This is an interesting op-ed in the morning edition of the WSJ:

We’re now in the 37th month of central government manipulation of the free-market system through the Federal Reserve’s near-zero interest rate policy. Is it working?

Business and consumer loan demand remains modest in part because there’s no hurry to borrow at today’s super-low rates when the Fed says rates will stay low for years to come. Why take the risk of borrowing today when low-cost money will be there tomorrow?

Why borrow at all, in the main?  Borrowing is the taking of leverage — “gearing.”  It magnifies both gains and losses, and it is the losses that turn into trouble, as often they wind up being borne by someone other than the borrower.

They’re supposed to be borne by the borrower and lender, incidentally.  But the lender rarely actually eats them, especially when things get “really bad” — then the taxpayer gets soaked, directly or indirectly, as we have seen.

Federal Reserve Chairman Ben Bernanke told lawmakers last week that fiscal policy should first “do no harm.” The same can be said of monetary policy. The Fed’s prolonged, “emergency” near-zero interest rate policy is now harming our economy.

It always was Charles.

The Fed policy has resulted in a huge infusion of capital into the system, creating a massive rise in liquidity but negligible movement of that money. It is sitting there, in banks all across America, unused.

No.  Capital and borrowing are not the same thing.  They spend the same, but they’re not the same.  Capital is economic surplus — that which you have after you earn and pay the necessities of life (or to run your business.)  Borrowing is leverage — “mechanical advantage” if you will, but it is always a negative-sum game as not only does it have to be paid back but the interest expense means you must earn even more to pay it with.

The multiplier effect that normally comes with a boost in liquidity remains at rock bottom. Sufficient capital is in the system to spur growth—it simply isn’t being put to work fast enough.

The paradox of debt is that due to the negative sum nature of it there is always less of a multiplier than the liquidity increase would suggest.  That is, mathematically it is a negative game for the borrower in every case.  This does not mean that a borrower cannot turn that disadvantage into advantage, but it does mean that the odds are against him or her in doing so.

The poker player in Vegas is at a similar disadvantage due to the house “rake.”  If six similarly-skilled players sit at a poker table in Vegas and play long enough they will all wind up broke, because the house rake will consume all their money.  It is a certainty if the game goes on for long enough, the skills are evenly-enough matched, and their luck is reasonably even.

The only way for such a player to win is to be better than the other people at the table by a sufficient amount to overcome the house rake.  He must also stop playing when he has amassed enough winnings and depart.  This means that for the player of superior skill he is incented to play at a higher level of wager, becasue he wants the fewest number of hands dealt to make his money to keep the rake’s “rape” of his stack to a reasonable level.

We’ve also seen a destructive run of capital out of Europe and into safe U.S. assets such as Treasury bonds, reflecting a world-wide aversion to risk. New business formation is at record lows, according to Census Bureau data. There is still insufficient confidence among business people and consumers to spark an investment and growth boom.

Business formation comes from capital formation which is the product of economic surplus.  That’s all.  Since capital formation is born of savings, that is, economic surplus, zero interest rates destroy the incentive to do so.  Low interest rates tend to cause people to borrow for uneconomic purpose, just as inflation provides incentive to buy things that aren’t really needed right now “because they’ll go up in price tomorrow.”  This is all malinvestment of one form or another and it’s destructive to the health of the economy.

Just look at SYSCO, which reported results this morning.  They showed that food inflation was 6.8% over the last year, contrary to the government lie that “inflation is non-existent.”  Uh huh.

What Mr. Schwab is missing here is that The Fed is hardly an “independent” central bank.  It is in fact beholden to Congress, which has pumped up $5 trillion in debt over the last three years.  That debt has a servicing cost, and it is the “ultra low” interest rates that make this temporarily affordable.

How is Congress going to service this debt when the rate of interest rises?  More to the point, where are the adults in the room in Washington DC?  We’ve had this on both sides of the aisle — “we must stimulate the economy!” — with borrowed money.

Outright bribery of the electorate both hasn’t and can’t work to lead to a durable recovery.  Instead, it has backed Bernanke and Congress into a corner.  When rates rise to just a blended 4% Congress will be facing a $600 billion annual interest bill.  From where will the money come?

This is the trap into which Japan fell and what we are facing today.  It is an extraordinarily destructive cycle that is very, very difficult to break, because it requires pulling the liquidity support at the same time Congress dramatically raises taxes, cuts spending (real cuts, not the imaginary cuts from “baseline” budgeting) or both.  In short it requires admitting that we took fiscal heroin to avoid pain and accepting the accumulated damage for a period of time, accepting the “deferred depression” that we all tried to hide.

Charles Schwab leaves this unsaid, of course, but then again he’s running a brokerage.  Were people to think this thing through they’d realize that the mathematical conundrum presented by Schwab has no resolution that doesn’t ultimately result in that contraction asserting itself.  There is always the matter of timing, but not outcome — that which is fueled by nothing other than fiscal methamphetamine either leads to a nasty crash when you stop taking or heart failure.  Pick one — both suck but while one is nasty the other is fatal.

The testimony and questioning this morning is rather interesting….

