The Final, Fatal Knot of
Derivative-driven Equilibrium Economics

by
William Krehm

The Wall Street Journal (14/07, “Are the Hunters Low on Magic Bullets?” by E.S. Browning) comes up against the final absurdities to which ever-expanding equilibrium economics has driven this supposed science: “Despite repeated intervention by the Fed and central banks and regulators world-wide, no one seems to be able to prevent further damage to banks and other financial institutions. Shares of mortgage-finance giants Fannie Mae and Freddie Mac slid more than 45% last week alone. At weeks end investors got a further jolt when California Bank IndyMac Bancorp Inc., a big mortgage lender with some $32 billion in assets, was seized by federal regulators.

“The Fed still has plenty of money to lend to ailing banks and other institutions. Investors expect that, if government-chartered Fannie Mae and Freddie Mac get into direr straits, the Fed and/or the Treasury Department will devise a program to keep them afloat.

“But the high-profile shock treatment that the Fed used last autumn and winter - most notably, a series of sharp interest-rate cuts - isnt readily available anymore. Since last summer, the Fed has knocked more than three percentage points off the target short-term lending rate, pushing it to 2% from 5.25%.”

What is notable is that this is a situation that could not have arisen if two features of the great Rooseveltian banking reform had not only been undone and its very memory excised from the textbooks. Instead of relying on the Federal funds rate that sets - not the rate at which the Fed will actually lend money to banks in need, but the benchmark interest rate at which one bank will lend the other to meet its obligations to the Fed.

That is an important distinction, since during the Depression and again after the abandoning of the gold standard in 1971, the debt of the government to the Federal Reserve was the only legal tender on the land. And it was important that that not get mixed up with questionable assets that might end up with the Fed to support loans to the banks. That of course would bring the very legal tender under a cloud, which is in fact happening today for this and other causes that we will deal with.

There is a discount window where banks can actually borrow short term from the banks, but at a higher interest rate, but that would signal to the financial community that they are in serious trouble. That facility is in normal times rarely used.

What lessened the dependence on the Federal Fund rate, which has been used to flatten out the price level, due to an error in logic, that only a hopeless dunce would make in a logic course, but has been the very essence of equilibrium theory that was brought in over a hundred years ago. It is true, that other things being equal, if there is an excess of demand over supply, prices will tend to rise, and if there is a deficit of demand over supply, they will tend to droop. But propositions in logic cannot be flipped around and remain valid. If I hold a pistol to my head and pull the trigger, I will fall dead. But that doesnt mean that if a man drops dead, that he has necessarily shot himself. There are thousands of other valid reasons for people falling dead. But equilibrium economics works on the assumption that higher prices mean that there is an excess of demand.

You Cannot Flip Propositions Around and Take Them to Remain Valid

Let me mention only a few samples of the of higher prices that have nothing to do with an excess of demand over supply. Nobody but a fool on moving from a town of 20 thousand to New York, will expect his living costs to remain the same. How, then, can we expect flat prices to prevail when humanity makes such a move? Life spans are increasing in many parts of the world. That requires more health services, many of which only governments can supply. Our modern technologies require a far more educated population that was the case a couple of generations ago. That requires an ever greater investment in education, which constitutes a public investment. Indeed, in the 1960s, on the basis of the forecasts of hundreds of economists sent by Washington to predict the length of time it would take Japan and Germany to recover from the destruction of WWII. Theodore Schultz in the 1960s was awarded Bank of Sweden Nobel prize from having concluded that the economists forecasts were so wide of the mark because they concentrated on the physical destruction, and ignored the fact that the highly educated and trained work force of those two lands had come through the war essentially intact. He concluded that investments in human capital were the most productive a government can make. But of course, if it is treated as a current expense and written off in the year it is made, you come up with the wrong answer, and the bulk of that investment is written off as a current deficit and interest rates are driven up “to fight inflation.”

