Posts Tagged Federal Reserve
U.S. Credit Card Trap
Posted by Harley in The Economy on August 18, 2009
by Jennifer Barry, GlobalAssetStrategist.com | August 13, 2009
With U.S. household net worth down US$14 trillion since the peak in 2007, Congress has belatedly started to act concerned about the financial condition of the American consumer. In May, legislators passed the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act to great fanfare. The law does end some of the worst abuses, prohibiting an increase in interest rates if a customer is late paying a different company, disallowing most retroactive rate hikes, and banning fees if the bank neglects to credit a payment.
However, if you have revolving balances on your credit cards, this is no time to relax. The law does not take effect until February 2010, giving credit card issuers a window to jack up fees and interest rates. It also fails to set an upper limit on these charges at the federal level. As financial institutions can incorporate in states without legal limits, major credit issuers can continue to charge any rate they wish as long as they disclose it. This permits banks to borrow from the Federal Reserve at a fraction above 0%, paying ridiculously low yields on deposits, while charging their credit card customers many times that percentage. For example, Wells Fargo is currently paying a laughable 0.05% on savings accounts in my area, with a $300 minimum balance.
The newest proposal debated in Congress is the formation of a Consumer Financial Protection Agency, which would allegedly protect the public from unscrupulous lenders. Politicians claim that fraud and risky financial behavior “fell through the cracks” in the regulatory system, even though many of these same individuals advocated for fewer controls a decade ago. Why should citizens believe that the same bureaucrats who failed to stop Bernie Madoff’s Ponzi scheme will act in their best interest?
It’s naïve to expect the U.S. government to take aggressive action against financial institutions, as both political parties receive ample campaign contributions from banks like Goldman Sachs. After all, Congress voted to make punitive changes to the bankruptcy laws in 2005, parroting the industry propaganda that many borrowers ran up their credit cards and then declared bankruptcy in order to avoid repaying their debts. In contrast, Elizabeth Warren’s data shows that 90% of bankruptcies are caused by family breakup from death or divorce, job loss, or health problems, not conspicuous consumption. The real gamers of the system were not borrowers, but the banks themselves.
The law, written by card issuer MBNA, made it more difficult and expensive to discharge debt, and limited the assets that could be protected from collection by unsecured creditors like – you guessed it – credit card companies. Sheltered by legislators, underwriting standards dropped on all sorts of consumer loans after the passage of this law. The banks were able to continue their pyramid scheme of packaging poor quality debt as AAA rated securities, selling it to trusting investors, and using that capital to make even more bad loans. Ratings agencies like Standard & Poors were complicit in the scheme, using the banks’ own models to evaluate these derivatives.
When this house of cards finally came tumbling down, it wasn’t the consumers who were helped, but rather the banks who cynically gambled with shareholders’ capital. Legislators allowed institutions to get “too big to fail” by eliminating protections like the Glass-Steagal Act in 1999, then threw trillions of dollars at these same banks when they later became insolvent. As Allan Sloan puts it, Wall Street’s attitude is “heads I win, tails I get bailed out.” Even sadder, the American taxpayer is still vulnerable to further “rescues,” as the mega-banks have not been chopped into manageable pieces, and they are still permitted to takeover their smaller insolvent rivals.
In reality, there is no need to create additional agencies or new burdensome regulation. There are plenty of laws against cheating and stealing on the books, just a lack of enforcement. For example, the FBI could have prosecuted financial crimes but much of the agency was diverted to fighting terrorism after 9/11. The CFTC pretends it doesn’t see the obvious manipulation in the precious metal markets, while the SEC has resisted prosecuting naked short sellers.
While Congress intervenes overtly in the credit markets, the Federal Reserve is acting as a debt pusher behind the scenes through the Term Asset-Backed Securities Loan Facility, or TALF. As this initiative is administered by the Fed, it lacks even minimal Congressional oversight. When the credit markets froze last year, the Federal Reserve designed this program to give loans to investors who want to buy consumer debt instruments. The Fed’s intervention increases the moral hazard in the economy by creating an artificial market for these derivatives. If lenders did not have a market for consumer debt, they would have to cut credit lines and close accounts. This would force fiscal austerity even in people reluctant to slash discretionary spending. However, beneficiaries like Cabela’s, a sporting goods company, are now marketing additional credit to customers, backstopped by Federal Reserve guarantees.
