When TBTF Meets TBTK

by Gary North

Recently by Gary North: Confessions of a Washington Reject

You probably know what TBTF stands for: too big to fail. We need a comparable acronym: TBTK. It stands for too big to kick, as in "kick the can."

"Too big to fail" is such a common phrase these days that HBO chose it as the title for a movie on the big bank bailout of 2008. The context of TBTF is correct: the largest banks, all over the world.

FOLLOW THE MONEY

The famous phrase, "follow the money," became famous because of All the President's Men, the movie about the investigation of Watergate. No one knows where it came from. The book's two authors don't recall. The screenwriter is not sure. But it has become part of the American language.

When you want to discover who is making the decisions, follow the money. This applies in two ways to banking, which is the source of money, but in a banking crisis, becomes the recipient of money. No other industry enjoys the privilege of being at both ends of the flow of money in good times and bad.

So, let us follow the money.

More than any other industry, large banking has the guarantee of high profitability and success. The bankers know that the government will not allow their banks to fail. So, they can take enormous risks based on the discrepancy between short-term rates (at which they borrow) and long-term rates (at which they lend).

When the spread reverses, which it always does at some point, driving up short-term rates and driving down long-term rates, the result is a recession. If a very large bank faces bankruptcy, the central bank intervenes and lends to it at low rates until the old yield curve (spread) returns: low short rates and high long rates. If central bank intervention is not sufficient, then the government intervenes and uses tax revenues to offer more bailout money to the biggest banks.

This arrangement has created a class of super-rich people. The arrangement is ideal for them. When they win, they win big. They do not lose, except when their bank is judged not quite too big to fail. Then the bank gets bought up at a discount by a TBTF bank. The government arranges the terms of sale.

This arrangement has been known by economists – and few others – for two centuries. There is a phrase for it: "moral hazard." It is just about the only phrase in the field of economics that is designated by the adjective "moral." Economics is said to be value-free science, and therefore economists are not supposed to invoke morality in their economic analysis. But "moral hazard" is an exception. We are never told why the hazard involved is a moral hazard rather than (say) a government-subsidized speculative hazard.

The arrangement is correctly described as a moral hazard. It puts morality at risk. It is a moral hazard because corporate beneficiaries are able to use money stolen by the government from voters, plus counterfeit money inflicted on the public by the central bank, to stay in the business of counterfeiting money. It is a misuse of the public trust. But economists never speak this way, for all but the Austrian School economists are in favor of counterfeit money and tax revenues to save large banks. This is why there was silence from all schools of economics, except the Austrians, in 2008 when the Federal Reserve intervened.

The system of national government is so totally controlled by the large banks that the knowledge of how the arrangement works never leads politicians to stop bailing out the biggest banks in times of crisis.

The voters in 2008 overwhelmingly opposed the TARP bailout. Their opposition delayed the House of Representatives for a few days, but a falling stock market, coupled with high-pressure appeals by Treasury Secretary Hank Paulson, the former Goldman Sachs CEO, and Ben Bernanke persuaded the House's leadership to join in a bipartisan thumbing of their collective nose at the voters. "Fork it over, voters. It's good for you!" The big banks were bailed out, so that they could pay huge bonuses the next year. The huge insurance company AIG got to participate in the free ride as if were a bank. It therefore did not default on its debts to the big banks. It used the bailout money to meet its obligations.

There were big losers. Bear Stearns was gobbled up. So was Wachovia. Lehman Brothers went bust. But the winners got fire-sale discounts on these assets and lots of new customers. How sweet it is to be on top of the food chain!

The arrangement exists in every nation. In 2008, the equivalent scenario was played out in Great Britain and Western Europe.

The big banks remain in charge. We know that, because we can follow the money.

More than any scholar, Murray Rothbard followed the money in America. As an economist, he wrote the best textbook on money and banking. It is so accurate that no college or university dares to assign it or even mention it. Rothbard did what no other economist had ever had done before when writing an economic textbook. He described the process of fractional reserve banking as immoral: a form of counterfeiting. The book is called The Mystery of Banking. You can download it for free here.

