Three blind mice. Three blind mice. See how they run. See how they run. Did you ever see such a sight in your life, As three blind mice?"
It's simple thought construction. Lending by the DFIs (+M +Vt) is inflationary (where S "≠" I ). Whereas lending by the NBFIs (transfers of title), is non-inflationary (where S = I ), ceteris paribus. But the shifting of other things, in other words Gresham’s Law of investors’ preferred stocks of assets, are not always equal. The aggregate supply-side, AS, depends upon how capital is used, e.g., mal-investment / speculation vs. real-investment, R and D, , or MFP enhanced outlets.
Productive business investment (gross private domestic investment) still boils down to where money flows, M*Vt, are less than or equal to, ≤, the existing flow of products to the marketplace (generating higher quantity, quality, and lower unit costs). And headline fake news, the CPI (or the Fed’s PCE, which “Shadow Stats” esp. deprecates), according to the Bureau of Labor Statistics “does not include investment items, such as stocks, bonds, real estate, and life insurance because these items relate to savings, and not to day-to-day consumption expenses.”
Dichotomy #1: “2 Measures of Inflation and Fed Policy”
Lance Roberts knows this: “Yesterday, I discussed the mathematical adjustment to the GDP calculation that added $1 trillion to economic growth. To wit:
“Where did a bulk of the change come from? A change in the calculation of “real” GDP from using 2009 dollars to 2012 dollars which boosted growth strictly from a lower rate of inflation. As noted by the BEA:
“For 2012-2017, the average rate of change in the prices paid by U.S. residents, as measured by the gross domestic purchasers’ price index, was 1.2 percent, 0.1 percentage point lower than in the previously published estimates.”
Importantly, the entire revision is almost entirely due to a change in the inflation rate. On a nominal basis, there was virtually no real change at all. In other words, stronger economic growth came from a mathematical adjustment rather than increases in actual economic activity.” And in the revision to statistics “It now transpires that income growth has been running ahead of consumption growth in the past five quarters, which was not the case previously”.
Dichotomy #2: Minneapolis Fed President Neel Kashkari:
“It is really hard to spot bubbles with any confidence before they burst. (2) The Fed has limited policy tools to stop a bubble from growing, even if we thought we spotted one. (3) The costs of making policy mistakes can be very high, so we must proceed with caution. (4) What we can and must do is ensure that the financial system is strong enough to withstand the inevitable bursting of a bubble. And finally (5) monetary policy should be used only as a last resort to address asset prices, because the costs to the economy of such a policy response are potentially so large.”
Spectacular example: The ratio of home prices to rental costs reached a 36 year high in 2006.
All interest used to be tax deductible before the Tax Reform Act of 1986. The Act encouraged home ownership, boosted home-equity lines, incentivized ATM cash-out refinancing, made local property taxes deductible, made up to $100,000 in interest deductible, made the first $250,000 of capital gains on home sales tax-free, etc. And when people own homes (instead of rent), they buy appliances, furniture, lawn mowers, tools, i.e., a lot of durable goods, etc. And in 2005, 28 percent of homes were purchased as investments rather than residences. So it’s no happenstance that with higher AD, and higher profit expectations, there was a burst in productivity growth during the same period: 1995 to 2004.1
This cloaked American Yale Professor Irving Fisher’s pro-rata share of the unrestrained inflationary real-estate price spiral (Gresham’s bubble). Note: Gresham’s Law is "a statement of the least cost “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most widely viewed as profitable.
However, Princeton Professor Alan S. Blinder’s (Ph.D. Economics, MIT, MSc, London School of Economics) had a convincing argument: "- How do you know it's a bubble?
(1) The historical data should be long enough to give us an historical perspective. (2) The data should be deflated (using real prices) (3) The data should be compared to the relative prices of other things.
“Using 120 years of historical home prices, the relative prices of houses in America barely changed over more than a century! The average annual relative price increase from 1890 to 1997 was just 0.09 of 1 percent. Then things changed dramatically. According to the Case-Shiller index, real house prices soared by an astounding 85 percent between 1997 and 2000—and then came crashing down to earth from 2006 to 2012. This represented a large, long-lasting, and a sharp deviation from fundamental value." Pg. 32 “After the Music Stopped”
The income-inequality pendulum began to swing with the fast-tracked impoundment and ensconcing of monetary savings, income not spent (the deregulation of interest rates by the most dominant economic predator, the American Banksters Association). The transition between early stagflation effects (beginning in c. 1965), and latent secular strangulation effects (which followed in 1981 - and persists in aggravated form since remunerating IBDDs), was the "monetization" (deregulation) of time deposits (the regulatory relaxation in time deposit gatekeeping restrictions, viz., the window of conversion, penalty of withdraw, etc.). The cumulative effect was to transform virtually all time deposits into the economic equivalent of low velocity demand deposits, since the holders of these accounts could: on demand, or in the marketplace, convert these holdings without significant delay or loss of principle, into demand deposits.
