Lessons from the Fed’s Mistake of 1932

July 29, 2012 1:42 pm

by Gavyn Davies




Ben Bernanke is a noted expert on the Fed’s monetary history, especially in the 1930s. When the FOMC meets on Tuesday, he may spare a moment to remember that this week sees the 80th birthday of a fateful Fed decision in 1932, a decision which some scholars believe led inexorably to the bank failures of early 1933, and the suspension of US membership of the Gold Standard. That decision was to end the only period of aggressive quantitative easing which was attempted by the Fed during the worst period of the Great Depression between 1929 and 1933.





The conditions the Fed faced in July 1932 do not represent a close parallel with the conditions they face this week. Far from it. Yet some of the arguments are uncannily similar, and the episode tells us what might have happened after 2008 if the Fed had adopted the same approach as it did in 1932. The lessons for the ECB this week may be more pertinent.




.
The 1932 episode, which is not as well known as the Fed’s notoriously mistaken tightening in 1937, came to my attention via this excellent piece by Bruce Bartlett, who has held many senior advisory roles in the Republican Party. Economic conditions in early 1932 were of course as dire as they had been at any time in US history. Real GDP and industrial production had not stabilised, and were on their way to declines from the 1929 peak of 27 per cent and 52 per cent respectively:
.

.



.
.
.
These declines in real GDP compare with a rise of 1.7 per cent in US GDP since the 2008 peak. Furthermore, in 1932, deflation was raging at an annual rate of -10 per cent per annum, thus increasing the real burden of outstanding debt at an alarming pace:
.

..


.

.
.
There had been two serious periods of bank failure before February 1932, which would eventually reduce the money supply (M1) by 33 per cent from its 1929 peak. In their classic history of American monetary policy, Milton Friedman and Anna Schwartz argue that most or all of this economic carnage could have been avoided if the Fed had taken steps to prevent the decline in the money supply after 1929. These steps would have involved more aggressive open market purchases of government bonds, crediting banks and others with enough liquidity to meet their rising demand for cash.




Instead, the scramble for liquidity caused runs on bank deposits and firesales of banks’ assets, which led inexorably to bank failures. By not accommodating the rise in liquidity preference, the Fed forced a huge contraction on the banking sector. Anyone who has not recently read the extraordinary Friedman/Schwartz narrative should do so, because it paints a picture of what might have happened after 2008 without the action which the Bernanke Fed has taken.




The Friedman/Schwartz conclusion is that monetary policy from 1929-33 was “inept”, and was based on faulty economic reasoning by the Fed. In particular, I interpret them as saying that the Fed should have adopted larger open market operationsquantitative easing in today’s language – to expand the monetary base more rapidly than actually occurred:
.
.



.
.


.
There was one exception to this blanket criticism of the Fed’s actions in the early 1930s, which was the period from February to July 1932, when the central bank embarked on large scale open market operations to ease monetary policy. Under pressure from a frightening collapse in the banking sector, and from the Goldsborough bill in the House of Representatives (which would have required the Fed to restore the price level to that seen in 1926 but which later failed in the Senate), Governor George L. Harrison of the New York Fed cajoled the Open Market Policy Committee to purchase $1 billion of government bonds in the summer of 1932, an amount equivalent to 15 per cent of the monetary base.




Harrison knew exactly what he was doing. His explicit intention was to arrest the decline in bank credit by increasing the excess reserves held by the commercial banks at the Fed. The public also knew what was happening. The New York Times said:




“By entering upon a policy of controlled credit expansion, designed to turn the deflation in bank credit and to stimulate a rise in prices, the Federal Reserve System has undertaken the boldest of all central bank efforts to combat the depression.”


Furthermore, according to Friedman/Schwartz, the open market purchases worked. Interest rates, which were previously under stress, tumbled. Activity data and price deflation showed signs of bottoming. Yet, 80 years ago this week, the Fed lost its nerve and stopped the open market purchase programme. Why?





