|
Our title is
borrowed from a caption of the Chicago economist and monetary scientist
Melchior Palyi (1892-1970) writing on the fiscal and monetary legerdemain of
the U.S. government in his Bulletin #401, dated February 27, 1960, as follows.
Faking balance
sheets legalized
A corporation publishing faked balance sheets would be barred from every
stock exchange. It may even face criminal prosecution. The objective is to
protect the public against fraud. But exactly the same fraudulent practice
has been legalized in so far as commercial and savings banks, and life
insurance companies are concerned. They can carry government bonds on
their books at par value. A $1,000 bond may be quoted in the market at
$800 or less; the balance sheet of your bank will still show it at $1,000.
The purpose of this regulation, adopted by all federal and state supervisory
agencies and by the Securities Exchange Commission as well, is to give those
bonds a sacrosanct status and guarantee against paper losses. Thereby they
are promoted to an absolutely safe and “liquid” status. The bank
examiners count the bonds of the federal government, whatever their maturity
and actual market price may be, as prime liquid assets, just like
cash. The more bonds in the portfolio, the more liquid is the bank by the
examiners’ standards, — never mind the paper losses.
It is small wonder that the banks purchase long term federal obligations,
thereby creating a market for them. The result is that with rising interest
rates and declining values of medium- and long-term securities, the modest
capital and undivided surplus of the banks – reserves against losses
– are impaired. In the case of quite a few banks the entire capital and
all reserves have been lost. In some cases, even a part of the deposits has been
wiped out.
Silence of the Sea
But the public knows nothing about this sad situation. No newspaper dares to
discuss it, or the preposterous practices of the govern-ment at the root of
it. The “Silence of the Sea” covers them up. Those on the inside
(and insight) hope and pray that a recession will reduce the pressures on the
capital market, lower interest rates, raise bond prices, and wipe out the
losses. Very likely it will; but what about the next cycle? And, above all,
for how long, or how many times, will the depositors and savers permit
themselves to be fooled and victimized? Sooner or later every legerdemain,
however clever or subtle, is exposed – and backfires.
A further consequence is that the bond portfolio of the banks “freezes
up”. By selling bonds the bank would convert paper losses into real
losses, which would skyrocket if major amounts were liquidated. While the
boom and high interest rates obtain, the “prime liquidity” turns
out to be the very opposite, unless the bonds are monetized at, and the
losses shifted onto, the Federal Reserve. But the central bank can be relied
upon to resist the “temptation” to absorb either or both.
The
above was written in 1960. In 2009 we are wondering what has hit our banks.
No mystery there. It was not subprime mortgages nor other loose lending
practices. The banking crisis is entirely self-inflicted or, more precisely,
government-inflicted the origins of which go back almost ninety years: faking
balance sheets. That practice cannot go on forever. The day of reckoning
comes when capital is called upon to do what it is supposed to do: to tie
over the bank during a temporary setback. The kitty is opened, and found
empty. Bank capital is gone, due to earlier legerdemain in trying to paper
over paper losses. (No pun intended.)
The situation is actually worse,
as far as the condition of our banks is concerned. So far deposits have not
been affected during this crisis. Depositors feel secure in the belief that
they are protected by the government and its deposit insurance scheme. Here
is Palyi, writing in the same article on this subject:
The hare-brained
Geithner-plan
Now, 50 years later, we have a fully-fledged banking crisis on hand, and the
FDIC will soon face its first real test since its establishment in the
1930’s. Is deposit “insurance” a myth as suggested by
Palyi, designed to mislead the public? There is plenty of evidence that it
is. Why did the big Wall Street banks not sell government bonds from
portfolio before begging Congress for bailout money? On the face of it this
would have been a good time to sell, as the bonds are quoted above par value
by the market, thanks to a super-low interest-rate structure. Could it be
that the bond market is rigged? Could it be that high bond values are
artificially maintained, e.g., by tempting bond speculators to the long side
of the market with risk-free profits, and threatening those on the short side
with sudden death — the essence of open market operations as I have
long suggested? This time we shall find out.
If you examine the latest measures initiated by the Geithner Treasury, there
is indeed reason for alarm. Treasury Secretary Timothy Geithner openly
invites private investors to speculate, risk free, in buying the toxic
assets of the banking system. The risks, should they materialize, are covered
by pledging, most improperly, the assets of the FDIC. If the gamble succeeds,
private investors may keep the assets they have bought on the cheap.
