2009 – The Year Monetarism Enters Bankruptcy
Henry C.K. Liu

Part I: Bankrupt Monetarism

Part II:  Central Banking Practices Monetarism at the Expense of the Economy

This article appeared in AToL on May 5, 2009 as The Burden of Elitism

From its founding in 1913, the dominant guiding principle of US central banking had been monetary rather than economic, notwithstanding that the Federal Reserve’s founding charter directed it to conduct monetary policy to “accommodate the needs of commerce and industry.” There is an extensive field of monetarism economics that attempts to define the causal relationship of economic growth to monetary conditions and policies. But this body of work has yielded mostly selective positivism to support ideological preferences for the importance of money. A positive analysis is supposed to yield a description of what is if left alone without intervention. Yet “what is” in economics is generally the outcome of policy. Central bank policymakers have since focused on monetary policies designed to prevent inflation in order to counter investor fears about money defaulting on its role as a reliable storer of value. Maximizing the role of money as a storer of value is often accomplished by sacrificing the role of money as a facilitator of the maximization of economic value.
Ironically, asset appreciation is viewed by monetarists as growth and not inflation. Inflation is supposed to be caused primarily by wage increases. While the preservation of the value of money is not an unworthy cause, neoclassical economics theory has given the Federal Reserve, the central bank of the US, doctrinaire justification to avoid policies that promote full employment. Anti-inflation bias has also prevented the central bank to reverse the falling income of working families, particularly wage earners and farmers. Central bankers speak of “liquidation of labor” to detach economic demand for labor from the natural demand of labor in a growing population. As a result, monetarists subscribe to stabilization of the nominal money supply rather than total aggregate nominal demand.
Joseph Schumpeter argues that monetary measures do not allow policymakers to eliminate economic depression, only to delay it under penalty of more severity in the future. In a market economy, economic depressions are painful but unavoidably recurring. Countercyclical monetary measures to provide more money to keep ill-timed investment on a high level in a depression are not creative destruction but are positive destruction. And such measures will ultimately be detrimental to the general welfare.
Artificially high asset prices absorb liquidity to stall economic activities to lead to high unemployment. High unemployment in a depression is merely a sign that the market economy is performing its prescribed function. It is the natural socio-economic mechanism for stabilizing production and consumption. Unemployment needs to be eliminated, but it cannot be eliminated by monetarist measures designed to hold up asset prices in a depressed market economy. Countercyclical fiscal measures are indispensable for the elimination of unemployment in an economic downturn. In a depression, unemployment can only be eliminated by fiscal-driven demand management, i.e. providing deficit-financed money through increased work with high wages to the working population so that they have enough money to buy what they produce without inflation.
Herbert Hoover wrote in his memoirs about mainstream liquidationist sentiments after the 1929 crash:
The ‘leave-it-alone liquidationists’ headed by Secretary of the Treasury Mellon…felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.’… He held that even panic was not altogether a bad thing. He said: ‘It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’.
Out of Mellon’s equalitarian liquidationist formula, only liquidating labor has become an essential part of monetary economics.  Theories behind monetary economics harbor an ideological bias toward preserving the health of the financial sector as a priority for maintaining the health of the real economy. It is a strictly elitist trickling-down approach. Take good care of the moneyed rich with government help and the working poor can take care of themselves by market forces in a market economy. All are expected to swim or sink in a sea of caveat emptor risk, but bankers can swim with government-issued life jackets filled with taxpayer money on account of a rather peculiar myth that without irresponsible bankers, there can be no functioning economy. The fact is: while banks are indispensable for a working economy, badly-run bank ignoring sound banking principles are not. What is needed in a depression is not more central bank money for distressed banks suffering losses on loans from collapsed assets prices, but government deficit money to sustain full employment with living wages.
In popular parlance, the Fed is the government-paid doctor of Wall Street, through taking care of the banking system it regulates, with unlimited state power to create money backed by the full credit of the United States, a nation founded as a democratic republic in which sovereign wealth is supposed to belong to the people, not the banks. Yet the Fed is not the doctor of Main Street where the nation’s wealth is created through full employment and living wages. Instead, under market capitalism, the fate of Main Street is left to the manipulated workings of market forces shaped by central bank money freely available to the financial elite beyond the understanding, control and even awareness of most retail market participants. Thus market forces are manipulated to favor those institutions deemed too big to fail, and at the expense of the general public who are hapless participants in a manipulated financial market.
Central bankers are savvy enough to know that while they can create money, they cannot create wealth. To bind money to wealth, central bankers must fight inflation as if it were a financial plague. But the first law of growth economics states that to create wealth through growth, some inflation must be tolerated. The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low- wage working poor, and not by the owners of capital the monetary value of which is protected from inflation.
Inflation is deemed benign as long as wages rise at a slower pace than asset prices. The monetarist iron law of wages worked in the industrial age, with the resultant excess capacity absorbed by conspicuous consumption of the moneyed class, although it eventually heralded in the age of revolutions. But the iron law of wages no longer works in the post-industrial age in which growth can only come from demand management because overcapacity has grown beyond the ability of conspicuous consumption of a few to absorb in an economic democracy.
That has been the basic problem of the global economy for the past three decades. Low wages have landed the world in its current sorry state of overcapacity masked by unsustainable demand created by a debt bubble that finally imploded in July 2007. The whole world is now producing goods and services made by low-wage workers who cannot afford to buy what they make except by taking on debt on which they eventually will default.
By its role of lender of last resort to an irresponsible, dysfunctional banking system, the Fed has essentially banished free markets from the financial sector. Worst yet, the Fed has in the past two decades mutated into a lender of first resort, by providing high-power central bank money to commercial banks to create bank money based on fractional reserve to feed a debt bubble the eventually burst in 2007. Structured finance enabled banks to securitize its risky loans and remove them from their balance sheets by selling them in globalized credit markets. Non-bank financial institutions in the so-called shadow banking system could monetize their liabilities through debt securitization and sell the collateralized debt obligation as risk-compensatory securities to investors.
In my May 2002 AToL article: BIS vs National Banks, I warned:
“… assessment of risks is complicated by recent structural financial developments in the advanced nations’ financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.