This is still a matter of some dispute among economic historians. Barry Eichengreen, in his definitive bookGolden Fetters” argues that membership of the Gold Standard precluded a prolonged period of aggressive open market purchases, because this would have caused problems with the dollar’s gold parity. Yet, according to this 2006 paper by Chang-Tai Hsieh and Christina D. Romer, there is no evidence that the Fed took this into account in the critical months of 1932. Nor were there any strains on the dollar.





Instead, the Fed changed its mind because old orthodoxies about monetary policy rapidly re-asserted themselves in policy makers’ minds as soon as the worst was over.





At the time, the Fed believed that monetary policy was axiomatically to be regarded as “easy if commercial banks held any excess reserves at all at the central bank; the scale of these excess reserves did not matter. In fact, it was thought that adding additional excess reserves was pointless, since in a recession the banks would not lend these reserves to firms and individuals.





Furthermore, it was argued that open market operations would distort the market in government debt, creating artificially low interest rates for short term government securities.




Finally, it was believed that bond purchases would undermine the strength of the balance sheets of key District Reserve Banks, including the New York and Chicago Feds. Even Harrison believed that the Fed’sammunition” was limited, and (bizarrely) that it was best used when the economy was expanding, not contracting. In consequence, the open market operations were halted, and the Depression continued into 1933.






Many of these arguments will be heard, in more modern form, in the FOMC meeting this week. In 1932, they proved wrong, because they missed the point that a massive rise in the private sector’s precautionary demand for liquidity needed to be accommodated via an increase in the central bank balance sheet. That is a point which the ECB, in particular, should reflect upon this week.


July 29, 2012 8:08 pm

Europe’s political union is an idea worthy of satire

.




Forming such a union implies nothing less than the end of the nation state. A European government would have to be created with powers of taxation and public spending, a corresponding European parliament and so on. There are powerful arguments whyEurope” – whatever this means and how many countries might be included – should have this ambition. However, to base the argument for integration primarily on saving monetary union is anything but convincing. And it is more than strange when foreign politicians and experts are pressing eurozone states to give up national sovereignty, out of fear that a collapse of monetary union might have severe consequences for their economies. Juvenal would have said: Difficile est satiram non scribere (It is difficult not to write a satire).




But, independent of any answer to these questions, political union is impossible to achieve within a few years. It cannot be a means of crisis management. And here comes the dangerous part: any proposals, for example, to extend the amount and scope of financial support mechanisms premised on further integration in the future.




Promising later action against requests for more money now does not look like a credible strategyquite the opposite. This approach would severely undermine the idea of establishing political union.


.
Take eurozone bonds, which would lead to higher interest rates for government bonds in countries of (so far) good reputation in financial markets. The implicit transfer of taxpayers’ money would be a violation of the fundamental democratic principle of no taxation without representation.


.
This is true for all forms of debt mutualisation. This is hardly the proper way to create a democratic European Union.





Or take the idea of banking union. There can hardly be any doubt that a monetary union should be accompanied by integrated financial markets. The concept of a banking union is based on European competences for bank supervision, for a resolution scheme and for deposit insurance.



.
However, the latter two elements imply a need for a fiscal backing and therefore cannot be separated from fiscal and eventually political union. A clean-up of banking systems would have to precede the introduction of a European resolution fund and deposit insurance. Otherwise funds collected so far in national schemes would be socialised. This would not only undermine efforts by weak – to put it mildlybanks to break with the past, but would create an uproar in countries in which depositors would be effectively expropriated. This is hardly a way to foster identification with Europe.




In 2009, the EU’sde Larosière reportrecommended that the European Central Bank become the home of macroprudential supervision (overall financial stability) but warned against giving it the power of microprudential supervision (individual banks’ health). Besides administrative problems, we (I was a member of the group) saw potential conflicts with the ECB’s fundamental task of monetary policy, namely price stability. “This could result in political pressure and interference, thereby jeopardising the ECB’s independence,” we wrote.



.
Developments since the publication of the report have strengthened those concerns. Take the longer-term refinancing operations, which in effect worked as a rescue mechanism for weak banks. In such a context how credible would the ECB be as banking supervisor?





