Quote of the Day: The Roots of the Too Big To Fail Doctrine

For fractional reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system. Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace). Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity–especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.

(italics original) 

This is from Austrian economics professor Joseph Salerno at the Mises blog

Pavlovian Markets Rise on ECB’s Proposed Deposit Guarantees

US and European stocks went back into a Risk ON mode last night while Asian stocks climb again today on another report of a planned stimulus: Deposit Guarantees.

From Reuters

European Central Bank Vice-President Vitor Constancio made a fresh push for the bank to become the supervisor of the euro zone's biggest banks on Tuesday, saying the wording of Europe's founding treaty meant it would be an easy change to make.

The ECB is the driving force behind a three-pillar plan for a euro zone banking union, consisting of central monitoring of banks, a fund to wind down big lenders and a pan-European deposit guarantee.

As previously pointed out, ‘guarantees’ signify as the politician’s and mainstream’s travesty where the public has been made to believe that government’s stamp or edicts can simply do away with the laws of economics. Everyone is made to look at the intended goal, while ignoring the reality of who pays for such guarantees and how to get there. Yet the crisis, since 2008, continues to worsen. These guarantees are really meant to pave way for massive inflationism

Nevertheless the past few days has seen an incredible surge in volatility

Monday, the US S&P had a fantastic rollercoaster 2% ride. The major US benchmark was initially up on the news of Spain’s bailout, but the day’s gains had been reversed where the S&P closed sharply down 1.14%. Last night was another huge 1.13% upside close which offset Monday’s decline.

The Risk ON-Risk OFF landscape has obviously been intensifying, all premised on government’s Pavlovian classic conditioning. I worry that these huge swings could become a dangerous precedent that could ominous of, or increase the risk of a ‘crash’, which I hope it won’t.

Financial markets has been transformed into a grand casino.

Caveat emptor

Eurozone’s Proposes Grand Bailout: Regional Banking Union

So the rally incited by the Eurozone yesterday may have been triggered by reports of a proposed region wide banking union.

From the CNN Money

The European Union unveiled a plan Wednesday to create a coordinated banking union rather than leaving troubled nations to deal with their own banking crisis.

But the plans for more a unified EU bank regulator and bailout fund won't come in time to deal with the crisis sweeping Europe right now, including the beleaguered Spanish banking system which has become the epicenter of the European sovereign debt crisis.

The EU proposal would include a single deposit guarantee organization covering all banks in the union, something similar to the FDIC that covers U.S. bank deposits.

There would also be a common authority and a common fund that would deal with bailouts needed for the cross-border banks that are major players in the European banking system.

G7 keeping close tabs on Euro crisis

In addition, there would be a single EU supervisor with ultimate decision-making powers for the major banks, and a common set of banking rules.

"Today's proposal is an essential step towards a banking union in the EU and will make the banking sector more responsible," said European Commission President Jose Manuel Barroso in a statement. "This will contribute to stability and confidence in the EU in the future, as we work to strengthen and further integrate our interdependent economies."

The amount of the common bank rescue fund was not disclosed.

Many substantially important questions that begs to be answered:

Guarantees based on what and paid for by whom? Mostly the Germans? And since resources are limited or scarce, up to what extent are the Germans and other productive EU nations be willing to redistribute their resources to the unproductive and capital consuming economies? How will this affect EU regional politics particularly the relationship between rescuers and the rescued? How will this affect domestic politics particularly of the rescuing nations?

The idea of ‘risk free’ from government guarantees has proven to be a mirage and a regional banking union will be no different.

And as previously noted, banking union based on deposit insurance will likely mean the endgame for the euro.

The only thing this does is to centralize the EU banking system which even magnifies systemic fragility. What really would emanate from this coordinated plan would be massive inflationism. It’s still a plan, though. But markets appear to be reading through the plan as something imminent. [As a side note, everything has been so fluid, such that I can’t find confidence on this until after an official response has been made.]

Bailout schemes have short term effects with nasty longer term consequences. As proof, the Euro debt crisis has been a continuing crisis since 2008 and seems self-perpetuating amidst the series of past failed bailouts.

Sadly the other cost of this region-wide banking union will be the loss of liberty for many of the freedom loving Europeans, over the interim, or until the dismemberment of the euro currency (and the EU), and of further economic tumult ahead.

It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.

Will US Taxpayers Profit From The Bailout? Unlikely

``We have a lot of money to play with. As long as foreigners have a lot of confidence in our ability to solve our problems, we can borrow the $1 trillion to $2 trillion we need to solve it….The real constraint is not a bookkeeping one…It is a sense of faith on the part of foreigners that the U.S. government will repay its debt. Our most precious asset is that credibility.”-Kenneth Rogoff, an international economist at Harvard (NYT).

