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Generational Dynamics Web Log for 17-Dec-2008
Fed's desperation move may be prompted by $50 billion Madoff swindle

Web Log - December, 2008

Fed's desperation move may be prompted by $50 billion Madoff swindle

On Tuesday, the Fed lowered interest rates to 0% and promised a flood of money on Tuesday, in the face of continually worsening economic news.

Most shocking was the 1.7% fall of the seasonally adjusted Consumer Price Index (CPI), indicating that the process of deflation was accelerating, the biggest drop since 1947. On a non-seasonally adjusted basis, the CPI fell by the biggest decline since 1932, the heart of the Great Depression.

In response, the Fed lowered the Fed funds rate from 1% to an effective value of 0% (specifying a target of 0-Ľ%).

An interest rate decrease is not going to do much to change the current worldwide credit crisis, and so the Fed is promising more: To flood the financial system with as much money as possible.

Here's an excerpt from the Fed statement:

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity."

These techniques, flooding the financial system with money, are called "quantitative easing." These are techniques that are used when interest rates have reached 0%, and can't go any longer.

I heard one pundit today say that there's no limit to the amount of money that the Fed can create -- even one quadrillion dollars ($1,000 trillion). (See "One, Two, Three ... Infinity.")

I admit right now to finding this whole concept absolutely stunning, but I'm also bemused because I can't see how it can possibly work. And that's because there's been a generational change of attitude that will not be reversed.

If quantitative easing is to work, then it has to use money that Fed creates to replace money that was created by the massive real estate and credit bubbles. How do you do that?

The credit bubble was created by massive fraud at all levels -- from people lying on loan applications to lenders providing predatory loans to banks creating worthless securities to ratings agencies and insurance agencies giving these securities AAA ratings in return for fat fees.

That fraudulent infrastructure is entirely gone now. There's no way to grant loans to people lying on loan applications; there's no way to provide predatory loans any more; no one would invest in worthless mortgage-backed securities; ratings agencies and insurance agencies have suddenly "gotten religion" for their own survival.

So the Fed can pour as much money into banks that it wants, but there's no place for the money to go.

As I've said many times, the crisis was caused by a lethal combination of stupid, greedy Boomers being led by destructive, greedy Gen-Xers. The generational change is that a lot of lessons have been learned, and the risk-seeking behavior that allowed the bubbles to grow has been replaced by risk-averse behavior that is now deeply embedded in both these generational groups.

The fond wish of policy makers is that if the Fed only puts enough money out there, then people will become risk-seeking again. But that's impossible: Are they really hoping for a lot of money to be lent in new subprime mortgages that will never be repaid? Of course not.

That's why quantitative easing will fail.

And incidentally, that's why Obama's massive stimulus package will fail as well. The plan is to pour hundreds of billions of dollars out into "shovel-ready" projects -- repairing roads and bridges, etc. But those jobs all take special skills and special equipment that can't be made available for months.

Law of Diminishing Returns

I've discussed the Law of Diminishing Returns several times in the past, and a year ago I had a lengthy discussion of it to explain the answer to the following question:

"If there's more than enough food in the world to feed twice the world's population, then why are people starving?"

Now I'm going to apply the same Law to the following question:

"Why do things like government stimulus packages and Fed interest reductions and quantitative easing become less and less effective as time goes on?"

The Law of Diminishing Returns says this: Suppose you have a process that requires multiple resources, A, B, C, ..., and produces an output X. Suppose that you keep adding more and more A to the process, without adding any more B, C, .... Then the law says each additional unit of A that you will be less and less effective in producing more X.

In this case, the resource that's being added is money.

When the credit crisis began in August, 2007, then the Fed lowered interest rates, and that seemed to solve the problem.

Each time the problem got worse, the Fed would do something more: More aggressive interest rate reductions, small bailouts, bigger bailouts, huge bailouts, etc., combined with a fiscal stimulus package last summer.

As I wrote last month in "One, Two, Three ... Infinity,") each of these bailouts was bigger than the last one, and seemed to be approaching infinity.

And now, as if to prove my point, we have the pundit that I quoted above saying that we could even have a one quadrillion dollar bailout if necessary.

But the Law of Diminishing Returns says that it won't do any good. Each time the bailout got bigger, the effect got smaller, and lasted less time. Now, as the bailout really does seem to be approaching infinity, the amount of benefit appears to be approaching zero.

You know, I'm always applying these laws that I talk about all the time:

The Law of Exponential Growth
The Law of Mean Reversion
The Law of Diminishing Returns

A lot of people think these laws don't matter. But what you're seeing now is the Law of Diminishing Returns, in action, right before your eyes.

The $50 billion Bernard Madoff swindle

This is being called the biggest Ponzi scheme (or pyramid scheme) in history. Madoff was able to convince investors to let him invest as much as $50 billion of their money.

And why not? 70 year old Madoff has been a financial manager since 1960. For a while, he was chairman of the Nasdaq Stock Market. He had an unblemished record, and he always provided good returns to his investors.

At some point, he began using one investor's money to pay off the dividends of other investors. This worked fine, as long as he could use his charm to convince more and more investors to invest more and more money. Ponzi schemes always start falling apart when economic conditions deteriorate, and people start asking for their money back, and that's what happened to Madoff. Last week he was arrested for fraud.

