Stealth Tax and the Money Tree

[This is a previously unpublished essay written by Sarel Oberholster in November 2004 but the subject matter of Basle accords and capital coefficients were considered not digestible fare for the readers of finance and investment essays. Perhaps this essay deserved to be published as it deals with the very reality that we are facing today. The content of this essay is even more relevant now in October 2008.]

Fractional Banking, the Money Multiplier and money creation by banks are economic concepts that need updating. Failing to do so will expose you to almost limitless taxation by stealth. Nothing is safe, not your income, or your wealth; even your pension is there for the taking.

Fractional banking is a derivative of the money multiplier theory, which works like this. A bank receives a deposit, which can then be recycled and multiplied throughout the banking sector subject to the “fraction” that a bank will or are obliged to retain as a “reserve” against withdrawals. Say the reserve is $10 out of $100, then the 1st deposit-receiving bank can lend out $90, the money recycles in the economy and ends up as a $90 deposit with the next bank who in turn will “reserve” $9 and lend out $81, ad infinitum until the fractions simply gets to small to matter. Not a complicated theory at all, only starting at the wrong place. The very 1st $100 is the only “money” the rest is simply an assumption about credit distribution. The multiplication may or may not happen. Of more importance is that the existence of “reserving” will act as a natural brake on the extent of credit distribution in any economy. This is the first area where updating is required.

The advent of a standardised worldwide approach towards bank supervision as new monetary policy embodied in the Basel Accords (Basel I – the 1988 Capital Accord and Basel II - 2001) have effectively superseded “reserving” as part of monetary policy. You can read up and find these accords at the BANK FOR INTERNATIONAL SETTLEMENTS, Basel Committee on Banking Supervision by following this link http://www.bis.org/bcbs/ . Implementation guidelines for the Basel II accord can be found at this link http://www.bis.org/publ/bcbs109.pdf .

These accords changed the focus of credit creation by banks as managed by central banks. All forms of credit and banking risks are graded (“risk weightings”) and banks are required to hold a prescribed percentage of capital against each class of risk. These are called capital co-efficients and banks must then comply with “Capital Adequacy Ratios”. It follows that capital adequacy ratios have taken over from fractional reserving as the limiting variable in credit creation by banks. The size of the reserving “fraction” has become so small such as to all but eliminate it as a brake on credit creation.

The new overarching credit creating policy variables are the Capital Adequacy Ratio from Central Bank Supervision over banks and Liquidity Accommodation to banks. First let’s look at Capital Adequacy.

The Capital Adequacy Ratio for banks under Basel II is generally targeted at 12% by 2005. This simply means that a bank’s capital must equal 12% of the sum of its risk exposures. A simplified example would be that a bank’s Capital Requirement would be $12 if it has advances of $100. It gets a bit more complicated with different “tiers” of capital and the fact that the $12 may also be lent out, but the fundamental principle of the example holds true irrespective. Risk weightings make up the sum of the risk exposures.

The risk weighting for standardised credit risks is 100% (the vast majority of all Bank lending other than residential mortgage lending, lending to government and public sector entities, and lending to other banks). This only means that the full 100% of the $12 shown in the above example will apply.

Special rules of “risk mitigation” apply to certain classes of loans made by banks. Residential mortgage advances of high quality can get risk weighted as low as at 35%. Again a simple process. $100 of these mortgages will get only 35% of the normal $12 Capital Requirement i.e. $4.20, which translates to almost 3 times as much Residential mortgage lending at the original $12 capital. Lending to governments can be as low a risk weighting as zero but normally would not exceed 10% as a risk weighting. That means banks can lend to government 10 times more than to anybody else, as a worst case scenario, but at a zero rating, banks can lend to government an unlimited amount. Hang on to this principle for it is part of a simple circular process to create unlimited government funding via the banking sector, for the Fed will supply the banks with all the “money” they need to advance to borrowers to complete the circle.

Armed with understanding the basics of Capital Adequacy, Risk Weightings and risk mitigation, facilitates understanding of the processes in place to distribute unlimited credit, or better known as unlimited debt. Banks are very capable in managing their capital needs to satisfy the capital adequacy requirements.

Banks do not actually create money. They distribute credit. Their ability to distribute credit used to be a function of the amount of deposits that they could attract. That was the next problem that stood in the way of limitless credit. This problem was solved through central bank “accommodation”, even before the advent of Basel I.

Banks are credit shops; they buy and sell credit. Banks operate on the basic principle of selling all qualifying credit on any given day and then try to balance the books at the end of the day. This they do by attracting deposits. They sell the excess, when deposits exceed their sales of credit, in the inter-bank market. Those banks experiencing a shortfall after exhausting all sources of deposits will access the inter-bank market for deposits. Obtaining a deposit from the central bank makes up a shortfall after exhausting the inter-bank market.

The process involved in obtaining such a deposit is normally described in complex technical language, but it remains just a deposit by the central bank at the bank with a shortfall. It is a structural given in the modern economy, that there will always be a daily shortage of available deposits. The shortage is made up by the central bank in terms of its liquidity policies towards the banks. The central banks would also penalise banks when they make use of this accommodation. Such penalties, hawkish or dovish, would be a function of prevailing monetary policy and will be expressed as an interest rate. Here, however, is the link in the chain; banks would normally need government securities as collateral to obtain accommodation, so banks will tend to hold fair volumes of government debt as “liquidity reserves”.

