Quote of the Day: The FDIC’s very paltry defense against defaults

Since then, FDIC recovered a bit, and as of 2013 had $47 billion back in its fund. This small defense was insuring some $6 trillion in insured bank deposits, a coverage ratio of 0.79 percent.

Now when I brought up this alarming situation at my personal blog, some people scoffed in the comments. Why, if there is ever another wave of bank failures, the FDIC can just borrow from the Treasury. Ultimately, the government can just turn to the Federal Reserve to create new money and make everybody whole. Now that we’ve gotten rid of that pesky gold standard, Uncle Sam can hand out unlimited amounts of dollars.

Such a reaction is shocking in its glibness. Remember that FDIC is supposed to be an insurance program. It doesn’t get its fund from taxpayers, but from premiums assessed on the insured banks themselves. Indeed, in order to replenish its fund, back in 2009 FDIC made the banks “prepay” thirteen quarters (i.e. a little more than three years) worth of premium payments. Once the immediate danger was past, FDIC issued refunds of these overpayments in 2013.

Nobody doubts that the government has the technical ability to create billions or even trillions of dollars and hand them out. But that isn’t a way for society as a whole to become richer. Yes, if a small number of depositors lose money on a few failed banks, then the rest of us can—via the government—act as a backstop, and spread the losses around, so that any individual feels just a slight amount of pain.

Yet having government-imposed deposit insurance makes the system as a whole far more vulnerable, particularly when the banks are being assessed such low premiums (in normal times). Precisely because people think, “My money is 100% guaranteed in the bank,” nobody ever does research on what exactly his or her bank does with the funds it lends out. People care about monthly fees, branch hours, and ATM locations, but they don’t ever inquire, “Does my bank make wise investments?”

FDIC as implemented thus gives us the worst of both worlds: It lulls depositors into a false sense of security, so that there is little market discipline reining in reckless lending by the banks. Yet at the same time, given that the system is pushed to embrace risk, FDIC nonetheless carries a very paltry defense against defaults. In the event of a major downturn, the government would have to freshly dip into taxpayers in order to take money from us, so that it could give us our money back.

(bold mine, italics original)

This is from Austrian economist, consultant and author Robert P Murphy at the Libertychat.com. 

The above is a noteworthy example where centralization of a complex process via political interventions, particularly applied to the US banking system, increases systemic risks. That's because such actions skews on the market's incentives to self regulate via the promotion of depositors' dependency on political authorities, as well as to advance the Moral Hazard incentives of the banking industry.

This also shows of the knowledge problem of political authorities who seem to underestimate the risks from the current system, or alternatively, appears to overestimate the strength of the banking system or the FDIC's capacity to contain risks.  And this may be aside from the possible "regulatory capture" where the banking industry may have influenced authorities on the "low premiums" for maintaining a tenuously funded politically controlled centralized deposit insurance. All these and more combine to produce "the paltry defense against default".

The Four Horsemen of the Financial Apocalypse

In the Book of Revelation in the Christian Bible, the end of the world or the ‘Last Judgment’ will be presided by the four horseman of the apocalypse. These figurative horsemen embodies conquest, war, famine and death.

While not exactly according to biblical prophesy, such allegorical omen may be seen as applicable to today’s modern day financial and monetary central bank based fractional reserve money system.

From the Sovereign Man’s prolific Simon Black (bold mine)

Today’s financial system is dominated by central bankers who have been awarded nearly dictatorial control of global money supply.

In allowing them to set interest rates, they are able to control the ‘price’ of money, thus controlling the price of… everything.

This power rests primarily in the hands of four men who control roughly 75% of the entire world money supply:

-Zhou Xiaochuan, People’s Bank of China

-Mario Draghi, European Central Bank

-Haruhiko Kuroda, Bank of Japan

-Ben Bernanke, US Federal Reserve

Four guys. And they control the livelihoods of billions of people around the world.

So, how are they doing?

We could wax philosophically about the dangers of fiat currency. Or the dangers of the rapid expansion of their balance sheets. Or the profligacy of wanton debasement through quantitative easing.

But let’s just look at the numbers.

In theory, a central bank is like any other bank. It has income and expenses, assets and liabilities.

For a central bank, assets are typically securities or commodities which have value in the international marketplace, such as gold or US Treasuries.

Central bank liabilities are all the trillions of currency units floating around… dollars, euros, yen, etc.

The difference between assets and liabilities is the bank’s equity (or capital). And this is an important figure, because the higher the capital, the healthier the bank.

Lehman Brothers famously went under in 2008 because they had insufficient capital. They had assets of $691 billion, and equity of just $22 billion… about 3%.

This meant that if Lehman’s assets lost more than 3% of their value, the company wouldn’t have sufficient cushion, and they would go under.

