In defense of free market fundamentalism

Jun 10, 2011 16:32 UTC

“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.

 

COMMENT

Another Good article, and thank you, Chris.

Posted by Laster | Report as abusive

Why Congress should vote no on raising the debt ceiling

Apr 13, 2011 14:38 UTC

By Christopher Whalen
The opinions expressed are his own.

“A spectre is haunting Europe — the spectre of communism. All the powers of old Europe have entered into a holy alliance to exorcise this spectre: Pope and Tsar, Metternich and Guizot, French Radicals and German police-spies.”

–Karl Marx – Friedrich Engels
The Communist Manifesto

There is a specter haunting the industrial nations, too — the specter of debt default and deflation. All of the powers of the post-WWII regime of neo-Keynesian economic management have entered into a holy alliance to exorcise this specter: Fed Chairman Bernanke, European Central Bank Head Jean-Claude Trichet, Democrats in the American Congress and the German centrist tendency under Angela Merkel.

All of these champions of the status quo ante are, ironically enough, serving as agents for the bond holders of the largest US and EU banks, the clients of PIMCO, Black Rock and even my friend David Kotok at Cumberland Advisors. These agents of the global creditor class are betting on the likes of Bernanke, Trichet and Merkel to collect their debts for them like so many China gunboats — and thereby plunge hundreds of millions of people into penury for decades to come.

It is no small irony that the interests of the banks and bond holders in the US are being protected by a Democrat from Chicago named Barack Obama. Far from being a leftist, Obama is a global technocrat who turned out to be the most perfectly compliant stooge for the interests of the large banks and institutional investors. With Timothy Geithner at Treasury and former JPMorgan banker William Daley at the White House, the only decision Obama needs to make every day is what shirt to wear.

On Capitol Hill, however, the long slumbering Republicans are starting to discover the political power of fiscal sobriety. In the negotiations with the White House over the budget for fiscal 2011, House Speaker John Boehner (R-OH) managed to win some significant concessions from the White House on spending issues — even if entitlements and military spending were off the table this time around. The next and more important fight comes over the question of raising the US debt ceiling. Once again, President Obama is not even in the game.

Secretary Geithner and his boss, JP Morgan Chase CEO Jaime Dimon, have made clear their distaste for a fight over extending the debt ceiling, in part because a debt default by the US would end the pretense of “too big to fail.” If Washington is willing to contemplate a default by the US Treasury, who cares about the fortress balance sheet of JP Morgan and other US zombie banks? But for a number of reasons, democratically elected governments from Lisbon to Dublin to Washington need to begin the process of financial restructuring whether the banks like it or not. And all of the political servants of the banksters are doing their best to avoid debt write downs.

In Ireland, for example, the new government of Fine Gael leader Enda Kenny is in a struggle with Trichet and his vile contemporaries at the ECB. The Euro central bank is essentially trying to keep together an under-funded bailout of the continent’s corporate and bank debts at the expense of public taxpayers. So muted is the political discourse in Western Europe that people are barely protesting — at least not yet. But offering Ireland the choice of default or decades of deflation and unemployment to repay its foreign obligations at par is untenable and risks comparisons with the German war reparations after WWI.

The Kenny government should reject the self-serving advice of the German-dominated ECB as well as the technocrats inside Ireland’s finance ministry, and tell Angela Merkel and French President Nicholas Sarkozy to try harder. Specifically, if the ECB and the core nations of the EU are not willing to offer Ireland more generous terms to bail out the private debts of EU banks, then the Kenny government should take the example of the people of Iceland and tell the technocrats in Brussels an emphatic “no” to bailing in the Irish bank debt at public expense.

Frankly, if you weigh the trade off between the immediate cash flow benefit to Ireland of walking away from its foreign debt and being cut off from the global capital markets, as Trichet has threatened to Kenny, a default seems the obvious choice. And with Portugal and other “peripheral” states of the EU tottering, the Kenny government has more leverage than it knows. Putting a gun to the head of Trichet right about now and daring him to blink might prove a very satisfying experience for any Irish officials with the guts to play the hand God has dealt to them.