Political union is not the solution. All measures that implicitly pre-empt the establishment of political union are inconsistent and dangerous.




They imply huge financial risks for a few member countries and could not only undermine honest efforts in the direction of political union, but also destroy the fundament on which such a process finally rests, namely the identification of the people with the European idea.





Is the collapse of the eurozone therefore unavoidable? This is a risk that can no longer be denied but there is a viable alternative.




The eurozone is based on treaties and commitments that were unfortunately broken time and again with the consequence of a deep loss of credibility. Can confidence be restored? A monetary union of sovereign states cannot function without the principle of no bailout, which means that every country is responsible for its policies. Financial assistance must be based on strict conditionality and be given at interest rates that do not undermine the will to reform. As such, monetary union could survive without political union.




After so many disheartening experiences, is it not naive to expect that credibility for such a regime can be restored? Probably yes. But if trust in treaties and commitments cannot be restored, how credible are all the much more ambitious plans in the direction of political and banking union? It would be the peak of naivety to put the future of not only the eurozone, but also of Europe, on such shaky ground.





.
The writer is a former member of the executive board of the European Central Bank



.
Copyright The Financial Times Limited 2012.

.
Gambling in the House?

By John Mauldin


Jul 28, 2012




Rick: How can you close me up? On what grounds?


Captain Renault: I'm shocked, shocked to find that gambling is going on in here!


– From the classic scene in Casablanca, made in 1942







The latest scandal du jour seems to be about what is now called LIBORgate. But is it a scandal or is it really just business as usual? And if we don’t know which it is, what does that say about how we organize the financial world, in which $300-800 trillion, give or take, is based on LIBOR? This is actually just the second verse of the old song about derivatives, which is a much larger market. Which of course is a problem that was not solved by Dodd-Frank and that has the potential to once again create true havoc with the markets, whereas LIBOR can only cost a few billion here and there. (Sarcasm intended.)



.
The problem is the lack of transparency. Why would banks want to reveal how much profit they are making? The last thing they want is transparency. This week I offer a different take on LIBOR, one which may annoy a few readers, but which I hope provokes some thinking about how we should organize our financial world.





There Is Gambling in the House? I Am Shocked...





Let’s quickly look at what LIBOR is. The initials stand for London InterBank Offered Rate. It is the rate that is based on what 16 banks based in London (some are US banks) tell Thomson Reuters they expect to pay for overnight loans (and other longer loans). Thomson Reuters throws out the highest four numbers and the lowest four numbers and then gives us an average of the rest. Then that averaged number becomes about 150 otherrates,” from overnight to one year and in different currencies. The key is that the number is not what the banks actually paid for loans, it’s what they expect to pay. Also, please note that the British Banking Association, on its official website, calls this a pricefixing.”




Most of the time the number is probably pretty close to real, or close enough for government work. But then, there are other times when it is at best a guess and at worst manipulated.



.
Back in the banking and credit crisis panic of 2008 the interbank market dried up. No bank was loaning other banks any money at any price. Thus there was clearly no way for the LIBOR number to be anything but fictitious. Anyone who was not aware of this was simply not paying attention.



The regulators certainly knew on both sides of the Atlantic. All along there were clear records, we now learn, that bankers were telling the FSA (the Financial Services Authority) that they had problems. Regulators were worried about what was happening but were pointing out that there was a large hole in the ship that was already admitting water, and they didn’t want to make it any bigger. Timothy Geithner, then President of the New York Federal Reserve Bank (and now Secretary of the Treasury) wrote a rather pointed letter to the FSA, suggesting the need for better practices.


.
Some banks reported lower rates, to make it appear they were better off than they were (since no one was actually lending to them), and others might have given higher rates, for other reasons. Remember, this was a British Banking Association number. Whether you personally won or lost money on the probably wrong price information depends on whether you were lending or borrowing and whether you really wanted the entire market to appear worse than it already was.


