Do Fewer Banking Controls Always Equate with a Free Market?

The proponents for less control in the banking industry hold that fewer restrictions imply a better use of scarce resources, which leads to the generation of more real wealth.

It is true that a free banking environment is an agent of wealth promotion through the efficient use of scarce real resources, while controlled banking stifles the process of real wealth formation. However, it is overlooked by the opponents of the Volcker rule that the present banking system has nothing to do with free banking and thus a free market.

What we have at present is a banking system within the framework of the central bank, which promotes monetary inflation and the destruction of the process of real wealth generation through fractional-reserve banking.  

In the present system, the more unrestricted the banks are, the more money “out of thin air” can be generated and hence greater damage inflicted on the wealth-generation process. This must be contrasted with genuine free banking, i.e., the absence of a central bank, where the potential for the creation of money out of thin air is minimal.

Elsewhere we have shown that in a free-banking environment with many competitive banks, if a particular bank tries to expand credit by practicing fractional-reserve banking, it runs the risk of being “caught.” So it is quite likely that in a free-market economy the threat of bankruptcy would bring to a minimum the practice of fractional-reserve banking.

The Existence of a Central Bank Encourages Fractional-Reserve Banking

This is, however, not so in the case of the existence of the central bank. By means of monetary policy, which is also termed the reserve management of the banking system, the central bank permits the existence of fractional-reserve banking and thus the creation of money out of thin air.

The modern banking system can be seen as one huge monopoly bank that is guided and coordinated by the central bank. Banks in this framework can be regarded as “branches” of the central bank.

For all intents and purposes the banking system can be seen as being comprised of one bank. (Note that a monopoly bank can practice fractional-reserve banking without running the risk of being “caught.”)

Through ongoing monetary management — i.e., monetary pumping — the central bank makes sure that all the banks engage jointly in the expansion of credit out of thin air. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. By means of monetary injections the central bank makes sure that the banking system is “liquid enough” so banks will not bankrupt each other.

The Myth of Financial Deregulation

Prior to the 1980s financial deregulation we had controlled banking. Banks’ conduct was guided by the central bank. Within this type of environment bank’s profit margins were nearly predetermined (the Fed imposed interest-rate ceilings and controlled short-term interest rates); hence the “life” of the banks was quite easy, although boring.

The introduction of financial deregulation and the dismantling of the Glass-Steagall Act changed all that. The deregulated environment resulted in fierce competition between banks. The previously fixed margins were severely curtailed. This in turn called for an increase in volumes of lending in order to maintain the level of profits.

In the present central-banking framework this increase culminated in an explosion in the creation of credit out of thin air — a massive explosion in the money supply. (In the deregulated environment, banks’ ability to amplify the Fed’s pumping has enormously increased.)

Rather than promoting an efficient allocation of real savings, the current so-called deregulated monetary system has been promoting the channeling of money out of thin air across the economy. From this it follows that, in the framework of the present monetary system, in order to reduce a further weakening of the real wealth-generation processes, it is necessary to introduce tighter controls on banks. Murray Rothbard wrote,

Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor. (Making Economic Sense, p. 279)

Bear in mind that we don’t suggest here suppressing the free market but suppressing banks’ ability to generate credit out of thin air. Please note that the present banking system has nothing to do with a true free-market economy.

It must be reiterated here however that more controls within the framework of central banking can only slow down the pace of the erosion of real wealth formation. It cannot prevent the erosion. (Remember that the Fed continues to pump money to navigate the economy.) More controls will suppress banks’ ability to significantly amplify the Fed’s pumping, so in this sense it is preferable to a so-called deregulated banking sector.

Summary and Conclusions

According to some commentators, the huge $2 billion loss by JPMorgan Chase, caused by the risky bets placed using the bank’s money, raises the need to implement the Volcker rule — more controls on banks’ activities. Critics of the Volcker rule are of the view that it will only make things much worse by stifling the efficient allocation of scarce real resources. Our analysis holds that as long as we have a central bank, in order to minimize the damage its policies inflict, it makes sense to impose tighter controls on banks. It is the central bank that enables banks to practice fractional-reserve banking, thereby polluting the economy with money out of thin air. A better alternative is of course to have genuine free banking without the central bank.

The Gold Report: David, you have talked and written about the effect of government-funded, debt-fueled spending on the stock market. What will be the real impact of quantitative easing?

David Stockman: We are in the last innings of a very bad ball game. We are coping with the crash of a 30-year–long debt super-cycle and the aftermath of an unsustainable bubble.

Quantitative easing is making it worse by facilitating more public-sector borrowing and preventing debt liquidation in the private sector – both erroneous steps in my view. The federal government is not getting its financial house in order. We are on the edge of a crisis in the bond markets. It has already happened in Europe and will be coming to our neighborhood soon.  

TGR: What should the role of the Federal Reserve be?

DS: To get out of the way and not act like it is the central monetary planner of a $15 trillion economy. It cannot and should not be done.

The Fed is destroying the capital market by pegging and manipulating the price of money and debt capital. Interest rates signal nothing anymore because they are zero. The yield curve signals nothing anymore because it is totally manipulated by the Fed. The very idea of “Operation Twist” is an abomination.

Capital markets are at the heart of capitalism and they are not working. Savers are being crushed when we desperately need savings. The federal government is borrowing when it is broke. Wall Street is arbitraging the Fed’s monetary policy by borrowing overnight money at 10 basis points and investing it in 10-year treasuries at a yield of 200 basis points, capturing the profit and laughing all the way to the bank. The Fed has become a captive of the traders and robots on Wall Street.

TGR: If we are in the final innings of a debt super-cycle, what is the catalyst that will end the game?

DS: I think the likely catalyst is a breakdown of the U.S. government bond market. It is the heart of the fixed income market and, therefore, the world’s financial market.

Because of Fed management and interest-rate pegging, the market is artificially medicated. All of the rates and spreads are unreal. The yield curve is not market driven. Supply and demand for savings and investment, future inflation risk discounts by investors – none of these free market forces matter. The price of money is dictated by the Fed, and Wall Street merely attempts to front-run its next move.

As long as the hedge fund traders and fast-money boys believe the Fed can keep everything pegged, we may limp along. The minute they lose confidence, they will unwind their trades.

On the margin, nobody owns the Treasury bond; you rent it. Trillions of treasury paper is funded on repo: You buy $100 million (M) in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out.

If that happens, the massive repo structures – that is, debt owned by still more debt – will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked.

TGR: Is that what happened in 2008?

DS: In 2008 it was the repo market for mortgage-back securities, credit default obligations and such. In 2008 we had a dry run of what happens when a class of assets owned on overnight money goes into a tailspin. There is a thunderous collapse.

Since then, the repo trade has remained in the Treasury and other high-grade markets because subprime and low-quality mortgage-backed securities are dead.

TGR: Walk us through a hypothetical. What happens when the fast-money traders lose confidence in the Fed’s ability to keep the spread?

DS: They are forced to start selling in order to liquidate their carry trades because repo lenders get nervous and want their cash back. However, when the crisis comes, there will be insufficient private bids – the market will gap down hard unless the central banks buy on an emergency basis: the Fed, the European Central Bank (ECB), the people’s printing press of China and all the rest of them.

The question is: Will the central banks be able to do that now, given that they have already expanded their balance sheets? The Fed balance sheet was $900 billion (B) when Lehman crashed in September 2008. It took 93 years to build it to that level from when the Fed opened for business in November 1914. Bernanke then added another $900B in seven weeks and then he took it to $2.4 trillion in an orgy of money printing during the initial 13 weeks after Lehman. Today it is nearly $3 trillion. Can it triple again? I do not think so. Worldwide it’s the same story: the top eight central banks had $5 trillion of footings shortly before the crisis; they have $15 trillion today. Overwhelmingly, this fantastic expansion of central bank footings has been used to buy or discount sovereign debt. This was the mother of all monetizations.

TGR: Following that path, what happens if there are no buyers? Do the governments go into default?

DS: The U.S. Treasury needs to be in the market for $20B in new issuances every week. When the day comes when there are all offers and no bids, the music will stop. Instead of being able to easily pawn off more borrowing on the markets – say 90 basis points for a 5-year note as at present – they may have to pay hundreds of basis points more. All of a sudden the politicians will run around with their hair on fire, asking, what happened to all the free money?

TGR: What do the politicians have to do next?

DS: They are going to have to eat 30 years worth of lies and by the time they are done eating, there will be a lot of mayhem.

TGR: Will the mayhem stretch into the private sector?

DS: It will be everywhere. Once the bond market starts unraveling, all the other risk assets will start selling off like mad, too.

TGR: Does every sector collapse?

DS: If the bond market goes into a dislocation, it will spread like a contagion to all of the other asset markets. There will be a massive selloff.

I think everything in the world is overvalued – stocks, bonds, commodities, currencies. Too much money printing and debt expansion drove the prices of all asset classes to artificial, non-economic levels. The danger to the world is not classic inflation or deflation of goods and services; it’s a drastic downward re-pricing of inflated financial assets.

TGR: Is there any way to unravel this without this massive dislocation?

DS: I do not think so. When you are so far out on the end of a limb, how do you walk it back?

The Fed is now at the end of a $3 trillion limb. It has been taken hostage by the markets the Federal Open Market Committee was trying to placate. People in the trading desks and hedge funds have been trained to front run the Fed. If they think the Fed’s next buy will be in the belly of the curve, they buy the belly of the curve. But how does the Fed ever unwind its current lunatic balance sheet? If the smart traders conclude the Fed’s next move will be to sell mortgage-backed securities, they will sell like mad in advance; soon there would be mayhem as all the boys and girls on Wall Street piled on. So the Fed is frozen; it is petrified by fear that if it begins contracting its balance sheet it will unleash the demons.

TGR: Was there some type of tipping that allowed certain banks to front run the Fed?

DS: There are two kinds of front-running. First is market-based front-running. You try to figure out what the Fed is doing by reading its smoke signals and looking at how it slices and dices its meeting statements. People invest or speculate against the Fed’s next incremental move.

