Explaining American Finance … because we have a Responsibility to Understand it

DON’T DO IT!  Don’t depend on supposed “experts” for your opinions about America’s financial system. Here’s why:  we have the most successful currency and economy the world has ever seen; but it doesn’t run on auto-pilot.

And the stakes have never been higher… The world economy has never been so globalized, so complex. If we fail, dozens of competing economies are standing by, ready to exploit our missteps. Ultimately, we will either master the game before us and flourish, or apathetically flounder. Success requires choosing awareness and involvement over ignorance and complicity…  Here are some critical things we all need to understand:

We’re All Motivated by the Same Things

What some call “greed,” others call “maximizing returns and responding to incentives.” Considered the latter way, perhaps Wall Street protagonist Gordon Gecko was right: “Greed is good.” In any case, it’s certainly a natural impulse, right along with our innate sense of competitiveness.

Whenever we taste a little success, “animal spirits” arise within us that cry out for ever-higher achievement. And these cries seem to awaken kindred spirits in people around us. A wave of contagious overzealousness often ensues, leading some to take dangerous levels of risks, become disdainful of rules and morals, rationalize away rationality, and embrace a sense of entitlement to success, an entitlement that subsequently triggers manic, irrational responses to loss. In the end, “irrational exuberance,” like a charging herd of bulls, ends up breaking things and wasting resources.  “Malinvestment” ensues – the misallocation of land, labor, and capital.

Greed however only resides on one half of the spectral spectrum. “Fear” haunts the other half:  People generally scamper away from defeat much more quickly than they chase success. And when things get dicey most prefer to retreat into their proverbial shells until someone else ventures out and shows them things are safe again. It’s this reflexive trepidation that sometimes takes down whole economies…overnight.

The Modern Economy is here to Stay

Market capitalism is only a few centuries old, and it’s been the greatest force for good that mankind has ever experienced. Today, every single country has a central bank – the global economic system is here to stay. But, we’re still learning how to manage it, and we undoubtedly have more to learn... Recently, the Great Recession of 2007-2008 taught us some hard lessons. The question now is how well we’ll use what we’ve learned…

We have to pay attention, because the dollar’s value lies solely in our hands. It’s based upon the relative attractiveness of the Dollar Economy. Arguments about returning to a gold standard are really just Libertarian “code” for wanting to defund America’s “interventionist” foreign policy along with her “excessive” social welfare programs – discussions worth having separately, but not in the context of an idea that would destabilize our economy and endanger our prosperity (Money, Gold, & the American Way).  

The Fed's System is Brilliant…in the Right Hands

In 1907, the Knickerbocker Trust company, New York City’s third largest bank tried to buy a controlling share of the world’s copper supply so it could subsequently control prices. It tried to “corner the market.” It kept buying copper and driving prices up. But alas, Knickerbocker ran out of money before the world ran out of copper… And when their scheme became apparent, copper prices rapidly returned to baseline, and Knickerbocker went under, triggering a financial system meltdown because of all the money it owed to other banks that it could no longer repay. A nationwide “run” on banks ensued, impelling many to simply close down…and wait.

Fortunately, J.P. Morgan stepped forward and became an American hero. He invited his “friends” over for dinner one night and locked them in his dining room until they all agreed to loan every vulnerable bank enough money to stem the “Panic of 1907.” Duly impressed, six years later, Congress created the Federal Reserve System to fill the shoes of J.P. Morgan & Friends thereafter.

The Federal Reserve gets its capital by requiring its member banks to buy “shares” in it at a formulated percentage of their current deposits and liabilities. About 3,000 banks belong to the Federal Reserve System, representing over 75% of the nation’s deposits. The Fed is an independent agency of the U.S. government (like the EPA or the GAO) that serves as our national banks’ bank – regulating them, clearing their checks, and providing them with short-term, “administrative” loans.

The Fed also issues “Federal Reserve Notes” – today’s dollar bills – and attempts to match the supply of dollar bills with worldwide dollar demand. Fed dollars are backed by U.S. Treasury Bonds that the Federal Reserve acquires from lending money to the U.S. government (USG). Fed dollars are perfectly legitimate as long as a “real” Treasuries market exists. So long as U.S. investment funds, China, and Saudi Arabia, etc. are purchasing Treasury bonds right alongside the Fed, then the Fed’s Treasuries have value too.