Even blue-chip global giants such as GE, JP Morgan/Chase and CitiGroup have overhanging dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in derivatives enjoy exemption from commensurate risk premiums.” (The auto giants were not mentioned because even in 2002, they were no longer considered as blue-chip companies.)
Alan Greenspan, as Chairman of the Fed from 1987 to 2006, proclaimed in 2004:
“Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”
By “the next expansion”, Greenspan meant the next bubble, which manifested itself in housing. The “mitigating policy” was another massive injection of liquidity into the US banking system. There is a structural reason that the housing bubble replaced the high-tech bubble. Houses cannot be imported like manufactured goods, although much of the content in houses, such as furniture, hardware, windows, kitchen equipment and bath fixtures, is manufactured overseas. Construction jobs cannot be outsourced overseas to take advantage of cross-border wage arbitrage. Instead, some non-skilled jobs are filled by low-wage illegal immigrants.
Total outstanding home mortgages in 1999 were US$4.45 trillion and by 2004 this amount grew to $7.56 trillion, and by 2007, $11.2 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgages stood only at $1.82 trillion. On his watch, outstanding home mortgages quadrupled. Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt.
(Please see my September 14, 2005 AToL article: Greenspan, the Wizard of Bubbleland)
When time comes for the Fed to “mitigate the fall out”, the Fed is not the lender of last resort to the average private citizens in whose name it derives its money creation power. While the Treasury takes money from private citizens in the form of taxes, only banks can receive sovereign credit support from the Fed. Not surprisingly, since the Fed, while enjoying the state-granted power to create high-power money, is a private entity owned and run by its member banks.
Normally, in a free market, when a financial institution get itself into financial trouble, the party coming to its rescue would have the right to take over ownership of distressed institution and be entitled to all future profit after the rescue. That is the basic rule of the game of capitalism: you default on your liabilities; you lose your company to the party who bails you out. Only when no private party steps in as rescuer because of the unappetizing prospect of future profit would the government acts as a rescuer of last resort with taxpayer money. It is not nationalization; it is just business, albeit for the common good.
But the Treasury under Henry Paulson giave the distressed banks taxpayer money from the Trouble Asset Relief Program (TARP) with no specific requirement for the banks to make loans to revive the stalled economy. This allowed the banks to use taxpayer money not to help the economy with making new loans, but to de-leverage by paying off liabilities the banks could not otherwise service. Subsequently, the bailed-out banks began to show profits on following quarters on de-leveraged balance sheets, but with little impact on the still impaired economy. Yet this profit is unsustainable unless the banks continue to receive more TARP money every subsequent quarter. Instead of the government collecting the banks’ post-rescue profit, banks are allowed to merely pay back the TARP money at below market rates at their convenience. This gave cause to the now popular saying that the best way to legally rob a bank is to own one and run it to the ground.
TARP allows the government to purchase up to $700 billion of “troubled” assets and equity from financial institutions in order to strengthen the financial sector. It is the largest component of government measures in 2008 to address the financial crisis caused by the subprime mortgage meltdown that started in July 2007.
“Troubled assets” are defined by the Treasury as:
“(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the [Treasury] Secretary determines promotes financial market stability; and
(B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.” 
In other words, “troubled assets”, popularly known as toxic assets, are illiquid, difficult-to-value assets held by banks and other financial institutions. The TARP-targeted assets can be collateralized debt obligations (CDOs) which were sold in a booming market until March 14, 2008 when they were hit by widespread foreclosures on the underlying loans.
TARP, as implanted by the Treasury, is intended to improve the liquidity of these assets by purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses.
TARP does not allow banks to recoup losses already incurred on troubled assets prior to October 3, 2008, but Treasury officials hope that once trading of these assets resumes, their prices will stabilize and ultimately increase in value, resulting in gains to both participating banks and the Treasury itself. The concept of future gains from troubled assets comes from opinion of some in the financial industry that these assets are commanding value that represents losses from a much higher anticipated default rate than currently shows. But if the default rate should continue to rise, such future gains may well be wiped out. Thus far, market value continues to fall below the value of the troubled assets paid by TARP.
The authority of the Treasury to establish and manage TARP under a newly created Office of Financial Stability was mandated on October 3, 2008 by Congress as H.R. 1424, enacting the Emergency Economic Stabilization Act of 2008.
On October 14, 2008, Secretary of the Treasury Henry Paulson and President George W Bush separately announced revisions in the TARP program. The Treasury announced its intention to buy senior preferred stock and warrants in the nine largest US banks. The shares would qualify as Tier 1 capital and were non-voting shares. In order to qualify for this program, the Treasury required participating institutions to meet certain criteria, including:
