Beginning on Sunday, September 7, when Henry Paulson
unilaterally nationalized the mortgage market of the United
States -- never using the word "nationalization" -- we have seen
a series of Treasury and Federal Reserve interventions into the
credit markets. Each intervention has been followed within a day
or two by declines in the American stock market. Take a look at
the chart of the Standard & Poor's 500 index over the last month.
It is down by 25%.
Calls from constituents opposed the big bank bailout by
something in the range of 50 to one. It may have been higher.
House members capitulated to the Administration and the House
leadership, which is apparently trusted. One Congressman, Brad
Sherman (D-CA), said on the floor of the House that he was
personally told by leaders that if the House did not vote for the
bailout, the Dow would fall by thousands of points. At that
point, some members were told, the President would declare
martial law. See the video of his remarks.
It was all a pack of lies. The House did reject the bill on
Monday, September 15. The Dow fell 777 points -- a sharp drop,
but not the prophesied thousands.
The Senate then larded the House's 100-page bill to 450
pages. It had been only three pages on Sunday, when Paulson
announced the need for a bailout. The 450-page bill passed
overwhelmingly by the House on Friday, the 19th. The American
people were saddled with an additional $700 billion in debt.
The stock market rose on the 19th, but it gave up all its
gains on the 22nd. The 19th was the peak. It has fallen 25%
On Tuesday, the 16th, the Federal Reserve System announced
that it would buy 80% of the shares of the largest insurance
company in America, AIG, for $85 billion. The Board of Governors
of the FED is legally a government agency, but its orders are
carried out by the Federal Reserve Bank of New York, which is
private. Congress said nothing.
On October 9, AIG announced that it needs another $38
billion from the FED. It will swap supposedly prime assets for
money. This swap sounds temporary. It is temporary in the way
that the bailout of $700 billion was temporary, i.e., permanent.
In short, the $85 billion bailout lasted for three weeks.
On October 7, the Federal Reserve announced the creation of
a new facility, called the Commercial Paper Funding Facility
(CPFF). It was accompanied by a Special Purpose Vehicle (SPV).
Got that? An SPV is like an SUV, I guess, but with poorer
mileage. Here is the FED's press release. I just love the bland
official language of a FED press release.
For release at 9:00 a.m. EDT
The Federal Reserve Board on Tuesday announced the
creation of the Commercial Paper Funding Facility
(CPFF), a facility that will complement the Federal
Reserve's existing credit facilities to help provide
liquidity to term funding markets. The CPFF will
provide a liquidity backstop to U.S. issuers of
commercial paper through a special purpose vehicle
(SPV) that will purchase three-month unsecured and
asset-backed commercial paper directly from eligible
issuers. The Federal Reserve will provide financing to
the SPV under the CPFF and will be secured by all of
the assets of the SPV and, in the case of commercial
paper that is not asset-backed commercial paper, by the
retention of up-front fees paid by the issuers or by
other forms of security acceptable to the Federal
Reserve in consultation with market participants. The
Treasury believes this facility is necessary to prevent
substantial disruptions to the financial markets and
the economy and will make a special deposit at the
Federal Reserve Bank of New York in support of this
Inspirational, isn't it? Let me translate the final
The Treasury believes this facility is necessary to
prevent substantial disruptions to the financial
markets and the economy and will make a special deposit
at the Federal Reserve Bank of New York in support of
Translation: "The sky is falling! We are heading over a cliff!
The day of reckoning is here!"
Then there is the phrase "commercial paper that is not
asset-backed commercial paper." Translation: "promises are as
better than gold, since we don't buy gold."
