Friday, May 31, 2013

"A" for Conduct. "F" for Guts.

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)

"You are lucky, if I may say so, that I'm the one who's standing here and not the ghost of Sen. Carter Glass. One hesitates to speak for the dead, but I am reasonably sure that the Virginia Democrat, who regarded himself as father of the Fed, would skewer you."

-James Grant, addressing the staff of the New York Federal Reserve, March 12, 2012

            Once upon a time (but not so long ago), the New York paper-pushers who deem which textbooks public-school children will read fell upon a history book that posited some fashionable minority had broken bread during an important historical event. It was pointed out there was no evidence of such, to which the paper-pushers agreed: "We know they weren't there, but it's a good idea."

            In this spirit, Craig Torres at Bloomberg wrote, or was handed, a historical account of the Fed's founding that is a "good idea," according to the Fed. (See: " Fed's 100-year Roots Grew From Virginia Congressman.")

            The article is wrong throughout, although, the first sentence may be true: "As Carter Glass began to sketch out plans for a central bank in 1913, all the U.S. representative from Virginia had to do was read his mail to know he had nationwide support." The gist of Torres' reconstruction is the mailbag in Carter Glass' office, from which the little people (a converter of cotton goods, a hardware proprietor, a butcher, and a candlestick maker) urged the Senator to pass a currency reform bill. The Federal Reserve Act became law on December 22, 1913.

            Skipping over Torres' study of why we needed the Fed ("America's strong growth potential was hobbled by a banking system that Glass called 'a rank panic breeder'"), one is left thinking Senator Glass went to his grave pleased with his accomplishment. Towards the end of the reporter's interpretation, we read: "For his part, Glass continued to defend the Fed during its early years. Speaking in the Senate, where he represented Virginia from 1920 to his death in 1946, he assailed the old system as 'bank reserve evil' and called the rigid currency and lack of flexible reserves 'the Siamese Twins of disorder.'"

            "Early years" may be taken to mean 1946, still early, from the vantage point of 2013. By 1917, Senator Glass was distressed with Fed's unaccountable usurpation.

The Federal Reserve Act of 1913 did not permit the bank to buy or hold government securities. The Federal Reserve Bank was formed to serve the needs of its constituent commercial banks. Commercial banks dealt in commercial receivables. Economists were not needed.

            H. Parker Willis was Senator Glass' aide-de-camp when the Act was negotiated. In 1936, he wrote The Theory and Practice of Central Banking. Willis fumed: "Central banks will do wisely to lay aside their inexpert ventures in half-baked monetary theory, meretricious statistical measures of trade, and hasty grindings of the axes of speculative interests with their suggestion that by doing so they are achieving some sort of 'vague' stabilization, that will, in the long run be for the better good."

            Torres writes the Federal Reserve System would "provide backup currency and credit - in effect creating a liquid market for the assets held by banks when they needed money." The system of semi-autonomous regional banks was funneled into a national bureaucracy. The centralized, open-market operations of the 1920s spawned the illiquid banking system of the early 1930s. Willis (1936) explained the inevitable consequence of having turned commercial banks into casinos. In the words of James Grant: "The idea of liquidity, too, had a hard time of it in the 1920s. A liquid asset, as Willis and his peers defined it, was a short dated commercial IOU - a money-good industrial purchase order, for example. Banks had no business owning any asset that did not, upon its maturity, generate a cash payment. Leave bonds, mortgages, and other long-lived capital instruments to the savings banks and insurance companies, Willis preached. Commercial banks were put on this earth to facilitate the exchange of goods, not to 'create' credit or finance speculation."

            Putting oneself in Craig Torres' shoes, what might he write in an unauthorized, Fed Centennial piece? It might not be much different. Where would he look? The current "literature" (per Ben S. Bernanke, ad nauseam) of economic "science" (BB, ad etc.) has blotted history. In Federal Reserve Chairman Ben S. Bernanke's Essays on the Great Depression, neither Glass' nor Willis' names are in the index. This is quite a feat, given that Carter Glass was co-author of the Glass-Steagall Act of 1933. The World's Greatest Authority on the Great Depression missed the most important bank reform of the Great Depression. Banking is central to his blunderbuss theories.

Bernanke is not atypical. The seventh-grade spelling bee champion from South Carolina undoubtedly received an "A" in conduct from romper room until he received Stanley Fischer's thumbs-up at M.I.T. It is not an accident that almost all Bernanke's academic references (the 'literature") are post-1980 academic papers written in the sandbox of such power-seekers as Professor Stanley Fischer, who has since gone on to destabilize banks and central banks on two continents. (Now heading the Israeli central bank, he is buying up the U.S. stock market.)

            It might not be literally incorrect, but worth extrapolating the proposition, that Ben S. Bernanke has never asked a question in his life. He may have asked if he could go the bathroom or if he could decant extra-credit projects at Harvard, but he would never put one of his betters on the spot. He pontificates among a generation of economists who all received an "A" in conduct. (What is worse, so an insider informs, the next generation of students that has studied under Bernanke is even more faint-hearted. They are now filling the Fed and Berkeley faculty ranks.)