Second, there is illicit front-running, where you have a friend who works for the Federal Reserve Board who tells you what happened in its meetings. This is obviously illegal.

But frankly, there is also just plain crony capitalism that is not that different in character and it’s what Wall Street does every day. Bill Dudley, who runs the New York Fed, was formerly chief economist for Goldman Sachs and he pretends to solicit an opinion about financial conditions from the current Goldman economist, who then pretends to opine as to what the economy and Fed might do next for the benefit of Goldman’s traders, and possibly its clients. So then it links in the ECB, Bank of Canada, etc. Is there any monetary post in the world not run by Goldman Sachs?

The point is, this is not the free market at work. This is central bank money printers and their Wall Street cronies perverting what used to be a capitalist market.

TGR: Does this unwinding of the Fed and the bond markets put the banking system back in peril, like in 2008?

DS: Not necessarily. That is one of the great myths that I address in my book. The banking system, especially the mainstream banking system, was not in peril at all. The toxic securitized mortgage assets were not in the Main Street banks and savings and loans; these institutions owned mostly prime quality whole loans and could have bled down the modest bad debt they did have over time from enhanced loan loss reserves. So the run on money was not at the retail teller window; it was in the canyons of Wall Street. The run was on wholesale money – that is, on repo and on unsecured commercial paper that had been issued in the hundreds of billions by financial institutions loaded down with securitized toxic garbage, including a lot of in-process inventory, on the asset side of their balance sheets.

The run was on investment banks that were really hedge funds in financial drag. The Goldmans and Morgan Stanleys did not really need trillion-dollar balance sheets to do mergers and acquisitions. Mergers and acquisitions do not require capital; they require a good Rolodex. They also did not need all that capital for the other part of investment banking – the underwriting business. Regulated stocks and bonds get underwritten through rigged cartels – they almost never under-price and really don’t need much capital. Their trillion dollar balance sheets, therefore, were just massive trading operations – whether they called it customer accommodation or proprietary is a distinction without a difference – which were funded on 30 to 1 leverage. Much of the debt was unstable hot money from the wholesale and repo market and that was the rub – the source of the panic.

Bernanke thought this was a retail run à la the 1930s. It was not; it was a wholesale money run in the canyons of Wall Street and it should have been allowed to burn out.

TGR: Let’s get back to our ballgame. What is to keep the U.S. population from saying, please Fed save us again?

DS: This time, I think the people will blame the Fed for lying. When the next crisis comes, I can see torches and pitch forks moving in the direction of the Eccles building where the Fed has its offices.

TGR: Let’s talk about timing. On Dec. 31, the tax cuts expire, defense cuts go into place and we hit the debt ceiling.

DS: That will be a clarifying moment; never before have three such powerful vectors come together at the same time – fiscal triple witching.

First, the debt ceiling will expire around election time, so the government will face another shutdown and it will be politically brutal to assemble a majority in a lame duck session to raise it by the trillions that will be needed. Second, the whole set of tax cuts and credits that have been enacted over the last 10 years total up to $400–500B annually will expire on Dec. 31, so they will hit the economy like a ton of bricks if not extended. Third, you have the sequester on defense spending that was put in last summer as a fallback, which cannot be changed without a majority vote in Congress.

It is a push-pull situation: If you defer the sequester, you need more debt ceiling. If you extend the tax expirations, you need a debt ceiling increase of $100B a month.

TGR: What will Congress do?

DS: Congress will extend the whole thing for 60 or 90 days to give the new president, if he hasn’t demanded a recount yet, an opportunity to come up with a plan.

To get the votes to extend the debt ceiling, the Democrats will insist on keeping the income and payroll tax cuts for the 99% and the Republicans will want to keep the capital gains rate at 15% so the Wall Street speculators will not be inconvenienced. It is utter madness.

TGR: It is like chasing your tail. How does it stop?

DS: I do not know how a functioning democracy in the ordinary course can deal with this. Maybe someone from Goldman Sachs can come and put in a fix, just like in Greece and Italy. The situation is really that pathetic.

TGR: Greece has come up with some creative ways to bring down its sovereign debt without actually defaulting.

DS: The Greek debt restructuring was a farce. More than $100B was held by the European bailout fund, the ECB or the International Monetary Fund. They got 100 cents on the dollar simply by issuing more debt to Greece. For private debt, I believe the net write-down was $30B after all the gimmicks, including the front-end payment. The rest was simply refinanced. The Greeks are still debt slaves, and will be until they tell Brussels to take a hike.

TGR: Going back to the triple-witching hour at year-end, if the debt ceiling is raised again, when do we start to see government layoffs and limitations on services?

DS: Defense purchases and non-defense purchases will be hit with brutal force by the sequester. As we go into 2013, there will be a shocking hit to the reported GDP numbers as discretionary government spending shrinks. People keep forgetting that most government spending is transfer payments, but it is only purchases of labor and goods that go directly into the GDP calculations, and it is these accounts that will get smacked by the sequester of discretionary defense and non-defense budgets.

TGR: I would think to unemployment numbers as well.

DS: They will go up.

Just take one example. According to the Bureau of Labor Statistics monthly report, there are 650,000 or so jobs in the U.S. Postal Service alone. That is 650,000 people who pretend to work at jobs that have more or less been made obsolete and redundant by the Internet and who are paid through borrowings from Uncle Sam because the post office is broke. Yet, the courageous ladies and gentlemen on Capitol Hill cannot even bring themselves to vote to discontinue Saturday mail delivery; they voted to study it! That is a measure of the loss of capacity to rationally cognate about our fiscal circumstance.

TGR: In the midst of this volatility, how can normal people preserve, much less expand their wealth?

DS: The only thing you can do is to stay out of harm’s way and try to preserve what you can in cash. All of the markets are rigged or impaired. A 4% yield on blue chip stocks is not worth it, because when the thing falls apart, your 4% will be gone in an hour.

TGR: But if the government keeps printing money, cash will not be worth as much, either, right?

DS: No, I do not think we will have hyperinflation. I think the financial system will break down before it can even get started. Then the economy will go into paralysis until we find the courage, focus and resolution to do something about it. Instead of hyperinflation or deflation there will be a major financial dislocation, which means painful re-pricing of financial assets.

How painful will the re-pricing be? I think the public already knows that it will be really terrible. A poll I saw the other day indicated that 25% of people on the verge of retirement think they are in such bad financial shape that they will have to work until age 80. Now, the average life expectancy is 78. People’s financial circumstances are so bad that they think they will be working two years after they are dead!

TGR: Finally, what is your investment model?

DS: My investing model is ABCD: Anything Bernanke Cannot Destroy: flashlight batteries, canned beans, bottled water, gold, a cabin in the mountains.

TGR: Thank you very much.

Let’s start with Europe. First, the Greek elections have created great uncertainty, hence, market risk. Voters hammered the two establishment parties, the main New Democracy and Pasok parties that were responsible for negotiating the two EU/IMF/ECB Greek bailouts. Fully 70% of the votes were cast for parties committed to abrogating European-imposed austerity measures. The surprise beneficiary was Syriza, the “Party of the Radical Left,” having placed second to New Democracy. Syriza is led by the radical and charismatic Alexis Tsipras, who this week gained additional support with his message that previous agreements are “null and void” and that Greece is well-positioned to call Europe’s bluff (blackmail the blackmailer, some have suggested).  

With leaders from the top three parties each individually failing to formulate a coalition government with sufficient seats to hold a majority in the Greek Parliament, it now appears likely that new national elections will be necessary (most-likely in mid-June). Polls this week showed Syriza building on recent momentum, so it is unlikely a coalition government can be created without Mr. Tsipras taking a leading role. The markets had been somewhat heartened by the prospect that new elections might be avoided. Now markets will likely face six weeks of uncertainty leading up to the next election. And while the Greeks for the most part state their desire to remain in the eurozone, there is little support for implementing austerity measures negotiated by previous governments. It’s very difficult at this point to envisage a favorable market scenario.

And while the majority of party leaders prefer to stick with the euro, it is also clear that a strong political consensus has developed that Greece must at the minimum renegotiate previously made commitments. Various European officials, including German Finance Minister Schaeuble, have made it clear that the Greek government must remain committed to previous agreements. At this point, the Greeks lack credibility, and EU officials’ patience has worn past quite thin. So, a dangerous game of chicken has begun, and contingency planning for a Greek exit from the euro will now command great attention. Such uncertainty supports risk aversion.

Now that a Greek exit appears unavoidable, it has become popular to surmise that this could be done without unmanageable financial and economic dislocation. Yet no one has a grasp of the consequences and ramifications for Greece, the euro, Europe, the markets, international finance and global economic prospects. It is very unfortunate Greece did not exit two years ago.

Today from Fitch Ratings: “In the event of Greece leaving EMU, either as a result of the current political crisis or at a later date as the economy fails to stabilize, Fitch would likely place the sovereign ratings of all the remaining euro-area member states on rating watch negative as it re-assessed the systemic and country- specific implications of a Greek exit…. A Greek euro exit would ‘break a fundamental tenet’ of the currency union, which was designed to be irrevocable…”

Along the lines of happenings in the periphery country Greece, things are also going from bad to worse at a European core country, Spain. After promising that no additional public money would be used to bailout Spain’s troubled banks, Prime Minister Rajoy was forced to backtrack this week with the nationalization of the fourth largest Spanish bank, Bankia. And today’s widely anticipated announcement of plans for addressing banking system issues was less than confidence inspiring.

Saddled with enormous real estate loan portfolios, confidence in the Spanish banking system is quickly evaporating. Analysts talk of the need for a massive (Irish-style) recapitalization program ($150bn-$200bn), an enormous sum for an already troubled sovereign borrower. Spain’s Credit default swap prices jumped another 36 bps this week to a record 517 bps. This week provided added confirmation that the European crisis has decisively infiltrated the “core.”

