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Quantitative Easing
is not Automatically A Keynesian Measure
By
Henry C.K. Liu
This article appeared in AToL
on July 17, 2013
In early April, 2013, the Bank of Japan, a central bank,
under its new Chairman Haruhiko Kuroda, announced that it will
implement both
quantitative and qualitative easing (QE and QualE) to stimulate the
stalled
Japanese
economy. (Please see my April
17, 2013
Article: Bank of Japan Bashing)
QE is a monetary measure that a central bank in desperation
can undertake as a last resort to stimulate a stalled economy when the
short-term benchmark inter-bank interest rate target is set at or near
zero and
cannot be lowered through central bank open market operations, in which
the
central bank buys or sells short-term government bonds in the open
market such
as the repo market to keep the inter-bank interest rate near its set
target.
Such a situation is known as a
Liquidity Trap, a term later
attributed to John Maynard Keynes (1883-1946) in 1936 to describe a
market situation
in which injection of cash by the central bank into the banking system
to lower
the short-term interest rate fails to stimulate growth. Such a
liquidity trap
is casued by market participants hoarding cash on expectation of
adverse market
developments such as deflation caused by insufficient aggregage demand
due to
high unemployment.
Paul Davidson, Editor of Journal of Post Keynesian Economics,
and author of THE KEYNES SOLUTION: THE
PATH TO GLOBAL ECONOMIC PROSPERITY
points out that Keynes would be against QE as a stand alone
stimulus without a fiscal deficit program to finance full employment.
Davidson points out that in a letter Keynes wrote to President
Franklan D. Roosevelt when Roosevelt tried in 1934 to increase the
quantity of
money in
the monetary system by devaluing the dollar in terms of gold, Keynes
stated
that to merely increase the quantity of money [without a fiscal deficit
spending program to create employment] was like buying a bigger belt in
order
to get fat!
Davidson has said, using this Keynes analogy, that buying a
bigger belt without eating more (i.e.,
additional fiscal spending on goods and services) is merely going to
let your
pants fall down. If you eat more you will need a bigger belt!
Davidson also points out that Keynes never
used the term "liquidity
trap" and in fact on page 202 of
the General Theory of Employment, Interest and Money (1936),
Keynes specifies
the speculative demand for money as a rectangular hyperbola - a
mathematical
function that never has a perfectly elastic demand for money segment--
which is
what James Tobin (1918-2002) et al mean by a liquidity trap.
QE by a central bank increases the money supply through
buying sovereign or other top-rated securities from big banks and other
systemically significant financial institutions at face value without
reference
to market value or interest rate. QE
floods stressed money-issuing/transmitting financial institutions with
additional reserves in an effort to provide more liquidity in the
market and to
boost bank lending into the stalled economy. In the current debt crisis
that
began in mid 2007, most over-leveraged institutions have been using QE
money to
de-leverage to lower required reserve rather than to raise existing
reserve to
boost lending.
QE measures generally expand the balance sheets of the
buying central banks, transferring troubled assets of eclipsed market
value
from the private sector to the central bank at full face value, saving
endangered systemically significant (too-big-to-fail) institutions from
pending
insolvency.
In an over-leveraged debt market economy, QE can run the
risk of reducing private sector incentive to try with determination to
create
new wealth to retire outstanding liabilities with newly earned money in
a
difficult market. This decline in incentive is due to the easy
availability of
unearned QE money issued by the central bank to relieve stressed
institutions
from pending insolvency.
Such unearned money released by central bank QE has no real
worth behind it except as sole legal tender accepted by government for
payment
of taxes. Yet tax payment by definition is reduced in a recession, thus
reducing the demand of money needed for payment of taxes. Under such
conditions, QE money released by central bank has reduced stored value
because
such money is not backed by additional tax claims by government. In
fact, even
fiat money already in circulation, presumably backed by its accpetance
for
payment of taxes, face impairment in value in a recession when tax
revenue
generally declines. Additional QE money in a recession further dilutes
the
stored value of all money in circulation.
QE money cannot be backed by stored value of any other kind
without such money being productively employed directly to create new
wealth
beyond the removal of troubled assets from the banking system in the
private
sector. Troubled assets held by creditors are assets whose market
values are
discounted by price deflation or debtor default.
Furthermore, QE money directly reduces the need on the part
of debtors in the private sector for earned money to repay debt because
such
debt has been transferred to the central bank at full face value in
exchange
for QE money not backed by eqivalent tangible assets or additional tax
revenue.
QE without direct focus or impact on reducing unemployment
is by definition not a Keynesian measure of deficit financing to reduce
unemployment in the recessionary phase of a normal business cycle.
Unless QE
money is targeted directly on creating new employment to restore
consumer
demand, and not targeted merely toward manipulative transfer of
troubled assets
to the central bank from financial institutions in private sector
facing insolvency,
QE is merely a monetarist maneuver.
A Keynesian fiscal measure cannot be one that merely
transfers from technically insolvent commercial banks troubled assets
at full
face value acquired earlier in a debt bubble with earned money of
stored value,
to a central bank which pays for it with newly-issued QE money that has
not yet
accumulated any stored value, being new fiat money that is nor
supported by new
tax revenue, but rather only by shrinking tax revenue in a recession.
Such QE
is merely a monetarist measure to relieve a gravely weaken banking
system
facing pending insolvency without real positive impact on the stalled
economy
while adding moral hazard to the entire financial system in the private
sector.
