What part did Hedge funds play in the crash of 2008?

By:


When Brooksley Born was interviewed on an episode of the PBS documentary series, Frontline, in October of 2009, it was the first time many viewers had ever heard of AIG’s involvement with credit default swaps. It was definitely the first time the majority of the American people had ever heard anyone quantify the depth of the abyss upon the edge of which Wall Street was teetering.

“We had no regulation,” testified the former chairman of the Commodity Futures Trading Commission (CFTC), who in 1998 had dared to cross swords with the Great and Powerful Greenspan. “No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing. There was also little or no capital being put up as collateral for the transactions. All the players in the marketplace were participants and counterparties to one another’s contracts. This market had gotten to be over $680 trillion in notional value as of June 2008 when it topped up. I think that was the peak. And that is an enormous market. That’s more than 10 times the gross national product of all the countries in the world.”

Not all derivatives are evil and destructive, but it is very crucial to understand the risks associated with these sophisticated products. This requires specialized high tech knowledge by professionals who have the necessary insight and expertise to know what tool to use and when it is appropriate.

The vast majority of hedge funds did not suffer significant damage due to the meltdown, although all of them certainly felt the shock waves. The ones that were most exposed and most leveraged are no longer with us.

Why has this gone on so long with no end in sight?

Because the Media has created and perpetuated the general perception that only people with money to burn invest in hedge funds. It is generally believed that the SEC has the opinion that if these rich people are so dumb as to give their money to Wild West fly-by-night money slingers, then they deserve to lose it. If it were the regular public that were losing their life savings, they say, it would be different story.

This is typical bureaucratic perception of financial reality.

The sad reality that everyone except the bureaucrats seems to have learned is that when all of the stupid rich people lose their money, the rest of the world economy suffers as well. This is why something real needs to be done about the more questionable hedge funds. I believe we need to have some regulation of the market, but it must be regulation that is well-thought out and anticipates unintended consequences.

I personally believe the SEC should require all hedge funds to operate in a true market-neutral mode, or not be allowed to call themselves hedge funds. It would be true capitalist caveat emptor (let the buyer beware) at its best.

As people put more and more money into hedge funds, another 1998 Long-term Capital Management debacle is just waiting around the corner to ignite another global financial crisis, requiring taxpayers to spend billions bailing out all of the firms that shouldn’t have been investing in them in the first place.

LTCM’s issue was ironically very similar to the issues that plagued Citibank most recently. The problem was not in what the fund traded nor in the strategies they followed, but in the size of their books and the fact that they had no limits on the overall volume of their arbitrage trades. They effectively became the market and couldn’t get out when things turned against them; and in the exposure of lenders to them, which no one was watching. It was therefore a question of unsupervised leverage and that is where the problem is in that sub-sector of the hedge fund industry. It is where the largest regulatory loophole is located.

This is what happened to Citibank and others more recently when the overall size of all of these deals went unchecked. This is where the regulators must find a way to measure the systemic risk of any particular fund. It is also why former SEC Chairman William Donaldson, CFA, has said this is the most distressing period since 1929.

“As hedge funds struggle to achieve returns,” he lamented. “I think there’s a tendency to skate on thinner and thinner ice, and it’s kind of an accident waiting to happen. ”

Bottom line on hedge funds

It is a fact that allocating a certain percentage of your investments to alternative investments does lower the volatility and risk of the traditional portfolio; but there is one very crucial difference between hedge funds and mutual funds.

Hedge funds are not infinitely scalable. Hedge fund managers cannot and do not accept unlimited amounts of capital. They all top out at some point and stop accepting additional investments as the capital available starts diluting their returns. Hedge fund managers rely instead on a small but steady inflow of investment capital that can be managed easier.

In the last few years, there has been an average of 2,000 new hedge funds start per year with about 1,500 closing within that time frame. This is not just due to losses. There are other factors, too; one of the main culprits is the inability to raise enough capital to sustain the operation. In general, allocators need at least two years of a successful track record before the may allocate money to a new fund. Many mangers cannot survive the costs alone and join with other funds. This also includes managers retiring after a long run. The bottom line is that the net number of funds is increasing, not decreasing, as a direct function of demand and the limited capacity of existing funds.

This increased demand for additional hedge funds to handle the amount of capital coming into the market has led, in the past, to unqualified and incompetent people setting themselves up as hedge fund managers. This is a very powerful incentive for literally thousands of people to set up new fake hedge funds every year – and most have no experience running money whatsoever. The Securities and Exchange Commission has done a less than stellar job of supervising and registering hedge fund managers. Commodities traders and managers whose funds deal with investing in any type of futures market must be registered with and are regulated by the CFTC.

