No Exit Strategy – War and Zero Interest Rates

by Richard K. Brawn, CCGA, MPA | December 5, 2008

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Intense questioning is ongoing about what is really going to happen within a debt-based economy with a fiat currency like the US has, when so much demand for credit is being created by government borrowing of money needed to prop up debt instruments, money being moved around in FED sterilization operations, AND when interest rates hit zero.  Where is this taking the buying power of the currency? We  are lost in a forest of politics and simply cannot see the true economic impacts. So, one has to return to basics for the answer.   

Only one thing matters in economics: how the individual pursues his/her economic needs.  This is exactly what has been disappeared as the notion that the overlaid political web is natural to economics.  As a science, economics, as seen by Adam Smith in Wealth of Nations, was a science of money flows through the institutions that grew up to help the individual more fully pursue his/her needs. No more! By economists assuming government, Wall Street, and central banks (GWC) are natural institutions arising from economic choice by individuals, the science of economics has become lost. Each of the GWC entities have political interests not related to their mission of helping the individual pursue his/her choices. Professors and pundits have shown themselves unable to separate politics from functional economic mission of the GWC. With it, the science of economics has fallen victim to goal reversal.  Briefly, goal reversal occurs when a goal is set by the organization but, over time, the organization finds itself on a track that has quite different from achievement of its original goal. The term ‘reversal’ is intended to highlight how we humans can somehow embark on a course and end up going in a completely opposite direction.  
Chairman Bernanke’s remarks today (December 4, 2008) make clear that private party interests in fulfilling mortgage contracts are secondary to the political interests of Congress and the Presidency. The protocol(s), about which he spoke (below), is, among other things, a rule making device to manipulate judicial decisions.

“However, despite the substantial costs imposed by foreclosure, anecdotal evidence suggests that some foreclosures are continuing to occur even in cases in which the narrow economic interests of the lender would appear to be better served through modification of the mortgage.  This apparent market failure owes in part to the widespread practice of securitizing mortgages, which typically results in their being put into the hands of third-party servicers rather than those of a single owner or lender.  The rules under which servicers operate do not always provide them with clear guidance or the appropriate incentives to undertake economically sensible modifications.9  The problem is exacerbated because some modifications may benefit some tranches of the securities more than others, raising the risk of investor lawsuits.  More generally, the sheer volume of delinquent loans has overwhelmed the capacity of many servicers, including portfolio lenders, to undertake effective modifications.

During more normal times, mortgage delinquencies typically were triggered by life events, such as unemployment, illness, or divorce, and servicers became accustomed to addressing these problems on a case-by-case basis.  Although taking account of the specific circumstances of each case remains important, the scale of the current problem calls for greater standardization and efficiency.  Loan modification programs with clearly defined protocols can both help reduce modification costs and protect servicers from the charge that they have acted arbitrarily.  The federal banking regulators have urged lenders and servicers to work with borrowers to avoid preventable foreclosures.  The regulators recently reiterated that position in a joint statement that encouraged banks to make the necessary investments in staff and capacity to meet the escalating workload and to adopt systematic, proactive, and streamlined modification protocols to put borrowers in sustainable mortgages.10 “

The tragedy we face is that political motivations are causing government to re-interpret its function of market oversight and regulation. The role is changing from ensuring corruption free functioning of the institutions upon which we rely for efficient financial transactions, to the use and manipulation of those institutions to achieve political objectives.  At this moment, the FED, Congress and the Treasury are navigating the economic seas using only statistics generated by their own models of how the national economics works. These models reflect the current thinking that cannot separate political interests from economic function. The net result is that all of actions being directed by governments are using false compasses. GWC is navigating the economic seas trying to force the statistics to fit their economic models. (Koenig and Dolmas – Dallas FED 2003) This approach is encountering an internal model fallacy that no grand economic model can accommodate changes without intervention by the creator of the model.  Models of human behavior define irrational behavior as those human actions that do not correspond to what the model predicts.   

Unlike models, Individuals register changes in their environment and respond. Individuals are responding to their environment in an entirely rational manner but the economic models, used by the GWC, register the current response by individuals as irrational. People are not acting in the way predicted by the models. Changing the model to fit people would be an admission of error, something the political interests find almost impossible to do. 

The individual looks at the risks involved, the low interest rates; and refuses to invest. GWC views failure to invest as irrational. For GWC, restraint due to risk analysis is an undesirable outcome as it is contrary to the “public interest”. The first sentence of the above quote says as much.  If the individual chooses to keep all the wealth that he or she earns as liquid cash, GWC perceives that as a ‘bad’ (irrational) response.  A dichotomy of interest is clear when comparing the interests.  Government will view loss from investment in mortgages as a government operating expense.   For the individual, such a loss is a capital loss.  For government the cost is an operating cost driven by ‘the public interest’.  For the individual, the loss gives no compensation. Doubtless, Chairman Bernanke understands that nobody will part with their money if he/she is not going to receive compensation for foregoing consumption and facing risk. Yet, his job is political and it is to espouse the FED politico-economic model.  The FED model for zero interest rates completely excludes the individual. It considers only the public welfare/political benefits.  In that environment of zero interest rates, the FED will be using extreme values in a mathematical model that functions only in theory at such extremes.  The FED has no actual human studies to back up its zero interest rate theories. A reality check is overdue.
Price is set by an individual acting as a buyer and another individual acting as a seller.  The environment and interests of each are paramount in the choice of price. Because price and interest rates are inversely related, the lower the interest rate, the higher the price. If the interest rate is set by individuals without GWC interference, the interest rate would reflect the balance between all of the factors such as foregoing consumption, investment loss/gain, etc.  GWC have inserted their interests in this process and have hijacked this process by using ‘public interest’ to fiddle with both the market price of debt and interest rates. Forgotten by GWC is that their reason for being is to support individual economic choice not to direct it. In order to accomplish the GWC political goals, GWC had to hijack the beneficial wealth of the country. I need to explain beneficial use. My use of the term in this context is not common.

