Monthly Archives: December 2014

Attack of the Zombies

There are many layers to the debate over derivatives trading, which is why we find David Stockman on the same side as Sen. Elizabeth Warren (D-MA). This, by itself, is remarkable. Stockman has a book and a blog wherein he bemoans the corruption of American capitalism, and Warren is an anti business populist – not to say “socialist.” Both hate investment banks. Here’s Stockman:

Banks are not free enterprise institutions; they … would not even remotely exist in their current Wall Street incarnation without state subsidies and safety nets … and deposit insurance

The debate is about the “swaps push out” provision of the Dodd-Frank reform act, which was postponed as part of last week’s crunch budget bill. This provision would have required Citigroup, notably, to move its swaps trading operation into a holding company separate from the FDIC insured bank. We mention Citi, as Sen. Warren does, because they have lobbied hardest against the provision.

[Dodd-Frank] required banks with access to deposit insurance … to move their derivatives business to separately capitalized affiliates.

Jeremiah is not among those who consider all derivatives to be “weapons of mass financial destruction.” Dodd-Frank makes an exception for traditional swaps trading, which is used to reduce risk. Swaps, like futures and options, grew out of the need to hedge things like currency risk. The textbook example of using an option to reduce risk is – buying a put temporarily to protect a long term investment.

Banks can keep what many consider more “traditional” swaps activity, including interest-rate and foreign-exchange swaps. A bank also can continue to engage in swaps to directly hedge its own risks.

Citi’s assertion that the push out provision would materially harm traditional hedging is a lie, because that’s exempt. The provision is meant to address dealers and market makers. Depending on how you feel about banks, here is a choice of policy approaches:

  • Outlaw swaps trading entirely
  • Outlaw swaps trading for FDIC insured banks
  • Outlaw all investment banking for FDIC insured banks
  • Get rid of deposit insurance entirely

Here, we are focusing on deposit insurance because that’s the most obvious source of risk to the taxpayer. The other form of federal assistance given to big banks is access to the Fed’s discount window. Once upon a time, the Fed provided liquidity “for good collateral, at a penalty rate,” but – with rates near zero and lax collateral standards – it’s a lot like free cash.

Note that, while neither the Fed nor the FDIC is funded by tax receipts, both are considered federal assistance by Dodd-Frank. The drafters considered, correctly, that market making in derivatives entails more risk than the FDIC can bear. That’s why the push out provision says swaps must be in a separate, non-deposit holding entity.

Alternatively, to compensate for the risk, swaps entities could be assessed higher FDIC premiums. That would be a free market solution. If you try to imagine what the market rate for deposit insurance might be, you get a good idea why it’s considered “federal assistance.” Deposit insurance is a subsidy to the banks, allowing them to pay less interest than they could in a free market.

FDICIn a free market, banks would display their capital ratios instead of the familiar FDIC plaque. Below are the Tier 1 capital ratios from selected banks’ most recent resolution filings:

  • Goldman Sachs: 16.7%
  • Morgan Stanley: 15.6%
  • J.P. Morgan Chase: 11.9%
  • Bank of America: 11.9%
  • Citigroup: 11.1%

These are the consolidated entities. As a depositor, you would want to look at your consumer banking entity – and you would want to know that it’s not funding the swaps entity. You would also want to look at how much capital your bank is projected to have in an “adverse scenario,” a.k.a. the Fed stress test. Note that Citigroup places last and, indeed, had failed the stress test.

The Fed has consistently raised the standards of its annual stress tests, leading some bankers to grumble that the regulators’ efforts … may be choking off credit to the broader economy.

This is the devil’s bargain we made with our banks. We need lots of credit to support our lifestyle, and the banks can’t survive in a free market. Instead, we pamper them with guarantees and smother them with regulation. We also worry about competition from similarly subsidized foreign banks.

Sound familiar? Regular readers will recognize this dynamic from industrial protectionism, which always cuts two ways. Protect the American steel industry, and you tax our car makers. Block cheap imports, and you raise consumer prices.

In the case of banking, we wanted our banks to compete internationally, so President Clinton repealed the Glass Steagall Act. We also want cheap credit for investment and – for you Keynesians – consumption. We pay the price in government guarantees, financial repression, regulation, and compliance.

It is ironic that the supposed heart of capitalism is, as Stockman says, a “ward of the state.” We know that bank protectionism leads to stagnation, because Japan and Europe are already there. We don’t need to join the zombie bank competition.

