A Real Phony

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

"You're wrong. She is a phony. But on the other hand you're right. She isn't a phony because she's a real phony. She really believes all this crap she believes. You can't talk her out of it.... She's nuts."

-Of Holly Golightly, from Truman Capote's Breakfast at Tiffany's (1958)

"While central planning may no longer be a credible form of economic organization, the intellectual battle for its rival - free-market capitalism - is far from won."

"Anti-capitalist virulence appears strongest from those who confuse "crony capitalism" with free markets. Crony capitalism abounds when government leaders, usually in exchange for political support, routinely bestow favours on private-sector individuals or businesses. That is not capitalism. It is called corruption."

-Former Federal Reserve Chairman Alan Greenspan, who centrally controlled and underpriced the most over-leveraged interest rate in the world for 18 years and is now cashing in like a reality TV celebrity. Financial Times, January 30, 2012, under the fanciful title: "Meddle with the Market at Your Peril"

Transparency Has Landed

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

See Frederick Sheehan's Interview on

"The Larry Parks Show" (Janurary 12, 2012)

Federal Reserve Chairman Ben S. Bernanke has finally achieved his childhood fantasy. He has passed into existence (note: not law, regulation, or any other formal apparatus that cannot be ripped from his bodice by the People's Representatives) a policy of achieving 2.0% inflation.

From a January 25, 2012, Federal Reserve press release: "The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." (For the prelude to his ploy, see: "Presidential Rivals: Drop the 'One Percent.' Trumpet the 'Negative Four Percent.'" and "A Quartet of Fed Chairmen Body Slam Bernanke.")

"Personal consumption expenditures" are calculated by the Commerce Department. They have been rising at a 1.7% annual rate. This must be why the ad lib policymakers at the Fed drop-kicked the CPI (consumer price index, calculated by the Bureau of Labor Statistics) into the Potomac, since it is rising at a 3.0% annual rate. The pilferers might still have chosen the CPI, after dropping food and energy: a measure Chairman Bernanke often talked about. The ex-food, ex-energy CPI rose at a much-closer-to-target 2.2% over the past year.

Whatever the Fed's reasons for siding with personal consumption expenditures, the BLS states (in its December Consumer Price Index Survey) that food prices rose 4.7% over the past year. Dairy and related products rose 8.1% in 2011. From the American Petroleum Institute: gasoline prices have risen 9.5% over the past year. McDonald's announced on Tuesday that it is increasing prices again - it did so three times last year - due to higher costs. That probably includes transportation. The recently released Cass Freight Index (through December 2011) noted that North American freight costs "were up an astounding 18.8% against an increase in freight volumes of only 0.7%."

After the Fed press release, Burglar Ben held a press conference. This is part of his "transparency" ploy. Among other oddball comments, the math whiz claimed: "At levels of inflation this low, interest rates should fully compensate for the losses to savers." To approximate, current savings rates in the United States are about 0.0001%. The Fed's press release left a clear path for someone to bludgeon the Bernanke Fed. (Nobody will, but we can pretend.) From the aforementioned press release: "The inflation rate over the longer run is primarily determined by monetary policy...." Monetary policy is in the hands of a man who cannot subtract.

It is slowly becoming clearer that Alan Greenspan should be warming up in the bullpen.

A Quartet of Fed Chairmen Body Slam Bernanke

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

"Ben Bernanke's quest to make the U.S. Federal Reserve more transparent may be nearing an end as it debates a new statement of goals and strategy that is likely to put a number on its preferred inflation rate. A formal, numerical goal for inflation could become Mr. Bernanke's most durable legacy as chairman of the Fed. It would bind his successors to stable prices; end confusion caused by Fed officials who can have slightly different goals; and by reinforcing the Fed's determination to control inflation in the long-run, it could create space for monetary easing."

--"Fed Nears Inflation Target Decision;" Robin Harding in the Financial Times, January 17, 2012

This P.R. release barely needs comment. For the purported "transparency," see "Presidential Rivals: Drop the "One Percent." Trumpet the "Negative Four Percent."" "Presidential Rivals" quoted from a strategy session at which the FOMC [Fed Open Market Committee] gathered a consensus to not tell a soul outside the temple that it would officially adopt a policy to create inflation (i.e., "Inflation Targeting"). The Federal Reserve does not command the authority for this "transparent" maneuver.

Previous Federal Reserve Chairmen were dead set against the idea of any inflation. Back in those days (Before Bernanke), "stable prices" meant no inflation. (That every Fed chairman quoted below failed, and some failed terribly, to accomplish this mandate, should be seen as a warning of what will happen now that the Fed is determined to create inflation.)

How did we arrive at this point? The central banking industry has turned what we know to be true upside down. For instance, Bernanke preens about the advances of the science of macroeconomics, yet, no previous Federal Reserve chairman even mentioned the need to give himself a two or eight or twelve percent inflation cushion to prevent economic implosion.

In what follows, former Chairman Martin explained exactly what the "99%" should know. Their beef is a direct consequence of the very policy that the Federal Reserve will now enshrine in its "goals and strategy." Former Chairman Volcker was dismissed by the current generation of central bankers when he encountered their Orwellian distortion of the term "stable prices." Former Chairman Greenspan's comments of the Fed's forecasting record ("terribly discouraging") should alert readers to sell dollars and buy things: gold, silver, land, canned goods.