And especially now that a Greek euro exit is on the table, banking system and sovereign debt fragilities take on new urgency. Importantly, markets have returned to a crisis-prone backdrop where I expect capital flows both between euro zone nations and out of the euro to become critical issues. It is today perfectly rational for wealthy holders of euro deposits – along with risk-averse corporate Treasurers managing cash holdings – in periphery banking systems to shift these funds to more stable core institutions (or perhaps even out of the euro altogether). And if Greek and euro troubles further escalate, there will be increased economic impact as corporations move to more aggressively manage business risks in various economies.

Apparently, the issue of “Target2” (Trans-European Automated Real-time Gross Settlement Express Transfer System) balances now garners considerable attention in the German media. Recall that “Target 2” refers to the eurozone’s inter-central bank payment system used for settling cross-border trade and financial flows. This system has not functioned as designed (trades have not fully settled) since the eruption of the financial crisis back in 2007. Instead of private financial flows counterbalancing trade imbalances (the settlement of cross-border obligations), these days trade imbalances and financial outflows from the periphery combine to create enormous and mounting IOUs from periphery central banks to the German Bundesbank. With euro stability now a serious issue and capital flight out of even “core” banking systems a definite possibility, the Target2 drama is poised to create only greater intrigue.

And I could be off-track on this. But I just don’t believe it is mere coincidence that JPMorgan dropped its bombshell $2bn loss announcement in the middle of market worries regarding Greece, Spain, the euro and European bank stability. And I know that in the grand scheme of JPMorgan’s business, balance sheet, capital levels and EPS, $2bn is indeed a “rounding error.” This news will certainly intensify the Volcker rule debate and there are, of course, very important longer-term issues to contemplate. But I think much of what I’ve been reading and hearing misses a key point with immediate market ramifications.

JPMorgan is a leading player in Credit insurance and prime brokerage. Their “synthetic credit securities” positions are integral to their business operations with hedge funds and the “leveraged speculating community.” Furthermore, derivatives reside at the epicenter of the dysfunctional global “risk on, risk off” market dynamic. And it’s also been my premise that “risk on” has been showing heightened vulnerability.

I’ll assume that JPMorgan’s enormous derivative portfolio was constructed with a particular market/risk environment in mind. It would make sense to me that JPMorgan has been comfortable building massive risk exposures throughout various markets, anticipating a relatively sanguine “risk on” landscape. Management was comfortable with the view that global policymakers had things under control – and were confident that global markets would remain abundantly liquid. They likely viewed the hedge fund community as relatively stable and likely to successfully work through recent challenges. And I will further presume that developments in Europe, throughout global markets and with the global leveraged players had recently made them much less confident in previous assumptions. It would make sense if they’ve decided to start hunkering down.

I’ll guess that top JPMorgan management was forced to respond to recent changes both in the marketplace and in prospects for the market risk/liquidity backdrop more generally. Recent developments and the abrupt return of de-risking/de-leveraging dynamics significantly changed the risk-profile of their positions and market insurance products more generally. They bet big on “risk on” but now must work to position for the likelihood of “risk off.”

In discussing Credit insurance and derivative markets over the years, I’ve invoked an analogy of writing flood insurance during a drought. It’s a truly wonderful business – that is until torrential rains arrive and the complacent community of highly-speculative (and thinly-capitalized) insurers flood the insurance market as they desperately attempt to offload (“reinsure”) the risk they accumulated during the profitable drought-period boom. Those seeking long-term survival (as opposed to the crowd trying to make a quick buck) better have a superior ability to discern weather patterns.

If I were JPMorgan top management, I’d surely be moving today to reduce the company’s risk profile – especially with respect to myriad global market risks. The clouds are darkening and much better to move before the heavy downpours commence (and buyers, along with their liquidity, run for the hills). While I will give no Credit for their self-serving self-flagellation, they are a savvy group that has demonstrated their ability to manage through crises. Certainly, writing Credit and market risk insurance has, again, become a risky proposition. And I’ll assume that JPMorgan’s market-making operations will be reined in throughout various risk insurance markets – and I’ll assume a similar change in tack will be afoot by the cadre of major derivatives operators. Importantly, this equates to less liquidity and more expensive market insurance. A less favorable insurance market equates to more restraint in risk-taking and an attendant tightening of financial conditions. As such, I would not be surprised if this week proves a major inflection point for global risk markets – and a major coup for “risk off.”

Charlie Munger is Warren Buffett’s partner. He is 88 years old. You can see his remark in this brief extract from an interview on CNBC. That sounded clever. But cleverness can conceal a great deal.

Jews in Vienna were civilized people. Uncivilized people had been running the government ever since March 1938. The Nazis were in charge.

The trouble facing civilized people who are under the control of uncivilized people is that they suffer from an illusion. They don’t understand the degree to which the uncivilized people are uncivilized.  

Munger should have been more specific. The hypothetical Jewish family in question should have done a lot more than sew gold coins into their clothes in 1939. The head of the household should have sold his house and his business. He should have transferred all of the family’s assets to Switzerland, England, or the United States. Then he should have directed the family to pack their bags and follow their money. After August 31, 1939, this became illegal. World War II broke out.

They should have begun the process no later than March 12, 1938, the day Germany’s troops crossed the border. Here’s why, according to Wikipedia.

Devoted to remaining independent but under considerable pressure from both Austrian and German Nazis, Austria’s Chancellor Kurt Schuschnigg tried to hold a referendum for a vote on the issue. Although Schuschnigg expected Austria to vote in favour of maintaining autonomy, a well-planned coup d’tat by the Austrian Nazi Party of Austria’s state institutions in Vienna took place on 11 March 1938, prior to the referendum, which they canceled. They transferred power to Germany, and the Wehrmacht troops entered Austria to enforce the Anschluss. The Nazis held a plebiscite within the following month, asking the people to ratify the fait accompli. They claimed to have received 99.7% of the vote in favor.

A FAMILY THAT GOT OUT IN MARCH 1938

I shall now tell a story known to a handful of people. It is the story of a man wise enough to get out: the Vice Mayor of Vienna, a long-term opponent of the Nazis. His name was Ernst Winter.

On the day the troops marched in, Winter sat down with his teenage son, Ernest Florian Winter, and told him that he was leaving. He did not say where he was going. He told his son to burn all of his papers. His son said that there was not enough time. His father then revealed why he was a man of great wisdom.

Son, this is Saturday. No bureaucrats work on Saturday or Sunday, not even Nazi bureaucrats. They will arrive here on Monday morning. They will arrest you, but they will not be able to hold you. You are 14 years old. They will release you soon enough. When they let you go, you will leave the country. I will contact you later.

They had a place outside Austria where they had already planned as an escape haven.

It happened exactly as the father described.

I was told this story in the late 1990s by the son.

The son later married the daughter of another man who took his family out of Austria: Col. Von Trapp.

It gets even more interesting. Years later, I asked him how his father had escaped. He told me that he had headed where the Nazis would not have thought to look: into Germany. As the troops were crossing the border into Austria, he headed in the other direction. He had contacts in Germany who took him in. Then, when the search for him grew cold, he headed for the agreed-upon destination. The family wound up in the United States.

Ernst Winter, Sr. fully understood how uncivilized the Nazis were. He had fought them politically ever since 1933, when the city of Vienna was in a civil war. Communists and Nazis shot up Vienna. Both sides were armed.

UNCIVILIZED ECONOMIC POLICIES

The Nazis were Keynesians. Hitler’s Minister of Economics, Hjalmar Horace Greeley Schacht, was the head of the central bank until 1937. He was a believer in fiat money and government spending, especially spending on public works projects. He believed this would reduce unemployment. He was a shovel-ready kind of guy.

He opposed military spending. He also opposed persecution of the Jews. He lost his position in 1937. He remained in Germany. He spent time in a concentration camp during World War II.

He should have gotten out in 1933. He surely should have gotten out in 1937. But he stayed, hoping for the best. The best eluded him.

The Keynesianism of Nazi Germany was of a special kind: highly centralized. Keynes had written this of the German planning system in the Preface to the 1936 German translation of The General Theory.

The theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory. Since it is based on fewer hypotheses than the orthodox theory, it can accommodate itself all the easier to a wider field of varying conditions.

Although I have, after all, worked it out with a view to the conditions prevailing in the Anglo-Saxon countries where a large degree of laissez-faire still prevails, nevertheless it remains applicable to situations in which state management is more pronounced. For the theory of psychological laws which bring consumption and saving into relationship with each other, the influence of loan expenditures on prices, and real wages, the role played by the rate of interest – all these basic ideas also remain under such conditions necessary parts of our plan of thought.

Keynes understood that his general theory is in fact a theory of central economic planning. He saw that it would be easier to apply his theory under the Nazi economy than under the free market.

The centralization of power in the hands of politicians, central bankers, and their economic advisors is the characteristic economic feature of our era. It distinguishes our era from the nineteenth century, both in theory and in practice. Keynes understood this, and he railed against the earlier era’s economic theory and practices. The earlier era had promoted the international gold standard, free trade, low taxes, and limited government. By 1936, Keynes rejected all of this. He believed in planning by experts like himself.

European critics of the Nazis, such as economists Ludwig von Mises, Wilhelm Röpke, and F. A. Hayek, were hostile to Keynes. They recognized that the Nazis’ fiat money, central planning, fiscal deficits, and price controls were all part of a worldwide movement away from the nineteenth century’s concept of free markets. The Keynesians demanded the substitution of expert economic planners for the decentralized planning that is characteristic of the free market.

The post-World War II era brought the triumph of Keynesianism in the West. Keynesianism is still dominant in academia and in central banking. Nowhere is this more clear than on the campus of Princeton University. Princeton gave us two representative figures: Ben Bernanke, who is now chairman of the Federal Reserve’s Board of Governors, and Paul Krugman, who won the Nobel Prize in 2008 – the year the recession escalated – and who writes a blog for The New York Times. These men are the leading spokesman for Keynesianism in the American intelligentsia.

THE DOER AND THE THINKER

Bernanke wrote a textbook on economics. It is Keynesian. He has timidly condemned federal deficits, but he has not called on Congress to balance the budget too soon, meaning anytime soon.

His Federal Reserve has supplied the raw materials of Keynesianism: fiat money. The monetary base in 2008 was $900 billion. Today, it is $2.9 trillion. This was the largest expansion of the monetary base in peacetime U.S. history.

