Gary North

May 8, 2009

It is often said that the Federal Reserve System is the lender of last resort. This indicates a misunderstanding of the financial system. The Federal Reserve is the lender of next-to- last resort. Holders of money are the lenders of last resort.

The lenders have no choice. They lend because there are two loan officers: Congress and the Federal Reserve. Congress collects the loans through direct taxation. The Federal Reserve collects it by indirect taxation: inflation.

Let us begin with Congress.

CONGRESS AS BERNARD MADOFF

We all know about Bernard Madoff. He ran a Ponzi scheme for over two decades. It siphoned off about $50 billion. No one besides Madoff knows where the money went. For decades, no one with big money asked this question: "How can thus guy beat the markets every year?" Instead, they asked: "How can I get inside Madoff's system? How can I become one of the chosen?" The winners were those got in early and got out, and those who never got in at all.

Madoff was a piker. Substitute "trillions" for "billions," and you have Social Security and Medicare.

Everyone gets on the inside. Everyone is forced to. Nobody gets out of the system.

Very few people ask this question: "How will the government pay off the participants?" Those who do ask are dismissed as cranks.

Who will redeem all those nonmarketable IOUs from the U.S. government that sit in the computerized accounts of the Social Security Trust Fund and the Medicare Trust Fund? No one in authority dares to ask this question in public view.

Madoff ran his scam through secrecy. He escaped detection. Congress runs a far larger scam in full public view. Hardly anyone notices. Of those who do notice, almost none say: "This Ponzi scheme will surely go bankrupt." This includes economists. Most of them are employed in universities, and they are counting on Social Security and Medicare for their retirement years. When it comes to faith, economists believe in statistical impossibilities. They see a Ponzi scheme in action, and they think: "I will get out in time. I will die."

Who will redeem those IOUs? To redeem is to buy back. Who will be the redeemer?

The Federal Reserve System, of course. It can afford to. It has the right to print money. A lack of money is never a problem for the FED.

THE KINSMAN-REDEEMER

In the Mosaic law, there was a peculiar office: the ga'al. The word means "redeemer." This office had two aspects: vengeance and redemption. The ga'al was both the blood-avenger and the kinsman-redeemer. He was the nearest of kin. When his closest relative was killed because of an alleged accident, the blood-avenger was legally allowed to pursue the suspect and kill him. The only way for the suspect to escape vengeance was to flee to a city of refuge. There, he would be tried by a court. If he was convicted of what we call manslaughter or criminal negligence, the ga'al could not legally kill him, unless he caught the man outside the gates of the city. He went completely free upon the death of the high priest (Deut. 19).

The ga'al also had the responsibility of buying his nearest of kin out of slavery, if the kinsman went into slavery because of forfeiting on a debt (Lev. 25:48-49). A central bank is the unofficial ga'al of the fractional reserve banking system. It is an agency of vengeance. It pursues those banks and would-be banks that offer loans that are more competitive than the banking cartel has established through the central bank. It is also the agency of redemption. When a big bank gets into a crisis because of its pyramiding of debt, the central bank redeems that bank.

The Federal Reserve System redeems large banks in two ways. First, it lends a technically bankrupt bank lots of newly created money. The bank puts up as collateral some of its nearly worthless assets, which it bought as sure things during the boom phase. Second, the FED temporarily swaps AAA-rated Treasury debt for the bank's depreciated assets, for which there is no market. It swaps at face value: like for like. This is like swapping a sterling silver set for a pile of crushed beer cans. As the senior bank regulator, it then tells the government's accountants that the borrowed AAA-rated securities are to be counted as the bank's assets, not as borrowed assets. The bank thereby meets its legal requirements for solvency.

This two-part strategy of redemption, along with some even more arcane subsets, is regarded by the media as financial wizardry of a high order.

No one has yet commented on what should be obvious. The Federal Reserve's solution to the bank capitalization crisis is a variant of the government's accounting solution to the Federal deficit. This accounting solution has been used by every Administration since Lyndon Johnson's. Congress consents.