QE monetary measures without a direct focus on creating
gainful employment are frothed with inevitable inflationary
consequences due to
an increase in the money supply without corresponding expansion of the
economy.
While inflation can be an effective macro means to ease the pain of
debt, such
pain is not extinguished, only transferred from debtors to the owners
of wealth
in the economy. Yet sustained inflation will eventually wipe out all
temporary
distributional benefits of contingent inflation to put all in the
economy in a
worse fix.
If sovereign or other top-rated securities that a central
bank buys from big banks or systemically significant financial
institutions
is of credit quality lower than the normally triple-A rating required
by
standard central bank open market operations to manage the benchmark
short-term
interest rate, as is likely the case in a market economy impaired by a
burst
debt bubble, then the central bank is conducting Qualitative Easing
(QualE),
weakening the asset side of the balance sheet of the buying central
bank. This
type of monetary easing is more detrimental if the troubled asset is
bought
not at discounted market price in the open market, but at full face
value
directly from impaired financial institutions to make them whole on
near
non-performing loans.
In such instances, not only is the money supply increased by
QualE without compensatory economic expansion or newly created wealth,
the
quality of the money supply also deteriorates with the introduction of
QualE
money of diluted quality, with significantly different and more
detrimental
consequences to the monetary system than standard QE in a regular
business
cycle recession.
Under such circumstances, a rise is the tax rate is the only
means by which the government can restore the quality of the QualE
released
fiat money which is backed by of the government's authority to set the
necessary tax rate and to collect more tax denominated in the national
currency
to preserve the quality of the QualE money.
Obviously, a rise in the tax rate risks neutralizing the
effectiveness of QE to stimulate a stalled economy. Therefore, QualE
under such
circumstances is more than an exercise in futility; it is a monetary
measure
that exacerbates the already gravely impaired economy and postpones
prospects
of recovery, often for decades, as happened in Japan
during the 1990s.
Treasury Secretary Henry Paulson asserted in 2008 that the
full resources of the Treasury Department were being used to ensure the
success
of its $700 billion Troubled Assets Relief Program (TARP). The “full
resources
of the Treasury Department” commands the full faith and credit of
the United States anchored
by Treasury’s taxing
authority as approved by Congress. Tax payments in the US are
made to the US Treasury via the Internal Revenue Service with money
earned from wages and/or profit out of the money supply controlled by
the Federal Reserve though its control of the short-term interest rate
target maintained through open market opreation and its setting
of bank reserve reqirements through the setting of the discount rate
the Fed charges eligible commercial banks and other depository
institutions at the Fed Discount Window to control liquidity and market
pressure on bank reserve requirments. A decrese in the discount rate
makes it less costly for banks to borrow money and thus expands
the money supply in the econmy. The discount rate is reset every 14
days
to reponse to market conditions. .
The Congress can approve taxes for and spending by the Administration,
but
Congress cannot create money as the Federal Reserve can. Treasury’s
money can
only come from current and future taxes approved by Congress. Article I
- Section
7.1 of
the Constitution stipulates that “All Bills for raising revenue shall
originate
in the House of Representatives.” The Federal Reserve has
the
authority to create money as part of its monetary policy prerogative
but
Treasury does not have any constitutional authority to expand the money
supply.
Treasury must depend on tax revenue for funds beyond which Treasury
must sell
sovereign debt to raise funds up to the national debt ceiling approved
by
Congress. Section 8.2 stipulates that only Congress have the power to
borrow
money on the credit of the United
States.
Proceeds from sovereign debt are advances on sovereign liability and
not
revenue, and must be paid back from future tax revenue, and not by QE
money
released by the Federal Reserve.
Thus far, Congress has approved $700 billion of taxpayer funds to be
used by
TARP. President Bush also signed a $634 billion spending bill on September 30, 2008 that
includes
funding for $25 billion in low-cost government loans for the distressed
auto
industry. More public funds may be approved as needed. Since the
Federal
government is and has been operating on a fiscal deficit, these funds
can only
come out of future tax revenue and/or more fiscal deficits. This money
should not be confused with QE money.
Also, Treasury came under increasing pressure in 2008 to expand its
financial
rescue
plan beyond banks to include direct assistance to the ailing auto and
insurance
sectors.
Subsequently, lawmakers and interest groups stepped up their efforts to
persuade the Bush administration to divert part of the $700 billion
authorized
by Congress to additional categories of companies that were not
originally
expected to be rescued.
TARP gives the Treasury broad authority to buy any troubled assets that
are
important
for the stability of the US financial
system. But participation in the sweeping $250 billion recapitalization
plan
had so far been confined to US banks.
On October 24, 2008 the
Financial Services Roundtable, an influential lobbying group in
Washington,
sent a letter to Neel Kashkari, interim assistant Treasury secretary
for
financial stability, a former Goldman Sachs banker brought to the
Treasury by
Paulson, himself also a former Goldman Sachs banker, urging the
administration
to consider taking stakes in “broker-dealers, insurance companies [such
as
Ambac and MBIA], and automobile companies [such as GM and Chrysler]” as
well as
“institutions controlled by a foreign bank or company” that play a
vital role
in the US economy by providing liquidity to the market. However, a
Treasury
department spokeswoman declined to comment on whether the US would
consider expanding the rescue in such a way.
Members of the Michigan congressional
delegation also sent a letter to the Treasury and the Federal Reserve
asking
them to take steps to “promote liquidity” in the US auto
industry. It was true that cars were not selling because leasing credit
had
frozen as had collateral debt obligations (CDO) backed by auto loans.
