Cato Institute still believes we're on the gold standard

Article by Steven H. Hanke of the Cato Institute. My comments in italics.

Since 2001, the bush administration has entangled the United States in a war that is undefined in terms of its scope, scale and duration. It has also been interventionist in the domestic economy, overseeing what the U.S. Congressional Budget Office terms a “substantial increase in spending” which has put the economy “on an unsustainable path.”

What's an "unsustainable path?" My guess is he is referring to the spending and why is he saying it is unsustainable? Is the government going to run out of money? That's ridiculous. The Federal Gov'ts spends by simply crediting bank accounts and its ability to do that is unlimited. Will the debt service become unmanageable? Hardly. It is currently about 2% of GDP and even if it doubles, it still represents only a small fraction of our national wealth.

Indeed, according to the CBO’s baseline budget projections issued in September 2008, the federal debt held by the public will grow to $7.9 trillion (in 2008 dollars) over the next decade, a 46% increase over this year’s $5.4 trillion estimate. That would still be only 54% of GDP, which would rank us behind Germany, France, Canada and way, way, behind Japan, which has a public debt that is 200% of GDP! And that’s only the tip of what could be a huge debt iceberg. 

More like a little icicle.

The trustees of the Social Security System estimate that the present value of the system’s unfunded liabilities is $13.6 trillion. A similar present value calculation by the trustees of the Medicare System results in a whopping $85.6 trillion estimate. To put these numbers into perspective, keep in mind that last year the United States generated a GDP of $13.8 trillion.

The assumptions used in these calculations assume a paltry, 1.5% GDP growth rate for the next 70 years and a similarly low rate of productivity growth (about 1.1%), when actual growth over the past 70 years has been more like 2.7% and productivity up around 2.5%. If we come in anywhere near the historical performance, then the shortfalls pretty much don't exist. He also doesn't tell you that annual GDP could by 2075 (where his debt numbers come from) will be $40 trillion and could be as high as $75 trillion if we average a 2.5% annual growth rate.

The Bush administration’s most recent economic intervention—the nationalization of Fannie Mae and Freddie Mac, two giant government-sponsored mortgage finance companies—could cost U.S. taxpayers hundreds of billions of dollars. Fannie and Freddie were not really private nor purely public—perhaps the worst type of hybrids imaginable.

Yes, that's why they failed. It was a bad model. (Basically a bad decision to have privatized them in the first place.)

Indeed, both followed a classic public-private partnership (socialist) business model—one that privatizes profits and socializes losses. This was a train wreck waiting to happen. Not surprisingly, the Cato Institute’s Economic Freedom of the World, 2008 Annual Report records a significant fall in the economic freedom index for the U.S.

Just the pendulum swinging back a bit from a totally unregulated environment, which was pretty much an aberration.

Given these developments and the squeeze that the credit crunch has put on the U.S. economy, some people have been shocked that the U.S. dollar has staged a spectacular rally against the euro. But in the world of exchange rates, it takes two to tango.

Don't know what he means by, "it takes two to tango." Each successive rescue and Fed action caused the dollar to rally against a broader universe of currencies.

Expectations about Europe’s economic prospects have turned negative. Super-negative European expectations, relative to those
in the U.S., have pushed the dollar up by over 14% from July 15 to September 11, 2008. And not surprisingly, commodity prices
(measured by the Commodity Research Bureau’s Spot Index) have tumbled by 9% over the same period. But consumer price and producer price indexes remained at elevated levels, registering year-over year increases in August of 5.4% and
9.6%, respectively.

Both CPI and PPI have started to edge down, reflecting lower commodity prices.

Now the U.S. is on a razor’s edge between deflation and inflation.

Not on a "razor's edge as far as inflation is concerned: We've actually had quite a bit of it. Things reverting to the mean now. Asset deflation underway.

This requires one to think through how each of these scenarios might unfold. The prospect of a debt deflation begins when a central bank pushes interest rates below where the market would have set them. This is exactly what the Federal Reserve did. In July 2003, the Fed funds interest rate target was pushed to a record low of 1%, where it stayed for a year.

Three-month T-Bills near 0%, yet the funds rate remains at 2% and reserves have not built in the system despite over $1 trillion of lending by the Fed. This would suggest the Fed funds rate is still too high.

This set off a credit boom which fueled a massive increase in leverage. Over the past year, we have witnessed financial stress, a stampede to deleverage and an economic slowdown. These events could be the precursors of a classic debt deflation.

Other factors led to the credit boom as well, like changes in ERISA statutes that allowed pension funds to invest in CDO's, CDOs-squared, etc. Now commodities.

It would take the following course:

Debt liquidation would lead to distress selling. As loans are paid off, a contraction in demand deposits would ensue. This would slow down the velocity of money circulation. This would cause a fall in the general level of prices. This would lead to a further fall in the net worth of businesses and an increase in bankruptcies.

All of the above pretty much occurring and it is the mechanism the Fed was counting on to bring inflation pressures down.

A fall in profits, often resulting in losses, would also occur. This would lead to a reduction in output, trade and employment. These losses, bankruptcies, and unemployment would generate pessimism and a loss in confidence.

These waves of pessimism would result in more hoarding and further reductions in the velocity of money circulation.

To some extent all true, however, government spending and exports still maintaining some level of aggregate demand. Economy logged a 3.3 percent growth rate in the second quarter and we have yet to see back-to-back negative quarters, let alone a single, yet sharply negative quarter.

The debt deflation process would eventually run its course, but only after asset prices have hit bargain basement levels.
Economists of the Austrian school of economics term this type of debt deflation a “secondary deflation”. If the forces of a
secondary deflation are strong enough, a central bank’s liquidity injections are rendered ineffective by what amounts to private sector sterilization. When people expect prices to fall, their demand for cash increases and soaks up central bank liquidity injections.

The central bank pretty much "sterilizes" its own liquidity injections to a certain degree because it targets interest rates. Therefore, any increase in reserves that puts downward pressure on the Fed funds rate causes he Fed to drain most or all of those reserves. That is why reserves in the system and the monetary base have not grown at all in the past year. A big chunk of that liquidity has been removed.

The Fed would also supply reserves as necessary to satisfy demand for cash by the public.

This phenomenon characterized Japan’s economy during most of the 1990s. But what if the Federal reserve—fearing a secondary deflation, as they feared (incorrectly) a mild deflation in late 2002—pushed the Fed funds rate lower (now it’s 2%) and turned on the inflation switch by monetizing more debt? Given the growing mountain of government debt, there is virtually an unlimited potential.

Again, T-Bill yields suggest the funds rate is still too high, so does the lack of growth in reserves and the monetary base. In addition, there is no direct link between inflation and the overnight lending rate. Up until now inflation has pretty much been an oil story. If the Fed cuts rates that doesn't create a shortage of oil.

It’s a scenario worth thinking about.

Not really.

To appreciate how the process would work in the extreme, consider what’s happening in Zimbabwe, the first country to realize a hyperinflation (an inflation rate of 50% or more per month) in the 21st century. The government of Zimbabwe issues debt and the Reserve Bank of Zimbabwe monetizes it by printing Zimbabwe dollars. While the RBZ produces a lot of currency, statistics on the quantity of currency in circulation and the inflation rate are in short supply. 

