In Defense of Gambling with Borrowed Chips, Part IV

We now get to the core of our dispute. (“At last!“ you cry.) Lament not, for we have passed through some essential preliminaries.

What is core is that Gravelle takes issue with my recommendation that the U.S. abolish its central bank, the Federal Reserve.

She says (quite accurately) that the Federal Reserve existed for 20 years before the abandonment of the gold standard in 1933. The Fed was founded by an Act signed into law by President Woodrow Wilson on December 23, 1913.

I can’t agree with her about the “why” of that decision, though. She writes that the Fed was “needed in part to deal with the rigidity of the gold standard itself, which provided insufficient money, particularly around harvest time.”

No, the Fed wasn’t needed. It came into existence as a simple matter of coalition management. What was needed, politically, was the passage and enactment of something that could be called a “banking reform bill.” There were a lot of reasons for this, most of them terrible, the best of them only slightly muddled. But the vacuity of the Federal Reserve Act as any sort of genuine reform may be seen by the four distinct currents of thought that contributed to it.

There were some important voices at the time who wanted a private and centralized banking system. They found their champion in Nelson Aldrich. There were others who wanted a system that would be private but decentralized -- this was the guiding idea of Carter Glass, chairman of the House Banking Committee when Wilson entered the White House. There was another group who demanded a system both public and decentralized -- that would describe William Jennings Bryan, for example, who was Wilson’s Secretary of State, and whose interest in monetary/banking issues was a critical source of his own appeal to his own following. Finally, there was a faction that wanted a system both public and centralized, in effect an adjunct to the U.S. Treasury. Among these was William Gibbs McAdoo, who was Wilson’s Secretary of the Treasury.

[You can find an account of all of this in the biography, Woodrow Wilson (2010), by John Milton Cooper Jr., which I reviewed for The Federal Lawyer that spring. See especially pp. 219 et seq. of that book. ]

Along the two axes involved (private/public on one side, central/decentralized on the other), there were then four possibilities and for various mutually inconsistent reasons all four factions were unhappy about the banking system, all four wanted a change. Some change was almost certain to come about, and that change (when nominally led by a Wilson, a man with no firm settled convictions of his own on the subject, but a strong desire to please everyone, or at least everyone with a suitably progressive pedigree) was bound to be a jerry-rigged mess.

We have inherited that mess, and I for one am certain that it does us all much more harm than good.
It was merely a mess for the first twenty years of its existence. After 1933, it became something much worse than a mess. The Fed became a nexus of power in its own right, and the center of machinations against the soundness of the dollar. There are always such machinations -- and there are always constituencies for them. What has proven disastrous is that they have had this great institutional leverage.

Their leverage was somewhat diluted by the Bretton Woods accord of 1944, which brought a precious metal back into the system. That brings us to the relation of hard metals and gold in particular to the value of money, which is the fourth and final point I must contest with Ms Gravelle.

Before I do, though, allow me to say this: gold is not logically necessary for the existence of a sound currency. There are other ways of achieving that goal. For example, as I write, the Republic of Greece stilll has a sound currency. That currency is known as the euro, and it is sound because its quantity is outside of the control of any politicians or central bankers within Greece. Thus, the soundness of the currency (which is as it happens not backed by gold) is forcing the Greek political system to make difficult decisions -- decisions that ought to be made but that all participants there would plainly much rather avoid.

It  is possible that Greek politicians may in fact avoid those decisions by abandoning their sound currency, and re-creating the drachma, which they can then manipulate at will. If they succumb to that temptation, though, they will I am sure rue the day.

With that understood, allow me to agree: yes, the abolition of fiat currency means, in the U.S. context and as a practical matter, the re-introduction of some role for gold. This is the one of my policy prescriptions that I haven’t yet discussed, and I will come to it tomorrow.

Equity and Prop Desks

Below is a brief passage from what may become the third chapter of my proposed book as represented in the table of contents I provided on December 10, 2010.

This complements materials I've provided for the two previous chapters, and we will continue our march in a measured pace.