(1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution;
(2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate;
(3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and
(4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.
The Treasury also bought preferred stock and warrants from hundreds of smaller banks, using the first $250 billion dollars allotted to the program.
The Emergency Economic Stabilization Act requires financial institutions selling assets to TARP to issue equity warrants (security that entitles its holder to purchase shares in the issuing company for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their former strength, the government will also be able to profit from their recovery. But if the companies receiving TARP money elect to pay back the money after stabilization but prior to profitability, the government’s right of future profit will be revoked. In that case, the government would have assumed all the risk, but be squeezed out of any rewards just before imminent profitability.
The prime goal of TARP is to encourage banks to resume lending again at levels before the crisis, both to each other and to consumers and businesses. If TARP can stabilize bank capital ratios, it should theoretically allow them to increase lending instead of hoarding cash to cushion against future, unforeseen losses from troubled assets. Increased lending equates to ‘loosening’ of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets. As banks gain increased lending confidence, the inter-bank lending interest rates should decrease, further facilitating lending.  This goal has turned out to be elusive as banks use the TARP money to de-leverage rather than to resume lending.
The TARP operates as a “revolving purchase facility”. The Treasury has a set spending limit, $250 billion at the start of the program, with which it purchased the assets and then either will sell them or hold the assets and collect the ‘coupons’. The money received from sales and coupons is supposed to go back into the pool, facilitating the purchase of more assets. The initial $250 billion can be increased to $350 billion upon the President’s certification to Congress that such an increase is necessary. The remaining $350 billion may be released to the Treasury upon a written report to Congress from the Treasury with details of its plan for the money. Congress then has 15 days to vote to disapprove the increase before the money will be automatically released. The first $350 billion was released on October 3, 2008, and Congress voted to approve the release of the second $350 billion on January 15, 2009.
Another way that TARP money is being spent is to support the “Making Homes Affordable” plan, which was implemented on March 4, 2009, using TARP money by the Department of Treasury. Because “at risk” mortgages are defined as “troubled assets” under TARP, the Treasury has the power to implement the plan. Generally, it provides refinancing for mortgages held by Fannie Mae or Freddie Mac. Privately held mortgages will be eligible for other incentives, including a favorable loan modification for five years.
The first allocation of the TARP money was primarily used to buy preferred stock, which is similar to debt in that it gets paid before common equity shareholders. This has led some economists to argue that the plan may be ineffective in inducing banks to lend efficiently.
In the original plan presented by Secretary Paulson, the government would buy troubled assets in insolvent banks and then sell them at auction to private investor and/or companies. Then overnight lending between banks came to a stand still because banks did not trust each other to be prudent with their money. On November 12, 2008, Secretary Paulson indicated that reviving the securitization market for consumer credit would be a new priority in the second allotment.
The original plan was modified after Paulson met with British Prime Minister Gordon Brown who came to the White House on November 15, 2008 for the first G20 Summit on the global credit crisis. In an attempt to mitigate the credit squeeze in Britain, Brown merely infused capital into banks via preferred stock in order to clean up their balance sheets and effectively nationalizing many banks. The British plan seemed attractive to Paulson in that it was relatively easier and seemingly boosted lending more quickly. The first half of the asset purchases might not have been effective in getting banks to lend again because they were reluctant to risk lending as before with low lending standards.
On December 19, 2008, President George W Bush used his executive authority to declare that TARP funds may be spent on any program he personally deems necessary to mitigate the financial crisis, and declared Section 102 to be nonbinding. This allowed President Bush to extend the use of TARP funds to support the auto industry, a move supported by the United Auto Workers which hoped to avert massive unemployment.
The Congressional Review Panel created to oversee the TARP concluded on January 9, 2009: “In particular, the Panel sees no evidence that the US Treasury has used TARP funds to support the housing market by avoiding preventable foreclosures.” The panel also concluded that “Although half the money has not yet been received by the banks, hundreds of billions of dollars have been injected into the marketplace with no demonstrable effects on lending.”
Government officials overseeing the bailout have acknowledged difficulties in tracking the money and in measuring the bailout’s effectiveness. On February 5, 2009, Elizabeth Warren, chairperson of the Congressional Oversight Panel, told the Senate Banking Committee that during 2008, the federal government paid $254 billion for assets that were worth only $176 billion.

May 4, 2009
Next: Stress Tests for Banks