What is this all about? This: the once-profitable but now
costly practice of borrowing short at low rates and lending long
at higher rates: the carry trade, as it is called. It has now
The commercial paper market has been under considerable
strain in recent weeks as money market mutual funds and
other investors, themselves often facing liquidity
pressures, have become increasingly reluctant to
purchase commercial paper, especially at longer-dated
maturities. As a result, the volume of outstanding
commercial paper has shrunk, interest rates on
longer-term commercial paper have increased
significantly, and an increasingly high percentage of
outstanding paper must now be refinanced each day. A
large share of outstanding commercial paper is issued
or sponsored by financial intermediaries, and their
difficulties placing commercial paper have made it more
difficult for those intermediaries to play their vital
role in meeting the credit needs of businesses and
In other words, lenders know that money market funds are
facing redemption -- not the redemption of one's immortal soul,
which money market funds do not possess, but redemptions by
investors who are saying, in the immortal words of Cuba Gooding
in "Jerry McGuire," "Show me the money!" They are refusing to
roll over the loans at low rates. In other words, they are
refusing to roll over.
By eliminating much of the risk that eligible issuers
will not be able to repay investors by rolling over
their maturing commercial paper obligations, this
facility should encourage investors to once again
engage in term lending in the commercial paper market.
Added investor demand should lower commercial paper
rates from their current elevated levels and foster
issuance of longer-term commercial paper. An improved
commercial paper market will enhance the ability of
financial intermediaries to accommodate the credit
needs of businesses and households.
This was a major announcement. The FED is now issuing money
to non-insured, non-banking financial institutions, in some cases
without marketable collateral: "commercial paper that is not
asset-backed commercial paper."
Three weeks earlier, it had bought $85 billion of
essentially worthless shares of AIG, which had been going
bankrupt. That had never been done before, either.
What happened to the stock market on October 7? The Dow was
a little under 10,000 in the morning. It closed a little over
On October 8, before the U.S. stock market opened, the FED
issued an announcement that it and six other central banks were
coordinating a reduction of the overnight bank lending rate by a
half of a percentage point. European stock markets had fallen
sharply by the time the American market opened. The announcement
had done no good to shore up the stock markets.
The Dow fell by 220 points within five minutes of opening.
Then it rebounded. Back and forth it went in 200-point swings
all day long. Then, in the final half hour, with the index up by
160 points, the rout began. The Dow fell by 350 points and
closed down 189.
In response to the joint announcement, Japan's Nikkei 225
dropped like a stone. Japan had not participated in the joint
declaration. It couldn't. Its rate is .5%. To drop it by .5
percentage points would have made the rate zero. The central
bank did announce its agreement with the joint statement. The
next day, Thursday, the index fell again. The central bank
injected $40 billion of fiat money -- the largest on record --
and still the index fell. It closest at its lowest point in five
There is a pattern here: "announcement-fall, announcement-
We need fewer announcements.
THE WAR AGAINST FREE MARKET PRICING
Franklin Sanders, who sells coins for a living, has
summarized the Federal Reserve System's policy options: inflation
and blarney. He was short-sighted, as we all were. The FED has
one other: swapping Treasury debt for assets that are rated AAA
by the ratings agencies, despite the inconvenient fact that these
assets do not have liquid markets.
This policy option is the equivalent of trading a silver
dinner set for crushed beer cans, which are priced officially at
The problem here is that the FED has swapped out about 40%
of its inventory of Treasury debt. What happens when it runs
Why does it do this? Because it does not have to create
fiat money when it swaps.
What does a swap achieve? Temporary bank solvency. Because
the institutions that borrow Treasury debt for 30 days --
hahahahaha -- are allowed by the regulatory agencies to list this
Treasury debt on their balance sheets as if they owned the
Treasury debt rather than the AAA-rated, non-marketable debt.
This keeps the regulators satisfied. Otherwise, the banks would
have to list the AAA-rated paper -- hahahahaha -- at market
value. No one really knows what this value is, other than this:
it is a lot lower than Treasury debt. The banks would then have
to call in loans because of asset losses.
Why? Because of a new rule which went into effect this
year: bank assets must be marked to market. Imagine that! Banks
must state what the value of the collateral is for their loans.
This is FASB 157, issued by the Financial Accounting Standards
Maybe you thought that banks had always done this. They
haven't. In the 1980's, savings & loan associations went bust
because they had been allowed to keep mortgages on their books at
historic value: the face value when the mortgage was issued.
Rising interest rates from 1980-82, coupled with the abolition in
1980 of the Federal government's interest rate ceiling on
passbook accounts, combined to create a run on the S&L's.
