Wall Street

Wall Street

In this post, “The Vanishing Middle Class,” I left off with this sentiment:

“There are no saviors remaining, and the next storm will be too big to control.”

Substantive changes, alas, usually emerge only through substantive shocks. Yet, if we can channel the proper momentum towards these upcoming changes, not all will be lost.

In this post, we will see that lower- and middle-income households have unknowingly bailed out the Wall Street banks again, in advance of the next storm.

To find support for this contention of a coming storm, I turn to an news analysis posted a couple of years ago by Ellen Brown on truth-out.org.

Brown, in her analysis on the liquidity squeeze for small and medium-size firms, laments over Wall Street banks’ sitting on $1.6 trillion in excess reserves (as of July, 2011, now at ~$1.5 trillion according to FRED), rather than lending this money out.

She quotes Ronald McKinnon, from his article “The Return of Stagflation” in the Wall Street Journal on how local banks are dependent on the interbank lending market, and why the inability to access this market created reluctance on the part of local banks to extend credit lines to small businesses:

“Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when – and by how much – he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines.”

In her article, Brown blames the large Wall Street banks for not tapping their excess reserves, affecting the interbank lending market and thus placing local banks in dire straits as just described by McKinnon.

But McKinnon’s observations equally apply to Wall Street banks. One of Modern Monetary Theory’s contentions is that “loans precedes deposits” rather than the traditional view of the converse. Reserves are thus always found to cover created lines of credit.

This creates two problems for all banks, but in particular the large Wall Street banks: First, the minimal reserve requirements in place prior to 2008 meant very little of the credit lines were actually covered by reserves in the event of a simultaneous draw-down of credit lines. This, however, is probably less likely than the very real (and second) problem of defaults arising on the money already tapped from credit lines (and home equity lines, mortgages and other non-performing loans still lurking, unseen, under the balance sheets of Wall Street banks).

When the Wall Street banks received their bailouts or soon after, in closed-door meetings between these banks, The Fed and the Treasury, government officials may have informed the banks that should another financial collapse occur, no second round of bailouts would follow. This inability to muster additional rounds of bailouts may have been caused either by the assumption that a lack of political will be there for subsequent bailouts due to popular outcry, or that simple, straightforward bailouts can no longer be pursued (but stealth bailouts, on the other hand, can still be pursued).

Now consider this in juxtaposition with what the Wall Street banks may be seeing from their exclusive 60,000-foot view of the global monetary system: high levels of stress remaining in global financial markets. Thus, the Wall Street banks are sitting on their excess reserves, understanding full well that they will have to bail themselves out after the next financial collapse.

The insidious unknown is whether the Wall Street banks will actually be capable of saving themselves. Yet this would explain not only the banks’ reluctance to tap excess reserves, but also the insatiable appetite for using their liquid capital to generate returns from commodity and equity investments. These banks are simply trying to build their war chests as quickly as possible.

And this excerpt from Bloomberg News underscores my contentions:

“Since the 2008-2009 financial crisis, U.S. regulators have tried to minimize the odds of another taxpayer rescue, compelling U.S. banks to retain some earnings and reinforce their buffers against possible losses. With the economy in the fourth year of expansion, banks are benefiting from… record-low short-term interest rates that boost earnings.”

Fear of Inflation? Or Deflation?

“The fear of price inflation has prevented governments,” Brown writes, “from using their sovereign power to create money and credit to serve the needs of their national economies.”

Au contraire.

Bernanke’s quantitative easing (QE) efforts have been a reaction to his singular obsession with preventing the onset of deflation. His wish may be to “create money and credit to serve the needs of (our) national (economy),” but QE isn’t working towards this end. Rather, it has fueled the rise in commodities and equities and the returns from these investments, actively pursued by Wall Street banks and their protégé hedge funds.

That Bernanke’s QE efforts have prevented deflation from setting in cannot be argued with, but it has also created a negative externality: In a period when most household incomes are in decline, any rise in commodity prices squeezes out what little money remains in circulation at the low- to mid-levels of income. There is no growth in incomes to cover the growth in food and energy prices. The money to cover the difference is coming out of households’ discretionary income, which of course assumes a discretionary income remains.

In essence, lower- and middle-income households have bailed out Wall Street banks (for the next financial crisis) by paying more than they should for food and energy. In fact, consumers of food and energy around the globe have contributed.

So we can draw the line from rising commodity prices to Wall Street’s war chests. But what about the gains from equities, from those rising stock markets? Wall Street banks have an exclusive view of stock-market activity, thanks particularly to high-frequency trading algorithms. They will know when to bail on equities and collect their profits. But for outside investors who have dived into the stock markets due to their rapid rise – the “muppets” of Wall Street lore – they will also contribute to Wall Street’s war chests… when they are forced to book their losses.

Without argument, such investments have helped Wall Street fill its war chests, and Bernanke to avoid deflation. It has helped them, not us.

No one should read this as a defense of Wall Street Bank’s actions, not even for excess reserves. Even if these reserves allow Wall Street banks to survive the next downturn, this will come as cold comfort, for it will mean the surviving banks will be more powerful than ever, while the economic scene at large will be strewn with the rotting corpses of smaller banks and small businesses, not to mention a precipitous growth in households with critically decimated finances.

I believe the Wall Street banks, while taking pains not to call attention to their survival tactics, are well aware of the coming storm. But they are out to save themselves, damn the taxpayers who helped them survive the last calamity.

03.14.2013 update: Finding additional support for the argument, here is an update from Bloomberg News on those topping the list in revenues from commodities. Guess who’s No. 1 and No. 2?

Photo from photographerglen licensed under Creative Commons