Why This Harvard Economist Is Pulling All His Money From Bank Of America

Courtesy of Zerohedge:

A classicial economist… and Harvard professor… preaching to the world that one’s money is not safe in the US banking system due to Ben Bernanke’s actions? And putting his withdrawal slip where his mouth is and pulling $1 million out of Bank America? Say it isn’t so…

From Terry Burnham, former Harvard economics professor, author of “Mean Genes” and “Mean Markets and Lizard Brains,” provocative poster on this page and long-time critic of the Federal Reserve, argues that the Fed’s efforts to strengthen America’s banks have perversely weakened them. First posted in PBS.

Is your money safe at the bank? An economist says ‘no’ and withdraws his

Last week I had over $1,000,000 in a checking account at Bank of America. Next week, I will have $10,000.

Why am I getting in line to take my money out of Bank of America? Because of Ben Bernanke and Janet Yellen, who officially begins her term as chairwoman on Feb. 1.

Before I explain, let me disclose that I have been a stopped clock of criticism of the Federal Reserve for half a decade. That’s because I believe that when the Fed intervenes in markets, it has two effects — both negative. First, it decreases overall wealth by distorting markets and causing bad investment decisions. Second, the members of the Fed become reverse Robin Hoods as they take from the poor (and unsophisticated) investors and give to the rich (and politically connected). These effects have been noticed; a Gallup poll taken in the last few days reports that only the richest Americans support the Fed. (See the table.)

image

Why do I risk starting a run on Bank of America by withdrawing my money and presuming that many fellow depositors will read this and rush to withdraw too? Because they pay me zero interest. Thus, even an infinitesimal chance Bank of America will not repay me in full, whenever I ask, switches the cost-benefit conclusion from stay to flee.

Let me explain: Currently, I receive zero dollars in interest on my $1,000,000. The reason I had the money in Bank of America was to keep it safe. However, the potential cost to keeping my money in Bank of America is that the bank may be unwilling or unable to return my money. Continue reading

NEW AUSTRIAN ECONOMICS MANIFESTO

I was fortunate enough to be at the launch of the New Manifesto. From this memorable time I understood that if we do not like the reality set before us, we must change it or accept the consequences. Courtesy of Professor Fekete.com:

July 4, 2013
Formally adopted at the Seminar held in the British Museum, London, on October 6, 2013

In a recent pamphlet Llewellyn H. Rockwell, President of the Mises Institute writes that we are all ceaselessly being bombarded by the media and college educators with propaganda to the effect

“that capitalism causes depressions and exploits the poor. That government is our salvation, and the bureaucrat a hero. That America owes its wealth to the Federal Reserve. That without massive regulation we’d be sunk…That cutting government even a smidgen and permitting free markets would be a disaster… John Maynard Keynes died more than 60 years ago, but his ideas still rule us from the grave: give government more power, and print more money…”

It is a pleasure to acknowledge that Mises University, the Mises Institute’s week-long summer program for students has done an outstanding service to society in flouting the conventional wisdom about government, and explaining the logic behind free enterprise. Continue reading

Why the Fed Can’t Stop Fueling The Shadow Bank Kiting Machine

I read this article by Bill Frezza on Menckenism blog. It explains why the Fed, as well as all the other central banks, cannot stop ‘printing money’ and a key piece for me is that TBTF banks privatise profits and socialise losses which drives riskier and riskier behaviour as they can always get a bailout. This is the anti-thesis to capitalism, if your business model does not work, the business fails.

More and more people are waking up to this mass fraud and when this hits critical mass with the public, through enlightenment, education or a financial crisis of epic proportions, these financial terrorists will be held to account. It’s time for a social and cultural revolution, viva la revolution. The article in full….

Fractional reserve banking is unlike most other businesses. It’s not just because its product is money. It’s because banks can manufacture their product out of thin air. Traditional commercial banks essentially create money through a well understood and time honored pyramiding of loans. Depositors who understand that their deposits are thereby placed at risk choose their banks accordingly.