In Washington as well, some Republicans are starting to appreciate that saying no to more debt and devaluation a la the Paul Krugman school of economic mismanagement is good politics. It is wrong to call Krugman and his ilk “Keynesians.” Lord Keynes was neither an apologist for debt or inflation, nor was he a free trader. He valued strong national industry and financial markets that were only supplemented by global capital and trade flows. What would Keynes tell Ireland today?

For the same reasons that the Kenny government needs to impose haircuts on Ireland’s creditors, the US Congress needs to vote no on the debt ceiling increase as part of a larger shift in thinking on debt and spending in Congress. Just as the people of Iceland have done the right thing by saying no to repaying corporate debts of UK and Dutch banks (all of which are now nationalized naturally), Americans need to take a page from the history books and begin the actual process of default on all manner of debt and entitlements obligations.

The only way we can force our citizens and also our trading partners to talk about the economic issues that are driving America’s growing mountain of debt is to stop adding to the pile. The role of the dollar as the primary means of exchange for global commerce and finance are the twin evils at the heart of the US fiscal disease. The role of the dollar as the world’s “reserve currency” is likewise a terrible millstone around the necks of American workers.

Saying “no” on raising the debt ceiling is the way for deficit hawks in Congress in both parties to seize the fiscal agenda and start a long overdue conversation about America’s place in the world. As I wrote in my book, Inflated: How Money and Debt Built the American Dream, this discussion must include an end to the dollar as the primary global means of exchange. When the dollar ceases to be the global currency, then the Fed can no longer monetize deficits with impunity as today.

One way of forcing this adjustment process is to start imposing losses on holders of dollar debt. Painful as it will be, helping the world to readjust the level of debt in the industrial nations back to realistic levels and rebalance the global currency markets into a peer-to-peer framework is a necessary process if America is ever to achieve a sustainable economic model. The only question is when and where will emerge the political leadership to do the right thing and begin to actively restructure debts.

Barack Obama has already failed that test of leadership by studiously avoiding any response to the US real estate meltdown, but new leaders in many heavily indebted nations will face the same issues — chronic levels of debt that will only grow heavier as and when global interest rates rise. If the ECB manages to bully Prime Minister Kenny in Ireland, do they really expect a more malleable regime after the next election?

The looming threat of debt is why we should expect to see a majority of Republicans and perhaps more than a few Democrats in Congress seek to block any increase in the US debt ceiling unless the measure includes a balanced budget amendment to the US Constitution.

My view is that Congress should vote down any debt ceiling measure unless President Obama agrees to sign the balanced budget amendment. Even if Secretary Geithner has to run the US government on cash, like the good people of Iceland and Ireland today, it will be a good thing for America’s political debate to default — at least for a few weeks. Then people will know that the once unthinkable is very possible.

COMMENT

I find it disappointing that Reuters would publish such a trite and hypocritical commentary on such an important issue. The suggestion that the government should switch in mid-course to a cash budget is utterly absurd for one. For another, the ideological bias of the author’s opinions demonstrates profound ignorance of the intricacies of central banking. The interrelation of inflation, interest rates, exchange rates, liquidity, and economic growth are far too complex to be dismissed as a conspiracy.

But above all, the idea that Americans will have to work like slaves to pay off the national debt to angry Chinese is both comical and utterly fictitious. The worst case scenario in the far future if we were to amass unrepayable amounts of debt is no worse than the author is proposing as the solution in the present day – default. So why default today when we can default tomorrow? This makes no sense.

Posted by prometheo | Report as abusive

It’s a wonderful life 2011

Jan 3, 2011 21:02 UTC

About a year ago, Arianna Huffington called my friend and colleague Dennis Santiago and asked if my firm could provide a list of “good banks” for an effort she was planning. Along with Rob Johnson from the Roosevelt Institute, Huffington conceived of something called “Move your Money,” which sought to get consumers to move their business from large banks to smaller community institutions.

