Insolvent Thinking

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)

            It is possible neither Janet Yellen nor another pretender will fill Bernanke's shoes in January. The odds of such a surprise may be once-in-a-history-of-the-universe, but those keep coming at a faster rate the longer we splurge. Simple Ben has been walking both his bank and the world's financial institutions closer to the cliff. Here, we will look at the precarious position of the Federal Reserve and the far-out financial securities entering the pipeline at an increasing rate.

The machinery of state demands exponential buying by banks, insurance companies, and pension funds. The purchasers risk insolvency by doing so. Chairman Bernanke would be the last to recognize this problem, unaware as he remains of his own institution's balance-sheet woes, and not understanding the financial calamity in 2007.

Central banking insolvency does not matter at the moment. The Emperor's New Clothes is preferred by Wall Street and the media alike.

            The Federal Reserve's balance sheet is a mystery, but not that much of a mystery. John Hussman wrote in his November 4, 2013, letter to clients in ("Leash the Dogma"): "A brief update on the bloated condition of the Federal Reserve's balance sheet. At present, the Fed holds $3.84 trillion in assets, with capital of just $54.86 billion, putting the Fed at 70-to-1 leverage against its stated capital. Given the relatively long maturity of Fed asset holdings, even a 20 basis point increase in interest rates effectively wipes out the Fed's capital. With the present 10-year Treasury yield already above the weighted average yield at which the Fed established its holdings, this is not a negligible consideration."

The 10-year yield has risen from 1.40% on July 27, 2012, to 2.6% or so today. Thus, the Fed is insolvent six times over. Life goes on.

There have been no sightings of central bankers jumping from windows yet. Of course, it's not their money; it isn't money at all, so we pretend. Since the Fed governors are academics, their financial knowledge is wanting. A practical reason for reducing quantitative easing (q.e.); actually, a practical reason for never getting started; is the reduction in top-rung collateral. Banks and other financial outfits borrow and lend in the trillions every day. Treasury securities that have disappeared onto the Fed's balance sheet are no longer available for collateral.

The Fed can lower standards of collateral. It has in the past, but it cannot make a bank accept Bit Coin receivables. This was central to the insolvency of Bear Stearns and onward in 2008. J.P. Morgan and Goldman Sachs were not going to repo (lend overnight) with an institution that might be shut the next morning.

This sinkhole of miscalculations was up for discussion on October 18, 2008, when the Wall Street Journal published an interview with Anna Schwartz. The article opened: "On Aug. 9, 2007, central banks around the world first intervened to stanch what has become a massive credit crunch. Since then [note: over one year later - FJS], the Federal Reserve and the Treasury have taken a series of increasingly drastic emergency actions to get lending flowing again. The central bank has lent out hundreds of billions of dollars, accepted collateral that in the past it would never have touched, and opened direct lending to institutions that have never had that privilege. [The Fed will do anything, so watch your wallet. - FJS] The Treasury has deployed billions more. And yet, 'Nothing,' Anna Schwartz says, 'seems to have quieted the fears of either the investors in the securities markets or the lenders and would-be borrowers in the credit market.'"

            Anna Schwartz was co-author with Milton Freidman of A Monetary History of the United States, 1867-1960. She went on to tell the Journal: "[T]he Fed has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is [uncertainty] that the balance sheets of financial firms are credible." This was true although Simple Ben and aligned interests still refer to the "liquidity crisis," not the "insolvencies" in 2007 and 2008. The title of the Journal's interview was "Bernanke is Fighting the Last War."

And now, Fed Chairman Bernanke has led the Fed itself into insolvency. You can be sure there have been high level meetings at the largest financial institutions, pondering what to do if a fellow Too-Big-to-Fail Bank steps away from repo loans between itself and the Fed.

The Fed has introduced a slew of other problems attributable to its q.e. and to ZIRP (Zero-Interest Rate Policy). U.S. money-market funds break even by purchasing lower-rated European bank debt. Reuters, on September 25, 2013, reported: "Life insurance is becoming an unviable business in Europe as low interest rates reduce insurers' profits, forcing many to compensate with higher-risk investments or move overseas, according to an industry survey." A Bloomberg headline from September 26, 2013: "Pension Funds Need to Buy Higher-Yielding Assets, Allianz Unit Says." Also from Reuters: "U.K. Pension Funds Take on Leveraged Loans in Search of Yield."

The longer investors find themselves buying while holding their noses, the worse are the securities offered. Corruption is one result. The Financial Times reported on November 10, 2010: "[T]he credit rating agencies are using 'deluded' processes to calculate the risks of asset-backed securities (ABS).... 'Here is a situation where you keep putting more untenable risks into the system,'" declared William Harrington, who "spearheaded analysis on derivatives between 1999 and 2010 at Moody's Investors Services."

"However," the Financial Times goes on, "institutional investors such as pension funds and insurers have begun to increase their exposure to ABS once again, as low interest rates force them to search for alternative sources for yield." 

Shooting Stars

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)

Following is a question-and-answer session between Congressman Scott Garrett from New Jersey and Federal Reserve Chairman Ben S. Bernanke before the House Committee on Financial Services, February 27, 2013.

It is puzzling why the Federal Reserve chairman is consistently unprepared to answer questions that fall directly inside the brief he has created for himself. It might be there is no need to understand questions such as those asked by Congressman Garrett, since nobody in the media seems to see through the fraud, either. In any case, this shows again Simple Ben has no idea what he is doing.

The reason for relaying this Q&A is not to explore the measureless depths of Bernanke's ignorance. Instead, the attraction is the final paragraph in which Congressman Garrett speaks. He has an exquisite grasp of how Federal Reserve policy has ruined markets. But, his time was up.

The Chair now recognizes the gentleman from New Jersey, Mr. Garrett, for 5 minutes.

Mr. GARRETT I thank the chairman and I thank Chairman Bernanke. Let me just try to run through in minutes three areas, what you talked about on remittances, what you talked about as far as some of the positive results, and if we have time, some of the effects of the somewhat current loose monetary policy on an international state. So, on remittances, I think you already said that the remittances are here, but they are potentially to go down in the future. If you look at the consolidated balance sheet of the Federal Reserve, we have capital of less than $55 billion, and assets of more than $3 trillion, so that means that all you need is about a 1 quarter of 1 percent increase in the interest rates, and you basically wipe out what you basically have right now, which is a 55 to 1 ratio, and you wipe that out. [Since that date, higher rates have wiped out the Federal Reserve's capital six times over. - FJS] So what is your prediction actually on that going forward with regard to interest rates wiping that ratio out and the effect on remittances to Congress? Can you be more specific on the numbers?

Mr. BERNANKE Certainly. So currently, as I have said, we have in the last 4 years, remitted $290 billion; we currently have more than $200 billion of unrealized capital gains on our balance sheet.  The capital issue is irrelevant. We have additional funding behind the capital. [That is, "we can print more dollars." He has. - FJS] We have $3 trillion of liabilities which are not callable liabilities, like cash, for example.