Depositors (legally, investors) refused to provide money at low
rates. They pulled their money out of S&L's to put it in money-
market funds that paid higher interest rates. The outflow of
funds bankrupted the S&L industry.
The Federal government then bailed it out to the tune of
hundreds of billions of dollars (factoring in interest payments)
The abolition in 1980 of Regulation Q, the interest rate
ceiling on banks and S&L's, coupled with rising rates due to the
credit crisis that began in early 1980, changed the terms of the
carry trade. The practice of borrowing short and lending long
blew up, as it always does.
The change in the accounting rules this year, coupled with
the credit crunch that began in August 2007, changed the terms of
the carry trade. It has blown up.
So, what is the credit crisis really about? The conflict
between Market pricing and governmental power to alter market
Commercial banks have played the carry trade game with
borrowed money: borrow short, lend long. This is the essence of
all fractional reserve banking. It always has been.
Fiat-money booms always become busts. There are no
exceptions. On this point, read Chapter 20 of Ludwig von Mises'
book, "Human Action." Read Murray Rothbard's short book, "What
Has Government done to Our Money?" They can be downloaded for
free from the Literature section of www.Mises.org.
Non-banking financial institutions got in on the carry trade
game during the expansion of fiat money under Greenspan. The
asset bubbles got very large, especially that most popular of
carry trade markets, residential housing.
Now the free market is re-pricing the assets that were the
focus of the carry trade. The Treasury and the FED are fighting
We have seen central banks and governments around the world
frantically pulling rabbits out of hats. The rabbits are dead.
The magicians keep telling the public not to panic, that
there is plenty more where that came from. Plenty more what?
More government debt. More fiat money. More regulation.
With every dead rabbit, the stock markets fall. The old
Keynesian strategy of increasing government debt in a recession
has failed so far. The supply side strategy of increasing fiat
money is also not working.
As the stock market falls, the pundits blame Chicago School
economics for having de-regulated the capital markets. But the
capital markets have never been anything near de-regulated.
The purpose of the dead rabbits is to keep market pricing
from operating. No matter what excuses the promoters of rabbits
are, they all boil down to this: "We cannot trust pricing to the
free market." The free market promoters add: "this time." The
Keynesians never add any qualifications. The supply siders
scream "pump and cut!" Pump up the money supply, pump up the
deficit, but cut marginal tax rates.
Politically, it's all over. The Chicago School's dream of
financial de-regulation is ending, all over the world.
The supply siders' dream of reduced marginal tax rates is
equally finished in the United States and Europe.
The Keynesians' dream of more deficit spending has come
true. Nothing new here. First, Nixon, then Reagan, then Bush
II, next . . . it doesn't matter.
Keynes' original call for government surpluses and a
reduction of government debt in boom times was dead on arrival in
1936. It has never happened, anywhere.
All three schools suffer from a fondness for fiat money at
all times. This, they will all get.
What do Austrian School economists have to show for all
this? This: "We told you so." Also, profits from shorting the
stock market (my call on November 5, 2007).
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A new era has begun: an era of lower economic growth in the
West, of greater instability in Asia, and monetary inflation
The free market is powerful. Human creativity is powerful.
If at least some people are willing to save and finance this
creativity, the economy will grow. But it will grow more slowly
in the West from here on. Like a dog returning to its vomit, so
are politicians and bureaucrats with respect to state power.
Government deficits do matter, contrary to supply siders,
Chicagoans, and Keynesians. We don't owe it to ourselves,
contrary to writers of government school textbooks.
Inflation is immoral as well as destructive, contrary to all
three schools of economic opinion. Inflation re-distributes
wealth by stealth. There is a price to pay. Economic busts are
one of these prices. The destruction of dreams of retirement is
Economic regulation substitutes red tape for productivity.
The bureaucrats trust in dead rabbits. In the past, so have
investors. But, these days, investors are not responding as
before. Main Street is headed for a recession, and the bailouts
of Wall Street will not change this. The real estate bubble has
popped. It will not revive anytime soon. The carry trade is
Dead rabbits will not change this.
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Gary North's REALITY CHECK
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