Overheard at a Washington, D.C. bar: “Truth is like poetry. And most people fucking hate poetry.”

This essay was started on February 5th, 2016 at the inception of the most recent bear market.

If you are reading this public essay, chances are it may be because of your abundant curiosity surrounding the most recent economic instability in the United States stock, housing, and employment markets. Subsequently, this instability ends in yet another devastating recession that makes each of its respective predecessors look like a tiny blip on the radar.

Thus, the whole point of this series of notes is to get your mind off social issues , higher minimum wage laws, the war on ISIS, feeling the “Bern”, and defeating Wall Street, for now at least, as I feel we, as a nation, have much bigger problems to confront. These so-called “problems” need to be addressed at the individual level through education, data analysis, and clever storytelling rather than repeating slogans from a political pundit to give oneself a sense of empowerment.

This series of notes aims to:

Bring clarity to the outrage that many are experiencing towards Wall Street Shed light on the root source of the problem ( i.e policy errors by central banks ) Keep the reader’s mind open to a change in philosophy regarding economics, personal responsibility, and specific political views when it comes to artificial price controls.

I challenge you, the reader, to think about the present moment in a much more practical sense, as many of the important life lessons we learn are quite simple and I would argue, with semi-reassuring confidence (with room for human error of course), that this particular instance is no different.

Man Crush Mondays, Am I Right?

Let’s take a look around for a second or two at the present U.S economic landscape; more jobs lost in manufacturing, higher tuition, higher food prices, higher rents etc (1). These price increases and job losses at the lowest levels of our economy have a profound negative effect on our working class when wages remain stagnant. Hence the rise of campaigns championing the attack on Wall Street, increasing taxes on the 1%, and raising the minimum wage. It would seem that the era of people wanting wealth distribution via government intervention is clearly underway, and has been for quite some time in the United States, but what we need to do is stop and take a clear and hard look at the events that have lead up to this pivotal moment in human history. We then need to ask ourselves whether or not we want to proceed forward with that particular line of thinking and activism. Take a look at the chart below.

How did this happen? is Wall Street to blame?

What we are going to talk about: how bubbles are blown, who causes it, and how we can fix it.

What is a Bubble？

Sharp rise in price of an asset or range of assets in a continuous process, with the initial rise generating generating expectations expectations of further rises and attracting new buyers (Kindleberger, 1978)

Who is to blame for all of this bubble blowing? I ask this question because we all love to play the blame game in the inception of our anger. (Dammit, someone already stole my idea for a TV show called “The Blame Game”) The popular consensus seems to lean towards the big bad Wall Street monster that is no longer hiding in America’s closet but has rather taken over your room and forced you to sit outside in the cold while Gordon Gecko relishes in your “Netflix and Chill” lifestyle. You are, like most, probably anger and then put that anger into words to communicate your distaste for the elite and “evil, money grubbing” corporations.

I’m sure you have heard this regurgitated sound bite before, but what does it really mean?

“Wall Street is too greedy, Wall Street collapsed the economy, Big Banks are the problem!! Wall Street this, Wall Street that!”

It’s easy to repeat it and nod your head in agreement so you don’t seem stupid in front of your peers, but ask yourself this:

How much do you actually know or understand about investing or banking for that matter?

Do you know how to read the spreads on an option or hedge a position?

How is the money supply controlled and what creates inflation?

It’s much harder to take the time to understand the systematic problems, and better yet to come to a conclusion on how to fix them in a comprehensive and well thought out manner than to sit in the peanut gallery and demand financial equality from your government.

I’m not saying outright that the above quotable words do not have some truth sunk into their regurgitated rhetoric, but with every infection, there always seems to be a root source of the “contagion”.

Think of Wall Street as the rash on your back that will not go away, and while it is certainly annoying, the problem only starts there. Any doctor or medical journal can tell you that a simple rash can be systematic of a much deeper threat to your health and well-being through several viruses, environmental causes, food allergies or god forbid a terminal illness.

Stop trying to treat the rash and focus on the bigger issue.

The bigger issue being our Policy Error Making, Debt Burdened, Central Banking System or as it is more commonly known as, “The Federal Reserve”.

What is the Federal Reserve System and why should you care?

The House that Greenspan Built

The Story of the Biggest Central Bank in Human History

When people talk about the “Big Banks” they are often referring to J.P Morgan-Chase, Deutsche Bank, Wells Fargo, Bank of America, Barclays, etc, but most seem to forget about the central bank and the larger role this particular banking system plays in manipulating these commercial and investment banks along with the overall economy.

The Federal Reserve (as seen above), often referred to as the “The Fed”, was brought into this world by The Federal Reserve Act of 1912 because of a series of banking panics, most notably that of 1907, that led to massive bank runs and civil unrest during the progressive era. A central banking system was thought to be able to bring stability in times of volatility by providing liquidity to markets so these banks did not have to close their doors and to a lesser extent so the President didn’t have to beg J.P Morgan for financial help after government-sponsored subsidies failed to stimulate major businesses resulting in bankruptcy from insolvency.

