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By Alasdair Macleod, on 29 January 12
Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement.
The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.
The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.
To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.
I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.
Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.
This article was previously published at GoldMoney.com.
By Billy Walsh, on 27 December 11
 I am an artist and serial entrepreneur, and I, like many, have been pillaged and plundered by the United States government. Heckle Sketch is my latest means of satirically venting frustration while communicating important messages about freedom and free market capitalism that are lost to the majority. The majority includes a government which was founded on such principles.
I have been involved in creating successful, innovative businesses for the past 16 years. I have lofty, but also realistic, visions for the advancement of mankind through biotechnology, space colonization, energy efficiency, etc. I have believed I can make a contribution toward these advancements through free market business creation and relevant investment. I am now realizing that I have been duped.
My latest venture, Tangerine Wellness, is a free market solution to rising health care costs, which the U.S. government cannot successfully address. The solution offers financial incentives to employees of large corporations for weight-loss and maintenance – lose weight, earn money is the motto. It is a solution that makes people healthier and has decreased healthcare costs for our clients.
Tangerine is solving the healthcare cost problem, yet we are being hindered from continuing to do so. In addition to the mountains of bureaucracy added to prospective clients’ operations because of massive healthcare reform, the changes have instilled uncertainty about their approach to employee wellness and about offering healthcare coverage at all. Prospective clients are not making market-driven decisions about the health of their employees, nor their healthcare coverage. They are basing their decisions on government coercion, which will result in continued rising healthcare costs.
When you spend over seven years putting your energy, heart and soul into a profitable endeavour that actually solves a major problem only to have the concept dismissed on government whim, you begin to question whether continuing to innovate is worth it. It is one thing to deal with natural free market forces; it is another to deal with free market forces as a secondary factor to unpredictable government intervention. Tangerine continues to be profitable and is wisely shifting toward a consumer-direct approach, but that is no cause for excitement when around the corner could be any new bulldozing regulation.
My nutshell story of Tangerine cuts to the point I am trying to make while leaving out many other similar painful, government-related experiences both in this and past endeavours. Driven by a need to understand the nature of the beast that threatens my survival, I have dug deeply into the landscape of economic theories and schools of thought. I see clearly why government is harming my businesses and others, why it is the core cause of our massive economic crisis, why it is stifling innovation and the advancement of mankind, and why it is so hopeless to expect the system to repair itself.
So, what does one do when one’s dreams are shattered by government injustice and there is no hope to fix the root causes through the current system? Well, if you’re also an artist with a sense of humour, you make fun of the injustice through art while trying to make it a form of education toward a brighter future. “Ben and the Fat Cat Banksters” is my first painting to do this by humorously exposing the harm the Fed produces through fiat money printing and bailouts. Do not be fooled – so long as I can put a brush to a canvas, or commission others to do so, every perpetrator of freedom and free market capitalism that exists will be…HECKLE SKETCHED!
By Sean Corrigan, on 22 October 11
Despite the general relief which greeted the release of China’s GDP data for the third quarter, as well as the still resilient industrial production data, we could not quite bring ourselves to join in the cheers.
As we all know, the mainstream is all too ready to treat such numbers as an end in themselves, without paying sufficient attention to the informational content involved in lumping together the sprawling, multifarious, activities of millions of people and boiling it down to one, single number — and that according to a methodology which subjectively combines the raw data in order to fit a pre-conceived concept of how an economy actually functions.
Hayek himself took pains to warn of the limitations of this approach in 1963, when he was discussing the great Methodenstreit of thirty years before:-
…it seems as if this whole effort… to ‘scientificize’ economics… were due to a mistaken effort to make the statistically observable magnitude the main object of theoretical explanation.
But the fact that we can statistically ascertain certain magnitudes does not make them causally significant, and there seems to me no justification whatever in the widely held conviction that there must be discoverable regularities in the relation between those magnitudes on which we have statistical information.
Economists seem to have come to believe that since statistics represent the only quantitative data which they can obtain, it is these statistical data which are the real facts with which they deal and that their theories must be given such a form that they explain what is statistically ascertainable.
There are of course a few fields, such as the problems of the relation between the quantity of money and the price level, where we can obtain useful approximations to such simple relations – though I am still not quite persuaded that the price level is a very useful concept. But when it comes to the mechanism of change, the chain of cause and effect which we have to trace in order to be able to understand the general character of the changes to be expected, I do not see that the objectively measurable aggregates are of much help…
Not only is GDP itself, far too overaggregated – and far too Keynesian—in its construction, but in China’s case the problem is not only compounded by the suspicion that the numbers are made to tell the story the Party wishes to tell, but also by the fact that where they are not actually incomplete, they are highly inconsistent.
