Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘assets’

• Banks’ Cheap Money is Economic ‘Poison’

Posted by Ron Robins on March 13, 2011

By Ron Robins. First published March 10, 2011, in his weekly economics and finance column at alrroya.com

Developed world bankers continue to proclaim that enforced low interest rates—cheap money—will lead their countries back to economic prosperity. But didn’t the same policies a few years ago help bring us to the precipice of financial and economic collapse? Do they still not understand that cheap easy money led to many large US and European banks becoming gambling institutions, eventually failing and bailed out at taxpayers’ expense?

And above all, that cheap easy money enticed people, companies and governments, to become horribly indebted, with many individuals and companies failing. Soon, even developed country governments may go bankrupt. As proof that cheap easy money is again causing extraordinary economic problems, just look at where some of it is now going—to the commodities’ markets. There, it helps inflate food prices, thus causing starvation and food riots around the world.

Do the bankers not read history and know that artificially induced cheap easy money can be economic poison?

Of course one simple reason that many bankers advocate cheap easy money is that it makes them a lot of money. When they can—as they did for many years and still seem able to do—‘leverage-up’ their assets in relation to their equity, they can make multiples of profits compared to before. And since, often courtesy of their benevolent central bank, they can frequently borrow at nearly free rates and ‘invest’ those proceeds in bonds/securities/commodities that often offer high potential returns, it is possible for them to make ever bigger profits.

For most large US and European banks, their assets frequently exceeded their equity by 20 to 60 times before the financial crises. That is, keeping it simple, they were somehow able to leverage every $1 of equity, usually by borrowing funds, to create $20 to $60 of assets! The risk in such high leverage is that a small loss in asset values of say, just five per cent, could wipe out their equity and cause insolvency and bankruptcy.

Unfortunately, very high leverage ratios continue in many developed countries’ banking and financial institutions. (Perhaps this is the real unspoken reason for cheap money: to inflate asset markets to keep the banks semi-solvent! Though, that topic is for another post.)

Therefore, the real story is the culture of leverage and risk that numerous developed world banks now embody as a result of easily available cheap money. This is in contrast to that during much of banking history when money was regularly relatively expensive (with higher rates of interest) than today and often difficult to obtain.

The easily available cheap money encourages enormous ‘moral hazard’ among bankers and all players in the financial system. Moral hazard denotes a lack of morality and a carefree greed mentality that produces excessive speculation. It is this attitude that promotes the creation of maximum leverage and the taking of big risks—and not caring too much about any potential losses as they are covered by others. Bankers under the influence of moral hazard are like addicted gamblers who cannot stop gambling. But the gambling is not at the card table. It takes place in their boardrooms and trading desks.

And fortunately for the bankers they can enjoy their moral hazard largely at the expense of taxpayers. As we know, much of the potential and accumulated massive losses in the US and European financial and banking systems have been transferred to governments and central banks. The US and European governments and central banks make light of these burdens saying that as their economies recover these losses will be greatly reduced. However, the ‘central bank of central banks,’ the Bank for International Settlements (BIS), has issued new global bank regulations (Basel III) that—if implemented—might reign in some of the excesses associated with moral hazard.

Of course not all banks speculate or gamble to the same extent. In Islamic banking, spiritual and ethical considerations greatly restrain speculation. Also, for instance, Canadian banks adhere to more conservative principles and are better regulated and so have not suffered the same fate as that of many of their US and European rivals.

For now though, cheap easy money is seen by bankers as our economic salvation. And it inflates global markets, including those related to food and energy. As their prices rise, the unforeseen repercussions of the bankers cheap easy money ‘poison’ assists in creating starvation, food riots, and political upheaval around the globe.

Furthermore, the continuing high leverage, moral hazard, and gambling tendencies within the banking and financial system assures that some of today’s ‘good’ investments will sour and suffer large losses. Will the taxpayers again assume those losses? If not, then what? Until the cheap easy money poison is banished it continues creating conditions for even bigger economic and social catastrophes in the years ahead.

Copyright alrroya.com

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Posted in Banking, Economics, Monetary Policy | Tagged: , , , , , , , , , , , , , , , , , , | Leave a Comment »

• An incendiary mix! Inflation, CPI and the U.S. Federal Reserve

Posted by Ron Robins on May 28, 2008

The U.S. Consumer Price Index (CPI) does NOT measure inflation
It is stunning how confusion reigns on the subject of inflation. Simply put: the Consumer Price Index (CPI) does not measure inflation. It tries, imperfectly, to measure the cost-of-living. Inflation and cost-of-living are not the same thing! As elite economists from Nobel Laureate Milton Friedman to the Bank of England’s Mervyn King comment, inflation is a monetary phenomenon. It is evidenced by excessive expansion of the money supply which exceeds economic growth. Therefore, the basis for higher prices in an economy is ‘too much’ money.

