Does the Fed really want banks to lend?

With the Fed yet to announce a new round of quantitative easing, some economists are starting to offer their own opinion about what else the central bank can do to introduce more money into the American economy and spur growth. One of the proposals I have heard is for the Fed to eliminate its policy, instituted in October of 2008, of paying interest on reserves and excess reserves kept by banks at the Fed.

I believe that anyone advocating for this proposal either does not understand why the Fed is paying interest on reserves to begin with, or believes that there is somehow enough loan demand for profitable investments that the enormous mountain of reserves now sitting with the Fed won’t result in hyperinflation if it were actually drawn down.

Let’s start first with the reason why the Fed is paying interest on reserves, because this is something entirely new and was only instituted in 2008 as a result of the crisis in the credit markets. You will recall at the time that interbank lending had frozen up, as banks were afraid that they may not have enough cash on hand to meet their short-term obligations. There was not only uncertainty about the health of a given bank’s own balance sheet (the value of its own assets and quality of its own loans), but there was also massive uncertainty about the health of other banks’ balance sheets, which is why we heard so much at the time about “counterparty risk.” The demand for money was high relative to the supply (drop in bank lending = drop in supply of money and credit), and so interest rates began to spike, as was seen most prominently in the interbank lending market (the interest rate set by this market is known as LIBOR). This is the core component of what we think of as the money markets, and it was freezing up. A freeze in money markets means that everyone from Fortune 500 companies to small businesses can’t get the money they need to meet their short-term obligations, since so much of today’s business is conducted on credit. And since a failure to meet one’s financial obligations is the definition of insolvency, the chain of events taking place at the time would have resulted in the bankruptcy of an untold number of banks, corporations, and small businesses, and could very well have collapsed the American economy into a state far worse than what we saw after 1929.

So, in response to this freeze in credit markets, central banks around the world (the Federal Reserve playing leader of the pack) needed to find a way to prevent, first and foremost, a collapse of the banking system. During the great depression, approximately 1/3 of all banks went belly-up, and many economists, Ben Bernanke included, contributed this collapse of the banking sector as the prime cause of the depression. It was his intention, therefore, to make sure that the financial system would be propped up at all costs, even if it meant risking hyperinflation at some unforeseen date in the future. I say hyperinflation, because the only way for the Fed to keep the banking system from failing as a result of all the bad loans and onerous debt that it had created over the years was to expand the money supply. It did this using all those “loan-facilities” we have heard so much about, and which were exposed by the most recent Fed audit by the GAO. Since banks would not lend to each other, the Fed decided that it had to pick up the slack, and it did just that, pumping in trillions and trillions of dollars worth of credit into the financial markets in order to keep the system from falling apart.

Most of this money came in the form of loans meant to meet short-term liabilities, but clearly a great deal of the money the Fed has created has simply been used to monetize outstanding debt (Treasuries, GSE paper and certain financial derivatives like the credit default swaps issued by AIG). The monetization is evidenced by the extraordinary rise in the adjusted monetary base since 2008, which is widely regarded as “money.” (in a fiat money world, money is not easily definable, so there are various definitions for money including the widely cited M1). In turn, because banks were afraid to lend money out during the crisis, and because the Federal Reserve incentivized banks to keep an excess amount of money on reserve by paying interest on overnight balances at the Fed, much of this newly created money began to accumulate as excess reserves on the balance sheets of the nation’s largest banks as can be seen here. And of course, with interest from the Fed being the equivalent of risk-free money, excess reserves held at the Fed can only grow the money supply over time, creating inflationary pressures that will eventually have to be released (the mechanism by which such a release could theoretically occur is something that we can speak about another time, but I have my doubts about how effective it will be).

