The Constitution fails us when no one is certain what to do about an important issue.
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The Global Interdependence Council (GIC) visited the Banque de France in May 2008.
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The European Union follows the American example. ... (1229)
With a dozen small variations, repurchase agreements are a new and streamlined way to make short loans in big volume. Bear Stearns dominated the repo market for hedge funds but the volume got too big to manage when interest rates shifted.
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The author finds himself on television, and wonders whether c-span is a variant of blogging. From that, we go on to question whether Franklin really liked the French.
(1471)Whither, Federal Reserve? (2)
Whither, Federal Reserve? (2)
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http://www.philadelphia-reflections.com/blog/1653.htm
Constitutionality of the Monetary System
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| The Constitution |
In noting that our Constitution has lasted for over two centuries, we assert that this simple short document has largely anticipated everything important to anticipate, including the Industrial Revolution, atomic warfare, and the Information Age, to name a few. When an occasional issue arises that is not only unmentioned in the Constitution but where no one is certain what to do, our system leaves us spiritually adrift. Such an issue is found in o0ur monetary system, where we have been wandering for two hundred years.
The founding fathers worried a great deal that popular majorities would abuse minorities, particularly in the case of the majority poor people voting themselves the property of minority rich ones, or that debtors in the majority might dishonor the rights of creditors. Although we have developed a welter of laws about debt and creditors, bankruptcy and taxation, they are if anything too specific. What is lacking is a few general words in the Constitution about the principles of credit and money. The problem now is the same as it was in 1787; we don't know what to say.
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| Albert Gallatin |
For a very long time, some very well educated people were strongly opposed to the creation of a bank, later to mean a banking system. Alexander Hamilton's proposition that a "national debt is a national treasure" was greeted with horror by several Presidents, as well as by Albert Gallatin, one of the most sophisticated financial thinkers of the time. Underlying this perplexing reaction to the simple proposal to create a bank was surely the perception that making the Federal Government into a substantial debtor creates a powerful ally to all debtors in their eternal struggle with all creditors; the outcome of such an unequal struggle would inevitably be to the disadvantage of creditors. In common parlance the word capitalist seems to imply a creditor. It took a very long time for it to become understandable that debtors, too, were essential beneficiaries of a capitalist system, but that idea still often meets with dissent. However, when millions of the world population belong to religions which prohibit the payment of interest, it should not be surprising to find many Americans who cannot get their heads around the idea that debtors and creditors need each other to an equal degree.
In the case of inflation, governments have always been somewhat favorable to debauching the currency. Naturally, a major debtor hopes to repay its debt with cheaper money. Since it has more or less always been necessary to use police powers to maintain a common currency, Kings and governments have long been in control of money, whether that means gold bars or beaded wampum. And for the same length of time, governments have been discovered bending the rules in favor of themselves. Bronze has been substituted for gold, the edges of coins have been shaved, the printing presses print paper money unrestrainedly, and the consumer price index has been manipulated to encourage inflation. Political parties have sought votes from debtors by promising to regulate banks, promote silver as a substitute for gold, disadvantage foreign competitors, inhibit or manipulate the value of currency on foreign exchanges.
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| Alan Greenspan |
For forty years we have operated without any fixed standard for money. Money for all that time has lacked any physical representation, or discipline. Money has become a computer notation. At first it was based on calculations of monetary aggregates, a bewildering concept promoted by Milton Friedman. More recently, it is entirely based on inflation targeting as promoted by Alan Greenspan. With a target of maintaining steady prices, an inflation rate of 2% is set as a specific target for the Federal Reserve. If inflation falls below that target, more money is created; if it rises above that level, less money is created. How much there is of it does not matter; it's beyond calculation. Although this simplified description fills almost any listener with doubts, it seemed vindicated by seventeen years without a notable recession. Even though events beginning in 2007 raise pretty serious doubts, it may still prove to be the best possible monetary system.
Even though this most fundamental of all commercial issues cries out for a simple principle to be stated in the Constitution so that neither populist congressmen not rapacious financiers can ruin us, it is not presently possible even to imagine what a new Constitutional amendment would, should or even could say. Meanwhile, some immense power rests in the hands of shadowy figures whom we blindly trust, for lack of a better idea about how we should select them or what we should instruct them to do.
http://www.philadelphia-reflections.com/blog/1557.htm
Macroeconomics of The 2007 Collapse
Sudden wealth creation, whether from the discovery of gold or oil, the conversion of poverty into useful cheap labor, or the sudden abundance of cheap credit, is of course a good thing. Sudden wealth creation can be compared with a stone thrown into a pond, causing a splash, and ripples, but leaving a somewhat higher water level after things calm down. The globalization of trade and finance in the past fifty years has caused 150 such disturbances, mostly confined to a primative developing country and its neighbors. Only the 2007 disruption has been large enough to upset the biggest economies. It remains to be seen whether disorder to the whole world will result in revised world monetary arrangement. One hopes so, but national currencies, tightly controlled by local governments, have been successful in the past in confining the damage. This time, the challenge is to breach the dykes somewhat, without letting destructive tidal waves sweep past them. Many will resist this idea, claiming instead it would be better to have higher dykes.
It is the suddenness of new wealth creation in a particular region which upsets existing currency arrangements. Large economies "float" their currencies in response to the fluxes of trade, smaller economies can be permitted to "peg" their currencies to larger ones, with only infrequent readjustments. Even the floating nations "cheat" a little, in response to the political needs of the governing party, or to stimulate or depress their economies as locally thought best. All politicians in all countries therefore fear a strictly honest floating system, and their negotiations about revising the present system will surely be guilty of finding loopholes for each other; the search for flexible floating will therefore claim to seek an arrangement which is "workable".
