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The Unbalanced Relation between Wall Street and US Government

Posted on: March 13, 2011

To anyone paying the slightest bit of attention, these remain very uncertain and trying times. On one side of the intellectual divide are the folks who are counting on deflationary forces overwhelming the normal credit-operated machinery of modern life, resulting in an implosion of economic activity. On the other side are those counting on hyperinflation as the most likely outcome of the grand printing experiment currently being conducted across the globe with its epicenter located within the United States.

In the middle of the intellectual divide are people like me, who are leaning slightly towards one view or the other. Not yet committed to any particular outcome, they are tensed and ready to spring in whichever direction necessary, like the last kids left standing in a game of dodge ball.

Some are expecting an imminent recovery (whatever that means), some a long, slow grind downwards, and others a rapid, if not chaotic, plunge into new and unwelcome territory of one sort or another.

There are no right or wrong views here. All sides are on equally firm intellectual standing. However, I want to let you know why it is that I lean towards the inflationary line a bit (okay, a lot, by some people’s standards) and why I think that a wide-scale, final fiscal collapse is in the cards.

More than a year ago I wrote an article entitled The Sound of One Hand Clapping, in which I framed the recovery in terms of bent rules, as opposed to what should be happening.

[Despite the bursting of a massive credit bubble,] everything just keeps perking along. What gives?

The answer, I believe, requires us to ask a Zen-like question along the lines of, “What is the sound of one hand clapping?” That question is, “If nobody recognizes a defaulted debt on their balance sheet, does it exist?”

Suppose, for the sake of argument, that there is a world in which banks are allowed by their regulators to pretend their default losses simply do not exist. And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.

What does “deflation” mean in such a world? Not much, as it turns out. At least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.

This is the world in which we currently live. Trillions in probable and provable losses quietly exist, out of sight, on the balance sheets of the Federal Reserve and other financial institutions. If they ever come out of hiding and onto the books, I think the deflationists will be proven correct beyond all doubt.

But let me ask this: What prevents the authorities from simply storing them out of sight forever? Or at least long enough to allow the wave of liquidity to work its inevitable magic? So far, much to my great surprise, they’ve managed to do exactly that, with hardly a squeak from the mainstream press (although the blogosphere is on the job, as usual). I am now wondering if they cannot keep this up indefinitely.

While I certainly took some heat from the deflation camp for these comments at the time, my words herald almost exactly what has happened since then. Losses have been ignored, the Fed has dedicated all of its efforts toward repairing bank balance sheets, and nothing really bad has happened to the financial system. Yet.

With the recent revelation that the Fed engaged with companies and banks headquartered here, there, and everywhere in over 21,000 separate transactions totaling $1.5 trillion dollars, in a successful effort to prevent bad investment decisions from turning into a series of cascading defaults, I think it’s safe to say that what should have happened (i.e., deflationary defaults) didn’t happen.

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