In Denial of Crisis: Part I
An Economy Undermined by Failures of the Monetary System, the Concentrated Media, and Political Will
David Jensen is the Principal of Jensen Strategic a Vancouver-based strategic planning and business advisory services company.
With economic growth estimates for 2005 of 2.5% and 3.4% respectively, Canada and the US look forward to steady if not stellar growth of their economies in the coming year. The Bank of Canada notes for 2005 that "the prospects for continued robust growth are quite favorable" 1.
Yet all is not as promising as it seems. Central Banks (Canada's and the U.S.'s included), on false grounding in economics and using a monetary system based-upon an endless cycle of debt creation, have for decades maintained that the economy could be controlled by central planning and manipulating the amount of money and interest rates in the economy. This has allowed over-spending for massive government programs, unsupportable promises of future benefits to retirees, and costly military adventures all incredibly coupled with seemingly endless growth in consumers' net worth and consumption.
In a repeat of errors committed in the 1920's, failure of central bank monetary policy led to the 1990's dot.com stock market bubble and correction in 2000 which now reveals a distorted economy saturated with unsustainable and increasing levels of debt just to continue the economy. The post-bubble response of the US Federal Reserve Bank in lowering interest rates to 1% now leads to rampant and destabilizing financial speculative bubbles in the economy including the North America-wide real estate bubble.
We have a concentrated media in both Canada and the U.S, which has provided little critical analysis of economic policy choices, and a political ruling class most interested in short-term crises and solutions, which hand-off chronic but acute problems to the next elected official. The result is in that we have not had any accountability and correction of highly visible economic policy failures by our government and monetary authorities that have been visible for years. We are now on the brink of a strong economic correction likely impacting our populations for generations.
Immediate and bold remedial action by government is required to mitigate the impact of the coming correction.
Under the placid surface [of the economy], there are disturbing
imbalances, disequilibria, risks -- call them what you will.
Altogether the circumstances seem to me as dangerous and intractable
as any I can remember, and I can remember quite a lot.
Paul Volcker, Former US Federal Reserve Bank Chairman 2
April 10, 2005.
If the American people ever allow private banks to control
the issue of currency, first by inflation, then by deflation, the banks and
corporations that will grow up around them will deprive the people of all property
until their children will wake up homeless on the continent their fathers conquered
The Debate Over the Recharter of the Bank Bill, 1809
The above two statements were made almost 200 years apart, however, they have a common concern - the consequent damage from the manipulation of the money stock (i.e. the money that exists in society) for economic gain.
Economists and politicians have long known that increasing the money stock has the beneficial consequence of stimulating the economy. The initial short-term effect is that it increases the money available to be spent and invested which for a period increases economic activity. However, manipulation of the money supply has negative consequences which have damaged countries (including Canada and the U.S.) who travel down this road, including:
- Inflation. In simple terms, with a fixed amount of goods in an economy, increasing the stock or amount of money (called the "money stock" by economists) results in more dollars being available for a basket of goods, causing inflation (or a rise) in the price of goods. Damaging because it impoverishes those holding savings and those on fixed incomes, price inflation of goods in the economy has a further negative impact in that, once it starts to climb, hoarding behavior by consumers and businesses to forward purchase goods creates artificial shortages driving prices even higher in a damaging spiral. Once the inflation spiral is started, it can only be shaken from the economy through an economic slowdown usually induced by sharply higher interest rates.
- Investment bubbles and mania. Examples include:
• 1920's stock market mania leading to the 1929 Crash followed by the 1930's Depression;
• the 1989 Nikkei stock market and real estate bubble in Japan followed by a 15 year malaise in Japan; and
• the 1990's dot.com stock market bubble followed by its correction in 2000; a market bubble and crash which created by and has now been so mal-addressed by the US Central Bank (the Federal Reserve or "Fed") that we face our impending economic correction
- Inevitable internal economic distortion resulting in growing imbalances which ultimately correct with economic busts, deep recessions and depressions.
It is the last item which politicians, central bankers, and economists popular in the political realm have denied is a consequence of their centrally-planned monetary control.
Readers in Canada or the U.S. will likely not have a concern regarding the current economy - however, as Chairman Volcker notes, large distortions exist beneath the surface which will manifest themselves. These distortions and coming correction are visible to our political leaders, but while Volcker notes that urgent action is needed, he also notes governments tend to react after the fact - which in this case will impart great damage to the both the U.S. and Canada.
The coming economic fall-out now militates that the damaging, anachronistic centrally-planned attempts by central banks and politicians to steer the economy using the monetary system must be curtailed.
If we read Jefferson's comments with today's definition of inflation and deflation, it makes little apparent sense. However, the meaning of the words "inflation" and "deflation" have changed over time so that they now mean, respectively, an increase or decrease in consumer goods prices. In their more classic economic sense, inflation refers to an in increase in the money stock (cash and debt) outstanding in the society. Deflation refers to a decrease in the money stock.
Jefferson's warning now becomes a little clearer. History is riddled with monetary inflation accompanied by uneconomic activity, speculative booms, and investment mania, all resulting from the excess inflation of the money stock, followed by crashes. There is nothing surprising or even unreasonable about market speculation - so long as one realizes the dynamic causing the speculation and limits exposure be it real estate, equities, bonds, interest rate derivatives, and other financial instruments. However, few retail investors do understand when a bubble is underway and the top usually occurs after the flow of new credit or increases in the money stock starts to slow - a visible signal within the financial system but not to the average investor.