Under the bygone rules of free market capitalism, only one thing kept banks from creating an infinite amount of money, and that was fear of failure. Failure occurs when depositors come to believe that their bank has lent out too much manufactured money to too many dodgy borrowers and may not be able to cover depositors’ withdrawals. When this happens, depositors rush to reclaim their money while there is still some left, leading to the bank’s collapse.

image

Under free market capitalism, banks compete along a spectrum of risk and reward. Conservative banks offer a higher degree of safety by maintaining larger reserves, thereby manufacturing and lending out less money. Through word and deed they let depositors know that they lend to only the most creditworthy borrowers, who generally must post valuable collateral. These banks remain profitable because they successfully attract prudent depositors willing to accept lower rates of interest.

Banks of a more speculative bent offer a lower degree of safety, maintaining smaller reserves to create and lend out more money. Seeking higher returns, they often lend to less creditworthy borrowers who may put up poor quality collateral or none at all. These banks attract risk-taking depositors looking for a higher rate of interest. They can be very profitable during periods of economic expansion but often fall into distress during economic downturns.

Periodic bank failures remind depositors of the connection between risk and reward. When caveat emptor rules, smart depositors who pay attention make money and dumb depositors who don’t lose theirs.

Because the latter outcome is intolerable in a democracy, we have government-provided deposit insurance and other taxpayer-financed backstops that shield most depositors from the risk of loss. In theory banks pay premiums to fund this insurance. In practice these premiums are not risk-based. Banks are not penalized for making riskier loans, in turn often leaving the premiums too low to finance payouts. This creates a huge moral hazard, as it frees depositors to seek the highest return without regard for safety.

Worse, it removes conservative banks’ competitive advantage. Under a government-guaranteed deposit insurance regime, conservative bankers who want to stay in business must take on more risk in order to pay the higher interest rates necessary to attract depositors. This often sets off a race to the bottom, which results in periodic banking crises.

After each of these crises, politicians promise taxpayers that it will never happen again. And each time it does, the government creates a new set of labyrinthine regulations that attempt to mimic the business judgment of conservative bankers. Minimum reserve requirements are established, which normally become the maximum as there is little advantage in exceeding them. And both depositors and the bankers themselves become complacent about the banks’ investments because it is so easy to privatize gains and socialize losses.

Banks also learn that competitive advantage can be obtained by either gaming the regulations or having cronies write them. As regulations get more intrusive and complex, politicians discover that they can be used to advance social policies, such as increasing home ownership among voters with poor credit, thereby increasing the risk on banks’ loan books.

This mixed economic system is the one that replaced free market capitalism in hopes that it would prevent bank failures. Despite, and some even say because of, a regulatory regime that discouraged conservative banking and rewarded reckless mortgage lending, the banking system crashed – again – in 2007-2008.

What is not widely appreciated is that the ensuing government bailouts allowed an underlying shadow banking system to not only survive but grow even larger. It is called the shadow banking system because it operates outside most government-regulated banking laws. This is primarily because regulations and accounting standards haven’t caught up with the practices of these banks, which are relatively new and poorly understood.

It was the seizing up of the commercial paper and repo markets that funds the shadow banking system that abruptly halted the flow of liquidity that kept the mortgage bubble propped up. This revealed the underlying insolvency of Fannie Mae, Freddie Mac, and many commercial banks stuffed with subprime mortgage securities accumulated under the mixed economic system described above.

Powered by an exclusive club of primary reserve dealers, a group that once included high flyers like Lehman Brothers, MF Global, and Countrywide Securities, these shadow banks work hand in glove with the Federal Reserve to manufacture money by pyramiding loans atop the base money deposits held in their Federal Reserve accounts.

