Friday, March 30, 2012

Samuelson Flunked 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" (, 2009)

The forecasting proficiency of central bankers is a topical issue. At least, a friend asked if I could help with a list of Federal Reserve Chairman Ben S. Bernanke's predictions. The list stops in 2008, although he has been no more accurate since then. I sent the list to a few others. To those lucky recipients, I attached Paul Samuelson's opinion of Ben S. Bernanke. It is the response (below) of one correspondent to Samuelson's statement that is most telling.

Bernanke has been a Federal Reserve governor since 2002. He was named Chairman in early 2006. He served as chairman of the president's Council of Economic Advisors from June 2005 until early 2006.

Here we go:

"[T]he recent capital inflow [has shown up in] higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things."

-March 10, 2005

"[I]ncreases in home values, together with a stock-market recovery that began in 2003, have [aided]...[t]he expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home-equity lines of credit."

-March 10, 2005

Interviewer: Ben, there's been a lot of talk about a housing bubble, particularly, you know, from all sorts of places. Can you give us your view as to whether or not there is a housing bubble out there? What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

Bernanke: Well, I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don't think it's gonna drive the economy too far from its full employment path, though.

-Interview on CNBC, July 1, 2005

"The housing market has been very strong for the past few years.... It seems to be the case, there are some straws in the wind, that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise but not at the pace that they had been rising. So we expect the housing market to cool but not to change very sharply."

-February 15, 2006

"In 1994, fewer than 5 percent of mortgage originations were in the subprime market, but by 2005 about 20 percent of new mortgage loans were subprime....[T]he expansion of subprime lending has contributed importantly to the substantial increase in the overall use of mortgage credit. From 1995 to 2004, the share of households with mortgage debt increased 17 percent, and in the lowest income quintile, the share of households with mortgage debt rose 53 percent."

-November 1, 2006. In case you are wondering if Simple Ben approved or disapproved of this development, the title of his speech says it all: "Community Development Financial Institutions: Promoting Economic Growth and Opportunity"

"[O]ur banks are well capitalized and willing to lend."

-June 5, 2006


Some views on derivatives:

Senate Banking Committee Chairman Paul Sarbanes: Warren Buffett has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast-growing market remain real. How do you respond to these concerns?

Bernanke: I am more sanguine about derivatives than the position you have just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced and diced, and given to those most willing to bear them. They add, I believe, to the flexibility of the financial system in many different ways. With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk in their institutions.

-November 15, 2005

"To an important degree, banks can be more active in their management of credit risks and other portfolio risks because of the increased availability of financial instruments and activities such as loan syndications, loan trading, credit derivatives, and securitization."

-June 12, 2006

"[M]any large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions."

[Chairman Bernanke testified before the Financial Crisis Inquiry Commission on November 17, 2009.This was at the beginning of the FCIC's investigation. Bernanke offered suggestions of what he thought the FCIC should investigate. Among Bernanke's comments: "I'm a little concerned still about systemic risk that comes from financial products or financial markets that aren't adequately seen or understood by a banking supervision kind of institutional approach. And I wish you'd comment on that. I mean, nobody really, totally saw the problems with securitization or OTC derivatives."]

"If you have two investment banks doing an over-the-counter derivatives transaction, presumably they both are well-informed and they can inform that transaction without necessarily any

government intervention."

-February 27, 2008

"Since September 2005, the Federal Reserve Bank of New York [led by New York Federal Reserve President Timothy Geithner - FJS] has been leading a major joint initiative by both the public and private sectors to improve arrangements for clearing and settling credit default swaps and other OTC derivatives.... I don't think the system is broken, but it does need some improvement in execution."

-July 10, 2008

[ November 17, 2009, before the FCIC: "So I guess my own view is that if the system had been adequately stable, had strong enough supervision, et cetera et cetera, it could have dealt with this problem or other problems without collapsing." Note: "This" problem: if the crisis was due, which Simple Ben did not concede, to Federal Reserve policy.]


"At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained"

-March 28, 2007

"While rising delinquencies and foreclosures will continue to weigh heavily on the housing market this year, it will not cripple the U.S."

-May 17, 2007

"We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

-May 17, 2007

"We have not seen major spillovers from housing onto other sectors of the economy."

-June 21, 2007

"For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly."

