Monday, October 24, 2011

What They Are Doing

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 Euro and You described a fundamental problem of world finance. The quantity of debt grows as the quality recedes. The problem of bad loans is no longer just the pre-2008 mortgages, CDOs, and LBOs. Debt issued after the bust is defaulting, such as Greek sovereign bonds, issued in June 2010. Some securities are born to part investors from their money, but it's remarkable the extent and variety of such instruments issued in 2011. The world choked on similar bonds and derivatives only three years ago, many of which are still held at false prices on financial institutions' books.

Of all the past century's downgrades, none has been greater than the borrower's promise that stands behind a "security," a word that once credibly described a paper contract backed by appropriate collateral. In Debt and Delusion, Peter Warburtin wrote: "It is easy to forget that, as recently as in the 1960s, the government budgets of the OECD countries were in approximate balance and that net issues of debt were comparatively rare. The outstanding stock of debt in public hands was a meager $800 billion at the end of 1970. At that time debt issue was typically reserved for the financing of large construction projects or investment by power generation companies by publicly owned companies." Today, PIMCO's Bill Gross manages $244 billion in a single bond fund.

The starting pistol was sounded on August 15, 1971, 40 years ago. On that date, the United States broke its long-standing promise to pay one ounce of gold to a foreign government that redeemed $35 for the same. (The ability of American citizens to redeem dollars for gold with the U.S. government was modified during World War I and ceased after the War.) As a prelude to the loosy-goosy financial contracts today, it is worth reviewing the wording of the contractual relationship between the United States government and the holder of its currency before and after. (A book should be written on the parallels between the century-long degradation of language, the American legal system, money, credit, debt, and the American people.)

The face of a $20 bill, a gold certificate, issued in 1882, stated: "This certifies that there have been deposited in the Treasury of the United States, twenty dollars in gold coin, repayable to the bearer on demand." The bearer of $20.67 received one ounce of gold in exchange. This is a simple legal contract. It is easy to understand. There was no theory. No economists were employed to interpret what did not require interpretation.

A 2011 Federal Reserve Note states: "This note is legal tender for all debts, public and private." As contracts go, this makes no sense. Nor does it make sense to a three-year-old. My extensive survey of three-year-olds did not uncover a single child, who, in exchange for a $20 bill, preferred another $20 bill rather than receive a one-ounce gold coin. (The current value of the one-ounce coin versus that of the $20 bill is not germane to this survey.)

The abstraction of money is related to the manner in which securities today are often backed by abstract or non-existent collateral. Contradictory theories employ at least 100,000 economists (probably multiples of this figure), among whom, there may not be a handful who ever write or think about money. Read (if you must) the theoretical papers or newspaper columns of these imposters. They retreated into a soothing bubble bath of differential calculus generations ago.

Many of the malignant securities issued in 2010 and 2011 have fallen into disfavor. Credit markets have suffered loss of liquidity, momentary or protracted. These issues, collateralized by hope and imagination, are on the books though, often at institutions that already hold wads of securities still valued at wishful prices (for purposes of accounting, capital requirements, and falsifying the institutions' dubious solvency). We should expect that when Federal Reserve Chairman Ben Bernanke revs up his money machine, more will flow.

It is a safe bet that Ben is preparing to welcome more unmentionable securities on the Fed's balance sheet. ("Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities to boost the ailing economy...." - Wall Street Journal, October 21, 2011.)

Guessing at why the Fed will splurge is a chicken-or-egg game. Is the Fed preparing for a downdraft in the stock market with its tried-and-false response: by creating more money? Or, is it preparing to transmit (by electronic keystroke) more dollars to absorb securities held at banks, insurance companies, money-market funds, and mutual funds that should be carried at a much lower value?

