongst its foreign creditors.

By the way, I do not have a problem with the direct issuance of currency by a Treasury, instead of a debt financed system managed by private banks.  But no matter how one structures the financing, the limitations as noted above remain the same.

Ilene: "Inflation" is an inconsistently defined term.  Different financial authors seem to define it in various ways which can be the difference in whether they will see it or not.  How would you define inflation? What would a situation be in "flation" terms when we have necessities - food and energy - and in this case stocks, gold and silver too - while the biggest investment many people have, their houses, are still falling in value?

Jesse: Inflation can mean many things to many people including a simple supply-demand imbalance, including a general slump in demand because of some business cycle fluctuation. But what is most problematic is a true monetary inflation. 

A monetary inflation is a condition in which the supply of money is expanding in excess of productive uses for that money and the organic growth of relatively riskless credit.  If the Fed were to double its balance sheet again tomorrow by buying stocks at a multiple of their closing price today, this would represent a monetary inflation.  The problem always comes down to measurements, definitions, and lag times.  I am not saying that the growth in real GDP must exceed 1:1 for each marginal dollar added, given the realities of investment and capital expenditure.  But when one is creating four or five dollars in a broad money supply for each new dollar in real GDP you know something is very wrong.

An expansion in the Fed’s monetary base does not immediately translate into an increase in money supply as more broadly measured in the economy, in something like MZM or M2.  (See Money Supply: A Primer.) 

And if they manage it correctly, and are also very fortunate, it may not to any significant degree. But the Fed is the locus of monetary inflation, the place where it originates.  At times it may be indirect, when for example the Fed fails to manage the credit creation and margin process and permits a stock asset bubble to form.  This is their job; this is why they were given the power to pull those levers. And it is a tremendous power for a small group of individuals to have.

They may make excuses, may say they did not know, but in point of fact subsequently released documents show that they did know, they knew exactly what they were doing.  And they did it anyway, and tried to bluff and hide what they have done by abusing their independent stewardship, which is another pretty invention that depends on a utopian vision of society, like the inherent goodness and freedom in markets without rules and regulations.

In a purely fiat system, monetary deflation and inflation are essentially policy decisions. And for a net debtor to choose deflation is tantamount to suicide.  But what the Fed cannot do is create a productive economy which requires labor, management, and investment.  And this is why my forecast has been for a stagflation to occur, roughly since 2002.  I think we would have seen it sooner but I underestimated the amount of cooperation which the US would receive from Japan and China in their ‘vendor financing’ arrangements.  I also underestimated the Fed’s willingness to create a massive housing bubble and turn a blind eye to systemic financial fraud. 

Ilene: We've been noticing that on POMO days (permanent open market operations, a tool to implement QE2), the stock market rises.  One way may be that as the value of the dollar falls, people (or high frequency trading machines) take their dollars and buy stocks so their dollars maintain some value as stocks go up but the dollar drops.  Because the market rises most on POMO days, we have suggested that the Primary Dealers who get the POMO money for selling Treasuries, are taking the money and throwing it into equities and commodities, driving these prices up (to the detriment of the world).  Would you agree with my assessment, or de-confuse me if I'm missing something? 

Jesse: I think this is a bit of a simplification but it is directionally correct. The Fed adds liquidity through the POMO facility, and that ‘hot money’ chases beta or higher risk returns in the markets, which remain broken in terms of efficient capital asset allocation.  This is a ‘bubble ready’ financial system, and will continue to produce bubbles until it is reformed. The financial sector is primarily a wealth transference mechanism. And with the productive economy foundering because of gross mishandling over the past twenty years or more, the sector is transferring wealth from the future of the economy in the form of Treasury debt to the monied interests on Wall Street in the form of asset bubbles, bonuses and fees.

Ilene: What are your thoughts on the markets, economy, commodity prices (oil, gold, silver) and U.S. dollar for the near future, and more distant future?

Jesse: I think that there are some significant policy and exogenous policy variables in there that will affect the timing of this.  What will China do?  What will Europe do?  In an ideal world according to the Fed, all of the world’s currencies would inflate and allow the US to inflate its dollar even more, to dilute the debts which are unpayable. Don’t laugh too much, because that is what has been done since the US rallied the rest of the world to this cause in 1971 with its unilateral dissolution of the Bretton Woods agreement.    

The central banks would like to have one currency, because this would make it much easier to engineer the financial system.  But they could not stop there; they would eventually have to become central planners in the manner of an autocracy because there are so many competing forms of wealth to their paper, particularly in troublesome commodities like food and real goods.

Ilene: Speaking of real goods, this question is from Elliott, who writes Stock World Weekly. He asked if you have heard rumors of gold bars that supposedly have a tungsten core with a thick plating of gold. He writes: "To date I have yet to see anything that I could point to as a seriously credible source for this story. Supposedly the fraud was exposed recently when the Chinese had the bad taste to melt down some bars they got from London, and when they melted the tungsten cores popped right up to the top of the melt and were floating around. Anyway, that's one story of fake gold I've heard. Is there any truth to it? If so, where's the "smoking gun" and why isn't this being reported in a big way?"

I think this is probably more of a side issue and a distraction.   Why worry about tungsten bars when the US will not agree to an independent audit of Fort Knox in the first place?   When the silver market is so obviously leveraged with essentially fraudulent paper in the manner of a Ponzi scheme? Let’s worry about the possibility of some tungsten bars in the midst of wholesale looting. Distractions tend to dissipate energy from the critical issue, which is the lack of transparency and accountability in the financial dealings of the Wall Street Banks and the Fed in particular. 

Ilene: With the horrific news coming out of Japan lately, first the earthquakes and tsunami, and now the nuclear meltdowns, do you have any thoughts on the tragic situation over there?

Jesse: The markets are getting very mixed news on this, depending on the source. There are weighty papers from MIT saying the risks are minimal, and the US Ambassador in Tokyo issued reassuring words this morning.  A new statement from the US came out after the close of trading today which called the levels of radiation dangerously high and urged caution. Therefore traders are jittery because of the uncertainty regarding the quality of information being released from a variety of sources, and some are thinking that risk is being understated by the Japanese government and Tokyo Electric in order to avoid a panic. So the bias is to act first and fact check later.

This is what is called a "trader's market." Triple black diamond slopes IF you can handle them. Danger, une chute dans cette piste peut entrainer de graves lesions et meme la mort. Most people should stay off the slopes and enjoy their coffee in the lodge. 


Philip R. Davis is a founder of Phil's Stock World (, a stock and options trading site that teaches the art of options trading to newcomers and devises advanced strategies for expert traders. Mr. Davis is a serial entrepreneur, having founded software company Accu-Title, a real estate title insurance software solution, and is also the President of the Delphi Consulting Corp., an M&A consulting firm that helps large and small companies obtain funding and close deals. He was also the founder of Accu-Search, a property data corporation that was sold to DataTrace in 2004 and Personality Plus, a precursor to Phil was a former editor of a UMass/Amherst humor magazine and it shows in his writing -- which is filled with colorful commentary along with very specific ideas on stock option purchases (Phil rarely holds actual stocks). Visit: Phil's Stock World (

© 2011 Copyright  PhilStockWorld - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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