A look at the Federal Reserve

Now you don't talk so loud...
Now you don't feel so proud...
About havin' to be scroungin' your next meal...

- Bob Dylan

A few months ago, working on Wall Street was about the most prestigious thing you could do. Rock legends earned less. Heart surgeons got less respect. Porches had less power. Screen stars had fewer girlfriends. You were on top of the world. You earned more than anyone else. You knew more. You were better educated...the top of the class from the top schools. You understood what a CDO was...and a swap...and a derivative.

Naturally, other people...ordinary people...looked up to you. They gave you good tables at restaurants. They parked your car without scratching it against a fire hydrant. Women wanted to meet you...and men asked your advice on economics, politics, fashion, art - you name it. You were what every mother wanted her son to be - a member of that special club...the secret order...the high priests of the modern world...the ruling elite of Planet Goldman...the Confrérie of Finance.

But now, they that did ride so high now lie in the gutters of lower Manhattan. People practically spit at you on the street. They blame you for their losses...for taking away their retirements...for wrecking the whole world's economy. You were a hero...now, you're a schmuck.

Yesterday, the Dow fell another 427 points - to under 8,000. This morning, stocks fell, as recession fears and jobs data plagued the market. O' Bama! Where is thy bounce!

Consumer price inflation fell by 1% - the biggest drop in history.

Houses in Southern California are now down 41%, according to the latest report. "Harsh reality," says the Wall Street Journal, is now "hitting home."

Architects, too, say their billings have taken a record dip.

About the only profitable business left is hijacking ships!

The typical stock market investor has lost about half his money. He's looking for someone to blame - surely, it's not his own fault!

And so now, poor Wall Street, the public is catching on to your scam...

...that the special knowledge you claimed was nothing but smooth talking claptrap...

...that you really didn't know any more than anyone else about what was actually going on...

...that what you were doing was skimming money from honest businesses with a lot of fancy shenanigans and unnecessary transactions...

...and selling stocks to naive lumpen - claiming that equities "always go up in the long run"

...and loading up business and consumers with more debt than they could carry...

...and then greasing the debt over to investors, softly assuring them that "our models show the risk of default is negligible...it won't happen, not in a thousand years."

That was only a few months ago. And now the debt has gone bad - trillions worth of it. And now, so many things that Wall Street promised have turned out to be lies and humbug that the whole world financial system has seized up.

Next week, we promise a more detailed expose of Wall Street's flim flam. (Heck...the whole industry is down...now's the time to kick.)

Meanwhile, we go on...into the wild blue yonder.

And here we switch from the "innocent fraud" of Wall Street, as Galbraith calls it, to the armed robbery of government.

You see, the Obama Administration will have one overriding priority: to unblock the credit markets, put things back to "normal," and get the economy moving again. If he can do that - or even appear to do that (which is the only possibility) - Obama will go down in history as one of the nation's greatest presidents.

Of course, everyone is rooting for him. When times are good...we like horror movies and terrorist threats. But when they are bad, we want flicks with happy endings. Obama's election was a landmark for many reasons. But he won largely because voters wanted a "Hollywood ending" to the campaign. And now they want a Hollywood ending to the new national nightmare.

Will they get it?

Nah...but they might like the show anyway.

*** Dan Amoss offers his two cents:

"Those fearing deflation assume that every American consumer is stereotypical: an overextended, credit card-addicted, house-flipping gambler. This is simply not the case. Many Americans don't have a mortgage. And most Americans with mortgages are still making their payments. They have, however, temporarily reigned in discretionary spending because of falling house and stock prices.

"Those fearing deflation also assume that demand for debt is low and falling. But demand for debt doesn't always come from businesses or households looking to invest more or spend more. Any business or household looking to refinance existing debt at lower rates - and there are many - is a source of demand for new debt. Banks borrowing at the Fed window at 1% or less will be looking to supply this new debt by make highly profitable loans to creditworthy borrowers.

"Once borrowers refinance, they may not be as aggressive about spending or expanding business as they used to be. But at least they will have access to credit. In the Great Depression, they did not. So the economy fell into a negative feedback loop of asset sales, bank failures, and rising unemployment.

"Treasury and the Fed will keep taking extreme measures to slow down the pace of credit contraction and housing prices - cutting off this deflationary feedback loop. This could include nationalizing Fannie Mae and Freddie Mac and using the Treasury's low borrowing costs to refinance hundreds of billions in existing mortgage debt into new 40- or 50-year mortgages with reduced principal balances.

"Sure, such an action would guarantee a decade or more of stagnation in housing prices, but it will also slow or flatten the rapid decline in prices. This is the essence of the Treasury and Fed actions: to stop the deleveraging from getting out of control - even at the cost of future economic stagnation. Like it or not, I think this is the most likely outcome from this crisis."

***And now, let's look at what the Federal Reserve is doing...

As you'll recall, the main man at the Fed, Ben Bernanke, has spent almost his entire life studying what went wrong in the United States in the '30s and in Japan in the '90s. He's determined not to let it happen again - not on his watch.

And so, he's taking America's central bank where no central bank has ever gone before.

From the day of its founding in 1913, the Fed's assets - the foundation capital of the U.S. banking system - grew, reaching $1 trillion on the 24th of September, 2008. But then, something extraordinary happened. Something breathtaking. And for a classical economist - something incredibly reckless. In the next six weeks, the Fed added another trillion. And the head of the Dallas Branch of the Fed said that he expected to add another trillion before the end of the year.

How does the Fed get these "assets?" Simple. It buys them. Where does it get the money to buy them? Simple again: it creates it. It makes it up. It conjures it out of nothing.

"If it comes from nothing," you might wonder, "what could it really be worth?" But we're not going to answer that question. We don't have time. Besides, it takes us in such a deep metaphysical swamp, we're afraid we may never slosh our way out...or at least not get out in time for lunch. Instead, we're going to answer this question:

"If it was that easy, how come the Fed didn't do it before?"

The answer to that is simple: because when the Fed inflates the money supply it risks inflating consumer prices. People don't like that. They like it when asset prices go up. But not when gasoline and milk increase.

But now, no one is worried about consumer prices. In fact, the Fed is worried about deflation...about falling prices. Bernanke knows what happens when consumer prices begin to fall. Consumers stop spending - knowing that they will be able to get a better deal in the future. That further depresses the economy...and pretty soon it's the '90s again and you're back in Tokyo. So the Fed has begun a huge program of monetary inflation, intended to offset Mr. Market's price-cutting.

And now another question: Isn't there some risk that the Fed will overdo it?

Oh, dear reader...that's a puffball of a pitch. If we can't hit that, you can take our laptop away...you can break our sword...and send us back to the dugout.

Remember what happened in the slump of the early 2000s? Alan Greenspan panicked...cut rates to 1%...and left them there for more than a year. He gave the market the wrong medicine at the wrong time...and then delivered such a horse-sized dose, it set off the biggest bubble in mankind's whole bubbly history.

Now, it's a different kind of slump...a credit slump. And once again, the Fed is on the scene, like a quack doctor at the side of a heart-attack victim. This time, he's giving stronger medicine...not just a 1% lending rate, but actual monetary inflation. Trillions of dollars worth of it.

For the moment, Mr. Market is taking away dollars faster than the Bernanke Fed is replacing them. That could continue...for a few months...or even for several years. But it won't continue forever.

And here, we affirm our unshakeable faith in the people who lead us. They are trying to cause inflation. Eventually, they will get the hang of it. They may shoot for 2% per year; but they are sure to overshoot. Money printers always do.

Until tomorrow,

Bill Bonner
The Daily Reckoning Australia

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