Think about it. Banks have no idea of exactly how much credit they will grant on any given day or what the level of withdrawals will be. So, a bank will not say, “lets see what deposits amount to for the day?” and then grant loans until the deposits have been used up. Any luckless, would be borrowers, would then have to wait until the next day to know if the bank managed to obtain enough deposits to grant them a loan. It just does not work that way. Banks sell credit first and then balance the books thereafter; there is no other way!

The economic and logical trap that creates the mirage of banks as money alchemists can be found in misinterpreting bank credit and fiat money as the same thing. They’re not. Every bank must balance its books every day. Credit sold must equal the sum of deposits taken, capital and central bank accommodation. It is no more complicated than that from a global perspective. The only money creation in this exercise is the accommodation by the Central Bank.

Here’s a sample from the Bank of Japan accommodation policy, where an “unlimited accommodation” policy has been in place for a long time. Available on the Home Page of the BOJ, by following this link, http://www.boj.or.jp/en/seisaku/04/pb/k041029_f.htm [this link has since been deactivated].

“[Monetary Policy Meetings]

October 29, 2004
Bank of Japan
(For immediate release)
________________________________________
At the Monetary Policy Meeting held today, the Bank of Japan decided, by unanimous vote, to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 30 to 35 trillion yen.
Should there be a risk of financial market instability, such as a surge in liquidity demand, the Bank will provide more liquidity irrespective of the above target.”

The Central Bank is the only entity that can show a deposit to a bank on one side of its balance sheet and a “money” liability on the other side of its balance sheet. It is of no relevance for money creation how many debits or credits are created in the books of all the banks in the world on any given day. That is simply the turnover of banks. The end of day “accommodation” where central banks balance the books of banks is where the money creation happens. The existence of providers of credit beyond banks, such as Mortgage Lenders Freddie Mac and Fannie Mae, Corporate Finance entities such as used by GM and other “in-house banks” and large scale direct investments in securities from junk bonds to high quality mortgage securitisations have made the measurement of “money supply” in M2 and M3 susceptible to gross understatement of the actual “money creation” taking place. Credit derivatives, collateralised debt obligations and other exotic financial instruments, actively used by banks and other financial entities will not even appear on the radar. In the end it is better to follow trends in debt rather than the traditional money supply variables.

Large-scale stimulation of the economy through budget deficits (fiscal stimulation) and quantitative easing (monetary stimulation) would be expected to show up on the balance sheets of commercial banks as an increase in holdings of Government Securities. More so if overnight interest rates for banks are much lower than yields on Government Securities and the Fed promises lower rates for longer (the “carry trade”). It is therefore interesting to observe how holdings of U.S. Government Securities at all Commercial Banks [1] increased since the 1st quarter of 2001 with the recorded growth rate at 5.52% in Feb 2004 the highest growth rate in this series from its inception in Jan 1947. Observing this increase against the advent of the downturn in equities and subsequent recovery is most illuminating. The down trends in both Commercial Bank holdings of Government Securities and the DJIA may just be a very ominous signal. Note also a similar down tendency early in the first bear phase of the DJIA.





The explosive growth in purchases by banks of Government Securities is consistent with similar increases in the budget deficit, the trade deficit, mortgage debt, in fact almost all types of debt, all of which manifested in an equally stimulated aggregate demand, creating an illusion of a healthy growing economy.

The money tree belongs to the Central Banks and only them. They guard this power jealously. Banks cannot create money; they can only function as the conduit for the Central Bank’s credit stimulation policies, which in turn is derived from monetary policy as expressed by government. Ultimately all other financial intermediaries’ actions will be captured in the central bank accommodation provided to the banks. Knowing also that central banks can actually provide unlimited accommodation and banks just need to ensure capital adequacy, leads to understanding how an economy can be stimulated with unrelenting quantitative easing at any level of interest rates. Add to this the arrival of all new forms of electronic banking and internet banking, facilitating the distribution of credit in almost real time and you will get an idea of how efficient and dangerous debt stimulation has become. Finally add the fact that the Basel accords are being implemented right now all over the world, duplicating the quantitative easing/liquidity accommodation circle like an internet virus in every nook and canny of the world and then decide for yourself how concerned you should be.

Stealth tax is the name of every turn of the circle between quantitative easing and liquidity accommodation, stealth tax on your assets, stealth tax on your future income and even stealth tax on your children’s income and their children’s income. The “debt ceiling” of $7.4 trillion must be raised urgently, a couple more turns of the circle and US Congress will be asked to raise it again, and again, and again …

Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
8 November 2004
E-mail – ccpt@iafrica.com

[1] Series USGSEC. Source: Board of Governors of the Federal Reserve System.

Economic Accounting

I often write about monetary policy because its abuse is behind the current woes of the world economy. It may create an impression that I recognise no fiscal implication so it is perhaps overdue to take a look at some economic accounting. We’ll keep it simple.

How does the “bailout with money from thin air” work?

In five simple steps:
1. Central Government raises a debt in the form of a government security (a bond, Treasury bill, etc.)
2. The Central Bank (FED) buys the security from the Central Government.
3. The Central Bank (FED) pays for the Central Government security with money that it does not have.
4. The Central Bank raises a monetary debt as a liability against the economy. (To be repaid with interest from taxes to be collected by Government.)
5. Central government uses the cash for “bailout” purposes.


