The New Welfare Queens

In my recent articles, I have attacked the popular notion that low interest rates will help the economy recover, arguing that they cause capital flight and remove the very resources needed for growth. After all, most investors and corporate executive are using all their mental energy figuring out ways to get money out of the U.S. economy, whether by owning gold or buying foreign stocks. Despite today's strong non-farm payroll report, we still face a structural employment crisis that won't start improving until the U.S. becomes a more attractive destination for capital.

Today I want to focus on who the Federal Reserve is actually helping, because it isn't the American economy or the American worker. It's serving the same banks that created the mess.

When resources are allocated based on need, rather than the ability to pay, it's called socialism. Most of us would argue against a Third World state propping up a failed automaker or airline. Likewise, we'd say transferring large amounts of money is wasteful and ultimately distorts incentives by rewarding the weak and taking from the strong.

We now have a situation in the U.S. where most of the large banks still face massive losses and are essentially insolvent. (If you don't believe that, wait for my next column.) Instead of letting them fail and allowing new industry leaders to emerge, the Fed is actively supporting failed institutions with a policy of low interest rates. This lets them take in funds at an absurdly low rate and "play the yield curve" by purchasing Treasuries and Agencies paying 200-300 basis points more than their cost of funds.

Most readers probably know this is a replay of the Fed's policies in the early 1990s after the Savings & Loan crisis, when Alan Greenspan created a steep yield curve so banks could recapitalize in the wake of their own terrible decisions.

What many readers probably don't realize is that the S&L crisis wasn't the first time the powers-that-be stepped in to prevent bank failures. It happened only a few years earlier following the Latin American debt crisis, when the U.S. banking system bordered on insolvency according to the Federal Deposit Insurance Corporation:

Unlike some European regulatory authorities, immediately after the Mexican crisis, U.S. banking officials did not require that large reserves be set aside on the restructured LDC loans or on the succeeding arrearages by other LDC nations. Such a policy was not feasible at the time and might have caused a financial panic because the total LDC portfolio held by the average money-center bank was more than double its aggregate capital and reserves at the end of 1982. Thus, regulatory forbearance was also granted to the large banks with respect to the establishment of reserves against past-due LDC loans.

[Emphasis added. LDC stands for "less developed countries." Regulatory forbearance is a euphemism for not enforcing the rules, like when Travelers and Citigroup were allowed to merge in 1999 despite Glass-Steagall. Like all trends, loose discipline has been a recurring theme for many years in our financial industry.]

This time the enablers were at Office of Comptroller of the Currency, the FDIC, the World Bank and International Monetary Fund more than the Fed, but it had the same results of rewarding bad conduct and shielding bank executives from the consequences of their own actions. (Fannie Mae and Freddie Mac also helped by taking over mortgage lending, as I discuss this article.) In fact the FDIC report partially blames the Latin American debt crisis on the OCC reinterpreting a statute that prevented banks lending more than 10 percent of their capital to a single lender.

Thanks to that 1979 decision, banks were allowed to count different government-related entities in a single country as separate borrowers. For instance, the Argentine government was one credit, while a government-owned and subsidized steel company, or a municipality, would be considered separate credits. The insanity of this decision is obvious when you consider that the borrowers paid interest and principal in dollars while receiving revenue were in local currencies.

Latin central banks kept rates low in the early 1980s despite rising inflation and high rates in the U.S. That caused almost every currency in the region to experience massive devaluation, which made their dollar-denominated debts unserviceable -- similar to what happened in Iceland or Eastern Europe last year.

The OCC's indulgence of the banks had a similar effect as the belief in the U.S. that "houses never lose value": It let them take excessive risk. This caused reckless lending to accelerate up to the moment when Mexico defaulted in 1982. Once again we see the power of regulation and government fiat to redefine reality in the blink of eye to serve the interests of those with access to the levers of power.

In Latin America, this cost tens of millions of human beings their life savings and inflicted two decades of misery and capital flight that decimated the middle class. In the U.S., this same regulatory anarchy cost tens of millions of human beings much of their life savings and is in the process of decimating our middle class.

When it comes to socialism, it's always the same. Only the names change.

Perhaps the most amazing thing about the Latin American debt crisis is how oblivious most U.S. investors and analysts were to the fact it was even happening. As the FDIC report observes, all the big lenders maintained AAA credit ratings as the debt bubble inflated. Even once the crisis hit, none of the dangers were reflected in bank share prices. As I will discuss in my next column, it appears that most investors today still don't understand how sick the banks truly are, or how little credence should be placed in their financial statements.

U.S. lenders have grown well-accustomed to being coddled and sheltered from the consequences of their own mistakes. The Fed gave them a similarly gentle treatment after the S&L crisis and again after the Long-Term Capital Management blowup. And, of course, today takes the cake, when the entire economy is on bended knee to keep the banks from experiencing pain.

Imagine a woman who doesn't work but has lots of children with different men, knowing that each new baby will bring a bigger welfare check. Few readers will dispute that letting someone proceed like that over the long run leads to poverty and social dysfunction. In the worst cases, it produces drug addiction, crime and violence.

Just as politicians are afraid to remove such benefits for fear of the poor rioting, investors and politicians oppose removing easy money because it "may produce another crisis." No carry trade, no peace! And the most insidious thing about the situation is that most investors and economists are still suffering under the delusion that low rates are inflationary, despite substantial contemporary evidence and classical economic theory arguing to the contrary.

It's also worth remembering the Fed is a collection of private corporations. It has government-like powers, but it belongs to the same banks it oversees. Some people raise this point to make conspiracy theories about Jekyll Island and a communist plot to take over the world. I think most of those arguments are silly, and suggest something simpler: The banks own and control the Fed, so it does what they want. That's why Ben Bernanke won't do the sensible thing and let the major banks fail so they can be replaced by new lenders who didn't make the same mistakes. In this respect, the Fed is a like a union that prevents members from getting fired, even if they come to work drunk or don't show up at all.

This understanding of the Fed also makes sense when you remember it was created as a "lender of last resort" after the Panic of 1907. Since then it has morphed into a broader economic watchdog with an alleged "dual mandate." But its main purpose remains being a wet-nurse to the financial system. Wall Street might self regulate, but banks self medicate.

The other interest group to benefit from these insanely low interest rates is the government itself, which is borrowing at an unsustainable pace. Politicians are running up impossible debt loads for our grandchildren so they can maintain public-sector payrolls and keep the union dues pouring into their campaign coffers.

The problem with any sustained welfare program, or socialism in general, is that everyone else is held hostage to the needs of the weakest individuals. In an inner city, this manifests itself in bad schools, falling taxes bases and a complete lack of investment. In a financial system, it manifests itself in bad loans, zombie banks and a complete lack of investment. Both denigrate the human mind and spirit as people are forced to endure an unreality where good is bad and the worst elements of our nature dominate the best.

There was a reason why Libor spiked last year: That was the reality of a credit crunch. Forcing it lower was a denial of reality. That's why higher rates now are not only good policy. They're a moral imperative.

(My former editor and colleague Mark Pittman passed away last week at age 52. Mark distinguished himself for questioning how our financial system is run, and for whose benefit. This column is dedicated to him.)

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