Many big institutions were victimized. Banks around the world lost billions of dollars. Steven Spielberg, real estate mogul Mort Zuckerman, and New Jersey Senator Frank Lautenberg were victims.

But it's the small investors who are hurt the most. Many old people simply trusted Madoff with the all their money, and now they've lost everything and may be facing homelessness.

In fact, even when banks were hit, they won't be the ones to suffer: In many cases, it's the bank's clients who will lose instead.

Strangely, the Jewish community may have been the hardest hit. Madoff was a highly respected, leading Jewish financier and philanthropist, and so many Jews trusted their money to him. This included many friends who had known him for years.

The SEC gets blamed - boo hoo

One of the most pathetic organizations in Washington is the Securities and Exchange Commission (SEC). The SEC was created in the 1930s to prevent another stock market bubble like the one in the 1920s, and they completely failed at that mission with the dot-com bubble of the 1990s and the various more recent bubbles.

A few months ago, the SEC was blaming economic problems on "false rumors." What a pathetic agency, to put out such garbage. They particularly blamed the collapse Bear Stearns on such rumors. This, despite the fact that Bear Stearns had been an industry leader in 2007 in creating worthless securities and repeatedly lying to the public about their value.

Now, with the Madoff scheme, the SEC actually investigated Madoff a couple of years ago, but gave him a clean bill of health, even though there were numerous warning signs, and there had been some complaints filed with the SEC.

The lethal combination of incompetent Boomers and destructive Gen-Xers also applied to regulatory agencies like the SEC. Just as the investment banks that created the worthless mortgage-backed securities were guilty of financial fraud, the SEC could well be found guilty of commiting regulatory fraud, defrauding the public with their stupidity.

Expect a flood of swindlers

What you're seeing, Dear Reader, is just the beginning of the flood of swindles and fraud that will be exposed in the next couple of years.

There was a great deal of embezzlement and fraud leading to the Great Depression of the 1930s. I've quoted this passage before, but it's worth posting again. John Kenneth Galbraith described what happened -- and what will happen again -- in his 1954 book, The Great Crash - 1929, as follows:

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely not in -- the country's businesses and banks. This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

The stock market boom and the ensuing crash caused a traumatic exaggeration of these normal relationships. To the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president who was himself trusting Kreuger, Hopson, and Insull was obviously unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.

Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.

After the first week or so of the crash, reports of defaulting employees were a daily occurrence. They were far more common than the suicides. On some days comparatively brief accounts occupied a column or more in the Times. The amounts were large and small, and they were reported from far and wide. ...

Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by Kreuger, Hopson, and Insull with the moey of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected." [pp. 132-35]

Galbraith's point was that there were many criminal activities going on before the 1929 crash, but nobody cared, as long as everyone was making money. But once the crash occurred, any irregularity was viewed with suspicion and led to an investigation. These investigations turned up many cases of embezzlement -- people who had "temporarily borrowed" money that wasn't theirs to invest in the stock market, and then got caught in the crash.

That's happening again. If you're one of the people who have committed embezzlement or fraud, then it's time to put your affairs in order, because you're going to get caught. A lot of others will be caught as well.

I heard a pundit today describe why so many people were taken in by Bernard Madoff:

"People didn't diversify their investments, there was a stunning lack of due diligence, and a willingness of people to suspend belief about consistent returns that others pointed out were almost statistically impossible -- too good to be true."

This raises a good point: Madoff's scheme was not the biggest swindle in history. Far from it.

The biggest swindle in history was perpetrated by Bear Stearns and other investment banks that created worthless mortgage-backed securities, and sold them to hapless investors. The swindle was also perpetrated by media like the Wall Street Journal and CNBC who, to paraphrase the above quote, "showed a stunning lack of due diligence, and a willingness to suspend belief about consistent returns that others -- including this web site -- have pointed out were almost statistically impossible -- too good to be true."

This swindle is still going on today.

Hedge funds and a financial crash

This brings us back to the Fed's interest rate cut to 0% on Tuesday. What was the source of the panic that led them to do this?

$50 billion is effectively gone - disappeared - and that's a hell of a lot money.

Hedge funds have been in a great deal of trouble anyway. They've been losing money this year, as the market fell, and investors have been getting nervous about losing their money. According to one estimate I've read, of the 10,000 hedge funds in the world, about 3,000 were going to collapse in the next few months anyway.

The Madoff swindle makes the situation much worse. The $50 billion loss will trigger other losses. A chain reaction has already begun whose full extent won't be known for some time.

That's the kind of thing that is panicking the Fed. It's exactly this kind of chain reaction that can cause a worldwide panic. In fact, the next-to-last international generational financial crisis, the Hamburg crisis of 1857 (panic of 1857), was triggered by a small event -- an employee of the New York branch of the Ohio Life Insurance and Trust Company was found to have embezzled money.

Generational Dynamics predicts that in fact there will be such a panic -- a worldwide panic that will be as memorable as the crash of 1929. There's no way to predict whether it will be triggered by the Madoff swindle or by something else, it's coming with absolute certainty.

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (17-Dec-2008) Permanent Link
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