Volcker: the Dollar is in Crisis, the Financial System Has Failed the Test of the Marketplace

Volcker Says Fed's Bear Loan Stretches Legal Power
By John Brinsley and Anthony Massucci

April 8 (Bloomberg) -- Former Federal Reserve Chairman Paul Volcker questioned the central bank's decision to rescue Bear Stearns Cos. with a $29 billion loan, saying it was at ``the very edge'' of its legal authority.

``The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices,'' Volcker said in a speech to the Economic Club of New York.

Fed Chairman Ben S. Bernanke last month agreed to lend against Bear Stearns securities, paving the way for JPMorgan Chase & Co. to buy its Wall Street rival. Bernanke, who worked with Treasury Secretary Henry Paulson to broker the bailout, last week defended the move as necessary to prevent ``severe'' damage to financial markets.

Volcker, the Fed chairman from 1979 to 1987, had implicit criticism for U.S. regulators and market participants who allowed ``excesses of subprime mortgages'' to spread into ``the mother of all crises.'' The Fed's Bear Stearns loan was unusual, he said.

``What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return,'' he said.

Wall Street Subsidy

Lawmakers, while praising the Fed and Treasury for averting a financial collapse, have also questioned the plan to subsidize Wall Street while the Bush administration resists using government funds to assist homeowners cope with the worst housing crisis in 25 years.

Volcker said the Fed's loan may send investors the wrong message.

``The extension of lending directly to non-banking financial institutions -- while under the authority of nominally `temporary' emergency powers -- will surely be interpreted as an implied promise of similar action in times of future turmoil,'' he said. (this is the very substance of moral hazard - Jesse)

Volcker said the modern financial system has ``failed the test'' of the marketplace.

When asked whether he predicts a ``dollar crisis,'' he said, ``you don't have to predict it, you're in it.''

The dollar has dropped 15 percent against the euro and 14 percent versus the yen in the past year.

$945 Billion in Losses

``What Chairman Volcker said in his remarks is that we need to make sure we are taking a look at the implications of the Fed decision,'' Glenn Hubbard, former chairman of President George W. Bush's Council of Economic Advisers, said in an interview. ``The question is: How do we then redesign regulation around a decision that bold?''

Volcker's critique comes as policy markers struggle to prevent the world's largest economy from contracting, a prospect Bernanke himself raised last week. The International Monetary Fund today said the global losses from securities tied to commercial real estate and loans to consumers and companies may reach $945 billion.

``The bright new financial system, with all its talented participants, with all its rich rewards, has failed the test of the marketplace,'' Volcker said.

As credit markets seized up, the Fed gave the 20 primary dealers in U.S. government bonds the same access to discount- window loans that had previously been reserved for banks. The central bank now auctions as much as $100 billion to lenders a month, and has cut the cost on direct loans to just a quarter- point above the overnight rate on loans between banks.

``The implications of these decisions, and the lessons from the unfolding crisis itself, surely deserve full debate and legislative review in the period ahead,'' Volcker said.

Fed's Response

The Fed has also lowered its benchmark rate six times since September to 2.25 percent from 5.25 percent, and traders anticipate it will cut by at least another quarter point this month to cushion the economy's downturn.

Volcker, 80, said the problems stemmed in part from trading of increasing complicated securities including derivatives that ``have taking on a trading life of their own,'' and said the turmoil ``adds up to a clarion call for an effective response.''

`There was no pressure for change, not in Washington which was spending money and keeping taxes low, not on Wall Street which was wallowing in money, not on Main Street with individuals enjoying easy credit and rising house prices,'' Volcker said. (that pressure ought to have come from the Fed. It is their job to 'take away the punch bowl.' - Jesse)

To contact the reporter on this story: John Brinsley in Washington at jbrinsley@bloomberg.net

Last Updated: April 8, 2008 17:50 EDT

The Fed is Increasingly Concerned about Stagflation

If we get an inflationary recession, it is because of Greenspan and Bernanke, Clinton and Rubin, Bush and Paulson, and their inability to keep their hands out of the markets, tinkering and fine-tuning them to advantage their own ends and those of their cronies.

Will they never learn? Do they really care?

Fed minutes: Severe downturn possible
Tue Apr 8, 2008 2:40pm

WASHINGTON (Reuters) - Members of the Federal Reserve's policy-setting committee worried at their most recent meeting that housing and financial market stress could trigger a nasty slide in the economy, even as inflation pushed higher, minutes of the meeting released on Tuesday show.

"Some believed that a prolonged and severe economic downturn could not be ruled out given the further restriction of credit availability and ongoing weakness in the housing market," minutes of the March 18 meeting said.

