Why Bernanke wants to keep responsibility for consumer protection at the Fed

Why is Bernanke so keen that responsibility for consumer protection be kept at the Fed? Presumably, with millions of consumers in a negative equity position thanks to the (Fed-induced) rise and collapse of the housing bubble, it isn't because he thinks the Fed has done a good job.

Both Bernanke and Greenspan continue to claim that it is impossible to prevent bubbles. Why do they so vehemently stick to this line? Because the minute they admit that it is untrue, as it undoubtedly is, the Fed will no longer be allowed to engineer bubbles that rip off consumers and transfer wealth from poor to rich. The Fed does not exist to protect consumers. The Fed exists to service the commercial banks', to act as their banker. Putting both roles under the same roof creates the mother of all conflicts.

Retaining the role of consumer protection is important to the Fed as it means it is kept out of the hands of an agency interested in fulfilling it. Putting the Fed in charge of consumer protection is, as it always has been, like appointing Saddam Hussein president of Save the Children.

How to recapitalise banks

As Bernanke pointed out, the problem with deflation is that you can't have negative interest rates, as people would withdraw their deposits and hold cash "under the matress". If interest rates remain high in real terms, people are inclined to save and not to spend, causing economic activity to contract further (Keynes' Paradox of Thrift).

There are some who have suggested encouraging people to spend by canceling, with a certain notice period, a certain percentage of notes in circulation (pick a number from 0-9 and cancel all notes whose serial number ends with that number - just don't tell anyone in advance what the number is).

Why not go a (big) step further and cancel, say, 10% of bank deposits? Not only would spending be encouraged, boosting the economy, but the canceled bank deposits would become bank equity, thus helping to recapitalise banks.

In recent decades we have increasingly confused money with wealth. Nowadays, money is seen as a means unto itself. This should be actively discouraged, using aggressive tactics if necessary.

Seacrest versus Sachs

To imply that Ryan Seacrest's $45 million three year American Idol deal announced last Monday is as obscene as Goldman's $3.4 billion second quarter profit is ignorant and unworthy of the New York Times. By my calculation, Seacrest is getting 40 cents per viewer per season, perhaps half this amount if viewership outside America is included. I think that 40 cents is well worth paying for the entertainment he provides. This is what is known as value-for-money.

Goldman's profits, on the other hand, should be considered scandalous, unless they accrue to taxpayers rather than Goldman employees by imposing a high tax rate on bonuses.

To understand why Goldman's profits are obscene, you have to understand where they came from. If Goldman had made the world a better place to the tune of $3.4 billion I would have no problem with them keeping it, or a large chunk of it, but in fact the opposite is the case. They came out of your pocket.

How much profit would the firm have made if hundreds of billions of dollars of your money had not been spent to stabilise the financial system and stimulate the economy? This is of course impossible to answer, but the write offs that Goldmans and other financials would have had to continue making in the absence of government intervention would have been considerable. As one commentator put it, it is the equivalent of the government reducing the production cost of the car industry to zero, then buying all the cars! Thanks to the government propping up the financial system, a company like Goldmans was able to take advantage of the extraordinary opportunities on offer.

Goldmans is so far up its own backside that it genuinely believes that its second quarter profits were the result of its talents. I might concede that Goldman workers are smarter than those elsewhere, but they do not deserve the 49% of the profit that the company commits to paying in bonuses. "It seems perverse to criticise firms that have done what they're asked to do for doing what they've been asked to do," said the Goldman spokesman.

It is this lack of honesty I abhor. Had Goldmans conceded the very special conditions in which their profits were made I would have had more respect for the firm. It would also have been the intelligent thing to do, as the huge profit has understandably sparked widespread anger, anger which is hurting the company. Perhaps, on second thoughts, those Goldman smarts aren't so smart.

Krugman's arrogance

I'm delighted that I have no formal training in economics as it means I can enjoy it as a keen amateur. Economics, it seems, is about predicting how people will behave under certain circumstances. How something as complex as human behaviour can be predicted is beyond me. Physics can tell us very precisely how long it will take an object to fall to the ground and chemistry what happens if we mix zinc with sulphuric acid, but to predict how I will behave at some point in the future is, frankly, absurd.

Indeed the absurdity of the so-called science is evidenced by the fact that two economists can come up with two, or sometimes three, different answers to the same puzzle. This was Isaac Asimov's point when he wrote in 1991 that he could not understand "the dismal science" nor did he believe did anyone else. "People may say they understand it and economists even win Nobel Prizes, but I think it's all fake", he wrote. While natural sciences have made extraordinary progress, economists are still arguing over whether the earth is round or flat.