In thousands of years of governments, they have invariably sought ways to substitute inflated currency for unpopular taxes. The heart of any international payment system is to find ways to resist local inflation strategems. Aside from using gunboats, only two methods have proven successful. The most time-honored is to link currencies to gold or other precious substances, which has the main handicap of inflexibility in response to economic fluctuations. After breaking the link to gold in 1971, central banks regulated the supply of national currency in response to national inflation, so-called "inflation targeting". It worked far better than many feared, apparently allowing twenty years without a recession. It remains to be investigated whether the substitution of foreign currency defeated the system, and therefore whether the system can be repaired by improving the precision of universal floating, or tightening the obedience to targets, or both. These mildest of measures involve a certain surrender of national sovereignty; stronger methods would require even more draconian external force. The worse it gets, the more likely it could be enforced only by military threat. Even the Roman Empire required gold and precious metals to enforce a world currency. The use of the International Monetary Fund (IMF) implies attempts to dominate the politics of the IMF. So it comes to the same thing: this crisis will have to get a lot worse, maybe with some rioting and revolutions, before we can expect anything more satisfactory than a rickety negotiated international arrangement, riddled with embarassing "earmarks". Economic recovery will be slow and gradual, unless this arrangement is better, or social upheavals worse, than would presently appear likely.
http://www.philadelphia-reflections.com/blog/1596.htm
Second Mortgages Want to Be First
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| Chrysler Logo |
In a bankruptcy proceeding, there has long been a traditional conflict between the holders of first mortgages and the holders of second mortgages. It goes like this: since the holder of a first mortgage gets paid first, his incentive is to hurry up the process and get the money. The holder of a second mortgage, however, only gets paid what is left, so this party will normally wish to stall proceedings in the hope the market will improve and give the second mortgage a better payout. Normally, this sort of predictable dispute is covered by contracts, and in any event most banks hold both kinds of mortgages and are neutral about what is just and fair. In the current banking crisis, however, the major banks have developed an incentive to favor the second mortgage, so they have a new view of what is just and fair. Four of the largest banks hold a total of $440 billion of second mortgages, but have very few first mortgages because they were sold off in the securitization process. The banks mostly retained the function of servicing first mortgages, however, so they now have quite a conflict of interest.
Something like this seems to be going on with the resolution of the Detroit auto makers, with the difference that politicians tend to favor the interest of the auto workers in the bankruptcies because there are more voters to be influenced. And in the case of the auto companies, there are stockholders who will be wiped out by a bankruptcy unless the liquidation of the company assets produces enough cash to satisfy the creditors, secured and unsecured. After all, stockholders aren't creditors at all; they are owners of the company. No matter how things turn out, however, the secured creditors would normally have first call on whatever is salvaged. So, it's one class of secured creditor against another, or else it is the secured creditors against the "stakeholders", employees or any other unsecured creditor. If the government intervenes, there is the additional issue of the Fifth Amendment of the Constitution, which prohibits government from the "taking" of private property without just compensation. Representative Conyers of Michigan, whose political allegiance is not in doubt, has introduced legislation to prohibit lawsuits in these matters. So now, the prospect grows of a constitutional clash between Congress and the Supreme Court, over the Constitutionality of such a law which denies due process. So that gets us into the fourteenth amendment, too. If we look beyond the technicalities, the looming clash is between President Obama and Chief Justice Roberts. One of them wants to take money from secured creditors and make it available to someone with more political clout; and the other surely wants to preserve the sanctity of contracts, the rights of property holders, due process, and the right of the Supreme Court to declare contrary laws to be unconstitutional.
Unless someone backs off, the situation would seem to be as monumental as Franklin Roosevelt's Supreme Court-packing proposal. Because -- there is every reason to anticipate a 5-4 vote by the Supreme Court, a 5-3 vote if Justice Souter is not replaced by that time, and strenuous efforts to alter the balance.
http://www.philadelphia-reflections.com/blog/1631.htm
Steep Yield Curve: A Useful Subsidy?
The steepness of the federal interest rate curve -- ten-year treasury bonds pay more interest than three-month treasury bills, and the rate for intermediate time intervals slopes gradually from one to the other -- is a function of the Federal Reserve; the slope of this curve concisely describes current Fed policy. The Federal Reserve controls the money supply by raising or lowering short-term rates, which "affects the slope at the short end", and mainly in this way restrains or encourages inflation, or alters the exchange value of American currency. For the most part, long term rates are set by the public bond market. Once in a while, the Federal Reserve does buy or sell long-term treasury bonds to modify long-term rates in the economy. By affecting rates at either end, the result is some kind of change in the slope of the curve.
Because banks make interest payments to depositors near the short-term federal rate, while the same banks charge borrowers at near the public long-term rate, the current slope is a main determinant of bank profits. Banks borrow short, and lend long. If Federal Reserve tinkering steepens the curve more than it would be without interference, then bank profits are subsidized. Of course, it works the other way as well; in a banking crisis, yield curves can be steepened to rescue banks from failure, thus potentially sacrificing ideal monetary levels temporarily. For the most part, what is good for the banks is good for the economy; but it remains that bank profits are subsidized much of the time. Artificially widened yield curves either punish savers by lowering interest rates on their savings accounts, or else punish borrowers by increasing interest rates on mortgages and other credit. For political reasons, the pain is usually shared among voting blocs. It can be argued this invisible subsidy of banks by the public creates a compensating benefit of economic stability despite occasional bubbles and recessions like the present one. However, the Federal Reserve system has been in operation for almost a century, revealing a long-term bias in favor of inflation, which is a subsidy of debtors by creditors. Present policy deliberately targets a steady rate of 2-3% inflation; the gold market responded to a century of this by raising the price of gold from $17 to $900 an ounce. A 1913 penny has become a dollar (before taxes) you might say. You might also say it took the Federal Reserve less than a century to make the present dollar worth a penny.
If gradual inflation is a consequence, a fair question must arise whether the Federal Reserve is worth its cost. Compared with an inflexible, relentlessly deflationary Gold Standard, yes, it is. Even accepting the monetary crisis as partly created by central banking, the international dominance of the American economy and recent smoothing of banking instability testify to the durable usefulness of the Fed. But another criticism must be faced: In subsidizing depository banks with an artificial yield curve, is the Fed backing the wrong horse for the future? To answer that question, examine two components: With computer technology rapidly advancing, can the Federal Reserve accommodate non-banking competitors to banks? And secondly, can international central banking appropriately accommodate globalization? There are, after all, aspects within the 2007-20?? crisis which suggest -- maybe it can't.