            This is the way of the world, spinning east, now, to the People's Republic of China. On the same day Torres' history lesson was released, Bloomberg published: "China Credit-Bubble Call Pits Fitch's Chu Against S&P." Charlene Chu, at Fitch Ratings in Beijing, had the nerve to publish some unseemly ratios. Total lending from Chinese banks and financial institutions rose from 125% of GDP in 2008 to 198% in 2012.

Chu explained: "You just don't see that magnitude of increase" in the ratio of credit to GDP. "It's usually one of the most reliable predictors for a financial crisis." To ensure there was no question of her forecast, Chu told an interviewer: "There is just no way to grow out of a debt problem when credit is already twice as large as GDP and growing nearly twice as fast"

S&P and Moody's do not, and will not, mention "no way out" assessments for U.S. Treasury bonds. Until they default, that is. Even then, they hedge and haw, the unvarying unlanguage within large bureaucracies. (A sample: March 14, 2008 (Bloomberg) - "Bear Stearns Cos.'s credit rating was reduced three levels to BBB [still investment grade - FJS] by Standard & Poor's after the securities firm was forced to seek emergency financing from JPMorgan Chase & Co. and the New York Federal Reserve.... 'Although we view the liquidity support to Bear as positive, we consider it a short-term solution to a longer term issue,' S&P analyst Diane Hinton said.") [My bold - FJS]

Other headlines drummed home the presumptuousness of Fitch's analyst: "A China Credit crisis? Yes, Says a Lonely Fitch analyst" "Fitch Defies S&P on China's Credit Bubble" [My italics - FJS] Channels that fear losing government "access" bear the state's message. There is Hilsenrath at the Wall Street Journal. America's most notable business-news channel suspends appearances by analysts who are unconscionably bearish. Hitler was asked when he would nationalize industries. Herr Schicklgruber responded he had no intention of doing so; He would nationalize the people instead.

Bloomberg TV interviewed S&P's leading light on Chinese credit: concerning Chinese banks, the pop-eyed fellow earned an "A" in conduct: "This is a good story unfolding here." When he was asked about Charlene Chu's forecast, the rising star at S&P spoke with the timidity we've come to expect from government-aligned corporations: "We will not be the one who will be giving those scare signals."

Shifting continents, a May 25, 2013, Economist editorial certainly went down well in Brussels and Strasbourg, but did its readers no good. It should be remembered the European media operates under the fist of ECB President Mario Draghi, a good reason to find a "good story unfolding here," no matter how improbable.

The opening paragraph of the Economist's latest Euro assessment: "You may have missed it, but the European Union held a summit this week. Taking in a nutritious working lunch, Europe's prime ministers, presidents and chancellors devoted half of Wednesday to weighty issues of energy and taxation. Gone are the panic-stricken sessions of last year, dogged by talk of the euro's imminent failure. Today, Europe's leaders note, reform is under way across most of the euro zone and some southern European countries are regaining their competitiveness. The government-debt market is back in its box, where it belongs. And over the past year share prices are up by a quarter. Nobody could pretend that life is easy; Europeans understand that hard work and sacrifices lie ahead. But the worst of the crisis is now safely in the past."

European banks are using toilet-trained, beanie babies for collateral, but the magazine wins an "A" for good conduct. Hot off the press, a headline: "Spain's Bankia Decimates Savers As Stock Plummets; Police Officer Stabs Banker Who Sold Him Shares" The story opens: "While investors across the globe applaud Bernanke and other central bankers for pushing stock markets to record highs, retail investors and savers in Spain are facing massive losses. Markets appear to have forgotten Europe's sovereign debt crisis and the woes in Spain." (Forbes)


           There are consequences to running a world with the self-appointed best and brightest. 

Saturday, May 25, 2013

Interview with Frederick Sheehan, by Lindsey Blumell

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)

Please follow the link to a 15-minute interview with Frederick Sheehan by Lindsey Blumell, on Cliff Küle's Notes: Reflections On Our World & Its Money (The Great Confidence Game), May 10, 2013.

Topics ranged from global imbalances, non-stop asset inflating by central banks, the exhausted morality of American institutions that still serve as a forum for Alan Greenspan's irrelevancies, and so much more.  

 (allow this link a few seconds to load)

**For those of you who had trouble reaching the interview with David Stockman in Thursday's blog, please CLICK HERE for an updated link.**

Thursday, May 23, 2013

Interview with David Stockman, author of The Great Deformation: The Rise of Crony Capitalism in America

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 reviews I have read of David Stockman's book, The Great Deformation: The Rise of Crony Capitalism in America, have dealt in trivia, clichés, and ignorance. This interview on Sunday, May 19, 2013, with Jim Campbell, provides depth to some of the most important topics.