Fed Chairman William McChesney Martin (1951-1970) has been quoted here before. His Senate testimony on August 13, 1957, was a particularly fine diatribe. He was fighting a losing battle against Harvard economists who told politicians we needed an inflation rate of 2% to compete with the booming Soviet economy.

Martin warned the Senate Committee on Finance that recent inflationary pressures arose from strong economic growth fostered by "'imbalances in the economy' in which 'rising costs and prices mutually interact upon each other over time with a spiral effect.'" Martin went on. The person most likely to be injured in the inflationary cycle was the "'hardworking and thrifty...little man' on fixed income who could protect neither his income nor the value of his savings." Harvard and the senators had other priorities (themselves), but this is a condensed History of the United States in the 55 Years That Followed. (The conquest of the 99 %.) Regarding the target of a 2% institutionalized inflation rate, Martin said: "[Two] percent may not seem startling [but] the price level would double every 35 years and the value of the dollar would be cut in half each generation. Losses would be inflicted on millions of people, pensioners...all who have fixed incomes.... [T]hose who would turn out to have savings in their old age would tend to be the slick and the clever...."

It can at least be said the current Federal Reserve understands who wins and loses when the Fed stimulates inflation. Current New York Federal Reserve President Dudley talked up asset inflation on October 1, 2010. In the first sentence (ahead), the former Goldman, Sachs economist describes the "spiral effect" of irresponsible money-making before the bankers were bailed out. The second sentence addresses consequences to the "little man." Sentence #1: "The surge in home prices was fueled by products and practices in the financial sector that led to a rapid and unsustainable buildup of leverage and an underpricing of risk during this period." Sentence #2: "These dynamics in turn provided the fuel that caused house prices and consumer spending to rise much faster than income."

Federal Reserve Chairman Arthur Burns (1970-1978) was a "no-percenter." Leading up to the 1960 presidential race between John Kennedy and Richard Nixon, MIT economists Paul Samuelson and Robert Solow argued in favor of "moderate levels of inflation." In his 1959 presidential address at the American Economic Association Conference, Burns chided this politically opportunistic position by declaring any inflation was untenable. The M.I.T. professors, and inflation, won. Solow was one of Ben S. Bernanke's Ph.D. thesis advisers.

Federal Reserve Chairman Paul Volcker (1979-1987) bemoans today's central banking incumbents. At the spring 2006 Grant's Interest Rate Observer Conference, Volcker told the audience the upstarts were a puzzle to him: "A great mantra of central bankers these days is 'inflation targeting.' I don't understand that nomenclature. I didn't think central bankers were in the business of targeting inflation. I thought we were supposed to be targeting stability. We all say we are in favor of stability. You hear these speeches, Bernanke saying 'We are in favor of stability. That is why we are targeting inflation.' There is a certain semantic problem for me in that connection."

Volcker went on to say he had returned from a central bankers' synod in Frankfurt, Germany. On the topic of inflation targeting, he believes he was the only dissenter in the room: "The debate was me on one side and all of the central bankers on the other side." It was explained to Volcker "the importance of inflation targeting was to never go above that. There was an ironclad agreement to keep the inflation rate below that or below the target." This is nonsense. The professors will never be wrong. They have prepared for 2, 4, and 6% inflation. The "literature" (Bernanke loves to say that) has been peer-reviewed and published.

Volcker also told his audience: "I can remember my old professors at Harvard, in 1951 or so, saying a little inflation is a good thing. 'We don't want very much, but 2% is good.'" Chairman Martin addressed the 2% target in his August 13, 1957 testimony: "There is no validity whatsoever that any inflation, once accepted, can be confined to moderate proportions." Martin was thinking of an intelligent person or shrewd FOMC: Either was doomed. That is not the case today. Martin could not have imagined the existence of a Bernanke.

Adam Posen, one of the co-authors, along with Ben S. Bernanke, of Inflation Targeting: Lessons from the International Experience, believes inflation rates of "4, 5, or 6 percent a year, say, will [not] hurt growth. It is just not there in the data." He went on to say (in Challenge, July/August 2008) that researchers have found once "you get to an annual inflation rate of 10 percent - some would say 8 percent, some people would say 12 percent," you "begin to see significant negative effects on growth." This is all too stupid to discuss, but Posen, an American, is now serving on the Monetary Policy Committee of the Bank of England. Why? Is it only American universities that produce ideas so bad they are needed around the world to inflate paper currencies out of existence? (Another of Ben Bernanke's MIT thesis sponsors was Stanley Fischer, also an American, who has been shipped off to run the central bank of Israel. Israelis are hereby warned: gold and canned goods.)

Three years after speaking at the 2006 Grant's Conference, Paul Volcker told the New York Times the Bernanke Fed "is not really in control of the situation."

Now we turn to the Maestro: former Fed chairman Alan Greenspan (1987-2006). At the February 1-2, 2005, FOMC meeting, he opposed inflation targeting. The transcript has the ring of Paul Volcker's séance in Frankfurt. The younger generation of central bankers, who now monopolize the debate, had spoken. Greenspan, always the gentleman, did not say they are up after their bedtime, yet they are.

CHAIRMAN GREENSPAN: I don't see how we can define a specific number for price stability....and the reason is that inflation targeting presupposes an ability to forecast, which I don't think any of us have, or can have." [The obvious question here, oh, forget it. - FJS] "The vast majority of examples we are going to run into, if we go to inflation targeting, will be cases where suddenly price inflation is at the outer edge of the target, or indeed, has actually breached it - and other evidence on the underlying trends in inflation is not clear." Greenspan went on to say the Fed may see "contrary notions," meaning, indicators that inflation is both rising and falling.