Ryan is going to town on him as I write this and I have to wonder if he reads Tickers, as he’s pointing out:

• He’s bailing out fiscal policy with near-zero interest rates.  That is, we are able to run trillion dollar plus deficits because he is playing with ZIRP and QE.  Ryan basically told Bernanke that Congress is not comprised of adults and that Bernanke must pull system liquidity in order to force Congress to do its job!
• He used the words stable prices.  What he did not do is bend him over the desk and give him one or two good ones from behind on the “2% inflation” game, but it’s a start.
• He’s pointing out that trashing saver’s investment income and forcing them into risk is counter-productive.  Mr. Ryan recognizes capital formation will get the job done?  THAT is a change.
• He called him out on creating the housing bubble.  Heh heh heh…..

There’s more — but this is a change, and a marked one, in how the questioning is unfolding.  With that, here’s my commentary on the testimony.

February 2, 2012

Chairman Ryan, Vice Chairman Garrett, Ranking Member Van Hollen, and other members of the Committee, I appreciate this opportunity to discuss my views on the economic outlook, monetary policy, and the challenges facing federal fiscal policymakers.

The Economic Outlook Over the past two and a half years, the U.S. economy has been gradually recovering from the recent deep recession. While conditions have certainly improved over this period, the pace of the recovery has been frustratingly slow, particularly from the perspective of the millions of workers who remain unemployed or underemployed. Moreover, the sluggish expansion has left the economy vulnerable to shocks. Indeed, last year, supply chain disruptions stemming from the earthquake in Japan, a surge in the prices of oil and other commodities, and spillovers from the European debt crisis risked derailing the recovery. Fortunately, over the past few months, indicators of spending, production, and job market activity have shown some signs of improvement; and, in economic projections just released, Federal Open Market Committee (FOMC) participants indicated that they expect somewhat stronger growth this year than in 2011. The outlook remains uncertain, however, and close monitoring of economic developments will remain necessary.

As is often the case, the ability and willingness of households to spend will be an important determinant of the pace at which the economy expands in coming quarters. Although real consumer spending rose moderately last quarter, households continue to face significant headwinds. Notably, real household income and wealth stagnated in 2011, and access to credit remained tight for many potential borrowers. Consumer sentiment has improved from the summer’s depressed levels but remains at levels that are still quite low by historical standards.

Note that nice hidden statement in there.  The entire problem with the last 30 years is that we have continually spent more than we made through the economy.  Again, for Mr. Ryan (who will get this by fax) and the rest of those on The Hill:

Over the last 30 years there was no actual growth funded by output.  It was all borrowed.

That’s the root of the problem and it must be addressed.  Addressing it will cause financial contraction for some period of time — it cannot be otherwise, as the demand represented by that excessive borrowing was not real and as such the withdrawal cannot do other than cause direct contraction in the economy itself.

Household spending will depend heavily on developments in the labor market. Overall, the jobs situation does appear to have improved modestly over the past year: Private payroll employment increased by about 160,000 jobs per month in 2011, the unemployment rate fell by about 1 percentage point, and new claims for unemployment insurance declined somewhat. Nevertheless, as shown by indicators like the rate of unemployment and the ratio of employment to population, we still have a long way to go before the labor market can be said to be operating normally. Particularly troubling is the unusually high level of long-term unemployment: More than 40 percent of the unemployed have been jobless for more than six months, roughly double the fraction during the economic expansion of the previous decade.

There as been no recovery in employment.

The key here is that tax receipts are inexorably tied to the Employment Rate.  But more tellingly the fact of the matter is that the US Government has never managed to extract materially more than 19% of GDP in taxes.  Expecting that we can do it now is naive — therefore, raising taxes will not raise revenue, but lowering taxes doesn’t spur actual revenue; the history is that what lower tax rates do is spur borrowing which in turn feeds bubbles instead of healthy economic growth!

The premise of continually borrowing more to create more and more fake demand is a Ponzi scheme.

Uncertain job prospects, along with tight mortgage credit conditions, continue to hold back the demand for housing. Although low interest rates on conventional mortgages and the drop in home prices in recent years have greatly improved the affordability of housing, both residential sales and construction remain depressed. A persistent excess supply of vacant homes, largely stemming from foreclosures, is keeping downward pressure on prices and limiting the demand for new construction.

The problem is not foreclosures.  It is the refusal of regulators to force actual values to be recognized by financial institutions, which in turn has prevented the market price from sinking to the level of actual value.

The fact of the matter is that the total loss that has to be absorbed in the housing market has been stymied by these policies, which in any firm without such “blessing” would be flagged instantly as an act of fraud, that is causing the market to remain “inflated” and is thus preventing it from clearing.

Yes, I know, everyone “hates” foreclosures. Except, that is, for the person without a house who would like to buy one cheap!  Funny how we all like low prices — except when we’re sellers, or worse, when we’re municipal governments that built tax bases and rates on bubble prices that were utterly ridiculous and banks that loaned money on fictitious values that would be rendered instantly insolvent were the truth to be recognized.  Then it’s “bad”.

In contrast to the household sector, the business sector has been a relative bright spot in the current recovery. Manufacturing production has increased 15 percent since its trough, and capital spending by businesses has expanded briskly over the past two years, driven in part by the need to replace aging equipment and software. Moreover, many U.S. firms, notably in manufacturing but also in services, have benefited from strong demand from foreign markets over the past few years.

Uh huh.  Look at the GDP report and the import/export balance lately?

