November 28, 2007

Extremist Hawks and Violent Radicalization

William Fischer writes in about the "The Violent Radicalization and Homegrown Terrorism Prevention Act" that is being put through the US legislative process. The act contains some definitions that enable really wide interpretations.

The act defines "violent radicalization" as "the process of adopting or promoting an extremist belief system for the purpose of facilitating ideologically-based violence to advance political, religious, or social change". Thought crimes, here we come. Who is capable of determining the "purpose" of believing in something? Who can say what is and is not "extremist"?

That definition is actually quite a fitting description of some of the most radically hawkish thinking in the US. If some of the activities of the people that were pushing for the war in Iraq were not cases of "promoting an extremist belief system for the purpose of facilitating ideologically-based violence", then nothing is. The same goes for the insane calls to nuke Iran, for example.

Extremist hawks should be careful in pushing through legislation that could be used to judge their own actions as well. The whole US political process since the 9/11 terrorist strikes has been an exemplary case of "violent radicalization". Mental projection—seeing one's own traits in others instead of oneself—is a powerful force in the human psyche.

November 18, 2007

Central Bank Transparency and Speculation

Comparing the levels of transparency in the US and UK central banks, Michael Shedlock, of "Mish's global economic analysis", writes:

Now that's candor and true transparency. In the UK, rate cuts are "penciled in" while the Fed disingenuously calls the risks balanced. In the UK there is talk of falling commercial real estate prices. In the U.S. the Fed knows commercial real estate is staring over the abyss but no one talks about it. While King says financial turmoil is "far from over", the Fed's Poole says "the market is healing".

I beg to differ. Even if Mervyn King is now talking straight, it does not deserve the name of candor and transparency. King has started to talk about the problems now that the problems are already self evident. He would make an ass of himself, if he was still trying to talk up the situation.

Compared with the people at the Fed, he is, of course, a paragon of virtue. The general US belief in the power of jawboning is quite ridiculous, and a fitting symbol of the insubstantial nature of the conceptual US economy. In the typical American mental state, only marketing is important, whether it is related to economic or political products.

If there was real wisdom and responsibility in the central banks, they would start talking when the problems are building up, not when a catastrophe can no longer be avoided. Mish writes:

Does anyone ever recall Bernanke, Paulson, Bush, or for that matter any Fed governor actually giving a genuine warning about possible economic malaise? Compare and contrast all of the above with the following.

Alan Greenspan had a moment of candor, when he tried to take up the issue of "irrational exuberance" in the early rising side of the dot-com bubble in December 1996. Unfortunately he was too weak to resist the shouting down by people with vested interests in blowing up the bubble.

So now Mervyn King is talking, when the damage has already been done and a catastrophe is imminent. Words of caution would have been so much more useful, if they had been uttered in the height of the hubris. But it takes a lot of courage to speak against a prevailing trend.

Central banks should be proactive in working against trends that have no cause in the underlying fundamentals. They should be actively discouraging useless speculation. It's a hard and ungratifying job, but price stability is in the interest of everybody in the long term.

Mish quotes an article from Bloomberg:

Bernanke said yesterday that Fed officials will add a third year to their forecasts and double the frequency to once a quarter. The reports will give investors and companies more details on why interest rates were adjusted and offer a map for where they are likely to go.

In promoting price stability, central banks should use their statements as a means of spreading information about fundamental aspects that have an indisputable effect on the values of assets. In this sense, the move to even longer term forecasts in central bank statements is a negative.

Central banks should discourage investment that is too heavily based on forecasting. They should have their focus on intrinsic values, and speculative trends that go against it. They should be making it clear that whenever they see excessive speculation, they will move against it. And they should back up their words with action, withdrawing the means of continuing speculation.

To make it clear, I am not promoting a tighter monetary policy at this state of affairs. The time of tightening has long gone. The credit market has already been forced to tighten itself dramatically. It is exactly this situation, where excessive looseness has resulted in a forced tightening at the worst possible time, that could have been avoided by a tighter monetary policy a few years earlier.

But the Fed should be honest about the situation. Even if it means a more rapid crash. A rapid crash might actually be better, because normal economic activity would return sooner, and the losses would be incurred by the speculators that deserve them. In fact, it would be best, if the crash in paper values would be so quick, that the real economy would not have time to react.

