Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘interest rates’

• Banks’ Cheap Money is Economic ‘Poison’

Posted by Ron Robins on March 13, 2011

By Ron Robins. First published March 10, 2011, in his weekly economics and finance column at alrroya.com

Developed world bankers continue to proclaim that enforced low interest rates—cheap money—will lead their countries back to economic prosperity. But didn’t the same policies a few years ago help bring us to the precipice of financial and economic collapse? Do they still not understand that cheap easy money led to many large US and European banks becoming gambling institutions, eventually failing and bailed out at taxpayers’ expense?

And above all, that cheap easy money enticed people, companies and governments, to become horribly indebted, with many individuals and companies failing. Soon, even developed country governments may go bankrupt. As proof that cheap easy money is again causing extraordinary economic problems, just look at where some of it is now going—to the commodities’ markets. There, it helps inflate food prices, thus causing starvation and food riots around the world.

Do the bankers not read history and know that artificially induced cheap easy money can be economic poison?

Of course one simple reason that many bankers advocate cheap easy money is that it makes them a lot of money. When they can—as they did for many years and still seem able to do—‘leverage-up’ their assets in relation to their equity, they can make multiples of profits compared to before. And since, often courtesy of their benevolent central bank, they can frequently borrow at nearly free rates and ‘invest’ those proceeds in bonds/securities/commodities that often offer high potential returns, it is possible for them to make ever bigger profits.

For most large US and European banks, their assets frequently exceeded their equity by 20 to 60 times before the financial crises. That is, keeping it simple, they were somehow able to leverage every $1 of equity, usually by borrowing funds, to create $20 to $60 of assets! The risk in such high leverage is that a small loss in asset values of say, just five per cent, could wipe out their equity and cause insolvency and bankruptcy.

Unfortunately, very high leverage ratios continue in many developed countries’ banking and financial institutions. (Perhaps this is the real unspoken reason for cheap money: to inflate asset markets to keep the banks semi-solvent! Though, that topic is for another post.)

Therefore, the real story is the culture of leverage and risk that numerous developed world banks now embody as a result of easily available cheap money. This is in contrast to that during much of banking history when money was regularly relatively expensive (with higher rates of interest) than today and often difficult to obtain.

The easily available cheap money encourages enormous ‘moral hazard’ among bankers and all players in the financial system. Moral hazard denotes a lack of morality and a carefree greed mentality that produces excessive speculation. It is this attitude that promotes the creation of maximum leverage and the taking of big risks—and not caring too much about any potential losses as they are covered by others. Bankers under the influence of moral hazard are like addicted gamblers who cannot stop gambling. But the gambling is not at the card table. It takes place in their boardrooms and trading desks.

And fortunately for the bankers they can enjoy their moral hazard largely at the expense of taxpayers. As we know, much of the potential and accumulated massive losses in the US and European financial and banking systems have been transferred to governments and central banks. The US and European governments and central banks make light of these burdens saying that as their economies recover these losses will be greatly reduced. However, the ‘central bank of central banks,’ the Bank for International Settlements (BIS), has issued new global bank regulations (Basel III) that—if implemented—might reign in some of the excesses associated with moral hazard.

Of course not all banks speculate or gamble to the same extent. In Islamic banking, spiritual and ethical considerations greatly restrain speculation. Also, for instance, Canadian banks adhere to more conservative principles and are better regulated and so have not suffered the same fate as that of many of their US and European rivals.

For now though, cheap easy money is seen by bankers as our economic salvation. And it inflates global markets, including those related to food and energy. As their prices rise, the unforeseen repercussions of the bankers cheap easy money ‘poison’ assists in creating starvation, food riots, and political upheaval around the globe.

Furthermore, the continuing high leverage, moral hazard, and gambling tendencies within the banking and financial system assures that some of today’s ‘good’ investments will sour and suffer large losses. Will the taxpayers again assume those losses? If not, then what? Until the cheap easy money poison is banished it continues creating conditions for even bigger economic and social catastrophes in the years ahead.

Copyright alrroya.com

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• Severe Debt Scarcity Coming to US

Posted by Ron Robins on December 30, 2010

By Ron Robins. First published December 26, 2010, in his weekly economics and finance column at alrroya.com

If US consumers believe it difficult to borrow now, just wait! In the next few years credit conditions are likely to go back seventy years when private debt was difficult to obtain. Most Americans intuitively believe there is too much debt at every level of society. But the economic and political vested interests do not want them worried about that. They want to give them credit to infinity to keep this economic mess from imploding. The US Federal Reserve’s new round of quantitative easing (QE2) is clear evidence of that. However, Americans are right about their inordinate debt load, and future economic conditions are likely to create a severe debt scarcity.