Mr. GARRETT. I guess I would just ask you if you could follow up on detail on that, because that is not the way I understand it, but I would ask you to put that in writing.

Mr. BERNANKE The main reality here is that if interest rates rise very quickly, then there may be a period where we don't pay any remittances at all to the Treasury. That is the actual outcome. That is important. Under most, and I would say virtually all scenarios, we will be sending remittances to the Treasury substantially higher than the norms established before the crisis.

Mr. GARRETT Since my time is limited, what we are looking at here is around $90 billion in remittances if-you said we could actually see that almost go down to eliminate it. Right now, we are trying to do a sequester at $85 billion. So it sort of puts us in perspective as to what the effect could be as far as your policies there. With regard to the positive indications that you have indicated, you said the stock market and the housing market have gone up because of your monetary policy, but previously you said that the Fed's monetary policy actions earlier this decade, in 2003-2005, did not contribute to the housing bubble in the United States. So which is it? Is monetary policy by the Fed not a cause of inflationary prices of housing, as you have said in the past, or is it a cause of inflating prices of housing? Can you have it both ways?

Mr. BERNANKE. Yes.

Mr. GARRETT. You can?

Mr. BERNANKE. Yeah, we can have it both ways, because they are different phenomena. The mortgage rate, um, uh, is a quantitative thing, so, house prices are going up a reasonable amount, given the strengthening of the housing market, given the strengthening of the economy, given where mortgage rates are. But the amount of movement in mortgage rates, mortgage rates in the early part of this, last decade were around 6 percent. That can't explain why house prices rose as much as they did. Maybe it was a small contribution, but it certainly can't explain the big run-up and then decline.

Mr. GARRETT. But, so now it is. [This was Garrett's dismissal of a man who had no idea what he was saying. - FJS]

So the other area you indicated why we should say your policies are working in a cost-benefit analysis is the stock market. I am sure you are familiar with Milton Friedman's work that says that people only really consume off of their permanent income, which basically means that you don't consume increased consumption because your stocks have gone up in the marketplace. And to that point, I know Mrs. Capito [Congresswoman Shelley Moore Capito, West Virginia, see below for Q&A - FJS] asked the question as to what seniors should do in this situation, and you said, take it out of some fixed assets and put it into the stock market. Heaven forbid that my 90-year-old mother would take her money out of fixed markets and put it in the stock market. I think that is probably the worst advice that is out there. And when you consider that a 1 percent increase in the stock market only has infinitesimal, maybe a 100 percent increase in GDP [sic], I really don't understand: a, how you can give that advice; b, how you can suggest that an increase in the stock market is a positive indicator of your work in a cost-benefit analysis to the rest of the economy.

Mr. BERNANKE. I was, I was not giving financial advice. I apologize if I gave that impression. I was just saying-

Mr. GARRETT. But she was asking you-

Mr. BERNANKE. -that generally-

Mr. GARRETT. She was asking you the question, what should you be doing to benefit the seniors, what should we say to the seniors. And your comments were-

Mr. BERNANKE. What I was saying was that the economy will get stronger because of good policies and that in turn will cause rates to rise in a sustainable way. If we were to raise rates prematurely, we would kill the recovery and rates would come down and we would have a long-term situation with very low rates.

Mr. GARRETT. But wouldn't you have provided for the certainty in the marketplace so you could have more price transparency? Earlier, you said that some risk-taking in the market is appropriate. That was one of your opening comments. Sure, risk-taking is appropriate, but it is appropriate when there is actual price discovery. When you have a market that is distorted, as it is right now by the Fed's monetary policy, you really don't have true price discovery. And so when you do risk-taking now, it is based upon I not really knowing what the appropriate value is of land prices, equity markets prices, so risk-taking now is worse than risk-taking is when the Fed's actions do not distort the marketplace. If you would say-

Chairman HENSARLING. The time of the gentleman has expired.

THE Q&A BETWEEN CONGRESSWOMAN SHELLEY MOORE CAPITO AND HIM:

MRS. CAPITO: Many of us are in that sandwich generation trying to help our parents, and our parents are doing a pretty good job trying to help themselves, but they're relying on their good planning and investments if they have been lucky enough to invest. And the dividend and interest availabilities to them are crushing our seniors as they see their healthcare costs go up. And some of the policies that you put forward I think, and that the Fed has, has caused concern for those of us who are concerned about seniors who don't have the ability to get another job, that's played out for them. What, what can I tell my seniors back home that is going to give them some optimism that they're going to be able to rely on that good planning that they had to carry them through the senior years?

HIM: Well I would say first that savers have many hats. They may own fixed income instruments like bonds, but they may also own stocks or a house or a business. All those other assets benefit when the economy strengthens and those values have gone up. The stock market is roughly doubled as you know in the past few years.

This was quite specific advice to Mrs. Capito. Besides crawling into Lucifer's den before answering Congressman Garrett, why is this nincompoop telling old people to buy stocks AFTER the stock market has doubled? We might give him the benefit of the doubt that, since Bernanke has banished "actual price discovery" in all markets, and thinks he can do so forever, he will double Mrs. Capito's money over the next few years.

Of course Chairman Bernanke is not the only lifetime bureaucrat to offer carpe diem financial advice.

Following is the good word of David Stockman, author of the masterpiece,  The Great Deformation: The Corruption of Capitalism in America . He was interviewed by Market Watch on April 3, 2013. Eric Rosengren is the President of the Boston Fed.

DAVID STOCKMAN: If you have your money in a 401(k) but you get it out of the stock market or ETFs or bond funds that have duration exposure, and you stay very liquid even if you're making almost no return, thanks to Ben Bernanke, who's crucifying the savers of America on a cross of ZIRP, at least you're safe. In the world ahead, there is such a huge collapse coming in the financial markets, the third one since 2000, it's better to preserve your capital, stay liquid, keep your head down, don't borrow money unless you absolutely have to. That is very discouraging because people would like to earn a return on their savings.

When we have this character Rosengren up in Boston saying, it's a good thing, we are trying to induce people to go into risk assets. Who in the hell is Rosengren to tell old ladies of America they have to buy junk bonds because the Fed tells them to!!!!! If the old ladies feel safer in a CD, they ought to be able to earn something besides dog food money on it. There is going to be a revolt against these arrogant mandarins running the Fed, they will rue the day they arrogated to themselves such massive power. [Italics are my irrational exuberance - FJS]

Knitting. Still Knitting.

 

Notes

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)

Between October 1998 and November 1999, the Nasdaq composite rose 150%. Everyone who was invested believed in Alan Greenspan and the Federal Reserve. At a Grant's Interest Rate Observer conference in November 1999, Michael Steinhardt, one of the best traders over the previous three decades, did not buy it.