In the meantime, Congress has legislated annual deficits in the $1.2 trillion range. This pattern shows no sign of decline. These are the largest deficits in peacetime U.S. history.

With this in mind, consider Krugman’s assessment of the current economy, as of May 3, 2012. He begins with utter nonsense – nonsense beyond the fringe.

Now, however, the Republican Party is dominated by doctrines formerly on the political fringe. Friedman called for monetary flexibility; today, much of the G.O.P. is fanatically devoted to the gold standard. N. Gregory Mankiw of Harvard University, a Romney economic adviser, once dismissed those claiming that tax cuts pay for themselves as “charlatans and cranks”; today, that notion is very close to being official Republican doctrine.

The full gold standard has not been advocated by any national Republican politician over the last 40 years, other than Ron Paul. Krugman is either lying for rhetorical purposes or else he is hypnotized by paranoia over what Ron Paul stands for. In either case, no one should trust him.

Note: he calls the current economy a depression. This, you understand, is four and a half years after the National Bureau of Economic Research dates the origin: December 2007. This is over three years after Obama was inaugurated.

Which brings us to the question of what it will take to end this depression we’re in.

Many pundits assert that the U.S. economy has big structural problems that will prevent any quick recovery. All the evidence, however, points to a simple lack of demand, which could and should be cured very quickly through a combination of fiscal and monetary stimulus.

I see. It’s a “simple lack of demand.” There really is nothing to solving this problem. It “could and should be cured very quickly through a combination of fiscal and monetary stimulus.” That’s all it would take? Why didn’t Congress and the Federal Reserve take these steps in 2009 and 2010? Pelosi’s House and then Reid’s Senate had the votes. Democrats had majorities. They controlled the White House. They passed a $787 billion stimulus package. Meanwhile, the FED more than doubled the monetary base. But, no, it is the Republicans’ fault. They did it.

No, the real structural problem is in our political system, which has been warped and paralyzed by the power of a small, wealthy minority. And the key to economic recovery lies in finding a way to get past that minority’s malign influence.

You see, despite the fact that the Congress was in the hands of the Democrats, 2009-2011, and despite the fact that Obama swept the Presidential election, the Republicans were the cause of the problem.

On partisanship: The Congressional scholars Thomas Mann and Norman Ornstein have been making waves with a new book acknowledging a truth that, until now, was unmentionable in polite circles. They say our political dysfunction is largely because of the transformation of the Republican Party into an extremist force that is “dismissive of the legitimacy of its political opposition.” You can’t get cooperation to serve the national interest when one side of the divide sees no distinction between the national interest and its own partisan triumph.

The Democrats did not seek bipartisanship in 2009-2011. They rammed Obamacare through, despite the votes of Republicans.

The Republicans had backed Henry Paulson and Bernanke in October of 2008, voting for the big bank bailout that the voters overwhelmingly opposed. They lost in November as a result of backlash against this bailout.

Bernanke, who has taken a leave of absence from Princeton to serve with the FED for a decade, emerges with clean hands. Krugman lets him off with nary a word of criticism. Somehow, the FED has not done all it could to overcome “this depression we’re in.” The reason is Republican partisanship. And here I imagined that the Federal Reserve System is independent of politics, as well as being run by professional economists, most of whom are Keynesians.

CONCLUSION

Charlie Munger thinks that gentlemen should buy profitable companies, not gold. But he fails to realize that the economy is being managed at the top by people who are not reliable. It is being run by Congress, the executive bureaucracy, and the Federal Reserve System. It is being run by men who share the views of Keynes, namely, that the gold standard is a barbarous relic and that politicians and bureaucrats and central bankers are the people who should set policies under which companies become profitable.

Men who shared these economic views – deficits, regulation, and fiat money – ran Austria in 1939. They had been running Germany since 1933. Some of us see that the present economic system cannot be trusted. So, we get out our sewing gear and start to work.

Civilized people should buy gold when uncivilized people are in charge. They should also buy it when civilized people in power adopt the economic policies of uncivilized people.

The seller in this case is very large and very sloppy, perhaps intentionally so. The buyer is also very large, but very patient and methodical. Trapped between these two powerful opposing market participants we find a “range-bound” gold market. Let’s take a closer peek at the curious goings-on…  

Last Monday, a large early-morning sell order in the gold market whacked the price of the precious metal by about $15 in a matter of seconds.

“The CME Group Inc.’s Comex division recorded an unusually large transaction of 7,500 gold futures during one minute of trading at 8:31 a.m.,” The Wall Street Journal reported. “The sale took out blocks of bids as large as 84 contracts in one fell swoop and cut prices down to $1,648.80 a troy ounce [from $1,663.00]. The overall transaction was worth more than $1.24 billion.

“Gold traders buzzed with speculation that the transaction was an input error — a so-called ‘fat finger’ trade,” the Journal continued. “‘Or a Gold Finger as it might be known in the bullion market,’ traders at Citi joked in a note to clients.

“Still, not everyone agreed Monday’s slip in gold was caused by a keystroke error,” said the Journal. “Chuck Retzky, director of futures sales for Mizuho Securities USA, said that silver prices suffered a similar leg down at the same time as gold, tumbling 35 cents to $30.805 a troy ounce, but other markets like Treasurys, currencies and stocks were unperturbed. ‘To do it both in gold and silver tells me that it wasn’t a trade done in error,’ Retzky said.”

A second trader chimed in, “No one who has the account size and the money to trade thousands of gold contracts would do it in one transaction, that’s just stupid.”

Or maybe this “stupidity” was intentional, as the folks at ZeroHedge suspect. Again yesterday, a large 3,000-plus lot gold sell order hit the Comex overnight trading system around 1:30 AM, Chicago time — causing the gold price to quickly fall more than $5. “Volume that size is unusual for that time of the day on the COMEX,” ZeroHedge remarks.

A few hours later, shortly after the Comex opened the gold pits for the regular daytime trading, a couple of very large sell orders knocked $10 off the gold price in a matter of minutes.

These large, sloppy sell orders are no accident, ZeroHedge insists. They are simply some of the most flagrant examples of what could be market manipulation by Western central banks. ZeroHedge does not point fingers at any particular “fat finger,” but it does wonder aloud if the Bank for International Settlements (BIS) may be involved.

“[A few weeks ago],” says ZeroHedge, “somewhat tongue-in-cheekly, we presented the ‘people bringing you currency manipulation on a daily basis,’ or in other words, the BIS execution team for Europe’s central banks, which is most directly engaged in FX and precious metals ‘interventions’ when needed.

“The execution chain we presented was headed by one Richard Austin Jones, head of central bank services at BIS, Basel, yet more importantly the actual trader at the bottom of the totem pole was a Mikaël Charozé, whose various tasks included the ‘management of the liquidity for big amounts’ primarily interventions and portfolio diversification, as well as ‘holding and managing proprietary positions on all currencies including gold.’

“We posted this observation on April 5,” reports ZeroHedge. “Funny then that just 10 days later, one would never know that Mikaël no longer counts ‘holding and managing proprietary positions on all currencies including gold’ among his duties as well as task of ‘management of liquidity for big amounts including interventions.’ [I.e. the BIS Website removed all of this language from Mikaël’s job description]. In fact his entire profile, since our little humorous exposés, appears to have been rather completely altered. Inquiring minds would love to know: why?”

Why, indeed?

Many gold-market participants have long-suspected that Western central banks (and other agencies of currency debasement) conspire to suppress the gold price. According to this conspiracy theory, the central banks periodically pound on the gold price in order to prop up the value of the paper currencies they print.

But despite the anecdotal evidence supporting the conspiracy theory, no one has ever caught one of the conspirators in the act. Like Sasquatch, the conspirators leave lots of great, big footprints, but no one ever manages to trap them in their caves.

So maybe there are no conspirators, just lots of really stupid and sloppy gold sellers.

Meanwhile, the buy side of the gold market is much less mysterious.

“Earlier this month it was revealed that Hong Kong gold imports into China totaled nearly 40 tonnes in the month of February, representing a 13-fold increase over the same month last year.” Sprott Asset Management observes in its April letter. “China has now imported 436 tonnes of gold through Hong Kong over the past 8 months, compared with only 57 tonnes over the same 8 month-period a year earlier (July 2010-February 2011).”

In other words, on the other side of every sloppy gold sale by a BIS trader (or whomever) you are likely to find an eager Chinese buyer. The recent surge in Chinese buying represents a whopping 25% increase in total global investment demand for gold.

“There isn’t a physical market on earth that can withstand that type of demand increase without higher prices over the long run,” Sprott declares, “and the gold market is no different. There are no sellers of physical gold that we know of who can satiate that scale of new demand, and global gold mine supply has been virtually flat for over the last 10 years…Where is the gold going to come from? We ask because we don’t actually know.”

So there you have it…The invisible “fat fingers” are selling gold. The very visible Chinese are buying it. Place your bets!

Two Jelly Donuts are an indulgent breakfast.

Three Jelly Donuts may induce a tummy ache.

Six Jelly Donuts — that’s an eating disorder.

Twelve Jelly Donuts is fraternity pledge hazing.

My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th Jelly Donut of easy money and wondering why it isn’t giving us energy or making us feel better. Instead of a robust recovery, the economy continues to be sluggish. Last year, when asked why his measures weren’t working, he suggested it was “bad luck.”

I don’t think luck has anything to do with it. The blame lies in his misunderstanding of human nature. The textbooks presume that easier money will always result in a stronger economy, but that’s a bad assumption. Here is a good example of how a real family responds to monetary policy.  

[Ed. Note: Though rather lengthy, this is quite a good read, with many useful points from a common-sense perspective not often represented in mainstream offerings.]

Consider my neighbors, Homer, Marge, and their three adult children, Bart, Lisa and Maggie. Homer has retired from the nuclear plant, and he and Marge live off savings and Homer’s pension. Bart is in a bit of trouble with too much credit card debt and an underwater mortgage. Lisa has been putting away her salary and has enough for a downpayment on her first home. Maggie owns her own business and is ready to expand.