While the Federal Reserve may share the same street name on their address(i.e Constitution Ave) as many government agencies, it is not, in fact, a branch of our government.

“Say What?”

That’s right.

The Federal Reserve is an independent bank.

The word “Federal” is probably what throws you off, as this word is associated with a government entity.

“ The Federal Reserve System considers itself “an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms.” (2)

The Federal Reserve System’s structure is composed of the presidentially appointed Board of Governors or Federal Reserve Board (FRB), partially presidentially appointed Federal Open Market Committee (FOMC), twelve regional Federal Reserve Banks located in major cities throughout the nation, numerous privately owned U.S. member banks, and various advisory councils.

You Don’t have the power to elect bank officials only presidents…see the problem?

Regional Banks were created as a safeguard against the Central Fed

There is a very small amount of people who have power over influencing markets with monetary policy and we all know what happens when a few people have power over such extraordinary wealth, but we will get to that discussion soon enough.

What Does the Fed Do?

Copied straight from The Board of Governors website

Conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices Supervising and regulating banks and other important financial institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets. Providing certain financial services to the U.S. government, U.S. financial institutions, and foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.

The 1st bullet point is the most important point to remember here as this is where the Federal Reserve really flexes their greased up muscles in the sparkling debt servicing sun.

Keep in Mind: The Federal Reserve CANNOT directly control these elements i.e full employment and prices; they simply use monetary tools to indirectly influence markets.

How does the Federal Reserve Implement Monetary Policy to Indirectly Manipulate Markets?

1) The Federal Funds Rate

The cliff note version.

The Federal Fund Rate is the short-term interest rate that the central banks use to charge interest to the regional banks, investment banks, and commercial banks when they loan these institutions money. Conversely, the banks will earn interest on the reserves they keep in the vault. The Federal Fund Rate essentially will dictate the amount of money that people and financial institutions are willing to put into or withhold from the market.

When the central banks change these rates the rest of the market adjusts to these rate changes as well. Otherwise, these banks would be unable to compete in free markets, lose profits, and have to close down their doors. Monkey see, monkey do.

Fed Set Rates, Commercial Banks adjust and is then loaned to people

- Tightening -

When you hear the word “tighten”, this means that the Federal Reserve is raising short-term interest rates and attempting to contract the money supply.

- Easing -

When you hear “easing” or “expansionary”, it means the Federal Reserve is lowering the short-term interest rates in order to make credit more freely available.

Why does the Federal Reserve tighten and ease short-term interest rates?

The idea is:

1) By lowering interest rates, this will encourage more people to borrow money from the bank to start a business, get an education, buy a car, etc.

2) Conversely, by making interest rates higher; it encourages people to save as the interest rate on loans becomes more expensive and the savings rates become a much more lucrative investment strategy .

Fed Interest rate change over time

As you can see in the above (I hope you can), the Federal Reserve has gone through many tightening and easing phases like the Paul Volker years of the 80’s and the low-interest rates mania of the 2000’s which were brought to us by the one and only King Alan Greenspan. (We will discuss his role in the dot.com bubble in the next note i.e Asset Bubbles 102)

Why manipulate rates? What is there to gain?

Time.

Time is a factor necessary for production, and unique in the sense that we cannot economically allocate it like other inputs. The choice of time is always “sooner or later” and never “more or less” (as is the case with other input factors). Interest rates help us determine how soon we should consume a good, or how long a production process should be. Low interest rates imply that the future is not heavily discounted. At a low rate, you will be willing to wait a longer period of time to realise the enjoyment of consumption or the profits of an investment. High interest rates invoke the corollary — you will want to consume earlier, or employ production processes that pay off in as short a time as possible. — (3)

By manipulating rates, the Federal Reserve is manipulating the rate of production and the amount of time it takes for profits to come to fruition; This is a “get it now, pay for it later” type of mentality. Thus, by indirectly manipulating the banks money supply they are attempting to create a “wealth effect” to indirectly influence the minds of consumers and investors to spur positive economic activity as no one can force you to spend or save money; market factors determine this.

If manipulating rates are not enough to influence markets, the Federal Reserve has one more trick up its snarky sleeve.

2) The Buying and Selling of US Government Securities on the Open Market

What in the Heck is a US government whatcha-ma-call-it? A government security — such as bills, notes, and bonds — are debt obligations of the U.S. government.

“Why would I ever want one of those?”, you ask.

People purchase these securities as it is assumed that a federal government is a safe place to store money, has a small chance of defaulting, and will pay interest on the loan. Uncle Sam needs our money and he is willing to pay a pretty penny to borrow it from us.