Please follow the link to the interview by Jim Campbell, “Business Talk with Jim Campbell” is nationally syndicated on the Business Talk Radio Network Sundays 10-11am EST. You can go to to find the station nearest you or to listen on the internet. Also available on Yale Radio –

Link: "JimCampbell Business Talk with Jim Campbell interview with David A. Stockmanauthor of The Great Deformation: The Rise of Crony Capitalism in America, May19, 2013" 

Mozilla users click here:

Wednesday, May 22, 2013

Big Money

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 difficulties of institutions that need cash for payment have grown acute during the chalk-brained professors' zero-interest-rate pogrom. Insurance companies are one victim, pension plans another. Looking specifically at defined-benefit pension plans, the plan sponsor (corporation, maybe, or municipality) is obligated to pay current and future retirees a specific dollar amount from now until a spouse's death.

            The discrepancy between income received from investments and cash needed to pay beneficiaries of public (state, municipal) pension plans dumbfounds the mathematically inclined. Actuaries make long-term projections of returns on assets and the change in liabilities. The assets on hand to pay benefits in 2025 will not look as susceptible to downgrade if the actuary projects annual investment returns at 8% rather than 3%. Thus, 8% is a typical investment return projected on plan assets today. High-yield bonds are often a sanctuary to justify such assumptions. Now in our fifth year of interest-rate confiscation, such bonds are bought, then bid up for their yields, thus compromising the virtue of such holdings since the higher prices drive the yields lower.

            Investment managers supply what pension funds want. It has been a curiosity that private-equity funds, that do a little bit of everything today, have been buying houses in quantities not seen since the Bolsheviks annexed Moscow. Among others, Texas Pacific Group (TPG Capital Management LP) is planning to buy at least $1 billion of real estate later this year. Others with similar initiatives, who are known better for buying companies, taking them private, then selling them back to the market, are Blackstone Group, Carlyle Group, and KKR. Other than the certainty that most similar organizations, be they private-equity firms or banks, spend more time looking at their competitors than at the investment, thereby misestimating the end of the cycle, why might there be this lurch for houses in 2013?

            Art Cashin, at UBS wondered the same, and asked one of the "very smartest" investors he knows. He quoted his informant in the March 15, 2013, "Cashin's Comments":     

"The more headlines I see like this [TPG buying $1 billion of real estate - FJS], the more I think these mega fund managers (KKR, Carlyle, Blackstone, Apollo) are gearing for the next leg of the MACRO economy. My opinion, this aggressive move into real estate is not just allocating capital to take advantage of a distressed sector. Funds managing $50 to 100 billion and more in some cases have determined that there is just not enough hedging product (CDS, options) to offset massive positions in private equity, credit, etc. I believe they have made the bet that economic theory has not changed that much in 500 years and the next leg will be much higher interest rates and consequently inflation. What is the poor fund manager to do when he has been forced to hold largely illiquid securities (private equity, credit)? Find a hedge. With none available at 35,000 feet you move to 70,000 feet. Hard assets combined with LONG term financing. I would guess that these funds are borrowing as much as possible in the debt markets for as long a duration is possible. (Not just funds, Disney and others have 100 year bonds)

"Conclusion, smart money is betting on coming inflation, possibly hyper-inflation. Hard assets and long term borrowing prudent at this point. Thesis supports a bid under real estate, so bubble is not imminent. Buy as much real estate as possible, borrow as much as possible (FIXED RATE), for as long a duration as possible. 

"And of course, stay very nimble with a tip of the hat......"

"The next leg" of inflation is apparent all day long: subway, parking, magazine, soup, sandwich, oil change, groceries: from $3.29 to $3.69, a seven-ounce rather than nine-ounce serving. The collective American mind, having been told otherwise for so long, may, in a flash, think: "it's 1973!" and the concerted efforts to inflate assets ("massive positions in private equity, credit, etc.") will come undone when the real costs of living are hot news.

It is impossible to hedge an entire market. The Smart Investor surmises Big Money is preparing and is buying the least bad alternative (for a company managing $100 billion). They are borrowing at miniscule interest rates, as much as possible, at a FIXED RATE, and buying long-term assets that may get squashed in the short- to middle-term. The squashing is a worst case, not assured, but one the investor should consider. When interest rates rise ("they have made the bet that economic theory has not changed that much in 500 years"), the value of assets, which are priced now for no interest costs, could - surprise a lot of people.

The May 15, 2013, Wall Street Journal published a laundry list under the title: "Private Equity Firms Build Instead of Buy." The heart of such an approach was expressed by David Foley, head of energy investing at Blackstone Group LP: "We always look at our returns as buy and hold forever, because you might."

Blackstone, teaming up with the Aga Khan Development network, built a new dam at the headwaters of the White Nile. The dam produces almost half of Uganda's electricity which Blackstone sells "at rates that ensure profits for Blackstone for years to come."