-July 18, 2007

The "expected impact from weaker housing... may flare in the future, today" - in the words of Ben Bernanke - "it is contained."

-July 18, 2007

"Bernanke said [subprime mortgages] were 'market innovations' and 'sometimes there are bumps' in the new-product road. 'We'll see how this works out."

-July 18, 2007

"I'd like to know what those damn things are worth," [CDOs - FJS] Mr. Bernanke said. Until investors "are confident in their evaluations, they are not going to be willing to fund these vehicle."

-October 15, 2007

"It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

-October 15th, 2007

"I expect there will be some failures. I don't anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system."

-February 27th, 2008

"Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."

-June 9th, 2008

[Freddie and Fannie] "...will make it through the storm", "... in no danger of failing","...adequately capitalized."

-July 16th, 2008

[This is the] "most severe financial crisis" in the post-World War II era. Investment banks are seeing "tremendous runs on their cash.... Without action, they will fail soon."

-September 19th, 2008

November 17, 2009 before the FCIC:

MR. BERNANKE: "But I think not withstanding the claims of one or two people out there who are now sort of living on the fact that they - quote - anticipated the crisis [A little jealous, Ben? - FJS], I would still say that the intersection of these things, the "perfect storm" aspect was so complicated and large, that I was certainly not aware, for what it's worth - and it could just be my deficiency - but I was not aware of anybody who had any kind of comprehensive warning. There are people identified - and the trouble is and particularly in this blogosphere we live in now - at any given moment, there are people identifying 19 different problems, crises."

VICE CHAIRMAN THOMAS "And some of them may be right at some point."

NOTE: It was at this point that Captain Queeg, when testifying in court, grabbed for his steel balls.


COMMISIONER THOMPSON: "So no calamity of this magnitude occurs without there being some early signals that something is going wrong. In the case of this calamity, what were the signals? Why did we -and had we acted on them, might we have averted the disaster?

MISTER BERNANKE: "Well, I don't know, I have to think about that."

Note: Could not the FCIC have reached its conclusion at that moment? It interviewed a few hundred witnesses and wrote a 500-page summary, but was not the master cylinder identified? - FJS


The Atlantic, June 17, 2009, Interview with Paul Samuelson - the man who established MIT as a magnet for economics. He wrote the best-selling economics textbook in history. The interview was conducted just before Samuelson died: "The 1980s trained macroeconomics - like... Ben Bernanke and so forth -- became a very complacent group, very ill adapted to meet with a completely unpredictable and new situation, such as we've had.... I looked up Bernanke's PhD thesis, which was on the Great Depression, and I realized that when you're writing in the 1980s, and there's a mindset that's almost universal, you miss a lot of the nuances of what actually happened during the depression."

A reply, from a friend who knew Paul Samuelson:

"The biggest surprise here--and perhaps the most damning--is Paul Samuelson's dismissive comments about Bernanke and his "...very complacent group, very ill adapted.... [that you] miss a lot of the nuances of what actually happened during the depression." That Samuelson, whom I knew when I was at MIT as generally a mild-mannered and kindly gentleman, should have checked Bernanke's PhD thesis done in Samuelson's department (for Stanley Fischer, governor of the Israeli Central Bank, but then an MIT Prof.) and then ended up stating such--for him--negative comments about Bernanke is extremely significant."

Monday, March 26, 2012

Mister In-Between is 100% Sure

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" (, 2009)

"This isn't right. This isn't even wrong"

-Wolfgang Pauli, Cambridge University physicist, attempting to read a colleague's paper.

60 MINUTES: "Can you act quickly enough to prevent inflation from getting out of control?"

"We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time. Now, that time is not now."

60 MINUTES: "You have what degree of confidence in your ability to control this?"

One hundred percent."

"60 Minutes," December 5, 2010

Federal Reserve Chairman Ben Bernanke's lecture series at George Washington University is most unfortunate. Whether he believes what he is saying or not, he is a punch bowl of contaminated mead.

The first instinct, at least here, is to let it pass. Wolfgang Pauli's exasperation came to mind when reading capsules of the Fed chairman's lectures. Where to start? Where to end? To what purpose.

The last, first. The purpose here is to throw light on a mind so inadequately prepared, yet 100% sure, of extracting the world from an unprecedented gamble. The gamble is Bernanke's dry run of his professorial emissions. The professor's chalkboard smog is the basis for his current policy. Real interest rates are below zero and the central bank is creating immeasurable quantities of dollar bills that Bernanke is sure will right the U.S. economy while not sacrificing his wandering price stability.

