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Privatizing
profits, socializing losses
The
0.7 trillion dollar bailout plan of Treasury Secretary Paulson must be seen
for what it is: a scheme to privatize profits while socializing losses. The
scare tactics with which he was trying to railroad it through Congress has
failed and the world is better for it. The malady has to be diagnosed
properly. I summarize the popular diagnosis in five points.
- The bursting
of the housing bubble has led to a surge of defaults and foreclosures
which has, in turn, led to a plunge in the value of mortgage-backed
securities ― assets which are in effect capitalized mortgage
payments.
- These losses
have left many banks short on capital account. Their problems were
compounded by the fact that as their capital ratios were shrinking,
rather than reducing their debt exposure they aggressively increased it.
- “Leveraging”
is the word to describe the deliberate shrinking of capital ratios,
i.e., making smaller capital support a larger amount of risks. Aggressive
leveraging was characteristic of the pre-crisis boom.
- When they
recovered after the dizzying ride, banks needed a microscope to read
their capital ratios and they reacted in a predictable way. They were
unwilling (unable?) to fulfill their mission to provide the credit that
the national economy needs for its day-to-day operation.
- As a
defensive measure financial institutions have been belatedly trying to
pay down their debt by selling assets, including mortgage-backed
securities, but as they were doing it simultaneously, they drove down
asset prices. This has damaged their balance sheets even more. A vicious
circle is engaged that some call the “paradox of
de-leveraging.”
Capital
destruction
I
should hasten to say that I disagree with this popular diagnosis which puts
the cart before the horse. My diagnosis, described in the first part of this
article, identifies the destruction of capital as the cause, and the credit
crisis as the effect.
The problem goes back to the U.S. government foolish decision to destabilize
the interest-rate structure (and, hence, bond prices) in 1971. As a
consequence, long-term interest rates shot up to 16 percent per annum by the
early 1980’s, from where they started their long descent that still continues.
Falling interest rates destroy capital as they raise the liquidation-value of
debt contracted earlier at higher rates. By ‘liquidation value’
is meant the sum that will liquidate the debt, should it be necessary to pay
it off before
maturity. In a falling interest-rate environment it will take a larger sum to retire
the same debt. Why? Because the scheduled stream of interest payments is now
capitalized at a lower
rate of interest and, therefore, it falls short in liquidating the debt.
This means that, paradoxically, falling interest rates do not alleviate but aggravate the burden
of debt. All observers miss this point as they blithely assume that debt is
automatically refinanced at the lower rate. It is not. Falling interest rates
create a deficiency on capital account since it takes a bigger bite to
service existing debt than originally provided for, and the deficit is made
up at the expense of capital. Over-leveraging is not the cause; it is the
effect. What it shows is that the banks do not pay heed; they persist in
error. They simply ignore shrinking capital ratios. This ultimately causes
wholesale bankruptcies, leading to the vicious downwards spiral.
The banks should have made provision to compensate for eroding capital as
interest rates were falling. None of them did. None of them understood the
insidious process of capital erosion in the wake of declining interest rates.
They reported losses as profits. Then they were hit by the negative feedback:
capital eroded further. When the truth dawned upon them, it was already too
late.
Interest rates have been falling for the past 28 years. The liquidation value
of outstanding debt has been increasing by leaps and bounds. It reached the
tipping point in February, 2007 as indicated by the unprecedented jump in the
price of credit-default swaps. It revealed that any further decline in the
rate of interest would plunge bank capital into negative territory. At this
point capital dissipation stops: there is nothing more left to dissipate. For
the banks, this is sudden death.
No commentator could explain why
banks have all run out of capital at the same time, while making obscene
profits. My explanation is simple. There have been no profits,
obscene or otherwise. The banks were paying out phantom profits in the belief
that their capital accounts were in good shape. They weren’t. The banks
were unaware that the falling interest rate structure has been making inroads
on their capital. Since all banks have been working with microscopic capital
ratios as a result of 28 years of capital erosion, the failure of one single
bank would trigger the ‘domino-effect’ on the rest.
Why
gold?
This
puts the role of gold into high relief. Had gold been retained as a component
of bank capital, credit-default swaps would have never been invented. Gold is
unique among financial assets in that it has no corresponding liability in
the balance sheet of others. Gold
is the only financial asset that will survive any consolidation of bank
balance sheets,in contrast with paper assets that are subject to
annihilation (e.g., when the bank is consolidated with its counterparty
holding the liability side of that asset). Suppose we consolidate the balance
sheets of the global banking system. Then all assets will be wiped out with the sole exception of gold.
But since the global banking system as it is presently constituted has no
gold assets, under any consolidation the banks will be denuded of assets
while note and deposit liabilities to the public remain. This is why the
regime of irredeemable currency is susceptible to collapse that could be
violent, taking place with lightening speed. It can also be seen that trying
to save banks from collapsing through consolidation, mergers, takeovers, and
shotgun marriages is pouring oil on the fire: it accelerates the meltdown of
bank capital, rather than retarding it.
