Loose Money, Asset Price Cycles and the Decapitalization of the United States

Ben’s Bubbles and the Bonfire of American Capital

Prepared by Kevin Dowd and Martin Hutchinson[1] for the 28th Cato Institute Annual Monetary Conference Asset Prices and Monetary Policy Washington DC, November 18, 2010


In the Gospel of Matthew (Matthew 25: 14-3), Jesus recounts the Parable of the Talents: the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence. He then returns and holds them to account: the first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn’t be bothered even to put the money in the bank where it could earn interest; instead, he simply buried the money and gave his master a zero return; he is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth.

In the modern American version of the parable, the eternal truth of the original remains – good stewardship is as important as it always was – and there is still one master (the American public), albeit a master in name only, who entrusts his capital to the stewardship of his supposed servants. Instead of three, however, there are now only two (the Federal Reserve and the federal government); they are not especially wicked, but they certainly are incompetent: they run amok and manage to squander so much of their master’s capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment. For their part, the two incompetent servants deny all responsibility, as politicians always do, and – since there is no accountability (let alone Biblical justice) in the modern version – ride off into the sunset insisting that none of this was their fault.

Asset Bubbles in the U.S.: Past and Present

The story starts with the Federal Reserve. Since October 1979, under Paul Volcker’s chairmanship, the Fed’s primary monetary policy goal had been the fight against inflation, a fight he went on to win though at great cost. Given this background, many monetarists were alarmed by Fed Chairman Alan Greenspan’s formal abandonment of monetarism in July 1993, but a subsequent tightening of policy in 1994-95 had caused satisfactory amounts of distress on Wall Street and seemed to indicate that the overall thrust of policy had not in fact changed.

The great change in U.S. monetary policy, so far as it can be dated, came early in 1995: in his bi-annual Humphrey-Hawkins testimony to Congress on February 22-23, Greenspan indicated that his program of rate rises, the last to a 6% Federal Funds rate on February 1st that year, had ended. Elliptical as ever, Greenspan’s hint of easing was veiled: “There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see that underlying forces are acting ultimately to reduce price pressures.”[2] The Dow Jones Index rose above 4,000 the following day, and was off to the races.

By December 5, 1996, the Dow was already at 6,400 and Greenspan famously expressed his doubts about the market’s “irrational exuberance”. Nonetheless, he did nothing tangible to reinforce his skepticism and pushed interest rates generally downwards over the next three years. In July 1997, he then came up with an explanation of why the high stock market might not be so excessive after all. In his usual Delphic manner, he remarked that “important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy.”[3] The press seized on these utterances as confirming a ‘productivity miracle’ that turned out later (like its predecessors the Philips curve and the Loch Ness monster) to be a myth, but not before it gave a nice boost to tech stocks in particular, which positively boomed. Only in 1999 did Greenspan begin to take action, pushing Fed Funds upwards to an eventual peak of 6.5% in 2000, by which time tech stock prices had reached stratospheric levels and then soon crashed.

The cycle then repeated. In January 2001, Greenspan began a series of interest rate cuts that saw the Fed Funds rate fall to 1% in 2003 – its lowest since 1961. He held it at that rate for a year and short-term interest rates were to remain below inflation for almost four years. This was a much more aggressive monetary policy and the results were entirely predictable: in Steve Hanke’s memorable phrase, there was “the mother of all liquidity cycles and yet another massive demand boom,”[4] the most notable feature of which was the real estate boom: subprime and all that. The rest is history.[5]

Greenspan’s successor Ben Bernanke then continued his predecessor’s loose monetary policy with missionary zeal. He brought the Fed Funds rate, which the Fed had belatedly pulled up to 5.25% in 2006 and held there for a year, back down to 2% by the onset of the crisis in September 2008; by then the rate of growth of MZM, the best currently available proxy for broad money, had been running into double digits for some time. Over the next six months MZM then increased at the rate of 20.4% per annum, while the monetary base doubled. Over this same period, the Fed funds rate was brought down from 2% to a mere 25 basis points, at which level it has remained ever since, and these loose money policies were supplemented with nearly $2 trillion in Quantitative Easing (QE). After March 2009, the monetary aggregates then remained flat for a year, but in April 2010 MZM started to rise again (at an annualized rate of 6.8% in the six months to October 2010) and, as we write, the Fed is embarking on QE2 – with yet another $600 billion in quantitative easing due to hit the system.