To the frustration of Keynesians, and despite an unprecedented Quantitative Easing (QE) by the Federal Reserve, conventional commercial banks have broken with custom and have amassed almost $2 trillion in excess reserves they are reluctant to lend as they scramble to digest all the bad loans still on their books. So most of the money manufactured today is actually being created by the shadow banks. But shadow banks do not generally make commercial loans. Rather, they use the money they manufacture to fund proprietary trading operations in repos and derivatives.

Where does the pyramiding come from if shadow banks aren’t making loans that get redeposited to fuel the cycle? Securities held as collateral by counterparties in a repo contract can be rehypothecated by the lender to obtain additional loans. (So can securities held in customer accounts, unless their brokerage agreements expressly prohibit it. This was an unwelcome discovery by MF Global’s hapless clients, who saw their assets whooshed off to London where different brokerage rules allow such hypothecation.) Loans made against securities held as collateral can then be used to either buy more securities, which can be fed back into the repo market, or trade a bewildering array of complex synthetic derivatives.

If this sounds like circular check kiting that’s because it is, especially when you add in the issuance of commercial paper required to grease the wheels. The biggest difference is that an embezzler kiting checks does not have the support of a central bank providing steady injections of liquidity, beefing up balance sheets that create confidence in their debt instruments.

How much of the original high quality collateral must shadow banks hold in reserve should some of their derivatives implode, as many did during the last crisis? Zero. By repeatedly spinning the wheel, the top 25 U.S. banks have piled up over $200 trillion in leveraged bets atop a thinning wedge of collateral, claims to which are spread across an opaque and complex chain of counterparties residing in multiple legal jurisdictions. These collateral claims are co-mingled with an estimated $400 trillion to $1.3 quadrillion in notional outstanding derivatives made by other banks around the world, altogether amounting to more than 20 times global GDP.

Due to the fact that accounting standards have not kept up with these innovative practices, banks are not required to report the gross notional value of the outstanding derivative contracts on their books, only their net asset positions. These theoretical Value at Risk positions, which would only be netted out if all the contracts were unwound in an orderly manner—as one might unwind a check kiting scheme before getting caught—can only be realized in a liquidity crisis if the counterparty chains across which these contracts are hedged hold up.

These counterparty chains froze in spectacular fashion during the last financial crisis. After the collapse of Lehman Brothers and with the insolvency of AIG looming, a chorus of politicians, bankers, and bureaucrats browbeat the government into delivering a system-wide bailout. As a result, many reckless banks and bankers that should have been driven out of the market are back doing business as usual.

The largest banks learned that they need not worry about the possibility of bankruptcy. When the next crisis hits, all they have to do is shout “systemic collapse” and another bailout will appear. Being Too Big To Fail, they can maximize profits without having to hold reserves against the risk of counterparty failure, knowing that the taxpayer will always be there to make them whole.

The solution is not more regulations, which will never keep up with the financial wizards whose lobbyists end up writing these rules anyway. In addition, trades can be made anywhere in the world, so to be effective the regulations would have to be global. As long as governments continue to prop up failing banks, regulation will always be inadequate to mitigate the moral hazard that accompanies bailouts. And, ironically, the added costs of regulatory compliance will make it harder still for smaller and more prudent banks to compete.

image

True to form, Congress has not solved the TBTF problem but has actually made it worse, loading ever more regulations on commercial banks through Dodd-Frank. Meanwhile, taxpayer exposure to the banking system has grown even larger.

Optimists believe that as long as everyone remains calm and keeps believing everything is fine, then everything will be. Central planning advocates hope that the kiting scheme can be unwound by extending banking regulations to cover the shadow banks while the Fed somehow weans them off of Quantitative Easing. Cynics believe that asking Washington to get the situation under control is a hopeless quest, especially since few Congressmen have a clue what is really going on.

Meanwhile uncertainty hangs over the system since bankruptcy laws, which differ from country to country, have not kept up with hyper-hypothecation. Moreover, the government’s handling of the auto bailout shows that investors cannot rely on existing bankruptcy law even when it speaks clearly on an issue. Therefore, no one really knows who will have first dibs on the collateral when the music stops. And just what are those high quality assets? Sovereign bonds and mortgage CDOs, which are themselves subject to precipitous losses.