David Foley may have frowned when reading "ensured," since there are untold contingencies that could disrupt a steady flow of profits. Speculating a bit here, a pension fund may invest in Blackstone's project and be permitted to log an 8% (for example) return-on-investment each-and-every year, for the next 30 years, or, until the dam is sold. Should evil spirits temporarily halt the flow of electricity ("rituals had to be performed to appease spirits.... A feud between two diviners who laid competing claims to remove the spirits went on for two years"), the fund may still be permitted to log an 8% return, given the long-term objective.

The Wall Street Journal story discusses other such projects: "Blackstone is pursuing similar dam projects elsewhere in Uganda, in Tanzania and along Rwanda's border with the Democratic Republic of the Congo. Using its power-plant builder Sithe, the firm has plants under construction in India and the Philippines.... Apollo [Global Management], for its part, is managing the investment of money that small savers put into fixed annuities promising them a steady rate of return.... KKR is developing a tract of houses and apartments in Williston, N.D., for the oil workers pouring into that region.... [KKR] has teamed up with Chesapeake Energy Corp. to drill for oil for years to come."

A similar strategy was described in the May 17, 2013, issue of Grant's Interest Rate Observer. NovaGold (NG) is "nature's own hyper-leveraged option on a much higher gold value expressed in terms of Federal Reserve notes...." In one estimation: "Only a value on the order of $2,000 an ounce would justify the projected outlays..." Tom Kaplan, through his Electrum Group LC, and owner of 86 million NovaGold shares, has done well buying resource companies that do not meet the criteria of the standard institutional investor: "[I]f you're trying to make 100 times on your money, whether or not you're right in 24 months or 60 months, it doesn't matter." 

Friday, May 17, 2013

When Prices Fall

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)

            "Real and Illusory Credit" bridged the destruction of phony, 1920s, Federal-Reserve wampum to Bernard Connolly's evaluation of today's deadly path. The aftermath of the twenties, as described in David A. Stockman's The Great Deformation: The Corruption of Capitalism in America, crippled capital spending. Plant and equipment investment tumbled by nearly 80 percent between 1929 and 1933. Inventories were liquidated. There were no buyers. Employment and wages collapsed.

An ameliorating tendency is never mentioned by Bernanke, "the Great Historian of the Great Depression." Prices also dropped, which had traditionally been true in depressions. This was well known and understood as inevitable to rebalancing an economy that had produced beyond what could be bought at then-current prices. Bernanke and his comrades have destroyed history, at least until history rebounds and destroys them.

Bernard Connolly explained that today's central bankers have decided consumption must not flag despite the necessity - history shows this - of a decline in consumption after a business peak. If the professors had understood their limits, not taken control of prices, especially the price of money (interest rates), industries, companies, and products that grew faster than could be sustained would have already been combined or liquidated.

Quoting Connolly, the current dynamic inefficiency "reduces future consumption possibilities; and this, in turn, means that much of the recent and current capital formation, notably in the United States, has been based on excessively optimistic expectations of future demand."  Such attempts "to bring spending forward and to avoid a near-term collapse simply reduce the (realistically) anticipated rate of return on capital still further, in a vicious downward spiral."

Note the historical precedent in Stockman's book. This must happen but will be more painful than if academics had never entered central banking. The protracted issuing of unproductive debt and sustained, false prices (the market signals to businesses and buyers alike) will cascade. Assets, and their prices, will take note.

An attempt to interpret this fate adds another layer in the valuation of companies. For instance, in the May 2, 2013, High-Tech Strategist, Fred Hickey wrote: "EMC, the world's biggest supplier of computer storage equipment, slightly missed sales and earnings estimates for Q1. EMC's revenue growth (5.6%) was the slowest pace of growth since the 2009 recession. According to CEO Joe Tucci on the conference call, customers are 'still being cautious with their IT spending to be sure.' 'The customers are for sure 'sweating their assets' more - it's a term we use. They are keeping them longer,' Tucci explained. Tucci also noted that many enterprise customers are now requiring higher executive approvals before signing off on contracts."

The May, High-Tech Strategist issue contains a litany of technology companies fighting a battle against an uncooperative world economy. This presents the question of how companies will fare after central banking funny-money and illusory-credit schemes fail. This is not "if," but "when."

Just how useless, wasteful and destructive is Bernanke's gizmo? Gary Shilling's May 2013 Insight shows the increase in real GDP per dollar of incremental debt was $4.62 (of additional GDP for each additional dollar of debt) from 1947-1952; $0.64 from 1953-1984; $0.24 from 1985-2000; and $0.09 for each dollar from the fourth quarter of 2001 through the fourth quarter of 2012: an extra nine cents of production for every dollar of debt. Not a fraction of this will ever be paid off, short of a Weimer inflation. (Shilling used Ned Davis Research and Federal Reserve data.)

EMC sales and profits have been artificially lifted by businesses that can borrow at 3% but should no longer exist. Their recalibration remains in the future. Those businesses employ workers who buy products produced by P&G. And so on. Government transfer payments have prevented the economy from sky diving. "Policymakers" have employed this modus operandi since the millennium.

