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The Global Carry Trade and the Crimes of Patriots
September 29, 2009

The Global Carry Trade and the Crimes of Patriots

"In a government of laws, the existence of the government will be imperiled if it fails to observe the law scrupulously. Our government is the potent, the omnipotent teacher. For good or ill, it teaches the whole people by its example. If government becomes a lawbreaker it breeds contempt for law: it invites every man to become a law unto himself. It invites anarchy."

Justice Louis Brandeis
From inside cover of The Crimes of Patriots
Jonathan Kwitny
WW Norton (1987)

Our trip to Chicago last week to participate in "The International Financial Crisis" conference sponsored by the Federal Reserve Bank of Chicago and the World Bank was instructive in several ways. First and foremost, it confirmed that the US economics profession is still trying to defend the old ways and means in terms of analytical methods for bank safety and soundness.

While there were many calls for "reform" of regulation, we heard nary a suggestion that the mish-mash of quantitative methods that currently comprise the framework for assessing the safety and soundness of banks needs to be set aside and a new approach defined. Indeed, the foreign participants in the two-days of presentations seem to be far more advanced in their thinking about bank safety and soundness than their counterparts from the US.

Andrew Sheng of the China Banking Regulatory Commission, reproached us for thinking that throwing debt at a global problem of insolvency will be successful. We have created the world's largest ever carry trade, Sheng noted, and suggested that the approach of exchanging a bank solvency problem for a sovereign debt problem could effectively replicate the lost decade of Japan on an international scale. He also wondered how any nation will be able to raise interest rates when vast sums of cash (i.e. fiat paper dollars) are ready to immediately pounce on any carry trade opportunities that arise.

Charles Goodhart of the London School of Economics provided a sobering reminder about the situation facing global banks and regulators when it comes to regulatory reform: "So the outcome of current (international) efforts to re-regulate remains obscure. The most likely outcome will be a generalized introduction of a leverage ratio, adjustable at local discretion, the promulgation of some form of (internationally agreed) liquidity ratio, and a tightening of capital adequacy requirements, though whether with, or without, counter-cyclical characteristics remains to be seen."

Goodhart reminded the audience that whereas Americans still debate the merits of regulation vs. innovation, in the EU the political class has already decided the robust regulation of banks is a necessary condition for stability. He also dismissed the idea that you can separate the "utility" bank from "the casino," again suggesting that the EU view of regulation of banks is comprehensive and should be emulated by the US.

We later reminded the audience that while the EU may think they have thoroughly regulated their markets, bad acts still flourish in public sector banks! In Germany, for example, a coalition has just been elected that plans to make the Bundesbank the sole bank regulator, ensuring that the government will not need to restrict spending to deal with the banking crisis. The head of the Bundesbank has just agreed to a heinous proposal of a leverage ratio limit that will severely damage European banks and revive securitization, arbitrage-style, in a way that can only make the EU's bank capital deficit worse.

The EU also has killed any entrepreneurial activity in private banking as well. There is virtually no private capital inflows into the EU banking sector and, in many markets, private and public sector EU banks mostly are insolvent. The EU member states now are the last redoubt for entire nations when it comes to credit. One wonders how the EU will participate in the stated intention of the G-20 to raise bank capital for riskier activities when many EU banks cannot meet current capital requirements and are facing losses that are equally as large as those unrealized losses facing US banks.

We also asked the audience whether they believe, as we asked in an earlier comment ("Systemic Risk: Is it Black Swans or Market Innovations?"), whether in the current crisis we are dealing with Black Swans or a collective failure to manage risk. The vote from this collection of high powered economists and regulators was unanimous for the latter.

In our comments, we focused on the lack of an objective basis for many new securities and derivatives, and asked why it is that virtually no one in the regulatory community, even now, who is willing to call these "innovative" securities what they are, namely unsafe and unsound. If you are going to pollute the marketplace with securities that are entirely subjective and thus entirely speculative, then effective bank supervision becomes impossible.

We also suggested that regulators must come up with their own metrics for measuring bank safety and soundness and stop the discredited practice of imitating the internal systems of the banks which we are supposed to regulate! Regulation, after all, assumes that regulators are actually able to measure something objectively and use these observations to ensure that banks are operating within the law. The current Basel II framework is a bad joke in this regard and we suspect that it will be replaced with a regime that looks very much like the description by Charles Goodhart.

While the members of our panel suggested various ways to restore balance and even virtue to the regulatory process, we suggested that Washington does not need another oversight agency or more platonic guardians. Rather, we need to address the problem where it truly resides, first with the debt issuance of our profligate government and second with the accommodative monetary policy of our central bank. As one participant noted, there is no longer any distinction between fiscal and monetary policy in the US.

Though there were many insightful and interesting comments made at the two-day conference in the FRB Chicago, the one thing that we heard virtually no one say is that the current financial crisis stems from irresponsible monetary and fiscal policies. Many participants talked about the role of "global capital flows" in fueling the crisis, but none made the basic statement that having printed this money to pay for imports and fund domestic deficit spending, the US was bound to see the dollars eventually come home in the form of a credit bubble.

Since the October 1987 financial crisis, the Federal Reserve System has not denied the Street either liquidity or collateral. The objective goal of policy, it seems, has been to keep the ability of Congress to issue debt intact all the while keeping the casino part of the banking system operating at full steam regardless of the impact on inflation and, more important, investor behavior. Seen in this light, the proliferation of hedge funds and OTC securities is the natural response of investors to inflationary fiscal and monetary policies in Washington, a city where income and the proceeds of borrowing are seen as being equivalent.

Today the amount of debt and fiat money issued by the US government is threatening not only the solvency of private financial institutions and companies, but the stability of the entire global economy. Yet virtually no observers make the connection between the reality of secular inflation in the US and the bad outcomes in the financial markets, and in the global economy, where trade flows continue to shrink. Indeed, if members of Congress ever wanted a reason not to give the Fed more power as a regulator of financial institutions, they should start with an investigation of the Fed's conduct of monetary policy, not bank regulation. Just imagine how the US economy would look several decades from now were the Congress to give the Fed hegemony over bank supervision via the rubric of "systemic risk" even as the central bank continues its reckless policies with respect to monetary policy and its accommodation of US debt issuance.

Systemic risk, it seems, is not the result of bad regulatory policies, but the natural outcome of a system where income from productive economic activities is being increasingly supplemented with debt and inflation. Our political leaders say that such policies are meant to help the American people, but we've heard such empty justifications before. Call the policies of borrow and spend and print the "crimes of patriots," a powerful metaphor used by author Jonathan Kwitny to describe the bad acts of the CIA in the banking world decades ago. Since then, the money game and the role of government in our financial markets has only grown larger.

If the American people want to get the US financial system under control, then the first areas of investigation, we submit, must be fiscal and monetary policies. And if Americans do not soon get control over the habit of borrow and spend practiced by the Congress and facilitated by the Fed, then end result must be a populist backlash against Washington and incumbents in politics and the corporate world. As Congressman Ron Paul (R-TX) writes in his latest book, End the Fed: "Nothing good can come from the Federal Reserve… It's immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty."

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