Malinvestments

It’s not QE2 exactly … QE-Lite maybe?  Whatever the case, the Federal Reserve made it official today that its board has decided (almost unanimously, as usual) to begin a new regime of “Quantitative Easing” (formerly known as “money printing”) and purchase some 340 billion in U.S. government debt*. The Fed assures us that its strong commitment to financing the government will make us all wealthy, productive, and happy.

Behind the scenes, there’s evidence that the Fed’s board has recognized that it has entered a kind of monetary Bizarro World in which most of what it once took for granted has been turned upside down. (Situations like this usually don’t end well.)

Exhibit A is the Fed’s Zero Interest Rate Policy (ZIRP). The Fed, of course, sets the “overnight” interest rate at which its member banks lend to one another; this has been one of its chief means of indirectly “managing” the U.S. money supply. Fed logic would tell us that if banks earn nothing by lending to their peers via the Fed, then they’d be incentivized to lend to businesses and individuals. ZIRP should “goose” the economy, expand credit and capital investment, and ultimately lead to higher prices.

I refrained from commenting on the passing of the recent financial reform bill for the simple reason that my reaction was much like that of other undeceived libertarians and conservatives: the people who laid the foundation for the crisis, Geithner and the Fed, are the ones empowered by the bill.

But over the past few days, some lesser known provisions in the bill have come to light that deserve analysis.  As reported by Investor’s Business Daily (and picked up by American Renaissance), the “Restoring American Financial Stability Act of 2010” will require that Washington institute all sorts of new affirmative-action and racial-preference programs in the industry it recently bailed out.

Yes, the bill gives Treasury the power to liquidate banks that pose a threat to financial stability. But it essentially exempts minority-owned banks and those approved by Acorn-style urban organizers.

“The orderly liquidation plan shall take into account actions to avoid or mitigate potential adverse effects on low-income, minority or underserved communities affected by the failure of the covered financial company,” it says.

{snip}

Sen. Richard Shelby and other GOP conferees moved to strike the language, arguing that making an exception for minority neighborhoods defeats the whole purpose of reform, which is to protect all consumers against systemic risk.

But Sen. Chris Dodd, who’s running the conference committee with his fellow Democrat, Rep. Barney Frank, shot them down by suggesting that they wanted to deny minorities access to credit.

{snip}

Studies show that CRA home loans have much higher failure rates. {snip}

Another section of the bill requires the proposed Financial Stability Oversight Council (headed by the Treasury secretary) to consider a zombie institution’s “importance as a source of credit for low-income, minority or underserved communities” before winding it down. {snip}

{snip}

The bill mandates placement of a diversity czar in each federal financial agency—including the Fed and its 12 regional banks.

Establishing a so-called Office of Minority and Women Inclusion within each agency is the idea of Democratic Rep. Maxine Waters, a Congressional Black Caucus leader and conferee.

According to her amendment to the bill, “Each agency shall take affirmative steps to seek diversity in the workplace of the agency, at all levels of the agency,” including:

* Recruiting at “historically black colleges and Hispanic-serving institutions.”

* Recruiting in urban communities.

* Placing ads in African-American and Spanish newspapers.

* “Partnering with organizations that are focused on developing opportunities for minorities.”

{snip}

Each agency, in turn, is required to report to Congress detailed information describing the actions it took to diversify its staff and contract with minority-owned firms. Which means they’ll do what their diversity officers advise. No official—particularly no regional Fed bank president—wants to be dragged before Barney Frank’s panel and accused of racism.

Still, as insurance, the bill also calls for an audit of Fed “governance” to examine, among other things, “the extent to which the current system of appointing Federal Reserve bank directors effectively represents the public without discrimination on the basis of race, creed, color, sex or national origin.”

I don't agree with all of the contentions of the market forecaster and "Elliott Wave" theorist Robert Prechter -- who has, by the way, recently predicted a sub-1000 Dow! -- but I think he is absolutely correct when he notes that bear and bull markets have something to do with efficient pricing and the rational distribution of capital and a whole lot to do with the herding of people (or rather their money) into and out of various asset classes.  

There's an old story (I've heard it retold in multiple variations) of a Wall Street tycoon who in September 1929, noticed that his shoe-shine boy was peppering his daily chatter with various stock tips and revelations of "sure winners." The pinstriped mogul concluded that when shoe-shine boys are dabbling in equities, the market must be massively over-bought. He went up to his office and sold everything and was unaffected by the subsequent crash.

