Explicit and Implicit Defaults

Institutional Risk Analytics: So Alex, a lot of people liked your rant about abolishing FASB (the Financial Accounting Standards Board). Got a good bit of mail on that one.

Pollock: I don't think it's a rant. I think it is a calm statement of what has to be done.

As Schumpeter said, progress in capitalism means turmoil.

The IRA: But what do you do when a society like the U.S. does not want to be inconvenienced with balancing budgets or going through a recession? We seem to live in a fantasy world where the only progress is made via a grudging admission of the truth. Ed Kane at Boston College makes this point regarding bank supervision and the Fed. We keep coming back to literally metaphors like Faust and The Matrix to explain our national dysfunction when it comes to the economy.

Pollock: It is always easier to borrow as long as someone will lend to you. When the lenders stop lending, that's what forces the change. Witness Greece and the EU.

The IRA: But is there any brake on the U.S. when we can lend to ourselves? So long as the Fed is able to make it all better via quantitative easing and other forms of currency inflation, there does not seem to be any political brake on the U.S. as there was in the 1970s and 1980s.

Pollock: You cannot really lend to yourself…

The IRA: But the Fed did buy the Treasury and agency market in 2009. The same quantitative easing that was used in the 1930s, incidentally. The St Louis Fed has an excellent monograph by Richard Anderson on this period. Here's an excerpt: "In early April 1933, Congress sought to prod the Fed into further action by passing legislation that (i) permitted the Fed to purchase up to $3 billion in securities directly from the Treasury (direct purchases were not typically permitted) and, if the Fed did not, (ii) also authorized President Roosevelt to issue up to $3 billion in currency. The Fed began to purchase securities in the open market in April at the modest pace of $50 million per week."

If you inflate the $2 billion in Fed purchases of securities between 1933 and 1936, plus Treasury purchases of gold with newly minted greenbacks, the total quantitative easing from the Great Depression in today's nominal dollar totals into the double-digit trillions, far larger than the Fed's latest exercise in currency inflation. Maybe we have not spent enough funny money to "jump start" the American economy, to use the Big Media Newspeak.

Pollock: Quantitative easing is only a temporary solution. European banks buying European countries' sovereign debt is another example of a temporary solution.

The IRA: But currency inflation is definitely the flavor of the month in policy circles.

Pollock: Currency inflation is another way of creating a default. In the end there are only two choices: debt is paid or it is defaulted upon. There are implicit defaults and explicit defaults. We are all headed for implicit default--that is my summary of the situation.

The IRA: So what is your take on financial reform?

Pollock: I don't see any. I call this type of legislation regulatory efflorescence bills. There is massive new regulation, but I don't believe that this constitutes reform in any meaningful way.

The IRA: Thanks Alex.

Alex J. Pollock is a resident fellow at AEI.

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