Chairman Ben Bernanke claims that TALF and similar bailouts are “emergency programs” that will be terminated soon, but their influence is already warping the business environment. Subsidies choose winners and losers, swamping any competitive advantages. Large corporations have an advantage over smaller companies, as they can afford to fill out the paperwork and lobby for access to bailouts. This crushes new innovative businesses, dampening job creation.
Despite the Federal Reserve’s disastrous stewardship, Congress plans to convert it into a “super-regulator,” giving it even more control over the U.S. economy. The Fed already has few checks on its power, as it is a private entity, not part of the government as many believe. In addition to driving monetary policy, it would gain “sweeping new authority to regulate any company whose failure could endanger the U.S. economy and markets.” This change would “sidestep most jurisdictional disputes” and centralize the economy under the direction of an unelected non-governmental body run by the banks.
The Democratic leadership intends to push this through Congress quickly, in what I think is a reaction to Dr. Ron Paul’s successful Audit the Federal Reserve campaign. He already has enough co-sponsors to pass his bill in the House of Representatives if it were allowed to come to a vote, but party leaders have blocked it. If the Fed gets to captain the economy, it can refuse to account for its actions as a matter of national security.
For years, the American people have passively allowed the banks to rake in obscene profits on the backs of the taxpayer. Finally, we are seeing some grassroots resistance to this blatant favoritism, with “tea party” protests and angry constituents confronting their representatives at formerly placid town hall meetings.
Unfortunately, this awakening is too late to prevent the destruction of the U.S. dollar. The debt bubble has already burst, and the attempts by the Fed to reflate it have created an enormous burden on the U.S. taxpayer. Since I first detailed the bailouts last October, obligations have ballooned from approximately US$2 trillion to an incredible $23.7 trillion according to Neil Barofsky, the special inspector general of the Troubled Asset Relief Program (TARP).
Don’t expect any government agency to protect you from the coming hyperinflationary depression in the U.S. Now is the time to reduce your debt, sell off unwanted assets, and live below your means. During times like these, paper assets have historically performed poorly, so move your savings into hard assets like the precious metals instead.
Copyright © 2009 Jennifer Barry
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You Say You Want a Revolution?
Posted by Harley in The Economy on August 6, 2009
“The following article by Rusty McDougal is a must read & further proof that people had better educate themselves financially & take control of their finances. That’s what our Elite Wealth Plan does along with a lucrative cash flow business opportunity.
Rusty McDougal – You Say You Want a Revolution?
Americans should have been in the streets to reclaim the country long ago. Patrick Henry and his fellow patriots are turning over in their graves about the present day USA. The savvy folks I talk to on a regular basis are exceedingly pessimistic that our blessed republic can pull out of this present financial, economic and political tailspin. The US as we have known it is on the ropes.
Our third President and signer of the Declaration of Independence, Thomas Jefferson, long ago stated …”Banking establishments are more dangerous than standing armies”.
He also declared …“If Americans ever allow banks to control the issue of their currency, first by inflation and then by deflation, the banks will deprive the people of all property until their children will wake up homeless.”
Hello.
A second American Revolution is now at least as necessary as the first one was though few citizens have an overall understanding of the problems we face. Anything short of a complete house cleaning will be mostly a waste of time and effort. The elitist banking entities running and ruining this country must be shown the highway. Nothing less will suffice!
Who exactly am I talking about? The Federal Reserve is exhibit one. Their partners in financial crime like Goldman Sachs (NYSE:GS), JP Morgan Chase (NYSE:JPM), et al absolutely must be excised like the cancer they are.
“Tea Parties” are once again on the horizon. Lots of citizens are awakening and protesting. How keen is their focus going to be?
Those that put the preponderance of blame on President Obama, ex-President Bush, the Liberals, the Conservatives, the Trial lawyers, the unions or any other distraction will never accomplish anything worthwhile. The rot is deep, systemic and centered on money and the banking system.
