Nomi Prins: How the Fed Created a Financial Frankenstein’s Monster

Can you name even one market… or one part of the economy… that doesn’t suffer from distortions?

We can’t. And we bet you can’t either.

Whether it’s groceries, cars, housing, travel, energy prices, or anything… there’s a distortion in there somewhere.

Most folks probably don’t realize that. But when you have the government and the Federal Reserve distorting the value of money (through interest rates) every day, nothing escapes the distortion effect.

The appearance of the Fed chairman, Jerome Powell, on “60 Minutes” is a perfect example of distortion and manipulation.

In a free market, interest rates would find an equilibrium… they would rise and fall based on the economy and opinions on the economy.

But when you add a central bank to the mix… everything changes. Not only does the bank interfere with market forces, but it means the market doesn’t just have to contend with what the economy will do… it has to guess what the Fed will do based on that information.

That isn’t always obvious.

But regardless of what the Fed will do next… how the market will try to anticipate it… and what the result will be… one person we always turn to for help understanding these distortions is Nomi Prins.

In today’s guest essay (adapted from Nomi’s book, Permanent Distortion), she explains how the Fed came to be in the position of acting for the benefit of “Wall Street” rather than for “Main Street.”

Check out Nomi’s essay below after we’ve taken a quick look at today’s market action…

Market Data

The S&P 500 closed down 0.3% to end the day at 4,942.81… the NASDAQ fell 0.2% to close at 15,597.68.

In commodities, West Texas Intermediate crude oil trades at $72.86, up 74 cents…

Gold is $2,041 per troy ounce, down $13…

And bitcoin is $42,389, down $581 since Friday.

Now, back to our story…

How the Fed Created a Financial Frankenstein’s Monster

The arc of high finance has many pivotal moments of speculation and crisis.

The Fed might not have come into being were it not for a squeeze in the copper market in 1907 that caused a financial panic.

That crisis presented a moment for J. P. Morgan to rescue the country by using the US Treasury’s money with President Theodore Roosevelt’s blessing.

It thrust him into the role of absentee host for a group of bankers and politicians at Jekyll Island, Georgia in 1910 that penned the initial blueprint that became the Federal Reserve System in 1913.

Even our terminology and language reveal history’s selection process.

The phrase “Ponzi scheme” might not have become such a common way to refer to con mania if the 1920s hadn’t produced the perfect environment in which to fall for the premise of the unsustainable returns that Ponzi promised.

What grew from zero to a $15 million empire in a few months for Charles Ponzi crumbled to zero and a jail sentence in about the same amount of time, popping as so many bubbles eventually do.

In 2008, the Fed created a financial Frankenstein’s monster that altered the course of money and power in the 21st century.

The idea was that cushioning the fall of a reckless banking system with whatever tools necessary (a phrase used repeatedly in 21st-century central bank lingo) was equivalent to securing the real economy, or Main Street.

For those on Wall Street monitoring the deteriorating condition of loans and toxic assets created from them, the global financial crisis had been brewing steadily since early 2006, when subprime loan foreclosures began to spike.

Eventually, the extent of the crisis born of the financial engineering of subprime loans would be blown into the open by the combustion of two Bear Stearns hedge funds. Those hedge funds were engaged in overborrowing to buy toxic securities laced with subprime loans and complex derivatives.

This combustion precipitated the May 31, 2008, takeover of Bear Stearns by JPMorgan Chase, with the Fed’s blessing and financial support, to ensure that JPMorgan got a good price and the Fed bore the brunt of the risk.

At the time, few even thought to question whether the Fed’s actions fulfilled or were even related to its dual mandate to maintain full employment and low inflation.

In the upper echelons of society, the concern was that banks weren’t functioning reliably, stock and bond markets were in free fall, and scores of investment bankers could see their bonuses evaporating.

On the lower rungs of the economic ladder, there was more visceral fear – of not being able to pay rent, losing jobs, being kicked out of homes, and having a less stable future.

There were many facets to the panic that ensued, but one pivotal moment changed the tone of everything. This followed the collapse of one of Wall Street’s oldest, most venerable investment banks, Lehman Brothers, on September 15, 2008.

The event didn’t appear to be based on a planned action on his part, but was more of a gesture: Hank Paulson – former Goldman Sachs CEO and chairman-turned-treasury secretary – dropped onto one knee before Speaker of the House Nancy Pelosi.

As the story goes, Paulson pleaded with her to do whatever her considerable political clout could muster.

The former Wall Street titan needed the Treasury’s $700 billion bailout package, which contained some crumbs for citizens and ample help for megabanks, to be approved by the House of Representatives.

Fears that ATMs over the world might effectively stop spitting out fresh new bills to customers were prevalent – the 21st-century equivalent of banks closing their doors as they had during the 1929 stock market crash and the ensuing Great Depression.

Passing the Emergency Economic Stabilization Act would save the day, said Paulson – or at least save Wall Street.

Markets were diving, a sign of worse things to come. That was the day that Paulson urged a fiscal solution (meaning funds approved by Congress and ultimately paid by taxpayers) for a banking-caused catastrophe.