What’s important is to close any regulatory loopholes that could cause a systemic problem due to the actions of one or more funds. The shenanigans of Bernie Madoff hurt not only his investors but also the hedge fund industry at large although he was NOT running a hedge fund operation. It did not help that the media failed to serve their primary mandate to inform and educate. Instead, they over-dramatized, sensationalized and misrepresented the issues; exacerbating the damage caused to the honest and innocent managers by Madoff’s actions.

The point is not to predict the future, but it is possible, for example, to identify trends. People need to understand the risks involved. There’s no such thing as a “riskless” investment.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Sources

Born, Brooksley. Interview on Frontline. WGBH Educational Foundation. 20 October 2009. Retrieved from:

http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html

Read more: http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html#ixzz1PrXCELpb

Fulford, Mike (2010) Opinion on the Usage of Hedge Funds. Tools For Money website. Retrieved from:

http://toolsformoney.com/hedge_funds.htm

Categories:
Tagged:

Have we learned anything from the Financial Crisis of 2007?

By:


I would say nothing at all…. In fact, instead of changing their behavior to prevent another crisis, the Powers-that-be seem to be doubling down on the strategies that Caused the Financial Crisis in the First Place

Liberals blame deregulation and reckless Wall Street greed for the economic crisis. Conservatives blame bad government policy.

What are they doing? Well here again…. they are:

  1. Pushing banks to make home loans to people with weaker credit (sound familiar?)
  2. Deregulating and even promoting insane levels of derivatives (ring a bell?)
  3. Following policies which lead to rampant inequality (that didn’t work out so well last time)
  4. Letting white collar criminals know that they have free rein to do whatever they want, and they won’t be prosecuted (once again)
  5. Letting the giant banks get bigger and bigger (the government helped them get big in the first place)
  6. Bailing out the banks with hundreds of billions of dollars a year (which creates dangerous “moral hazard” – just like before the 2007 crisis – and once again destroys sovereign nations). Indeed, crony capitalism has gotten worse than ever (even though heroes have been fighting it for 100 years)
  7. Enacting policies which suck money out of the U.S. economy … and ship it abroad (as they’ve been doing for 50-plus years now)
  8. Enacting policies which discourage people from even trying to find work
  9. Giving the Federal Reserve more power than ever (while a neutral government agency says that the Fed is riddled with corruption, and economists say the Fed caused many of our problems in the first place, and has too much power for the good of the economy)
  10. Blowing insanely large speculative bubbles (when they burst in 2007, that caused the last crisis)

As to the big banks and financial institutions, looks like nothing has changed for them too as they are still engaged in the same risky behavior which got us into the 2007 crisis in the first place by:

  1. Trading even more risky derivatives than at the height of the financial crisis
  2. Taking insanely risky bets with the money that we deposit into our bank accounts. When some of their risky bets blow up, they will either look to the government – once again – for a bailout, or to our bank deposits
  3. Getting back into “synthetic” financial instruments – which are even more disconnected from real assets than regular derivatives
  4. Doing no-document mortgage loans

What could possibly go wrong?… Go figure

Tagged:

How stupid does Wall Street think we all are? – Financial Policy Council

By:


While the big boys try to sell the “dumb money” on a recovery under a “greater fool” theory, the smart money knows the score.While the snake oil salespeople at the retail investing level selling financial channels have been saying for years that we’re in a “recovery” (albeit a slow one), we all know that nothing has changed and that we’ll soon have another crash.

Why am I so confident this crash will happen sooner than later and is inevitable?

  1. It is because the causes of the previous financial crisis haven’t been resolved and the government hasn’t done anything to fix the basic problems in our economy.
  2. It is because we still have a quadrillion dollar derivative overhang which dwarfs the size of the total global GDP by a factor of 10 to 1
  3. It is because derivatives still haven’t been regulated and are still growing strong.
  4. It is because creditors and investors are still at the behest of a central bank (Federal Reserve) and policymakers that are robbing them of their money every day.
  5. It is because complacency is coming back and we are losing momentum every passing day.
  6. It is because regulators and lawmakers who needed to impose rules so failing banks could be shut down, allowed those incompetent banks to operate indefinitely with taxpayer support. They clearly have taken all the wrong steps in terms of the structural underpinnings of our capital markets.

In the meantime, Utah has declared gold and silver to be legal tender – with the value of the coin determined by the weight of precious metal it contains.

