Bernanke of Warren-Vitter & Last Resorts

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By Biiwii

Ref. Warren-Vitter and the lender of last resort

I have always liked Ben Bernanke, in that I think he is a soft-spoken, nice guy who took the hand off from Alan Greenspan in stride, heroically making chicken soup out of the chicken excrement he was left with. He kept his dignity and calm demeanor during the days when inflationist gold bugs codified the term “Helicopter Ben” and turned it into just another accepted way of saying “Ben Bernanke”.

Mr. Bernanke met the impossible challenges left him by the Greenspan Fed and the Bush White House, and being a scholar of the Great Depression and an intellectual Keynesian, did what he was always meant to do. He employed tried and true Central Bank policy-making against a natural bust (i.e. reaction to Greenspan’s policy-induced 2003-2007 inflationary boom) of the system.

Only this time, under the guidance of Bernanke’s really big brain, the Fed went into uncharted waters with several new twists (pun intended) to the linear policy-making of Greenspan. Operation Twist, with its brilliant objective to simply “sanitize” inflation by selling short-term Treasury bonds and buying long-term Treasury bonds was a brilliant and/or evil stroke of genius.

It was brilliant to those who believe that within a paper-based system, anything is possible. After all, any would-be balance sheet reconciliations can simply be categorized as separate line items or stored in special accounts. Anything is possible when it is just paper and digital keystrokes neatly placing debt somewhere out of sight and out of mind.

It was evil to those Luddites who cannot think past the honesty of the statement ‘1+1 must always equal 2, eventually’.

So I always liked Ben just as I like President Obama. I like nice people. I want to have a beer with them *. But these are the financial markets and they are ever more subject to booms and busts. We are on a boom currently, and it is a boom in the ‘right’ assets. Janet Yellen took a hand off in positive momentum from Ben Bernanke (unlike what Greenspan perpetrated upon Bernanke). But her time will come because Ben also handed off a hell of a lot of distortions (the dark side of the genius) within the system, if you happen to be in the Luddite’s camp.

*I never got the thing where people used to say George Bush was a guy you’d want to have a beer with. No thanks. Compared to Al Gore, maybe, but I digress…

Some clips from Bernanke’s blog above, with some responses…

Earlier this week Senators Elizabeth Warren (D-Massachusetts) and David Vitter (R-Louisiana) introduced a bill they call the “Bailout Prevention Act of 2015.” If enacted, the bill would further restrict the Federal Reserve’s emergency lending powers in a financial crisis. That would be a mistake, one that would imprudently limit the Fed’s ability to protect the economy in a financial panic.

That is the whole point, isn’t it? Printing emergency funds and lending them into the financial system does not create real economic activity. It stimulates certain areas and allow entities high up on the food chain to disproportionately benefit while by definition creating a greater debit across the entire economy. There is some demand stimulation, but it comes ‘out of nowhere’ and is thus, unsustainable. Rich get richer, poor get poorer anyone?

During the 2007-2009 crisis, the Fed used its emergency lending authorities in two quite different ways. First, it made loans to help prevent the collapse of two systemically critical firms, Bear Stearns and AIG. The Fed took these actions, with the support of the Treasury, because it feared that the disorderly failure of a large, complex, and highly interconnected firm would greatly worsen the financial panic and damage the economy—a judgment confirmed by the aftermath of the bankruptcy of Lehman Brothers in September 2008.

And why were these firms at risk to begin with? Over dosing on Fed policy, that’s why. “Large, complex and interconnected” is another way of saying leveraged; systemically leveraged. So you are saying that you were trying to prevent the failure of a system hard-wired to fail eventually. Okay, job well done… for now.

Second, the Fed created a variety of broad-based lending programs, to unfreeze dysfunctional markets and to help stem devastating runs that left whole sectors of the financial system without adequate funding. In providing this funding via short-term, fully collateralized loans, the Fed was fulfilling the traditional central bank role of serving as lender of last resort. This lending, all of which was repaid with interest, was essential for stabilizing the financial system and restoring the flow of credit.

Dysfunctional markets are actually fully functional. A market does not just decide to be dysfunctional on its own. The function of the market is to correct itself naturally by liquidating malinvestment of all kinds in preparation for a future growth cycle. Fully collateralized? With what? It seems that offending institutions were bailed out first with tax payer dollars and then with the Fed’s balance sheet. In continuing to hold bonds, and enormous debt, the credit bubble has been offloaded to official entities as opposed to the Greenspan credit bubble, which instigated commercial credit excesses.

The Fed intervened in the cases of Bear and AIG with great reluctance, doing so only because no legal mechanism existed to safely wind down a systemic firm on the brink of failure. A key element of the Dodd-Frank financial reform bill, passed in 2010, was to provide just such a mechanism—the so-called orderly liquidation authority, which gives the Federal Deposit Insurance Corporation and the Fed the necessary powers to put a failing firm into receivership without creating financial chaos.

Orderly liquidation? The problem is that these firms needed to liquidate in the first place. I hate to sound too unwashed, but picture pigs and troughs… being fed (no pun intended) to excess with policy designed to stimulate demand in the economy. i.e. the Keynesian way.

With the creation of the liquidation authority, the ability of the Fed to make loans to individual troubled firms like Bear and AIG was no longer needed and, appropriately, was eliminated. As Fed chairman, I was delighted to see my institution taken out of the business of bailing out failing behemoths.

Okay fine, the Fed no longer makes the loans. An “authority” does. On whose authority? Seriously, I am ask where this funding comes from.

