State and City Default Crisis Deepens

Two major forces are now grindingthrough the financial system and the economy. I have posted on this before and the failure to act in a timely manneris on its way to making the d√©nouement into a major crisis.

First, a massive global creditcontraction is continuing.  This isreflected in little ways and some major ways. The Greek bailout is a major event. While the persistent decline inhousing values in the USAand the massive buildup of unsold foreclosures is how it is happening in littlebits and pieces.

As I posted immediately two yearsago, it was necessary to recapitalize the American people in order to bail outthe disaster in the housing industry brought on be reckless lending.  That was not done and the inevitable resultis now upon us.

The corollary to that failure andthe inability to cleanse the inventory of housing is a sharp contraction ofmunicipal revenues and state revenues worsened by the loss of eleven millionwage earners. Of course Federal revenues are also contracting at the same time.  All governments are about to become very desperateas all this sinks in during the coming year.

Main Street has already adjusted to thenew reality and is once again beginning to grow.  Except that they were notched back and thatmodest growth does not mean recalling workers too fast.

The good news is that the rest ofthe world was not so stupid.  They are wellahead of all this and will be in full swing and providing plenty of orders forAmerican business.  Thus weak domesticdemand is not the end of the world for Main Street as it was back in thethirties.

So far the Fed has failed torecap the American people and is now failing to recap the State and Municipalgovernments.  They also failed to nationalizethe investment banking structure in exchange for bailing out their treason.  It is my contention that those were theappropriate actions at the time and continue to be the appropriate actionstoday.

We should be in a full blownrecovery today and not worrying about the pending State and City defaults thatwill soon be crashing through the bond markets.

America's Economic and Social Crisis: The Fed has Spoken: No Bailoutfor Main Street

By Ellen Brown January 13, 2011

The Federal Reserve was set up by bankers for bankers, and ithas served them well.  Out of the blue, it came up with $12.3trillion in nearly interest-free credit to bail the banks out of a creditcrunch they created. That same credit crisis has plunged state andlocal governments into insolvency, but the Fed has now delivered its ultimatum:there will be no “quantitative easing” for municipal governments.

On January 7, according to the Wall Street Journal, Federal Reserve Chairman BenBernanke announced that the Fed had ruled out a central bank bailout ofstate and local governments.  "We have no expectation orintention to get involved in state and local finance," he said intestimony before the Senate Budget Committee. The states "should not expectloans from the Fed."

So much for the proposal of President Barack Obama, reported in Reuters a year ago, to have the Fed buymunicipal bonds tocut the heavy borrowing costs of cash-strapped cities and states.

The credit woes of state and municipal governments are a direct resultof Wall Street’s malfeasance. Their borrowing costs first shot up in2008, when the “monoline” bond insurers lost their own credit ratings aftergambling in derivatives.  The Fed’s low-interest facilities couldhave been used to restore local government credit, just as it was used torestore the credit of the banks.  But Chairman Bernanke has nowvetoed that plan.

Why?  It can hardly be argued that the Fed doesn’t have themoney.  The collective budget deficit of the states for 2011 isprojected at $140 billion, a mere drop in the bucket compared to the sums theFed managed to come up with to bail out the banks.  According to data recently released, the central bank providedroughly $3.3 trillion in liquidity and $9 trillion in short-term loans andother financial arrangements to banks, multinational corporations, and foreignfinancial institutions following the credit crisis of 2008. 

The argument may be that continuing the Fed’s controversial“quantitative easing” program (easing credit conditions by creating money withaccounting entries) will drive the economy into hyperinflation.  Butcreating $12.3 trillion for the banks – nearly 100 times the sum needed bystate governments -- did not have that dire effect.  Rather, the moneysupply is shrinking – by some estimates, at the fastest ratesince the Great Depression.  Creating another $140 billion wouldhardly affect the money supply at all. 