[*Note: I find it interesting and noteworthy that, for the first time to my knowledge at least, the nominal supply of base money in the economy is greater than M1, which actually includes demand deposits. This may very well be the result of the perverse incentives now operating in the marketplace that reward banks for not lending money out, thus preventing base money from turning, through the multiplier effect of fractional reserve lending, into demand deposits. Hence the term "Zombie Banks"]

So, taking into account the fact that we may be headed back into recession (by official standards at least), banks may still be unwilling to lend out the reserves they have on hand, and the Fed unwilling to promote such action, for fear that further write downs on overvalued assets and non-performing loans will force banks to draw down their reserves anyway. The larger-than-required reserves being held by the banking system, therefore, may be all too justified given the continued uncertainty about the health of global balance sheets. However, even if banks were willing to lend the money out, there is good reason that the Fed should be extremely skeptical about allowing for such a prospect, and the reason why is because it could cause run-away inflation or even hyperinflation.

I have talked before, both on this blog, as well as in interviews, about how the money multiplier is broken in the banking system. The money multiplier is just another name for the fractional reverse lending process by which base money is converted into demand deposits. It is the process by which a bank takes X amount of money, and pyramids on top of it fresh loans that show up as deposits in other banks within the system. Here, the bank is functioning with the expectation that, at no given moment in time will the demand for bank capital (basically, depositors withdrawing their money from the bank) outstrip the amount of money that the bank has on reserve. In this sense, any bank engaged in fractional reserve banking is inherently and theoretically bankrupt, but in practice it usually does not have to acknowledge this fact since the amount of money it keeps on reserve is enough to cover its expected short-term obligations. In the even that depositors’ demand for their money exceeds the amount of capital that a bank has on hand, the bank goes from being theoretically bankrupt, to functionally bankrupt. When this occurs, it is usually referred to as a “run on the bank,” but unlike banks in the 1930′s which instructed tellers to slowly count the cash leaving depositors hands from the front as money was being rushed in through the back, today’s banks have been able to rely on a much more powerful, and institutionally rested Federal Reserve System to keep them from sinking into the bankruptcy abyss.

Once you understand how money is pyramided in a fractional reserve system, then you can understand how even a modest increase in base money (or actual money lets say) can quickly expand by at least 10 times that amount through the multiplier effect. Therefore, not only would Bernanke and the Fed have to worry about the inflationary effects of adding an extra 2 trillion or so dollars into circulation by emptying out excess bank reserves (prior to the onset of the financial crisis, excess reserves were roughly $1.5 billion, whereas now they are right around $1.7 trillion!) they would also need to be concerned about the multiplier effect that this money would have on demand deposits in the economy. In essence, the alarming amount of money now sitting in reserve at the nation’s largest banks has the potential, if lent out, to create runaway or hyperinflation. If this were to occur, arresting the process would prove extraordinarily difficult for the Fed, as it would have to raise interest rates dramatically by selling assets from its portfolio in exchange for trillions of dollars in federal reserve notes that it created in the past 3 years. Such an action would collapse the US economy, and this is why I said earlier that I do not believe the Fed will be able to stop inflation if it gets started this time around in the way that the Volker Fed did during the 1980′s. In any case, the rate of interest on deposits would have to go much higher than the 20% reached by Paul Volcker during his inflation fighting, because the potential for the problem today is much greater, so it’s really a practical impossibility. Let’s not even pretend like the Fed could stop the inflation, because it can’t. Sorry.

So, if the Fed can’t afford to allow banks to lend the money that they have accumulated on reserve, then how exactly is “credit supposed to start flowing again?” It isn’t, and that’s the point. The banks, having recklessly inflated the largest credit bubble in history, have now decided that the option that best benefits them is to allow the economy to slowly roast under decades of zero or negative growth as the economy dips in and out of recession and deflation as far as the eye can see. As long as the banks can remain afloat, they will continue to generate risk-free revenue through Fed subsidies of various sorts (the interest paid on reserves is just one form that these subsidies take) as the economy is allowed to collapse all around them. So long as social unrest does not become unmanageable, the cumulative effect of such a policy over time is to grossly accumulate a disproportionate amount of the world’s wealth on the balance sheet of financial institutions with a lifeline to the central banks. Bank executives become the new global landlords, and we rapidly move from what was once a relatively free-market capitalist economy into a neofeudal state where banks and multi-national corporations own the bulk of the world’s assets and charge onerous rents, payment for which is made by issuance of more loans by the largest banks, for the most basic type of accommodations. It will be subsistence farming on a global, technocratic scale, and this is again, why you hear me say that I will alway choose a system reset over what we have today, because the only thing that the current system is leading us towards is global serfdom.