This is a ridiculous example. Oil imports are roughly equal to about 40% of Zimbabwe's GDP and oil is priced in dollars and Zimbabwe is not the issuer of dollars, the U.S. Federal Reserve is. Any country that does not spend and borrow in its own currency is at risk of hyperinflation if their income and debts are not carefully balanced. The U.S. is a completely different case. We borrow and spend in our own currency and we are the
monopoly issuer of that currency. Moreover, our trade deficit represents a tiny fraction of our GDP. This is not the case in Zimbabwe.

The most recent official data for currency in circulation were for January 2008, and inflation data were last released for June 2008. To remedy that shortcoming, I have developed a hyperinflation index for Zimbabwe. As indicated in the accompanying table, the monthly inflation rate on September 5, 2008 was 9,914%. That’s a whopping annual inflation rate of 36 billion percent. To effectively trade currencies, commodities, or for that matter, any assets, traders must build alternative scenarios—like those for deflation or inflation. To give the scenarios life, probabilities must be attached to each of them. The resulting array can then be used to inform, in part, one’s trading activities.

Analysis and understanding must be correct too!

Bernanke quoting Buffett

CNBC has been running promos that show the Fed Chairman telling Congressional lawmakers that he saw Warren Buffett "on TV," saying he is buying a stake in Goldman because he "thinks the government will do the right thing." The Fed Chairman also quoted Buffett as saying, "we would fall off a precipice of the bailout did not happen."

I don't know about you, but I find watching our Fed Chairman back up his arguments by saying he watches Buffett on TV, a bit disconcerting.

Dems seek to slash bailout

Probably irrelevant at this point. While any reduction in the size of the bailout will (negatively) affect the markets short-term, the long term result would probably be the same anyway. The proper course of action would be a significant increase in government spending to inject demand into the economy. That would boost employment, output and demand for credit. None of this is being considered, however. We are in trouble.

Listeners of the Mike Norman Show on BizRadio get it!

Dear Mike:

I am a CEO of a small Pink Sheet company here in Houston and listen to you almost every day. I just want to thank you for speaking out on economic and political issues and giving us the information we need to understand the economic issues of the day and to further our understanding of public and private finance. Your web site is very well organized and informative. The lack of understanding by elected officials of our monetary system is the root cause of many of our economic problems. I also commend you on introducing us to people such as the President of Overstock.com and Mark Mitchell whose Deepcapture.com site has exposed what is really going on in what has become a totally unregulated market place. I believe my own small Pink Sheet company was also hit with naked shorting although is is hard to prove. Thanks once again for you great contribution to our knowledge base and keep it coming.

Sincerely,

Graham

Pension funds behind the subprime mess

Tnis is taken from Warren Mosler's blog:

Did you know that ERISA was amended on November 2000 to allow pension funds and employee benefit programs to buy ABSs with investment grade below A; and to buy senior tranches of CDOs as long as they have an investment grade of at least AA. Here is the sentence taken from this amendment: “The Amendment permits inclusion of assets with LTVs in excess of 100%. However, securities backed by such collateral (a) must be senior i.e., non-subordinated securities and (b) must be rated in either of the two highest generic ratings categories by a rating agency.” It seems to me that this is what was behind the bubble in the2000s, i.e., the explosion in the growth of CDOS, CDOs-squared, under-regulated mortgage companies etc."

By the way, we are doing the same thing with oil and commodities now by allowing pension funds to essentially buy and hoard these "assets." Unless stopped, there is no upward limit to the price of oil, corn, food, etc.

Oil back up

Speculators are re-entering the oil markets on the long side and how can you blame them? They've had some encouragement in the form of Opec cutting output. In addition, the perceived inflationary impact of the bailout (though it won't be inflationary at all--read my last several posts) will get the herd stampeding once again. Congress failed to act on reigning in speculation back in July and it will fail to do so now. Yesterday the Democrats caved in on their opposition to offshore drilling. All the "geniuses" have been telling us that once that happened, oil prices would plummet because the market will instantly start factoring in higher output down the road. That's a bunch of nonsense. Watch as oil moves back to $130. That is was Monday's high in the expiring, October Nymex contract. After $130 a combination of speculation and Opec control will force crude to above the record highs, and perhaps, eventually, to$200.

Bailout could be contractionary

Once again, Warren Mosler is spot on in his analysis of what could a very contractionary result if Congress acts as if this bailout must be "paid for" in some way. Read below:

"It would be counter productive to add the $700 billion to the budget deficit calculation if the proposal goes through and is executed, since Congress is likely to take measures to somehow constrain spending or increase revenues to try to ‘pay for it’. This would be highly contractionary at precisely the wrong time. Note that if the Fed buys mortgage securities it doesn’t add to the deficit, while the Treasury buying the same securities does? And in both cases treasury securities are sold to ‘offset operating factors’; either way, Fed or Treasury, the government exchanges treasury securities for mortgage securities. When any agent of the government buys financial assets, that particularly spending per se doesn’t add to aggregate demand, or in any way or directly alter output and employment. Yet here we are listening to the Fed Chairman, the Treasury Secretary, and members of Congress talking about $700 billion of ‘taxpayer money’ and a potential increase in the deficit of $700 billion. And no one argues with statements like ‘it is even more than we spent in Iraq’ and ‘that much money could better spent elsewhere’. Unfortunately for the US economy, this supposed addition to the deficit is likely to negatively impact future spending, perhaps at the time when it’s needed most to support demand. I recall something like this happened in 1937, when revenues collected for social security weren’t ‘counted’ as part of the Federal budget, and the millions collected to go into the new trust fund were in fact simply a massive tax hike. Unemployment went from something like 12% to maybe 19% (and stayed about that high until WWII deficit spending brought unemployment down to near zero). After that happened much was written regarding public vs private accounting and the cash flow from social security and other programs was subsequently counted as part of the federal budget calculation, as it is today, and for the same reason."

Link to article

The bailout is NOT inflationary!

The media has been reporting that the bailout will lead to a Germany style hyperinflation. This is completely ridiculous. Below is an example of this type of misunderstanding. It came from Vince Farrell's email to me, earlier today:

"The fear of an inflationary surge from expanding government debt by hundreds of billions of dollars is getting more press than the reverse side of the argument. Private credit has been destroyed, and the financial system is being massively delevered (banks borrow about $10 for every dollar of equity, broker dealers borrow $20 to $30. There are no more big broker dealers and the debt reduction is large.) It looks more like a standoff with the inflationary threat of government debt being checked by the deleveraging of the system."

Here was my response:

Vince,

The notion that the bailout will be inflationary displays a lack of understanding of monetary policy and how the Fed and Treasury, together, manage bank reserves. Over the past year both total and excess reserves in the system have not grown at all (they’ve actually come down), despite over $1 trillion in lending by the Fed. That’s because the Fed has removed excess reserves through open market operations.

The Fed is obligated to do this in order to maintain the Fed funds rate where it targets it. If excess reserves grow by too large an amount there would be downward pressure on the funds rate, which is something the Fed does not want. Therefore, the Fed has been selling securities from its portfolio (mostly T-Bills) to sop up excess reserves. Thus, no growth in the monetary base and no growth in money supply. (And, no inflation—at least in the monetary sense.)

Recently the Fed’s holdings of T-Bills have fallen to under $8 billion. That is why it asked the Treasury to sell $40 billion of bills in a special auction. The media reported it as the Fed needing more money, but that is erroneous. The sale of these bills was nothing more than a reserve maintenance operation. They were intended to sop up the reserve build tied to the $85 billion loan to AIG.