He did not think the Fed's leadership would be worth much when it was needed most. He spoke about Wall Street's abandonment of controls, leadership and responsibility: "The liquidity safeguards, historically, were the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms. They were the mechanisms that the stock exchange itself had provided, and they were all structured for a system where trading was a very, very small fraction of what we're seeing today. Now there are no specialists' books; there is no serious liquidity provided by brokerage firms; and the trading mechanisms of the exchange are hardly relevant to the sorts of volumes that exist today. So yes, the Federal Reserve, if you define that broad context of liquidity in a financial sense, does still exist, but in a securities market sense, none of the former ones do."

That was 14 years ago. In this age of uplift and improvement, does the current Federal Reserve Board understand the consequences (as seen in April 2000 and in 2007 and 2008) of the lost "liquidity safeguards...."?

This can only be answered in the future, 500 years from now - it will take that long for the human mind to believe this Arsenal of Annihilation was given responsibility above latrine duty. From all sources though, the top of the Fed has grown more withdrawn, abstract, and divorced from reality since the millennium. The king pins are not interested in the functioning of markets. Markets exist to fulfill economic policy of our policy-makers. It is unfathomable to the anointed that government control of markets would even be questioned.

AT THE COUNCIL ON FOREIGN RELATIONS, June 28, 2013:

James Grant, addressing Governor Jeremy C. Stein, Federal Reserve Board: "Good morning, Governor. James Grant of Grant's Interest Rate Observer. Could you help us understand the economic difference - not the legal one, but the economic distinction - between the private manipulation of Libor, on the one hand, and the public manipulation of markets, on the other, doing business as ZIRP, QE, Twist, the "portfolio balance channel"? What ever did happen to the price mechanism?"

Governor Jeremy C. Stein, Federal Reserve Board: "You know, that's a hard question for me to answer, because [laughter] I don't see the connection between these two whatsoever. I mean, obviously, the Libor set - it is a set of criminal and near-criminal activity, which is a very substantial policy concern. A lot of effort is going into trying to, you know, both reform Libor itself, look at other benchmarks, see if they're more resilient. That's a whole set of issues. To be frank, I just don't see the connection to that and the monetary policy issue."

            This is the type of thinking that gives investors confidence (apparently) that the Fed will not permit the stock market to fall 20%. Yet, the man has no interest in how people participate (or don't) in markets.

            Over these same 14 years, technology has turned public-market investing into a much more dangerous arena. Some will say the withdrawal of private money from markets shows the public understands this, since there is very little trading left, except by institutions and their algorithms.

            The curious investigator, 500 years from now, will study our worship of technology despite daily evidence of its failure. Here, we discuss the malfunctioning of public markets. The Nasdaq took a mid-week siesta on August 22, 2013, and there are no answers. (An hour before the Nasdaq died, NYSE Euronext announced a breakdown of its Arca exchange, for symbols from TACT through Z. Two days before, Goldman Sachs pushed a wrong button and stock-options with ticker symbols between H through L fell to $1.00. After the Nasdaq ran through the usual excuses - "software bug" "connectivity issue" "latent flaw" "system overload" - the exchange magnanimously announced it crashed "to protect the integrity of the market.") With technology, any excuse for obvious failure is taken as gospel.

            None of this nonsense would exist if "liquidity safeguards, historically...the specialists' books, the retail system, and the institutional liquidity providers in the major brokerage firms" - that is, people, were still on the chopping block.

            Turning exchanges back into public utilities is sine qua non.

            OF ALL THE COMMENTARY REGARDING THE NEXT FED CHAIRMAN, NONE WAS MORE FETCHING than that offered by star Financial Times columnist Gillian Tett. Under the headline "Central bank's chief needs to master the art of storytelling," she wrote: "The next Fed chair also needs to be a masterful storyteller and cultural analyst, who can read social sentiment, shape norms, (re)create trust and persuade us all to think in a manner that suits the Fed's economic goals, without us even noticing. Somebody, in other words, who can cast spells with both their spreadsheets and words. In short, what is needed is nothing less than a monetary shaman."

            A test of such talent will be the day stock markets shut - and never reopen - claiming they are protecting the integrity of the market. Very few will protest.

            In fact, the new Fed head may have more leeway to "shape norms, (re)create trust and persuade us all to think in a manner that suits the Fed's economic goals." So we learned under the headline: "U.S. Repeals Propaganda Ban, Spreads Government Made News to Americans." ForeignPolicy.com, July 14, 2013 [Note: Bastille Day].

 

Reporter John Hudson: "For decades, a so-called anti-propaganda law prevented the U.S. government's mammoth broadcasting arm from delivering programming to American audiences. But on July 2, that came silently to an end with the implementation of a new reform passed in January. The result: an unleashing of thousands of hours per week of government-funded radio and TV programs for domestic U.S. consumption in a reform initially criticized as a green light for U.S. domestic propaganda efforts. So what just happened?"

 

            That's as far as I got. The propaganda machine seems to be working at full tilt already.

 

            This was announced on the heels (July 12, 2013) of a Washington Post article by Josh Hicks after the Department of Homeland Security had "warned its employees that the government may penalize them for opening a Washington Post article containing a classified slide that shows how the National Security Agency eavesdrops on international communications.... An internal memo from DHS headquarters told workers on Friday that viewing the document from an 'unclassified government workstation' could lead to administrative or legal action. 'You may be violating your non-disclosure agreement in which you sign that you will protect classified national security information,' the communication said. The memo said workers who view the article through an unclassified workstation should report the incident as a 'classified data spillage.'" Hicks provided a link to the double-secret Washington Post article.

OF COURSE, FINANCE IS ONLY A SUBSET OF THE GENERAL DELERIUM. IT WAS QUITE A LEAP for Secretary of State John Kerry to sit before Congress and extort the imagery of Americans dying during the Normandy invasion ("You ask the question, 'Why does the United States have to be out there?' You ever been to the cemetery in France? Ya know, above those beaches? Why'd those guys have to go do that?") as reason to invade Syria. The congressmen did not seem to notice. Maybe they felt sorry for him.. He was stumbling all over the lot trying to make sense.

Numbers and Prices

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 is fully committed to its asset-propping strategy: It will raise the economy by lifting asset numbers.

            This is where it is important to remember the Federal Reserve does not care about economics. The economists at the Fed are central planners. It's not that they don't like economics, they simply are not interested in, so ignore, economics. Those of us not so inclined think of asset numbers as prices, be they shares in the S&P 500 or wheat germ. But the Fed operates in an abstract world; humanity is a distraction.

            At the moment, the Fed's asset-lifting model deigns that the economy, which is a derivative of asset-lifting, will pass muster when the S&P 500 rises another 500 points and house prices rise another 11%.

            These numbers have been typed into the Fed's model. It summons variables to achieve those levels. One supposes the waning influence of QE (looking at the increasing units of QE needed to lift stocks or houses to a specific number) demands a higher level of QE.

            The Fed is currently buying $85 billion of Treasuries and mortgages each month. This will remove about $1 trillion of securities from the market in 2013 (85 x 12). The effort should be aiding its residential real-estate goal, since a large part of the U.S. mortgage market is moving onto the Fed's balance sheet.