Why didn’t the $12.3 trillion drive the economy intohyperinflation?  Because, contrary to popular belief, when the Fedengages in “quantitative easing,” it is not simply printing money and giving itaway.  It is merely extending CREDIT, creating an overdraft on theaccount of the borrower to be paid back in due course.  The Fed issimply replacing expensive credit from private banks (which alsocreate the loan money on their books) with cheap credit from the centralbank.  

So why isn’t the Fed open to advancing this cheap credit to thestates?  According to Mr. Bernanke, its hands are tied. He says theFed lang=EN-US>is limited by statute to buying municipalgovernment debtwith maturities of six months or less that is directly backed bytax or other assured revenue, a form of debt that makes up less than 2% of theoverall muni market.  Congress imposed that restriction, and onlyCongress can change it.

That may sound like he is passing the buck, but he is probablyright.  Bailing out state and local governments IS outside the Fed’smandate.  The Federal Reserve Act was drafted by bankers tocreate a banker’s bank that would serve their interests.  No othersneed apply.  The Federal Reserve is the bankers’ own private club,and its legal structure keeps all non-members out.  

Earlier Central Bank Ventures into Commercial Lending

That is how the Fed is structured today, but it hasn’t always been thatway.  In 1934, Section 13(b) was added to the Federal Reserve Act,authorizing the Fed to “make credit available for the purpose of supplyingworking capital to established industrial and commercial businesses.” Thislong-forgotten section was implemented and remained in effect for 24years.  In a 2002 article called “Lender of More Than Last Resort” posted on the Minneapolis Fed’swebsite, David Fettig summarized its provisions as follows:
· [Federal] Reserve banks could make loans to any establishedbusinesses, including businesses begun that year (a change from earlierlegislation that limited funds to more established enterprises).

· Reserve banks were permitted to participate [share in loans] withlending institutions, but only if the latter assumed 20 percent of the risk.

· No limitation was placed on the amount of a single loan.

· A Reserve bank could make a direct loan only to a business in itsdistrict.

Today, that venture into commercial banking sounds like a radicaldeparture from the Fed’s given role; but at the time it evidently seemed like areasonable alternative.  Fettig notes that “the Fed was still lessthan 20 years old and many likely remembered the arguments put forth during theSystem's founding, when some advocated that the discount window shouldbe open to all comers, not just member banks.” In Australia and other countries,the central bank was then assuming commercial as well ascentral bank functions.

Section 13(b) was repealed in 1958, but one state has kept its memoryalive.  In North Dakota, thepublicly owned Bank of North Dakota (BND) acts as a “mini-Fed” for thestate.  Like the Federal Reserve of the 1930s and 1940s, the BNDmakes loans to local businesses and participates in loans made by localbanks. 

The BND has helped North Dakota escape the credit crisis.  In 2009,when other states were teetering on bankruptcy, North Dakota sported the largest surplus ithad ever had.  Other states, prompted by their own budget crises toexplore alternatives, are now looking to North Dakota for inspiration. 

The “Unusual and Exigent Circumstances” Exception

Although Section 13(b) was repealed, the Federal Reserve Act retainedenough vestiges of it in 2008 to allow the Fed to intervene to save a varietyof non-bank entities from bankruptcy.  The problem was that the toolwas applied selectively.  The recipients were major corporateplayers, not local businesses or local governments.  Fettig writes:

Section 13(b) may be a memory, . . . but Section 13 paragraph 3 . . .is alive and well in the Federal Reserve Act. . . . [T]his amendment allows,"in unusual and exigent circumstances," a Reserve bank to advancecredit to individuals, partnerships and corporations that are not depositoryinstitutions.

