REAL CLEAR MARKETS

The global banking system in 2012 has seen a marked transition from the monetary concept that gained universal traction nearly 100 years ago. The United States in 1912 was the only economic power without a central bank, but by 1913 one had been created, though its creators, both bankers and government officials, were very cautious about having the words "central bank" in the title of the agency. Instead the Federal Reserve System was born as a private corporation capitalized by individual regional banking interests, by far the largest being the banks in New York City. As we have navigated this current crisis, monetary policy is unmistakably a bank-first approach. In other words, banks are viewed as the mechanism whereby monetary policy should create economic success, to the exclusion of all other means.

Similarly in Europe, the European Central Bank (ECB) was created for and by the respective governments of Europe. The conflict of interest there is easily determined in the continued quasi-bailouts of sovereign states through price manipulation in asset markets. Both the Fed and ECB have engaged in forms of monetary easing that, in their essence, are distinct variations on the theme of money elasticity that launched the Fed nearly a hundred years ago. The manner of that change is, on the surface, seemingly minor - central banks create additional money and means of easing during crises. But below that surface lies a much more direct and significant paradigm shift that again calls into question exactly who central banks work for.

The reason for instituting an American version of a central bank where one had been absent for seventy years was largely in response to the banking panics that seemed to crop up seemingly out of nowhere with an almost regularity. There was a massive wave of failures in 1893 that led to the worst depression in our history to that point. By the time of the 1907 banking panic, economic opinion was shifting toward the concept of "monetary elasticity". More and more elite opinion, especially from within the banking interests themselves, were settling on a lack of liquid money as the proximate cause for these panics. That bank panics were usually linked to economic depressions gave the elasticity movement a populist edge (in addition to a universal currency).

The concept of monetary elasticity is quite simple in theory, something we are now well accustomed to in the current age of consistent crisis. During times of distress, investors within the banking system's cumulative liability structure increase their preference for holding cash over the continued holding of those bank liabilities (whether that is demand deposits, hybrid preferred securities, commercial paper or senior bonds). Since the banking system operates on a fractional basis, the demand for cash far outpaces a bank's ability to pay all of those redemption requests - a liquidity event.

Monetary elasticity "fixes" this problem through central bank injections of "liquidity". If the central bank pushes enough money into the banking system to meet those redemption requests, then the panic should largely subside as liability holders are further assured that liquidity remains available on reasonably easy terms. But money elasticity, at least in its traditional format, presupposes that "access" to money is the overriding factor in this shift in liability-holder preferences.

In the 21st century, access to currency has never seriously been threatened. Instead, the shifting preference of liability-holders has been based solely on avoidance of capital losses. I have maintained that deflation in the real economy was never really possible because access was never seriously threatened. Instead, banks were threatened because bond-holders, especially those holding very short-term liabilities, refused to continuously rollover various obligations within the cumulative banking system structure. That refusal was, again, not about access to cash, it was about avoiding losses that would inevitably follow from banks whose cumulative assets were worth less (and in some cases far less) than liabilities, i.e., solvency.

From the central bank perspective, at least their publicly avowed perspective, the central issue of solvency was due to market-based declines in the prices of relatively illiquid assets. To wit: on July 28, 2008, Merrill Lynch (then a standalone company) "sold" a super senior tranche of a mortgage-ABS CDO. The notional value of the tranche was $30.1 billion. In June 2008, the tranche was valued at $11.1 billion, a huge $19 billion writedown. The reported sales price was $6.7 billion, another 50% wipeout from the June level.

Putting those numbers into perspective, since this was the super senior piece with some amount of credit enhancements above it in the capital structure of the CDO, would have meant a 100% default rate with an epically low recovery rate of about 36% (or an 80% default rate with about a 20% recovery rate). None of those numbers were anywhere near the true conditions of the mortgage market, even the subprime mortgage market in its worst state. In other words, the market price of the tranche during this period was nonsense, brought about by supply and demand factors (illiquidity and dysfunction) in credit default swap trading.

