“Economists have failed to analyze the effect of open market operations on bond speculation. “See no evil, hear no evil, speak no evil.” I leave the problem to future researchers to find out whether economists made an error of omission, or whether they knowingly became accomplices to the conspiracy of the Treasury and the Fed in a scheme to the aggrandize the power of the federal government….”

That’s Professor Antal Fekete, refusing to mince his words. 

          “Here is what happens when the Federal Reserve resorts to open market operations to buy government bonds as the preferred means to increase the money supply. Bond speculators are very much alive to the need of the Fed to make periodic trips to the open market to buy the bonds. They lie in wait for the Fed. They want to preempt it; they want to buy the bonds first. Later, they would dump them in the lap of the Fed, making risk-free profits in the process at the expense of the public. The Fed does not mind being ambushed. It condones the risk free profits of the bond speculators. It all comes to the same thing: lower interest rates by hook or crook.

Destruction of bank capital

With the open market operations of the Fed providing a dependable tail-wind, the sails of speculators are bulging. The unison bullish response to monetary policy by the speculators has the effect of steadily driving down the rate of interest. The Fed could report to the boss: “mission accomplished”.

          Nobody bothered to investigate the question whether the symbiosis of the Fed and bond speculators (mostly banks) might somehow have a detrimental effect on the economy. It certainly looked like a brilliant scheme of creating positive value out of nothing — nay, out of negative value! Nobody has raised the objection that there “ain’t no free lunch”, that in our world strict conservation laws govern and draw a line between what is possible and what is not. In particular, it is not possible to create value out of nothing. Any appearance to the contrary must involve the destruction of value somewhere else.

          Indeed, creating bond values out of nothing has coincided with the destruction of capital. Capital consumption is an insidious process. It has no obvious symptoms. If anything, like narcotics, it has a euphoric effect on the economy. Its role is to desensitize the victim before picking his pockets. It may fatten the wage envelope, widen profit margins, jack up managerial compensation, but all that is charged to the capital account. As long as there is a capital account, that is. Trouble bursts on the economic scene when the bottom of the capital barrel has been scraped clean. Of course, by that time it is too late. Nothing can be done to stop the rot.

          This is what we have experienced in the fateful year of 2008. While the capital of the banking industry was eroding, there was a feeling of euphoria, a sense of weightlessness, the exhilaration of levitation as capital consumption has given banking operations an extra lift in defying gravity. But no sooner had the last crumbs of consolidated capital disappeared than gravity came back with a vengeance and the banking industry fell out of the sky. All banks, at the same time. It was not a consequence of local mismanagement. It was not primarily a consequence of too lenient lending standards, it was not primarily a consequence of reckless risk-taking. It would have been a statistical oddity if all banks had bankrupted themselves at the same time. There was a common cause: the erosion and ultimate destruction of capital…..”

Here’s more on the details of open market operations.