Even if the Treasury spent all of the $700 billion of the bailout money, it would likely issue an equal amount of Treasuries, meaning that reserves would not grow at all. The public would be exchanging bad debt for good Treasuries, which would result in no increase in bank reserves, the monetary base and, most likely, money supply.

The important thing to remember about money supply is that the vast majority of what we call money (bank credit) is created in the banking system and that comes from demand for loans. (Loans create deposits.) If there is no demand for loans, or if banks are just not making loans, money supply will not grow, regardless of where overnight interest rates are. Moreover, if the government is just replacing one asset with another, that is not in and of itself a reason for money supply to grow.

-Mike Norman

Household debt levels fall

The Fed's Financial Obligations Ratio, which looks at all debt service payments as a percentage of income, is now down to the lowest level in three years.

Oil Short Squeeze Prompts Call to Curtail Speculators

A provision in the bailout bill would seek to limit speculators. This is necessary as part of a "comprehensive" package to fix the markets.

Oil spikes $25 a barrel on anxiety over US bailout

Specs are back, big time! Congress must curb (or put a ban entirely) on speculators now. And they will!

Too many loose ends, still

Too many loose ends

The Treasury bailout plan is a good start. There must be a vehicle to remove the bad assets from bank balance sheets and at this point only the Federal Government has the money and long-term staying power to do what needs to be done.

I still agree with the freeze on short-selling and think that should remain in effect. It should also be expanded to firms that are not financials. As far as the short-sellers are concerned, I find them to be a hypocritical lot. They cry about market manipulation by government and how that is bad, yet they are okay with policies such as capital gains tax cuts, reduced regulation, free trade, wage and income suppression and other policy, which is also designed to “manipulate” markets.

Credit default swaps (which are not really “swaps” at all, but insurance policies) must be traded on regulated exchanges or shut down completely, at least for now. It is too easy to manipulate these OTC products and they are being routinely manipulated. In many cases this is what is behind the nosedive in many financial companies.

The speculators are back! Congress failed to pass a bill to limit speculation last July (mainly because Republicans wanted to attach an offshore drilling provision to it) and that was a mistake. Expect to see a lot of speculative buying of oil again as the dollar weakens and you’ll hear the same old, tired arguments explaining the rise in crude, none of which are true. OPEC will add to this rally by cutting production. Don’t be surprised to see crude hit a new, all-time high soon.

Short selling ban was a necessary move

Private companies are not subject to short selling, yet private companies are bought and sold every day and poorly run private companies fail all the time. Public equity markets are slightly different, in that they are designed for capital formation and the spreading of risk (the ownership of a company is spread among many shareholders.) However, short selling is a practice that can be and often is, abused. Extraordinary times demand extraordinary measures and this was necessary. There will be the critics who say that this harms the public equity markets by reducing liquidity. Don't believe them. Watch the volume explode and watch how the publicly traded markets function in a more "normal" fashion, encouraging risk taking at a time when it is sorely needed. It's just a shame for Bear Stearns and Lehman Brothers and their employees that this didn't come sooner.

Bailouts are a part of the "ownership society"

Let’s face it; we live in the “ownership society.” The government has been telling people to “own” their future. That means owning your own home and perhaps other real estate, along with stocks, bonds and other financial assets. All of our policies—tax, regulatory, trade, monetary, income and wages—have been fashioned to encourage the participation in the ownership society. No…they have been DESIGNED to make us owners. So, what were we supposed to do? That’s why we all became owners or have strived to become owners. It’s also why people should not be surprised at government attempts to support the markets. Bailouts are a normal in a society where the government tells you to be an owner.

When I was a kid, if I got in trouble for something I shouldn’t have been doing, my parents would say to me, “Michael, you shouldn’t have been doing that.” I was left to suffer the consequences of my actions without any support—moral or otherwise. There was no fostering of any moral hazard in my family.

However, when my parents encouraged me to do things and I failed or got injured (yes, there was that broken ankle in the summer of ’74 racing Motocross, which my father said I should do) I was not scolded or left to stew in my own juices. I was cared for, supported, nurtured, and pretty much encouraged to go on.

That is why it is stupid to criticize bailouts. Bailouts go hand in hand with the ownership society in the following regard: If you tell people to buy stocks and real estate for their retirement and if you fashion tax codes, regulations, monetary and social policy and everything else for that to happen, but things turn sour, then don’t act surprised when people come asking for help!

It’s normal!

I’ll tell you what would be abnormal. It would be if you told everyone to “own” their future and they went out and did just that, but then things turned sour and you said, “You shouldn’t have done that!”

Is this the message we are sending? I am afraid that some people, but I won’t mention names (Conservatives) are saying just that.

The dangers of "mark to market" asset pricing

Here is an excellent article by Dr. Thomas Palley about the dangers of the "mark to market" rule.

He also has a wonderful blog at http://www.thomaspalley.com/

The Liquidation Trap

The U.S. financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.

Current conditions are the result of bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.

First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.

Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence, and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.

Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.

Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.

Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too.

This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.

Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.

The Fed must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.

Fears about a price – wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.

The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.

At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer duration loans available to qualified insurance and finance companies too.

The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.

Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of need to restore market discipline and stay moral hazard.

The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.

Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.

Copyright Thomas I. Palley

My posting to a Fox Business blog

As you correctly pointed out the Fed acted under Section 13, paragraph 3 of the Federal Reserve Act, which states:

“In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.”

Here’s the link: http://www.federalreserve.gov/aboutthefed/section13.htm

That means they can “discount” (or lend against) anything they want. So, the Fed is clearly within its powers to do what it did.

Second, the Fed’s Maiden Lane Portfolio, which contains the assets of Bear Stearns that were originally valued at $28.8 billion, is now up to $29.33 billion as of last Thursday. If they did “unload” it they’d have a nice profit of over $500 million. Here’s the link: http://www.newyorkfed.org/aboutthefed/st.txt

Finally, David Rosenberg's comment that "the money supply has just been expanded by $85 billion" is incorrect (if that's what he actually said). While reserves in the banking system (this is not part of money supply) will rise by $85 billion due to the loan to AIG, the Fed has instructed the Treasury to sell $40 billion of new T-Bills. This reserve maintenance operation is designed to reduce those level of reserves.

To date, despite all the lending the Fed has conducted, total bank reserves stand $500 million less than where they were in August 2007 and excess reserves are down more than 50% from where they were. Mr. Rosenberg clearly does not understand monetary operations and how the Fed uses that to maintain a level of reserves that anchors its funds rate.

Moreover, M2 is growing at below 5% annually, far below the 12.5 percent growth rate after 9/11. Other monetary aggregates, like the monetary base, something that the Fed has most control over, is not growing at all, and total bank credit is also expanding very slowly.

Contrary to media reports, the Fed is not running out of money

One of the big stories today was about a special refunding that the Treasury will conduct. There will be $40 billion of short-term bills sold. The media is saying that this is necessary to give cash to the Fed. Once again the media has no understanding of monetary operations and, unfortunately, the Fed and Treasury have bad media relations departments and have not explained the situation very well. (The don’t even try.)