But
everyone knew the automakers were facing insolvency in the long run
beyond
credit problems.
Separately, AIG, the insurer that had been rescued by the government,
revealed
it had already used $72 billion of an $85 billion government loan and
$18
billion of an additional $37.8 billion credit facility from the
Fed.
An expansion of the recapitalization plan beyond US banks would mark a
significant new chapter in the government’s response to the financial
crisis.
TARP’s Seven Policy Teams
Ten days after the new $700 billion TSRP was signed into law on October
3, 2008
Treasury announced that it created seven policy teams to develop
several tools
and other important elements that are required under the new
law.
1) Mortgage-backed
securities purchase program: This team was identifying which
troubled
assets to purchase with taxpayer funds, from whom to buy them and which
purchase mechanism would best meet Treasury policy objectives “to
protect
taxpayers by making the best use of their money.” Treasury
was
designing the detailed auction protocols and would work with vendors to
implement the program.
For more than a year after, the market had been unable to identify with
clarity
troubled assets, their owners and how such assets could be purchased
and at
what price. The uncertainty was real and it created justified fear of
yet
unknown losses in the market. It was not likely that the new team at
Treasury,
no doubt highly capable, could solve this riddle quicker than the
market could
without the existence of a central clearing mechanism.
2) Whole loan
purchase
program: Regional banks were particularly clogged with whole
residential mortgage loans that had not been securitized and sold to
dispersed
investors. This team was working with bank regulators to identify which
types
of loans to purchase first, how to value them, and which purchase
mechanism
will best meet policy objectives “to protect taxpayers by making the
best use
of their money.” This was not a simple task. It would involve value
judgments
and political calculations inherent in the policy objectives. It was
not clear
how this program will work more effective than market forces without
distorting
market value.
3) Insurance
program: Treasury
said it established a program to insure troubled assets. It had several
innovative ideas on how to structure this program, including how to
insure
mortgage-backed securities as well as whole loans. At the same time, it
recognized that there were likely other good ideas out there that it
could
benefit from. Accordingly, on Friday,
October 10, 2008 Treasury submitted to the Federal Register
a
public Request for Comment to solicit the best ideas on structuring
options.
The Treasury was requiring responses within fourteen days so it could
consider
them quickly, and begin designing the program.
With many insurance companies on the verge of insolvency from rising
claims on
counter-party defaults, the Treasury’s insurance program on troubled
assets
looked like an attempt to insure losses that have already occurred, in
violation
of the basic principle of insurance.
4) Equity
purchase
program: Treasury designed a standardized program to purchase
equity
in a broad array of financial institutions. As with the other programs,
the
equity purchase program would be voluntary and designed with attractive
terms
to encourage participation from healthy institutions. It would also
encourage
firms to raise new private capital to complement public capital.
On a voluntary basis, it was a puzzle why healthy institutions would
need or
want to sell equity to the Treasury. On Tuesday, October 14, 2008, an
hour
before the market opened in New York at 9:30 am, Treasury Secretary
Henry
Paulson, Federal Reserve Chairman Ben Bernanke and Federal Deposit
Insurance
Corporation (FDIC) Chairman Sheila Bair, supported by SEC Chairman
Christopher
Cox, Commodity Futures Trading Commission (CFTC) Chairman Walter Luken,
Office
of controller of Currency (OCC) Controller John Dugan and Office of
Thrift
Supervision (OTS) Chairman John Reich, announced that the government
would
invest up to $250 billion in preferred stocks, half of it at large
banks. The
lists of banks participating include Goldman Sachs Group Inc. ($10
billion),
Morgan Stanley ($10 billion), JP Morgan Chase ($25 billion), Bank of
America
Corp. – including the soon to be acquired Merrill Lynch ($25 billion),
Citigroup Inc. ($25 billion), Wells Fargo ($25 billion), Bank of New
York ($3
billion), Mellon ($3 billion) and State Street Corp. ($2 billion).
These moves
were designed to keep money flowing through the frozen banking system
to keep
the economy going.
The government would purchase preferred stocks, an equity investment
designed
to avoid hurting existing shareholders and deterring new ones. The
preferred
stocks did not have voting rights, and carried a 5% annual dividend
that would
rise to 9% after five years. The government’s plan would be structured
to
encourage firms to bring in private capital. Firms returning capital to
government by 2009 might get better terms for the government’s stake.
Financial
institutions would have until mid November 2008 to decide whether they
wanted
to participate in the government recapitalization scheme. The minimum
capital
injection would be 2% of risk-weighted assets and the maximum would be
3% of
risk-weighted assets, with an overall cap at $25 billion. Critics were
asking
why the government was only getting 5% when Warren Buffet was getting
10%
guaranteed dividend in his recent investment in Goldman Sachs.
The senior preferred shares would qualify as Tier 1 capital and would
rank
senior to common stock and pari passu,
which was at an equal level in the capital structure, with existing
preferred
shares, other than preferred shares which by their terms ranked junior
to any
other existing preferred shares. The senior preferred shares would pay
a
cumulative dividend rate of 5% per annum for the first five years and
would
reset to a rate of 9% per annum after year five. The senior preferred
shares
would be non-voting, other than class voting rights on matters that
could
adversely affect the shares. The senior preferred shares would be
callable at
par after three years. Prior to the end of three years, the senior
preferred
might be redeemed with the proceeds from a qualifying equity offering
of any
Tier 1 perpetual preferred or common stock. Treasury might also
transfer the
senior preferred shares to a third party at any time. In conjunction
with the
purchase of senior preferred shares, Treasury would receive warrants to
purchase common stock with an aggregate market price equal to 15% of
the senior
preferred investment. The exercise price on the warrants would be the
market
price of the participating institution's common stock at the time of
issuance,
calculated on a 20-trading day trailing average.