David Stockman on what it’s going to take for the US to cut spending

David Stockman, former budget director in the Reagan White House, appeared on Bloomberg recently to give his take on the latest budget negotiations and what he thinks it is going to take in order for the government to seriously address the ballooning national debt.

According to Mr. Stockman, solving this budget problem will require “a major dislocation in the bond market, a real conflagration on the part of the people who have to buy this debt, before the country wakes up.”

Unfortunately, history is on the former budget director’s side. Governments may be exceptionally talented at finding innovative ways to spend money, but they are not particularly well known for their accounting skills. After all, the biggest benefit of being elected to public office is that one gets his/her hands on the federal purse strings. What is the point of going to Washington if you have to enact austerity measures?

Dollar falls back below 73 on the Index

Every time the dollar looks like it’s going to stage a rally, it falls flat on its face. I am not one of those that expected any type of bounce off the news that Osama bin Laden was killed, but I’m still amazed at the weakness of the world’s reserve currency given the massive money printing that is going on in Japan right now, and the pandora’s box of problems facing the euro.

Even the 10% drop in silver seen recently has hardly put a dent in the gold price, and the dollar is back below 73 on the DXY. We are definitely walking a tightrope here…

Dollar Breaks 2009 Lows

The dollar continues to tumble, even despite recent concerns that a new credit crisis may be on the way. Now that it has taken out the 2009 lows, some people think the next stop for the dollar index is 70.698, the all-time low made in early 2008. Of course, we all remember what happened a few months later as a rush for liquidity sent the greenback shooting back up to 90 on the index.

What will happen this time? Well, one never knows for sure, but we do like to speculate here on Delta, so I would say that we will not break the all-time low before rebounding significantly as part of a renewed rush for liquidity and a reversal of the carry trade.

The Great Gamble: is the Federal Reserve preparing us for a derivatives nuclear holocaust?

Post Derivatives Apocalypse

MarketSkeptics has published incredible information detailing what is not only fraud by the Federal Reserve, but something that has the very real potential of blowing up the entire financial system on a scale previously unimagined. The information comes almost exclusively from a June 24-25, 2003 Federal Reserve meeting, where it was explained in very clear terms, that the Federal Reserve had actually seriously contemplated using derivative products, specifically put options on US Treasuries, as a means of pushing down long-term rates:

The alternatives that could be adopted while changing only the composition of the balance sheet are listed in the top panel. These include (1) extending the average maturity of the outright holdings in the SOMA, (2) setting explicit ceilings on longer-term Treasury yields, and (3) using derivative instruments.

Let me explain, first, why this may have been more than a theoretical proposition, and second, why it is even important to begin with.

The above excerpt from the 2003 transcript quotes System Open Market Account (SOMA) manager Dino Kos, who was in the process of proposing a series of policy tools that the Federal Open Market Committee (FOMC) could use in order to drive down long-term interest rates. Traditionally, the Federal Reserve only targets the short end of the yield curve, and we are actually taught in economics that central banks are incapable of affecting 10, 20 or 30 year interest rates (no need to go into why right now). I never bought into this argument, and anyone who watched the yield curve flatten, and subsequently invert during the late Greenspan era will find plenty of reason to exercise similar skepticism on the subject.

Now, in reference to Kos’ specific suggestions, points (1) and (2) have already been implemented. “Extending the average maturity of the outright holdings in SOMA” simply means buying a greater share of long-term treasury debt. The Fed has already been doing this for some time. Meanwhile, “setting explicit ceilings on longer-term Treasury yields” simply means that the fed won’t allow interest payments on newly issued US government debt to exceed a specific target, presumably by stepping in as a buyer to fill the demand gap in the treasury market that would otherwise drive rates higher. This is pretty much what the Fed does in the short-term money markets by setting the artificial federal funds rate target. To put this another way, points (1) and (2) are both influenced by the Federal Reserve monetizing the long-term debt obligations of the United States, which is what QE1 and QE2 were all about.

