Robert Reich: Stop Subsidizing Wall Street

Robert was on a roll this last few days. He has published articles that have popped up on different web scans as significant comments.


Dr. Reich is an academic that loves to serve his fellow man. He has been a member of three Democratic administrations and believes that he is an expert on “public policy”. Surveying his “policy” recommendations, I conclude that he feels that he was born too late. He would have been very happy to be a leading Marxist economist. At every turn he has recommended turning away from capitalism toward state control of all aspects of the economy. He regards actions taken by the government as wiser and morally superior to individual action. The use of force is okay with Dr. Reich.

What brings him to mind is that I came across his blog. This particular entry is entitled: “Financial reform bill unlikely to end taxpayer subsidy of derivative trading on Wall Street”

This may not sound particularly controversial because the federal government subsidizes many industries and companies. Handing out federal money is a major activity of both political parties and nothing at all new.

You might ask, which specific taxpayer subsidy is he talking about? How are the taxpayers subsidizing derivative trading. One answer could be that our government has decided that financial companies who traded derivatives were bailed out because of the “too-big-to-fail” irrationality. That is, some financial companies got carried away trading derivatives, lost gobs of money, and the government bailed them out by giving them money. That would be a subsidy, you say. Sorry, no. That is not what our Dr. Reich has in mind.

Just like any other sector of the economy, existing banks do receive a portion of the public dole. Considering how convoluted and contrived federal spending and the means of providing subsidies and support has become in the U.S., there are possibly many different actual subsidies that the banks receive. I have not researched it. But, upon reflection, I can think of two. One is that a considerable proportion of the money that the bank lends comes with no expense. It comes from the expansion of the money supply by way of the Fed. When the Fed. expands bank credit the bank receives new money in its reserve/deposit account at the Fed. The bank can then take that money into it’s own coffers and loan it out. The bank’s only expense or risk is that the Fed. may decide that the amount of money it has put into the economy should be reduced and begin a process of restriction and shrink the reserve accounts, which would require the bank to call in loans. The risk of restriction is small. It rarely happens.

Another benefit that existing banks receive from the current situation is a considerable reduction in competition. The regulatory burden on banks (and the rest of the financial sector as well as the economy as a whole) is extremely large. Even someone who has some understanding of banking would be staggered by the amount of paperwork, filing, extraneous record keeping, staff, and expense of the regulations. Just keeping track of all of them, and learning about and implementing new ones takes a considerable staff and administrative expense. The cost of regulation is one of the factors leading to bank consolidation. The economies of scale of a larger bank make it easier to cover the cost of regulation. Competition is reduced by the consolidation and by the tremendous expense and risk involved in starting a new bank of any size.

But none of these means of supporting the current banking establishmen is what Dr. Reich means is that banks are protected against their folly by government guarantees of customer deposits. What he is referring to is the Federal Deposit Insurance Corporation, which isn’t a corporation at all but a government entity. You see its initials all the time. Somewhere on its promotional and contractual material, every bank has placed “Member FDIC”. I’m not sure that “membership” is optional, but the marketplace, supposedly, would punish any bank that wasn’t a member. I mean, who wouldn’t want their deposits insured?

The FDIC collects funds from the banks, just like insurance, and guarantees that if the bank defaults, the FDIC will cover the difference between the bank’s assets and the deposits, up to $250,000 per customer (not per account). The FDIC was created during the depression to try to give people some confidence in their banks. Banks had been failing at a rapid pace for want of capital. People were afraid that they wouldn’t be able to get their money. Deposit insurance seemed the ticket.

But it is a fraud. It isn’t insurance. The fees collected by the FDIC could not cover much, and are certainly not sufficient for the size of the major banks today. Even when it was created it was recognized that the FDIC could not stand on its own, so it was backed with federal government guarantees. When the FDIC runs out of money, the federal purse bails it out. It did, too, during the 70’s when Thrifts began failing in large quantities (more government malfeasance). So, today, everyone who has paid attention knows that if banks begin failing the feds will have to pony up more money to cover the FDIC’s obligations.