.
This was the equivalent of an open-book test where you got to grade your own paper. And we are supposed to be shocked that there might have been a few badexpectationshere and there by bankers acting in their own self-interest, with the knowledge of the regulators? The more amazing proposition would be that in a time of crisis the number had any close bearing on reality to begin with. Call me skeptical, but I fail to see how we should be surprised.



The larger question that really needs to be asked is how in the name of all that is holy did we get to a place where we base hundreds of trillions of dollars of transactions worldwide on a number whose provenance is not clearly transparent. Yes, I get that the methodology of the creation of the number after the banks call in their “expectations” is clear, but the process of getting to that number was evidently not well understood and looks to be even muddier than my rather cynical previous understanding of it.





It now seems that there will be a feeding frenzy as politicians and regulators hammer the various banks for improper practices. And they are pretty easy targets: there is just no way you can explain this that does not sound bad.



.
You’re a big banker. The world is falling down before your eyes. No one trusts anyone. If you put out a bad number (whateverbadmeans in a time of sheer utter blind panic) the markets will kill you even more than they already are and you could lose your job. You have got to come up with a number in ten minutes.




“Hey, Nigel, what do you think we should tell Tommie [Thomson Reuters]?”


“I don’t know, Winthorpe, maybe Mortimer has an idea; let’s ask him.”





Simply fining a few bankers is not going to fix the larger problem: the lack of transparency for arguably the most important number in financial markets. A very clear methodology needs to be developed, along with guidelines for what to do in times of crisis when the interbank market is frozen and there really is no number. Having no number might be worse than having a number that is a guess. But having a number that can be fudged by banks for their benefit is also clearly not in the public’s interest.



.
The point of the rule of law is that it is supposed to level the playing field. But the rule of law means having a very transparent process with very clear rules and guidelines and penalties for breaking the rules.





I had dinner with Dr. Woody Brock this evening in Rockport. We were discussing this issue and he mentioned that he had done a study based on analysis by an institution that looks at all sorts of “fuzzydata, like how easy it is to start a business in a country, corporate taxes and business structures, levels of free trade and free markets, and the legal system. It turned out that the trait that was most positively correlated with GDP growth was strength of the rule of law. It is also one of the major factors that Niall Ferguson cites in his book Civilization as a reason for the ascendency of the West in the last 500 years, and a factor that helps explain why China is rising again as it emerges from chaos.



.
One of the very real problems we face is the growing feeling that the system is rigged against regular people in favor of “the bankers” or the 1%. And if we are honest with ourselves, we have to admit there is reason for that feeling. Things like LIBOR are structured with a very real potential for manipulation. When the facts come out, there is just one more reason not to trust the system. And if there is no trust, there is no system.




Opacity and Credit Default Swaps





Which brings me to my next point. We just went through a crisis where derivatives were a major part of the problem, and specifically the counterparty risk of over-the counter (OTC) derivatives.





Taxpayers had to back-stop derivatives sold by banks (and specifically AIG) that were clearly undercapitalized. That cost tens of billions. Yet the commissions and bonuses paid for selling those bad derivatives went on being paid. Congress held hearings and expressed outrage, but in the end Dodd-Frank sold out.





Efforts to create an exchange-traded futures contract tied to credit-default swaps haven't yet gained traction after 18 months of talks, but banks dealing in the private multitrillion-dollar market for credit derivatives believe such contracts will eventually appear for a simple reason: They should attract new players.





Credit-default swaps function like insurance for bonds and loans. Investors use them to hedge or speculate against changes in a borrower's creditworthiness. If a borrower defaults, sellers of the protection compensate buyers.





“The swapstraded over the phone or on-screen, with prices known only to trading partners – are the domain of asset managers and hedge funds with the sophistication and financial wherewithal to take on complex risks.




Futures, by contrast, are more routine instruments used by institutions and individual or "retail" investors. Futures prices are displayed publicly on exchanges, and customers can trade them directly with other customers unlike in the swaps market, where a dealer is on one side of every trade.