More recently, the pace of growth in business investment has slowed, likely reflecting concerns about both the domestic outlook and developments in Europe. However, there are signs that these concerns are abating somewhat. If business confidence continues to improve, U.S. firms should be well positioned to increase both capital spending and hiring: Larger businesses are still able to obtain credit at historically low interest rates, and corporate balance sheets are strong. And, though many smaller businesses continue to face difficulties in obtaining credit, surveys indicate that credit conditions have begun to improve modestly for those firms as well.

Economic growth does not come from credit.  Bubbles come from credit.

Economic growth comes from economic surplus, otherwise known as “profit.”  Borrowing suppresses economic surplus as the cost of borrowed funds, otherwise known as “interest” comes off the top line and thus is a dollar-for-dollar charge against profit.

So low interest rates may appear to reduce this impact but in fact all they do is produce uneconomic output — that for which there is no driver from profit.  This is otherwise known as “malinvestment” and it is bad, not good.

Globally, economic activity appears to be slowing, restrained in part by spillovers from fiscal and financial developments in Europe. The combination of high debt levels and weak growth prospects in a number of European countries has raised significant concerns about their fiscal situations, leading to substantial increases in sovereign borrowing costs, concerns about the health of European banks, and associated reductions in confidence and the availability of credit in the euro area. Resolving these problems will require concerted action on the part of European authorities. They are working hard to address their fiscal and financial challenges. Nonetheless, risks remain that developments in Europe or elsewhere may unfold unfavorably and could worsen economic prospects here at home. We are in frequent contact with European authorities, and we will continue to monitor the situation closely and take every available step to protect the U.S. financial system and the economy.

Short form:

Let me now turn to a discussion of inflation. As we had anticipated, overall consumer price inflation moderated considerably over the course of 2011. In the first half of the year, a surge in the prices of gasoline and food–along with some pass-through of these higher prices to other goods and services–had pushed consumer inflation higher. Around the same time, supply disruptions associated with the disaster in Japan put upward pressure on motor vehicle prices. As expected, however, the impetus from these influences faded in the second half of the year, leading inflation to decline from an annual rate of about 3-1/2 percent in the first half of 2011 to about 1-1/2 percent in the second half–close to its average pace in the preceding two years. In an environment of well-anchored inflation expectations, more-stable commodity prices, and substantial slack in labor and product markets, we expect inflation to remain subdued.

Against that backdrop, the Federal Open Market Committee (FOMC) decided last week to maintain its highly accommodative stance of monetary policy. In particular, the Committee decided to continue its program to extend the average maturity of its securities holdings, to maintain its existing policy of reinvesting principal payments on its portfolio of securities, and to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee now anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014.

As part of our ongoing effort to increase the transparency and predictability of monetary policy, following its January meeting the FOMC released a statement intended to provide greater clarity about the Committee’s longer-term goals and policy strategy.¹ The statement begins by emphasizing the Federal Reserve’s firm commitment to pursue its congressional mandate to foster stable prices and maximum employment. To clarify how it seeks to achieve these objectives, the FOMC stated its collective view that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate; and it indicated that the central tendency of FOMC participants’ current estimates of the longer-run normal rate of unemployment is between 5.2 and 6.0 percent. The statement noted that these statutory objectives are generally complementary, but when they are not, the Committee will take a balanced approach in its efforts to return both inflation and employment to their desired levels.

Oh really Ben?  Your mandate is for stable prices.

I will note that 2% inflation produces this over the “longer term” for an item that costs $3.50 today (say, for example, a gallon of gasoline) and I’ve taken the liberty of extending it over a working man’s life (45 years)

That’s gas prices for you, Mr. 20 year old, by the time you’re 65.

How about your kids?  Let’s extend this out 100 years:

Oh yeah that’s gonna work out real well.

Now what if Ben is off by just 1%, and it’s 3% instead?

And over 100 years?

This is why a mandate of stable prices must be enforced as exactly that — stable, or unchanging, and we must start imprisoning those who “interpret” things otherwise.

Fiscal Policy Challenges In the remainder of my remarks, I would like to briefly discuss the fiscal challenges facing your Committee and the country. The federal budget deficit widened appreciably with the onset of the recent recession, and it has averaged around 9 percent of gross domestic product (GDP) over the past three fiscal years. This exceptional increase in the deficit has mostly reflected the automatic cyclical response of revenues and spending to a weak economy as well as the fiscal actions taken to ease the recession and aid the recovery. As the economy continues to expand and stimulus policies are phased out, the budget deficit should narrow over the next few years.

That’s a nice theory.  It does not, however, fit with the facts.

Unfortunately, even after economic conditions have returned to normal, the nation will still face a sizable structural budget gap if current budget policies continue. Using information from the recent budget outlook by the Congressional Budget Office, one can construct a projection for the federal deficit assuming that most expiring tax provisions are extended and that Medicare’s physician payment rates are held at their current level. Under these assumptions, the budget deficit would be more than 4 percent of GDP in fiscal year 2017, assuming that the economy is then close to full employment.² Of even greater concern is that longer-run projections, based on plausible assumptions about the evolution of the economy and budget under current policies, show the structural budget gap increasing significantly further over time and the ratio of outstanding federal debt to GDP rising rapidly. This dynamic is clearly unsustainable.

