Breaking the Banks

Simon Johnson at the New York Times takes Ron Paul seriously:

Mr. Paul  has a clearly articulated view on the American banking system, laid out forcefully in his 2009 book, “End the Fed.” This book and its bottom-line recommendation that the United States should return to the gold standard – and abolish the Federal Reserve System – tend to be dismissed out of hand by many. That’s a mistake, because Mr. Paul makes many sensible and well-informed points.

But there is a curious disconnect between his diagnosis and his proposed cure, and this disconnect tells us a great deal about why this version of populism from the right is unlikely to make much progress in its current form.

There is much that is thoughtful in Mr. Paul’s book, including statements like this (on Page 18):

“Just so that we are clear: the modern system of money and banking is not a free-market system. It is a system that is half socialized – propped up by the government – and one that could never be sustained as it is in a clean market environment.”

Mr. Paul is also broadly correct that the Federal Reserve has become, in part, a key mechanism through which large banks are rescued from their own folly, so that their management gets the upside when things go well and the realization of any downside risks is shoved onto other people.

But Mr. Paul’s book also acknowledges the imbalance of power within the financial system that prevailed at the end of the 19th century. Wall Street financiers, like J.P. Morgan, were among the most powerful Americans of their day. In the crisis of 1907, it was Morgan who essentially decided which financial institutions would be saved and who must go to the wolves.

Would abolishing the Fed really create a paradise for entrepreneurial banking start-ups, enabling them to challenge and overthrow the megabanks?

Or would it just concentrate even more power in the hands of the largest financial players?

Important questions, no doubt — but also something of a contradiction.

Absolute power — who gets bailed out, who gets access to a lender of last resort, who gets access to money at next-to-zero rates, who gets stimulus funds — is today concentrated in the hands of the largest financial players— the US government, and the Federal Reserve system.

And the US government is susceptible (understatement is an art!) to the activities of lobbyists.

Here’s the NYT on that issue:

The financial industry has spent more than $100 million so far this year [2011] to court regulators and lawmakers, who are finalizing new regulations for lending, trading and debit card fees. During the second quarter, Wall Street spent $50.3 million on lobbying, a small dip from the prior period, according to an analysis by the Center for Responsive Politics.

 Big banks are among the most prolific spenders. JPMorgan Chase‘s team of in-house lobbyists spent $3.3 million, a slight uptick over last year. The biggest war chest among organizations focused primarily on Dodd-Frank belongs to the American Bankers Association, which so far spent $4.6 million on lobbying. The organization wrestled the top spending spot from the Financial Services Roundtable, a fellow trade group that represents 100 of the nation’s largest financial firms.

And the Federal Reserve itself is much worse still. Its stock is owned by private banking interests:

The 12 regional Federal Reserve Banks  issue shares of stock to member banks. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

The banking industry effectively writes much of its own regulation, because it is enmeshed into the governmental-bureaucratic superstructure:

Frankly, I don’t think that power could get any more concentrated.

So surely only the naive would be surprised that the banking industry — through their benefactors at the Fed — bailed themselves out of the last crisis to the tune of $29 trillion.

And that is not just unfair; it’s unhealthy.

As I wrote in November:

Bailing out failed and failing financial institutions creates a zombie economy. Why?

In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.

These bailouts have tried to turn nature on its head — bailed out bankers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.

So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008.

So while it is all very well debate the various schemes to end the problem of too-big-to-fail, it is important to remember that the problem will ultimately solve itself — a system that rewards failures and creates zombies is fundamentally unsustainable.

Ron Paul does not need to end the Fed. By bailing out a system shot with fragility, leverage junkies and counter-party risk — by attempting to sustain a system that is fundamentally unsustainable — the Fed is quietly abolishing itself, or at very least strongly endangering the status quo.

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$29 Trillion

From the Levy Institute:

There have been a number of estimates of the total amount of funding provided by the Federal Reserve to bail out the financial system. For example, Bloomberg recently claimed that the cumulative commitment by the Fed (this includes asset purchases plus lending) was $7.77 trillion. As part of the Ford Foundation project “A Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis,” Nicola Matthews and James Felkerson have undertaken an examination of the data on the Fed’s bailout of the financial system — the most comprehensive investigation of the raw data to date. This working paper is the first in a series that will report the results of this investigation.

The extraordinary scope and magnitude of the recent financial crisis of 2007–09 required an extraordinary response by the Fed in the fulfillment of its lender-of-last-resort function. The purpose of this paper is to provide a descriptive account of the Fed’s response to the recent financial crisis. It begins with a brief summary of the methodology, then outlines the unconventional facilities and programs aimed at stabilizing the existing financial structure. The paper concludes with a summary of the scope and magnitude of the Fed’s crisis response. The bottom line: a Federal Reserve bailout commitment in excess of $29 trillion.

These bailouts saved a failed system. It allowed a broken system to stay broken, so it can break again another day. It saved broken companies, corporations and business models.

It did absolutely nothing whatever to address underlying systemic issues, like America’s oil addiction and systemic financial fragility.

Most disappointingly of all it sustained high systemic debt levels. Without liquidation of bad assets and bad debt capitalism stops working. An essential mechanism of capitalism is that new systems continually grow up to replace the old. That’s creative destruction. Without creative destruction, there is just stagnation.