Those that demonize Republicans and worship Democrats, or vice versa, have been suckered into a divide and conquer plan. My expectation is to never again vote for a Republican or a Democrat in their present form. The Demofrauds and the Republishams must go.
The Fed is a serial bubble blower. Their funny money products initially line the pockets of their cronies closest to the trough. From there it is directed towards distorting prices in stocks, real estate or the latest manipulated craze. Economies without foundation inevitably collapse. Our central planners need to take an indefinite overseas vacation.
America’s biggest exports over the last decade have been toxic and fraudulent financial products. The creators of this crap are the ones who have brought us to the present disaster – yet they remain in charge of sweeping changes designed to perpetuate their power and imprison us.
All of these Wall Street entities and the lackey politicians who support them must hit the road. Those behind the scenes pulling the strings have to be stripped of their illicit power.
Surely you heard about Goldman Sachs’ record second-quarter earnings of $3.44 billion? Making money hand over fist comes fairly easy when you get to implement official policy. Records follow when front running is the name of the game. They may get their bonuses now but ours will be even larger when tar and feathers once again hold sway.
Congressman Ron Paul has sponsored a bill to audit and put congressional oversight on the Federal Reserve. 261 representatives have so far signed on to this meaningful element of true change. A similar Senate bill is just getting started. Knowledgeable citizens seriously doubt the Fed could withstand an audit because of its shady dealings. This is one bill that holds some promise.
The huge majority of US citizens are really peeved, justifiably so. That anger will certainly play out in the coming months and years. The tea parties could even spill into the streets. You can rest well assured that nothing will be accomplished without a purposeful and focused anger.
Concerned Americans have a critical choice. We can rid the system of all the parasites and malignancies or just stay home and continue to get our reality through television.
You know by now I’m also going to advise you to protect yourself and those you care about. The monetary metals, gold and silver, sniff out economic, financial and monetary chaos. They’ve had a massive snort lately and more is coming. These precious metals have appreciated nicely almost every year of this decade for good reason. They should still be purchased and the speculators amongst you may consider my Resource Windfall Speculator for leveraged gains in the resource sector.
Live Free and Resourcefully,
U.S. Economic Outlook
Posted by Harley in Financial Education, The Economy on July 30, 2009
By Steve Christ
Thursday, July 30th, 2009
Before the bulls break out the champagne here, I would warn them not to get too far ahead of themselves.
After all, euphoria is a dangerous emotion that can lead to big losses — in this market, or in any other, for that matter.
And as for Dennis Kneale’s breathless prediction that the “recession is now over,” the picture on that score is about as clear as mud. . . the U.S. Economic Outlook is murky, to say the least.
What is crystal clear, however, is that our problems are actually getting worse, not better. Fundamentally, is as bad as it has ever been — even though the bulls have broken out the party hats, insisting that somehow the markets really can grow to the sky.
Of course, we know otherwise. If only it were so. . .
Instead, I’m firmly in the camp that believes a “new normal” has begun, and it’s based more upon frugality more than frivolity.
That’s because as unemployment surges, home prices continue to drop, and more wealth evaporates, consumers are more likely to try a least to live within their means. . . no matter how hard that may be.
As a result, without an uptick in jobs and a boost in income, a repeat of the debt-financed binge we just lived through simply isn’t going to happen.
It can’t be recreated either — even though the Fed is trying its best to do just that.
So, what we’re essentially left with is a classic case of a reluctance to borrow or consume: a big problem, since that is what the lion share of the U.S. Economy has been based on since 1982.
As a result, we have too many cars, we have too many houses, and we have too many debt holders teetering on the brink.
What we don’t have — or what we have a lot less of — are people with the cash flow to support it all. Sure, money still exists and there is lots of it, but it has very little velocity when a nation of “Good Time Charlies” suddenly turns frugal.
That being said, I thought we would play a game of connect the dots today as we view the current rally not only with awe, but also a deep-seeded suspicion.
Here are nine reasons why the champagne will have to stay on ice for the time being. . .
9 Hurdles to the U.S Economic Outlook
1. The Wealth Effect in Reverse
During the heydays, rising asset prices were all it took to get consumers to spend themselves into deeper into debt. However, these days the reverse is actually true.
