'...the Federal Reserve System, in 1913 ... This virtual nationalization of the banking system ... The result was the cartelization of banking under federal control, with the government standing ready to bail out banks in trouble'<blockquote>'Having deposed the central bank in the 1830s, the United States enjoyed a freely competitive banking system — and hence a relatively "hard" and noninflated money — until the Civil War. During that catastrophe, the Republicans used their one-party dominance to push through their interventionist economic program. It included a protective tariff and land grants to railroads, as well as inflationary paper money and a "national banking system" that in effect crippled state-chartered banks and paved the way for the later central bank.
The United States adopted its central bank, the Federal Reserve System, in 1913, backed by a consensus of Democrats and Republicans. This virtual nationalization of the banking system was unopposed by the big banks; in fact, Wall Street and the other large banks had actively sought such a central system for many years. The result was the cartelization of banking under federal control, with the government standing ready to bail out banks in trouble, and also ready to inflate money and credit to whatever extent the banks felt was necessary.
Without a functioning Federal Reserve System available to inflate the money supply, the United States could not have financed its participation in World War I: that war was fueled by heavy government deficits and by the creation of new money to pay for swollen federal expenditures.
One point is undisputed: the autocratic ruler of the Federal Reserve System, from its inception in 1914 to his death in 1928, was Benjamin Strong, a New York banker who had been named governor of the Federal Reserve Bank of New York. Strong consistently and repeatedly used his power to force an inflationary increase of money and bank credit in the American economy, thereby driving prices higher than they would have been and stimulating disastrous booms in the stock and real-estate markets. In 1927, Strong gaily told a French central banker that he was going to give "a little coup de whiskey to the stock market." What was the point? Why did Strong pursue a policy that now can seem only heedless, dangerous, and recklessly extravagant?'
- Murray N. Rothbard,
Reliving the Crash of '29, November 12, 1979</blockquote>
“In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions.”*
<blockquote>'As I have repeatedly noted, mainstream economists and financial advisors have been using faulty and unrealistic models for years. See
this,
this,
this,
this,
this and
this.
And I have pointed out numerous times that economists and advisors have a financial incentive to use faulty models. For example, I
pointed out last month:
The decision to use faulty models was an economic and political
choice, because it benefited the economists and those who hired them.
For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.
Specifically, as Simon Johnson, William K. Black and others
point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will
bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also
bet against the same products they are selling during the boom (more
here), knowing that they’ll make a killing when it busts.
But economists have
pretended there is no such thing as a bubble. Indeed, BIS
slammed the Fed and other central banks for blowing bubbles and then using “gimmicks and palliatives” afterwards.
It is not like economists weren’t warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was “inconvenient” to discuss this “impolite” issue.
Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.
...
The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn’t matter.
And – even now – mainstream economists are STILL willfully ignoring things like
massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.'
- George Washington, *
Guest Post: Economists Are Trained to Ignore the Real World, December 21, 2009</blockquote>
'The jury is out on how well one can expect to manage wrong-way risk. I can’t see how any numerology can possibly do it...'<blockquote>'The BIS analysis of the 2007-09 banking crisis floats my boat. Here is their headline list of causes: excessive on- and off-balance sheet leverage, diminutive and low quality capital bases, insufficient liquidity buffers at banks. That gave us a banking system unable to absorb the systemic trading and credit losses, and unable to cope with the reintermediation of large off-balance sheet exposures from the imploding shadow banking system. The crisis was intensified by panic deleveraging and by the interconnectedness of systemic institutions via OTC transactions. “During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions.”
In the tradition of a certain kind of official document, it gets more punchy as you get away from the executive summary; additional factors are either spelt out in the detail of the reforms, or implicit: OTC securities markets were mostly a bad idea; there was a complete failure to manage counterparty risk; opacity of accounting facilitated the gaming of capital rules, which concealed massive leverage; there were “basic lapses” in liquidity risk management; there was excessive reliance on ratings, which led to outsourcing of risk management functions properly kept in-house; initial margins were too low, and shot up during the crisis, intensifying the liquidity squeeze; there was “Measurement Error”; “model risk” was underestimated. It turned out that banks tested their credit risk models very badly indeed, and they were impressively defective. This last applies particularly to credit risk models: for instance, counterparties defaulted just when volatility was at its peak and exposure at its highest (think AIG, monolines); which appears to have come as a surprise. The Basel committee rejects more colourful coinages (“chocolate teapot risk”), and calls this “wrong way” risk.
...
Rating agencies reform isn’t pretty. They are as firmly embedded in the new Basel rules as they were in the old. Once again the Committee is in a cleft stick. They rightly mistrust banks’ internal ratings as an alternative, but are reluctant to admit the possibility that the rating agencies aren’t really all that independent from banks. Perhaps they are just being polite to the US.
As mentioned, banks are given a general whack on the muzzle for not testing their credit risk models properly, and are given a whole slew of new specifications of what their models should be like. We are now to have stressed EPE (an attempt to tackle wrong-way risk), stressed VaR (actually this was specified back in July), extra back testing requirements, extra stress-testing requirements, extra model validation requirements. This will be a geeks’ bonanza.
The jury is out on how well one can expect to manage wrong-way risk. I can’t see how any numerology can possibly do it, since it doesn’t have any insight into the deteriorating fundamentals that drive a company’s creditworthiness.
- Yves Smith,
“Basel III – the OK, the Unfinished and the Ugly”, December 22, 2009</blockquote>
'In another part of the Basel III forest, the document is very keen for OTC derivatives to be traded on an exchange.'<blockquote>'
Second, banks will soon have a VERY big equity hole!Haven’t seen any analysis of how the new Basel bank capital calculations would affect US bank regulatory capital but if Credit Suisse’s back of an envelope calculation is right for Eurobanks (they will need EUR 1.1 Trillion of extra capital of one sort or another), then a crude read-across is that American banks need another $400Bn of capital, of one sort or another. I am ignoring ridiculous basket cases like Citi. This is based on Eurobanks representing about 50% of the world banking asset base, with US banks acounting for another 15%, and on the assumption that US and Eurobanks have been gaming their capital requirements so the same overall extent. (Yves comment: the assumption in the US is that US banks are further along on their writedowns than the Eurobanks are, but given that the US banks just got an expected break from the FASB re not having to implement a rule change that would have required them to consolidate their off balance sheet entities, that cheery assumption may not include those lovely “qualified special purpose entities”).
In another part of the Basel III forest, the document is very keen for OTC derivatives to be traded on an exchange. It doesn’t distinguish between CDS and other derivatives such as swaps, so I take this as an implicit admission that the entire OTC market was a crap idea – rather radical and smack on from my perspective.
- Yves Smith,
Some Things Went Bump in The Night Last Week (Bank Regulatory Shenanigans Edition), December 21, 2009</blockquote>