The principal reasons for the coming debt scarcity are that ‘debt saturation’—where total income cannot support total debt—has arrived, say some analysts; also, the growing understanding that adding new debt may not increase GDP—it could decrease it; and that the banks and financial system are a train wreck in waiting, eventually being forced to mark their assets to market, thus creating for them massive asset write-downs and strangling their lending ability.

The realization that debt saturation has arrived will not surprise many people. But understanding that new debt can decrease economic activity might surprise them. And the numbers illustrate this possibility. In Nathan’s Economic Edge, Nathan states, “in the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP!”

In fact Nathan also shows that for decades, each new dollar of debt produces less and less in return, from a return of close to $0.90 in the mid 1960s to about $0.20 by 2007. One explanation for this is that as societal debt increased it focused disproportionately on consumption rather than productive enterprise, whose return appears greater.

On the subject of consumption, the renowned economist David Rosenberg in The Globe & Mail on August 16 stated that “U.S. household debt-income ratio peaked in the first quarter of 2008 at 136 per cent. The ratio currently sits at 126 per cent, but the pre-2001 norm was 70 per cent. To get down to this normalized ratio again, debt would have to be reduced by about $6-trillion. So far, nearly $600-billion of bad household debt has been destroyed.” This data reaffirms Americans growing aversion to debt, that debt has become too onerous, and is suggestive of debt saturation.

Replacing declining consumer debt is the exponential growth of US government debt. For 2009 and 2010, the combined US government’s fiscal deficits required or require borrowing an extra $2.7 trillion or so. Yet with all that spending—combined with about $2 trillion of ‘money printing’ from the US Federal Reserve (the Fed)—it created only around $1 trillion in increased economic growth!

One may argue that the phenomenal US government borrowings will provide returns far into the future and that the present low economic returns are due to not funding areas with potentially better returns. Some economists say that spending on infrastructure and education provides the best returns. However, with economists such as Nobel Laureate Paul Krugman and numerous others predicting huge continuing deficits for years ahead, and with a Japan-like slump in economic activity, the odds are likely that any new borrowed dollar will continue to provide only poor returns for years to come.

A further, major reason for the coming debt scarcity will be the tremendously impaired financial condition of the banks. The values assigned to many bank assets are fictional according to numerous experts. QE2 is about many things but one of them is aimed at delaying the potential for implosion of the banking system. In 2009, the Financial Accounting Standards Board (FASB) caved in to government and banking industry lobbyists to allow many bank assets to be ‘marked to fantasy’ and not ‘marked to market.’

This viewpoint is best expressed by highly respected Associate Professor William Black (and formerly a senior regulator who nailed the banks during the savings and loan debacle) and Professor L. Randall Wray, who wrote an article on October 22 in The Huffington Post, entitled, “Foreclose on the Foreclosure Fraudsters, Part 1: Put Bank of America in Receivership.” They wrote that, “FASB’s new rules allowed the banks (and the Fed, which has taken over a trillion dollars in toxic mortgages as wholly inadequate collateral) to refuse to recognize hundreds of billions of dollars of losses. This accounting scam produces enormous fictional ‘income’ and ‘capital’ at the banks.”

However, the Federal Reserve may be realizing that it might not have been such a good idea to buy some of these ‘toxic’ securities. Bloomberg reported on October 19 that, “citing alleged failures by Countrywide to service loans properly… Pacific Investment Management Co., BlackRock Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America Corp. to repurchase soured mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit, people familiar with the matter said.”

Also, on November 2, CNBC reported that Citigroup could be liable for huge amounts of toxic security buy-backs as well. “If all four mortgage acquisition channels turn out to be equally as defective… Citi’s liability for repurchases could soar to about $100 billion dollars at a 60 per cent defect rate – and to around $133 billion dollars at an 80 per cent defect rate.”

Clearly, such numbers are staggering. These, as well as many other banks and financial entities, could collapse. Politically, in the present circumstances, it would be difficult for the US government to provide massive new funds to support the financial system. Therefore, it will be up to the Fed to decide what to do.

If the Fed prints ever increasing amounts of new money to try to moderate the financial collapse, hyperinflation could be the result. If it does not print massive amounts of new money, a deflationary depression could be born.

In high inflationary or hyperinflationary conditions, few will want to lend as they get paid back in dollars that are declining very rapidly in value. In a deflationary episode, lending is reduced due to huge loan losses. Therefore, during either, and/or after such events, debt scarcity will be in full force.

Data indicates that American consumers do not want to increase their debt. Debt saturation is occurring, and with it a declining return on each borrowed dollar—even for the US government. Most significantly, the banks and the financial system will probably soon experience a new round of massive real estate related losses and subsequent financial institutions’ bankruptcies. Thus, a new major financial crisis will likely soon engulf America, greatly impairing its lending facilities and creating a severe scarcity of debt.