Source: Market Skeptics

Figure 1 – short-term US government debt is replaced with long-term debt

The chart above shows how the Federal Reserve began to unwind its position in short-term government paper in the beginning of 2008, only to expand dramatically its purchase of long-term paper at the start of 2009. The reason for the lull in buying by the Fed that you see during the last three quarters of 2008 is probably a result of natural market pressures driving up prices for US government securities as people were rushing out of riskier assets into the “safer” short-term US treasury market. This would have freed up the Federal Reserve from having to make the type of large-scale asset purchases in treasuries that have subsequently characterized QE1 and QE2. This “freedom” is also reflected in the giant spike that you see for other “credit programs.” The buying of long-term US debt has subsequently taken up an increasing amount of room on the Fed’s balance sheet.

In other words, people were losing interest in holding US treasuries at prevailing market prices. When this happens, the natural effect is for prices to drop, signaling to the government that it needs to raise rates (the yield on its newly issued bonds) in order to compel buyers to purchase more treasuries. In order to prevent this natural rise in rates, the Fed rushed in to make up the difference, serving as a buyer and thus creating artificially high demand for treasuries. This put a floor on prices and worked as a cap for long-term rates. This is what QE1 and QE2 were meant to accomplish.

Ok, so now we have established that points (1) and (2) have already been implemented. This is important to recognize because it makes it all the more likely that point (3) would have, at the very least, been seriously considered as well. Now, we will turn to why the implementation of point number 3 (the use of derivative products) is such a scary prospect.

When Dino Kos proposed the use of derivative products in this 2003 fed meeting, he specifically made reference to the use of treasury put options. Without going into great detail, a put option is basically a derivative product used as a means of selling-short a particular asset. If you buy a put option on wheat, it means that you are expecting the price of wheat to decline, and so you are entering into a bet to that effect. Of course, every trade has a counter party, and so, if you are buying a put option on something, it means that there is someone else on the other side of that trade who is writing the option. This other party, in a free market at least, would be writing the option because he/she expects the price of the underlying asset to rise above the strike-price.

Buying put options on US government debt is essentially a way of selling-short the treasury market. You are basically betting that the price of government debt is going to drop and that yields are going to rise. If the demand for put options on US treasuries is growing, then pressure begins to build on yields. In short, the market for treasury put options is just another way for bond traders to provide an up or down vote on the US credit rating, and thus on benchmark interest rates in the economy. 

As we already mentioned, the Federal Reserve can influence interest rates by buying up US bonds, thus driving up prices and pushing down yields. This is what quantitative easing means. However, the policy becomes increasingly ineffective with every purchase. It stands to reason that if the Fed wants to continue to keep rates artificially low in the face of market sentiment to the contrary, it must find new ways to influence prices. One such way would be through the derivatives markets, specifically using treasury puts. According to Dino Kos:

Alternatively, we could sell put options on longer-term Treasury securities at strike prices associated with desired longer-term yields…[The] ultimate success would hinge on the quantity of options sold—that is, how big a bet the Federal Reserve were willing to make. The more options sold, the greater the chance they would have the desired effect on longer-term rates even if not associated with any policy commitment, either by raising the costs to the Fed associated with options being exercised, or by lowering risk premiums on longer-term rates.

What Kos is saying here is plain as day: issue put options on long-term debt at artificial strike prices that are likely to produce the sort of yields that the Fed is looking for. This is just another way of manipulating the interest rates in the economy. However, Kos recognizes that, in order to have the desired effect, the Fed would need to issue an increasingly high number of these put options. Here is the kicker:

[O]f course the risks to the portfolio, to reserve levels, and of capital losses would rise in equal measure. And an exit strategy for options may not be as straightforward as it seems, even apart from the possibility of their being exercised. Of course, the Desk could stop auctioning new options at any time. But a decision to stop selling more options or not to issue new contracts with later expiration dates as time passes likely would be interpreted in the market as a statement about future policy intentions. The resulting rush to unwind market positions would likely be very disruptive and send yields sharply higher.

