Not many people are aware that on the 5th of April 1933, the US citizens were instructed to deliver up all their gold (money at the time) to the Federal Reserve and get less in purchasing power back. This confiscation of wealth would make even Emperor Nero or Henry VIII blush with its boldness.
Congressman Ron Paul has always campaigned for the Fed to open its books and have this gold counted as there are rumours that all of it is not there. An open audit would settle the matter. The Fed refuses. You can draw your own conclusions from this.
Rep. Ron Paul (R-Texas) said he plans to introduce legislation next year to force an audit of U.S. holdings of gold.
Paul, a longtime critic of the Federal Reserve and U.S. monetary policy, said he believes it’s “a possibility” that there might not actually be any gold in the vaults of Fort Knox or the New York Federal Reserve bank.
The libertarian lawmaker told Kitco News, a website tracking news about precious metals, that an audit was necessary to determine how much the U.S. maintains in gold reserves in case the government were to use gold to back the dollar.
“If there was no question about the gold being there, you think they would be anxious to prove gold is there,” he said.
“Our Federal Reserve admits to nothing, and they should prove all the gold is there. There is a reason to be suspicious and even if you are not suspicious why wouldn’t you have an audit?
“I think it is a possibility,” Paul said when asked if there was truth to rumors that there was actually no gold at Ft. Knox or the New York Fed.
Paul had been one of the Republicans to spearhead a broader audit of the Fed as part of the Wall Street reform bill passed through Congress this year. The provision, which was weakened somewhat in the final version, found Paul joining with a number of Democrats to require the Fed to open its books and outline its assets and liabilities.
The gold reserves, which Paul’s new bill would audit, are generally seen as a guarantee on a nation’s currency, but the U.S. moved the dollar away from being tied to the price of gold in 1972.
Paul stopped short of calling for the reinstitution of the gold standard and instead called for the government to allow the use of hard currency — gold and silver tender — alongside the use of the dollar.
“If people get tired of using the paper standard they can deal in gold or silver,” he said.
Desperate times lead to desperate measures and on a side note, I wonder what is being planned now. I remember being told at the start of my business career by a wise old multi millionaire, “remember, when the banks or the government need money, they can only come after you if you have money,” i.e. they can’t confiscate what you do not have.
Mr Schiff discusses the once-supposed monetary exit plan for the Federal Reserve, which he predicted last year that they would never actually execute. This prediction was boosted this week when the Fed announced that it would not be shrinking its balance sheet. This disappointed the government-led US markets, because they wanted the Fed to announce that it was going to keep expanding its balance sheet by printing up even more new paper Dollars and by soaking up even more market assets with this scrip.
Schiff thinks these government-focussed speculators will not be disappointed in the long run, because the Federal Reserve only possesses one arrow in its quiver, which is pointed straight at the ‘On’ switch on a paper Dollar printing press; though the Fed does have to pretend that one day it will aim this arrow at the ‘Off’ switch.
The problem with the Fed’s paper stimulus is that the extra paper currency generated is employed to suck in more consumption goods from overseas, whereas what America really ought to be doing is producing more of its own real goods rather than cranking out yet more paper for the world to soak up. However, this will fail to happen as long as the Federal Reserve keeps intimating to the markets that it will keep printing more currency and keep accumulating US Treasury bonds, all of which is based upon ‘indefinitely’ low interest rates (as set by the Federal Reserve).
When interest rates eventually rise to avoid a Misesian crack-up boom, Schiff predicts there will then be a Dollar currency crisis and a US sovereign debt crisis and outlines how this will happen. He also thinks the Federal Reserve knows this potential outcome, though they are afraid of stating their thoughts out loud due to the panic that would then ensue; they have trapped themselves in a double-bind.
[One almost imagines that the strategic policy inside the Federal Reserve is now officially, "Hang On as Long as Possible and Wait for a Miracle".]
Over at CentreRight, I have set out briefly the mistake presently being made by policymakers in the US, which I expect to be mirrored in the UK later this morning. For example:
Injecting more new money, whether through QE or credit expansion in excess of real savings, will not “fight recession”. It will merely delay and worsen the eventual downturn, because injecting new money is bound to shift activity from sustainable economic action to action supported only by that new money.