The law is the first of its kind in the United States. Several other states, including Minnesota, Idaho and Georgia, have considered similar laws.

Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

Now if all currencies are moving up or down together, the question is: relative to what? Gold is the canary in the coal mine. It signals problems with respect to currency markets. Maybe central banks should pay closer attention to it.

On the same note, China just recently edged out India to become the world’s largest buyer of investment-grade gold products, according to a World Gold Council report.

In the first quarter, Chinese consumers purchased 90.9 metric tonnes in gold bars and coins, valued at $4.1 billion.

That’s more than double the amount Chinese consumers were buying a year ago.

With virtually all of the world’s countries printing money like mad, it is not gold – but rather fiat currencies themselves – which are in a bubble. In that light, maybe gold is not really overpriced as some Wall Street analysts are leading us to believe.

So maybe it is time to stop listening to the supposed “Wall Street gurus”, since all that we’ve been hearing from them, for a decade now, is disinformation, stupidity and ideas that only fit their narrow agenda and bottom line.

Your feedback as always is greatly appreciated.

Thanks much for your consideration.

Tagged:

The Seeds of our Destruction – An academic outlook

By:


When I became a citizen of the United States, I had to study the nation’s history in order to pass my citizenship examination. I approached this task with the same focused intensity with which I approach every challenge. I wanted to be as well versed on American history as the average person who was born here.

Imagine my surprise when I discovered that the average native-born citizen knows very little about their nation’s history. Many people with whom I have talked think that 1776 is the date we celebrate the victory of the United States over the British. It isn’t. It is the year that Thomas Jefferson wrote the Declaration of Independence. The American Revolutionary War went on for another seven years. A study by the American Historical Association randomly selected four hundred people from “Who’s Who in America” to take a multiple choice test on a general overview of American history. Over 70% of the respondents thought that Thomas Jefferson was one of the framers of the Constitution in 1787. He wasn’t. He was in Paris at the time, serving as Minister to France. Had he been in Philadelphia, we might not have some of the economic problems that we have today.

The common misconception is that the War for Independence was fought for political liberty. That is simply not true. The inhabitants of the American colonies were almost all British subjects who shared the same rights and privileges of any man or woman walking down Fleet Street in London. The Englishmen who settled in the New World brought with them charters that protected their rights and liberties as granted under the Magna Carta, the Great Charter issued in 1215 by King John and the basis for all British law.

What America fought for and won was economic liberty. In 1763, George Grenville became Britain’s Prime Minister. That country was broke from their Seven Years War with France. Grenville’s solution was to impose a series of direct taxes and trade regulations on the prosperous American colonies. The Americans would have none of it. On July 4, 1776, the 56 delegates to the Continental Congress adopted and signed the United States Declaration of Independence declaring that the thirteen American colonies were now independent and sovereign states and were no longer part of the British Empire. In 1781, the several sovereign American States formed a “firm league of friendship with each other” codified as the Articles of Confederation and called themselves The United States of America. The War for Independence finally ended with the signing of the Treaty of Paris and the Treaties of Versailles on September 3, 1783.

The Americans knew they had created something new and different; something that had never been done before. They had established a nation whose economy was based upon merit, not upon garnering the favor of the crown or some royal advisor. They had created an economy in which reward was in direct proportion to effort; where the laws of supply and demand determined a man’s success in the marketplace instead of the arbitrary dictates of some governmental authority. They had created a land where anyone could come up with an idea or provide a needed good or service and make as much money as they could for as long as they could.

America needed a government that supported and nourished this new economic model. They knew they had the resources to become a mighty nation if they just could find the balance between freedom and regulation; but there had to be checks and balances. History had taught them that the Utopian dream of communal sharing of resources and responsibilities was a beautiful vision and a lofty goal; but one that always broke down in the face of human self interest. They reasoned that what they needed was a central government with strong but limited powers to ensure that there was fair trade between the states and protection from foreign influence and interference.

In the summer of 1787, delegates from all of the states except Rhode Island, met in Philadelphia for the purposes of discussing ways to fix the Articles of Confederation. They wanted to have a stronger central government with powers over foreign and domestic commerce. They also hoped to find an acceptable means for Congress to fairly and reasonably collect tax revenues from the individual state treasuries. Virginia lawyer, James Madison, was joined by New York banker, Alexander Hamilton, in convincing other delegates to scrap the Articles of Confederation and adopt a new constitution for a completely new form of government; a union of sovereign states under a central government of elected representatives – a federal republic. Madison’s motives were his concerns over the fragile bonds of the Articles; Hamilton’s motives, it turned out, were far more pecuniary in nature.