When interest rates are high, Homer and Marge park their savings in CDs or Money Market accounts and get a decent return. There is no incentive for them to take much risk with their money. Bart gets into trouble very quickly and defaults on his loans. Lisa decides she can’t afford a mortgage until rates fall. And Maggie, who’s been helping out Bart with some of his expenses, believes that she’d make money if she grew the business, but possibly not enough to service the debt she’d be undertaking.

When interest rates are low, everything changes. Homer and Marge are getting only a little interest on their savings, and are struggling to live off Homer’s pension. They need to rethink their finances. Bart can manage to keep up the minimum payments on his credit cards and stay in his house. Lisa can get a cheap mortgage, and Maggie doesn’t need to make such optimistic assumptions in order to expand her business.

Everyone agrees that low interest rates are a good way to stimulate a stalled economy. The Fed takes this logic a step further. It believes that if low interest rates are good, then zero-interest rates must be even better. As a brief emergency measure, such drastic behavior is reasonable and can even be necessary. In 2008, Chairman Bernanke had near unanimous support for his decision to drop rates to near zero. At the peak of the crisis, it made sense. But that was four long years and many jelly donuts ago. In the 2012 economy, a zero rate policy not only adds no benefit, it’s actually harmful. Just ask the Simpsons.

When Homer was approaching 65, he and Marge met with a financial planner to figure out if they had enough money saved for retirement. They assumed they’d live to be 90, and could count on receiving a fixed amount from Homer’s pension and social security checks. Marge, the cautious one, has not forgotten that stock market meltdown better known as the bursting of the tech bubble. She didn’t want to take any investment risk and was content to have just enough for regular haircuts for herself, a bowling and beer budget for Homer, and visits with the children. They were told that, with nominal interest rates at 3%, they could safely retire with $200,000.

“What happens if interest rates go to zero and stay there?” Marge asked the advisor.

“You mean indefinitely? If you weren’t willing to start taking investment risk, you’d need 50% more in savings, or $300,000. But why would you ask such a silly question?” asked the advisor.

To which Marge replied, “Well, we were thinking about moving to Japan…”

Homer and Marge aren’t the only ones doing this sort of math. Every single day for the next 19 years, more than 10,000 Baby Boomers will turn 65. Those who started saving for retirement 15 years ago are suddenly finding themselves with insufficient savings to do so.

Some will stay in the work force longer, some will drastically reduce their spending, and some will do both. In a recent survey, 20% of U.S. workers say they have postponed their planned retirement age at least once during the last year. And those who have already retired have fewer options. Returning to the workforce could be challenging. David Rosenberg points out that the workforce for those 55 and older has expanded by 4 million since the start of the recession, and they are returning to the workforce at lower wages. Even more challenging is trying to find safe investments that generate a decent yield.

Zero-rate policy makes traditional riskless investments, such as CDs and Money Markets, unattractive to savers. Rather than view this as an unfortunate consequence of policy, Chairman Bernanke sees this as a benefit. He subscribes to the philosophy that rising stock prices will contribute to a ‘virtuous cycle’ of economic growth. He’s hoping that those approaching retirement, and even the retired, will abandon the idea of making safe returns, and put their savings into equities instead.

In a similar vein, the Fed believes that by lowering interest rates, it makes bonds unattractive compared to stocks. Using logic worthy of Montgomery Burns, Homer’s old boss at the Springfield Nuclear Plant, the Chairman is hoping to create a Wealth Effect. I can almost hear Mr. Burns and his sycophantic aide Smithers now:

Smithers: “Sir, you’re saying we need the stock market to go up?”

Burns: “Yes, that’s the fix we’re looking for.”

Smithers: “And why would that be, sir?”

Burns: “Don’t you get it? A rising stock market allows people to feel wealthy. And a seemingly wealthy person is a profligate person.”

Smithers: “Profligate, sir?”

Burns: “Profligate. It means they spend money they don’t have on things they don’t need.”

Smithers: “So instead of enabling people to actually have more disposable income, we’ll get them to spend more by simply making them feel rich?”

Burns: “Exactly! Now how can we do that?”

Smithers: “Well, we can always encourage them to sell their bonds and buy stocks.”

Burns: “Now how would we ever convince them to do something as foolish as that?”

Smithers: “Just set interest rates to zero indefinitely. Then no one can afford not to invest in the market.”

Burns: “Why, Smithers, that’s brilliant! This is exactly the kind of counter-intuitive thinking we’ve been needing around here!”

Only it’s not counter-intuitive; it is simply misguided thinking that persists among the Fed Chairman and other government ivory tower thinkers. They do not understand or relate to the prime component of capitalism and a free market: greed. And because they do not understand greed, they also do not understand fear, which presents a double whammy for making bad policy decisions.

****

Let’s think about it from an investor’s perspective: For about 30 years, bonds have mostly risen in value. By directly intervening in the bond market and by promising zero percent short-term interest rates through 2014, the Fed has all but guaranteed that it will do what it takes to keep bond prices from falling. Right now, Homer and Marge own bonds that yield 2%, practically risk-free. What rational investor will sell when there is no downside?

For years, people have talked about the ‘Greenspan put’ or the ‘Bernanke put’ on the stock market. Some question whether such a put is deliberate, others question its effectiveness, and some even question whether or not it exists at all. The Fed has always explicitly denied using monetary policy to create a floor on the markets, and its inability to do so should have been settled when the NASDAQ fell 78%. As for whether or not the Fed puts are a myth, I think it depends on where you look.

It isn’t where you think: The real Fed put is under the bond market.

If the Fed’s hope is to drive investors into equities, propping up the bond market is counter-productive. While there are many parts of the cycle where higher bond prices fuel higher stock prices, at this point in the cycle the relationship has reversed. In recent months, stocks and bonds have developed a strong negative correlation — what is bad for bonds, is good for stocks. The Fed does not understand investor psychology: If you want to get people to sell bonds and buy stocks, the best way to do that is to show them that bond prices can, and do, fall.

Another flaw in the Fed’s logic is that many savers aren’t willing to participate in the virtuous cycle experiment. Some might be convinced to take on this risk. But others who, like Marge, have seen the market get cut in half twice in the last dozen years, will resist. They don’t believe it is prudent to gamble their nest egg in the market.

Those who have given up on earning more will have to save more and spend less. This is the antithesis of a wealth effect, and their reduced spending is a drag on the economy.

This reduced spending has unintended consequences for the Simpson kids as well. Chairman Bernanke is unwilling to raise rates, even by a modest amount. He’s hoping that his zero-rate interest policy will encourage Lisa to buy that house and persuade Maggie to start expanding the business. He worries that a rate hike will discourage them from doing so. What he cannot seem to acknowledge is that it’s been three years of ZIRP, yet credit-worthy borrowers still are not looking for loans.

Interest rates are only one consideration when looking to invest. If it makes sense to build a factory in a 2% ten-year note environment, it probably still makes sense to build it with long rates at 4%. Long duration investments of that nature have so many other risks that, once rates are low enough, further reductions in the marginal cost of money no longer make much difference.

The corollary is that if it doesn’t make sense at 2%, it isn’t going to make sense at 1% or even at zero, because there must be some other reason not to build. The cost of money has long since passed the point where it is a constraint on otherwise sensible economic behavior in the real economy. Incrementally lower rates no longer trigger large refinancing, let alone construction booms, in the mortgage and housing markets.

Putting money back into the hands of savers would stimulate the economy and might be just the push that Maggie needs to go ahead with that business expansion.

Another blob of jelly that we are still working to digest is the Fed’s promise to keep rates at zero for a long time. Chairman Bernanke hopes this will encourage borrowing and investment, but it may have the opposite effect because it undermines any sense of urgency. By setting the time value of money to zero, the Fed devalues time.

Retailers know that to create short-term demand for a promoted special, you have to create a reason to Buy Now! — “One day Bonanza,” “First 1,000 customers through the door,” and even the softer, “Good while supplies last,” incite action. The promise to keep rates low invites procrastination. Why should anyone make a marginal decision to borrow and spend or build today, knowing that low-cost financing will still be available through the end of 2014?

Chairman Bernanke’s strategy of bringing Walmart’s Every Day Low Pricing to central banking has not worked. If the Fed Chairman wants to light a fire under Lisa and Maggie, announcing a small rate increase with the possibility of more to come could provide the incentive they need to buy or build rather than risk missing out.

****

Some will argue that if the Fed raises rates, it will cause deflation. Just the word ‘deflation’ makes Chairman Bernanke break into a cold sweat and reach for the Jelly Donuts. Fear of deflation should depend on what, exactly, is deflating.

The sort of deflation that puts pressure on wages is a clear negative, as it leads to a lower standard of living. On the other hand, lower prices caused by scientific progress and higher efficiency are unambiguously positive.

Apple’s newest iPhone has twice the memory, a better camera, and other small improvements and carries the same price as the prior version. Government statisticians see an improved product at the same price and count it as a price cut, or deflation.

There is no reason for the Fed to conduct monetary policy to offset advances that improve our standard of living, in particular when it results in driving up the price of something else, like oil.

Yet, while the Fed seems compelled to respond to innovation as if it were a bad thing, it throws up its hands when confronted with rising oil prices. Unfortunately, when the Fed sets policy with a goal of driving prices higher, it doesn’t get to choose which prices are most affected.

When asked about the rising oil price, Chairman Bernanke concedes that it is a negative for consumers. He then disclaims any responsibility, and states it is beyond the power of the Fed to affect it. He blames oil prices on emerging markets, political turmoil and speculators. If we take him at his word that speculators are causing the problem, it’s worth considering what might be causing the speculation.

From the 2010 Jackson Hole speech that kicked off the QE2 frenzy, spot oil went from $73 to $114 a barrel in eight months. The price of food and most other commodities went up even faster.

While Chairman Bernanke hopes that flooding the market with dollars will get people to buy stocks, he appears less willing to accept that many respond by scrambling for hard assets in fear of dollar debasement. The rush into commodities is further exacerbated by cheap money that enables the inexpensive financing of speculative, levered positions. Again we see the two drivers — fear and greed — at work. The consequences of this speculation are reflected in the prices of food and energy.