Executive compensation, including golden parachutes would be limited at
banks
that accept government investments. The Fed would guarantee all senior
debts
issued by banks over the next three years. This requirement was a
reason
some banks decline to participate in the program.
The FDIC, invoking a “systemic risk” clause in Federal banking law,
would
provide unlimited insurance to all non-interest-bearing accounts
primarily used
by businesses. The cost of this insurance will come from user fees paid
by
banks outside of the $700 billion TARP. It appeared that the US had
joined the global race to guarantee bank deposits to prevent US
5) Homeownership
preservation: The Treasury said when it purchases mortgages
and
mortgage-backed securities, it will look for every opportunity possible
to help
homeowners. This goal was consistent with other programs - such as HOPE
NOW -
aimed at working with borrowers, counselors and servicers to keep
people in
their homes. In this case, Treasury is working with the Department of
Housing
and Urban Development to maximize these opportunities to help as many
homeowners as possible, while also protecting taxpayers.
Yet none of the government programs launched so far have been effective
in
helping homeowners because ready opportunities to help them have not
been found.
The bottom line is that it is not possible to help distressed
homeowners and
protect taxpayer money at the same time.
6) Executive
compensation: The law sets out important requirements
regarding
executive compensation for firms that participate in the TARP. This
team is
working hard to define the requirements for financial institutions to
participate in three possible scenarios: One, an auction purchase of
troubled
assets; two, a broad equity or direct purchase program; and three, a
case of an
intervention to prevent the impending failure of a systemically
significant
institution.
Management would opt for bankruptcy protection if executive
compensation should
be more liberal under bankruptcy than participation in the
TARP. Also, the interconnected nature of financial markets
in
contemporary times has produced a large number of “systemically
significant
institutions”, even smaller banks.
7) Compliance: The
law establishes important oversight and compliance structures,
including establishing
an Oversight Board, on-site participation of the General Accounting
Office and
the creation of a Special Inspector General, with thorough reporting
requirements. The Treasury said it welcomes this oversight and has a
team
focused on making sure it gets it right.
The Impact of Leverage and De-leverage on Asset Price
The accumulation of assets via debt is known in finance as leverage,
expressed
as debt-equity ratio. Leveraging can push up the price of assets so
acquired by
the enlarging the ability of buyers to access more money and
de-leveraging can
push down the price of such assets by limiting the same ability.
A broker-dealer trades securities for customers as well as for
proprietary
accounts. In US markets, a broker-dealer must register with the
Financial
Industry Regulatory Authority, a self-regulating organization under the
Security Exchange Act of 1934 introduced as part of the New Deal by the
Franklin D. Roosevelt Administration.
When executing trade orders on behalf of a customer, the
institution is said to be acting as a broker. When executing trades for
its own
proprietary account, the institution is said to be acting as a
dealer.
Many broker-dealers had been routinely leveraged to over 40 times
during the
credit bubble released the Fed under Alan Greenspan. Firms are now
frantically
trying to bring leverage down to below 20 times, still twice as high as
what
was at 12 times considered prudent by the SEC since 1975 until the net
capital
rule was exempted for five major institutions in 2004.
The net capital rule created by the SEC in 1975 required broker-dealers
to
limit their debt-to-net-capital ratio to 12-to-1, and they must issue
early
warnings if they began approaching this limit, and were forced to stop
trading
if they exceeded it, so broker-dealers often kept their debt-to-net
capital
ratios much lower than 12-1. The rule allowed the SEC to oversee
broker-dealers, and required firms to value all of their tradable
assets at
market prices, a practice known at mark to market. The rule applied a
haircut,
or a discount, to account for the assets’ market risk. Equities, for
example,
had a haircut of 15%, while a 30-year Treasury bill, because it is less
risky,
had a 6% haircut. But a 2004 SEC exemption -- given only to five big
firms
after intensive lobbying -- allowed them to lever up 40 to 1.
The five firms were Bear Stearns, Lehman Brothers, Merrill
Lynch, Goldman Sachs, and Morgan Stanley. They wanted for their
brokerage units
an exemption from the 1975 regulation that limited the amount of debt
they
could take on to $12 for every dollar of equity. The exemption would
unshackle
billions of dollars held in reserve as a cushion against losses on
their
investments. Those equity funds could then flow up to the parent
company,
enabling it to invest in the fast growing but opaque world of
mortgage-backed
securities, credit derivatives, credit default swaps - a form of
insurance for
bond holders - and other exotic structured finance
instruments.
In 2004, the European Union passed a rule allowing the SEC’s European
counterpart to manage the risk both of broker dealers and their
investment
banking holding companies. In response, the SEC instituted a similar,
voluntary
program for broker-dealers with capital of at least $5 billion,
enabling the
agency to oversee both the broker-dealers and the holding companies.