Alexander Hamilton was a member of the New York delegation along with State Supreme Court Justice Robert Yates and John Lansing, Jr., the mayor of Albany. Hamilton, the illegitimate son of a Scottish prodigal and a married French Huguenot woman, had been born into abject poverty around 1757 on the island of St. Nevis in the Caribbean. He had come to Boston in 1773, presenting himself as the grandson of Scottish nobleman John Hamilton and eventually landed in New York where he attended King’s College, now known as Columbia College. His intelligence, ambition and organizational talents led him to serve as Washington’s aide-de-camp during the war. He later distinguished himself in combat, attaining the rank of Colonel. Hamilton married Elizabeth Schuyler in 1780, the daughter of one of the wealthiest businessmen in New York. In 1784, he founded the Bank of New York, America’s oldest continuously operating bank.

The Man Who Would Be King

Hamilton was a man driven by a need for social status and a craving for Fame. He was an elitist who viewed the people of the American colonies as having “the passiveness of the sheep in their compositions” and unable to be roused from “the lethargy of voluptuous indolence.” He disguised his true disdain for his fellow citizens with an avowed mission to serve “the public good,” but held a firm distaste for anything parochial and regarded the “local attachment” to the interest of the states over that of the nation as undermining the American cause and his own ambitions. Management and control of his public image was a paramount obsession with Hamilton. Defense against a perceived slur was what eventually led to his untimely death in a duel with Aaron Burr in 1804.

On Monday, June 18, 1787, he rose in the Philadelphia convention to offer his opinions as to which direction the delegates ought to take regarding amending the existing Articles of Confederation. He spoke candidly because the candidates had passed a motion to conduct the convention in secret; however, James Madison was taking notes as an unofficial recording secretary. What neither Hamilton nor anyone else knew at the time was that Judge Yates was also recording statements almost verbatim, using a form of shorthand he had developed to record testimony before his court.

Hamilton supported scrapping the existing compact and writing an entirely new guiding document for the nation. Hamilton was “fully convinced that no amendment of the Confederation leaving the states in possession of their sovereignty could possibly answer the purpose.” Hamilton was a nationalist and an adherent of the mercantilist model of economics. His plan was for a strong central government that controlled the economy through a central bank.

Mercantilism is often confused as a preference of business and industry over agriculture. It is, in fact, the use of the government to fulfill ones personal objectives and self interest. In other words, if Goldman the Sockmaker becomes the favorite haberdasher of the king, then Goldman gets to make all of the king’s clothing. He also gets to produce all of the finery for the royal family, all of the clothing for the members of the court, garments for the castle servants, the uniforms for the king’s army and so on. All of the other tailors in the realm have to scramble for the leftovers. Mercantilism creates an elitist commercial monopoly which eventually corrupts the state bureaucracy and infuriates its citizens. America was founded and originally set up to expressly counteract mercantilism by diffusing power in such a way that there would be no place that a mercantilist entity could find a single patron with whom to curry favor.

Hamilton’s proposal would have codified the wealthy elite as the upper chamber of a bicameral parliament, elected the President for life and effectively transplant the English form of monarchy and mercantilism to American soil. There were even persistent rumors that he was involved in a conspiracy to actually establish a monarchy on America’s shores by installing the Duke of York, King George III’s son, to rule.

He was voted down by the convention. In fact, Hamilton’s continual machinations and backroom conniving so infuriated his fellow New Yorkers that Yates and Lansing left the convention in July, ethically negating Hamilton’s role at the convention. As was to be the model throughout his political career, Hamilton was never one to be hindered by what he considered to be minor technicalities. He wasn’t allowed to participate in further votes, but when the final resolution was drafted, Alexander Hamilton was one of the signers of the new Constitution. He also worked tirelessly to see that the nation’s new compact was ratified, writing 51 of the 85 Federalist essays that explained the new Constitution and have shaped interpretation of that document ever since. New Hampshire became the ninth State to ratify the new Constitution of the United States of America on June 21, 1788, and the new federal government began operations just eight months later.

George Washington became the nation’s first President in 1789 and his Cabinet consisted of just seven men. John Adams was Vice President, Thomas Jefferson was Secretary of State, Henry Knox was the Secretary of War, Samuel Osgood was the Postmaster General, John Jay was the Secretary of Foreign Affairs and the Attorney General was Edmund Randolph. Washington remembered his former aide and, on the recommendation of Robert Morris, named Alexander Hamilton as the first Secretary of the Treasury. Hamilton was considered to be one of the brightest candidates for the position despite the fact that he was self-taught in the law, economics and finance.