Without getting too far into the weeds of the intricacies of correlation trading, by March 2008 tranches of various pieces of various vintages of various structures were quoted in correlations above 100% - a mathematical position that is meaningless. The bottom line here was that, for reasons that had nothing to do with the fundamental properties of the mortgage marketplace, overvalued as it was, pricing in these "toxic" assets was nothing but noise, inappropriate under any circumstance. That gave credence to the March 2009 move to do away with mark-to-market, and further support to QE 1.0 where the Fed would buy these mortgage assets at some value that was probably far closer to par or nominal than many people would feel comfortable with.

This brings up the uncomfortable debate about what prices are the most "appropriate", especially within the framework of a full-on crisis. Should these market prices, meaningless in terms of fundamental valuations, be used when deciding which bank is solvent at any given time? Obviously, given the way policies were structured, central banks have come down emphatically on the side of manipulation - basically denying that the market has any rational sense in setting the price of these types of assets and further determining the general solvency of bank institutions, both idiosyncratically and, more importantly, cumulatively. In the case of those "toxic" mortgage securities, this, again, seems to be the appropriate course, at least on the surface.

Where money elasticity comes into play here is the liquidity pressure that this tug-of-war in pricing generates. Banks may believe that assets are money good and that market-based prices are absolutely inappropriate benchmarks for solvency, but individual investors can and do see things differently (that is what makes a market) and react for different reasons. Investors might even concur that assets, in the long-run, are "money good", but not be able to stick around and take that chance if there are reasonable doubts or questions surrounding those assets. Holding on to questionable assets entails real risks to those investors, ancillary as they may be in the context of fundamental valuations, that are not well understood by anyone other than those unique investors. I'm talking about hedging and its impacts on how assets, especially credit assets, are dispersed and held throughout the "system" (indeed, that was the primary problem with credit default swap trading, the increased need for hedging created worse pricing in structured finance, which created the need for more hedging, and so on). Even in the Merrill Lynch example I cited above, it is very likely that Merrill Lynch felt it was getting fleeced on the sale, but could not hold onto that particular asset any longer for reasons that had little to do with the fundamentals or even their outlook for that asset.

So central banks have become the firesale buyer of last resort, supposedly taking the long view on these assets. Since central banks have none of the pressures of investors, and control the ability to generate liquidity on demand, they can mediate the short-term noise and apparent meaninglessness of market prices and the longer run cash flow of any asset in their possession. That is what money elasticity has become - the bridge from insanity (from their perspective) to more docile conditions where investors can "come to their senses".

Except that it appears, on more than one occasion, that investors and their crazy market prices have been right. Greece is the most well-known example. For over two years, the ECB has used this new money elasticity process to prop up the value of Greek bonds, all in the name of avoiding a Merrill Lynch-type situation in peripheral sovereign bonds, and the general "contagion" that might foster. But for all the bonds the ECB purchased, for all the price manipulation done in the name of creating a bridge to saner days, all the ECB did was fool more banks (ahem, MF Global, Dexia) to follow it down the rabbit hole to further instability, and, yes, even greater insolvency.

So the paradigm of money elasticity is no longer about access to cash in the real economy, it is used as a measure of countering market prices, all done in the name of the market always being wrong. However, even in the case of subprime mortgage bonds that were pricing insanity, the Federal Reserve, which until now looks to have been correct in stepping in, may yet follow Greek debt into full-blown default (especially if housing prices continue to contract, or re-contract, not to mention the current, still-hidden state of commercial real estate). That brings up a very important point that does not seem to be fully appreciated, especially in the context of continued faith in central banks. What if, instead of building a bridge to saner conditions, money elasticity in its current usage is actually creating even more instability that leads to even worse calamity?