The day the Fed becomes the last one loaning the USG money is the day the dollar is done….

The Fed controls U.S. money supply by manipulating both the “Federal Funds Rate” – the rate Fed banks charge each other for overnight loans – by increasing or decreasing its purchases of Treasuries, and the "Discount Rate," the interest rate it charges member banks for short-term loans they use to mitigate exceptional fluctuations in their daily withdrawal levels. It also has a “divine-like” power to expand member bank loan portfolios by “key-stroking” money to them that didn’t previously exist (minus their reserves percentage) whenever those banks want to add new qualified loans to their portfolios… The banks’ new money appears – literally – out of nowhere. Then, when the banks’ loan portfolios shrink (because their customers pay down their loans), the Fed gets repaid, and the banks get their reserves back. Finally, with a second key-stroke, the Fed sends the money that the banks returned to it back into oblivion… Pooff – it’s gone!  

Lately, the Fed has also been purchasing extra Treasury bonds and USG-backed mortgage securities on the open market as a means of keeping mortgage interest rates low and encouraging people to “come out of their shells and invest in the stock market.” Subsequent profits are turned over to the U.S. Treasury minus monies to pay a roughly 1% annual dividend to member banks and fund the Fed’s operations. Fed governors earn the same salary as congressmen – the Chairman earns a little more. Nobody receives additional commissions.

Since profits get returned to the USG, governmental borrowing is essentially cost-free, as long as it doesn’t spike U.S. inflation, in which case then the borrowing is paid for by “snipping” a little bit of purchasing power off of everyone’s dollars….

The Fed tailors its actions around dual objectives of keeping inflation in the range of 2.0-2.5% and national unemployment below 6.5%. It’s a really cool system, as long there are lots of oversight, transparency, and smart people at the helm who really understand – and, dare I say, “Love,” – the U.S. economy.

Question “Experts” – Make up your own Mind

We have to know what’s going on ourselves because too often “experts” let us down. They are notorious for relaxing their critical thinking skills once they’ve gotten a few predictions right... And too often, they’re just plain wrong:  Before 2008, experts told us over and over again that houses were an investment, which was certainly true when you’re in the midst of a real estate bubble… But for the past century, the best that can be said about average housing prices is that they’ve managed to keep up with the inflation rate.

Sometimes experts blow the call:  Incompetent credit rating agencies, for example – Moody’s, S & P, and Fitch – brought the 2008 Financial Crisis upon us by completely bungling the task of assessing the risks of collateralized debt obligations (CDO’s). CDO’s are a means of bundling mortgages and reselling them to investors who can choose their own preferred level of risk because the mortgages are re-sorted into “tranches” that are classified by their respective underlying net risk. But ratings agencies grossly underestimated the riskiness of mortgage-backed CDO’s all across the board by misjudging the high degree to which mortgage defaults are inter-connected; it turns out they’re more like dominoes than individual coin flips...

This misinformation led AIG to insure hundreds of billions of dollars worth of overrated CDO’s against default (credit default swaps – CDS’s), assuming risk levels it couldn’t come close to covering when reality bit the company in March, 2008. And when you can’t pay your clients off, then you haven’t really assumed any of their risk. Overnight, Goldman Sachs lost $20 billion. And since CDS’s aren’t traded publicly, nobody knew how much exposure their fellow banks had to AIG’s default… So they stopped lending each other money altogether. Fortunately, we had the Federal Reserve on guard to “unlock” the financial system and prevent another Great Depression… Eventually, taxpayers even made a profit on AIG’s bailout … but this was no way to run an economy.

Finally, government officials are a “special class” of experts worth considering… Cognizant of Fear’s devastating effects, they sometimes whitewash bad news, because they know how quickly one of their less-than-rosy statements can single-handedly stall an economy and send it into an exaggerated, fear-driven tailspin...sometimes overnight. That’s why it’s so important for you and me to be able to judge things for ourselves.

Public Policy is what prevents Crises

Financial crises don’t have to happen…  There are countries such as Canada, with well regulated and supervised financial systems, where these things don’t occur. It’s not that Canadians are more moral, or less greedy, or more competent. They just get regulation “right” – not too much, not too little, and focused in the right areas.

Human nature is universal. Absent controls, it leads to excesses – the Law of the Jungle…  Thoughtful, well-informed public policy is what prevents crises.