The Fed washed its hands of credit analysis on January 6, 2011, when it issued its weekly H.4.1 "Factors Affecting Reserve Balances." The federal agency that vaunts its "transparency" (i.e.: the Fed) implanted a note that transferred all capital losses to the taxpayer. The January 6, 2011, "Factors Affecting Reserve Balances" stated that beginning on January 1, 2011, all capital losses in the Federal Reserve's mangy and non-transparent portfolio would henceforth be transferred to the Treasury Department. In a sense, this is only an accounting frivolity, since the taxpayer ultimately pays for the New York Fed's reckless mismanagement of its highly leveraged portfolio (103:1); that could soon, absent the January 6 sleight-of-hand, mirror Enron's jambalaya.

After the 2008 credit meltdown, the Fed, led by Simple Ben, fought for greater regulatory control of the banking system. The cranks who warned against Federal Reserve regulatory authority have been vindicated, on a comically inflated scale.

Wild-and-wooly securities that cratered after the credit cycle turned (circa 2007) are back, for instance: low doc, cov lite, payment-in-kind toggle notes, the proceeds of which pay private-equity firms up-front dividends. Century bonds (Mexico, the University of Southern California) sold swiftly, never a good sign. "Synthetic junk bonds" warned the Financial Times" resemble transactions linked to U.S. mortgages, which proliferated before the crisis" and "staple deals" counseled the Wall Street Journal "came under sharp criticism during the buyout boom for causing a number of conflicts of interest" have been structured by the banks that Ben Bernanke regulates. This highlights the greatest conflict of interest: the false claim that the Federal Reserve regulates the banks.

One security in the pipeline (possibly on hold during the current market mayhem) is a "synthetic deutsche mark," that would "create shadow trading in legacy currencies in a synthetic market." Paul Volcker said somewhere the only financial advancement of the past 30 years is the ATM card. Comparing the collateral behind Peter Warburtin's bond market to the absence of such behind the synthetic deutsche mark (a currency that ceased to exist over a decade ago) outlines the enormous waste of capital, human ingenuity, and savings over the past 40 years. With nothing learned, this will continue, until uncollateralized paper spawns a New Era in post-fiat origami.

Tuesday, October 18, 2011

Harrisburg Fails to Get the Word

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)

Municipal bondholders have something else to worry about. If Occupy Wall Street has legs, and, if labor unions handcuff the protestors' agenda ("Major Unions Join Occupy Wall Street Protest" - New York Times, October 5, 2011), will that effectively downgrade general obligation (G.O.) bonds another notch? That is unlikely. In fact, trends over the past few months have shown states and municipalities are more inclined to meet general obligation bond payments as long as they possibly can. Union workers who press municipalities into bankruptcy (the Harrisburg, Pennsylvania bankruptcy might be interpreted as such) should take heed.

States and municipalities are averse to filing for bankruptcy. If they wobble, the courts remind them of their priorities. The State of Minnesota could not reach a budget agreement this past fiscal year (ending June 30, 2011). In advance, a June 29, 2011, District Court expressed its opinion: "Only minimal levels of staff and operating expenses that are necessary" should continue. "All others are recommended to close." Of "activities recommended to continue" number one on the list (although it is not stated if the sequence is in order of priority) was "bond payments and related activities."

Minnesota political alliances belie such a full-throated bondholder decree. The attorney general petitioned the District Court for an Opinion; the governor opposed the attorney general's Petition, arguing executive and legislative authority over budget priorities are not judiciable. In private, the political actors agreed that payments to bondholders were more important than paying a single salary. (The impasse, during which bondholders were paid and non-critical state employees were idled, lasted until July 20, 2011, when an agreement was reached.) Such a cordial behind-the-scenes concord can be expected in other states and municipalities. The consequence of not paying bondholders includes the assumption they will be unable to issue general obligation bonds for several years and, even then, at higher interest rates.

A second reason to remain current is to retain control. When a municipality enters bankruptcy, the court can exert enormous control over the legislative bodies. The court will decide who gets paid in the case of Harrisburg, leaving aside for the moment the Commonwealth of Pennsylvania's legislative and legal attempts to thwart the bankruptcy filing, as well as the mayor of Harrisburg's legal action against the city counsel's decision to file. (Note: this discourse addresses situations when it is not necessary to default. There will be many situations when there is no choice.)

