Those FOMC Transcripts: Watch Out Below

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

                    The Federal Reserve releases transcripts of FOMC (Federal Open Market Committee) meetings after a five-year wait. The 2008 transcripts were made public late, last week. The FOMC is the monetary policymaking body within the Federal Reserve System. Having read at least 10 years of transcripts when writing about Greenspan and his Fed, there is a lingering question of what might have been redacted before the public release as well as what might be said outside the boardroom so as to escape transcription. Every once in awhile some forward-thinking FOMC attendee (a rarity, to be sure) will remind the mob: "Remember, that comment will be public in five years."

The FOMC transcripts also do not include "other meetings at which smaller groups of Fed officials, working with the Treasury Department, arranged the bailouts of bankrupt Bear Stearns, the American International Group (NYSE: AIG), and housing service entities Fannie Mae and Freddie Mac. Nor do the transcripts include notes from the meetings at which policy makers decided to let Lehman fail." (FOXBusiness, "Fed Releases Transcripts from 2008 Meetings")

Nevertheless, the initial stories across news channels were full of ridicule and indignation at the FOMC's real-time ignorance as banks and markets collapsed. We are fortunate that two of the scheduled FOMC gatherings happened to be on March 18, 2008, and September, 16, 2008, immediately after the collapse of Bear Stearns and Lehman Brother, respectively. The FOMC also held a conference call on March 10, 2008, days before the Bear Stearns failure. The conversations from each show a body more incapable of making connections, translating their macro models to the real world, than a five-year-old. (I remember clearly: a five-year-old walking into the kitchen, looking at the September 16, 2008, New York Times, seeing a large picture of an ex-Lehman employee carrying her belongings out of the building, and asking: "Daddy, are we in a Depression?")

The story of the 2008 transcripts will fade. It must: to preserve faith in the Fed and the stock market. If the Fed was thought unable to "make connections," as it so clearly failed to do in 2008, this might cause a reduction in market exposure (from 99% to 98% leverage). Market authorities remind investors of "considerations which must nowadays modify ideas about the future. One is the power and protective resources of the Federal Reserve." (New York Times, September 9, 1929).

The Fed has been awarded greater power and resources than ever before (to put it mildly) since 2008, yet, the results of its "learning by doing" experiments show the FOMC is no wiser than when Chairman Ben S. Bernanke, Great Depression scholar and legend in his own mind, gathered his flock on September 16, 2008. In the same monologue, the professor claimed: "I think that our policy is looking actually pretty good" and "I am decidedly confused and very muddled about this." He might seem to possess the wiring of a schizophrenic, but there actually is no contradiction in the professor's mind. It is we who wander without full knowledge.

The Fed, ECB, IMF, and fellow travelers operate under the presumption any disturbance can be corrected by central bankers. Their model says so. The Dynamic Stochastic General Equilibrium (DSGE) model made it certain the Fed would not take action before the 2007 financial implosion. The economist Bernard Connolly wrote to his clients in 2006 (when at AIG) the Federal Reserve would not - could not - act beforehand. The holy DSGE model was the reason Bernanke could feel kinda' good when he was confused and muddled. The model provides a central-banking solution for all human errors. Connolly wrote on February 4, 2008, the "DSGE contention that negative demand disturbances (although perhaps exhibiting some serial correlation) rather soon revert to an expected value of zero, is, in conditions of intertemporal disequilibria, nothing more than a fairy tale..." This is difficult to absorb, especially in such an abbreviated form, but it is way the world works (currently). All of Connolly's work from that period can be read at his firm's website, "Hamiltonian Associates," under the "AIG" tab.

The vote was unanimous at that September 16, 2008, meeting: to do nothing, leave the funds rate at 2.0%. Within days, Bernanke and Hank Paulson were terrorizing congressmen and Americans: the end was nigh. In case you have forgotten the general panic, an example was at a Whole Foods outlet where a woman of means turned and asked "I'm worried. Do you think we're in a Depression?" The customer so queried told the worrywart: "You'll have to ask my daughter." Which she did. This customer's five-year-old daughter, having given some thought to her confusion on the morning after Lehman's failure, replied: "Some parts of the country are in a depression, but we are not, at least, yet." This response relieved the anxiety of the woman of means.

The point is not whether the five-year-old was correct or not, but that she had given more thought to current events than the entire FOMC bureaucracy. Chairman Bernanke spoke for those who worshiped the DSGE model at the October 7, 2008 meeting: "It's more than obvious that we have an extraordinary situation.... I should say that this comes as a surprise to me." This is to be expected. Financial markets are not part of the model.

Since 2008, central bankers have been "learning by doing," as Simple Ben told a Jackson Hole, Wyoming audience on August 31, 2012. His speech carried the title of "Monetary Policy Since the Onset of the Crisis." The speech made clear the model was holier than ever. ("It is likely that the crisis and the recession have attenuated some of the normal transmission channels of monetary policy relative to what is assumed in the models...") Reliable sources report the DSGE model is still sacred at the Yellen Fed. In fact, the younger generation of economic Ph.D's who now tweak the input have often learned nothing else in their post-graduate work.

            It is important for the rest of humanity to comprehend the consequences. No action will be taken to prevent what cannot happen. The media sometimes veers towards the fatal FOMC flaw but lacks a full understanding. Thus, Binyamin Appelbaum, writing about the 2008 transcripts in the February 21, 2014, New York Times, explained: "The Fed's understanding of the crisis, however, was clouded by its reliance on indicators that tend to miss sharp changes in conditions. The government initially estimated, for example, that the economy expanded in the first half of 2008 because it basically assumed that some economic trends, like the pace of business creation, had continued apace. The Fed also relied on economic models that assumed the existence of smoothly functioning financial markets, limiting its ability to project the consequences of a breakdown."