The effort was modestly successful in terms of increasing awareness of consumers about the alternatives for financial services. But it did not really change the competitive equation between the too big to fail (TBTF) behemoths — Bank of America, JPMorgan, Wells Fargo and Citigroup — and the rest of the industry and the economy. Now that insurgents like Washington Mutual, Countrywide, Lehman Brothers and Bear Stearns & Co. and many others have disappeared, the banking industry is more concentrated than any time during the past century, both financially and in terms of the industry’s icy grip on political power.

One of the themes that motivated the “Move your Money” effort was the image of James Stewart as head of the mutual Building & Loan, who fought to keep his bank open in the Frank Capra film “It’s a Wonderful Life.” His nemesis was Potter played memorably by Lionel Barrymore, the head of the big bank that sought to take over the Building & Loan and thereby gain a monopoly position in the allegorical American town.

But given the state of the U.S. economy and the fact that almost 15% of the banks in the U.S. are considered “troubled” by the FDIC, perhaps we should reconsider this interpretation of the film’s apparent story line. My friend Fred Feldkamp, a veteran lawyer with decades of experience in banking and securitization, notes that the Capra movie “portrays Potter as the owner of the bank in town, but I see him as a stand-in for the conservators FDIC put in place at selected ‘too big to fail’ institutions which were supposed to buy local banks, fix them and re-sell them to locals.”

If you think of Potter not as a Robber Baron a la J.P. Morgan but instead as a government bureaucrat working for the FDIC or even the Reconstruction Finance Corporation, that puts a different light on the big bank vs. the world battle, does it not? Feldkamp notes that from the Great Depression of the 1930s and again in the 1980s real estate bust, the government played an important role in restructuring the banking industry — and never more so than today.

“Small banks ended up being temporarily swallowed into the designated “banks of last resort” in various states,” Feldkamp relates regarding previous banking busts going back to the 1930s. “Conservators ran most of those banks until the mid-1950s.  I represented one such bank in the 1970s… The only way the “managers” (conservators) could be criticized was by the head office of the FDIC in Washington D.C. That happened if they acted like real “bankers” and made loans into the community.”

Today many of my friends on the left and right are engaged in a protracted rear-guard battle, arguing over whether government sponsored entities such as Fannie Mae and Freddie Mac were the cause of the mortgage bubble. Most recently we saw the clash between Peter Wallison of American Enterprise Institute and Joe Nocera at the New York Times, essentially disputing whether these government sponsored entities are the cause of the financial collapse that has been unfolding since 2007.

Liberals like my friends Nocera and Johnson still cannot believe that the government was the moved-mover in the mortgage mess, the catalyst for Wall Street’s entirely rational exuberance that merely followed Washington’s bad example. But such distinctions are meaningless. The corrupt relationship between the large TBTF banks and the federal government is long-standing and should be the focus of people on all points of the political compass.  Indeed, somebody should tell Nocera he owes Peter Wallison and AEI an apology.

Look at the just announced settlement between Fannie and Freddie and Bank of America, where the government-sponsored enterprises (GSEs) now controlled by the Obama Administration are providing what appears to be a huge subsidy to Bank of America to the tune of tens of billions of dollars. If you look at the most recent quarterly earnings disclosure to the SEC from Bank of America on future losses from the GSEs, then look at today’s settlement with the GSEs, which was approved by the Geithner Treasury, and it is hard not to conclude that the settlement was a gift.

The losses hitting Fannie and Freddie will be borne by the American taxpayer and not the bond holders of Bank of America. The single digit billions BofA paid to Fannie and Freddie is less than a quarter of my firm’s estimate of such losses prior to the announcement. And our estimates were by no means the highest.

How can bankers like JPMorgan Chase CEO Jaime Dimon, who settled his own tab with Fannie and Freddie on equally attractive terms last year, complain about Barack Obama when the supposedly liberal President is so generous with public subsidies for the zombie banks? The truth of the matter is that the federal government, through agencies like Fannie, Freddie, the Federal Home Loan Banks and the FDIC, have been calling the shots in the banking industry since the 1930s.

While American banks have, from time to time, shown a certain degree of independence, this in the form of speculative lawlessness known as “innovation,” all lenders in the U.S. are ultimately appendages of Washington. The degree of government support for the financial markets has never been greater in the history of the American republic and the largest players in the industry thereby exercise enormous political power. This is why calls from observers as disparate as Kansas City Fed President Thomas Hoenig, Vermont Senator Bernard Sanders and Dallas Fed President Richard Fisher to break up the largest banks are entirely on target.