The chairman who was never Time's Person of the Year continued: "Now, one of things we always forget, looking back, is how little we knew at the time things were occurring or about to occur. When I read the transcripts of earlier meetings, I am surprised, because I thought we were really knowledgeable about what was going to happen. Something happens and I say to myself, 'Well, we got that right; our forecasts were terrific and our insights were great.' When I go back and read the transcripts, I find that it just isn't so....Go back and read the 1979 transcripts....I found reading those transcripts terribly discouraging. My view of the extraordinary institution of which we are all part fell about 20 percent because some of the comments being uttered around this table were absolute nonsense. If you go back to October 1979 and read the transcripts from that time on, you will see how little everybody knew or thought they knew...."

It was on October 6, 1979, with consumer price inflation rising at a 12% rate, that Federal Reserve Chairman Paul Volcker announced the Fed would no longer peg interest rates, specifically, the fed funds rate. The FOMC would concentrate on controlling the supply of money. Looking back, Volcker's decision was correct. On October 6, 1979, the funds rate bounced within a target range of 11-1/4% to 11-3/4%. Cast loose, it rose to a monthly average of 17.6% in April 1980, fell to 9.0% by July, and traded at an average rate of over 19% in June 1981.

Greenspan continued: "I don't wish to downgrade the importance of the actions taken. They were tough and they were the right actions. But to presume there was great intellectual control over what was going on is completely undercut by reading the contemporaneous transcripts. That's just the way we are. We have a recollection of what we did which is, unfortunately, fictionalized. I've been in this business for too long!"

The Fed's genius for always being wrong is not a revelation to readers of Panderer to Power, but: Why does the Federal Reserve employ a single economist? It should stick to funds transfers.

Of course, Bernanke had never made an economic forecast in his life until he was chosen as Fed chairman, yet his economic predictions are televised and quoted and move markets.

Legendary investor Jim Rogers was interviewed on TV in May 2011. The interviewer asked Rogers something (long since forgotten) about a recent Bernanke forecast. Rogers, fuming that he (or, probably, anyone else) should be asked to analyze Bernanke's prediction, replied: "This guy Bernanke - YOU should do an expose - You should go back and just - EVERYTHING he said for eight years was wrong! It's astonishing....He's a great contrarian indicator!"

It is clear that Ben S. Bernanke has never given a moment's thought to the possibility his accommodating and manipulative policies may demand a similar decision to Paul Volcker's in October 1979. Nor could he possibly orient his mind to acknowledge that today's economy will react more violently. By the fall of 1979, interest rates had gradually risen for close to three decades. Today, floating rates would either (1) crush an economy dependent on low, low, low rates, (2) pass 19% about 10 minutes after the change in policy, or, first (2), and then (1).

A practical question: how can anyone really "invest" with government conduits around the world attempting to control every market: a mad hatter's scheme that is doomed, that has established price corridors convenient to a bureaucrat, will snap back in a vicious manner, but at an unknown time?

Chairman Bernanke was interviewed on "60 Minutes" on December 5, 2010. When asked with what degree of confidence he could prevent inflation from getting out of control, he replied: "One hundred percent." In 2008, the Chicago Tribune quoted globetrotting economist David Hale. Bernanke had told Hale: "We have lost control. We cannot stabilize the dollar. We cannot control commodity prices." In an earlier (March 2009) interview on "60 Minutes," Bernanke told America he had "never been on Wall Street." In 2006, Simple Ben enlightened Congress that Wall Street operated at a new, permanent high plateau: "The management of market risk and credit risk has become increasingly sophisticated.... [B]anking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks. The banking agencies will continue to promote supervisory approaches that complement and support banks' own efforts to enhance their risk-management capabilities." From personal knowledge, Ben believed every word in that statement.

What will they make of us in 100 years?

Presidential Rivals: Drop the "One Percent." Trumpet the "Negative Four Percent."

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Frederick Sheehan will be interviewed on "The Larry Parks Show," Thursday, January 12, 2012, from 7:00 to 7:30 PM, on Time Warner Channel 56, RCN Channel 83, and Verizon Channel 34.

Here is a topic begging for a presidential candidate's attention. It is simple to explain and to understand. The White House hopeful should grab the baton from the weary "one percent" couriers. In its place, "I'll stop those negative four percenters," will shine with "a cross of gold" in America's heritage. The "one percent" is a vague call-to-arms since it is not clear where the disenchanted should concentrate their energies. The "negative four percent" is directed at a single source.

An outline of what follows: First, will be an explanation of the negative four percent. Second, a look at the gestation of Inflation Targeting. Third, the constitutional question: is such an adoption within the authority of the Federal Reserve System? Fourth and finally, will be comments behind closed doors by Federal Reserve officials of whether the Fed should receive authorization by Congress for Inflation Targeting. A preview: on the whole, participants thought it would be best not to open this can of worms before the legislators. A future episode will explore the comments of four former Federal Reserve chairmen who either are (or were) enemies of such a leap into academic abstractions.

The formula follows. The Federal Reserve is rumbling towards an official "Inflation Target." On January 5, 2012, St. Louis Fed president James Bullard told Bloomberg radio: "I think we're very close to having inflation targeting in the U.S. This may be an opportunity to get something done that everyone on the committee can rally around."