"Immeasurable," since Bernanke and other members of the FOMC do not know when they will stop. Listen to their contradictory speeches. We are not witnessing the introduction of an economic theory. We are chips in a poker championship.

Rather than address my stated purpose by rehabilitating either Bernanke's disfigured explanation of the 1930s or how the gold standard functioned - the disentanglements alone would require pages - we will look at one of his simpler claims. Following is an effort in pointillism.

Two of the man's characteristics will be addressed in what follows. First, his inability to anticipate. Second, his limited understanding of the past, which is a cause of his inability to anticipate.

On March 22, 2012, the Fed chairman told students at George Washington University: "The decline in house prices by itself was not obviously a major threat." To clarify this statement, Bernanke was responding to a question about the housing bubble. He was addressing the aftermath, when prices fell. He concluded that falling house prices, by themselves, were not obviously a major threat to the economy, and, presumably to the financial system that serves to finance that economy.

Wolfgang Pauli would probably agree that Bernanke's attempt at clarification is neither right nor wrong. It is meaningless. As a general statement, rising house prices do not constitute a bubble. Nor, are falling house prices synonymous with a crash. The most important distinction is the degree of borrowing that contributed to the upswing. Of the recent housing enthusiasm,
Panderer to Power made this clear. During the Greenspan-Bernanke chairmanship, the U.S. did not experience a housing crash, it suffered a mortgage collapse.

Bernanke claims the "decline in house prices by itself was not obviously a major threat [before it crashed in 2007 - FJS]." The man was either unaware of how housing finance was conducted in the U.S. during bubble years or considered it irrelevant.

As a Federal Reserve Board member (from 2002 to the present day, with a short sabbatical as economic adviser to President Bush)
Bernanke completely missed the coming mortgage collapse. He admits that. He also claims nobody else saw it coming. The Federal Reserve chairman, like all cloistered academic economists, would never condescend to read a newspaper, so would not see what the average bartender knew. Anyone reading the following knew that houses were the new momentum trade that replaced the fandango:

August 8, 2001, Wall Street Journal, Headline: "'Subprime' Could Be Bad News for Banks: Riskier Loans, Now Prevalent in Industry, Show Problems" We read: "American Express so far this year has taken more than $1 billion in junk-bond-related write-downs."

August 31, 2001, Wall Street Journal, Headline: "Is Appraisal Process Skewing Home Values?" We read: "Appraisers are frequently encouraged to fudge the numbers." From Mark Vitner, an economist at First Union Corp., the "upward spiral of prices becomes self-reinforcing." The Wall Street Journal reporter concluded: "Some believe home prices are beginning to act like technology stocks. Mr. Vitner says they're moving up so fast that any value seems reasonable."

September 3, 2001, Forbes magazine
, Cover: "WHAT IF HOME PRICES CRASH?" Picture on the cover of a young couple: "Their house lost $1 million in value. It could happen to you. It could happen to a lot of people and wreck the economy." We learn that their house - in Palo Alto, California, fell in value from $2 million to $1million over 7 months.

March 28, 2002, Economist
, cover story: "The houses that saved the world" We read: " have kept the world economy aloft."

April 18, 2002, Wall Street Journal,
Headline: "Reverse-Mortgage Rules May be Loosened" We read: "Congress is looking to loosen the rules on reverse mortgages. The move could allow millions of seniors to extract far more money from their homes than is possible - though to some critics that isn't necessarily a good thing."

July 22, 2002, Business Wire
, Reporting on recent testimony of Federal Reserve Chairman Alan Greenspan: "We've looked at the bubble question and we've concluded that it is most unlikely."

July 22, 2002, Business Wire, Same article, quoting National Association of Home Builders Chief Economist David Seiders: "The time has come to put this issue to rest. The nation's home builders have said it, the Realtors(R) have said it, and now Alan Greenspan has said it once again, in no uncertain terms: there is no such thing as a current or impending house price bubble."

The web of interests was obvious by 2002. Princeton professor Ben S. Bernanke joined the Federal Reserve Board on August 5, 2002.

At that point, the question that occupied the alert observer was how long the web could keep spinning. When Ben Bernanke joined the Federal Reserve Board in 2002, he dragged his "zero-bound" twaddle to FOMC meetings, and soon enough the Fed was launching helicopters, suffering conundrums, and holding real rates below zero.