This is exactly what happened. Their assets tanked and the company failed.

So let’s apply the same yardstick to central banks and see how ‘safe’ they really are:

US Federal Reserve: $54 billion in capital on $3.57 trillion in assets, roughly 1.53%. This is actually less than the 1.875% capital they had in December. So the trend is getting worse.

European Central Bank: 3.69%

Bank of Japan: 1.92%

Bank of England: 0.843%

Bank of Canada: 0.532%

Each of these major central banks in ‘rich’ Western countries is essentially at, or below, the level of capital that Lehman Brothers had when they went under.

What does this mean?

Think about Lehman again. When Lehman’s equity was wiped out, it caused a huge crisis. The company’s liabilities instantly lost value, and almost everyone who was a counterparty to Lehman Brothers lost a lot of money because the company could no longer pay its debts.

Accordingly, if the US Federal Reserve’s assets unexpectedly lose more than 1.5% of their value, the Fed’s equity would be wiped out. This means that any counterparty holding the Fed’s liabilities (i.e. Federal reserve notes) would lose.

More specifically, that means everyone holding dollars.

Theoretically if a central bank becomes insolvent, it can be bailed out. It happened in Iceland a few years ago.

There’s just one problem with that thinking.

Iceland’s government wasn’t in debt at the time. So they were able to borrow money in order to bail out their central bank. Today the government is in debt over 100% of GDP, but the central bank is solvent.

But governments in the US, Europe, Japan, England, etc. are all too broke to bail out their central banks. These governments are already insolvent. So if the central bank becomes insolvent, there won’t be anyone to bail them out.

This is one of the strongest indicators of all that the financial system as we know it is finished. When central banks can no longer credibly issue liabilities, and their home government are too broke to bail them out, this paper currency standard can no longer function.

Such data really underscores the importance of owning real assets such as productive land and precious metals.

Given its nominal roller coaster ride lately, there has certainly been a lot of scrutiny and skepticism about gold.

But to paraphrase Tony Deden of Edelweiss Holdings, if you dispute the validity of gold as a hedge against declining fiat currency, that makes you, by default, a paper bug. Can you really afford to be confident in this system?

As been repeatedly noted here, QEs by major central banks have been meant to shore up asset markets which underpins the assets on the balance sheets of crony banks, and their guardians, the central banks. 

Of course QEs has fostered a low interest rate environment, which in effect, subsidizes debt financed government spending and the welfare warfare bureaucracy that the banking system, by virtue of Basel regulations, holds mainly as 'risk free' collateral.

And the same set of collateral have been used by crony banks to get loans from discount windows of central banks, and likewise, these collateral constitutes one of the major instruments used by central banks to conduct QE.

So all these ‘merry-go-around” or 'cul-de-sac' or 'loop-a-loop' arrangement has been designed to eliminate the threat of insolvencies of the cartelized unsustainable centralized debt-based political economic system

But there’s more. For the major economies, central banks can use changes in accounting methodologies to elude insolvencies, similar to the US Federal Reserve in January 2011.

As Austrian economist Robert Murphy noted, “It is now mathematically impossible for the Fed to become insolvent, through the magic of "negative liabilities."”

Ultimately central banks will tap the printing press should "bank runs” occur. 

Again Professor Murphy: 

But for the case of the Federal Reserve — with dollar-denominated liabilities — it is hard to see what actual constraints it would face, should its accountants suddenly announce its insolvency. Even if there is a "run on the Fed," where all of the commercial banks want to withdraw their electronic reserves on the same day, the central bankers need not panic: they can order the Treasury to run the printing press in order to swap paper currency for electronic checkbook entries. (This is a neat trick unavailable to the mere commercial bankers.)

The smaller central banks will not have the same privileges. Nonetheless, their assets are also anchored on assets of their major contemporaries.

I would like to further point out that aside from Iceland, another example of a bailed out insolvent central bank has been the defunct Central Bank of the Philippines (CBP)

As I wrote in June 2012

Central Bank of the Philippines, the predecessor of the BSP, suffered massive losses to the tune of an estimated Php 300 billion as consequence of the series of bailouts provided by then President Cory Aquino to her favorites.

The losses were eventually transferred to the central bank board of liquidators.

Don’t take just take it from me. Canadian monetary analyst JP Koning recently noted (bold mine) 

Consider the case of the Central Bank of Philippines (CBP), for instance. According to Lamberte (2002), the CBP was harnessed by the government in the 1980s to engage in off-balance sheet lending and to assume the liabilities of various government-controlled and private companies. All of this was to the benefit of the government as it lowered the deficit and kept spending off-budget. Later on these loans proved to be worthless, leaving the central bank holding the refuse. This has shades of Enron, which used various conduits and SPVs to hide its mounting losses.