Over the past year the Fed, through various lending facilities, have lent out a fair amount of T-Bills. On the most recent Fed statement that covers the period through September 11, 2008, the New York Fed (which conducts monetary operations) held $7.7 billion in bills. Compare that to the same period last year, when the Fed held $96 billion in bills (system wide: $277 billion).

The Fed could, if it wanted, just buy bills held by the public. It could do a $200 or it could do a $500 billion repurchase. It doesn’t matter because it is not constrained by any, “lack of funds,” as the media likes to say.

But it is not doing this.

Why?

Because doing so would affect its target interest rate also known as the Fed funds rate. For now the Fed has decided that it wants that rate at 2% (a mistake in my opinion, it ought to be lower). If the Fed bought bills from the public, it would be adding reserves to the system and that would drive down the Fed funds target rate. The Fed would then have to just sell the bills right back to defend its target.

At the same time we know that the Fed is giving AIG an $85 billion loan. That will boost reserves by that amount and likely put downward pressure on the Fed funds rate—something the Fed does not want, at least for now. Normally, to counteract this pressure, the Fed would sell bills that it owns and recover whatever excess reserves necessary to keep the target rate at 2%. However, the Fed has only $7.7 billion worth of bills ($22 billion system-wide). So it asks the Treasury (they both work together in the maintenance of reserves) to sell the bills. The Treasury can issue as many as it wants. That drains excess reserves and helps the Fed manage its target rate.

The Fed could also sell other securities, like the $411 billion of notes or bonds that it holds, but chooses not to for whatever reason. (Could be that it would affect investor asset mix and their duration preferences.) So it asks Treasury. No big deal. The Fed is not out of money and can never be out of money because it has the authority to credit bank accounts—infinitely if it wants to.

By the way, the Federal Reserve System assets as of September 11 totaled $940 billion, and total currency in circulation was $835 billion. The Fed is well capitalized (not that that means anything) and all the currency is “backed.”

A dangerous new policy

The market turmoil today is easy to explain and easy to correct, but sadly, we will neither get a good explanation nor will we get the proper remedies. You will hear that it is because of the never-ending stream of bailouts that we are suffering through this, however that is not true. Up until last Sunday’s balk by Treasury Secretary Hank Paulson regarding a rescue of Lehman, things had been going fairly well: banks were recapitalizing, shares in some of the most beleaguered sectors like housing and banks were starting to recover, commercial credit issuance was rising, mortgage lending was picking up and most important, the U.S. was outperforming other countries around the world both in terms of its stock markets and its economy. That’s how it looked right up until Paulson uttered those famous last words: “I never once considered using taxpayer money to help Lehman.” What followed was the largest stock market decline since 9/11 and a virtual Who’s Who of financial firms who are now queuing up to witness their own demise. At this very moment, we are in a virtual freefall with no endgame in sight.

Perhaps it was not necessary to save an investment bank like Lehman. After all, in a $14 trillion economy the failure of what was essentially a financial intermediary should have been taken in stride. The problem, as I see it, was that by essentially throwing up his hands and saying that the government was prepared to leave the resolution of this crisis to “the free markets,” he changed the game in one fell swoop.

First and foremost let us understand that the idea of the “free markets” is a fallacy. Markets exist within the framework of a national and indeed, sometimes global, political system; they operate and are governed by laws, regulations and tax codes. In some cases they are even accorded special protections and rights, like in the case of patents and trademarks, etc. The word “free” in free markets is a misnomer. We have competitive markets, not “free” ones.

Yet the fallacy persists and many feel that all problems are better solved by the omniscient free market. Markets do react to problems and eventually “resolve” them, in their own way and sometimes that can be brutal. I’ll invoke the words of the philosopher Thomas Hobbes, who said, when talking about the natural state of nature and man, that life in that state can be “nasty, brutal and short.” As humans we give up some personal freedom to form societies in which there are rules and authorities. This keeps us from devolving into what Hobbes observed as man’s natural state of war and chaos. The markets are no different: they can be reigned over and controlled and corralled to some degree, or they can exist in a wild state.

I believe that our naïve appeals to “the hand of the free market” are being heeded and that is what makes this so very scary. Many of those who have longed for this day will be surprised, and not in a good way mind you. I said on Fox Business the other day that those who were against bailouts are seeing their dreams come true, however, their dreams will soon turn to nightmares. The current situation has devolved into that natural state that Hobbes described. Moreover, no one will be spared; not even those misguided folks who railed against the bailouts thinking that their good behavior (they paid their mortgages on time, never over-leveraged and wisely saved) somehow insulated them from any possible misfortune. They’ll be sadly mistaken.

Even policy makers have gotten influenced by this perception. Misinformed and misguided cries of “taxpayer on the hook” is leading to dangerous new policy, where the government is no longer acting as a backstop or countervailing force (because that is viewed as putting taxpayers in jeopardy) but rather, acting unilaterally to seize private property with some warped idea that the government needs to make profits. This is highly dangerous in my opinion.

Thirty-six hours after Paulson said that he would not help Lehman, he and the folks at the Fed appeared to go back on their pledge, saying that they would rescue AIG, the insurance giant that was taking its last few steps up the gallows. The Lone Ranger came riding in at the last moment. Or did he? For this help (which was not asked for at least in the way it came), AIG would have to pay loan-shark interest rates and the company’s owners—the shareholders—who had already lost pretty much everything (AIG’s largest shareholder, Hank Greenberg, is said to have seen his net worth decline by as much as $7 billion in a matter of days), would have just about zero, as the government takes a majority ownership position.

Herein lies the problem as I see it. The government is not a profit seeking enterprise. Rather, it exists for the public purpose. Yet mandating the government to “make profits” on the false notion that this someone behooves taxpayers, will not only destroy taxpayers but destroy the economy as we know it.

At the end of the day no private business can compete for profits with government in an economy where taxes must be paid in a currency that the government has the monopoly power to issue. Think about it. A company is set up to sell widgets. It has to raise capital (remember, the government’s cost of capital is zero ‘cause it issues the stuff), it makes a profit of $100 and gives 10% to the government as tax, leaving it with $90. It also has to pay back investors or the bank that lent it money to start up. So, it’s really left with less than $90.

In contrast, the profit seeking government uses its own money, which it can issue without constraint, then sells widgets for $100 and pays no taxes to itself. It should be clear that pretty quickly the government ends up owning the means of all production. That’s not called Socialism; that’s called Communism. The markets are not afraid of Democratic Socialism, however, the markets ARE afraid of Communism. Really afraid!

By operating under the false notion that the government must “make a profit” and that private owners and risk takers must be destroyed each and every time a firm needs something as simple as a loan or loan guarantee, private sector risk taking understandably collapses. Who will take risk when the government stands ready to take your property, unilaterally, without invitation or even a discussion of whether or not you are getting some fair compensation for it? The answer is nobody! That is why you are seeing stocks collapse today.

In all of the recent examples: Fannie Mae, Freddie Mac and AIG, the Fed or the Treasury could have extended loans or loan guarantees backed by these companies’ assets, charged an interest rate of whatever it chose, but preferably just above the yield on a 10-year Treasury, say. (Even though it could have chosen 0.0001% or any increment above 0% because the government’s cost of funds in zero) and that would have been sufficient “payback.”