In his “First Report on the Public Credit,” delivered to Congress on January 14, 1790, Hamilton laid out a plan for the establishment of a properly managed but ongoing national debt as the vehicle for easy credit and prosperity for all. The federal government would assume all of the old debts of the Confederation in exchange for new government bonds paying 4% interest. He was convinced that the only path to success in any society was to tie the interests of the wealthy, the primary government bondholders, to the state in the belief that they would support his dreams of a larger, centrally controlled government. He maintained that his plan would restore land values, stimulate manufacturing, lower interest rates and “promote the increasing respectability of the American name.” This new scheme was widely endorsed by people all over the country who quickly exchanged their worthless Confederation notes for new Treasury bonds. He then introduced a series of tariffs and excise taxes in order to raise the revenue to back the bonds.

It was claimed to be merely an unfortunate coincidence of the day that the news of the payoff was slow to reach the nation beyond the city limits of New York, allowing many of Hamilton’s friends and relatives the opportunity to scour the countryside buying up old Confederation notes from unsuspecting holders for pennies on the dollar. Hamilton scoffed at those who raised questions of impropriety and arrogantly waved off their concerns stating that “how things are done governs what can and will be done: the rules determine the nature and the outcome of the game.” This philosophy became known as Hamiltonianism and underscored the policies and platforms of his newly formed political party, the Federalists. Continuing his campaign for “the common good,” he had the federal government assume the debts which the individual states had accumulated fighting the War of Independence.

The second nail that Hamilton drove into America’s free-market coffin came in 1790 with the establishment of the Bank of the United States. This was the nation’s second attempt at a central bank. The Bank of North America had been chartered by the Continental Congress in 1781 and was organized by Philadelphia merchant and Revolutionary War financier Robert Morris. By 1783, the Bank of North America had died an ignoble death under allegations of fraud and mismanagement; however, Hamilton convinced Congress that this new central bank was going to be different.

Thomas Jefferson considered Hamilton to be dangerously ambitious and raised the point that the Constitution did not grant Congress the power to create a bank or any other entity. With uncanny foresight, Jefferson wrote “To take a single step beyond the boundaries thus specially drawn around the powers of Congress, is to take possession of a boundless field of power, no longer susceptible of any definition.”

Hamilton countered in his Opinion on the Constitutionality of an Act to Establish a Bank that “principles of (Constitutional) construction like those espoused by the Secretary of State (Jefferson) and the Attorney General (Edmund Randolph) would be fatal to the just and indispensable authority of the United States.” Then Hamilton delivered the estocada, or ‘death blow’ to the free market economic model. He claimed that the Constitution “implied” power to the federal government by the very fact that the government was sovereign and had the right to assume any power it needed to perform its duties as a sovereign entity.

“It is not denied,” argued Hamilton, “that there are implied as well as expressed powers and that the former are as effectually delegated as the latter.”

In one swift and deliberate motion, the concept of limited government was tossed out the window and the new government assumed the authority to do nearly anything it wanted.

This plan was opposed by Thomas Jefferson, James Madison and others as a concentration of economic power in the hands of the central government, and more specifically, in the hands of Alexander Hamilton. The proposal was defeated in Congress five times before Hamilton and Jefferson struck a deal. Hamilton agreed to support Jefferson and Madison’s plan to move the nation’s capital out of New York to a new, centrally-located national capital city which they had planned in northern Virginia. His price was their support of his central bank plan. Jefferson didn’t believe the Congress would ever approve Hamilton’s blatant grab for federal power, so he agreed to Hamilton’s offer. Because of the way he had doled out the advance notices for funding and paying the government bonds on the war and old Continental debts, Hamilton knew he had the votes he needed to get his bank charter through Congress. Thus was Washington DC created, as well as the establishment of the perpetual debt of the federal government and its ability to use taxation policies to affect political policies and social agendas.

On February 24, 1791, Washington signed the bill chartering the Bank of the United States and formalizing the principle of implied powers for Congress. The new American economy was quickly introduced to boom-bust business cycles as the federal government borrowed, spent too much and then printed money to cover its shortcomings. Between 1791 and 1796, price levels jumped 72%.

Hamilton wasn’t finished defining the new government to his own specifications. He had one more act to fulfill his dream of a New Britain; the federal government had to function in the mercantilist model, centrally controlling the economy and involving itself in every aspect of the citizen’s daily life. In December of 1791, he submitted his magnum opus to Congress, The Report on Manufactures. This report was in response to a request from Congress for Hamilton’s opinion on “the means of promoting such as will tend to render the United States, independent of foreign nations, for military and other essential supplies.”

