Power & Market

Fed officials are meeting today to discuss the central bank’s next course of action amidst bank failures and persistent inflation. The financial press is busy pumping out articles lamenting the tough position Fed officials find themselves in as they debate another rate hike. That’s true, it is a tough position. But the blame for that lies squarely on the Fed’s own shoulders.

This often goes unsaid because the way people think about central banking is wrong. Most seem to imagine the national economy as a hot air balloon trying to get from point A to point B. The Fed is like the pilot whose job is to keep the balloon stable and at a safe altitude. When conditions demand it, the pilot can either blow hot air into the balloon (monetary expansion) or vent the hot air out (monetary contraction) to increase or decrease buoyancy. If the Fed does its job well, the economy would be guided gently along with occasional monetary interventions to account for economic fluctuations—just as the balloon pilot gently corrects for changing atmospheric conditions.

The quest for a “soft landing” makes sense in this view. The “balloon” climbed too high (inflation), and venting hot air (rate hikes) has yet to bring the balloon back down to the target altitude (2% inflation). But continuing to vent air risks sending the balloon into an unrecoverable descent to the ground (recession). The analogy seems to work well because we’re inundated with central bank discourse that uses this framing. But the framing is wrong. The Fed is not a gentle guide keeping the economy stable; it’s the culprit behind the inflation and imminent recession we’re now forced to deal with.

Recessions don’t come out of the blue. They have a cause—malinvestment encouraged by central bank credit expansion. Artificially low interest rates send a false signal to investors and producers to start, or continue, producing things that either customers don’t actually want—at least not in the quantity now being produced—and/or are unable to be completed with available resources. At some point, often when rates come back up, the precarious nature of these production lines becomes impossible to ignore, and a painful period of correction takes place. That’s a recession. 

So we can see the problem with the typical framing of the Fed’s situation. Besides falsely identifying the Fed as an essential part of the economy, it presents a recession as possible to avoid. Not only is it impossible to avoid, it was the Fed who caused it. They may still have room to delay the correction, but the malinvestment that needs correcting is already here. 

A better analogy than the hot air balloon would be a false shortcut. Imagine you’re running on a trail in the woods. Say it’s the second half of a trail marathon. You’re exhausted and desperate to get to the finish line when you round a corner and see a steep hill up ahead that seems to go up forever. You stop, devastated. You don’t feel like you have the energy to get to the top, much less all the way to the finish. Then out pops a Race Official. He says he can tell you’re exhausted and points excitedly to a small trail to the left of the hill. He explains that it’s a shortcut that avoids the hill. You don’t believe him. A shortcut? In a race? That can’t be allowed. But he insists. He is an official, after all. This shortcut isn’t just allowed, he says, it’s encouraged. 

He’s persistent, and eventually, you’re convinced. You start down the trail and immediately feel much better. It’s shady and has a slight downhill. Your pace increases, you stand taller, and you feel more energized. But above all, you feel grateful that the Race Official happened to find you at the base of that hill. However, what you don’t know yet but will eventually figure out is that you were fooled. There is no shortcut. You’re running off course. Every step you take brings you further and further from your goal. At some point, you will need to recognize this, turn around, and run all the way back up to the base of the first big hill you were misled into thinking you could skip. And because you’re now running downhill and every mile you run not only doesn’t count towards your race but will need to be re-run just to get back to where you initially went off course, correcting your mistake will be extremely painful. But it’s necessary. And the longer you refuse to face that, the worse the eventual correction will be.  

Now imagine you realize your mistake. You turn around and start your painful climb back up to the trail when, again, out jumps the Race Official. He reassures you that you’re on the right path and should continue down this trail. The climb is painful, so you’re inclined to believe him. You keep on down the trail, occasionally turning around when your doubts return, only to have the Race Official again usher you back down his false shortcut. 

By now, I hope it’s obvious what this analogy represents. The hill is the economic pain made inevitable by the lockdowns in 2020 and 2021. The Race Official is the Fed, and the false shortcut is the artificial boom and malinvestment caused by the $7 trillion created out of thin air and injected into the credit markets. I hope it’s also clear that the worst thing you, as the runner, could do would be to continue seeing the Race Official as a helpful guide. Correcting for malinvestment is always painful. But ignoring or aggravating it is worse. 

We’re running off course. Don’t have pity for the people who got us here. And certainly don’t look to them to get us out.

Citizens Financial Group Inc (CFG.N), PNC Financial Services Group (PNC.N), JPMorgan Chase & Co (JPM.N) and US Bancorp in NFL Draft parlance are “on the clock.” These banking white knights are thought to be among the bidders vying for the remaining carcass of First Republic Bank in an auction process being run by the Federal Deposit Insurance Corp, reports Reuters.

Reuters says, “A deal is expected to be announced on Sunday night before Asian markets open, with the regulator likely to say at the same time that it had seized the lender, three of the sources said. Bids are due by Sunday noon, one of the sources said.” 

