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September 18, 2008

What the World Needs Now...
by Adrian Ash

"...Monetize labor, monetize stocks, monetize the farmers, monetize real estate..."

DAMNED IF THEY DO, damned if they don't, politicians the world over are looking pretty sheepish right now.

Nationalizing failed banks, mortgage lenders and insurance firms hardly makes for a strong election pitch. It won't do much to coax fresh risk capital into shoring up financial balance-sheets, either.

But letting them fail would only look worse.

"The Fed and Treasury have not yet provided a panacea, but merely avoided another imminent disaster," reported BCA Research on Wednesday. That was before the Treasury recapitalized the Fed's balance-sheet with an extra $100 billion...just in time for the Fed to lead the world's big central banks in pumping $242bn into the US and European money markets.

Sure, that quarter of a trillion dollars helped talk inter-bank lending rates down off the window ledge. But for the third time this week, government action failed to stem losses in financial stocks. Because "they have not yet found a fiscal solution targeted at ending the underlying rot," as BCA goes on - "i.e. putting a floor under the housing market and economy.

"Congress is now starting to consider a system-wide solution (similar to the Resolution Trust Corporation) but any initiative may have to wait for the next administration."

And the next administration won't be short of policy prescriptions to choose from. No one is, in fact.

"Don't pay too much attention to the financial sector's self-interested bleating. Protect public interests first," urges Martin Wolf in the Financial Times. Dishing out four do's and four don'ts for the UK government on Thursday, he must be a different Martin Wolf from the economist writing in the Wednesday FT - even though they've both got a plan.

"Governments cannot credibly promise to wash their hands of a financial breakdown," wrote the doppelganger. "This is the lesson of at least a century of financial history."

So what to do? "An enormous Resolution Trust Corporation-style approach for the banking and securities system may be required," says Bill Clinton's former deputy Treasury secretary, Roger Altman - also in the FT - even though "the cost to taxpayers would be huge."

How huge? "American will need a $1,000bn bail-out," says Kenneth Rogoff, ex-head of the International Monetary Fund (IMF), yet again in the Financial Times. "Regardless of the Fed and Treasury's most determined efforts, the political pressures for a much larger bail-out [up to $2,000bn] are going to be irresistible."

And the details exactly? "Instead of investors relying on the guarantees provided by insurance companies and taking comfort from the work of the ratings agencies," reckons Tim Congdon - a former "wise man" on the UK Treasury's panel writing in (you guessed it!) the FT - "the credit assurance should come from the banking industry itself. At least two strongly capitalized and well-regulated banks should provide a guarantee that, in the event that the issuer of a bond defaults, they would cover the deficiency."

But wouldn't that simply swap relying on, say, AIG or Ambac for ultimate guarantees to relying on...well...relying on whom exactly? Congdon and his co-prescriber Brandon Davies, a former treasurer of Barclays bank, don't say which banks can clear this "well capitalized, well regulated" hurdle just now. But never mind; they'd actually rely on the Fed or Bank of England standing behind the entire system anyway.

"The task of assessing banks' capital strength and balance-sheet qualities could lie with the central bank and an appropriate regulatory agency, as at present," Congdon and Davies explain. "Once the guaranteed securities could be transacted freely and readily with central banks, liquidity would quickly return to the wholesale markets."

This assessment role would differ from today's model how exactly? The Fed and the FDIC...the Bank of England and the FSA - these dynamic duos judged banking balance-sheets and capitalization amid the greatest mis-reading of risk in history.

And that "free and ready" trading of rated securities; it would mark a change from current practice in what way precisely? The developed world's six largest central banks swapped $242 billion-worth of liquidity (i.e. government bonds) for system-approved securities on Thursday morning alone.

Yet the FTSE100 in London still ended the day 0.7% lower. The S&P slipped into the red to stand almost one-tenth below the start of September.

Oh, for the old days of certainty and clear thinking! "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate..." Those were the days! Policy wonks like Andrew Mellon - US Treasury secretary between 1930-33 - knew how to deal with a debt-led depression. None of these namby-pamby rescues, bail-outs or weasel-worded "conservatorships". Let the whole thing go bust! Teach 'em a lesson they'll never forget!

"Purge the rottenness out of the system [so that] values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

Trouble was, of course, Mellon's shock-and-awe plan was too shocking by half for the half-democratic United States of the early '30s. Britain had already tried the same tack of abject collapse...putting three million people out of their jobs by 1926 and risking a true revolution before finally admitting defeat - and abandoning the Gold Standard - ready to start reflating for growth even as Mellon spoke out.

Seven decades later, the long shadow of dole queues and soup-lines still darkens the way for today's politicians. The mere mention of 1929 or Austria's Credit Anstalt also shines a torch to the exit, however.

"Debt retirement which is financed by money creation is an appropriate anti-deflation measure," as Nobel-prize winning economist James M.Buchanan explains in his Public Principles of Public Debt. "This may be called debt monetization."

Sounds intriguing, professor! Tell us more before we call Ben Bernanke...

"Debt instruments are replaced by money," he explains - which is already happening today. Three-month US Treasury bonds are now yielding precisely nothing, making these "near-cash" items so near cash you could roll them up to light your cigar. And you can see how the loans of T-bonds now being made by the Federal Reserve against mortgage-backed bonds, stock-market equities and all investment-grade debt does just what "debt monetization" requires:

Central banks are swapping weak debt for cash. Bingo! The bad debt has vanished. Or maybe not. Maybe it's just been dumped onto everyone else - consumers, savers, investors and business. But hey! A problem shared if a problem halved. And with $1,000bn-worth of trouble still due on Ken Rogoff's best guess, would $900,000 of debt monetization per household really prove something to fear?

"Liquidity is increased, and spending will be encouraged," Buchanan goes on. Or at least, that's what theory would claim. It certainly looks like a way to fend off debt deflation...and make good on Ben Bernanke's promise of avoiding a repeat of the Great Depression. Albeit at the cost of rampant inflation in your cost of living. But fact is - or so everyone says - the money supply needs to leap to redeem the banks' losses.

"Monetize labor, monetize stocks, monetize the farmers, monetize real estate..."

Got a certain ring to it, don't you think?

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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