In closing I will leave you with this example: Imagine if you went to buy a house and asked a bank for a loan, which the bank granted at some interest rate above the bank’s own cost of funds. That would be the bank’s “profit.” The bank will also secure the loan with the house. In other words, the bank can take the house if you default on the loan. I’m sure everyone understands this. Now imagine a scenario where the bank lends you the money at a specified interest rate, secures the loan with the property and owns whatever equity you build up in your home as well!! What kind of deal is that??? In the meantime, you are still stuck having to pay taxes and forking out money for the upkeep of the property. Who would buy a house??? The answer is nobody. But that is exactly the system we have set up here with the “bailouts" and this idea that the government should make profits. Herbet Hoover once said, "The business of government IS business." We had the Great Depression afterward.It should be no wonder, then, why investors are dumping stocks.

Greenberg calls AIG, "A National Treasure!"

Former AIG CEO, Hank Greenberg, called the firm he built, "A national treasure," during an interview with Maria Bartiromo of CNBC. (See interview here.)

Give me a break! That is monumental hubris!! Greenberg's tangled web of derivatives is now falling apart and while I understand him wanting to save it, pitching the need for a rescue to the American people like that he just oozes with phoniness.

Come on, Hank! You want it saved because your billions are on the line. Hey, you're 80-something and you'll still have plenty of money left for you to spend for the rest of your life, but don't go playing the American people for idiots. AIG may be your treasure, Hank, but it's is not a national treasure. Stop whining! I thought as a former marine, you'd be a lot tougher.

Next to fall: AIG. Will the Merrill/BofA deal collapse?

With the Fed standing pat on rates and Treasury not extending help to AIG, the insurer is likely to fail, touching off even more market turmoil. Talk in the market now of the Merrill/BofA deal being scuttled. If Merrill dies, the negative psychological impact to the markets and the economy will be enormous! Fed has been hijacked by a couple of hawks--Fisher and Plosser. Blame these guys!

Fed does nothing!

In the midst of possibly the worst credit crisis in history, the Fed's Open Market Committee caved in to pressures by two of its most hawkish members: Richard Fisher of the Dallas Fed and Charles Plosser of the Philly Fed. As Warren Mosler would say, "It's a function of price, not quantity." These guys still don't get it. More bank and investment bank failures to come!

My interview with David Walker

Here is my interview with former Controller General, David Walker.

Part 1.

Part 2.

Who's Paulson kidding??

Just a short while ago Treasury Secretary Hank Paulson told Americans that they should have "confidence in the financial system." Who's he kidding??? The private financial system has been shut down for the past 13 months and were it not for the Fed and his own Treasury Department providing supports, pretty much all commerce would have ceased. Now, as he basically tells the citizens of this country to "drop dead, you're on your own," he leaves the resolution of all this to the markets, which means it is certain to be devastatingly brutal. Whereas much of this was mainly confined to the financial sector and Wall Street, expect the contagion to spread rapidly and fiercely now to Main Street.

Treasury, Fed, leave Lehman to the wolves

Stock market in a free fall on Sunday night as talks to save Lehman fail. Treasury Secretary Hank Paulson said no “taxpayer funds” would be used to save the firm. This is a purely political decision, nothing more. It also ignores the effect to taxpayers of a financial collapse that destroys the economy. Many critics of the Fed and Federal government will get to see their preferred version of a “workout,” as in, “let the markets take care of it.” The outcome is likely to be violent and terrible for stocks, the dollar and the economy.

Barry Ritholtz's comments on the bailout of Fannie and Freddie

I had an interesting conversation with Barry Ritholtz today. Ritholtz runs Fusion Analytics, whatever that is. To me, however, he is more like a real-life Zelig; a guy who manages to show up in the background at big-wig economic gatherings or whose name pops up in articles and columns as the expert source on some economic subject. He seems curiously ubiquitous. It is interesting to note that Ritholtz is not a trained economist; he has a law degree, but we won’t hold that against him.

The subject of the discussion was the bailout of Fannie and Freddie. Ritholtz said, as so many others have been saying, lately, that by standing behind the GSE’s, the Treasury had, in one fell swoop, added $5 trillion to the national debt and thereby “raised the taxpayer’s share of the national debt” by some ungodly amount. In other words the bailout was put on our tab and every one of us now has to pay for it.

When I asked him to explain how, exactly, I was going to pay for it (because I had not received a bill in the mail for my share of the bailout), he became vague. In essence his response was that I would have to pay, maybe not in the form of a bill or new tax levy (because there won’t be any), but in some other form, which, again, he had difficulty defining.

I asked him why I have not had to pay for the enormous debt our parents and grandparents racked up for the cost of WWII. After all, the debt swelled to an unheard of, 120% of GDP back then, far above the current, 67% of GDP that our debt now represents (38% of GDP when you consider the debt owed to the public, which is a more realistic way to look at it).

Heck, even if you assume that every single one of the $5 trillion of those mortgages that Fannie and Freddie owns or guarantees goes bad, our debt still would be far less than the debt that we incurred as a result of fighting WWII. (To his credit, Ritholtz admitted that only a small percentage of that outstanding $5 trillion was likely to be bad.)

At this point, Ritholtz, being the good lawyer that he is and realizing he was in trouble with the WWII debt example, tried to shift the discussion by saying that the war had to be fought because the very survival of our nation was at stake. Yet bailing out the GSE’s was not a necessity.

The problem with that response is that we are not discussing the moral arguments for how the debt came about, but rather, the debt itself and the assertion that it represents a claim on future generations’ standard of living.

There is no question about it: Our parents and grandparents left us with a legacy of debt. So what happened? Did it destroy our wealth and make us a third world nation? Did we suffer with high unemployment, high interest rates, surging inflation and sub-par economic growth? Did we transit a long period of economic malaise or depression? The answer to all these questions is, No!

In fact, quite the opposite happened. Since that debt was incurred the country’s economy has boomed. Output has gone from $220 billion at the end of 1945 to $14.5 trillion today. Private investment skyrocketed from $2 billion annually to over $2 trillion per year. Personal saving was $10 billion in 1947; it’s $280 billion today. Unemployment is up slightly today because we are battling recession; however, last year’s 4.4 low in the unemployment rate is pretty similar to the 4.0 percent unemployment rate in 1948.

More to the point, however, is the fact that the prior generation’s huge debt has shrunk to a third the size it was. Tax rates have come down (the top rate was 91% at the end of WWII and even if Obama wins and he raises it back to 39%, that would still be less than half of the rate in 1946), even interest rates have remained more or less constant: The yield on the 10-year Treasury note was about 2.5% at the end of the 1940s and it’s about 3.7% now. Not a huge difference. Inflation has even declined.

Most important of all, however, is the fact that our parents’ generation, the very same generation that racked up an enormous legacy of debt that purportedly would be handed over to their kids and grandkids, is now in the process of transferring some $40 trillion in assets to us! That was the real heritage left to us, not a bill. And when the current generation sails off into the sunset, they'll be handing over what is currently, $75 trillion of assets to their children and grandchildren.

As the late, Nobel Prize wining economist, William Vickrey once said, “debt is the means whereby the present working generation is enabled to earn more by fuller employment and invest in the increased supply of assets, of which the debt is a part, so as to provide for their own old age. In this way the children and grandchildren are relieved of the burden of providing for the retirement of the preceding generations.”

Zelig should read this.

Oil Investors Pulled $39 Billion in Futures, Triggering Decline

$39 billion in futures is the equivalent of 354 million barrels of crude oil at $110 per barrel. Compare this to the paltry, 70 million barrels that some lawmakers want sold from the Strategic Petroleum Reserve. You can see here how it works a lot better just to get the speculators out!