The government borrows money from Social Security Trust Fund, issuing nonmarketable IOUs as receipts. This is a swap. It then tells the government's accountants to count the borrowed money as net revenue in the government's on-budget account, thereby reducing the deficit. It also tells the accountants not to count the IOUs as liabilities.

This is how Enron shoved its liabilities off its books: dummy corporations taking the liabilities. This is also how hedge funds did it. Substitute "Social Security Trust Fund" and "Medicare Trust Fund" for "dummy corporations," and you have the government's program to reduce the deficit. Voters are the dummies.

Senior politicians always have known how this accounting charade works. The average voter, who trusts in Social Security, does not.

The public is forced to play the role of kinsman-redeemer. It puts up the money to redeem its profligate nearest of kin: Uncle Sam. It gets IOUs for its money. It thereby redeems the government.

The difference between redemption by taxpayers and redemption by the FED is this: the taxpayers surrender their own money. The FED creates money as an agency of the government. The government then spends the money.

The Federal Reserve System is the kinsman-redeemer of the big banks. The investment world knows this. The media know this. Almost everyone accepts this as a good thing. We need a lender of last resort.

The FED is not the lender of last resort. The lender of last resort is the taxpayer, who rests his hope of retirement in those IOUs in the trust funds. The lender of last resort is the holder of promises to pay fiat money. The money will be paid. It just will not buy much.

BIG BANKS HAVE A RICH UNCLE

Graydon Carter is the editor of "Vanity Fair." His magazine has run two detailed studies of Bernard Madoff. I find this delightfully amusing. Here is a magazine, named after John Bunyan's legendary city of commerce and corruption, which has done yeoman service in exposing the lifestyles and recently lost dreams of the residents. Chapter 6 of "Pilgrim's Progress" described the raw material for Mr. Carter's magazine back in 1678.

At this fair there are at all times to be seen jugglings, cheats, games, plays, fools, apes, knaves, and rogues, and that of every kind.

While firms and families large and small around the country struggle to obtain financing or refinancing, and with the Fortune 500 companies' earnings down 85 percent on average (the worst performance in the ranking's 55-year history), the banks at the heart of the financial meltdown are beginning to report profits again. Bank of America, which received $45 billion in bailout money, reported $4.2 billion in first-quarter earnings. I'm certainly no financial whiz -- when the economy tanked last year, what money I had was sitting in a checking-savings account -- but who wouldn't be able to show a $4.2 billion profit after getting $45 billion in bailout money?

It can fairly be said that the chain of catastrophic bets made over the past decade by a few hundred bankers may well turn out to be the greatest nonviolent crime against humanity in history. They've brought the world's economy to its knees, lost tens of millions of people their jobs and their homes, and trashed the retirement plans of a generation, and they could drive an estimated 200 million people worldwide into dire poverty. In other words, never before have so few done so much to so many. And has there been even one major, voluntary resignation by an American financial executive? One sincere apology? One jail sentence?

As is usual in the media, he has ignored the ringleader: Alan Greenspan. Mr. Greenspan headed the Cosa Nostra of fractional reserve banking from 1987 to 2006. He was cheered by Congress -- Ron Paul excepted -- Wall Street, and Main Street. He was surely cheered on by the large New York banks, whose interests the Federal Reserve System has represented faithfully since 1914, when the purchasing power of the dollar was 20 times higher. Greenspan, it seemed, could do no wrong. He departed just in time, leaving Dr. Bernanke as the heir to the bust phase of the latest and greatest of the Federal Reserve System's many boom-bust cycles.

Greenspan's predecessor, the cigar-smoking Paul Volcker, also is untouchable, despite the fact that he did to Greenspan what Greenspan did to Bernanke. Greenspan had not been Chairman a month when the world's stock markets declined by over 20% in one disastrous day in October 1987. The next day, Greenspan's FED began flooding the world with fiat money. This was conscious policy. The stock market recovered. Greenspan, ex-gold standard advocate, learned his lesson: "When recession looms, inflate." He never deviated from this play book: in 1991, 1999, and 2001.