A staff forecast buttressed that somber outlook, projecting "a contraction of real GDP in the first half of 2008 followed by a slow rise in the second half," the report said.

At the same time, Fed officials found recent inflation reports "disappointing," noting also with concern that some indicators of inflation expectations were edging higher.

Policy-makers said there were limits to what could be done through interest rate cuts to deal with problems underlying the collapsed housing market and the credit crunch, but agreed trimming borrowing costs might provide some help.

However, Fed officials said it would be hard to calibrate policy responses because their aggressive rate cuts in recent months would take some time to show their effects on economic activity.

The Fed has cut benchmark interest rates by three percentage points to 2.25 percent in six months.

U.S. rate futures rose on the gloomy Fed economic outlook, and the implied chance of the federal funds rate being cut to 1.75 percent by mid-year rose to 90 percent from 68 percent. U.S. stocks stayed weak after the minutes were released.

The Fed said that while exports were getting a boost from a cheapening U.S. dollar, there also was a risk that the devalued greenback will further add to inflationary pressures from costlier oil and other commodities.

(Reporting by Mark Felsenthal and Glenn Somerville; Editing by Theodore d'Afflisio)

The Dollar is Being Devalued

This chart is from an excellent blog called Sudden Debt. We read it regularly, and suggest you do as well.

Someone sent us this chart and asked: What do you make of this? and by inference: What does it mean, what does it imply?

We make a lot of it, because it has been a recurrent theme at this blog since the first: The Die is Cast for the US Dollar, Is the Fed Monetizing Bad Debt, Is the Fed Accountable? and The Odyssey of Ben Bernanke.

It has also been a recurrent theme at The Crossroads Cafe, postings at various places around the web, and a primary investment strategy in our personal portfolios since about 1999. Let's put it up as a headline, and in one nice simple sentence.

The Fed is being forced to devalue the US Dollar.

At one time the dollar was backed solely by US sovereign debt: AAA Treasuries and a few fully guaranteed agencies like Ginnie Mae. Now it is backed at least in good part by collateralized debt obligations for which there is no market at stated values.

The devaluation of the dollar has been gaining steam relative to the other fiat currencies around the world like the euro and the yen under the Bush Administration. The strong dollar under the Clinton administration was effectively an accounting illusion. Commodities are a real problem because so many of them are controlled by non-G8 countries.

A lot of breath has been wasted debating the Hegelian dialectic between inflation and deflation. In a purely fiat regime it is a policy decision, nothing more.

Japan made their decision for their own reasons and got a protracted deflation, probably because they had a huge national savings at hand, an industrial policy of net exports, and a complex kereitsu controlled economy in cooperation with the bureaucrats at Ministry of International Trade and Industry 通商産業省 or MITI.

The US is making its decisions its way and is getting inflation, probably because it has a huge national deficit and no savings. Debtors do not willingly choose deflation. Without external standards its a policy decision. But the debate masks the real issue, that we are falling into a centralized command economy, and moving away from free market discipline. The further they go, the more the Fed will have to control directly. Some say that dollars can only be created if banks make loans, as if it is some law of physics. Oh really? Who says this? Where and by whom is it written? When will the decisive moment come when this is put to the test.

Its all about moving to a common and interlinked fiat system, not necessarily one currency. Its an arranged system similar to Bretton Woods with a renewed dollar hegemony, except the fix might be more flexible and less explicit. Its does not have its basis in evil. Its fault is hubris, the fatal flaw of all central command economies and those who would rule them.

Its a neo-liberal Keynesian dream in which the country is managed as a command economy by a small group of elites, and the rest of the world accepts their designated place in the grand scheme of things.

An important milestone along the way will be when the Fed runs out of Treasuries to back the dollar currency in circulation. Will people care that the dollar is now backed by questionable Wall Street debt? Will the Treasury find a graceful way to give them unlimited supplies? Will the rest of the world keep providing us with key commodities and manufactured goods? Its an awkward bridge that must be crossed in which appearance slips and the crowd gets a brief glimpse of reality. But its not the last obstacle, and perhaps not the biggest.

Will it succeed? We surely do not know. As the president said, it would be easier to make things happen if we had a dictatorship. We like the idea of hedging against a possible failure.

Until 1971 the US dollar was backed by gold. The Dollar is no longer the reserve currency of the world. Until last month it was backed by the sovereign debt of the United States government. One can presume that it is still backed by the full faith and credit of the federal government, no matter what. Although the nature and character of its backing is clearly changing, the final outcome of what it will become exactly is yet to be decided.

The die is cast

Someone just sent me this April 8 interview with Jim Rogers in which he says similar things. Its worth reading. Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve