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Friday, April 3, 2009

Financial Industry Bailouts and the Compound Interest Paradox

The mainstream media occasionally mentions this question, but they give the usual pro-State trolling answer.

Why is it necessary to bail out the banks? Why can't they just go bankrupt? Why are they "too big to fail"?

The answer to this question is the Compound Interest Paradox.

Another closely related unasked question is:

Why does a bank need to be bailed out? If Bear Stearns goes bankrupt, why does that threaten Goldman Sachs? Aren't they supposed to be competitors?

Suppose I write my own wiki engine. If people use my website instead of Wikipedia, and Wikipedia goes bankrupt, that should not affect my business. As a business owner, you don't mind if inefficient competitors go bankrupt!

The pro-State troll argument is "Banks are closely interrelated." If you're a prudently run bank, you should assess the risk that your counter-parties will go bankrupt, and protect yourself. In a true free market, such precautions are necessary.

Back when the USA had a freer banking system, this was a sure tipoff that your bank is insolvent. If other banks are refusing to redeem your bank's paper at face amount, then you know your bank is insolvent! Starting after the US Civil War, there was a State-mandated banking clearing system. This system allowed insolvent banks to cheat prudently run banks, because State violence/regulations mandated they cleared their checks.

The "too big to fail" policy means that executives of a large bank do not need to guard against the risk of insolvency by counter-parties.

When you price a derivatives transaction, one of the risk components is supposed to be "risk that the other party will go broke". If I trade on margin, my broker demands collateral and margin calls. When large banks trade with each other, there are no such safeguards. Banks charge their customers a premium for "risk the customer will default".

A bankruptcy by Bear Stearns or Citigroup or AIG threatens the solvency of Goldman Sachs and other banks. That is evidence that they are not true competitors. Instead, they are colluding to loot and pillage the American people. In a true free market, if one of your competitors goes bankrupt, the correct response is "Good for me! I have less competition now!"

The "too big to fail" propaganda is a dead giveaway symptom of a corrupt system.

The USA has a fiat debt-based monetary system. Money-printing power does not lie with the Federal government or even the Federal Reserve. Money-printing power lies with the financial industry.

Physical Federal Reserve Notes and physical coins are printed/minted by the Treasury Department. However, that is an illusion/fnord. When a mainstream media outlet discusses monetary policy, they show images of a Treasury printing press that's printing new Federal Reserve Notes. That imagery reinforces the fnord "Money is issued by the Federal government."

The Treasury sells coins to the Federal Reserve for face amount. A quarter costs approximately $0.05 to mint, and the seignorage profit of $0.20 accrues to the Federal government's budget. The Treasury Department sells Federal Reserve Notes to the Federal Reserve for the printing cost. A Federal Reserve Note costs approximately $0.03 to print. For Federal Reserve Notes, the seignorage profit accrues to the financial industry. Most of the value of newly created physical money is in the form of paper.

The vast majority of money is created electronically. As new electronic money is created, new physical money must also be occasionally created. Usually, when the Federal Reserve monetizes the debt, it creates new money electronically. Sometimes, the Federal Reserve monetizes the debt and pays with physical Federal Reserve Notes or coins. That is how new physical money is introduced into circulation.

New money is only created when someone borrows money. Only the principal is created, and not the required interest payments. Over time, "total outstanding debt" grows exponentially faster than "money supply". This naturally leads to booms and busts.

Whenever the Federal Reserve monetizes the debt, the Compound Interest Paradox applies with the full force of law. It also applies somewhat with financial industry profits.

If you look at the balance sheet of an individual bank, all interest income is paid as expenses or profits. The books of each individual bank balance, which helps hide the Paradox from pro-State troll economists. If you look at the books of "society as a whole", the books do not balance. Look at my page of examples for more details. A lot of pro-State trolls say "FSK is wrong about the Compound Interest Paradox!", but nobody has provided any convincing counter-evidence.

If all the banks simultaneously stop issuing new loans, then it's a statistical impossibility that all loans can be repaid. Some people lose their homes, and the banks take possession of tangible assets, even though they loaned money they printed out of thin air.

