Money Narcosis

by Richard Brawn, CCRA, MPA, April 7, 2009Print

On April 1, 2009, Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas was interviewed on CNBC. After a pregnant pause to reflect on a question, he stated that he was sure that not only was the extent of current situation not foreseen by the US Federal Reserve central bankers, but that none of the central bankers he knows foresaw the current financial crisis. This means not a single member of the Federal Reserve Board of Governors or any of the staffs of any of the world central banks were aware of the situation. The only conclusion possible is that worldwide conventional economic analysis suffered complete failure. John Kenneth Galbraith calls this periodic lemming-like behavior “Financial Euphoria.” In his April 2, 2009 WSJ opinion piece David Henniger refers to the behavior as “Psychosis.” Some sort of monetary narcosis was surely the reason that these economists/bankers were impervious the debt to income ratio being far, far from the norm and thereby signaling: “System Overload” “Failure Assured!!” Surely some form of self-delusion occurs when danger signals are flashing and people, who know better, refuse to see them.

For those of you who want to read my outrage first, it is at the end of this editorial. You betcha I am angry!! But let’s not put anger ahead of investment cool.

Self-Delusion

At the heart of the current financial difficulties is the fact that econometric models and mathematical formulas equate money and capital. This equality works within certain constraints but fails outside those constraints. All of our economic formulas and models have been built on the foundation that money is the same as capital. With the Federal Reserve Bank balance sheet expanding at a rate never before envisioned, nobody seems to have asked if the theory that money equals capital is now beyond its operational constraints. That point of divergence is probably when the creation of additional units of exchange (dollars not backed by capital) exceeds the rate at which the economy produces capital. Then, the banking system crash commences when the number of dollars that are not backed by capital has induced so much mal-investment that real capital is unable to produce the income necessary to sustain the service costs of mal-investment.

Galbraith and a Short History of Financial Euphoria

As John Kenneth Galbraith points out, despite claims to the contrary nothing new ever occurs in finance. All that changes is the packaging. At its root, finance is a simple equation. Money is loaned at a rate of interest with the amount borrowed to be repaid in the future. Yet, every epoch in which values of financial assets seem to rise with little or no work - as if by miracle – the epoch is followed by another in which values decline sharply – as if by some evil spell. This is no miracle or magic. The epochs are simply created by leverage and deleverage. The constantly rising prices of financial instruments induce greed-based euphoria. Every period of miraculous increases in the value of financial instruments is under laid by a time of stable growth in the Main Street economy. This era stability initiates a trend in which financial instruments are leveraged with borrowed money. The bet laid on the financial table is that the period of economic growth will go on forever and therefore stock dividends will grow forever. The growing stock dividends are capitalized at greater and greater dividend capitalization ratios. The image of rising dividends plus the rising dividend capitalization ratios with no end in sight is the financial equivalent of the ancient Greek sirens. By compounding that enticement still further with leverage, the magic of compounding can be captured like water behind a dam simply by borrowing money to buy the instruments today and watch the dividends rise tomorrow and push up the price of the instrument. Each generation becomes so enraptured with this new-found ability that it fails to ask how high the financial-water can rise before the leverage-dam must break. Each generation, according to John Kenneth Galbraith, finds a new way to make itself believe it has captured this magic in a way that will not result in a bust.

Where were the Strong-Willed Wise Men/Women?
We count on the wise men in both the private sector and government to act in the interests of the nation/shareholders. I have read enough of the US laws that underlie our Code of Federal Regulations to know that what really saves America from becoming a dictatorship is not Congress, but is the backbone of the people surrounding the President who will say “no” to Presidential demands. During the past decade, the strong-willed, wise men/women that we needed failed to show up for duty. Instead, for example, the Bush appointee as Secretary of Housing and Urban Development and the senior elected representatives in the House and Senate all sought to politically benefit from policies that exacerbated an enormous deviation from housing ownership norms. The politically appointed hierarchy within HUD ignored warnings from HUD staff real estate appraisers about inflated real estate values.

Despite the drift from historical norms for home ownership and real estate prices rising far faster than economic growth, neither HUD, nor mortgage banks, nor the buyers of mortgage backed securities demanded increased capitalization rates. Instead they continued to on the easy path of ignoring their fiduciary responsibilities. They let developers set the capitalization rates. 1 Boards of directors created compensation arrangements that encouraged leverage without regard to effect on the unsuspecting shareholders of a reversal of that same leverage. The regulatory system was staffed with otherwise good people who, too often, were impotent and not up to their job. The weakness of character of people in high positions fermented persistent increases in borrowing and spending year after year. This created the mirage of steady, sustainable growth that re-cycled back into Main Street and induced mal-investments.