Extraordinary Popular Delusions and the Madness of Crowds3 was initially published in 1841 and documented excess credit and money creation inducing trading bubbles and collapses such as the Dutch Tulip Mania (Holland - 1630's), John Law's Mississippi Scheme (France - 1720 : a stock market bubble engulfing France induced by massive inflation (or debasement) of France's money stock), The South Sea Bubble (England - 1720 : investment mania where even Sir Isaac Newton lost his family fortune), etc.
In a more recent work4, Edward Chancellor documents more than a dozen historical and contemporary monetary and credit booms that drove speculative mania including the 1920's stock boom, the late 1980's Nikkei stock market and real estate boom in Japan, and the 1990's dot.com stock market bubble in the US.
The excess which can be attained during an investment bubble are well illustrated by the following words from an investment prospectus to raise money during the South-Sea Bubble of 1720: "A company for carrying on an undertaking of great advantage, but nobody to know what it is."5
Creation of investment bubbles and their subsequent crashes are directly and obviously negative as they simply result in the transfer of wealth from the public to those promoting investments (such as through Initial Public Offerings (IPO's) of a stock ) during an investment bubble. Thus, the phenomenon of speculative boom and bust acts as a "wealth ratchet". The financial industry, speculators, stock industry promoters and traders make enormous profits on the ascent stage and, if savvy, can roll-out of investments with gains into cash or other stable asset positions before a correction, then buy assets at prices of pennies to the dollar in the subsequent bust when investors must liquidate assets to settle losses.
Key bankers, politicians, and Wall Street traders wanted the creation of the U.S.'s central bank in 1913 and worked through a White House insider Edward Mandell "Colonel" House to see the Federal Reserve Act developed and passed. (Colonel House was a wealthy Texas patrician who had never served in the military and whose family fortune was acquired by his father in the South during the American Civil War.) Although called the Glass-Owen Bill (after Congressman Carter Glass and Senator Robert Owen), the Federal Reserve Act was the creation of President Wilson's point-man on banking matters, Colonel House.
The immediate effect of the creation of the new central bank (The U.S. Federal Reserve Bank) to control the money supply was the price inflation of 1914 to 1920, then the 1920's stock market mania and crash of 1929 which revealed that average citizens who were skeptical of the wisdom of creating a central bank were correct. That the Fed caused the stock market bubble resulting in the crash of 1929 and the Great Depression is not argued by today's supporters of the Fed. In 2002, at the 90th birthday party for famed economist and monetarist Milton Friedman, then Fed Governor Ben Bernanke commented "You were right, we did it. But thanks to you we won't do it again."6 Whether the Fed and other central banks can prevent another financial rupture is a question on which the jury is still very much out.
Our "Stable" Economy - Stable or a Redux to Another Apparently Stable Time?
So what is former Chairman Volcker's concern today? The economy is healthy: inflation is apparently low, the stock market has corrected to lower stock price to company earnings (p/e) ratios, the housing market is booming, we are looking forward to further growth: what's the problem?
First, The US (and in fact the World's) economy is still very much in recovery from the dot.com stock market crash of March 2000. As we will see, Mr. Greenspan's declared victory when stating "we were very much correct in our decision to address the after-effects of the bubble rather than the bubble itself" may have been a little premature.
The stock market bubble of the late 1990's was a textbook recreation of the 1929 bubble and the late 1980's Japanese Nikkei stock market and real estate bubble. They all relied upon the creation of excess credit in turn brought about by excessive monetary policy of central banks (note that money enters the economy as loans from banks to borrowers. Increasing the money stock therefore means increasing the debt level in the economy).
The origin of the 1920's stock market bubble, notes Economist Murray Rothbard was that, in order to "assist" Britain in artificially maintaining the strength of its currency while it was in economic decline, America increased its money stock by an average of 7.7% annually over an 8 year period from 1921 to 1929. In his words, it was "a very sizable degree of (monetary) inflation"7 and "the entire monetary expansion took place in money substitutes which are products of credit creation... The prime factor in generating the (monetary) inflation of the 1920's was the increase in the total bank reserves."8
Yet, like today, while the 1920's economy roared ahead, consumer price inflation was apparently tame while the stock market appeared "reasonably" priced. Rothbard notes "The fact that general prices were more or less stable during the 1920's told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware."9 Economists who support manipulation of the economy by varying the money stock and interest rates are dubbed "monetarists". The father of modern monetarism and the Quantity Theory of Money, which is the basis of central bankers' expansion of the money supply, is Irving Fisher, who was himself so enthused about future prospects that in October 1929, one week before the markets crashed, he made his famous (mis)statement:
"Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months."10
The DOW would decline 89% from its 1929 peak value of 381 bottoming 3 years later in 1932 at 40. Fisher who had a net personal wealth of $10 million from designing and patenting the Rolodex, lost his entire fortune in the crash and ultimately died penniless. But his Quantity Theory of Money still built favor with economists, politicians and central bankers of the future.
What Fisher missed, and one of the reasons there are so few billionaire economists, was their fundamental misunderstanding of the economy and the distortions engendered by their monetarist economic theory. Like today, after administering the wrong thing (excess money (debt) creation), they were measuring the wrong things (goods inflation) and had a crucial misunderstanding regarding the apparently limitless suspension of the 1920's economy distorted by more than a decade of excess monetary and credit expansion.