Steady inflation of 1000% per century may well be preferable to 19th Century volatility of 1000% every ten or so years. But a gradual rise of, say, 500% or less each century might be even better. Relentless political pressure on the Federal Reserve has typically been used to explain its slow retreat from truly stable prices, and this defense takes the form of mentioning its dual mission of minimizing unemployment while holding prices as steady as possible. In recent years, European political rhetoric goes further, aspiring to add the right to employment to their fifty-page Bill of Rights; similar utopianism has crept into our own newsmedia. Governments for thousands of years have cheapened their currencies. But while the drift is clear, our own pace is set by the amount of subsidy required to maintain a steep yield curve. As retail banks have struggled to compete with the wholesale investment banks, their increasingly uncompetitive costs require greater subsidy from the yield curve. It is always going to be more expensive to aggregate deposits for lending purposes than to raise large sums by floating a bond issue. Securitization is here to stay, because retail banks have consolidated and savings banks have gone out of business by the thousands; the mortgage industry can no longer survive without substantial amounts of mortgage-backed securities. Nor should it; securitization is a sensible route for importing capital from nations with a trade surplus. Depository banks long ago lost the borrowing business of corporations large enough to float their own bonds; securitization provides a means for smaller borrowers to share the same efficiency. After it has tried everything else, Congress will eventually devise a reasonable regulatory system for derivatives. Except for smoothing the transition to whatever proportion of market share the investment banks can justify, perhaps all of it, the subsidized yield curve impairs efficiency. It would be a mistake to allow some foreign nation to exploit such an opening before we do. The technical problem for all central banks is to devise a suitable alternative method of controlling the currency, other than by targeting inflation with adjustments in interbank lending rates.
Observers led by Martin Wolfe the economist for the Financial Times feel the 2007-20?? financial crisis can be adequately explained by Chinese pegging their currency too low, and could be rectified by persuading the Chinese to float their currency. Regardless of this extreme view, globalization is clearly both a good thing and an inevitable one. Thus some form of discipline must be devised to prevent central banks from destabilizing it for their own advantage. Wolfe proposes the use of a strengthened International Monetary Fund, which is unfortunately apt to project international politics into a process which could be harmed by it. An alternative to be examined might be to pool sovereign wealth funds as a pooled currency reserve, although this system probably could not withstand present extremes between surplus and debtor nations, so getting world acceptance could be protracted. Ultimately, everyone realizes that the real backing for an international finance system is the net worth of the whole world. But the example of Lloyd's of London is a haunting one; no one relishes putting absolutely everything at risk, down to the last shoe button. In the event of disaster, everyone wishes to hold back some nest egg to use for a recovery. Because of the same line of thinking, almost no one would trust foreigners to control more than a limited share of their future.
The future of international monetary relations is thus quite murky, but current pressures would seem to be driving something fundamental to change. When it does, regulating artificially manipulated yield curves had better be kept in mind.
http://www.philadelphia-reflections.com/blog/1638.htm
Oil Prices and The Federal Reserve: Chicken or Egg?
Although there is little public gloating from the green environmentalists, the price of oil has finally and decisively soared, with Americans actually taking public transportation to work. Although it would seem that more conservation would result from paying attention to household heating than to automobile mileage, it is summer and vacation driving is more on the public mind than buying sweaters for a lower thermostat setting. The rise of oil prices by 40% in a year has started conspiracy theories, and drags the Iraq war into the presidential election chatter. It's quite true oil consumption could not have risen 40% in the developing world of China and India, and nothing drastic has happened to world oil reserves or extraction. A glance at the accompanying charts shows that oil prices have risen much like commodities in general; it
http://www.philadelphia-reflections.com/blog/1467.htm
GIC in Paris
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| GIC logo |
Delegation Agenda
Sunday, May 11th:
6:30pm -7:00pm: Arrival and cocktails
Location: Aux Anysetiers du Roy, 61, rue St. Louis en L'Isle Metro: Sully Morland or Pont Marie
7:00pm: Dinner will be served; Registration and pre-payment was required for this event.
Monday, May 12th:
9:00am - 9:15am: Arrival and registration. A light breakfast will be provided.
Location: Bistro de la Muette, 10, Chaussee de la Muette 75016 Paris Metro: Muette
9:15am - 10:00am: Presentation by Michael Kennedy, Head of the General Economic Assessment Division, Department of Economics, OECD, on Outlook by the OECD.
10:15am - 11:30am: Round-table discussion directed by John Silvia, Chief Economist, Wachovia Bank, including Paul Thomas, Chief Economist, Intel, Tom O'Connell, Assistant Director General of Central Bank of Ireland, Sandra Pianalto, President of Cleveland Federal Reserve Bank, Mario Baldassarri, Senator, The Republic of Italy, and David Kotok, CIO, Cumberland Advisors. Each participant will introduce a topic of concern to the group with GIC delegates acting as discussants. Chatham House Rule will apply.
12:15pm - 1:30pm: Lunch at Bistro de la Muette, sponsored by Cumberland Advisors and Wachovia.
1:30pm-7:00pm Free Time
7:00pm - 7:30pm: Cocktails and Hors d'oeuvres.
Location: Cercle de L'Union Interalliee, No. 33 Rue du Faubourg Saint-Honor� 75008 Paris Metro: Concorde or Madeleine, 5-10 minute walks
7:30pm: Private dinner with Paolo Garonna, Deputy Executive Secretary United Nations
Economic Commission for Europe and sponsored by Cohen and Company. Dress code for the club requires a jacket and tie, no blue jeans or tennis shoes please.
Tuesday, May 13th:
8:45am-1:10pm: GIC & CEPII Conference "Monetary Policy and the Exchange Rate: The Euro and the Dollar"
Location: Maison des Arts et M�tiers, 9 bis Avenue d'I�na, 75116 Paris, Metro: Iena
Full Program will be distributed at the event. Speakers and moderators include:
William Dunkelberg, Chairman, Global Interdependence Center
Agn�s B�nassy-Qu�r�, Director, CEPII
Lionel Fontagn�, CEPII
David Kotok, Chief Investment Officer, Cumberland Advisors
David Woo, Head of Foreign Exchange Strategy, Barclays Capital
Manuel Balmaseda, Chief Economist, CEMEX
Denis Verret, Senior Vice Preside of Operations and Sales, EADS
William Clark, Director, New Jersey Division of Investments
Laurence Boone, Chief French Economist, Barclays Capital
Sandra Pianalto, President, Federal Reserve Bank of Cleveland
Christian Noyer, Governor, Banque de France
1:10 pm � 2:30 pm: Luncheon for conference attendees at the Maison des Arts et M�tiers sponsored by Barclay's Capital
7:00 pm: Dinner hosted by Christian Noyer, Governor of the Banque de France.