And now, on March 23, 2012, the man running the Federal Reserve, who not only could not see the housing bubble but can not rotate his mind to believe anyone else did, is "100% sure" he will extract the world from a money-printing escapade that has increased central bank balance sheets from about $4 trillion in 2008 to about $13 trillion in 2013 (these numbers are from memory), and not destabilize the world price structure.

The second characteristic of the Bernanke mind to be addressed is his historical illiteracy. Given the quoted statement made to George Washington University students, he does not know how financing contributed to previous housing booms and busts. We will look at one state, where, it is 100% clear that fly-by-night finance was the leading cause of post-binge trauma.

The population of Los Angeles rose from 10,000 in 1880 to 50,000 in 1890. Yet, a severe real estate bust wiped out most of the wealth in 1887 and 1888. David Starr Jordan described the boom and bust in
California and the Californians: "[A]lmost every bluff along the coast, from Los Angeles to San Diego and beyond was staked out in town lots." He continued: "Every resident bought lots, all the lots he could hold. The tourist took his hand in speculation. [My italics - FJS] Corner lots in San Diego, Del Mar, Azusa, Redlands, Riverside, Pasadena, anywhere brought fabulous prices. A village was laid out in the uninhabited bed of a mountain torrent, and men stood in the streets in Los Angeles... all night long, to wait their turn in buying lots. Land, worthless and inaccessible, barren cliffs' river-wash, sand hills, cactus deserts' sinks of alkali, everything met with ready sale. The belief that Southern California would be one great city was universal. [The far-sighted investor was correct, but lost his shirt in 1888. - FJS] The desire to buy became a mania. 'Millionaires of a day,' even the shrewdest lost their heads, and the boom ended, as such booms always end in utter collapse."

"Tourists" includes speculators from the east, north, and south, drawn to the latest California gold rush. It was not only Los Angeles. Kansas City crested in 1888, Chicago in 1890, and the country as a whole in 1888-1889. When everyone from Alan Greenspan to Standard & Poor's swatted down bubble concerns ("real estate slumps are local affairs"), the nation's participation in regional manias was not considered. Other significant features of L.A. in the 1880s were a price collapse when the population rose 500%, and, no central bank existed to prod the insolvency.

Los Angeles boomed in the 1920s as did its real estate. The sun, movies and discovery of oil in Los Angeles County encouraged wagon trains from the East. Across the country, speculators were drawn to real estate between 1920 and 1925.

Ten Years on Wall Street, Barnie Winkelman set the stage: "The shortage of offices, apartment houses, and dwellings which had resulted from the protracted holiday from construction during the World War, had brought on a wave of building. In its wake came the flotation of real-estate bonds running into hundreds of millions, financing practices which embodied the worst practices of Wall Street bond flotation, and saddled millions of school teachers, physicians, widows, the aged and infirm, who had forsworn stocks on the Exchange and railroad and industrial bonds, with realty obligations infinitely less substantial. On back of these over-appraised real estate liens were second mortgage loans held by individuals and building and loan associations. The collapse of many building and loan associations in 1925 marked the gradual recession in real estate prices....."

That's enough. Upon reading "financing practices which embodied the worst practices of Wall Street," you knew how this would turn out. The Florida land boom and bust (1926) is synonymous with the decade. Today, the degree of national participation is not so celebrated. Nor, that the residential real estate building boom across the country generally peaked at the same time. Real spending on new, private, non-farm housing fell 89% from its peak in 1926 to its trough in 1933.

A chart of Los Angeles County residential real estate activity points nearly straight up between
1920 and 1925. (Lewis A. Maverick, "Cycles in Real Estate Activity: Los Angeles County") Chicago also achieved its personal best in 1925, though New York was just warming up, particularly in the commercial area, rising until 1930. (The average price of office-building bonds fell from $1,000 upon issue to $187 in 1932.) Even with the booming Southern California economy, the graph of L.A. County real estate activity falls from 1926 through 1930, and presumably beyond.

The 1970s was a boom time for houses, but much of those gains were lost to inflation. House prices rose 8.0% a year during the decade, while the consumer price index rose at a 7.4% rate. (Nationally, house prices rose 17.7% in the first nine months of 1979; the CPI passed 16% that year.)