Small businesses are ruined by boom/bust cycles. Negative real interest rates send a false price signal during the boom. Artificially low interest rates send a false price signal that it's a good idea to borrow to expand your business. During the bust, the small business owner loses everything. Insiders always qualify for a bailout.

You don't know how long each boom phase and each bust phase will last. This makes it very hard to plan a business.

Suppose a small business owner refuses to borrow. During the boom, he's at a disadvantage to his competitors, who can borrow to expand. The money in his checking account loses value to inflation. A large corporate competitor can profitably borrow to buy out a smaller competitor.

The Federal Reserve, via its Fed Funds Rate manipulation policy, forces banks to collude to issue more or fewer loans.

Suppose banks collude to start issuing more loans. Then, there is massive inflation. This happened when the Federal Reserve cut the Fed Funds Rate to 1% in 2001-2002. This happened when banks lobbied for less restrictive rules regarding mortgages. Home buyers were not required to make as large a percentage downpayment. Less creditworthy borrowers qualified for bigger mortgages. Banks and hedge funds were allowed to use higher leverage ratios when investing in mortgages.

During the housing boom, the banksters made huge profits. They paid themselves huge salaries and bonuses. These bonuses were paid with money the banksters had printed themselves.

During the housing boom, a lot of new money was printed, *PROVIDED* this money was used to purchase a house. This led to a housing bubble. Similarly, in the .com boom, a lot of new money was printed, *PROVIDED* this money was used to purchase tech stocks. Fiat debt-based money causes new money to be created, but only when it is used to purchase the currently-booming asset class.

The Fed Funds Rate was 1%. Mortgage interest rates were 6%. Banks were using leverage ratios of 30x or more. They were making a guaranteed riskless profit of the spread (5%) times their leverage ratio (30x+), making a profit of 150%+.

As long as more new loans are issued, at an exponentially increasing rate, the scam/boom continues.

Eventually, the boom must end. Prices in the bubble-sector rise faster than the overall rate of money supply expansion. For example, during the housing boom, housing prices were rising a lot faster than workers' salaries. That's an unsustainable trend.

Suppose banks collude to stop issuing loans. This happened when the Federal Reserve raised the Fed Funds Rate to 5.25% in late 2006. Banks started issuing fewer loans. The housing market started crashing. All the regulations that allowed for liberal mortgage lending were changed. All of a sudden, it was impossible to get a new mortgage or refinance a mortgage. Fewer people qualified for mortgages, and they were only allowed to use lower leverage ratios. The housing market crashed further.

Suppose that all the large banks went bankrupt. No new loans would be issued at all, while outstanding loans would still be due. There would be a massive hyperdeflationary depression. People would be scrambling for dollars to repay their loans. Anyone without debts would be able to buy things cheaply.

Inflation bails out insiders during a deflationary recession/depression. Insiders buy tangible assets with newly-printed money. At the bottom of the recession/depression, insiders load up on debt and buy as much as they can. They know that, in a few years, inflation will make their investment profitable.

Financial industry insiders love the fact that the Fed Funds Rate is 0.25% while inflation is 20%-30%. They don't care about true inflation. They borrow at the Fed Funds Rate and issue loans or buy tangible assets. They profit from the spread times the interest rate, independent of the inflation rate. Continuous inflation means that productive workers will be able to repay their loans.

Suppose that the Fed Funds Rate is 4%, while mortgage rates are 6%, and leverage ratios are 30x. In this example, banks make a guaranteed riskless profit of 60%.

Suppose there is a mild recession. The default loss rate on mortgages is 3%. Instead of borrowing at 4% and investing at 6%, now the banksters are borrowing at 4% and investing at 3% (6% interest minus 3% default losses). They will go bankrupt in a hurry. In a mild recession, the Federal Reserve bails out the banksters via a Fed Funds Rate cut. The Federal Reserve cuts the Fed Funds Rate to 1%. Now, the banksters are borrowing at 1% and investing at 3%. Their profit equation is restored. In a year or two, there is inflation. Any homes that were confiscated/foreclosed for less than the outstanding mortgage can now be profitably sold. Then, the Federal Reserve raises the Fed Funds Rate again, setting up the next recession.