This "clearing of the decks" allows us to suppose the court adapts the "Municipal Financial Recovery Act Recovery Plan [for the] City of Harrisburg" submitted (by several concurring organizations) on June 13, 2011. Since Harrisburg's finances are no better than four months ago (at best), the court may save itself some time by reviewing this 422-page, 11-megabyte plan.

Among its conclusions, the Plan states: "[T]he City must [note: "must"]... outsource [its] commercial sanitation collection; eliminate [its] Park Ranger program; combine Park Maintenance in the Department of Public Works..." These are only a few of many structural changes. Henry Kravis has a bigger heart.

The Plan does not shrink from expressing its disgust at backroom City deals by certain politicians: "The City must contain fast growing employee compensation by immediately challenging the extensions made by the previous Mayor immediately prior to his leaving office that increased compensation for employees despite the looming financial crisis..."

The nexus between previously negotiated employee compensation - particularly by unions - and the dwindling revenues to fulfill their legally negotiated pay and benefits (both parties signed), will be a battle royale. Although the Plan does not state a specific reduction, it is unambiguous in regard to which is Peter and which is Paul: "[T]he city is forced to reduce its existing operating budget by a minimum of $2.5 million to pay debt service and compensate for lost revenue...."

Although not generally mentioned, both the municipalities and the unions understand which comes first. The unions know it is better to press their demands up to the point before default and (possibly) bankruptcy. This puts them in accord with the politicians' top priority: to make bond payments. A central figure in the mid-1970s, New-York-City negotiations recalls: "Union leaders need to look as tough as they can. When they have to back down, they vilify the city's negotiators. It's a macho thing."

Why, then, did Harrisburg file for bankruptcy, given that many parties did not think it was necessary? This is a big country and not everyone gets the word. Mistakes will be made. That's why they are where they are.

Thursday, October 13, 2011

The 8% Solution

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 terminal stage of Dr. Frankenstein-style central banking is disgorging ridiculous claims of authority motivated by reckless efforts to retain control. One such pincer attack is the Federal Reserve's purported 2% inflation target. Behind our very eyes, this fictional mandate is being raised, all the more reason that savers need to speculate, not a welcome prospect with both inflationary and deflationary influences expanding and bound to burst.

A certainty of this age (post-Western-Civilization) is the ease with which libertine policies escalate to fantastic proportions even as they are failing. The Federal Reserve mumbles its 2% inflation target while the "economic literature" has sown the garden for an 8% inflation rate, in the name of "price stability."

To be more precise, "inflation" to the Federal Reserve is conveniently defined as the consumer price index - without including food and energy. This 2% or 8% target should be understood as a negative interest rate. The Federal Reserve will (through its current policy, although this will boomerang at some point) hold Treasury yields at zero-percent. It will target inflation at 2% to 20%.

In The Beginning, at least in this short narrative, a Harvard economist told a Senate committee the United States must accept a 2% inflation rate as the cost of prosperity. That was in 1957, a very good year to wrap such a career-advancing declaration inside a Cold War mandate. "Growth" would defeat the Soviet Union.

Federal Reserve Chairman William McChesney Martin did not agree. On August 13, 1957, Martin warned that recent inflationary pressures had risen from a period of 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.' . . . 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."

Martin was doomed to lose this battle and the media misunderstood hemorrhaging inflationary tendencies. Inflation was National Worry #1 when the business editor of the New York Times calmed his readers: "Luckily, the Government has the ability and the wisdom not to let inflation break into a gallop as it has happened recently in other countries." That was in 1966.

President Richard Nixon held a farewell gala for Martin in 1970. The soon-to-be ex-Federal Reserve chairman sobered up the tipsy revelers when he removed the punch bowl during his valedictory speech: "I wish I could turn the bank over to Arthur Burns [the next Fed Chairman] as I would have liked. But we are in deep trouble. We are in the wildest inflation since the Civil War."