After the tech bust in 2000, the percentage of sales by tech companies to the government rose sharply. That saved them. Despite the recent attempt to brainwash the electorate into believing the U.S. budget deficit is no longer a problem, that is only true as long as the Federal Reserve continues to buy the majority of U.S. Treasury auctions.

Parenthetically, the TIC (Treasury International Capital) data released May 15, 2013, for the month of March 2013, shows China, Japan, Taiwan, Singapore, and India were net sellers of dollars. Andy Lees AML Macro Ltd. writes: "Japanese holdings were down USD0.5bn and have gradually been falling since October last year. This may just be rotation into other assets, but it may also be a reflection of a current account swinging into deficit in Japan and question marks over the Chinese data." Whatever the case, if the New York Fed trading desk takes a lunch break in Battery Park, the dollar will slip to 40 on the dollar (DXY) index (currently 83.61).

Not to pick on EMC, "the world's biggest supplier of computer storage equipment" bears advantages during the worst of depressions, but the loss of central-banking support will sharply reduce its sales, thus inventory, thus capital equipment (or, R&D, for a software company). The consequent loss of jobs, consumption, and falling asset prices will slide "still further, in a vicious downward spiral."

Correction: In Real and Illusory Credit, it was in 2012, not 2013, when the Federal Reserve released its Survey of Consumer Finances that showed the wealth of American family was $77,000 in 1992, rose to $126,000 in 2007, and fell back to $77,000 in 2010.

Wednesday, May 8, 2013

Real and Illusory Credit

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)

 "When Ro-Ro goes No-No" expounded upon the ultimate futility of conjuring illusory wealth. Bernard Connolly's analysis, "Rethinking the Rogoff-Reinhoff Thesis," made the case. Connolly wrote This Time is Different: Eight Centuries of Financial Folly, "is largely an exercise in measurement rather than theory (while many of the data in the book are new, little or none of the theory is), it can give rise - and has given rise - to dangerously misleading popular interpretations of the data which its authors had so painstakingly assembled." Connolly then offered the theory; what follows is complementary data.

A cheat sheet: The annual increases in U.S. non-financial credit - 1995: $654 billion; 1997: $793 billion; 1998: $999 billion; 1999 $1.012 trillion; 2002: $1.429 trillion; 2004: $2.096 trillion; 2006: $2.388 trillion: 2007: $2.552 trillion. Between 1995 and 2007, non-financial credit in the U.S. inflated from $13.141 TN to $32.621 trillion, or 148%. (From the Prudent Bear "Credit Bubble Bulletin," May 3, 2013.

This is what Federal Reserve Chairman Ben S. Bernanke calls "The Great Moderation." He and his comrades have attempted to erase what we have learned since the dawn of time. We await their proclamation that the months have been changed to Vendemaire, Brumaire, and Frimaire. In the end, they cannot pin nature under their tommyrot research, that will decay to dry rot.    

The 1920s bubble is instructive. From David Stockman's The Great Deformation: The Corruption of Capitalism in America: "[T]he financial bubble was not just domestic. It began way back in 1914 when the 'guns of August' suddenly transformed the United States into the arsenal and granary of the world and an instant, giant global creditor."

America had been a debtor nation for 300 years. American citizens owed Europeans $3 billion in 1914; Europeans owed Americans $3 billion in 1919. The U.S. bustled with commercial activity before the War; Europe was in ruins after the peace. In the words of historian William E. Leuchtenburg: "These figures represent one of those great shifts in power that happens but rarely in the history of nations."

Stockman continues: "A crucial element of the postwar stabilization process, especially in central Europe and commodity-producing nations of Latin America, was the $10 billion of foreign loans underwritten by Wall Street. That was the equivalent of $1.5 trillion in today's economy, and went to borrowers ranging from the Kingdom of Denmark and German industrialists to municipalities from Hamburg to Rio de Janeiro."

Wall Street bond houses played a role not much different from the People's Bank of China in recent years (or Cisco and Intel during the Internet years). This was vendor financing: lending currency so that others would have the funds to buy the lenders' products. Foreigners, for the most part struggling or devastated by the Great War, received Wall Street funding to buy U.S. crops, cars, and radios. On the home front, booming foreign sales spurred capital investment, consumer spending, an unsustainable real-estate escapade, and, of course, the Crash That Made the Decade Famous, in stocks.

Credit flowed. The credit system had been nationalized during World War I, through the fortuitous creation of the Federal Reserve System. In outline, the Fed boosted credit through two initiatives.

First, it greatly reduced reserve requirements of the banks. The average reserve requirements of all banks prior to the Federal Reserve Act were estimated at 21.09%. By the 1920s, the Fed, having distinguished between demand and time deposits, had reduced the reserve ratio against demand deposits (to 7% - 13%) and against time deposits (to 3%).