            Yet, there are reasons to think the house-lifting program is waning. One of the more interesting developments is the widely reported tactic of house builders holding inventory off the market, or not building houses, to raise prices. Whether true or not (or, whether it matters or not), there seems to have been no reaction. What would Eric Holder's Once-in-Awhile Justice Department do if Big Oil or Big Pharma announced it was doing the same? This is another (supposed, in this case) example of tolerated flim-flammery in the Crony Capitalist growth model.

            The Fed has not boosted, nor talked beyond, its $85 billion a month asset-absorption (and money-printing), since, in April 2013, the Bank of Japan commenced its $80 billion a month of magic wand waving. That is $165 billion of magic money emitted each month by the central banks of the U.S. and Japan. They are not alone: "ECB Says Bond-buying Program is Unlimited" (Reuters, June 9, 2013)

The Japanese experiment is not working as planned, maybe it's early, or maybe another $80 billion a month will be introduced. Some recent headlines: "Yen Drops After Abe Adviser Says BOJ Can Do More" (Bloomberg, May 28, 2013) "BOJ Beat: Mortgage Rates Rise" (Wall Street Journal, June 1, 2013) "Bond Fund Smack-down as 10-Year Treasury Yield Surges" (Reuters, May 29, 2013) For the callous observer, watching everything Chairman Bernanke taught, wrote, and preached turn into its opposite is a delight.

            Continuing in that vein, asset exuberance is slowing down. A new issuance of Rwanda bonds would probably not pass muster today.  (See: "Big Money") Some recent headlines show the change in tone: "Apple Wows Market with $17 Billion Bond Deal" (Reuters, May 1, 2013) "Rising Mortgage Rates, Home Prices a Lethal Brew" (Yahoo, May 29, 2013) "U.S. Bond Funds Suffer Second-biggest Withdrawal Since 1992" (Bloomberg, June 7, 2013) "This is Increasingly Looking Like an Emerging Market Meltdown" (Business Insider, June 11, 2013) "Global Sell-off Hits U.S. High-yield Market (TD Waterhouse, June 11, 2013) "Apple Bonds Lose 9% in Six Weeks" (CNBC, June 12, 2013) "Rising Mortgage Rates Elicit Fears They Could Hurt Recovery" (Washington Post, June 18, 2013) "Mortgage-bond Failures Reach Most in 2013 as Prices Drop" (Bloomberg, June 20, 2013) "Fed Chairman Bernanke Optimistic About the Economy" CBN News, June 20, 2013) "Drunken Ben Bernanke Tells Everyone at Neighborhood Bar How Screwed Up the Economy Is" (The Onion, August 3, 2011)

            Central planning is failing. This means we will get more of the same. After that, the central banks plan to hand out money. Gold fell below $1,300 and silver below $20 on June 20, 2013. Get it while it's cold. 

It's All in the Flows

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 2007 Federal Open Market Committee (FOMC) transcripts were released last week. Media reports have concentrated on the Fed's forbearance during the credit meltdown. Implied, but not stated (in what I have read) is the major reason for such nonchalance: The Fed only acknowledges flows, not stocks. This might sound boring. It is also very important to understand.

            This approach to central banking has not changed. All of the major central banks use the same framework. The media and Wall Street spend most of their time interpreting the meaning of central-bank talk. Central banks will never mention a growing concern about loan defaults since the academics can always thwart potential catastrophes by modeling preventive flows (e.g., liquidity). The catastrophic financial failure that most of us endured in 2007 and 2008 was not a failure at all, according to central bankers. Their models still conclude there is always a central-banking solution that will prevent any catastrophe. In conclusion: when the current financial bubble topples, there will no forewarning from central bankers, the media, or Wall Street. Given their processes of thinking, they will be more surprised than the average hairdresser.  

            "Stocks," in this case, does not refer to common stocks, but the accounts and categories in which assets (and their liabilities) accumulate. The Fed, a creature of academia, knows everything. Knowing everything limits policy to sufficient "liquidity": flows. It - to be more precise - its DSGE model, does not care about accumulations: stocks.

The Fed was taken unaware when credit cracked up in the summer of 2007. Unlike many local realtors and carpenters, the FOMC did not understand the connection between flows (bad loans pouring into off-balance sheet Special Investment Vehicles) and stocks (of mushrooming mortgage credit going sour). The Fed presumably noticed pieces of the mortgage machine (subprime lenders, appraisers, Fannie Mae, commercial banks, investment banks, CDOs) even though it did not comprehend the artificiality of this contrived structure. Hence, the Fed missed the connection between the economic expansion of the mid-oughts and its artificial nature. (As we know now, the Fed does not blanch at running an economy by rigging its prices, so, we know now, central banks do not understand an artificial economy is unsustainable.)

All of which is to say the Fed and its FOMC did not know a loss of forward momentum would be followed by an abrupt shift to backward momentum. Again, this has not changed. Despite talk of deleveraging, the U.S. economy has continued to lever up since the non-catastrophe of 2007 and 2008. Total non-financial debt has risen from 240% of GDP in the fourth quarter of 2008 to 249% of GDP after the second quarter of 2012.

The Fed does not understand the artificial credit created by central banks that has flowed since 1971 has coagulated into unsustainable imbalances around the world. The FOMC will be in the caboose when government debt loses its imaginary, "riskless" character (e.g., banks do not need to reserve against most sovereign bonds). As in 2007 and 2008, the stated price of artificially produced assets is illusory, so the assets cannot stand on their own without ever increasing flows to support prices. The flows accumulate in stocks, the artificial composition of which will topple.

The rate of non-financial debt production in the U.S. economy has slowed down. It increased by 4.6% in the first quarter and 5.1% in the second quarter of 2012. Third quarter growth was 2.4%. When forward momentum is lost, backward momentum will prevail.

The jig was up by the summer of 2007. Those monitoring the Mortgage Lender Implode-o-Meter website were waiting. The mortgage-makers on parade were not necessarily bankrupt but had, at least, abandoned a major segment of their lending activities. By the end of March 2007, the Implode-o-Meter list had grown to 49, including some of the largest vacuums that fed the machine: HSBC Mortgage Services, Ameriquest, ACC Wholesale, New Century, Wachovia Mortgage. Except for those who worshiped liquidity flows, it was impossible to miss the credit crash.

Yet, following are comments from the August 7, 2007, FOMC Meeting:

CHAIRMAN BERNANKE: "I think the odds are that the market will stabilize. Most credits are pretty strong except for parts of the mortgage market."

            Of course, this is to be expected. Bernanke was quoted in October 2008 as not knowing if there was a housing bubble.

            More importantly, the man with his hand on the tiller, who should have enlightened the professors, was just as dense:

WILLIAM DUDLEY: "We've done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns, Countrywide, and some of the commercial-paper programs. There is some strain, but so far it looks as though nothing is really imminent in those areas. Now, could that change quickly? Absolutely."

