Guest Post: Bernanke Employs a Modified 'Pump and Dump'

From Jeffrey Snider first posted at RealClearMarkets

Bernanke Employs a Modified 'Pump and Dump'

Gold is not money, according to Federal Reserve Chairman Bernanke. When pressed on the subject, he demurred that banks, including, I presume, central banks, continue to hold gold due to nothing more than "tradition". Thus, he feels there is a vast difference between dollars and gold. It is curious word for him to choose because Mr. Bernanke is actually correct, but probably not in the way he intended with his unspoken pejorative connotation, politely dismissing any value for the precious metal.

Value itself is nothing more than the outward expression of individual faith. The traditional value of money is really just an outgrowth of its historical reputation, earned through so many actions and consequences. Money may seem to add a level of objectivity into the discussion of value, but that is only because of a more universal "faith" in the transactional price discovery process it allows.

This discussion of "tradition" in the context of "value" is the central problem of our financial age. The question of faith in valuations is at the very heart of the ongoing crisis, infecting all facets of finance and economics. Almost three years after a major banking panic, we are still wrestling with the idea of valuations, and more innately, value itself. Economic and financial unease and uncertainty trace their roots to the shaky valuations that have been provided or interjected into every marketplace, keeping up with the grand tradition of fiat currencies and centralized policy.

For example, U.S. treasuries are supposed to be, pardon the pun, the gold standard of riskless assets. Yet they are increasingly questioned (ask Bill Gross and China). The value of the paper is a derivative function of the ability to tax, as in full faith and credit of the United States. But the same is also true of Greek paper, as sovereign Greek debt derives its value from the Greek government's ability to tax. Yet U.S. debt is more "valuable", in money terms, than Greek debt solely because the Greeks have a "tradition" of default while the U.S. does not. Tradition matters.

By engaging in quantitative easing, the Fed is creating cash for primary dealers that, it hopes, will be used to fund the purchases of "riskier" assets. But those additional purchases only push up the momentary price of the asset, so this flow needs to be ongoing otherwise it is supremely susceptible to reversal. This means a constant state of interference. After establishing such a flow and the follow-on "favorable" price trend, the ensuing faith that higher prices are supposed to generate is thought to lead directly to spending "velocity", which yields economic flow and a healthy economy. That is the theory of the "wealth effect". It is being practiced on both sides of the Atlantic with equal fervor, though with slightly different mechanics.

If prices are the independent variable in the economic equation, that is, the x-factor that needs to be manipulated, then why not just remove the marketplace and mandate specific valuations? Why go through the charade of "managing" a market-based price discovery process? Greece would not need restructuring if the European Central Bank simply decreed that it would convert all Greek debt at par, setting the universal price. After all, Greek principal and interest payments are denominated in euros, so the ECB can easily supply them.

The answer here is that value in any human economic system cannot be directed by diktat or fiat order. If it could, central banks would have done it by now. Instead, value is conferred by scarcity . In engaging in market manipulations to create the appearance of monetary values for financial and derivative financial assets, central banks have turned value on its head by making money plentiful. Plentiful money has always been problematic.

Anyone with the means, and that includes those that hold the power of money printing, can pay $1 million for a stick of gum, but that only establishes a price, not a wider acceptance of value. But that is what central bank intervention is, the establishment of price in a narrow way. Greek debt scarcity and its attendant real value are governed by the perceived ability to repay, a direct link to the quantity of debt for a given tax base. If the market perceives a stable or declining tax base but the Greeks issue twice as much debt at a consistent price, the level of scarcity falls in relation to repayment probabilities, affecting the larger question of value.

It does not matter if the ECB buys a substantial portion at par; the larger system is not fooled into blindly believing in scarcity, or that price action equals true value. The marketplace will instead buy on the foolishness and irresponsibility of the central bank, buying up all Greek debt solely on the ability to pawn it off on taxpayers at an unearned profit. But even here, it only works as far as faith in the ECB and the euro is maintained, since value has not really changed. The central bank interference is nothing more than a game of musical chairs, with risk investors willing to play as long as they believe the music will keep playing. The second the music stops, that entire intervention and managed price discovery becomes irrelevant as the assets suddenly become bidless.

This is the essence of central bank liquidity management: ensuring that marketplace actors have enough money to prop up prices. But all that liquidity fails if there is no implicit, sometimes explicit, backstop of central bank guarantees. Moral hazard is fully acceptable because without it many more markets will find themselves bidless. This is the opposite of what investing is supposed to be - buying assets with the hope that the rest of the world never finds out what they are truly worth.

In fact, successful investment is predicated on buying something valuable before the wider world recognizes that value, with the greatest hope that the rest of the world will see that value. Investment scams work because they get a small audience to believe that they are discovering something valuable just before the rest of the world makes the same realization, meaning the subject of the scam is presented as undervalued by current prices.

