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Basic Lending Lending can occur only if there is capital to be lent. That capital is produced by inducing people to forego spending of current income. The name of that inducement is interest. Added to that inducement is a premium called risk premium that acts to insure against loss of the capital that is lent. So the market rate for lending is determined by the inducement to save and the cost of protecting the capital. To be collateral, the ownership of that which is offered must be available for sale. Collateral provides a floor for any potential loss from the lending. Perverting the Principles of Lending Oddly, the US Federal Reserve Bank has no capital but it still engages in lending to the US Treasury and others. (The US has gold in its vaults but that gold is beyond the reach of the FRB to sell.) How is this possible? The United States Constitution created an icon called a dollar which, at the time of inception, represented accumulated capital under the control of the government. The icon had both utility as a medium of exchange and the value of the accumulated capital. At any time the capital backing could be redeemed from the US Government by presenting one of the icons. The FRB engineered a split between medium of exchange and the capital backing each icon. Then, in economic hard times, the President and the Congress agreed to create a quasi-governmental entity that would be responsible to separate the icon from its capital backing. The job of the Federal Reserve Bank became one of managing the separation between icon and its backing. Such separation has been a common practice in history and much is known about how to maintain price stability without capital to back the currency. Nothing about this is new! The Bank’s job is to maintain a singular perception. As long as the users retained that perception of price stability, while their wealth increased in currency units, few, if any, would demand the capital backing the icon. This made the FRB free to issue icons without capital backing them. Drawing from case studies in history, the FRB concluded that under worst case scenarios, the icons turned in should be less than 10% of the outstanding icons. But, alas, government is run by politicians. Politicians know that expenditure of money is virtually the only source of political power in a democracy. Wedged between the Congress and the President, the continued existence FRB will always depend upon the good will of Congress and the President. So, The FRB cannot be anything but politically responsive to their needs for money. Today, the collateral is far below the 10% level. In fact, it probably does not exist. None the less, the FRB continues to increase the number of icons in circulation without apparent value through sleight of hand between the US Treasury and itself. The Bank issues dollar icons in exchange for Treasury Obligations as if the Obligations are capital collateral. The Treasury Obligations become the collateral for the issuance of dollar icons. What Collateral? The Federal Reserve Bank thus gained the ability to engage in false lending; lending capital it did not possess. Are Treasury Obligations real collateral? They pledge the revenues from tax receipts to buy back the obligations. What tax receipts? With extensive debt on the books and with no balanced budget in sight, how would the FRB ever collect on the tax receipts (collateral) backing the icons? Certainly the US has land, roads, gold, buildings, etc. that could be sold. But those are not available to be sold. No such enforceable promise exists to make those possessions into real collateral. But the trading in the Treasury Obligations as if they were collateral gives the impression that they are redeemable. From the public point of view, as long as the Treasury obligations appear to have value, the icons are acceptable despite their lack of capital backing. Who cares as long as prices are stable and our net worth increases in terms of those units! It would seem everyone forgot the basic lending principles. First, the collateral acts to ensure the borrower has incentive to repay the loan. Second, it also acts as a floor for loss by the lender in the event the loan cannot be repaid. For collateral to be real, the lender must have the capability of gaining ownership. The illusion of being able to gain ownership of the collateral (tax revenues) behind the Treasury Obligations is created by the FRB trading in the Obligations. In view of the unavoidable deficits run by the Federal Government, The Treasury has no means by which to repay icons lent by the Federal Reserve Bank. The FRB simply cannot gain access to the revenue stream. By operation of the definition of collateral, the revenue stream is not collateral. The ability of the Treasury to redirect revenue will get much worse as an increasing proportion of tax revenues will have to go to Social Security and Medicare etc. Again, the only way government (or people) can create capital through revenues (income) that exceed expenditures. So where will the tax revenues come from to back the Treasury Obligations? If prices increase, the perception of value without collateral backing will be breached. Because the FRB and Treasury are so extended, the loss of control of this perception is a real worry. This precarious situation has been made into a real threat to the currency by the FRB involvement in interest rate manipulation that was so extreme it created a second tier of asset churning. What the FRB interest rate action did was to effectively eliminate the policeman in the financial markets. That policeman is the risk