Nominal Net Worth
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May 12, 2001

"They use trickery and deceit because they are weak…"

…a quote I pinched from the movie: Attila the Hun, where Attila assesses the crafty Roman Army. But it was not until I looked over at my dog that I realized that human or animal, it has always been about territory. And U.S. Dollar policy makers, headed by Alan Green-spin and Paul O-kneel, are peeing all over the world today - Ed Bugos.

Never underestimate the power of the word, I read (irony) once somewhere, and yet, that is all that the Treasury has got going for them today.

What if we viewed the world this way?
Have you ever wondered why it is that banks have not had to compete with the free market for your deposits? If they really wanted your capital, they would raise their deposit rates to attract it, wouldn't they? But instead of paying us for capital, in this strange world we pay them to store it for us - after deducting all of the fees and inflation that they charge for other "valuable" services that is. A term deposit pays a little more than a savings account, but you have to surrender some withdrawal privileges - and even then, it is still not enough to lure considerable capital away from the Treasury market.

At any rate, the main reason that banks don't need to compete is that they have learned how to extort the Fed into providing them with boundless deposits to invest in higher yielding markets - traditionally mortgage, treasury, and municipal debt. As the lines of distinction between banking, brokerage and investment banking blurred, their investment portfolios have necessarily grown to include exposure to riskier assets, such as technology and telecom paper. Soon it will also include Real Estate, if the Fed has its way with deliberations now in progress. If there is an investment fact that is still not appreciated enough today, it is that as the risk of the asset increases so does the probability that the Fed will have to come to the rescue at some point, even if to rescue the counterparty(s) that the risk has been shifted to. That is the nature of the extortion: banks know that Mr. Greenspan will write the check, so they will do the deed.

Since we live in a remarkable epoch where stock and bond markets earn double-digit returns, and perceptible inflation rates are expected to be enduringly low, consumers and baby boomers alike have become more aware of the broader array of savings options available to them outside of the banks over the years. Interestingly, the banks have responded by virtually taking over the capital markets. You can't get away from them. They've bought many of the brokerages where you might store your T-bills so that they have access to your capital without having to raise deposit rates to attract it. And although they cannot use your segregated securities as collateral for their investment ambitions, at least not directly, they could and do easily use the cumulative non-segregated cash balance for collateral.

Alternatively, they could also enter into all manner of swaps and other alchemies, which may effect a reclassification of a broader array of assets as being of money quality. We're thinking specifically of what Wall Street hazily calls the money market today, where bankers and financial companies do their dirty laundry. Most of the short end of the yield curve in this market qualifies as M3 now. In other words, they have the ability to manufacture their own capital - independent of the Fed.

Yet another way to access capital, though a little more expensively, is to issue equity or debt through the same markets, preferably to their own customers who might also fortuitously store the newly acquired paper at a brokerage, which the bank owns. And whereas it makes little economic sense to use leverage to invest in a deposit, it might be profitable to use leverage for investment in a bank stock issue or bond - provided there is liquidity.

It makes big money sense particularly when the buyer is a large institution such as Fannie Mae that does not need to have any meaningful reserves on hand in order to guarantee the bulk of the nation's mortgages. So long as it engages in the daily activity of buying them from the bankers, the bankers will return the favor and buy their debt and equity, which they can classify as money now because the size of the contingent liability has become too big for the Fed to allow failure. Is this not true? Sure it is. It's the American dream - no money down upside down capitalism! With the creation of Fannie Mae and Freddie Mac, the banking system had created another way to manufacture money. Now, by allowing it to grow so large, it has also effectively put a gun to the Fed's head.

What is the liability, or threat, exactly? I think that in a monetary system like this its mere existence will create demands on the borrower for either cash or performance. Since performance in the money business is all about more money, the demand will be on the Fed to support those obligations with the liquidity that the creditors demand. In other words, to keep the credit cycle going forward rather than reverse, because in reverse, the darn things aren't redeemable - there is no liquidity. Interestingly, as I reread this paragraph I could not help but think about how German peoples must have interacted with the pressure of their nation's indebtedness after WWI and just before the 1923 explosion in inflation.

Now suppose that the Greenspan Fed, already moving on this pressure, wins control over the mortgage markets. What better way to provide creditors with liquidity then to acquire a mandate to print it on demand, or in other words, to provide the mortgage markets with an everlasting bid? How are they going to acquire that mandate? With the claim that the growing government budget surplus will make US Treasury securities obsolete. Of course, the hope is probably that it will never come down to anything more than a contingent promise to offset a contingent liability, but in spirit, they will acquire control over the mortgage markets, and they will provide enough liquidity to convince us that they stand by their promise. Ok, so we're speculating a little, but I'll be darned if it is not gonna' happen this way, more or less. And guess who will bail them out? Perhaps the Bank for International Settlements will, whose board is now occupied by Greenspan. But if not, it will be you and I, as always, count on it.

Nevertheless, while everyone keeps borrowing, nothing beats the privilege that a tier I US bank attains by having all the liquidity available to it that it wants for a cost, which is substantially less than the prevailing market rate, courtesy of the Fed, without which, deposit rates would surely have to soar to support the bank's increasingly ambitious investment needs.

The difference between what the bank would have to pay you for your capital and what it pays the Fed now is the difference between the natural interest rate and the fixed government rate. This discretionary, thus theoretical, difference is the main source of economic distortion today, primarily because there is absolutely no discipline to prevent it from self-correcting. Alas, while policy makers have thoughtfully constructed self-correcting mechanisms all around them, they have forgotten to provide such a mechanism to correct the human proclivity for greed and optimism, particularly with regard to the conduct of monetary policy.

Thus, if the world really worked this way, which I know it doesn't because I just reviewed my old Keynesian authored economics textbook from college just to double check my theory, then the capital, which banks refer to as reserves becomes worth much, much less, if the credit happy merry-go-round that we call an economy suddenly stops. For the paper is only redeemable if the credit reshuffling business remains a "going concern." Yet increasingly, that is the very question. Is the credit cycle too mature to grow?

Of course, if we were writing for a newspaper we could probably end the article right there because I think we all know the answer. But we aren't, so let's see what else we can say about it: it is too mature to grow at this point without obliterating the purchasing power of the dollar unit.

This Month in The Goldenbar Report:

  • What contingent liabilities has the strong dollar wrought on the US / global economy?
  • Does the Federal Reserve have an interest in Real Estate? If so, how far do they plan to take it?
  • Is the trade deficit a hot potato, or a cruch?
  • A brief focus on the consumer and the difference between nominal and real net worth.
  • Bond prices break down and gold prices/XAU begin to break up!!

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Over and out.
Edmond J. Bugos

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