Because according to the Federal Reserve, U.S. household net worth fell by $1.3 trillion in the first quarter, proving that green shoots are something of a fairy tale — at least for the American consumer.
In fact, since its peak in the third quarter of 2007, household wealth has decreased by 21.6%, or more than a fifth. That is the most dramatic fall in the series since reporting began more than 50 years ago.
Yet somehow, the bulls keep pounding the table, saying there is light at the end of the tunnel, even though consumer spending is over 70% of the U.S. GDP. The truth is when taking huge losses, belts usually get tightened, not loosened.
2. The Heavy Chains of Debt
Meanwhile, consumer debt is still off the charts. In fact, household debt as a proportion of disposable income hit 133% as the recession began. Since then it has eased a bit to 128%, but its still way too high — not to mention unsustainable. At minimum, consumer debt should be 100%, and even that is a slippery slope.
By comparison, the consumer debt level coming off of the tech bubble in 2003 was around 85%, which tells you where all that “growth” came from: Households levered up. This time that’s impossible — for a whole host of reasons. So the while the FED has cut this rate to zero, it hasn’t done much to get people to the mall this go-round. . .
So just looking at it from a balance sheet perspective, either wages have rise quite a bit or debts have to be reduced dramatically. Otherwise the numbers for the average consumer just won’t add up.
3. Rising Unemployment
On a day when the stock market shot up by more than 250 points two weeks ago, the Fed minutes from June were quite a bit more sobering. Unemployment, according to the Fed, will top 10% this year. . . while most Fed policy makers said it could take “five or six years” for the economy and the labor market to get back on a path of full health in the long term.
So it looks like 2015 will be the year to look forward to. At best, the recovery will be jobless — which makes you wonder how it could be called a recovery at all.
Here’s betting unemployment tops 11%.
Meanwhile, 7.2 million people have lost their jobs since December 2008, making this the only recession since the Great Depression to wipe out all of the job growth from prior periods of expansion:
By the way, the real unemployment rate, or U-6, is 16.5% It accounts for those poor folks who are unemployed but are so discouraged that they have stopped looking.
4. Tax Revenues are Plummeting
Calfornia’s fiscal woes are only the tip of the iceberg. Falling tax revenues in 45 of the 50 states have left all of them facing fresh budget shortfalls.
In fact, according to a recent report from the Rockefeller Institute of Government, tax collections dropped by 11.7 % the first quarter — the largest fall on record. Meanwhile, early figures for April and May show an overall decline of nearly 20 per cent for total taxes. That will undoubtedly reduce demand and slow down the recovery, since government spending acccounts for 18% of U.S. GDP:
As for the Federal government, there has been a 22% drop in individual tax receipts so far this year, along with a 57% drop in corporate taxes.
In short, while the government is always out of money, it has never been close to this bad. Without the printing presses, we would already be bankrupt.
5. Rising Prime Mortgage Defaults
Remember when subprime mortgages began to blow up? Of course you do. . . that’s old hat at this point. Today, those defaults have moved right on up the value chain.
Delinquency rates on the least risky mortgages more than doubled in the first quarter from a year earlier, as prime mortgages 60 days or more past due climbed to 2.9 percent through March. Serious delinquencies on prime loans, which account for two-thirds of all U.S. mortgages, rose to 661,914 in the first quarter from 250,986 a year earlier. Meanwhile, mortgages 60 days or more past due rose 88 percent from last year.
The good news is this is the last of the mortgage dominos. After prime mortages, there’s nothing left to fail. Unfortunately, this is the biggest domino of them all.
6. Oh, but Wait. . . I Forgot about Option ARMs
As my pal Ian Copper has been writing for some time now, Option ARM resets will be tougher for the economy to handle than subprime and we will see greater numbers of bank failures, foreclosures, delinquencies, and economic hardships because of it.
What should concern you is that about $750 billion worth of option ARMs were issued between 2004 and 2007 and will begin resetting shortly. Worse, as of December 2008, about 28% of option ARMs were either delinquent or in foreclosure, according to reports.