The lender-of-last resort concept is centuries old. Walter Bagehot, the English economist, discussed the lender-of-last resort policies of the Bank of England in his famous 1873 tract Lombard Street. Bagehot famously advised that, in a panic, the central bank should lend freely, at a penalty rate, against good collateral. By providing liquidity—for example, to banks facing runs by their depositors—the central bank can help end a panic and limit the economic damage. Indeed, the Federal Reserve was founded in 1913 in large part to serve as a lender of last resort and thereby reduce the incidence of banking panics in the United States.

The Federal Reserve addresses banking panics, which result from the buildup of distortions in the financial system. Through history I suppose these distortion can be created by the Fed or they can develop out of human nature over time (greed). The natural result is a correction of greed called fear… and eventually, panic. But the panics have not stopped. The Fed tries to sanitize every disturbance that crops up and in so doing, plants the seeds of the next liquidation every time. Again, what is this collateral you speak of? Can it be liquidated today to make the Fed’s balance sheet whole? I mean, the backing entity in this great system must certainly be 100% viable, right?

The Warren-Vitter bill would impose two additional requirements on the Fed’s broad-based lending programs. First, it would require the Fed and any other supervisors of a firm receiving loans to certify the firm’s solvency, and to make its solvency analyses public immediately. Second, it would require that the interest rate on any emergency loans be at least 5 percentage points above the Treasury rate. The Fed could suspend these two conditions, but Congress would have to approve the suspensions within thirty days or the lending programs would have to be shut down. (Warren-Vitter also would define a “broad-based program” as one in which at least five borrowers are eligible to participate.)

Superficially, the two new conditions that Warren-Vitter would impose seem consistent with Bagehot’s dictum, to lend freely at a penalty rate against good collateral. Unfortunately, in practice, they would eliminate the Fed’s ability to serve as lender of last resort in a crisis.

But it is all good collateral! There are no hidden, off balance sheet items and the money is all going somewhere, to productive ends… right? So what is wrong with more transparency and regulation? It almost seems like you are saying ‘please don’t take away the Fed’s ability to operate in opaque corners of the system where my Fed staged its most ingenious operations!’

The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay.

In the case of AIG and others, I am wondering if those “good assets” only stayed good because other system distorting policy (like ZIRP, 6+ years and counting, certain aspects of TARP, etc.) kept them in the game, allowing them to be termed as “good” collateral. This was a brilliant and multifaceted bailout, but ‘the distortions… oh the distortions’ think the Luddites.

If financial institutions and other market participants are unwilling to borrow from the central bank, then the central bank will be unable to put into the system the liquidity necessary to stop the panic. Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector.

This thinking can only come from a died in the wool Keynesian. A real economy is based in saving and productive investment; risk taking in search of reward that comes from the savings produced by previous cycles of investment, profit and savings.

Look, to many the Keynesian system is and has been working for decades upon decades. But that does not change the fact that the rich get richer, the poor get poorer and over time, inflation benefits some and impoverishes others. I happen to be fairly long-term bullish on the US dollar now (as the best paper in corrupt casino), but its purchasing power has been destroyed over the decades of Keynesian oversight. The handy replacement for purchasing power? Why, credit of course.

Ben Bernanke talks about loans and collateral and last resorts but the truth is that it is all just another way of saying credit/debt creation. Debt is not productive, it is destructive eventually.

The Warren-Vitter legislation would create an insuperable stigma problem. (It has other drawbacks as well, but my focus here is on stigma.) First, the requirement that solvency analyses be released immediately (or quickly) would publicly identify any potential borrowers. No borrower would allow itself to be so identified, for fear of the inferences that might be drawn about its financial health. Second, the five percentage point penalty rate requirement would remove any doubt that those borrowing from the central bank had no access to other sources of funding, further worsening the stigma problem.

Please, an entity about to liquidate is not going to worry about stigma. It needs the funding. Let’s not keep the shameful in the shadows. Why on earth would the lenders – including tax payers either directly or more likely, indirectly – want to know what’s really going on with these troubled institutions?

As for the percentage on interest, I understand that your term as Fed chief was all about artificial interest rates. Why was that? Because leverage must not be allowed to turn into dominoes, I would guess. Are you applying the same principlel here? We must not allow the market to set its own rates (those by which creditors might actually want to risk their principal). Is that the idea?

I don’t think Senators Vitter and Warren mean to stop broad-based emergency lending in all circumstances, although their bill would have that effect. Their goal, I assume, is to induce financial firms and market participants to be less reliant on possible government help, for example, by holding more cash to protect against possible runs and panics. But their approach is roughly equivalent to shutting down the fire department to encourage fire safety; or—more relevant to the current context—eliminating deposit insurance so that banks will be more careful. Rather than eliminating the fire department, it’s better to toughen the fire code. Dodd-Frank and the international Basel III Accord have already greatly increased the amount of cash that banks are required to hold, for example. This bill would not have any marginal effect on the behavior of banks or other financial firms.

Senator Warren in particular has been a staunch defender of Dodd-Frank. It is puzzling that she would propose legislation to overturn one of the key legislative bargains in that bill—the trade of liquidation authority for reduced emergency powers—by further reducing the nation’s ability to defend against financial panics.

It is the Fire Department that has set the wildfires; routinely and under the guise of helping. The Fire Department is playing its designated role within a burning system. It’s a slow burn so few actually see it. But give it time.

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