As the debate drags on and global economic conditions worsen, the growing pyramid is being kept afloat by the easy money policies of central banks too frightened to withdraw their support lest a stock market correction trigger a cascade of margin calls that brings down the whole system—much like last time.

All this money creation has not yet generated much visible consumer price inflation. This is partly because official inflation measures are suspect but mostly because the bulk of the new money being created is flowing into financial assets and not the consumer economy. This has inflated asset bubbles to levels impossible to justify based on underlying economic conditions, in particular the stock market where investors have fled in search of yield. No one knows when the bubble will pop, but when it does a donnybrook is going to break out over that thin wedge of collateral whose ownership is spread across counterparties around the world, each looking for relief from their own judges, politicians, bureaucrats, and taxpayers.

When that happens and the clamor for regulation, nationalization, confiscation, and demonization arises there is only one thing we can be sure of. The disaster will once again be blamed on a free market capitalism that has not existed in this country for over 100 years.

UK’s Current Debt Based Economic System

The current economic model is a debt based system using fractional reserve banking and fiat currency. What does that mean and what does it look like?

Money is created almost exclusivley by commercial banks who create the money supply through debt, this is called fractional reserve banking. By issuing more debt and loans they increase the money supply but only keep a fraction of the paper money in reserve. The majority of money now is digital money…numbers on a screen.

Currency is termed fiat because it is intrinsically worthless and derives it value from confidence in the currency only. The alternative would be to have a gold or silver backed currency.

image

I’ll explain fractional reserve banking by giving an example:

Imagine you deposit £100 into Bank A. Assuming a 10% fractional reserve ratio, Bank A then takes 10 percent of it, £10, and sets it aside as reserves and then loans out the remaining 90 percent, or £90. At this point there is actually a total of £190 in the system, not £100. The bank has loaned out £90, kept £10 in reserve, and substituted a newly created £90 IOU claim for the depositor which charges interest and is a profit loan for the bank. At this point Bank A still holds £100 reserves on its books, but £90 of those reserves are soon going to be needed to satisfy the loan recipient. The loan recipient soon spends the £90. The receiver of the £90 then deposits it into Bank B. Bank B demands £90 to be delivered from Bank A to Bank B.

Bank B is now in the same situation as Bank A started with, except it has a deposit of £90 instead of £100. Similar to Bank A, Bank B sets aside 10 percent of that £90, or £9, as reserves and lends out the remaining £81 thus creating £81 of IOUs to its depositors. As the process continues, more electronic number money is created.

Fractional reserve banking and its effects on the money supply have reaching consequences for the business cycle, monetary inflation, price inflation and interest rates. What disturbs me is that the banks are creating and benefiting from the interest generated from creating new money, rather than the UK itself. Should we as a country not issue the money and charge the banks for the privilege?

A study by Huber and Robertson ‘Creating New Money‘ (2000) suggested that the loss to the government of allowing commercial banks to create money was in the order of £49bn per annum. Plus the cost of servicing the national debt, at £32bn per annum and the cost of stimulating a recovery during recession after inevitable recession, runs to hundreds of billions, if not trillions.

What does our debt based system look like compared to other countries and is it working?

image

The UK as a country is no longer in control of its finances. We have a GDP/Debt ratio of over 900% and with bank debt over 600% of GDP. Our financial sector is disgustingly over-leveraged, couple that with close to zero percent interest rates which allows banks to speculate for free. They take riskier and riskier bets and its the UK public who pick up the tab if it all goes wrong! Iceland had a debt to GDP ratio of 1000% before it collapsed.

We need to be in charge of our currency, move on from a debt based currency and return to sound economic principles. The system hasn’t failed, its just coming to its logical conclusion and history has plenty of examples how this will play out.