Opec decides to curb output

Classic Opec ploy. Fool the market into thinking they are going to do nothing. (In this case, saying they would keep output steady and driving prices down, then announcing a surprise cut.) They buy futures aggressively as prices fall and they will profit handsomely now that prices increase on the production cut. By doing this, they maintain their huge profits without ever having to take their oil out of the ground. The markets get fooled every time.

Jim Rogers in perspective

Here's a great blog post I came across that puts Rogers in perspective.

"The man is arrogant, rude and ignorant to a degree even beyond that to which I have become accustomed after a long career in finance. I have never met him - but from his letter, I imagine him very short, and having great difficulty getting laid. His comically insecure arrogance is reminiscent of the Proust's pathetic Baron de Charlus. Profound insecurity transpires everywhere; he is driven to continually remind us of his brilliance, with the corollary that anyone who disagrees with him is not merely misinformed, but is indeed a total fool, deserving only of his scorn. Common courtesy seems alien to him.

Yes, he can drive a bike; indeed, he has made some money (he repeatedly reminds us of what a genius he is - although perhaps "Fooled by Randomness" would be a rather better reference than "Money Masters of our Time.")."

"Ordinarily, I would not stoop to arguments ad hominem, but Rogers' rudeness goes far beyond anything one ordinarily encounters in discussions amongst supposedly sane people. He affirms his intellectual superiority by screeching 'You really should have kept your mouth shut'
- his stylistic genius by starting paragraphs with 'Oh my' and 'my goodness'. and this gentleman claims to be a writer?"

"Apparently, a successful career in money management has done nothing to shelter his fragile ego. When he tells us that "All the public is extremely aware (sic) of my record of investing in many markets all over the world for many years" (verily, it thinks of nothing else!) and ends his note by inserting a book review from Amazon.com - surely the ante-room to the Noble prize - he goes from the sublime to the grotesque."

Jim Rogers is stark raving mad!

Here is a recent interview that Jim Rogers gave on the Fannie/Freddie bailout. My comments run through some of it.

Jim Rogers: How the Federal Reserve Will Fail and the One Sector Every Investor Should Be In
Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

These are the rantings of a crotchety, old, lunatic. He will be remembered for this hysterical rant and then, hopefully, he will be discredited and just go away.

VANCOUVER, B.C. - The U.S. financial crisis has cut so deep - and the government has taken on so much debt in misguided attempts to bail out such companies as Fannie Mae and Freddie Mac - that even larger financial shocks are still to come, global investing guru Jim Rogers said in an exclusive interview with Money Morning.

Fannie, Freddie, Bear stearns, total $230 billion, maybe. That is not even 2% of GDP. It is less than 0.4% of household net worth and about 0.15% of the nations assets. It's peanuts.

Indeed, the U.S. financial debacle is now so ingrained - and a so-called "Super Crash" so likely - that most Americans alive today won’t be around by the time the last of this credit-market mess is finally cleared away - if it ever is, Rogers said.

Hopefully, Rogers himself will be long gone SOON. No person can live long with that much nastiness and negativity buried inside their body. But I digress.

The end of this crisis "is a long way away," Rogers said. "In fact, it may not be in our lifetimes."


During a 40-minute interview during a wealth-management conference in this West Coast Canadian city last month, Rogers also said:

Why U.S. Federal Reserve Chairman Ben S. Bernanke should "resign".
How the U.S. national debt - the roughly $5 trillion held by the public - essentially doubled in the course of a single weekend.

Yes, assuming that ALL of the mortgages that the GSE's guarantee are bad. They're not. Less than 3% of all mortgages in the U.S. are in foreclosure.

That U.S. consumers and investors can expect much-higher interest rates - noting that if the Fed doesn’t raise borrowing costs, market forces will make that happen.

Why? Borrowing costs are controlled by the Fed. When Japan's bubble imploded rates remained near zero.

Which stocks he’s holding onto for the rest of the year
Rogers first made a name for himself with The Quantum Fund, a hedge fund that’s often described as the first real global investment fund, which he and partner George Soros founded in 1970. Over the next decade, Quantum gained 4,200%, while the Standard & Poor’s 500 Index climbed about 50%.

Thanks to Soros, not Rogers.

It was after Rogers "retired" in 1980 that the investing masses got to see him in action. Among his historic market calls, Rogers predicted China’s meteoric growth a good decade before it became apparent and he subsequently foretold of the powerful updraft in global commodities prices that’s fueled a year-long bull market in the agriculture, energy and mining sectors.

[Editor’s note: Rogers recently released a new book, "A Bull in China," a page-turner that reveals what China stocks to buy… when to buy. To learn how you can get "A Bull in China" for free, please click here.]

If Rogers was such a great investor, he'd be writing fewer books; doing more investing and less talking.

Rogers’ candor has made him a popular figure with individual investors, meaning his pronouncements are always closely watched. Here are some of the highlights from the exclusive interview we had with the author and investor, who now makes his home in Singapore:

Keith Fitz-Gerald (Q): Looks like the financial train wreck we talked about earlier this year is happening.

Jim Rogers: There was a train wreck, yes. Two or three - more than one, as you know. [U.S. Federal Reserve Chairman Ben S.] Bernanke and his boys both came to the rescue. Which is going to cover things up for a while. And then I don’t know how long the rally will last and then we’ll be off to the races again. Whether the rally lasts six days or six weeks, I don’t know. I wish I did know that sort of thing, but I never do.

(Q):What would Chairman Bernanke have to do to "get it right?"

Rogers: Resign.

And Rogers should just go away, for good.

(Q): Is there anything else that you think he could do that would be correct other than let these things fail?

Rogers:Well, at this stage, it doesn’t seem like he can do it. He could raise interest rates - which he should do, anyway. Somebody should. The market’s going to do it whether he does it or not, eventually.

Raise interest rates? What for? That won't fix anything.

The problem is that he’s got all that garbage on his balance sheet now. He has $400 billion of questionable assets owing to the feds on his balance sheet. I mean, he could try to reverse that. He could raise interest rates. Yeah, that’s what he could do. That would help. It would cause a shock to the system, but if we don’t have the shock now, the shock’s going to be much worse later on. Every shock, so far, has been worse than the last shock. Bear-Stearns [now part of JP Morgan Chase & Co. (JPM)] was one thing and then it’s Fannie Mae (FNM), you know, and now Freddie Mac (FRE).

How does raising interest rates "reverse" what's on the Fed's balance sheet? This makes no sense. The Bear Stearns assets are already up nearly $500 million from where they were at the time the Fed acquired them.

The next shock’s going to be even bigger still. So the shocks keep getting bigger because we kept propping things up and this has been going on at least since Long-Term Capital Management. They’ve been bailing everyone out and [former Fed Chairman Alan] Greenspan took interest rates down and then he took them down again after the "dot-com bubble" shock, so I guess Bernanke could try to start reversing some of this stuff.

But he has to not just reverse it - he’d have to increase interest rates a lot to make up for it and that’s not going to solve the problem either, because the basic problems are that America’s got a horrible tax system, it’s got litigation right, left, and center, it’s got horrible education system, you know, and it’s got many, many, many [other] problems that are going to take a while to resolve. If he did at least turn things around - turn some of these policies around - we would have a sharp drop, but at least it would clean out some of the excesses and the system could turn around and start doing better.