Moving ahead, Professor Ben S. Bernanke wrote a book that was well received in the right circles: Inflation Targeting: Lessons from the International Experience (2001). One of his co-authors was Frederic Mishkin. Those in the know understand the implications of Mishkin's cooperation. The book propagated the awful euphemisms ("the zero-bound" and "inflation targeting") used to disguise their mandate to inflate. Rather, they could have simply stated: "Let's ruin the dollar."

Some economists took exception. Lee Hoskins, president of the Federal Reserve Bank of Cleveland from 1987 to 1991, wrote: "Pundits, economists, and some Fed officials often talk about the fight against inflation or the battle against it or the need to contain it as if it is some preternatural event. The Fed does not have to battle or contain inflation, it creates inflation.... So when a Fed official says the goal for inflation should be 2 percent, he is explicitly choosing to create that rate of inflation." ("Zero Inflation: Goal and Target," 2005) Hoskins is not a regular on CNBC's short list. (See "The Education Gap.")

Federal Reserve policy of 2% inflation is a product of failure and verbal repetition. Bernanke's Fed needs room to maneuver ("infinite bound"), and a wide fairway to compound its broadening failure, while not losing credibility. Thus, this fictional authority is repeated over and over. Current Federal Reserve Governor Janet Yellen: "This increase in core inflation was below the 2 percent rate that I and most of my fellow Fed policymakers on the Federal Open Market Committee (FOMC) consider an appropriate long-term price stability objective."

Note the structure of Yellen's statement. She hides the arbitrary ("consider an appropriate") under legal cover ("price stability"). The Fed and its accomplices in the professorate train the public mind through such repetition.

Even with 2% inflation touted as a mark of price stability, higher figures are working their way into the public conscience. N. Gregory Mankiw, a Harvard economics professor who consistently establishes new lows in personal integrity, wrote a column in the April 19, 2009, New York Times: "It May Be Time to go Negative."

It should be remembered that Mankiw made his proposal because Federal Reserve Chairman Ben S. Bernanke's grand theory was failing. In October 2011, we know it has failed. Bernanke's foolish interpretation of the Great Depression has done nothing to halt the housing bust. It is far worse today than in 2009, and probably about to take another tumble. This was an inevitable consequence of the credit binge, of which Bernanke's Fed has no understanding. We have paid a heavy price for this ignorance. Investment continues its drift towards short-term trading gains and not into industries that need long-term investment to prosper. The result: a country with an inflation-adjusted median income that is 6.7% below that of June 2009.

In his 2009 column, Mankiw wrote: "[T]here is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates - interest rates measured in purchasing power - could become negative. Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. Ben S. Bernanke, the Fed chairman, is the perfect person to make this commitment to higher inflation...." That's enough. Mankiw consistently makes Eddie Haskell's syrupy conversations with Ward Cleaver sound like General Patton's misadventure with the hospitalized soldier.

Note that Mankiw was behind the times. He needed to justifying negative interest rates even though such a course is inconsistent with the Fed's mandated goal of "price stability." No insufferably pliant economist would make that mistake today - note Yellen, above.

It is obvious that Mankiw is vying to head the Fed, with such maneuvers as his recently announced post as Presidential candidate Mitt Romney's economic adviser. Romney has stated he will jettison Bernanke. (Romney's other adviser is Glenn Hubbard - See: Inside Job) The resourceful Bill Black, author (The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry) and currently professor of Economics and Law at the University of Missouri - Kansas City recently quoted from a paper written by Mankiw in 1993: "[I]t would be irrational for operators of the savings and loans not to loot."

Harvard economics professor Kenneth Rogoff, author of This Time is Different: Eight Centuries of Financial Folly, told Bloomberg News on May 19, 2009: "I'm advocating 6 percent inflation for at least a couple of years." Rogoff has not changed course, recently advocating 6% inflation in the Financial Times.