Ever since the 1930s Great Depression, the government has
tried to limit the leverage available to the public in the US stock
market by maintain margin requirements. But regulators, led by former
chairman
of the Federal Reserve Alan Greenspan, thought financial innovation
would be
hampered, and financial activity driven to unregulated market overseas
through
cross-border regulatory arbitrage, if there were any attempts to impose
limits
on leverage in the unregulated credit and capital markets. After all,
innovation was viewed as the driving force in US
prosperity, and risk-taking is the justification for high profit. The
global
financial system embarked on a race to assume more risk under a
mentality of
“if I don’t smoke, somebody else will.” Another rationalization
was that
"debt is good, for it tightens a company to make it more efficient."
This brave new approach, which all five qualifying broker-dealers
voluntarily
and aggressively adopted, altered the way the SEC measured their
capital. The
five big firms led the charge for the net capital rule change to
promote
financial innovation, spearheaded by Goldman Sachs, then headed by
Henry
Paulson, who two years later, would leave Goldman to become the
Treasury Secretary, who then had to deal with the global mess
created by
high leverage.
Using computerized models provided by the five big firms, the SEC,
under its
new Consolidated Supervised Entities (CSE) program, allowed the
broker-dealers
to increase their debt-to-net-capital ratios, as in the case of Merrill
Lynch,
to as high as 40-to-1, which was immediately became industry standard.
It also
removed the method for applying haircuts, relying instead on another
math-based
computerized model for calculating risk that led to a much smaller
discount.
The SEC justified the less stringent capital requirements by arguing it
was now
able to manage the consolidated entity of the broker-dealer and the
holding
company, which would ensure better management of risk. “The
Commission’s 2004
rules strengthened oversight of the securities markets, because prior
to their
adoption there was no formal regulatory oversight, no liquidity
requirements,
and no capital requirements for investment bank holding companies,” a
spokesman
for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer
in
turbulent times, the SEC also decided to rely on the five big firms’
own
computer risk models, essentially outsourcing the job of monitoring
risk to the
banks it was supposed to supervise. Over subsequent years, all market
participants would take advantage of the looser capital rule to
increase
leverage.
The leverage ratio - a measurement of how much the companies were
borrowing
compared to their total assets - rose sharply at Bear Stearns, to 33 to
1. In
other words, for every dollar in equity, it had $33 of debt. The ratio
at the
other firms also rose significantly. This advantage enabled the
Big Five
to go on a frenzy of asset acquisition, expanding risk to the entire
financial
system. The abuse of leverage was particularly severe in the hedge fund
industry in which the Big Five were big players both in proprietary
funds and
as broker-dealer for large hedge funds who in turn were highly
leveraged, as in
the case of Long Term Capital Management (LTCM) which had a leverage
ratio of
1,000 to 1.
The SEC did reexamine its efficacy after the Bear Stearns collapse in
2008.
“Immediately after the events of mid-March 2008, when the
run-on-the-bank
phenomenon to which Bear Stearns was exposed demonstrated the
importance of
incorporating loss of short-term secured funding into regulatory stress
scenarios, the Consolidated Supervised Entities (CSE) program revised
the
analysis of liquidity risk management, with enhanced focus on the use
and
resilience of secured funding,” Securities and Exchange Commission
Chairman
Christopher Cox testified at the July 2008 hearing. “The SEC has also
worked
closely with the Federal Reserve in directing this additional stress
testing.”
Two months after Chairman Cox testified, however, two more big
broker-dealers
collapsed, and one of the two remaining broker-dealers - Morgan Stanley
- was
in talks to merge with Wachovia which itself was in trouble and had to
be taken
over by Wells Fargo. It is now clear that the SEC leverage modification
in 2004
was a primary reason for the massive losses that occurred in 2008.
On Sept. 26, 2008, Chairman
Cox announced a decision by the SEC Division of Trading and Markets to
end the
Consolidated Supervised Entities (CSE) program, created in 2004 as a
way for
globally active investment banking conglomerates that lack a supervisor
under
law to voluntarily submit to self regulation. Chairman Cox also
described the
agency’s plans for enhancing SEC oversight of the broker-dealer
subsidiaries of
bank holding companies regulated by the Federal Reserve, based on the
recently
signed Memorandum of Understanding (MOU) between the SEC and the
Fed.
Chairman Cox made the following statement along with the SEC
announcement on
ending the CSE:
The last six
months have made it
abundantly clear that voluntary regulation does not work. When Congress
passed
the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the
Glass-Steagall
Act of 1933 which had prohibited a bank from offering investment
banking and
insurance services], it created a significant regulatory gap by failing
to give
to the SEC or any agency the authority to regulate large investment
bank
holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch,
Lehman
Brothers, and Bear Stearns.
The SEC said it had no plans to re-examine the impact of the 2004
changes to
the net capital rule, yet it put out a proposal to revise the rule once
again.
This time, it was looking to remove the requirement that broker-dealers
maintain a certain rating from the ratings agencies.
On Sept. 26, 2008
the SEC
formally ended the 2004 program, acknowledging that it had failed to
anticipate
the problems at Bear Stearns and the four other major investment
banks.
When the need to de-leverage is triggered by insufficient revenue,
asset prices
will fall and insolvency can result. Undercapitalization is merely a
euphemism
for insolvency unless new capital can be raised quickly.
Recapitalization is a
euphemism for dilution of sunk equity with new capital.
Recapitalization alters
the capital structure of a financial firm or corporation. It is often
accomplished by an exchange of bonds for stocks. Pending bankruptcy is
a common
reason for recapitalization. Debentures might be exchanged for
reorganization
bonds that pay interest only when earned.
Under US law,
a healthy company might seek to save taxes by replacing preferred stock
with
bonds to gain interest deductibility from its tax liabilities. In
corporate
finance, in-substance defeasance is a technique whereby a corporation
discharges old, low rate debt prior to maturity without repaying it.
The
corporation uses newly purchased securities with a lower face value but
paying
a higher interest or having a higher market value. The objective is to
produce
a more debt-free balance sheet and increase earnings in the amount by
which the
face amount of the old debt exceeds the cost of the new
securities.
The use of defeasance in modern corporate finance began in 1982 when
Exxon
bought and put into an irrevocable trust $312 million of US government
securities yielding 14% to provide for the repayment of principal and
interest
on $515 million of old debt paying 5.8% to 6.7% and
maturing in
2009. Exxon removed the defeased debt from its balance sheet and added
$132
million – the after tax difference between $515 million and $312
million – to
its earnings in that quarter. In-substance defeasance may well be the
magic
bullet to get out from the curse of overleverage.
Global stock markets staged a historic rally on Monday September 13, 2010 as European
governments
pledged a total of €1.87 trillion ($2.55 trillion) to shore up their
banking
system and the US prepared
to unveil its own comprehensive rescue plan a day later. In New York,
the
S&P 500, which the week before fell 18.2%, rose 11.6% – the biggest
daily
gain since the volatile trading of the Great Depression. The Dax index
of
the Frankfurt stock exchange closed up
11.4%
while the CAC40 in Paris rose
11.2%. In London, the
FTSE 100
rose 8.3%, its second largest one-day gain in history, and in Hong
Kong, the Hang Seng index rose 10.24%. Yet, the Treasury
announcement on Tuesday
September 14, 2010 failed to
extend the
one-day market rally that had greeted every one of the government’s
precedent–breaking previous measures. All the governmental
spectaculars
failed to break the secular bear market in which each rebound fails to
breach
the previous low.
Three-month Sterling Libor was just 2 basis points lower at about
6.25%, more
than 2 percentage points above where markets are pricing UK interest
rates and
higher than where the rate set before the coordinated interest rate
cuts by
major economies in the second week of October 2010. Similarly, euro
three-month
Libor, which was down 7.37 basis points at 5.225% on October 14,
remained high.
There were only weak signs of relief in the frozen credit markets at
the centre
of the financial crisis, as three-month dollar Libor eased to 4.75%
from 4.82%,
even after the Fed lowered the Fed funds rate target to 1.5% on October
8 and
3-month treasuries were yielding 0.5%. This left the so-called Ted
spread,
which measures the difference between inter-bank lending rates and
risk-free
government lending rates, at a hefty 420 basis points.
Recapitalization, while lowering leverage to protect the market value
of debt,
further depresses asset value. Such are the laws of finance in market
economies. For this reason, taxpayers may never recoup their investment
in the
Treasury’s nationalization program of the banking system if government
funds
received by banks are used to de-leverage rather than new lending.
The US government’s
misguided approach of monetizing illiquid troubled assets held by
distressed
institution to remove insolvency threats is self defeating. In each
step, it
has predictably failed to jump start credit and capital markets under
seizure
because excessive liquidity cannot be cured by more liquidity. Assets
become
illiquid because their price stubbornly stays above their market value.
Such
assets will stay illiquid until price adjustments bring about market
transactions. Government monetization of illiquid assets will only
prolong
their illiquidity life span.
Markets are not the best intermediaries of long-term value, because for
market
economies, markets are the prime intermediaries of short-term value.
This is
why economist Hyman Minsky thought that a substantial public sector is
needed
to moderate short-term volatility in the private market sector. When
the
private market sector dominates the economy, the price regime will be
excessively tilted by short-term conditions.
Markets can only function when there are matching numbers of willing
buyers and
sellers at any one time. When the number of sellers is larger than the
number
of buyers, prices will fall, or in a reverse situation, prices will
rise until
the numbers of buyers and sellers match up. Price is the point where
willing
sellers and willing buyers meet for a fair transaction free of
coersion. Until
the price is right, the market remains in suspension. Price fluctuation
then is
the key factor in addressing imbalances between buyers and sellers in
the
market. This is both the strength and the weakness of market
economies.
This is why central bank intervention in the market amount
only to a temporary distortion and nothing more. Central banks are
constituted
as lenders of last resort to the banking system inn their jurisdiction.
They
cannot be market makers of last resort, nor are they constituted to do
so.
Free markets require an equal degree of market power between buyers and
sellers. Ideally, a truly free market always leaves both buyers and
sellers
happy, each being satisfied that the transaction price reflects their
differing
judgment of fair market value at the point of transaction. The buyer
thinks he
will gain from future appreciation and the seller thinks he will avoid
loss
from future depreciation. Only one party in the transaction will turn
out to be
right at any future point in time. The probability of being wrong is
the risk
in the transaction. That is the basic principle of market
fundamentalism, which
is governed by the principle of fluctuating supply and demand through
time,
intermediated by fluctuation in price.
When market power is not equally distributed among market participants,
a free
market is replaced by a coerced market. A coerced market is one when
one side,
either buyers or seller, has more market power. Uneven market power
distorted
prices to generate market inefficiency merely to meet temporary
contigency.
A failed market is one when there are no buyers or sellers
at any price. The ultimate coerced market is one where the
government,
which by definition possesses overwhelming market power by virtue of it
s
ability to print money by fiat, is the only buyer or seller.
Market fundamentalists are right in their belief that
government should stay away from the market to avoid destroying the
market. Yet
they are wrong in thinking that government should deregulate markets to
keep it
free. Government's role is to ensure equal market power among market
participants
to prevent transactions under undue coersion.
And above all, ,arket fundamentalists are dangerously wrong
in thinking that markets can satisfy all economic needs. The truth is
that
there are large segments of the economy that only government can handle
effectively
and efficiently, national defense being one obvious example, health
care and
education being two other, and all other public untilities. This
governmental
economic segment is known as the public sector in a market economy. As
economist Hyman Minsky pointed out insightfully, the public sector
performs a
much needed function in stabilizing the business cycle in the private
sector. A
society without an adequate public sector leans towards economic
anarchy that
will eventually implode.
In finance, to make a market means maintaining ready, firm bids and
offer
prices in a given security by standing ready to buy or sell at publicly
quoted
prices in round lots (generally accepted units of trading on a
securities
exchange – on the New York Stock exchange, a round lot is 100 shares
for stock
and $1000 or $5000 par value for bonds). The dealer is called a market
maker in
the over-the-counter market outside of exchanges. On the exchanges, the
dealer
is called a specialist. A dealer who makes a market over a long period
is said
to “maintain” a market.
The NASDAG requires that there be at least two market makers for each
stock
listed in the system. The bid and asked quotes are compared to ensure
that the
quote is a representative spread. Registered competitive traders in the
NYSE
are market makers because, in addition to trading for their own
accounts, they
are expected to help correct an imbalance of orders. Registered
competitive
traders are NYSE members who buy and sell for their own accounts.
Because their
members pay no commission, they are able to profit from even small
changes in
market prices, thus tend to trade actively with high volume. Like
specialists,
registered competitive traders must abide by exchange rules, including
a
requirement that 75% of their trade be stabilizing, meaning they cannot
sell
unless the last trading price on a stock is up, or buy unless the last
trading
price was down. Orders from the trading public take precedence over
those of
registered competitive traders, which normally account for less than 1%
of
total volume.
The central bank cannot be a market maker because the central bank is
empowered
to create new money. This power to create new money gives the central
bank
unequalled market power and turns it from a market maker into a market
destroyer. Throughout history, the sovereign who enjoys the power of
seigniorage refrain from being a market participant for good reasons.
When the
sovereign owns everything, there is no way to tell how much the
sovereign is
worth. This is why even in a communist society where the
people as
sovereign own the means of production, markets are still required to
establish
prices to efficiently allocate economic and financial resources.
The government’s intervention has created a relative advantage for
companies to
raising funds through guaranteed bank paper versus the asset-backed
markets.
The ability of banks and other financial groups to raise money via
government
guarantees means funding through more traditional routes like
asset-backed
securities will be much more expensive. In the short-term, the
government moves
is having an effect. There has not been any issuance in credit cards
because
all the major banks now have another, cheaper option. In addition to
offering
banks cheaper sources of funding, the explicit government guarantees on
many
bank securities has led to a sell-off in bonds issued by mortgage
financiers
like Fannie Mae and Freddie Mac, as well as asset-backed securities. As
a
result, the cost of borrowing in asset-backed markets has soared, with
the
premiums over US government bonds at record highs. This makes private
sector
funding even less attractive.
There are also signs that government funds are being used by banks to
buy
rivals, rather than provide new lending. On Friday, October 14, PNC
Financial
became the first bank to make use of the US government’s
bank recapitalization program to merge with a weaker rival. In the
longer term,
credit card debt securitization have to be revived because the
government
programs are not large enough to cover all the banks’ funding
needs.
Central Banks Have Become Market Destroyers
The recent opening of the Federal Reserve discount window to borrowings
by
commercial banks, collateralized by illiquid assets, and the extension
of
discount window access to investment banks have pushed the central bank
across
the line of being a lender of last resort to being a market destroyer.
It is no
wonder that its liquidity injection moves have failed to moderate
seizure of
global credit markets. This is because the central bank, not
constrained by the
supply and market value of money, can set the price of illiquid asset
by fiat,
thus destroy the very function of the market in setting meaningful
prices that
can defuse market seizure. Central bank intervention into
credit
markets to artificially support asset prices above market levels
carries no
fundamental market implication, save the impact of future inflation.
The market
knows that asset prices assigned by the central bank are not real and
will be
adjusted downward as soon as central bank intervention ends. And until
central
bank intervention ends, the market remains in suspension.
This explains why despite central bank intervention, and perhaps even
because
of it, inter-bank lending stayed halted, with LIBOR (London Inter-bank
Offer
Rate) rising high above normal spread over Fed funds rate targets. In
the
non-banking financial sector, new commercial paper issuance, the
short-term
funding source of choice for financial and non-financial corporations,
could
not find buyers. In sum, global credit markets continue to fail despite
escalating and increasingly desperate government intervention
measures.
One of the key objections behind the House of Representative initial
rejection
of the Treasury’s $700 billion rescue package was that at the end of
the rescue
term of 30 years, the public may not be paid back on account that the
illiquid
collateral might still not yield returns that match after inflation
face
values. The overvaluation of such illiquid assets cannot be made whole
through
inflation because de-leveraging made possible by inflation will keep
the market
value of such assets below its after inflation face value. The
congressional
opposition wanted prearranged authority to tax the finance industry to
recoup
the investment for the public whose tax money was being used for the
rescue of
distressed institutions.
The market was more honest than most paid pundits and special interest
policymakers. Market participants knew the crisis was not merely a
passing
liquidity crunch, but a widespread insolvency created by excessive
asset value
unsupported by compensatory revenue. Insolvency will translate into
sharp
declines in asset price. The government can destroy the market in the
name of
saving it but the laws of market cannot be negated by government
intervention.
Some critics have mistakenly complained that the US government
has turned to socialism for solution to the current financial crisis in
a
capitalistic system. Yet what the US
government has done is merely turning failed market capitalism into
state
capitalism. Nationalization alone does not lead to socialism. Socialism
is not
merely collective ownership of the means of production. It must also
subscribe
to an operative goal of fair sharing of the fruits of the economy
through
collective ownership of the means of production.
In a socialist state, state-owned enterprises are the venue of
socialist
ownership of the means of production which is deployed to support the
interests
of workers. But in a capitalist state, state-owned enterprises do not
entertain
such populist goals. State capitalism continues to oppress workers for
the
benefit of capital while the state represents the interest of
capitalists
rather than workers. State capitalism subscribes to the trickling down
theory –
saving the banks to save the citizenry. What is needed is for
government to
save the citizenry by direct assistance with job creations and wage
guarantees,
not inter-bank loan guarantees.
Incoming data for September showed unemployment at 6.1% and still
climbing,
above the non-accelerating inflation rate of unemployment (NAIRU) of
6%.
Non-farm payroll employment declined by 159,000; in a civilian labor
force of
154.7 million, with a labor force participation rate of
66%. Total
employment was 145.3 million and the employment-population ratio was
62%. Since a recent high in December 2006, the
employment-population ratio has declined by 1.4 percentage
points. The number of persons who worked part time for
economic
reasons rose by 337,000 to 6.1 million in September, an increase of 1.6
million
over the past 12 months. This category includes persons who
would
like to work full time but were working part time because their hours
had been
cut back or because they were unable to find full-time jobs. These data
suggests an extremely weak economy going forward.
The entire global market economy, fueled by decades of excess liquidity
and
debt denominated in fiat dollars imprudently released by the US Federal
Reserve, had turned even prudent debt to equity ratios in normal times
into
precariously over-leveraged debt structures. Asset price inflation,
defined as
growth by central banking doctrine, had allowed the global market
economy to
assume debt levels that could not be serviced by relatively stagnant or
even
falling wage income. In an asset price bubble unsupported by
corresponding rise
in wage income, even normally prudent debt-equity ratios will result in
precarious debt leverage.
Either wage income must rise, or asset prices must fall to restore
financial
equilibrium. Government intervention to prop up inflated asset prices
without
compensatory wage rise will only end in hyperinflation.
A sharp decline in assets prices will unavoidably spell widespread
bankruptcy
for many financially overextended companies and individuals. This will
constrict demand temporarily to delay inflation effects but
hyperinflation will
result as certainly as the sun will rise because modern democracies
cannot
allow deflation to cause widespread bankruptcy even in a debt bubble.
In my January 11, 2006 AToL
article: Of
debt, deflation
and rotten apples, I wrote (Central banks fear deflation more than
inflation): “Although
Greenspan never openly acknowledges it, his great fear is not
inflation, but
deflation, which is toxic in a debt-driven economy. ‘Price stability’
is a term
that increasingly refers to anti-deflationary objectives, to keep
prices up
rather than down.”
By now, it is becoming clear that government policy has been mostly
focused on
maintaining asset price at levels that the market has rejected. Logic
suggests
that such a policy will result in hyperinflation at the end of the day
that
will lead to more bankruptcies down the road in a protracted downward
spiral.
The government’s attempt to save overextended financial institutions
may well
cause the total destruction of market capitalism. And if past
experience is any
guide, unless wage income is indexed to inflation, the dilution of
asset value
through inflation will only hasten the arrival of total market failure
and a
total melt down of the market economy.
So far, not much is heard from official circles that suggest the
solution to
the current credit crisis can only come from an immediate and
substantial rise
in wage income. Instead of bailing out insolvent financial
institutions, the
government should use sovereign credit to maintain full employment and
boost
wage income to catch up with inflated asset prices. If the Fed must
print new
money to save the system, the new money should go to job creation and
wage
increases rather than to recapitalize insolvent
corporations. Full
employment and rising wages will halt the fall of asset prices with a
rising
floor.
The approach adopted by the Bush administration is not designed to
rescue a
collapsing global economy from total meltdown but to resurrect free
market
capitalism from ideological bankruptcy with state capitalism.
Both QE and QualE are last resort monetary measures a
central bank can undertake when it has exhausted the effectiveness of
its
front-line monetary tool to lower the cost of money. That tool is the
benchmark
short-term interest rate set by the central bank for depository
institutions
actively trading overnight with each other their immediately-available
excess
balances held at the central bank. But the effectiveness of the
benchmark
short-term interest rate is drained as it approaches zero and cannot be
lowered
further to stimulate more economic activities.
In late May 2013, European Central Bank (ECB) President
Mario Draghi triggered a public debate on whether ECB should impose
negative
interest rate as a policy mechanism to stop the euro from further
decline in
exchange value in a deep government debt crisis, by shifting the pain
of
deflation from banks to depositors.
Next: The Debate on
Negative interest Rates
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