In the carrot and stick approach towards negotiation, threats of a market meltdown to get the necessary votes represents as the stick. The carrot approach could be accounted for by bailout adherents suggesting that US taxpayers might be able to “profit” from the present bill.

They contend that the US could be faced with a “once-in-a-lifetime” opportunity to profit from the “greatest” of all carry trade by earning from 1) the spread of borrowing cheaply via US treasuries relative to prevailing mortgage rates and 2) profiting from future appreciation of depressed asset values.

One of the fundamental contention from which led to the earlier defeat in the lower house of the US Congress of the $700 billion out has been the issue of pricing.

It is said that if the US government were to acquire existing mortgages at lower prices, any transaction would thus be set a benchmark that would essentially exacerbate the price discovery problems via loss recognition (mark-to-market regulation) and thus require the necessary adjustments (raise capital or shrink balance sheets).

Remember, the reason why banks have been reluctant to lend to each other is because they don’t trust the underlying collateral within their contemporary’s balance sheets (which is why they can’t be priced-aside from being illiquid, their values are undetermined). Thus, the role of the government’s bailout is one of market maker.

On the other hand, concerns about the US government overpaying on illiquid assets would lead to unnecessary taxpayer losses.

Given that the US Congress has upheld the Bailout plan, it is so decreed that the relatively lesser evil would be for the US government to pay for higher prices on the worst possible assets held by major financial institutions in order to regain market confidence and reinstitute the normal flow of credit.

Opportunity Cost of Productive Investments

Let us set a hypothetical example to see whether such claim of profitability for the US taxpayers is valid.

Rewind to 2000; let say that US decided to pay 70 cents to a US dollar to all those who were unfortunate enough to have invested in the late stage mania of the dot.com boom as part of the bailout scheme.

Figure 2: Bigcharts.com: Nasdaq Bust Hasn’t Recovered After 8 years!

Since the peak of the boom was at 5,000, 70 cents would mean the index at 3,500. Let us therefore further assume that every investor had been given a chance in 2001 to partake upon the US government’s “tender offer” to liquidate at the designated level at profit or loss to the account of the US taxpayer.

In figure 2, 8 years after the 2000 peak, the Nasdaq has hardly regained 50% of its losses even during the latest peak last October and is now 60% below its 2000 apex.

In finance 101 we have been taught in TIME VALUE of Money that a Dollar or Peso today is worth more than a Dollar or Peso tomorrow. And the reason we agree to defer spending today’s money is to get compensated for with a premium over our principal at a given future date or what is known as the interest rate.

Given that bailout schemes are commonly undertaken by either borrowing or printing (the last option would be the most politically unpalatable- raising of taxes), this means that the taxpayer losses from a theoretical Nasdaq rescue program even considering its annual dividend yield (.66%-Nasdaq 100 as per indexarb.com) would have not been sufficient to cover its deficit from borrowing in US treasuries (between 4%-6% for one year bills in 2001) or even considering Nominal (not inflation adjusted) terms.

In short, US taxpayer loses real money and continues to bleed aside from the opportunity cost of gaining from higher yielding return on productive investments.

Now going back to reality. The problem of today’s housing boom turned into a bust has been UNPRECEDENTED in US history since 1980! (take a look at figure 3.)

Figure 3: New York Times: Unparalleled Housing Boom!

According to Satjayit Das, ``Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans.” (highlight mine).

This means the US government would be paying for very high or steep prices for mortgages issued during the boom days even considering hefty discounts from the TOP. Using the above chart, at 50% off from the peak of 200 or at 150 from the baseline yardstick of 100 (since 1890), housing prices would still be about 35% higher than its 1950-2000 averages!

Besides, any profit assumption hinged upon an immediate recovery seems far fetched even when seen from the standpoint of the Nasdaq experience. The US would need to undertake another frenzied bout of PONZI pyramid type of credit bubble in order to push up housing prices back to its most recent highs…something which we think would seem unlikely even for the next ten years.

Thus the argument that a profitable carry trade exists seems to be illusionary or part of the political legerdemain, especially considering today’s highly charged political environment.

The Inflation Tax; Massive Inflation Amidst A Snowballing Deflationary Setting

Next is the issue of inflation.

Because of the limitations of charts I can attach to every issue of my newsletter, I posted how the US Federal Reserve has been undertaking an astounding series of intensive liquidity injection program largely unknown to the public but published on my blog post last Friday The Mises Moment In Pictures.

Yes, while the headlines carryover the riveting debate about the $700 billion of bailout, our favorite fund flow analyst CFR’s Brad Setser estimates that the US Federal Reserve have issued about $1.25 trillion in liquidity support, nearly double the cost of the fiscal bailout! And its not about to stop here.

Let us revert first to the theoretical Nasdaq bailout example above.