Mankiw was quoted in the same article as declining to "put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that." The "model" trick is the mental ghetto that permits fourth-rate economists to become Federal Reserve chairmen.

But Mankiw is on to something. Why pin yourself to a rate, when triple-digit inflation may be required to really ruin the country?

The following sequence is a lesson in how bureaucracies insinuate their failures into accepted policy.

Stanley Fischer, current Governor of the Bank of Israel, doctoral Ph.D. thesis adviser to Ben S. Bernanke and to Greg Mankiw (at MIT), with stops at every institution of impeccable prestige among the anointed (chief economist at the World Bank, vice chairman of Citigroup) professed in 1997 that: "The fundamental task of a central bank is to preserve the value of the currency." That is the first sentence in "Maintaining Price Stability," a paper published when Fischer was First Deputy Managing Director of the International Monetary Fund. Five paragraphs later (wasting no time) Fischer wrote: "Barro (1995) and Sarel (1996) do not find a clear negative relationship below 8 percent inflation..." That is, as long as it remains at 8 percent or below, inflation is not a burden to economic growth.

We can be sure the conclusion rested on the result of some computer model. Barro (1995) and Sarel (1996) cited as their authority Fischer (1993), which is noted later in Fischer (1997).

In 2001, IMF economic researchers Mohsin S. Khan and Abdelhak S. Senhadji wrote a staff paper "Threshold Effects in the Relationship between Inflation and Growth." The authors declare "[F]irst identified by Fischer (1993)" [addressing inflation below an 8 percent rate], "inflation does not have a significant effect on growth, or it may even show a slightly positive effect." Note the change from the (1997) model Fischer from whom they quote: from "do not find clear negative relationship below 8 percent inflation," to "it [8% inflation] may even show a slightly positive effect." This sequence was arranged by Sheehan (2011)

In 1978, Federal Reserve Governor Henry C. Wallich spoke before the graduating seniors at Fordham University. His topic was inflation. Wallich explained the loser is labor. "Inflation becomes a means of exploiting labor's money illusion."

His speech is interesting in a contemporary context. The Wall Street protestors, who are probably building igloos in front of the Nome, Alaska city hall by now, are on to something; or, it seems, some things; but they are diffusing their influence. One of the protestors' tendencies leans towards a government solution. This is a barren tangent. A supersized government uses supersized banks to remain supersized.

Wallich told the Fordham students, that government is one of the winners in an inflation. From this Federal Reserve official: "It [inflation] allows the politician to make promises that cannot be met in real terms, because, as the government overspends trying to keep those promises, the value of those benefits shrinks." This creates a "diminishing ability of households to provide privately for the future.... One may ask whether it is not an essential attribute of a civilized society to be able to make that kind of provision for the future."

Wallich went on to emphasize "the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government." If alive today, he would not be surprised the protestors are looking to the government for help. Wallich (1914-1988) grew up in Berlin and lived through what he warned against (1978).

Wallich added that inflation "creates a vacuum in the private sector into which the government moves." He worried that the consequences of the inflation would be "a shift into the third dimension, away from democracy and toward authoritarianism."

In Wallich's Germany, Joseph Goebbels (1897-1945) spoke at Nuremberg (1934):

"It is no sign of wise leadership to acquaint the nation with hard facts over night. Crises must be prepared for not only politically and economically, but also psychologically. Here propaganda has its place. It must prepare the way actively and educationally. Its task is to prepare the way for practical actions. It must follow these actions step by step, never losing sight of them. In a manner of speaking, it provides the background music. Such propaganda in the end miraculously makes the unpopular popular, enabling even a government's most difficult decisions to secure the resolute support of the people. A government that uses it properly can do what is necessary without running the risk of losing the masses."

Friday, October 7, 2011

The Golden Constant

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 following is a brief outline of "Gold and the 'Flations," published in the April 2005 Gloom, Boom & Doom Report.

