WSJ: Bernanke's Exit Strategy

http://online.wsj.com/article/SB10001424052748703699204575017462822204340.html

We can end bank panics forever by limiting the ability of lenders to create money out of thin air.

Last week, voting 70-30, the Senate confirmed Federal Reserve Chairman Ben Bernanke for another four year term. So now what will he do?

 Phase one of the recovery is certainly complete. Since September 2008, the Fed has bought mortgage-backed securities and Treasurys, and increased the monetary base to $2 trillion from $850 billion. The flood of dollars has bank profits booming.

Sadly, banks still have all those underwater mortgage-backed securities and derivatives, but Mr. Bernanke is assuming they will just earn their way out of this problem. Banks also are not lending enough to get the job-creation engine rolling again—though sooner or later they will, at which point inflationary pressures will build tremendously. So every currency trader, bond buyer and man on the Street wants to know one thing: "What's the exit strategy, Ben?" Raise interest rates, shrink the money supply and risk cratering the economy, or keep rolling along and risk a collapsing dollar?

My guess? Mr. Bernanke will leave the money out there but restrict banks' ability to create more out of thin air. He'll be called crazy. Crazy like a fox.

The Fed has a once-in-a-millennium opportunity to do away with banking panics. Investors will rejoice, but Wall Street firms are not going to like it one bit.

The Fed has a once-in-a-millennium opportunity to do away with banking panics

Our banking system has changed little since the days of Elizabethan goldsmiths writing more gold receipts (aka banknotes) than they had gold in their vaults. This "fractional reserve banking" system has caused every major panic in this country—I've counted at least 16 of them since 1812.

Whatever the era, the story is always the same. Banks keep small reserves, and then invest in supposedly safe "sure things" to generate profits beyond the interest paid to depositors.

Sure things can be real-estate loans, home equity, credit card and commercial debt. But bankers are terrible investors. There are no sure things.

Thus modern banking is protected by the twin pillars of the Fed and the Federal Deposit Insurance Corporation (FDIC). The Fed, founded in 1913 out of the failure of Knickerbocker Trust when it tried to corner the copper market, finally learned after the banking crisis of 1930 that it is the lender of last resort. And the FDIC was established in 1933 to insure depositors against losses in case the bank is so bad at investing that there is nothing left for the Fed to lend to.

The end of bank runs? Mostly. Panics? Hardly. And Paul Volcker's proposal to restrict proprietary trading won't change a thing. Banks write bad loans at the top and dump them at the bottom.

Here is some recent history. The 1988 Basel accords set minimum bank capital at 8%, meaning banks could leverage their capital at ratio of 12.5 to 1. As long as their investments didn't fall by 8%, they stayed solvent. In 2001, U.S. minimum capital was set at 10%, more or less, but banks were allowed higher leverage if some of their capital was AA or AAA rated mortgage-backed securities. The rationale was that these instruments could never possibly drop more than 5%, let alone 10%. Oops.

Under the 2004 Basel II accords, so-called shadow banks (which don't take deposits) with $5 billion in capital were exempt from these regulations. So institutions such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns regularly used 20 to 1 or even 30 to 1 leverage. This allowed these firms to effectively print money, inflate the housing bubble, and then watch those same AA and AAA mortgage securities fall by 70%-90% in value.

To sum up, the Fed creates a monetary base and the banks can create $10 for every $1 of monetary base. Wall Street firms created $20 for every Fed $1. In other words, the Fed only seeds the market. Beyond crude instruments like interest-rate policy, it has little control over how much actual money supply exists. In good times banks lend too much. And in bad times, such as today, they don't create enough money because they lend too little.

Perhaps the lesson Mr. Bernanke drew from 2008-09 is not that we need more regulation but that financial firms should not be allowed to generate money out of thin air to write soon-to-be-bad loans. To seal his legacy, it is fractional reserve banking that he can rein in. Limit leverage and you take away the hot air from these bubbles.

Free marketers blanch at the idea of more regulation. But banking isn't a normal market. Banks create money when it did not previously exist. We've built a regulatory structure around this sleight-of-hand and each time are astonished that banks still fail. I doubt we will ever get to no leverage, a dollar loan backed by a dollar of capital, but I think Mr. Bernanke could be headed in that direction. One potential target is a 5 to 1 leverage limit—he could increase reserve requirements by 1% per year until it hits 20% by 2020. With credit dear, perhaps banks will do a better job of deciding what is a "sure thing."