Worse is that, even if Chairman Bernanke believed his policies were influencing oil prices, it’s not clear that it would change his behavior. He seems to believe that inflation is a necessary by-product of growth, and that as long as it is kept under some control, accommodative monetary policy will help the economy.

In the current economic cycle, I do not believe this is true. There is nothing that slows the economy faster than rising oil prices, and most recessions have been preceded by rising or even spiking oil prices. Money spent at the gas pump is not available to be spent at the Kwik-E-Mart on other items.

Inflation has ceased to be an unfortunate by-product of growth. Rather, it is a direct hindrance to growth. We see the evidence in the disappointing growth during the first half of 2011. When the Fed finally signaled that there would be no QE3, commodity inflation stopped, oil prices retreated, and the economy began to improve. Oil prices again rose with the serving of the “Operation Twist” Jelly Donut, putting 2012 growth estimates at risk.

Tighter monetary policy would limit inflation and in all likelihood trigger a pronounced reduction in oil and food prices, which would provide a substantial boost to the real economy. While this thought runs contrary to Fed groupthink, it is consistent with recent experience. In light of this, I cannot understand why we are even discussing, let alone hoping, for QE3.

****

Chairman Bernanke recently gave a series of speeches outlining his view of the role of the Fed and its performance during the financial crisis.

To summarize his version: The crisis wasn’t the Fed’s fault; the Fed did a heroic job in reacting to the crisis; and the Fed isn’t going to repeat perceived mistakes from 80 years ago.

Chairman Bernanke made a number of comments that while historically questionable, reveal his point of view and lend credence to the theory that he has and is likely to continue to under-price the cost of money:

•He points out that to encourage stability central banks are supposed to mitigate financial panics or crises, but pays no similar thought to the idea that they should encourage stability by preventing bubbles.

•He said, “Tightening of monetary policy in 1928 and 1929 to stem stock market speculation” was a “policy error.”

•In discussing the causes of the Great Inflation of the 1970s, he said “monetary policymakers responded too slowly” but made no mention of abandoning the gold standard as one of the causes.

•He said that the housing bubble was created by deteriorating underwriting standards and downplays the role of the overly accommodative monetary policy.

Taken together, the message is that when monetary policy proves inadequate, the Bernanke Fed’s response has been, and will be, even more aggressive intervention.

So, where are we now? Real GDP is growing between 2-3% and reported inflation is running at between 2 and 3%. Excluding the calculated deflation from technological progress would add about another 1% to inflation. On that basis, nominal growth is probably about 5-7%.

In the face of this, we have a policy of near zero cost money with promises to keep it that way for years, and an open debate as to whether we need more quantitative easing. When this monetary policy is combined with a large fiscal deficit, it leaves policy makers very little flexibility should we enter another recession or encounter another crisis.

I know this isn’t conventional thinking, and it certainly isn’t the way the Fed looks at it, but I believe that raising short rates — not to a high level, but to a still low level of 2 or 3% — would be much more conducive to both growth and stability.

The household sector balance sheet has a negative duration gap, meaning that it holds proportionately more short-term floating assets like bank deposits and money markets compared to its liabilities, which are disproportionately long-term fixed obligations including mortgages.

Raising rates would directly transmit income to families, enabling them to spend more freely and boost the economy — a stimulus so to speak.

Unfortunately, it appears that Chairman Bernanke is more focused on financial institution balance sheets. While the Fed recently declared most of the largest banks to be healthy, and approved programs to reduce bank capital, continuing with zero rates several years into the recovery reveals a focus to support banks rather than households.

Zero rates allow the banks to carry non-performing and other questionable assets indefinitely. When the cost of money is nearly zero, dead beat borrowers can appear current by making nominal payments. When banks can finance their non-performers for free, they have little incentive to work them out. This lengthening of the work-out process supports banking profits and defers needed pain for some underwater borrowers. But, it also prevents the markets — particularly the real estate market — from clearing. This in turn delays the economic recovery and postpones job creation.

Income inequality remains a headline issue. Democrats argue for higher taxes for top earners, and increased transfer payments to those on the other end of the spectrum. Republicans remain opposed to any redistributive policies. Ending the Jelly Donut monetary policy would do more to alleviate income inequality than any of the widely debated changes in the tax code.

For the super wealthy, zero rates supported by a Bernanke put on the bond market encourage outsized income through leveraged speculation. For everyone else, zero rates reduce the standard of living because greater food and energy costs soak up income. Ironically, it is some Republicans that are beginning to question the Jelly Donut monetary policy, while Democrats generally support it. Democrats who sincerely care about income inequality should speak out against the Fed’s policies…

****

It’s time for Chairman Bernanke to begin restoring the markets to their natural balance. Provide the proper incentives for Lisa and Maggie to start investing in the economy again. Let Bart possibly default on his unsustainable debts so that the banks can start getting those loans off the books. Stop giving Mr. Burns access to free money that he can use to speculate in bonds and commodities at the expense of the middle class. As for Homer and Marge, quit trying to fool them into thinking they’re wealthy and instead give them the opportunity to retire with some financial security. With a little extra money in their pocket, Marge can go back to the beauty parlor, and Homer can support the beer and bowling economy.

I’d like to turn my attention to the stock market. There are a lot of cheap and even very cheap stocks. The companies in the S&P will earn over $100 per share collectively this year, and the consensus for next year is for higher earnings and no recession. The market is at 14 times earnings and only has to compete with 2% ten-year Treasury notes. Even with the recent rally, equities are cheap enough that they should not need the Fed to push risk-averse savers into stocks or a Bernanke put in order to do well. What gives?

I believe that stocks are depressed because there is a pervasive feeling that something awful is going to happen. What is this enormous tail-risk? It’s the intersection of reckless fiscal policy with Jelly Donut monetary policy.

There is a fear that our Fed Chairman is an academic willing to take great systemic risks in an experiment to prove out his thesis as to how we should have fought the last Great Depression.

I believe that removing the tail risk that Chairman Bernanke will feed us a coma inducing dose of Jelly Donuts would go a long way toward restoring the relationship between P/E multiples and long-term interest rates to the benefit of stocks, at the expense of bonds. If the Fed were to stop trying so hard to prop-up the stock market, the reduction in tail risk would probably fuel the market going up on its own.

I think we’ve reached the point where even Homer can see that the last thing he needs is another Jelly Donut, but the Fed Chairman is oblivious.

We can all say “D’oh!”

****

While I hope that you found this discussion thought-provoking and persuasive, as an investor my job is to figure out what will happen rather than what should happen. If we didn’t have a Jelly Donut monetary policy, I would sell gold, sell bonds and buy stocks. But, the Fed is filled with academics who thoughtlessly rely on econometric models that reflexively indicate that repeated Jelly Donut orgies are the best way to get a sugar rush into the economy. And, the Fed Chairman seems to have no trouble rationalizing any policy failure on the basis that “monetary policy cannot be a panacea,” or “it’s bad luck,” or as proof that he just hasn’t force fed us enough Jelly Donuts, yet. As long as this is the case, it seems unlikely the Fed will change course.

As a result, I will keep a substantial long exposure to gold — which serves as a Jelly Donut antidote for my portfolio. While I’d love for our leaders to adopt sensible policies that would reduce the tail risks so that I could sell our gold, one nice thing about gold is that it doesn’t even have quarterly conference calls.

David Einhorn is president of Greenlight Capital, Inc., which he co-founded in January 1996. Greenlight Capital is a value-oriented investment advisor whose goal is to achieve high absolute rates of return while minimizing the risk of capital loss. David is also Chairman of the Board of Greenlight Capital Re, Ltd. (NASDAQ:GLRE). He is the author of Fooling Some of the People All of the Time: A Long Short (and Now Complete) Story, published in December 2010.

April 30 – Bloomberg (John Gittelsohn): “The U.S. homeownership rate fell to the lowest level in 15 years in the first quarter… The rate dropped to 65.4% from 66% in the fourth quarter and fell a full percentage point from a year earlier…”

May 1 – Bloomberg (Lucy Meakin and Emma Charlton): “European Central Bank measures to stem the region’s debt crisis threaten instead to undermine the euro. ECB loans worth more than $1.3 trillion have been recycled into government bonds, capping borrowing costs. As Italy’s reliance on its local institutions increases and Spanish banks accelerate purchases of domestic government securities, however, the economic ties that bind the fate of euro members to each other loosen, weakening the incentives for cross-border support to defend the currency union. ‘As the local bond markets have become owned only by domestic institutions, there is less and less incentive for the other countries to support and bail out one of those,’ said Stephane Monier, who helps manage more than $150 billion as head of fixed income and currencies at Lombard Odier Investment Managers. ‘Basically you’re planting the seeds for the disintegration of the euro zone.’”

May 2 – Bloomberg (Giles Broom): “Rich Americans renouncing U.S. citizenship rose sevenfold since UBS AG whistle-blower Bradley Birkenfeld triggered a crackdown on tax evasion four years ago. About 1,780 expatriates gave up their nationality at U.S. embassies last year, up from 235 in 2008… The embassy in Bern, the Swiss capital, redeployed staff to clear a backlog as Americans queued to relinquish their passports.”  

Money Notes:

One-month Treasury bill rates ended the week at 5 bps and three-month bills closed at 7 bps…Ten-year yields fell 5 bps to 1.88%. Long bond yields dropped 5 bps to 3.07%…Corporate bond spreads widened. An index of investment grade bond risk ended the week up 4 to 99 bps. An index of junk bond risk jumped 16 to 595 bps.

Spain’s 10-year yields declined 14 bps this week to 5.71% (up 67bps y-t-d). Italian 10-yr yields dropped 22 bps to 5.42% (down 161bps)…an French yields fell 18 bps to 2.82% (down 32bps). The French to German 10-year bond spread narrowed 7 to 124 bps. U.K. 10-year gilt yields dropped 13 bps to 1.99% (up 2bps)…

Federal Reserve Credit declined $14.6bn to $2.846 TN. Fed Credit was up $159bn from a year ago, or 5.9%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 5/2) jumped $13.4bn to $3.496 TN. “Custody holdings” were up $75.6bn y-t-d and $43.5bn year-over-year, or 1.3%.

