OPINION

MAY 31, 2011, 6:45 P.M. ET.

The Fed Has Trapped Itself on Rates

Thanks to borrowing short and lending long, the central bank could end up losing big money

By GEORGE MELLOAN



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Markets have been nervous for months about the Federal Reserve's inflationary monetary policy. Main Street is nervous too, as food and fuel prices rise. The recent drop in commodity prices was a correction, but the long-term prospect is for a further pocketbook pinch at the gas pump and checkout counter.


So why doesn't the Fed change course? One possibility is that it feels obliged to help the Treasury cope with the vast deficits generated by the Reid-Pelosi Congress. Another is that raising interest rates to curb inflation could create discomfort for the Federal Reserve itself, given the disordered state of its balance sheet.


The Fed has been committing an ancient sin that has tripped up many a banker: borrowing short and lending long. Although this is a common practice—for example, issuing one-year CDs to depositors to buy 30-year mortgages—it involves an inherent vulnerability. The bank makes its money on the differential between the low interest rate on short-term borrowing and the higher rate it gets on long-term lending. But if its long-term portfolio suddenly loses value, the bank is subject to a large loss that eats into its capital and jeopardizes its ability to continue attracting short-term investment. Banks go broke that way.


Last year, the Fed launched a second round of quantitative easing, QE2, in which it set about to buy $600 billion in Treasury bonds and notes as a form of economic stimulation. As the current sluggishness of the economy makes evident, there hasn't been much stimulus. But the Fed has helped the U.S. Treasury finance a massive federal $1.6 trillion deficit and refinance the maturing portion of the $14 trillion national debt.


The Fed has not bought up Treasury bonds and notes with newly created money. Instead, it has been getting its $600 billion by borrowing from the vast excess reserves owned by the private banks. These are deposits with the Fed in excess of those required by law. They expanded enormously post-2008, when the Fed was creating new money to replace the liquidity the banks had lost in the market crash.

The Fed is borrowing the money cheaply, at only a quarter of a percent interest rate. The Treasurys it buys yield over 3%. Meanwhile, the Fed can claim that it also is "immobilizing" reserves that, if loaned into the economy, could be inflationary. Sounds pretty clever, doesn't it?


It sounds even more clever when you look at last year's robust earnings of the 12 Federal Reserve banks. For 2010, they posted combined earnings of $81.7 billion, about $6 billion shy of the earnings of the entire commercial and savings bank industry. By law, the U.S. Treasury got most of this bonanza, $79.3 billion, with some $1.4 billion going into dividends to member banks and less than $1 billion to expand Reserve bank capital. It looked like nothing short of a heroic performance by the much-criticized Fed.


But the Fed is running a big interest-rate risk. Over the past few years, the Fed has borrowed about $1 trillion in excess reserves from member banks. The banks can call in those loans to the Fed on demand, which is about as short-term as you can get. Should the economy pick up and banks need that money to make private loans, the Fed would have to offer a higher rate to try to hold those reserves. But when interest rates go up, the value of bonds goes down—and so too would the market value of the Fed's $2 trillion-plus portfolio of Treasurys and mortgage-backed securities.


Writing in Forbes.com on May 6, William F. Ford (a former Atlanta Fed president) and Walker F. Todd (who did stints with both the Cleveland and New York Feds as a lawyer and economist) note that a one percentage point rise in long-term interest rates would lower the market value of the Fed's current bond portfolio by $100 billion. That would more than wipe out the $81.7 billion in earnings the Fed reported for 2010.


The reserve banks' skimpy capital base could be wiped out. Federal Reserve banks don't adhere to the asset-to-capital requirements imposed on private banks. And according to Messrs. Ford and Todd, the New York Fed has an "astounding" 98-1 leverage ratioworse than Fannie Mae in its heyday.


Of course this is all theoretical, given that the Fed isn't obliged to acknowledge a loss on its portfolio until it sells securities and actually realizes the loss. But it does explain why the Fed is uncomfortable with any development that would cause the cost of long-term credit to rise and the value of existing portfolios to fall. It shows no inclination to raise its near-zero interest rate target, whatever critics say.


The QE2 process is due to end this month, not with a shout but a whimper. It didn't stimulate much, and given the dollar's weakness, markets seem to have been savvy about the risks of what the Fed was up to.
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Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).


Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Intolerable choices for the eurozone

By Martin Wolf

Published: May 31 2011 20:33


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The eurozone was supposed to be an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks. Unemployment then drives down wages and prices, causing an “internal devaluation”. In the long run, this should deliver financeable balances in the external payments and fiscal accounts, though only after many years of pain. In the eurozone, however, much of this borrowing flows via banks. When the crisis comes, liquidity-starved banking sectors start to collapse.

Credit-constrained governments can do little, or nothing, to prevent that from happening. This, then, is a gold standard on financial sector steroids.

The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds.

A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US.

At last month’s Munich economic summit, Hans-Werner Sinn, president of the Ifo Institute for Economic Research, brilliantly elucidated the implications of the response to this threat of the European System of Central Banks (ESCB). The latter has acted as lender of last resort to troubled banks.

But, because these banks belonged to countries with external deficits, the ESCB has been indirectly financing those deficits, too. Moreover, because national central banks have lent against discounted public debt, they have been financing their governments. Let us call a spade a spade: this is central bank finance of the state.
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The ESCB’s finance flows via the euro system’s real-time settlement system (target-2). Huge asset and liability positions have now emerged among the national central banks, with the Bundesbank the dominant creditor (see chart). Indeed, Prof Sinn notes the symmetry between the current account deficits of Greece, Ireland, Portugal and Spain and the cumulative claims of the Bundesbank upon other central banks since 2008 (when the private finance of weaker economies dried up).

Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door. Indeed, that this is likely to happen is quite clear from the striking interview with Lorenzo Bini Smaghi, a member of the board of the European Central Bank, in the FT of May 29 2011.

Prof Sinn makes three other points. First, this backdoor way of financing debtor countries cannot continue for very long. By shifting so much of the eurozone’s money creation towards indirect finance of deficit countries, the system has had to withdraw credit from commercial banks in creditor countries. Within two years, he states, the latter will have negative credit positions with their national central banks – in other words, be owed money by them. For this reason, these operations will then have to cease. Second, the only way to stop them, without a crisis, is for solvent governments to take over what are, in essence, fiscal operations. Yet, third, when one adds the sums owed by national central banks to the debts of national governments, totals are now frighteningly high (see chart). The only way out is to return to a situation in which the private sector finances both the banks and the governments. But this will take many years, if it can be done with today’s huge debt levels at all.

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.

Events have, in short, thoroughly falsified the premises of the original design. If that is the design the dominant members still want, they must remove some of the existing members. Managing that process is, however, nigh on impossible. If, however, they want the eurozone to work as it is, at least three changes are inescapable. First, banking systems cannot be allowed to remain national. Banks must be backed by a common treasury or by the treasury of unimpeachably solvent member states. Second, cross-border crisis finance must be shifted from the ESCB to a sufficiently large public fund. Third, if the perils of sovereign defaults are to be avoided, as the ECB insists, finance of weak countries must be taken out of the market for years, perhaps even a decade.

Such finance must be offered on manageable conditions in terms of the cost but stiff requirements in terms of the reforms. Whether the resulting system should be called a “transfer union” is uncertain: that depends on whether borrowers pay everything back (which I doubt). But it would surely be a “support union”.

The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged. How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does.

Copyright The Financial Times Limited 2011.

Israel's Borders and National Security

Created May 30 2011 - 20:37

By George Friedman


Israeli Prime Minister Benjamin Netanyahu said May 30 that Israel could not prevent the United Nations from recognizing a Palestinian state, in the sense of adopting a resolution on the subject. Two weeks ago, U.S. President Barack Obama, in a speech, called on Israel to return to some variation of its pre-1967 borders. The practical significance of these and other diplomatic evolutions in relation to Israel is questionable. Historically, U.N. declarations have had variable meanings, depending on the willingness of great powers to enforce them. Obama’s speech on Israel, and his subsequent statements, created enough ambiguity to make exactly what he was saying unclear. Nevertheless, it is clear that the diplomatic atmosphere on Israel is shifting.