What we need to do is systematically reduce federal assistance, segregate investment banking, cull the TBTF ranks, and tighten the discount window. In short, we need to expose American banks to market discipline.

Contrary to the hype, our economy does not depend on investment banking. This industry can be overinvested just like any other. This means resources that could be employed better elsewhere – resources like capital, government attention, and bright young kids who should have been engineers.


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The Good Old Days

The tagline of this blog refers to the decline of America, which we hope to stem by creatively presenting some of the problems and an occasional solution. Jeremiah is an old man, though, and open to the charge of nostalgia. Were things really better in the old days? Indeed, the simple topic of whether things are getting better or worse has become politicized. The incumbent party always wants us to feel rosy, and no one wants to talk about a secular decline.

Oswald shot Kennedy and the straitlaced bulwark gave way to the gargantuan banana republic – Philip Roth

Another crabby old man, Philip Roth, wrote that America went to hell after President Kennedy. That would mark a decline starting in 1963, which is the same year identified by Jeremiah. But don’t take our word for it. Below is a chart of America’s trade balance, with annual deficits from the 1970s, and approaching $800 billion in the new century.

Trade Balance

Here are some key dates that marked America’s peak in the 1970s.

  • Nixon ends gold standard, 1971
  • Real weekly earnings peaks, 1972
  • End of Apollo space program, 1972
  • Personal saving rate peaks, 1975
  • Trade balance goes negative, 1976

Some trends, like mortality, stature, and income continue to be positive, but lag other advanced economies since roughly 1960. See infant mortality, for example. The income trend is not so rosy once we correct for inflation. See chart below.


Civil rights have improved since 1960 but, again, not in comparison with other countries – and now we seem to be backsliding. The security state represents an attack on everyone’s civil rights, regardless of race or gender.

We admitted we were powerless over alcohol—that our lives had become unmanageable.

Our purpose is not to diagnose the problem (links for that are here and here) but to make plain that there is a problem. This is the first step in any treatment program – and maybe the hardest. That’s why our collective American consciousness is in such deep denial. Try replacing “alcohol,” in the sentence above with, say, “consumerism.”

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Follow the Money

Since we covered the drop in crude a month ago, prices have continued to fall. An updated chart is below. A commodity crash looks like any other crash. If you are holding oil stocks or futures, you want to get out today because it may go lower tomorrow.

This is worse, actually, because everybody knows the other guy’s cost of production. Here in America, shale oil is comparatively expensive – and subsidized with cheap (relative to risk) financing. The producers best equipped to endure price pressure are the Saudis, and they know it.


Yesterday, we read that the oil crash is not a problem for Russia because the ruble is also crashing. Jeremiah enjoys the unique insights at Zero Hedge, but this is the dumbest idea ever. They printed a chart showing that the price of oil is stable – in rubles. All this proves is that Russia has two crises, and they’re related. So what if oil consumers in Russia have a stable cost? Their purchasing power is still getting crushed.

This is an example of “reasoning from your conclusions.” The author must have some thesis about the Russian economy, and he’s looking for a way to support it. Maybe he’s long Russian stocks. The key to understanding the world is always to have an unbiased model of reality. As Saint Francis said, “Seek first to understand.” Only then is it safe to make investments – or public policy. Jeremiah is not even interested in the stock market. We only follow it because of Mark Felt’s advice.

Some pundits say the Saudis have spiked the price of oil because America asked them to help crush the Russian economy. That’s a little conspiratorial, but it does explain the (one) cause and effect. Our original post was more market oriented, and held that the target is actually marginal American shale producers. Only the Saudis know what went into their analysis, but we’d like to believe it was based on maximizing their long term revenue.

The catalyst could have been any early warning of lower prices to come. Destroying Russia? How about a slowing global economy? One would certainly want to be proactive about that – or Venezuela. The wheels have been coming off the Bolivarian Revolution since Chavez died. It was only a matter of time before a glut of North and South American supply ran into waning global demand. The present crash was unpredictable only because a key participant chose to force the issue.

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America’s Deep State

us-ciajpg-5d21951bc95bc9da_largeThe intriguing thing about the CIA torture report is not so much the content, but the timing and motivation for making it public. For the record, Jeremiah feels the way most people do. America should not torture people anywhere, on any pretext. It’s against our principles, and it’s ineffective.

