Lawson for Congress

It started last week with the Freddie and Fannie bailout, where our Treasury ignored our national interests and bailed out foreign central banks, PIMCO, and other sophisticated investors. What was wrong with this story? Most importantly, the Treasury offered public funds to guarantee debt that has never had any government guarantee, implicit or explicit:

Read the bold print on that prospectus. Should there be any confusion here? If homeowners start falling into default and not paying their mortgages, and the rate of default exceeds Fannie’s ability to make payments to its lenders, is there any reason to believe that the holders of those mortgages should expect our Treasury to make up the difference?

As Jim Rogers notes, in the wake of our Treasury volunteering our liability for Freddie and Fannie’s debt, we are perfecting the art of welfare for the rich:

While some well-meaning Americans attempt to rationalize this bailout as a “necessary evil,” the unintended consequences are beginning to reverberate. First, our government’s destruction of Freddie and Fannie’s preferred stockholders has closed the door on preferred stock for other at-risk organizations who might have wanted to use that route in attempts to raise capital. As Denninger noted:

If you’re a bank or other financial and need to issue (or have outstanding) preferred stock, you’ve got a problem - a serious problem.  The Federal Government just declared out loud that it will declare that stock essentially worthless any time they think there’s an accounting irregularity, and they will value things as they - not GAAP - sees fit.

Here’s what happened to you if you held just one of the many series of Fannie Mae preferred (the others are all essentially identical)

How about that - $13 to $2.50 in one fell swoop.

That’s an instantaneous 80% loss.

Now think about this from the perspective of, say, Lehman.  You have a capital problem.  You’d like to go out and issue some preferred stock - essentially a junior debt issue, where you pay interest in exchange for money, and perhaps its convertible into common stock at some point in the future.

However, you have a bunch of Level III assets, which might include mortgage bonds - not Agencies, but private-label stuff and commercial real-estate backed.

As a potential buyer of these securities, are you going to take this sort of risk?  Remember, Fannie and Freddie did not file bankruptcy; even in a bankruptcy, you’d likely get something as a preferred stockholder!

But in this case you got essentially nothing as a result of an (arguably) unlawful “taking” of your ownership interest in the firm!

My opinion?  This move just destroyed all preferred stock issues going forward for financials in the United States.

Paulson attempted to argue just the opposite in his press release:

Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing the GSEs so they can better perform their mission, today’s action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

Right. Well-capitalized institutions. That obviously doesn’t include Lehman, which is on the chopping block this weekend.

So now what?

Well, many observers believe that this unwinding of our banking and financial system is just getting started, with damaging consequences. Representatives from the New York Fed and major banks are working this weekend to orchestrate an orderly resolution for Lehman Brothers. Such meetings sound refined and sophisticated, although the situation is best described as a giant game of “chicken,” with our banking system hanging by a thread.

If Lehman fails suddenly, it is likely that its collapse would bring down its trading partners, as well. As Roubini notes:

If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

The potential for a widespread meltdown has brought banks to the table, each eager to avoid a similar fate. However, while banks are collectively motivated by self-preservation, no one individually wants to pay scarce money for Lehman’s questionable assets. So the “chicken” comes in when the banks look (again) to the Treasury and U.S. taxpayer to guarantee their purchase, thus bailing out the system and allow the status quo to continue:

But suitors like Bank of America, worried about the risk of buying an ailing financial institution like Lehman, want the government to step in with a package similar to what was offered to J.P. Morgan when it bought Bear. Then, the federal government agreed to absorb as much as $29 billion in losses. In seeking a Lehman deal, Bank of America Chairman and Chief Executive Kenneth D. Lewis is likely to face a tough sell to investors if he doesn’t secure some federal government backing.

As of this evening, no deal has been reached. Of course, the goal will be to reach a definitive plan by Sunday evening, before Asian markets open. We wouldn’t want to upset the new owners.

What can Americans do about our current predicament?

The first thing we need to do is educate ourselves about how we arrived at this precipice. It’s taken us a long time to get to this point, but the pressures have been gradually building since our current money and banking system were established in 1913.

One must first understand the system itself: a debt-based money system combined with fractional reserve banking. Once one understands how the system works, it becomes clear that our entire economy rests on an unstable foundation — and that the turmoil we’re experiencing is not unexpected. In fact, the system is working exactly as designed. As was noted by Robert Hemphill of the Atlanta Federal Reserve Bank in 1936:

“If all the bank loans were paid, no one would have a bank deposit and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture the tragic absurdity of our hopeless position is almost incredible, but there it is. It (the banking problem) is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.”
- Robert Hemphill, Federal Reserve Bank of Atlanta.

Our money and banking system is the antithesis of a “free market” — it is a private monopoly managed for the benefit of the banking system itself. Are you surprised that inflation has been attacking American families, and that even two jobs are often insufficient to pay for gas, groceries, healthcare, and save for retirement? Are you surprised that our goverment, in attempting to “help,” has taken on a $9.6 trillion national debt with over $50 trillion in long-term liabilities that we cannot afford?

Based upon understanding the system, we shouldn’t be. Again, it’s working exactly as designed — although it’s been pushed past the limits of sustainability, and is nearing tragic absurdity.

It’s time to change the system. Congress unconstitutionally delegated control of our money to the Federal Reserve, a private central bank, in 1913. Congress can, and must, return control of our money to the people.

There has been much discussion about the use of the rebate package passed by Congress and signed by the President to stimulate the economy. B.J. recently covered the topic in his post, “Shiller vs. IMF,” laying out the arguments of those who favor using it and those who oppose it. As with most government initiatives, success is best measured by its unintended consequences:

President Bush Boosts Porn Industry With Economic Stimulus Plan, According to AIMRCo

NEW YORK, July 2 /PRNewswire-USNewswire/ — An unforeseen and surprising beneficiary of the Economic Stimulus Plan, a plan that George Bush contends will “boost our economy and encourage job creation,” has surfaced this week. An independent market-research firm, AIMRCo (Adult Internet Market Research Company), has discovered that many websites focused on adult or erotic material have experienced an upswing in sales in the recent weeks since checks have appeared in millions of Americans’ mailboxes across the country.

According to Kirk Mishkin, Head Research Consultant for AIMRCo, “Many of the sites we surveyed have reported 20-30% growth in membership rates since mid-May when the checks were first sent out, and typically the summer is a slow period for this market.

