US $ 92 QUADRILLION: FEDERAL RESERVE COMPUTER ALGORITHMS

Time to Pay (up), Pal
By Chan Akya

Imagine waking up one morning, seeing your monthly bank statement with US$92 quadrillion showing as your account balance. I don't know about you, but it would certainly make my day. In any event, as with all things that look too good to be true, this one too was the result of an administrative error that saw PayPal, the online payment engine that powers E-Bay and a number of other entities around the e-commerce world and increasingly even in the real world, credit the amount into someone's bank statement.

The mere fact that a computer program would be allowed to dispense these sort of amounts seems problematic when one considers that the amount represents $13.17 million for every man, woman and child on this planet. Heck, I would love to wake up to see that number on my bank balance in the morning, leave alone the 92 quadrillion.

It is also a reminder that 90% of the volumes reported by Wall Street come from electronic trading platforms, a number of which are powered by computer algorithms that perform automated trading, and occasionally lead to massive system errors - one remembers the Knight Capital trade in August 2012 that saw the company losing over $460 million.

That kind of error is problematic but one needs to start considering the mistakes in the light of what stands as actual, official policy these days across the United States, much of Europe and Japan: specifically, the myths being built around quantitative easing (QE) programs.

Remove all the trappings of policy and vastly unproven family of assumptions underpinning QE, and what you are left with is a simple, inescapable truth: the Federal Reserve is simply and randomly crediting bank accounts with vast sums of money in the hopes of re-igniting economic growth.

The QE process is simple; using the US example - the Fed buys off US government securities from the dealer banks, which go into the auction of these bonds knowing full well that they have a buyer behind them. Interestingly, they also make a bit of money in the process, buying the bonds at one price and selling to the Fed at a slightly higher price (lower yield). It is not much on the face of it, but for what is essentially a risk-free activity, they do make a lot of money off the Fed.

What do the banks do with this money? For the past few years, dealer banks, which are basically the largest US banks, have been plugging the holes in their accounts from the financial crisis - losses arising from sub-prime loans and commercial lending for sure, but perhaps more importantly all the losses racked up from reckless investments in collateralized debt obligations (CDOs) and asset-backed securities (ABS) even more.

The other effect of the US Fed purchasing federal government bonds is that overall yields drop; and therefore push investors off the "safe" investment choices to be replaced with other possibilities such as corporate bonds and non-guaranteed (riskier) government securities such as those issued by state governments and municipalities. Whilst that trickling down of investments has indeed happened - witness the sharp run up in ABS prices for the past three years - there are still significant gaps in the functioning of various markets.

Various states such as California have highlighted issues with their borrowing programs, but the story is much worse one level down at municipalities. Small cities across the US have been badly affected by the financial crisis, with many having to shut down essential services including fire and police to cut their overall spending, even as other expenses such as pensions have remained bloated and essentially out of control due to worker legislation.

Detroit, which announced a Chapter 9 filing on Thursday, simply was the largest city to have declared a filing thus far; it is unlikely to be the last. Given all the QE sloshing around the system, why is Wall Street not funding Detroit and similar cities? Simply because the intrinsic credit risk of such cities is far too high for bankers to enter into without sufficient downside protection.

Put another way, bankers don't want to jump out of the frying pan of subprime loans into the fire of municipal bonds. It is of course rather ironic that it was the initial granting of subprime loans that helped house prices to rocket up in various cities, pushing up property taxes (collected by cities), and in turn pushing them to increase wages and services. The revenue is gone, but the cost remains - hence the spate of bankruptcies.

From an intellectual perspective though, the question begs: why is the Fed bailing out private sector entities (banks) when public sector entities (cities) are going bankrupt?

Now, I am not one to recommend bailouts of either; but the question is key as it attacks the very basis of Keynesian idiocy that underpins today's QE programs around the US, Europe and Japan. The very notion of trickle-down economics is questionable when one considers the data - high unemployment in the US and Europe - and more so when one considers the mechanics.

Why not lotteries?
Perhaps it is time - tongue in cheek if nothing else - for various governments to consider a lottery system in place of QE. Here is the idea - take a list of all citizens and make lottery payments at regular intervals directly into their bank accounts. The only stipulations for "winners" should be:

• All winnings to be spent or invested within six months, after which the bank accounts will be 'swept' back to the government;
• No investments in stock or bond markets;
• If winners want to invest in property or real estate, they will be required to buy only "new builds" or else pay off the mortgages on their existing property;
• No currency exchange or repatriation outside the country;
• No purchase of any products or services from outside their national boundaries.

Economists will immediately agree that under the above conditions, lotteries will immediately add to the gross domestic product of these countries running them, rather than very circuitous way that is employed currently, which has produced precious little for economic growth and/or employment. As winners will have to spend the money on buying consumer goods or buying houses, employment will immediately increase inside these countries as well.

Jokes aside, the point being made here is that QE hasn't worked for the economies involve. Rather, it has become a pure market phenomenon that seems completely divorced from reality and is also the key cause of market volatility, as the last few weeks' ups and downs have shown. Unless more thought is put into addressing the lack of any real economic impact, QE will remain a failure; and cities/states around the world will continue to go bankrupt.

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