In the first few paragraphs, Hamilton acknowledged the commonly held notion that “it can hardly ever be wise, in a government, to give direction to the industry of its citizens. This, under the quick-sighted guidance of private interest, will, if left to itself, infallibly find its own way to the most profitable employment: and it is by such employment that the public prosperity will be most effectually promoted. To leave industry to itself, therefore, is in almost every case the soundest as well as the simplest policy.” This is commonly referred to as a laissez-faire economic model in which transactions between private parties are free from excessive government interference in the form of regulations, taxes or tariffs.

Hamilton then proceeded for 26,000 words; laying out a detailed economic policy that not only decidedly opposed a laissez-faire economy, but was firmly rooted in English mercantilist principles. He went into exhaustive detail listing the specific industries that the government should promote and outlining the instruments the government could use to exercise economic control over these favored industries. Tariffs and bounties were to become the weapons of choice in Hamiltonian economics.

His grand ambition blinded him to one small truth; government bureaucrats have no way of knowing which enterprises will thrive and which won’t. They are usually operating on nothing but theoretical knowledge and supposition; they have no skin in the game and often have little accountability for the mistakes that they make.

I have no dispute with the historical portrait of Alexander Hamilton as an intelligent and articulate man who had a smooth way of ingratiating himself with the affluent and powerful; however, the portrait of him as a Champion of Freedom and Liberty simply isn’t true in the looking glass of historical investigation. He was an ambitious and arrogant nationalist who held the notion of individual sovereignty in contempt. He was more than willing to rewrite historical fact to prove his point. On June 29, 1787, he put forth the argument that the citizens of the states had never been sovereign and that the states themselves were merely “artificial beings” that had nothing to do with the creation of the union. This statement revealed an illogical sense of reality in the mere fact that the Constitution which created the national government had to be ratified by the individual states, each of them choosing to voluntarily enter into a compact with each other for the purpose of “forming a more perfect union.”

The Hamilton Legacy

When Thomas Jefferson became President in 1800, he rolled back or eliminated many of the taxes and tariffs that Hamilton had encouraged. The charter of the Bank of the United States was allowed to lapse in 1811 under James Madison, but Madison was forced to charter the Second Bank of the United States due to the debts incurred by the War of 1812; a war ignited, coincidentally, by the mercantilist policies of Britain.

Hamilton’s legacy was further codified in 1819 when Chief Justice John Marshall, a Federalist and self-described admirer of Hamilton, ruled in McCulloch v. Maryland that the word “necessary” in the necessary-and-proper clause of the Constitution didn’t mean “indispensable,” but instead meant “appropriate;” almost quoting Hamilton verbatim in the ruling. Marshall had also concocted the power of “judicial review” in his 1803 ruling in Marbury v. Madison that was based largely upon Hamilton’s inferences in Federalist No. 78; that “the authority which can declare the acts of another void must necessarily be superior to the one whose acts may be declared void.”

President Andrew Jackson became so incensed by the loose credit policies and the currency manipulation of the national bank that he made it his personal mission to return the nation to hard currency. This caused the Depression of 1837 and a twenty-six year period known as the “Free Banking” Era during which the money supply and price controls fluctuated wildly, causing many banks to last no more than five years.

Abraham Lincoln invoked Hamilton’s thesis on the unlimited power of the federal government when he prosecuted the wholly unnecessary and antithetical military action against the states that chose to secede from the Union which they had voluntarily entered just seventy-four years earlier. Lincoln then used Hamiltonian reasoning to pay for his $3-billion War of Northern Aggression by initiating a federal income tax civil and signing into law the Legal Tender Act of 1862. This legislation gave the federal government the power to print a national paper currency. The accompanying National Bank Acts of 1863 created a series of national banks which issued the “greenbacks,” a fiat currency backed up by Treasury securities. It also created the Office of the Comptroller of the Currency and charged him with regulating the banks and controlling monetary policy.