Location: Banque de France, Gold Library, 39, rue Croix des Petits Champs � 75001.
Please enter via 2 rue Radziwill, at the north end of the Bank. Recommended metro stops for the Banque de France are Bourse, Palais Royal-Louvre, Louvre-Rivoli or Pyramides, all a ten minute walk to the Banque de France. Dress code for the evening requires a jacket and tie. For security purposes, please bring invitation and photo ID and allow an extra ten minutes for security processes.
Wednesday, May 14th:
9:30am: Arrive at the French National Archives, for security process. Please bring your passport for security purposes.
Location: French National Archives, 1 rue Roberty Esnault Peltierie, corner of 37 Quai d'Orsay, 75 007 Paris Metro: Invalides
10:00 am: Private tour of French National Archives where GIC delegation will have a viewing of French historical treasures such as the Louisiana Purchase signed by Thomas Jefferson, Original Treaty of Alliance signed by Benjamin Franklin, Original Treaty of Versailles as well as other historical documents.
1:00 pm: Luncheon hosted by Mr. Arnaud de Bresson, Managing Director, Paris EUROPLACE.
Location: Place de la Bourse, Palais Brongniart, 75 002 Paris Metro: Bourse (line #3)
Lunch will be followed by presentation of the Paris financial market place.
4:00 pm � 5:00 pm: Travel to meeting with Christine Lagarde, Minister of Finance. Please arrive by 4:30 to pass through security.
Location: Ministry of Finance Building,139 Rue de Bercy, Paris 12 Metro: Bercy.
5:00 pm � 6:00 pm: Private meeting with Christine Lagarde, Finance Minister of France. Please bring a passport for security purposes.
http://www.philadelphia-reflections.com/blog/1451.htm
Milton Friedman on Capitalism
http://www.philadelphia-reflections.com/blog/1673.htm
Fixing the Financial Mess
Two years after August 2007, it remains uncertain whether we know enough about how the great financial disaster came about. There may be other shoes to fall on the floor, announcing unexpected dimensions of our problem. In particular, the recovery may be brief, followed by a resumption of downward trends we had hoped were finally behind us. That seems to have happened in 1937. If it happens again in 2010, what seemed like a three-year recession may prove to have been a twelve-year one, with early successes exposed as mere flashes in the pan.
Nevertheless, politicians are searching for answers to give the public; no one wants to delay solutions if they exist. Analyses can be revised if new information appears. Presently attractive approaches can be divided into three categories: International, Regulatory, and Goal-focused.
International monetary diplomacy. There is fairly uniform agreement that a major source of instability came from the unprecedented transformation of third-world countries into economic powerhouses. As many as a hundred million people were raised up from poverty in less than a generation; there was inevitable commotion in the world's economy as a result of a fundamentally very good thing. The British economist Martin Wolfe is the chief spokesman for the view that there was almost nothing the Americans could do about the upheaval, although the Chinese government made it much worse by pegging its currency too low. This line of analysis leads to the proposal of world monetary diplomacy, offering the Chinese greater influence in the International Monetary Fund in return for floating their currency, and negotiating a greater role for the IMF in world finance.
Regulatory restructuring. With or without the creation of a new international monetary order, others feel that individual nations must create internal regulatory barriers to prevent the ebbs and flows of international currency from circumventing local laws, upsetting local stability. The problems daunting this approach are two: many nations will fail to respond adequately, with consequences which could overwhelm those nations who institute responsible reforms. And second, the recent pace of financial innovation has been so rapid that regulation is easily circumvented. Draconian controls would surely lead to a loss of local competitiveness, and disadvantaged local captives would soon rebel. Urgently needed regulation and effective regulation often prove to be two different things.
Goal-focused adjustment. In recent decades, considerable success resulted from forcing the system to produce a certain desired outcome, essentially ignoring the myriad intermediate adjustments. Inflation targeting has come to be a description of stable prices forcibly maintained by one technical method (also called inflation targeting in a narrow sense). It lets the economy produce its own responses, and if necessary lets academics produce their own explanations. Unfortunately, this approach in time translates into Congress announcing there shall be no inflation, and the Federal Reserve responds, lo, there is no inflation. Since Congress has very little idea what is involved in this process of waving Merlin's wand, transparency, financial innovation and reduced transaction costs can suffer unduly before the underlying dynamics reach the surface of public awareness. In short, there are too many hidden steps between public awareness and the feed-backs which modulate the policy. One of those steps is apt to be blatant denial that policy had a given adverse effect.
http://www.philadelphia-reflections.com/blog/1674.htm
Federal Reserve Rolls the Dice
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| Lehman Brothers |
For the year preceding, it was general opinion that the financial crisis was caused by $100 billion or so of mortgage-backed securities, mostly California and Florida home mortgages. But around Labor Day 2008 Lehman Brothers collapsed, and the problem became twenty times as large. What that was about is unclear, but seemingly had to do with money market funds being treated as "funds in transit" in consequence of the international monetary agreement known as Basel I, and thus not requiring bank reserves to be maintained for them. It will take time to unravel the intricacies of, and assign the blame for, this mess. However, the markets responded by refusing to trade at now uncertain prices, thus "freezing up". The response of the Federal Reserve was to double the money supply through international markets, mostly using "Central Bank liquidity swaps". The participation of various countries in this action has not been made public.
The doubling of the money supply required borrowing between one and two trillion dollars. After five months, or just after the inauguration of the new Presidential Administration, the markets had seemingly started to function more normally, and the stock market had rallied somewhat. The obviously bewildered leadership of both political parties agreed to the proposal to purchase $1.75 trillion of the troublesome assets, taking them off the market and presumably hoping the markets would function as if they did not exist. By July 2009 this operation was only about half completed. Not only was there disagreement about what these securities were really worth, but the banks which held them were reluctant to allow prices of what they continued to hold to be driven down by comparison with these forced transactions.