Asimov told of a bet between two economists about the future of commodity prices. One said the cost of certain key metals would rise over the next ten years, because he felt that rising population and the declining availability of resources would make that necessary. The other said that the cost would decline because of advancing technology and because the higher the population the better-off the world would be.

Asimov was “naturally” on the side of pessimist and was shocked to find that he’d lost the bet. To him it was obvious that a steadily rising population is deadly. “If basic commodities are going down in price, what is it that’s going up and drowning them out?” he asked.

Recently, I have been reading The Accidental Theoritst by (Nobel Prizewinner) Paul Krugman. Krugman does not hide his arrogance, laying into William Greider and his book The Manic Logic of Global Capitalism early on. Now I am not suggesting that Greider's logic is correct (I'm not an economist) but his uncontroversial conclusion is that there are severe flaws in the market system. Krugman writes "Greider's view, if I understand it, is that [the boom of the 80s and 90s] is just a reprieve - that any day now the whole economy will start looking like the steel industry." Well whadyaknow, Paul, it just did!

Where am I going with this? OK, here goes. It is increasing wealth and income inequality that, when it cannot get any greater, results in a big bust. Simple as that. But nowhere in Keynesian literature does one find reference to such inequality being a problem (for that, we have the Austrian school to thank). To Keynesians like Krugman economic slumps can be cured with money. "It is deeply implausible" he writes "to suggest that the cause of so much suffering can be something as trivial, technical, and fixable as the failure to print enough money. Indeed there would be no reason to believe such a silly story, except that it happens to be true."

If, as I contend, it is extreme wealth and income inequality that is the root of the problem - since there is a point at which the poorer half of society, on whom the other half relies, gets so stretched that it cannot spend any more - how does printing money solve this? The answer is, it doesn't.

I have found it useful to think of people as companies, each with their own income and assets (or not as the case may be) and debt. Viewed this way let me, or rather David Cay Johnston (winner of the Pulitzer Prize and author of Perfectly Legal: The Covert Campaign to Rig our Tax System to Benefit the Super Rich - and Cheat Everybody Else), tell you where we are today, and you decide if it's healthy. Here are the facts:

• The richest 1% of "companies" (people) own almost half the US's financial assets
  
• The richest 15% own nearly all of the financial assets
  
• The richest 1% earned 21% of total "profits" (income)
  
• From 1970 to 2000, average profit for the poorest 99% of companies rose 8% from $32,763 (inflation adjusted) to $35,473, during which time real GDP per capita rose 89%
• From 1970 to 2000, average income for the richest 0.01% rose 558% from $3,641,285 to $20,328,482

Imagine if you will a society composed of just two people, let’s call them Thrifty and Scrounger. For whatever reason, Thrifty’s output is higher than Scrounger’s, meaning that the real value of what Thrifty produces every day is higher than what Scrounger produces (this is a fair reflection of reality, in which some, because they are more skillful or have greater opportunity, are more productive than others.) Part of their output they consume themselves and part of it they give - or sell - to the other, but Thrifty, because he produces more, always gives more to Scrounger than Scrounger gives to Thrifty. To keep track of this imbalance, Scrounger writes IOUs to Thrifty, promising to do a certain amount of work some time in the future in lieu of Thrifty’s "excess" work.

But Scrounger must pay a price for consuming more than he produces and for having to write IOUs. Thrifty says that an hour of Scrounger’s work that is deferred is worth less than an hour of work carried out today (the IOUs wouldn't be worth much if Scrounger were to drop dead), and so demands that Scrounger pays ‘interest’, at regular intervals, on the IOUs for as long as they remain outstanding. At first Thrifty is careful to make sure that he receives this interest in the form of extra work carried out by Scrounger, rather than in more IOUs. But of course Thrifty is still the more productive of the two, and thus both wants to and can do more for Scrounger than Scrounger does for him. Anyway, likes IOUs, they make him feel rich, and he wants as many of them as he can get his greedy hands on.

But there comes a point where Scrounger cannot do any more for Thrifty. He’s working flat out and, anyway, there’re only so many shoes that Thrifty can wear or so many yachts that he can sail. But it’s OK, Thrifty agrees that Scrounger can start paying his interest with new IOUs, instead of with work. Thrifty thinks that is better than nothing.

But of course Thrifty is charging interest on these new IOUs which are in lieu of interest on the old IOUs, in other words charging interest on the interest, and so the amount of IOUs keeps on going up without Scrounger actually doing any more work!

In the meantime, Thrifty has been trying to use some of the IOUs he has accumulated to buy back from Scrounger the things that he made for him in the past. He’s got to do something with them, and it gives Scrounger a chance to cancel out some of his debt. But, thanks to interest, the IOUs, the debt, keep piling up.

Then one day, Thrifty goes to Scrounger to see what else he can buy off him. And Scrounger says, “Sorry, I’ve got nothing left! You’ve bought it all! I’ve got no assets and I’m hugely indebted to
you.”