The CBO estimates ridiculously large expansion of the economy as a whole, expiration of all of the tax cuts passed (and no new ones) and ridiculously small expansion in overall spending at a number of levels.  The one place they’re reasonably accurate is in their projection of health expense, which has grown by about 9% over the last 30 years (from $53 billion to ~$820 billion) and will continue to do so.  This is not a demographic problem either, as is often said — it also present in the private economy which is not subject to that distortion.

These structural fiscal imbalances did not emerge overnight. To a significant extent, they are the result of an aging population and, especially, fast-rising health-care costs, both of which have been predicted for decades. Notably, the Congressional Budget Office projects that net federal outlays for health-care entitlements–which were about 5 percent of GDP in fiscal 2011–could rise to more than 9 percent of GDP by 2035.³ Although we have been warned about such developments for many years, the time when projections become reality is coming closer.

Actually it’s coming now.  With a 9% rate of growth the rule of 72 tells us that health spending doubles every eight years!  If you think we can keep doing this for even one more eight year cycle, you’re wrong.

We are literally a few years — three or four at the outside — from hitting the wall at 120mph as within four years we will have added $410 billion a year to deficits and in eight nearly one trillion per year.  That’s not a one-year deal, it’s every year and it will utterly destroy any attempt to bring balance to the budgetary process.

This must be stopped right now or it will kill us and we do not have time to address it.  Those are the facts.

Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth. To the extent that increasing debt is financed by borrowing from abroad, a growing share of our future income would be devoted to interest payments on foreign-held federal debt. High levels of debt also impair the ability of policymakers to respond effectively to future economic shocks and other adverse events.

No.  This grossly understates the case; we will not make it through the next one cycle (eight years) say much less two.  To believe we can manage to spend over three trillion dollars at the Federal level in 16 years is an outrageous lie and the idea that we can absorb another $400+ billion annually in deficits before 2016 and $800+ billion annually by 2020 is preposterous. 

That which cannot happen will not happen.

This puts the lie to claims by Ryan, Southerland, Miller and others that “those over 50 will not see their Medicare tampered with.”  Oh yes they will, as for them to “not have it tampered with” they’d have to make it through four cycles of doubling, not two, which would increase Federal health spending at present rates of acceleration to more than $13 trillion by the time that person reaches 85, or some 16 times the present amount.

I have put forward a number of points on this issue and how to address it under the Health Care topic — we have to stop bleating and start doing, right here and right now.  Look particularly at my postings on this topic from 2009 and 2010.

Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point.

No, we will go off the cliff.  Stop mincing words Ben — see above, and that’s just health care; it ignores everything else.

To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. Attaining this goal should be a top priority.

Even as fiscal policymakers address the urgent issue of fiscal sustainability, they should take care not to unnecessarily impede the current economic recovery. Fortunately, the two goals of achieving long-term fiscal sustainability and avoiding additional fiscal headwinds for the current recovery are fully compatible–indeed, they are mutually reinforcing. On the one hand, a more robust recovery will lead to lower deficits and debt in coming years. On the other hand, a plan that clearly and credibly puts fiscal policy on a path to sustainability could help keep longer-term interest rates low and improve household and business confidence, thereby supporting improved economic performance today.

Nonsense. Again, we have never managed to grow the economy faster than we’ve accumulated debt over the last 30 years.  We must accept this and reduce debt, which means we must accept economic contraction.  I know nobody wants to, myself included, but what I want and what I must do are two different things.

Fiscal policymakers can also promote stronger economic performance in the medium term through the careful design of tax policies and spending programs. To the fullest extent possible, our nation’s tax and spending policies should increase incentives to work and save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. Although we cannot expect our economy to grow its way out of our fiscal imbalances, a more productive economy will ease the tradeoffs that we face and increase the likelihood that we leave a healthy economy to our children and grandchildren.

You cannot both add to debt and support capital formation (which is saving.)

It’s really that simple — we must accept the economic adjustment that has to be made, and we must accept it now.

The Market-Ticker

Discussion (registration required to post)

The U.S. and European economies are firmly between various rocks and various hard places.

Having stipulated that “Forecasting Is Not Humanity’s Strength,”  I will not make any foolish forecasts that will assuredly be proven wrong, but it is undoubtedly true that the U.S. and Europe are both entering a “crunch time” politically and financially.

In essence, both economies are between multiple rocks and multiple hard places. Eventually, this ceases to be an academic question and becomes one of actual financial impact on people via higher taxes, smaller checks, lower purchasing power, etc.

For example, the dismal failure of the Federal Reserve’s QE2 goosing of the economy has eroded its political support and thus its freedom of action.  Fed Chairman Ben Bernanke has the look of someone who is realizing his own limits and is thus pondering retirement (a speculative forecast I made last year, i.e. that Ben wouldn’t last and would be forced out or quit).

Bernanke has more or less confessed that he 1) doesn’t understand why the economy isn’t responding “like it should” i.e. as described in textbooks, and 2) that he is tired of the political heat created by QE2 and he is dropping the burden of “saving” the U.S. economy.

He looks like  a person who has lost his confidence and is going through the motions until he can figure out a way to exit the leadership stage gracefully. It is painfully obvious to all that his QE2 did nothing to heal the real economy while attracting global attention and ire. The whole project was lose-lose, with the only gain being “extend and pretend.”

