New tricks required to bail out financial system

April 10th, 2008

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As we all know, last month, the Fed engineered a bailout of Bear Stearns over the weekend. It’s no secret that the Fed had to invoke an obscure law passed in the 1930s to save Bear Stearns. Some news media claimed that this law had not been invoked since the Great Depression, which is not true but is certainly attention grabbing. The truth is that, it was last used in the 1960s.

You may have recalled that we said in Recipe for hyperinflation,

Such scheme of arrangements is just a tiny fraction of ?rules? that ?govern? the vast power associated with the authority to create money. Now, imagine that those above-mentioned ?rules? are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?

Wrong.

The main point is, once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

Let’s review a sample of how some of these ‘rules’ had been rolled-back and relaxed:

  1. Most of the time, banks lend to and borrow from each other to cover their daily shortfall or surplus cash. But banks can also borrow directly from the Fed through the discount window. But the Fed would prefer that they do not do so by keeping the discount rate higher than the Fed Fund Rate as a disincentive. It used to be ‘humiliating’ for banks to have to go to the Fed to beg for money. But today, due to the credit crisis, staying solvent is more important than to stay ‘dignified.’ Furthermore, the Fed helped by auctioning more money (fiat money that is created from thin air) to the banks.
  2. The Fed used to only accept Treasuries as a collateral for loans. Now, it has come to the point of accepting AAA mortgage bonds (other central banks are guilty of this too). Congratulations to the Fed for getting involved into the landlord business!
  3. The Fed cannot lend to non-banks such as Bear Stearns. But last month, it had to invoke an old law to be able to lend to Bear Stearns. As this news article said, Fed Invokes Little-Used Authority to Aid Bear Stearns (Update4),

    Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allow it to lend to corporations and private partnerships with a special board vote. The Fed chief probably sought to stave off a deeper blow to the financial system from a Bear Stearns collapse…

  4. The US government embarked on an economic ‘stimulus’ plan by sending newly printed money (nicely called a ‘tax rebate’) to Americans (see Watch the US government).

In the weeks and months to come, we will get to see more ‘ingenious’ plans and actions by the Fed to ‘solve’ the worsening credit crunch problem. They will try every new, weird and unprecedented tricks not found in the book to achieve that aim. As this Wall Street Journal article, Fed Weighs Its Options in Easing Credit Crunch said,

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.

Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.

As long as the Fed keeps on trying to ‘solve’ the problem, we will not rule out hyperinflation.

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  • Pete

    I guess it is all reminiscent of Japan in the 80’s isn’t it?
    They sure solved their problems didn’t they.

    It wouldn’t surprise me one bit if they bring in some new laws on the never-never to combat this type of thing. It seems almost anything can get through congress if it has money behind it.

    It is very much like a person trying to play god with nature. A lion chases the weak gazelle, only to have this ‘god’ interfere and save the gazelle, because he feels sorry for it. How then will the lion eat? Even more disturbing is that this weak gazelle will go on to have weak offspring. If that continues, then before we know it, all gazelles are lazy and fearless, totally incapable of outrunning a lion. But this will not matter because the hand of god will always be there to save them.
    Hrrmm, that does sound a bit like the US financial system… (and not limited to)

    I wonder if there will come a time when governments will leave these things well alone…

    Here’s a question(s) Ed… how do you think the effect of hyperinflation in the US would impact on the global economy? Surely the world would need to adopt a new base currency? I know many suggest the Euro, as unstable as that actually is.
    To go one step further, what do you think would happen if the Euro became the base currency? Given it’s problems(?) due to it spanning many countries, do you think that it would even last long? I suspect that as soon as the global base currency changed, it would be a very volatile time for everyone.
    Yet another question: If the US currency was no longer the base currency, what effect do you think this would have on the US itself, when it would be trying to deal with it’s economic crisis?

    Thanks again for the articles, they have been good reading ๐Ÿ™‚

    – Pete

  • Pete

    I guess it is all reminiscent of Japan in the 80’s isn’t it?
    They sure solved their problems didn’t they.

    It wouldn’t surprise me one bit if they bring in some new laws on the never-never to combat this type of thing. It seems almost anything can get through congress if it has money behind it.

    It is very much like a person trying to play god with nature. A lion chases the weak gazelle, only to have this ‘god’ interfere and save the gazelle, because he feels sorry for it. How then will the lion eat? Even more disturbing is that this weak gazelle will go on to have weak offspring. If that continues, then before we know it, all gazelles are lazy and fearless, totally incapable of outrunning a lion. But this will not matter because the hand of god will always be there to save them.
    Hrrmm, that does sound a bit like the US financial system… (and not limited to)

    I wonder if there will come a time when governments will leave these things well alone…

    Here’s a question(s) Ed… how do you think the effect of hyperinflation in the US would impact on the global economy? Surely the world would need to adopt a new base currency? I know many suggest the Euro, as unstable as that actually is.
    To go one step further, what do you think would happen if the Euro became the base currency? Given it’s problems(?) due to it spanning many countries, do you think that it would even last long? I suspect that as soon as the global base currency changed, it would be a very volatile time for everyone.
    Yet another question: If the US currency was no longer the base currency, what effect do you think this would have on the US itself, when it would be trying to deal with it’s economic crisis?

    Thanks again for the articles, they have been good reading ๐Ÿ™‚

    – Pete

  • Hi Pete!

    These are good questions and we must admit we don’t have all the answers. There are far too many Black Swans and tricky dynamics lurking around the extremely complex global financial landscape. But we have some thoughts which may be useful to you to chew on…

    How about this? We’ll sure others has the same questions. So, we’ll write an article to answer your question. ๐Ÿ™‚

    And by the way, someone has a reply to your comment at Myths on the Australian housing/rental crisis & its implications.

  • Hi Pete!

    These are good questions and we must admit we don’t have all the answers. There are far too many Black Swans and tricky dynamics lurking around the extremely complex global financial landscape. But we have some thoughts which may be useful to you to chew on…

    How about this? We’ll sure others has the same questions. So, we’ll write an article to answer your question. ๐Ÿ™‚

    And by the way, someone has a reply to your comment at Myths on the Australian housing/rental crisis & its implications.