Now along comes Dr. Reich, who wishes to expound on the virtues of government and, since it is popular to bash banks these days, bash the “rich” bankers. He capitalizes on the ignorance and poor education of most Americans, and forthrightly declares that the banks are being subsidized.

He has to ignore that the precarious situation of the banks over the last five years is directly related to the cheap money policies of the Fed., the efforts of the federal government to eliminate sound credit practices in the mortgage industry, and the forced semi-nationalization of the largest banks. Ignoring facts and reality is a way of life for Dr. Reich.

So the subsidy that Dr. Reich is referring to is actually no subsidy at all but a insane obligation left over from the 30’s that could put the federal government on the hook for trillions. Now, does Dr. Reich want to end the subsidy? No. He thinks that the FDIC is a fine organization. Instead, he is focusing on the derivative trading.

Not just any derivative trading, but the defensive or hedge trading. There are really two different approaches to derivative trading. One approach is intent on making money, just like most investment. This derivative trading is generally short term and is a form of speculating, i.e., expectations of advantageous price changes. This kind of trading can often result in significant losses, just like speculating on the price of a stock. You expect the price of the stock or derivative to go up, but it often goes down, and until you sell it, you lose money on the market price. Not all derivatives function that way.

A defensive or hedge approach to derivative trading is exemplified by the corn farmer, perhaps the source of one of the first derivative markets. When the corn farmer plants his crop he founds his expectations on the current price of corn, or perhaps on what his experience suggests the price will be when he harvests and delivers his crop to market. But of course, the future is not known. The price could be very different in a few months. It the market price for corn is lower, the farmer is sure to lose money. So the farmer buys a derivative. He buys a financial product that will pay him money if the price falls. He buys what is called a put option. If the price of corn on his delivery date is the same as the put or higher, the farmer reaps his expected profits and is happy. The money he paid for the put is lost. If the price of corn has dropped, the farmer makes up for his losses from his crop by the return on the put. The farmer has maintained his position.

The put option is purchased from another party who holds the same view of the future as the farmer, that the corn prices in future will be the same or better than today. He knows that he has a risk of lower prices, but he has factored that into his business, and has either reserves or a hedge of his own to cover potential losses. The farmer regards the cost of the put as a business expense and the seller of the put regards the potential loss as a factor in his business. The transaction and the decisions are done in a very businesslike manner.

So the bank has certain exposures to interest rates. If the interest rates change in a manner that is unprofitable, the bank will lose money. To offset potential losses, the bank buys derivatives just as the farmer did. For these derivatives to make sense, they must offer significant return with little cost, just like the corn farmer’s put option. The bank regards this as a business expense. It is a good banking practice.

What Dr. Reich does is confound the two different types of derivative activities. It may be true that some, most, or even all banks engage in both types of derivative trading. But it is clear that Dr. Reich is trying to have it both ways in that he yells “derivatives” in such way to capitalize on the danger of volatile aggressive trading, while also mentioning in an aside that banks are using hedge derivatives.

Reich says, “If derivative trading is so useful to them in order to “mitigate the risks” of other banking activities, the banks should be willing to foot the bill.”

Dr. Reich wants it to seem that the taxpayers are getting ripped off by overly aggressive banks who are risking huge taxpayer funds by aggressive, semi-rational derivative trading. He says that taxpayers are footing the bill. This is the same thinking that considers tax breaks or reductions to be a government expense. No money is going to the banks (in fact it costs the banks money to “belong” to the FDIC). As noted above, the reason the taxpayer may pay any money is if the Fed. policies drive many banks to the brink of default. If one or two banks fail because of poor business practices or banking decisions, for example, the FDIC will generally be able to meet its obligations. The problem is when there is a systemic or broad problem. But, according to Reich’s thinking, the bankers have a sweet deal: if the bankers have “bet” right, they pocket lots and lots of money; if they “bet” wrong, the taxpayers will have to pay. He says, “Derivatives can generate huge risks for the economy unless carefully regulated. Neither logic nor experience suggests that you and I and every other taxpayer should be subsidizing this gambling.” But none of his argument is related to reality from start to finish.