Jillian Fox, spokeswoman for LSGmodels.com, one of the sites reporting figures to AIMRCo, added, “In a June 15, 2008 survey to our members, thirty two percent of respondents referenced the recent stimulus package as part of their decision to either become a new member, or renew an existing membership.”

The economic stimulus plan, which includes a check for up to $600 for individuals and $1200 for married couples (among other benefits), is the product of an agreement between House leaders and the Bush Administration, focused on reviving a struggling economy in the wake of flagging economy.

Fox also added, “Getting more people to buy porn was probably the last thing Bush had on his mind when he came up with his ’stimulus package,’ but we’ll take it.”

One might reasonably question if the money we borrowed to pay for these “rebates” are going to spur capital investment and wealth creation. Or do these data suggest that we’re simply seeing “Congressmen Gone Wild”?

It appears our incumbent Representative and others in Congress who supported this legislation have succeeded in seeking a short-run economic boost to satisfy their constituents and facilitate their re-election while ignoring — and in fact exacerbating — very serious fundamental and long-run challenges.

Long-run economic growth results from a number of fundamental factors, which include the accumulation of physical capital (which is a function of personal saving in a healthy economy), human capital (which is a function of education), technological advancement, protection of property rights, and a strong legal system. The accumulation of high debt by government necessitates that resources in the future must be redistributed from investment in these productive forces to paying the bills we’re stacking up now, which crushes long-run economic growth.

Furthermore, the building of a large government debt has a number of negative by-products in an international economy. Absorbing private domestic saving necessitates reliance on foreign saving for domestic growth, as well as possibly on foreign purchasing of government bonds to finance deficit spending. When foreign investment decreases and/or leaves the country, which may occur for a number of reasons (market insecurity, a decline of the value of the dollar due to inflationary monetary policy or payment of foreign debt… either of these sound familiar?), then with it goes the source of growth. At this point, interest rates increase with high government borrowing, and the central bank is in a tough spot. It can either inflate to lower interest rates, which will hurt consumers, increase costs for businesses, and decrease returns of investors; or it can do nothing and allow high interest rates to lead to a recession.  In any of these situations, economic growth is either stagnant or significanlty negative in the end. Thus, “stimulus” spending ultimately gives no real economic boost at all.

By creating more debt to “stimulate” the economy, Congress is attempting to rebalance a house of cards and delay its eventual collapse, even at the cost of potentially worsening it. We are delaying action on making hard choices that must be made today to shore up the country’s financial future and are making the these choices much harder for ourselves down the road. A $9.4 trillion national debt — with more hundred-billion deficits and skyrocketing interest payments expected down the road — and $53 trillion in present value of unfunded liabilities are absolutely nothing to ignore. These are phenomena that will wreck the economy much more powerfully than any near-term recession that may come, and they will not go away on their own nor by creating a significant amount of new debt.

Finally, we should note that the “stimulus packages” being in the form of rebates implies somehow a lessened burden of taxation for now to achieve a change in some economic variable. Real tax cuts are cuts in the burden of government on the taxpayers, and as such, they are long-term commitments that allow us and our communities to keep more of their resources.

Cutting taxes in the short-term and continuing deficit spending in no way represent a tax cut, as the government has one of two options to finance remaining spending. It can borrow and accumulate debt, which necessitates either a future tax increase to pay off the debt or a stalling of long-term growth and decline in opportunities available to the future. Or, the government can print money to finance deficits, which causes price inflation that squeezes consumers. As Milton Friedman would say (paraphrasing), “A tax cut is not a tax cut at all without a spending cut.”

Paige Michael-Shetley is the Volunteer Coordinator and Youth Coodinator for Lawson for Congress. He is a Senior at the University of North Carolina at Chapel Hill and is majoring in Economics and Math.

Slowly, our government is catching on to the fact that the Federal Reserve is the cause of our slow-motion train wreck. Senator Jim Bunning from Kentucky appropriately questioned increasing the Federal Reserve’s power in today’s hearing:

Now the Fed wants to be the systemic risk regulator. But the Fed is the systemic risk. Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that and will use all my powers as a Senator to stop any new powers going to the Fed. Instead, we should give them less to do so they can do it right, either by taking away their monetary policy responsibility or by requiring them to focus only on inflation.

While I don’t understand specifically what he means by “taking away their monetary policy responsibility”, or even “requiring them to focus on on inflation”, another dissenting voice is a good start.

As Mike Shedlock noted, “In an unusual but encouraging development, someone besides Ron Paul is calling Bernanke on his hogwash.”

Encouragingly, bipartisan opposition to the Treasury’s ill-advised “confidence game” is apparently growing.

As mentioned in our press release, the most appropriate approach to the Freddie/Fannie problem is a decisive restructuring of the GSE’s debt at the expense of the bondholders, as outlined by Nouriel Roubini:

First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.

For those who study our financial system, the past few weeks have been interesting, and concerning. I don’t know if it’s possible to overstate my concern for our future — both as citizens as the United States of America, and as inhabitants of a world that is increasingly interconnected yet dependent on a fundamentally flawed financial and monetary system.

If asked to pick one word to describe why I’m running for Congress, that word is sustainability. Sustainability doesn’t mean stability, it doesn’t mean safety, and it doesn’t mean protection from life’s inevitable uncertainties. Sustainability does mean recognizing and obeying the natural laws that govern of our world.

Every branch of science has certain laws: Objects in motion tend to stay in motion; force equals mass times acceleration; every action has an equal and opposite reaction; energy in a closed system cannot be created or destroyed but merely changed in form; and closed systems tend towards increased entropy are a few good examples.

These laws of motion and conservation of energy are not limited to high school physics class. Every system in nature must obey these underlying principles — including our financial and monetary systems.

Let’s start with Newton’s laws of motion — it’s a short hop from there to defining leverage as the ability to move a large object a short distance using a small force exerted over a long distance. Leverage is a concept in finance, as well — using borrowed money to increase returns based upon small underlying price movements. Just as the car lifted with a hydraulic jack can hurt you if it falls, a small price movement in an imprudently leveraged investment can wipe out a lifetime of savings.