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3. Equity and Prop Desks

The distinction between equity and debt is critical to any serious discussion of modern finance. It is also, not coincidentally, critical to the understanding of corporate liquidations or reorganizations. We will begin there, and soon enough we’ll be discussing corporate governance, government regulation, and the mysteries of federalism.

Think of a newly bankrupt corporation as a see-saw with a much heavier weight on the left and a lighter weight on the right. The right end, then, is up in the air. The left end (the equity) sits on the ground. The fulcrum is in the middle.
In terms of the right to receive a payoff, the most senior debt has first dibs. This is the airiest part of the see-saw. After those debts are paid off, payments follow in a sequence defined by contract and law. In time, the liquidators of the estate come to the fulcrum – the point at which what remains to be distributed is the good will of the ongoing enterprise.

Let’s assume that there is some such value (if not, we’d be dealing with a liquidation rather than a reorganization). On this assumption, the holders of the “fulcrum security” will be reimbursed by the transformation of their securities into the equity of the reorganized company. The classes of security that are lower than the fulcrum security, including the holders of the old equity, will get nothing.

One quick way of expressing all of this is to say that the holders of the equity of a company are the ones who bear the “residual risk.” They are the ones most certain to lose out in the event of liquidation. Thus, their interests are aligned with the interests of the corporation as a continuing, sustainable, entity.

To use a serious maritime image rather than the frivolous playground imagery above, we might say this: it is because the captain would go down with the ship, in accord with maritime tradition, that the captain is the best one to entrust with the task of steering the ship safely. Passengers with secure access to a rowboat in the event of a mishap are less suitable for the task.

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A footnote in there may refer to “Chapter 11 Reorganization Cases and the Delaware Myth” by Harvey R. Miller (2002), an article that sought to rebut the widespread impression, the “myth” that “there is something fundamentally wrong, even reckless, with the reorganization process as it is practiced” in the federal bankruptcy court in bellwether Delaware.

A further theme of the chapter as it develops will be the critical role of speculation in uncovering the real value of assets. Specifically, the equity markets (and their speculators) reveal the value of an ongoing enterprise as its market cap. The difficulties caused by regulations that obscure that process, thus hiding the true value. Prices as data. Leonard Read’s pencil.

From there to the role of shorts, a return to the Enron scandal, what Skilling called a certain short. Hedge funds and the prop desks of banks.

Lending out the TARP funds

So ... what should banks do with their TARP funds -- the money Uncle Sam has given them under the bail-out program Congress enacted in September?

Given them to their top executives? Good idea. "Job well done guys, you led your company into so much trouble that the feds had to give you money. Here's your personal chunk!"

Let's assume, just for giggles, that some of it won't simply be divvied up among the honchos in charge as takehome. What should they do with the rest? Lend it out to the buyers of homes or of cars and large appliances? lend it out to businesses and entrepreneurs for start-up ventures or expansions?

Or just sit on it and call it a capital reserve? There has been some sentiment that larger capital reserves are good. If the balance sheet looks better, that fact might increase the confidence of bank counter-parties, hastening a return to normalcy.

Frankly, it seems to me that the argument gives much too much importance to cosmetics.

Banks can only be self-sustaining private corporations, then can only cease to be wards of the state, if they get themselves back in the loan-extending business.

Does this mean government should use its new leverage as the provider of the capital infusion to order them to make loans? Heaven forbid! Japan's policy of directed credit, once seen as part of the "Japan Inc." juggarnaut, is now regarded by almost all who've studied it as a colossal failure. South Korea's efforts at directing credit have likewise amounted to waste and the promotion of stagnation.

So, you might ask: what should be done? If banks aren't lending out the money, and should be lending out the money, then how can they be induced to do so?

IMHO, the down side of the housing cycle simply has to play itself out. There won't be any lending activity in that particular field for awhile. A burnt cat doesn't get right back on the stove.