In a way, central banks are engaged in nothing more than a modified "pump and dump". They are attempting to create the illusion of value through price action. By maintaining high valuations due almost solely to their own purchases, they hope to "attract" additional investors into the process. Whereas the exit plan of the traditional version seeks a higher price to disgorge the schemer's original holdings, the legal, central bank version is trying to buy public faith in order to disgorge a larger acceptance of a return to normalcy. In both cases, the public gets abused - suckered investors in the first, taxpayers in the second.

Contrary to Chairman Bernanke's meaning, in this vital respect tradition and reputation are far more important, not less. The more central banks fool investors into placing money into investments of ill repute through these legal confidence schemes, the less faith about the wider marketplace they will engender. There is already considerable damage to reputation after the great pains the ECB took in 2010 to repeatedly assure investors that Greek, Portuguese, Irish, Spanish, and Italian debt were safe and secure. Any investors that committed to purchasing such debt as a result of these assurances have fallen prey in the same way stock investors are taken in by illegal "pump and dump" schemes.

Considering the potential losses that the ECB, now heavily assisted by China, continues to create as all the PIIGS persist in issuing billions of euros in new debt, central banks are building on their own tradition of dishonor. Now the debate is about what kind of default should be employed by Greece; essentially who should be identified as the Greatest Fool.

The Federal Reserve, for its part, has added to its own fine tradition. Before the crisis, the Fed used much of its credibility to "assure" markets that everything was fine, right up and into a full-blown panic. After the panic, the Fed lost still more credibility on assurances of monetary efficacy with regard to the recovery, yet no recovery exists. It proclaims a job well done in "saving" millions of jobs, to the amazement of any impartial observer.

Trillions of dollars have been used on price discovery, especially in the stock market, but 45 million people continue on food stamps and the average duration of unemployment is now twice the previous record. Banks are enjoying healthy profitability, assisted by loan loss accounting, at the same time withholding credit from all but the largest obligors. Individual American savers who are doing everything right are bearing the brunt of all this monetary success, as zero interest rates transfer money from them to the very banks that colluded in creating this disaster in the first place.

Those that have the means will always dilute currencies. It is the greatest temptation of any fiat regime - the easy answer to all the hard problems. No one has to lose money if it can be created out of nothing. It sounds like the path to financial and economic paradise but it is the devil's bargain. No matter how much money they print, it will never be circulated fairly enough.

Market discipline, no matter how brutal, is at least objective and often meritorious, an acceptable condition to free people - free to succeed, free to fail, all regardless of size or stature. General interference, including fiscal interjections such as General Motors and Chrysler, breeds distrust. Fiat is simply an invitation to chaos and discord, so three years of ongoing uncertainty is wholly unsurprising. Price discovery due to interference is not really price discovery at all, meaning the larger class of investors will never fully commit or regain faith. If the game is rigged, fewer and fewer will play.

The interbank money markets are now, invisible to the broader public, tightly in the grips of amplifying turmoil because banks simply do not believe in each other's prices. Banking rules allow German and French banks, among others, to hold PIIGS debt at par on their books, establishing a price for their credit portfolios that no one actually believes (the very same problem as 2008, so much for progress).

Instead of transforming these artificial prices into increased faith within the intercontinental banking system, especially the eurodollar market, they have unleashed nothing but havoc. The mass of overnight lending activity has shifted out of unsecured transactions into collateralized loans whereby U.S. treasury bills are now the only accepted collateral - fewer and fewer institutions are willing to play the unsecured lending game. So we see the general collateral rate, for the first time in history, fall below zero. Inspiring confidence is not how I would describe this action.

For Mr. Bernanke and his contemporaries, gold's traditional value is not in question, which is probably what Congressman Paul's query was driving at. Rather, it was the value of fiat in light of its well-earned and sordid reputation that was being indirectly questioned.

Ironically, it is the ongoing tradition of central bank intervention and currency devaluation that is shining the brightest light on gold's intrinsic value. You may not be able to eat gold, but it is a constant reminder of the constraints that it places, even in our modern times, on central bankers - earning their scorn and pejorative dismissal. There is a reason that Americans' private gold holdings were confiscated by executive decree in 1933; they offered actual protection against the currency devaluation that was being planned. Gold is the foil, the opt-out, of every central bank confidence scheme.

Central banks are betting the financial health of their constituents on the theory that they can buy prosperity. Just like the eccentric art collector that vastly overpays for some obscure artist's original work, the Fed and its global counterparts are hoping that the rest of the world comes to see what they see, to value what they have valued. They are hoping that the prices they establish through narrow transactions become universally accepted as true value. If not, then the central banks will once again transfer to the rest of us the cost of eating their art.


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