Volcker had tightened money in late 1979, allowing short- term T-bill rates to climb to 22% in 1980. He kept a tight reign on money through Carter's phase of the recession (1980) and then Reagan's (1981-82). But, when Mexico threatened to default on its debt to Western banks on Friday the 13th of August, 1982, Volcker turned on the money spigot on Monday. On August 13, the Dow Jones Industrial Average bottomed at 777. From there, it was upward and onward for the money supply and the stock market.

With the exception of the short-lived chairmanship of G. William Miller in 1978-79, every FED chairman has presided over a recession ever since the end of World War II. They all have escaped recessions by expanding the money supply. Dr. Bernanke knows this history well, and he is following the traditional game plan. But, with this latest snap of the business cycle's whip, the crack was very loud.

It will get louder still.

TAXPAYERS ARE HOLDING THE BAG

Federal taxes come in three varieties: direct payment, loans that are defaulted on later through inflation, and savings held in the form of the national currency unit. Everyone pays the first form of taxes, although candidates for high-level government offices seem to escape some of this tax burden until their confirmation hearings.

Who pays the second form? Foreign central banks, insurance companies, pension funds, and individual investors with high net worth. These are the buyers of government debt. If you have a pension program or a cash-value insurance policy, you have paid and will pay when price inflation catches up with monetary inflation, as it will.

Who pays the third form? Anyone with savings that are not held in inflation-resistant assets. Even when people hold gold, their profits in dollars are taxed at ordinary income rates, which means up to the 40% range. There is no legal escape from Federal taxes for people above the poverty level.

The name of the capital gains game has been to be leveraged. That is how the forcibly retired senior officers of now-busted or broken investments banks and brokerage houses took home a hundred million dollars apiece in the go-go years. They pyramided their companies' assets on top of the pyramid of fractional reserve banking, which in turn pyramided on top of the Federal Reserve System's monetary base (balance sheet).

Graydon Carter asked rhetorically: "And has there been even one major, voluntary resignation by an American financial executive? One sincere apology? One jail sentence?" Of course not. It was all legal. It was more than legal. It was subsidized by Congress. When fractional reserve banking is legal, wealth gained through pyramided debt is subsidized. When something is subsidized, there is increased demand for it.

Who paid for the subsidy? Taxpayers. Who else? There are no free lunches. Someone must always pay.

If you are a taxpayer, you have barely begun to pay. The bills are being piled up, day by day. The subsidies will continue. In the next phase of the banking crisis, which will be triggered by the collapse of commercial real estate, the bailouts will rev up again. The FDIC will be forced to bail out local banks. These will be swallowed up by larger banks. The taxpayers will pick up the tab. That is what the FDIC has always been designed to do: transfer bad bank assets to taxpayers, and transfer good bank assets to larger banks.

How great is the threat of commercial real estate bankruptcies? Dr. Bernanke summarized the situation fir the Joint Economic Committee on May 5. Conditions in the commercial real estate sector are poor. Vacancy rates for existing office, industrial, and retail properties have been rising, prices of these properties have been falling, and, consequently, the number of new projects in the pipeline has been shrinking. Credit conditions in the commercial real estate sector are still severely strained, with no commercial mortgage-backed securities (CMBS) having been issued in almost a year. Leverage giveth, and leverage taketh away. Blessed be the name of leverage. Dr. Bernanke continued.

To try to help restart the CMBS market, the Federal Reserve announced last Friday that recently issued CMBS will in June be eligible collateral for our Term Asset-Backed Securities Loan Facility (TALF).

There is no end to this. Bernanke and Geithner repeatedly assure us that there will be an unwinding of these bailout efforts when the economy revives. This is the promise -- always broken -- of original Keynesianism. Keynes argued for government deficits during recessions, but surpluses in boom times. But the deficits grow in boom times and bust times. They just grow faster in bust times.