California was a star performer where house prices rose 20% in 1974, 17% in 1975, and 28% in 1976. (The standard belief that lower interest rates will solve house troubles is taken for granted. The prime rate rose from 9.50% in early 1974 to 15.50% in late 1979.) William Greider wrote in
Secrets of the Temple: "People were not buying houses to live in or even as long-term investments. They were buying homes in order to sell them."A builder in Contra Costa County (California) found that 60% of his sales were to speculators. In San Diego alone the number of realtors doubled between 1975 and 1979. A condominium bought in Irvine Ranch (California) for $87,000 was sold for $117,000 - two weeks before the mortgage closing was completed. We need not tarry here; this is so old that it's new.

The 1970s boom was followed by a bust, but not of today's dimensions. One reason being that mortgage lending did not rocket off its moorings, either in terms offered or in the variety of lenders.
In the early 1980s, homeowners' average equity (nationally) equaled 70% of house market values.

The 1980s savings-and-loan catastrophe left the Southern California mortgage market in a miserable state. The S&L boom was the product of relaxed regulations, funny finance, and dreadful accounting - all of which should have been evident to Ben S. Bernanke in 2002. According to the San Diego Union Tribune:
"When the bubble burst in 1989, some home prices fell 10 to 20 percent, while the price of raw land dropped even more. End result: As real estate analysts see it, local developers, builders, bankers, planners and home buyers all made a fatal assumption three years ago. [They splurged near the peak. - FJS] .... [I]n 1987, 1988 and 1989 prices soar[ed], doubling from $89,000 to $198,000. The average price now stands at $95,000 per acre and [a market analyst] doesn't think it will recover even half its former, inflated value any time soon."

The market analyst may have been correct if not for L. William Seidman. He headed the Resolution Trust Corporation (RTC), which closed the bad banks and disposed of the busted real estate at fire sale prices. We should have followed the same blueprint today, but have done exactly the opposite. Thus, instead of clearing the market, we have millions of houses floating in limbo.

Upon completion of his assignment, Seidman shut down this federal agency. He was very critical of Bernanke's (and Paulson's) TARP (Troubled Asset Relief Program). Comparing TARP to the RTC: "What we did, we took over the bank, nationalized it, fired the management, took out the bad assets and put a good bank back in the system." Comparing Seidman's purging of bad banks to Bernanke's handling of the Too-Big-to-Fail Banks (which hold much larger quantities of assets today than in 2008), is, again, cause to believe Bernanke has no idea what he is doing.

Like Sisyphus, California real estate prices pushed and pushed harder up the hill from 1995 to 2005. This is too well known to recall here. Some reminders: The median price for an existing, single-family house in California rose from $237,060 in 2000 to $542,720 in 2005. That this was a mortgage bubble par excellence, and not so much a housing bubble, can be seen in the evolution of financing: Mortgages written in California responded to Bernanke's "zero-bound policy" in spectacular form. Only 2% of home mortgages were of the non-principal paying "interest-only" version in 2002. This rose to 47% in early 2004 and to 67% by late 2004. In February 2012, the median price for an existing, single-family house in California was $266,600, and falling at a 7% annual rate.

Doug Noland, author of the Prudent Bear's Credit Bubble Bulletin, wrote untiringly during the boom years of the "moneyness of credit." (He still writes every week and is still well worth reading.) Noland wrote that the Fed and Wall Street refused to understand the explosion of credit and credit derivatives were behaving like money and inflating house prices. This should have been understood. It was the ability to buy (sort of) a house without showing up with one penny at the closing that gave Sisyphus his third and fourth wind.

Bernanke has shown no understanding of either the quantity or the quality of credit. Yet, he is 100% sure of his infallibility.

Wednesday, March 21, 2012

Peak Imbalances Are Falling

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" (, 2009)

The topic at hand is the 10-year U.S. Treasury bond, its falling price, and consequent rising yield. The ten year was trading at a 2.03% yield on March 9 and rose to 2.38% on March 19, 2012. These things happen and the ten-year may fall back to a price and yield that satisfies central bankers and Wall Street. Nevertheless, the era of artificially low government bond yields is coming to a close.

There is a simple reason for the new, protracted bear market in bonds, however complicated it is to divine the particulars and time of the unwinding. Starting with animal impulses, the remaining market participants believe that central banks control markets today. On the date it is
recognized the Fed has lost control, yields across the curve - and on corporates, junk, municipals, and stocks - will be adrift, without their bearded anchor.