Meanwhile, the Fed has to keep printing money to enable every debt holder has enough to service their debt next month, never mind next year. As frequent contributor Harun I. noted in a private email to me, the amount of leverage is so staggering that if “real money” (cash, gold, etc.) were applied to debt, a vast sum would still be left unpaid.

That’s a rock and a hard place, to be sure, as I have noted on the blog: if you print enough money to keep the Status Quo in “extend and pretend” mode, then you get inflation, which creates another set of difficulties and acts as a tax on the entire economy.

The loss of faith in Fed fixes is profound, part of the delegitimization process I have mentioned in previous Musings and blogs.

The same loss of faith is evident in Europe.  The EU leadership has to cobble together another “extend and pretend” bailout of Greece, but nobody believes it will fix anything–that belief has been shattered. Once that faith is lost, then the value of “extend and pretend” is lost as well.

There is no way Greece can meet its debt obligations, even as its creditors clamor for it to sell off its assets.  Why bother, if most of the debt will remain unpaid?  The answer is to transfer the wealthof thenation to international banks, of course, but the Greek people may not acquiesce in their impoverishment.

The only other option is for bondholders to “take a haircut,” that is, get back less than 100% of their bond.  The EU leaders are banking (pun intended) on some sort of “minor default” being the “fix” that puts the problem to rest, but they fail to grasp the subsequent loss of faith in the entire euro banking system.

If Greece’s bondholders are going to take a loss, then what’s stopping those holding Irish, Portuguese, Sanish or Italian debt from taking a loss as well?

The answer is of course nothing: there is no way to stop the “haircut” from happening in every cituation where the borrower is insolvent.

And as borrowers default, then so too do insolvent lenders.

This is the ultimate rock and hard place:the only way to clear the economy for future growth is to clear away the deadwood of uncollectible debts, yet clearing away the impaired debt will necessarily take down all the “too big to fail” banks on both continents, an action that is politically “impossible” as those banks have their hands on the throats of the governments in question.

As I have noted before, once faith in “extend and pretend” policies has been lost, then the next “extend and pretend” fix will no longer have its desired effect of calming the waters. Indeed, the failure of central institutions to grasp the nettle will be recognized as a failure that dooms the Status Quo.

The “solution” for three years has been “extend and pretend,” and now that faith in that muddle-through strategy has been lost, then there are only two choice open to policy makers:

1) enact a visibly transparent “extend and pretend” fix once again, basically pushing the crisis forward once agin for a few weeks or months, or 2) grasp the nettle and pursue a politically “impossible” real fix that wipes out uncollectible debt and insolvent borrowers and lenders.

Unfortunately for the Status Quo, the cat is out of the bag, so to speak; nobody believes minor policy tweaks  or more bailouts will actually fix their economies. So the “extend and pretend” fixes that will be presented  as meaningful will be increasingly recognized as artifice and propaganda.

This will feed the profound political disunity that already characterizes the politics of the U.S. and the E.U.

I would like to believe that the people are finally ready to lead their leadership  to real solutions, but their insecurity, doubt and fear about their own slice of the pie seems to have frozen them in a weird warp: they recognize “extend and pretend” is futile, but they have no confidence in the “impossible” choices, either, as the risk is doing anything other than “extend and pretend” frighten them.

The way out of the dilemma would be a new political consensus forms in favor of writing off all bad debt and breaking the banks’ grasp on our collective throats.  Right now that seems as “impossible,” but all sorts of other “impossible” things have happened in the past decade.

The one thing we know is truly impossible is that “extend and pretend” will actually fix anything.

As noted here before, a number of intersecting cycles suggest the end-game of “extend and pretend” will play out in 2012-2013.

Charles Hugh Smith – Of Two Minds

Stephen Roach on US Economy

Jan. 26 (Bloomberg) — Stephen Roach, non-executive chairman of Morgan Stanley Asia, talks about the U.S. economy and Federal Reserve monetary policy.     Roach, talking with Tom Keene on Bloomberg Television’s “Surveillance Midday” at the World Economic Forum in Davos, Switzerland, also talks about China’s economic strategy and the prospects for Europe. (Source: Bloomberg)

Hell has frozen over.

These columns have defended the independence of the Federal Reserve from attacks on the right and left, but after last week the central bank is on its own. It’s impossible to defend the Fed’s rank electioneering as it lobbies for more political and taxpayer intervention in the housing market—just in time for the election campaign.

This extraordinary political intrusion came in the form of a 26-page paper that the Fed sent to Capitol Hill last Wednesday, without invitation, graciously offering what Chairman Ben Bernanke called a “framework” for “thinking about certain issues and tradeoffs.” He was underselling his document. The paper is a clear attempt to provide intellectual cover for politicians to spend more taxpayer money to support housing prices.

I didn’t Ticker that paper originally as it was simply too outrageous to bother with.  There’s a point at which The Fed’s actions reach into the realm of rank politicking and attempts to protect their “chosen many” from their own foibles; we’ve certainly seen plenty of games played in the last three years.