If the decline in paper values is prolonged, there will be a sustained deadlock of actual economic activity, and that would not be in the interest of the general public. This deadlock is currently happening the US housing market, where the gap between the buyers and the sellers has brought the market to a virtual standstill. The quicker the sellers come to terms with the situation, and capitulate on their bubbly asking prices, the quicker the market comes back to life.

November 13, 2007

Ahmad Chalabi is Back

Christian Berthelsen of The Los Angeles Times writes about the new role that was given to Ahmad Chalabi, the infamous conduit of bogus intelligence that was used to justify the invasion of Iraq.
Now the 63-year-old Chalabi, ever the political chameleon, has maneuvered back into prominence and power. Prime Minister Nouri Maliki appointed him to a pivotal position last month overseeing the restoration of vital services to Baghdad residents such as electricity, potable water, healthcare and education. The U.S. and Iraqi governments say the job is crucial to cement security gains of recent months - and that failure could cause the country to backslide into chaos.
Seems that Mr Maliki is not fazed by Chalabi being a fugitive from justice, having been convicted in absentia for bank fraud in Jordan in 1992. I wouldn't trust him with a penny of public funds.
Chalabi espouses free-market doctrine as the best way to cure the area's ills, a prescription that would buoy his neoconservative benefactors if they were here to hear it.

"Everyone is looking for employment with the government," he says. "This is a dead end. It's not possible. We need to get the economy going. Construction projects are needed."

With a billoin dollars in seed money from the Iraqi government for housing projects and a loan program to help residents buy a home, he says, "we would have no unemployment."
Exactly what does a billion dollars of "seed money" from the government have to do with free-market doctrine? I guess he is not getting that seed money anytime soon.

Are housing projects and a "loan program" really the best way to alleviate the huge problems of no electricity, no drinkable water and no health care? I can't imagine that the first thing on the minds of the Baghdad residents would be plunging themselves into debt.

Ahmad Chalabi is a former banker. The old saying fits his situation pretty well: When all you have is a hammer, everything looks like a nail.

Seeing what the "free-market" doctrine--actually, a financial-political cartel--of his buddies in Washington and New York has brought about, the Iraqi government would be well advised to stay away from him. But maybe they could use him as a negative indicator and a decoy for trapping corrupt officials.

November 10, 2007

Banking Deregulation, Unlimited Creation of Credit and Asset Price Bubbles

In "Why We Are Not in a Recession, Yet, and What a Recession Will Look Like" at, Robert Wallach writes about business cycles being created by the Federal Reserve's erratic creation of money, and how this causes asset bubbles.

He is correct in that it is the Fed's policies that are the culprit, but it is not the Fed that is printing the money. In the current surge of money supply growth, it is not the Federal Reserve that is creating new money, but commercial banks and other privately held financial institutions. The Federal Reserve has actually been very stable in their creation of money.

Commercial banks are creating money when they issue new credit. When a bank "gives out" a loan to a private customer, the money is not taken from anywhere. The bank just creates a new deposit, which is covered by nothing except the debtor's promise of paying it back.

Robert Wallach cites the growth of the MZM (money of zero maturity) statistic as a sign of monetary inflation. This figure is now well above $6 trillion. But only a bit more than $800 billion of this figure is actually created by the Federal Reserve. This relatively small amount of high-powered money is the Monetary Base, which Gary North has been referring to. All the rest of this money is actually credit, which is forever in danger of default, though the risk is very small for most of the deposits.

Even though commercial banks have tightened their lending standards, the MZM is growing, probably because of people moving their deposits from long term investment contracts into shorter term accounts, which is shown as a spike in the MZM measure. That the MZM is growing so fast relative to the monetary base is a worrying sign in itself, because such a growth can not go on forever. When people start shifting their money from long term investments contracts into short term deposits, it is a sign of increasing intentions of withdrawal.

When the housing market was inflating, and new credit was created quickly, people put their profits into savings accounts and other long term investments. Now that people can not go any further into debt, they have started to dig into their savings, which puts a strain on the banking system. The MZM, as well as other monetary statistics figures, is actually a liability for the banks. It is a measure of deposits. Increasing short term liabilities at a time of decreasing asset values is not a good environment for the banks.

M3, the widest available money supply statistic, which was discontinued by the Fed in 2006, has also hastened its growth in the last couple of years, now going at well above 10% per year. This means that the creation of new credit has not come to a halt. There might be new bubbles brewing in other asset classes except just houses.