Banks lent as one might expect. Demand deposits did not grow in the 1920s. Between 1921 and 1929, commercial loans - those loans for commerce and industry that fulfill the traditional function of banks - fell, from $12,844,000 to $12,814,000. Time-deposit lending, with lower reserve requirements, boomed. Real-estate speculation and securities lending were part-and-parcel to degenerate gambling propensities encouraged by Prohibition. Between 1921 and 1929, loans on securities rose from 19% to 28% of bank assets; loans on real estate rose from 3% to 8%. (Commercial loans fell from a 53% composition of all Federal Reserve member banks' balance sheets to 36%.)

Mortgage debt rose through the decade, from $8 billion in 1919 to $27 billion in 1929. The fastest acceleration in new mortgage debt was between 1924 and 1927 (even though construction peaked in 1926) when mortgage debt rose from $15.5 billion to $24.2 billion - a 57.4% rise, or, a 16.3% annual rise. (Not all of this was bank lending.) Are you paying attention Canada? (See "Time to Go Short: Here Come Those Experts Again." Yep, any minute now.

A second Fed initiative was open-market operations. Today, the Fed enters the market every day, fixing interest rates while electronically transferring dollars it has created. These are open-market operations. Benjamin Strong grew addicted to more and bigger open-market operations through the decade. (Don't they all?). He had initially opposed such personal intervention most vehemently: "What I can't understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal."

Such shenanigans were not contemplated when the Federal Reserve System was rushed into law. Only "real bills" were accepted for rediscount. Government bonds need not apply. By 1927, Benjamin Strong was freelancing as America's super-government. Federal Reserve governor Adolph Miller testified to Strong's mad-scientist scheme in 1932: "[T]he Federal Reserve [put] money into the markets, not because member banks asked for it by offering paper for rediscount, but in pursuance of a policy of our own which in effect said, 'We shall not wait to be asked to provide increased money through rediscounts; we will operate upon our own responsibility....'"

Returning to Bernard Connolly's interpretation of This Time is Different, today's fantasy credit will crumble. It is backed by fanciful dreams, but not by money. James P. Warburg, a financial adviser to President Franklin Roosevelt who then became a fierce opponent of FDR's whimsical schemes, wrote in The Money Muddle (1934): "Credit cannot create money for capital investment. The credit machinery can only direct the flow of capital into productive investment, but the capital must be there - it must have been created, or be in the process of creation, by the savings out of incomes. Credit can, and frequently does, anticipate the creation of capital, but when it does, the capital it creates 'out of thin air' will again vanish into the air, if the anticipated savings do not materialize."

Rediscounted commercial bills are backed by trade or inventory. It's the real thing. Strong and Bernanke's bilge is backed by faith or absent-mindedness.

The populace at large was party to the imbalances. Between 1923 and 1929, worker's wages rose 11%, which did not keep pace with corporate profits (up 62%) and dividends (up 65%). Radio sales rose from $60 million to $852 million. Along with cars, vacuum cleaners, refrigerators, silk stockings and movie tickets (by 1918, the movie business was already one of the ten largest industries in America) there was a lot more money spent than earned.

How was all this purchased? "Installment" debt financed 75% of all radio purchases and 60% of all automobiles and furniture. [Margaret Mitchell wrote of 1926: "Everyone I knew had a car, a radio, an electric ice box and a baby that they were buying on time (everybody except me!)."] Over 40% of department store sales were purchased on credit by 1926. Margin loans blossomed in the second half of the decade. At $16 billion in October 1929, this source of instability equaled about 18% of stock market capitalization. Rising demand for credit raised borrowing rates.

Bank customers, both individuals and corporations, instructed banks to lend their deposits in the call-loan market. It has been estimated that corporations (including U.S. Steel, General Motors, AT&T, and Standard Oil of New Jersey) had lent $5 billion to New York Stock Exchange purchases by September 1929. They were drawn to the call-loan market as rates rose to 10%. In consequence, total securities loans increased from $12.4 billion on October 3, 1928 to $16.9 billion a year later. Foreign banks also lent in New York, while neglecting the local tool-and-die manufacturer in Linz or Pinsk or Omsk.

This has a modern ring to it. The Internet years. The mortgage scramble. And now, the central bankers' Disney dust. Assets far and near are bubbling. What will happen to inventory chains and their suppliers when those buying on time falter?

Reading the weekly list of international issuers in Doug Noland's Credit Bubble Bulletin could be interpreted as a shift of wealth from the west to the east or bubbleitus spread to countries with oddly distributed consonants.

A comparison:

Week of April 10, 2009:

"International debt issues this week included Korea $3.0bn, KFW $3,0bn, Suncorp $2.5bn, and Hutchinson Whampoa $1.5bn."

Week of April 26 2013:

"International issuers included African Development Bank $2.17bn, Boligkreditt $1.0bn, Costa Rica $1.0bn, Neder Waterschapsbank $900 million, Toronto Dominion Bank $2.25bn, Transport de Gas Peru $850 million, Schaeffler Finance $850 million, Panama $750 million, Turkiye Bankasi $750 million, Uralkali $650 million, Sinochem $600 million, Promsvyazbank $600 million, Saci Falabella $600 million, Andrade Gutier $500 million, Korea Resources $500 million, Credit Bank of Moscow $500 million, Far Eastern Shipping $500 million, Banco Sudameris $300 million and International Bank of Reconstruction & Development $250 million."