But here’s the kicker: nearly 61% of option ARMs originated in 2007 will eventually default, according to a Goldman Sachs report. And due to the way these mortgage nightmares are structured, the rest of them won’t fare much better.
61%??? That’s enough to make a banker take a leap.
7. Next Up: The Credit Card Debacle
According to reports earlier this month, credit card losses are continuing to accelerate with Capital One reporting that write-offs have reached 9.4%. . . with no end in sight. Meanwhile, American Express Co., the largest U.S. credit card company by purchases, wrote off 10 percent of its own loans.
Simultaneously, revolving credit totaled $939.6 billion in March and the Federal Reserve reported that 6.5 percent of it was at least 30 days past due. That is the highest percentage since the Fed began tracking this number back in 1991.
What has evolved is an environment where banks are much less eager to hand out the plastic, since the business isn’t exactly what it used to be. And as a result, banks sent out only about 500 million credit card solicitations in the first quarter. That is fewer than in any year since 2000, as overall available credit shrinks.
And when the credit card swamp finally gets drained, a “new normal” will be here to stay.
8. The Commercial Real Estate Crash
At this point in the cycle, most people recognize that commercial real estate is following the same exact path as the housing bubble — the exact same path!
And we all know how that one turned out.
In fact, losses on commercial loans could reach as high as $30 billion by the end of the year as property values plummet, rents decline, and defaults reach record levels. All of this is a recipe for disaster. . . and industry leaders have estimated that 200,000 businesses and 10 percent of the nation’s shopping malls will shut their doors over the next year.
That means that we’re maybe only in the second inning here as this crisis unfolds.
So, with roughly $530 billion in commercial mortgages coming due for refinancing in 2009-2011, and some estimates showing that as many as 68% of loans maturing during that time will FAIL TO QUALIFY for refinancing, you have to wonder how it will all get done.
The short answer is. . . it won’t.
In fact, as Federal Reserve Bank of Atlanta President Dennis Lockhart said earlier this year, the mortgage bonds due this year and next “are coming up against capital markets not active enough to deal with those maturities.”
When that happens. . . big companies go under.
9. The Ghost in the Machine
Here’s a chart that speaks for itself. It is a measure of U.S. Industrial capacity that shows almost one third of US industry is now sitting idle:
Enough said.
Now if there is a pony somewhere in all of that mess, I just can’t find it. And I haven’t even brought up the prospect of higher taxes through cap and trade, or what a massive health care package will do to small businesses.
Meanwhile, I think we are going to find out this fall that the government doesn’t have any of the answers after all.
Besides, violent bear market rallies are entirely commonplace. In fact, some of strongest occured after Black Monday in 1929.
Take a look:
So while the bulls have had their way here lately, the bigger picture lurks in the background.But to see it, you have to have the courage to connect the dots.
That means that now, more than ever, it’s a stock picker’s market — especially if you have a taste for champange.
Your bargain-hunting analyst,
Steve Christ, Investment Director
P.S. According to Moody’s, commercial real estate values around the country have dropped 35 percent from their peak in October 2007. But that’s just the beginning. . . the decline appears to be accelerating. In fact, values have dropped by more than 15 percent over April and May. To learn more about how to win big as commercial real estate crumbles, click here.
Option ARM Resets
Posted by Harley in The Economy on July 15, 2009
Presenting the Most Profitable Event of the Next 2 Years
By Ian Cooper
Tuesday, July 14th, 2009
Investors are getting it. . .
In fact, they’re figuring out what the bullish talking heads of CNBC can’t—or won’t.
It’s what we’re calling the biggest profit opportunity of the next two years.
Of course, CNBC’s goons aren’t the only ones to miss it. . .
Remember when Richard Fuld told us the worst of the crisis was “behind us”?
Or when FDIC Chairman Sheila Barr said we were in the 7th inning?
Or when Morgan Stanley said we were in the 3rd?
See a pattern developing here?
You see, the worst is far from over. The President is aware of this. Even the director of the president’s National Economic Council believes the worst isn’t over, saying, “‘It’s very likely that more jobs will be lost. It would not be surprising if GDP has not yet reached its low.”