Dudley ran the New York Fed's open-market desk. He is now President of the New York Fed. He had been an economist at Goldman Sachs. It is expected the academics are out-to-lunch, but Dudley had dealt in money from Goldman. His misunderstanding is appalling. (On August 16, 2007, Countrywide drew down its entire credit line of $11.5 billion. On August 17, 2007, there was a bank run on Countrywide. This was the real McCoy. The Los Angeles Times published pictures of customers lined up outside branches. The Federal Reserve cut its discount rate (not the fed funds rate) from 6.25% to 5.75% on the same day. After the August 7, 2007, meeting, the FOMC announced: "Economic growth was moderate during the first part of the year." Eight days later (the FOMC held emergency telephone calls on August 10, 2007, and August 16, 2007), the Fed justified the discount-rate cut by declaring: "Financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth.")

To conclude, a flavor of what was happening when the FOMC met in August 2007:

July 31, 2007 - "Mortgage insurers MGIC Investment Corp. and Radian Group Inc. said they might write off their combined $1.03-billion stake in a venture that invests in subprime mortgages on which payments were past due."

July 31, 2007 - "American Home Mortgage Investment Corp., which lends to people close to the sub-prime category, postponed payment of its dividend, took 'major' write-downs and said its lenders were demanding that it put up more cash. Its stock plunged 39%. 'Bankruptcy is not out of the question' for American Home, said Matt Howlett, an analyst at Fox-Pitt Kelton Inc. in New York. 'It needs to find a partner with alternative funding and hope the market turns around.'"

July 31, 2007 - "Insurer CNA Financial Corp. wrote down $20 million in sub-prime-backed securities."

July 31, 2007 - "In Germany, shares of IKB Deutsche Industriebank, which 10 days earlier said the [U.S.] sub-prime crisis wouldn't affect it, fell 20% in Frankfurt on Monday after it reported problems with investments in U.S. sub-prime mortgages."
 

August 1, 2007 - "American Home Mortgage Investment Corp. shares yesterday plunged 90 percent after the Melville, New York-based lender said it doesn't have cash to fund new loans, stranding thousands of home buyers and putting the company on the brink of failure."
 

August 1, 2007 - "Bear Stearns Cos., the New York-based manager of two hedge funds that collapsed last month, blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages."
 

August 3, 2007 - (Reuters): "AMERICAN HOME MORTGAGE TO CLOSE FRIDAY" - American Home Mortgage Investment Corp plans to close most operations on Friday and said nearly 7,000 employees will lose their jobs.... American Home originated $59 billion in loans last year, and mostly to people with better credit than risky subprime borrowers. About half of those mortgages were adjustable-rate loans, whose defining feature is an interest rate that can be adjusted upward. 'It is with great sadness that American Home has had to take this action which involves so many dedicated employees,' Chief Executive Michael Strauss said in a statement." [My italics - FJS]
 

August 3, 2007 - "Moody's Investors Service said this week it plans to take a harder look at bonds backed by those Alt-A mortgages, which are turning out to look more like subprime loans than it expected."

August 9, 2007 - (Reuters) - "American International Group, one of the biggest U.S. mortgage lenders, warned on Thursday that mortgage defaults are spreading. While saying most of its mortgage insurance and residential loans were safe, AIG made a presentation to analysts and investors that showed delinquencies are becoming more common among borrowers in the category just above subprime. Although acknowledging the "significant declines" in subprime securities, Chief Executive Martin Sullivan said AIG's tight underwriting standards had minimized losses and he was 'poised to take advantage of opportunities' in the mortgage market.'"

A final note: Some media reviews of the 2007 FOMC transcripts have given San Francisco Fed President (as she was then) Janet Yellen an A+ for anticipating the mortgage crash at early 2007 FOMC meetings. I doubt this. Since serving as Federal Reserve governor in 2004, Yellen has consistently wanted to cut rates. At one meeting, she was aghast when she learned the consumer savings rate had risen, since this would reduce consumption, push the economy into recession, so let's cut rates before the world ends. She's as witless as Simple Ben.

Unpublished Letters to the Financial Times and the New York Times

Frederick 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).



To the Financial Times, October 7, 2010:

Dear Sirs,

It is scandalous that you continue to give Alan Greenspan a forum ["Fear undermines American economy," FT, October 6, 2010]. He prattles on in his successful effort at rehabilitation by writing and speaking with the imprimatur of the Financial Times, the Brookings Institute, the Council on Foreign Relations and other institutions that should have no truck with the man most responsible for the financial ravages inflicted on The American people, and, indeed on the rest of the world.



To the Financial Times, October 13, 2010

Dear Sirs,

Edwin Truman, regarded as the wisest staffer during his time at the Fed, argued for the U.S. Treasury to sell the country's gold stock. ["Time to Unlock Fort Knox and Sell the Bullion" FT, October 13, 2010]. Truman rebuts the common argument for the gold stock to be held as a "rainy day precaution" with a question: "But after the recent economic and financial crisis and with the prospect of misery for several more years, how much more rain must pour before the US acts?"

In the Walt Disney movie Aladdin, the wise Blue Genie states: "You'd be surprised what you can live through".

It's a shame Mickey Mouse is not running the Fed. On second thought, he already is.


To the New York Times, October 15, 2010

Dear Sirs:

In "The Next Bubble," [editorial: October 13, 2010] you rue the "large inflows of capital" that "complicate macroeconomic management" of emerging economies. You identify the deadly consequences: These flows "promote fast credit expansion - which can cause inflation, inflate asset bubbles, and usually leave a pile of bad loans."

Here, you have stated matters of fact. But, you then write, there "is little policy makers in the rich world can do to stop these flows." There is everything the policy makers in the rich world ("formerly rich" -?) can do to stop these flows. We simply don't want to do what needs to be done; that is a different matter. The heart of the problem lies with the enormous creation of money and credit, most conspicuously in the United States, and which the Federal Reserve largely controls, that ricochets around the world and leads to such ruin.

The solution to this problem, both at home and abroad, is for the Federal Reserve to reduce the supply of money and credit. Your economic writer, Paul Krugman, wants the Federal Reserve to increase the supply of money and credit by several trillion dollars. Obviously, this will cause even greater "inflation, asset bubbles, and pile of bad loans" than those that are asphyxiating us today.

Leadership is not easy. You must choose your poison: Save the world or publish Krugman.


To the Financial Times, October 25, 2010

Dear Sirs,

Frederic Mishkin has made a useful suggestion in "The Fed must adopt an inflation target," [Financial Times, October 25, 2010]. He has not always been so radiant.

In 2006, when he served as adviser to the Icelandic government, Mishkin gave the green light to the country's banking system, claiming, "financial fragility is currently not a problem, and the likelihood of a financial meltdown is low." In 2007, Federal Reserve Governor Mishkin stated: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability."

In this morning's Financial Times, Mishkin, the current A. Barton Hepburn Professor of Economics at Columbia University, and, co-author with Ben S. Bernanke of the text Inflation Targeting, writes that the Federal Reserve should adopt "a specific numerical inflation objective." The pen pal of the Federal Reserve chairman thinks 2% is the rate to hit.

