Liquidity Won’t Help Insolvency

Dec 12, 2007 – The Federal Reserve today announced a new scheme to inject more liquidity into the money markets. It cobbled together a partnership arrangement, as the Canadian, UK and European central banks also agreed to participate in the scheme.

The process of ‘injecting liquidity’ is a euphemistic way of saying ‘creating money out of thin air.’ The Federal Reserve doesn’t need a printing press to do this. They simply create a book entry on its balance sheet, and presto, $40 billion (or whatever amount they deem appropriate) of new ‘money’ is created, which the Fed then lends to those bankers coming to it hat in hand.

Creating money this way is a barbaric process because it further debases the dollar, but is hailed by the banking insiders and their apologists as a brilliant maneuver to fight the worsening liquidity crunch. Of course it is a view of those with vested interests, and bluntly, is just their selling pitch to the masses. It is a view so horribly misguided these insiders obviously realize it is wrong. They must know that the problem impacting banks today is insolvency, not liquidity.

Years of reckless credit expansion are coming home to roost. The boom is over, and since this past summer we have been in the bust, which is worsening day-by-day. Solvency is a problem of asset quality, not access to sources of funding. For example, Citibank didn’t have any trouble raising $7 billion of funding from a sovereign wealth fund at the right price, which was 11% – a rate far above the rates Citibank is paying to its depositors. This 11% rate reflects the risk of dollar inflation and the risk that Citibank has a lot of bad loans and other inferior assets on its balance sheet that will never be repaid.

There are gaping ‘black holes’ on the asset side of bank balance sheets. These black holes cannot be filled by creating money out of thin air. These black holes were created by assets that have ‘disappeared’. In other words, bank balance sheets are loaded with assets that are not worth what they once were, or in the worst possible case, no longer have any value at all. The bank liabilities remain, but their assets have been reduced. If this gap is larger than bank capital, then bank solvency is called into question, and that is the process now being evaluated by the markets.

Even though they have already announced countless billions of write-offs, banks have a long way to go in toting up their total losses. They face a daunting task. Many – but in reality, probably most – of their assets are impossible to value.

Sub-prime paper no longer has a functioning market to provide even a nominal market price for these assets. As economic activity slows and unemployment rises, people who the banks now believe to be good borrowers will increasingly default on their loan obligations. For example, The Wall Street Journal reported on December 6th: “First came housing loans and the subprime-mortgage crisis. Now, signs of stress are creeping into another key consumer area: auto loans. Delinquencies in the auto-loan market are ticking up to their highest level in several years.”

The economic boom-to-bust cycle caused by bank lending and their subsequent credit contraction is not rocket science, nor a startling revelation. The last banking bust occurred in the late 1980s and early 1990s. Before that, a much deeper bust occurred in 1973-1974, and it more closely mirrors the severity of the way the present bust is developing. Here’s how Ludwig von Mises described the process nearly one-hundred years ago, making clear the inevitable destruction of fiat currency from inflation.

“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services … at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people … who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and … increase their cash holdings.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time … the things which were used as money are no longer used as media of exchange. They become scrap paper.”

And scrap bank accounts. While paper was the predominant form of currency in Mises time, today bank deposits moved around by check, plastic cards and wire transfer are a much more significant form of currency than paper.

Given this new market intervention scheme announced today by the Federal Reserve, it is reasonable to ask, where else are central banks intervening today? It seems clear that they are capping gold, and I would not be surprised to learn about huge central bank sales taking place today when they get around to reporting it a few weeks from now. With new dollars being created with abandon, crude oil climbing back above $92 and the Commodity Research Bureau Index climbing to another record high, why is gold so quiet?

GATA knows the answer, and so does everyone else who has been following GATA’s work, which is available free at the GATA website, www.gata.org In another barbarous market intervention, central banks are obviously capping the gold price, but that creates a wonderful opportunity to buy more gold bullion and get rid of overvalued dollars, dollars that continue to be debased and inflated. Gold is much lower today than it would be if central banks weren’t capping its price. So use this opportunity to continue accumulating physical gold bullion.