            After 1929, the phony credit evaporated. Stockman writes: "[T]he trouble was that this prosperity was neither organic nor sustainable. In addition to the debt-financed demand for American exports, stock market winnings and the explosion of consumer debt generated exuberant but unsustainable purchases of big-ticket durables at home. So, when the stock market finally broke, this financially fueled chain of economic explosion snapped and violently unwound.

            "The first victim was the foreign bond market, which was the subprime canary in the coal mine of its day. Within a few months of the crash, new issuance had dropped 95 percent from its peak 1928 levels, causing foreign demand for U.S. exports to collapse. Worse still the price of the nearly $10 billion of foreign bonds outstanding also soon plunged to less than ten cents on the dollar, meaning the collapse was of the same magnitude as the subprime mortgage collapse of 2008."

            The interlinking relationships of the economy were now collapsing in unison rather than inflating. Stockman continues: "Needless to say, [the] 75 percent shrinkage of auto sales cascaded through the auto supply chain, including metal working, steel, glass, rubber, and machine tools.... The collapse of these 'growth' industries also caused a withering cutback in business investment. Plant and equipment spending tumbled by nearly 80 percent between 1929 and 1933, while nearly half of all the production inventories extant in 1929 were liquidated over the next three years. The unprecedented liquidation of working inventories - from $38 billion to $22 billion - amounted to nearly a 20 percent hit to GDP before the cycle reached bottom.  

            "Overall, nominal GDP had been $103 billion in 1929 but by 1933 had shrunk to only $56 billion. Yet the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and equipment, and consumer durables. [Bernanke and Yellen claim open-market money printing in 1931 would have sparked an economic recovery. This is their foundation for quantitative easing. - FJS] These components declined by $33 billion during the four years after 1929 and accounted for fully 70 percent of the decline in nominal GDP."

            In this spirit, it is worth looking further into Bernard Connolly's critique of Rogoff-Reinhart's non-theory: "The underlying problem is dynamic inefficiency, which reduces future consumption possibilities; and this, in turn, means that much of the recent and current capital formation, notably in the United States, has been based on excessively optimistic expectations of future demand. To prevent a hole from emerging as today becomes tomorrow, more and more incentives to keep on bringing spending forward from the future have to be given, whether in the form of reduced 'risk-free' bond yields, or attempts to ease credit conditions, or fiscal 'stimulus." Such attempts "to bring spending forward and to avoid a near-term collapse simply reduce the (realistically) anticipated rate of return on capital still further, in a vicious downward spiral."

            In June 2012, the Federal Reserve released its Survey of Consumer Finances. It showed the wealth of American family was $77,000 in 1992, rose to $126,000 in 2007, and fell back to $77,000 in 2010. The Fed is responsible for this Ferris wheel. Quoting page 2 of Panderer to Power: "From the time Greenspan was named Federal Reserve chairman until he left office, the nation's debt rose from $10.8 trillion to $41.0 trillion. He usually referred to the "debt" as "wealth." This image matched what he was selling - first stocks, then houses. He expanded money and credit; he oozed praise for derivatives. The larger volume of credit shrunk the consequences of immediate losses. It was easy to overlook areas of the economy that had shriveled and the instability of finance that compounded over the past half-century. In early 2007, this massive inflation of paper claims, many of which were claims on abstractions rather than on material assets, tottered then collapsed: the first to go was the subprime mortgage market."

            On April 24, 2013, the Republic of Rwanda issued a $400 million, 10-year Eurobond with a yield of 6.875%. The issue attracted more than $3 billion, "allowing bankers to tighten the yield to just 6.875 per cent, comfortably below the 7 per cent to 7.5 per cent that had initially been expected." (Financial Times) Some potential buyers of this single-B issue were deterred because of its small size. Bonds below a $500 million limit are excluded from "influential" bond indices. Half of the foreign currency flowing into Rwanda last year came from foreign remittances. (Rwandans working abroad.) Ten percent of GDP is foreign aid.

            Except for the (suspect) higher coupon, the symmetrical return to Earth of the Rwandan bond issue will not differ much from 10-year U.S. Treasuries.

Wednesday, May 1, 2013

When Ro-Ro Goes No-No

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)

            A book finds favor when public opinion is willing to accept its proposition. This Time is Different: Eight Centuries of Financial Folly (2009) by Carmen Reinhart and Ken Rogoff funneled the debate of whether post-2008-crisis governments should increase spending ("fiscal stimulus") or cut it ("austerity"). The media's interpretative abilities further refined the on-off debate into a single interpretation of Rogoff and Reinhart's book. A country where public debt exceeds 90% of GDP is walking the gangplank. There is no shortage of such countries; the most heated debate has been in Europe. It is at emergency meetings among the world's acronyms where bureaucrats decide whether formerly sovereign nations are to be hexed with "austerity," or not.