So, unlike traditional policies of buying and selling the underlying asset (as is the case when the Fed buys or sells treasuries in order to add or extract liquidity and thus raise or lower the Federal Funds Rate), a strategy of issuing put options to counter parties interested in hedging against an environment of rising rates puts the Fed in a dangerous trap of having to supply ever more derivative contracts in order to suppress the price of long-term yields – the very yields that they are issuing insurance against.

First of all, this is fraud. The Fed is effectively issuing credit protection against itself. That’s like me taking out a $1 million loan and then issuing another $1 million in credit protection against my own default. This is absurd. If I default on my debt, then this means that I won’t be able to make good on the insurance contract either. This is just a fraudulent means by which to borrow more money.

Second, and more importantly, this has the potential to blow up the entire financial system, and I will explain why in as simple terms as I can. If the Federal Reserve is issuing more and more insurance contracts, effectively betting against a rise in long-term yields, this means that it is also increasing its exposure to a fat tail event that would drive rates suddenly higher. In order to prevent a rise in the rates, the Fed can only do one thing and this is to continue issuing more and more put options (insurance contracts against default). However, just like with bond purchases, there is a point at which the issuance of ever more insurance through put options will prove ineffective.

At this point, the Fed would be left with two options. 1) it could start to buy up all the options it has outstanding, which would probably cause hyperinflation and thus a break down in the economy or 2) it could default, in which case the entire financial system would blow up. In either case, the outcome would be a total catastrophe the likes of which none of us can comprehend.

It all comes down to just how involved the Fed is in the derivatives market for treasuries, and if this activity is large enough to scale back without blowing up the entire system. I am not a bond trader and do not monitor this market, so I don’t have any idea if the Fed is actually doing what MarketSkeptics is implying. The guys at ZeroHedge seem to give this scenario a great deal of credibility, and as traders they are in a better position to express an opinion on the matter either way. Still, no one really knows, and the prospect is so apocalyptic in its consequences that even if I had an answer I wouldn’t know what to do with it.

Inflation or Deflation?

Those of you who listened to last tuesday’s live broadcast of Covering the Spread, or for those who heard the Sound Money podcast online, you will know that one of our guests was the always informative and highly thoughtful Mike “Mish” Shedlock.

Originally, I only wanted to have one interview for the show and spend the rest of the time covering important news and headlines. However, after finishing a taped segment with Gerald Celente earlier in the week, it dawned on me that almost everyone in the media, the blogosphere and within “intellectual circles” were either exclusively on the inflation bandwagon, or otherwise, saw stable prices and positive economic growth going forward.

The inflationist alarm bells that rang so violently in the months following the Fed’s unprecedented intervention into the markets were quickly silenced once it became clear that, despite an astronomical increase in base money supply, an all-out collapse in prices could not be avoided. Commodities and equities crashed and the economy fell off a cliff, contracting almost 12% (GDP) in the span of just 6 months. The dollar strengthened, the Dow dropped a further 40% (and was chopped in half if measured from its 2007 high), and precious metals were liquidated as investors scrambled to meet margin requirements. All this despite a historically unprecidented increase in the adjusted monetary base.

I should mention here that I too believed, wrongly, that the Fed’s intervention into the economy was going to crash the dollar and send us into a hyper-inflationary tailspin. Granted, I did not expect this change to happen right away, but certainly before the end of 2013. In fact, I believed that a forced devaluation of the dollar was going to occur at some point over the next 5 years, and that a new global currency, either the SDR or a carbon credit unit issued by some bank in Copenhagen, was going to be floated as a replacement (I still believe that a global currency will be attempted, but am less confident that efforts to implement it will succeed).

Fortunately, my economic outlook did not impair my investment decisions since, my single biggest hedge against the debasement of the currency and my hyper-bearish outlook for the credit system and property rights made me a big buyer of gold between the months of October and December of 2008 (see my Dec 2008 article on the future of gold). The rush for liquidity eventually led investors to dump anything and everything they could in order to raise the money they needed in order to stay afloat and meet their margin and capital requirements, making plenty of gold and silver readily available to investors willing to buy and hold at these very low prices.