Let me make one observation about derivatives and the banks. The derivative tools banks and other intelligent large volume traders use are the result of brilliant inductions from highly complex, high-speed, high volume, international trading. They are intellectual marvels. But, at root, the banks and other financial traders are being taken for a ride. The tools work very well when the basic data they depend upon are real, but the data isn’t. Instead, the data, which is interest rates and money flows, is contrived and manipulated by governments around the world, mainly the U.S. In the long run, and when they need it most, the banks will be let down by their tools precisely because the tools depend upon being connected to reality, and the governments interfere. This situation is an excellent example of von Mises observation that prices are cognitive tools.

At the beginning of this entry I mentioned that Dr. Reich had two articles of interest recently. I will discuss the second in my next blog, hopefully in a day or two.

What next? Negative Interest?

A couple months ago I saw an analysis that showed the rate of interest targeted by the Fed Open Market Committee had declined over the last twenty years or so. Each cycle showed the targeted interest rate to be lower than the previous cycle. The question posed was, what would happen the next time, and if the economy gets going again, there will be a next time, But the Fed is already at zero. What will they do?


The target interest rate is what we hear called the Federal Funds rate or the Discount Rate. It is the rate the Fed charges banks, members of the Fed, to borrow from the Fed to maintain the minimum level of their deposits (sometimes called reserves) at the Fed. The law that set up the Fed. requires all member banks to maintain deposits (reserves) at the Fed. These funds are not available to the bank to use for any purpose except the Fed’s manipulation. The amount of the deposits that a bank must have with the Fed is a percentage of its demand deposits, called checking accounts by you and me. The Open Market Committee decides what percentage of demand deposits a member bank must have on hand, currently 10%.


If a bank’s deposits falls below 10% at any point, the bank must either deposit funds, borrow from another bank, or borrow from the Fed. And the Fed charges an interest rate, which, as I said, is called the Discount Rate or the Federal Funds rate. This is the interest rate that you hear or read about all the time in the popular press. It is considered a big deal. “Investors” buy or sell on expectations about the rate, banks connect their “Prime Rate” to the Discount Rate, mainstream economists connect their predictions on the economy based upon the Discount Rate, and so on.


The Discount rate is not maintained by decree, actually. It is a market rate, which is why it is called a target. The Fed. maintains the rate by adding or subtracting the amount of money available for bank member borrowing to cover minimum Fed. deposits. Ultimately, this is how the Fed. manipulates the money supply, but adding or subtracting money in the member banks Fed. deposit accounts (see elsewhere in my blog for a detailed explanation).


Therefore, the Fed. lowers the discount rate by adding money to the economy through the banks deposits. Currently, the Fed. Discount Rate is 0.00 to 0.25%, or nothing. The rate has been zero for well over a year. Supposedly, when rates are low, banks will loan more money, and, in current “thinking”, the economy will whiz along. Oh. You noticed no whizzing? What a surprise. Actually, banks have been contracting lending for well over a year, both to businesses and to consumers. Even with a zero percent interest, the Fed. can’t get the economy going. Even with the “stimulus” packages, they can’t get the economy going. What a surprise.


The chart I mentioned at the beginning suggests that future efforts of the Fed. will have a problem. That each successive round of encouragement from the Fed. has required lower interest rates. Well, you can’t get lower than zero. Free money would seem to be the ideal from these people. Hmmmm. The current situation is somewhat confused by the fact that the Fed. is paying interest for the first time ever on the Fed. member bank deposits. Before September, 2008, the way banks made money on expanded Fed. deposits was by taking 90% of the dollars the Fed. had given them in their member deposit account into their bank and loaning those dollars out (theoretically, there was nothing stopping them from just creating new demand deposits in their bank that equaled ten times the new Fed. deposits, but accounting niceties kind of made that difficult). Because the Fed. had created a massive amount of member bank deposits, about $1T vs. the normal $50B, the Fed. wanted to encourage the banks to keep the money at the Fed. so it began paying interest (not much, but more than zero). It turned out that it wasn’t necessary to offer interest, since the banks aren’t lending.