To this day, monetarist economists suggest that there was nothing wrong with the stock market in 1929. The National Bureau of Economic Research (NBER) issued a working paper in December 2001 titled "The Stock Market Crash of 1929 - Irving Fisher was Right" (McGrattan and Prescott) in which they stated "We find that the stock market in 1929 did not crash because the market was overvalued. In fact, the evidence strongly suggests that stocks were undervalued, even at their peak." The Federal Reserve agrees. In March 1999, the Federal Reserve Bank of San Francisco issued an Economic Letter that stated that with stock prices at 30 times dividend yields, the market was not overvalued.11 (For a clear-eyed comparison of today's and the 1920's economy, see the article "How Could Irving Fisher Have Been So Wrong?" by Doug Noland12)
The standard response by economists of today's Milton Friedman / Irving Fisher monetarist school is that the depression of the 1930's was caused by Fed incompetence in not increasing the money stock adequately in response to the crash starting in 1929. In fact between January 1930 and December 1933, the Fed did intervene by increasing their purchases of bonds from Banks by 98% per annum thereby injecting dollars into the banking system.13 This added $2 Billion to bank reserves which should have resulted in further loans and an attendant increase in economic activity. However, bank credit contracted 30% during this period as the initial contraction had revealed the non-productive nature of many enterprises and speculative investments and their dependence upon repeated rounds of financing used to sustain the boom.
The excess credit financing of speculative and unproductive activities dried-up as did consumer stomach for debt - a form of credit revulsion took hold and the economy slowed (ultimately declining almost 50% by the mid 1930's) shaking-out the unproductive enterprises that had grown in the economy after a decade of loose credit.
That economists like Milton Friedman and Fed Chairman Greenspan could today advocate that a stock market bubble and crash caused by excess credit accompanied by resultant economic distortions could and should be addressed by even more excess credit, raises serious questions. And yet, that has been Chairman Greenspan and the Fed's response to the correction of the 1990's dot.com stock market bubble the Fed and Treasury Secretary Robert Rubin started in 1995 with their "strong dollar" policy (we will see it was anything but).
The U.S. and Canada now find themselves in an economic corner. There is a need to continue raising interest rates to combat rising inflation yet we are surrounded by investment bubbles and a housing bubble which will strongly correct if the required action is taken by our central banks.
Origins of the dot.com Bubble and Post-Bubble Federal Reserve Action
In 1993 and 1994, the Fed increased the broad money stock (called M3) by roughly $80 Billion each year. In 1995 the Fed suddenly reversed policy and started growing the money stock in the U.S. by larger amounts each year thereafter ( up $267 Billion in 1995 and rising until it was increased $597 Billion in 1998) - the stock markets immediately responded with the Dow Industrials Index growing 34% in 1995 vs. an historical annual average of 10%. In December 1996 when the Dow was at 6,500 (up 71% from it level of 3,861 in January 1995, 2 years earlier ) Greenspan warned of "irrational exuberance". Instead of cutting the annual growth of the money stock, The Fed accelerated its growth and all US stock markets grew tremendously until the bubble pop in March 2000. From 1998 on, Greenspan lost his concern about irrational exuberance lauding the "new economy" and technologically driven "productivity" as justifying the elevated stock market levels. The Dow closed 1999 at 10,970 having increased more than 7,000 points (gaining more than 200%) in just 5 years and the NASDAQ gained more than 500% from a starting value of 752 points in January 1995 to an ultimate peak of over 5,000.
Source: U.S. Federal Reserve (Money Stock Data)
The creation and crash of the dot.com stock market bubble represented a complete failure of the Federal Reserve central bank - yet no accountability or consequences have stemmed from this failure either at the Fed, in the financial industry or in the media which all cheered on and justified the wildly inflated market as it grew.14 Unchastened, Greenspan went on in 2001 to encourage the massive Bush administration tax cuts despite the fact that the Congressional Budget Office warned that capital gains and other taxes received by the Government would drop along with the declining stock market craze and corporate profits were projected to grow modestly until 2010.15
Given the Fed's money (debt) creation combined with further government deficits, the U.S. economy is now more financially indebted than at any other time in history - exceeding even the debt vs. GDP levels of 1934 which were only attained after the U.S. economy GDP declined almost 50% during the great depression.
Source: Clapboard Hill Investment Partners; Barron's Magazine
In the aftermath of the crash in 2000 of the dot.com stock market bubble, the Fed and U.S. Treasury Department (now under the auspices of President Bush's Treasury Secretary Paul O'Neill) stood ready to make sure that everyone could continue to access credit to rescue the economy and the markets. In January 2001 interest rates were first lowered from an initial 6.5 % Fed Funds Rate to an ultimate 1% (the Fed Funds determines short term interest rates in the credit system).
Before the Fed's low interest rate response to the dot.com market crash, there were clear warnings made to the Fed about an already developing real estate bubble. The Fed insisted that a real estate bubble was not possible as the U.S. real estate market was composed of many small markets. The Fed now says it has heard "anecdotal" evidence that some real estate markets may be "somewhat frothy". Single family homes in the entire state of California, representing 20% of the U.S. real estate stock, have increased 35% in price in the last 2 years where single family dwellings are currently 290% of their 1997 price level. The California market has now hit the silly stage where home purchases are using financing methods such as increasing principal loans where the borrower does not pay the full monthly interest on a mortgage (and hopes the house increases in value at a faster rate than the increase in the loan principal). Home prices in North America increased by double digit rates in 2004.