The DFI’s buying of their liquidity, instead of following the old fashioned practice of storing their liquidity, brought an end to the U.S. Golden Era in Economics (where GDP = PI), i.e., George Baily’s “It’s a Wonderful Life”, and the “3-6-3 rule”; bankers paying 3% interest to depositors, lending money at 6% interest, and playing golf by 3 PM (i.e., the savings-investment hyperactivity after WWII and up until 1965).
Back when prices were rising rapidly and interest rates were high, a severe penalty was attached to holding idle cash balances. Money had to be spent or invested immediately if this penalty was to be avoided. During this unhinged period, Vt, the transactions velocity of circulation, thereby accelerated.
The acceleration in money velocity was significantly impacted by two institutional factors: (1) the issuance of negotiable certificates of deposit by commercial banks, and (2) the daily compounding of interest on savings. These two institutional innovations allowed everyone, from the treasures of the largest corporations, to the smallest savers, to hold any temporary surplus cash in an interest bearing account, which could be shifted at little or no cost, and no loss of accumulated income, into demand deposits or currency.
Example: “Use of negotiable certificates of deposit as a means of attracting large accumulations of money market funds began in February 1961, when the First National City Bank of New York announced it would offer large denomination negotiable CD’s, and the Discount Corporation, a Government securities dealer, announced it would make a market for them.~ The transferability of these CD’s enhanced their desirability as a financial asset.”
See: page 4 graph – “Negotiable Certificates of Deposits Outstanding” for growth rates.
From c. 1961-1981, asset-liability management, ALM, accelerated money velocity in the DFI’s less volatile liabilities (liabilities with little or no reserve requirements, liabilities where Reg. Q restrictions were first to be relaxed and then removed, liabilities which expanded the fastest). The increasing use of electronic means to transfer funds also quickened payments’ velocity. Most of this “S-Curve” dynamic damage (sigmoid function), was done by the first half of 1981, with the widespread introduction of new negotiable demand drafts, e.g., the effervescent “saturation value” of ATS, NOW, and MMDA accounts.
Compounding the problem was the expansion of the money stock during the same period. The excessive increase in the primary money stock combined with a sharp rise in the transactions velocity of circulation (debits to deposits) were responsible for those high rates of chronic inflation. This in turn was wholly the cause of century highs in market clearing interest rates.
During the decade before 1965 the annual compounded rate of increase in our means-of-payment money supply was about 2 per cent (during the U.S. Golden Era in Economics). And during this same period, 1955-1964, the rate of inflation, based on the Consumer Price Index, increased at an annual rate of 1.4 percent. Unemployment averaged 5.4 percent. In contrast today, the stagflationist advocate inflationary targets in excess of 2 per cent (and no one is advocating WIN). No, Keynesian modeling myths, e.g., the Phillips Curve – trade-off between inflation and unemployment, wealth effect -tendency of households to spend some fraction of an increase in net worth., etc., don’t work. If incomes stop growing and prices keep rising (real wages), workers lose ground financially.
During the same period, the annual transactions velocity of money increased from c. 21 to 31. In ten in-year period since 1964, the money stock grew at an annual compounded rate of c. 6.5 percent and the transactions velocity of money reached an average level of 70 in 1973.
Velocity continued to increase to over 80 during 1974. The impact of both an accelerated increase in the volume and velocity of money on prices is made even more evident if the rate of increase in aggregate monetary demand (money time’s velocity) is examined. During the decade ending in 1964, money flows increased at an annual compounded rate of about 6 percent. In the nine years since 1964, the increase was more than 13 per cent, and in 1972-73, nearly 30 percent. Because R-gDp and presumably, the volume of goods and services offered in the markets, was increasing at a rate of less than 5 per cent, it should have been no surprise that there was an intensification of our chronic rates of inflation to devastating levels, thereby validating OPEC’s administrative (synthetic) price increase.
This inflationary debacle was ended by the Depository Institutions Deregulation and Monetary Control Act of March 31st 1980 (H.R. 4986, Pub.L. 96–221), when the new regulations began to soak in. In the stroke of a legislative pen, the DIDMCA turned 38,000 non-banks / thrifts into commercial banks, and in the process wiped out 38,000 financial intermediaries. I.e., the MSBs, CUs, and Savings and Loan Associations were converted into deposit taking, money creating, financial institutions, one’s that could now issue demand drafts, credit cards, offer consumer loans and brokered deposits.
The fallout in 1981 (with the funding yield curve being inexorably inverted), was that approximately 3,300 of the 3,800 thrifts lost money. Dr. Lawrence H. White, a senior fellow at the Cato Institution wrote about duration risk in the borrow short to lend longer, savings-investment paradigm: “in 1979-1981 it rendered insolvent about two-thirds of US thrift institutions (FSLIC, NCUSIF, insured), who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits”.