COMMENT

Brill! THANKS, Arianna!

For years I’ve been favoring credit unions and small banks. Not only do I believe in their principles, I dig NOT feeling like a peon/number.

The big banks left, with our money (immoral home-loan policies), and then stole some more through the bailouts. I think their goal is to ‘delete’ the Middle Class and with it, a work force that requires something of the employer, and a populace that requires something of their government. No integrity.

Posted by JnetNW | Report as abusive

Is Ben Bernanke driving the QEII or the Titanic?

Dec 6, 2010 22:26 UTC

Our colleagues in the media have been diligently pouring over the latest disclosure by the Federal Reserve on rescue loans made to banks and corporations around the world in the hope of uncovering a pearl. For one thing, the details of the extensive rescue operation by the Fed following the collapse of Lehman Brothers in 2008 confirms the role of the U.S. central bank as the global lender of last resort, a job description as yet unauthorized by Congress. But there are some rather subtle revelations which do deserve investigation.

A number of writers have noticed that the fact that the Fed did not reveal these operations until now doubtless effected how the Congress finally legislated in the case of the Dodd-Frank law. “The Fed’s current set of powers and the shape of the Dodd-Frank bill over all might have looked quite different if this information had been made public during the debate on the bill,” American Institute for Economic Research fellow Walker Todd told Gretchen Morgenson in the Sunday New York Times. “Had these tables been out there, I think Congress would have either said no to emergency lending authority or if you get it, it’s going to be a much lower number — half a trillion dollars in the aggregate.”

Perhaps more important is the fact that there is now confirmation that the Fed took in equities as collateral during the market liquidity operations in 2008 and 2009. As one of our favorite equity market observers wrote last week, the fact of the Fed financing equity positions was known in September of 2008, but as my colleague noted at the time, “you had to read between the lines.”

As it turns out, the Fed’s primary dealer credit facility or “PDCF” was essentially able to take any paper, debt or equity, proving once and for all that the Fed had abandoned any pretense at market discipline. For 25 pips over Fed funds, you could finance any equity security: “Eligible collateral will include all collateral eligible in tri-party repurchase arrangements with the major clearing banks as of September12, 2008,” said the Fed in a press release.

Previously I had heard from a number of large bulge bracket firms that there was no problem financing anything with the Fed during the crisis: office furniture, equities, whatever. So now this latest data dump from Chairman Bernanke seems to confirm that eye-opening fact and more, namely that during the crisis dealers were using the Fed to finance equity positions as well as Treasury bonds and mortgage-backed securities.

Thus the question becomes: Will the U.S. central bank continue to backstop equities when (not if) falling economic growth, rising employment and rising interest rates push equity valuations lower? There are a number of reasons to be concerned that a sustained increase in interest rates will not only make bonds and other interest rate instruments more competitive with stocks, but that an overly optimistic consensus behind the prospects for growth is about to be brought down to earth.

For one thing, the Fed’s zero interest rate policy has made the equity markets seem relatively attractive. Putting cash into blue-chip equities makes more sense, at least for some investors, than buying bonds at what may be the lowest yields that will be seen for a generation. Given the Fed’s purchases of Treasury debt via QE II, volatility is understated and thus the duration risk on bonds is likewise being understated in the markets. As one trader asked me recently: “Is Fed Chairman Ben Bernanke steering the QE II or the Titanic?”

The other issue that has made equities relatively attractive is liquidity. When investors are buying large-cap stocks, even financial names such as Citigroup, JPMorgan and Wells Fargo, they are buying size, not quality. Whereas most of the largest US banks have single digit or event negative risk-adjusted returns, smaller regional exemplars such as Cullen Frost, BB&T or US Bancorp have consistently out-performed the larger players when it comes to growing fundamental value at reasonable levels of risk.