Next consider conservation of energy and open versus closed systems. Since energy within a closed system cannot be created or destroyed, and since closed systems tend towards increasing entropy, every growing system must be open to an external energy source. In this setting, one can immediately see problems with our debt-based monetary system.

What is debt-based monetary system? It’s where money is debt, and every dollar in circulation exists because a bank created it out of nothing based upon someone’s promise to pay it back, with interest.

Our economy is an open system relative to money, which is created and destroyed by banks. Banks create the money through loans — but they only create the amount you borrow. They don’t create the interest that you also promise to repay. Where do you get the interest? You have to earn it, but first it has to be created — yes, by someone else borrowing more money that they promise to repay with still more interest.

In the end, our monetary system is like a game of musical chairs — the banks create money based upon someone’s willingness to borrow, and the bank’s ability to lend. The constant demand for new money to repay interest on existing money compels growth and new money creation at an accelerating rate.

Refer to the chart of America’s total debt, which raises obvious questions about sustainability. Trees do not grow to the sky — and when banks cannot lend, or people are no longer willing to borrow, the music stops. When the music stops, there are more loans outstanding than money to repay, so everyone left standing loses whatever they pledged in exchange for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the room.

Leverage, debt-based money, fractional reserve banking, and interest are fundamental features of our economic system. Our economic history of boom/bust cycles and decisions dominated by short-term gain as opposed to long-term stewardship are fundamental consequences of this underlying system. In short, our system has undesirable consequences and is fundamentally unstable — but it’s working as designed.

What we are experiencing today is a perfect storm of rising demand for natural resources in the setting of  global growth, a declining domestic currency due to decades of unsustainable debt (= money) creation and spending, coupled with an unfolding credit crisis that has crippled the debt (= money) creation system. What happens next?

I don’t know. Economists and analysts are searching for an analogy to our current position. Are we in the 1970s? Are we Japan in the 1990s? Are we entering the 1930s? Each situation is unique, and this one is no exception. There is evidence that we have experienced “peak credit“, and are popping a credit bubble that has been forming for over 20 years. That is reminiscent of Japan in the 1990s, or the 1930s. We’re also suffering from high energy prices, like the 1970s, although in this case we’re facing global tight supplies in the setting of rising demand.

Today’s news capped off several weeks of concerning developments. Illustrating the danger of leverage, our largest mortgage companies, Freddie Mac and Fannie Mae, are fighting rumors of insolvency:

The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

The government officials said that the administration had also considered calling for legislation that would offer an explicit government guarantee on the $5 trillion of debt owned or guaranteed by the companies. But that is a far less attractive option, they said, because it would effectively double the size of the public debt.

These companies funded 80% of the mortgages issued in the first half of 2008, and are thus almost fully responsible for supporting the housing market at its current levels. Ready to talk about leverage? In May, Fannie and Freddie had $83 billion in capital supporting over $5 trillion in debt and other obligations. That’s leverage — every dollar in debt is supported by less than two cents.

Here are some excellent commentaries on the dangers of these quasi-federal companies (read: we’re all going to take the hit) that inflate housing prices and define moral hazard:

Former St. Louis Fed President Poole Calls Freddie, Fannie “Insolvent”

Disaster Planning for Freddie and Fannie

Freddie and Fannie: Conservatorship as Endgame?

Fannie and Freddie Waterfalls Are Too Big to Bail

Fannie and Freddie are just the most recent problem to flare up, however. A contraction in the mortgage market was only the beginning — losses are spilling over throughout the economy. As Nouriel Roubini notes, total loss estimates from the credit crisis across all sectors of the economy are up to $1.6 trillion:

As I argued in writings last February such credit losses would be at least $1 trillion and could be as high as $2 trillion, well above the $300 billion of subprime writedowns that have been recognized so far. At that time the $1 trillion estimate was considered as lunatic but by now the IMF estimates these losses at $945 billion, George Magnus of UBS estimated them at $1 trillion; Goldman Sachs put them at $1.1 trillion, the legendary hedge fund manager John Paulson (who made last year $3.5 billion of income on shorting subprime) put them at $1.3 trillion; and a couple of days ago Bridgewater Associates estimated such losses at $1.6 trillion. Thus, as I argued then $1 trillion would be floor, not a ceiling, to such credit losses.

Of course such losses have been in part transferred from US banks to capital market investors and to foreign investors via securitization. But with the entire capital of the US financial system at $1.3 trillion such staggering losses will lead to a systemic banking crisis and systemic financial crisis. No wonder that Bernanke is now telling non-bank primary brokers that the Fed exceptional liquidity support (TAF, TSLF and especially PDCF) will be extended into 2009. And no wonder that Geithner, Paulson and Bernanke have now all three spoken of the need to find orderly ways to let even large and systemically important institutions go bankrupt if they are insolvent.

The consequences of this credit unwinding and a hard landing in the United States have damaging global consequences, as well. This article, again by Nouriel Roubini, outlines why the current international monetary regime known as Bretton Woods 2 could collapse in the wake of an expanding global credit crisis, and our current trade imbalances:

Will the Bretton Wood 2 Regime of fixed and/or heavily managed exchange rates in many emerging market economies collapse in the same way as the Bretton Woods 1 regime (the “dollar standard” regime that ruled after 1945 in the global economy) collapsed in the early 1970s? What are the similarities and differences between those two regimes? It is interesting to note that the same factors – U.S twin deficit, U.S. loose monetary policies and fixed pegs to the U.S. in the dollar standard regime of Bretton Woods (1945-1971) - that led to the commodity inflation and goods inflation in the early 1970s and thus to the demise of the Bretton Woods 1 regime (in the 1971-73 period) are also partially the same factors that are leading now to the rise in commodity and goods inflation in emerging markets that are pegging to the U.S. dollar and/or heavily managing their exchange rates.

Thus, like the rise of commodity and goods inflation led to the demise of BW1 the current rise in commodity and goods inflation in emerging market economies may be the trigger that will lead – as argued in my 2005 BW2 paper with Brad Setser and a more recent 2007 paper of mine – to the demise of BW2. It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

Every country is between a rock and a hard place:

By now inflation has become so high in so many emerging market economies that – in some dimensions – it is almost too allow these currencies to appreciate: inflation is so high that only an abandonment of pegs or of heavily managed rates and a very sharp nominal exchange rate appreciation would be able to control inflation Even in that case nominal appreciation would not be enough to control expected inflation: a much tighter monetary and credit policy – that is feasible only if enough exchange rate flexibility is allowed – would be necessary to control actual and expected inflation. But now the global economic outlook has much worsened with the US recession and the sharp economic slowdown in most advanced economies. The need to control inflation with a stronger currency and much tighter monetary policy in emerging markets is happening at a time when downside risks to growth are emerging in these countries because of the US recession and the slowdown in the advanced economies growth rate. Thus, emerging market policy makers face a serious dilemma: controlling inflation requires exchange rate flexibility and much tighter monetary and credit policy. But such policy may exacerbate the growth landing of these economies at the time when global conditions are leading to a sharp slowdown of growth in advanced economies that – in due time – will slow down exports and growth of the emerging market economies.

Thus, it is not obvious that the members of BW2 will decide to phase out this regime and move to greater currency flexibility and tighter monetary and credit conditions. Rising oil, energy and food inflation in these economies is already leading to popular unrest, riots and – in some cases – ruling governments being toppled. Thus, the last thing that these economies need is a sharp growth slowdown on top of socially unpopular rising inflation. That is why – while the rational choice would be phasing out BW2, allow greater exchange rate flexibility, regain monetary autonomy, allow currencies to appreciate and tighten monetary/credit conditions – many of these BW2 may be reluctant to follow this painful policy path.

But again, these problems, consequences, and suboptimal “solutions” are simply the result of a suboptimal and unstable system working as designed.

Finally, we must consider these financial instabilities in a world where the fundamental life-giving resources such as food and energy are becoming increasingly precious:

Every Barrel Now Counts: What Prospects for More Oil Supplies?

IEA Medium-Term Outlook

While we complain about high food prices, other countries — some to whom we owe a great deal of money — are seeing riots and social unrest. The bottom line is that food and energy prices are not separate from this economic crisis. They are intimately related, for two reasons.

First, food and energy are fundamentally equivalent even beyond irrational corn ethanol subsidies. By some estimates, our unsustainable system of industrial agriculture requires 10 calories of fossil fuels for each one food calorie produced. What happens as fossil fuels become more expensive based upon growing global demand against finite supplies?

Second, many countries with food and fuel inflation high enough to spark riots and social unrest, and to whom we owe a lot of money, are keeping their currency artificially low against our dollar to stimulate exports. What happens if the pain of social unrest in China is great enough for them to abruptly let their currency float?

A rapid strengthening of China’s currency would reduce the value of their $1.4 trillion in dollar holdings. On the other hand, such a rapid appreciation would give them an instant discount on their dollar-denominated commodities such as fuel and fertilizer, and is the ultimate solution to their price inflation.  What would be the consequence for us, however, as high prices causing riots and social instability abroad transfer to our shores?

Mutually assured destruction did not end with the Cold War — our position in the global economy can also be described as mutually assured economic destruction.

We need principled leadership that recognizes the root causes behind the threats we face, and we need a government that empowers us to build a sustainable society. Such sustainability has not, and cannot, come from a federal government that consolidates power, exceeds its Constitutional authority, and serves corporate and special interests.

Critically, we must recognize that our economic, energy, environmental, and agricultural policies do not operate in isolation — they are all related, and they all exist on the foundation of an unstable monetary system that bring us to this precarious situation. We live in interesting times.

Back in August of last year, Barack Obama proposed a solution for the subprime crisis, perfectly following the “bubble script“. Nine months later, we’re still on schedule — right up to high-profile government prosecutions of Bear Stearns hedge fund managers and promises of perpetuating but “regulating” a corrupt system in Senator Dodd’s Housing Bill:

The bill calls for a new, independent regulator for Fannie Mae, Freddie Mac and the Federal Home Loan Banks that would have the authority to establish capital standards and “prudential management standards,” as well as to “restrict asset growth and capital distributions for undercapitalized institutions,” among other powers, according to a summary of the bill.

As our markets and economy continue sagging under the weight of our unwinding debt (= credit) bubble, and a weak currency continues to send energy and food costs surging, it should be clear that our monetary, banking, and economic systems are sick.

After my two prior blog posts on the banking and monetary systems, it should also be clear that the problems we face are innate feeatures of a deeply flawed system. Or, as we used to say in the software business, “that’s not a defect — it’s working as designed!”

Things are working so well, in fact, that our banking system itself is propped up by “borrowed reserves” — the Federal Reserve has traded its government bonds, which normally serve as the foundation for our monetary system (don’t ask), for a variety of sketchy “assets” that banks are finding impossible to value. In other words, banks are dodging the bullet of having to accurately value some of their assets based on mortgages, credit card debt, and other consumer loans by “borrowing” the Federal Reserve’s treasury debt and leaving their questionable assets as collateral. As a result, the non-borrowed reserves in our banking system are now negative:

Wow. That’s an odd looking chart. What does that mean?

Nothing, really. It means that we’re living in a grand illusion. Don’t worry, go shopping, and go Celtics. Everything will be just fine.

But what about the mortgage bubble, and subsequent bust?

Do you really want to know? NPR’s This American Life had a fantastic episode a few weeks ago that explains the processes, people, and pathologies involved. It’s a great illustration of our financial system’s inherent instability. If you don’t have time to listen to the entire episode, there is a wonderfully concise and illustrative online slideshow that explains the mortgage mess in colloquial terms (Warning: Rated R for language).

So what now? Will Senator Dodd and other august leaders in Washington be able to stop the Great Credit Unwind, restore stability to our financial markets, prevent foreclosures, and empty California’s tent cities?

Time will tell.

But wait, there’s more. In an Orwellian twist, today we learn that language was inserted into Dodd’s Senate Housing bill that would require small businesses and third party payment processors to report all electronic transactions to the federal government:

Hidden deep in Senator Christopher Dodd’s 630-page Senate housing legislation is a sweeping provision that affects the privacy and operation of nearly all of America’s small businesses. The provision, which was added by the bill’s managers without debate this week, would require the nation’s payment systems to track, aggregate, and report information on nearly every electronic transaction to the federal government.

What? Unconstitutional police state surveillance tactics in a housing “relief bill”? Is the government trying to feed us with one hand, while holding us down with the other?