            At the moment, there is a hiccup over the book's interpretation. That is not the topic here. The ruckus among noted economists concerns some re-regurgitation of the authors' data. Some new computer output aids the anti-austerity forces, who believe central bankers can eventually produce enough money on a keyboard to restore world prosperity. This accumulated phony wealth accompanied by asset-price targeting is the reason these institutional has-beens still control the public forum and weary us with recreational mathematics.

Outlined below is an interpretation that matters. The Summer 2012 edition of The International Economy published "Rethinking the Rogoff-Reinhoff Thesis," by economist Bernard Connolly, author of The Rotten Heart of Europe, and proprietor of Connolly Insight, his economic consulting firm in New York.

Connolly recognizes that the parties above (Rogoff, Reinhardt and all the categories of data interpreters mentioned) have mishandled This Time is Different. They have done so because the data has "not been set within a theoretical framework." The reason for such ignorance is "straightforward. The world, or at least the United States, became dynamically inefficient in the second half of the 1990s (perhaps for the first time since the 'roaring twenties'): the real interest rates tended to be less than the expected trend real growth rate. The culprits? Fed Chairman Alan Greenspan, European monetary union, the academic macroeconomics industry as a whole and its worse-than-useless DSGE models, and central banking theology as a whole with its dangerous inflation-targeting obsession. Over-financialization and excessive risk-taking by financial institutions were the consequence of this mess, not the cause."

Cutting to Connolly's point of illusory wealth, central bankers believe they can right any economic disturbance: the heart of their DSGE model. Why did Ben Bernanke claim sub-prime was "contained" in 2007 and wave off bubble concerns presented to him (February 2013) by the new bureaucracy he commissioned to warn him of bubbles? Because his dynamic stochastic equilibrium model is correct. It is always correct. He is the "A" student.

Except, it is wrong when the economy is dynamically inefficient, characteristics of which (see examples above) are exactly those being chased by central bankers today. Connolly quotes from "the magnificent, awe-inspiring Foundations of International Economics" (1996), written by Rogoff and Maurice Obstfeld: "The behavior of dynamically inefficient economies wreaks havoc with much of our intuition about the laws of economics." (Connolly explains the economic problems currently being exacerbated by official policy cause a reduction in future consumption possibilities, meaning, much of the capital formation is based "on excessively optimistic expectations of future demand." This is explained in his paper.)

Connolly corrects a possible misunderstanding of how the illusion of wealth will end: "It is very important, in thinking about the implications of the Reinhoff-Rogoff research, to realize that what deters new participants in a Ponzi scheme is not an accumulation of debt, but a destruction of wealth, or more accurately, a realization that the wealth supposedly backing debt is illusory.... [I]f the wealth of debtors is illusory, the wealth of creditors must also be illusory."

The illusory wealth will be extinguished. Capital formation based on excessively optimistic expectations of future demand will end where it started. This may happen quite fast. I tend to think Bill Fleckenstein, my co-author of Greenspan's Bubbles, is correct. Bill has written on his "Daily Rap," that, "in today's money printing world, as I have noted, problems don't matter until they do, as the discounting process essentially fails to function."("Daily Rap," April 3, 2013)

Current market prices are controlled, or, at least significantly altered, by central-bank interference. Investors who enjoy the latitude of investing or not investing, and choose to hold "risk assets" (discussion for another day) believe, or hope, that central banks will continue to boost prices. There is no question that boosting asset prices is the top goal of central banks today.

The "realization that the wealth supposedly backing debt is illusory" (paper currencies are a liability of the issuer) will end. Connolly writes: "traditional 'fundamentals' have now largely been transformed into one overarching 'fundamental': the assessment of solvency. As a result, markets are exhibiting binary behavior ('risk-on' and 'risk-off'.)"

This is another way of saying: "the discounting process essentially [is] fail[ing] to function." When ro-ro goes no-no, the currency of choice will be real money: gold and silver.

As it happens, Bill Fleckenstein quoted Paul Singer of Elliott Management (who has been quoted here before), in this afternoon's "Daily Rap":

"The world is on a seemingly one-way trip to monetary debasement as the catchall economic policy, and there is only one store of value and medium of exchange that has stood the test of time as 'real money': gold. We expect this dynamic to assert itself in a large way at some point. In the meantime, it is quite frustrating to watch the price of gold fall as the conditions that should cause it to appreciate seem more and more prevalent. Gold may not exactly be a 'safe haven' in the sense of an asset whose value is precisely known and stable. But it surely is an asset that, in a particular set of circumstances, becomes a unique and irreplaceable 'must-have.' In those circumstances (loss of confidence in governments and paper money), there are no substitutes, and the price of gold may reflect that characteristic at some point." ("Daily Rap" April 30, 2013)