Christopher Whalen

“Extremism in the defense of liberty is no vice. And moderation in the pursuit of justice is no virtue.”

–Senator Barry Goldwater (R-AZ)

There is a great deal of debate in the media about the economy and whether the “recovery”, which supposedly occurred in the US in 2010, is faltering. While the macro economic statistics, which fascinate many economists, show that there was indeed some increase in financial flows through in the US economy, it remains debatable whether any real economic benefit trickled down to the lowest common denominator, namely people.

The growing political unease in the country over economic policy and job creation is starting to become downright nasty. For the first time since the 1970s, Americans face the prospect of a low or no growth economy and this is not an outcome that is at all welcome. The swing from the irrational exuberance of the past two decades to something more closely akin to “normal” is shocking for the public. The latest evidence of pressure for fiscal cuts is shown in the proposal this week by Democratic New York Governor Andrew Cuomo to limit public pensions.

Reading various online threads, it never ceases to amaze me that advocates of what we will call a more liberal or progressive line of economic thinking inevitably embrace the corporate state for solutions. We need to buy every American a copy of George Orwell’s Animal Farm, a book you need to read a couple of times during your life. Orwell was a long time supporter of the socialist Labor Party in the UK , but he was also a fierce libertarian who saw the authoritarian side of socialism so beautifully told in Animal Farm.

The individualist or free market tendency in economics, on the other hand, is ridiculed by supposedly liberal economists and others as the choice of greedy people who are really sociopaths or worse. Free market fundamentalism, to paraphrase environmental activist Vandana Shiva, is at the root of the economic woes of the earth. She writes in her book War on the Earth:

The predatory practices of corporations are increasingly turning our fragile garden into a junkyard. Citizens are told by their political masters and the corporados who pay them that there is no alternative. That’s true if one’s only concern is profits. That approach is fast turning our planet into a toxic waste dump.

What is fascinating about Shiva is that even as she attacks the excesses of big business, much of her work and also her background as a physician and scientist is very similar to that of the great libertarian economic thinkers such as Ludwig von Mises, F.A. Hayek and Frederick Bastiat. Shiva’s focus on empowering individuals to think and to act in a free fashion as actors in a larger civil society to achieve collective needs is very much in line with von Mises, not to mention the classical liberal view of America’s founders who embraced diversity and equality of opportunity for all as the basic rule of civil society.

The rapid commercialization of American society since WWI and the rise of the corporation as the dominant model in the global political economy raises many challenges for those who struggle to protect individual liberties. First and foremost its is necessary is to understand the distinction between true individual choice as economic actors and people being swept along by a consensus about economic policy that is molded by the public relations apparatus of government and large corporate enterprises.

Geoffrey West, in a conversation published by Edge, “Why Cities Keep Growing, Corporations and People Always Die, and Life Gets Faster,” illustrates the dilemma facing society. Large organizations, which seem to promise stability and security, often are actually dying and thus unable to promote wealth creation and employment. Noting the quality of great cities as economic entities which promote and encourage individual diversity, West raises basic questions about whether industrial consolidation and the rise of global corporations is really good for society — that is, individuals in aggregate — in terms of long-term economic growth.

Von Mises argues in his classic 1945 book, Human Action, that it was the development of economic thinking generally, not merely the free market variety, which made the period from the industrial revolution onward so powerful in terms of expansion of benefits for all people. Von Mises wrote:

People fall prey to the fallacy that the improvement of the methods of production was contemporaneous with with the laissez faire only by accident. Deluded by Marxian myths, they consider modern industrialism an outcome of the operation of mysterious ‘productive forces’ … Hence the abolition of capitalism and the substitution of socialist totalitarianism for a market economy and free enterprise would not impair the further progress of technology.

So when author and professor Nassim Taleb is reported to say that all CEOs and economists are basically “sociopaths,” a person with a lack of conscience and extreme antisocial attitudes and behavior, what does he mean? My interpretation is that Taleb accurately notes that most CEOs of large enterprises are value destroyers in the sense described by West, while individuals and smaller enterprises tend to be far more productive in terms of creating value for society and employment for people.