With low interest rates and sharply rising real estate values, consumers were quick to spend their new found "wealth" through cash-out home mortgage refinancing and home equity loans. However, this only represents an increase in indebtedness relying on artificially inflated assets as collateral, not a creation of new or sustainable wealth in the U.S. economy (Noland).
The low cost of borrowed money fed speculative finance activity not only in real estate, but also in bonds, derivatives, and the stock markets. Although the stock markets have corrected from historically high valuations, they continue to be over-valued on historical terms.
US stock market performance has tracked the Nikkei post 1989 crash profile while, with the lowering of interest rates, yet speculation has returned to the stock markets along with increasing overvaluation of stocks. Excess has returned - the market value of the internet stock Google is now over $76 billion with a p/e ratio of 109.
In aggregate, stocks are still over-valued compared to historical norms:
Source: Century Management Inc.
A Distorted Economy
Item: The U.S. has a total debt (Government, Corporate, and Household combined) of $38 Trillion. In addition, in 2002 Treasury Secretary Paul O'Neill commissioned a report identifying that the U.S. had future unfunded entitlement liabilities (Medicare, Medicaid, and Social Security) with a present value of $43 Trillion16 which in 2002 would have required an immediate and perpetual income tax of 69% if they were to be met. The U.S.'s net annual economic production (Gross Domestic Product or GDP) is $11.75 Trillion with a current budget deficit of $500 Billion per year (includes Iraq War costs). It is clear from these numbers that, even if the economy was healthy, these debts and liabilities cannot be paid.
Item: According to the Fed, in 2004 U.S. debt (government, corporate and household combined) increased by $2.72 Trillion dollars17 (23% of GDP) yet this debt spending in the U.S. Economy can only produce economic growth this year of 3.4% of GDP. Thus $6.50 of debt increase is producing $1 of growth in the economy.
Item: The U.S. requires an injection of $2 Billion in foreign investment each day to sustain its economy absorbing more than 80% of the World's annual savings.
Something is amiss.
After decades of monetary and debt injections to provide a fix for the economy, the U.S. economy now stands saturated and severely distorted by its credit excess. From a vitally productive and inventive society to one where financial speculation reigns supreme, the US economy has been transformed to a financial betting parlor. Where, historically, manufacturing had accounted for 45% of business profits and financial services accounted for 15%, this relationship has been turned on its ear in the new economy with less than 15% of profits now generated by the manufacturing sector and 45% of profits generated by shuffling paper in the financial sector (stocks, bonds, derivatives, mortgage financing, etc.) . According to the U.S. Bureau of Labor Statistics, the Financial Services Industry accounts for 6% of current U.S. employment giving a sense of outsize profits being generated by the Financial Services sector.
Source : Bridgewater Associates; The Money Shufflers Vig
"Globalization" was one of the critical component of the Greenspan / Rubin "strong dollar" policy talk which was initiated in 1995 - it was actually a gross, inflationary dilution of the US dollar (the "strong dollar" policy position is today amusingly repeated by the Bush Administration Treasury Secretary John Snow - despite U.S. Federal Reserve policy, deficit spending and trade policy which is flooding the world with US dollar debt and money).
The service industry jobs which were supposed to be generated by globalization have been muted. Instead, the "internet driven global arbitrage in labor", as identified by Morgan Stanley's Chief Economist Stephen Roach, has led to a transfer of high skills job out of the U.S. service industry. Operations in China and India using highly educated and skilled workers can provide overnight legal, accounting, engineering and business services over the internet at a fraction of the price of North American service providers.
Instead of gradually transitioning to a free trade environment, the U.S. market's door has been swung wide-open. While this has gutted the production base of the U.S., the pressure of Chinese worker salaries of $0.50 per hour and lax Chinese environmental laws on the U.S. factory worker wages until recently kept consumer goods price inflation at bay. Cheap imports have effectively served as a substitute for prudent stewardship of the money stock by obscuring central bank monetary inflation.
This allowed the Fed and Treasury under the Bush Administration to lower interest rates to 1% resulting in a further injection of debt into the economy thereby delaying the consequences of the popping of the dot.com stock market bubble. The correction we face with a housing bubble added to the fray will now be much worse.
The depressing impact of cheap imported goods in the manufacturing industry, in combination with the distorting economic impact of the Fed's decades of credit creation on the U.S. economy, have resulted in the economic "recovery" since the 2001 post-bubble recession posting no net private sector job growth despite claims the economy is healthy. According to Morgan Stanley, the U.S. now has 10 million fewer jobs post the dot.com economic decline than it would in an average previous recovery.18
While the official unemployment rate has declined from 6.3% in 2003 to 5.2% in 2005, the actual percentage of the workforce that is employed has declined from over 67% of the population in 2000 to 65.5% of the population in 2005 - this despite an increase in the number of elderly forced back into the workforce after the 2000 stock market correction.19 These contradictory figures arise because the U.S. and Canada both define those unemployed only in terms of individuals actually looking for work. If jobs are not available and an unemployed person is discouraged and in recent weeks has not actively searched for a job, they are no longer counted as unemployed and the government can ignore them in the "unemployment" survey.
The Chinese economic "miracle" with unheard of 15+ % per year economic growth is itself the product not only of the U.S. export market but also of central bank monetary distortion within the Chinese economy. In the headlong rush to develop Chinese infrastructure and import technology in the shortest term possible, rather than grow at a measured pace that can be maintained over the long-term, loose Chinese central bank policy has resulted in Chinese banks now sitting on $US 800 billion of bad (or in banking parlance "non-performing") loans equating to 50% of GDP. Also like the U.S., China maintains interest rates below the inflation rate. Chinese goods are thus subsidized by their own expandable elastic money system and with prices that do not reflect the true cost of production within China.