There are many questions concerning this shift, ranging from the competing moral and historical claims of the Israelis and Palestinians to the internal politics of each side to whether the Palestinians would be satisfied with a return to the pre-1967 borders. All of these must be addressed, but this analysis is confined to a single issue: whether a return to the 1967 borders would increase the danger to Israel’s national security. Later analyses will focus on Palestinian national security issues and those of others.


Early Borders


It is important to begin by understanding that the pre-1967 borders are actually the borders established by the armistice agreements of 1949. The 1948 U.N. resolution creating the state of Israel created a much smaller Israel. The Arab rejection of what was calledpartitionresulted in a war that created the borders that placed the West Bank (named after the west bank of the Jordan River) in Jordanian hands, along with substantial parts of Jerusalem, and placed Gaza in the hands of the Egyptians.






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The 1949 borders substantially improved Israel’s position by widening the corridors between the areas granted to Israel under the partition, giving it control of part of Jerusalem and, perhaps most important, control over the Negev. The latter provided Israel with room for maneuver in the event of an Egyptian attack — and Egypt was always Israel’s main adversary. At the same time, the 1949 borders did not eliminate a major strategic threat. The Israel-Jordan border placed Jordanian forces on three sides of Israeli Jerusalem, and threatened the Tel Aviv-Jerusalem corridor. Much of the Israeli heartland, the Tel Aviv-Haifa-Jerusalem triangle, was within Jordanian artillery range, and a Jordanian attack toward the Mediterranean would have to be stopped cold at the border, since there was no room to retreat, regroup and counterattack.


For Israel, the main danger did not come from Jordan attacking by itself. Jordanian forces were limited, and tensions with Egypt and Syria created a de facto alliance between Israel and Jordan. In addition, the Jordanian Hashemite regime lived in deep tension with the Palestinians, since the former were British transplants from the Arabian Peninsula, and the Palestinians saw them as well as the Israelis as interlopers. Thus the danger on the map was mitigated both by politics and by the limited force the Jordanians could bring to bear.


Nevertheless, politics shift, and the 1949 borders posed a strategic problem for Israel. If Egypt, Jordan and Syria were to launch a simultaneous attack (possibly joined by other forces along the Jordan River line) all along Israel’s frontiers, the ability of Israel to defeat the attackers was questionable. The attacks would have to be coordinated — as the 1948 attacks were not — but simultaneous pressure along all frontiers would leave the Israelis with insufficient forces to hold and therefore no framework for a counterattack.
From 1948 to 1967, this was Israel’s existential challenge, mitigated by the disharmony among the Arabs and the fact that any attack would be detected in the deployment phase.


Israel’s strategy in this situation had to be the pre-emptive strike. Unable to absorb a coordinated blow, the Israelis had to strike first to disorganize their enemies and to engage them sequentially and in detail. The 1967 war represented Israeli strategy in its first generation. First, it could not allow the enemy to commence hostilities. Whatever the political cost of being labeled the aggressor, Israel had to strike first. Second, it could not be assumed that the political intentions of each neighbor at any one time would determine their behavior. In the event Israel was collapsing, for example, Jordan’s calculations of its own interests would shift, and it would move from being a covert ally to Israel to a nation both repositioning itself in the Arab world and taking advantage of geographical opportunities. Third, the center of gravity of the Arab threat was always Egypt, the neighbor able to field the largest army. Any pre-emptive war would have to begin with Egypt and then move to other neighbors. Fourth, in order to control the sequence and outcome of the war, Israel would have to maintain superior organization and technology at all levels. Finally, and most important, the Israelis would have to move for rapid war termination. They could not afford a war of attrition against forces of superior size. An extended war could drain Israeli combat capability at an astonishing rate. Therefore the pre-emptive strike had to be decisive.


The 1949 borders actually gave Israel a strategic advantage. The Arabs were fighting on external lines. This means their forces could not easily shift between Egypt and Syria, for example, making it difficult to exploit emergent weaknesses along the fronts. The Israelis, on the other hand, fought from interior lines, and in relatively compact terrain. They could carry out a centrifugal offense, beginning with Egypt, shifting to Jordan and finishing with Syria, moving forces from one front to another in a matter of days. Put differently, the Arabs were inherently uncoordinated, unable to support each other. The pre-1967 borders allowed the Israelis to be superbly coordinated, choosing the timing and intensity of combat to suit their capabilities. Israel lacked strategic depth, but it made up for it with compact space and interior lines. If it could choose the time, place and tempo of engagements, it could defeat numerically superior forces. The Arabs could not do this.