Sooner or later, the mainstream economic paradigm must shift to accept the importance of time and hence a robust capital theory. Everyone’s prosperity depends upon it.
Jim Rickards is the Senior Managing Director for Market Intelligence at Omnis, Incorporated, and was interviewed recently by Eric King to discuss the US quantitative easing push proposed by Dr James Bullard, the President of the Federal Reserve Bank of St. Louis.
In this refreshing 18 minute interview, Mr Rickards produced some forthright views of what this new plan may mean in the Politburo machinations at the Federal Reserve, plus he provides an excellent technical analysis of the Bullard plan to both raise interest rates and fire the bazooka of quantitative easing at the same time, to stimulate the US economy. Does this sound like a monetary description of a painting by Escher?
If you are as intrigued as I was, then the radio interview is available below:
According to Rickards, the following is how the Keynesian puppet controllers at the Federal Reserve think they can deceive the US population into obeying their strictures on spending more:
[Austrian readers of a nervous disposition may feel the need to grab hold of something firm before continuing, because we have to enter a Keynesian/Monetarist mental mindset to reach the other side of this chain of ideas, without otherwise turning into gibbering slavering lunatics. At no point are you allowed to ask 'Why is this true?', or 'How did you work that out?', or 'Why don't we just get rid of the Fed?']
Interest rates at 0% have failed, therefore something new needs to be tried
There is a danger of the US flipping into a Japanese-style deflation
General investors want to receive inflation, as measured by the CPI, plus at least 50 basis points, to compensate them for tying their money up for any period of time
The Fed targets 2.3% inflation as being optimal for a successful economy
Therefore interest rates should be 2.8% to create an optimal economy
Unfortunately, with interest rates at 0%, the expectation is that inflation is negative, at minus 0.5%, and in deflation territory
Therefore behaviour patterns have set in which expect deflation and which have stopped spending and investment
To combat this, the Fed must raise interest rates to increase expectations of ‘good inflation’ at 2.3%
So interest rates must go to 2.8%
This will stop deflationary fears and get people investing again to prevent a Japanese style denouement for the US economy
Unfortunately, these higher interest rates will dry up credit for many US businesses
Therefore we need to flood the US with a second round of quantitative easing, and put the pedal to the printing press metal, and do whatever it takes to provide this credit
Hence, behavioural expectations about inflation will be optimal and credit levels will be optimal
All will then be sweetness and light
You can let go now.
[I don't know about you, but if you thought reading that was bad, you ought to have tried writing it. For the brave at heart, you can download Dr Bullard's paper yourself, 'The Seven Faces of Peril', at Scribd. For a discussion on deflation, try the recent piece by Dr Frank Shostak. For a tangential piece on how all of this may be an attempt to push us towards a global paper currency, try the recent article by Lew Rockwell.]
Getting back to Jim Rickards, he was as unimpressed by Dr Bullard’s comments as Peter Schiff was, in his recent response.
Here’s a synopsis of the radio interview above:
Bullard and Bernanke may disagree on the tools that the Fed should use, but they do agree that deflation must be combatted with inflation. ‘But what is so wrong with deflation?’ asks Rickards.
The greatest period in US economic history was perhaps 1870 to 1900, an entirely deflationary period, in which the US shifted from being a Jeffersonian agrarian power to becoming a world-girdling industrial giant, even displacing Great Britain, which itself was going through its own enormous boom in industrial output, within its own deflationary monetary system.
Rickards contends that if prices go down, standards of living go up, because the same amount of money goes further, as it has with personal computers over the last three decades. However, the US Treasury hates this, because they have no way of taxing a rise in the standard of living caused by the price level going down.
[Which is why they perhaps solved this 'terrible problem' by instituting inflation in the first place, from 1913 onwards, with the creation of the Federal Reserve, a.k.a., The Creature from Jekyll Island.]
Deflation also increases the real value of debt, and although at first this may seem good for the banks, who hold debts on their books as assets, in the medium term it is bad for banks because the level of defaults rises as people walk away from debts they should never have taken on in the first place, and never would have taken on in a constant deflationary environment [and as the assets they have collateralised against these debts go down in monetary value].