He was also a master historian. He wrote several books on the relationship between fractional reserve banking and American politics, which have been intertwined from the very beginning of the nation. A posthumous collection of his articles is A History of Money and Banking in the United States. You can download it for free here.

KICK THE CAN

The phrase "kick the can" refers to a specific form of procrastination: to delay making a decision regarding a problem that can be deferred but cannot be avoided indefinitely. With each kick of the can, the problem grows worse. The problem compounds. The resources required to solve it do not compound at an equally high rate. The can-to-foot ratio grows larger.

The classic example of this problem in the West is the combined programs of old age retirement and old age medical care, especially the latter. These two programs in every Western democracy are underfunded. The unfunded liability of the combined programs in the United States is so large that experts do not agree on just how large. A low-ball figure is $60 trillion. I have seen estimates as high as $100 trillion, but only in the last two years.

This problem received almost no attention as recently as 1999, when Peter G. Peterson's book appeared, Gray Dawn. The book was ignored by the media. He has put a substantial percentage of his fortune into publicizing this. He is gaining some hearing among a few people in the American intelligentsia, but he is gaining no traction politically.

In Gray Dawn, he said that he had spoken with senior political figures around the West. As the Chairman of the Council on Foreign Relations from 1985 to 2007, he was in a position to meet these people. Without exception, he reported, they all knew of the statistical reality of the problem. Without exception, they all chose to ignore it, since it would not become impossible to deal with until after they had retired from office. It was not a high priority, because it was not an immediate political priority. In the meantime, the retirement tax funds flowing into the governments' treasuries provided funds for immediate expenditures.

The governments are the mirror image of the fractional reserve banks. The banks are borrowed short (from depositors) and lend long (bonds and mortgages). In contrast, the governments spend short (voters) and borrow long (retirees).

Politicians are in the business of buying votes. The currency of the realm of politics is votes. In the United States, the Congress faces an election every two years. So, the time frame of a Congressman in an insecure district is rarely longer than two years. The money that flows in is immediately spent, for the flow of funds out (follow the subsidies/payoffs) must come close to match the flow of votes (follow the political money). There is a fairly tight matching temporally of the flow of funds.

So, if Congress taxes directly and spends rapidly, it faces a problem. The voters' benefits are offset by costs (taxes). A balanced budget leaves little room to maneuver. The votes obtained by the beneficiaries of the subsidies are threatened by the votes lost because of the taxes.

The politicians therefore search for a way to pay short and borrow long. If they find a way to do this, they can buy more votes than they lose. Like the banks, they make it on the spread. The spread is based on differences in time.

Politicians beginning in Germany in the 1880s and universally by the 1930s discovered a way to cash in on the spread. They promised voters that the government would offer them retirement programs. Taxes would be low. The voters cheered.

In the United States, 1965 brought the next phase: Medicare. It was the same great deal: buy votes now with an old age payoff later. In short, buy votes with promises. Collect taxes now, which can be spent on anything Congress wants before the next election.

To make the deal work, there had to be a way to avoid present costs of funding the old age programs. If the programs had been private, they would have had to be funded, as with any insurance contract. That would have created political resistance. So, the politicians offered something for nothing: large benefits in old age, but low, low monthly payments in the present – payments that had to be lower than what funding required statistically. What would have been illegal for any private firm to offer became the universal solution for politicians to cash in on the "spend short, borrow long" opportunity.

In other words, politicians imitated the banks. They found a way to make it on the spread: a spread made possible by differences in time.

THE CAN HAS GROWN LARGE

The day of reckoning was built into the arrangement. At some point, the funds collected from Medicare and Social Security (FICA) taxes would be less than the payments to beneficiaries. That day arrived several years ago for Medicare. It arrived in 2010 for Social Security.

Here is the political problem, which is the only problem that Congress always cares about. The time constraints have shrunk. The government is still borrowed long, but the payments to beneficiaries are now rising rapidly. They now exceed the revenues from taxes. The payoffs to voters are now in excess of the revenues from voters. To balance the budgets of Medicare and Social Security, there must either be tax hikes (politically risky) or reductions in payoffs (politically suicidal).