Large corporations tend to avoid risk and over time try to control markets and even governments to protect their interests. While the vast majority of business people, who run smaller enterprises, are honest and support a civil society (and generate the majority of jobs), the captains of the largest corporations often take actions antithetical to a democratic society and their shareholders.

Far from being an achievement of the era of laissez faire economics, the rise of the large corporation is a throwback to the period of monarchism and tyranny before the industrial revolution. In The Modern Corporation and Private Property by Adolf Berle and Gardiner Means, published in 1932, the authors warn:

The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital … [Such owners] have surrendered the right that the corporation should be operated in their sole interest.

Likewise, the wonderful reference to economists as sociopaths conjures images of the dominance of the statist mindset among the dismal profession. The notion that national economies can be managed from the macro level and that human action, as opposed to market perception, is not significant are entirely authoritarian perspectives. Yet this type of thinking is precisely what passes for mainstream economic thought in the academic world and in important institutions such as the Federal Reserve System. The Fed likes the idea of large banks because they serve as conduits for make-believe macro economic policy, not because large banks are good for the economy or its inhabitants.

Just as large, mature organization tend to lose the ability to innovate and thus destroy shareholder value, the economic thinking which celebrates big government and cartels in finance and industry is slowly killing the private sector in America and diminishing the rights of individuals. In the difficult debate over economic restructuring and renewal which must occur in the US over the next several years, we ought to begin with an assessment of elemental principles. Americans need to leave aside labels like left and right, and start asking basic questions about what mixture of policies will best enhance the economic and political lives of individuals.

Once we understand that many of the problems we face today as communities of individuals called nations come about due to concentrations of power in large governmental and corporate enterprises, and the corruption of these structures, then people on all sides of the supposed political debate are going to discover new common ground.

Focusing on individual economic and political rights is no vice, as Barry Goldwater famously declared. Rather, a new focus on individual rights and responsibilities in an economic and social sense is the start of a long overdue discussion about the American political economy. If we inform our discussion with the focus on individual liberties that was the point of departure for our nation’s founders, we will be successful.

This week all eyes are on the Federal Open Market Committee (FOMC) and Federal Reserve Chairman Ben Bernanke. The FOMC must decide whether to stop monetizing the federal debt issued by the Treasury, which is what the U.S. central bank calls “quantitative easing.”

Americans continue to believe — and hope — that the Fed can save us from our collective idiocy when it comes to debt, both public and private. While there are growing signs that the Fed’s zero interest rate policy, or “ZIRP,” is greatly damaging individuals and financial institutions alike, we also need to question whether the Fed can let rates rise without provoking another financial assets collapse.

In effect, the Fed and other global central banks are all caught in a “Catch-22″ situation, to borrow the phrase from the 1961 novel by Joseph Heller. The Fed’s aggressive easing of interest rates and purchases of trillions of dollars in Treasury debt and other assets has stabilized and even raised the price of financial assets, but in other respects the Fed’s policy of reflation has failed — especially compared with past interest rate cycles.

In a comment published by IRA this week, Chief Monetary Economist of Cumberland Advisors Bob Eisenbeis notes:

“From the 50s through 70s, the main channel for monetary policy was through housing: when interest rates exceeded the Reg Q ceilings that banks and thrifts could pay for funds, the supply of funding to housing was cut off. Then construction declined and the effects rippled through the rest of the economy. Most of the economic models have that structure and international isolation embedded within them. Yet this is not the world that policy makers are now dealing with … “

In an earlier comment in one of my pieces on Reuters.com, I looked at the fact that “the Fed faces continued asset price deflation at home even as the impact of its accommodative policies are already boosting global inflation.” My friend and mentor Alan Boyce, who ran the risk book at Countrywide, has been trying to educate people in Washington about the lack of “trickle down” money in terms of the Fed reliquifying the housing sector.

While the Fed’s QE and ZIRP have been a boon to the largest banks and investors on Wall Street, Main Street has been left in the cold. The continued decline in home prices in February as reported by Case-Shiller — now down eight months in a row — has been ignored to a great peril by the Obama administration. As I’ve noted previously in this blog, how does President Obama expect to win reelection if the U.S. housing sector and the banks that hold these assets are melting down come election day 2012?