The Naked Money Genie

The power of the FED to force interest rates to zero is entirely due to the prevailing use of econometric models and math formulas that do not differentiate between units of account added to accounts by the Federal Reserve Bank and real capital. By law, Federal Reserve Notes are money regardless of the value or validity of what backs those notes. Pursuant to law, they are the only money government will recognize. The fact that this law exists sets aside the assumptions underlying these formulas and models. So to comply with law, these systems must use dollars not backed by capital as if they were the same as those with a capital base.

The Congressional fiat does not bridge the chasm of reality that exists between government lending and private lending. Owners of real capital operate for a profit and thus must have lending rates include a premium to compensate for expected loan losses. In contrast, any dollars lent by government are classified as an operating expense with repayment classified as future income 2. Loss in the future is accounted for as a reduction of expected income, rather than a capital loss. The tax code adds another level of deceit. It is not indexed to the rate of inflation sought by the FED. The tax code makes it impossible for money managers to report the true increased/decreased value of the account using an inflation adjustment.

False Statistics

The statistics collected by government and private organizations are subject to the same fiat that all dollars are equal, regardless of origin or backing. This fiat created increasingly false representations of the true economy. The fundamental assumption that regardless of the number of hollow dollars, all dollars possess the same value had become increasingly untrue. This shift in the relationship resulted in the creation of false government and private economic statistics. Never was there more truth in the axiom: garbage in; equals garbage out. But this garbage prodded Main Street into mal-investments.

With the passage of time prosperity became a mirage. False capital fed false statistics which fed mal-investment. Eventually the mirage had to be replaced by reality. But it took a long time. The public used the low interest rates to tap into the appearance of increased monetary value of their homes and this fed into the statistics that gave the appearance of ever rising disposable income. The increased borrowing created more spending. Disposable income, reduced taxes, and spending of borrowed money were co-mingled and counted as net income. The rising expenditure statistics driven by spending of money acquired through public and business borrowing was then transformed into rising value of financial instruments of all types. This had the perverse effect of increasing government tax revenues. In turn the increasing tax revenues could be and were extrapolated forever using the time-value of money formulas. That buttressed still more government borrowing. Everyone was in the money-making game. It became a goldmine without a mine or gold. Everyone who benefitted insisted that “If it ain’t broke, don’t fix it!”

Prevailing ‘wisdom and paradigm’ assumed that capital would grow forever and ‘excess investment’ would bring interest rates ever lower. Non-conformers were met with enforced measures not much different than the morality police in Saudi Arabia. The entire Administration and nearly all members of Congress seemed to be acting as money narcosis facilitators. “Don’t try to fix what ain’t broke.” And those who wanted to publically expose the red flags were picked off in the media like turkeys in a turkey shoot. Some investors suspected trouble, and while waiting for the opportunity to get out, they quietly avoided the public condemnation.

Mal-investment

Mal-investment is an investment that cannot be fully serviced by whatever source of funds served to guarantee the mortgage payments. Rather than force foreclose or go into bankruptcy, the artificially low interest rates by the FED kept these mal-investments on low-interest life support. Business used the opportunity to do long term capital financing and debt for operating funds using short term market securities that they rolled over as obligations became due. Eventually the cost of commodities like petroleum and raw materials sucked up so much income that mal-investment service costs were made truly un-payable. The tide went out on capital availability and, like swimmers with no swim suits, a lot of naked exposure became evident. An “unforeseen” real capital shortage acted like musical chairs to the short term financial markets.

At the heart of all finance is the ability of Main Street to pay interest on all this leverage. That money comes from only one source: income. Income drawn from real capital is the only thing that gives income of the quality and assurance required by capitalization theory. Laws that supposedly create capital out of debt in the form of Federal Reserve Notes are as real as a law that would dictate 1 + 1 = 3. Only savings can create capital.

Systemic collapse began when the real disposable income shortage acted like a switch in the minds of the speculators and investors as they realized financial instruments could not be serviced and the cloak of false data hid which assets were toxic. Lack of income to support the huge debt overhang is what burst this leverage dam. What came up missing was not money to buy nonperforming/mal-investment assets, but willing buyers with real capital to buy performing assets. Nobody wanted to pay real capital for failed or failing assets.