Here is the accounting:

A) Central Government: - Credit bank account (Asset), debit loans (Liability).
B) Central Bank: - Credit Government Securities (Asset), debit money stock (Liability).


Here is a graphic representation:





The graphic representation shows the interaction between monetary policy and fiscal policy. The newly created “cash” is menacingly not neutral for the economy. It most certainly is not a reshuffling of resources or a redistribution of existing resources. It is an outright new FISCAL DEBT in the hands of Central Government to be repaid by taxpayers or future generations of taxpayers. It is a monetary dilution of economic value (pure monetary inflation) in the hands of the Monetary Authorities until it has been repaid from taxpayers’ money and then neutralised form monetarised debt. Meantime the Monetary Authorities can swap the new Government Securities for toxic banking assets.

The summarised logic behind the bailout is that the Stock Exchange losses of the Great Depression of 1929 resulted in a loss of money supply and to prevent the depression the Monetary Authorities have to “create cash out of thin air” to replace the loss of money from the system. The problem with this theory is that it ignores the pre-existence of a Babelian Tower of Debt built on reckless debt expansion supported by loose monetary policy. The pre-existence and collapse of the Babelian Tower of Debt is the true problem not the fact that the collapse of the Babelian Tower had left a gaping bad debt hole behind. How can the solution be to fill the hole with Government debt to be repaid by taxpayers, most of whom are already overextended in debt? The world had mercy on geese being force fed to produce enlarged livers, perhaps some mercy for debt force fed taxpayers would also be in order.

The solution to the debt problem cannot be found in adding Fiscal irresponsibility to Monetary irresponsibility. Nor is it wise to doom future generations to debt enslavement or endemic inflation in an irrational effort to sustain a collapsing Babelian Tower of Debt.

The expectation that “some inflation” will be good and will prevent a downturn is a fallacy. The very foundation for a depression is built upon the bailout activities. It spreads an ill in the financial sector, via irresponsible Government borrowing aimed at replacing a market proven unsustainable private debt load, to the healthy sectors of the economy. The banking bailout method even surpasses the debt enslavement of Keynesian infrastructure spending. At least the Keynesian method buys infrastructure with the debt and leaves future generations with the inherent infrastructural capital. The banking bailouts only buys bad debts, bad securities, loss making entities, exit strategies for stock exchange speculators, exit strategies for reckless executives and many more similarly dubious assets. What kind of a legacy does this leave behind for future generations who must repay the debt?

The markets must be allowed to clear and rebalance. Intervention should be restricted to policies that will allow the process of clearing and rebalancing to proceed in an orderly manner. Authorities should not reach for oppressive regulation to sustain the Babelian Tower of Debt nor should they be tempted to discount the labour of our children and grandchildren to save the reckless of yesterday.

Beware the danger should the “bailout cash from thin air” escape from the financial economy into the “real” economy. Why would it not, as there are no actual barriers between the “financial” economy and the “real” economy? The competing new money created from thin air will usurp the production surplus of the economy and drive us into depression. (1.)

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
October 2008



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Please feel free to comment on this blog but let's be polite.


ooooOOOoooo



1. From “bailout” to Depression.


I have previously explained the process whereby the production surplus is removed through monetary excess from the economy in my essay “Praxeology of Commodity Pricing” published at this link http://sareloberholster.blogspot.com/2008_08_01_archive.html .


I reproduce an extract hereunder explaining the process whereby competitive new money skims the production surplus from the economy. Use the “bailout cash” as an input of competitive new money in Exhibit 3 to see how such an escape into the “real” economy could result in a depression where the participants to the “real” economy literally starve.



© Sarel Oberholster

Here is a simple static construct of a ten unit economy with ten units of money available to buy the oil. Thus one unit of money will buy one barrel of oil (price formation). The next step is to introduce motion into the static construct.

Farmer buys the ten barrels of oil, adds his labour and produces 20 units of grain. Farmer use 10 units of grain to feed himself and his family and sells 10 units of grain to Oil producer for 10 units money. Oil producer feeds himself and his family and uses his labour to produce another 10 barrels of Oil. This is now a perpetual and stable economic construct.


© Sarel Oberholster

Next we introduce a State as another economic participant. We do not give State the power to tax but we grant the power to create money. State uses this power and openly creates ten more units of money. State enters the economy with the new money and competes with the old money for the available ten barrels of oil.

The entry of State as an economic participant with new money has very significant consequences for the stable economic construct. First look at what happens to the static construct of Exhibit 1. We add the new money and observe the effect. We also make the assumption that State consumes the Oil for its own purposes (for example to make war or consuming it as a source of energy). The result is shown in Exhibit 3 [and Exhibit 4].


© Sarel Oberholster

The equilibrium in the economy has been disturbed. The presence of twenty units of money competing for the same ten barrels of oil has the effect of changing the price of oil from 1 unit of money to two units of money (100% inflation). State now receives 5 barrels of Oil for its 10 units of money while Farmer receives the other 5 units of Oil.