.
Dealers have long been fiercely protective of keeping the status quo in credit-default swaps or ‘CDS’ because they have booked fat profits from customers not being able to see where other customers are trading.” (Market Watch)



.
And that is the issue. Bankers do not want transparency, because it will seriously cut into their profits. And while I like everyone to make a profit, the implicit partner in every trade is the taxpayer and, last time I looked, we do not get a piece of that trade. Derivatives traded on an exchange were not part of the problem during the last credit crisis; OTC derivatives were.


.
An exchange makes it very clear where the counterparty risk is and what the price mechanism is. It creates a transparent rule of law and places the risk on the backs of those buying and selling derivatives and not on the taxpayer. Exchange-traded derivatives do not pose a potential threat to the economies of the world, while we don’t know the extent of the threat posed by OTC trades. JPMorgan has lost around $6 billion on the trading of their “London Whale.” If Jamie Dimon and the JPM board couldn’t guarantee reasonable corporate governance, then why should we assume that in another crisis we won’t find another AIG?


.

Dodd-Frank needs to be repealed and replaced. The last time, the process was too clearly in the hands of those being regulated and has contributed to their profits. Enough already.


.
Credit default swaps and any other derivative large enough to put the system at risk must be moved to an exchange, to make clear the counterparty risks.






No Access for Spain





Let me close the letter by noting that Spain has clearly lost access to the bond market, absent intervention by the rest of Europe and more specifically the ECB. Spanish 10-year rates jumped over 7.5%. Then Super Mario Draghi said that the ECB would do whatever it takes to defend the euro, and the market rebounded. Why this was news is not clear, but sometimes the market just needs some hand holding.


.
Now the ECB is going to be forced to follow through or face a rather violent market correction downward. It will be interesting to see how long the markets will exhibit patience without a clear program from the ECB, while Germany would of course prefer that nothing is done until after its Constitutional Court ruling on September 2.



We are getting closer to the moment when European leaders will be forced to act. Spain is going to need a bailout and not just of its banks. Germany and the other northern-tier nations have not yet agreed on a path.




We will delve further into Europe over the next few weeks. The situation is getting increasingly problematic. There is no plan, and the eurozone lurches from crisis to crisis. One country after another is falling into recession and then depression. Austerity without default (or monetization, default’s cousin) produces misery. I think France is likely to be downgraded within a few months, putting Germany, the Netherlands, and Finland in a very difficult position. Will they put their own balance sheets and ratings at risk? Because that is what will be needed if the eurozone is to hang together. Stay tuned.




Your “feeling good, Louisanalyst,



John Mauldin


.
Copyright 2012 John Mauldin. All Rights Reserved.


Pension Schemes are The Latest Gigantic Rip-Off
.
July 27, 2012
.
By Shah Gilani, Capital Waves Strategist, Money Morning Money Morning









You made me promises, promises,
Knowing I'd believe.
Promises, promises
You knew you'd never keep.


.

Those lyrics are ripped from the early '80s band Naked Eyes' hit song "Promises, Promises."


I use the word ripped, not because it's a term used in the music business, but because of its more common meaning, as in ripped-off.



Because that's what we've been - ripped off.







This time, which has been going on for a long time, I'm talking about how grossly underfunded both private and public pension funds are, and how we'll all suffer the consequences.


.
I'm going to strip out the mumbo jumbo so you see the truth with your own naked eyes.



.
Retirement is getting further and further away for most Americans. And if they get there, they may not be reasonably compensated by the pension plans they thought they were paying into along with their co-payers, their private and public employers.


.
That's because a lot of those co-payers aren't paying up.

.
And that's only part of the problem...

.
Here's the other, even more insidious, naked truth.

The investment return assumptions inherent in pension plans' calculations are so unrealistically high that the chances of funds ever meeting future obligations, or "promises," is halfway between slim and none.









Don't worry, I'll come back to the co-payers not paying up. But first let's talk about assumptions (as in, making asses out of you and me).

.