The automobile market is a different matter. If banks were convinced that there was once again a basis for a sound US auto industry, they would resume lending both to that industry, to its accessories (auto parts and the like), AND to their customers for the purpose of buying their products. So the solution to the question: what to do about the banks? depends in large part upon the answer to the question: what to do about automobiles?

And the answer to that is: consolidation. It appears that in the world market and given locked-in cost considerations such as pension commitments, there is only room for one domestic US automobile manufacturer. The government may have a positive role to play (I seldom type those nine words): enter into negotiations and facilitate a merger of the three battered and torn-up US auto makers. They can, together, constitute ONE decent productive auto maker.

That one in turn will enliven the ancillary industries, and together they'll give the banks some one to whom to make loans again.

On the bailout bill's passage

That was a sad spectacle. I cheered when the back-bencher's rebellion wrecked the "leadership's bipartisan compromise."

Likewise, I mourn now that the "leadership" has put down the rebellion.

"Ah," you say, "but they had to be practical. Wall Street tanked after the bill failed Monday."

So, what did Wall Street do after the bill's passage Friday? See the above graph.

The Dow Jones was up for the day by about 1% of total value when voting began. It fell immediately (this is the 1:12 peak and drop on that chart) when the early numbers on the C-Span screens showed that the bill was heading to passage.

As the process dragged on, the index recovered, returning almost to the earlier intra-day high, by about 1:25 in the afternoon.

Then the finality of it, realization the mess HAD passed, and the index dropped dramatically. And kept dropping, so that it was in negative territory for the day by 2:30.

And well I'm on the subject, can we please retire the use of "Main Street" as a metonym for "the broader economy"? I'm tired of it, I suspect you dear reader are tired of it, and even the people who keep using it are likely tired of it.

As far as the broader economy is concerned, the bailout likely substitutes the scary prospect of a brief sharp panic (followed, as such a panic was in the period 2001-03, by a prompt recovery) for the scarier prospect of a very long period in the doldrums. A lost decade or more.

After all, what has the bill done? Will this money recapitalize and de-leverage the banks? No. As I read it, it will simply allow them to jigger their numbers and pretend that they've been recapitalized.

But pretending that they're making loans will be more difficult. Pretending that the loans are going to productive borrowers will be trickier still. The experience of Japan throughout the 1990s seems dispositive here.

Get ready for a brief and malaise-plagued Obama presidency, followed by the rise of a new hyper-conservative reaction. Get ready, in short, for President Huckabee after 2012.

Deregulation as a Scapegoat

No debate analysis here. I don't do tactical campaign stuff.

I do want to take a look at the notion, though, broached by Obama, that "deregulation" is the cause of the present Wall Street crisis. I think that a mistaken diagnosis, and reform instituted on such a premise will likewise be mistaken.

The current Wall Street crisis appears to have taught many of our nation’s politicians that every important piece of financial deregulation in the last thirty years has been an error. In this scramble to ‘learn from our mistakes,’ each of several measures – each blameless, and each indeed a forward step for the U.S. and world markets – has come under fire.

I refer for example to: the securitization of mortgages; the abolition of the walls that for decades kept commercial banking apart from investment banking, and that kept both sorts of banks isolated from insurance companies; the exemption of over-the-counter derivatives from a regulatory system designed for standardized exchange-listed products; the abolition of the uptick rule. Of those changes only one, the the abandonment of the uptick rule, can be blamed upon -- or credited to -- this administration. These are all the new “usual suspects,” rounded up when something has gone wrong in “Casablanca.”

In order to think straight about such matters, we might begin by abandoning the label “subprime crisis." Yes, subprime mortgages are inherently risky. That's what the word "subprime" means, after all: more risky than prime. The current troubles may early on have taken the form of a subprime problem, but if it had been only or chiefly that they would have long since have settled down.

What we have is the aftermath of a credit bubble. That bubble burst, which is what bubbles do. The bursting in turn caused an equity bubble to do likewise, because the equities are so leveraged. That, in turn, is inspiring moronic socialistic moves by alleged free marketers.