In the eyes of the wider people, though, the greater trouble with these bailouts is their morality. If I leveraged all my assets, went to Vegas and lost it all playing blackjack, I wouldn’t get a bailout. That’s what the arbitrageurs of the international financial system did: they might have dressed up their addictions in the sophistry of mathematics, but the truth is it is all just gambling. Bailing out upper-echelon gamblers is just looting and pillaging the faith and credit of the world.

The True Cost of Zombification

Hank Paulson, George W. Bush & Ben Bernanke killed Western capitalism. During the 2008 crash, when the banking system was failing (as is entirely predictable and natural in a hyper-levered house-of-cards economy) they decided to end market-led creative destruction, and institute a system of government-led bailouts, bailouts and bailouts — or, more accurately, uncreative stagnation.

Uncreative stagnation deserves its name for a number of reasons:

  1. As Steve Jobs put it: “Death is very likely the single best invention of Life. It is Life’s change agent. It clears out the old to make way for the new.That is just as true for businesses, markets and governments as it is for organisms. When businesses, systems and markets fail, they open holes to be filled by new businesses, systems and markets.  Without allowing for the natural death of failed systems and businesses, governments close the door to new — and often necessary — innovation.
  2. Without the market (i.e. the preferences of people in the economy spending their money) determining what businesses and systems work, those decisions are transferred to central planners and bureaucrats — in this case those who decide who gets bailed out (and who gets state subsidies) and who doesn’t. This means that capital will be allocated to things that people out in the market don’t want or need.
  3. The high debt-acquisition levels necessary to “save the system” necessitate higher taxation, which means that significant quantities of capital — instead of being reinvested into new businesses and ideas — go toward paying down interest on debt. Broadly, because American and Western debt is often owned by Eastern manufacturing nations, this means that productive capital that could be used by Western businesses is being siphoned eastward. So the capital will still get invested, but in businesses in the East.
  4. The money-printing necessary to “save the system” necessitates inflation, which discourages saving and investment and encourages spending on consumption, transferring more capital from Western consumers to Eastern producers.

Just how much debt and money-printing was necessary to “save the system”?

Here’s a chart Nomi Prins produced in 2009. The spending levels (and therefore debt levels) are truly staggering:

So not only did the bailouts disable creative destruction (the engine of innovation and social progress), they also created so much debt that they have already damaged the ability of future generations to save, invest and innovate.

Worse, they did nothing to address the fundamental fragility of the system. All of that interconnected debt means the system is still fragile to a default cascade, which means that if the system is to be “saved” again, it will require more bailouts and more debt-acquisition, further eroding the ability of taxpayers to save and invest, as governments tax and inflate the currency to pay down the debt.

I expect future generations to look back on this episode as a bizarre aberration. America — surely the greatest producer and innovator in the history of human civilisation — forgot how markets work and the notion of creative destruction, forgot that an empire dependent on hostile partners (i.e. China and the Arab world) is hugely fragile, and then forgot the fact that America emerged as a superpower as a direct result of its status as a great creditor and manufacturer, and that the old European empires lost their superpower status through loss of productivity and massive debt acquisition.

Future historians in the post-American epoch may attribute this bizarre lapse of concentration to a desperate desire for stability, in the wake of the world-shattering events of 9/11. The public and the establishment simply could not face radical change. America got too old, too stubborn, too rich and too established to face the kind of creative destruction that had historically shaped American politics and civilisation. America traded the liberty of creative destruction for the “security” of bailouts, the security-state, and governmental paternalism. As we shall see in the next decade (and contrary to Japan’s experience thus far) this is a totally false security.


What does the market slump of the past couple of days show?

When the market prices in favourable government intervention (endless free cash), and the government doesn’t meet expectations the easy-credit junkies slouch into a stupor, suffering harsh withdrawal symptoms.

From BusinessWeek:

Goldman Sachs Asset Management Chairman Jim O’Neill said the global financial system risks repeating the crisis of 2008 if Europe’s debt crisis escalates and spreads to the U.S. banking industry.

“This is where the parallels with 2008 are relevant, even though I think they are being over exaggerated,” O’Neill said in an interview on CNBC today. “It was when the financial system really imploded that financial firms stopped extending credit to anybody that the corporate world had to destock and we know what happened after that. We are not far off the same sort of thing.”

More than $3.4 trillion has been erased from equity values this week, driving global stocks into a bear market, as the Federal Reserve’s new stimulus and a pledge by Group of 20 nations fails to ease concern the global economy is on the brink of another recession. O’Neill said the Fed’s plan to shift $400 billion of short-term debt into longer term Treasuries hasn’t convinced investors it will strengthen growth.

“The fear that it’s all dependent on the Fed, together with this mess in Europe, is really getting people more and more worried as this week comes to an end,” O’Neill said. “The markets have taken the latest FOMC move rather badly, which adds a whole new angle to it. It’s the first time since the global rally started in early 2009 that the markets have rejected a Fed easing.”

“As the problem in Europe spreads from Greece to more and more other countries and in particular Italy, the exposure that so many people bank-wise have to Italian debt means the systems can’t cope easily with that and it would spread way beyond Europe’s borders,” O’Neill said. “This is why the policy makers need to stop being so sleepy and get on and lead.”

Yes — of course — what the market junkies need is another hit, another tsunami of easy liquidity, money printing and endless “bold action”. Otherwise, the junkies would be left shivering in a corner, cold turkey.

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