“The Federal Reserve is in business to create moral hazard.” Harvey Rosenblum from the Dallas Fed. This whole video makes me want to rush for the heads and throw up. This is why we are so screwed. The Fed keeps trying to deliver an economy which is not real, by creating an illusion of safety and persuading lenders that they will be saved from the consequences of excessive risk. Distorting credit risk is a bad idea, because it does not eliminate the real losses, as we are finding out. It just causes risk to be mispriced, so that when the losses do come, they are lethal, because credits were written too cheaply and there is no cushion from the fat spreads that should have been charged.

The Fed’s proposition is that it is both a lender of last resort, and the controller of interest rates, and it will use these powers to make the world a safe place for lenders. A lender of last resort can certainly provide liquidity, but that does nothing to offset credit losses, which destroy capital.

The Fed’s strategy to deal with capital losses has been to increase bank earnings by cutting short rates, so that the banks can rebuild capital by borrowing short and lending long (in the past this has meant buying long Treasuries, which carry no credit risk and therefore use less capital than other assets). But this only works so long as the lenders can continue to expand their balance sheets, in other words as long as they can be made profitable despite their credit losses. And, of course, it helps the banks at the expense of everyone else, discouraging saving and investment and encouraging over-consumption. But now so much capital is being destroyed that lenders can only borrow at high rates, closing off this traditional remedy for the lending excesses caused by the Fed’s moral hazard. You can’t make a positive carry with Treasuries at 4% or so when you have to pay 5% on a CD (APY, rate 4.89%, WaMu, today, 1-year CD, per bankrate.com). We are facing a depression because the financial system has been encouraged to be over-leveraged, a “Bridge Too Far,” with too much liquidity and not enough capital.

How can these people be so incredibly stupid?

Edit: WaMu trawling for dollars. (credit CR)

Probably the most powerful meme in the market today, held by both bulls and bears alike, is the belief that the Fed can inflate at will. Of course, to some extent it is always true. The Fed can print physical currency in vast quantities, which leads to the pictures of people buying their groceries with wheelbarrows (Weimar Germany) or backpacks (Zimbabwe) full of bank notes of staggering denominations.

However, it is my opinion that, despite his words, Mr Bernanke doesn’t want to be associated with Mr Mugabe’s economic theories and so he will not resort to physical currency printing on that scale. Therefore, if he is to inflate the “electronic money” supply, he needs to work through the banking system, because the “electronic money” supply is credit - bank credit. Just as a reference point, M2 is about $7.7 trillion, and the currency supply is about $0.77 trillion, so the “electronic money” supply, at least basis M2, is about nine times as large as the currency supply. Arguably, there are many other liquid assets that fill the role of money but the essential point is that any expansion of the “electronic money” supply depends upon an expansion of bank balance sheets. Which depends, in turn, on an expansion of the banking system’s capital base. With 60% or more of their collective assets dependent on real estate-related lending, the banking system is losing capital, not expanding. This is exactly what happened in Japan. The BoJ flooded the banking system with reserves, but banks crippled by loan losses could not expand their lending and deflation lingers to this day. In the end, the Japanese government took steps to recognize the losses with a program very similar to the RTC which cleaned up the Texas S&L massacre, and re-established a healthy - but smaller - banking system. It is worth noting, by the way, that M2 has essentially stopped growing since March of this year, and M3 has begun to fall.

But, you say, the price of just about everything, especially food and energy, is going through the roof. True enough. But that’s not inflation. “Inflation is always and everywhere a monetary phenomenon” said Milton Friedman, and they gave him a Nobel Myrdal prize, so he must have been correct. And even price inflation is about the “general” price level. While the prices of corn and crude oil have been going up, the prices of houses have been falling - about 15% in the last year, according to the S&P Case-Shiller index released this morning. Housing constitutes 23 percent of the CPI, but is measured with a ludicrous and arbitrary measure called “Owner’s Equivalent Rent“. If the CPI were calculated with a proper measure of housing costs, core price inflation would probably be negative, although food and energy price increases would have kept the headline number higher.

But the food and energy price increases are probably transitory, because they are primarily a result of speculative activity. Yes, China and the rest of the developing world have increased their consumption of resources, but the price signals have been doing their work and Americans have been reducing their consumption by, for example, reducing their driving by more than 5% over the last year. The inflation meme has led a lot of people to want to hedge their assets against inflation, leading to the creation of “real asset” or commodity index funds which simply stay long various commodities, usually by rolling huge futures positions. These funds of course have driven up prices, because the commodity supply couldn’t increase fast enough to absorb the influx of money into these funds. Then of course the folks who put money into these funds thought they were incredibly smart as they caused the inflation that they set out to hedge against. There couldn’t be a better example of George Soros’ reflexivity idea:

The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

It is ironic that this whole idea of real asset funds was started by Jim Rogers, who was Soros’ right hand man for many years. But I digress. Price signals in commodities adjust both demand and supply. Energy is probably one of the slowest to respond, but it is well established that supply responds to price signals with a two to five year lag and five years ago, crude oil was under $40. This is not to say that we don’t have a long term supply issue with oil, we do, but for the time being I expect to see energy prices continue to fall. This will bring price inflation more in line with monetary inflation - moving from disinflation to outright deflation.

The true threat to the economy is not the Fed printing currency, it is the slow collapse of the financial system, starving consumers and businesses of the credit that has been the fuel of growth, bringing about an economic dark age. It is, however, the Fed that caused the collapse of the financial system, by encouraging it to over-extend itself. 

The mainstream press and the victim-seeking politicians continue to understate the role that fraud has played in the property bust. A CNNMoney piece calls out the ongoing lying and scamming: 

With the housing market in turmoil and lending standards tougher than ever, you’d think that the kind of unscrupulous activity that helped plunge the industry into crisis would be a thing of the past.

You’d be wrong. Mortgage fraud is still soaring, according to a new report from the Mortgage Asset Research Institute (MARI), a division of ChoicePoint. 

Now that the taxpayers have bought FDIC Chairman Sheila Bair a bank, IndyMac, she is trying out her ideas on how to run a bank. At our expense, of course. Chiefly this seems to be a “pay what you can” policy for borrowers, sort of like a soup kitchen. Send in 38% of your income.  Just another opportunity for fraud, in my view. Now the race will be on to understate incomes instead of overstate them.

The problem is that the FDIC is clearly settling in to run this bank indefinitely. As usual, the bureaucrats think they know better. Can we presume that the banking system will be stealthily nationalized, that is, as banks fail, they will become government agencies as IndyMac clearly has, vague talk of a future sale notwithstanding?

Edit: Further on this subject, Tanta at Calculated Risk:

If, as I fully expect, they don’t do any better at making a silk purse out of a sow’s ear than anyone else can, maybe Sheila Bair will quit pontificating about a subject that remains a lot harder than she thinks it is. That, too, we could all get behind.

I’m not a big fan of M3 as being predictive of anything very much. The Fed dropped the series for that reason. However, others still calculate it and its growth has been a favorite indicator for those who believe that the Fed is covertly printing or something. Interestingly, the Telegraph reports that M3 is now dropping. I don’t think this means anything much, but it will be interesting to see how the inflation advocates spin it.

The US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown in coming months.Data compiled by Lombard Street Research shows that the M3 ”broad money” aggregates fell by almost $50bn (£26.8bn) in July, the biggest one-month fall since modern records began in 1959.

“Monthly data for July show that the broad money growth has almost collapsed,” said Gabriel Stein, the group’s leading monetary economist.