One key lesson is never learned, however often this sort of drama plays out: that what causes a bubble to burst is precisely the fact that it has been blown. The seeds of the bust are always planted by the boom. Only in October weren’t some of the administration’s admirers complaining that it wasn’t receiving enough credit for the record-high stock market index figures of that time? The Bushies should get exactly as much credit as they are willing to shoulder blame: because the Dow 14,000 of October is one facet and the Dow 11,000 of the following September is another facet of the same fact, the fact of boom-bust psychology.

Question: what is it that markets are good at?

Answer: aggregating information. Any price (whether the price of a barrel of crude oil, a newly manufactured pencil, or a share of equity in a corporation) expresses information. It either does so accurately (and keeps the whole productive system humming) or it does so inaccurately (and throws sand into its gears).
Leonard Read’s famous 60-year-old fable about the price of a pencil makes this point marvelously well.

Let’s observe, while we are so close to the point, that the Securities and Exchange Commission’s decision to impose an emergency ban on short selling was idiotic. Capital markets are obviously less efficient without shorting than they are with it, simply because shorts bring information to the table.

At any rate, every one of the deregulatory moves listed above was a good idea, one that smoothed the flow of information into prices, and so assisted the optimal alignment of incentives throughout the economy.

The risks inherent in subprime mortgages, and in the instruments built from them, are in principle familiar and manageable. Why have they not been managed? Because there are a lot of new restraints on the free flow of information that impeded that risk management task. None of these restraints by itself would have been disastrous, but they’ve had a cumulative effect. Consider the condition of an artery near the heart of an over-eater. It is hard to say which donut is fatal. But in sum, they are. They create the arterial gunk that will block the flow of vital blood/oxygen/information to tissue that needs it.

Gordon Crovitz had a fascinating op-ed piece on this subject in Monday’s [Sept. 22]Wall Street Journal, under the headline, "Information Haves and Have-Nots."

The money quote. "There are now about half as many Wall Street analysts as in 2000. Former New York Attorney General Eliot Spitzer eviscerated the profession with $1.4 billion in settlements and a new mandate for how the industry would be structured, which made the analysts uneconomical....The now-former senior executives at Bear Stearns, Lehman and Merrill must wish they had been able to retain all those star banking analysts."

Another Spitzer legacy that has contributed to our present troubles was his Ahab-like pursuit of Hank Greenberg, effectively kicking him out of the executive suites of the insurance company Greenberg did so much to build -- AIG.
Other issues that contributed to the crisis: a ramping up of insider-trading prosecutions (including a perp walk for Ralph Cioffi and Matthew Tannin in June). The people who are deterred from trading by insider trading prosecutions are being who are … the best informed. The whole idea of criminalizing such trades strikes at the heart of the real function of markets.

Further, there is room for concern that the federal bankruptcy courts have become part of the problem. This March, Judge Posner, of the 7th circuit court of appeals, suggested that bankruptcy trustees need to be reined in, writing: “While the management of a going concern has many other duties besides bringing lawsuits, the trustee of a defunct business has little to do besides filing claims that if resisted he may decide to sue to enforce.”

In particular, trustees have become quite aggressive of late in pressing claims for fraudulent conveyance. The result is that counter-parties to any institution that may even be close to bankruptcy, which may even be rumored to be close to bankruptcy, have gotten very jittery. Why set one’s self up to be the defendant in a lawsuit brought by the next aggressive trustee?

It is a legal climate that encourages “runs on the bank,” and that is what we have gotten.

So the right lessons to draw emphatically aren’t lessons about how deregulation has “gone too far.” Nor are they lessons about the GSEs, or about the greedy golden-parachute-endowed CEOs.

No. The right lessons to draw are that the information arteries in the U.S. market system have become clogged, and after the immediate crisis has passed, the U.S. will have to take up a new metaphorical diet to keep that from happening again.
In the meantime, though: what is to be done? How can the immediate situation best be addressed?

I'll have something to say under that heading tomorrow.