Who has won and who has lost? State has gained 5 barrels of Oil and walks away an outright winner. Oil producer still received all the money in the economy so perhaps Oil producer is no worse off, but we shall see. Farmer has clearly lost 5 barrels of Oil as Farmer held all the money when half the purchasing power of the total money in the economy was transferred to State through its action of creating 10 units of money. It is only when we assess the impact of State's money creation behaviour on the dynamic but stable economic construct that we see the extent of damage done to this very simple economy. State has managed to acquire the total production surplus in the economic construct through its money creation action.

The construct must remain constant but for the behaviour of State and the consequences thereof. State has created money and vested half the economic product on itself. The new money had competed on an equal footing with the existing money in the economy and has reduced the purchasing power of Farmer by half. Farmer can now only purchase half the production inputs (5 barrels of Oil) needed for his farming production. Farmer can only produce half the grain on half the production inputs. However, Farmer uses this half of his farm product to feed himself and his family and no longer has a surplus product (sellable grain) to sell to Oil producer. Pity Oil producer, holding all the money in the economy yet cannot buy any food. Oil producer will starve. Yet Farmer earns no money to purchase any Oil (production inputs) from Oil producer for the next production cycle and will therefore starve when the next production cycle arrives. See Exhibit 4 hereunder.


© Sarel Oberholster

Two Rules

The sport of kings they call it. Horseracing. Perhaps not so well known is the two rules that form the foundation for this industry.

o Thou shall not race with any horse other than a stud horse; and
o Thou shall not bred stud racing horses with artificial insemination.

Consider the consequences of these two rules. Nobody but the owners of stud horses may race their horses, means that the supply of eligible horses is monopolised within a small group. Thus the price of a thoroughbred racing horse would be vastly more that the price a “farm” horse which may in fact be faster that the racing horse. Clearly the speed of the “racing horse” is not the first priority as one would have expected in a sport which race horses. Note how these two rules are Siamese twins. The one is useless without the other.

Limiting the supply of stud animals by banning artificial insemination further enforces the monopoly. Normal scientific livestock management would require that the quality of the herd be maximised and the gene pool be managed. Artificial insemination plays a pivotal role in managing the quality of the herd. Again the rule against artificial insemination has an objective which is diametrically opposed to breeding the fastest race horse.

It is clear that these rules are designed to sustain an artificial market and an artificial industry. Fundamental to the two rules are price control and as with all price control rules, quantity control. The consequences are limited in its impact as few are the economically active participants in this industry relative to the total world economy.

Much more menacing are the two rules for money.

o The government shall decide the interest rate, the price of money; and
o The government shall decide the supply of money.

Would you dare to consider the consequences of these two rules? The normal practice in all markets is to discover the price of anything through the process of negotiation between willing buyers and willing sellers. Note the plural. This is a collective process, more collective, inclusive and honest than any collectivism proposed by interventionists. How is it that a few persons around a table can decide what the rate of interest should be? Totally ignoring the process of price discovery. As with the racing industry, ignoring the fundamental purpose of interest rates. Why is it at all a surprise that a credit bubble is fermented and a credit collapse is achieved. What happened to the principle that the interest rate is a reflection of the credit risk? All gone in total artificiality. I need to repeat this; all interest rates derived from a government decided “Target Rate” is fake.

The next rule is even scarier. The sole right to print money. How easy it has become for politicians to propose a “plan”, any plan, which requires money without having to discuss where the “money” would come from. When government has an emergency, real or perceived, and it has no money to pay for it, this is the answer. Create the money. This is an option only available to government. It is not without consequences but I have often written about those. Underlying everything is the total disconnect with reality inherent to these two rules. Again they are Siamese twins. The one without the other is ineffective as the economic consequences are direct and decisive when only one is deployed.

Together these two rules can build a massive artificial economy. The economic particle accelerator stuffed with abuse of these two rules produce a credit explosion. The credit explosion touches every part of the economy and spread the artificiality like a plague through the whole system. The uncontained structural distortion achieves the unthinkable result of systemic failure.

The only solution to preventing a perpetual cycle of systemic failures is the removal from the power of government of at least one of these two rules. Accelerating the abuse of these two rules will not fix the systemic failure. It will only make it worse.

Sarel Oberholster
BCom (Cum Laude), CAIB(SA).
October 2008

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster

Introducing the FED Carry Trade

“The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured--that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.” - Chairman Ben S. Bernanke At the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming
August 22, 2008. Reducing Systemic Risk.


Intervention into markets always has consequences. The interventionist has specific objectives and plans the intervention to achieve those objectives. The narrowly defined objectives are actually achieved more often than not but as “the market” is a collection of infinite variables and infinite interactions between those variables, it is a given that most consequences will never be known in advance. The interventionist will attempt to anticipate consequences and will mitigate in the planning against undesirable consequences. No matter how much care is taken, intervention always produces unintended consequences. Liquidity intervention suffers from the same unintended consequences as all interventions must. However, do not fall into the trap of believing unintended consequences were necessarily unknown or unexpected. Interventions are powerful counter forces inside a market already crowded with forces and counter forces. Picture exploding a bomb inside a SSHS code 5 tropical cyclone to alter some of the forces already unleashed. The monetary powers of the FED are similar when bombing market forces.

Let’s not hesitate to also describe the credit crisis as the spawn of previous monetary interventions. The credit bubble was anticipated and identified by many informed writers including this author. Systemic banking failure happened recently in Japan and was a known outcome of easy monetary policy. As such it should have featured as a known consequence of this monetary intervention in both the quantity and price of money. Most unintended consequences are known potential outcomes but dismissed as improbable.