Regular readers know the story behind the story. (For instance, see The 8% Solution and "Who Am I? What is Money? The Fed is Here to Help". Federal Reserve Chairman Ben S. Bernanke is the partial author of Inflation Targeting: Lessons from the International Experience.

Inflation Targeting (not normally capitalized, but it needs celebrity promotion) is a toy with which a central bank picks an inflation rate out of the air. The People are then subjected to a race against inflation. The rate might be any single-digit number other than zero. (Purists may claim zero is not a number, but this is a political campaign.)

Only two variables need to be explained and understood by the public. One is the interest rate; the other is the inflation rate. Put together, the Federal Reserve is vectoring towards an official policy of reducing Americans' personal wealth by four percent each year.

In fact, this Fed would hold short-term rates at zero forever, if the real world allowed it. Its policy permits no one in the United States to save. It would still be possible to retain one's savings and accumulated wealth with a zero-percent inflation rate. However, the Fed is about to instate an official policy of inflating prices and devaluing the dollar.

The inflation rate chosen for this presidential campaign is 4%. Thus, zero percent of interest earnings and 4% inflation equals a confiscation of 4% of American's personal property - compounded - each year.

Why 4%? The Bureau of Labor Statistics' consumer price index (CPI) is around 3.5%. There is no reason to insist on precision with the campaign slogan. According to John Williams of Shadow Government Statistics, if the BLS used the same methodology to calculate the CPI that it used in 1990, it would be over 7%. If the BLS used the same methodology that it used in 1980, the CPI reported by the media today would be 10%.

A different John Williams, this one is President of the San Francisco Fed, and, as of January 2012, a voting member of the FOMC, has publicly proposed an Inflation Target of 4% (See: Heeding Daedalus: Optimal Inflation and the Zero Lower Bound). He is the Fed's new poster boy.

Wall Street Journal reporter Jon Hilsenrath wrote a profile of John Williams (of the San Francisco Fed, not Shadow Government Statistics) in the January 9, 2012, edition. Hilsenrath relays the Fed's publicity releases to the public through the Journal. The "brainy" San Francisco Fed president "might consider an inflation objective even higher than 2% under some circumstances." This hardly does Williams justice. He has already proposed going much higher, but it apparently is not yet time to break that news.

Even more unsettling is the Federal Reserve's decision to pursue Inflation Targeting without review. How did it receive authority to construct a policy of currency debasement? Section 8 of the U.S. Constitution states: "Congress shall have the power... to coin Money." Leaving aside Congressional dereliction of said Section, the Federal Reserve is pursuing its confiscatory policy by stealth.

What follows is an unusual opportunity to read Fed officials' honest reasons (behind closed doors) for violating institutional checks-ands-balances. Inflation Targeting was the topic of discussion at the February 1 and February 2, 2005, FOMC meeting. In summary, they veered towards importing Inflation Targeting on the sly.

This is such a ripe topic for an ambitious candidate. It's on record. It is easy to understand: just a "0" and a "4." Americans know, or at least sense, they are being abused. A candidate can direct energies to a single, concrete source.

Vincent Reinhart, then a Federal Reserve staff economist, now at some think tank, presented "Considerations Pertaining to the Establishment of a Specific, Numerical, Price-Related Objective for Monetary Policy." Reinhart broached the question: "Should the inflation goal be decided by the Congress (presumably through the process of amending the Federal Reserve Act) or by the Committee?" Reinhart presented the pros and cons. One con: "In particular, is the Committee comfortable in seeking amendment to the Federal Reserve Act? Reopening the act could lead to other changes that the Committee might not welcome...."

Reinhart later added: "[A]n inflation target should be delegated to a conservative central banker. That seems to have been the equilibrium worked out over time, and you might not want to perturb that equilibrium now." Compromise of what, with whom, and the equilibrium not to be perturbed were not discussed. Let's take a guess since the period between 2005 and 2012 needs to be addressed. The Fed and Congressional oversight committees have reached a "see no evil, hear no evil, speak no evil" accord. If true, this is fertile ground for a candidate. If false, it is still fertile ground since the overseers are derelict.

Board member Ben Bernanke thanked the staff for its pro and con discourse. (Alan Greenspan would be chairman until January 2006.) Bernanke regretted it "was difficult to get precise empirical evidence on...whether or not low inflation is good in the first place." [Editor's note - This question was asked by the "conservative central banker" about to run amok bespattering America with his college thesis. - FJS]

Chairman Greenspan put an end to this silly distraction, stating that low-inflation and "sustainable long-term growth" are "as close to a generic macroeconomic principle that we can have." [Editor's note - The non-academic chairman had to waste his time telling the former head of the Princeton University economics department, who loves to remind audiences: "I am a macroeconomist rather than a historian," of the "the most generic macroeconomic principle that we can have." - FJS] [From the editor who won't stop butting in - The specific "macroeconomist/historian" quote just cited comes from page six of Ben S. Bernanke's Essays on the Great Depression. The professor wanted it understood up front that he has no patience or time for the history of the Great Depression. - FJS]

Janet Yellen, president of the San Francisco Federal Reserve (at the time; she is now vice chairman of the Federal Reserve System), thought the Fed could slide Inflation Targeting in the back door. In Yellen's words: "augmenting the status quo" could be pursued by "very carefully crafted language" from a 2003 speech by Federal Reserve Board member Ben S. Bernanke. Yellen's suggested course (in her mind) would explain "to the public why the Committee endorses an inflation objective that actually differs from true price stability." [Italics added - FJS.]