One of the DIDMCA’s repercussions, was to destroy money velocity (freezing an increasing proportion of monetary savings: transaction type deposits vs. savings-investment accounts, all moored in the newly augmented payments system). Exactly as professor emeritus Pritchard pontificated in May 1980: “The Depository Institutions Monetary Control Act will have a pronounced effect in reducing money velocity”. The professor could just have gone on and said the DIDMCA will have a pronounced effect in reducing real output. Secular strangulation, chronically deficient aggregate demand (and all its undesirable trappings, increased indebtedness, stagnant income growth, income inequality, social unrest, etc.), was the direct outcome.
The DIDMCA caused dis-intermediation (a U-turn in the utilization of savings, in the savings-investment process), an economists’ word for going broke (an outflow of funds end masse, or negative cash flow). Unlike as fabricated by: the ABA, professional economists, and Congress, this ill-conceived volte-face only occurred in the thrifts – largely by the DFIs outbidding the NBFIs (although the MMMF’s, because of an extremely flawed monetary policy, also intertemporally, outbid the thrifts).
As Republican Alf Landon’s daughter, Senator Nancy Landon Kassebaum wrote me back: 11/4/81: “Today, less than two years since the DIDMCA was established, most of the liabilities have been deregulated with no change in the asset structure that would enable payment of higher rates to depositors”.
The Savings and Loan Association crisis, an economic implosion due to the thrifts’ disintermediation (yield curve inversion), - the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to *1995*, was the inevitable result of this Act (where home prices fell 3% over 8 months).
Percentage of time (savings-investment type deposits) to transaction type deposits: 1939 ,,,,, 0.42 1949 ,,,,, 0.43 1959 ,,,,, 1.30 1969 ,,,,, 2.31 1979 ,,,,, 3.83 1989 ,,,,, 3.84 1999 ,,,,, 5.21 2009 ,,,,, 8.92 2018 ,,,,, 4.87 (declining mid-2016 with the increase in Vt)
The ABA’s propagandizing was widespread. Wall Street Journal: "In a letter of March 15, 1981, Willis Alexander of the American Bankers Association claims that: 'Depository Institutions have lost an estimated $100b in potential consumer deposits alone to the unregulated money market mutual funds.'
As any unbiased banker should know, all the money taken in by the money funds goes right back into the banks, in the form of CDs or bankers acceptances or other money market instruments; there is no net loss of deposits to the banking system. Complete deregulation of interest rates would simply allow a further escalation of rates by the banks, all of which compete against each other for the same total of deposits." -Written by Louis Stone whom the movie "Wall Street" was dedicated to - Vice President Shearson/American Express
The recessionary-crisis, July 1990 –Mar 1991 (the first negative RoC in bank debits since the Great Depression), ended with the FSLIC becoming insolvent (being rescued by the FDIC), and the rest of the damage being mopped up under the auspices of the Resolution Trust Company (underwritten by taxpayers to liquidate real-estate assets of failed thrifts). The RTC was the “bad bank” that consolidated bad assets off weakened or insolvent S&L’s balance sheets. It held these assets, sold them (held auctions to clear / mark to market) when the real-estate market improved (retaining ownership on assets that they sold for less than face value, sharing in any subsequent recovery), recouping what RTC could, and then writing off the rest.
I.e., the Federal Home Loan Bank Board was absorbed into the U.S. Treasury, and when necessary the Treasury’s OTS, the Office of Thrift Supervision [sic] (which replace the Federal Home Loan Bank Board), nationalized (sequestered) the insolvent thrifts and wiped out shareholders. The OTS resolved c. 750 insolvent thrifts - while the FSLIC was only able to resolve c. 300. Notably, exacerbating secular strangulation, this eliminated the federal government’s insuring of macro-scale, intermediated, pooled, retail funding deposits (the backbone of the U.S. Golden Era in Economics). The Savings and Loan Associations share of the residential mortgage market fell from 53 percent to 30 percent, from 1975-1990 and continued to fall into the 1990s.
The deterioration of our financial infrastructure had many causes; the chronic mismanagement of our money system since the early 60s; the confusion of economic competition with financial permissiveness; the blurring (by law and administrative practices) of the important distinction between money creating institutions and financial intermediaries; and a seeming unwillingness of the monetary authorities, especially in the Federal Home Loan Bank Board and the FSLIC, to adequately monitor the Savings and Loan Associations and take appropriate action to prosecute obvious fraudulent management practices (especially in Texas and California).
The thrifts were especially vulnerable because they were forced by competitive conditions and the nature of their business to borrow short and lend long (funding outflows adversely exacerbated by an inverted yield curve, exacerbated by flawed monetary policies). Thrift’s business model and home ownership was originally sponsored by depression era legislation, through the buttressing of financial intermediaries, which stimulated the post WWII housing boom (in order to combat the defaults and foreclosures, that by 1933, encompassed 40 to 50 percent of all home mortgages in the United States), e.g., the “Home Loan Bank Act of 1932”, the “Home Owners' Refinancing Act of 1933” responsible for “the Home Owners' Loan Corporation” (HOLC) and the “National Housing Act of 1934” responsible for the Federal Housing Authority (FHA).