With a declining U.S. economy and rising inflation, it will be increasingly difficult for foreign investors to continue to finance the U.S. deficits at 4% interest on a 10-year bond and sustain the real estate and speculative investment booms in the U.S. Not covered well in the media, is that in September 2004 and November 2004, the Japanese and Chinese, who had been the major purchasers of U.S. Treasury debt, veritably stopped their purchases. How long "Caribbean Banking Centers",20 who initially filled the gap as foreign purchasers of U.S. bonds, can sustain the U.S.'s debt addiction is open to question. All the while, both Canadian and US household debt is increasing each year by more than 10% per annum.
This path is unsustainable, yet U.S. and Canadian leaders have chosen the path of cheerleading the economy along with an obeisant media. And each day consumers are led on by rising and unsustainable housing market prices and a sense that the economy is healthy, to walk deeper and deeper into the quicksand of debt.
The Central Bankers' Delusion : The Root of Our Economic Malaise
In his book " Debt and Delusion: Central Bank Follies that Threaten Economic Disaster",21 Peter Warburton identifies that deregulation of the world's financial markets since the 1970's allowed Central Banks to embark on a trajectory of inflating the money stock thereby also inflating by multiples the world's stock, bond and real estate markets - this all while apparently containing price inflation (for an good summary of Warburton's book, see the paper Debt and Delusion commentary by Robert Blumen at www.mises.org/fullstory.aspx?control=1579&id=71).
The containment of "inflation" depends upon one's definition of inflation. With the monetary injection into the economies of the West, investment values in almost all financial asset classes have ballooned with the stimulus of the money injected.
The world's equity (stock) markets are now valued at more than $26 Trillion; the bond market has grown from less than $1 trillion in 1970, to $23 trillion in 1997, and $43 trillion in 2002.22 Real estate is in a bubble. And the derivativesi markets have grown to total invested values of $9.1 Trillion and using financial leverage to multiply the opportunity for gain (but also loss), the levered exposure value of these derivatives (what the Bank of International Settlement optimistically calls "notional value") has grown from $47 Trillion in 1995 to now exceeding more than $200 Trillion - more than 500% of the world's entire annual economic output.23
Inflation, while very much around us, has until recently been constrained to financial investments while central bankers have claimed that their inflation of the money supply has not produced classic consumer goods price inflation.
Interest rate related derivative instruments (70% of outstanding derivatives), in particular, are sensitive to sharp interest rate moves.ii Fed intervention to buffer investment losses are a previous pattern of Chairman Greenspan as the Fed has invariably turned to liquidity injections and bail-outs of destabilized market participants in times of crisis ( 1987 stock market crash, 1997 Asian currency crisis, 1998 LTCM bail-out, etc.). Lulled by past Fed Intervention and soothing words during Greenspan's tenure, spiking interest rates are something the bond and derivatives speculators are betting won't happen.
The financial system risk which derivatives represent have long been known (derivatives have been labeled "weapons of mass destruction"), yet Greenspan has for years argued against regulation of the derivatives market. If there is a sufficient interest rate acceleration, this market can quickly lock-up as the levered nature of derivatives which multiplies losses means that, without regulated derivatives exchanges, large amounts of money can quickly be lost and derivatives holders on the wrong side of a trend can be quickly financially bankrupted. Given the level of unstable and levered risk in this market which exceed greatly exceed the assets of all financial trading institutions combined and entering a period where inflation has started to rise, the financial system is particularly vulnerable.
Past Fed monetary policy and intervention has combined to form this lethal mixture: excess liquidity and low interest rates combined with the creation of moral hazard as market speculators believe that any crisis brought on by speculative excess will be buffered by a Federal Reserve bailout. In this vein, Warburton notes the danger in central banks serving as the interventional saviors or "lenders of last resort" (LLR's) to bail-out with public money not just banks but private sector entities which are designated as "too big to fail". In Warburton's words "Central banks' unquestioned roles as LLR's to the commercial banks and guardians of the financial system maintain an ambiguity over the ultimate responsibility for catastrophic loss, however and wherever it occurs. This ambiguity has promoted excessive risk-taking in the private sector and has fostered the very circumstances in which financial disasters have occurred before."24
Until recently, consumer goods inflation were restrained in their price rises because (1) "Globalization" providing cheap imports have until now capped consumer goods prices, (2) our governments have defined inflation measures in a way that understates true price rises (see discussion below), and (3) financial investment vehicles have absorbed the lion's share of the profligate money creation bloating all investment classes during this period.
This is the failure of the Fed and the all the world's central banks: they have viewed inflation in terms of prices of goods in society as opposed to an increase in the money stock and have increased money and debt in society believing they were free to do so without understanding distortion this engenders in the operating structure of the economy.
While the inflationary monetary liquidity is locked in the financial markets, our notion is that consumer price inflation remains apparently stable - however, if speculation in commodities and then goods inflation occurs or if investors seek stability by investing in commodities and traditional safe havens such as precious metals, then even a relatively small portion leaking from the multi-trillion dollar financial investment silos can drive commodities prices skyward thereby resulting in an explosive appearance of consumer price inflation, forcing up interest rates to contain the inflation. The kimono so cleverly hiding central bank fiat monetary inflation for decades will suddenly be dropped.