“Oops”, says Thrifty, who’s still sitting on piles of IOUs. It dawns on him that these IOUs are effectively worthless bits of paper and perhaps it wasn’t so clever to have accumulated so many of them after all.

Thrifty’s “Oops” is also known as a Minsky Moment, named after renowned economist Hyman Minsky, at which it suddenly dawns on a society that the amount of debt owed by one part of it to the other is so huge that it could never be fully repaid, or not during either’s lifetime. And this is where we are today, or rather where we were two years ago.

Under our fractional reserve banking system, most of the money in circulation (bank deposits) is debt money, backed by future work of the borrower, not by an existing, income-generating asset. The system works just fine until lenders want to cash in their IOUs, which of course they can't. In other words, it is the ultimate Ponzi scheme.

How wealthy we are influences our spending, and lower spending by lower income households, seeking to rebuild balance sheets, will result in economic stagnation for many years. Thanks to the collapse of the housing bubble, many are now in a negative net wealth position that will take years of frugality, declaration of bankruptcy, or debt relief to resolve. It must be remembered that one person's debt is another's asset, so the inevitable debt deflation will go hand in hand with asset deflation. The more wealthy stepping in to fill the spending hole would go some way to addressing the problem, but sadly this is not what tends to happen. It is hard for someone already consuming as much as they need or want to consume any more. Anyway, right now, the wealthy are preparing for increases in their taxes to fund massive government budget deficits.

Don't get me wrong, I believe in the free market. But throwing money at the problem isn't the solution. Until such time as human beings are all equally productive, only time can heal.

Pinning colours to the mast

I've been thinking about starting a blog for a while but Goldman Sach's obscene second quarter results have finally got me off my backside. A year or so ago, a rather bizarre image entered my head that has, stubbornly, stayed with me. It was of Chuck Prince, former Chief Executive of Citigroup, dancing cheek-to-cheek with David Viniar, current CFO of Goldman Sachs. In July 2007, Mr Prince, talking about securitisation, told the FT, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."

I, like many, thought this remark was pretty dumb. But, hey, if he wants to dance, wherever he's hiding, let's find him a dance partner! Who better than Goldman's CFO David Viniar, who trumped Prince with his own dumb remark a month later? Viniar's remark was made in a call to investors in two of Goldman's model-driven quant funds. The funds' poor performance, he explained, was attributable to them having experienced "25 standard deviation events, several days in a row". It is utterly absurd to even think about explaining how unlikely such an occurrence is (though an alternative explanation is that the funds' models might, just might, be flawed). So, instead, I'll just let him and Chuck dance the night away. A heavenly merger.

Anyway, back to Goldman's results. That the bank making a profit of US$3.4 billion thanks to direct and indirect support from taxpayers, many of whom have lost their jobs in recent months as a result of the financial crisis, is obscene is without question. What is unclear is what the backlash will look like. As George Bernard Shaw noted, "A government that robs Peter to pay Paul can always depend on the support of Paul." If Obama does not act to ensure that it is Paul, not Peter, who benefits from Goldman's windfall, Paul may be compelled to take the law into his own hands.

Dangerous risk, also known as fat tail risk, relates to events that have not been contemplated, so is unlike the common-or-garden variety that the financial industry naval-gazes over. If we had seriously contemplated two planes being flown into the World Trade Center, not only would the probability of 9/11 happening have been much lower, as Saudis inquiring about commercial jet simulator lessons, among other things, would have raised red flags as well as eyebrows, but our response to the event would also have been different. By being able contemplate an event, we can act to reduce both the probability of it occurring as well as our exposure to it, physically or emotionally. In fact it is this combination of (objective) probability and (subjective) exposure that is what is known as risk (an event may be likely to happen, but it poses no risk to us if we would not be impacted by it.)

Dangerous risk, therefore, relates to "unknown unknowns", as Donald Rumsfeld might have put it, whose probabilities, of course, cannot be known (outcomes of the throw of a die, like day-to-day stock price movements, are "known unknowns"). However, for the investment world's risk models to have an output, probabilities (the input) must be known. The models are spitting out something, but it's not a measure of risk, that's for sure (naval variations, perhaps?) David Einhorn, President of Greenlight Capital, likened Value-at-Risk, the flagship of the financial risk management world, to “an airbag that works all the time, except when you have a car accident.”

We assume that fewer tremors in stock markets, economies, societies etc. to mean that risk has fallen. In fact, like volcanoes, it normally means the opposite, as pressure, hidden from view, builds and builds, eventually to be released in violent fashion. Paul has been patient, but the blatant robbing of lower income groups by government and its bankster paymasters seems, to me, an eruption waiting to happen.