PHILADELPHIA REFLECTIONS
Musings of a Philadelphia Physician who has served the community for six decades

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Dislocations: Financial and Fundamental
The crash of 2007 was more than a bank panic. Thirty years of excessive borrowing had reached a point where something was certain to topple it. Alan Greenspan deplored "irrational exuberance" in 1996, but only in 2007 did everybody try to get out the door at the same time. The crash announced the switch to deleveraging, it did not cause it.

Whither, Federal Reserve? (2)After Our Crash
Whither, Federal Reserve? (2)

Philadelphia Economics (3)
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Controlling the Currency
Robert Morris confronted an enduring theme of American politics in 1779: how can citizens without political power protect their assets from government confiscation?

American Finance After Robert Morris
Robert Morris can be fairly said to have made the American Revolution possible.

..Tax and Fiscal Issues in the Constitution
For some founding fathers, monetary issues were all that mattered.

Great Depression (1929-1939)
New topic 2012-08-29 11:32:11 description

Right Angle Club: 2013
Reflections about the 91st year of the Club's existence. Delivered for the annual President's dinner at The Philadelphia Club, January 17, 2014. George Ross Fisher, scribe.

Banking Panic 2007-2009 (2)
New topic 2013-02-14 19:27:06 description

Bernanke's QE3: A New Titanic, or A New Bretton Woods?

{Ben Bernanke}
Ben Bernanke

Nobody likes to execute a guilty prisoner, but in finance it is surely true that allowing bad debts to remain unresolved harms the whole economy. It makes little difference whether a bank fails to mark its debts to market, whether debts are "extended", or insolvent institutions are subsidized. Andrew Mellon once advised Herbert Hoover that he should "wring the rottenness out of the system", but that is such poor politics that even Hoover rejected it. In time, the process of "good bank, bad bank" was devised to isolate bad debts into a single institution so the rest of the economy could begin to recover. QE3 is a version of good bank, bad bank. Unfortunately the public is easily misled in these matters, so although all three Q's involve the Federal Reserve buying long bonds, QE1 unfroze a frozen financial marketplace (successfully), QE2 meant to stimulate the economy (unsuccessfully), but QE3 seems to have much grander ambitions. So it is unfortunate that three different activities share the same name, and still more unfortunate that name is made so mysterious. Let's forget about the first two, and concentrate on QE3.

The Federal Reserve is well along in a program of buying huge quantities of questionable long bonds, and has announced it is going to keep buying huge quantities until either inflation exceeds 2.5% or unemployment falls below 6.5%. That's not exactly the same as buying every bad bond in existence, but it could come to that. Instead of letting the holders of those bonds go bankrupt, the Fed is buying the bonds out of circulation, which could rescue a great many investors. Small businesses do not ordinarily issue bonds, so there is some bias in favor of large businesses and banks, but surely not an intentional bias. The effect is to make the Federal Reserve both a good bank and a bad bank at the same time. The main difference between this and wringing the rottenness out, is that bankrupt institutions cannot come back to haunt you, while in the more benign purchase of bonds, you have assumed an obligation to pay them back. When you sell them back you drive the price down and money disappears. Furthermore, when the price of bonds declines, interest rates will rise and the national debt will increase more rapidly. If the economy cannot withstand higher interest rates, a recession will deepen. You have to get the timing right, and the world is in such a delicate state that it is impossible to get the timing entirely right for everybody. Because interest rates are now essentially zero, they cannot go lower, so investment advisors are increasingly advising clients to sell some bonds while they still can. If that gets out of hand, it could start a panic.

{United States Federal Reserve}
United States Federal Reserve

However, the United States Federal Reserve is not an investor, it controls the currency and can print unlimited amounts of it. There is nothing which can force it to sell its bond holdings, ever. Without going into the details of the Bretton Woods Treaty, the tie to gold was eliminated nearly fifty years ago. Meanwhile, its bonds are paying interest, which at the moment it is returning to the U.S. Treasury to reduce the national debt. It can reduce this outflow more or less at will, and it can increase it by raising interest rates (ie by selling bonds, as described). With a few extra steps, this enormous pot of debt could become the basis for an international currency reserve. At the least, it could bring a halt to an international currency war. If it chooses, it can decide to wait as long as fifteen or twenty years for economic demand to recover from a century of overleveraging, and then pay it back by letting the bonds reach maturity. But there is at least one big flaw in this dream.

At some point, the bond market may decide to take the bull by the horns and raise rates before the Federal Reserve wishes to. Political appointees come and go, and the bond market could easily decide that a misjudgment has been made by somebody. It could easily happen that public apprehension could grow that something doesn't smell right. In that climate, a few heavy sales could trigger a panic. And then everyone will try to get out the door at the same time.

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