Israel needed two things in order to exploit this advantage. The first was outstanding intelligence to detect signs of coordination and the massing of forces. Detecting the former sign was a matter of political intelligence, the latter a matter of tactical military intelligence. But the political intelligence would have to manifest itself in military deployments, and given the geography of the 1949 borders, massing forces secretly was impossible. If enemy forces could mass undetected it would be a disaster for Israel. Thus the center of gravity of Israeli war-making was its intelligence capabilities.


The second essential requirement was an alliance with a great power. Israel’s strategy was based on superior technology and organizationair power, armor and so on. The true weakness of Israel’s strategic power since the country’s creation had been that its national security requirements outstripped its industrial and financial base. It could not domestically develop and produce all of the weapons it needed to fight a war. Israel depended first on the Soviets, then until 1967 on France. It was not until after the 1967 war that the United States provided any significant aid to Israel. However, under the strategy of the pre-1967 borders, continual access to weapons — and in a crisis, rapid access to more weapons — was essential, so Israel had to have a powerful ally. Not having one, coupled with an intelligence failure, would be disastrous.
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After 1967
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The 1967 war allowed Israel to occupy the Sinai, all of Jerusalem, the West Bank and the Golan Heights. It placed Egyptian forces on the west bank of the Suez, far from Israel, and pushed the Jordanians out of artillery range of the Israeli heartland. It pushed Syria out of artillery range as well. This created the strategic depth Israel required, yet it set the stage for the most serious military crisis in Israeli history, beginning with a failure in its central capability intelligence.




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The intelligence failure occurred in 1973, when Syria and Egypt managed to partially coordinate an assault on Israel without Israeli intelligence being able to interpret the intelligence it was receiving. Israel was saved above all by rapid rearmament by the United States, particularly in such staples of war as artillery shells. It was also aided by greater strategic depth. The Egyptian attack was stopped far from Israel proper in the western Sinai. The Syrians fought in the Golan Heights rather than in the Galilee.


Here is the heart of the pre-1967 border issue. Strategic depth meant that the Syrians and Egyptians spent their main offensive force outside of Israel proper. This bought Israel space and time. It allowed Israel to move back to its main sequential strategy. After halting the two attacks, the Israelis proceeded to defeat the Syrians in the Golan then the Egyptians in the Sinai. However, the ability to mount the two attacks — and particularly the Sinai attack required massive American resupply of everything from aircraft to munitions. It is not clear that without this resupply the Israelis could have mounted the offensive in the Sinai, or avoided an extended war of attrition on unfavorable terms. Of course, the intelligence failure opened the door to Israel’s other vulnerability — its dependency on foreign powers for resupply.


Indeed, perhaps Israel’s greatest
miscalculation was the amount of artillery shells it would need to fight the war; the amount required vastly outstripped expectations. Such a seemingly minor thing created a massive dependency on the United States, allowing the United States to shape the conclusion of the war to its own ends so that Israel’s military victory ultimately evolved into a political retreat in the Sinai.


It is impossible to argue that Israel, fighting on its 1949 borders, was less successful than when it fought on its post-1967 borders. What happened was that in expanding the scope of the battlefield, opportunities for intelligence failures multiplied, the rate of consumption of supplies increased and dependence grew on foreign powers with different political interests. The war Israel fought from the 1949 borders was more efficiently waged than the one it fought from the post-1967 borders. The 1973 war allowed for a larger battlefield and greater room for error (errors always occur on the battlefield), but because of intelligence surprises and supply miscalculations it also linked Israel’s national survival to the willingness of a foreign government to quickly resupply its military.


The example of 1973 casts some doubt around the argument that the 1948 borders were excessively vulnerable. There are arguments on both sides of the issue, but it is not a clear-cut position. However, we need to consider Israel’s borders not only in terms of conventional war but also in terms of unconventional war — both uprisings and the use of chemical, biological, radiological or nuclear (CBRN) weapons.