We have passed the peak of post-Bretton Woods accumulations. Peak Imbalances are falling.

The United States cut the world loose from the International Gold-Dollar Standard on August 15, 1971. Thereafter, international trade and financial balances (obligations among countries and other counterparties) have not settled. Such liberties were not possible prior to President Nixon's repudiation. Now, there is no constraint, other than the parties' willingness or ability to fill other parties' deficiencies. Since obligations never settle, they accumulate. The United States has accumulated a $7.5 trillion current account deficit. (The current account is composed of trade, services, and transfers, but mostly trade)

This deficiency on the part of the U.S. has been most conspicuously filled by the Chinese government's willingness to finance American shoppers' every wish. The PRC's continued willingness is not a question, but China is no longer able to harbor this imbalance.

China produces and America buys. The Chinese have financed American purchases by purchasing U.S. securities, primarily Treasuries and mortgages: we'll ring fence (as the eurocrats like to say) the discussion around U.S. Treasuries. Since the U.S. was buying (importing) more goods than it was selling abroad, China accumulated dollars, year after year. From this pile of dollars, China bought U.S. Treasuries. The recycled dollars financed granite, kitchen countertops and trips to Wally World.

This arrangement has ended. China's Minister of Commerce Chen Deming announced that China will be the world's largest importer in a few years. (
Xinhua, March 18, 2012) We have reached, actually passed, China's peak purchases of U.S. Treasuries. Instead of buying, the Bank of China will need to sell U.S. Treasuries to finance its trade deficit.

The same is true of Japan. It is now an importer rather than an exporter. To pay for goods coming ashore that exceed goods shipped abroad, it will need to sell U.S. Treasuries.

Even as these accumulations roll over, the U.S. Treasury needs to borrow at an increasing rate. In February 2012, the Treasury spent one dollar for every 31 cents it received in revenues (basically, tax receipts).

The post-1971 arrangement described above fostered an accumulation of central planning by central bankers. Today, central bankers are economists. They do not have experience in markets. They consider markets to be a tool for "policymakers," as Federal Reserve Chairman Ben S. Bernanke describes himself. Central bankers opened this pretense of mental perfection by interposing their superior egos into markets. Lately, they have manhandled each and every one of them: government yield curves, stocks, commercial paper, money-market funds, commodities, currencies, credit-default swaps, and houses.

"Houses?" one might ask. Yes, support operations (in the United States) of securities markets are underwritten by the Fed's house market collapse prevention policy. Above all else, the Fed is a Muppet of Too-Big-to-Fail banks. It encouraged the criminal financing of mortgages on the way up, and still props house prices today. The preternatural policymakers would not consider the improbability that they cannot perpetually elevate bond, stock, commodity, currency, and houses, even though their seedy, CDO-mortgage economy came a cropper.

It was not only China that underpriced its currency while overpricing the diminishing value of American credit. Other Asian central banks have operated in a similar fashion. The U.S. current account deficit rose from $114 billion in 1995 to over $800 billion in 2006. To pay for this underproduction of goods and services, the United States borrowed $2 trillion from abroad in the 1990s. Then, the U.S. borrowed another $4 trillion between 2001 and 2010. Recall that borrowing and lending never need be settled under the present dispensation. The $2 trillion in 2000 expanded to $6 trillion by 2010.

China posted a $31.5 billion trade deficit with the rest of the world in February 2012. Exports grew 18.4% to $114.5 billion while imports grew 39.6% to $145.9 billion. Commentators explained that waning exports to a waning Europe caused the deficit. Yet, exports increased 18%. The Chinese New Year and industrial retooling were other explanations. Noted.

Bill King (
The King Report) was probably on the mark when he wrote that China is now importing inflation. This being so, the Bernanke answer to all problems (create money) will exacerbate the Chinese trade deficit.

Japan had a trade deficit in 2011, the first such deficit since 1980. Exports shrank by 2.7% in 2011 and imports rose by 12.0%. Japan is the second largest holder of U.S. Treasury securities, after China. They both hold over $1 trillion of Treasuries. Reasons stated for Japan's falling trade fortunes include the 2011 earthquake and tsunami, falling exports to waning Europe, and its aging population.