Thomas P. Kane, former Deputy Comptroller of the Currency from 1886 until 1922, believed that a system was necessary that offered the advantages of a centrally controlled currency, but had none of the inherent opportunities for political favoritism and malfeasance that had been the bane of the Bank of the United States. In his comprehensive history of banking entitled “The Romance and Tragedy of Banking” (Bankers Publishing, 1922), he noted that there may have been too much optimism for the National Bank Act because “… history teaches us that the public faith of a nation alone is not sufficient to maintain a paper currency. There must be a combination between the interests of private individuals and the government. ”

According to Kane, the first of four major bank panics during the forty year National Banking Era occurred in 1873 and was caused by New York bankers manipulating the Stock Exchange by “creating and fostering the fictitious valuations attained at home and abroad for railroad and other corporate securities…”

The Congress had been so anxious to have a transcontinental railroad that they employed Hamilton’s tactic of bounties in the Pacific Railroad Act of 1862, creating political entrepreneurs like Thomas Clark Durant. They chartered the Union Pacific Railroad to head west from Iowa and the Central Pacific Railroad to head east from San Francisco. For each mile of track they laid, they were given twenty sections of land and loans ranging from $16,000 per mile across flat prairie to $48,000 per mile in mountains. Nobody in the federal government thought to have oversight on the project, resulting in massive waste and corruption. Union Pacific ended up defaulting on $16-million in government loans which sent the stock market into a tail spin.

Fortunately for the nation, for every political entrepreneur who needed government financial grants or guarantees to launch their business, there were more market entrepreneurs who saw a need and invested their own capital and sweat equity to come up with a solution. This was the entrepreneurial spirit that had launched America and had seen it through its growing pains. By the first decade of the Twentieth Century, it appeared that it had returned in full force. Nearly 20,000 banks had been opened and over 80% of them were not national banks. What was even more alarming to the tight-knit banking fraternity in New York City was that these upstarts held more than half of the nation’s deposits, were maintaining a healthy balance between debt and savings, were not exceeding the reserve limits based on the gold and silver that they held and were making profits! Even the federal government was using its stockpile of gold to redeem its bonds and was reducing the national debt. To the Ivy League disciples of Hamilton’s principles of perpetual debt, this was sacrilege.

The Panic of 1907 was “officially” caused by a failed attempt to corner the copper market and led to a two week period of bank runs and a near collapse of the stock market. Historical anecdotal evidence points to the crisis having been ignited when J.P. Morgan published rumors that the Knickerbocker Trust Company was insolvent. Whatever the true cause, the Panic prompted Congress to create the National Monetary Commission. The Commission, led by Republican U.S. Senator Nelson Aldrich of Rhode Island, spent $300,000 for a year long fact-finding tour of Europe to study European central banking methods and monetary policy. That is the equivalent of $20.2 million dollars today. The visible result was a 30 volume report on the history of banking in Europe that was designed to make the American people think that the issue had been well researched. Not as visible was the process used to draft the legislation that was to finally and permanently bring Hamilton’s dream to reality.

What relevance does the nation’s first Treasury Secretary have today? He has become the patron saint of those who worship at the altar of Big Government and eternal deficit spending. Robert Rubin, the former Goldman Sachs Co-Chairman and U.S. Treasury Secretary during the Clinton administration, has started a forum to honor Hamilton and to further his philosophy of government and economics. “The Hamilton Project” is under the auspices of the Brookings Institution, a liberal think tank based in Washington, DC. The stated philosophy of this new venture is “long-term prosperity is best achieved by fostering economic growth and broad participation in that growth, by enhancing individual economic security, and by embracing a role for effective government in making needed public investments.”

It is a fitting tribute to Hamilton, the man who created the system that made it all possible. Unfortunately, the phrase “broad participation” doesn’t mean that there should be a sharing of the economic growth by a greater number of Americans. You must remember, this is banker-speak. The correct interpretation is finding a wider assortment of ways for the banksters and the federal bureaucrats to appropriate the fruits of that economic growth for their personal aggrandizement. Rust never sleeps.

