Kessler: Bernanke’s Exit Strategy
Posted By thestatedtruth.com on February 4, 2010
Kessler: Bernanke’s Exit Strategy
~~~~~~~~~~~~
ANDY KESSLER, The Wall Street Journal (02/04/10): We can end bank panics
forever by limiting the ability of lenders to create money out of thin
air.
Â
Last week, voting 70-30, the Senate confirmed Federal Reserve Chairman Ben
Bernanke for another four year term. So now what will he do?
Â
Phase one of the recovery is certainly complete. Since September 2008, the
Fed has bought mortgage-backed securities and Treasurys, and increased the
monetary base to $2 trillion from $850 billion.
The flood of dollars has bank profits booming.
Â
Sadly, banks still have all those underwater mortgage-backed securities
and derivatives, but Mr. Bernanke is assuming they will just earn their
way out of this problem. Banks also are not lending enough to get the
job-creation engine rolling again—though sooner or later they will, at
which point inflationary pressures will build tremendously. So every
currency trader, bond buyer and man on the Street wants to know one thing:
“What’s the exit strategy, Ben?” Raise interest rates, shrink the money
supply and risk cratering the economy, or keep rolling along and risk a
collapsing dollar?
Â
My guess? Mr. Bernanke will leave the money out there but restrict banks’
ability to create more out of thin air. He’ll be called crazy. Crazy like
a fox.
Â
The Fed has a once-in-a-millennium opportunity to do away with banking
panics. Investors will rejoice, but Wall Street firms are not going to
like it one bit.
Â
Our banking system has changed little since the days of Elizabethan
goldsmiths writing more gold receipts (aka banknotes) than they had gold
in their vaults. This “fractional reserve banking” system has caused every
major panic in this country—I’ve counted at least 16 of them since 1812.
Â
Whatever the era, the story is always the same. Banks keep small reserves,
and then invest in supposedly safe “sure things” to generate profits
beyond the interest paid to depositors.
Â
Sure things can be real-estate loans, home equity, credit card and
commercial debt. But bankers are terrible investors. There are no sure
things.
Â
Thus modern banking is protected by the twin pillars of the Fed and the
Federal Deposit Insurance Corporation (FDIC). The Fed, founded in 1913 out
of the failure of Knickerbocker Trust when it tried to corner the copper
market, finally learned after the banking crisis of 1930 that it is the
lender of last resort. And the FDIC was established in 1933 to insure
depositors against losses in case the bank is so bad at investing that
there is nothing left for the Fed to lend to.
Â
The end of bank runs? Mostly. Panics? Hardly. And Paul Volcker’s proposal
to restrict proprietary trading won’t change a thing. Banks write bad
loans at the top and dump them at the bottom.
Â
Here is some recent history. The 1988 Basel accords set minimum bank
capital at 8%, meaning banks could leverage their capital at ratio of 12.5
to 1. As long as their investments didn’t fall by 8%, they stayed solvent.
In 2001, U.S. minimum capital was set at 10%, more or less, but banks were
allowed higher leverage if some of their capital was AA or AAA rated
mortgage-backed securities. The rationale was that these instruments could
never possibly drop more than 5%, let alone 10%. Oops.
Â
Under the 2004 Basel II accords, so-called shadow banks (which don’t take
deposits) with $5 billion in capital were exempt from these regulations.
So institutions such as Goldman Sachs, Morgan Stanley, Merrill Lynch,
Lehman Brothers and Bear Stearns regularly used 20 to 1 or even 30 to 1
leverage. This allowed these firms to effectively print money, inflate the
housing bubble, and then watch those same AA and AAA mortgage securities
fall by 70%-90% in value.
Â
To sum up, the Fed creates a monetary base and the banks can create $10
for every $1 of monetary base. Wall Street firms created $20 for every Fed
$1. In other words, the Fed only seeds the market. Beyond crude
instruments like interest-rate policy, it has little control over how much
actual money supply exists. In good times banks lend too much. And in bad
times, such as today, they don’t create enough money because they lend too
little.
Â
Perhaps the lesson Mr. Bernanke drew from 2008-09 is not that we need more
regulation but that financial firms should not be allowed to generate
money out of thin air to write soon-to-be-bad loans ….
Â
Read On:
Comments