If past expansionary monetary policies led to bubbles, then we should expect the even more expansionary policies pursued since the onset of the crisis to produce new bubbles, and this is exactly what we find. Within the U.S.,[6] there are at least three very obvious bubbles currently in full swing, each fuelled by the flood of cheap money: Treasuries, financials and junk:[7]


The Treasury bond market has seen a massive boom since 2007, fuelled by a combination of large government deficits, enormous investor demand and low interest rates pushing prices up to record levels. Treasury bond issuance totaled $350 billion in the third quarter of 2010 compared with $73 billion in the third quarter of 2007 yet the long-term composite interest rate declined from 4.81% on October 1, 2007 to 3.26% on October 1, 2010. International official purchases for the Treasury bond market, which had declined from $52 billion in net purchases in the year to August 2006 to $9 billion in the following year, have rebounded to $194 billion in the latest twelve-month period. However that is nothing compared to private net purchases, which have soared from $175 billion in the year to August 2007 to no less than $569 billion in the latest twelve month period.


The current ‘recovery’ in financial stocks is almost entirely an artificial bubble. The Fed’s interest rate policy allows the banks to borrow short-term at close to zero and invest at 3% or so in long-term Treasuries or at about 4.5% in mortgage bonds (which are now openly guaranteed by the federal government). This enables them to sit back with their 3%+ spreads, leveraged 20 times to give a comfortable 60%+ gross return: becoming a yield curve player is far more profitable and avoids all the tiresome effort and risk of lending to small business.[8] It is therefore no wonder that lending to small and medium enterprises – on which economic recovery really depends – remains, at best, anemic, with small business loans down 25% since ’08. The result is a bizarre situation in which the banks appear to recover whilst their supposed core activity – lending – remains stuck; the reality, of course, is that lending is no longer their core business.

The banks’ true weakness is confirmed by other factors:

•    Current accounting rules – so called ‘fair value’ accounting rules – artificially inflate banks’ profitability in many ways. In practice, ‘fair value’ (sometimes known as market-to-market accounting, but in reality, mark-to-model accounting) boils down to giving practitioners license to abuse financial models for their own ends. This allows them to hide true losses and loot the system: you use a model to create fictitious valuations and hence fictitious profits, and then pay yourself a handsome (and very real) bonus for the ‘profit’ you have created. Needless to add, such practices are all the more damaging because they are so hidden.

•    Clever financial engineers are always finding ingenious ways to play the system and are currently very much hard at it. Many of the most lucrative of these schemes involve gaming the Basel capital rules to create fictitious profits and ‘unlock’ capital that can then be used to pay bonuses to clever financial engineers and their managers. U.K. banks seem to lead the field in this antisocial little game but one imagines that their NY colleagues must be pretty good at it too. A good example is the ingenious ‘pig on pork’ scam, introduced in the U.K. a decade ago and since widely copied; the current flavor of the month is the even more ingenious ‘failed sale’ scam, a transaction that looks like an innocent Repo, but which is really a backdoor way of hypothecating bank assets and deceiving bank counterparties who do not realize that the prime assets that appear to buttress banks’ balance sheets are in fact already furtively pledged to other parties.[9] Such practices secretly decapitalize the banks and are of course just another form of looting.

•    Underlying these, the banks are only able to continue operating because they are on state life support, propped up by repeated bailouts (including lender of last resort lending, TARP, government purchases of bank equity, repeated large-scale quantitative easing, etc) and government guarantees (including too-big-to-fail, deposit insurance, blanket guarantees of home mortgages, etc).


A third bubble is junk (sub-investment grade corporate bonds). In the year to September 15, 2010, junk bond issues raised $168.5 billion, more than the 2009 full-year record of $163 billion, and which itself represented an annual increase in total outstanding junk bonds of over 200%. Such growth is extraordinary in the deepest recession since World War II. Moreover, much of this growth takes the form of ‘covenant-lite’ bonds, which had been thought an aberration of the 2006-07 bubble. The key factor driving this growth would appear to be low interest rates: these not only reduce borrowing costs (for those able to borrow, i.e., larger firms rather than SMEs) and stimulate borrowing, itself encouraged by the tax-deductibility of debt; recent ultra-low interest rates also suppress yields on Treasuries, and this encourages yield-seeking investors to go for junk. These same causal factors have also given a big boost to the Leveraged Buy-Out (LBO) market, not least in so far as they have allowed company after company to avoid bankruptcy (and indeed prosper, temporarily) through aggressive refinancing.[10]

Each of these bubbles was/is characterized by obvious irrationality:

•       In the tech boom we had Pets.com, based on the idea that there was money to be made fedexing catfood around the country, and which could not cover the costs of sending kitty litter through the post: it made its IPO in February 2000 amid a welter of Superbowl ads and went for its final walkies a mere 288 days later. As an investment, Pets.com was a real dog.