But this paper, sent to Congress unsolicited, apparently went too far for even the Journal’s bankster-crank-stroking reflexes.  Among other things it said:

In this report, we provide a framework for thinking about directions policymakers might take to help the housing market. Our goal is not to provide a detailed blueprint, but rather to outline issues and tradeoffs that policymakers might consider. We caution, however, that although policy action in these areas could facilitate the recovery of the housing market, economic losses will remain, and these losses must ultimately be allocated among homeowners, lenders, guarantors, investors, and taxpayers.

This is where the problem is, of course.  Where does the government get the right to “allocate losses” through interventions?  The dirty little secret about the housing mess is that:

• The Fed was largely complicit in causing the housing bubble.  In fact, Greenspan intentionally stoked this speculative orgy and further, both he and Bernanke intentionally averted their eyes from the monstrous credit expansion that “maintained” economic output and which was utterly unsustainable — a mathematical fact that was obvious to anyone who bothered to look at the very data The Fed maintains!  In other words The Fed is now trying to find ways to evade responsibility for what it did.
• The losses are real but being hidden by further Fed actions!  Just one example is the hundreds of billions of dollars of second lines (Home Equity and “Silent Second” mortgages) that are behind underwater, non-performing first line mortgages.  These have an actual net present value in a foreclosure of zero, as they’re not entitled to one penny of recovery until every dollar of the first is satisfied, and the first is underwater and thus will not be fully recovered.  All of our large banks have monstrous exposures in this regard — almost none of these loans were securitized and thus they are all sitting on bank balance sheets, most at nearly 100 cents on the dollar.  These accounting values are fictions.

The reason that The Fed and our Government are desperate to hide these losses, praying for a miracle to somehow keep them from being recognized, is quite simple — these long-duration investments are typically held by insurance companies and pension funds.  Recognition of these losses will cause the allegedly “healthy” firms and funds that hold this paper to be shown to be severely impaired or worse.

Yet there is no evading these losses.  I’ve been pounding the table on these issues for five years and yet the alleged “extend and pretend” game has not led to value recovery.  Instead, the value of homes has continued to decline!  At some point the games end as these notes mature and an actual accounting must be made.  The idea that The Fed would propose that “taxpayers” eat these embedded losses is both an outrage and a circular argument — do you really care if you have your taxes raised to the point that you go bankrupt or you lose your pension and go bankrupt?  Either way you’re bust!

The only solution is to accept that which we cannot change.  Bad loans create losses when the loans are made and nothing can be done about that later on.  You can change who eats the loss, but when it all devolves back down to the public then which hand you pick someone’s pocket with makes no difference at all.

The more important issue here is holding those at The Fed personally and professionally accountable for this massive cock-up.  There is a long history of intentional evasion of the law, including Alan Greenspan’s “approval” of the blatantly-unlawful Citi/Travelers merger that was later made retroactively legal by Gramm-Leach-Bliley and evasion of reserve requirements with sweeps.  These sorts of machinations are nothing more than allowing a gambler to double down on a lost bet, and when one looks at the history of leverage in the financial markets and The Fed’s active and outrageous actions in this regard, given their charter which mandates that they control credit aggregates, it is clearly time to stick a fork in these mendacious bastards and remove the Board of Governors wholesale.

Ben Bernanke’s zero-interest rate policy (ZIRP) and command-economy efforts to maintain mispricing of risk, debt and assets are destroying capital and capitalism.  No wonder his policies have failed so miserably.

To understand why Federal Reserve Chairman Ben Bernanke’s efforts to restart economic “growth” have failed so completely and miserably, we need to compare the present with the end of the Great Depression.There is a wealth of irony in the Chairman’s supposed expertise on the Great Depression, as his policies have backfired on “fixing” the Great Recession.

Rather than “fix” the economic malaise by re-inflating the credit-boom bubble, he has only increased the systemic vulnerability to a much greater crash.

This is akin to an “expert” on World War I recommending a bigger, stronger more costly Maginot Lineas the “solution” to military vulnerability.

In the Great Depression, excessive speculation built on systemic fraud and embezzlement led to the implosion of a vast credit bubble.

The “solution” touted then and now by saviors of the Status Quo was to “save” the financial sector and debtors by substituting Federal spending (with the money being borrowed via the full faith and credit of the U.S.A.) for collapsing private borrowing and spending.

This “solution” failed because it refused to address the real problem, which was over-indebtedness in service of mal-investment.People lost faith in the system for good reason–it was fraudulent and opaque, and thus mispriced risk. If you can’t price risk or assets, then it’s insane to either borrow or invest.

The “solution” to the Great Depression was massive Federal debt and spending on World War II–but the “solution” had a key characteristic that is almost universally ignored.

Depression-era calls to bulldoze homes to be rebuilt and destroy grain so it could be regrown were rightly dismissed as mal-investment on a vast scale. But war is more or less an equivalent “consumer” via destruction.  Hundreds of ships were built and then sunk, thousands of aircraft were built and then shot down or lost, and monumental mountains of provisions and supplies were manufactured and then either consumed or lost to enemy submarines, bad weather, rot and a host of other causes.

At the end of the war, most of the leftover goods manufactured–ships, tanks, aircraft, munitions, etc.–were mothballed or scrapped.

Despite this staggering waste, the war spending launched a long boom.  How did it work this magic? One, it constructed new plant; unlike the Keynesian calls to bulldoze houses so they could be rebuilt, the war investment created factories that could then be converted to produce consumer goods.