“Unclear to some involved in the process is whether regulators might use a bid for a so-called open-market solution that avoids formally declaring First Republic a failure and seizing it,” Bloomberg reports. 

Bank analyst Chris Whalen tweets the hard facts. “Hello. Bid is zero with a loss share agreement @FDICgov Haircut loan book 15%. Equity number is negative…”

Yes, the taxpayers will be the unwitting holders of First Republic’s bad assets, while one of the FDIC’s favored bidders gets the good stuff at a discount. Jamie Dimon’s J.P. Morgan already has ten percent of the nation’s deposits making that bank ineligible to pick up First Republic but don’t be surprised if Jamie receives a “special government waiver” if he submits the winning bid. 

Mr. Dimon has been viewed as the fair haired banker for decades. Ex-FDIC Chair Sheila Bair, in her book Bull By The Horns, called Dimon “deeply experienced” and related a story when she served on a panel with Bill Clinton and Dimon with the JP Morgan CEO calling the FDIC “creditworthy” and “would be happy to lend [the FDIC] money anytime.” Writing about the WaMu failure Bair said, “If Chase had not acted, the FDIC would have suffered tens of billions of dollars in losses.” The FDIC remembers. 

James "Jim" Herbert founded First Republic in 1985. Merrill Lynch acquired the bank in 2007, but after Merrill was purchased by Bank of America in the throes of the great financial crisis, BoA sold First Republic and the bank blossomed by luring high-net-worth customers with preferential rates on mortgages and loans. What came with those low loan rate products was uninsured deposits amounting to 68% of the bank’s total deposits.

As was the case with Silicon Valley Bank, First Republic saw more than $100 billion in deposits fleeing in the first quarter, leaving it scrambling to raise money.

Mr. Dimon’s bank, PNC and 9 other big banks made a 120-day deposit at FRC totaling $30 billion in March. It’s unclear if that deposit is insured (why should they be insured? Asks ZeroHedge), uninsured or could be converted into equity as a part of a bailout. This writer can’t believe Mr. Dimon would put up that kind of money uninsured. 

Former Treasury Secretary Lawrence Summers told Bloomberg Friday that he was “surprised and disappointed that this situation has continued to linger as long as it has.”

Sounding almost Rothbardian, Summers said “These are things like forest fires, it is much easier to prevent them than it is to contain them after they start to spread.”

Now First Republic is a political football: cover all the deposits or not. Jim Bianco tweets, 

Don't bailout the uninsured depositors (who are also uninsured creditors) and most likely they take a loss. Yes, the 11 banks will lose, but so will any other uninsured depositor.

If so, sit back and watch 41% of the US deposit base that is not insured (mainly businesses with deposits greater than $250k) try and get their deposits out of their “not-too-big-to-fail” bank and into one that is too-big-to-fail. Chaos in banking because Yellen reneged about protecting uninsured depositors 5 weeks after her promise to protect them.”

"If no business firm can be insured," Murray Rothbard wrote,

then an industry consisting of hundreds of insolvent firms is surely the last institution about which anyone can mention "insurance" with a straight face. "Deposit insurance" is simply a fraudulent racket, and a cruel one at that, since it may plunder the life savings and the money stock of the entire public.

If Jamie Dimon wants the First Republic, he’ll get it, on his terms. And the fraudulent racket will continue. 

One of the problems we’re forced to confront when considering the role of the Federal Reserve is whether it’s better for the Fed to take losses and capitalize them as deferred assets, or go back to an era of “Fed profitability” whereby the Fed remitted money to the Treasury on a weekly basis.

The path to profitability is an easy one, consider: Last year the central bank earned $170 billion in interest revenue (paid by government and mortgage holders), then expensed $102 billion to banks, literally 60% of the Fed’s revenue.

What would happen if the Fed simply stopped paying interest to banks?

The chart below shows Reserves held at the Fed since 1959:

reserves_of_depository_institutions.png

The reserves balance held at the Fed didn’t fluctuate for decades and then suddenly banks started keeping a lot more money at the Fed. By 2009 over $1 trillion was held there, and in 2021 over $4 trillion.

This October 6, 2008 announcement solves the mystery:

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances.

Required and excess reserve balances no longer exist, they’ve been combined into reserve balances, and so, as the Fed’s FAQ shares:

The Federal Reserve Banks pay interest on reserve balances.

Currently at a generous 4.9%.

The interest rate on the Fed’s US Treasuries held are not disclosed in its financial statements, but the interest rate on its nearly $3 trillion Mortgage-Backed Securities is:

interest_rate_on_mbs_held_by_the_fed.png

Nearly $2 trillion earns the Fed 1.5% to 2.5%, whereas the Fed pays 4.9% on the $3 trillion that banks hold on reserve. And so, it’s probably time to consider putting an end to this nearly two-decade long experiment of transferring wealth from the poor and middle class to the rich and powerful.