It appears so.

Liberty is Priceless — support our Congressional campaign, and help us question the system that feeds our addiction and enslavement to perpetually-growing debt. Also, help us bring the Read the Bills Act and One Subject at a Time Act to fruition in Washington.

In a previous post, we discussed the hazards (moral and otherwise) of fractional reserve banking. Once you understand fractional reserve banking, you understand why we need a central bank.

When you have a fractional reserve banking system, each bank is technically insolvent in that it cannot meet all of its depositors’ demands for their money. If all holders of demand deposits came to the bank to withdraw their funds, the run on the bank would force the bank to close down. It’s only the depositor’s confidence that the money will be there that keeps the bank in business.

Since that confidence proves shaky — witness the case of Northen Rock, or even Bear Stearns — the idea of “reserve pooling” gradually arose. The idea is that if an individual bank runs into trouble, other banks can temporarily lend it funds to meet its demands. The endgame for reserve pooling, however, is a single bank that has the power to arbitrarily create money — the central bank.

Our central bank, the Federal Reserve, was commissioned in 1913. It is not federal, and is owned by its member banks. The Federal Reserve interacts with the banking system in a simple but important way — it is the “lender of last resort”. That means that when a bank runs into trouble, the Federal Reserve will be there to bail it out, or orchestrate a merger or other transaction that will prevent collapse of the institution, or the entire system.

How does the Federal Reserve do its job? Today’s Federal Reserve is best known for setting the so-called “Fed Funds Rate“, or the price at which banks borrow money from each other overnight. Why would banks borrow from each other? One reason is to meet reserve requirements. If you own a bank, and make a new car or mortgage loan, you create new money for that loan in your borrower’s demand deposit account. You don’t need to have enough “reserves” in advance to make that loan, however — you can just borrow the necessary reserves in an overnight loan from other banks, and you should expect to pay close to the Federal Reserve’s target rate.

The Federal Reserve manages this interest rate by so-called “open market operations“, where the Federal Reserve buys and sells securities in an effort to keep interest rates close to its target. Right now, the Federal Reserve’s “Fed Funds Rate” is set at 2%. When banks are unwilling to lend to each other, and rates creep upwards, the Federal Reserve will add reserves to drive that interest rate down towards its target. Even if banks don’t have surplus reserves to lend, the Federal Reserve will still work to ensure that banks can borrow reserves at its target rate.

So what’s the problem with this system? Well, let’s take the words “add reserves”. The Fed “adds reserves” by purchasing debt, or providing a loan against debt (called a repurchase agreement, or repo).

When the Federal Reserve purchases debt from our government, or provides a loan against debt for a bank, it pays for that debt in Federal Reserve Notes. Where does the Federal Reserve get its Federal Reserve Notes? Well, the Federal Reserve has the unique ability to create new ones. In other words, the Fed has the ability to write a worthless check, and create new money.

Besides the moral issue of letting our central bank create new money that competes with money you’ve earned for goods and services, does this system really make sense?

No, it does not. Many people believe that in order for a bank to make a loan, someone must have first saved money, and made a deposit. That’s simply not true. When the Federal Reserve sets the interest rate at which banks can borrow to meet their reserve requirements, banks compete to make loans and create new paper money based upon their cost of borrowing, as opposed to the amount of reserves they have on deposit. Practically speaking, banks are limited in the amount of loans they can make based upon capital requirements, not reserve requirements.

In addition to the Federal Reserve’s ability to create money to lend to banks is the Federal Reserve’s ability to create money to give to our government. Our United States Treasury is constantly issuing new debt — we’re a “payday lender” nation whose government is constantly rolling over old debt into new debt, and issuing additional debt to pay for our constant budget deficits. Who buys all this debt?

Lots of people, and lots of institutions, purchase our Treasury’s debt. Many of these investors are overseas. The Federal Reserve also purchases our Treasury’s debt. But when the Federal Reserve purchases our government’s debt, unlike you or me, the Fed can give the Treasury a check with no money in the checking account. While you would be charged with fraud for writing worthless checks, it’s business as usual at the Federal Reserve. The Fed’s “checks” simply create new dollars in the Treasury’s checking account.

Money doesn’t grow on trees any more — it’s even easier than that. The Treasury just needs to sell some bonds, and if there aren’t enough willing purchaser with existing dollars, the Federal Reserve creates new electronic money to make up the difference.

So why do we have inflation? One important factor is the Federal Reserve’s new money competing with your earnings and savings for goods and services. Ultimately, our flawed system makes everyone’s dollar worth less.

While the American worker and saver gets hurt by this arrangement, who benefits?

Consider the banks — banks are protected from failure by a central bank that can create money out of nothing. Furthermore, this perception of “stability” allows banks to create loans out of nothing, backed with minimal reserves, and thus claim an ever-greater share of borrowers’ future income through interest payments. More loans leads to more profits — it’s definitely a winner for the banks.

Consider our government — politicians can make promises that we can’t begin to afford, but our central bank’s ability to create money to buy our government’s debt means that politicians can spend obscene amounts of money without raising taxes. Instead, they simply borrow and print new money. As long as the American public is unaware that government benefits are paid for by newly-printed money, and don’t understand the link with rising prices, this system is tolerated. Even the mainstream media is widely ignorant of how this system works.

But the dynamics are changing. We can no longer ignore gas prices, and grocery bills. We can no longer ignore the future costs that our children face. A speech on May 28 entitled “Storms on the Horizon” by Dallas Federal Reserve President and CEO Richard Fisher (world government fans unite — check out his biography in Spanish!) paints a surprisingly realistic picture:

Tonight, I want to talk about a different matter. In keeping with Bill Martin’s advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—“frightful storm”—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker’s point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation’s fiscal predicament.

…

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation’s retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the “infinite horizon discounted value” of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker–retiree ratio and leaving today’s workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders—Wilbur Mills was the most credible of them before he succumbed to the pay-as-you-go wiles of Fanne Foxe, the Argentine Firecracker—who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program’s unfunded liability is by itself one-third greater than all of Social Security’s.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

What do we do about that? How can we begin to “fund” a $99 trillion liability?

Let’s say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household’s income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation’s entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it’s because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

OK, so if we can’t cut spending, and if we can’t increase taxes, are there other options?

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today’s Zimbabwe, that running the printing press to pay off today’s bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed’s dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers’ purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

Mr. Fisher, I wish I could believe you. Based upon the performance of our dollar against other currencies, it appears that we are doing exactly that. In fact, Alan Greenspan was asked about the problem of how we could meet our Social Security obligations back in 2005. His response at the time? “We can guarantee cash, but we cannot guarantee purchasing power!” In other words, we can print the money, but it won’t buy anything.

Odds are, despite Mr. Fisher’s wishes, we keep borrowing and printing. As Mr. Fisher concluded his speech:

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times [3] that one reason for the demise of the British pound was the need to liquidate England’s international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser’s army and Hitler’s bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Mr. Fisher, you are correct. We do have the power to prevent this destruction. The cause of this destruction is the system itself. We cannot afford a debt-backed monetary system controlled by a private central bank that creates money out of nothing — thus facilitating unrestrained spending by politicians interested only in their re-election.

Coupling an unstable banking and monetary system with a government that gives favors in exchange for growing its power is a recipe for collapse into tyranny.

I’ve been struggling with a blog post to outline my concerns with our economy in light of the challenges in the housing and credit markets. Two excellent books, Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash and Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, are timely additions to the dialog that explore the financial market’s “innovations” behind our current boom/bust cycle. However, as great as these books are at explaining the immediate cause of our difficulties, neither of them get to the root of the problem that has plagued our financial system, and economy, for generations.

Beyond the headlines of “writedowns” and management turnovers, the problems in today’s financial industry ultimately stem from its unstable, and many would say immoral, foundation. That foundation is “fractional reserve banking”.

What, exactly, is fractional reserve banking? Quite simply, it’s where banks lend more money than their depositors have given them for that purpose. Perhaps the best way to explain it is to talk about how “honest” banking would work, and then highlight the differences.

Broadly speaking, banks serve two customer needs: safeguarding wealth for the depositor’s peace of mind and convenience, and matching up savers who want to lend money with borrowers who want to borrow money. Those purposes are completely separate, and should not be confused. However, the temptation to confuse them in pursuit of greater profit has always led the banking industry to a precarious state.

In the world of “honest banking”, banks recognize two types of deposits, demand deposits and time deposits:

• Demand deposits, as the name implies, are available “on demand” and reflect the bank serving the customer’s first need: safeguarding wealth for peace of mind and convenience. Since the bank is offering this service, the customer should expect to pay for the safety and convenience offered by a demand deposit (or typical checking account). The customer expects that her money is always available, and effectively “in the vault”.
• Time deposits, in contrast, are not available on demand. They are savings that the depositor is looking to invest, and use to earn income. The simplest example of a time deposit is a Certificate of Deposit, or CD. CDs pay an interest rate, and the funds in a CD are returned with interest after a certain period of time. With a CD, the money is not available for immediate withdrawal. In fact, the customer expects that the money is not “in the vault” — she can’t access the funds until the CD matures since the money is literally “out working”, and being used to create value by another customer who borrowed it through a loan.

From the descriptions above, you can imagine that a bank’s income would come from two sources: fees for offering demand deposits, and the difference between interest paid to savers (who lend the bank money) and received from borrowers (who borrow money from the bank). That’s pretty much the way banking should work. Unfortunately, however, it doesn’t.

You see, unscrupulous bankers throughout history realized that they could increase their profits by loaning out their demand deposits as well as their time deposits. You can easily see the temptation — as long as most customers don’t ask for all their money out of their checking accounts, what’s the harm in loaning out some of that demand deposit money and earning interest for the bank? No one will know the difference, and it’s a profitable risk to take.

Even better, once merchants began accepting checks or receipts from this banker instead of the underlying “money” (whatever it was) itself, the banker began to realize that he could create even more loans. Who will know, if the community accepts the bank’s receipts as money? Suddenly the bank is no longer just in the business of storing money, and matching lenders and borrowers. Now the bank is in the business of falsely creating new money when a customer takes out a loan.

The problem is that eventually, inevitably, the bank’s customers get suspicious — perhaps in the face of rising prices, as new money floods the local economy. The customers realize that the bank has more receipts, or checks, outstanding than it can possibly cover. Once the bank’s customers lose confidence, they all show up and demand their money. The bank, of course, doesn’t have enough money to honor all the claims, so the depositors are left in the lurch. This “run on the bank” reveals the deception, and exposes the fractional reserve bank as an inherently bankrupt institution.

From a social perspective, what are the consequences of the banking industry creating new money (at essentially zero cost), only to loan it to you with interest? When the bank creates “money”, is it actually creating value? The answer is no — the banking industry is not creating value when it creates new money to fulfill a loan. In fact, the bank’s new money is taking value from everyone else by reducing the purchasing power of everyone’s savings, investments, and earnings.

You’d think that after generations of repeating the same pattern of booms, busts, and bank failures, we’d put control, and the rule of law, firmly on the side of the customers whose assets form the basis of society’s prosperity. You’d think that fractional reserve banking would be illegal, and those who fraudulently make multiple loans against the same money, or loan out money that already has another claim against it, would be liable for civil or criminal prosecution. In fact, even the Bible warns against this practice, termed “multiple indebtedness”:

If you ever take your neighbor’s garment as a pledge, you shall return it to him before the sun goes down. For that is his only covering, it is his garment for his skin. What will he sleep in? And it will be that when he cries to Me, I will hear, for I am gracious (Exodus 22:26-27)

This verse is talking about the prohibition of interest in loans to poor fellow believers, also known as usury. In this case, the borrower is so poor that his cloak is his collateral. While this is not a business loan, it’s still important, and acceptable, that the borrower offer collateral — even something as humble as his cloak. The fact that this impoverished borrower physically gives the cloak to the lender during the day is protection against the borrower being corrupt at heart — the borrower cannot make the rounds of moneylenders, securing loans out of sympathy from each, and pledging his coat multiple times as collateral. Since only one lender can hold the cloak, there can be only one loan made against it.

As a matter of common sense, and as a matter of morality, it’s wrong (and typically prohibited) to secure multiple loans with the same piece of collateral.