“The HOLC's lasting legacies were long-term, low-interest, mortgages, and the establishment of uniform national appraisal methods throughout the real estate industry. The FHA's enduring legacies were long-term mortgages insured by the federal government and the establishment of national standards of home construction…The creation of the Federal National Mortgage Association (Fannie Mae) under the Reconstruction Finance Corporation (RFC) in 1938 completed the New Deal's housing program.”
This unnecessary, unequal, and unreal quagmire of competition, between the thrifts with the commercial banks (irrespective of the “The Interest Rate Adjustment Act of 1966”), resulted in a deterioration of the credit worthiness of the thrifts.
In the tug of reality, savings flowing through the non-banks (thrifts) never leave the payment’s system. Thus, the complete deregulation of interest rates sabotaged the economy. To make matters worse, the response of the monetary authorities and state legislatures was to give the thrifts more and more discretion in lending. As the Savings and Loan Association managers were allowed to become real estate developers with many opportunities for self-dealing, it came as no surprise that greed and fraud reached monumental levels in the thrift industry.
The sugar-coated universal problem encountered by the Savings and Loan Associations was adverse interest rate differentials (an inverted yield curve compressing marginal costs), the unfavorable difference the thrifts paid to attract and hold savings, and the rate-of-return on pre-affixed long-term mortgage commitments made at substantially earlier, and substantially lower rate periods. Loan delinquency on the other hand was much less a problem for the thrifts as compared to the commercial banks. During the late 70s and early 80s this adverse differential often amounted to more than four percentage points. Even for the most efficient thrifts, a pre-arranged positive spread of at least two percentage points was required to break even. Thus, the annual losses amounted to approximately 6 percent of loans outstanding.
This fundamental misconception of the role of the commercial banks vis a vis the thrifts in the savings-investment process did not create financially lethal problems for the thrifts as long as the commercial banks did not, or could not, due to the interest rate ceilings, pursue an aggressive policy to expand their time deposits. As late as 1956 member banks were paying an average rate of only 1.5 percent on their time deposits. The Fed capped the interest rate member banks could pay through its Regulation Q, and the FDIC followed the practice of applying the same rate structure to all insured nonmember banks. As a consequence of the unprecedented housing boom following WWII the thrifts prospered and grew; and at a much faster rate than the commercial banks. This intensified the desires of the commercial banksters to “get a piece of the action”.
The expansion of time deposits (savings-investment type bank accounts) adds nothing to the payment system’s total liabilities, assets, or earning assets. And the cost of maintaining time deposits is $ for $ greater than the cost to maintain demand deposit accounts; as the much lower cost of administration of time deposits as compared to demand deposits, are more than offset by the interest cost on time deposits and the loss of activity (service charge) revenue derived from demand deposits.
“If savings are “lent” to the commercial banks there is no change in the volume of deposits, no change in the volume assets, nor any change in the volume of excess reserves. The only change that has taken place is the passive or negative change of total inactivity of the deposits.” - L.J.P.
But this inactivity shrinks aggregate demand and thus lowers gDp. It has the longer-term effect of shrinking business opportunities for investment, CAPEX or real private non-residential fixed investment, and consequently, increases transfer payments to non-productive recipients (disguising actual private-sector growth rates).
Business investment (spending on capital goods, such as factories, machinery buildings, raw materials, and other goods used to produce tangible products) is proportionately much smaller than consumer spending, but is paramount to expanding productive capacity. Business fixed investment by country. The U.S. ranks 114th. The U.S. biggest export is its debt (importing savings, increasing net foreign investment, raising indebtedness, increasing unemployment and underemployment). I.e., the U.S. is pointlessly, a net borrower of capital. Since 1976, the U.S. has always run a trade deficit.
Subsequent conjoined legislation, the Garn–St Germain Depository Institutions Act of 1982 (Pub.L. 97–320, H.R. 6267, enacted October 15, 1982), contributed to the deterioration in any intermediated “J-Curve shaped” hyperactivity by liberalizing Savings and Loan Association’s heretofore specialized portfolios of conventional mortgages (by law, thrifts could have no more than 20 percent of their lending in commercial loans).
The deregulation added risk, e.g., Alt-A mortgages and permitted ARMs, allowed the Savings and Loans to take ownership stakes in properties in which they made loans, and buy junk bonds. It: “increased the proportion of assets that thrifts could hold in consumer and commercial real estate loans and allowed thrifts to invest 5 percent of their assets in commercial, corporate, business, or agricultural loans until January 1, 1984, when this percentage increased to 10 percent”. And interest rate reset hazards were shifted back to the borrowers.
From that twisted point forward, aggregate monetary demand, AD’s mix, was increasingly concentrated inside the payment’s system, or by commercial bank credit financing (by a disproportionately sharp acceleration in non-reservable, non-m1 components), as galvanized by dropping statutory reserve requirements by 40 percent (which eliminated that credit control devices’ legal constraint on money growth). The DFIs were formally restricted to putting no more than 60% of their time deposits into mortgage loans. The upshot was that regulatory avoidance lead to regulatory arbitrage and malfeasance:
“risk never left the originating institution (the sponsor), <typically a commercial bank> ”
This decoupling of statutory reserve requirements in *1995* coincided with the jump-start of the housing boom. Thus there was no restriction on BLS outlier price-level asset growth, as real-estate coerced growth was driven by new-money substitutes, the securitization of mortgages (financial re-engineering).