Hard cases who don’t mind “waterboarding some Arabs if it saves American lives,” seem to be mostly on the right. We refer them to über Republican John McCain, who has been a vocal critic of torture from the outset.

National security policy is forged and carried out by a managerial class that is effectively removed from electoral and constitutional constraints

If you’re a whistleblower, like Dan Ellsberg or Edward Snowden, you must go to the press because there’s no other authority you can appeal to. Dianne Feinstein, however, chairs the Senate Intelligence Committee. Publishing a report like this declares that she, her committee, and Congress have not been able to control the CIA. It damns not only the spooks, but their elected handlers in Congress and the White House.

The right says Sen. Feinstein has an axe to grind with the CIA, and wants to release the report before losing her chairmanship in the next Congress. Well, yes! The CIA has done everything it could to bury the report, including hacking the Senate’s computers. That’s quite alarming, if you think about it – an intelligence agency attacking the civilian government.

Mr. Obama can and has ordered the assassination by drone of a US citizen without crossing the door of a judge.

Not that the left should gloat, either. President Obama has his own personal drone war, and NSA surveillance has not slowed since the Snowden revelations. The report shows that the same spooks who have been lying to Sen. Feinstein also lied to President Bush – which brings us to the issue of why a high ranking Senator feels the need to take her case public.

Why hasn’t Obama been able to brake the NSA? Why couldn’t Congress check the CIA? We like the FT’s introduction of the term deep state. This would explain the trend we see, in which rotating red and blue figureheads have no impact on our evolving police state. It’s no different from Iran, where you may vote for Rouhani instead of Ahmadinejad – but the Council of Guardians is always in charge.

See also: Extrajudicial Killing

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Highway Robbery

Police-might-shoot-you-during-a-traffic-stopThe last word on civil asset forfeiture is the Post’s four part report, starting here. Be sure to read all four parts. This guy will be getting a Pulitzer. It is six parts, if you count the two follow up stories. If you don’t have time to read it all, a short video is here.

There is not, as you may have heard, an official warning for Canadian tourists, although there was this scathing editorial on CBC news. Since CBC is government funded, you could argue that it’s official. Canadian journos are so erudite. They call the program “Kafkaesque.”

There have been 61,998 cash seizures made on highways and elsewhere since 9/11 without search warrants or indictments … totaling more than $2.5 billion

And indeed it is. If you refuse a friendly request to search your car, then you’re “suspicious.” In any case, your car gets searched. The police then help themselves to your cash and anything else that seems valuable – er, suspicious. You need never be charged with a crime. The cops just take your stuff. Here are highlights from CBC:

  • The businessman from Georgia who was relieved of $75,000 he’d raised from relatives to buy a restaurant in Louisiana.
  • The church leaders who were carrying nearly $30,000 from their Baltimore parishioners to carry out church activities in North Carolina and El Salvador.
  • The young college grad with no criminal record on his way to a job interview out West who was relieved of $2,500 lent to him by his dad for the trip.

As the editorial says, you might expect this from dirty cops in, say, Tijuana – but America? There is, unbelievably, a legal framework for this, plus training programs and online forums. “Equitable sharing” means the seizures are deemed federal – harder to sue than the local sheriff – and they split the money.

It’s easy to see why the DOJ and local police like the program. Budgets are strained to pay salary, benefits, and retirement for public sector employees. See Detroit, Stockton, Rhode Island, and San Bernardino, to name a few. You can expect this budget challenge to gather pace across the country. Some places have cut police services, like responding to 911 calls.

Civil asset forfeiture allows the police to fund themselves, by robbing passing motorists. Some police forces even plan such takings in their annual budget. Instead of facing up to the budget challenges, we simply empower the police to “live off the land,” or as Deputy Ron Hain put it, “turning our police forces into present day Robin Hoods.”

Turning our police forces into present day Robin Hoods

We have been following Barton Hinkle and Radley Balko on police militarization. Hinkle compares the police to a conquering army, and this completes the paradigm. Sun Tzu (and other generals) said that the army should be able to support itself by pillaging the conquered territory.

See also: The Praetorian Guard

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Asian Values

Jeremiah confesses to becoming somewhat of an Asiaphile. Check out this ad from Bank of Singapore. We looked into this “Asian values” thing, and found Kishore Mahbubani.