When Bernanke et al therefore try to stop deflation, what they are actually doing is helping the banks collect every penny on their loans and punishing the people by keeping them nailed under increasing tax and debt burdens.
In short, Rickards thinks the Fed are fronting for the US Treasury and the banks in their monetary exploitation of the American people.
[I know. You're staggered and amazed.]
Rickards then moves away from the broader canvas and steps down a gear into more technical detail. He challenges Bullard on how the St. Louis Fed President thinks inflation can so easily be fine-tuned and dialled up and down as the Politburo controllers at the Federal Reserve dictate. ‘Who says this dynamically unstable process can be so easily controlled?’ asks Rickards.
In the Weimar Republic in 1920, the Reichsbank increased the money supply significantly, though nothing dramatically life-threatening happened for two years. However, in 1922, the German economy moved from serious inflation, in June, to hyperinflation, in the matter of a month [with the price level rising 16 times between June and December of 1922].
Rickards contends that the velocity of money is the crucial thing and that the volatility of velocity is consistently underestimated by the Keynesian/Monetarist school.
Although nothing is ever certain in a volatile Black Swan world, Rickards thinks the Bullard money printing plan could tip an inflationary situation into one of hyperinflation, and that if this should occur, then it will be a relatively overnight event.
He goes on to predict that if this monetary collapse does ensue in the US, then each consumer business will run an electronic billboard for its customers, at their tills, which will provide a second-by-second update on the Dollar price against a gold weight unit.
[Please let this gold weight unit be called The Rothbard, with one Rothbard equal to one Troy ounce of gold. For those who have yet to read it, there is also a gem of a novel about this potential paper money breakdown scenario by J. Neil Schulman, entitled Alongside Night, which may still be freely available at Google Books]
Getting back on topic, however, businesses will set all prices using this gold numéraire as an exchange price, but will still take dollars in payment [because it will probably be illegal for them to refuse]. However, businesses will use the gold numéraire to set a constant pricing standard on all the goods labels in the store, with the dollars constantly ticking up in red diode terminator-style numbers beside the unitary gold weight denomination at the till.
Nicknaming Bullard ‘Son of Helicopter’, after the famous Bernanke Helicopter Speech, in which the future Chairman of the Federal Reserve Board quoted an earlier Milton Friedman analogy about the dumping of money from helicopters to solve the Keynesian/Monetarist liquidity trap problem, Rickards does state that he finds the Bullard plan more elegant, technical, and refined, than Bernanke’s usual level of output, but no more persuasive for all that.
Eric King breaks into the interview at this point and asks Mr Rickards what he thinks will happen next at the Federal Reserve?
Rickards thinks the FOMC (Federal Open Market Committee) currently has two camps, both of which want to scare people into spending more money:
Group One: Keep interest rates at zero percent for a ’sustained’ period (i.e. indefinitely)
Group Two: Use intellectual stalking horses to later raise interest rates sometime in the middle of next year
Unfortunately for the Fed, most people are de-leveraging themselves, while they still can, from high debt levels, plus cutting down their spending on everything else as the continuing spectre of rising unemployment levels eats into the American psyche [see Up In The Air, with George Clooney]. The Fed’s Inner Party response is to threaten the Proles with massive inflation, to get them to do what the Fed wants.
Rickards thinks it is arrogant for the Federal Reserve to treat American citizens like this, as laboratory mice in an experiment imposed upon them by self-declared geniuses. These are the same geniuses, he says, who missed the Dotcom bubble, who missed the housing bubble, and who have devalued the Dollar by over 95% since their federal reserve system was created in 1913.
They have messed up everything they have ever attempted in their entire existence, which includes the super-extended 1930s depression, so why should anyone think their new plan will work now? The Bullard plan, if implemented, will add lighter fuel to a charcoal barbecue. Nothing may happen for a while, but then one day it will all go boom and the US will switch from a low inflation environment to a hyperinflative one, almost overnight.