So, for example, we are told that the year-on-year rate of real GDP slowed slightly to 9.1% from the previous quarter’s 9.5%, yet the nominal figures—so far as we can recast them - seem to have accelerated from 17.9% to 20.6%. Indeed, this last figure would not be inconsistent with the simultaneously reported 23.6% rise in SOE business revenues over the first nine months (of which more in a moment)
If true, this would not only have represented the fastest gain since before the GFC itself intruded, but it would imply a price inflationary component which had accelerated to 10.5% – also the highest in nearly four years and significantly above, and moving in opposition to, the supposedly slowing, 6.1% pace of CPI increase!
In looking for further clues, one finds that, over the spring and summer, nationwide rail freight slowed from its usual 9.5-10% annual rate to a relatively languid level of 6.5%. Electricity usage, too—though more subject to the vagaries of the weather—has been rising at less than 11.5% over the past two quarters, rather than at the more typical 14.0-14.5% registered during recent periods of full-blooded expansion.
But more telling still—and yet another good illustration why the burn-the-furniture-to keep-warm inadequacy of GDP accounting is such a poor gauge of economic well-being—those same SOEs whose revenues we mentioned above have seen an unbroken run of consecutive monthly declines in profit, so far in the second half.
Given that these mighty bastions of the one-party state represent the favoured few, upon whom the available credit is showered, upon whom the best tax breaks and greatest subsidies—as well as the most advantageous resource pricing—is lavished, that is surely a telling statistic, as is the fact that their reported return on equity—of 5.8% – lay below even the official rate of price rises.
So, even as these behemoths have squeezed out their SME competitors—up to four-fifths of whom are reputedly losing money—they have been unable to parlay growing revenues into growing profits, much less yield a positive real return on capital.
On top of this, there have been any number of warnings from among the Party high-ups about the dire state of the export market — sufficient alarm, indeed, having been generated that Premier Wen pledged an ‘essentially stable renminbi’ from now on: in effect, therefore, signalling the end of an appreciation which has led to all sorts of extended currency gambles in places as diverse as Hong Kong’s Dim-sum bond market and the copper warehousing, L/C-manipulating tricks of the shadow importers.
Finally, it should be noted that not only has the stock market closed at its lowest level since the global asset markets began to recover in March 2009, but an accelerated liquidation of industrial commodities is well underway, with materials as diverse as steel, copper, zinc, rubber, cotton, polyethylene, and terephthalic acid all losing 30-40% from their highs, and all setting new multi-month—even multi-quarter—lows in the process.
Far from being ‘ruled out’ by the numbers — as the most credulous of mainstream macromancers have been claiming — China’s hard landing may actually be unfolding as we write, hidden from wider apprehension by the gaudy veil of that one, damnable, statistical fiction which is the stage prop of charlatans and the false comfort of the biddable alike.
China is a prime exemplar of everything we Austrians deprecate, whether in terms of its heavy-handed pretence of knowledge; the fatal conceits of its central planners; its multitudinous suppressions and perversions of the pricing system; or the endemic corruption and influence-peddling which, absent an economically impartial means of allocating means, is the only way to ration scarce resources between competing ends there.
As such, we cannot assume other than it will one day to be revealed to be a heroic disaster; that its attempt to maintain the privileged superstructure of the Party while seeking out a more effective way of marshalling the matériel needed to sustain its all-pervading apparatus will prove to have been the cause of a vast waste of human effort and earthly treasure, even if it has been infinitely preferable to the Maoist horrors which preceded this, the latest grand experiment in socialist Utopianism.
The only professional problem we have with this analysis is the rather crucial one that to be convinced of such an outcome from a grand historical perspective is of precious little use in knowing what or when to buy or sell in the hurly-burly of the fibre-optically fast marketplace in which we operate.
There will undoubtedly prove to be just as much ruin in the Middle Kingdom as there was in Adam Smith’s Britain of the 18th century. Economic law cannot be repealed, but its verdict can often be long suspended, if usually at the cost of a harsher sentence when ingenuity finally fails those seeking to deny its implacable judgement. If the extended nonsense of our own, last four years of swimming against the tide of inevitability proves anything, it surely proves this.