In 1957, an Ivy League economics professor on the make (Sumner Slichter) charmed the Senate by claiming the United States needed 2% inflation. Federal Reserve Chairman William McChesney Martin told the senators that such a plot would place the heaviest burden on those who could not protect the value of their income or savings. Those "savings in their old age would tend to be the slick and clever rather than the hard-working and thrifty."

This may have been the best market prediction of the past half-century.

The advantage of Mishkin's proposal will be to put the long-running Fed policy of impoverishing the American people into writing. It will be official, as follows:

The Federal Open Market Committee (FOMC), in its September 21, 2010 press release, stated: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent..." As a consequence, the average bank passbook savings rate in the U.S. is 0.09% (Bankrate.com, September, 21, 2010).

The adoption of Mishkin's 2% numerical inflation objective will be an official confiscation of Americans' savings, at an annual 2% rate. Once this policy is in writing, the Federal Open Market Committee will be as guilty of robbery as Willie Sutton and FOMC members can be prosecuted and sentenced with the same determination and result.

Municipal Deflation: Consequences of the Greatest Speculation

Frederick 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).

"The financial difficulties of local governments in consequence both of the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate...."

-Herbert D. Simpson, Meeting of the American Economic Association, 1933

On March 10, 2010, the Kansas City Missouri School Board voted to close nearly half its schools (28 of 58). On the same day, Illinois Governor Pat Quinn warned that if the state income tax is not raised by 1%, education will face "draconian cuts."

To employ the most hackneyed metaphor of the recent financial meltdown, we are only in the first inning of municipal deflation in the United States. This has not gained much attention in the recovery vs. recession debate. Yet, states and municipalities spend around twice as much money as the federal government. (Since only the federal government can print money, this comparison may have changed in the last year.) The gap between tax receipts and spending is forcing big changes in Missouri and Illinois, though it is probable these cuts are miniscule in comparison to what is ahead. A recovery is expected in tax receipts by those who think the economy is rebounding, but in fact the broad swath of municipalities will suffer deeper reductions in tax receipts for a long time to come. (Municipalities - cities and towns - receive most of their revenue from real estate taxes. State revenues are skewed towards income, corporate, and sales taxes.)

The Great Depression taught this lesson but it was tossed in some ash heap of history. Revered economists are particularly immune to events that contradict their theories. In the 1938 Alfred Hitchcock movie, The Lady Vanishes, the mistaken psychiatrist is told: "You must think of a fresh theory." Doctor Hartz responds: "It is not necessary. My theory was perfectly good. The facts were misleading."

Doctor Hartz had a sound reason not to change his theory since reconsideration may have precluded his intent to murder his victim. In a similar vein, intended or not, Federal Reserve Governor Frederic Mishkin espoused a murderous theory that has claimed many victims: "To begin with, the bursting of asset price bubbles often does not lead to financial instability....There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability.... In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble." This prediction was made in January 2007 before the Forecaster's Club of New York. (Novelists shy from such parody.)

Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form if not degree. There was a flight to the suburbs. The building balloon included houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."

This was speculative building on a grand scale, as Professor Herbert D. Simpson of Northwestern University informed the Forty-Fifth Annual Meeting of the American Economic Association in 1933: "Throughout this period there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate 'speculation' carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."

In The Crash and Its Aftermath, A History of Securities Markets in the United States, 1929-1933, Barrie Wigmore wrote: "Municipal governments were expected to be an active countervailing force in the anticipated business downturn after the Crash. However, many municipalities were not in a position financially to bear the twin burdens of unemployment relief and capital construction...." It is easy to see why. Municipalities were spending because tax receipts rose. Since tax receipts rose, local governments could leverage growth through bond issues. Outstanding municipal bond debt doubled in the 1920s. Over the same period, federal government debt fell by 30%.

With nothing learned, states and municipalities borrowed $23 billion in 2000 and $215 billion in 2007. One reason credit rained on bubbly school committees was the ever-rising revenue stream from real estate taxes: receipts increased from $254 billion in 2000 to $421 billion in 2008.

Federal Reserve Governor Frederic Mishkin dismissed the body blows of real-estate bubbles, but A.M. Hillhouse, author of Municipal Bonds: A Century of Experience, wrote in 1936: "[T]he major portion of overbonding by municipalities arises out of real estate booms.... The prize crop of boom bond troubles of all time came with the collapse of the Florida real estate speculation in 1926." In consequence, the property tax in West Palm Beach, Florida was raised to 42.5% of assessed value. This effort to balance the books failed.

At the 1933 meeting of the American Economic Association, Simpson was not a happy professor: "During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest.... The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."

Simpson delivered his paper at the bottom of the Depression but the number of beleaguered municipalities kept rising until 1935, when there were at least 3,252 municipal issues in default. There are at least three reasons to think current municipal problems will be worse. First, the latest real estate bubble has probably been much bigger and more leveraged than in the 1920s. Second, expenses are not as easy to cut. The earlier retrenchment was not hamstrung by bloated government retiree pension and health benefits. Third, property assessments lag current prices. This promises to be a fierce battle. Towns want to hold the status quo so are in no hurry to tax properties at falling market values; residents do not want to fund comfortable teacher retirements when they are wondering what happened to their own pension plans.

At the One Hundred Twenty-First Annual Meeting of the American Economic Association in 2009, Professor Frederic Mishkin (who has departed the Fed and returned to Columbia University) contributed a paper, "Is Monetary Policy Effective During Financial Crises?" Whatever he had to say, may it gather dust as the world learns the lessons taught and discarded by Professor Herbert D. Simpson.

From the Greenspan Put to the Kohn Put: Our Brilliant Central Bankers

Federal Reserve Vice Chairman Donald Kohn announced his retirement on March 1, 2010. In his obligatory lament, Federal Reserve Chairman Ben S. Bernanke was half right: "The Federal Reserve and the country owe a tremendous debt of gratitude to Don Kohn." What is good for the Fed is generally not good for the country. The influence of Donald Kohn supports this view.

A rarity, Kohn rose through the ranks of the Federal Reserve System. After 32 years of grunt work, he was named a Federal Reserve governor in 2002 and assigned the vice chairmanship in 2006. He participated in Federal Reserve Open Market Committee (FOMC) meetings long before his governorship. He had been a staff economist (Director of Monetary Affairs) and Secretary at FOMC meetings.

Donald Kohn will be smothered in praise from now until his June retirement. The media will quote celebrity economists who will deify the celebrity vice chairman. Alan Greenspan was "the greatest central banker who ever lived," according to former Federal Reserve Vice Chairman Alan Blinder at a 2005 conference. These farewell hosannas are necessarily vague and meaningless, as was the March 6, 2010, appraisal of Kohn in the Economist: "Mr. Kohn is widely considered one of the most experienced and thoughtful central bankers in the world." Given the worldwide failure of central bankers, this may well be true, so a critique of Kohn's brilliance is necessarily specific.