To summarise, the Rickards’ position is thus:
Deflation can be a good thing
The more quantitative easing is engaged in, the more likely a hyperinflative shock will occur at some unpredictable Black Swan moment in the future
To keep up with Jim Rickards, you can keep track of his Twitter page, here:
Mr Schiff opens up his latest economic video blog by discussing the recent interest rate hike by the Reserve Bank of New Zealand, to 3%, which followed a similar move, the day before, by the Reserve Bank of India, to 4.5%. He welcomes these upward moves and wonders when the same upward moves in interest rates will be carried out by the Federal Reserve in the United States.
“Don’t hold your breath,” he says, because the phoney US economy is on the artificial life support of zero percent interest rates; if the Fed pulls the plug, then the phoney economy will die. It needs to die, thinks Schiff, and needs to be replaced by a viable economy.
He then analyses the situation in terms of his fundamental view that a collapse in the value of the US Dollar is almost inevitable.
In terms of the housing market, Schiff thinks the Federal Reserve may be afraid of raising interest rates because many US banks are loaned out for 30-year terms at low interest rates (e.g. 4%) and if interest rates go up to perhaps where they should (e.g. 6%) then all of these banks will go bankrupt again and the Fed will come under massive political pressure to bail them all out for a second time with Ben Bernanke’s helicopter money.
Even if the Fed should send out a second wave of helicopters, a further problem emerges. When central bank interest rates eventually go higher, to something like 6%, although the current home owners may still be locked into 4% fixed-rate long-term loans, new potential home owners will be looking at 30-year loans at much higher rates (e.g. 8%-10%). Therefore demand for housing will collapse, along with house prices.
So not only will the banks need an immense second wave of helicopter bailouts to prop them up, their loans will then be held against collateral rapidly diminishing in value.
To this Gordian Knot, we can add the further Cat’s Cradle of the US government’s own need to keep interest rates low. Low rates enable it to keep rolling over its $13 trillion Dollars worth of debt, much of which is in one-year T-bills, with the total outstanding amount of explicit government debt expected to go over $18 trillion Dollars by 2014.
Hence, when the time comes to put interest rates up in Paul Volcker style to prevent the Dollar from collapsing, then the Federal Reserve will almost certainly lose its nerve and refuse to do the right thing. The Dollar will then collapse under the resultant runaway inflation.
Here’s the rub, thinks Schiff:
The sooner this crash is endured, the easier it will be to survive and the quicker the recovery will kick in once we have hit the true bottom. However, if the Federal Reserve is incapable of inducing this crash at the current time, due to political pressure, then the political pressure will be that much worse in a couple of years, when the repercussions of pricking the bubble will be even worse.
Hence, expect eventual runaway inflation and a collapse of the Dollar, as the Federal Reserve stands immobile, incapable of action.
The Fed has boxed itself in, says Schiff. Rates must go up but it cannot raise rates. The irresistible force has met the immovable object.
Expect fireworks when the force and the object clash, as one day they must.
In a somewhat startlingly-named new video blog, Mr Schiff begins by discussing inflation trends within the US, with reference to Ben Bernanke and the perceived Keynesian belief that a ‘little bit of inflation’ is actually good for an economy.
Schiff contends that once the genie of monetary inflation is left to skip out of the bag, then it always proves highly difficult to squeeze it back into the magic lamp. He thus predicts that Ben Bernanke will fail in his attempt to walk an extremely high tightrope of falling asset prices and rising consumer prices.
Mr Schiff then reflects upon the interesting news that after a hundred years of America topping the energy usage charts, that China has now become the world’s largest consumer of energy. Schiff explains why he believes that this will prove a major single step on the long Chinese road to also generate a larger GDP than the United States, within the medium-term future.
To finish off his monologue, Schiff argues with the widespread idea that an even larger war than the current Iraq/Afghanistan/Pakistan imbroglio will get the United States out of a recession, in the same way that the murderous believers of this crazy Keynesian idea think that WWII got America out of the Hoover-Roosevelt depression.
[Of course, Gerald Celente's Trends Research Institute thinks that WWIII is already underway. You may also want to check out a Mises.org article which talks about the myth of WWII 'saving' us from the depression and how this myth is based upon Bastiat's broken window fallacy, writ large.]