It is worth tucking that sentence away. It is not likely we will read another admission from a central banker that Inflation Targeting is a different species from "true price stability." Congress has established a mandate for the Federal Reserve to maintain "stable prices." Yellen made it crystal clear that the Fed ignores "true price stability."

Mark Olson, president of the Fed's Atlanta branch, was leery of telling Congress the FOMC was adopting Inflation Targeting in its mandate. Olson thought "if we tinker with any element of the Congressional mandate, we would do so at our peril." Olson told his cronies that when he went through his confirmation hearing in 2001, "at least one member of the Senate informed us that if they opened up the Federal Reserve Act, he would want a mandate that zero inflation ought to be the law."

Chairman Greenspan spoke, as was his wont, after all FOMC members had their say: "[T]he political issue bothers me a great deal." He did not say why. Possibly, he looked upon the day's discussion as exploratory in nature. He had less than a year remaining as chairman, so knew Inflation Targeting was a decision for the next chairman. Greenspan discussed operational problems of Inflation Targeting. These will be quoted in the next episode: discourses by former Federal Reserve chairmen about Inflation Targeting.

Markets Vanish - "In a Flash"

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

What follows is the same warning broadcast in January 2011. In his January 6, 2012, Credit Bubble Bulletin, Doug Noland discussed the same topic: "The '08 crisis is considered a low-probability "tail event" - a so-called rare "black swan" or "hundred-year flood." Yet I would argue that such a financial crisis was in reality a high probability outcome. Bubbles burst - plain and simple. It is the act of predicting the timing of their demise that tends to be an exercise in low probability outcomes. This is especially the case when government policymaking is a major factor fueling Credit and asset Bubble excess...

Government interference extends unstable market conditions longer than would otherwise be true. By doing so, George Eliot's observation (at the bottom, here) is even more appropriate in 2012. - FJS - January 8, 2012

Following is a short excerpt from "War of the Nerds," which I wrote for the December, 2006, edition of the Gloom, Boom & Doom Report. I discussed the crises an investor ("Our Serious Investor") navigated from the 1960s to the present. Doomsday had been predicted since the dollar crises of the 1960s, yet risk had been transient. By the fall of 2006, it was obvious the U.S. mortgage market and banking system were in collapse, but securities markets were deemed riskless, as measured by bond and credit-default spreads. It is timely to resurrect the vanishing bond markets of 1914 and 2007 after the failed or distressed auctions since December 27, 2010, of euro zone, Chinese, and U.S Treasury bonds with 5-year and 7-year maturities.

The historian Niall Ferguson (The Cash Nexus, War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: "Political Risk and the International Bond Market Between the 1848 Revolution and the Outbreak of the First World War." Published in the Economic History Review earlier this year, his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary and Russia) comes to a surprising conclusion - the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

....It is 2006. Our Serious Investor has grown calloused to once-in-the-history-of-the-universe events. Our Investor survived the dollar crises, the stock market collapse and deep recession of 1973-1974, the Business Week "Death of Equities" front cover, the $250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past twenty years (far more prevalent than between 1950 and 1970), the current $500 billion federal budget deficits, and the (prospective) $1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the "Greenspan put" (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away....

Ferguson's narrative of the countdown to war is a splendid chronology of how quickly the world can change: "It was not until 22 July [1914] - more than three weeks [after Archduke Franz Ferdinand of Austria was assassinated, on June 28, 1914] - that the possibility of a European political crisis was first mentioned as a potential source of financial instability in the financial pages of The [London] Times....

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 - a single basis point of fear.... Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now [British] consols rose to 3.45%. The St. Petersburg exchange closed on July 29 and the Economist considered the "Berlin and Paris bourses closed in all but name."

....A wholly unanticipated domino effect now engulfed London. The bond market did not seem to acknowledge this vaporization of liquidity: "....The Economist was especially struck by the widening of the bid-ask spread for consols (the gap between buyers' offers and sellers' asking prices) to a full percentage point, compared with a historic average of one-eighth of 1 per cent... "

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%.

As to how much we can trust the Greenspan "put": "[T]he British and Continental financial authorities pulled every trick." [Ferguson] furnishes a list of clever, arbitrary and confiscatory maneuvers, but, "systematic central bank interventions to maintain bond prices" only worked for a time. Government assistance "could only disguise the crisis that had been unleashed in the bond market; it could not prevent it." [My bold- FJS]

Ferguson scrapes up the debris: "For all save the holders of British consols, who could reasonably hope that their government would restore the value of their investments when the war was over, these outcomes [for French, German, Austrian, and Russian sovereign bond holders] were even worse than the most pessimistic pre-war commentators had foreseen. The fact that investors do not seem to have considered such a scenario until the last week of July 1914 surely tells us something important about the origins of the First World War. It seems as if, in the words of The Economist, the City only saw 'the meaning of war' on July 31-'in a flash'."

Aside from the origins of World War I, the last week of July 1914 surely tells us something important about investors today.

"The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."

-George Eliot, Silas Marner

Volatility Lurks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

The European Union is putting its money where its mouth is. Never taking the slightest blame for euro woes, its New York employees are moving to new offices at 666 Third Avenue. The EU's United Nations delegation will "take about 45,000 square feet .... and pay about $60 a square foot annually for 15 years...." reported Bloomberg on December 23, 2011. Negotiations with its prospective new landlord, Tishman Speyer Properties L.P., are nearing completion. The real estate company should consider an anti-EU hedge at the moment the EU signs up.