When the Fed uses QEII to subsidize the largest players on Wall Street, it is disadvantaging the smaller, better run banks, and it is also playing with politics. Priyank Gandhi and Hanno Lustig, in a National Bureau of Economic Research working paper issued in November (No. 16553), suggest that the implicit collective guarantee extended to large U.S. financial institutions reflects an annual subsidy to the largest commercial banks of $4.71 billion per bank, measured in 2005 dollars. But, even more important, the paper notes that subsidies for the “too big to fail” banks shows the Fed’s willingness to support the equity markets, an extraordinary and ultimately political act that requires further hearings by the Congress.

Like it or not, indices such as the dollar, the Dow Jones Industrials and S&P 500 are a litmus test not only for the markets, but for the credibility of American political leaders. When the Fed deliberately bails out some banks but not others, and also relieves Congress and the White House from doing their collective jobs in terms of fiscal policy, Chairman Bernanke provides short-run stability via endless liquidity, but ultimately hurts the American people by short circuiting the political process.

It is time for Fed Chairman Bernanke and the other members of the FOMC to step back from crisis mode and demand that Congress and President Obama pick up the ball. Specifically, Washington needs to take an example from our friends in the United Kingdom and begin the process of economic and fiscal restructuring now, before the next phase of the economic crisis crests next year. That may require letting equity markets sag when the full truth of the remaining economic adjustment is accepted by the public.

As I wrote in Zero Hedge last week, “Loss Given Default: From Madrid to Los Angeles Foreclosures Set to Crest in 2011-2012”), next year, IMHO, we are going to see a further sharp decline in residential home prices as the tide of foreclosures begun in the past year starts to clear the courts and move to market via involuntary sales. The same thing is happening in Spain, by coincidence, “Foreclosed Homes May Flood Spanish Market as Banks Offload Unwanted Assets”. When this next deflationary leg in the “revenue side” of the economic equation ripples through the economy, both restructuring and aggressive action by the Fed to provide liquidity will be required.

COMMENT

I think Jim Rickards’ proposal that the U.S. permit gold and silver to be revalued to a market price would go a long way as a market clearing mechanism. However, you are right, at some point the second point of the clearance, that of writing off debt, must occur. It is the millstone preventing recovery. I would go so far as to say a partial default on Treasuries is the answer. The debt market and derivatives market are far too large in relation to the world economy to make any rational sense. Price is the word.

Posted by Fazsha | Report as abusive

Triple threat: Fannie, Freddie, and the triumph of the corporate state

Oct 27, 2010 21:56 UTC

Below is an excerpt from the October 27, 2010 issue of The Institutional Risk Analyst, “Triple Down: Fannie, Freddie, and the Triumph of the Corporate State.”  To read the entire article, click the link at the bottom of the excerpt:

“JOHN BULL can stand many things but he cannot stand two per cent.”

That aphorism, quoted by Walter Bagehot, a 19th-century editor of The Economist, expressed savers’ traditional distaste for very low interest rates. For the first three centuries of the Bank of England’s existence, 2% was indeed as low as the central bank was willing to let interest rates fall. Not even the Depression, nor the long Victorian period of stable prices, induced the bank to go any further. Some minimum return on capital was deemed to be required.

Buttonwood
The Economist
September 16, 2010

In this issue of The Institutional Risk Analyst, we are going to slay a few dragons and eviscerate a few currently popular myths, but first let’s start with two positive data points: (1) the strong results of Ford Motor Co (F) and (2) the continuing improvement of the smaller banks in the U.S. financial sector.

Yesterday F reported net earnings of $1.7 billion, or 43 cents per share for the third quarter, compared with last year’s profits of 29 cents per share. More important, F is paying down debt and continuing the process of restructuring which began years ago. The moral to the story is that enterprises which restructure thrive and grow, while large banks and government sponsored entities that avoid restructuring shrink and increase the overall losses to the shareholders and society.

Last year, we commented on the way in which Bill Ford had saved his family’s century-old firm by hiring a new CEO, Alan R. Mulally, and levering up the company with bank loans to raise cash to fund necessary restructuring (‘Should Washington & Wall Street Take a Lesson from Bill Ford?’, April 23, 2009). Even though F did not actually file bankruptcy, the massive losses and asset sales of the past several years have now put the company in a position to rapidly repay debt and expand internationally. And the Ford family retained voting control without significant dilution.