Suppose there is a severe recession/depression. Suppose the default loss rate on mortgages is 20%+. Now, the banksters are borrowing at 4% and investing at -14% (6% minus 20% default losses). This is what happened in the current recession/depression.

The Federal Reserve cannot lower nominal interest rates below 0%. There are a couple of additional tricks that can be used to bail out the banksters.

1. The Federal government can explicitly bail out the banksters. This is the way TARP worked. Another explicit bank bailout is in the works.

2. The Federal Reserve can purchase the bad loans from the banks, but pay the banks an above-market rate. This is "expanding of the Federal Reserve's balance sheet", which the Communists keep talking about. Suppose a mortgage CDO bond is worth $100M, while the mortgages have a face amount of $1B. The Federal Reserve makes a two year repurchase agreement, valuing the bond at $200M. The Federal Reserve carries the CDO on its books at $200M. The Federal Reserve gives the bank $200M of Treasury debt in exchange for the CDO. Two years later, the Federal Reserve gives the bank its bonds back, while the bank returns the Treasury debt. In the meantime, inflation probably was 20%-30%+ per year. Now, the CDO's value has increased due to inflation.

By moving the CDO from its books to the Federal Reserve's books, the bank avoids "mark-to-market" accounting and insolvency.

"Mark-to-market" is used as an excuse for the State to seize direct control of smaller banks. At the same time, mark-to-market is used as an excuse for insiders to get bailed out.

Most debt contracts are backed by some tangible assets. As there is inflation, those assets rise in value, even while the debt contract is in default. As long as the bank is not forced into bankruptcy, the bank can recoup its loss later via inflation. All the bank has to do is hang onto tangible assets as the money supply reinflates, while not repaying its creditor (the Federal Reserve or other depositors/creditors).

The Federal Reserve has an unlimited budget. The Federal Reserve may take as much debt/assets off the balance sheet of banks as it chooses. The Federal Reserve has no obligation to treat all banks equally. Some banks get better deals than others.

3. The Federal government may cause further inflation via deficit spending. Inflation helps bail out the banksters, as explained above. The Federal government may have unlimited debt without being forced into bankruptcy. The Federal government only has dollar-denominated debt. The Federal government may always print new Treasury bonds to keep borrowing more and more.

This is the point of the "stimulus package". According to pro-State troll Keynesian economics, deficit spending by the Federal government is the cure to a severe recession/depression. The bad guys will never seriously consider reforming a fundamentally corrupt monetary system.

Inflation and bailouts aren't free. Non-insiders pay the cost via inflation. The money in your checking account or your paycheck loses its value due to inflation.

With fiat debt-based money, the banksters must be bailed out, lest the entire economic system unravel. Due to the Compound Interest Paradox, new loans must continually be issued, lest there be a hyperdeflationary collapse of the dollar.

In a mild recession, the banksters are bailed out via a Fed Funds Rate cut. In a severe recession/depression, the banksters qualify for an explicit and direct State bailout.

No mainstream media outlet questions a fundamentally corrupt monetary system, which makes periodic bailouts necessary. The Federal Reserve is treated as a politically untouchable issue. The Federal Reserve chairman is always hyped as a genius/god who knows exactly what to do to "manage the economy".

A handful of people "managing the economy" is the exact opposite of a free market. The Federal Reserve is an immoral price fixing cartel.

Lobbying the State for favors is more profitable than useful productive work. This is the virtuous positive feedback cycle of complete economic collapse.

When the pro-State troll comedians on the Communism channel argue "The financial industry must be bailed out!", they are citing the Compound Interest Paradox (without explicitly stating it). Due to the Compound Interest Paradox, the productive workers are continually dependent on the banksters. The banksters must keep issuing new loans, lest the entire economic system collapse.

State violence prevents people from boycotting the Federal Reserve and using real money instead. If you object to the "bailout economy", your best recourse is to boycott the Federal Reserve and financial industry as much as possible. You should convert your savings to physical gold and silver, so you cannot be robbed via inflation. You should also boycott the income tax. State violence and taxation create an artificial demand for otherwise worthless paper.

2 comments:

J. Nick Puglia said...

Very well done. Us freedom lovers need a 'real' monetary system.

Anonymous said...

Very good.

This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.