Last summer, my firm earned condemnation from Wall Street for suggesting that U.S. banks were not out of the woods and that net interest margins were starting to fall. Dawn Kopecki at Bloomberg reports: “At JPMorgan, almost half of the New York-based bank’s earnings came from the release of reserves previously set aside to cover bad loans. Net revenue at the second-largest U.S. bank dropped 8.9 percent to $25.2 billion.”

The reason that revenue at many banks is falling is largely due to the Fed’s policy stance, but also reflects the still dismal economic situation on Main Street. Most banks are seeing the revenue from interest earnings fall as older assets run off and new assets with far lower yields are put in their place. But the lack of demand for credit from consumers and business is also a big factor behind the sharp drop in bank assets.

The chart below is of the gross loan yield for Bank of America vs. its large bank peers. It is taken from the IRA Bank Monitor using data from the FDIC and shows the gross yield on the loan book for Bank of America Corp’s subsidiary banks going back a decade. Notice that in the 2000 timeframe, just before Chairman Bernanke joined the Fed and his predecessor Alan Greenspan stepped on the monetary gas pedal, bank’s were earning yields on loans almost two times today’s levels. Notice, too, how competition in the 2005-2007 period drove bank loan yields down, but from 2007 the Fed’s QE and ZIRP temporarily boosted lending spreads.

Now, however, the benefits of Fed easing and FDIC debt guarantees are fading. Bank loan yields are starting to fall as lenders compete ever more aggressively for the few borrowers in the market who want credit and can actually qualify for a loan. The shrinking pool of earning assets and the lack of yield on these assets is perhaps the greatest danger to the banking system — and makes it next to impossible for Chairman Bernanke to put off raising interest rates much longer.

As we told clients of The IRA Advisory Service last week during the Q1 2011 earnings reports from the banks:

Our predominant impression from top universal banks is slack revenue to date and weak demand, and thus doubtful backlog going forward. In Q1 2011 US banks are reflecting the true situation facing their customers in the US economy. We were struck this past week by the fact that several bank executives basically said during calls and Q&A that the Fed needs to allow rates to rise so as to counter the effects of the accelerating run-off of earning assets and subsidized funding such as FDIC TLGP. Perhaps the appropriate policy formulation for the Fed is to force the cost of funds up while continuing to support overall volume of market liquidity via QE, reductions in bank reserves. End of QE without liquidity support is a very dangerous path for this fragile market in our view.

Back in October, after the meeting of the Federal Open Market Committee, the Associated Press reported that “The Federal Reserve is likely to take additional action to rejuvenate the economy and lower unemployment, an influential member of the central bank’s policymaking group said.”

Of course the Fed neither rejuvenates economies nor creates jobs.  For some reason members of the media attribute magical powers to the US central bank and its employees.

Part of the reason for this divine veneration is that there is little in the way of ideas or resources elsewhere in the federal government, thus the holy printing press is now well and truly the only game in town.

Since October the Fed has purchased hundreds of billions of dollars in US Treasury debt in an effort to force liquidity into private assets.  But while the U.S. central bank is able to float the Treasury’s red ink on a sea of new fiat paper dollars, overseas the great deflation has left global central banks largely emasculated.  Unable to create their own money with the ease of the Fed, even the largest central banks in Europe have gone begging for alms in the form of dollar swap lines from Chairman Bernanke.

Other global central banks are chronically short dollars and the Fed is the proverbial tail wagging the global doggie.  Treasury Secretary Timothy Geithner brags about collecting hundreds of billions in nominal greenbacks recovered from the TARP, Ally Financial and AIG bailouts, among others, but it is Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee who are playing the big game with trillions of new fiat paper dollars.

The Daily Bail asks: “Will Bernanke Scoop Up $50 Billion Of Ireland’s Toxic Assets? Fine Gael Seeks MASSIVE Loan From U.S. Fed” This is a very good question since the Irish government likely to be elected in a week or so is going to face an assortment of very unpleasant choices.  If Ireland’s new political coalition goes hat in hand to the American central bank, the new regime is not likely to last very long, especially with the IRA now talking of great conspiracies among private business.