Despite examples of the success of restructuring with F and even General Motors, the invidious cowards who inhabit Washington are unwilling to restructure the largest banks and GSEs. The reluctance comes partly from what truths restructuring will reveal. As a result, these same large zombie banks and the U.S. economy will continue to shrink under the weight of bad debt, public and private. Remember that the Dodd-Frank legislation was not so much about financial reform as protecting the housing GSEs.

Because President Barack Obama and the leaders of both political parties are unwilling to address the housing crisis and the wasting effects on the largest banks, there will be no growth and no net job creation in the U.S. for the next several years. And because the Obama White House is content to ignore the crisis facing millions of American homeowners, who are deep underwater and will eventually default on their loans, the efforts by the Fed to reflate the U.S. economy and particularly consumer spending will be futile. As Alan Meltzer noted to Tom Keene on Bloomberg Radio earlier this year: “This is not a monetary problem.”

Indeed, the public embrace by the Federal Open Market Committee of further quantitative easing or “QE”, instead of calling for the immediate restructuring of the largest zombie banks, actually threatens to push the U.S. into a deeper and far more dangerous economic path. According to the Q2 2010 Bank Stress Index survey conducted by IRA and our review of the Q3 2010 earnings results, the financial condition of smaller lenders is actually improving. While the FDIC now has over 800 banks on its troubled list, the righteous banks for which we currently have “positive” outlooks in The IRA Advisory Service are showing better earnings and less credit stress.

Part of the reason for the improvement is that the FDIC and state regulators have taken a very hard line with smaller banks, pushing many into resolutions and distressed asset sales. But for the healthy lenders that survive and investors that buy failed banks, there will be a lot of money left on the table — profits that will come back into earnings via recoveries and other windfalls and help to boost the private economy. Resolution and liquidation is how a free market economy regenerates. The trouble is, the approach taken with the large banks and the GSEs is precisely the opposite of that applied to smaller lenders. The policy of the Fed and Treasury with respect to the large banks is state socialism writ large, without even the pretense of a greater public good.

Forget Treasury Secretary Tim Geithner lying about the relatively small losses at American International Group (AIG), the fraud and obfuscation now underway in Washinton to protect the TBTF banks and GSEs totals into the trillions of dollars and rises to the level of treason. And the sad part is that all of the temporizing and excuses by the Fed and the White House will be for naught. The zombie banks and GSEs alike will muddle along until the operational cost of servicing bad loans engulfs them. Then they will be bailed out — again — or restructured.

Think that credit allocation and availability isn’t a grassroots issue? Check out the comment in the Huffington Post by IRA CEO Dennis Santiago about helping the City of Los Angeles fashion a local rule for bank reinvestment in the community: This model is spreading to cities around the country.

So why did our BSI measure show rising stress in Q2 2010? Over the past several years, the large zombie banks actually looked better on our BSI survey than the average, this due to overt subsidies, QE and low interest rates. But now the larger lenders are sinking under the weight of rising servicing costs, falling asset returns and other problems linked to mortgage securitizations. So while the Fed continues to try to revive the largest banks via massive monetary ease, the FOMC is at the same time preparing to do further damage to solvent lenders, insurers and other investors via QE2.

The IRA has spoken to a number of executives in banks and life insurance companies about the impact of QE and Fed zero interest rate policy on their income statements and balance sheets. The universal message: If rates do not return to “normal” levels by year-end, the pain in terms of reduced earnings on assets and the resultant negative cash flow will start to become so apparent that the financial markets will actually notice. In particular, we have been told that by year end several of the largest publicly traded banks and life insurers could show significant declines in net interest earnings due to QE — declines driven by falling net interest income that may provoke ratings downgrades. And when this next systemic crisis comes — whether in December or later in 2011 — the full blame will belong to the members of the Bernanke Fed and the Obama Administration.

- more -

COMMENT

Great article !! Thanks to Chris Whalen and Reuters.

Posted by gramps | Report as abusive
  •