Otherwise the FDIC will pick up the tab and will reimburse investors for their
losses.
Let me ask the only relevant question. Why would private investors, in their
right mind, speculate in toxic assets which have no market, given the
fact they can already speculate, directly and risk-free, in the
“ultimate” asset that is held in the guaranty fund for those
toxic assets, that do have a market in which the troubled banks
compete with overseas central banks for the bonds of the U.S. government? The
Geithner-plan is a hare-brained plan, and is bound to fail.
Portfolio frozen as
the Antarctic
When
it does, there will be a run on the banks. It will be ugly and unstoppable.
Only about ten percent of the money supply is in the form of Federal Reserve
(FR) notes, and people will be scrambling for them. The printing presses will
be run 24 hours a day, seven days a week, and they will still not be able to
meet the demand. Apparently, foreigners are already scrambling for FR notes.
They could of course have FR deposits in the form on electronic money, but
they wouldn’t touch them with a ten-foot pole. They want dollars they
can fold.
Make no mistake about it, behind this unprecedented world panic and bank run
is the book-keeping legerdemain that the U.S. government and its bank
examiners have adopted after the 1921 panic in the bond market. Thereby the
commercial and savings banks, as well as insurance companies in the U.S. were authorized to carry government bonds at par value in the balance sheet, as if
they were a cash item, in complete disregard for what they would fetch in the
open market. Moreover, banks and insurance companies could also use them as
gambling chips, buying and selling them to pocket risk-free profits. They
just have to second-guess the Federal Reserve (Fed). Whenever the Fed has
nature’s urge to go to the open market to relieve itself (read: to buy
more bonds for the purposes of collateral in order to be able to increase the
money supply), they could pre-empt it in buying the bonds first. In this way
they bid up the price of bonds and then dump them in the lap of the Fed for a
quick profit.
Now the whole shady scheme of misleading the public through balance-sheet
hocus-pocus is coming unstuck. Make-believe bond values have backfired badly.
As it turns out, the banks’ portfolio of government bonds is as frozen
as the Antarctic − just as Palyi predicted fifty years ago that it
would be.
Grand Canyon-size
holes in the balance sheets
The banks cannot liquidate it without revealing Grand Canyon-size holes in
their balance sheet, several times larger than bank capital. They desperately
need to retain their portfolio of government bonds for “window-dressing”
purposes, that is, to show at least the remnants of what had been bank
capital in happier times. They desperately try to hide the fact that
even the ruins of their capital are gone. The much advertised
“stress-test”, no doubt, is using the same metric that has
steered the banking system to the ground during the past four-and-a-half
score of years: the metric assuming that government bonds can never lose
value, and bank balance sheets are there to falsify based on that false
metric. Such an assumption is especially dangerous when the interest-rate
structure is at the low-end of the spectrum, and the country is suffering
from a chronic balance of payments deficit. It is difficult to see how one
can treat the stress-test and its results with respect.
We
shall see how adroitly Ben Bernanke will handle the printing press which he
is in the habit of boasting that the U.S. government has given him to use in
a situation like this. He will not be able physically to print FR
notes so fast as to replace electronic money that has been lost, or will be
lost through rejection by the public. Electronic money had been created in
the belief that nothing more was needed to pacify the markets. But it is one
thing to create electronic money with a click of the mouse; it is quite
another thing to print FR notes on real paper with real
ink.
This is the secret of deflation, and the answer to the much-debated question
whether you can have hyperinflation and deflation all at the same time. The
answer is that you can, because hyperinflation refers to electronic money
that people reject, and deflation refers to FR notes that people hoard.
The moment of truth has arrived. You cannot fool all the people all of the
time. The Emperor is naked: the tailors who created his garments are
impostors.
Too
bad for the impostors. Unlike in Andersen’s story where they decamped
in a hurry, Bernanke and Geithner stayed and will have to face the ire of the
Emperor — and that of the people when they find out that their deposits
are “gone with the wind”.
Antal E. Fekete
San Francisco School of
Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright © 2002-2008 by Antal E. Fekete - All rights reserved
| 