Stocks that are left in margin accounts can be lent by the brokerage.  The brokerage has what is called beneficial use of the shares. The brokerage can borrow them from your margin account and lend them to another entity in order to back up a short sale. The brokerage would guarantee the return of the shares to your account unless they bankrupt before they could do so. Fiat currency is backed by government right to extract wealth from the individual; in other words, taxation. But, the actual value of the currency is based upon the wealth of the all the individuals in the country, not the ability of government to tax. The clearest current example is that the government of Zimbabwe has to power to take everything from anyone but the Zimbabwe Pound is worthless. 

In order to have paper currency accepted, the issuer has to anchor the value.  Without that anchor, paper would not be accepted.  However, political interests that hold the levers of power to create currency understand the value which anchors the currency can be used beneficially to serve their political interests in exactly the same way your shares would be used by your stock broker. That beneficial use is not a threat to the value of your shares or the value of the currency as long as the contract for both requires return of the shares and return of the anchor for the currency.  Unlike your brokerage where you have a choice to withdraw your shares or convert your account or seek damages, there is no such recourse against government. The beneficial use of the wealth of the country by government is constrained only by the interests of the politicians who pull the levers of power. Within this milieu, the fact that wealth belongs to the individual, not to the government, is completely lost. 

GWC are using the currency anchor as the collateral to take on more debt.  Beneficial use of American wealth allows GWC buy debt and thereby create an artificial demand for the debt. In this manner, GWC actions increase the price of the debt instruments and achieve the inverse relationship of lowering interest rates. Lowering interest rates is further accomplished by a central bank lending to retail banks at rates below what the economy would otherwise dictate.  GWC can claim a zero sum situation. The theory is that buying debt increases the value of that debt.  Raising the value of debt in this manner increases the American general wealth (e.g. bond prices rise), while simultaneously increasing the debt load on the wealth. In theory, the bookkeeping entries balance. Not stated is that GWC actions will reduce the wealth of Americans by the amount of debt that will not be repaid.  

Taking the extreme risk of manipulating interest rates to zero has become necessary only because government did not build up a capital cushion in expectation of an economic downturn (J. M. Keynes).   If interest rates become zero the inverse of that is that the value of the debt has gone to infinity. Voila, the books balance! However, the whole idea places the individual and GWC interests are at opposite poles. Using “Public Interest” as the source of its right, the government chooses to lend the very wealth that individual Americans have chosen not to lend.  The books balance as long as GWC can ensure no loss accruing from in their beneficial use of American wealth.  

Another leg to the zero interest rate theory is that GWC possess the power to become first in line as creditor. By now, everyone except GWC can see the fallacy of being first in line to a creditor with no assets. The third leg is truly crass.  GWC has no concern for the repayment burden added to tax revenues because that is a problem for another group of politicians sometime in the future.

“Public Interest” and “Public Policy” are the assertions that political interests possess an importance that surmounts those of the individual. The entire sovereign power of government has become subsumed by this idea.  Despite the horrendous cost of the failure of models at the SEC, FED, Treasury, and oversight in Congress; this body politic is unable to admit failure. Chairman Bernanke said as much when he was asked if the exchange of treasury debt for other debt was legal. His answer was that he was acting in the best interests of the country and if Congress did not want him to do so, it should tell him so.  The congressional response to that challenge was then and continues to be:  thunderous silence.

Economic models predict that zero interest rates will pump up home prices, pump up equity prices, and lower interest rates. These are potent populist political fodder. The assumption, however, is that this action does not cause savings/capital creation to fade.  Without capital creation to raise wages and cover losses, the scheme creates its own deflationary forces. If retail lenders input into their smaller economic models, the levels of debt and the ability of government to fulfill its promises, their models will predict rising interest rates (see Credit Default Swaps on Selected Sovereign Reference Credits – Panzer). The fiduciary responsibility in the private sector virtually prevents investing in the long term as higher interest rates will generate absolutely certain loss. So, the holders of capital refuse to lend. When all is said and done, all of this pumping reallocates beneficial wealth but creates not a penny of capital.

GWC are consumed with the idea that some change to the economic model input will result in an output that they want. Problem:  the input required to achieve that end result conflicts with their political interests.   The GWC are willing to offer up trillions of dollars they have borrowed using their access to the beneficial wealth of Americans, but nobody in GWC has stated the end game of all this manipulation.  We are now engaged in a war in the Middle East and an economic disaster in America with no clear exit strategy from either.

Post Script

For those interested in the inflation/deflation/gold revaluation questions, a graph in the (Koenig and Dolmas – Dallas FED 2003) paper explains clear that the FED must embark on a mission to create inflation. The graph shows the authors view of how Roosevelt used gold revaluation to create the inflation needed to end the Great Depression.

 

 

Copyright © 2008 Richard K. Brawn
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Richard K. Brawn, CCGA, MPA | Petaluma, CA USA | Email
California Certified General Appraiser (CCGA) | Master Public Administration (MPA)

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