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| Federal Reserve Bank of Philadelphia |
In any event, the second stage of this huge government bailout of the banking system is projected as follows: The portfolio of assets would be worn down, either by allowing debts to mature, or by selling them at what is hoped will be advantageous prices. Who will buy them is to some extent dependent on the state of the economy, and to some extent on the perception of the fairness of the pricing. The Federal Reserve Bank of St. Louis has been assigned the task of designing a public formula for how much to buy or sell, depending on selected indicators of the economy. A public formula is felt to be necessary in order to reassure the markets that purchases and sales are not being made in response to secret information or unsuspected problems.
The reasoning would be that if these assets are sold to speculators at fire-sale prices, the money supply will shrink inappropriately, and the recession will be prolonged by the need to borrow replacement reserves for the monetary system. Unduly profitable sales would probably lead to inflation, since the present level of monetary reserves is twice as large as was thought appropriate, as recently as a year or two ago. But this maneuver by a central bank has never been tried before, and the results may well differ from present predictions. The Federal Reserve is prepared to take as long as ten years to accomplish the complete maneuver, but that plan presumes ten years of recession, and five congressional elections. It also implies that the economy could swing between 7% annual inflation, and 7% annual deflation, in the two worst cases, and assuming nothing extraneous happens to the economy.
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| President Barack Obama |
In the meantime, two other ominous notes. Although the nationalities of the lenders have not been made public, one can safely assume the Chinese are a major component. Since they are refusing to lend us money beyond two, and at the most five, years, we would be indefinitely in the position of borrowing short and lending long. In other situations, that imposes a risk of depositors starting a run on the bank. And secondly, it is hard to imagine that Mr. Obama's presently ambitious programs in healthcare, environmental protection, two wars and several election cycles, will be allowed to proceed without enormous public resistance to even further fiscal deficits.
http://www.philadelphia-reflections.com/blog/1688.htm
U.S. and E.U. Exchange Experiences (1)
The Global Interdependence Center (GIC), founded by Nobelist Lawrence Klein in 1976, brings noted foreign financiers to address Philadelphians interested in finance, and takes those Philadelphians abroad to return the visits. It's a gracious, entertaining, and highly stimulating travel club of very nice folks. Its 25th Annual Monetary and Trade Conference was especially exhilarating. Christian Noyer, President of the Banque de France, gave a description of the rationale and direction of the European common currency. Since he was the Euro's driving force right from the beginning, the experience of hearing him was pretty much like hearing Alexander Hamilton tell the story of the founding of the American banking system. Such a notable event needs to be reported.
Christian Noyer urges that the central concept of the European Union is deliberate, voluntary surrender of national sovereignty -- for a mutually beneficial purpose. The declared purpose of limited surrender of national control of the currency is economic; price stability, lower interest rates, the stimulation of international trade by lowering transaction costs. But the unstated, grander, purpose is the elimination of war. Because the limited technical purpose has been achieved in almost all areas, the grander purpose of eliminating war has not been an accident. With this simple, even humble, declaration it immediately becomes possible for a mildly irritated American audience to understand that European reluctance to become our active military ally grows out of a highly commendable set of motives, and widely differing historical experiences.
As things worked out, the new nations who have recently joined the Union ("The U") are anxious to modernize, because the people of those nations demand modernization and their leaders must agree to achieve it. Inflation, that hitherto inevitable fund-raiser for national goverments, must be eliminated in order to join, and stays eliminated because the other members of The U will not tolerate it in a partner. In his curious way, "price stability" has placed the Union on the side of the people against the locally powerful, although it would be untactful to emphasize it. From the elimination of inflation comes lower interest rates, and from that, a stable currency. From that comes economic growth, for which the political lingo seems to be "modernity". As a consequence of this undeniable success, all nations in the area want to join the Union, and none wants to leave it. If that prevailing attitude doesn't lead to the elimination of what might then be a civil war, it's hard to know what will eliminate it. The marvel of all this skillful analysis is how natural, soft and modest it sounds, feeling like an old soft shoe. Eventual political unification is clearly an old dream in Noyer's head, but for now he seems content with the vindication that it is possible to have a currency without having a country control it. It seems to be a steamroller of economic logic, flattening out the pretenses of merely political power.
No less an economist than Martin Feldstein has written that stable unified currency is doomed in the European context of widely diverse labor markets; Noyer seems pleasantly serene in the face of this argument. He wouldn't say so, of course, but some in the audience got the idea that Noyer probably believes the power of this cooperative idea will eventually discipline the unions the way it disciplined the politicians. One certainly hopes so, for the sake of this smooth, cuddly French aristocrat.
http://www.philadelphia-reflections.com/blog/1229.htm
U.S. and E.U. Exchange Experiences (2)
 America can learn about itself from the E.U. 
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To see the economic power of unifying the currencies of Europe, and the political attractiveness of its results among the people of those countries, makes it suddenly more clear why our own Civil War is so often said to be about the Union and not about slavery. Unlike our grandfathers in the Civil War, we take the benefits of free interstate commerce for granted, while for them it was still a demonstrated achievement. Lincoln for example, was an ardent Whig, which in those days meant an advocate of helping commerce by the intervention of government. There is even a shadow of present concern that Americans will have so forgotten the lessons of free interstate commerce that they might somehow surrender it for some other blandishment. Certainly, free international trade has its enemies. The abolition of slavery was of course an overdue achievement, too, but perhaps our long slog toward equal rights has allowed this second crusade to overshadow the history of what really was the main one. In case anyone feels impelled to start a quarrel about this viewpoint, let me remind him that Quakers started the abolition movement, right here in Philadelphia, and have nothing to apologize about.
Going further back, we got our Constitution more or less right before we convinced the public of the economic benefits of unification; eventually we got a bad Civil War. The Europeans learned that complicated words in a Constitution have consequences, suspiciously loaded the proposed document with interminable conditions, and eventually rejected it. It's an old political trap that a proposal so loaded with attractions will often gather more opposition from objectors to multiple small points than proponents for the big points. Keep it simple, senor. If you expect men to die for that document, they have to be able to recite it. If you must make it complicated, just appoint a Supreme Court and wait a little.
http://www.philadelphia-reflections.com/blog/1230.htm
What's a Repo?