October 15, 1998: Fanning the Greenspan Put

The FOMC held a conference call on October 15, 1998. This remains the most infamous FOMC discussion on record. It was held shortly after Wall Street paid over $3 billion to bail out Long-Term Capital Management (LTCM), a hedge fund. The Nasdaq Composite Index fell 20% from mid-July to mid-October. It had boomed for the past three-and-one-half years (a 160% return), but the Fed decided a hiatus would not do.

In the wake of the conference call, the Fed announced a surprise rate cut at 3:14 p.m. The bond market had already closed for the day, stock-option contracts expired the next day, and investors panicked. A frenzy of buying pushed the S&P 500 futures up 5% in five minutes. The Nasdaq Composite rose from 1,540 on October 14, 1998 to 4,069 on December 31, 1999.

Donald Kohn's contribution, as Secretary of the FOMC, was to announce at the meeting's conclusion: "We are not constrained by the practice followed after regularly scheduled FOMC meetings where the release time is set for 2:15 p.m. We will try to move through the process of preparing the press release as rapidly as possible."

It was after this surprise rate cut that the "Greenspan Put" came into common use. A put option is bought by investors to limit losses when the market falls. Now, instead of buying protection, the Greenspan Put inspired such confidence that speculators replicated the borrowing and leveraging of LTCM. Kohn's faux pas, if that is what it was, served the interests of the Fed but not those of the American people. Around $5 trillion was lost by investors after the Greenspan Stock-Market Put failed in 2000.

Joining the Inflation Targeting Team

The Fed's deflation team was beefed up on August 5, 2002. Both Ben Bernanke and Donald Kohn were appointed as Fed governors, and to the FOMC. Bernanke had devoted his adulthood to inflationary economics. His book, which he wrote with three other economists, Inflation Targeting: Lessons from the International Experience made clear that an economy should always be inflating.

At Bernanke's first FOMC meeting (August 13, 2002), it was the other newcomer, Donald Kohn who sounded as if he was reading from Bernanke's book: "I don't see a zero real rate as a natural bound for monetary policy." He not only was unconcerned about real rates below zero, Kohn stated the opposite case: [I]nflation is already as low as I would like to see it go." He intimated that real rates were already below zero (when inflation exceeds the borrowing rate), and stated a desire for even lower real rates.

This was an about face. At the May 2002, Donald Kohn, speaking as a staff economist, had warned the committee it would soon need to address a fed funds rate hike from "its currently unsustainably low level." He also told the FOMC the fed funds rate "will have to be tightened at some point to forestall increasing inflationary pressures."

Donald Kohn has been an asset inflator since his coming out party at the August 2002 meeting. Although (the current) Chairman Bernanke has led the charge against deflation at all costs, Donald Kohn has been a loyal sidekick.

The FOMC had started cutting the fed funds rate in 2001 and did so until 2003, when it stopped at 1.0%. There are few precedents to a 1.0% borrowing rate. When we sift through the wreckage in future years, the zero-percent school will deserve a healthy portion of the blame.

"[H]ouseholds Have Bought More and Larger Houses and Cars, Have Taken on More Debt..."

Ignorance will not be an excuse. Donald Kohn knew what he was doing. After the Greenspan Stock-Market Put had failed, the FOMC instituted the Greenspan Home-Equity, Cash-Out Put. On April 1, 2004, Kohn spoke at Widener College in Chester, Pennsylvania. He opened by reminding his audience of the gratitude it owed the Federal Reserve: "Starting in January of 2001, the Federal Reserve moved to counter [the weak economy] by lowering the funds rate.... This prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record." Attendees among the cohort that had lost the $5 trillion may not have appreciated this P.R. stunt.

Kohn acknowledged there were dissenters to the Fed's current 1.0% fed funds rate: "[S]ome observers have been calling for the Federal Reserve to begin the tightening process sooner rather than later." They were concerned "that the Federal Reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. In particular, these critics worry that a continued environment of low interest rates is giving rise to economic imbalances - excessive indebtedness, and elevated prices of houses, equities, and bonds - that in the longer run will come back to haunt us."

Since the financial meltdown, the Fed has recited from its handbook: "No one saw it coming." The credit crash in 2007 had been widely anticipated and in all its severity. The question was not "if," but "when." The media quotes the Fed without correction, and so, Ben Bernanke was recently awarded another term as chairman.

Kohn dismissed concerns before the Pennsylvania college audience: "[H]ouseholds have bought more and larger houses and cars, have taken on more debt, and generally have spent more than would have been the case if interest rates had been higher.... [T]hese developments... are by-and-large the intended and logical consequences of the Federal Reserve's efforts to reduce economic slack through low interest rates."

Should there be credit "adjustments", Kohn assured his audience: "Commercial banks remain highly profitable and well capitalized...." They were only well capitalized as long as they remained highly profitable.

Of course, Kohn praised the Fed's regulatory vigilance: "Banking supervisors at the Federal Reserve, for example, in the course of the ongoing examination process, have been paying close attention to the sorts of vulnerabilities we have reviewed and have been discussing these risks with the commercial banks they oversee."

Regulation: "It's a Very Hard Sell to the Banks."

On March 4, 2008, Vice Chairman Kohn testified before the Senate Banking Committee about the "Condition of the U.S. Banking System." He made an honest admission: "I don't know that we fully appreciated all the risks out there." He also made a self-serving claim: "I'm not sure anybody did, to be perfectly honest."

Kohn was among the slow minded. In October 2007, Kohn had predicted that once "we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment."

At the March 2008 hearing, Kohn acknowledged that banks had not priced certain risks appropriately, but "It's a very hard sell to the banks." Senator Richard Shelby, a member of the committee, was not amused: "It's a hard sell to the banks, yes, but you are the supervisor of all the bank holding companies, and you are also the central bank.... So you have not just a little bit of power, but a lot of power." Shelby asked Kohn if the Fed "was afraid of the banks they regulate." Kohn responded in the negative. If this was true, a classroom of rookie bank tellers would have done - and would do - a better job supervising the banks.

Donald Kohn was talking through his hat on September 9, 2009. Again, selling the virtues of the Fed, he claimed the Fed's myriad bailouts (not his description) over the past year had followed the "precepts derived from the work of Walter Bagehot [author of Lombard Street, a central-banking blueprint from Queen Victoria's time.] Those precepts hold that central banks can and should ameliorate financial crises by providing ample credit to a wide set of borrowers, as long as the borrowers are solvent, the loans are provided against good collateral, and a penalty rate is charged." [Italics added]

Bagehot's precepts were stated correctly but Fed practices contradicted the Victorian author. Kohn betrayed a complete ignorance of what the Fed was doing. Kohn and Company had provided loans against collateral that was so damaged it was necessary for the Fed to buy it from the banks and hide it from the public on its own books. We still do not know what the Fed bought and this is probably the main reason the central bank is resisting an audit. As for charging a "penalty rate," the Fed has charged a negative real rate of interest (below the rate of inflation). A double-digit interest rate would meet Bagehot's requirement.