So how does the concept of multiple indebtedness relate to banks? In the same way that the poor man should not defraud lenders by taking out multiple loans on the same piece of collateral, banks should not defraud their customers by creating multiple loans against the same money, or loaning out money that already has another claim against it.

In a nutshell, that’s the problem with our financial system. If a pawnbroker were to make loans against family heirlooms with counterfeit paper currency photocopied in his office, he would be arrested. But when the bank gives you a mortgage against your house, and creates a new deposit in your checking account that’s only partially backed by depositors’ money, the bank has created new money just as certainly as the pawnbroker with counterfeit bills.

For an entertaining description of fractional reserve banking and its interaction with paper money, watch this video:

While this video does an excellent job of showing the problems with our current system, there’s still much discussion to be had on proposed solutions. But we need to begin an honest discussion as we look towards the future.

On a more humorous note, here’s a great video on the Northern Rock bank failure in Great Britain:

Next, we’ll explore how the Federal Reserve and our government attempt to keep this fragile system intact.

I’ve dissected the credit crisis in previous posts since last August, and outlined the bureaucratic overreach that we can expect as a result:

http://blog.lawsonforcongress.com/2008/02/24/mortgage-fun-and-games/

http://blog.lawsonforcongress.com/2007/12/19/a-review-of-the-mortgage-crisis/

http://blog.lawsonforcongress.com/2007/12/09/unintended-consequences/

http://blog.lawsonforcongress.com/2007/11/19/whered-the-money-go/

http://blog.lawsonforcongress.com/2007/08/30/obamas-gonna-fix-it/

Since then, we’ve witnessed the Bear Stearns debacle, where a bankrupt investment bank will have its trading losses covered by the Federal Reserve for up to $29 billion in taxpayer dollars. Clearly, these actions illustrate that the Federal Reserve puts the interest of Wall Street well ahead of Main Street. Even worse, these actions open a pandora’s box where further bailouts will be justified and expected.

So what is a bailout, anyway? Essentially, the government (through the Federal Reserve) is using its ability to create money out of thin air. This new money is given to those affected either directly or in the form of “loans” backed by questionable assets. That new money from the Federal Reserve enters into the banking system, and competes with your hard-earned dollars for goods and services. Did the Federal Reserve give you your Bailout Bucks today? If not, you suffer from the higher prices that result as your dollars purchase fewer goods and services.

Our financial system is broken. The inherent instabilities we’ve been experiencing are a symptom of a debt-based paper currency that’s managed by a money monopoly headed by our nation’s third central bank, the Federal Reserve. The Federal Reserve’s shareholders are its member banks, so it is owned by the banking industry. Furthermore, the Federal Reserve also regulates the banking industry. Talk about the fox guarding the henhouse.

The Federal Reserve has been widely implicated in the financial crises that have afflicted our economy since its founding in 1913, starting with the Great Depression. Here’s a recent apology for the Great Depression from our own Ben Bernanke:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

The “Anna” mentioned in Bernanke’s apology is revered economist Anna Schwartz. Dr. Schwartz doesn’t seem too impressed with the apology, as this past January she publicly blamed the Federal Reserve for its creation and mismanagement of the current credit crisis:

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. “The new group at the Fed is not equal to the problem that faces it,” she says, daring to utter a thought that fellow critics mostly utter sotto voce.

	Anna Schwartz wrote a seminal text on the causes of the Great Depression

“They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence,” she told The Sunday Telegraph. “There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,” she says.

The Federal Reserve’s ability to create new money and allow the government to live beyond its means without raising taxes is the primary driver of inflation — you’ve noticed this recently if you’ve been watching your grocery and gas bills. Indeed, since the Federal Reserve was founded in 1913, its $1 Federal Reserve Note (a.k.a our dollar) now requires $21.38 to purchase the equivalent goods (by the government’s own optimistic estimates). So much for a stable currency.

Given this mess, one would think that we’d finally be ready to ask questions about how to arrange an alternative to the current system. Instead, Treasury Secretary Henry Paulson and the Bush administration propose to give us more of the same — more regulatory powers to the Federal Reserve, more bailouts for its friends on Wall Street, and higher prices for working American families.

Not surprisingly, the Wall Street crowd is singing its praises:

Wall Street’s main lobby group, the Securities Industry and Financial Markets Association, embraced Paulson’s proposals. “Our present regulatory framework was born of Depression-era events and is not well suited for today’s environment where billions of dollars race across the globe with the click of a mouse,” said Tim Ryan, chief executive of the association. “That fact, teamed with the current market conditions, result in an universal agreement that it is time to modernize and revitalize the current system.”

And our Chairman of the House Banking Committee is weighing in with his support:

Last week, Massachusetts Congressman Barney Frank said Congress should authorize the Fed to act as a risk regulator across the markets. “To the extent that anybody is creating credit, they ought to be subject to the same type of prudential supervision that now applies only to banks,” he said.

Instead of Frank’s gentle acquiescence, here’s the key question we need to ask: Can we continue allowing banks and other financial institutions to have a monopoly over creating money, through credit, in Federal Reserve Notes? The answer is no, we cannot. The current system is not sustainable, and we need to provide an option for the American people that includes the use of Constitutional money. Americans need to be free to save, invest, and transact business in gold and silver in addition to Federal Reserve Notes, without any sales or capital gains taxes.

While treating the symptoms of the credit crunch through “liquidity injections” and bailouts is a short term solution that may prevent the financial system from freezing up, it will cause accelerating inflation and further rob American workers of their purchasing power. The true solution to our current financial crisis is not giving more power to a broken system. That’s simply rearranging the deck chairs on the Titanic. We need the Honest Money Act, HR 2756. Allowing Americans to transact business with honest, Constitutional money instead of only paper created out of thin air by our central bank will provide a needed alternative during this period of turbulence.

Americans today are slowly being crushed by our currency’s decline. Oil is $110 per barrel, gold is over $1,000 per ounce, and foreign currencies across the board are hitting new record highs against the dollar.

These prices and events are not theoretical concerns. Americans across the board are facing rising prices for food, energy, and manufactured goods. Unfortunately, however, we’re not supposed to talk about the dollar here. In fact, we have such a provincial view of money in the United States that your average American consumer doesn’t even have the ability to save him or herself from a collapsing paper currency. In other countries, however, consumers are much more sophisticated:

In Bolivia, billboards feature George Washington’s image on a $1 bill alongside a bright pink 500 euro note, encouraging savers to turn to the euro to tuck away money earned abroad or sent home in remittances.