When I was in college, I was much like the proverbial shoe-shine boy: I had turned a few thousand into 20 grand in unrealized profits by buying dot.com companies I knew little about. I was very proud of myself. I, of course, ended up significantly poorer than I began once the bubble in Global Crossing, eToys, Lucent Technologies and the like finally burst. I remember my mom telling me that it wasn't just greedy undergrads who had entered the market: her handyman had apparently opened up an Ameritrade account and was buying stocks on margin! I assume he didn't fare much better than I did.

The point here is that major tops, bottoms, and turning points occur at moments of absolute certainty on the part of the general public. Remember back to the mid-2000s when you'd get instructed by women at cocktail parties about how "housing only goes up" and "it doesn't make sense to rent." It was a good time to sell your house. Moreover, once the go-with-the-flow Business Week reported on the "death of equities" in 1979, a wise man would have concluded that it was the right time to start loading up on stocks.

Bad advice: Time, July 13, 2005; Business Week, August 13, 1979. (Image: Market Oracle)

When Daniel Gross of Newsweek -- a useful font of liberal conventional wisdom -- reported last April that "America is Back!" he sounded a unequivocal sell signal for all who have ears to hear. 

I mention this because there are compelling reasons to believe that we are about to experience a horrifying deflation/inflation whiplash.

Most everyone has been convinced of falling (or at least, stable) prices in assets. This has inspired some good behavior. With the exception of the federal government, most individuals, businesses, states, and municipalities have been de-leveraging: that is, selling assets, liquidating or retracting credit, reducing inventory, and saving money. Among economists and market watchers, "deflation" (defined here as falling prices in goods and assets) is reality, inflation but theory.  (And this despite the fact that the Fed has doubled the monetary base over the past two years.)

Cash is now king, but at some point soon, everyone will be trying to get rid of his cash, on any and everything, in fits of hysteria. 

I am not predicting that this will happen in the coming months; and it might not occur for a couple of years. (I am confident that run-away inflation will occur within the next decade.) What I am stressing here is that this dramatic shift in public sentiment will occur in a flash of the eye, spontaneously, seemingly overnight. 

It's worth noting that, as Ambrose Evans-Pritchard reports, at this point of widespread fear of falling prices, some insiders have become curiously interested in the Weimar hyperinflation. 

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot). [As of this writing, the Amazon marketplace has the book available for $229!]

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck. People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

When hyperinflation hits, who knows how much these books will go for?

One of the many reasons I don't think Tom Woods's "nullification" strategy will be effective is that quite a few -- perhaps at some point soon all -- of the 50 states will require federal bailouts. Forty-six currently have budget short falls. Even the state with the strongest tradition of independence (Sam Houston: "Texas can survive without the Union, but the Union can't survive without Texas"), secession (Texas joined Dixie), and fiscal responsibility is now in the hole as bad as is California.  

It’s come to this: The Texas budget outlook has become so bleak that we’re comparing rather favorably to the one state where balanced budgeting goes to die.

People, our budget deficit is now as bad as California’s.

Yes, the over-spending, over-regulated capital of hippiedom now has a state fiscal outlook on par with the Lone Star State.

That fact may not sit well with some people—especially in the governor’s office, which loves to bash California and never misses an opportunity to point out how Texas’ low-tax, business-friendly model has led to a more robust economy and sound state finances. When California faced a $60 billion deficit last year—a shortfall that was bigger than the entire budget of most states—you could almost hear the chortling from the Texas governor’s office. It seemed a handy example of what happens when you put big-spending liberals in charge.

It wasn’t that simple, though. The causes of California’s problems—and Texas’ lack thereof—were varied and complex. And now the states’ budget deficits are looking very similar.

Texas: $18 billion shortfall (estimated) or about 20 percent of state spending.

California: $19.1 billion shortfall (official estimate) or about 20 percent of state spending.

The numbers match up pretty neatly.

A couple of caveats: Texas—as you probably know—budgets in two-year cycles. If the budget gap does turn out to be $18 billion (and we won’t have an official number until early next year), that would represent about 20 percent of the $87 billion in state funds that Texas allocated for 2010-2011.

California budgets one year at time. But the state spends about double what Texas does. So a $19.1 billion budget gap represents about 20 percent of the roughly $83 billion California will spend this year from its general fund.