The Kohn Put: Inducing "Savers to Diversify into Riskier Assets"

This past fall, the Kohn Put was announced. Maybe because he was speaking to the choir - at a Federal Reserve conference - he explicitly stated the Fed's grand plan. "[R]ecently the improvement, in risk appetites and financial conditions, in part responding to actions by the Federal Reserve and other authorities, has been a critical factor in allowing the economy to begin to move higher after a very deep recession.... Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years."

In other words, the Federal Reserve is attempting to rescue itself as it did in 1998 and in 2002. Afraid the LTCM failure would cause financial institutions to freeze, the October 15 Greenspan Put inflated confidence and the stock market. In 2002, Federal Reserve governors, in speech after speech, terrorized Americans into believing it had to lift prices or the United States would suffer another Great Depression. This was the rationale for the 1% fed funds rate, the means by which the Fed inflated another asset bubble, the mortgage market, to compensate for its earlier mistake. And now, with the housing market and economy in despair, Kohn has announced the Fed's zero percent interest-rate policy will induce savers into the stock market and the already inflated municipal and federal government bond markets.

Presidential adviser Larry Summers and Secretary of the Treasury Tim Geithner are leading the search for Donald Kohn's replacement. We can be sure this pair of insiders will identify a candidate who will serve the Federal Reserve first and the American people last.

Economists Serving their Political Masters

On January 14, 2010, an academic economist took a rare stance. Tenured professors rarely lift the veil from numbers that governments invent. In “Don’t Like the Numbers? Change ‘Em,” Michael J. Boskin, Ph.D., formerly, an economics professor at Harvard and Yale; formerly, chairman of the Counsel of Economic Advisers in the George H.W. Bush administration; currently, T. M. Friedman Professor of Economics at Stanford University; research associate at the National Bureau of Economic Research; senior fellow at the Hoover Institution; and board member of the Exxon Mobil Corporation, Oracle Corporation and Vodafone PLC (among others), wielded his sword.

The Wall Street Journal devoted a half page to Boskin’s list of offenders. Politicians are interfering with the Gross Domestic Product calculations in France and Venezuela. They have toyed with the inflation rate in Argentina. In the U.S., the Obama administration has taken the phony numbers game “to a new level.” Here, Boskin is writing of the current adminstration’s calculations of jobs “created or saved” from its stimulus bill.

The “created or saved” job calculation is nonsense, but the very last person one would expect to decry the miscarriages is Michael J. Boskin.

In the early 1990s, Senator Patrick Moynihan from New York warned his fellow legislators about rising social security commitments. Then the worm crawled out of his hole, so to speak. Federal Reserve Chairman Alan Greenspan testified before the Senate and House Budget Committee on January 10, 1995. He told the Committee the inflation rate was probably overestimated by 0.5% to 1.5%.

If Greenspan was correct, this was a godsend. Social security payments are increased each year at an inflation rate calculated by the federal government: the change in the Consumer Price Index (CPI). If the CPI could be increased at a lower rate in the future, benefits would rise more slowly, without Congressional action. This would reduce government spending and delight politicians, who knew of the looming crisis in social security but did not want to imperil their careers by reducing benefits, or, in this case, by cutting the rate at which social security benefits were raised each year.

The Boskin Commission was duly formed. Michael Boskin was the right man for the job. He had served as chairman of the President's Council of Economic Advisers (CEA) from 1989 to 1993, a post previously held by such government functionaries as Arthur Burns and Alan Greenspan.

Jumping to the conclusion, the Boskin Commission, as it was known (formally, the "Advisory Commission to Study the Consumer Price Index") found that inflation was overstated by 1.1%. Several recommendations were made by the Commission to the Budget Committee. These were instituted with great efficiency by the Bureau of Labor Statistics.

The changes have lopped off far more than 1.1% in most years since 1997. From the time the changes were instituted through 2008, the compounding of an artificially low Consumer Price Index reduced payments to social security recipients by about half (according to John Williams, author of the newsletter Shadow Government Statistics).

How the CPI calculation was changed is not important here. (Chapter 12 of my book Panderer to Power is devoted to the Boskin Commission.) One adjustment may help to understand Boskin’s contribution to the impoverishment of older Americans. “Hedonic adjustments” by government number crunchers substitute imaginary prices for prices actually paid. Hedonic adjustments (purportedly, the “quality improvement” of an item) reduce the CPI. (Hedonic adjustments had been employed before the Boskin Commission, but sparingly. Afterwards, even the prices of textbooks – if they had color graphics – were adjusted for quality.)

Steve Leuthold, founder and chief investment officer of the Leuthold Group, calculated the price of a new car in the U.S. had risen from $6,847 in 1979 to $27,940 in 2004. Using hedonic adjustments, the government calculated the price of a new car had risen from $6,847 in 1979 to $11,708 in 2004.

The Boskin Commission was one scandal that economists actually denounced. Greg Mankiw, chairman of George W. Bush’s Council of Economic Advisers from 2001-2003, said at the time “the debate about the CPI was really a political debate about how, and by how much, to cut real entitlements.”

Barry Bosworth of the Brookings Institute called the revised CPI an “ ‘immaculate conception’ version of deficit reduction in which spending is cut without Congress taking the blame.”

Jack Triplett of the Brookings Institute extended the argument: “What I liked least about the Commission Report was exactly what made it so influential – its guesstimate of 1.1 percentage points of bias….The Commission (and others that have followed) used ad hoc reasoning to come up with a number….”

Jacob Ryten, from the Canadian statistical office, wrote in the same vein: “Without the guesstimates, the Commission Report was just another dry, academic study to be perused by professionals…Conversations with Committee members suggest that some, at least, were ill at ease themselves with guesstimates….My personal preference is to resist the seductive blandishments of politics and politicians….”

Jack Triplett chided the Report as succumbing “to the lure of political statements in its choice of language to describe the effect of CPI measurement errors on Social Security expenditures…. Professionals at any rate, should understand that improving the accuracy of the CPI is not the same thing as improving the basis for allocation to the dependent population….”

Professionals, at any rate, have seen fit to keep Michael Boskin at the summit after he succumbed to “seductive blandishments of politics and politicians.” It cannot be said that Boskin dishonored his profession, since he is still a superstar. Other professions institute bodies such as the American Bar Association and the American Medical Association that take action against negligence.

Federal Reserve Chairman Ben S. Bernanke, another pliant alumnus of the CEA, sits before the Senate claiming there is no inflation in the economy. He uses the CPI as his measure, taking the additional step of removing food and energy costs.

Near the end of his Wall Street Journal effort, Boskin wrote of the Obama job numbers: “One piece of good news: The public isn’t believing much of this out-of-control spin.” He’s probably correct, but spinning the number of jobs “created or saved” has no consequence, other than to increase the public’s distrust of government. The distortion of the CPI should have been censured by his profession, if it is that.

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) His blog is at AuContrarian.com