We need to distinguish between unintended consequences which came as no surprise and unintended consequences which were truly not foreseen as a possibility. Can one really make the assumption that the FED and all the monetary policy hacks could not have contemplated a credit crisis outcome as a result of the applied monetary policies? I have read commentators claiming the credit crisis was a market failure. Which masters are they trying to please when clearly the Fed dictates the price of money (interest rates) and its supply (liquidity)? This policy failure can never by any stretch of imagination be called a market failure. Any analysis of the behaviour of the FOMC will show that it engages in price fixing based on an objective (intended consequence) as opposed to the market’s price discovery process derived from the behaviour of all market participants. They do not propose to guess at what the economic version of the price of money should be. They simply fix the price for a targeted outcome. The price fixing activity disregards market supply and demand for money as the FED has monopoly power on creating money and control money supply at the margin where it matters most. The FOMC even names the target FED rate as the “Intended Rate”. Price fixing is a particularly blunt policy approach and by application, disregards the known negative consequences of such blunt policy tools.

The following is a short summary of the interventions by the Fed since the collapse of the credit bubble.

Step 1: Reduce interest rates as fast and as low as possible. The FED reduced the FED rate by 3.25% from 18 September 2007 to 30 April 2008, over a period of only 5 months, in 7 increments ranging from 0.25% to 0.75% to the current 2%pa. That is an interest rate more than 3% below the inflation rate. It is important to place the reductions into perspective. There has been only one 0.75% interest rate adjustment in the 17 year period from June 1990 until September 2007; an increase of 0.75% on 15 November 1994. Two increments of 0.75% reductions in the FED target rate took place in the 5 month period of the latest down cycle; on 22 January 2008 and again on 18 March 2008.



Source: FOMC - Intended federal funds rate (Target Rate)

Step 2: Provide liquidity in conventional and unconventional ways in unlimited quantity (no FED internal constraint or limit) to conventional and unconventional participants against collateral where the quality terms and conditions of collateral accepted are expanded and the terms of collateralisation are eased to maximise liquidity distribution. The actual policy tools can be studied on the website of the FED as provided hereunder by those interested. The headings also provide us with a descriptive list of the policy tools which is reproduced hereunder with links to each.


The “Tools” can be found at http://www.federalreserve.gov/monetarypolicy/default.htm

Policy Tools
Open Market Operations
The Discount Rate
Reserve Requirements
Term Auction Facility
Primary Dealer Credit Facility
Term Securities Lending Facility

Lesser reported tweaks were driven by a very real desire to maximise the liquidity distribution impact. It includes measures such as reducing the System Open Market Account ("SOMA") securities lending program minimum fee by half and accepting securities maturing in more than 6 days from more than 13 days (that neatly brought 7 day securities into the discount window). How does these measures impact banks and can early unintended consequences be identified?

The basic operational premise of banks is often misunderstood. Lending out money (credit) is the product that banks sell. Turnover or Total Sales, as with any business, is very important to banks. Turnover growth is an important growth variable.

Where does a bank get “product” to sell? Money placed with a bank on deposit is the undifferentiated answer. One step deeper is a differentiation on four levels. Retail deposits, wholesale deposits, interbank liquidity and FED liquidity. Retail deposits are usually a stable source of liquidity but not readily available in quantity. Wholesale deposits are available in quantity but can be more unstable and movements have more liquidity risk effects. Large single deposits can be fatal. Banks have each other on radar in the interbank market all the time and any increased funding requirements by an individual bank is cause for suspicion. Suspicion very quickly turns into a loss of interbank limits. Bank defaults inevitably follow this sequence:

1. Loss of interbank funding.
2. Loss of wholesale funding.
3. Loss of retail deposits. A classic “run” on the bank is an extreme development in banking and supposed to be an extremely rare occurrence.

It becomes vitally important, for understanding FED activity, to know the process of “product” distribution. Banks use the absolute levels of existing deposits and their maturities only as a guideline for new loans. Capital constraints would dictate absolute size of asset portfolios. Liquidity provision is a dispensation entirely attributable to the “lender of last resort” function inherent to all central banks. There is a timing disconnect between granting a loan and when such a loan is drawn down. Consider for example your credit card. You will normally use your credit inside a “limit” as and when you wish to access your credit. The bank has no knowledge in advance of such a drawdown or even repayments. The bank would only know that you have the ability to use a certain quantity of credit at any time over the next 12 to 24 months. Generally a bank would advance all requests for money and attempt to manage liquidity in such a way as to always be able to meet any drawdowns. The fact is that a bank will never balance its books without a balancing mechanism. The balancing mechanism is located in the interbank market and access to FED liquidity.

The bottom line is that a bank would on any given day be short (lacks sufficient deposits to cover drawdowns) or long (have taken in more deposits than is required to provide product). The extent to which a bank is short or long will directly impact profitability. The marginal funding required to cover a shortfall is inevitably a little more expensive than retail or wholesale deposits. Still, banks prefer to be marginally short provided that they can cover the shortfall with relative inexpensive interbank money or with the FED at an interest cost lower than the interest rate to be earned on the loan. This is the crux of the matter.