In a perverse replay of the 1970's, we may potentially see loose monetary policy followed by weak economic growth and rising commodity prices (or stagflation) - except in this version we will have twice the debt-to-GDP ratio and investment bubbles as the inflation starts to manifest itself.
Speculation in commodities has already started. Driven both by international demand as well as a hedging against currency declines, the past 4 years have seen a 65% increase in the price of commodities shown in the CRB Commodities Index chart below. Inflation has now also reared its head in the U.S. consumer price index which is rising at an annualized 6.2% in the first quarter of 2005 and 3.5% in the 12 months through the first quarter. And these price rises are in spite of cheap import compressing price rises in the economy.
The manifestation of strong goods price inflation can result in one of two responses by the Fed and the World's Central Banks:
With an aim to maintaining foreign investor confidence, defend the dollar and ultimately other fiat currencies by strongly raising interest rates. This would eventually control inflation but pop the debt-dependent investment and asset bubbles (including the real estate bubble) with severe economic fall-out. This would leave heavily indebted consumers in a form of indebted servitude unable to pay-down debt incurred in a low interest rate, real estate bubble environment.
Abandon defense of the dollar injecting massive amounts of liquidity (money) into the banking system resulting in a hyper inflationary spiral and ultimate collapse of existing paper currencies.
There is third scenario which is unlikely. However, the loss of personal privacy and freedoms in the US and Canada since the 9/11 "War on Terror" was initiated makes what would have seemed absolutely impossible a decade ago now at least a considered, although remote, possibility. That would be to declare the free market too "dangerous" and the imposition of tighter government control over the economy and individuals (a scenario suggested by Jim Sinclair "Mr. Gold" of www.jsmineset.com). It would be an irony indeed that an economic emergency caused by the failed paradigm of central planning in turn applied by central banks to a mal-designed monetary system should be deemed a failure of the free market.
The game now remains one of confident statements by central bankers and politicians worldwide to continue the debt, investment and speculation cycle in financial markets. "Inflation is contained; commodities price surges are temporary; the world foresees steady growth." It is essential that the silos of investment capital, that have temporarily enabled their policies, be maintained and constrain capital from flowing into commodities and precious metals.
Former Federal Reserve Governor Ben Bernanke's 2002 statement that the Fed stood ready to drop money from helicopters if deflation becomes a threat, perhaps becomes clearer. What sounded like an irresponsible boast made some look the wrong way (away from speculation in commodities) by giving the impression the Fed was fighting deflation, an environment where commodities lose value, not the explosive inflation that lies in the wings. The irony in Bernanke's statement is that the Fed and central banks have been figuratively dropping money from helicopters for decades.
A U.S. national savings rate being below 1% of GDP ( a record low vs. an historical norm of approximately 6% of GDP) has been driven by the Fed interest rate being lowered to its low of 1% (and at 3% today, still below the rate of inflation). This has made the U.S. dependent upon foreign sources for financing of budget deficits and trade deficit requiring the daily injection of $ 2 billion of foreign capital. With the Japanese and Chinese pause in US Treasuries purchases, a sustainable source of foreign financing for the US has not yet appeared.
Foreign investors already hold more than $5 Trillion in U.S. Treasuries, currency and stocks alone. A decline in foreign appetite for U.S. investments can send investment paper washing back to the U.S. Just a slowdown of US debt purchase by foreigners, not a full stoppage or dumping of U.S. dollars, is all that is required to cause a further fall in the US dollar and interest rates to rise steeply disrupting markets and precipitating a further decline of US investments held by foreigners.
Compounding the tenuous nature of the current situation is that 60% of the outstanding $4.5 trillion U.S. Treasury bonds (net $2.7 Trillion) in the hands of the foreign and domestic public will mature within the next 3 years. Thus in addition to the $500 billion in treasuries that need to be floated each year to finance the budget deficit and the Iraq war, another $900 billion on average must be rolled-over into new bonds to continue the U.S. debt at the current low interest rates.25 In total, $1.4 trillion of U.S. Treasuries need to be purchased each year by foreign and domestic investors - unless the Fed wishes to print more money and purchase the bonds itself. This is perfectly possible but will be attended by much higher interest rates as even the lethargic "bond vigilantes" recognize the aggressive dollar dilution this signals.
How did we ever get to this point?
That the money stock can today be manipulated at will by central banks is a consequence of our current unbacked (or "fiat" ) monetary system.
In years past, the world's industrial economies were limited in their ability to manipulate the money stock as most currencies were on a strict "gold standard". Gold backed a country's money at a fixed ratio and currency was freely redeemable for gold from a country's treasury and banks at that fixed ratio.
Because the gold standard monetary system prevents limitless creation of money, it has been noted:
"Gold is an unimaginative taskmaster. It demands that men, banks, and government be honest. It demands that they create no debt without seeing clearly how these debts can be paid... ... But when a country creates debt light-heartedly,... ...then gold grow nervous. There comes a flight of capital (gold) out of the country." 26
Benjamin M. Anderson
Much to the bane of politicians and central banks, currency backed at a fixed gold ratio and freely redeemable for gold coin from a country's banks and Treasury allows that currency's citizen holders to convert that currency to gold coin and to either hold it in hand or safety deposit boxes within a country. Foreign holders could also remove the gold from a country that exercises economic policy that cannot be supported by reasonable taxation and fiscal policy. By removing the backing mechanism (gold) from banks and the Treasury, such action essentially removes money from circulation within that country forcing-up interest rates and forcing a change in policy by the offending government (Fekete).