It is exactly as hypothesized, but not explicitly why, Dr. Pritchard predicted in May 1980 (but occurred much faster): “our means-of-payment money supply” (then designated as M1A by the Board of Governors) “will come to approximate M3”. I.e., the DIDMCA removed statutory reserve requirements, as correspondent balances, IBDDs, in respondent banks were not properly tethered. The volume of their IBDDs vastly exceeded complicity, hence RRs were not “e-bound” / binding.
The recycling of savings, the circular flow of pyramided income, financial perpetual-motion, the churn (all savings originate in the payment’s system), not of infamously, of re-pledged collateral chained insurance, but the opaque and 30:1 leveraged off-balance sheet funded: originate, securitize, rate, to distribute model, obfuscated this near-money, velocity of circulation development (unfortunately, just as the G.6 Debit and Demand Deposit Turnover release, was discontinued in Sept. *1996* by KU economist Ed Fry, its Washington D.C. BOG manager).
Note: bank debits reflect both new & existing residential & commercial real-estate sales/purchases. This is because > 95% of demand drafts clear through transaction type deposits (and all demand drafts clear through the payment’s system). Otherwise the boom in real-estate would have been utterly glaring, utterly unambiguous.
Consequently Chairman Alan Greenspan 12/5/1996 was utterly myopic:
"The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near-money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.”
Greenspan: “We ran into the situation, as you may remember, when the money supply, non-borrowed reserves, and various other non-interest-rate measures on which the Committee had focused had in turn fallen by the wayside. We were left with interest rates because we had no alternative.”… – Alan Greenspan, FOMC Transcript, July 1-2, 1997, pp. 80-81.
Greenspan: "The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."
Not so. The RoC in bank debits fell below zero during the S&L crisis. From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense. The definitions include numerous items over which the Fed has little or no control (e.g., MMMFs, esp. after the SEC adopted reform rules 7/23/14), including many the Fed need not and should not control (currency, counterintuitively the cash drain factor peaked 2/2008).
The definitions also assume there are numerous degrees of “moneyness”, viz. Greenspan’s, “near-money” (highly liquid assets that can be quickly converted into demand deposits or cash), thus confusing liquidity with money. Money is the “yardstick” by which the liquidity of all other assets is measured. And bank debits represent money flows (money transferred between counterparties).
The definitions also ignore the fact that some liquid assets (time deposits) have a direct one-to-one, relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs. The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.
But you can blame Alan Greenspan’s ignorance on Bill Clinton’s Paperwork Reduction Act of 1995:
“A substantial amendment, the Paperwork Reduction Act of 1995, confirmed that OIRA's authority extended over not only agency orders to provide information to the government, but also agency orders to provide information to the public.” Accordingly, both the BOG’s G.6 release and M3 reporting were discontinued.
Bank debits never lie (as financial transactions are not random). Velocity figures were taken directly from the Federal Reserve Bulletin in the archives of the Federal Reserve Bank of Kansas City research department.
Funny, we knew this already. In 1931 a commission was established on Member Bank Reserve Requirements. The commission completed their recommendations after a 7 year inquiry on Feb. 5, 1938. The study was entitled "Member Bank Reserve Requirements -- Analysis of Committee Proposal" Its 2nd proposal: "Requirements against debits to deposits"
After a 45 year hiatus, this research paper was "declassified" on March 23, 1983. By the time this paper was "declassified", Nobel Laureate Dr. Milton Friedman had declared RRs to be a "tax" [sic].
Great Moderation not! Great exultation only until the music stops.
Greenspan, in his book “The Map and the Territory, pg. 277: “I still find the money supply to price relationship of that period (during the S&L crisis) puzzling…money supply does not directly translate into price…the ratio of price to unit money supply is the virtual algebraic equivalent of what economists call money velocity, the ratio of nominal gDp to m2”.
Do not be bamboozled. Contrary to what the Austrian economists claim, Henry Hazlitt in his 1968: “The Velocity of Circulation”, and Ludwig von Mises in "Human Action", and Murray Rothbard, an American heterodox economist of the Austrian School, who wrote in Man Economy and State:
“But it is absurd to dignify any quantity with a place in an equation unless it can be defined independently of the other terms in the equation.”
These economists were debating Vi (which, for example, excludes intermediate goods), not Vt (or all physical transactions in American Yale Professor Irving Fisher’s truistic modeling). The transactions velocity, Vt, is an “independent” exogenous force acting on prices. And there is never any mention of money velocity in the FOMC deliberations.
The point is, obviously, because of the off-bank balance sheet risk transfer, no money stock figure acting alone, or even commercial bank credit, is adequate as a solitary “guide post” for monetary policy. That is why economists, e.g., William Barnett of Divisia Monetary Aggregates Index, brings the liquidity ex-post test of an asset to his modeling. That is why Shadow Stats reconstructs and reports M3.