There will be no unwinding of Federal Reserve purchases. There will be no unwinding of Federal deficits. On the contrary, there will be increases.

The next crack of the business cycle's whip will be louder than the most recent one. The level of subsidies is vastly higher. The level of monetary base expansion is unprecedented: more than a doubling over the last year. To unwind this is impossible in a year when the Federal deficit will approach two trillion dollars. In a $12 trillion economy, a third of which is government spending, the Federal deficit will be $1.8 trillion. That is over 22% of the private sector's total output -- not net output, but total output.

Nobody cares. The economists do not sound a warning. The stock market rises. For now.

Taxpayers will pay. They will be told to pony up the resources necessary to continue the transfer of bad bank assets to the government and the FED. Taxpayers will be told to perform the miracle of what Ludwig von Mises described as stones into bread. In the name of the common man, the common man will be squeezed. In the name of saving the economy from capitalism, the greatest beneficiaries of capitalism will be forced to subsidize fascism: the government-business partnership.

The crisis we now face had its origin in the fractional reserve banking system. The Federal Reserve System is both the protector and the enforcer of the biggest banks.

"IT COULD BE WORSE"

This phrase underlies the recent recovery of the stock market. Unemployment rose in April by another 491,000 private sector jobs. The Dow rose by 100 on the day the news was released. "It could be worse." Unnamed economists at unnamed institutions had forecasted worse unemployment, the media reported. "The recession's severity is slowing. Buy! Buy!" There was no discussion of how much longer we will be subject to job losses of almost half a million a month.

The May 6 estimate Bank of America's shortfall of capital was $33 billion. The stock's price immediately rose by over 15% on the news. Why? The estimated shortfall had been $45 billion.

Housing sales rose a little in March. Anyway, existing home sales rose. But prices were down by 19% from a year earlier. "Yes, Virginia, sales do sometimes increase when prices fall." This decline in prices, on a year-to-year basis, is reported month by month.

There were 19 million empty houses in December. RealtyTrac, a firm that specializes in tracking foreclosures, estimates that there will be 3 million more this year. Yet the media reported that housing sales are getting closer to a bottom. But what how much lower will prices be when it bottoms? How long will housing remain on that bottom? Nobody says. Nevertheless, we are assured that the economic situation is less dire than the unnamed economists had forecasted. This is good news.

What is the collective forecast for next month's many statistics? We are never told. We are told only that initial reports indicate that the economic decline is slowing, compared to last month's forecasts, which were also not reported.

It pays to be an unnamed economist at an unnamed institution that does not publicly issue a forecast for next month. I am not sure how much it pays, but it must pay something. There are no free lunches.

The Federal deficit has moved from a supposed surplus under Clinton -- by counting Social Security revenues as on-budget income, while counting the liabilities as off-budget -- to half a trillion under Bush to two almost trillion under Obama. No major economist has issued a warning of national bankruptcy. Congress has, as always, rolled over. The thought that a $1.8 trillion deficit in 2009 will be followed by a $1 trillion deficit in 2010 and again in 2011 causes no perturbations in the bond markets. It is as if capital were endless and free: a zero percent federal funds rate, with 10-year Treasury bond rates under 3%. Nirvana draws near.

It does not matter how high the deficit goes. "It could be worse."

It will be worse.

CONCLUSION

Most people are trusting souls. They may say that they do not trust politicians, but they do. Congress knows this. This is why Congress has authorized Social Security and Medicare to designate the conduits of politically stolen money as "Trust Funds."

There are no funds. The trust is misplaced.

Taxpayers will be the lenders of last resort. They have no say in the matter. They can seek ways of escape, but every legal way of escape is taxed.

There will be winners and losers in the Great Debacle that lies ahead. There always are. But most people will be losers, and the winners will be taxed for their privilege of having escaped the worst of the looting.

The difference between Congress and Bernard Madoff is this: Congress will not go to jail. The difference between the big banks and Enron is this: they have a kinsman-redeemer, the Federal Reserve System.