Politicians like Rick Perry might find it cute to talk about the 10th Amendment and secession in order to rile up the base, but does anyone think that such a person would give up the ability to benefit from the Fed's printing press once his state's accounts become entirely unmanageable? And if Bernanke and Obama bailed out AIG, Goldman Sachs, and (indirectly) Greece, do you really think they could justify telling any bankrupt state to drop dead? The reality is, before the whole system breaks down, the debt crisis will bring the union closer.    

There is overwhelming agreement among economists that the Second World War was responsible for decisively ending the Great Depression. When asked why the wars in Iran and Afghanistan are failing to make the same impact today, they often claim that the current conflicts are simply too small to be economically significant.

There is, of course, much irony here. No one argues that World War II, with its genocide, tens of millions of combatant casualties, and wholesale destruction of cities and regions, was good for humanity. But the improved American economy of the late 1940s seems to illustrate the benefits of large-scale government stimulus. This conundrum may be causing some to wonder how we could capture the good without the bad.

If one believes that government spending can create economic growth, then the answer should be simple: let's have a huge pretend war that rivals the Second World War in size. However, this time, let's not kill anyone.

Most economists believe that massive federal government spending on tanks, uniforms, bullets, and battleships used in World War II, as well the jobs created to actually wage the War, finally put to an end the paralyzing "deflationary trap" that had existed since the Crash of 1929. Many further argue that war spending succeeded where the much smaller New Deal programs of the 1930s had fallen short.

Originally published at King World News.

In the early 1930’s, the US dollar money supply as measured by M3 dropped by approximately 30%.  This deflation, i.e., drop in the quantity of money, was one of the steepest in history.  The purchasing power of the dollar -- until 1933 redeemable into gold and thereafter redeemable into silver -- rose dramatically because less money was in circulation compared to the quantity of goods and services available in commerce.

Today, the Federal Reserve no longer reports M3, which is unfortunate because it eliminates the possibility of accurate historical comparisons.  M3 is estimated by economists by modeling historic trends.  However, these models become less reliable as we move further from February 2006, the date the Federal Reserve stopped reporting M3.  Eurodollars, a major M3 component, is particularly difficult to model.

In any case, much attention is being given to these private estimates, even though the decline in M3 they are reporting stands in marked contrast to M1 and M2.  The Federal Reserve reports that these two money supply measures have grown 7.1% and 1.7% respectively over the past twelve months.  Thus, by these two measures, the dollar is inflating, i.e., the quantity of dollars is expanding -- particularly so for M1 -- relative to the available stock of goods and services being produced in today’s depressed economy.

The Federal Reserve Note (also known as the “dollar”) is an arbitrary financial instrument signifying nothing, an IOU … zilch; it possesses no intrinsic value besides paper and in digital form, no intrinsic value whatsoever.

It’s funny how so many people around the world treat it as the ultimate measure of value. Funnier still how one can be, temporarily at least, knocked out the dream-like trance the dollar induces when one sees people actually treating the dollar as if it had real value, and not treating it as crumbled up colorful paper with random units assigned to it. The world’s monetary system begins to appear like a bizarre fetish.

Zimbabweans wash dirty US dollars with soap, water 

By Angus Shaw, The Associated Press -- Tue Jul 6, 2010

HARARE, Zimbabwe – The washing machine cycle takes about 45 minutes — and George Washington comes out much cleaner in the Zimbabwe-style laundering of dirty money.

Low-denomination U.S bank notes change hands until they fall apart here in Africa, and the bills are routinely carried in underwear and shoes through crime-ridden slums.

Some have become almost too smelly to handle, so Zimbabweans have taken to putting their $1 bills through the spin cycle and hanging them up to dry with clothes pins alongside sheets and items of clothing.

It's the best solution — apart from rubber gloves or disinfectant wipes — in a continent where the U.S. dollar has long been the currency of choice and where the lifespan of a dollar far exceeds what the U.S. Federal Reserve intends.

Zimbabwe's coalition government officially declared the U.S. dollar legal tender last year to eradicate world record inflation of billions of percent in the local Zimbabwe dollar as the economy collapsed.

This story also reveals something important about the process of (hyper)inflation.

Paul Craig Roberts discusses the bear market in financing the American Empire. 

When Nevada Republican Senate candidate Sharron Angle suggested that unemployment benefits might be a disincentive to look for a job, liberals threw a fit.  How dare this woman be so cold hearted!

Today an article from the Wall Street Journal confirms she’s right.

Management Recruiters of Sacramento, Calif., says it recently had a tough time filling six engineering positions at an Oregon manufacturer paying $60,000 a year—and suspects long-term jobless benefits were part of the hitch.