What's a politician to do?

Answer: Borrow more money.

The enormous size of the on-budget deficit, at $1.6 trillion, dwarfs the size of the immediate deficits for Medicare and Social Security, which are off-budget with respect to long-term liabilities. But the preliminary day of reckoning has arrived: the on-budget effects of the twin off-budget programs. The trustees of the so-called trust funds are cashing in the nonmarketable IOUs issued by the Treasury years ago, demanding enough money to make the pay-outs. The Treasury must write checks to the trustees. This money comes out of the General Fund, which is on-budget and immediate.

The government is concealing the fact that the two old age programs are now in operational deficit condition. The size of these deficits are small relative to the overall Federal deficit. Hardly anyone follows the details of the trust funds, which are declining. The decline in these funds is paralleled by an increase in the on-budget deficit, but no one notices.

The government has seen its spread shrink, namely, the time frame between the money spent to buy votes immediately and the tax collections needed to keep the subsidies flowing. The average maturity of the Federal debt to those lenders other than the trust funds fell to 50 months in 2009, although recent purchases by the Federal Reserve under QE2 has lengthened this. We read on Wikipedia,

In addition to the debt increase required to fund government spending in excess of tax revenues during a given year, some Treasury securities issued in prior years mature and must be "rolled-over" or replaced with new security issuance. During the financial crisis, the Treasury issued a sizable amount of relatively shorter-term debt, which caused the average maturity on total Treasury debt to reach a 25-year low of just more than 50 months in 2009. As of late 2009, roughly 43% of U.S. public debt needed to be rolled over within 12 months, the highest proportion since the mid-1980s. The relatively short maturity of outstanding Treasury debt, coupled with the increased reliance on foreign creditors, puts the U.S. at greater risk of sharply higher borrowing costs should risk perceptions change abruptly in credit markets.

We are told by the Federal Reserve that its purchases of Treasury debt will end this month. So, investors must be found to replace the demand for Treasurys by the FED. It is not clear who these investors will be or at what rate of interest.

THE DEBT CEILING

We are in the midst of the first public debate over the debt ceiling since 1995. The Republican House and the Democrat Senate are at odds over how to raise the ceiling. Any talk about actually freezing the ceiling is merely for show. To freeze the debt ceiling is to cease kicking the can. That would be the day of reckoning.

The can is growing very large. Kicking it is what the voters really want Congress to do. They do not want the subsidies to cease. But, as always, they do not want to pay for all of the subsidies. Not since World War II has the percentage of GDP actually collected in taxes from the public exceeded 20%.

So, kicking the can today involves adding to the Federal debt. No matter what Congress does, it will not balance the budget by tax increases. Even in World War II, the ratio of tax revenues to GDP did not exceed 23%, and that only for a year. Usually, the post-War ratio has been around 17% to 18%, as you can see.

Congress therefore has no ability to balance the budget by anything other than cutting spending dramatically, but the voters do not want that. This is why the debt ceiling will be raised by Congress. The public may say it does not want this, but voters will extract vengeance on Congressmen whose votes really do lead to spending cuts sufficient to balance the budget. This is not going to happen. Congress will not make the attempt.

CONCLUSION

At some point, too big to fail banks will find that the government can no longer kick the can. There will not be lenders to the government at interest rates that the government can afford to pay. Even the Federal Reserve System will stop lending, unless the FED's managers decide to go to hyperinflation. When the government cannot continue to meet its obligations, it will default in some form to some beneficiaries. This is the dilemma facing all Western democracies.

If the big banks are too big to fail, then they need the government to bail them out in a crisis. But if the government can no longer afford to bail them out, then what?

That will be the day of reckoning for the West: when TBTF meets TBTK.

It is going to happen.

Don't get caught in between. Don't be dependent on either the Federal government or the TBTF banks.

June 15, 2011

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North

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