There are those who argue that there will be no more peer-to-peer conflicts. We doubt that intensely. However, there is certainly a great deal of asymmetric warfare in the world, and for Israel it comes in the form of intifadas, rocket attacks and guerrilla combat against Hezbollah in Lebanon. The post-1967 borders do not do much about these forms of warfare. Indeed, it can be argued that some of this conflict happens because of the post-1967 borders.


A shift to the 1949 borders would not increase the risk of an intifada but would make it moot. It would not eliminate conflict with Hezbollah. A shift to the 1949 line would eliminate some threats but not others. From the standpoint of asymmetric warfare, a shift in borders could increase the threat from Palestinian rockets to the Israeli heartland. If a Palestinian state were created, there would be the very real possibility of Palestinian rocket fire unless there was a significant shift in Hamas’ view of Israel or Fatah increased its power in the West Bank and was in a position to defeat Hamas and other rejectionist movements. This would be the heart of the Palestinian threat if there were a return to the borders established after the initial war.


The shape of Israel’s borders doesn’t really have an effect on the threat posed by CBRN weapons. While some chemical artillery rockets could be fired from closer borders, the geography leaves Israel inherently vulnerable to this threat, regardless of where the precise boundary is drawn, and they can already be fired from Lebanon or Gaza. The main threat discussed, a CBRN warhead fitted to an Iranian medium-range ballistic missile launched from a thousand miles away, has little to do with precisely where a line in the Levant is drawn.


When we look at conventional warfare, I would argue that the main issue Israel has is not its borders but its dependence on outside powers for its national security. Any country that creates a national security policy based on the willingness of another country to come to its assistance has a fundamental flaw that will, at some point, be mortal. The precise borders should be those that a) can be defended and b) do not create barriers to aid when that aid is most needed. In 1973, U.S. President Richard Nixon withheld resupply for some days, pressing Israel to the edge. U.S. interests were not those of Israel’s. This is the mortal danger to Israel — a national security requirement that outstrips its ability to underwrite it.


Israel’s borders will not protect it against Iranian missiles, and rockets from Gaza are painful but do not threaten Israel’s existence. In case the artillery rocket threat expands beyond this point, Israel must retain the ability to reoccupy and re-engage, but given the threat of asymmetric war, perpetual occupation would seem to place Israel at a perpetual disadvantage. Clearly, the rocket threat from Hamas represents the best argument for strategic depth.
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The best argument for returning to the pre-1967 borders is that Israel was more capable of fighting well on these borders. The war of independence, the 1956 war and the 1967 war all went far better than any of the wars that came after. Most important, if Israel is incapable of generating a national defense industry that can provide all the necessary munitions and equipment without having to depend on its allies, then it has no choice but to consider what its allies want. With the pre-1967 borders there is a greater chance of maintaining critical alliances. More to the point, the pre-1967 borders require a smaller industrial base because they do not require troops for occupation and they improve Israel’s ability to conduct conventional operations in a time of crisis.


There is a strong case to be made for not returning to the 1949 lines, but it is difficult to make that case from a military point of view. Strategic depth is merely one element of a rational strategy. Given that Israel’s military security depends on its relations with third parties, the shape of its borders and diplomatic reality are, as always, at the heart of Israeli military strategy.


In warfare, the greatest enemy of victory is wishful thinking. The assumption that Israel will always have an outside power prepared to rush munitions to the battlefield or help create costly defense systems like Iron Dome is simply wishful thinking. There is no reason to believe this will always be the case. Therefore, since this is the heart of Israeli strategy, the strategy rests on wishful thinking. The question of borders must be viewed in the context of synchronizing Israeli national security policy with Israeli national means.


There is an argument prevalent among Israelis and their supporters that the Arabs will never make a lasting peace with Israel. From this flows the assumption that the safest course is to continue to hold all territory. My argument assumes the worst case, which is not only that the Palestinians will not agree to a genuine peace but also that the United States cannot be counted on indefinitely. All military planning must begin with the worst case.


However, I draw a different conclusion from these facts than the Israelis do. If the worst-case scenario is the basis for planning, then Israel must reduce its risk and restructure its geography along the more favorable lines that existed between 1949 and 1967, when Israel was unambiguously victorious in its wars, rather than the borders and policies after 1967, when Israel has been less successful. The idea that the largest possible territory provides the greatest possible security is not supportable in military history. As Frederick the Great once said, he who defends everything defends nothing.