Figure 4: BLS.gov: Inflation Calculator

You’d realize that based on the US government’s Bureau of Labor Statistics’ Inflation calculator, in figure 4, a US $100 in the year 2000 has an equivalent buying power of $127.23 today. This means that aside from cost of borrowing deficit and nominal deficits from asset values, US taxpayers would incur an inflation tax of about 1.5% per year! Thus this adds to our evidence why bailouts won’t be profitable for US taxpayers.

Besides, with the extent of inflationary “do something” measures being conducted to preclude what central bankers fear most as the “debt deflation” spiral this could likely add up tremendously to the future cost of today’s bailout.

While today’s environment would be considered “deflationary”, governments from around the world have been collaborating to address such concerns by flooding the world with money, from which if a recovery should take hold, we could likely see an inflationary spiral over the longer horizon. We could be sowing the seeds for the next more fatal crisis.

As a reminder, bank or investment losses are not the fundamental causes of deflation, because money issued will always be spent somewhere. It is the secondary effects from the negative feedback loop of reduced income and spending and the lack of borrowing and lending or specifically the “decrease in the velocity of the circulation of money (an increase of demand to hold cash balances)” are what the Austrian economist consider as “secondary deflation” (John Egger, The Contributions of William Hutt, p.18).

Figure 5: Wall Street Journal: FED FUND Rates Below Target Rates

To consider, part of the proposed bill is to allow the US Federal Reserve to go around the cumbersome way of injecting money into the system by pumping money while at same time sterilizing money by way of the Fed’s buying of US Treasuries, which at present has led to Fed Fund Rates below its target as shown in figure 5.

The bill thereby allows US Federal Reserve to pay interest rates to bank deposits held at the Federal Reserve giving enough leeway for them to pump money at liberty; since banks will not be required to lend to each other and thus put a floor to the Fed target. In short, Fed Chairman Ben Bernanke’s Helicopter seems ready for takeoff for the next sortie.

In addition, it is likely that given the sharply deteriorating conditions in the US and Europe, there is a strong chance for OECD central banks to embark on a coordinated simultaneous interest rate cut aimed at restoring liquidity conditions despite the ongoing solvency issue.

Yet we can’t discount or rule out extreme measures similar to a blanket guarantee on ALL deposits such as the recent actions by governments of Greece and Ireland. To reckon that in the US only 63% of the $7,063 billion deposits are insured, while leaving out $ 2,457 billion of uninsured deposits in the US could be a source of a destabilizing run.

Of course one may always argue that the collateral damage from a system wide failure could be nastier and costlier compared to charging the taxpayers for mitigating today’s crisis. But that would be speculation on our part.

As in the Japan experience, the TARF’s version was the Cooperative Credit Purchasing Corporation (CCPC) established in late 1992 which failed to bring about the end to Japan’s crisis whose crisis lasted for more than a decade.

According to Takeo Hoshi of RGE Monitor Asia, ``There is no guarantee that the TARP will be able to avoid those mistakes that the CCPC made. There are no tools that the Treasury can use to force the financial institutions to sell substantially all troubled assets. Even with the tax-related motivation, the Japanese banks were reluctant to sell bad loans to the CCPC. With the TARP, the restrictions on executive pays and others may discourage some financial institutions from coming forward. Similarly, how the Treasury will dispose of the purchased assets is not clear, yet.”

At the end of the day, it won’t be the issue of governments’ not doing anything but would be the issue of the public’s expectations that government actions will succeed even though the risk is that they won’t.

Have you not noticed, this has been going on for over a year and yet the crisis seems to be getting even worst!

Bureaucracies Exist To Spend Money Not To Earn You A Profit!

Besides even assuming that government does end up “profiting” from today’s undertaking, it is unlikely that US citizens will be mailed with their dividend checks from their share of capital appreciation profits or from the revenues streams from the profitable mortgage arbitrages. This isn’t how governments function.

Eventually, all these so called surpluses will end up in the coffers of the politicians who would, in no time, quickly find new boondoggles to spend it with.

As Ludwig von Mises wrote in the Bureaucracy (pp. 48–50), ``The objectives of public administration cannot be measured in money terms and cannot be checked by accountancy methods… In public administration there is no connection between revenue and expenditure. The public services are spending money only; the insignificant income derived from special sources (for example, the sale of printed matter by the Government Printing Office) is more or less accidental. The revenue derived from customs and taxes is not "produced" by the administrative apparatus. Its source is the law, not the activities of customs officers and tax collectors. It is not the merit of a collector of internal revenue that the residents of his district are richer and pay higher taxes than those of another district.”

So it wouldn’t be advisable to expect government actions today to be seen in the light of “profitability” but rather from the perspective that they could buy enough time for the global economies to recover in order to give a lift to the US.