Sixty Euro employees will occupy the space (per Bloomberg). This works out to a 25-by-30 square-foot office for each. "Austerity" is imposed on the lower 99%, but not yet in Brussels, Strasbourg, or points west.

The potential break up of the European Union is more a consideration for a landlord holding a fifteen-year lease agreement than for the average investor. Yet, current havoc and future bedlam are clearly underpriced in all markets. European and U.S. mispricings will be discussed here.

The S&P 500 volatility index - the VIX - is a measurement of volatility expectations. It has fallen 50% since the (latest) agreement to save the euro was announced. From 30.59 on December 8, 2011, (the Eurocrats trumpeted their fiscal union pact on December 9, 2011) the VIX fell to a 20.72 close on December 23, 2011.

Whether or not fiscal continence is the route to euro salvation does not seem to matter. As discussed in The Rotten Heart of Europe, the Euro establishment (Brussels, banks, and bond markets) vectored towards that conclusion. Having done so, the implied volatility of markets is a derivative of what negotiators accomplished on December 9^th.

European Voice, a Brussels-based, English-language newspaper "maintains an independent stance regarding the affairs of the European Union." So it claims. It is owned by the Economist Group. This disabuses the notion of neutrality. The Economist's heart, soul, liver, and spleen promote the European Union over national sovereignty.

Thus, Van Rompuy Sends European Leaders Draft of Fiscal Union Pact, published on December 14, 2011, distills the best efforts of euro fans to promote the fiscal union pact. We learn that Herman Van Romney, the president of the European Council, has (on December 14) sent a draft of an inter-governmental treaty that will seek to boost economic discipline in the eurozone. It will enter into force once nine of the 17 eurozone member states have ratified it. It contains tougher rules on economic discipline. [Underlined words to be explored - FJS]

Since the purpose of the pact is to convince skeptics of the euro's stability, Van Rompuy must be planning an early retirement. Maybe next week.

The "draft" will transmogrify into a treaty by March 2012. (This and what follows is gathered from European Voice.) How many of the still (somewhat) sovereign states will sign is unknown. We do know that most countries "have shown interest." Whether any more is expected of countries is not clear: "If a eurozone country does not ratify it, it will not be bound by the new rules." That's the problem with the euro today.

However, an EU official told European Voice that rejection by a country would "make life politically very uncomfortable for a non-ratifying member." Here is the mailed fist of the lifetime bureaucrat. The EU official continued: "It ["It' seems to mean the state's sovereignty - FJS] would not be durable for long." The second decade of the 18^th, 19^th, and 20^th century were marked by continental European skirmishes. Four-in-a-row looks plausible.

European Voice reports there are references in the treaty to "work jointly towards an economic policy fostering growth through enhanced convergence and competitiveness." Yet, these references - "remain vague." Please recall that markets, by and large, believe the Eurocrats will prevent a euro breakdown.

"Once adopted, the treaty will force countries to run a balanced budget and enshrine that rule in their constitutions." This is the out-to-lunch attitude of the bureaucrat: expecting, by the beginning of March 2012, the parliaments of nine - or is it 17? - European countries to cede their parliamentary authority (and the opportunity to hand out vote-gathering favors) regarding respective national budgets, at a time voters are ready to lop off parliamentary heads.

Standards to enforce fiscal discipline were ignored in 2005 when "Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt stability pact..." (From: The Rotten Heart of Europe.) That was during a time of relative prosperity. Actually, it was a time when all countries could borrow and spend with abandon, the very problem that has caused the euro's decline.

In any case, an inter-government pact is unenforceable since "the European Commission cannot take member states to court when they breach budget rules." This is worth $60 a square foot?

Amidst this incoherence, gold and silver wallow. The VIX rose from a fat, dumb, and happy 17.56 on July 22, 2011 to 48.00 on August 8, 2011. It was during that time Standard & Poor's cut the credit rating of the U.S. government and the debt ceiling terrified the nation. Should another rating agency do so (Fitch has been making noises) one should expect volatility. (Washington Post headline, December 27, 2011: "Obama to Ask for Increase in Debt Ceiling")

Jim Bianco [Arborresearch.com], president and television star at Bianco Research, explained the potential problem in an interview with Kate Welling (Welling@Weeden). When a country loses its AAA-rating, Basel III capital requirements and central bank rules require banks to apply haircuts against the downgraded bonds. This would create a problem in repo markets, among others. Borrowers in the repo market (somewhere around $4 trillion for U.S. banks) would need to find additional collateral. (Here is the problem of falling standards of collateral leading to demands for more collateral, again.)

Bianco explained the potential rumpus: "Since [Moody's and Fitch] are still at triple-A, we can pretend S&P did nothing. The next downgrade, if Moody's or Fitch were to follow S&P's lead, would actually matter a lot.... The next one that issues a downgrade would make the U.S. a split-rated double-A-plus, which would change some of the rules."

If the VIX falls to 18, call options are worth considering.

