classical economics
for analysis,  forecasting
and policy design

Trust in Government
By Wayne Jett
© February 5, 2009

    An economy operating under rule of law and sound economic policy does not run into the ditch. Business cycles result, not from irrationality overtaking management decision-making in the private economy, but from political and governmental actions which arbitrarily affect commerce. Whenever an economy is found in a ditch, absolutely the first inquiry to be made is what government has done to put it there. Here is the short checklist for answering the question:
•    Does monetary policy provide currency with stable value?
•    Does fiscal policy burden commerce with taxes or tariffs at rates beyond the point of diminishing returns?
•    Does rule of law prevent fraud, manipulation and monopolization?
    With every economy worldwide presently in dire circumstances, fair examination of the cause is long overdue. The good news is that the answer is close at hand. The bad news is that the culprit is the U. S. government, where change is hard to accomplish by rational argument.
Currency Manipulation
    Applying the first test, evidence is unmistakable and long-established that the Federal Reserve fails completely to provide stable currency, and does so purposely – not accidentally or because stable currency is hard to accomplish. Even prior to the unprecedented actions of the past year, Fed treatment of the dollar’s value has been very much as French president Sarkozy described it to Congress: as if intended to cause a trade war.
   Sharp devaluation of the dollar robs Americans of the value of their work as other economies lose employment, while the Fed keeps its deliberations close to the vest for all but insiders. The Federal Reserve has eroded the quality of its balance sheet to a condition unimaginable as recently as two years ago. The monetary base has doubled almost overnight – a statement never before true since the Fed’s creation.

Worst Fiscal Policy in History
    U. S. fiscal policy for the past two years has threatened to revoke existing tax rates in 2010 by the mere passage of time. As the Obama administration takes office, the only thing holding back immediate tax increases is economic crisis. This gives rise to expectations that tax hikes will occur just as soon as the economy gets to its feet, if not before. On the spending side, fiscal policy is the worst in U. S. history, with deficit spending completed and planned at unprecedented levels.    
    Both in monetary policy and in fiscal policy, the U. S. government fails badly in producing conditions conducive to economic growth. Without proceeding to the third prong of the short checklist, the first two inquiries already put the U. S. economy on quicksand. Although most of the damage flowing from the two is still to come, they are not the central cause of the global collapse already afflicting the country and the world.
Wall Street Jungle
    That central cause is the U. S. government’s total submission to mercantilist demands for universal license to commit fraud, manipulation and “consolidation” (the polite term for monopolization) throughout the financial markets. Lawlessness has chased private capital out of the markets, stripping large portions away from its owners as they retreated to shelter in gold and Treasury securities. Credit default swaps, originally designed to hedge risk only for the bondholder, were redesigned to permit buying by investment banks and hedge funds as “side bets” that the bond issuer will default. More importantly, CDS tipped the scales heavily in favor of the bond issuer defaulting because each CDS seller immediately hedges risk by selling short the equity shares of the bond issuer.
    In today’s U. S. financial markets, short selling by institutions almost certainly means naked short selling – selling short without borrowing or delivering shares to the buyer, while taking the buyer’s money anyway. This being the case, buying CDS in unlimited quantities practically assures failure/default of the bond issuer, as its share price tumbles, cutting off access to capital and frightening customers. Even sound companies are destroyed in short order. Except for predators engaging in this fraud, what private investor would not bolt from the markets and seek shelter for any remaining capital?
    The FASB “fair value” accounting rule (not used since the Great Depression until 2007), the ABX index of sub-prime MBS, the use of crude oil “swaps” to treble prices and collapse economic growth globally – these tools of fraudulent predators were well within capabilities of the U. S. government to recognize and to prevent. Government’s failure to do so sprang from complicity with the predators – not from ignorance or negligence. True believers in laissez faire free market policy do not espouse lawlessness, fraud and manipulation. Laissez faire was the foe and conqueror of mercantilism in the 18th and 19th Centuries. But as voiced by Treasury secretary Henry Paulson’s acolytes, it was merely political cover for mercantilism’s second all-out assault on global prosperity in the past 100 years.
Government as Savior
    As during the Great Depression, with private capital taken and driven from markets, government has become the only player. Private entities cannot get credit, while government borrows trillions at historically low interest rates. Private mortgage companies were destroyed by mark-to-market accounting juiced by ABX index manipulated by CDS and naked short selling – not by deficient underwriting standards of some among them.
    Now government is about to assume the role of universal home mortgage lender, because government can borrow and lend more cheaply than anyone else. That is easily true when capital is driven from private firms into the waiting grasp of government hands. Government can borrow so cheaply only because private firms cannot borrow at all.
    Government cannot borrow at 3.5% interest on 30-year bonds unless private borrowers are frozen from the market. Government can borrow at 3.5% and lend at 4.5% to subsidize and to prop up real estate prices, but this cannot restore prosperity in an economy that provides no capital to private enterprise. Government’s borrowing power at low interest will be short-lived, because it has occurred due to destruction of private prosperity. Private prosperity is the ultimate foundation of government strength and, without it, government strength and borrowing power will not last.

Big Bang Bad Bank – Bad Idea
    Treasury secretary Gaithner reportedly is mulling a “big bang” plan for restoring vitality to U. S. credit markets, including housing mortgages. Among ideas being weighed is a “bad bank” which would buy MBS from banks at book value, taking warrants on shares of the selling bank that would be exercised only if “bad bank” eventually sells the MBS at a loss. Because “bad bank” doesn’t have $4 trillion to buy the marked-down MBS, “bad bank” would pay selling banks with certificates that the Federal Reserve would treat as acceptable bank reserves.
    Consider the incongruity and irony of these government machinations. Problems U. S. banks have with MBS assets can be solved overnight if government merely suspends depression-era mark-to-market accounting rules and stops CDS and naked short attacks on bank shares. Federal officials adamantly refuse these simple acts to restore bank capital, yet they ask banks to trust government’s good faith in reselling MBS for fair value. What bank will risk wipeout of its shareholders by government warrants, based on trust that government officials will not resell MBS to Wall Street cronies at fire-sale prices? Or trust government to pay money to replace “certificates” when no money is available now? After all the scandalous behavior by the Federal Reserve, Treasury, SEC and CFTC, not to mention Congress, don’t expect a rush into the arms of a government-run “bad bank.”
    Government must be required to drive fraud and manipulation from U. S. financial markets, which means corruption must first be driven from government. Americans have no other path to recover acceptable and improving standards of living. ~