Not long before we reached the stock market bottom of March 2009 however, my views on the effectiveness of monetary policy as a tool for preventing liquidations, crashes and market declines began to change. I saw that, despite the massive money printing and government bailouts, the potential losses that banks could suffer far outweighed anything the Fed had provided through its open-market and discount operations (TARP included). It was also clear to me that banks had no intention of lending all the free money provided to them by the Fed that was showing up as excess reserves. Instead, this money was going to pay for record bonuses and into proprietary trading operations. Very little, in other words, was being redistributed into the larger economy where it could cause real price inflation, and for good reason: the banks were not being honest about the just how impaired their balance sheets were. They needed this extra money to safeguard against more loan defaults.

Still, after bottoming out in March 2009, equity and commodity stocks have sharply risen in value, and in the past year or so we have also seen an undeniable rise in the price of consumer items. Anyone who goes grocery shopping, fills his/her gas tank or pays to take the train to work can attest to this. In fact, this dramatic increase in the price of assets and consumer prices, coupled with the massive ongoing debt monetization by the Federal Reserve, has slowly weeded out many of the prior deflationists from the mainstream debate, bringing inflationist mantra back to the forefront.

Now, with the end of QE2 and the prospects for even more stimulus, the “inflation vs. deflation” debate has taken on an even greater imperative. Is someone like Marc Faber, correct when he says that any deflationary market event will be met with even more money printing that will lead to hyperinflation? Or, are people like Mish, Stoneleigh and Robert Prechter correct in pointing to the massive amounts of outstanding debt in the global financial system, and the potential for further credit contractions that will, once again, overwhelm any efforts by the Fed to monetize the defaulting loans and thus buffer bank deposits in time to prevent a new round of insolvencies? After all, 2008 proved just how impotent the Federal Reserve is when trying to influence credit contraction across the broader economy, and even hyperinflationist John Williams of Shadow Government Statistics points out that M3 (the broader measure of the money supply that the Federal Reserve no longer reports) has continued to contract year-over-year.

Although I agree, in part, with people like John Williams and Peter Schiff, that the dollar will eventually become worthless, I do not believe that this will happen as soon as these gentlemen expect. As impaired as the dollar is, there is no global currency alternative that businesses around the world feel confident holding instead. The Japanese yen has a plethora of problems, and the very viability of the Euro is now in doubt. The swiss frank has historically been a safe place to hide, but not a place to conduct daily business. In other words, although investors may be willing to diversify their dollar holdings further, dumping the dollar would require that they “dump it for something,” and that something does not exist. Would you feel safer holding Japanese yen or euros in place of your dollars?

The only way that I can see a currency crisis developing in the dollar at this point is if investors and businesses begin to convert a larger share of their dollar holdings into multiple currencies. This would require a real breakdown in global trade and US hegemony. If there were less of a need for a global reserve currency, then certainly the artificial edifice upon which the dollar is supported, would collapse. In such a scenario, we could indeed see a dollar crisis. Imports would collapse and prices would soar for anything not produced within the United States. Again however, this is a scenario that I would expect to see after renewed deflation and further loan and asset liquidation.

What is more likely, in my view, is that some unforeseen deflationary event will spook markets, precipitating a renewed rush for liquidity and a freezing of global credit. Such an event can manifest itself in many forms, but because of the fragility of the banking system, the result will almost certainly be further liquidations and a crash in prices. I simply cannot see the inflation of the past year continuing for much longer without sparking a crisis. How much more stagflation can people take? This is not the 1970s; Americans do not have savings to tap into. As home prices and wages continue to either stagnate or decline, the rise in consumer prices will generate unbearable pressure on American households at a time when their finances have never been in worse shape. Such conditions are deflationary, not inflationary, and no matter how much the Fed prints, it will not be able to resurrect the real economy, which will eventually drag the financial markets down with it.