And so it began…

On December 16, 2008, the Fed cut interest rates to zero and provided the biggest banks access to cheap funds with no strings attached.

Money that cost nothing wasn’t enough, though. Fears about credit seizing up plagued markets. Recessions engulfed the world. This led to a rate-cutting exercise, predominantly by the larger central banks.

Around the world, leaders were deeply concerned that the hubris and greed underlying Wall Street would crash their own markets and subsequently their economies.

The chaos that abounded led those countries not in the inner circle of power to call into question the entire US-dollar-centric global monetary system.

Smaller emerging countries, larger ones such as China and Russia, and the United Nations and the Organisation for Economic Co-operation and Development (OECD) united in admonishment over the lack of oversight of US banking practice.

Developing countries faced more inequality and civil strife, as foreign direct investment favored markets over long-term economic projects, too.

What transpired in the years that followed was social unrest from Hong Kong to Brazil and from Spain to the United Kingdom as people felt economically violated by their governments, while financial markets rallied.

Easy money had a profound impact on political decisions and economies in countries from Latin America to Asia and throughout the European Union.

Despite the premise that emergency central bank action would save the Main Street economy, the unprecedented monetary support from the world’s main central banks to the banks and markets increased inequality, magnified debt, ushered in isolationism, and elevated the wealthy and powerful.

Ultimately, it was a catalyst for destabilizing the international economy.

As a result of the financial crisis, central bank leaders from highly developed economies could fabricate more money than inflation-constrained emerging-market central banks could.

Latin American and East Asian governments were forced to make a “Sophie’s choice” calculation: to suffer hyperinflation alongside more attractive interest and exchange rates and employment levels, or to try to control inflation with higher domestic rates at the risk of harsh internal credit conditions and rising unemployment.

East Asian nations were “luckier,” in a sense, as they could target money toward production and industry and sell public and private assets to balance their budgets, instead of simply privatizing their nations for the benefit of foreign-country investment and control.

How did this spark the massive inequality wedge between the real economy and the financial markets? How did it further the divide between developed and developing nations?

By institutionalizing a system that fabricates unlimited money without reference to the productive economy and its participants – workers, consumers, Main Street retailers, households.

Central banks were both unable and unwilling to direct support int the real economy. But that didn’t stop them from providing back-door financing to Wall Street.

They insisted that markets and the economy were tightly linked. But the evidence derived since the financial crisis proves they’re not.

Central banks were no longer just in the business of balancing money and credit, as per their mandates. Instead they had become the force of the markets themselves.

Unconnected Dots

Our main task at the Daily Cut is to try to “connect the dots.” That is, we help you figure out what events are about, what makes them important, what their consequences are, and what it all means for you.

But sometimes, we see the individual “dots,” but can’t yet figure out how they connect to anything. Maybe they never will connect to anything.

Regardless, if those unconnected dots feel as though they could be important, we’ll mention them here. And we’ll let you draw your own conclusions.

Today’s unconnected dots…

• To follow up on the market distortions, two stories from the Financial Times illustrate this point. First, this one:

  The dollar hit its highest in about three months as recent comments from Federal Reserve chair Jay Powell prompted traders to reassess the potential quantity and pace of interest rate cuts in the US this year.

  We follow that with the second story from the FT:

  U.S. private equity firms are rushing to take advantage of lower borrowing costs by loading debt on to their portfolio companies and using the cash to pay dividends to themselves and their investors.

  Corporate borrowers sold $8.1bn worth of junk-rated US loans to fund payments to shareholders in January, more than six times December’s total and the highest monthly figure in more than two years. Most were issued by companies backed by private equity firms, according to data from PitchBook LCD.

  With weak deal volumes and sluggish demand for initial public offerings making it harder to offload existing investments, private equity firms are turning to such so-called dividend recapitalisations to pacify investors eager for a return on their capital.

  There’s a clear example of a distortion for you right there. Company “A” ends up in a whole bunch of debt… meaning it may have to raise prices or cut costs.

  This is because a private equity firm needs to pay an income for investors… due to competition for income from other investments because the Fed has raised interest rates.

  Whatever the problem in the economy, you can always draw a direct line from that back to the Fed.

More Markets

Today’s top gaining ETFs…

• KraneShares Bosera MSCI China A 50 Connect Index ETF (KBA) +2.4%

• iShares MSCI Turkey ETF (TUR) +2.3%

• VanEck Semiconductor ETF (SMH) +2%

• FlexShares STOXX US ESG Select Index Fund (ESG) +1.9%

• Siren Nasdaq NexGen Economy ETF (BLCN) +1.5%

Today’s biggest losing ETFs…

• SPDR Kensho Clean Power ETF (CNRG) -3.2%

• Global X Lithium & Battery Tech ETF (LIT) -2.6%

• iShares U.S. Basic Materials ETF (IYM) -2.6%

• Materials Select Sector SPDR Fund (XLB) -2.5%

• Amplify Transformational Data Sharing ETF (BLOK) -2.4%

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Cheers,

Kris Sayce
Editor, The Daily Cut