The correct answer is that the Fed should be abolished, but this will not happen anytime soon. Realistically, they could revert to the pre-2008 policy and pay no interest, or because too many people won’t like that, then at least lower the rate paid to banks to something smaller, like 1, 2, or 2.5%. It’s all arbitrary, but anything less than 4.9% would be an improvement.

One might fear that in doing so, this $3 trillion reserve would leave the Fed and go back to the banks; however, this is fine as the world functioned a lot longer in the former way rather than the latter.

Also consider how ideas like liquidity crisis, lending crisis, or credit crunch, have been mentioned since the banking crisis of 2007-09. Lending programs like the Paycheck Protection Program, and all the other bank assistance schemes, appear more suspect when we remind ourselves that the banks had trillions of dollars earning interest at the Fed this entire time. Given that we’re living at a time when the risk of bank-runs have become a real threat, it’s almost comical to think banks would lend “too much,” or wouldn’t benefit by increasing their own reserve amounts, so claims to the contrary seem unfounded.

In a truly free market, a bank would have the ability to either lend money or keep it on reserve as there would be no central bank to offer a third choice. A Fed that does not pay interest on reserves would bring us a step closer to such a market. 

It doesn’t bode well that stopping interest payment on reserves or at least reducing the 4.9% rate is not being considered as a viable solution. The fact that the Fed has the power to enact this change, literally tomorrow, but continues not to, speaks volumes. Hopefully there’s another way, but if not, the conclusion is clear: If the Fed refuses to cut expenses by reducing interest paid to banks, then the only way for the Fed to make more money is for the Fed to “make more money.”

January 27th of this year marked fifty years since the draft was officially suspended in the United States. And while young American men are still forced to register with the Selective Service, we have been fortunate to go without a draft for half a century, despite Washington's hyper-aggressive foreign policy.

That amount of time can make things feel distant. And even though the program is all set to fire right back up with a word from the president, there's a sense that the draft is an issue from a different era.

But the war in Ukraine offers a window into what conscription looks like in today's day and age. Both sides have resorted to forcing a part of the population to put their lives on the line to serve the interests of the regimes in Kyiv and Moscow. And the lack of condemnation, or even interest, from our fellow Americans should concern all advocates of self-ownership.

After the fall of the Soviet Union, both Ukraine and Russia continued to require male citizens to serve time in the military, though the term was gradually reduced from two years to one.

In 2013, Ukrainian President Viktor Yanukovych abolished conscription. Less than a year later, the new Western-backed Ukrainian government reinstated the draft and forced men to fight the people of eastern Ukraine who didn't want to live under the new government in Kyiv.

After serving their time as active duty soldiers, Ukrainian conscripts remained in a reserve status, eligible to be recalled until the age of 55.

Within hours of the first Russian airstrikes that signaled the beginning of the February 2022 invasion, Ukrainian President Volodymyr Zelensky declared martial law, called up men in the reserves, conscripted new soldiers, and prohibited men between the ages of 18 and 60 from leaving the country.

Zelensky also authorized the "release" of convicts with combat experience to bolster Kyiv's forces. At the same time, conscription appears to have been implemented as a new form of punishment. Men caught breaking curfew and getting into street fights have received conscription notices after being detained by police.

Russian conscription followed a similar trajectory to Ukraine's after the fall of the USSR. The mandatory term of military service for Russian men was rolled back to one year in 2008. And as recently as 2019, Russian President Vladimir Putin voiced support for abolishing conscription.

But, genuine or not, those sentiments disappeared as the region descended into war. Shortly after the February invasion, Russia held its spring draft and conscripted 134,500 people. 120,000 were conscripted last Fall. The Russian government has claimed conscripted soldiers are only being sent to replace volunteer soldiers in their posts, with the volunteer soldiers then sent to the front in Ukraine, but some have disputed this.

Today, over a year into the invasion, Ukraine is relying more on conscripts as their losses mount. Until recently, officials could only deliver draft notices to someone's home address. Some found they could avoid the summons by staying away from their official addresses.

New rules allow officials to track down new conscripts wherever they may be. Men are being stopped in the street and questioned about their draft status. With few eligibility exceptions available and a brutal front line, the stricter rules have many Ukrainian men fearing for their safety. The conscripts have so far received worse equipment and inferior training than the volunteer forces before being sent into battle.

Russia has also had an issue tracking down new conscripts. The Kremlin's approach has been to transition to a digital platform. All eligible men are required to register through an online government portal. Draft notices are sent out electronically and are considered “delivered” immediately, meaning the man is instantly on the clock for reporting to his local recruitment office.

In the enduring words of William Norman Grigg, "conscription indisputably rests on the assumption that each individual is the State's property, to be sacrificed when those controlling the State deem it necessary for their protection."

The draft may lie dormant in the U.S., but that assumption remains. The war in Ukraine serves as a reminder that conscription is not extinct. It remains a clear and present threat to liberty.