On St. Patrick's Day, 2008, Bear Stearns became insolvent and was given to J P Morgan. The Federal Reserve assumed all risks. Effectively, the fifth largest investment bank in America was nationalized for $2 a share, because no private bank would buy it at any price. A year earlier it was worth $170 a share, even one trading day earlier it sold for $26.
At the heart of this catastrophe were "repo's", or repurchase agreements. (They should not be confused with repossessions of cars and other hard goods bought on time, which are also called repo's.) Although most people had never heard of the high-finance version of repo's, the volume of these instruments had grown to $5 trillion by January 2005, presumably even several times larger than that when they caused the nationalization of Bear Stearns. Newsmedia accounts offered the guess that 16% of the resources of the whole financial sector were caught in open repo's when the music stopped. Repo's must be awfully good, or awfully bad.
They were both of these things at once. Like so many innovations in the post-computer era, they offered a major cost saving to an inefficient transaction system, but were so successful they overwhelmed the institutions which flocked to their reduced cost. The unanticipated difficulties might have been imagined, but they were not adequately guarded against. Essentially, these loans limited exposure to a few days, a feature that made them appear quite safe. Unfortunately, tons of these loans could expire simultaneously if a rumor got started and everyone held off using them for a week. With a run on a bank, at least people have to take action to withdraw their money; but with these things, simple inaction quickly led to massive cash shortages at the bank. Speeding up the loan process had made it cheaper, but made it vulnerable.
Consider the inefficient complexities of a bank loan. The bank wants collateral, perhaps 80% of the value of the loan. The ability of the borrower must be investigated, a clear title assured, and papers arranged for transfer in case of defaulted collateral. Lawyers must organize the agreements, and it all takes time, costs money. To go through all this for a one-week loan for anything less than huge transactions is simply not practical. So the idea was devised to sell the collateral to the lender at a discount, together with a repurchase agreement to buy it back at full price. For safety sake, the discount could be greater than the interest cost, and part of it returned if all went well. The collateral could be held by a third party, who essentially guaranteed the details while the collateral itself never moved. Bear Stearns had perfected these variations at such favorable prices they dominated the market for them with hedge funds; the margin for error narrowed when interest rates dropped, cash got scarce when investors got uncomfortable, the whole hedge fund industry was suddenly paralyzed, and everything connected to hedge funds was frozen secondarily. Much of this was handled automatically by computers, so huge volume made it impossible for anyone to know who might be insolvent. It seemed comparatively harmless to decline to play this game for a few days, but it was not harmless if most people decided to do so at the same time. The daily variations of interest rates and/or duration generate a ("Gaussian") normal distribution curve for the risk, predicting serious deviations will occur once every two centuries. But when events --even false rumors -- suddenly get everyone's attention at once, small daily fluctuations no longer bear much relationship to the frequency of violent fluctuations. Once-in-a century events start to happen every few years. At those times, the public stops speaking with a million voices and shouts in unison. Quite often, there is no cataclysmic event to trigger it. Like the conversational babel of a dinner party, it can all stop at once for no particular reason.
The mathematics of this matter could be taught to a tenth-grade math class. It starts to get beyond everybody's anticipation however when two such Black Swan events happen at the same time. In this case, an unanticipated pause for a few days bumped into the rule that non-bank institutions must mark their portfolios to the market every day. But for days at a time in this crisis, there could be no trading in certain issues; there was no market to mark to. How then can you demonstrate your solvency -- what might your competitors be hiding during these unannounced market holidays? And, since banks are in the same pickle but aren't required to mark to market, how can you trust them to pay bills? When you see European banks, who must obey new rules called Basel II, go bankrupt and get nationalized, how can you be sure American banks, who needn't obey Basel II until 2009, are any safer bet?
Progress is progress, but how much of it can we cope with?
The 'repo' market from Marketplace on Vimeo.
http://www.philadelphia-reflections.com/blog/1420.htm
HowTo Create A Subprime Derivative
http://www.philadelphia-reflections.com/blog/1439.htm
Novation
Novation is a term that perhaps nobody but a specialist expert can now define, but is nevertheless destined to be politicised in the coming election campaign to the point where almost everybody could be shouting it like a war cry. That is, unless the hired political consultants decide some other feature of credit derivatives serves warcry purposes better. We're talking sixty trillion dollars here, about five times the size of the domestic American stock market.
Someone owned or thought he owned pieces of paper worth this staggering sum, which can be regarded as side bets on the bond market. Just as in a horse race, where you don't usually own the horse when you bet on the winner, you needn't own the bonds to bet on whether they will default. The side bet is often between two outsiders who acquired their bets through, well, novation. The process begins as a credit derivative, in which someone gets paid an annual sum in return for agreeing to pay off -- if the bond defaults. That could be regarded as a useful insurance policy, making more credit available by making it safer to buy bonds. The bondholder gives up a little interest in return for assurance the bond is now completely safe. Sucker.
Like the Sun Belt mortgage originator, the originators of these derivatives often wasted little time clipping off a fee and passing the carcass to someone else. And that process got repeated until the accumulating fees in the chain slowed the process to a point where the weakest or most reckless holder got into danger. The game might have slowed to the point where it became self-correcting, but what actually seems to have happened is that much of the long-term debt involved was financed by short-term borrowing, and the start of some rumors triggered a run on the bank. Not exactly, of course, but when institutions which had made one-week or one-month loans stopped lending, it only took a few days for the money to run out and Bear Stearns was quickly unable to pay its bills even though it started the week with $18 billion in reserves.
That short description is about the best that can be made out of an opaque situation, based on what the Securities and Exchange Commission is willing to tell reporters about its investigation. More will be forthcoming, and no doubt some villains and fools will emerge with a lot of blame. For example, the price of credit derivatives concerning Bear Stearns debt had been creeping up steadily during the month before the explosion; whether somebody knew something bad, or whether there really was something bad is presently unclear. It's disconcerting to learn that Goldman Sachs was dumping this paper, and JP Morgan Chase was mostly buying it, but it's early days for unfounded suspicions. More will come.