But this is academic - he’s not going to do it. But again the best thing for him would be to abolish the Federal Reserve and resign. That’ll be the best solution. Is he going to do that? No, of course not. He still thinks he knows what he’s doing.

These are the rantings of a pure lunatic. To say that Bernanke should "abolish the Fed," is patently absurd. He doesn't have the power to do this and even if he did, doing so wouldn't solve a thing. Credit markets have all but shut down. The only thing that is keeping the fiancial system functioning "normally" is the Fed.

(Q): Earlier this year, when we talked in Singapore, you made the observation that the average American still doesn’t know anything’s wrong - that anything’s happening. Is that still the case?

Rogers:Yes.

(Q): What would you tell the "Average Joe" in no-nonsense terms?

Rogers: I would say that for the last 200 years, America’s elected politicians and scoundrels have built up $5 trillion in debt. In the last few weekends, some un-elected officials added another $5 trillion to America’s national debt.

Yeah, it took 200 years to build up $5 trillion in debt, but over that time we built an economy that generates $14 trillion PER YEAR in economic output. Households have $57 trillion of positive net worth. Not a bad job those scoundrels have done, eh? Moreover, that $5 trillion of debt is only 38% of GDP. Japan's debt is 150% of GDP.

Suddenly we’re on the hook for another $5 trillion. There have been attempts to explain this to the public, about what’s happening with the debt, and with the fact that America’s situation is deteriorating in the world.

Even if the whole $5 trillion of mortgages backed by the GSE's were bad (which they are not), we'd still have a lower debt as a percentage of GDP than Japan. The Japanese live pretty well, I might add.



I don’t know why it doesn’t sink in. People have other things on their minds, or don’t want to be bothered. Too complicated, or whatever.

Because most people have too much sense than to listen to the rants of a lunatic like Rogers.

I’m sure when the [British Empire] declined there were many people who rang the bell and said: "Guys, we’re making too many mistakes here in the U.K." And nobody listened until it was too late.

The British Empire died when Britain lost its military dominance of the world's oceans. Britain was supplanted by America.

When Spain was in decline, when Rome was in decline, I’m sure there were people who noticed that things were going wrong.

All were related to military decline.

(Q):Many experts don’t agree with - at the very least don’t understand - the Fed’s current strategies. How can our leaders think they’re making the right choices? What do you think?

Rogers:Bernanke is a very-narrow-gauged guy. He’s spent his whole intellectual career studying the printing of money and we have now given him the keys to the printing presses. All he knows how to do is run them.

The Fed targets interest rates, that's it. Although the Fed has lent out over $1 trillion in the past year through the discount window and other lending facilities, monetary aggregates have not grown.

Bernanke was [on the record as saying] that there is no problem with housing in America. There’s no problem in housing finance. I mean this was like in 2006 or 2005.
(Q): Right.

Rogers: He is the Federal Reserve and the Federal Reserve more than anybody is supposed to be regulating these [financial institutions], so they should have the inside scoop, if nothing else.

Banks were regulated and all their assets must conform to OCC

(Q): That’s problematic.

Rogers: It’s mind-boggling. Here’s a man who doesn’t understand the market, who doesn’t understand economics - basic economics. His intellectual career’s been spent on the narrow-gauge study of printing money. That’s all he knows.

It's still more than Rogers knows.

Yes, he’s got a PhD, which says economics on it, but economics can be one of 200 different narrow fields. And his is printing money, which he’s good at, we know. We’ve learned that he’s ready, willing and able to step in and bail out everybody.

Yes, the Fed has the authority to lend to anyone it sees fit.

There’s this worry [whenever you have a major financial institution that looks ready to fail] that, "Oh my God, we’re going to go down, and if we go down, the whole system goes down."
This is nothing new. Whole systems have been taken down before. We’ve had it happen plenty of times.

Yes, and it was incredibly disruptive. There's a better way.

(Q):History is littered with failed financial institutions.

Rogers:I know. It’s not as though this is the first time it’s ever happened. But since [Chairman Bernanke’s] whole career is about printing money and studying the Depression, he says: "Okay, got to print some more money. Got to save the day." And, of course, that’s when he gets himself in deeper, because the first time you print it, you prop up Institution X, [but] then you got to worry about institution Y and Z.

(Q): And now we’ve got a dangerous precedent.

Rogers: That’s exactly right. And when the next guy calls him up, he’s going to bail him out, too.

(Q): What do you think [former Fed Chairman] Paul Volcker thinks about all this?

Rogers:Well, Volcker has said it’s certainly beyond the scope of central banking, as he understands central banking.

(Q): That’s pretty darn clear.

Rogers: Volcker’s been very clear - very clear to me, anyway - about what he thinks of it, and Volcker was the last decent American central banker. We’ve had couple in our history: Volcker and William McChesney Martin were two.

You know, McChesney Martin was the guy who said the job of a good central banker was to take away the punchbowl when the party starts getting good. Now [the Fed] - when the party starts getting out of control - pours more moonshine in. McChesney Martin would always pull the bowl away when people started getting a little giggly. Now the party’s out of control.

(Q): This could be the end of the Federal Reserve, which we talked about in Singapore. This would be the third failure - correct?

Rogers: Yes. We had two central banks that disappeared for whatever reason. This one’s going to disappear, too, I say.

(Q):Throughout your career you’ve had a much-fabled ability to spot unique points in history - inflection points, if you will. Points when, as you put it, somebody puts money in the corner at which you then simply pick up.

Rogers:That’s the way to invest, as far as I’m concerned.

(Q): So conceivably, history would show that the highest returns go to those who invest when there’s blood in the streets, even if it’s their own.

Rogers:Right.

(Q): Is there a point in time or something you’re looking for that will signal that the U.S. economy has reached the inflection point in this crisis?

Rogers: Well, yeah, but it’s a long way away. In fact, it may not be in our lifetimes. Of course I covered my shorts - my financial shorts. Not all of them, but most of them last week.
So, if you’re talking about a temporary inflection point, we may have hit it.

If you look back at previous countries that have declined, you almost always see exchange controls - all sorts of controls - before failure. America is already doing some of that. America, for example, wouldn’t let the Chinese buy the oil company, wouldn’t let the [Dubai firm] buy the ports, et cetera.

But I’m really talking about full-fledged, all-out exchange controls. That would certainly be a sign, but usually exchange controls are not the end of the story. Historically, they’re somewhere during the decline. Then the politicians bring in exchange controls and then things get worse from there before they bottom.

Before World War II, Japan’s yen was two to the dollar. After they lost the war, the yen was 500 to the dollar. That’s a collapse. That was also a bottom.

These are not predictions for the U.S., but I’m just saying that things have to usually get pretty, pretty, pretty, pretty bad.

It was similar in the United Kingdom. In 1918, the U.K. was the richest, most powerful country in the world. It had just won the First World War, et cetera. By 1939, it had exchange controls and this is in just one generation. And strict exchange controls. They in fact made it an act of treason for people to use anything except the pound sterling in settling debts.

(Q): Treason? Wow, I didn’t know that.

Rogers: Yes…an act of treason. It used to be that people could use anything they wanted as money. Gold or other metals. Banks would issue their own currencies. Anything. You could even use other people’s currencies.

