Saturday, May 4, 2013

Elliott's Paul Singer debunks myth of Fed as knowing what it is doing

The economics profession has been having a hard time with our current financial crisis.

First, it failed to predict the crisis.  Those handful of professionals who pointed out there was a problem with subprime mortgages were dismissed by the mainstream as cranks to be ignored.

Second, it has failed to produce a policy, whether fiscal, monetary or some combination of the two that has brought an end to the crisis.  This failure to produce a policy for ending the crisis is not surprising as the economists' models exclude the banking system and we have a bank solvency led financial crisis.

Third, as demonstrated by the Reinhart and Rogoff debacle, economics is an academic discipline completely lacking any minimum standards that its practitioners have to meet in order to get their articles published in even its top peer reviewed journal.  This has lead Paul Krugman to issue yet another defense of economics and observed that
 the reputation of the intellectual enterprise as a whole has clearly suffered.
In a letter to his investors posted on Zero Hedge, Elliott's Paul Singer unloads on the myth of the Fed knowing what it is doing.

By way of background, Mr. Singer, like your humble blogger, predicted the financial crisis.  What Mr. Singer and I both see in the Fed's response to our current crisis is panic and not insight into the actual mechanism that is continuing to cause a problem with the financial system and global economy.

Panic that was first shown by Ben Bernanke as he sat white as a ghost next to Hank Paulson as Mr. Paulson asked Congress for a $750 billion blank check to deal with the financial crisis.  Panic that was revealed when Mr. Bernanke said a blank check was needed in order to avoid a second Great Depression.
[T]he financial system (including the institutions themselves, products traded, and risks taken) has “gotten away from” the Fed’s ability to comprehend. The Fed is primarily responsible for that state of affairs, and it is out of its depth.
Please re-read the highlighted text as Mr. Singer has succinctly put the simple fact that an institution that relies on models that ignore the financial system and assume that the financial system will always work is highly unlikely to understand how to fix the financial system.
Former Chairman Greenspan created – and reveled in – a cult of personality centered on himself, and in the process created a tremendous and growing moral hazard. By successive bailouts and purporting to understand (to a higher and higher level of expressed confidence) a quickly changing financial system of growing complexity and leverage, he cultivated an ever-increasing (but unjustified) faith in the Fed’s apparent ability to fine-tune the American (and, by extension, the world’s) economy. 
Ironically, this development was occurring at the very time that financial innovations and leverage were making the system more brittle and less safe. 
He extolled the virtues of derivatives and minimized the danger of leverage and risky securities and dot-com stocks, all while he should have been putting on the brakes. 
It was not just the disappearance of vast swaths of the American financial system into unregulated subsidiaries of financial institutions, nor was it just government policies that encouraged the creation and syndication of “no-documentation” mortgages to people who could not afford them. It was also the low interest rates from 2002 to 2005, the failure to see the expanding real estate bubble caused by an unprecedented increase in leverage and risk, and the general failure to understand the financial conditions of the world’s major institutions.
Greenspan put his faith in the market without understanding that the necessary condition for the invisible hand of the market to function properly was transparency (buyers and sellers have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision).

Financial innovation was all about introducing opacity into the financial system.  As Yves Smith so memorably put it: nobody on Wall Street was compensated for creating low margin, transparent products.
Under Chairman Bernanke, the combination of ZIRP and QE completed the passage of the Fed from sober protector of a fiat currency to ineffective collection of frantically-flailing, over-educated, posturing bureaucrats engaged in ever more-astounding experiments in monetary extremism. 
Again, please re-read the highlighted text as Mr. Singer has just described what I refer to as PhD defense syndrome.  No policy is too extreme to be undertaken in defense of what an economist wrote and defended on their way to getting a PhD.

Recall that Chairman Bernanke refers to himself as an expert in the Great Depression.  An expert who Ann Schwartz, Milton Friedman's co-author and an individual who lived during the Great Depression, said learned all the wrong lessons.
If you look at the history of Fed policy from Greenspan to Bernanke, you see two broad and destructive paths quite clearly.  
One path is the cult of central banking, in which the central bank gradually acquired the mantle of all-knowing guru and maestro, capable of  fine-tuning the global economy and financial system, despite their infinite complexity. 
On this path traveled arrogance, carelessness and a rigid and narrow orthodoxy substituting for an open-minded quest to understand exactly what the modern financial system actually is and how it really works.
I am not sure that this "arrogance, carelessness and a rigid and narrow orthodoxy" applies only to central bankers.  My experience is that it applies across the vast majority of participants in the economics profession.

I have had economists tell me that it is easier for a bank to manipulate its historic cost numbers on its individual exposures than it is for a bank to manipulate an accounting construct called bank capital.  Not true.  In their audits, accounting firms looks to see if historic cost numbers are manipulated.

Meanwhile, both banks and regulators manipulate bank capital.  Banks manipulate by how they value their assets.  Regulators manipulate by engaging in regulatory forbearance and letting banks engage in 'extend and pretend' to turn nonperforming loans into 'zombie' loans.

I have had economists tell me that transparency is less effective at constraining bank risk taking than is bank capital.  Not true.  Jamie Dimon showed in his desperation to hide JP Morgan's London Whale trade that the last thing a bank wants is to disclose its proprietary bets for fear that the market will trade against them.

Meanwhile, bank capital is all about using opacity to hide just how much risk banks are taking.  The whole idea behind Basel I was to use complexity to hide the leverage the banks were taking on in an effort to allow banks to generate a return on equity that would attract capital to the banking system.  Naturally, this trend continued with Basel II and III.

I have had economists tell me that once per month data is adequate for setting monetary policy and therefore it is adequate for valuing opaque, toxic subprime mortgage-backed securities.  Not true.  In the absence of observable event based reporting, buying or selling these securities is simply betting on the contents of a brown paper bag.