Implosion
of the derivatives monster
My
thesis also explains the explosive growth of the derivatives markets. First
round insurance against decline in the value of bonds in the banks’
portfolio can be had by selling bond futures. Those writing first-round
insurance need to cover their assumed risk in the form of second-round
insurance, they do so by selling call or buying put options on bond futures.
But those writing second-round insurance also need to cover their risk: they
do it in the derivatives market by purchasing credit-default swaps. The point
is that an infinite chain of credit-default swaps is being built on every
bond in the banks’ portfolio, as shown by the derivatives
monster’s more than doubling in size every other year, already having
reached the size of one
half quadrillion dollars and still counting.
Why is the derivative monster so dangerous? Because it is subject to
implosion that could destroy an inordinate amount of bank assets. If the
derivatives tower is consolidated, then its value collapses to zero as claims
are wiped out by counter-claims. It is possible that this implosion has
already started, but the banks (and their supervisory agencies) keep the lid
on this information to avoid a world-wide panic. The earth quakes badly under
the foundations of the Derivatives Tower of Babel. Its toppling may be
imminent. If gold had been retained as a component of the bank capital
structure, then there would have been no derivatives monster to fret about.
Those who explain the proliferation of derivatives by the popularity of
“dry swaps”, that is to say, swaps created for the sole purpose
of speculative profits they promise in view of their ultra-low
price-to-reward ratio, are wrong. All those credit-default swaps were
purchased by actual insurers insuring actual risks going with bond ownership,
in trying to hedge their own risks.
Recapitalizing
banks with gold
The
credit crisis could be solved through the recapitalization of banks with gold. The
Treasury should pledge to match subscriptions of new private capital, in
gold, at the ratio of two to one. This means that two gold shares of capital
stock subscribed by the private sector (individuals, firms, and institutions)
shall invite one share of capital stock subscribed by the Treasury. Gold
subscribed by the private sector should be constitutionally guaranteed
against capital levy and confiscation.
There is no better use to which Treasury gold can be put which has been
foolishly idled for the past 36 years. What is needed is the mobilization of
gold hoarded by the Treasury, as well as of gold hoarded by the private
sector. The trouble is that much of the privately owned gold is in hiding and
won’t surface for reasons of lack of confidence in the monetary system.
But as soon as there is a market for the shares of the recapitalized banks,
private gold can be coaxed out of hiding and made to participate actively in
the great task of rebuilding world credit.
Capital stock of the recapitalized banks would pay dividend, in gold, at the
rate of one tenth of one percent per annum to stockholders, exempt of all
taxes. This would make it possible, even for people of modest means, to
acquire gold earning a safe return in gold. The maliciously false propaganda
of the past decades that gold is a sterile asset in that it earns no interest
is easy to refute. Gold has been lent and borrowed at interest (facetiously
called the ‘lease rate’) without interruption, in spite of its
so-called ‘demonetization’ by the government. In fact, the gold
rate of interest is the benchmark on which all other interest rates are still
based, after adding a risk-premium reflecting the risk that the monetary unit
may lose its gold exchange value.
The tax-exempt feature of dividends has great merits to recommend it,
especially if no other exemptions across the economic landscape are granted.
You could look at it as society’s protection of widows and orphans, and
other members of society who are unable to fend for themselves in a
competitive environment, to live in dignity away from the hurly-burly of the
investment world.
What is the use of recapitalizing banks with irredeemable promises to pay? It
has been tried for the past 36 years; it doesn’t work.
No
chain is stronger than its weakest link
The
newly recapitalized banks must offer their old assets for sale to the public,
in exchange for the gold shares of capital stock, through competitive
auctions. In this way the true value of the old paper assets can be
determined, and whatever can be salvaged will be salvaged. The market for
bank assets, presently frozen, would be made liquid once more. If a bank
wants to retain a part of its old assets in the balance sheet, it must bid
for it in the same way as if it were buying from another bank through
competitive auction. If an asset cannot be disposed of in this way, then it
must be written off. Any delay in validating bank assets through the sieve of
competitive auction will only prolong and deepen the crisis.
The ‘securitization’ of bank assets was an idiotic strategy
motivated by the fraudulent idea that in lumping sub-prime assets together
with valid assets would somehow impart value to the former, and the
marketability of the product would be enhanced. This, of course, is just a
ploy to cheat the buyer. It is like trying to make a chain containing a weak
link stronger by adding any number of strong links. The weak link must be
replaced with a strong one. No chain can be stronger than its weakest link.
The re-liquefying of bank assets is a first order of business in the present
runaway global credit crisis. We are past the point that the wild-fire can be
localized. Mobilization of gold is the only way.
Save
the pension funds!