Neither are Chairman Bernanke and the Fed likely to endure if they continue to play the role of de facto global central planning agency without explicit legal authority from Congress.  The trouble here is both one of legal authority and the deleterious effects of current Fed policies.  The more the Fed tries to help the domestic economy with low rates and explicit bailouts, the worse our collective predicament.  Recall the advice of Martin Mayer, who always taught that the Fed (and government generally) should emulate the physician and “first do no harm.”

The Fed keeps interest rates artificially low to “help” the current situation, but in doing so only stokes inflation and bubbles in sectors such as food, energy and strategic commodities — and also market sectors such as equities.  In the past, the central bank has attempted to fine tune the national economy, most recently in the period a decade ago when then-Chairman Alan Greenspan stepped on the monetary gas.  Not only did the resulting surge in cheap credit stoke a domestic housing boom in the US, but it created booms in global financial assets and also internationally traded goods that impacted investment and asset allocation decisions around the world.

With the 30-plus percentage decline in US housing prices so far and another 10-20% in prospect this year and in 2012 before we hit the bottom, the Fed faces continued asset price deflation at home even as the impact of its accommodative policies are already boosting global inflation.  The combination of volatile weather and poor logistical planning in terms of stockpiles could make the global food supply situation acute in 2011-2012.  The Fed, not hedge funds, is making the situation worse in markets for energy, commodities and food.

The Fed’s extreme monetary policies used to bail out the largest banks are creating bubbles with cheap credit.  Look at the bull market in commercial real estate assets, for example, an entirely speculative financial phenomenon.   Prices for well-located assets are driven up by speculative interest among investors who prefer CRE risk to zero yields on Treasury paper.  But is there sufficient cash flow under these assets to support these valuations?

With yields on longer maturities climbing, it seems that the greatest risk facing the Fed is the transition from life support to something that resembles a sustainable run rate.  Trouble is, Bernanke and a majority on the FOMC still seem to be making policy decisions based upon domestic criteria, this even as the extreme easy money policies of the Greenspan/Bernanke era have already achieved the implicit policy goal of asset price reflation.  It’s all relative, you understand.  When an election-focused White House calls for economic recovery, Bernanke, like Greenspan before him, dutifully steps on the gas, seemingly heedless of the risks.

Of course, classical reflationists argue that the Fed is doing precisely the right thing by using low interest rates to force liquidity into private assets.  One reader of my work rebukes those who argue for monetary restraint and invokes Irving Fisher in his famous 1931 “Econometrica” article.  By lowering rates on Treasury bonds below where they might otherwise be, he argues, Bernanke “is likely to push investors into corporate bonds and lower spreads–which, in the end, are the ONLY real engines of growth in the financial markets.”

The trouble with this argument, like the neo-Keynesian corollary about the use of debt to fund fiscal stimulus, is that expedients such as low interest rates and deficit spending are meant to stimulate economic growth on the margins, not to replace private sector demand and economic activity that does not exist.  Bernanke and his fellow travelers on the FOMC, it seems, have entirely embraced the world view of Paul Krugman and Robert Reich, and echoed among the inflationati in the EU led by Martin Wolf, that new monetary emissions are an apt replacement for fiscal spending.

The problem with living in a world where relativity is the operative standard is that there is no truth in an objective sense.  Political survival, not civil society, is the first priority, so members of the FOMC will say and do anything to get through the day, no matter how internally inconsistent or reckless.  Until Bernanke and the FOMC start to recognize that their well-intentioned efforts to help the domestic US economy are creating the precursor for future global economic collapse, we cannot truly bring the Fed under effective public control and begin the process of national restructuring in America.

The opinions expressed are the author’s own.

For the past several years, governments around the world have been trying to avoid dealing with excessive debt, shrinking revenue and economic activity. The main approach has been for governments to lend their credit rating and cash to help banks and public sector entities paper over the problem, in the hope that a rising tide of economic activity will lift all boats.

Unfortunately, the efforts by the Federal Reserve and other monetary authorities to “reflate” asset prices and economic turnover have failed. The reason for this failure is a basic one, namely that once nations reach a certain level of indebtedness, each marginal increase in debt and/or the supply of fiat money has less and less impact. In the U.S., for example, the velocity or turnover of the money supply has fallen because the free flow of credit and related economic activity has been withdrawn.