Fears rise that Japan could sell off U.S. debt

From the Washington Times:

Some lawmakers and market analysts are expressing rising concerns that a demand for capital by earthquake-ravaged Japan could lead it to sell off some of its huge holdings of U.S.-issued debt, leaving the federal government in an even tighter financial pinch.

Others say a major debt sell-off by Tokyo is unlikely, but noted that the mere fact that questions are being raised speaks volumes about the risks involved in relying so heavily on foreign investors to fund U.S. debt.

“This natural disaster in Japan concerns me that it could speed up what’s coming, because they are the second leading buyer of our debt,”Sen. Rand Paul, Kentucky Republican, told The Washington Times. “Small degrees of differences in how much they buy of our debt, I think, can make a big difference in interest rates that we have to pay people to buy our debt.”

Read Full Article here

Why the Fed is Committed to Inflation

“I spent my entire life studying for this moment!!”

Some will recall the speech that then NY Fed Governor, Ben Bernanke, gave in late 2002 honoring, Milton Friedman, in which he famously apologized to the great monetarist for what he saw as the Federal Reserve’s failure to prevent the Great Depression:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Unfortunately, Bernanke got it backwards. If he was going to apologize for anything, it should have been for the Fed’s central role in enabling the conditions for, and then prolonging the duration of the Great Depression.

But of course, the Federal Reserve was never really created in order to prevent depressions, only to manage them in such a way so that its most powerful member banks could continue to profit, no matter which way the wind was blowing. More specifically, the Federal Reserve was created with the primary objective of protecting an established money trust of elite banking institutions, chief of which were the House of Morgan, National City Bank, the Rockefeller controlled Chase National Bank, and Kuhn, Loeb & Co., which had strong ties to the Rothschilds in England.

The Money Trust is seen here, exacting a toll from the average investor

In point of fact, after the passage of the 1913 Federal Reserve Act, Paul Warburg, widely recognized as the “father” of the Federal Reserve System (Warburg was very close to the Rothschilds and was brought to the United States in part because of his intricate knowledge and understanding of the type of central banking practiced in Germany and England, on which the new American system was to be closely modeled), began a long process of lobbying the smaller banks around the country to join the new Federal Reserve System. You see, membership was, and still is for state banks, optional. At the time, however, there was great hesitancy on the part of less well-connected and influential banks to join the new system for fear that they would eventually be bullied around and even swallowed up by the larger banks. So, how did Warburg eventually convince them to join? Easy, by promising them the prospect of profits the likes of which they could scarcely imagine or even believe…

The gist of Warburg’s sell to the smaller banks rested on the reality that, functioning in a free market, these banks were constrained in how much credit they could create through fractional reserve lending due to the ever-present potential for a bank run. The number of loans that they could pyramid on top of their existing deposit base – i.e. the amount of money that they could create out of thin air – was limited. Joining the Federal Reserve System however, would not only provide a central backstop and “lender of last resort” for these banks, but more importantly, it would unify all the pools of money that existed in dispersed, regional waterholes into one giant sea of capital. This is the origin of what is now known as the federal funds or inter-bank lending market, but which, at the time, was referred to as the market for bankers’ acceptances. It is this unified pool of money that all participating banks can access in order to meet their short-term liquidity needs, and it is here where the Federal Reserve Bank of New York conducts its open market operations (OMO), swimming about like a Great White shark amongst a sea of blue fish.

Paul Warburg

Its unlimited access to credit, which it itself creates out of thin air, allows the Fed to manipulate the key federal funds rate from which all subsequent rates and prices in the economy are ultimately determined. Therefore, just as the shark cannot exist outside the water, the Federal Reserve would be powerless if it didn’t have a big enough ocean of money within which to swim and from where it’s monetary manipulations could be sufficiently amplified. The more banks that participate, the more powerful the Fed becomes and the more influence its open market operations have on overall prices. This is why participation in the Federal Reserve System is necessary in order for the system to function. If the banks believed that it was not in their interest to participate, then the entire system would fall apart, since the Fed would have no money market in which to swim.

