The Fed's Decade of Deception - By Martin Hutchinson

"it has often been innovation without substance. And it's achieved nothing. It's been cosmetic."
-- Satyajit Das ( Source )


"The UK’s Financial Services Authority warned last week that there was probably more fraud on the way, either because of misdeeds surfacing from more lax times or because individuals were now pressed into wrongdoing by falling markets. Place your bets on how many cases will involve derivatives."
-- Tony Jackson, Derivatives is an industry tainted by its side effects, February 3 2008


“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years."
-- Warren Buffett ( BBC Article ), Avoiding a 'Mega-Catastrophe', 2003


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The Fed's Decade of Deception

By Martin Hutchinson
Thursday, January 10, 2008
Source

Aggressive obfuscation of economic reality — in pursuit of fees — has become standard practice on Wall Street. With central banks and the U.S. Federal Reserve scrambling to manage the latest capital crisis, Martin Hutchinson argues that much of modern finance is based on swindle and deception.

There has in recent years been an excessively snake-oil-salesman quality to the policies and promises of politicians, monetary authorities and financial intermediaries.

Decade of deceit

The Japanese public has dubbed 2007 the "Year of Deception," as expected GDP growth there for the year has been revised down from 2.1% to 1.3%, and the stock market has fallen by 10%.

In the United States, the country’s economic policymaking since 1995 has involved not just a “Year of Deception” but a decade of it.

In examining the record, one is tempted to quote Mary McCarthy’s verdict on Lillian Hellman’s autobiography: “Every word she writes is a lie, including 'and' and 'the.'"

History lessons

In 1996, the U.S. Bureau of Labor Statistics adopted “hedonic pricing” — by which price statistics were “corrected” for improvements in quality.

There were two problems with this. First, it counted quality improvement in the tech sector by raw processing power, which experience has shown to be wrong. Functionality of tech equipment rises at best logarithmically with processing power.

Dubious productivity

Second, it did not include the additional costs imposed on consumers by companies as a result of such innovations as automated telephone answering systems, which hugely increase the time and effort expended in conducting necessary consumer transactions.

The result of hedonic pricing was to reduce U.S. consumer price increases by close to one percentage point per annum, producing an entirely spurious decline in reported inflation and a corresponding increase in “real” GDP growth.

The second deception chronologically, though in many respects the most important, was Fed Chairman Alan Greenspan’s “recognition” in 1997 that a new era of faster productivity growth had dawned — so higher stock prices and lower interest rates were justified.

Consequences of deception

Part of this “acceleration” was just random fluctuation (much of which was eliminated in later statistical revisions), part was the result of increasing capital intensiveness in the U.S. economy, caused by lower real interest rates — and part was the effect of hedonic pricing, which artificially inflated GDP growth, and hence productivity.

The reality, when you look at the data over a long term, was that well over 100% of any rise in U.S. productivity in the late 1990s can be explained by these factors. The “miracle” was a mirage, and lower interest rates and higher stock prices were wholly unjustified — inevitably leading to huge misallocations of capital.

Dangerous bubbles

As the bubble intensified in 1999 and 2000, the Federal Reserve moved to the pretense that it was impossible to know when a bubble was taking place — so monetary authorities couldn’t burst it. In that case, one may well ask what the point of having a monetary authority is.

Of course, a monetary authority can deflate a bubble, as has happened many times. The Fed under Alan Greenspan and Ben Bernanke has, however, been a thoroughly political institution that doesn’t want to incur even the temporary unpopularity from doing so.

Connected with the last point is the U.S. monetary authorities’ obfuscation of the monetary basis, both domestic and international, of their job. From 1993, the Fed abandoned the entirely sound Paul Volcker-era practice of money supply targeting, which had successfully brought inflation down with only moderate pain.

Spreading danger

Allegedly, in the new world of technology, monetary aggregates were no longer accurate enough to steer policy by. It is no coincidence that immediately after this change, the Fed embarked on its program of reckless expansion of M3 money supply, by almost 10% per annum for a decade when nominal GDP was growing at only 5-6%.

In 1999 and 2000, Wall Street sold dot-com and telecom stocks to investors on the basis of non-existent earnings. They were aided in this sales effort by corporate top management, which proceeded to pay itself vast sums by means of stock options, while pretending these had no cost to shareholders. Again, deception.

Reckless government

On public spending, too, the electorate can reasonably claim to have been sold a false bill of goods. The Republican Congresses elected after 1994 initially pursued tight fiscal policy. However, after Newt Gingrich was replaced as Speaker of the House of Representatives by Dennis Hastert in December 1998, Hastert and Tom DeLay proceeded to go hog-wild at the public trough.

They used it for innumerable corrupt pork-barrel schemes, to which Bush joined counterproductive public spending boondoggles like the “No Child Left Behind Act.”

After the stock market bubble burst, the Fed cut interest rates viciously, decimating the income of U.S. savers — and thereby causing a savings dearth and a huge balance of payments deficit. The Fed justified this by claiming to see a “deflation” — for which there was no evidence whatever. After all, retail prices continued rising gently, stock prices remained overvalued by historical standards and house prices were soaring. Once again, deception was used to justify a mistaken policy.

Housing shocks

In housing itself, the current U.S. housing finance market has been built on deception. Instead of assessing a credit risk and making a loan, the modern housing financier merely collects a fee — and passes the risk off to some unknown investor, preferably a foreign bank.

Needless to say, this has resulted in a substantial percentage of U.S. housing loans being entirely fraudulent. It is increasingly becoming clear that a large proportion of modern finance rests on similar deceptions, with asset-backed commercial paper, securitization in general — and much of the derivatives market — resting solely on aggressive obfuscation of economic reality in pursuit of fees.

No confidence

To return to the Fed, both it and the ECB have now decided that the inevitable illiquidity in the interbank market following exposure of the U.S. banking system's shenanigans in housing and elsewhere can be cured by cutting interest rates aggressively and pumping $600 billion of taxpayer money into the banking system.

Such activities do not restore a systemic confidence that has proved itself unjustified. They simply prop up the stock market and cause an increase in inflationary pressure, while pushing oil prices up over 30% in four months.

Again, it’s quite literally a confidence trick — and one which, rest assured, will be exposed during 2008.

A sign of things to come

Which leads me back to Japanese investors who regard 2007 as a “year of deception.”

What is truly astonishing is that the Tokyo stock market has dropped 10% — the only large market to have done so. However, in a year of a major international financial crisis, in which several medium-sized banks have collapsed and $600 billion in emergency funds has been pumped into the interbank market, it may reasonably be questioned why any of the world’s stock markets should have risen.

Perhaps the Tokyo stock market is currently the only major market in the world that is not ruled by deception — and stock-market-pumping central banks.

Editor's note: Martin Hutchinson's essays appear regularly at Prudent Bear.com.