premium in lending. The financial/capital markets depend upon profit to keep operating. A profit has to be obtained by the difference between what lenders lend for and what borrowers are willing to pay for financial assets. When the FRB cut their lending rates below what holders of real capital would lend at, the Bank made honest profit impossible. What was traded and packaged was false capital; an illusion created by multiple transactions and complexity. An illusion of profit was created by people who needed to keep their jobs. Organizations such as pension funds and insurance funds were also affected. They needed predictable cash flow were faced with interest rates that did not reflect the risk they had to take in order to continue in business. Using interest rates representative of political interests; not economic necessity, the FRB created incentives among both the buyers and sellers of financial instruments to be dishonest in order to survive to the next pay check. The borrowers and lenders evolved into a relationship strikingly similar to that between the Federal Reserve Bank and the Treasury. Both traded with Illusionary collateral disguised only by constant churning and complexity. It would seem that the correlation raises unpleasant questions about the currency. Illusion dies when the magician screws up. Eventually all illusions have to fall. The seriousness of the economic problem lies in the breadth and depth of the illusion. Not only was profit an illusion, but so was the collateral. But the losses are real and real losses have to be absorbed from real capital. The FRB has no real capital. The Treasury has no real capital available from surplus tax revenues. All it has are icons issued on loan from the Federal Reserve Bank. The Treasury is naked of real collateral. The FRB cannot reduce the number of these dollar icons (money supply) to comport with the loss of capital because the Treasury cannot redeem them. The only way the FRB and Treasury could generate capital would be for the Federal Government to generate a surplus of revenue. That is unthinkable. The US dollar and all modern currencies lack enforceable collateralization. The value is solely dependent upon the individual inhabitants using the currency to acquire or sell goods and services for their personal needs. The money put in to circulation for political reasons brings with it no value whatsoever. The FRB has repeatedly made clear that it has decided on an ‘acceptable level of price inflation’. Price inflation is a policy of both branches of the US Government. That policy unequivocally displays the unconstrained nature of government to pursue political interests with economic powers. The manipulation of interest rates by the FRB is driven by political motives. In summary then, interest rates are a product of political interests within the government. Trying to pull from the interest rates the interwoven political interests is impossible. Interest rates subject to political manipulation can only be false gauges of incentive to save or economic risk. The current American savings rate and economic disruptions are a direct result of pursuit by the FRB of non-market political interests. The Wreckers Prepare to Fix Their Wreck The initial efforts by the Secretary of the Treasury to deal with the lack of enforceable collateral appear to be typical of government. Officials seem to seek to hide the lack of real collateral under a carpet of government obscurity. Doubtless, the rules pertaining to accounting will be changed and effectively unenforced. We will see explanations using words like ‘temporary’, ‘under review’, ‘delayed’, ‘relaxed’ etc. The naïve will be fleeced. Few people realize that Government can, in a nuance way, withdraw from enforcement of its regulations quite easily. Placing new regulations into effect requires a period of public exposure. But, in most cases, the law does not require prior notice when regulations are ‘withdrawn’. Various key political appointees, commissions and regulatory offices will use ‘judgment’ and the ‘urgency of need’ to lay the groundwork for the delay or change accounting rules and policies. Besides, if anyone in government were to actually break a law, can one realistically expect the Attorney General to engage in enforcement? Congress can be relied upon to support such behavior with the usual grand political platitudes. Some such scheme is surely being hatched. I want to reinforce something. Any regulations not mandated by actual law can be eliminated without public scrutiny. Congress has given the heads of the various departments a literal carte blanche with regard to assessing what regulations are needed to fulfill directed objectives. Congress wants those it approves for appointment to executive positions to be able to respond to emergencies. Congress reserves for itself, the opportunity to review such activities. Self-preservation is the top priority for any government. The government can and will act in whatever draconian manner it feels necessary in order to preserve itself and do so without interference from the Judicial Branch. What to do? If you agree that self-preservation is the highest priority of any government, then one must consider that the government has no capital beyond current tax receipts and those are already committed. But, real loss must be absorbed. If government cannot absorb it…guess who will! This situation has features that are ominously familiar. See No, Not Again!!! With so much that is false masquerading as having real collateral value, why stick around and take on risks one simply cannot measure?
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