We must understand therefore, that it is in the interest of the financial industry to have a Federal Reserve. In fact, the Federal Reserve is directly responsible for the profitability and size of this industry, so we must immediately dispense with the silly notion that the Federal Reserve is a regulator; it is no more a regulator of wall street than OPEC is of the Gulf states. Its role is that of a front company. It is a legal cartel created by and for the benefit of its member banks, with one extra and very important benefit. It has the explicit backing of the United States government, making it legally impossible for any other bank or syndicate of banks to challenge it without legislative reform.

So, what has been the outcome of all this collusion? Well, one outcome was the boom of the 1920′s, brought about by a tremendous lending euphoria that simply could not have existed without the deterioration of credit standards and reserve requirements. In fact, mandated reserve requirements themselves only became necessary with the creation of the Federal Reserve, since before, banks had to determine for themselves what the proper amount of capital they needed on hand was. This amount varied from bank to bank, but was almost always much higher than that mandated by the Federal Reserve System, since the later had a new and much larger pool of capital from which to fund short-term liquidity needs (as well as the godly power to issue new federal reserve notes and call them money). The dream of financial alchemy had finally been achieved.

This is why the “too big to fail” debate is a mute point. To ask the Fed, along with congress, to help regulate the financial system so that no institution would be too big to fail is a contradiction in terms. The only reason why any single company in any economy can be too big to fail is because it has a direct lifeline to the Central Bank, and thus to an unlimited supply of money. If there were no Federal Reserve, then there would be no ability to fund a bailout, and if there were no such implicit guarantee to protect a company from failure, then no financial institution on earth would every lend out 20, 30 or even 100 times (as was seen during the most recent credit boom promoted by the Greenspan Fed) their deposit base. Such a move would be tantamount to suicide.

It was the inordinate and unprecedented expansion of credit, the deterioration of lending standards and the subsequent inflation in asset prices (seen most notably in the Florida land boom and in the stock market) that was ultimately responsible for the great depression. It was not the subsequent “reluctance” on the part of the Federal Reserve to lower interest rates in the economy by issuing more fiat liabilities through open market operations (i.e. printing money out of thin air) that was to blame. If anything, the Federal Reserve, along with the Hoover and Roosevelt administrations, crowded out private capital formation by issuing more debt and printing more money, making it more difficult for prices to adjust after the boom. This created a climate of excessive uncertainty and pessimism for the entrepreneur and businessman who is ultimately responsible for any recovery.

Picture of a Breadline from the Great Depression

So, come to think of it, maybe Ben Bernanke didn’t get it backwards when he apologized to Milton Friedman after all. Maybe what the Fed Chairman really meant to say was that the Fed failed in its primary objective: to save as many banks as possible. Maybe the real failure, in Bernanke’s eyes, was all the bank holidays, bankruptcies and bank runs. Maybe the “Great Depression” to Ben Bernanke, actually meant the 4,000 or so banks that went belly up in the three years between the Crash of 1929 and the election of FDR. Maybe it was JP Morgan’s inability to save the Knickerbocker Trust Company during the Panic of 1907 or the failure of New York’s Bank of the United States two years after Black Tuesday that nagged at the former NY Fed Governor the most.

Whatever his motivations, any doubts we may have had about Bernanke and his willingness to walk the walk when it came to fighting deflation the best way he knows how – by printing ungodly amounts of money – have now been laid to rest. Benjamin S. Bernanke, and his accomplices on the Federal Reserve Board have already committed the dollar to the currency dustbin of history. The inflation has already been baked into the cake. To reverse policies now would be tantamount to laying off half of the nation’s workforce within the matter of a year. Allowing prices to adjust would lead to the failure of not only the entire banking system, which has grown like a malignant tumor on the back of every honest wage earner in America, but a significant chunk of whatever real economy we have left. So discombobulated have the traffic signals become in our marketplace, that the Federal Reserve has little choice left but to keep its foot on the pedal, and drive us all right over the cliff.

Silver Breaks $38

Source: ZeroHedge

We knew this was going to happen, but it’s still big news…

USD Breaks 3-Year Trend Line

Source: Bloomberg