Dec 14 2007
James Turk: Liquidity won’t help insolvency
Today a guest article from colleague James Turk.
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Liquidity won’t help insolvency
[December 11, 2007]The Federal Reserve today announced a new scheme to inject more liquidity into the money markets. It cobbled together a partnership arrangement, as the Canadian, UK and European central banks also agreed to participate in the scheme.The process of ‘injecting liquidity’ is a euphemistic way of saying ‘creating money out of thin air.’ The Federal Reserve doesn’t need a printing press to do this. They simply create a book entry on its balance sheet, and presto, $40 billion (or whatever amount they deem appropriate) of new ‘money’ is created, which the Fed then lends to those bankers coming to it hat in hand.Creating money this way is a barbaric process because it further debases the dollar, but is hailed by the banking insiders and their apologists as a brilliant maneuver to fight the worsening liquidity crunch. Of course it is a view of those with vested interests, and bluntly, is just their selling pitch to the masses. It is a view so horribly misguided these insiders obviously realize it is wrong. They must know that the problem impacting banks today is insolvency, not liquidity.Years of reckless credit expansion are coming home to roost. The boom is over, and since this past summer we have been in the bust, which is worsening day-by-day. Solvency is a problem of asset quality, not access to sources of funding. For example, Citibank didn’t have any trouble raising $7 billion of funding from a sovereign wealth fund at the right price, which was 11% – a rate far above the rates Citibank is paying to its depositors. This 11% rate reflects the risk of dollar inflation and the risk that Citibank has a lot of bad loans and other inferior assets on its balance sheet that will never be repaid.
There are gaping ‘black holes’ on the asset side of bank balance sheets. These black holes cannot be filled by creating money out of thin air. These black holes were created by assets that have ‘disappeared’. In other words, bank balance sheets are loaded with assets that are not worth what they once were, or in the worst possible case, no longer have any value at all. The bank liabilities remain, but their assets have been reduced. If this gap is larger than bank capital, then bank solvency is called into question, and that is the process now being evaluated by the markets.
Even though they have already announced countless billions of write-offs, banks have a long way to go in toting up their total losses. They face a daunting task. Many – but in reality, probably most – of their assets are impossible to value.
Sub-prime paper no longer has a functioning market to provide even a nominal market price for these assets. As economic activity slows and unemployment rises, people who the banks now believe to be good borrowers will increasingly default on their loan obligations. For example, The Wall Street Journal reported on December 6th: “First came housing loans and the subprime-mortgage crisis. Now, signs of stress are creeping into another key consumer area: auto loans. Delinquencies in the auto-loan market are ticking up to their highest level in several years.”
The economic boom-to-bust cycle caused by bank lending and their subsequent credit contraction is not rocket science, nor a startling revelation. The last banking bust occurred in the late 1980s and early 1990s. Before that, a much deeper bust occurred in 1973-1974, and it more closely mirrors the severity of the way the present bust is developing. Here’s how (economist) Ludwig von Mises described the process nearly one-hundred years ago, making clear the inevitable destruction of fiat currency from inflation.
“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services … at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people … who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and … increase their cash holdings.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time … the things which were used as money are no longer used as media of exchange. They become scrap paper.”
And scrap bank accounts. While paper was the predominant form of currency in Mises time, today bank deposits moved around by check, plastic cards and wire transfer are a much more significant form of currency than paper.
Given this new market intervention scheme announced today by the Federal Reserve, it is reasonable to ask, where else are central banks intervening today? It seems clear that they are capping gold, and I would not be surprised to learn about huge central bank sales taking place today when they get around to reporting it a few weeks from now. With new dollars being created with abandon, crude oil climbing back above $92 and the Commodity Research Bureau Index climbing to another record high, why is gold so quiet?
GATA knows the answer, and so does everyone else who has been following GATA’s work, which is available free at the GATA website, www.gata.org. In another barbarous market intervention, central banks are obviously capping the gold price, but that creates a wonderful opportunity to buy more gold bullion and get rid of overvalued dollars, dollars that continue to be debased and inflated. Gold is much lower today than it would be if central banks weren’t capping its price. So use this opportunity to continue accumulating physical gold bullion.
James Turk is the founder & Chairman of GoldMoney.com.James has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics. His business career began at The Chase Manhattan Bank (now JP Morgan Chase Bank), which included assignments in Thailand, the Philippines and Hong Kong. He subsequently joined the investment and trading company of a prominent precious metals trader based in Greenwich, Connecticut. He moved to the United Arab Emirates in December 1983 to be appointed Manager of the Commodity Department of the Abu Dhabi Investment Authority, a position he held until resigning in 1987.Since 1987 James Turk has written The Freemarket Gold & Money Report, an investment newsletter that publishes twenty issues annually. He is the author of two books and several monographs and articles on money and banking. He is the co-author of “The Coming Collapse of the Dollar” (Doubleday, December 2004).
Doesn’t the Fed money disappear just as quickly as it appeared?
These are, as I understand it, loans. So – in archaic metaphor – the Fed prints a billion dollar bills and loans them out. When the loan comes due, the dollars are burned. It’s a wash (which of course begs the question: Why do it?)
I’ve been trying to understand this ever since I read in the WSJ that the Fed “injected” $40 billion dollars. There was no description of what that meant. Presumably everyone but me knows.
In theory, yes, but only if the Fed decides to sell off the debt it buys instead of rolling it over indefinitely, as is usually the case. In other words, there would be not one dollar in circulation were all debt paid off. That is the credit relationship to the currency. Debt is created, the fed effectively buys is temporarily, and issues freshly minted dollar notes. Obviously, governments enjoy central banks for the very reason they can expand spending without having to confiscate more money via taxes. Rather, they often issue fresh Treasuries that invariably end up at the Fed.
Moreover, with the banking reserve ratio being what it is, the banks that gets $40 billion from the fed are effectively able to loan out $400 billion digital currency. The joys of fiat fractional currency.
The system is only understood by a small percentage of the population, and it is a bit confusing — some argue by design, given the Fed is a private banking cartel and it favors specific large banking interests and works quid pro quo with the U.S. Congress re deficit spending. You’ll definitely not be taught much about it unless you go out of your way to fully understand it. Conventional economics courses often teach it in the context of a particular school of economic thought, and hence the way it functions is not questioned, but rather as a given — much like one might expect the sun to rise in the east and set in the west, it is taken for granted.
I’d recommend searching http://www.mises.org for Rothbard’s “what has the government done to our money” and “The Mystery of Banking“. Both are free to download in .pdf format. For those attempting to figure this all out, they are indispensable and for many, life changing (in a way not unlike the movie The Matrix… pick the blue bill or the red pill!).