This disciplinary "problem" was addressed gradually over the 20th Century by governments' transition to today's monetary system where no currency redeemable in gold thus allowing central banks to control the money supply by central bank edict or "fiat" - a privilege that all have abused.
With the elastic, fiat monetary system where the money stock is freely expandable, Governments are able to generate large debts by issuing government bonds then dissipating the debt at a later date by printing currency to consume that debt by inflationary dilution and devaluation.
Creation of money to stimulate an economy is nothing new. The Romans secretly diluted their silver coins and the Chinese (the first to use paper money) experienced monetary inflations in the 1300's.
During the 20th Century the world witnessed Weimar Germany undergoing hyperinflation (defined as more than 50% per month) in 1922 - 1923 which consumed its WW I reparations debt. Serbia issued 500 billion dinar notes as recently as 1993 with daily rates of inflation of 100%. Hyperinflationary periods result in currency crashes so the helicopter money scenario discussed by Ben Bernanke is not an attractive scenario.
In the U.S., the United States Revolutionary War in 1775 was financed by the Continental Congress issuing notes ("Continentals") which were unbacked by gold or silver and were predictably printed and inflated to worthlessness leading to the saying "not worth a Continental" and George Washington to comment "A wagonload of currency will hardly purchase a wagonload of provisions."27 This as well as other bank currency schemes in the 1800's left a deep and abiding distrust for irredeemable paper currency in the American people.
How is money created and the money stock controlled?
"This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system..."
Robert H. Hamphill, Formerly of the Atlanta Federal Reserve Bank
Three concepts are key to understanding the creation of money,.
When we think of money, we tend to think of cash - both bills and coin. However, less than 5% of money exists in this form - the majority of money in existence exists as bank deposits. They are merely accounting totals.
All money in existence has come into existence as a loan and reflects a current loan in the financial system. The constant increase in the money stock reflects a continual increase in debt in the fiat money banking system. Conversely, if loans are paid-down, the money stock contracts.
- Money is created by Banks , not the government or the central bank, with
loans injecting money into the monetary system and economy. Banks simply
credit accounts by making loans in response to two mechanisms:
• Money is lent from the Central Bank to chartered banks which in turn lend out multiples (typically 10 times the amount received ) thus creating money in the economy. This is referred to as "fractional reserve banking". If interest rates are held constant and central banks lend money beyond demand in the banking system, banks lower credit quality requirements for borrowers to stimulate demand and "deploy" their assets.
• Central banks lower interest rates thus stimulating demand for loans which are then offered by banks, again as multiples of their cash deposits, to create money by simply crediting accounts.
Contrary to popular belief, a loan does not necessarily come from someone else's savings. It is merely created as an account entry as a response to the issuance of a loan.
The flip side of this consideration is that if all loans were paid-off, the money stock disappears - thus Mr. Hamphill's comment that our system exists without a permanent money stock and the need for increasing debt levels.
By the broad monetary measure called M3, all the money in existence (Canada roughly $930 billion and in the U.S. $ 9.6 Trillion) reflects institutional loans that require the payment of interest.
Our central banks, the US Federal Reserve and Canada's Bank of Canada are relatively new creations - they are not the inevitable result of using currency whether or not that currency is backed by gold
There is an alternative to this monetary system and that is one where the Treasury of Canada or the U.S. would issue money which is permanent (whether backed or unbacked by gold is another discussion). In such a system, the Treasury would issue money, typically through government spending, without money being created through bank loans.
Such money would be permanent and exist without being originated as a loan - however this would remove a major profit generating mechanism from our financial institutions as it would greatly slow the growth of debt.
The Fiat Cat Keeps Coming Back
In America, the failed "Continentals" were followed in 1861 by another attempt at issuing a central currency because, as noted by the Federal Reserve itself, "once again the need to finance a war provided the impetus for a change to the monetary system."28 That war was the Civil War.
Thus, in 1861 Congress authorized "Demand Notes" (called greenbacks due to their green ink) which were unbacked by gold and then in 1862 also began issuing "United States Notes" which, during the Civil War and until 1879, were also made irredeemable in gold and silver coin.
Both the North's Notes and the South's Confederate Notes were printed (and counterfeited) en masse during the Civil War deepening the mistrust of U.S. citizens (North and South) for irredeemable paper currency. (It should be noted that the Federal Reserve on its website states the fact that paper currency U.S. Notes issued by the North starting 1861 (Confederate notes were in the end worthless) are still redeemable for modern monetary notes at face value is important for "the record of currency stability which this represents".29 That this currency only has a fraction of its original buying power seems to escape the Fed.)
The US Federal Reserve Bank was created in 1913 when the American people were reticent to have a central bank - a sentiment arising both because of numerous upheavals from previous failed currency manipulationiv in the U.S. and in other countries. The reticence also existed because of a fear of concentration of power which many believed would be abused by "Money Trusts" in the Eastern financial banking centers.
Reflecting this mistrust, the Wizard of Oz was written as an allegory about the dangers of central bank wizards; where the Wizard of Oz represented central bankers who promised ceaseless wealth by magical means; Oz was short for the gold ounce, Dorothy represented the average rural American citizen, the Cowardly Lion represented the weak William Jennings Bryan who, although a leading Democrat populist supporter of full gold and silver backing of the dollar, caved to the interests proposing the Federal Reserve Act, the Tin Woodman representing the American factory worker, and so on.30
To address the concern of American citizens about a Central Banking System, the Federal Reserve Act of 1913 created a system of 12 regional banks now overseen by 7 governors appointed by the President. In theory, this was a system of regional banks. In reality, these reserve banks formed the U.S.'s Central Bank overseen by the Board of Governors and its principal policy making body, the Federal Open Market Committee (FOMC).