The Fed. keeps talking about the time when the economy begins growing again and it can raise interest rates, absorb all that money it created, and wallow in its self congratulations. But, here we are, a few months from two years of Fed. and BO encouragement, and no recovery. Some slight good news is published and everybody gets excited, and the next week there is new bad news and everyone feels worse. Unemployment figures continue to look bad. Well, I won’t dwell on the sorry picture.


So the chart I mentioned implies that if and when things get going, to the extent they can go at all with the huge burdens the BO has saddled us with, the Fed. is going to have to keep interest rates lower than in the last cycle, which was lower than the cycle before that. Of course, that will mean huge flows of made-up money, both in bank credit expansion and government spending, asset inflation, price inflation (currently 2.4% in the much criticized CPI), and probably very slow, real growth. Then, a couple years down the road the next bust comes (in a shorter cycle, I would think), the Fed. will have nowhere to go. The interest rates for the boom would be very close to zero, say 1-2%, and zero will not do much, probably even less than now. True to his convictions, Bernanke, the Fed. Chairman, will have flooded the country with more made-up money (we need to start calling him “Flood Money” Bernanke), and the next recession will just continue. We can expect more condemnation of capitalism, more destruction of our productive capacity, further crippling regulation of our financial system, a move toward greater violence and despair, and no economic growth or future. At least the cycle of boom and bust might have come to an end.

A Prediction from Henry Hazlitt, Meaning for Us

Recently I was searching for a book on telescopes in my library when I came upon a book that I didn’t recall owning. It was obvious why I owned it, when I bought it, and from whom. I just didn’t remember it. I probably haven’t read it. I will. The book is The Inflation Crisis, and How to Resolve It, Second Edition (1983), by Henry Hazlitt. I read the Preface to the Second Edition and was shocked. It was written in March,1983 and suggested a future far different than what we lived through. I have copied all but the first couple paragraphs:



I do think it necessary, however, to call attention here to a development of the last two or three years that was not analyzed in my earlier book because it had not occurred up to 1978 – at least not to such a dramatic extent. This has been the sudden and sharp rise in real interest rates to a level that brought about a deep recession in business and consequent mass unemployment.

Economists have long pointed out, of course, that in an inflation that has gone on for some time, and is expected to continue, nominal interest rates rise. Lenders want not only a normal rate of return, but a “price premium” to compensate them for the expected fall in the purchasing power of their dollars when they get them back. I discussed this in my 1978 book. (Ch. 17, pp. 121 et seq.)

But the rise in interest rates in the summer of 1982 was much grater than the general expectation of the future inflation rate prevailing at that time would have brought. It was a “real” and not merely “nominal” rise in interest. It made private borrowing almost prohibitive.

This was a result of a combination of two factors. The first was a sharp increase in the size of the deficit. The second was the refusal of the Federal Reserve System to monetize the debt to any but a minor extent.

The deficit for the fiscal year 1982, which ended Sept. 30 of that calendar year, was $110.7 billion (compared with an average deficit in the tree preceding years of $48 billion). If the Federal Reserve had bought the government’s securities in the open market to an equivalent amount – a frequent practice in the past – this would have led immediately to an accelerated inflation. But it refrained. The result was that the government’s enormous borrowings in the open market sent interest rates soaring, and “crowded out” part of the private borrowing that would otherwise have taken place for business expansion or even for continuance of normal production.

As long as deficits of the dimensions of fiscal 1982 continue there is a prospect of either prohibitive interest rates or galloping inflation in the immediate future, depending on how the deficits are financed. We could easily have a combination of both.