The CBP was replaced in 1993 by the newly chartered Bangko Sentral ng Pilipinas (BSP). The BSP took over the CPB's note and deposit liabilities, as well as its foreign reserves and other valuable assets (the bad assets were allocated elsewhere).

A non-partisan observation on the populist perception which sees political leadership then as a 'virtuous' regime.

Bottom line: Small central banks will be bailed out. But if troubles of the four biggest and the most important central banks aggravates, then as Mr. Black notes “the financial system as we know it is finished” or financial apocalypse from the biblical equivalent of the four horsemen.

Quote of the Day: The Virtues of Stock Market Speculation

But the speculator’s actions have conferred definite services to the community. He has smoothed out the jumps in Acme’s share price. By buying the undervalued stock, he has put upward pressure on the price. (Likewise, if he short sells an overvalued stock, he puts downward pressure on the price.) Rather than Acme’s stock jumping from $10 to $20 when war breaks out, it jumps only from $13 to $20, because (in our example) the speculator’s heavy buying had already closed 30% of the gap.

By reducing stock price volatility, speculators take some of the risk out of holding stocks. For example, it’s not necessarily true that the person who sold early to the speculator at $11 “lost” $9 to the wily profiteer. It’s entirely possible that the person needed to sell his holdings of Acme because he had lost his job or because his kid’s tuition went up again. Thus, the speculator has actually made this person — who had planned to sell even if Acme remained at $10 — richer.

More generally, by anticipating future changes in the “fundamentals” and translating them into current stock prices, speculators reward even long-term investors, the kind whom most people praise (as opposed to the short-term, quick-buck speculators). For example, if an institutional investor thinks she has found a solid company that will pay high dividends and will be around for at least 20 years, it is speculators who will help keep the day-to-day stock price from straying too far out of line with these long-term facts. If a financial panic sets in and shareholders are dumping stocks across the board, it is speculators who will staunch the bleeding and swoop in to pick up “deals” at fire-sale prices.

This shows that speculators provide liquidity to the stock market and make it more lucrative for other, long-term investors to do their homework and put some of their savings into corporations they believe have a solid future. A major risk of such an investment is illiquidity — that the investor may have to sell under duress and accept a much lower price than she could get if she only had more time — but speculators mitigate this risk. If the price gets well below “what the stock is really worth,” then that’s exactly when a speculator has an incentive to swoop in and buy.

[italics original]

 

This is from Austrian economics Professor Robert Murphy at the Laissez Faire Books.

Tom Woods and Bob Murphy Refutes HuffPo’s 11 Myths about the Fed

Austrian economists Tom Woods and Bob Murphy turns the table on an apologist for the FED at the Huffington Post with a terrific smackdown

From Messrs. Woods and Murphy [bold original]

The other day the Huffington Post ran an article by a Bonnie Kavoussi called “11 Lies About the Federal Reserve.” And you’ll never guess: these aren’t lies or myths spread in the financial press by Fed apologists. These are “lies” being told by you and me, opponents of the Fed. Bonnie Kavoussi calls us “Fed-haters.” So she, a Fed-lover, is at pains to correct these alleged misconceptions. She must stop us stupid ingrates from poisoning our countrymen’s minds against this benevolent array of experts innocently pursuing economic stability.

Here are the 11 so-called lies (she calls them “myths” in the actual rendering), and our responses.

HuffPo’s Myth #1: “The Fed actually prints money.”

She leads off with this? As if this is some big discovery that will refute the end-the-Fed people? When we talk about Fed money-printing, we are speaking in shorthand. We’re pretty certain someone like Ron Paul knows the Fed doesn’t actually print money. But he, along with pretty much the whole financial world, speaks of the Fed as printing money. You know why? Because it’s a teensy bit more convenient than saying, “We need the Fed to credit some banks’ accounts with increased balances, which it does by means of a computer, though if these balances are lent out and the borrowers prefer to use some of this lent money as cash, the Treasury will go ahead and print the cash.”

HuffPo’s Myth #2: “The Federal Reserve is spending money wastefully.”

You may think the Federal Reserve is throwing around money like crazy, just like the federal government. But you’re wrong! As Kavoussi explains, the Fed doesn’t spend money like the federal government does; it creates money! That’s just totally different! And so we read, “Both CNN anchor Erin Burnett and Republican vice presidential nominee Paul Ryan have compared the Federal Reserve’s quantitative easing to government spending. But the Federal Reserve actually has created new money by expanding its balance sheet.”

She then points out that hey, the Fed earned a profit of $77.4 billion last year. We are supposed to be impressed. But if you can create money out of thin air and buy bonds with it, and then earn interest on those bonds, wouldn’t it be pretty hard to lose money? (But they just might, if interest rates should spike.)