•       In the housing bubble we had NINJA and ‘no doc’ loans, and house prices in some parts of the country running at 8-10 times annual income, i.e., we had loans being made with no concern for whether they would or could ever be repaid.

•       With interest rates so low, the prices of Treasuries are close to their peak and the only major change can be down; investors face a classic ‘one-way bet’ scenario reminiscent of a beleaguered currency facing a speculative attack: think of the U.K. currency crisis in September 1992, for example. In such circumstances the only rational response is to sell[11] and yet investors’ money still pours in.[12]

•       In the current financials market, we have the irrationality of the banks apparently profitable and prospering whilst the credit system is still jammed up and most of them remain dependent on state life support to continue in operation.

•       In the current junk bonds market, we have the irrationality of a major boom in lending to the riskiest corporate customers taking place in the middle of a major credit crunch and in the certain knowledge that many of these borrowers will default when interest rates rise.

We can be confident that these current bubbles will come to unpleasant ends like their predecessors, but on a potentially much grander scale. The bubbles will then burst in quick succession:

•       Sooner rather than later, it will dawn on investors that Treasuries are over-valued and confidence in the Treasuries market will crack: one possibility is that rising inflation expectations or higher deficits will then push up market interest rates, causing bond prices to falter and then fall; an even more imminent prospect is that some combination of the Fed’s quantitative easing and yawning Federal budget and U.S. balance of payments deficits will cause a further decline in the dollar that makes foreign holders of Treasury bonds lose confidence in their investments. In either case, there is then likely to be a rush to the exits – a flight from Treasuries on a massive scale – forcing up interest rates in general and inflicting heavy losses on bondholders, especially on those holding long-term bonds.

•       The collapse of the Treasuries market will cause the banks’ previously profitable ‘gapping’ adventure to unravel with a vengeance: the very positions that yielded them such easy returns will now suffer swingeing capital losses. Confidence in the banks – never strong since the onset of the crisis – will collapse (again) and we will enter a new (and severe) banking crisis.

•       The bursting of the Treasuries and financials bubbles will then feed through to the junk bond bubble: the collapse in the Treasuries market and the renewed banking crisis will lead to sharp falls in the values of corporate bonds and sharp rises in credit spreads. Highly leveraged firms will then default in droves, the junk bond market will collapse and LBO activity will dry up.

We also have to consider the nontrivial knock-on effects: the Treasuries collapse will trigger an immediate financing crisis for governments at all levels, and especially for the federal government, and one which will likely involve the downgrading of its AAA credit rating, and so further intensify the government’s by-then already chronic financing problems. Nor should we forget that these financial tsunamis are likely to overwhelm the Federal Reserve itself: the Fed has a highly leveraged balance sheet that would do any aggressive hedge fund proud; it too will therefore suffer horrendous losses and is likely to become insolvent. The events of the last three years will then look like a picnic.

There is also the problem of resurgent inflation. For a long time, the U.S. has been protected from much of the inflationary impact of Federal Reserve policies: developments in IT and the cost reductions attendant on the outsourcing of production to east Asia had the impact of suppressing prices and masking the domestic impact of Fed policies. Instead, these policies produced a massive buildup in global currency reserves: these have increased at 16% per annum since 1997-98[13] and caused soaring commodity prices and rampant inflation in countries such as India (current inflation 16%) and China (maybe 20%, judging by wage inflation, and definitely much higher than official figures acknowledge) whose currencies have been (more or less) aligned to the dollar. U.S. inflation was already rising by 2008 (annual rate 3.85%), but this rise was put into reverse when bank lending and consumer spending then fell sharply. However, there are good reasons to think that inflation will soon take off again: (1) The combination of booming commodity prices and a depreciating dollar (trade-weighted dollar exchange rate index down 15% since March ’09) means that imports will cost more in dollar terms and this must inevitably feed through to U.S. inflation. (2) Rising labor costs in the Asian economies mean that the outsourcing movement is coming to an end and even beginning to reverse itself,[14] and with it the associated cost reductions for American firms that outsource to Asia. Most importantly, (3), there is the huge additional monetary overhang created over the last couple of years (or, to put it more pointedly, the vast recent monetizations of government debt), the impact of which has been held temporarily in check by sluggish conditions over 2009-2010, but which will must eventually flood forth – and, when it does, inflation is likely to rise sharply.