“If the dollar’s going down … save it in Euros!!!” say the signs popping up around La Paz for Bolivia’s Banco Bisa.

Just try going down to your local bank and switching your savings account to Euros. Not so much. (You can visit RBC Centura and gain access to Canadian dollars fairly easily, however.)

American consumers shouldn’t feel badly about their lack of knowledge regarding the dollar crisis, however. It turns out that even the White House isn’t allowed to talk about the dollar. Here’s a memorable quote from a recent press conference on March 7 by Dana Perino and Edward Lazear, Chairman of the Council of Economic Advisers:

Q I’d like to follow up on their refusal to talk about the dollar, if I could. I mean, we’re in a kind of a bad situation here, when OPEC says the reason for $105 or $106 a barrel of oil is the falling value of the dollar — and you won’t address that issue. Where do we go to find out who is right?

MS. PERINO: Well, as he just said, the Treasury Secretary is where you go to talk about the dollar. It’s a longstanding policy that predates this administration, and I’m not going to change it today. But Treasury can talk about it.

Q I don’t expect you to change it, but I do expect you to be able to say whether OPEC is completely wrong about this, or whether there is at least something to their claim that the dollar is responsible for the high price of oil right now.

MS. PERINO: Wendell, I’m under strict instructions, and have been from the beginning, to not talk about the dollar, and I’m not going to get fired to satisfy your question. (Laughter.)

That’s funny, all right. It’s funny that the current crisis is cloaked in bureaucratic “secrecy”, and folks aren’t willing to be honest about a crisis of historic proportions.

Today, the Federal Reserve opened up the money spigots to bail out a broke investment bank. Not surprisingly, our currency continues its free-fall against commodities and other currencies. The American worker, saver, and retiree has never been so endangered as in today’s inflationary environment.

For folks who don’t understand why we’re in such danger, here’s the answer: un-Consitutional debt-backed paper money that can be created or destroyed at will by a private central bank. Right now, your salary and savings are being stolen by the rising cost of food, energy, and other necessities just so we can keep a corrupt system solvent.

It’s time for a change, and time for Americans to talk about the dollar again. My favorite quote from this recent post:

I urge all voters to apply this crucial test to their representatives before supporting them.

Make them commit squarely and unequivocally to these questions. Do you believe Congress should exercise its sovereign power as provided in the Constitution of the United States to create money and regulate the value thereof and control the circulating medium in the interest of the whole people? Or do you believe this sovereign power should be transferred to Banks of Issue?

Their answers will prove conclusively whether they are with the people or against them.

Or do you believe that Banking Corporations should issue a credit substitute and through it control the money and circulating medium of exchange of the people of the United States in their own interest?

Watch your presidential candidate carefully and see that he commits himself clearly on this vital question. It will be a true test of his honesty and fitness for office. Admitted ignorance on the monetary issue should not excuse him. The subject is as old as our government, and if he does not know enough about it now to answer these test questions, he is not qualified to fill the position he aspires to, and should not ask your votes.

These words were written in 1912. When’s the last time you considered the nature of money?

I just read a fascinating book, High Cost of Living by Thomas Cushing Daniel, published in 1912 and now digitized thanks to Google Books. It is a fantastic “living documentary” of the history of our monetary and banking system. I especially recommend these quotes from the chapter “Responsibility Rests with the People”, on pages 157-158 of the electronic document or pages 150-151 of the book:

I urge all voters to apply this crucial test to their representatives before supporting them.

Make them commit squarely and unequivocally to these questions. Do you believe Congress should exercise its sovereign power as provided in the Constitution of the United States to create money and regulate the value thereof and control the circulating medium in the interest of the whole people? Or do you believe this sovereign power should be transferred to Banks of Issue?

Their answers will prove conclusively whether they are with the people or against them.

Or do you believe that Banking Corporations should issue a credit substitute and through it control the money and circulating medium of exchange of the people of the United States in their own interest?

Watch your presidential candidate carefully and see that he commits himself clearly on this vital question. It will be a true test of his honesty and fitness for office. Admitted ignorance on the monetary issue should not excuse him. The subject is as old as our government, and if he does not know enough about it now to answer these test questions, he is not qualified to fill the position he aspires to, and should not ask your votes.

If he is unwilling to commit himself before election, he would be able, after becoming President of the United States, to fall in line with the great banking and corporate influences that have controlled the finances and business of the country up to the present time, and enable them to act into law the Morgan-Rothschild-Aldrich Bankers Bill now pending in Congress; or a bill based upon the same principles, which would make permanent the absolute control of all the business of the people of this country by a gigantic money trust.

This story did not end well for the Republicans. Going into the 1912 election, the Republican incumbent president William Howard Taft split the party into conservative and progressive branches. This philosophical divide was cemented by former president Theodore Roosevelt’s forming a separate Progressive party after he challenged Taft for the nomination in 1912. Sure enough, Taft and Roosevelt split the Republican vote, and Wilson was elected.

President Wilson signed the Federal Reserve Act in 1913. Along with the Federal Reserve, we also receive the sixteenth amendment, Internal Revenue Service, and the income tax. Since the Federal Reserve was created, our dollar has lost 97% of its purchasing power, and we send an unprecedented amount of money to foreign central banks as interest payments on a $9.2 trillion national debt.

Perhaps Thomas Jefferson said it best, one hundred years previously:

If the debt which the banking companies owe be a blessing to anybody, it is to themselves alone, who are realizing a solid interest of eight or ten per cent on it. As to the public, these companies have banished all our gold and silver medium, which, before their institution, we had without interest, which never could have perished in our hands, and would have been our salvation now in the hour of war; instead of which they have given us two hundred million of froth and bubble, on which we are to pay them heavy interest, until it shall vanish into air… We are warranted, then, in affirming that this parody on the principle of ‘a public debt being a public blessing,’ and its mutation into the blessing of private instead of public debts, is as ridiculous as the original principle itself. In both cases, the truth is, that capital may be produced by industry, and accumulated by economy; but jugglers only will propose to create it by legerdemain tricks with paper. [emphasis mine]

Letter to John W. Eppes, 1813. ME 13:423