This
crisis is a warning, possibly the last one, that the recapitalization of
banks with gold cannot be further postponed without risking the total
collapse of the financial system. If there was some hope that the Treasury
might have a contingency plan to mobilize gold in case of a crisis such as
this, the Paulson bailout plan has dispelled it. When the moment for the
‘break-the-glass’ rescue plan has arrived, what did we find
behind the broken glass? More irredeemable promises to pay, to augment bank
capital. All chaff, no grain.
Global credit collapse would bring enormous hardship in its train for
ordinary people who have worked hard and saved hard through a lifetime only
to see the fruits of their efforts going up in smoke. The result could be
total social chaos and lawlessness. At risk are all the insurance companies,
pension funds, money market funds. Also at risk is the taxing power of the
government, as a prostrate economy won’t be able to bear the tax
burden, but will spawn a grey economy that finds ways to evade taxes. The
rejection by the U.S. House of Representatives of Paulson’s bailout
plan can be viewed as a taxpayer revolt. Is it the first, with more to come?
Close
of Keynes’ and Friedman’s system
Understandably,
it will be hard for policy-makers, academia and media, and the
accountants’ profession to admit that they have been wrong all along
about gold and its essential role in the economic bloodstream and in
accounting. They have fallen victim to the charm of John Maynard Keynes, the
prankster who invented the idea that gold was a barbarous relic, and the gold
standard was a ‘contractionist fetter’ upon the world economy.
Now we have proof that the blame for the contraction should be assigned, not
to the use but to the misuse
of gold. The debt collapse is the burial ground for Keynesianism.
After Keynes was gone, policy-makers, academia and media, and the
accountants’ profession fell under the spell of another visionary and
adventurer talking with a forked tongue, Milton Friedman. He was fond of
posing as a free-market man, but in promoting irredeemable currency he did
more than anybody, save Keynes, to destroy the free market. Friedman promoted
the spurious idea that gold is superfluous in the international monetary
system as floating foreign exchanges rates can mimic the operation of the gold
standard and will balance the trade accounts. But as the record shows,
Friedmanite nostrums have ruined the dollar, as well as the once flourishing
and peerless American productive apparatus.
Politicians, academia and media, and the accountants’ profession must
swallow their pride and get the confession off their chests that their
prognostication, policies, and advice about gold have been in error. If they
fail to do this, and continue to block the way of gold to make a return to the
economic bloodstream, then their responsibility for the suffering caused by
the credit collapse in this country and in the world will be total. They will
be shown as doctrinaire wreckers of human cooperation under the system of
division of labor, who muzzled their critics and usurped unlimited power,
while paving the way to a world disaster akin to that of the Bolshevik
revolution.
After the close of Marx’ system, the close of Keynes’ and
Friedman’s system is inevitable. But the wounds they have caused would
take a long, long time to heal.
The mission of Gold Standard University Live is to do the research that
academia refused or was forbidden to do: find out the consequences of ousting
gold from the monetary system by the U.S. government, following its 1971
default on the Treasury’s gold obligations. Unfortunately our sponsor,
Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his financial
support saying that our “results do not justify the expenditure”.
I am forced to terminate the sessions. Our last activity will be a panel
discussion on the present credit crisis to be held in Canberra, Australia, on
November 15, 2008, under the title: The
chickens of 1933 and 1971 are coming home to roost and take out bank capital.
I invite you to come and contribute to the success of Gold Standard
University Live with your questions and comments. At any rate, the sessions
will be taped and the DVD’s made available to the public, along with
the conference proceedings.
Calendar
of events
New York City,
October 16, 2008
Committee for
Monetary Research and Education, Inc., Annual Fall Dinner.
Professor Fekete is an invited speaker. The title of his talk is:
The Mechanism of Capital
Destruction.
Inquiries: cmre@bellsouth.net
Santa Clara,
California, November 3, 2008
Santa Clara
University, hosted by the Civil Society Institute
Professor Fekete is the invited speaker. The title of his talk is:
Monetary Reform: Gold and Bills of Exchange.
Inquiries: ffoldvary@scu.edu
San Francisco,
California, November 4, 2008
Economic Club of San
Francisco
Professor Fekete is the invited speaker. The title of his talk is:
The Revisionist Theory
and History of the Great Depression ― Can It Happen Again?
Inquiries: ifkbischoff@yahoo.com
Canberra,
Australia, November 11-14, 2008
Gold Standard
University Live, Session Five. (This is the last session of
GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has
withdrawn his support saying that in his opinion the results do not justify
the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ―
Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early
Warning System for Everybody Else.
Inquiries: feketeaustralia@yahoo.com
Canberra, Australia,
November 15, 2008
Panel Discussions: The chickens of 1933 and 1971 are
coming home to roost and take out bank capital.
Inquiries: feketeaustralia@yahoo.com
Reference
Is Our
Accounting System Flawed? ― It may be insensitive to capital
destruction
www.professorfekete.com
May 23, 2008.
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
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