The Bank of Japan also faces a new problem of funding the Japanese Government Bond (JGB) market. The Japanese people and companies have been reliable buyers. This will no longer be possible. Even if Japan's trade deficiency is arrested, the Japanese are now spending their accumulated savings.

Another complication is the need to fund the United States' deficit. The United States had accumulated a public debt of $3.8 trillion by 2007. It is expected to reach $11.6 trillion in fiscal year 2012. Foreign central banks hold over $5.5 trillion of U.S. Treasury securities. This is Exhibit #1 of policymaker interference in markets. These holdings demonstrate a blatant manipulation of the Treasury market. What yields might be without central banking policymaking is not known. After it is recognized the Fed has lost control, we may find out.

In February 2012, U.S. Treasury receipts were $103.4 billion and federal spending reached $335.1 billion. The Treasury only received 31 cents for every dollar spent.

In concert with falling trade surpluses, foreign central bank buying of Treasuries has waned. Between August 1, 2010, and July 31, 2011 foreign central banks increased their U.S. Treasury holdings by $381 billion. Since August 1, 2011, their holdings have fallen, not by much, but the behemoth wad of forthcoming Treasury issues requires elephantine buyers that are indifferent to prices: that is, central banks.

The ECB, Bank of England, and Central Bank of Iceland are unlikely candidates. It is possible some U.S. financial institutions can be persuaded to buy with abandon, but there would seem to be a limit. ("There would seem to be": Who knows anymore the limits of crony capitalism?) This leaves the Federal Reserve as buyer of Treasury securities at the same moment they are issued by the Treasury Department. Have no fear: Ben's modeled that.

Wednesday, March 7, 2012

Eurocrats and Their Vassals

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" (, 2009)

On February 29, 2012, the European Central Bank (ECB) lent €529 to European banks, most of it, in three-year loans. This was the second such operation, launched with another mind-numbing acronym: LTRO (long-term financing operation). In the first LTRO (December 2011), €489 was lent to European banks. In the February 29, 2012, operation, 800 banks borrowed. According to the Financial Times, "broader collateral rules drew in smaller banks."

In the spring of 2011, the number of securities accepted by the ECB as acceptable collateral for loans to European banks was expanded from 19,000 to over 28,000.
That was a desperation maneuver to save the euro. Since, the ECB has expanded the collateral list at least twice. Leading up to the latest LTRO, the ECB added over €7 trillion of previously forbidden collateral - that is, €7 trillion, if one accepts the value at which this nuclear waste was carried on European bank balance sheets. Now, it sits on the ECB's balance sheet, which has risen to €3.02 trillion ($3.96 trillion), 30% larger than the Federal Reserve's Pandora's Box.

In this entirely fraudulent paper chase, the banks that borrowed LTRO money put some of it to work in sovereign carry trades. The banks have borrowed at 0.25% from the ECB and are buying sovereign bonds with much higher yields. Intesa Sanpaolo SpA received €24 billion and "said they would use part of the cash to buy Italian sovereign bonds. Bank Civica SA did the same with Spanish sovereign bonds." Italian 10-year bond yields fell on February 29 from 5.33% to 5.17%. Spanish 10-years fell from 5.03% to 4.98%. Interestingly, Portuguese 5-years rose from 15.75% to 16. 54% on the same day, which may indicate the next default.

Market commentators are saying how well the LTRO worked: their proof being lower sovereign bond yields, which show "market participants have been reassured the Euro Project is back on track." (This is not a single, direct quote, but the form in which dozens of market commentators have reassured the banks that employ them of their added value.) There is some truth to that claim. The euro bureaucrats will do
anything to prevent the euro's failure. Deceptions such as the LTRO may reassure market participants, even though the additional debt burden (that will not produce a single gumball) sinks Europeans into a deeper crypt.

It should be understood that the LTRO produced nothing other than more finance and inflation. (Gasoline in Europe now costs 9% more than in 2008. Andy Lees (
AML Macro Limited) estimates that, converted into U.S. dollars, gas now costs $9.65 a gallon in Europe.) European businesses and the little people are not target audiences.

The Eurocrats continue to dine well in Brussels while adding another layer of debt under which their vassals are crushed. Returning to a long-term theme here, trustworthy collateral in proportion to the stated value of paper assets continues to fall. When the world once again understands the importance of collateral in relation to the worth of the paper it is printed on, the price of trusted collateral will soar.