The presence of cheap FED money allows banks to push credit with inherent protection against the risk of being unable to fund a shortfall. The cheaper the FED money and the more ready the availability, the more credit will be pushed. The consequence is a credit bubble.

The opposite is expensive money at the FED. We all know that the outcome of providing expensive liquidity to banks is rising interest rates. The FED has to supply commensurate liquidity when the FOMC fix the price of money low.





The second round (September 2007 to April 2008) in doing more of the same introduces some complications. The first round of approaching the zero bound was from January 2001 (6.5%) to June 2003 (1%). The advent of the busting credit bubble normally grinds the interbank market to a halt. A dysfunctional interbank market drives banks to balance their books with the FED rather than amongst themselves. The credit tap is forced wide open when the FED lowers quality standards for collateral to access FED liquidity. One very undesirable consequence originates from the principle that access is indiscriminate with regards to purpose. Therefore banks can use the liquidity for any purpose, for instance to fund losses, while unsecured creditors (read retail deposits and wholesale deposits not covered by deposit insurance) are compromised with a FED holding all potential collateral. Contemplate the quality of assets that unsecured depositors must collect to achieve repayment in case of a bank’s failure and understand why wholesale money runs fast. The lower the liquidity access standards fall, the more other creditors will be compromised when banks are allowed to carry losses via the FED.

The income search alternative is that banks will look for new asset classes (other than already deflating credit bubbles) within which to deploy the cheap liquidity and turn a profit. The greater the margin, the more encouraged banks will be to take up cheap funding and distribute it. Selling credit is a bank’s reason for existence. The best outcome is distribution against credit which will be in a form acceptable as collateral to the FED with perceived acceptable credit risk. Say welcome to emerging market debt.

Investing in emerging market debt is not without problems but easy options exist. Emerging countries will often obtain funding by selling US$ denominated securities. These have lower currency risk and interest rate risk but margins are not nearly as attractive as those issued in their own domain and currency. These are more challenging investments where the most obvious risks are exchange rate movements and interest rate mismatches. These risks would be considered manageable and capable of managed hedging by any fair sized multinational bank. Even smaller banks would not be without skills in managing these risks and may take on the challenge. The temptation is huge when margins as high as 8-10% can be achieved.

A prime target in the current economic environment would be resource based economies. Sovereign risk is the defined credit risk for “other countries”. The same principles that encouraged and perpetuated credit deployment in mortgage bonds are driving credit into emerging debt. Well known historical rules of deploying credit to emerging countries are ignored. One of the most reliable and time tested measures is limiting debt deployment to countries with significant trade deficits. The economic ratio is expressed as the size of the Current Account of the balance of payments expressed as a percentage of the GDP of that country. This is in theory much the same as the loan to income (LTI) ratio applied to mortgage debt. Bankers ignored the safe levels of LTI and even accepted unreliable “proof” of income to overcome prudent credit deployment based on safe LTI ratios. We now see the same development taking place on Sovereign risk with regards to the Current Account deficit to GDP ratio. Observe how far the “safe” deficit limit of 3% of GDP is exceeded by the following countries. Access to “international” funding is the only way in which such excesses can be financed.



Source: International Monetary Fund (IMF) *IMF estimates.

It is clear that the tried and tested ratio of 3% of GDP is not applied in the above cases. The temptation is also very clear. Accept the Sovereign risk of for instance South Africa and earn the interest rate differential on assets priced around a 12% Central Bank benchmark rate. Ignore the danger signals of a 7.3% CA deficit to GDP ratio. Turkey at 16.75% Central Bank benchmark rate and “only” a 5.7% CA deficit to GDP ratio must be an attractive target. Pushing current account deficits into danger territory can only be blamed on the availability of easy credit. Japan and the USA share a need to encourage their banks in need of income margin to finance such Current Account deficits. This encouragement may be an unintended consequence but surely cannot be an unexpected consequence. However, where will today’s troubled banks with access to cheap credit turn to for “yield pick-up”, if not to emerging markets?

The Current Account surplus developing countries are not necessarily “safe” or excluded form this process. They are, for now, producing the income to provide for repayment of debt channelled into their economies. How long will it take before the access to cheap and easy credit is tied up in malinvestment? How long will reliance on a high commodity prices allow the Current Account surpluses to be maintained? Take a look at the graphic depiction of the US$ carry trade and note the bubble blowing cycle inherent to this development.


The US$ Carry Trade Cycle




The four steps in the cycle will be self reinforcing. It is no wonder that the level of international reserves have been sky rocketing. The new zero bound unlimited liquidity monetary policy has added the USA as a significant player in the carry trade where previously only Japan engaged in the this banking rescue by stealth activity. It did not work particularly well for Japan. The final verdict is still out on Sovereign risk as Sovereign defaults and debt standstills are long forgotten concepts. Where will the financiers of carry trade stand when the 3% of GDP deficit rule re-asserts itself? Who and by what means will a new round of Sovereign defaults and debt standstills be mitigated? Already the first warning bells are ringing in Eastern Europe.




Cheap and easy money as a policy tool to repair the ravishes of a previous monetary policy of cheap and easy money will not heal the income streams of banks, nor will it heal the capital destroyed by bad debts. A repetition of such a policy will blow new credit bubbles in expected but ignored and unexpected places and repeat another cycle of bad debt explosions. The credit crisis outcome of easy monetary policy is known and probable and therefore should never be granted the status of an unintended consequence. A mature credit bubble already exists in emerging market debt. The Fed may bail out Freddie and Fannie but who will bail out emerging markets? Nobody.




Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
September 2008




References:

1. Reducing Systemic Risk. Chairman Ben S. Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming. August 22, 2008.
2. Economic Projections and Rules of Thumb for Monetary Policy. Athanasios Orphanides and Volker Wieland. Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 307-24.
3. Open Market Operations in the 1990s. Cheryl L. Edwards, of the Board’s Division of MonetaryAffairs, prepared this article. Gerard Sinzdak provided research assistance. Federal Reserve Bulletin November 1997, pp. 859-74.
4. Alternative Instruments for Open Market and Discount Window Operations. Federal Reserve System - Federal Reserve System Study Group on Alternative Instruments for System Operations. Board of Governors of the Federal Reserve System, Washington, D.C., December 2002.


Comments are welcome. E-mail me at ccpt@iafrica.com or comment on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster 2008.

Praxeology of Commodity Repricing.

Zimbabweans must be wondering what comes after trillions since the recent introduction of a 100 billion Zimbabwean Dollar bill. I have been wrestling with the concept of rising prices particularly in commodities and factors of production while simultaneously having the economy in the grips of a Japan-like economic crash combined with stagnation, banking systemic failure and destruction the of the wealth and savings of the middle class. Could it be that prices of factors of production continue to rise when other parts of the economy are in a downward spiral?

Just looking back upon the last six years shows us that asset classes experienced extreme levels of inflation in contrast with official inflation levels remaining very benign. Clearly these economic dichotomies can coexist at the same time. It becomes somewhat more complicated to fixate on one harmful development when its economic counter force is also in play. Can inflation and deflation manifest at the same time? Can commodity prices, such as the oil price, continue to rise when consumption slumps? What impact has the money creation monopoly power of State and is its effect only inflationary?

I will use the technique of constructs to isolate the creation of money activity and to gain understanding of complex economic principles. Ludwig von Mises gives an excellent explanation of praxeology, which can be found by following this link to a recently published article by the Mises institute; The Scope and Method of Catallactics.


© Sarel Oberholster

Here is a simple static construct of a ten unit economy with ten units of money available to buy the oil. Thus one unit of money will buy one barrel of oil (price formation). The next step is to introduce motion into the static construct.

Farmer buys the ten barrels of oil, adds his labour and produces 20 units of grain. Farmer use 10 units of grain to feed himself and his family and sells 10 units of grain to Oil producer for 10 units money. Oil producer feeds himself and his family and uses his labour to produce another 10 barrels of Oil. This is now a perpetual and stable economic construct.


© Sarel Oberholster

Next we introduce a State as another economic participant. We do not give State the power to tax but we grant the power to create money. State uses this power and openly creates ten more units of money. State enters the economy with the new money and competes with the old money for the available ten barrels of oil.

The entry of State as an economic participant with new money has very significant consequences for the stable economic construct. First look at what happens to the static construct of Exhibit 1. We add the new money and observe the effect. We also make the assumption that State consumes the Oil for its own purposes (for example to make war or consuming it as a source of energy). The result is shown in Exhibit 3.


© Sarel Oberholster

The equilibrium in the economy has been disturbed. The presence of twenty units of money competing for the same ten barrels of oil has the effect of changing the price of oil from 1 unit of money to two units of money (100% inflation). State now receives 5 barrels of Oil for its 10 units of money while Farmer receives the other 5 units of Oil.

Who has won and who has lost? State has gained 5 barrels of Oil and walks away an outright winner. Oil producer still received all the money in the economy so perhaps Oil producer is no worse off, but we shall see. Farmer has clearly lost 5 barrels of Oil as Farmer held all the money when half the purchasing power of the total money in the economy was transferred to State through its action of creating 10 units of money. It is only when we assess the impact of State's money creation behaviour on the dynamic but stable economic construct that we see the extent of damage done to this very simple economy. State has managed to acquire the total production surplus in the economic construct through its money creation action.

The construct must remain constant but for the behaviour of State and the consequences thereof. State has created money and vested half the economic product on itself. The new money had competed on an equal footing with the existing money in the economy and has reduced the purchasing power of Farmer by half. Farmer can now only purchase half the production inputs (5 barrels of Oil) needed for his farming production. Farmer can only produce half the grain on half the production inputs. However, Farmer uses this half of his farm product to feed himself and his family and no longer has a surplus product (sellable grain) to sell to Oil producer. Pity Oil producer, holding all the money in the economy yet cannot buy any food. Oil producer will starve. Yet Farmer earns no money to purchase any Oil (production inputs) from Oil producer for the next production cycle and will therefore starve when the next production cycle arrives. See Exhibit 4 hereunder.