In the aftermath of the GFC, in a belated and failed attempt at outlier asset restitution, FASB 166 and 167 rulings restored some warehousing on banker’s balance sheets (restored in-house servicing, like a community banker).
“The effects of banks’ adoption of FASB’s Financial Accounting Statements No. 166 (FAS 166), Accounting for Transfers of Financial Assets, and No. 167 (FAS 167), Amendments to FASB Interpretation No. 46(R), will be incorporated in the H.8 commercial bank balance sheet data for March 31, 2010 (to be published on April 9, 2010).”
Déjà vu. The 1933 Glass-Steagall Act was a bill designed: “to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes”. It limited securities to 10 percent of a bank’s earnings and prohibited underwriting and dealing in securities. It was repealed by the 1999 Gramm-Leach-Bliley Act.
Economics is a science. Dr. Leland James Pritchard, Ph.D., Economics, Chicago 1933, M.S. Statistics, Syracuse, in May 1980 wrote: “One of the principal purposes of the DIDMCA was to provide the housing industry with a reliable source of funds. That may be achieved through various governmental and quasi-governmental corporations (Think GSEs). But the role of the S&Ls in housing finance will probably diminish significantly. By becoming commercial banks and having a larger spectrum of loans to choose from, the Savings and Loan Associations will act like banks and whenever possible eschew “borrowing short and lending long”. Sources of mortgage funds will shift from the subsidized rates heretofore provided by the small saver to “bond-backed” sources which will reflect the higher interest rates prevailing in the loan-funds markets.” (Think packaging MBS – a major class of investments)
Fast forward 38 years later:
Investopedia: “Savings and loans can no longer afford to remain mere mortgage providers with their margins narrowing down as higher interest rates continue to inflate borrowing costs. At the same time, growing competition has impacted the lending rates making it impossible for S&Ls to reap the same level of profits they used to make earlier. Some of the major players in the mortgage market such as Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), have taken over a huge portion of S&Ls business by offering mortgages at much lower rates on the secondary market. In order to offer substantial profits to their shareholders, S&Ls today choose to imitate other banks and offer commercial and automobile loans along with a host of other banking services and products such as mutual funds, checking and loans. Thus, it will be increasingly difficult to distinguish S&Ls from conventional banks due to this gradual transition from thrift to bank-like institutions.”
Financing by FSLIC pooled small savers was supplanted by FNMA and GNMA (exempt from state and local taxes). The 1989 FIRREA gave both Freddie Mac and Fannie Mae additional responsibility to support mortgages for low- and moderate-income families. In 1992 the Department of Housing and Urban Development set low-income loan targets for the GSEs. In 2000, Fannie Mae announced vest expansion plans, focused on purchasing mortgages made to riskier, low-income borrowers over the coming decade (George W. Bush’s call for “an ownership society”).
Fannie & Freddie became involved with exotic / designer mortgages, buying existing MBS from lenders, packaging them as CDOs, viz., the artificial conversion of credit agency rated creditworthiness via hedging of trillions of notional outstanding wrapped OTC derivatives, CDS (used to evade higher capital requirements and spur ROE), by means of convoluted algorithms (regulatory supervision otherwise having been eviscerated by the 2000 Commodity Futures Modernization Act) and selling bond-backed securities to investors (severing the risk retention link between lenders and borrowers, as opposed to “covered bonds”, with “skin in the game” issuance). These algorithms failed to take into account falling home prices (negative equity). It is estimated that the GSEs accounted for between ½ to ¾ of all mortgage lending pre GFC – buying mortgages and repackaging them to sell in the bond markets. Fannie and Freddie (exempt from state and local taxes) were taken under conservatorship on 9/7/2008 (due to regulatory undercapitalization relative to their assets or debt). And Edward Pinto, Fannie Mae’s former chief credit officer stated that 34% of both GSE’s loans should be classified as subprime, Alt-A, other nonprime loans (toxic assets).
From 1995 to 2003, the portion of conventional loans being securitized grew from 46 percent to 76 percent. This synthesizing enabled conventional loans to be converted into tradeable bond-backed asset instruments, ABSs, the transfer of off-balance sheet holdings with lower capital requirements and risk transmogrification - the transfer of risk to 3rd parties.
Gramm–Leach–Bliley Act reinvented commercial banking by changing DFI’s focus from loan lending and holding (M2M based on historical based costs), to trading securities. And FASB 115: mark-to-market, M2M, is different for trading securities and available-for-sale vs. held to maturity securities. M2M valuations figured uniquely: on relentlessly falling / distressed asset prices, which produced margin calls / upping collateral requirements (irrespective of the protection from Sarbanes–Oxley Act during 2002). On 9/30/2008 the SEC relaxed restrictions related to forced liquidations in a disorderly market.
Further, Section 132 of the Emergency Economic Stabilization Act of 2008, passed on 12/3/2008, restated the SEC's authority to suspend the application of FAS 157, but the SEC reneged to do so on 12/30/2008.