You do need lending for an economy to function, but you don't need all that much leverage. Increased reserves may be the best financial reform we can hope for without politicians mucking it up. No need for pay czars and repressive rules.

Even a whiff of lower leverage and increased reserves will create a dollar rally, as inflationary fears—that banks will create too much money when the economy gets going again—subside. Oil at $50? Gold at $700?

If I'm right, banks and Wall Street are going to scream bloody murder at their new shackles. But so what, they've had plenty of time to recapitalize themselves and show record profits and compensation, a gift of Mr. Bernanke's zero-interest-rate policy.

Tighter control of money supply would mean the Fed no longer has to guess if banks are creating too much or too little. Lower leverage would keep bubbles from forming in the first place. Crazy.

Comments

[John Donovan]

I hope to hell you’re right, but where’s the evidence that Bernanke thinks along these lines? Or are you, too, slyly trying only to ‘seed’ these ideas?

Gentle Ben seems publicly clueless about the multiple dimensions of his policies and prescriptions. Yes, ballooning the monetary base and keeping rates at zero for ‘an extended period’ may be what’s required for now, but it would be much more reassuring of his grasp on reality if, for example, he would shade his public pronouncements with acknowledgments that such policies hurt savings and fuel the very kind of reckless reach for extra yield that corrupted credit markets in the last decade.

Beyond pledging easy money and defending the Fed’s authority (and seeking to enlarge it), does he, or anyone at the Fed for that matter, show leadership, or even true understanding, about the dangers of excessive credit creation, the temptations toward which have only grown in our era of global fiat money?

[Robert Dobb]

On this subject, your key quote, Andy.... "without politicians mucking it up"... sums it all up.

Lots of luck here.

Just like your previous suggestion of The Paulson Purchase? Once again, Congress got in the way of a very good, very simple solution.

[nicholas kass]

once again ...leadership counts....perhaps
Ben can demonstrate the sovereignty of the Federal Reserve and make this move

[Chris Selland]

Great post - for the sake of the country I hope you're right...

[Willy G Lago]

All that money.
All that years of "works hard" and sacrifice.
All that smart people.
And EEUU is going to do the same errors that 3rd world economies.
I hope for all the world (not only USA), you have right and the leverage and instruments in what the banks can invest will be controlled for the FED.
Thanks for open our blind eyes.

[bubba]

I guess the reader doesn't read mish. The correlation of gold to inflation hasn't proven out. However, there is a strong correlation between gold and credit. If credit gets reined in, watch gold soar.

[sgi]

Mr. Kessler, I've read a lot about the crisis since it happened but being a genuine idiot about our financial system, most of it has been lost on me.

But this post is an exception. I understand, finally, how it happened. And most importantly, I can relate this to my own perceptions of what has gone wrong, not at the level of the American FED but with our society in general.

We have all been living on too much easy credit, every one of us. We have been living beyond our means for decades. That is the biggest bubble and if that were to burst, which I think it is, we will eventually land on our feet on solid ground.

Perhaps then it doesn't matter if the FED reduces the leverage available to banks. We can starve them by reducing our own demand for easy money by living within our means. Yes we will suffer in the short term but prices for everything will eventually come down and we will be able to afford the things we want and need without going into unbearable debt.

[Michael Smith]

What is needed is an end to government participation in the economy -- including, especially, an end to government involvement in the financial sector.

This means eliminating the Fed and eliminating fiat money. Until that is done -- until we strip government of the power to manipulate the money supply -- it will continue to exercise that power and attempt to "manage" and "plan" and "stimulate" economic activity -- and our wealth-destroying roller coaster ride from crises to crises will continue, with the leviathan of federal power growing with every dip we experience and with the leviathan‘s inflationary appetite consuming ever-more of our lives.

Unless we change course, the leviathan will eventually eat us alive. It will be an ugly ending indeed.

[John]

There is a much easier way---only permit banks to make non-recourse loans. Such really forces them to know their customer

There have studies about California lending, which is often non-recourse, that shows this works better for everyone