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Thursday, July 31, 2008


nationalizing the banking establishment

doesn't seem possible, does it? and yet, in the throes of crisis, the door has been opened.

The Federal Reserve will be able to lend more easily to failed banks under government control because of a provision in legislation that bailed out Fannie Mae and Freddie Mac.

In the rescue signed into law by President George W. Bush yesterday, the Fed will no longer have to pay penalties on loans it makes to institutions taken over by the Federal Deposit Insurance Corp.

The measure may mean more use of the central bank's balance sheet to prop up the U.S. financial system,...

prop up is one thing, nationalize another. but the clear implication here is that the fed will abet the FDIC, removing the pressure for the FDIC to liquidate failed banks by selling their assets. the unwillingness to liquidate is already in plain sight at indymac, which the FDIC is now operating with no prospect of asset sale.

For some, the exemption opens up the Fed to more political pressure to lend to government agencies, instead of forcing Congress, the FDIC, or the Treasury to explain to taxpayers why they need more money.

``Once the Fed starts lending to a bridge bank, or indirectly to the FDIC, where is the incentive to ever stop?''
said Walker Todd, a former Cleveland Fed attorney and visiting research fellow at the American Institute for Economic Research in Great Barrington, Vermont.

The FDIC had $52.8 billion in its deposit-insurance fund as of March 31. The FDIC could raise more money by tapping a $40 billion credit line it has with the U.S. Treasury, increasing assessments on its members, or turning to Congress.

``Like any open depository institution, there will be short-term borrowing needs by the bridge bank,'' which may need to ``tap the discount window,'' Gray said, referring to the name for the Fed's direct loans to commercial banks. ``Longer-term borrowing needs would typically be met by a loan from the FDIC.''...

A request by the FDIC could always be rejected by the central bank. Still, the removal of the penalties may open up the Fed to more political pressure, possibly encroaching on its independence, analysts said.

``Why should they be doing it?'' said Robert Eisenbeis, former Atlanta Fed research director and now chief monetary economist at hedge fund Cumberland Advisors LLC. ``The whole idea'' of the rules in the Federal Reserve Act is ``to make it costly and difficult to support an insolvent institution.''

indeed that was the purpose of the federal reserve act, which -- being written by bankers in more capitalistic times with a greater fear of government -- was designed to prevent the central bank from usurping the private banking industry piecemeal. that fear has clearly been superceded.

with mass bank failures likely just around the bend, the fed, treasury and FDIC are quietly arranging for a nationalization of a significant segment of the banking industry in an effort to delay or prevent -- not assist or ease, but delay or prevent -- broad financial asset liquidation and a debt deflation that would be deeply injurious to the money center banks that are their primary constituency. government agencies have been aiding and abetting insolvent institutions for many months now, the most recent manifestations being the de facto bailout of fannie mae and freddie mac as well as the delays in the implementation of accounting rules that would reintermediate banks. as every effort is made to slow the liquidation, systems are being put in place which will allow for the strengthening of these too-big-to-fail banks at the expense of their smaller bretheren.

one might consider this as a preparing of the way to a reprise writ large of the early 1990s nordic banking crises. questions remain as to whether the migration of bad private debts onto the government balance sheet will spark a currency crisis, as the united states today -- unlike the nordic recapitalizations then or japan in 1992 -- is a massive net debtor to foreign securities holders with a much higher degree of financialization and national-debt-to-national-income.

this last point is essential. government is in essence taking steps to prevent the eradication of debt in a massive deleveraging liquidation, as this effectively constitutes a destruction of the supply of credit and therefore money. the consequence, occuring as it would from such lofty heights of indebtedness, would be a powerful deflationary spiral.

but the primary problem in the united states is an inability to support these levels of indebtedness with the underlying income of the society -- and at a time when it is becoming clear that national income will be falling -- a point re-emphasized just today with a five-year-high in unemployment claims. virtually every fix now being proposed within the establishment involves the encouragement of further indebtedness by using the government balance sheet and currency management to artificially lower the cost of credit.

in the end, however, this is tantamount to driving private credit out of the system. the cost of credit for the borrower is, after all, the return realized by the investor. proposals to suppress credit costs are equally proposals to foist minimal or negative real returns on investors. which is in part why foreign private investors are already diversifying away from the united states.

in the cases of the nordic economies or japan, those poor returns were foisted upon domestic savings. but the united states is a country, please recall, that currently has no savers -- it is the greatest debtor nation the world has seen, dependent on flows from foreign investors on the order of 6% of gdp, or $700bn a year.

minyanville's kevin depew articulates at length today on the american banking welfare state that is being assembled. his thought is that we are to experience a serious deflation without much hazard of a severe currency crash.

The dollar crisis camp misses two key points: 1) massive widespread reduction in debt requires accumulation of dollars to pay it down. 2) the government's balance sheet won't be simply the expansion of liabilities, but assets too. Not everything is going to zero.

I'm not defending the spending of taxpayer money on public works projects, but simply pointing out the reality, which is that whether one agrees with these projects or not, they often build up the asset side of the ledger as well. Infrastructure spending, research and development, military spending. These will all be projects we see going forward.

Also, which has been the main thing I want to point out, this is a multi-year, perhaps decade-long process. The key, for now, to avoiding the dollar calamity you mention, is in extending for as long as possible the unwind.

Everything the government is doing, everything the Federal Reserve is doing, everything the Treasury is doing, is taking place with that aim solely in mind: extending the unwind. By extending it for as long as possible, the potential for a currency crisis - which, by the way, no entity on the planet wants - is reduced in probability. It could still happen, but the probability of it is reduced.

As long as the unwind is extended, the deflationary process will occur as an orderly progression, people will see their wealth evaporate in slow motion, and on the other side of this "crisis" politicians will be free to resume their inflationary policies and the looting of the assets of the middle and lower classes.

this slow unwind is exactly what the nationalization of the banking establishment would facilitate. even as unrewarded foreign holders of american debt move out of dollars, the demand for dollars to be employed in debt reduction is likely to soak up redemptions for so long as the chain reaction is effectively slowed by government intermediation. this will be the key to preventing a dollar crash and some form of runaway inflation.

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