In 2008, the Fed bailed out investment company Bear Stearns andinsurer AIG, neither of which was a bank.  John Nichols reports in The Nation that Bear Stearns gotalmost $1 trillion in short-term loans, with interest rates as low as0.5%.  The Fed also made loans to other corporations, including GE,McDonald’s, and Verizon

In 2010, Section 13(3) was modified by the Dodd-Frank bill, whichreplaced the phrase “individuals, partnerships and corporations” with thevaguer phrase “any program or facility with broad-based eligibility.”  Asexplained in the notes to the bill:

Only Broad-Based Facilities Permitted. Section 13(3) is modified toremove the authority to extend credit to specific individuals, partnerships andcorporations.  Instead, the Board may authorize credit under section13(3) only under a program or facility with “broad-based eligibility.”

What programs have “broad-based eligibility” isn’t clear from a readingof the Section, but long-term municipal bonds are evidently excluded.  Mr.Bernanke said that if municipal defaults became a problem, it would be inCongress’ hands, not his. 

Congress could change the law, just as it did in 1934, 1958, and2010.  It could change the law to allow the Fed to help Main Street just asit helped Wall Street.  But as Senator Dick Durbin blurted out on a radio program in April 2009, Congressis owned by the banks.  Changes in the law today are more likely togo the other way.  Mike Whitney, writing in December 2010, noted:

So far, not one CEO or CFO of a major investment bank or financialinstitution has been charged, arrested, prosecuted, or convicted in whatamounts to the largest incident of securities fraud in history. In themuch-smaller Savings and Loan investigation, more than 1,000 people werecharged and convicted. . . . [T]he system is broken and the old rules no longerapply.

The old rules no longer apply because they have been changed to suitthe moneyed interests that hold Congress and the Fed captive.  Thelaw has been changed not only to keep the guilty out of jail but to preservetheir exorbitant profits and bonuses at the expense of their victims. 

To do this, the Federal Reserve had to take “extraordinarymeasures.”  They were extraordinary but not illegal, because theFed’s congressional mandate made them legal.  Nobody’s permissioneven had to be sought. Section 13(3) of the Federal Reserve Act allows it to dowhat it needs to do in unusual and exigent circumstances to save itsconstituents.

If you’re a bank, it seems, anything goes. 

So Who Will Save the States?

Highlighting the immediacy of the local government budget crisis, The WallStreet Journal quoted Meredith Whitney, a banking analyst who recentlyturned to analyzing state and local finances.  She said on a recentbroadcast of CBS's "60 Minutes" that the U.S. could see "50 to 100sizable defaults" in 2011 among its local governments, amounting to"hundreds of billions of dollars."

If the Fed could so easily come up with 12.3 trillion dollars to save thebanks, why can’t it find a few hundred billion under the mattress to save thestates?  Obviously it could, if Congress were inclined to putnon-bank lending back into the Fed’s job description.  Then why isn’tthat being done?  The cynical view is that the states are purposelybeing kept on the edge of bankruptcy, because the banks that hold Congresshostage want the interest income and the control. 

Whatever the reason, Congress is standing down while the nation is sinking.Congress must summon the courage to take needed action; and that action is notto impose “austerity” by cutting services, at a time when an already-squeezedpopulace most needs them.  Rather, it is to create the jobs that willgenerate real productivity.  To do this, Congress would not even haveto go through the Federal Reserve.  It could issue its own debt-freemoney and spend it on repairing and modernizing our decaying infrastructure,among other needed works.   Congress’ task will become easier if thepeople stand with them in demanding action, but Congress is now so gridlockedthat change may still be long in coming. 

In the meantime, the states could take matters in their own hands andset up their own state-owned banks, on the model of the Bank of North Dakota.  Theycould then have their own very-low-interest credit lines, just as the WallStreet banks do.  Rather than spending or selling off valuable publicassets, or hoarding them in massive rainy day funds made necessary by the lackof ready credit, states could LEVERAGE their assets into a very strong andabundant local credit system, following the accepted business practices of the WallStreet banks themselves. 

The Public Banking Institute is being launched on January 13to explore that alternative.  For more information, see  

Ellen Brown is anattorney and the author of eleven books, including Web of Debt: The Shocking Truth About Our Money System and HowWe Can Break Free.  Her websites are,, and

No comments:

Post a Comment