Once inflation makes a comeback, a point will eventually come where the Fed policy has to go into sharp reverse – just like the late 1970s, interest rates will be hiked upwards to slow down monetary growth. The consequences would be most unpleasant: the U.S. would experience the renewed miseries of stagflation – and a severe one at that, given the carnage of a renewed financial crisis and the large increases in money supply working through the system. Moreover, as in the early 1980s, higher interest rates would lead to major falls in asset prices and inflict further losses on financial institutions, wiping out their capital bases in the process. Thus, renewed inflation and higher interest rates would deliver yet another blow to an already gravely weakened financial system.

The Decapitalizing Effects of Repeated Bubbles

Federal Reserve monetary policy over the last fifteen years or so has produced bubble after bubble, and each bubble (or each group of contemporaneous bubbles) is bigger in aggregate and more damaging than the one that preceded it. Each bubble destroys part of the capital stock by diverting capital into economically unjustified uses – artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon.[15] These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and ‘bubble blight’ – massive over-capacity in the sectors affected.[16] This has happened again and again, in one sector after another: tech, real estate, Treasuries, financials, and junk – and the same policy also helps to spawn bubbles overseas, mostly notable in commodities and emerging markets right now.

We also have to consider how periods of prolonged low (and often sub-zero) real interest rates have led to sharply reduced saving and, hence, led to lower capital accumulation over time. U.S. savings rates have fallen progressively since the early 1980s, falling from nearly 12% to little more than zero in recent years.

Even without Federal budget deficits, it is manifestly obvious that U.S. savings rates over the last two decades are inadequate to provide for the maintenance, let alone growth, of the U.S. capital stock (or, for that matter, its citizens’ desires for a secure retirement): the U.S. economy is effectively eating its own seed-corn. Now add in the impact of federal budget deficits of around 10% of GDP and we see that the deficits alone take up more than the economy’s entire savings, without a penny left over for investment. It then becomes necessary to supply U.S. capital needs by foreign borrowing – hence the persistent and worrying balance of payments deficits – but even this borrowing is not enough. Hence over the long term, low interest rates are decapitalizing the U.S. economy, with damaging long-term implications for its residents’ living standards: in the long run, low interest leads to low saving and capital decline, and they in turn lead to stagnation and eventually to the prospect of declining living standards as America ceases to be a capital-rich economy.

Not to put too fine a point on it, savings have been suppressed for close on two decades, preventing the natural accumulation of capital as baby-boomers drew closer to retirement, while much of the country’s magnificent and once unmatched capital stock is being poured down a succession of ratholes.

The Federal Government is a Pretty Good Capital Destroyer Too …

We should also see these problems against the context of a vast number of other government policies that are decapitalizing the U.S. economy in myriad other ways. The wastefulness of government infrastructure projects is of course legendary. One instance is the Amtrak proposal for a Boston-Washington high speed railroad, costed at $117 billion, compared to $20 billion equivalent for similar lines in France and under $10 billion for a line recently opened in China. Even more striking is the ARC tunnel project between Manhattan and New Jersey, recently killed by Governor Christie because of its excessive cost of $8.7 billion plus likely overruns. Yet the Holland Tunnel, performing an identical function and opened by President Coolidge in November 1927, came in at $48 million, equivalent to $606 million in 2010 dollars. Even allowing for the higher real wages of today’s construction labor, and a certain amount of fiddling of the consumer price statistics by the BLS, it should have been possible to bring the ARC project in at under $1.5-2 billion, less than a quarter of the actual projected cost. The high costs of infrastructure problems boil down to the onerous regulations under which such projects are carried out, such as the 1931 Davis-Bacon mandate to use union labor on federally funded projects and a whole welter of health & safety and environmental regulations, which massively push up overheads.