Global central bank “international reserve assets” (excluding gold) – as tallied by Bloomberg – were up $678bn y-o-y, or 6.9% to a record $10.457 TN. Over two years, reserves were $2.476 TN higher, for 31% growth.

M2 (narrow) “money” supply dropped $40.5bn to $9.814 TN. “Narrow money” has expanded 5.7% annualized year-to-date and was up 8.9% from a year ago…

Global Credit Watch:

May 2 – Bloomberg (Lucy Meakin and David Goodman): “German government bonds rose, driving the nation’s borrowing costs to record lows, on speculation Europe’s economic slump is deepening and exacerbating the region’s financial crisis. Yields on German two-, five-, 10- and 30-year securities fell to all-time lows as reports showed unemployment in the euro area rose in March and manufacturing contracted for a ninth month in April…”

May 2 – Dow Jones: “Jens Weidmann, chief of the German central bank who carries considerable weight among European Central Bank rate-setters, stepped up his defense of fiscal rectitude… His comments come amid a raging debate in Europe about whether governments should continue to pursue strict budget discipline amid signs that cutbacks are impeding economic growth. ‘Precisely in times of uncertainty it is important that policy remains credible and sticks to that which it has committed itself,’ he tells the German weekly Die Zeit. ‘A forceful budget restructuring and decisive structural reforms are the best growth policy, because through this confidence is created and the capacity of the economy is strengthened…’”

May 2 – Bloomberg (Gabi Thesing and Simon Kennedy): “European Central Bank President Mario Draghi’s insistence on shielding his institution from losses on Greek debt risks blunting his crisis-fighting tools. Investors forgave about 100 billion euros ($132bn) of Greek debt in March in the biggest sovereign restructuring ever, swapping existing bonds for new securities with clauses making future overhauls easier. The ECB’s holdings, however, were excluded from both the losses and the new terms. That exemption suggests private bondholders will rank behind the… central bank in any future euro- region restructurings, making them wary of accompanying any revival of the ECB’s currently-suspended bond-buying program with purchases of their own. ‘The ECB’s sticking-plaster is less sticky now,’ said Laurent Fransolet, head of fixed-income strategy at Barclays… ‘While the Security Markets Programme may help reduce the probability of a country defaulting in the short term, any foreign investor will be wary that they’ll end up at the back of the queue if it does go wrong in the end.’”

May 2 – Bloomberg (Paul Dobson): “Italian and Spanish banks are running out of cash borrowed through the European Central Bank’s three- year-loan program, diminishing their ‘firepower’ to buy government bonds, according to Royal Bank of Scotland Group Plc. Banks in Italy have spent the equivalent of 46.4% of the funds they received from the longer-term refinancing operations, while Spanish ones have used up 42.3%, Harvinder Sian, Biagio Lapolla and Simon Peck, interest-rate strategists in London, wrote…”

Global Bubble Watch:

May 3 – Bloomberg (Lee Spears): “Facebook Inc., the world’s most popular social-networking site, is seeking as much as $11.8 billion in its initial public offering, the largest on record for an Internet company… The company was considering an IPO valuation of as high as $100 billion…”

May 3 – New York Times (Carol Vogel): “It took 12 nail-biting minutes and five eager bidders for Edvard Munch’s famed 1895 pastel of ‘The Scream’ to sell for $119.9 million, becoming the world’s most expensive work of art ever to sell at auction. Bidders could be heard speaking Chinese and English (and, some said, Norwegian)…”

Currency Watch:

May 4 – Bloomberg (James G. Neuger): “Four elections this weekend have the potential to reshape the European political map and show how the response to the financial crisis remains hostage to the whims of voters on both sides of the region’s economic divide. Recession-weary Greeks will pick a new government and polls show the French will probably install a Socialist president for the first time since 1981. Local elections will test Italy’s political pulse, and voters in a northern German state may deal a symbolic blow to Chancellor Angela Merkel’s coalition. The May 6 elections capture the popular agitation in debtor and donor countries alike, after emergency loan packages worth 386 billion euros ($507bn) and a focus on deficit reduction failed to halt the debt crisis.”

The U.S. dollar index rallied 1.0% this week to 79.50 (down 0.8% y-t-d). On the upside for the week, the Japanese yen increased 0.5%, the South Korean won 0.3%, and the Taiwanese dollar 0.2%. On the downside, the New Zealand dollar declined 3.3%, the Australian dollar 2.8%, the Brazilian real 2.1%, the Canadian dollar 1.6%, the Mexican peso 1.5%, the Swedish krona 1.5%, the euro 1.3%, the Swiss franc 1.35, the Norwegian krone 1.3%, the Danish krone 1.3%, the South African rand 1.1%, the British pound 0.7%, and the Singapore dollar 0.6%.

Commodities Watch:

The CRB index fell 2.7% this week (down 2.7% y-t-d). The Goldman Sachs Commodities Index sank 4.5% (up 1.3%). Spot Gold slipped 1.2% to $1,642 (up 5.0%). Silver dropped 3.1% to $30.43 (up 9%). June Crude slumped $6.44 to $98.49 (down 0.3%). June Gasoline sank 5.4% (up 12%), while June Natural Gas rallied 4.3% (down 24%). July Copper fell 2.7% (up 8%). May Wheat ended the week down 6.0% (down 8%), while May Corn gained 1.4% (up 2%).

China Watch:

May 3 (Bloomberg) — China had a trade surplus in April of just above $10 billion as exports and imports showed ‘very small growth,’ Commerce Minister Chen Deming said… The trade figure compares with a median estimate of $9.9 billion… and an $11.4 billion surplus in April 2011. Chen… said exports and imports expanded ‘maybe just several percentage points.’ Economists had forecast an 8.4% rise in exports from a year earlier and an 11% increase in imports.”

Europe Economy Watch:

April 30 – Bloomberg (Gabi Thesing): “Growth in loans to households and companies in the 17-nation euro area slowed in March as a cooling economy curbed demand for credit. Loans to the private sector grew 0.6% from a year earlier after gaining an annual 0.8% in February, the European Central Bank said today. The rate of growth in M3 money supply, which the Frankfurt-based ECB uses as a gauge of future inflation, increased to 3.2% from 2.8%.”

May 3 – Bloomberg (Jennifer Ryan and Fergal O’Brien): “Euro-region unemployment rose to a 15- year high and manufacturing contracted for a ninth month, adding to signs the economic slump is deepening. The jobless rate in the 17-nation euro area increased to 10.9% in March from 10.8% in February…”

May 4 – Bloomberg (Simone Meier): “Euro-region services and manufacturing output contracted more than initially estimated in April, adding to signs of a deepening economic slump. A euro-area composite index based on a survey of purchasing managers in both industries dropped to 46.7 from 49.1 in March… That’s the fastest rate of decline since October…”

May 2 – Bloomberg (Lorenzo Totaro): “Italy’s unemployment rate rose more than economists forecast in March to the highest since 2000… Joblessness increased to a seasonally-adjusted 9.8% from a revised 9.6% in February…”

April 30 – Bloomberg (Rupert Rowling and Lananh Nguyen): “Mumtaz Ozkaya, a leather-clothing salesman in London, is slashing his usual 1,000 miles (1,609 kilometers) a month of driving by 30% and taking cheaper vacations, as record fuel prices burden European motorists. ‘Wages are still the same so I am cutting back on miles and also on holidays,’ Ozkaya said… a Shell-branded service station near Old Street in the U.K. capital, where regular gasoline costs 143 pence a liter ($8.76 a gallon). ‘Whereas we used to go on holiday to a five-star hotel for three weeks that is now a four-star for two weeks.’ The average retail price in the European Union’s 27 member nations surged to a peak of 1.69 euros a liter ($8.44 a gallon) on April 20…”

U.S. Bubble Economy Watch:

Central Bank Watch:

May 3 – Bloomberg (Jana Randow and Jeff Black): “European Central Bank President Mario Draghi left open the option of further stimulus if the economy continues to deteriorate as investors await the outcome of elections in Greece and France. While policy makers didn’t discuss lowering interest rates at a meeting in Barcelona today, Draghi pointed to new growth and inflation forecasts next month that may change the ECB’s policy stance. Uncertainty about the commitments of future leaders in Greece and France to fiscal reforms, paired with worsening economic data and renewed tensions in financial markets, may force the ECB’s hand.”

May 1 – Bloomberg (Michael Heath): “The Reserve Bank of Australia cut its benchmark interest rate by half a percentage point as inflation pressures abate, delivering a bigger-than-forecast reduction that sent the local dollar and bond yields tumbling. Governor Glenn Stevens and his board slashed the overnight cash rate target to a two-year low of 3.75% from 4.25%, the deepest reduction in three years…”

May 2 – Bloomberg (Caroline Salas Gage and Joshua Zumbrun): “The odds of more Federal Reserve stimulus diminished… as four central bankers said it probably won’t be needed and an unexpected acceleration in U.S. manufacturing provided fresh evidence of economic strength. John Williams, president of the San Francisco Fed, joined his counterparts from Richmond, Philadelphia and Atlanta in casting doubt on the need for additional purchases of bonds to push down longer-term interest rates.”

Real Estate Watch:

May 4 – Bloomberg (Scott Hamilton): “U.K. house prices dropped the most in 1 1/2 years in April as a stamp-duty exemption for first-time buyers ended and the economy fell into its first double-dip recession since the 1970s, Halifax said. Prices dropped 2.4% from March…”

Muni Watch:

May 3 – Bloomberg (William Selway): “More than half of U.S. states expect to end their budget years with cash surpluses as a recovery in the economy buoys tax collections, a sign of easing pressure in statehouses across the country. Twenty-nine state governments, including New Jersey, Indiana and Arizona, anticipate ending their fiscal years with more money on hand than forecast when they put together their annual budgets, according to a survey…by the … National Conference of State Legislatures.”