The United States Treasury creates these debt obligations, and the Federal Reserve can either buy or sell them to banks.

- Buying Treasuries -

The Federal Reserve will buy securities by purchasing them from the open market and crediting the reserve accounts of the banks that sell these securities.

When the Federal Reserve buys these bonds, they are creating money. Period.

- Selling Treasuries -

When the Federal Reserve sells these securities, they take the funds away from the banks by withdrawing money from their reserve accounts.

Why would the Federal Reserve want to do this? For the same reason they want to raise and lower interest rates: They want to indirectly control the money supply and buy/sell more time.

As you can see from the above, The Federal Reserve has more than tripled their balance sheet since 2008; this is not normal policy. Before the crisis, the amount they loaned out to the banks was trivial and the amount of T-bills bought was slow and steady. Their main way of controlling the money supply was through short-term interest rate manipulation until the financial panic of 2008; this changed everything.

However, I want to hold off on discussing this topic as we will talk about the massive debt purchasing program known as “quantitative easing” in part 4 of this series of notes.

Note: These are the two main ways, there is also the discount rate as well as changing the reserve requirements but these are seldom used as major instruments in manipulating markets and more or less are for security and last resort measures.

Onto the grand question…

How does all of this affect me?

#YOLO

After reading the above, my hope is that you, the reader, can see that the Federal Reserve’s main goal is to indirectly control markets by adjusting interest rates and buying/selling securities. What could possibly go wrong?

Would you agree with me that humans are capable of error? That even with all our extensive algorithms, economic theories and fancy universities that our brightest minds are still susceptible to making mistakes? Well, what if the Federal Reserve adopted a poor economic plan and then implemented it? What effect would that have on the rest of us?

The money on “Wall Street” is affected by the Federal Reserve and if the Federal Reserve makes a policy error that in turn affects the banks, which then affects the amount of debt in the economy, which can then subsequently affect businesses, wages, consumer prices, home prices, and your ever so precious piggy bank.

Federal Reserve Policy Error (The contagion) → Wall Street/Investment and Commercial Banks selling garbage assets and issuing bad loans → Businesses investing incorrectly and Bankruptcy → Then finally you, the consumer, buying superfluous products, losing your job and being buried in debt.

This chain of events is referred to as “trickle down banking”. It is because of this that many investors around the world are becoming concerned that these polices have turned toxic and are creating an environment that is now the opposite of what they aimed to achieve i.e growth and stability.

“This is where delusion arises. Not only have wealth and currency effects failed to spur a meaningful recovery in post-crisis economies; they have also spawned new destabilizing imbalances that threaten to keep the global economy trapped in a continuous series of crises.”-(4)

“Far from making the world safer, then, there is a risk that the post-crisis policy mix has simply suppressed problems, making markets stickier, and may even have added to them, by driving the global credit cycle far ahead of the current interest rate cycle. “ — Matt King (Citi Group, Head of Product Strategy)

Take a look at the graph below:

S&P 500 Index Compared to Federal Funds Rate

Notice something? As the Federal Funds Rate falls the prices of stocks explode to never before seen highs. This is a prime example of how central bank policy will manipulate market psychology into buying and selling assets at “artificial” prices. You are now potentially overpaying for goods and services while your wages have not moved because of a central bank policy that was decided by a small group of individuals rather than the masses.

Get the picture?

The Federal Reserve possess the capability of blowing “Asset Bubbles”, and we are currently in the midst of another one.

For instance: If we lower Interest rates below what the market rate is currently returning, more people will pull their money out of CD’s, savings accounts, and government treasuries to invest in stocks, corporate bonds, housing, etc to chase higher yields. This is one way to blow an asset bubble as we will discuss in the next section i.e Asset Bubbles 102.

Summation

Essentially, the stock market crashes that millennials have grown up with are not normal parts of an economy, but ,unfortunately, we haven’t lived in a world without them, so how could we possibly believe in another way of thinking? Which is why the information I’m presenting is so extremely relevant in present terms and gives us insight into the way debt is structured and how it can create massive problems for the “common people” when central planning runs a muck.

Let me put it to you this way. Trying to control an economy of 300 million people by manipulating interest rates and government incentives while also competing against a global supply chain sounds like the most difficult, if not the most impossible, endeavor to take on for which central planners ,time and time again, have failed to achieve throughout modern human history. Will it be any different this time?

What we do know is that Wall Street did not inflate those prices on its own, so let’s start investigating who or what did.

Act 1. scene 1

Enter the Alan Greenspan Put, and the beginning of irrational exuberance in America.

See Asset Bubbles 102 to continue on this magical, yet abysmal financial journey through our nation’s history.

Lastly, I will leave you with this quote from one of our founding fathers, Busta Rhymes. No, that’s not right. Ah yes, here it is. What I meant to say was, Thomas Jefferson.