More importantly, the war spending created a vast pool of private capital–what we call savings.As resources were diverted to the war effort, rationing limited both the manufacture and availability of consumer goods. Meanwhile, tens of millions of people were put to work, either in the Armed Forces or in the war manufacturing sector, and most had few opportunities to spend money. Industrialists also piled up war profits.

Though extend-and-pretend policies did not write off the overhang of debt that had depressed the economy and destroyed the market’s ability to properly price risk and assets, this gargantuan pool of private capital simply overwhelmed the remaining debt overhang.

Third, trust in the system was restored: the Federal government had effectively “won the war” by printing money and drawing upon the nation’s vast surplus of energy and labor, and the manufacturing and financial sectors had been brought to heel by the extraordinary demands of the war and by legislation that had responded to financial fraud and over-reach.

Recall that the root of “capitalism” is capital.  Capitalism requires two fundamentals–capital to invest and open markets for goods and services that openly price risk, assets, hedges and goods.

Note that debt is not listed.  Debt is not essential to capitalism. Indeed, if we explore the roots of modern capitalism in the 14th and 15th centuries, we find that commercial credit and hedges were the key ingredients, not debt. Lacking sufficient coinage to handle the rising volume of trade, merchants settled accounts at the great trading fairs in Europe.

Long, risky trade voyages were hedged with the equivalent of options and limited stock companies that distributed risk for a price. Leverage was limited by the transparency and appetite for risk.

Compare that with Bernanke’s policies, all of which severely punish savers (i.e. the accumulation of capital) and reward leverage and debt.By lowering interest rates to zero, Bernanke has imposed the opposite of the World War II experience of forced savings–he has made cash into trash and pushed everyone into risk assets.

By making credit dirt-cheap and backstopping financial-sector losses (i.e. institutionalizing moral hazard), Bernanke has destroyed the market’s ability to discipline mal-investment and openly price risk and assets.

World War II launched a boom precisely because private capital accumulation/savings were enforced;  when the war ended, there was a vast pool of capital available for investment and consumption.

Bernanke’s policy is to punish capital accumulation and reward leveraged debt expansion.Rather than enforce the market’s discipline and transparent pricing of risk, debt and assets, Bernanke has explicitly set out to re-inflate a destructive, massively unproductive credit bubble.

This is why Bernanke has failed so completely, and why he will continue to fail. He is not engaged in capitalism, he is engaged in the destruction of capital, investment discipline and the open pricing of risk, debt and assets.When the next “credit event” sweeps round the Fed’s Maginot Line of encouraging mal-investment and masking fraud and rolls up the entire financial sector’s defenses against mispriced risk and credit, Bernanke will be inside the over-run HQ, wondering how his “brilliant” policies could have failed so spectacularly.

Charles Hugh Smith – Of Two Minds

As if we aren’t already there….from The Hill this morning:

The Federal Reserve is turning its attention to reviving the ailing housing market, calling on policymakers to provide a boost to the sector and lift the broader economy. 

The Fed on Wednesday sent a 26-page white paper to Congress, providing a framework — including several steps that are already in the works within the Obama administration — designed to provide greater stability for the sector and the overall economy.

Uh huh.  As if there is something wrong with asset values correcting to come back into line with incomes. 

And here’s the blatant return to feudalism:

The Obama administration is examining ways to reduce the number of vacant, foreclosed homes by putting together properties to sell to investors for rental units. 

Sen. Jack Reed (D-R.I.) is pushing legislation that would convert hundreds of thousands foreclosed properties into rentals as demand rises for those types of properties. 

Isn’t that nice?  Subsidize investors (neo-Lords, many of the same culprits who caused this mess in the first place) so they can rent us (the serfs) back our own foreclosed homes without the banks taking a loss.

It goes on to explain:

“We caution, however, that although policy action in these areas could facilitate the recovery of the housing market, economic losses will remain, and these losses must ultimately be allocated among homeowners, lenders, guarantors, investors and taxpayers,” the paper said.

Here is an idea, why don’t we remove taxpayers from the line above and insert — banksters, congressmen, senators, legislative aides, lobbyist and employees of the Federal Reserve system. That way we can stick the losses onto the back of the people who caused the losses.

Now that would create real improvement in the economy.

Well look what we have here….

America’s central bank, the Federal Reserve, is engaged in a bailout of European banks. Surprisingly, its operation is largely unnoticed here.

The Fed is using what is termed a “temporary U.S. dollar liquidity swap arrangement” with the European Central Bank (ECB). There are similar arrangements with the central banks of Canada, England, Switzerland and Japan. Simply put, the Fed trades or “swaps” dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one-half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

…

The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan.

Actually, The Fed claimed it was not bailing Europe out in direct conversations with Senators at a closed-door meeting.

It’s convenient that Bernanke wasn’t under oath in recorded testimony when he made those comments isn’t it?

The reality of the so-called “bailout”, however, is small.  We’re talking about $60 billion, more or less, which is tiny in the grand scheme of things.

This makes one wonder “why”?  If it’s just year-end shenanigans, well then it is.  But what if it’s a trial balloon — to see if Congress — or anyone else — calls Bernanke on it?

If so then we better pay attention eh?

Ben Bernanke and his Fed mates’ secret letterhead: “destroying capitalism from within.”