We also have to consider the impact of government fiscal policy. Large government deficits reduce capital accumulation in so far as they crowd out private investments; large levels of government debt also reduce capital accumulation in so far as they imply large burdens on future taxpayers and these burdens reduce their ability (not to mention their willingness) to save. Over the three years, the government’s deficits have risen from 1.14% of GDP in 2007 to a projected 10.64% of GDP in 2010.[17] In the process, US government official debt has grown from almost 64% of GDP in 2007 to a little over 94% of GDP in 2010. This latter figure is very high by traditional standards and the rate at which it is rising would suggest that the U.S. government’s credit rating will soon be threatened, even without the racing certainty of an imminent Treasuries collapse; indeed, this figure alone portends a rapidly approaching solvency crisis.

Yet even these grim figures are merely the tip of a much bigger iceberg. The official debt of the United States, large as it is, is dwarfed by its unofficial debt: the Social Security and other entitlements (Medicare, Medicaid, etc) to which the federal government has committed itself, but not provided for, i.e., additional debts that future taxpayers are expected to pay for. Recent estimates of the size of this debt are hair-raising. Using CBO figures, Laurence Kotlikoff recently (Aug 11, 2010) estimated that this debt was now $202 trillion. To put this into perspective, this is 15 times the ‘official’ debt and nearly 14 times annual U.S. GDP – implying that the average U.S. citizen would need to spend almost 14 years of their life (and still counting) working to pay off this debt alone: no wonder Kotlikoff matter-of-factly concluded that the US is bankrupt and we don’t even know it.[18] This burden implies punitive tax rates on future employment income (and hence major disincentives to work or at least declare income), but will also greatly discourage future capital accumulation as investors will (rightly) fear that there is little point building up investments that will eventually be expropriated by the government.[19]

Long-term Outlook for the U.S. Economy

The long-term effect of U.S. economic decapitalization will not necessarily be apparent in day-to-day headlines; instead, the process will be almost glacial: mostly slow but utterly devastating in its longer term impact.

For all of its history, the United States has enjoyed many advantages over most other countries: abundant wealth and capital, world-class education and technology, a highly innovative culture and, underpinning these, a freer economy. However, the US economy is now far less free than it used to be 80 or more years ago; partly because of this, but partly because of the natural ongoing processes of globalization, the U.S. is steadily losing its other advantages as well. Owing to globalization and the outsourcing and wealth transfer that has brought about, the U.S. has long lost many of its advantages of technology and education against Europe and Japan. The same process then started relative to the small ‘tiger’ economies of east Asia and, more recently, relative to the giant Asian economies of China and India, whose wage levels are still only a fraction of those of the United States. In the long run, American citizens can expect higher living standards than Chinese or Indian citizens only if they maintain some ‘edge’ over them.  However, as the American capital stock gradually dissipates and their capital stocks increase, then that edge becomes increasingly tenuous and living standards will converge. Consequently, over the long term, there is no reason to expect U.S. living standards to exceed those in countries such as China, Malaysia, Thailand and Brazil that are coming to equal the U.S. in many of its factor inputs.

Americans might also take heed from the experiences of other once wealthy countries whose economies were crippled by progressive decapitalization:

•       One is Britain, which was still a wealthy country at the very frontier of technological advance in the late 1930s. However, when the War broke out the government took complete control of the economy and seized its entire capital stock, foreign investments and all. Over the next decades a bloated state sector and onerous controls deprived British industry of the capital it needed to refit, and the country went into long term economic decline. By the late 1970s, in consequence, Britain was being referred to as the new “sick man of Europe” and British living standards by the late 1970s were 30% lower than its European competitors’ and half those in the United States. By contrast, West Germany, which had suffered much more devastation in the War and the loss of most of its physical infrastructure, rebounded quickly under the free-market policies implemented by Konrad Adenauer and Ludwig Erhard from 1948, and soon rebuilt both its capital stock and its prosperity.

•       Another role model to avoid is Argentina, one of the world’s wealthiest economies in 1930, with enormous foreign exchange reserves from wartime trading as late as 1945, which embarked on wildly extravagant schemes of corruption, nationalization and income redistribution. Successive governments tried to restore Argentina’s position – it was after all superbly endowed with resources and in the 1940s had a highly competitive education system – but without adequate access to capital were unable to do so. The result was progressive impoverishment, repeated debt defaults and the country’s descent into its present Socialist squalor, in which even with high commodity prices it comes between Gabon and Libya in the global table of GDP per capita.

This will therefore be the fate of a decapitalized United States: its major cities will descend through the position of Cleveland, in which decay is mixed with dilapidated old-world charm, to that of Youngstown, Ohio in which devastation is universal, with the only flourishing markets being those for chain-link fences, tattoos and rottweilers.