Things were so bad in the U.K. in the 1930s they made it an act of treason to use anything except sterling and then by ‘39 they had full-exchange controls. And then, of course, they had the war and that disaster. It was a disaster before the war. The war just exacerbated the problems. And by the mid-70s, the U.K. was bankrupt. They could not sell long-term government bonds. Remember, this is a country that two generations or three generations before had been the richest most powerful country in the world.

Now the only thing that saved the U.K. was the North Sea oil fields, even though Prime Minister Margaret Thatcher likes to take credit, but Margaret Thatcher has good PR. Margaret Thatcher came into office in 1979 and North Sea oil started flowing. And the U.K. suddenly had a huge balance-of-payment surplus.

You know, even if Mother Teresa had come in [as prime minister] in ‘79, or Joseph Stalin, or whomever had come in 1979 - you know, Jimmy Carter, George Bush, whomever - it still would’ve been great.

You give me the largest oil field in the world and I’ll show you a good time, too. That’s what happened.

(Q):What if Thatcher had never come to power?

Rogers: Who knows, because the U.K. was in such disastrous straits when she came in. And that’s why she came to power…because it was such a disaster. I’m sure she would’ve made things better, but short of all that oil, the situation would’ve continued to decline.

So it may not be in our lifetimes that we’ll see the bottom, just given the U.K.’s history, for instance.

(Q): That’s going to be terrifying for individual investors to think about.

Rogers: Yeah. But remember that America had such a magnificent and gigantic position of dominance that deterioration will take time. You know, you don’t just change that in a decade or two. It takes a lot of hard work by a lot of incompetent people to change the situation. The U.K. situation I just explained…that decline was over 40 or 50 years, but they had so much money they could have continued to spiral downward for a long time.

Even Zimbabwe, you know, took 10 or 15 years to really get going into it’s collapse, but Robert Mugabe came into power in 1980 and, as recently as 1995, things still looked good for Zimbabwe. But now, of course, it’s a major disaster.

That’s one of the advantages of Singapore. The place has an astonishing amount of wealth and only 4 million people. So even if it started squandering it in 2008, which they may be, it’s going to take them forever to do so.

(Q): Is there a specific signal that this is "over?"

Rogers: Sure…when our entire U.S. cabinet has Swiss bank accounts. Linked inside bank accounts. When that happens, we’ll know we’re getting close because they’ll do it even after it’s illegal - after America’s put in the exchange controls.

(Q): They’ll move their own money.

Rogers: Yeah, because you look at people like the Israelis and the Argentineans and people who have had exchange controls - the politicians usually figured it out and have taken care of themselves on the side.

(Q):We saw that in South Africa and other countries, for example, as people tried to get their money out.

Rogers:Everybody figures it out, eventually, including the politicians. They say: "You know, others can’t do this, but it’s alright for us." Those days will come. I guess when all the congressmen have foreign bank accounts, we’ll be at the bottom.

But we’ve got a long way to go, yet.

(Q): There’s a lot of talk that the Chinese will use the Olympics to launch a new wave of nationalism and to move ahead. Are the Olympic Games as relevant as some people think?

Rogers:They’ve already got tremendous nationalism. But the international reactions about Tibet and the Olympic torchbearers re-awakened it.

And the politicians, of course, need it because they’ve got their own problems with inflation and overheating and [pollution and] the rest of it. So, like politicians throughout history, they fan it - do their best to say: Hell, it’s not our problem. It’s the evil farmers. It’s the French. See that store over there: It’s their fault. It’s the Americans."

So that is happening, anyway.
As far as the Olympics themselves, they’re irrelevant.

America had the Olympics in ‘96 and it had no effect on the American economy - before or after. Some people in Atlanta were affected before and after. And some people who were involved with the Olympics were affected before and after.

America at that time had 270 million people. China’s got five times as many people, and it’s a much bigger country geographically.

Sydney, Australia had the 2000 Olympics. It had virtually no effect on the Sydney, or on the Australian economy - even though Australia had 18 million people. It’s tiny … nothing. Yes, it had an effect on some people.

Greece, in 2004, had the Olympics. You haven’t heard stories of a major collapse or a major revival of Greece in 2005, because the fact is that the Games didn’t have much of an effect - not a noticeable effect, anyway. It had spot effects only, so I ignore the Olympics as far as the Chinese economy - and its stock market - is concerned.
(Q): Are you still bullish on China?

Rogers:Oh, yeah. I never sold anything in China. In fact, I bought more. I bought Chinese Airlines (CHAWF) last week. I flew one coming here. Maybe I made a mistake [with the investment], because it was emptier than I thought it would be.

(Q): Any thoughts why?

Rogers:One thing, you know, is that China’s made it extremely difficult to get a visa right now. In the past, it’s been hard to get a seat because Chinese airlines were so full. On this flight there were empty seats.

That brought home to me that they are cutting back enormously on visas right now. Discouraging travel, trying to clean the air, trying to protect against somebody blowing up the Forbidden City, et cetera. So the fact that planes are empty right now may be smarter than I thought.

Maybe I did get the bottom on the airlines, because if they are going to reissue the visas again, after all this, after September [after the Olympic Games have concluded], then the planes are going to fill up pretty quickly again. I would have picked the stock up at a bottom.

(Q):Yes.

Rogers:Anyway, I’m still around China. I have never sold any of my Chinese companies. You know, selling China in 2008 is like selling America in 1908. Sure, let’s say the market goes down another 40% - so what! You look back over 100 years, you look back from the beauty of 1928, or even 1938 [in the depths of the Great Depression], and there is somebody who bought shares in 1908. He was still a lot better off having not sold in 1908.

It's NOT our money.(The gov't doesn't need our taxes to spend)

One of the biggest misconceptions I come across everyday is the idea that the government must collect taxes or borrow in order to have the funds to spend and invest. This idea probably comes from most peoples’ self-centered view of finance. They view the government like they view themselves, in that, it is impossible to spend unless you have the funds in hand first.

This does not apply in this case because the government uses its “own” money, which it can create in limitless quantities. The money is essentially IOU’s, which can take the form of Treasuries, printed bills or simply, bank reserves (mere credits to the banking system).

Moreover, there is no constraint to how many of these IOU’s the government can issue, as stated above. Constraints can only be self-imposed, like when there is a desire to achieve “balanced” budgets or, when policymakers feel that too much spending is creating inflation. At that point they might decide to slow spending. However, these constraints are political in nature, not operational constraints.

The government can spend all it wants of its own currency and usually does so even before one cent in taxes is ever collected or before a single security is ever sold. Indeed, that is the only way that deficits can exist in the first place: the spending is done first and in greater quantities than what comes in, hence, the deficit.

Think about it: If the government first collected taxes and sold securities, there would be no deficit because it could be said to be operating on a “pay as you go” system.

Why, then, does the government need to collect taxes and sell securities if it can spend all it wants of its own money? Because doing so would quickly lead to hyperinflation. Government spending, if left unchecked would swell bank reserves beyond the Fed’s control and cause money supply to grow very rapidly. In order to prevent this, the government collects taxes and sells securities as a means of draining off some of the excess liquidity pumped in by all of the spending.

Therefore, we can correctly state that “the money to pay taxes and sell securities comes from government spending.” It’s not the other way around.

Next post: Enforcing the collection of taxes as a means to give the government’s money value.