A key feature of the Rooseveltian banking legislation that would have helped the Fed and other central banks out of their present quandary. Thousands of banks had closed their doors by the time Roosevelt was inaugurated for his first term in January 1933. One of the first things he did as President was to declare a bank moratorium which was renewed when it expired to prevent a continued run on the banks. When they finally reopened their doors the essence of the new banking legislation did not depend on the benchmark interest rate entirely to guide the economy. For interest is the basic income of banks and money-lenders, and giving it a monopoly in controlling the economy, lends itself to abuse. Two measures were provided under Roosevelt to prevent or at least to moderate the monopolist power that would otherwise result. in the hands of speculative capital.

Why the Statutory Reserves Were Crucial

The “statutory reserves” that required the banks to deposit with central bank a portion of the deposits they receive from the public, on which on which the central bank pays them no interest. By raising or lowering the proportion of the redeposits according to whether the economy required restraint or stimulus, this lessened the dependence on the federal funds rate. It also provided a safeguard against excessive power by the banks. The statutory reserves were reduced drastically in the US by being made interest-free only when banks were open for business. During the non-banking hours they were automatically shifted to interest-bearing accounts - and hence the statutory reserves rendered feeble. In Canada they were completely abolished between 1991 and 1993. Strange the leading business journal should not even mention them as being a tool in the Rooseveltian tool-kit to dealing with the problems that have overtaken the world banking system. Obviously if banks were kept out of acquiring stock markets, mortgages and insurance companies, they would not have access to the cash reserves that such “other financial pillars” need for their own businesses. Once the banks get their hands on them they use them as base money to which they apply the “bank multiplier” - the ratio of the near-money (i.e., is interest-bearing money) to the actual cash in their vaults.

But to fully appreciate the trouble that the world financial system is in we must move to another article on the same page of WSJ (“As Cost of Protecting Traders Hope to Turn Doubts Into Profits” by Liz Rappaport). “US Treasury Bonds are widely considered as close to a riskless investment as money can buy. But with financial woes mounting, some investors are betting they may profit from weighing an unthinkable question: Could the US government default?

“US Treasury bonds are triply-A-rated - the highest of ratings - and have American corporate and individual taxpayers behind them. So such an event is hard to imagine.”

What is missing here is a mention of the fact that since 1971 the US is no longer on the gold standard, and that as a result the only legal tender in the land is precisely the debt of the federal government. But there is debt and debt. Behind the debt of the federal government is not only the taxation power, but the vast investments in physical infrastructures and other physical assets. These finally were recognized as assets, though significantly they are listed in the Department of Commerce statistics as “Savings” which they are not, of course, because savings signifies cash and the highest quality assets that can readily be transformed into cash. But what has not been recognized in the governments accountancy even as token values are investment in human capital - education, training, health, social services for which Theodore Schultz was briefly celebrated. Today both Schultz and his great principle have been deliberately erased from economists memories. For that has been the fate of any economists that come up with insights that block rather than serve the ever growing power of our globalized and deregulated banks.

When we say, then, that the only legal tender is central government debt, we assume serious accountancy has been introduced into our governments books to distinguish between investments that will last even for generations, and appears as debt because it has been written off (or fully “depreciated”) as a government assets in the year that it is paid for. Were it treated as capital, let alone as the most profitable investment a government can make, the books would have been in perfect shape, and instead of appearing as debt to mislead the electorate. We have long emphasized that the debt of the central bank which could provide near-interest-free financing of the government for its investments, is not really a debt but should be considered to have a positive rather than a negative sign before it. That can be simplified by recognizing once again what Schultz taught us in the 1960s - that investment in human capital - that would include not only education and training, but looking after the environment is an investment, not a luxury, and as such it should have a positive sign before it.

And then there is still a more shocking bit of tomfoolery that has replaced accountancy and economic logic that is playing a key role in the subprime banking crisis that has spun out of control. And, of course, it concerns derivatives in one of its most powerfully brainless forms, that we have warned against to no affect. Because of the deep distrust of the Feds supposed solution of the banking crisis, doubting investment funds have placed bets through swaps that will increase in value as the mortgage investments they hold with trepidation shrink in value, with the market price of the mortgaged houses that are their security. There is no necessary relationship with the total value of the swaps and the value of the mortgage. It not only stands the economy on its head, but can actually shift the net interest of the investor to the value growth of the swaps. But there is also no assurance the counterparty of such a deal will be solvent and around when the swaps are called to bail out a trusting investor.