Amygdalotomy: Surviving the Intentional Demolition of Warning Signs

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On corporate welfare, bankruptcy, and bank failures

We begin with several propositions, all that will be demonstrated below, but that may be useful to include up-front in order to prime what follows:

1) One of the most dangerous forces currently threatening U.S. economic, financial, and public health is the intentional demolition of warning signs that would otherwise enhance survival.

2) Market lows associated with U.S. recessions have generally occurred at valuations that were about 40% of those prevailing today – and sometimes even less. If investors assume that valuations will never again approach historical norms, they must also accept that future investment returns will be dismal compared to historical norms. To say that “low interest rates justify high valuations in stocks” is also to say “low interest rates justify low future returns in stocks.” If one wishes to protect overvalued prices, one also has to accept meager long-term returns.

3) Investors should be careful to avoid the misconception that easy money always supports the market. The fact is that market outcomes are conditional on whether investor psychology is inclined toward speculation or toward risk aversion. This is best inferred directly from the uniformity or divergence of market internals. Despite the fact that the Fed eased the whole way down during the 2000-2002 and 2007-2009 collapses, investors have come to believe that Fed easing always supports stock prices. That’s the wrong lesson, and the re-education of investors is likely to be excruciating.

4) As long as the public has confidence in government liabilities, the Fed can do as much “quantitative easing” as it wants – buying government bonds and replacing them with base money – or vice versa, and it won’t change the underlying belief that those pieces of government paper are “good” – regardless of which form they take. Quantitative easing in itself does not produce inflation.

5) It is not simply currency creation that creates inflation, but currency creation for the purpose of financing government deficits, to such an extent that public confidence in government liabilities is destabilized. The inflationary consequences tend to be particularly severe when these deficits occur during “supply shocks” when production of goods and services becomes constrained for one reason or another.

6) These pieces of paper created by government, even if they were non-inflationary, are not just monopoly money. Each dollar represents a claim on real goods and services produced by others. It matters who gets them – free and without collateral – and for what purpose. They are a grant of purchasing power to those who receive them, and they have a profound distributional impact.

7) The announced plan of the Federal Reserve to “leverage” Treasury funding in order to purchase outstanding uncollateralized corporate bonds from investors is a wholly illegal violation of Federal Reserve Act Section 13(3), as well as CARES Act “Terms and Conditions” Section 4003©(3)(B), which “for the avoidance of doubt” applies 13(3) requirements to the use of public funds “including requirements relating to loan collateralization, taxpayer protection, and borrower solvency.” Uncollateralized corporate bonds do not serve as their own collateral. Moreover, there is no assurance that investors will use the proceeds to support those same companies, or even the U.S. economy.

8) The moment the government runs a “deficit,” there is absolute certainty that at least one other sector – households, corporations, or foreign countries – will run a “surplus,” in which the income of that sector will exceed its consumption of U.S. goods and services and net real investment (e.g. homes, buildings, capital equipment). The structure of the aid package affects which sector accrues this “surplus” (which in equilibrium, must ultimately be invested in the very government liabilities that created it).

9) Two policy features are essential to prevent public funds from being used for excess compensation, private profit, inventory accumulation, deferred expenses, or “new” payments by corporations to related parties and subsidiaries:

a) Set a “basic income” threshold that creates a uniform playing field across programs such as unemployment, PPP, and corporate grants, above which public funds would not subsidize.

b) For any company receiving public support, allow loan forgiveness only to the extent that the company shows an “adjusted loss,” after disallowing expenses any excess compensation paid to management or employees above their “basic income” amount, as well as any expenses incurred for unused inventory, prepayments, items that don’t represent 2020 operating costs, or increased total expenses versus prior years.

10) It was not “bankruptcies and bank failures” that contributed to the Great Depression, but rather “disorganized and piecemeal bankruptcies and bank failures.” What happened in the Depression was that bank depositors had no insurance, nor was there an FDIC to ensure rapid purchase-and-assumption of insolvent banks. So instead, the insolvent banks tried to call loans in, leading to a domino-like chain of disorganized failures and bank runs by uninsured depositors. It is not bankruptcy, but disorganized and piecemeal bankruptcy, that causes dislocations.

11) Emphatically, “bankruptcy” does not mean that the business of a company evaporates, nor do its assets or employees. Similarly, “bank failure” does not mean that depositors lose a dime. In both cases:

a) The assets and goodwill, along with most of the liabilities and payables – are typically acquired by another company, or the bankrupt entity is recapitalized, and the company, its employees, and its operations essentially continue on under new ownership.

b) Under the “depositor preference” provision of Title 12, Section 1821(11)(A) of U.S. banking law, bank depositors receive preference over any other general or unsecured senior liability of the bank. No depositor has ever lost a penny of their insured deposits (currently $250,000 of coverage per depositor per bank) since the FDIC was created in 1933, nor have bank restructurings cost the FDIC more than it has taken in as insurance premiums from banks.

c) Risk-taking stockholders and bondholders lose money, because they are supposed to lose money in these situations.