What Can Be Done?

Thankfully, such a dire future is not inevitable – unless current policies persist – but radical reforms will be needed if it is to be avoided. Any reforms need to be based on a diagnosis of the underlying problems, however, and one of the most important of these is, quite simply, that U.S. policy-makers place too much emphasis on the short-term and fail to take adequate account of longer-term consequences. Nor should this be any surprise: the political environment in which they operate – the fact that they are accountable over limited terms of office, etc. – encourages them to focus on the short-term, so it is only to be expected that they would respond to such incentives: what happens after their watch is not their problem.

As far as monetary policy is concerned, these short-termist incentives create an inbuilt expansionary bias that has manifested itself in repeated asset price bubbles and now the prospect of renewed inflation, and the solution is to build-in barriers to contain his bias. The key here is to reduce – or better still – eliminate their discretionary powers; this would put a stop to those who would meddle with the short term interest rate and so kill the asset bubble cycle at its root. Interest rates would then be higher (and more stable) than they have been over recent years and so provide a stronger incentive for saving.

One possible reform would be to ‘Volckerize’ the Fed and give it a single overriding objective – namely the maintenance of price stability – and reform its institutional structure to protect its independence from the federal government. Reformers could take their lead from the Bundesbank: instead of a federated central bank accountable to the federal government and headquartered in the federal capital, the American central bank could be reconstituted as a unitary central bank accountable to the States and relocated in the heartland of the nation: our recommended choice would be St. Louis, which also has the attractions of a strong monetarist tradition and of being less susceptible to the influences of Washington DC or Wall Street. The ideal Fed chairman would then be more concerned with the St. Louis Post-Dispatch than the Washington Post or the WSJ, and even the feeblest appointee would be strong enough to stand up to the badgering of east coast politicians and financiers.

However, a far better reform – and a far more appropriate one, given the Fed’s dismal record since its founding – would be to abolish the Federal Reserve altogether and re-anchor the dollar to a sound commodity standard. A natural choice would be a gold standard, with the currency issued by commercial banks but pegged to and redeemable in gold. Interest rates and money supply would no longer be determined by central bankers but by market forces subject to the discipline of the gold standard. An alternative anchor might be some broader commodity basket, which has the additional attraction of promising greater price-level stability than a gold standard.[20]

Yet monetary reform on its own will not be enough to reverse the destruction of US capital: the federal government also needs to reform its own vast range of capital-destroying policies. Such reforms would include, among others, the following: [21] (1) Government should stop meddling in the financial system: it should stop giving guarantees such as mortgage guarantees or deposit insurance guarantees, and it should implement measures to prevent future bailouts and abolish government-supported enterprises such as Fannie, Freddie, etc. whose machinations have devastated the U.S. housing market. (2) Reformers should acknowledge the tendency of government to grow and be excessively short-term focused, and push for a systematic program that will cut government back and limit any future growth, the goal being to return the government back to the levels of the Coolidge Administration (motto: “The business of America is business”) in the 1920s. (3) A range of tax reforms is needed to abolish tax-based incentives to borrow, remove tax penalties from saving, investing and the transfer of capital between generations. (4) Government should tackle major budget imbalances. This requires a major reversal of current expansionary fiscal policies and, for once, the U.K. provides a positive role model: the U.K. faces similar problems, but the new Coalition Government acknowledges these problems and is in the process of implementing cutbacks to take Britain back from the brink; the U.S. needs to do the same.

The longer term fiscal prospects for both countries are of course dire but the good news is that most actuarial deficits are not so much hard and fast debt obligations as projections of what would happen if current policies persist, and there are obvious economies that can be made once the U.S government finds the courage to tackle these problems. Moreover, recent political developments – in particular, the recent Congressional elections, the rise of the Tea Party Movement and increasing dissatisfaction with the Federal Reserve, most notably the growing ‘end the Fed’ movement – suggest that the U.S. is at least beginning to move in the right direction.


Dowd, K., “An almost ideal monetary rule.” Greek Economic Review, Vol. 19, No. 2, Autumn 1999, pages 53-62.

Dowd, K., and M. Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, Wiley, 2010.