After four years of disastrously wrong policies, let’s declare stubborn, hubris-soaked wrongheadedness a virtue and saint Ben Bernanke and his Federal Reserve mates.  If we had to distill down the Fed Chairman and the Federal Reserve’s policies since the wheels came off the Fed’s “shadow banking” system of fraud, collusion, embezzlement  and free-floating leverage, we’d have to start with a systems-analysis perspective.

Any system which separates risk from results (gain/loss) is doomed to implode,as the lack of feedback from the real world (also known as consequences) enables the self-reinforcing feedback known as “moral hazard”: losses by those who took the risk to reap a gain are made good by those who did not take the risk and who do not stand to gain from the risk they are covering.

In this case, the  mortgage origination and  packaging “industry” and the investment banks’ origination and marketing of fraudulent-from-inception derivatives “industry” took the risks to reap outsized gains from the financialization of mortgages and other debt instruments via leverage, commodifying debt and  arcane derivatives, all of which were sold as “low-risk.”

Capitalism’s primary characteristic is that capital is put at risk for a gain/loss.If risk is off-loaded onto the Fed’s bottomless balance sheet and the taxpayer via government-funded bailouts and guarantees, then capital is not actually at risk. Thus what we have isn’t capitalism, but cartel crony-capitalism, a phony version of the real thing which guarantees private banking profits and socializes banking losses.

The Fed was recently revealed as having arranged billions in private gain via secretly backstopping the banks with $7.7 trillion.This highlights Bernanke and his buds’ second catastrophically wrong policy, that of systemic opacity.

The acme of open markets is transparency. Without transparency, markets are not free or open, they are manipulated–both to hide those who are benefitting from the destruction of transparency (monopolies, cartels, fiefdoms, kleptocracies, oligarchies, etc.) and to manipulate the market as part of a permanent propaganda campaign to  “manage perceptions:” the market’s up, everything’s dandy.

Bernanke and his faithful banking-sector lackeys have destroyed transparency at every turn, refusing an audit (an audit smacks of–sniff–democracy–how distasteful), masking the $7.7 trillion in backstopping, and hiding the toxicity of the Fed balance sheet, which is loaded with over $1 trillion in distressed mortgage securities that the Fed lovingly took off the bankrupt balance sheets of its craven masters, the banks.

In other words, the Fed has massively rewarded the reckless and rescued the incompetent from the consequences of their actions.If that isn’t the perfection of wrongheadedness, what is?

Then there’s the disastrously destructive ZIRP–zero interest rate policy.The Fed’s idea here is childishly simple, and childishly ignorant: if we lower interest rates to zero, then everyone who is over-leveraged and over-indebted will be able to borrow more, but for less interest, and that will buy the system time to magically heal itself.

The Fed cannot dare grasp that “healing” in capitalism means writing off uncollectable debt and sending insolvent lenders and debtors to bankruptcy court. Capitalism would quickly dispense with their cronies in the banking sector, and so capitalism must be destroyed. That is the Fed’s raison-d’etre: destroying capitalism from within.Lenin would be envious.

ZIRP has myriad pernicious consequences.  Let’s say you have some capital that you want to apply such that it earns a fair return. If interest rates are near-zero, then a fair return has been rendered impossible by Fed policy.

The Fed leaves you only two choices:either put your capital into “risk-on” assets that are inherently risk-laden, or loan the capital out at low rates in an opaque market  and hope you’ll actually get the principal back.

Imagine being in charge of issuing mortgages which weren’t guaranteed by the Federal government agencies of Fannie Mae, Freddie Mac and FHA–that is, imagine you actually lived and worked in a capitalist system, instead of a kleptocratic crony-capital haven.

You might hesitate to loan out large sums of money (jumbo mortgages) in a market where the  risk of a decline in the asset (real estate) is obvious but official manipulation means you can only receive a very paltry return on the capital you’re putting at risk.

Since the market isn’t able to price real estate, risk or credit transparently, then prudent investors would be forced to shun the market: how can you invest wisely when assets, debt and risk can’t be priced by the market?

Prudent lenders would withdraw from such a rigged, risky market, which is precisely what has happened.Literally 99% of the mortgage market is now guaranteed by the Federal fiefdoms, all of which are losing tens of billions of dollars and require monumental taxpayer bailouts to keep underwriting the banking sectors’ private profits.

Private mortgage lending has simply vanished, and no wonder: if you can’t price assets, risk or debt, then only the reckless would enter the market, and even they would only do so if the Fed guaranteed the profits would be theirs to keep but losses could be transferred to the Fed or taxpayers.

The only way to restore trust and clear the market of uncollectable debt is to let the market transparently price, risk and credit–precisely what the Fed’s policies are designed to stop.  The Fed’s knees are chafed from kow-towing to their banker masters, and worshipping the “magic” of their Keynesian Cargo  Cult and  Lenin (“destroying capitalism from within” should be stenciled on the Fed letterhead).

Separate risk from gain, obliterate transparency and choke the market  with zero interest rates, and you’ve not only destroyed capitalism, you’ve also destroyed the economy by rewarding the most venal, corrupt, fraudulent and  capital-destroying players while stranding the prudent on an island of opacity where the true price of assets, credit and risk cannot be discovered.

Charles Hugh Smith – Of Two Minds