One measure of current U.S. broad money supply shows it growing at an annual rate of over 16%! However, there is considerable debate as to what money supply measure best links it with inflation. (I suspect that for developed countries, we might see credit expansion playing a much more important role in understanding the inflationary process than is currently appreciated. But that is for another post to research.)

Most people believe the CPI measures a fixed basket of goods and services over time. That is again, incorrect. It used to be the case, but not anymore. The current CPI basket of goods and services is constantly changing according to what bureaucrats think people are buying, and by numerous statistical alterations they deem ‘appropriate.’

How the U.S. Bureau of Labor Statistics (BLS) modifies the CPI to show tame inflation
The kind of huge modifications the U.S. CPI is subjected to include the following:

  • Substitution of products. Should prices rise, it is inferred people will substitute with something less expensive.
  • ‘Hedonic’ adjustments. If computers’ performance doubles, the relevant index component is halved.
  • Weighting changes of index components. If an item becomes suddenly expensive, it may receive a smaller index weighting.
  • Chain-weighting. Applies to some ‘versions’ of the CPI. This smoothes-out sudden price changes over many months and means indexes using this are always ‘behind-the-curve.’
  • Intervention analysis/seasonal adjustments. Bureaucrats adjust index components according to historical seasonal variations, whether warranted in the current year or not. (See: The Government’s Statistical Whopper of the Year, by Robert P. Murphy.)

Hence, the BLS is able to manipulate the CPI to whatever doctrine holds sway at the time. Prior to about 1980, there actually was a fixed basket of goods and services that comprised the CPI. It did a much better job of measuring inflation caused by monetary expansion. But politicians and some academics did not like this as they said it overstated the actual cost-of-living. For instance, they figured that if beef became expensive, people might buy chicken, and so on, thereby reducing living costs, and thus effectively lowering the index.

Of course, these types of changes also inferred lower living standards. But no politician, or a bureaucracy headed by a political appointee such as the BLS, would want to say that!

CPI inflation over the past year: using 1980’s configuration, nearly 12%; using current methodology, 3.9%!
So around 1980 the CPI began to be massively modified and thus began the trek of divorcing it from monetary inflation. The difference in numbers between the 1980s CPI inflation measure and today’s cost-of-living CPI is extraordinary! John Williams at http://www.shadowstats.com/alternate_data shows that for April 2008, the CPI using 1980s methodology shows inflation over the past year of close to 12%; using CPI (CPI-U) as constructed today it is just 3.9%!

There is no doubt that the ideal of trying to get a consumer price index that reflects the reality of consumer buying behaviour is a good one. But to rely on the current CPI as a means of determining U.S. inflationary pressures so as to modify its monetary policy, is, at first glance, illogical. However, there is something else going-on here.

The Federal Reserve uses current CPI to fool the world in supporting U.S. economy and artificially high bond, stock prices
The U.S. Federal Reserve often cites the CPI as being very influential in shaping its monetary policy. From the foregoing this seems to be a very strange policy. When viewed through a political lens and the need to maintain confidence in the U.S. economy though, it makes sense to try to fool the world at large that inflationary pressures are minimal within its economy.

The U.S. economic problems are so big that if the Federal Reserve and other government agencies came clean on the true rate of inflation, we would see:

  • U.S. economic growth would be shown to have been negative for several years now (real GDP growth rate = nominal growth less inflation)
  • Bond yields would soar
  • Stock market could rise in highly inflationary environment or crash should deflation take-over
  • U.S. government deficit rocket higher
  • Severe economic downtown. Perhaps a depression

As consciousness rises investors everywhere will begin to understand the distinction between U.S. monetary based inflation that is in the double digits, and a highly stylized, theoretical, consumer price index that minimizes the monetary inflationary threat. Prices of everything will then be re-set accordingly.

There is huge danger ahead should the U.S. monetary and credit expansion continue unabated. The excess funds will find their way into more asset classes and lead to further big asset bubbles – and busts. Commodities anyone! Oh, what an incendiary mix!

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© Ron Robins, 2008.

Posted in Monetary Policy | Tagged: , , , , , , , , , , , , , , , , , | 2 Comments »

 
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