The creation of the Federal Reserve was on the eve of World War I which began in 1914 and the Federal Reserve Act was passed on December 22, 1913 by the U.S. Senate by a vote of 43 to 25, at a time when 28 Senators were away for Christmas vacation, and signed by President Wilson on December 23. With the creation of the Fed, money was backed by gold but could be created in greater quantities than held in gold by Treasury.
Copyright © 2005 SafeHaven.comAfter running on an election platform promising to retain the gold standard, President Franklin D. Roosevelt (FDR) reneged in 1933, confiscated gold held by U.S. citizens in their Bank deposit boxes and suspended the right of citizens to own gold or redeem U.S. notes and Federal Reserve notes for gold (although foreign holders could). Finally in 1971, after having run an exceptionally loose monetary policy and creating money at multiples of the official gold reserves of the US to finance the Vietnam War, after France (initially) then other countries redeemed massive amounts of U.S. currency for gold. To prevent such further delivery of national assets for outstanding debt, ending all pretenses, President Nixon officially defaulted and made all U.S. currency and debt instruments held by foreigners also irredeemable for gold. The U.S. public was once again able to own gold by law.
The dollar has lost 92% of its buying power since the Fed's initiation of operation in 1914 while during the 1800's, despite bouts of currency manipulation, the buying power of the gold-backed dollar was ultimately steady when the interventionist schemes subsided.
Continue to: In Denial of Crisis: Part II
i Derivatives are financial instruments reflecting
a bet upon some underlying market characteristic such as interest rates or
the price of commodities. Derivatives include instruments such as futures,
puts, calls, swaps etc.
ii Much has been written about the unregulated derivatives market and the threat of systemic instability that it poses to the monetary system (for a derivatives primer, see: http://www.financialpolicy.org/dscprimers.htm; for a discussion regarding the dangers posed by derivatives, see: http://www.ex.ac.uk/~RDavies/arian/scandals/derivatives.html & http://www.financialpolicy.org/fpfspr8.pdf )
iii Note: the term "printing money" is used loosely to denote an increase in the money stock as today the majority of money in society are number entries indicating holdings in bank accounts.
iv Central Bank and currency manipulation preceded the Depression of 1819 caused by currency inflation by the Second Bank of the U.S.; Slump of 1836-37 again caused by inflationary distortion of Second Bank of the U.S. - enough that President Andrew Jackson prevented it's re-charter; 1873 post - Civil War downturn following the excesses of Civil War "greenback" money creation (ref. Lawrence W. Reed; Great Myths of the Great Depression, Mackinac Center for Public Policy)
1 Bank of Canada, Monetary Policy Report - Summary,
2 Washington Post, April 10, 2004. http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html
3 Charles Mackay: Extraordinary Popular Delusions and the Madness of Crowds, Prometheus, 1852.
4 Edward Chancellor, Crunch Time for Credit? An inquiry into the state of the credit system in the United States and Britain", Harriman House, 2005.
5 Charles Mackay: Extraordinary Popular Delusions and the Madness of Crowds, Prometheus, 1852, pg. 55.
7 Murray N. Rothbard, America's Great Depression, The Ludwig von Mises Institute, 1963, pg. 92 - 93
8 Murray N. Rothbard, America's Great Depression, The Ludwig von Mises Institute, 1963, pg. 93
9 Murray N. Rothbard, America's Great Depression, The Ludwig von Mises Institute, 1963, pg. 169
10 Irving Fisher, 15 October 1929.
11 Dr. Sam Wakind Ph.D., The Bursting Asset Bubbles,www.globalpolitician.com/articles.asp?id=647&print=true
12 Doug Noland, How Could Irving Fisher Have Been So Wrong?, http://www.safehaven.com/showarticle.cfm?id=42
13 Frank Shostack, Does a Falling Money Stock Cause Economic Depression?, http://www.mises.org/story/1211
14 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm
15 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm
16 The Boston Herald, Debt Level Places U.S. at Risk, April 4, 2004.
18 Stephen Roach, www.morganstanley.com/GEFdata/digests/20050606-mon.html#anchor0
19 Dean Baker, Dangerous Minds: The Track Record of Economic and Financial Analysts, http://www.cepr.net/dangerous_minds.htm
20 U.S. Treasury Monthly Foreign Holders of Treasuries Data: http://www.ustreas.gov/tic/mfh.txt
21 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin.
22 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin Pg. 3 and Robert Blumen www.mises.org/fullstory.aspx?control=1579&id=71
24 Peter Warburton, Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, 1999, Penguin Pg. 42
25 See U.S. Department of Treasury presentation: http://www.treas.gov/offices/domestic-finance/debt-management/qrc/2005/2005-q1-charts.pdf and http://www.publicdebt.treas.gov/opd/opds042005.htm
26 Benjamin M. Anderson; Economics and the Public Welfare, a Financial and Economic History of the United States, 1914 - 1946, Chapter 64 cited Antal E. Fekete; Lecture 13 - The Unadulterated Gold Standard, www.gold-eagle.com/gold_digest_02/fekete102802pv.html.
27 28 29 Federal Reserve Bank of San Francisco www.frbsf.org/publications/federalreserve/annual/1995/history.html
30 Jack Weatherford, The History of Money, Crown Publishers, 1997.