Copyright alrroya.com

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• Manipulated Markets Can Cause Ruin

Posted by Ron Robins on December 10, 2010

By Ron Robins. First published October 9, 2010, in his weekly economics and finance column at alrroya.com

Market manipulations eventually led to Soviet economic collapse. Though not as overt as the Soviets, it is the manipulation of currencies and interest rates by major economic powers that has mostly led to massive misalignments in investment and consumption that pose extraordinary dangers to global economic health.

Ask anyone if they believe that the Chinese currency, the renminbi, is manipulated. Almost everyone agrees that it is. Are US interest rates manipulated? Again, everyone knows they are. (Not too long ago it was only the short term rates that were controlled. Now the US Federal Reserve [the Fed] is buying longer dated US treasury bonds to bring their rates down too.) Countries all over the world are manipulating their currencies lower to gain export advantages and maintaining near zero interest rates to spur domestic demand and cheap government borrowing.

It is basic economics that where markets are manipulated, supply and demand are distorted. And one distortion creates the need for a further distortion, and so on. The longer the distortions continue the greater the possibility of total market failure. We are near that point today with currencies and interest rates.

The Chinese have scored a major mercantile advantage by pegging their currency, the renminbi, at a relatively set and undervalued rate to the U.S. dollar. Not only have US exports suffered, but the exports of many other countries have suffered as well. Under US law, the Chinese should probably have been labelled a ‘currency manipulator.’ However, by bowing to Chinese demands that they not be labelled a currency manipulator, President Obama’s administration is losing credibility everywhere.

So, Americans are waking up to find that not only does China dictate U.S foreign exchange policy, but China indirectly influences its domestic economic agenda as well. Everything from employment policies (export expansion) to government funding needs (requiring Chinese funding) are all partly defined by the present exchange rate policies.

Increasingly, Americans realize that on the foreign exchange front they have been ‘checkmated’—as in the game of chess—by China. Should difficult economic times continue, or worsen, increasing American anger is likely at this arrangement. It could pass the breaking point and encourage America to act unilaterally against China. Currency turmoil might then embrace the globe.

However, one never discussed but possible reason why the US government has been afraid to label China (and Japan previously) as currency manipulators may be because the US itself may be acting covertly to manage the dollar exchange rate.

According to the US government’s own legislation, it can act secretly in currency exchange markets to affect the dollar’s exchange rate using the Treasury’s Exchange Stabilization Fund (ESF). The US Treasury says that the ESF, “with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities.” The ESF was established by the Gold Reserve Act of 1934 and then amended in the late 1970s.

Also, the Fed engages in opaque currency ‘swaps’ with other nations, and there is significant evidence of U.S Treasury and Fed engagement in gold price suppression. Gold is the ‘anti-dollar’ and barometer of confidence in the dollar. (See my August 24 column, “The Ethics of Gold,” at http://english.alrroya.com/node/54671 and gata.org)

Another manipulation of the Fed is its control of short term rates—and now possibly long term ones as well—to smooth out the booms and busts of the economy. However, we see the falsity of this argument. After almost two years at a near zero per cent federal funds rate the US economic quagmire continues—or worsens.

Induced low rates over the past ten years or so created a massive real estate boom and bust, discouraged savings, led to inordinate financial risk taking and moral hazard, unsustainable consumer debt, and now excessive, possibly uncontrollable government deficits and debt.

In their seminal work, “Growth in a Time of Debt,” published January 2010, Professors Carmen M. Reinhart and Kenneth S. Rogoff found that when government debt/GDP ratios exceed 90 per cent, economic growth rates fall considerably. According to the BIS, U.S. government debt/GDP will be 92 per cent by the end of 2010 and 100 per cent in 2011.

Furthermore, on September 1, the International Monetary Fund said, “general government debt in the G-20 advanced economies surged from 78 per cent of GDP in 2007 to 97 per cent of GDP in 2009 and is projected to rise to 115 per cent of GDP in 2015.”

Unfortunately, the present and future private deleveraging of debt in the U.S. and some other developed countries means potentially continued high—or higher—government deficits as economic growth is retarded or declines further. The Fed has said that to counter any renewed softness in US economic activity it will significantly expand its purchases of US government bonds and possibly other assets. This has the potential for fuelling a huge expansion of the money supply and creating high or even hyperinflation.

The U.S. and some other countries are following a path whereby every manipulation begets further manipulation, and which then begets even further manipulation. With China, perhaps Japan again soon, and other countries controlling their currency values, the U.S. may be forced overtly or covertly to counter their currency manipulations. And with continuing economic difficulties, with interest rate policy having created a debt nightmare and becoming increasingly ineffective, the Fed may institute money proliferation policies that have the possibility of leading to high or even hyperinflation.

If a vicious circle of manipulations by US authorities and other countries occurs, given time, it might rival some aspects of the Soviet command economy—and with a possibly similar tragic outcome. Hopefully, Americans and others will wake up before it is too late and realise that manipulated markets can eventually cause ruin.

Copyright alrroya.com

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