It is only with observable event based reporting that investors know how the loans underlying these securities are currently performing.  It is only with this information that investors can assess the risk of the loans and value the securities.

Regular readers know that your humble blogger created the FDR Framework to explain "exactly what the modern financial system actually is and how it really works".

It is the FDR Framework that underlies the financial systems in Europe, Japan, the UK and US.  This is not surprising as the US exported this framework after World War II.
The second path is one .... In its acute and later stages, it can destroy the social cohesion of a society as wealth is stolen and/or created not by ideas, effort and leadership, but rather by the wild swings of asset prices engendered by the loss of any anchor to enduring value.  
In that phase, wealth and credit assets (debt) are confiscated or devalued by various means, including inflation and taxation, or by changes to laws relating to the rights of asset holders. Speculators win, savers are destroyed, and the ties that bind either fray or rip. We see no signs that our leaders possess the understanding, courage or discipline to avoid this.

Regular readers know I have used the FDR Framework to show how a modern banking system is designed to absorb the excesses losses in the financial system under the Swedish Model and protect the real economy and society.

It is true that the CEOs of the world’s major financial institutions lost their bearings and were mostly oblivious to their own risks in the years leading up to the crash. 
However, as the 2007 minutes make clear, the Fed was clueless about how vulnerable, interconnected and subject to contagion the system was.
The Fed had no clue about what opacity was doing to undermine the soundness of the financial system.
It is not the case that the Fed completely ignored risk; indeed, several Fed folks made “fig leaf” statements about the risks of the mortgage securitization markets, as well as other indications that they appreciated the possibility of multiple outcomes. 
But nobody at the Fed understood the big picture or had the courage to shift into emergency mode and make hard decisions. 
In the run-up to the crisis the Fed was a group of highly educated folks who lacked an understanding of modern finance. After convincing the nation for decades of their exquisite grasp of complexities and their wise stewardship of the financial system, they didn’t understand what was actually going on when it really counted.
Please re-read the highlighted text again and recall that both Mr. Singer and I were trying to get the attention of the Fed and explain what was happening so that the impact of the financial crisis could be moderated.
Ultimately, of course, as the system was collapsing and on the verge of freezing up completely, the Fed shifted into the (more comfortable and much less difficult) role of emergency provider of liquidity and guarantees.
A more comfortable role and one under which it can continue to deny that we are dealing with a bank solvency and not liquidity led financial crisis.
All this background presents an interesting framework in which to think about what the Fed is doing now. 
QE is a very high-risk policy, seemingly devoid of immediate negative consequences but ripe with real chances of causing severe inflation, sharp drops in stock and bond prices, the collapse of financial institutions and/or abrupt changes in currency rates and economic conditions at some point in the unpredictable future. 
However, the lack of large increases in consumer price inflation so far, plus the demonstrable “benefits” of rising stock and bond markets, have reinforced the merits of money-printing, which is now in full swing across the world. 
In the absence of meaningful reforms to tax, labor, regulatory, trade, educational and other policies that could generate sustainable growth, “money-printing growth” is unsound.  
We believe that the global central bankers, led by the Fed as “thought leader,” have no idea how much pain the world’s economy may endure when they begin the still-undetermined and never-before attempted process of ending this gigantic experimental policy. 
If they follow the paths of the worst central banks in history, they will adopt the “tiger by the tail” approach (keep printing even as inflation accelerates) and ultimately destroy the value of money and savings while uprooting the basic stability of their societies. 
I agree with Mr. Singer that the Fed's response to the financial crisis has the potential to cause very high levels of pain to the world's economy and society.
Read the 2007 Fed minutes and you will understand how disquieting is the possibility of such outcomes and how prosaic and limited are the people in whom we have all put our trust regarding the management of the financial system and the plumbing of the world’s economy. 
Printing money by the trillions of dollars has had the predictable effect of raising the prices of stocks and bonds and thus reducing the cost of servicing government debt. It also has produced second-order effects, such as inflating the prices of commodities, art and other high-end assets purchased by financiers and investors. 
But it is like an addictive drug, and we have a hard time imagining the slowing or stopping of QE without large adverse impacts on the prices of stocks and bonds and the performance of the economy. 
If the economy does not shift into sustainable high-growth mode as a result of QE, then the exit from QE is somewhere on the continuum between problematic and impossible. 
Central banks facing high inflation and/or sluggish growth after sustained money-printing frequently are paralyzed by the enormity of their mistake, or they are deranged by the thought that the difficult and complicated conditions in a more advanced stage of a period of monetary debasement are due to just not printing enough.  
At some stage, central banks inevitably realize, regardless of whether they admit the catastrophic nature of their own failings, that the cessation of money-printing will cause an instant depression. 
Even though at that point the cessation of money-printing may be the only action capable of saving society, that becomes a secondary consideration compared to the desire to avoid immediate pain and blame. 
The world’s central banks are in very deep with QE at present, and the risks continue to build with every new purchase of stocks and bonds with newly-printed money.
Mr. Singer has been far more blunt about the consequences of what I call the Fed's needless policy actions.

As regular readers know, there is a simple alternative to what the Fed is doing.  That alternative is to use the modern banking system as it is designed to be used.

By making the banks absorb the losses on all the excess public and private debt in the financial system, the need for the Fed's pursuing its current monetary policies is ended.

Lifting the debt service burden from the real economy will restart growth as capital that is needed for growth, reinvestment and to support the social contract is no longer diverted to debt service.

At the beginning of this financial crisis, Iceland showed that this solution works.  It is time that it is adopted in Europe, Japan, the UK and the US.

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