This might also be a sign of financial institutions frantically searching for new sources of profits to cover up their losses in the housing market. In doing so, they are probably taking ever higher risks, with ever higher levels of leverage, because they have less and less to lose.

The wider the gap between the amount of credit and the monetary base, the bigger the eventual crash is going to be. At some point, the game will be whistled to a stop, and a counting of losses will begin. This game has been going on for over 25 years.

The Federal Reserve is duly blamed for encouraging such excess credit creation by the commercial banks. The relative explosion of credit-based money supply was started in the early 1980's, when the reserve ratios were drastically cut in the name of "deregulation". Ever since, the answer to financial troubles has been more easing of restrictions.

Even researchers at the Fed itself have figured that the banks' reserve balances are not much affected by the reserve requirements, which are so small, that the logistics of cash handling itself is a more important restriction. The final detachment from reserve requirements came in 1995, when sweep accounts were taken into use.

When this game with continuously easing rules has been going on so long, what happens when there are no more rules to be eased anymore? We have already seen the Fed giving up on enforcement of section 23A of the Federal Reserve Act, which limits the exposure of depositor insured funds to the more risky broker-dealer units of financial corporations to 20% of the bank's capital. Every time that the banking system has been at risk since the early 1980's, there has been a relaxation of rules, and everything has been fine again for a while. What happens, when there are no more rules to relax, and the system is still in trouble?

These relaxed rules mean in practice that banks can create just as much new credit as they want. The only remaining regulatory restriction is the capital ratio, which is there to protect against actual insolvency. But the capital ratio is severely infected by the mostly symbolic "paper values" of banks' assets. This restriction has also been actively avoided by using off-balance-sheet structured investment vehicles.

Even though it has been mainly discussed as a "liquidity crisis", the
current crisis is in fact a solvency crisis created by simple overextension. In a deregulated competitive environment, occasional bankruptcies all but inevitable. But the whole system is built on the supposed infallibility of major financial institutions.

The Fed's slashing of the federal funds target rate to 1% for a prolonged time created a massive encouragement for banks to increase their lending, without the Fed actually having to print that much new money at all. By extending credit, banks can create not only brand new "assets", but also a lot of new money from nothing at all. This money has in turn the ability to affect the prices of other assets.

The prices of bank assets have been inflated by excess credit. In inflating asset prices,
the banks have also inflated their own capital. Because capital ratio is one of the few remaining constraints to lending, this has allowed the banks to create ever more credit, resulting in ever higher asset price inflation, and a self-reinforcing cycle. With no reserve requirements, the amount of credit has been totally unhinged from the actual amount of money that is created by the Federal Reserve.

The banks have been left holding a mass of assets whose value depends on their own willingness to pay for those assets, either by extending credit for purchases by a customer, or by direct purchases themselves. When that willingness is taken away, these asset prices collapse. Liquidity is naturally constrained in a situation like this, because the sellers of these assets (banks) and the potential buyers (banks) are in fact the same entities. It is a simple case of herd mentality, which is found in the background of every bubble and even a minor business cycle.

So banks have huge holdings of assets, whose values are completely dependent on perpetual growth of credit. But credit can not be extended beyond the debtor's ability pay back. This very hard wall has now been hit, and the value of these loans, as well as the underlying collateral, i.e. the houses, has become questionable.

The credit market is now in a valuation crisis that puts the banks'
solvency into question. Because the reserve ratios are so small, about $300 billion of cash assets against $6600 of deposits, the banks can not survive long without liquidity. They have to be able to quickly sell their assets at a decent price or risk defaulting on their obligations.

But liquidity can only be provided by the banks themselves, because they are the principal creators of money. The Fed has lost its influence. Even a rapid flow of cash from the Fed could be overcome by an even greater withdrawal of credit by commercial banks. There is an actual risk of a complete banking system meltdown. If that risk is realized, we can forget inflation.

This scenario would bring us back to the great depression, with much bigger excesses this time. This is what the bankers, including Bernanke, are really scared about. They are willing to risk serious inflation to avoid that.

The fact that the US dollar is sinking might be a sign of expectations of actual monetary inflation. But there is a delay in the effect of monetary inflation. It takes time for the new money to end up in the pockets of the average consumer, so a severe recession and even nominal deflation can possibly not be avoided.

If an actual solvency crisis in the banking system occurs, there might be a mad dash for cash, with bank runs everywhere, and an associated spike the US dollar's foreign exchange rate.