© Sarel Oberholster

I can hear the critics saying this is an artificial construct, an over simplification. It may be expressed in simple, easy to understand terms but it is irrefutably the outcome of an isolation of the money creation activity of State. Its purpose is deliberate in its isolation of the activity of State without allowing that activity to hide behind a myriad of other variables ever present in a fully functional economy. It is also intolerable to have a stable in-equilibrium economy but it is in the form of this extract that one can focus on the consequences of State's money creation behaviour. The construct can be expanded to add productivity improvements or any other concept which can alter the economic outcome of the construct. For instance Oil producer may realise that Farmer must have 10 barrels of Oil and increase his labour to produce 15 barrels of Oil, yet the price mechanism will still be out of balance until Oil producer has increased production to 20 barrels of oil. At 15 barrels of Oil State will compete equally for 7.5 barrels of Oil. Only at 20 barrels of Oil will the Oil crisis be over. One can add innovation, capital improvements, State exchanging Oil for grain or any of the variables that vest with the ingenuity of humans to improve their economic circumstances, especially in the face of something as devastating as starvation. A magnitude of potential interventions to fix the imbalances opens up a magnitude of consequences. The fact remains that the impact of State's money creation on the production surplus in the economy can ultimately only be remedied through economic behaviour of Oil producer and Farmer.

Money creation via credit expansion, low interest rates and almost unlimited liquidity provision to banks have unleashed an explosion in competing new money in all economies of the world. The competing new money jumped like a wild fire from one asset class to another as it circled the globe. As expected, it had to reach the units of production of which Oil became a focal point. Oil, a strategic production input, faced supply constraints and could not adjust easily to the demand created by the new money. The result was that Oil in particular had to adjust mainly through price increases to the presence of competing new money. The outcome is similar to Exhibit 3 where the competing new money and the old money had to share the existing production, thus the price continued to increase and will continue to increase until new money stops competing for existing production or production is expanded to accommodate the new money or a combination of the two options. The prices of scarce resources will continue to adjust upwards for as long as new money competes for its acquisition. It is altogether possible for competing new money to overwhelm the effects of falling demand arising from high prices. The impact of State's money creation was also not restricted only to inflating prices.

The effect of rising prices stands apart from the hardships introduced to the economic participants other than State. The prices will rise but the rise may be mitigated through the actions and sacrifices of consumers and producers. Farmer and Oil producer had to share the burden of replacing the production surplus required to restore balance in the economy. Similarly will consumers and producers other than State have to shoulder the burden of restoring that portion of the production surplus lost to the creation of competing new money. That burden translates into bad debts, over extended consumers and weak purchasing power parallel with rising prices in the factors of production (for instance scarce commodities) which, in the case of substantial volumes of competing new money, will wreck the banks in systemic paralyses and destroy corporate profits until the rebalancing process has been completed. Any attempts by State to intervene in a monetary manner to further increase competing new money in the economy will perpetuate the adjustment process. Bail-outs, nationalising banks, easy liquidity access against questionable collateral to all and sundry and re-capitalisation of GSE's (Government Supported Entities) would all qualify as monetary interventions injecting competing new money into the economy.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time." USA FOMC statement" 25 June 2008.

Translates into low interest rates and lots of new money should help growth.

"At the Monetary Policy Meeting held today, the Bank of Japan decided, by a unanimous vote to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will encourage the uncollateralized overnight call rate to remain at around 0.5 percent." 2008 Jul 15, Bank of Japan - Statement on Monetary Policy

Translates into we will provide as much new money as needed to keep our ultra low interest rate at 0.5%.

"To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1).

"Without prejudice to the objective of price stability", the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These include a "high level of employment" and "sustainable and non-inflationary growth". Objective of monetary policy, European Central Bank website http://www.ecb.int/ , Monetary Policy. 28 July 2008.

Translates into we say one thing and do another (See also "Notes" at the end of this essay).

"There had been a positive reaction to the co-ordinated announcement of central bank actions on 11 March, designed to relieve liquidity pressures in money markets. But the funding crisis at Bear Stearns in mid-March, leading to a Federal Reserve supported buy-out of the firm by JPMorgan, had temporarily heightened concerns about counterparty credit risk further. The functioning of money markets remained heavily impaired, with interbank lending still concentrated at very short maturities. Term spreads had risen again and market prices suggested that they were expected to remain higher than normal throughout 2008 and beyond - longer than expected at the start of the year." 23 April 2008, MINUTES OF MONETARY POLICY COMMITTEE MEETING 9 AND 10 APRIL 2008, Bank of England.

" ... co-ordinated announcements of central bank actions ... designed to relieve liquidity pressures in money markets" sure sounds like more competing new money entering the economy. This is Central Banks working together to maximise the new money effect. Do not chase after speculators, greedy hoarders, naked short sellers or stingy producers for they have not the power to alter the reality of competing new money. Watch for new money and follow its progress into repricing commodities upwards to the dismay of interventionists. Only in the absence of competing new money will the rebalancing process complete. If not, start counting towards the still unfamiliar Quadrillion even as asset deflation bites.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
August 2008


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Notes:
1. Latest on Zimbabwe money is that the Central bank has knocked off 10 digits from the currency converting a 10 billion Zimbabwe dollar into 1 Zimbabwe dollar. I suppose they no longer need to worry about quadrillions in the short term.)

2. "Stocks jumped as the European Central Bank, the U.S. Federal Reserve and the Swiss National Bank announced an enhancement of their dollar liquidity-providing operations to ease credit strains that have weighed on the global economy. The central bank actions were intended to ease persistent global financial instability as institutions write down losses from exposure to risky U.S. mortgages." FTSE up as central banks act to boost liquidity - Reuters, July 30 2008.

© Sarel Oberholster - 2008