U.S. Exposure to Europe - Unknowns Unknowns

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - there are things we do not know we don't know. "

-Former United States Secretary of Defense Donald Rumsfeld, February 12, 2002 There were reasons to criticize Donald Rumsfeld's turn as Defense Secretary but this was not one of them, even though the media quoted and re-quoted this most sensible approach to uncertainty as proof of a retarded intellect. As Eurocrats dissemble (see: The Rotten Heart of Europe), ratios that quantify U.S. financial system exposure to European insolvency are dated, even as they are published. Credit default swaps or loans may have been traded in the interim, may have been hedged, or may have slithered from For-Profit-or-Bailout Banks onto the Federal Reserve balance sheet (i.e., nuclear-waste securities). Aggregate bank balance-sheet figures may be gross or net (and we debate whether gross or net is the more consequential measure), may be the tip of an iceberg compared to submerged, off-balance-sheet liabilities, and ultimately, we do not know the timing of the Fed's $5 trillion academically certified money dump into the banking system. These limitations have been compounded by a recently revealed "unknown unknown," at least to most of us. On December 7, 2011, Reuters published "MF Global and the Great Re-Hypothecation Scandal." Reuters' reporter Christopher Elias opened: "A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back." (Re-hypothecation will be described below.) Some lessons here: First, if not for the money stolen from MF Global's customers, Reuters probably would not have set Elias on the trail to re-hypothecation. Second, it is when good credit is receding that such scandals come to light. (Madoff.) If not for the slide in European sovereign bond prices (the route by which MF Global's CEO leveraged and bet the solvency of his firm), MF Global would not have disappeared. Third, and very much related to the previous point, the world's good collateral shrinks by the hour. Fourth, the supposed bond "guarantees" that authorities bray about are a chimera. Quoting Elias: "Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow." The EFSF is backed by words, not assets. The more that governments and international bodies vote to back spiraling guarantees, the less their guarantees are worth. Thus: good collateral as a percentage of paper and paper promises shrinks. Fifth, and very much related to points two through five, it is only the spiraling of financial leverage that prevents the financial economy from collapsing. Re-hypothecation is a revelation in financial leverage. Most readers understand "hypothecation," even if they never heard the word. Elias explains: "By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is 'hypothetically' controlled by the creditor, who has a right to seize possession if the borrower defaults." An example would be an investor who holds a margin account with a broker. If the value of the assets (shares of IBM) fall to a certain point, the broker requires that the investor put more money into the account. If the client does not put the required money into the account, the broker has the right to sell shares of IBM. The cash received in the sale restores the minimum level of equity required by the broker. Elias explains the process as follows: "In the U.S., this legal right takes the form of a lien.... A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default." Now we get to the scary part. Re-hypothecation, explains Elias: "occurs when a bank or broker re-uses collateral posted by clients... to back the broker's own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal." He quantifies the legal scam: "Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as 'churn'), the original collateral being used may have been as little as $1 trillion - a quarter of the financial footprint created through re-hypothecation. Hot off the press (dated December 2011) is an IMF report: The-Non-Bank-Bank Nexus and the Shadow Banking System. Authors Zoltan Pozsar and Manmohan Singh give an example of how re-hypothecation works (on page 11 of the paper). A dealer holds a Treasury security as collateral which "comes with the rights for the dealer to repledge it." The dealer uses this collateral as his (the dealer's) collateral with an asset manager. The asset manager "may re-use the Treasury security to post collateral with another dealer..." On it goes, each party in turn using the same Treasury security as collateral. The IMF authors proffer: "Since these transactions are underpinned by a single piece of collateral, such daisy-chains may be referred to as dynamic chains." They may also be referred to as an illusion of credit that nonetheless has inflated asset prices from Shanghai apartments to Apple common stock to European and U.S. Too-Levered-To-Die Banks. Pozsar and Singh write the traditional thinking of how banks fund themselves "ignores the significant funding that banks receive from the asset management complex" that permit "both individual banks and the banking system as a whole [to] quickly lever up." Understanding this lends credibility to MF Global Chief Executive Officer Jon Corzine's statements before Congress that he does not know where his clients' money is. Pozsar and Singh write: "The securities that asset managers invest on behalf of households are seldom left lying around passively in portfolios. In order to capture their value as collateral, securities are routinely lent out for use in the shadow banking system, a fact few households, whose securities are ultimately being lent, are oblivious to." [My italics, should you have nodded off during all the IMF talk. - FJS] It is generally believed that U.S. banks are in much better shape than European banks today. Of what value is this? Back to Pozsar & Singh: "The repeated use of... collateral facilitates system-lubrication [and] also the build-up of leverage-like collateral chains between banks and managers." A down drift of collateral values, which should be expected since there is no value to the compounded layers, may be a reason European banks are in such dire straits. (European Central Bank President Mario Draghi to the European Parliament on Thursday, December 1, 2011: "We are aware of the scarcity of eligible collateral.") Bloomberg reported on December 13, 2011: "EU Banks Selling 'Crown Jewels'..." The banks are selling some of their most profitable arms (lines of business) to raise cash. Is this the fire sale of the century? Probably not. Selling profitable lines at discounts to their fair value today drags down prices which may lead to another round of discount sales, at even lower prices tomorrow. Distorted pricing of assets by a leveraged financial system with few real assets has led to some strange observations. Izabella Kaminska reports in the Financial Times (alphaville) that it is not regulators or authorities, but "the markets themselves... [that] are demanding a re-collateralization in all funding areas." She notes: "[T]he latest trend towards gold collateralized bank loans shows in some ways the market is demanding the recollateralization of credit with gold." Kaminska notes: "Gold is switching places with [U.S.] Treasuries as the ultimate form of security." It is surprising U.S. Treasuries still hold that princely position. The FDIC is now guaranteeing $53 trillion (not billion, but: trillion) of Bank of America's (transferred from its Merrill Lynch subsidiary) credit default swaps. This maneuver was executed by the Federal Reserve. This is both reprehensible and meaningless. Assume a 25% default rate on the credits and that Bank of America also defaults. A $13 trillion tax on Americans to make good on our guarantee is meaningless, other than to induce an immediate credit downgrade to F-. Speaking of the Fed, specifically of Federal Reserve Chairman Ben Bernanke, he told Congress on November 2, 2011, that MF Global had been approved as a primary dealer by the New York Federal Reserve, "but we are not the regulators of MF Global," nor is there any reason the Fed should be overseers or regulators to such a firm. Authors Poszar and Singh placed dealers at the heart of the re-hypothecation racket. Oh, Ben! Aggressively stupid to the end. From the close on November 30, 2011, to December 12, 2011, (when Kaminska wrote), the spot gold price fell about $90, from $1,746 to $1,659. Kaminska explained why: Right now: "Banks don't need gold as much as they need cash." (This relative lack of need for gold is what she refers to below as "surplus gold.") As has been written many times "gold is the ultimate form of payment," and so it is being lent by banks "for its use as a funding instrument: collateral." Gold now is being lent by banks (repoed) at a negative rate. "The more negative the rate, the higher the cost of funding using the collateral." Kaminska concludes: "With surplus gold being put into the system, the price of gold has no choice but to stall." Maybe Kaminska should have considered another possibility: as the panic for collateral worsens, the price might continue to fall. In fact, over the past two days (December 12 to December 14), gold has fallen another $90, to $1,567 (as this is written). If Kaminska's analysis is correct, the price of gold could spring back up, with alacrity. With the European banking system near collapse, we may soon find just how exposed is the U.S. banking system to continental credit, credit default swaps, and "repeated use of... collateral facilitates system-lubrication [and] the build-up of leverage-like collateral chains between banks and managers." There is no question that, if it was within their power, the Eurocrats would have absorbed every last bond and bank loan on a bank balance sheet that is trading at a discount. "Oh," they must be wishing "if only we had the arrogated authority of Federal Reserve Chairman Ben Bernanke." They know that when (not if) the Federal Reserve chairman is in a similar position to theirs, he will beckon $5 trillion of funny money into existence. This would exceed his authority, but after members of a Congressional committee read him the riot act, they will thank him for saving the system, even as the inflation rate passes 30% during the hearing, and he will be Time magazine's Hero-of-the-Year again. As for the Eurocrats, they will find a way to do the same. They must: otherwise the pampered satraps in Brussels will have to move home and pay taxes. But could this "known known" (speaking of both the U.S. and Europe) be a miscalculation? That is to say, could the parties mentioned miscalculate and not act in time to pump up the sinking structure of leveraged ether? Possibly so. There is precedence. Benjamin Anderson, economist at the Chase Bank from 1920 to 1939, wrote about two such misjudgments in the 1930s, in his highly recommended book, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946. On May 12, 1931, "there came an unexpected run on Oesterreichische-Credit-Anstalt," a large Austrian bank. To be noted: (1) Oesterreichische-Credit-Anstalt was forced into a merger with a weaker bank in 1929. This might be analogous to Bank of America's acquisition of Countrywide Financial, and, (2) quoting Anderson: "The Austrian government guaranteed certain of the investments." (Oh, those government guarantees again!), but "the merged bank had been inadequately financed... the big merged institution was still insolvent." Just as in Europe today: how good is the credit (collateral) of the guarantor? The bulk of a sovereign state's collateral is future tax revenues. From Greece to the United States, this does not inspire confidence today. On May 14, 1931, the Bank for International Settlements coordinated support by central banks. "This made a great show of international cooperation... but the effect was bad when eleven central banks were providing among them only $5.6 million. Creditors grew more frightened, rather than less. If the thing were to be done at all, it should have been done adequately. The first principal of bank loans in a crisis is that if the borrower needs $100,000 to save him, you give him $100,000 or you give him nothing at all. You don't give him $20,000." Here, as described above, is where the U.S. (today) can hyper-inflate at will, while Europe is encumbered. Back to Anderson and 1931: "Panics are not dealt with effectively through delay, through public discussion, and through fighting for position. A loan of $25 million made promptly at the first sign of panic would probably have stopped it. There came a time when $100 million would not stop it. By the time the Austrian government on May 29, [1931], voted the guarantee of $150 million, the credit of the Austrian government was so shaken that no one cared about the pledge. When on June 6, 1931, the Bank for International Settlements arranged to give a... 100 million shilling credit [$14 million - FJS] to Austria, the Austrian financial disaster was very little helped thereby." German banks endured a run on June 1, 1930. "In the beginning of the run on Germany, again the effort of international banking cooperation was made. Again $100 million promptly provided by concerted action of British, American, and French banks, publicly announced and instantly made available, could have stopped the crisis. A month later $500 million would not have been sufficient." There were squabbles: It is "in the French character and the French tradition that immediate acceptance of a contract proposed by another party is out of the question.... France delayed, and France delayed to long.... The German people, as well as foreign creditors, were engaged in the run on German banks." France was not the only culprit. Anderson criticizes New York bankers for being too timid and too late. This was not the end for German banks. Publicized meetings among government authorities and official proclamations dragged into 1932: the Euro summits of the day. Hope sprang eternal that a reconstruction of German debts (and war repatriations) could be managed, but it was not to be. Anderson observed (literally: he was confidant to participants) that "governments move slowly and politicians look to the next election." He concluded: "If the governments had acted that winter, Hitler would never have come to power, and we should have saved the democratic regime of Germany." This was an unknown unknown.