            Appelbaum does not quite understand the assumption "of smoothly functioning financial markets" is imbedded in FOMC policy. Financial markets are not part of the DSGE model since "negative demand disturbances" of financial markets "rather soon revert to an expected value of zero." Therefore, they do not exist and FOMC transcripts from 2009 through 2014 will show discussions by the hallowed professors made no allowance for reality and were "nothing more than a fairy tale."

An unrelated note. From the February 26, 2014 Wall Street Journal: "LONDON - Last summer, Adrian Eady, a banker with Royal Bank of Scotland, was nearly crushed hauling a crate of feta cheese off a forklift truck in a North London warehouse."

Does anyone understand what's going on? 

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" (Aucontrarian.com, 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.

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" (Aucontrarian.com, 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.

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" (Aucontrarian.com, 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) 

A Quarrel in a Far-Away Country between People of Whom We Know Nothing

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

            Even for those living on a distant continent, the confiscation of state-guaranteed bank deposits in Cyprus is a reminder. (At this stage, it is not clear the Eurocrats will succeed.) Governments and central-banks blew their capital to save a financial Ouija board - not system - in 2008. Former Federal Reserve Chairman Paul Volcker reminded an audience last week there is no financial system: "And what I'm talking about is the international monetary system.  Of course you know it's hard to call it a system. A system concerns itself with some interrelated parts and a mechanism that are working together to produce some stability and progress.  That's hardly a description of the international monetary system.  And as many people have said, 'international non-system.'"

            The arbitrary decisions made by Americrats and Eurocrats in 2008, of what to save and what to sink, must veer towards sinking more and saving less in 2013. It has been noted the decision to confiscate bank deposits in Cyprus was a stupid move instituted by the acronyms (ECB, EU, IMF, G-somethings). This should remind residents in other countries that, first, what is theirs isn't, and second, relying on logic (e.g., "the government wouldn't do that, it would be shooting itself in the foot") is not a wise path to self-preservation.

            First, and foremost, the capital on which the bureaucrats can draw is low. That is financial, political, and psychological capital. In 2008, the central banks and governments stood behind the public's bank deposits and panic subsided. The veneer is much thinner now. Again, logic is not the path to estimating when the public recognizes its exposure, since that should have happened so long ago. These are states whose authority only exists as long as their paper-currency bills are trusted. (Yes, buy gold and silver).

All that is left is central-bank, money-printing and assurances of future money-printing - sometimes in the form of guarantees. The guarantees have been recklessly awarded. Revenues are harder to come by. Apparently - at least this is the current story - there was no other source of funds to back the failing Cypriot banks. The Eurocrats had drawn a line in the sand. They would only award X euros to save the banks. Cyprus had to supply the rest. The Euros would not accept debt issued by the Cypriot government as good collateral. (This is farce, given what is permitted.) Where to turn? The bond holdings in the banks were insufficient to make up the difference. Tax receipts are also insufficient, but the arbitrariness of what can be taxed and what constitutes a tax is constantly redefined in the western so-called democracies. So, the Cypriot government announced that bank deposits are hereby taxed - confiscated - to fund the deficiency. What value should bank customers place on deposit insurance in other countries?

Resourceful is spreading - reading a new interpretation by the minister of finance and administration in Spain. From El Pais, on March 19, 2013: bank deposits can be taxed since this would standardize taxes across regions. I have no idea what that means, not speaking Spanish only being one problem. Its importance though, should it be imposed, to the average Spaniard, is not the clumsy legal route to confiscation, but: "the government is taking my money."

Looking to the day of reckoning in the U.S., there are two other potential sources: private or public investment. Cyprus and Russia are negotiating now; Russia potentially supplying the missing capital. Foreign investors made the mistake of supplying U.S. financial institutions with capital in 2008. For the most part, that did not work out well for the investors. Cyprus is much smaller, though. Could Cyprus and Greece join a new ruble block?

Those with assets in the U.S. are well aware of resourceful money grabs by the government in recent years. Theft from General Motors bondholders is an example. When the Federal Reserve is buying 100% of the U.S. Treasury issues and bond yields are rising, the U.S. government will probably apply new confiscatory taxes on savings, investments, and assets. (U.S. Treasury gold holdings will become a point of contention, to express this vaguely, at some point.)

To look optimistically, the discrediting of the power brokers can not come too soon. These awful people are now so bereft of tolerable choices they write the script for their original sin when they speak. On March 19, 2013, German Finance Minister Wolfgang Schaeuble told "lawmakers" the current problem is the result of "a failed business model over decades." Schaeuble is acknowledging the euro was always a façade, a means to a different end than a functioning currency. If those who launched the euro wanted to establish a currency, a currency that required trust across borders in an experiment never before attempted, they would not have plagued it with bubonic pathologies.

Their intention was command and control, as the most prescient critic, Bernard Connolly wrote in his 1995 book, The Rotten Heart of Europe (a new edition was published in 2012): "My central thesis is that the ERM [Exchange Rate Mechanism] and EMU [Economic and Monetary Unit] are not only inefficient but undemocratic: a danger not only to our wealth but also our freedoms, and ultimately, our peace. The villains of the story... are bureaucrats and self-aggrandizing politicians." Monetary union "is a mechanism for subordinating the economic welfare, democratic rights, and national freedom of the European countries to the political and bureaucratic elites whose power-lust, cynicism, and delusions underlie the actions of the vast majority of those who now strive to create a European superstate. The ERM has been their chosen instrument and they have used it cleverly."