Modern Day Mutually Assured Destruction

Before the most recent report on Lehman Brothers’ use of Enron-like methods to hide debt from its balance sheet, Greece had recently been accused of similar shenangians. The sovereign was under scrutiny for swaps it had set up with Goldman Sachs that allowed the nation to mask its real debt load, effectively cooking its books in order to meet the fiscal standards required for admittance into the Eurozone in 2001. This was not the first time this type of deceptive transaction had been consummated.

The joyfully iconoclastic financial blog Zero Hedge had uncovered a little-known 2001 report by a little-known Italian Economist named Gustavo Piga which showed that Italy had used almost the exact same transactions as those used by the Greeks to mask their finances and gain entrance to the Eurozone in 1997. For his courageous exposé, most disturbingly Piga’s life was threatened. Why was this the case?

Piga had been the first to find “…a real-world example of how sovereign borrowers can use derivatives to window-dress public accounts as a means of achieving short-term political goals.” As the Council on Foreign Relations which collaborated with Piga on the report noted, Italy was able to do this by “taking a cash advance in 1997 against an expected foreign exchange profit in 1998. Under accounting rules, this is simply impermissible. Borrowers cannot use loans to anticipate capital gains on a bond.” The transactions allowed Italy to artifically reduce their deficit in 1997 by increasing their deficit in 1998.

And according to the CFR, what was the significance of this Enron-like Italian book-cooking?

First, governments have clear incentives to cook the books. The EU continues to impose fiscal expenditure restrictions on eurozone governments, violation of which can result in censure and fines. The International Monetary Fund imposes fiscal conditionality on its client governments, which naturally have a strong incentive to keep the Fund from closing the money spigot. Derivatives can be used to shuffle cash flows through time in ways that current accounting rules do not prevent.

Second, banks are only too willing to market derivatives tricks to their big client governments, particularly when it puts them at the front of the queue for future bond issues and privatisations.

Third, if the integrity of government financial data is fatally undermined, the damage to stock and bond markets will dwarf the “Enron effect” that has recently pummelled the Dow.”

Is nothing sacred?!

One might ask why we in the US in 2010 should care about this 2001 report on Italy’s sleight of hand in 1997. Besides reminding us to always question government data, in my view this story represents the sort of incestuous relationship between big finance and big government that has transcended all eras, and which has significant explanatory power when it comes to our current economic situation. The above anecdote taken with what is forthcoming serves to show us that banks exist at the mercy of governments, while governments exist at the mercy of banks, with each side knowing that the death of one will trigger the death of the other. It is the 21st century’s version of Mutually Assured Destruction. Ergo bailouts.

For all intents purposes, this relationship began in the United States when we chartered our first central bank in 1791. President Andrew Jackson upon taking office in March of 1829 said of the second iteration of the Bank of the United States that it was a:

“monster, a hydra-headed monster…equipped with horns, hoofs, and tail so dangerous that it impaired the morals of our people, corrupted our statesmen and threatened our liberty. It bought up members of Congress by the Dozen…subverted the electoral process, and sought to destroy our republican instutions.”

Historian Douglass Adair’s critique of the architect of our initial national banking system read as follows:

“In carrying out his scheme…Hamilton transformed every financial transaction of the Treasury Department into an orgy of speculation and graft in which selected senators, congressmen, and certain of their richer constituents throughout the nation participated.”

Indeed it was the original Hank Paulson that had lobbied against the sage Jeffersonians and won his prize of a national bank, Treasury Secretary Alexander Hamilton. Hamilton pushed for this bank for a handful of reasons. First, the central bank allowed the government to issue increasing amounts of debt to be held by the wealthy (politicians included), as the debt could be serviced through its monetization. Second, the central bank allowed the government to inflate the currency and increase and cheapen the supply of credit, in the case of the former through debt monetization and in the latter mere pump priming in order to both increase the size of government and artifically grow and prop up favored businesses such as those of Hamilton’s manufacturing friends in the Northeast, without explicitly increasing taxes. Third, the central bank granted lawmakers leverage over other private banking institutions by virtue of its size and political clout, either crowding out competitors or bending them to its will. For Hamilton had learned well from his statist predecessors. It was because of this monetary inflation that America suffered its first central bank-induced boom-bust cycle in the Panic of 1819, a Hamiltonian tradition that remains to this day. Though President Andrew Jackson would ultimately kill our national bank, the precedent for government-bank tethering and its pernicious effects had been set.

Due to President Woodrow Wilson’s creation of the Federal Reserve in 1913, a bank that had been long agitated for by the nation’s largest financial interests, and FDR’s ending of all fiscal restraint in effectively abolishing the gold standard, today we have a monetary system that has all the defects of our original one and many more. Our PINO (Private In Name Only) central bank overtly cartelizes all of our major financial institutions and serves as their moral hazard-inducing “lender of last resort.” The banks no longer need to pyramid paper money off of gold or silver because instead the Federal Reserve prints money which it lends to our banks who create ever-increasing amounts of money out of thin air through a process called fractional reserve banking. As an aside, for those interested in this intentionally pedantic minutiae, I have written brief primers on our monetary system and the oft-misunderstood function of money in general.

In any event, the constant expansion of the money supply by the Federal Reserve allows the government to spend endless amounts of money without explicit tax increases, create artificial booms beneficial to favored constituencies that ultimately bust allowing the government to intervene even more, pay off entitlements and debt in ever-cheaper cash and generate increasing costs in goods and services that further distort the market mechanism of the price system even during the deepest of downturns, hindering economic calculation. It allows the government to prevent the necessary adjustments in the markets to clean out the wastes and imbalances that the government’s money printing has created, for the benefit of borrowers, spenders and those who get their hands on the money first, the banks.

This charade exists because of a quid pro quo between governments and banks. The government is given the freedom to do as it wishes, with the banks willing to continue to underwrite and make markets in government debt, and clearly in certain circumstances help government mask its fiscal sins (for a fee) so long as the banks are protected. Perhaps only the bond vigilantes can save us, save being a relative term because our borrowing costs would skyrocket. The governments need the banks to help finance themselves in insolvency, while the banks need the governments to help cover their own insolvency through the use of their coercive power to bilk the taxpayer. Any financial reform bill will merely perpetuate this symbiosis. And in this system of Mutually Assured Destruction, at every turn the prudent, the responsible and the moral will be further abused.

In 1790 when Mayer Amschel Rothschild said “Let me issue and control a nation’s money and I care not who writes the laws,” the man was not kidding. That Italy and Greece used major banks to mask their fiscal problems, and that the major banks throughout the world were bailed out by sovereigns is no coincidence. With each country’s central bank printing money and cartelizing their banking institutions, sovereigns and banks have become inextricably linked. The result is that they must continue to support each other until the taxpayer is bled dry. Unlike in the time of Hamilton however, today the government has developed similar arrangements with other industries, such as that of the automobile, energy, education, manufacturing and agriculture, in addition to other interests that can be subsidized or otherwise bribed for votes.

But in no other industry (national defense aside) does the government centrally plan to such a great degree as that of finance. The government’s monopoly control of the supply of money and credit, and its backstopping of our banks makes the Treasury-Federal Reserve-controlled system the heart of our Leviathan. It is not only anathema to our freedom, but a major threat to it because it secretly facilitates the exponential growth of government. This intentionally opaque system of money creation – not to be confused with wealth creation as it actually reduces it – out of thin air suffers from the same failures as every other system of central planning, but it has become so ingrained in our psyche, and as a result its few questioners so marginalized that we continue to accept it. And so the government will continue to support the banks, and the banks the government until the system bankrupts itself, or the people rise up and refuse to give it their sanction.