Tag Archives: bank funding

Why Short-Term Interest Rate Management is Harmful to the Economy: The Unseen Funding Dynamic

Ben Bernanke Testimony
Pondering the folly of Short-term interest rate management

7/1/2013 Portland, Oregon – Pop in your mints…

There are days when things are muddled and days when things are so painfully apparent it disturbs us that we did not happen upon it sooner.  Today is one of the latter.

We have been pondering the failure of centralized planning.  While the evidence is clear that centralized planning is a failure, pointing to the reasons why can prove elusive.  The same holds for our working theory that in order for the activities of mankind to be in balance with the natural world, the monetary premium, a concept that is commonly referred to as money, must be affixed to the natural realm.

Today, a revelation regarding the problem with fixing short-term interest rates (or any interest rate for that matter) came upon us which we will share with you now.  We believe that the revelation deals with both the problem of short-term interest rate fixing as well as the larger issue of the placement of the monetary premium, for the two are linked.

The revelation is the following:  Imagine you are a banker who needs to fund a loan.  In order to fund this loan, you would presumably need to have the money available with which to fund it.  This is simple logic, however, in the real world of banking, the decision of whether or not to fund a loan is completely disconnected from the availability of funds, which is primarily determined by the overnight funding markets which, in turn, are completely reliant upon short-term interest rates.

In a world that followed the rules of financial physics, the short-term interest rates would be completely dependent upon the availability of funds in the system.  However, the centralized management of interest rates makes this critical data point, which would otherwise provide a snapshot of the amount of capital in an economic system which is held in liquid form and available for deployment, irrelevant.  The amount of capital available in system can be determined on whim, such is the power of centralized discount rate management.

As such, the ability of the banker to fund the loan is not dependent upon an availability of funds that represents the amount of capital available in the real world, rather, his ability to fund the loan is completely dependent upon the borrower’s ability to pay, the size of the loan, and the structure of the bank’s balance sheet.

The three criteria above are important, as any underwriter will tell you, but the invisible fourth criteria, the true availability of the funds for the loan, what we call the funding dynamic, is completely ignored in the following fashion:

When the short-term interest is managed to be low, as is the case currently, any borrower who has the capacity to pay and has a lending need that fits well with a certain bank’s loan mix is extremely likely to get funded, regardless of whether or not the economics system as a whole has the capital available to fund his or her loan.  When the short-term interest rate is managed to be high, as it was in the early 1980’s in the US, funding any loan, regardless of the ability to pay and fit with then bank’s balance sheet, becomes impossible to fund.

In both cases, both the borrower and the banker are left completely in the dark as to whether or not there exists the necessary capital stock or productive capacity in the economy for the funds to be deployed in the manner that the borrower envisions, for the short-term interest rate signal has been genetically modified to send a common signal to all participants.

Unfortunately, it is a signal that blinds everyone to the facts of the situation.  For many are the hopes, dreams, and ideas of mankind, but it is the funding dynamic which keeps these hopes, dreams, and ideas in harmony with the natural world upon which we all depend.

Right now, we are floating in the clouds, completely disconnected from reality.  The landing caused by the next round of high rates, via a natural rebalancing of accounts or further genetic modification of the short-term rates, will be very hard indeed.

The funding dynamic is so delicate that mankind cannot hope to optimize genetically modification, for when left alone, it is optimized by definition.  Again, by definition, every attempt to modify will bring about sub-optimal results.

As with all complex economic and political systems, dissent is information, and serves to manage the system’s outputs while at the same time increasing the resiliency of the system, making it less susceptible to shocks.

Centralized short-term interest rate management must be abandoned before it is too late, for it is leading the activities of mankind towards a dangerous showdown with the limitations of the natural world.

Stay tuned and Trust Jesus.

Stay Fresh!

David Mint

Email: davidminteconomics@gmail.com

Key Indicators for July 1, 2013

Copper Price per Lb: $3.14
Oil Price per Barrel:  $97.99
Corn Price per Bushel:  $6.55
10 Yr US Treasury Bond:  2.48%
Mt Gox Bitcoin price in US:  $89.74
Gold Price Per Ounce:  $1,253
MINT Perceived Target Rate*:  0.25%
Unemployment Rate:  7.6%
Inflation Rate (CPI):  0.1%
Dow Jones Industrial Average:  14,975
M1 Monetary Base:  $2,452,200,000,000
M2 Monetary Base:  $10,628,800,000,000

Euro funding doesn’t pencil out

Rumors today that Greece would default on its sovereign debt were received with relative calm by the bond markets.  Now that Greece’s public debt is approaching 150% of GDP and is forecast to increase by at least 10%, even the most optimistic analysts, namely S&P, are coming to one inescapable conclusion:

Greece is in technical default.

This is news to no one in the world of finance.  The numbers in Greece haven’t penciled out for at least three years and have shown absolutely no sign of improvement.  Anyone with significant exposure to Greece has either sold it or obtained some sort of guarantee from the ECB and/or IMF that they will be made whole on their exposure.

Hence, the lack of panic in the markets.

For financial market participants, the guarantee of the ECB works as a hallucinogen.  Traditional analysis no longer applies once an infinitely solvent guarantor signs on to back the debt of a weak partner.  The weak partner is no longer seen as insolvent, but rather, devoid of credit risk.

However, 2012 is shaping up to be a tough year for the ECB itself.  With every cent of spare Euro liquidity fleeing to American shores, the ECB is now the lone ranger as its lending activity increasingly dominates the Euro money markets.

Assuming that it must fund a large majority of the Eurozone’s debt rollovers in in 2012, how many Euros will the ECB need to conjure up?  The rough tally is 740 billion euros worth of European sovereign debt.

Additionally, it is almost a bygone conclusion that the ECB will need to step in and buy the debt of European banks whose country’s sovereigns are under pressure.  This includes:

  • 25% of Irish banks outstanding debt
  • 20% of Spanish banks outstanding debt
  • 15% of Italian banks outstanding debt; and
  • 15% of Italian banks outstanding debt

To borrow an old but relevant metaphor, 2012 will be the year that the ECB’s wine, the Euro, turns to sewage.  Thanks to their unlimited swap line at the Federal Reserve, the US currency is likely to begin to smell funny as well.

Could this be why the FED funds rate has creeped up from its flatline the past few days?

No matter how you look at it, the 2012 Euro funding picture does not pencil out.  The sooner that Greece and the other insolvent sovereigns and banks declare the default that the markets have long since priced in, the sooner growth and hope will return to the Eurozone.

On the other hand, the longer the sewage is allowed to backup at the ECB, the greater the risk of a Euro currency collapse.  Nobody wants to see that, especially the FED.