Sources

i McDonald, Forrester, Alexander Hamilton: a biography (New York: W.W. Norton & Company, 1979), p. 4.
ii Ibid, p. 19.
iii Madison, James, Notes of Debates in the Federal Convention of 1787, (New York: W. W, Norton & Company by arrangement with Ohio University Press, 1840), Pg. 129.
iv Chernow, Ron, Alexander Hamilton (New York: Penguin Press, 2004), p. 237.
vDiLorenzo, Thomas J., Hamilton’s Curse: how Jefferson’s archenemy betrayed the American revolution – and what it means for Americans today (New York: Three Rivers Press, 2008), p. 45.
vi Alexander Hamilton: First Report on the Public Credit (Chicago: Encyclopedia Britannica, 1982) Annals of America, Vol. 3, pp. 407 – 415.
vii McDonald, p. 123.
viii Kroos, Herman E., ed. Documentary History of Banking and Currency in the United States (New York: Chelsea house, 1983), vol. III, pp. 147-48.
ix Chernow, Ron, p. 354.
x Gordon, John Steele, Hamilton’s Blessing: The Extraordinary Life and Times of Our National Debt (New York: Penguin, 1997), p. 29.
xi Rothbard, Murray N., A History of Money and Banking in the United States: The Colonial Era to World War II (Auburn, Alabama: Ludwig von Mises Institute, 2002), p. 69.
xii Lowrie, Walter and Clarke, Matthew, eds., American State Papers, Documents, Legislative and Executive, of the Congress of the United States, etc. etc., (Washington DC, 1832), Volume V, pp. 123-144.
xiii DiLorenzo, p. 103.
xiv DiLorenzo, p. 26.
xv Chernow, p. 355.
xv Kane, Thomas P., The Romance and Tragedy of Banking, (Boston: Bankers Publishing, 1922), p. 6.
xvii Ibid. p. 47.
xviii Folsom Jr., Burton W., The Myth of the Robber Barons, (Herndon, Virginia: Young America’s Foundation, 2010), pp. 18-19.
xix Kolko, Gabriel, The Triumph of Conservatism, (New York: The Free Press of Glencoe, a division of the Macmillan Co., 1963), p. 140.

Tagged:

Wreckonomics: America’s Fiscal Policy in Action

By:


“The Moment of Truth” is upon us or so proclaims the title of the report issued by the bi-partisan National Commission on Fiscal Responsibility and Reform. The report correctly identifies the fiscal mess we now find ourselves: deficit spending that is unsustainable and entitlement programs that can’t possibly keep their promises without massive tax increases. To the Commission’s credit, its proposals likely would find broad support from economists. But for political reasons, little or nothing is likely to be done, at least until a crisis develops. The same factors that put us into this mess are the ones blocking reform: politicians prefer policies that provide benefits now and costs later. The Commission’s proposals would do just the reverse.

The behavior of politicians reminds me of a personal experience with a troublesome bear in Minnesota. The big bear appeared at my cabin porch one day drawn by aromas of some steaks cooked the night before. The bear tried to enter the cabin by rearing on its hind legs and trying to push in windows and doors. Finally I resorted to banging pots and pans to drive the beast off, but not before he knocked over a few things in the yard. I called the Department of Natural Resources to report the bear. I had hope of getting someone to come out to move the bear further into the wilderness. The DNR officer asked me to explain what had happened. After doing so, the officer said: “So he was just doing bear things?” It was obvious the DNR was not riding to the rescue.

Politicians are a lot like bears in that they just do “politician things.” It is just the nature of the beast. To get elected, successful politicians know that they must provide benefits to constituents who can provide votes and/or money. These constituents are usually members of special-interest groups who receive substantial individual benefits while costs get dispersed over a large numbers of taxpayers. Some years back, a study on the milk-price support program showed the program raised milk prices about a penny per quart. Benefits to the milk producers were in the hundreds of millions of dollars. Few government programs can stand up to a rigorous benefit-cost study. Far too frequently, the benefits of the programs are less than the costs to taxpayers.

The “cash for clunkers” program in 2009 provides a nice illustration. Billed as a program to help save the environment and put autoworkers back to work, the government gave people with “clunkers” up to $4500 to trade in their old vehicles for new more fuel efficient vehicles. The “clunkers” that were traded in had to have their engines and transmissions destroyed. I and a fellow economist, George Parsons, put the clunker program under a cost-benefit analysis and concluded that for every $4000 spent by taxpayers there was a $1,000 net loss in value, even after including environmental benefits. Imagine a private business that took $4000 worth of inputs to produce a product worth $3,000. How long would this business survive? But politicians seem to flourish.

On a much larger scale, the Medicare, Medicaid and Social Security systems already have provided or promised benefits far in excess of any reasonable ability for us to pay for them. Economists have estimated that, if these programs were actuarially sound, they would have amassed an additional $60 trillion or so in financial assets. One prominent economist and past President of the St. Louis Fed has said that the future tax rates needed to finance these programs with their current promises would “produce tax rates inconsistent with a market economy.” Obviously promised benefits are going to be cut, but which politician is going to step up to the plate? It likely will require a monumental crisis before a solution is seriously sought.

Is there any way to improve government governance? This is a key question, but one with no easy or obvious answers. Improving government governance is arguably even more difficult than improving corporate governance. I’m working with a colleague on a book and we plan to explore some possibilities. But don’t expect any magic solutions.

Transcript of Research Presentation given on February 24, 2011 at the New York Historical Society

Tagged:
Page 12 of 13
1 10 11 12 13