Home > Uncategorized > Did the FeD bet the bank on betting money?

Did the FeD bet the bank on betting money?

Why is the FeD unable to kickstart the US economy despite pumping in Trillion of dollars into it?  Have Keynesian techniques of stimulating slack demand failed? As the world wades into the swamp of another recession, the question takes on urgency.


Banking crisises are not new in history. Some suggest they follow a 50 year Kondratieff cycle. A Credit crisis is caused by a fractional reserves banking system that allows credit expansion far in excess of what is required to support the real economy. Excesses create loans that cannot be repaid by known income streams.  This eventually causes new credit creation to stop and a downward spiral of credit contraction results. The crash of 2008 was essentially a credit crisis brought on by excessive debt.


If credit crisises are that well known then so must be the solutions. Unfortunately that doesn’t appear to be true. To see why, we must briefly examine the changing nature of debt created by banks over time.


Good old debt isn’t what it used to be. Time was when debt was a loan you took to create an income creating asset. Over time, the income was sufficient to pay down the loan and leave a surplus. Hence debt was economically productive and helped spur growth by giving innovators access to capital with which to exploit new opportunities. Excesses were possible due to a herd chasing the same idea creating an oversupply.  But it was easy to stop the process, recalibrate valuations to reality, take the losses and start over again in a relatively straightforward way. Capitalism worked by weeding out the inefficient and making room for the efficient.


When you add consumer credit to the mix of debt that banks create, the nature of the banking crisis changes.  Consumer debt is basically preponed consumption against existing streams of income. If you are young, and being rapidly promoted, increasing income may justify a permanent hike in living standard.  But in most cases, when you take on a consumption loan, the repayment has to come, not from income growth, but from reduction in future consumption. This is true in terms of housing loans as well. You may be justified in buying a house with a loan paid out of future savings. But the essential difference with a productive loan remains. You are looking to future savings to pay off your loans; the loan is not self-liquidating from income generated by it. Sadly, in recessions that follow credit crisises, incomes shrink.  So it is that much more difficult to stimulate your way out of a credit crisis caused by excessive consumption. It takes more time to train and move a labor force to a higher level of productivity.


Even that would be manageable but for a new and strange kind of debt that began to creep into the system in 90s. For want of a better name, we shall call it derivative debt. Consider writing a call option. To do so, one would [1] buy the underlying asset laying out money, owned or borrowed, [2] Buy a put from a put seller to hedge against the possibility that the price might fall exposing one to a loss, and then [3] sell the call, valid for say 30 days, to the call buyer. At expiry, the value of the call if any would be paid out to the buyer by selling the asset at the market price and repaying the money to self or to whoever it was borrowed from. If the call has any value the put expires worthless. So derivative debt is self-unwinding so long as the options written have an expiry date and the whole chain of transaction is unwound in an orderly fashion at expiry. But for the duration of the call, or put, credit to buy or short-sell the underlying asset is created, usually by banks, and remains outstanding. For the duration, this credit creation is real, not imaginary.


Starting early 90s, banks were not only writing long term options, swaps etc over the counter but also warehousing these internally. Long term options don’t self-liquidate like the 30 day call we examined above. The credit they create persists in the system. Worse, such credit gets “delinked” from the underlying written options as credit by itself is traded as a commodity. In short, we neither have a measure of the “orphaned” derivative credit so created by the banks nor do we have established “clearing houses” in which to settle these OTC options in a transparent fashion.  When you don’t know, you can’t regulate. As events after 2008 showed, these transactions, and the derivative credit associated with them, had overwhelmed the normal asset backed loan making function of the banks many times over.


How is “derivative credit” repaid or unwound? Imagine some people placing bets on the outcome of a match. The bets are placed with a bookie who collects all the money before the match. Let us assume the bookie doesn’t bet himself. When the match is over, the bookie pays out all the bets and should be left with zero in his kitty barring his commission. Only if the bookie miscalculated the odds, or took a position himself, would there be a deficit or surplus. Betting is a zero sum game no matter how many players play and what the nature of odds.  The same is true of the whole game of trading derivatives. There is utility to the trades beyond the game in terms of risk mitigation for some. In the immediate context of such trades, somebody’s loss is an others gain. So the big question is: if the banks and institutions were simply running agency accounts in derivatives trading, how did credit losses come about?  Were banks lending for speculation?  Or were they speculating for their own account? We still do not know the true extent of such transaction though we know they were humongous.


Betting losses have to squared off, settled or cancelled. Investment banks in the US were betting shops not lending shops. Some like AIG, though an insurance company ran huge betting shops in the name of credit assurance basically writing puts on toxic assets that went wrong. They also speculated on their own accounts. When the music stopped, most were left high and dry by defaulting counter parties and own losses. FeD stepped in, not to force their liquidation, but to bail them out. Hundreds of billions of dollars were paid to add cash to the betting pool that should never have been in deficit. Furthermore, FeD purchased trillions of dollars of assets far in excess of their market value in order to shore up bank balance sheets indirectly adding billions of more dollars to betting pool. Which future stream of income does the FeD have to recover these payouts?


FeD effectively assumed the betting losses of the banking system. Fine. But to pay for them the US Government can raise taxes, resort to negative real interest rates or debase currency. Or resort to a combination of all three. Spending in recession is used to stimulate demand. Instead FeD is using it mend holes in the banking system that neither creates additional demand nor jobs. In the process the weak haven’t been weeded out and continue to bleed profits from the efficient. FeD has negated the basic creative-destructive force of capitalism.

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