Now to return to novation. We legal novices learn that novation transfer is the same as assignment transfer, except all parties have to agree to novation before it can take place. That's going to make it harder for a lot of people to deny they knew what was happening. The astonishingly large sums involved are apparently not entirely real, because in some way the old debt is not extinguished, and the new debt is merely added to the sum total outstanding. That surely means the same debt is counted several times, and the apparent sum is to some unknowable extent much larger than the underlying reality. This also accounts for the amazing speed of growth. In January 2007 the total was said to be about $25 trillion, in January 2008 it was reported to be $42 trillion, and in May 2008 it was said to be $60 trillion. Things which move that fast can quickly spin out of control, especially when short term creditors need do nothing much for a couple of weeks as their money emerges from the pool. Some people did sell short, of course, but whether that was panic or malicious must probably be left to politicians to declaim.
Surely the most terrifying part of this simple story is that so much money could be moved around without public awareness. When the $25 trillion figure emerged, a number of people asked what in the world was going on, and kept asking that question for eighteen months. Nobody knew nothing.
http://www.philadelphia-reflections.com/blog/1460.htm
Franklin's Admirers on TV
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| Brian Lamb |
There are now three channels of C-span, continuous cable television programs about the influence of history on current problems. Sessions of Congress and its committees, the speeches of the President, political campaigns, are shown as they happen. But interviews and book reviews are shown in parallel, with an opportunity to go into the archives and organize originally unrelated programs into seminars on a current topic. The editor, Brian Lamb, has a light hand and considerable impartiality. But he's there, all right, organizing blogs into topics just as Philadelphia Reflections tries to do.
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| Friends Select School |
This similarity of design had been floating around for some time, but it suddenly came into focus when I recognized myself in the front row of an audience on C-span, listening to Edmond S. Morgan talking at the Friends Select School about his new book on Benjamin Franklin, a few months earlier. Thank goodness I bought a book and had it autographed, because the filming had been so unobtrusive I hadn't noticed it at the time. I clearly need to have haircuts more frequently. Professor Morgan's parting words that evening had stayed with me, "Franklin doesn't tell you everything about himself, but what he tells you -- is straight." That's quite a compliment from the editor of 47 volumes of Franklin's work.
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| Walter Isaacson |
Grouped with this tv portrayal of me as a groupie were interviews with Walter Isaacson and some other Franklin biographers, taken at other times and placing focus on other aspects. Here again, more insights emerged from quickly considered replies to audience questions than from the prepared speeches. Replies to questions from the audience are more in a class with blogs, anyway. Whenever you get all of the adjectives and qualifications polished, you sometimes don't say what you mean. Perhaps that last comment can be rearranged to say that answering audience questions occasionally leads to blurting out precisely what you mean.
And so, two unrelated audience answers need to be linked. A question about Franklin's love life caused Isaacson to refer to Franklin as a lifelong seducer. From the unknown mother of his illegitimate son William, to the simultaneous flirtations with two famous French ladies that took place when he was an octogenarian, and not overlooking several other affairs with Cathy Green and Polly Stevenson and allusions to others, Franklin was obviously an accomplished seducer in the full meaning of the term. It is thus legitimate to suspect the techniques of seduction at work in many of his public projects, from starting the Library Company to persuading the French to help the Revolution. He discovered late in life what many have discovered about the life of a diplomat, and quickly recognized that he was already pretty good at what that seemed to entail. Let's slide to a slightly different application of that idea.
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| Benjamin Franklin and French Women |
By the accident of hostess seating arrangement, I found myself seated next to two historians from Harvard, and somehow it came out that one of them felt that Franklin loved the French. Simply loved them. Somehow that didn't sound quite right when compared with Franklin's early years of mobilizing Pennsylvania to fight the French, starting the first National Guard militia unit to defend Philadelphia against French raiders, supporting General Braddock's expedition with his own money, urging the British government to sweep the French from Canada, and working most of his life to assemble the colonies and Great Britain into one world-dominating entity. It's true that 18th Century France was at the peak of scientific achievement, and Franklin the inventor of electricity was quickly taken in by the European scientific community; but that's scarcely the same thing as loving France. Louis XVI was in fact quite annoyed by all the attention Franklin was receiving. And so the scholar on TV went on to say that correspondence had been discovered in which Franklin quite casually remarked that during the Continental Congress he had strongly argued that America should stand alone and have no European allies. Congress it seems overruled him, so he dutifully set sail for France to seduce them.
We come to another chance social encounter. On a recent trip to Paris, the GIC had taken along as a speaker, no less than a member of the Open Market Committee of the Federal Reserve, a Governor of a Federal Reserve District, to speak about the threat of inflation and currency crisis. In time, our French hosts invited us to look at some documents of interest, like the Louisiana Purchase. Lying on the table was the original treaty between America and France, signed by B. Franklin. The Federal Reserve governor, making small talk, observed that Franklin sweet-talked the French into loaning America too much money, eventually leading to their bankrupcy. As I recall, my rejoinder was, "Well, just print some more paper money, right?" It was intended to be a jocular remark, but it somehow didn't seem to be taken as such.
http://www.philadelphia-reflections.com/blog/1471.htm
Linking to Whither, Federal Reserve?
To skip back to the Whither, Federal Reserve?, click the indicated place below:
» Click here back to WHITHER, FEDERAL RESERVE? (1)«
http://www.philadelphia-reflections.com/blog/1715.htm
Commercial Credit Sinks Globalization
In August, 2007, the world sort of woke up to the housing bubble in California and Florida, along with the ingenuity of securitized mortgages. About $100 billion was involved, and credit markets froze up as the risk premium of low quality loans (relative to U.S. Treasury bonds) gyrated furiously, almost always in the direction of down. There was a staggering amount of credit default swapping, some $60 trillion, but it did not seem to be unraveling. Why in the world did a problem of that magnitude, while admittedly large, lead to continuing panic which was widely believed to require $4 trillion in rescue funds eighteen months later? There were obviously some big missing pieces of this puzzle. Worse than a money panic itself, was the realization that we only understood about 5% of the problem after a year of investigation.