Pension Plans are Based on Unrealistic Projections





The average assumption in the great majority of pension plans is that their assets will appreciate at 8% per year. Now, with compounding, that's a really great deal.



.

Too bad the actual hand we've been dealt, courtesy of a no-interest rate (actually its closer to zero)
Federal Reserve policy, for years now (and rammed-down low rates for years prior, thank you Big Alan Greenspan, with his goofy Ayn Rand hat now sitting in a corner facing backwards somewhere; or at least he should be), makes fixed income returns impossibly low. Low to the point that the "bond" portion of plan asset portfolios are causing the hole they are all slipping into to get bigger and bigger.



.

As a result of low return investments on the fixed income (make that failed income) side of portfolios, plan managers have nowhere to go but further and further out on the risk spectrum (read equity markets, private equity, and hedge funds).
.
And, given how swimmingly equities have performed over the past 10 years (my goodness, they've been essentially flat, how stunning; are we turning Japanese? I really think so), maybe some plans made out like bandits (that's a joke) by wisely cherry-picking stocks. Or, on the other hand, maybe a lot of them loaded up on equities right around 2007.

.
Oh, the humanity!







.
The point is obvious. Return assumptions of 8% annually are facing the reality of 4% to 5% at best - and that's on a good day.



.
Between that underfunding (it's coming, I promise) and absurd investment return assumptions, S&P estimates private pensions are about $354.7 billion short on the front end of obligations. They're another $233.4 billion short if you add in OPEB stuff (Other Post Employment Benefits, promises of stuff like life insurance and medical benefits).



.
But those numbers are a day at the beach compared to public shortfalls in their thousands of state and local plans and "systems."

 .
That number is somewhere between $1 and $4.6 (wait for it...) TRILLION.

.

And Then There's Those Pesky Contributions




.
So why aren't private and public employers putting in their share of contributions? Well, it's about the money, stupid.

.
Some of them, like the many corporations sitting on more that a trillion dollars in cash, don't want to put that money into the promise pools, because they promise that they'll find better uses for it (like bigger bonuses and salaries and benefits for executives) to make their companies more, well, profitable. You see, then they can pony up on those pesky promises. That's capitalism under the cronyism system.

.
As far as public pension funds, well, you know what's going on there. There's no money, honey.


.
How can underfunded public plans get additional contributions when there's no money at state and local levels to contribute? (Well, not exactly additional, but the ones they were supposed to have put in already, but forgot, or actually took out; yeah, funds were taken out to pay for other spending items; it's just criminal.)



.
Okay, exhale, because there´s been a brilliant resolution to that riddle.


.
.

Leave it to our experienced legislators, you know, Congress, those amazing magic wand wipers, to come up with an elegant and transparent solution.

.
It's Highway Bill S. 1813. That's right. Who would have guessed the answer could be found in a highway funding bill? Simply brilliant.

.
It works like this: Under Section 40312 (you can Google any of this, I'm not making this up), "pension smoothing" is allowed. Pension smoothing lets plan administrators and puppeteers spread out pension asset shortfalls over multiple years so that pension plans don't have to face the piper now and make employer contributions they don't have, or would rather keep as dry powder for the next Great Recession.

.
.

If you call that kicking the can down the road, hey, you're just another cynic. Because what this does is actually raise about $9.5 billion in taxes over 10 years by setting aside contributions from being contributed (and written off) so they can be taxed.



-

If you're not getting it, let me help you here. It's a Highway Bill because the $9.5 billion will go to the Highway Fund so the punters in Congress don't have to raise the federal gas tax to pay for highway building and improvements. So that pension plans get deeper and deeper into doodoo.



.
It's about keeping taxes low, don't you know? It's an election year, don't you know?



.
Seriously, here's what I think: The fabric of the dream of retirement is unsustainable, because the "safety quilt" is already threadbare.


.
In the meantime, by the way, this pension fund mess isn't the only "pyramid scheme" running in our economy. My colleagues just released a new investigation. If you haven't seen it yet, I urge you to take a look today. Just click here.