March 11, 2010

How can you tell a European financial regulator from an American financial regulator? The European thinks Credit Default Swaps (CDS) are very dangerous weapons; that the bankers selling the CDS tricked Greece and pushed that country into a debt crisis; that CDS has the potential to melt down the EU. American regulators think CDS is a commission generating tool that allows financial firms to generate big profits while reducing risk. A battle is brewing.

The bankers could create money and they could also create booms and busts, which were very profitable. Debt inevitably leads to booms and busts. The economy expands when money is borrowed and put into circulation. The economy contracts when the debt must be repaid. Bankers could finance wars, which were also profitable. Wars destroy things, which have to be replaced; the purchase price is financed by debt. Central banking failed to bring economic stability. The thirty years that followed the creation of the Fed marked some of the most challenging times in America’s history: World War I, the Panic of 1920, the Great Depression, and World War II.

Immediately after World War I, the Federal Reserve debased the dollar to help rebuild the British economy. In order to lower the value of the dollar and raise the value of the pound, the Fed embarked on purposeful monetary expansion. Money supply expanded from $12 billion in 1914 to $26 billion in 1929. The result of monetary expansion was the Roaring Twenties, a huge stock market boom, and equities that kept being bid higher as cheap money poured into the economy. The challenge for the bankers was to keep the stock market flying high.

The Federal Reserve has been keeping short-term rates artificially low. Banks and hedge funds can borrow from the Fed at 25 basis points and use this money to buy treasuries yielding 3.5% to 4%. This is called a carry trade.

Banks and hedge funds can leverage their assets by 10 to 30 times. Remember that banks consider loans to be assets and deposits are liabilities. This means that if a bank or hedge fund has a loan for $1 million (let’s pick a round number for this example) they can go to the Federal Reserve and borrow up to $30 million (30 times) against that loan. They can then buy treasuries and earn an easy 3.5%, or $1,050,000. At 10 times leverage, they can borrow $10 million and earn $350,000.

The pre-Revolutionary United States enjoyed a prosperous and growing economy. Benjamin Franklin captured the economic essence of his time with succinct and memorable lines: “a penny saved is a penny earned,” and “he who goes a-borrowing goes a-sorrowing.” Franklin provided more in-depth analysis in his autobiography: “In the Colonies we issue our own money. It is called Colonial Script. We issue it in proper proportion to the demands of trade and industry to make the products pass easily from the producers to the consumers. In this manner, creating for ourselves our own paper money, we control its purchasing power, and we have no interest to pay to no one." – Benjamin Franklin.