On 4/02/09, FASB 157 was suspended (and has not been reinstated) eliminating the requirement banks to use mark to market accounting to value their assets. The banks’ assets are still recorded at their original value, and not based current market FASB “fair-value “prices.
What's arguable, is that FASB 157’s effective date accelerated the March 2008 run on Bear Sterns (which had a 35.6 to 1 leverage ratio at 2007 year’s end):
Bloomberg: In response to a question by Henry Kaufman, the former Salomon Brothers Inc. economist who now runs a New York firm bearing his name, Bernanke said investment firms “need to be as transparent as possible” about how they value their assets.
“This current financial stress is not likely to disappear overnight; partly it is an information problem,” Bernanke said. “It is going to take a while for investors to appropriately value these assets.”
Kaufman asked Bernanke what market and economic information he would need for more effective policy making.
“I would like to know what those damn things are worth,” Bernanke joked, referring to the products that investors have shunned in the credit rout. “This episode has revealed a weakness in structured credit products,” namely the difficulty in coming up with valuations in periods of stress.
Shadow banking (loosely regulated hedge funds, private equity funds, pension funds, investment banks, etc.) sported leverage ratios of 30 to 1. Leverage measures the relationship between a financial institutions’ liabilities and its capital.
Example: Citibank held USD $960 billion in off-balance sheet assets in 2010, which amounted to 6% of U.S. gDp.
In the borrow-short to lend-longer stratagem, as David Stockman said in his book “The Great Deformation”: “The preponderance (of the leveraged investment banks) fabled profitability, however, was generated by massive trading operations which scalped spreads from elephantine balance sheets that were not only preposterously leveraged, but also dangerously dependent upon volatile short-term funding to carry their assets. Indeed, perched on a foundation of several hundreds of billions in debt and equity capital, these firms had become voracious consumers of “wholesale” money market funds, mainly short-term “repo” loans and unsecured commercial paper.
From these sources, they had erected trillion-dollar financial towers of hot-money speculation.”
“On the eve of the financial crisis, Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the trillion-dollar mark. Much of their massive wholesale funding, however, had maturities of less than thirty days, and some of that was as short as a week and even overnight. When Bear Sterns hit the wall in March 20008 for example, it was actually rolling over $60 billion of funding every morning –until, suddenly, it couldn’t.”
Like some OTC unregulated derivative, Lehman used a "Repo 105" instrument to fly under the benchmarked radar (to illegally, per Section 401, move assets and debt off-balance sheet to enhance its outlook to investors). Note: “Repo 105 is Lehman Brothers' name for an accounting maneuver that it used where a short-term repurchase agreement is classified as a sale. The cash obtained through this "sale" is then used to pay down debt, allowing the company to appear to reduce its leverage by temporarily paying down liabilities—just long enough to reflect on the company's published balance sheet” - Investopedia
FASB 157 unnecessarily accelerated and exacerbated GFC’s implosion with its announcement in Sept. 2006 (delivering a cataclysmic effective date of November 15, 2007). FASB 157 defined "fair value" in Sept. 2006 as: "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date"…“forced private equity firms to mark down the value of assets on their balance sheets – causing a destructive feedback loop of asset write-downs that threatened the solvency of the banking system” - Investopedia
During the GFC home prices, S&P/Case-Shiller U.S. National Home Price Index (CSUSHPINSA) fell by 27% for 5 years and 10 months. Gresham’s bubble was deflated by an extremely flawed monetary policy, one where Bankrupt-u-Bernanke drained legal reserves for 29 contiguous months, representing 29 contiguous months in which the RoC in long-term monetary flows, volume X’s velocity, was less than zero (negative). I.e., it lowered American Yale Professor Irving Fisher’s price-level, where real-estate assets were the most vulnerable to price-deflation.
The Financial Accounting Standards Board (FASB) issued ASU No. 2011-03, "Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements." The rule has been improved upon, the FASB said in a press release, "by eliminating consideration of the transferor's ability to fulfill its contractual rights and obligations from the criteria in determining effective control."
Thus, when the recession hit in the 2nd half of 2008, the downswing was un-necessarily worsened on Oct. 6th by remunerating interbank demand deposits, IBDDs - an FOMC administrated rate inversion (not free market deterministic). Thus Gresham’s bubble was hit hard on both sides of the ledger domain, on its funding liabilities, and on its earning assets. As in David Stockman’s example: “the voracious consumers of “wholesale” money market funds, using mainly short-term “repo” loans and unsecured commercial paper”. This was reflected in the prevailing free-market clearing interest rates, effectively ZIRP, resulting in wholesale funding interest rates (the short-end segment of the yield curve), being positioned lower than the remuneration rate which the FOMC pegged @ .25%.
Thus, during open market operations of the buying type, LSAPs, the “buyer-bid/seller-asked” competition between the commercial banks and the non-banks, the commercial banks had a decisive edge (one diametrically opposed to the: S = I preferential differential that existed for the thrifts under the BOG’s and FDIC’s administration of Regulation Q ceilings). This emasculated the FRB-NY’s “open market power”, the power to automatically inject ex-nihilo, and gratis, showering money both exogenously and endogenously, into the payment’s system -- by Simon Potter’s Market Group “trading desk”.