So, what is it CNBC bulls know that we don’t?
Nothing. They’re pandering to the corporate elitists who sign their checks. And what they’re not telling brings us to…
The most profitable event of the next 2 years…
As we’ve been warning for months, the next phase of the real estate disaster is upon us. It’s just shifted from subprime to Option ARM.
And with many economists predicting unemployment will rise into the double digits, foreclosures will only accelerate, which will add to bank losses, which will add pressure to the financial system and broader economy.
The Fed is well aware of what’s coming. Why do you think they’re so desperate to pump up the economy before the next fiasco?
Truth is, the amount of debt wrapped up in these Option ARMs is much worse than that of subprime. And if the government or the banks fail to understand this, the second round we’ve been warning about will begin and banking instability will wreak havoc yet again.
Option ARM resets will be tougher for the economy to handle than subprime. And we will see greater numbers of bank failures, job losses, foreclosures, delinquencies, and economic hardships.
Honest.
Look at what the Wall Street Journal had to say this weekend:
For the third straight month, option adjustable-rate mortgages are generating proportionally more delinquencies and foreclosures than subprime mortgages, the scourge of the housing crisis.
A further acceleration of troubles among the loans could mean higher-than-expected losses for Wells Fargo & Co. (WFC) and JPMorgan Chase & Co. (JPM), as well as the Federal Deposit Insurance Corp.’s own insurance fund.
“The realization of the issues related to option ARMs is just beginning,” says Chris Marinac, director of research at Atlanta-based FIG Partners.
The Year of Option ARM Resets. . . and Why There’s No Foreseeable Bottom.
Just as 2007 and 2008 were the years of subprime woes, this one will go down as the year of Option ARM resets (or adjustable rate mortgage resets). With billions in Option ARM resets in 2009 and 2010, this crisis is about to unleash a fury no one’s prepared for.
It won’t be as bad as subprime, of course. It’ll be worse.
That’s because lenders created these ARMs with “teaser” features for borrowers, which included making lower minimal payments for the first few years before the loan reset to a higher payment schedule. And if that weren’t bad enough, there was another feature called “negative amortization,” which meant you weren’t paying back any principal.
In fact, with negative amortization loans, your loan balance increased over time. Incredulously, every time you made a payment, you owed the bank even more. These are the loans that allowed consumers to buy houses they couldn’t otherwise afford.
As for speculators, they may use negative amortization loans if they believe prices will increase at a fast pace. But with the opposite happening, they’re out of luck.
And the banks will be left holding the bag.
What should concern you is that about $750 billion worth of option adjustable mortgages (option ARMs) were issued between 2004 and 2007. . . and will begin resetting shortly. And banks like Bank of America, JP Morgan Chase, and Wells Fargo are in for a rough ride, given their exposure to option ARMs.
Worse, as of December 2008, about 28% of option ARMs were delinquent or in foreclosure, according to reports. Compare that to the 23% default rate in September 2008. And nearly 61% of option ARMs originated in 2007 “will eventually default,” according to a Goldman Sachs report.
What will happen is this: many borrowers, if they haven’t already, will start throwing in the towel as they realize just how far under water they really are. And the likes of JP Morgan (JPM) could be heavily and negatively impacted.
One thing’s for certain. . . we’ll be paying for someone else’s mistake yet again.
Good Investing,
Get Ready for Inflation and Higher Interest Rates
Posted by Harley in Financial Education, The Economy on June 10, 2009
The unprecedented expansion of the money supply could make the ’70s look benign.
Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be “wasted.” Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.
Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.
With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.
But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.
About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.
The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!
Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.
Banks are required to hold a certain fraction of their liabilities — demand deposits and other checkable deposits — in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren’t able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.
The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company’s IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank’s sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed “stress tests” on banks are nothing more than checking how well a bank can weather differing levels of default risk.
What’s important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases. For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.
At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.
With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.
It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.
Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.
Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury’s planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.
In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it’s a Hobson’s choice. For me the issue is how to protect assets for my grandchildren.
Mr. Laffer is the chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen” (Threshold, 2008).
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Printed in The Wall Street Journal, page A15
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