Hanke, S. H., “Greenspan’s bubbles.” Finance Asia, June 5, 2008. Available at http://www.cato.org/pub_display.php?pub_id=9448

Hanke, S. H., “Booms and busts.” Finance Asia, January 2010. Available at http://www.cato.org/pub_display.php?pub_id=11084

Hutchinson, M., “They don’t call them junk bonds for nothing.” The Bear’s Lair, September 27, 2010. Available at http://www.prudentbear.com/index.php/component/content/article/33-BearLair/10443-martin-hutchinson

Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Public debt and demography – an international comparison using generational accounting.” Research Center for Generational Contracts, Freiburg University, CESifo Dice Report 4/2009, 2009a.

Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Ehbare Staaten? Die deutsche Generationenbilanz im internationalen Vergleich.” Argumente zu Marktwirtschaft und Politik 107, Stiftung Marktwirtschaft, 2009b.

Kerr, G., “How To destroy the British banking system – regulatory arbitrage via ‘pig on pork’ derivatives.” Cobden Centre. Available at https://www.cobdencentre.org/2010/01/how-to-destroy-the-british-banking-system.

Kotlikoff, L., “U.S. is bankrupt and we don’t even know it.” Bloomberg, August 11, 2010. http://www.bloomberg.com/news/2010-08-11/u-s-is-bankrupt-and-we-don-t-even-know-commentary-by-laurence-kotlikoff.html

Norberg, J., (2009) Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis.Washington DC: Cato Institite, 2009.

O’Driscoll, G. P, Jr., “Money and the present crisis.” Cato Journal, Vol. 29, No. 1, 2009, pp. 167-186.

Woods, T. E., Jr., Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington DC: Regnery, 2009.

[1] Kevin Dowd is a Visiting Professor at the Pensions Institute at Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, United Kingdom and an adjunct scholar at the Cato Institute; email: kevin.dowd@hotmail.co.uk. Martin Hutchinson is a financial journalist and former banker, correspondent for Reuters BreakingViews and author of the weekly column “The Bear’s Lair”: 8307 Colby Street Vienna VA 22180, e-mail karlmagnus@aol.com. The authors thank Toby Baxendale, Steve Hanke and Gordon Kerr for helpful inputs. The usual caveat applies.

[2] Testimony to the House Banking Committee, February 22, 1995.

[3] Testimony before the Senate Banking Committee, July 23, 1997, p2. St. Louis Fed., FRASER.

[4] Hanke, 2008.

[5] There are many excellent accounts of this story, and we particularly recommend, e.g., O’Driscoll (2008), Hanke (2008), Norberg (2009) or Woods (2009). We also had a go at it ourselves in Dowd and Hutchinson (2010).

[6] There are also major bubbles overseas, most notably those in the Chinese and Indian real estate markets, and which (given the reserve currency status of the dollar and the huge expansions in these countries’ dollar holdings over a long period) are also due, in part, to the same expansionary Federal Reserve policies.

[7] We also mention two others in passing. (1) Stock prices are in a moderate bubble: analysis of stock fundamentals suggests that stocks (up 60%+ since the lows of March 2009) are now somewhat overpriced, though low interest rates are pushing up profits, especially for highly leveraged businesses. (2) Commodity prices are already approaching and in some cases surpassing their 2008 highs: e.g., since early ’09, gold is up nearly 60%, silver is up 100%, copper up 350% and crude oil up nearly 250%. Commodity prices are driven partly by rapidly growing demand in emerging markets and partly by continuing ultra-cheap money.

[8] There is also a large boom in fast/insider trading that illustrates, if not the irrationality, then at least the economic pointlessness of much of what the financial system currently does. High-frequency trading using fast computers and automated algorithms has grown enormously and now accounts for 70% or more of trading volume, up from very small amounts a few years ago. Its defenders claim it promotes market liquidity, but we would argue that their impact on market liquidity is at best minimal as markets are already liquid for the most part and the machines are switched off when markets become unstable. We would also argue that they are potentially destabilizing (as evidenced by the May 2010 ‘flash’ in the Dow Jones when the market fell 10% after a rogue machine went on a rampage) and in some cases their activities are fraudulent (e.g., when they program their computers to “ping” markets with orders that are instantaneously retracted). We would argue that most high-frequency trading is rent-seeking activity that has no place in a truly rational system and really needs to be shut down: this is where a Tobin tax would come in useful as a stop-gap, pending more radical reforms (free banking, extended liability, etc.) that would restore such a system.

[9] We thank Gordon Kerr for this information; further details on ‘pig on pork’ are provided by Kerr (2010).