California Watch:

May 2 – Los Angeles Times: “The legislative analyst’s office has a new number that is adding to California’s financial headache: $3 billion. That’s the total amount that tax revenue has lagged behind goals set by Gov. Jerry Brown’s administration in the current fiscal year… Much of that gap comes from a disappointing April, the most important month for income taxes. Income taxes were $2.07 billion short of the $9.43-billion goal, and corporate taxes fell $143 million short of an expected $1.53 billion…”

May 2 – Associated Press (Judy Lin): “The leaders of California’s three higher education systems warned… that more budget cuts will hurt the state’s economic recovery. The heads of the University of California, California State University and California Community Colleges spent the day lobbying state lawmakers and the governor’s office to make higher education a priority as they prepare to put together a new spending plan for 2012-13. Frustration over rising tuition and fewer courses have been playing out across California’s college campuses. At the same time, administrators have been criticized for handing out handsome compensation packages.”

May 1 – Bloomberg (Alison Vekshin and James Nash): “Police officers and firefighters in San Jose, California, can retire at age 50 with 90% of their pay. The deal has left Silicon Valley’s capital so short of cash that a library and community center has stood unused since its completion two years ago. The predicament of the 10th-biggest U.S. city reflects the painful choices that rising public-worker pension and health costs are inflicting on municipalities. In San Jose, the burden has become a $2.7 billion unfunded liability, costing the city its AAA bond rating. Next month, voters will decide on a measure that would trim the city’s payments for its two pensions. ‘Our police officers and firefighters will probably make more money in retirement than they did while they were working,’ Mayor Chuck Reed, 63, said… ‘We’re seeing the impacts of that on our ability to provide services.’”

To be sure, those promoting only more aggressive fiscal and monetary stimulus ignore Credit theory and financial history. There is absolutely no discussion of Credit Bubbles or financial Manias – as if there’s no evidence that either has ever existed. Dr. Krugman proposes only more egregious deficits and central bank monetization without factoring in myriad risks, including the risks of Credit revulsion, currency collapse and global financial meltdown. Rather than 2008 developments alerting officials to systemic Credit collapse vulnerability, the inflationists have hung their (and everyone’s) hats on the specious “100-year flood” premise.

When the inflationists point to consumer price inflation as the predominant risk to their suggested policy course (and then quickly dismiss it), it just strikes me as disingenuous. They somehow ignore how the current policymaking course is increasingly impairing the creditworthiness of the heart of our and the world’s financial systems. They disregard how these policies have patently contributed to unprecedented global economic imbalances. Moreover, the inflationists somehow remain oblivious that policy interventions have fomented dangerous speculative dynamics throughout global securities markets.  

Quite complex dynamics have become critical to macro analysis. From my study of Credit inflations, it is clear that unfettered Credit growth attains a propensity for exponential expansion throughout the upside phase of the Credit cycle. Pro-cyclical policymaking, especially in our age of unconstrained global finance, fundamentally exacerbates Credit boom and bust cyclicality. The current interplay of global Credit cycles is extraordinary: Europe’s Credit Bubble is bursting, China’s (and the developing world’s) is booming, and ours is somewhere in between.

Importantly, in the late phase of Credit excess, in what I refer to as the “terminal phase,” things tend to go haywire. First, the amount of new Credit balloons uncontrollably, while the resulting heightened risk of a bust invariably ensures aggressive pro-Bubble policy interventions. Second, as the quality of the new Credit deteriorates, the overall increase in system Credit risk turns parabolic, imperiling highly exposed (leveraged) financial sectors. Third, this bulge of risky new finance tends to be distributed haphazardly throughout the real economy. In short, well-entrenched Monetary Processes responsible for huge amounts of risky finance foster malinvestment, economic fragility, wealth-redistributions, and destabilizing speculation. “Activist” inflationary policymaking exacerbates these deleterious processes, and the inflationists completely disregard ample global evidence of this harsh reality.

There is just no getting around the fact that efforts to sustain Credit cycles turn perilous. As should be obvious these days, prolonging the “terminal phase” of Credit excess poses great risk to underlying Credit systems, the financial markets and real economies. Here in the U.S., Keynesian policies ensure a historic expansion of government debt, blunt stimulus that inflates incomes and consumption while doing little to incentivize sound investment (hence a self-sustaining, job creating recovery). Massive government-imposed distortions instead foment market and economic uncertainty, in the process thwarting necessary economic restructuring. In Europe, several futile years of policy measures meant to stem the downside of the Credit cycle have done little to stabilize the “periphery” – while doing irreparable damage to the “core.” Globally, unprecedented fiscal and monetary activism has only aggravated imbalances and fostered highly speculative securities markets.

My thesis holds that LTRO and concerted global central bank liquidity measures from late-2011 were destabilizing for global markets, while providing quite limited, at best, medicine to underlying Credit stress. There was added confirmation this week that, despite unprecedented policy measures, Europe is sinking into a problematic economic downturn. There was also evidence of heightened vulnerability in the highly-speculative global “risk on” market dynamic. And with securities markets increasingly susceptible, sentiment toward global economic prospects has begun to shift.

Crude oil sank $6.44, or 6.1%, this week. The Goldman Sachs Commodities Index dropped 4.5% to the lowest level since January. This week the New Zealand dollar was hit for 3.3%, the Australian dollar fell 2.8%, the Brazilian real 2.1%, the Indian rupee 1.7%, the Russian ruble 1.6%, the Canadian dollar 1.6%, and the Swedish krona was down 1.5%. The U.S. dollar index gained 1.0%.

Payroll data again disappointed, with U.S. job growth having now declined for three straight months. There will of course be various bullish and bearish spins on the data, yet it should be clear that the U.S. economy is lacking sufficient momentum to bolster global economic prospects. With downside risks abounding and economic locomotives not evolving, the global economy is now at heightened vulnerability.

My bearish thesis back in December was premised on the view that an impaired European banking system would prove a catalyst for a problematic tightening of Credit conditions in Europe, as well as in the developing economies where Europe’s banks were important financiers. Moreover, the European debt crisis was a likely catalyst for a bout of global speculator de-risking/de-leveraging, implying a tightening of liquidity throughout global markets. However, the $1.3 TN LTRO and other global central bank interventions incited a dramatic change in the global liquidity backdrop. “Risk off” was abruptly ousted by “risk on.” A major short-squeeze, reversal of risk hedges and speculative leveraging together created a tsunami of liquidity. And as markets rallied, a view took hold that a new multi-year bullish liquidity cycle had commenced. Somehow, it even turned euphoric.

The first quarter saw record global corporate debt issuance, along with huge flows into global risk markets. Investors and speculators alike turned remarkably bullish, determined to fixate on the favorable policy backdrop while dismissing global fragilities. Even the non-believers couldn’t afford to not jump aboard. Such a speculative backdrop bolsters the perception of ongoing liquidity abundance, in the process setting the stage for eventual disappointment, risk-aversion, de-leveraging and a return of market liquidity issues.

Perhaps it’s premature to declare The Revenge of “Risk Off.” But it’s moving in that direction. Clearly, the sanguine view of global economic prospects was based upon an ongoing favorable financial backdrop. The LTRO was to have bolstered the capacity of European banks to lend, while continued heady global securities markets were to inspire both general confidence and booming corporate debt issuance. To boot, there remained significant capacity for stimulus throughout the developing economies. Weaker data in China was seen in positive light, ensuring looser policies and an unending Chinese boom (along with unrelenting Chinese demand for everything desired, real and financial).

A more bearish view of the world might begin to look at China in the context of a historic, and increasingly fragile, Credit Bubble. A shift in sentiment might also find global players pondering Chinese corruption, market integrity, financial sector solvency, and political stability. And while loose policies can prolong “terminal phase” excesses, there undoubtedly reaches a point where financial distortions and economic imbalances overwhelm the (overestimated) capacities of policy measures. My sense is that China is somewhere between inching and lurching closer to such a point. And, increasingly, bullish and bearish global views on China are wildly divergent, fostering market uncertainty. A problematic global scenario would see a bout of de-risking/de-leveraging coincide with waning confidence in the vaunted model of Chinese financial and economic engineering. At the minimum, doubts are growing in the optimistic view that economic resiliency in China and recovery in the U.S. will counter European weakness.

There will be important elections this weekend in France and Greece. Mr. Hollande, the presumptive new Socialist French President, has handled circumstances capably and has somewhat calmed market fears. Yet his election will signal a decisive leftward lurch in European politics. The Greek election has the potential to destabilize that nation’s troubled reform efforts. The political landscape is unusually splintered, with extremist parties making headway. There is the potential for political chaos pushing forward what seems like Greece’s inevitable exit from the eurozone.

Interestingly, in the face of unsettled global markets, European bond markets performed well this week. Spanish 10-year yields declined 14 bps to 5.71%, Italian yields dropped 21 bps to 5.42%, and French yields fell 18 bps to 2.82%. There is talk of a more pro-growth approach to policymaking, with even ECB President Draghi supporting a new “growth pact.” In Spain, efforts are said underway to create a “bad bank” structure to offload problem loans from an increasingly impaired banking system. That said, perhaps part of this week’s European bond strength can be linked to short covering, as a vulnerable speculator community increasingly finds itself on the wrong side of various global markets.

He continues: “They – the vampire squids – have manipulated virtually every single price and valuation in the capital markets. People ought to recognize when they invest that one of the unspoken risks is the risk that this hall of mirrors, this Barnum and Bailey world that the Fed has created for us is going to vanish one day because they will not be able to hold it any more… It’s not as if there is nothing to do in investing, but one must always keep in mind that the valuations that we see, that the prices that we watch flicker across the tape are prices that are fundamentally manipulated by these well-intended, dangerous people in Washington called the Federal Reserve“.

And to think that 3 short years ago Grant would have been branded a loony, tin-foil hat wearing gold bug, while now it has become trendy for hedge fund managers to bash the Fed with impunity. It is all downhill from here.

Link to Video:

http://www.zerohedge.com/news/jim-grant-federal-reserve-vampire-squid-vampire-squids