Unlike Treasury issuance, because the belligerent bifurcation (the mis-aligned distribution of sales and purchases of debt by the FRB-NY’s trading desk and its customers/counter-parties is largely unpredictable, so too now is the volume and rate of expansion in the money stock on even a quarter-to-quarter basis. FOMC policy has now been capriciously undermined by turning excess reserves into bank earning assets.
Thus, the commercial banks knowing that they would receive the IOeR, were thereby provided the opportunity to bid higher, bid more aggressively, so as to initially narrow the auction spread, but later receive a rate of return guaranteed greater than what the DFIs could obtain in the money market or by purchasing treasury debt (as the DFIs always previously did during economic recessions, obviating the need for excessive government intervention). And when the DFIs won the QE contest, only IBDDs were added. When the NBFIs won the QE contest, both IBDDs and the money stock were enlarged.
The remuneration rate of the EES Act of 2008, submarined and subverted the savings investment process. It destroyed money velocity (particularly savings velocity). And it was set at an illegal level, per the FSRR Act of 2006, in which it exceeded all retail and wholesale money market funding rates (which in turn, finance the capital market). This caused dis-intermediation, where the size of the non-banks shrank by 6.2 trillion dollars, and the size of the commercial banks remained unaffected, increasing by 3.2 trillion dollars in the same period.
Gresham’s bubble burst, precipitating the GFC’s catastrophic outcome: the “Four Horsemen of any Apocalypse”, to wit, inversion, dis-intermediation, impaired assets, and recession, which were driven by many basic accounting improprieties - ones that were forgotten after the extinction of the Great Depression.
Never forget. It’s much more egregious than the press portrays. Any congressional legislation enacted almost solely involves public elected officials being influenced by private back-office lobbyists making “campaign contributions” in order to sway policy decisions and legislation. E.g., King of the Hill, Barron’s 1/13/97 “interested parties seeking to influence the House & Senate Banking Committees spent nearly 60 million in “campaign contributions” in the first 183 of the 95-96 election cycle, exceeding all other industry and labor groupings”
Take note the same bad actors: Former Chairman and CEO of Citicorp, Walter Wriston, on Citi’s Latin Loans: “Mr. Wriston scapegoated Paul Volcker’s tight money policy. Defending his loans, Mr. Wriston blustered: “The difference between a skinflint banker and a reckless lender is a recession.” Note the parallel thinking: Citigroup’s CEO Chuck Prince: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Fiddler on the Roof is apropos: “And how do we keep our balance? That I can tell you in one word. Tradition! Tradition! Tradition!”…”Because of our traditions we’ve kept our balance for many, many, years. How does this tradition get started? I tell you. I don’t know. But it’s a tradition.” What it is, is the re-writing and obfuscation of historical facts, viz., “Should Commercial banks accept savings deposits?” Conference on Savings and Residential Financing 1961 Proceedings, United States Savings and loan league, Chicago, 1961, 42, 43.
Hypocrisy / irony come in disguised schemes. The Ph.Ds. on the Fed’s technical staff are grossly unqualified to do their jobs (grossly incompetent). There is no such thingamajig as “long and variable lags”. Macro lags are math constants. And the pretense of the 3 stars * , is subterfuge.
Monetarism’s predictive device (which was never used), is predicated on the assumption that the commercial banks will immediately expand credit and the money supply (invest in some type of earning asset), if they are supplied with additional excess reserves (which they undoubtedly did between 1942 and Oct. 1, 2008).
However, William McChesney Martin Jr. reinstated pegs in c. 1965, or the Fed Funds “bracket racket” (coterminous with the rise in monetary inflation and inflationary expectations). Then legal reserve requirements (cut by 40% in 90-91), ceased to be binding by c. 1995 (coincident with the start of the housing boom). And the remuneration of IBDDs emasculated the Fed’s “open market power” (set at a level which destroyed money velocity).
Using interest rate manipulation (accommodating the ABA), is non-sequitur, as interest is the price of loan-funds (a free-market clearing price), whereas the price of money (the FRB-NY trading desks’ bailiwick), is the reciprocal of the price-level. Keynes liquidity preference curve (demand for money), is a false doctrine. For example, savings flowing through the non-banks increases the supply of loanable funds, but not the supply of money (a velocity correlation).
The effect of tying open market policy to an interest rate, is to supply additional (excessive, and costless legal reserves - not a tax) to the banking system whenever loan demand increases, and of course, vice versa.
The effect of FRB-NY trading desk’s operations on interest rates (now largely via interest on IBDDs), is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given additional OMOs, nobody knows until long after the fact. The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the payment's system.
The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be properly controlled is legal reserve management. The Fed’s monetary transmission mechanism, Interest rate manipulation, will always be subject to exploitation (i.e., Sir Thomas Gresham’s bubbles).