Schiff expounds on this idea in an article which we have reproduced from his Euro Pacific Capital web site:
There is overwhelming agreement among economists that the Second World War was responsible for decisively ending the Great Depression. When asked why the wars in Iraq and Afghanistan are failing to make the same impact today, they often claim that the current conflicts are simply too small to be economically significant.
There is, of course, much irony here. No one argues that World War II, with its genocide, tens of millions of combatant casualties, and wholesale destruction of cities and regions, was good for humanity. But the improved American economy of the late 1940s seems to illustrate the benefits of large-scale government stimulus. This conundrum may be causing some to wonder how we could capture the good without the bad.
If one believes that government spending can create economic growth, then the answer should be simple: let’s have a huge pretend war that rivals the Second World War in size. However, this time, let’s not kill anyone.
Most economists believe that massive federal government spending on tanks, uniforms, bullets, and battleships used in World War II, as well the jobs created to actually wage the War, finally put to an end the paralyzing “deflationary trap” that had existed since the Crash of 1929. Many further argue that war spending succeeded where the much smaller New Deal programs of the 1930s had fallen short.
The numbers were indeed staggering. From 1940 to 1944, federal spending shot up more than six times from just $9.5 billion to $72 billion. This increase led to a corresponding $75 billion expansion of US nominal GDP, from $101 billion in 1940 to $175 billion by 1944. In other words, the war effort caused US GDP to increase close to 75% in just four years!
The War also wiped out the country’s chronic unemployment problems. In 1940, eleven years after the Crash, unemployment was still at a stubbornly high 8.1%. By 1944, the figure had dropped to less than 1%. The fresh influx of government spending and deployment of working-age men overseas drew women into the workforce in unprecedented numbers, thereby greatly expanding economic output. In addition, government spending on wartime technology produced a great many breakthroughs that impacted consumer goods production for decades.
So, why not have the United States declare a fake war on Russia (a grudge match that is, after all, long overdue)? Both countries could immediately order full employment and revitalize their respective manufacturing sectors. Instead of live munitions, we could build all varieties of paint guns, water balloons, and stink bombs.
Once new armies have been drafted and properly outfitted with harmless weaponry, our two countries could stage exciting war games. Perhaps the US could mount an amphibious invasion of Kamchatka (just like in Risk!). As far as the destruction goes, let’s just bring in Pixar and James Cameron. With limitless funds from Washington, these Hollywood magicians could surely produce simulated mayhem more spectacular than Pearl Harbor or D-Day. The spectacle could be televised- with advertising revenue going straight to the government.
The competition could be extended so that the winner of the pseudo-conflict could challenge another country to an all-out fake war. I’m sure France or Italy wouldn’t mind putting a few notches in the ‘win’ column. The stimulus could be never-ending.
If the US can’t find any willing international partners, we could always re-create the Civil War. Missed the Monitor vs. the Merrimack the first time? No worries, we’ll do it again!
But to repeat the impact of World War II today would require a truly massive effort. Replicating the six-fold increase in the federal budget that was seen in the early 1940s would result in a nearly $20 trillion budget today. That equates to $67,000 for every man, woman, and child in the country. Surely, the tremendous GDP growth created by such spending would make short work of the so-called Great Recession.
The big question is how to pay for it. To a degree that will surprise many, the US funded its World War II effort largely by raising taxes and tapping into Americans’ personal savings. Both of those avenues are nowhere near as promising today as they were in 1941.
Current tax burdens are now much higher than they were before the War, so raising taxes today would be much more difficult. The “Victory Tax” of 1942 sharply raised income tax rates and allowed, for the first time in our nation’s history, taxes to be withheld directly from paychecks. The hikes were originally intended to be temporary but have, of course, far outlasted their purpose. It would be unlikely that Americans would accept higher taxes today to fund a real war, let alone a pretend one.
That leaves savings, which was the War’s primary source of funding. During the War, Americans purchased approximately $186 billion worth of war bonds, accounting for nearly three quarters of total federal spending from 1941-1945. Today, we don’t have the savings to pay for our current spending, let alone any significant expansions. Even if we could convince the Chinese to loan us a large chunk of the $20 trillion (on top of the $1 trillion we already owe them), how could we ever pay them back?