HuffPo’s Myth #3: “The Fed is causing hyperinflation.”

Is it just us, or does Bonnie Kavoussi word things awkwardly? Do you know of anyone who says the Fed is causing – as in present progressive tense — hyperinflation?

Kavoussi then goes on to tell us that the CPI is showing low price inflation — again, as if she’s reporting some extraordinary revelation that will put all Fed critics to shame. There is no hyperinflation because the banks are holding the newly created money as excess reserves with the Fed. If the banks begin lending and the money multiplier is enacted, an inflationary spiral could easily occur — trillions of dollars of high-powered money would expand via the fractional-reserve banking system into tens of trillions of dollars. The only way for the government to stay ahead of the curve would be for the Fed to keep creating boatloads of new money — which is how hyperinflation happens, after all. If that were to happen, we rather doubt Kavoussi would want to come tell us how the CPI is doing.

HuffPo’s Myth #4: “The amount of cash available has grown tremendously.”

“Some Federal Reserve critics claim that the Fed has devalued the U.S. dollar through a massive expansion of the amount of currency in circulation,” says Kavoussi. “But not only is inflation low; currency growth also has not really changed since the Fed started its stimulus measures, as noted by Business Insider’s Joe Weisenthal.”

This looks like another silly gotcha with definitions, like the “printing money” canard. The graph below shows that the currency component of M1 hasn’t shot up like a rocket, it’s true; but M1 itself (which consists of not just physical paper but also checking account deposits) has indeed risen sharply, notwithstanding the insights of Business Insider’s Joe Weisenthal.

HuffPo’s Myth #5: “The gold standard would make prices more stable.” 

Kavoussi writes, “Rep. Ron Paul (R-Tex.) has claimed that bringing back the gold standard would make prices more stable. But prices actually were much less stable under the gold standard than they are today, as The Atlantic’s Matthew O’Brien and Business Insider’s Joe Weisenthal have noted.”

Does our critic even read the things she links to? Her two authors’ blog posts depict a very brief period in the twentieth century, after the classical gold standard had already given way to the gold exchange standard. What is that supposed to prove?

So against Bonnie Kavoussi’s two blog posts that examine the gold exchange standard and only for a period of about 15 years at that, all we have in reply is only the most meticulous study of gold and its purchasing power ever written, Roy Jastram’s The Golden Constant: The English and American Experience 1560-2007, which finds gold to be extraordinarily stable over four and a half centuries.

Even John Kenneth Galbraith, not exactly gold’s biggest fan, conceded that once someone had gold, there was little uncertainty about what he would be able to get with it. “In the last [19th] century in the industrial countries there was much uncertainty as to whether a man could get money but very little as to what it would do for him once he had it. In this [20th] century the problem of getting money, though it remains considerable, has diminished. In its place has come a new uncertainty as to what money, however acquired and accumulated, will be worth. Once, to have an income reliably denominated in money was thought…to be very comfortable. Of late, to have a fixed income is to be thought liable to impoverishment that may not be slow. What has happened to money?”

Of course, gold standard advocates, at least in the Austrian tradition, are not fixated on price stability in the first place.

Read the rest here

Quote of the Day: Spending Isn’t Production

If we take a step back and think about it, it’s obvious that spending per se isn’t the source of economic benefits. It’s easy to spend. If that were really the only thing holding back economies in recession, then one wonders why humans still suffer from recessions, in so many countries and so repeatedly throughout history.

No, the real difficulty in economic life is production, in turning scarce resources into goods and services that the consumers value. This takes judgment on the part of entrepreneurs directing the process, and it takes hard work from their employees.

In addition to inventions as well as commercial innovations in business operations, a major source of economic growth is saving and investment. Even with a fixed amount of technological know-how, people can gradually increase their standard of living over the years if they defer immediate gratification. By saving out of present income—by living below their means—people “free up” scarce resources that no longer need to be used up to make burgers, iPods, and sports cars. Instead, these resources can be redirected into making tractors, drill presses, and microscopes for drug researchers. Rather than making consumer goods for present wants, the economy cranks out capital goods to cater to future wants. This is the physical analog of how the economy as a whole grows, just as an individual household’s bank balance grows with constant saving.

It should be clear that spending per se doesn’t drive economic growth. It’s true, in a modern economy money plays a crucial role in coordinating our activities, and in that sense spending is an integral part of the story. But from this truism it hardly follows that government spending is all we need right now to “boost the economy.” On the contrary, government spending simply siphons real resources away from the private sector and into politically-chosen channels, where they will be used in inefficient ways.

(bold emphasis mine)

This is from Professor Robert P. Murphy at the American Conservative

Video: Understanding The Difference Between Private and Public Enterprises

Dr. Robert Murphy explains the fundamental difference between private businesses and public enterprises.