[10] See also Hutchinson (2010).

[11] To give a simple illustration, take a Treasury bond with a duration (average time to cash flow) equal to say 25 years: using conventional duration analysis, a rise in interest rates of just 1% would lead to a capital loss of 25%; at the same time, with interest rates so low and the government flooding the market with more, thanks to its gaping borrowing requirements, the bond has little chance of going up in price.

[12] A free investment tip, guys: cash out and try the mattress – at least there is no danger of a capital loss when interest rates rise. Alternatively, you might take a leaf from the wicked servant in the Parable and bury the cash in the garden: that strategy is not as bad as it is cracked up to be – so long as you don’t just bury paper money in a damp garden.

[13] IMF COFER database

[14]As an example, recent stories in the U.S. press report that Indian helpdesk companies are now finding that they can operate more cheaply in the rural U.S. than in India itself: the fall in rural U.S. wage rates due to the recession has combined with the rise in Indian costs to produce an astonishing reversal of the original outsourcing driver.

[15] See also, e.g., Hanke (2010). We can illustrate this impact by applying duration analysis familiar from bond market analysis: if an investment with given expected future cashflows has a duration (or average time to cashflows) of T years, then a fall in interest rates of 1% will lead the value of the investment to rise by (approximately) T%. The impact on asset values will be ameliorated if longer term rates do not fall so much, but the essential story still holds.

[16] We gloss over various knock-on effects. One such is how the lowering of short-term interest rates depresses yields: this encourages investors to look for higher-yielding, investment outlets which, in turn, reduces credit spreads and diverts capital from ‘safe’ investments into higher risk investments such as junk bonds or emerging markets. If Vietnam, for example, can then raise money almost as easily as Ohio, then capital will be diverted to lower cost Vietnam and US manufacturing jobs will migrate with them.

[17] We gloss over here but take as read the vast amount of wastage and loss (much of it not even estimable) in recent federal government spending programs: TARP (cost said to be only about $30 billion) and other bank bailouts, the AIG rescue (which will be much higher than that), the rescue of Fannie and Freddie (currently worst case about $360 billion), the $1 trillion or so FHA loans made since it stepped in during the crash (and no one yet knows how many are bad), cash for clunkers and the auto bailouts, the over-hyped American Recovery and Reinvestment Act and quantitative easing, the costs of all of which are still unknown.

[18] See Kotlikoff (2010). Other scholars come up with different estimates, though still very alarming ones: for example, Hagist et al. (2009, 2010) suggest that the ratio of unofficial U.S. debt to GDP was 350.8% in 2004 and an update for 2009 gave an estimate of 567.4%. This suggests the problem is growing rather rapidly. The same study also provided an international comparison of the U.S. against selected European economies, and their results suggest that the U.S. has now displaced the U.K. as the country with the shakiest long-term public finances, a not inconsiderable achievement.

[19] Indeed, it would appear that the U.S. government is already laying the groundwork: the recently passed Foreign Account Tax Compliance Act requires U.S. taxpayers to inform the IRS of their foreign investments, and also requires foreign funds to name their U.S. investors on pain of a flat 30% confiscation tax each year. As one (non-U.S.) institutional investor informed us in private correspondence, “Naturally, we are divesting ourselves of all U.S. holdings.” This does not augur well for the future of the U.S. as a magnet for foreign investors; it also raises specter of the seizure of private gold holdings in 1934.

[20] An example of such a scheme is the ‘almost ideal monetary rule’ suggested by Dowd (1999). The idea is to create a monetary rule that stabilizes the CPI without the central bank having to buy and sell the CPI ‘basket’ of goods and services itself, which would obviously not be feasible. Instead, the Fed creates a new form of CPI-based financial derivative – in this particular case, this derivative would be a perpetual American put option on the U.S. CPI, the term ‘American’ here being used in the sense of standard options language to refer to an option with unrestricted early exercise rights. The Fed would then buy and sell these contracts on demand at a fixed price, and the system is so designed that its only zero-arbitrage equilibrium is one in which the expected change in the future CPI is zero; this would ensure that the system delivers price-level stability. In our (preferred) free-banking version of the scheme, commercial banks would be allowed to issue dollar-money on this same basis, and the Fed itself could then be abolished.

[21] For more on these reform proposals, we refer the reader to Dowd and Hutchinson (2010).

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2 replies on “Loose Money, Asset Price Cycles and the Decapitalization of the United States”
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