How Much Internal Systemic Rot Exists

The quantity of real income was inaccurate because the capital was a hollow mirage composed only of units of account. The ‘too big to fail’ financial organizations further leveraged their hollow capital base so that Hernando de Soto notes in his WSJ Opinion on Toxic Assets (WSJ Mar 25, 2009):

“At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings and patents world-wide, and some $170 trillion representing ownership over such semi-liquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage backed securities collateralized debt obligations, and credit default swaps) that have flooded the market.”

I do not know how many complete obligation contracts are included in this $1 quadrillion amount. However if one assumes that the fees on these derivatives were as infinitesimal as 0.01% (one one-hundreth of one percent) the fees on the $1 quadrillion (1 with 21 zeros after it) total $10 trillion. The fees were probably taken at the front end and are now amortized within the derivatives. This means that to the interest payments on the basic underlying instrument must somehow pay the $10 trillion in fees. In 2007, the service cost for this way to cover risk shot up. Gjerstadt and Smith (WSJ Apr 6, 2009, note The cost of insurance on AAA MBS tranches went from $50,000 up front plus $9,000 annual premium for $10 million of insurance to over $900,000 up front (plus annual premium)3. This added huge costs without one iota of capital being produced.

Continuing to Hollow Out Meaningless Statistics

Unfortunately adding naked money to an economy that is starving for income to pay for leverage will not increase the capital needed to create that needed income. Instead, it will just exacerbate the already false reading of income. The purchase, by government, of assets from the private sector is simply replacing private sector leverage with public sector leverage. And, the capitalization of the public sector cash flow (that is the tax revenue) is dependent upon the very same income that pulled the valuation plug on private asset values.

Unlike Harry Potter, government possesses no wand or book of spells with which to convert naked money into capital. Authorization given by Congress to the US Treasury to borrow from the FED does not convert the naked money it has obtained from the FED into capital. The authority of government to tax does not change the fact that taxation simply diverts national income from becoming capital into becoming just interest payments on government leverage.

Here We Go Again

I have tried to add an updated chapter to John Kenneth Galbraith’s book “A Short History of Financial Euphoria”. Unfortunately, I lack his wisdom and casual writing skills. His book makes very clear that we are encountering something that is highly repetitive throughout American history. This is not the first crash due to Financial Euphoria or money narcosis or whatever you want to call this human failing. With the events occurring daily, now could not be a better time to read this book.

Ok, my tirade…

Americans are absolutely correct in being outraged about the malfeasance of their government and the financial firms. Right now we have vast future commitments of American income based in a farcical assumption that the economy will generate increasing resources. The assumption counts income twice; once as tax revenues and second as national income. We have absolutely nothing to show for those commitments. Nobody is in jail. None of the culprits of this massive fraud have been apprehended, charged, or even appear to be under investigation. Madoff and Stanford were easy fish that surprised the regulators by simply jumping into their boat. The two of them are now nothing more than political red herrings. In no other line of human endeavor has a whole knowledge-based system been created and then allowed by elected authorities to strip the public of their wealth. The American politbureau which we spineless Americans call the US House of Representatives is doing its utmost to deflect the blame due to it, and to the private sector fraudsters. Right now, we are tolerating a political establishment which demands that we first pay the bills run up by these fraudsters, and then, just maybe, they might make some cosmetic fixes. Ok, enough of my tirade….

Footnotes:

Capitalization rates used by real estate appraisers are derived from the capitalization rates used in three or more similar development projects that were previously funded by a lender. The capitalization rates represent the rates used by developers to assess the risk to their equity. Lenders always have the opportunity to modify that capitalization rate during negotiations with the developer/borrower... However by doing so, the individual banker could find himself in trouble. First it may make the deal uneconomic and thus no fees would be earned. Second, mortgage banks and brokers are merely middlemen. If the buyer of the securitized mortgages will accept the capitalization rate the banker has no justification for interference.
Whitehouse Press Secretary comments on TARP accounting, April 2, 2009. This is standard practice for repayment of congressionally appropriated loans.
From Bubble to Depression? Steven Gjerstadt and Vernon L. Smith, WSJ, April 6, 2009

Contact Information

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