The chief result of the temporizing approach to the crisis taken by the leaders of the G-20 nations has been to delay the day of reckoning and erode the credit standing of the member nations. First Greece, then Ireland and next likely Spain have been left insolvent due to efforts to prop up equally bankrupt commercial banks.

But now with the citizens of sovereign states from the Germany to California rejecting bailouts and cuts in government services, the day of reckoning is coming for the banks and creditors. But therein lies the path out of hopelessness and toward national renewal.

If you consider that the average price of a home in the U.S. has fallen by more than 25% from the peak levels of the housing boom, the fact of insolvency among our largest financial institutions is no big surprise. Indeed, one of the reasons why this writer has been so bearish on the situation facing the largest banks is that something like half of their assets are tied to housing — more if you include loans sold to investors.

The Fed has been attempting to reverse this large drop in asset values with a variety of expedients, but unfortunately the courts are open every day. Even as the U.S. central bank has used quantitative easing to artificially support asset prices in the securities markets at the macro level, the fact of liquidation and resolution is slowing eroding the capital of the biggest banks.

Likewise, as I wrote in an earlier piece for Reuters.com, “Bernanke conundrum is Obama’s problem,” the fact of financial insolvency makes the largest banks unwilling to refinance American homeowners, adding further deflationary pressure and thwarting Fed efforts to increase the velocity of money in the U.S. economy.

Earlier this month, Ambac Financial Group, a leading insurer of municipal bonds, was forced to file bankruptcy because claims by holders of residential mortgage backed securities (RMBS) were slowing eating away all of the company’s capital. The response by Treasury Secretary Timothy Geithner has been to try and paper over this situation and, once again, bail out the largest U.S. and European banks. The holders of RMBS with Ambac guarantees may get nothing if Secretary Geithner prevails (see “Ambac, CDS and Geithner: It’s AIG All Over Again,” The Institutional Risk Analyst, November 16, 2010).

So what is to be done? The first thing that Americans must do is to accept that the level of home prices, GDP, velocity and other indicia are not going to return to pre-crisis levels for many years to come. Once we accept this reality, then restructuring and recapitalization will become the obvious if painful choice. When I am speaking on the banking industry, I tell the audience that the task ahead is like cutting off a few fingers with a kitchen knife. The bad news is that it will hurt like hell. The good news is that the fingers, eventually, will grow back.

The Obama Administration needs to change direction and to embrace restructuring and national renewal instead of the current policy of extend and pretend. The same factors that drove Ambac into bankruptcy are working on Bank of America, Wells Fargo, JPMorganChase and will eventually force a restructuring. The sooner we start the process, the sooner the U.S. economy will recover.

Indeed, I expect that the Obama Administration will eventually, reluctantly be forced to invoke the powers under the Dodd-Frank law and restructure the top-three U.S. banks. This will be near-total losses for equity holders and haircuts for creditors, but the end result will be a solvent bank that is smaller, profitable and able to again lend.

It is important for Americans to remember that bankruptcy and liquidation are necessary steps to national renewal and economic stability. The Founders of the United States embedded bankruptcy in the U.S. Constitution for precisely this reason. The Founders knew that prolonged uncertainty and a lack of finality when it comes to insolvency was bad for society, thus they commanded Congress to create federal bankruptcy courts.

Having been through a personal restructuring a decade ago, the end result of five years of civil litigation, I do not make the recommendation of embracing restructuring lightly. But restructuring and liquidation of debt allowed me to rebuild my life. Each time that a family looses a home to foreclosure, that tragedy creates an opportunity for another family to make a fresh start. When a bank is restructured, the creditors lose money, but the bank is then able to support economic growth. And when an individual declares bankruptcy in the U.S., our Constitution provides the right for fresh start.

By speeding the process of resolving bad debts and restructuring viable companies, the U.S. courts are moving forward with the process of national renewal even though our politicians have not yet found the courage to lead the way. I suspect that this, too, is going to change and very soon. No amount of talk and obfuscation in Washington can prevent the process of liquidation underway on Main Street. Before long, the fact of renewal and restructuring at the micro level will be visible at the macro level as well, and that is good news.