Like you, we believe success is built on the Asian values of integrity and hard work

In addition to integrity and hard work, Professor Mahbubani has identified seven “pillars of wisdom.”

  1. Free market economics
  2. Science and technology
  3. Meritocracy
  4. Pragmatism
  5. Culture of peace
  6. Rule of law
  7. Thirst for knowledge

Sound familiar? Those sneaky Asians have lifted our values! Jeremiah distinctly remembers free market economics in America, as recently as the 1980s. In fairness, this is a Singaporean list. For China, meritocracy and rule of law may be more aspirational.

[Western intellectuals] had sharp minds, always producing new insights as they spoke. It has come as a huge personal shock for me to see this same group of Western intellectuals now totally blind to emerging new realities.

Mahbubani writes that he is personally surprised to see intellectual leadership – or wisdom, as he calls it – waning in the West. He draws lessons from our policy failures, as in this article, motivated by the minimum wage debate.

If the powerful American Constitution and its system of checks and balances have failed to prevent dysfunctional governance in the US, we in Singapore should take heed

America is not a place, they say, but an idea. If we have forsaken the idea, we should be glad it has found a new home. Good values are good for everyone. We hope to see them discovered – and rediscovered – around the world.

See also: The Road from Serfdom

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Stories to Frighten Children

MedalCommentators like to exclaim about how much “market cap was lost” or “wealth was destroyed” by the latest drop in price. In a market crash, however, the drop does not destroy wealth. It merely reveals the true level of wealth. Destruction happens on the way up, as irrational exuberance leads to poor investments.

Watching the numbers on Wall Street, it’s easy to forget that investments ultimately are made in earning assets like shops, labs, and factories. It’s during the bubble phase that wealth is destroyed, by funding investments that never pay off.

The EU has had to deal with two crises … The first was obviously the global financial crisis, caused by major falls in asset values. – Douglas Flint, remarks to House of Lords October 2014

We were reminded of this popular misconception when we read it recently in Douglas Flint’s testimony before the House of Lords. This statement is an oversimplification, to put it politely. “Major falls in asset classes” did not materialize out of nowhere.   Is there anyone in the House of Lords who accepts this account of the crisis? It seems scripted – for children, perhaps, or the CNBC cheerleaders.

Masaaki Shirakawa comes off as rather better informed, but still surprised (!) to discover asset price bubbles. In fairness, the Japanese bust was the first of its kind among developed economies in the postwar era.

We have to start by recognizing this odd reality of bubbles being accompanied by price stability, yet then followed by instability of the financial system, subsequently bringing about low growth and often inflation that is lower than desired. – Masaaki Shirakawa, remarks at BIS conference March 2014

Yes, this odd illusion of stability – like ice over a flowing river. He goes on to describe a central bank misled by consumer prices into “accommodating” an asset bubble, which in turn destabilizes the financial system. The ensuing low growth, we have to say, is the true trend rate.

Our purpose here is not to single out people, like Mr. Flint, who should know better. We are intrigued, however, by the long list of trained professionals who continue to be surprised by this well understood chain of events. This prescient article, subtitled “central banks should pay more attention to rising share and property prices,” is from 1999.

U.S. house prices have risen by nearly 25 percent over the past two years … but these increases, [Bernanke] said, “largely reflect strong economic fundamentals.”

This studied “surprise” is starting to wear thin. Have America’s central bankers purposely inflated bubbles and then lied about it? That seems a little extreme. Maybe there’s another explanation. Here is an iconoclastic way of looking at our American trendline:


Maybe, without the tech bubble and the housing bubble, the S&P 500 would have run flat around 1,200. Raghuram Rajan has said that Western leaders are using credit to compensate for their citizens’ loss of purchasing power. They have a powerful incentive not to admit their economies are in decline. Boom and bust cycles, six or seven years long, are preferable to obvious stagnation – especially on an elections calendar.

If the Fed were not complicit in this deception, politicians would change the Fed. Consider Sen. Schumer’s famous “get to work, Mr. Chairman,” or this one from Sen. Gramm – mere weeks before the NASDAQ crash:

 “Don’t become so frightened by success that you throw wet blankets on a fire that isn’t burning.”

Central bankers aren’t stupid, and they aren’t independent. They know their political masters enjoy a rising stock market, and can easily escape blame for the inevitable crash – especially if the crash is inexplicable, and entirely unforeseen.

See also: America’s structural trap

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