"We called several engineers that were unemployed," says Karl Dinse, a managing partner at the recruiting firm. "They said, nah, you know, if it were paying $80,000 I'd think about it." Some candidates suggested he call them back when their benefits were scheduled to run out, he says.

Rick Jewell has a different take on extended jobless benefits: He didn't want to be on the dole, but had no alternative. He has been out of work since he lost his $12-an-hour job driving a forklift for a cosmetics company in Greenwood, Ind., in December 2008. He collected $315 a week in benefits until early June—when Congress declined to renew the law that gave workers in Indiana and some other states up to 99 weeks of assistance.

Let’s do some math here.  The guy was making $12 an hour.  Assuming a 40 hour work week, that’s $480 a week.  He now receives $315 in unemployment benefits.  480-315 = $165.  So if Mr. Jewell went back to work at the same rate it would be for $4.13 an hour.  If he found a job paying $7.50 an hour he'd actually lose $15 a week.  No wonder he remains unemployed.  Not even Mexicans would work for those wages.  

In the long recession and the lackluster recovery, the government expanded unemployment payments more than at any time since the benefits were rolled out in the 1930s. And workers have gone jobless for longer than any time since official tallies began in 1967.

 I’m sure those two facts are completely unrelated.

The debate remains pressing as Congress wrestles with whether to extend the expired benefit program. The House passed an extension renewal backed by President Barack Obama as part of a broader bill that died in the Senate, after skirmishes about the wisdom of enlarging the deficit. The House passed a scaled-down version last week, but the Senate won't revisit this issue until after its week-long recess.

Economists have argued for years about the extent to which government benefits prolong unemployment—and possibly augment the overall jobless rate. Most believe that expanding benefits does discourage some unemployed people from looking for work or taking available jobs. But they disagree on how acute that effect is, particularly at a time when jobs are scarce.

The recent recession was unusual in almost every respect. Compared to other post-World War II recessions, it was deeper, longer and put more people out of work. A year after the economy began growing, unemployment is still a very high 9.5%. Nearly half the jobless—6.8 million total—have been out of work for more than six months, and 4.3 million of those have been without work for more than a year. The typical unemployed person has been out of the job market for a median of 25.5 weeks.

The government response was also unusual, and not just in the big bank bailout. In normal times, the unemployed are offered up to 26 weeks of benefits, largely financed by a tax on employers. In recessions, state and federal governments often jointly finance up to an additional 20 weeks in hard-hit states. In this recession, Congress added up to another 53 weeks of federally funded benefits; in the deep crisis of the 1980s, the maximum total never exceeded 55 weeks.

The article goes on to describe studies showing that subsidizing doing nothing gets your more of doing nothing, proving a basic rule of economics (the classic case being when the federal government started subsidizing bastard children and the out-of-wedlock birth rate shot up).

This simple argument needs to be made no matter how much feminized liberals screech about how insensitive it is.  

The Richmond Fed’s Kartik Athreya has decreed that only the knob-twisting, interest-rate tweaking Banking Priestly Class should be allowed to talk about economics.

Ambrose Evans-Pritchard puts him in his place:

Like a mad aunt, the Fed is slowly losing its marbles.

Kartik Athreya, senior economist for the Richmond Fed, has written a paper condemning economic bloggers as chronically stupid and a threat to public order.

Matters of economic policy should be reserved to a priesthood with the correct post-doctoral credentials, which would of course have excluded David Hume, Adam Smith, and arguably John Maynard Keynes (a mathematics graduate, with a tripos foray in moral sciences).

“Writers who have not taken a year of PhD coursework in a decent economics department (and passed their PhD qualifying exams), cannot meaningfully advance the discussion on economic policy.”

Don’t you just love that throw-away line “decent”? Dr Athreya hails from the University of Iowa. […]

Dr Athreya’s assertions cannot be allowed to pass. The current generation of economists have led the world into a catastrophic cul de sac. And if they think we are safely on the road to recovery, they still fail to understand what they did.

Central banks were the ultimate authors of the credit crisis since it is they who set the price of credit too low, throwing the whole incentive structure of the capitalist system out of kilter, and more or less forcing banks to chase yield and engage in destructive behaviour.

They ran ever-lower real interests with each cycle, allowed asset bubbles to run unchecked (Ben Bernanke was the cheerleader of that particular folly), blamed Anglo-Saxon over-consumption on excess Asian savings (half true, but still the silliest cop-out of all time), and believed in the neanderthal doctrine of “inflation targeting”.