General talk has it that gold is a hedge against inflation. We might take this a step further and conclude that a unit of gold will purchase a constant basket of goods when prices are inflating.

Standard advice does not include gold in one's asset mix during non-inflationary periods. The evidence presents a more complicated picture.

Taking the data alone, gold has been a better wealth gatherer, and preserver, during deflations than inflations. (The following discusses gold vis-à-vis goods prices, not asset prices.) That is beside the point today: Gold has consistently been of greatest value during times of disintegration.

Roy W. Jastram, professor of economics at the University of California, Berkeley, spent two decades collecting data and sifting through the evidence. He published his conclusions in The Golden Constant (1977). (There is a recent successor book that is not consistent with Jastram.)

Jastram's interest was the value of gold in relation to purchasing power. Given most, if not all, paper currencies' decline in this regard, the author's findings are worth studying.

First, over long periods of time, gold maintains its purchasing power. "The intriguing aspect to this conclusion is that it is not because gold eventually moves towards commodity prices but because commodity prices return to gold." The author called this "the retrieval effect." The implication today is the price of goods, which have increased in the low single-digits over the past decade according the government, will catch up to the 18%-or-so annual increase in the spot gold price over the same time. Gold and Silver Stocks made the case that the miners are primed for heady gains. The farcical characters ruining the world's paper currencies make an even better case that gold is headed to 36,000 (as prophesized by Glassman and Hassett. They identified the wrong market. )

Second, gold has held purchasing power to a greater degree in deflationary periods than during inflationary times. That distinction is not important today, since this is a time of disintegration. Thus, we come to the heart of the matter:

Third, "gold has served as a financial refuge in political, economic, and personal catastrophes." The current collapse of central banking, the practitioners of which are destroying the world's financial system in an attempt to salvage their reputations, fits all three. Jastram labeled this the "Attila Effect."

That is the case, pace Jastram, for owning gold and the miners today.

Following are some very brief comments on Jastram's methods and review of his figures, originally published at much greater length in "Gold and the 'Flations."

Jastram collected data from two countries to produce his "purchasing power of gold." These were England (1560-1976) and the United States (1800-1976). England is a country "for which data are available over unusually long spans of time" and "with constant political boundaries for many centuries." Jastram recognized the United States cannot "match all of the attributes cited earlier for the choice of England" but "it is fully justified by its great importance both as a national economy and as an economic influence on the rest of the world."

He approached this excursion into economic history as a statistician: "I do not presume to take on the role of an economic historian or a monetary economist as well." Nonetheless, patterns of monetary behavior under analogous historical events do repeat themselves.

In England, the purchasing power of gold declined during inflationary periods: 1623-1658: -34%, 1675-1695: -21%, 1702-1723: -22%, 1752-1776: -21%, 1793-1813: -27%, 1897-1920: -67%, 1933-1975: -25%.

Again, in England, the purchasing power of gold rose during deflationary periods: 1658-1669: +42%, 1813-1851: +70%, 1873-1896: +82%, 1920-1933: +251%

The numbers require interpretation. Gold has been a much better hedge against inflation than is shown. For instance, during the inflationary period of 1933-1976 in England, gold lost 25% of its purchasing power but prices rose 1,434%. (As to what might have kept pace with inflation, "crime" comes to mind, the tendency at Too-Big-to-Fail banks.)

Importantly - for the investor and shopper - Jastram concentrated on periods that lasted a generation or more. He was "not concerned with a transient swing of upward or downward price movements of short duration, but rather with fundamental changes in price levels of substantial duration." He emphasized that gold is an ineffective hedge against yearly commodity price increases.

Jastram's findings should be compared to the traditional investment adviser's rationale for owning or not owning gold. As outlined:

Gold is a poor hedge against major inflations.

Gold appreciates in operational wealth in major deflations.

Gold is an ineffective hedge against yearly commodity price increases.

Over long periods of time, gold maintains its purchasing power.

Gold has no equal during times of disintegration. The "Attila Effect" is coming soon to stores near you.