Europe is the central case study on this point. By its very liquidity methods, the ECB actively encourages banks, especially banks that are already in the most trouble, to buy more and more of "troubled" sovereign bonds. The biggest buyers of Spanish and Italian debt during the LTRO periods have been Spanish and Italian banks. And the more Spanish and Italian debt these banks buy, the more depositors flee. In the European system, that has led to dramatic and drastic Target II imbalances, where capital (over and above merchandise current account deficits) is received in the "core" countries, especially Germany, and forcibly recycled back to the periphery via National Central Banks (NCB). So the money elasticity doctrine of the ECB forces the Bundesbank in Germany to accept claims for cash against Spain and Italy (and Greece before it). The more individual depositor and bondholder money flows out of the periphery, the more the Bundesbank is forced to "front" the periphery.

This forced liquidity injection, rather than help "solve" the periphery's problem, creates additional and greater tension, including and especially political tension. Rather than isolating and breaking the perpetuating feedback loop of crisis, this doctrine spreads "contagion" far and wide without ever addressing the original imbalances in the first place.

Again, Greece is useful as an example here. The ECB ostensibly bought two years time for Greece to "clean up its act", reign in deficit spending and get its current accounts under control, but during the whole of those two purchased years every single measurable parameter worsened, and worsened significantly. For its part, the Greek government's adherence to "austerity" and ability to meet specifications were overstated at every interval, missing key targets regularly, as if bailouts were never really serious (we know conclusively today that they were not). Even now, after actually defaulting, the country continues to miss key targets that were set just a few months ago as conditions for the latest bailout (a bailout in this context is just the mechanism for money elasticity, especially since most, if not all, of the actual money ends up in the hands of banks).

Furthermore, perhaps far more importantly, investors were correct to flee Greek debt, while the ECB was fully wrong in supporting its price. In terms of time, the past two years bought the Greek government enough liquidity support to run up an additional EUR43 billion in fresh debt (CY 2010 + 2011), that was ultimately flushed down the hole in the default, nearly taking the entire system with it on December 8, 2011, before that default was finally "decided". As it is now, with Spain and Italy now at the forefront without a Greek distraction, markets are following the exact same pattern as 2011. The feedback loop of investor fear has not been broken by all this liquidity because it has never been liquidity that has been feared. The issue has always been one of solvency, as in who gets to bear the brunt of losses generated by market prices incorrectly over-valuing assets and cash flow during one of the most artificial growth periods in history.

Under the current rules of the banking system, liquidity is not even a significant factor in credit creation - vault cash is an anachronistic notion that has no bearing on a 21st century bank. Therefore, money elasticity as it was understood and designed in 1912 has no reference in 2012. Since equity capital is the bank parameter that drives credit, including prices, that over-valuation leftover from the housing bubble period diminishes equity capital directly, and thereby liquidity conditions derivatively. The more the system has to take losses on credit assets, the more the system has to actively deleverage itself, either through direct asset sales or raising equity capital.

In 2008, losses on super senior tranches accounted for 42% of worldwide writedowns of credit assets according to creditflux.com ($218 billion worldwide, $145 billion in North America alone). Since credit is pyramided on top of equity capital reserves, not cash reserves, that $218 billion taken out of equity capital (losses on the income statement ultimately reduce retained earnings on the balance sheet, the largest component of Tier 1 capital) meant a multi-trillion dollar hole in the global banking system's ability to hold any and all assets. That is why central banks and governments were "forced" to recapitalize the banking system (including the final version of TARP in the U.S.) as part of each bailout attempt, funded by each central bank's money elasticity doctrine.

Would we have avoided the panic of 2008 had money elasticity been fervently applied prior to Lehman Brothers failure? Not likely, since only 42% of the losses were what I would consider due to irregularities in the credit default swap marketplace. That left (leaves) $300 billion in losses that were all too appropriate. And that is the largest problem. Investors know that there are losses to be taken, but central banks have decided to use money elasticity on each and every asset class or "systemically important" obligor. Again, as in the case of Greece, investors were correct. In the case of "toxic" mortgage assets, investors were mostly correct (perhaps 58% correct). Money elasticity cannot work where everyone is saved, with no regard to how irresponsible they may have been. In that case the irresponsible are simply sheltered enough to continue to be irresponsible, an anathema to a functioning marketplace.