Yet this is precisely the policy that is now officially planned. The President’s budget message of Jan. 31, 1983 projected a deficit of $188.8 billion for the fiscal year 1984. And even on the assumption that his proposed cutbacks and freezes in spending are adopted, his budget message forecasts deficits of $194 billion in fiscal 1985, $148 billion in 1986, $142 billion in 1987, and $117 billion in 1988. When we consider that we have already had 44 deficits in the 52 years since 1930, that future budget deficits have been chronically underestimated, and that President Reagan himself, at the beginning of his term, projected a balanced budget for the fiscal year 1984, the outlook at the moment of writing this is frightening.



Now I have several things to say about this, the foremost being that every time I write or say something about the future of the economy I am well aware that it might be just as far off as Mr. Hazlitt’s remarks. There are just so many potential influences on an economy that it is very difficult to get a prediction correct. This is especially true when predicting gloom and doom in the American economy. Americans do not want to experience declining standards of living. They’ve seen it and want no more of it. So, in spite of what the government might do, Americans will work very hard to avoid really severe consequences.


Another comment that can be made is that Mr. Hazlitt did not and probably could not anticipate the understanding and competence of Fed Chairman Volker or the advisors supporting Reagan. Volker did not want a return to the inflation of the 70’s, and he led the Fed away from the actions that would “monetize” the federal debt. Reagan put money back into the hands of actually productive people by reducing taxes. So, in spite of the apparent level of deficits, the economy had room to grow. Of course, we have neither of these benefits in today’s government.


But probably, most of all for me to point out is the lesson for the reader. Economic predictions by those who oppose the government are often presented as definite, precise conclusions. People offering products or who have prominently presented a prediction will argue that their expectations will come true regardless of other, unforeseen events or influences. It doesn’t mean that their reasoning is wrong so much as that they do not realize the limitations of predictions in an economy as complex as ours.


The worth of my last set of comments can be seen in today’s financial crisis. Many, reasonably drawing on the insanity of U.S. government actions, have predicted the continued drop in the dollar. It isn’t happening. Why? Because of higher levels of insanity in other governments, plus a crisis in minor countries attracts as much attention as any other crisis. How long will the idiots in other countries keep acting in such a way that people don’t notice how poor an asset the U.S. dollar is? Who knows? There are literally dozens of other countries with their own set of idiots and insane economic programs. In comparison, the dollar might be a better option. How long will this situation favoring the dollar continue? Again, who knows?


What is a person who wants to protect themselves from the very bad policies of the U.S. government going to do? After all, the current situation is one of high risk. The dire predictions that I have been referring to and my own comments in this blog are all grounded in well thought out economics and accurate information. This is why caution, diversification, vigilance, reading, and just paying attention are all important. Patience, too. Be prepared for bad news, and do not react, by which I mean, do not be one of those who makes big changes on bad news (and be selective on the good news you react to).


In a wider perspective, Mr. Hazlitt’s comments suggests that there are some epistemological issues to consider about economics. Some contend, for example, that Ludwig von Mises is really, at root a rationalist. His presentation is seemingly deductive. I understand the source of that accusation, but in reading, for example, his Theory of Money and Credit I see significant references to events that support his position or counter the claims of another economist. He seems to me to be very grounded in real events. But, at the same time, economics is not a science that allows the type of isolation of causal factors that a physical science does. Even in the analysis of past events, in which all the information may be available, separating out the events and identifying the causal factors is far from easy and often open to ambiguity. The question of which analysis you accept ultimately falls to your understanding of the process of production and of human action (to coin a phrase). It is exactly like history. What factor in human action do you identify as primary: human intelligence, individual genius, geology, or philosophy? If your understanding of mankind is correct, your understanding of history, and also economics will tend to be correct also. Exactly how that works out in a specific situation, however, may be very complex, and the uncertainties in predicting what will happen before the event sufficient to throw off apparently well-reasoned expectations.


The lesson: figure it out as best you can, and hedge your bets. Don’t tie your actions to specific expected events but to the general trends, and don’t be surprised when actual events go against you. The point to remember is that when living within a generally irrational culture, the irrational will happen.