If all of this seems absurd, that’s because it is. War is a great way to destroy things, but it’s a terrible way to grow an economy.
What is often overlooked is that war creates hardship, and not just for those who endure the violence. Yes, US production increased during the Second World War, but very little of that was of use to anyone but soldiers. Consumers can’t use a bomber to take a family vacation.
The goal of an economy is to raise living standards. During the War, as productive output was diverted to the front, consumer goods were rationed back home and living standards fell. While it’s easy to see the numerical results of wartime spending, it is much harder to see the civilian cutbacks that enabled it.
The truth is that we cannot spend our way out of our current crisis, no matter how great a spectacle we create. Even if we spent on infrastructure rather than war, we would still have no means to fund it, and there would still be no guarantee that the economy would grow as a result.
What we need is more savings, more free enterprise, more production, and a return of American competitiveness in the global economy. Yes, we need Rosie the Riveter – but this time she has to work in the private sector making things that don’t explode. To do this, we need less government spending, not more.
In their working paper Assessing UK money supply measures in the light of the credit crunch, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.
This article was originally published in October 2009.
Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?
When the Bank is concerned about the risks of very low inflation, it cuts Bank Rate – that is, it reduces the price of central bank money. But interest rates cannot fall below zero.
So if they are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money – in other words, inject money directly into the economy. That process is sometimes known as ‘quantitative easing’.
But when I consider quantitative easing, I am concerned with the following problems:
It is not clear that the Bank of England has a useful definition of the money supply. The present measures do not correspond to economic activity — which is what the Bank is trying to increase with new money — and this crisis was famously not foreseen.
As commentators have reported, “the Bank’s Governor, Mervyn King, seemed pretty confident that QE could work. But even he would admit he has no idea how long it will take – or how much money he will have to print to get there.” This uncertainty seems less than ideal given the risk of price inflation.
According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity1.
As my colleagues point out in their working paper, the fact that the monetary authorities have turned to increasing the quantity of money will focus attention on how that quantity is measured. This article provides some background information and indicates Baxendale and Evans’ key findings.
“The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.” Hayek, 1974 Nobel Prize Lecture [↩]
To set Toby’s “Emperor’s New Clothes” proposal in context, we are bringing forward a number of classic articles.
This article was originally published on 20 January 2010. It is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
Federal Reserve Chairman Ben S. Bernanke has given testimony before the Committee on Financial Services of the U.S. House of Representatives.
If you thought things were moving our way, look at the remarks at the end of note nine.
The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
This has been copied from Money, Bank Credit, and Economic Cycles which can be downloaded here or bought here.
PREFACE TO THE SECOND ENGLISH EDITION
I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury.
The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 percent per year (which means that every seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly created loans granted at very low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets and the securities which represent them, and are exchanged on the stock market, where indexes soared.
Curiously, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted the real productivity of consumer goods and services even further. The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. I analyze this phenomenon in detail in chapter 6, section 9.
As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their liabilities exceeded that of their assets (mortgage loans granted).
At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their monetary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990–1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monetarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent.
In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence. The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of the corresponding rates in France and Germany. Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy.
Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future which, for the good of all, I hope is not long in coming.
We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets. In this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.
In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting.
It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, must be reversed. This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.” Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption [1], by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929.
In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles:
the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents;
the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and
the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard.
This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen.
I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system.
The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world [2] may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction.
[1] See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2 (August 1934), reprinted in Profits, Interest and Investment and Other Essays on the Theory of Industrial Fluctuations(Clifton, N.J.: Augustus M. Kelley, 1979; first edition London: George Routledge & Sons, 1939). See especially section 9, “Capital Accounting and Monetary Policy,” pp. 130–32.
[2] Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation, which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly (Moscow: Sotsium Publishing House, 2008). Three thousand copies have been printed initially, and I had the satisfaction of presenting the book Octo- ber 30, 2008 at the Higher School of Economics at Moscow State University. In addition, Professor Rosine Létinier has produced the French translation, which is now pending publication. Grzegorz Luczkiewicz has completed the Polish translation, and translation into the following languages is at an advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan- ese, and Arabic. God willing, may they soon be published.
In their working paper