Instead of trying to save the whole system, preserving it as it was before 2007, central banks should have been focused on helping the system take the painful medication of market discipline. Greece should have been put into default in 2010 (at the latest) rather than deny that a default was even a remote possibility. It would have been a serious blow to markets, but better then than now after all the new debt that has been added. The modern version of money elasticity allows imbalances to grow far greater to the point they become systemically dangerous - market discipline is the pressure release to those imbalances. The largest banks in the US are now even larger today than in 2008 because there were none but a few minor failures "allowed" (what if Bear Stearns was unwound rather than shepherded into JP Morgan, or if Merrill Lynch failed instead of being absorbed by Bank of America?). Lehman Brothers failed and it kicked off a panic, but had others been allowed to follow we might not today, nearly four years later, be still looking for the next Lehman Brothers.

Market discipline, while painful and certainly disruptive, actually solves imbalances. The 2008 panic was likely fully unavoidable, and that is tragic that these same imbalances were ever allowed to grow so large, but there is no reason we have to have a rerun every few years along largely the same lines. Taking losses and having deflation in the financial economy would not have been the end of the world as we know it. Central banks can proclaim that banks and the economy are one and the same, but that does not make it true. Again, there was no real danger of deflation in the real economy as currency, as in the usage of money to transact, was never in short supply. What has been in short supply, and remains in short supply, are sustainable streams of real income due to productive activities - the kinds of activities that have a hard time flourishing under continuously dysfunctional monetary regimes.

Greece's problem, any more than subprime obligors' problems, continues to be a lack of sustainable income due to productive activities, i.e., jobs and profitable businesses and taxes on both. That is now universally recognized as the problem, meaning that investors know the full score. Propping up prices, while maintaining the illusion of solvency, does not really address solvency. No one is fooled by money elasticity; even John Corzine was not fooled. This doctrine of monetary elasticity, applied as it is universally in the 21st century model, does not enhance the marketplace for assets, returning it to a more normal or "rational" footing. Reckless money elasticity of this kind is intended to supplant the marketplace (which is what Corzine was foolishly betting on). In one very important respect, this is not all that much removed from executing capital controls, the kind of soft bureaucratic control we have come to expect in the age of central bank indirect economic planning. Capital controls, given this level of dysfunction, effectively lock in these imbalances, forcing investors to seek other, even more destructive avenues to fulfill their negative expectations. The noose only tightens.

If central banks wanted to commit themselves truly to avoiding real deflation and a rerun of 1930-33, they could have pledged these trillions in new currency units not to the banking system, but to the real economy to ensure access to currency (instead of adhering to the century-old, traditional notion of money elasticity - depositors at IndyMac, for instance, had little trouble with its deserved demise and the subsequent transition to a new institution). Banks would have failed, prices would have fallen and it would have been nasty (it already was), but the system that emerged, hopefully chastened at that point, would have created a foundation for a real recovery. How different would our current outlook be if investors the world over were relatively sure that most or nearly all appropriate losses were behind us? The real question that gets to the heart of the matter is: what kind of a recovery would we have experienced if the irresponsible were no longer able to be irresponsible?

These counterfactuals are always hard because there is no real way to be sure. What we are sure of, and what suggests there is something rotten at the core of this new central bank application of money elasticity, is that current policies have most decidedly not delivered. Europe is already in re-recession, one that will, in my opinion, be worse than predicted by economic professionals (admittedly a low bar). The U.S. is not that far ahead, and by summer I have little doubt we will again, for the third time in as many years, be joining Europe in the re-recession chatter. Regardless of which direction we head, the one constant is that markets will be denied, under the faux-auspices of a hundred-year old paradigm, their proper role of correcting imbalances because it might just work and belie the canard that the real economy cannot survive without the banking system as it is. Capitalism can flourish on its own without monetarism.