The case in point is that in the fall of 2008, world trade almost came to a total stop. How does $100 billion of dud mortgages in California, discovered a year earlier, do that? It would appear that Lehman Brothers was one of four or five large banks who were so overstretched in securitized mortgage debt that it looked as though they would collapse without huge infusions of government money. The government rescue team knew they could not rescue every bank that looked shaky, and they knew that rescuing anybody carried the risk that this kind of episode would be repeated in the future, as a result of knowing that any sort of risky behavior would be protected by the government treating big banks as "too big to fail". To bring the collapsing markets to their senses, some relatively big bank had to be allowed to fail, and it turned out to be Lehman. The CEO of Lehman afterwards expressed public bitterness that Lehman suffered while others were saved, but it was clear that there were too many people in the lifeboat, so someone had to go overboard or they would all sink. Lehman went bankrupt.
What had not been considered in the choice of Lehman, was its heavy involvement in commercial credit, short-term loans, sometimes only overnight, with inventories as collateral. Because of the huge volume of commercial credit, with extremely fast turnover, the conventional payment mechanism was a repurchase agreement. In a repo, the loan takes the form of a sale with a guaranteed agreement to repurchase in a short time. The mechanics of lending are greatly simplified by actually selling the inventory of, say computer chips, for enough more to pay the interest cost, associated with an agreement that the lender owns the security outright if there is a default by a date certain. The arrangement is very clever and efficient, but it has one flaw: the bank really has no use for a boatload of computer chips. Commercial credit repos had grown to immense size. When the banks encountered a credit freeze, the collateral simply could not be transformed into anything useful to the banks, even though industries throughout the world were on the edge of collapse for lack of components to assemble. It was a dangerous mess, all right.
Underlying all of these moving parts was globalization of the industrial process. It was not very long ago when automobile manufacturers like Ford would own the majority of the steps in the process, down to growing trees to provide wood for the floor-boards. Or IBM would make substantially all of the parts of a computer and assemble them as a a final product. But, in order to take advantage of cheap labor or available resources of other types, pieces of components of cars and computers started being fashioned together in several foreign countries and shipped to another foreign country for assembly. In the most extreme case, only the design and marketing of a product might take place in America, while everything else was assembled in many places. Almost every step of a complex manufacture involved paying the subcontractor for his piece, using the pieces as collateral for a loan to pay for itself. Because a tangible price was being charged for delays in the process, "Just in time" assembly was absolutely essential.Everything had to work like gigantic clockwork, but if it did, it considerably reduced the price and increased the sales of the final product.
The collapse of Lehman Brothers (ultimately triggered by real estate mortgage securities), caused the whole world's manufacturing to come to a halt in just a few days. When the nature of the problem became apparent, it was comparatively easy to patch up, at least by a government savior who had unlimited amounts of money available, and was willing to spend "whatever it takes".
What's left to do, now, is to figure out a system that will prevent international trade paralysis without slowing down or eating up the profitability of globalization. A great deal is at stake in repairing a problem we didn't even recognize as a possibility. And probably similar things remain to be discovered.
http://www.philadelphia-reflections.com/blog/1732.htm
Thieves of Baghdad
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| Col. Matthew Bogdanos |
Col. Matthew Bogdanos, of the U.S. Marines, gave an interesting insight into what the Baghdad Museum really was, how it was captured, and how the treasures were recovered, at the University of Pennsylvania Museum the other night. Our own museum is said to be the second largest archeology museum in the world, after the British Museum. After discovering what was really in the Baghdad museum, that ranking may have to be revised; but the chief Philadelphia interest traces back to the discovery of the ancient city of Ur by Philadelphia archeologists during the last century, an event which essentially created the University Museum. This was where civilization began, and we discovered it.
The reserve Colonel happens to be a prosecutor for the New York District Attorney, was trained extensively in classical antiquities; and so was the perfect point man to lead the capture of the Museum during the Iraq war, very well suited to follow the looted treasures into the international antiques market -- and recover substantially all of it. Something like 62,000 pieces were recovered, and all of Nimrud's Treasure, the prize possession of the museum.
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| The Baghdad Museum |
There has been criticism of our troops -- some of it right out of this Philadelphia audience -- for allowing the place to be looted in the first place. But that sort of assumes the place was lying vacant and undefended while our troops were out shooting innocent civilians. That's a misapprehension quickly dispelled by scenes of real live shooting and rocketing coming out of the place at the time, which the Colonel was happy to display. Questioners were invited to claim they would have been willing to go into that hornet's nest in order to save the alabaster statues, but others in the audience were inclined to give the Marines benefit of doubt.
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| Hussein Millions |
That place was thoroughly vandalized when the troops got into it; in a sense, there was a lot of looting. The big surprise was to find there were hidden storage rooms behind steel bank doors, filled with the best antiques, as well as vast boxes of American hundred-dollar bills. By weighing the hundred dollar bills (22 pounds for each million dollars) it was estimated that Saddam Hussein had about $800 million in U.S. currency stored in that one place. Gold as a raw commodity has since gone up considerably in value since that time, but many of the best antique pieces on display in the museum were only copies, the originals being kept in the secret vaults. The international market appraises quite a few of these pieces at over $10 million apiece. Apparently the thieves knew exactly which pieces were valuable, and went straight to them without even pausing to notice other rooms full of objects of lesser value. The museum had been closed to the public for the previous twenty years; it seems rather obvious that Saddam was storing these objects in order to buy weapons for continuing guerilla activities underground, or in exile. The museum itself consisted of nearly twenty separate buildings in the center of Baghdad, and the custodians obviously knew where things of serious value were kept, in order to get to them so precisely.
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| Nimrud's Treasure |
Offering an amnesty, no questions asked, brought in thousands of recoveries from the local public. Getting other pieces back from art galleries in London, Geneva and Berlin required methods that were not described in detail. Some of us who remember the German and Japanese mementos which were "liberated" during World War II, have an immediate appreciation of the improved American troop discipline which must have been imposed in the Iraq War. That's something to think about, too. Our troops had been given extensive training to respect the cultural heritage of the enemy, and they evidently did so to a remarkable degree. One certainly has to doubt that Saddam was locking that material in vaults for twenty years in order to preserve culture of any sort. If it had any other purpose than to serve as a way of transforming oil wealth into munitions, it's a little hard to imagine what it was.
http://www.philadelphia-reflections.com/blog/1795.htm