Thus, while we are convinced that the hard landing in China will be more of an asteroid impact than a mere bender of the undercarriage when it eventually arrives, we cannot honestly say that this will be the inescapable result of the nation’s present constellation of difficulties.
In seeking to avoid such a shattering return to earth, the authorities there may yet hit upon new ruses to hide the losses, to defer the final reckoning, and so to sway production patterns and alter input pricing in any manner of unforeseeable ways before they tangle their ankles in a Gordian knot of their own ravelling and measure their mighty length in the dust of human vanity.
Here and now, however, all we are prepared to say is that this COULD be the Big One, but it might also be a lesser, pre-cataclysmic tremblor—much more severe than many of those constructing investment portfolios out of the straw of China’s invincibility can hope to withstand—but, nevertheless, only an ominous reminder of a mighty upheaval yet to come.
What goes for China, goes for its neighbours around the Pacific, of course, so we should not be surprised to see regional air freight falling into the negative column, or US West Coast container imports dropping markedly short of 2010 levels, nor at Taiwan export orders moving decisively below their pre– and post-Crash levels.
In Europe, all of this is playing second fiddle to the ongoing farce of the EFSF negotiations while, in the US, the fiscal arithmetic remains parlous and the arena for a round of vituperative, but ultimately sterile, infighting.
If the burdens of the first region remain yet unalleviated, at least the impasse shows that there are still those who recognise — albeit dimly — that to earmark trillions of euros of the citizens’ money so as to reward both gross irresponsibility on the part of the member states and the cynical exploitation of moral hazard by the barons of the banking boardrooms is as ethically dubious as it is economically suspect. While all the bien pensants may flood the airwaves and stuff their column inches by decrying this as the fault of the characteristically stiff-necked Germans, we can only sigh that a few more of our glorious leaders do not also disport a suitably Teutonic fusion of the cervical vertebrae.
Meanwhile, the situation in America goes from bad to worse. Indeed, the US deficit now seems almost pre-ordained to grow at $1.3 trillion or so each and every year—around 2 1/2 times the concurrent increase in private sector GDP (that number again!) and unfunded to the tune of a dangerous, potentially intractable and thus highly inflationary 35-40% of expenditures.
Whether or not the Fed is successful in its misguided quest to de-emphasise the so-called price stability part of its mandate in favour of the wild goose chase of trying to reduce unemployment on a permanent basis by monetary means, the lack of continence it has encouraged among an intellectually-vacant political elite—as well as the dire budgetary consequences of any reversal in bond yields from their post-War nominal lows on a full GDP-scale debt mountain—argue against any easy reversal of their joint stance.
It might not go unnoticed that the simplistic, but nonetheless illustrative, measure of the ‘misery index’ — unemployment plus consumer price inflation — currently stands at a 19-year high (even under what many darkly mutter are today much less exacting standards than heretofore prevailed) and is, moreover, pushing resolutely onward into territory only visited in the post-WII era during the dreadful spell between 1973-83 when it seemed as if we had finally driven a stake through the heart of the bloodsucker of Bloomsbury.
This is not just a matter of passing interest, since rising prices amid chronic joblessness is a mix which often widens the split between input costs and output prices—a phenomenon which also tends to go hand in hand with higher levels of CPI itself. Such a combination is usually disastrous for equity multiples, which are themselves the main determinants of stock returns, so — even by his own rather dimmed lights — Chairman Bernanke is again on track to achieve exactly the opposite effect of the one at which he is aiming.
Anyone requiring a further explanation of how this arose should go and read Ron Paul’s cogent rehearsal of the ills that afflict the nation in his recent WSJ editorial, a well-justified Philippic in which he also adopts a view about just what it is that is forestalling the recovery which will be familiar to readers of these pages:-
What exactly the Fed will do is anyone’s guess, and it is no surprise that markets continue to founder as anticipation mounts. If the Fed would stop intervening and distorting the market, and would allow the functioning of a truly free market that deals with profit and loss, our economy could recover. The continued existence of an organization that can create trillions of dollars out of thin air to purchase financial assets and prop up a fundamentally insolvent banking system is a black mark on an economy that professes to be free.
Hear! Hear!
Commodity Corner
Around about this time last year, the market began to shake off its angst and buy anything and everything in sight in an increasingly indiscriminate move which would see commodities, stocks, junk—and just about anything else with the word ‘Risk’ attached—rise for the better part of seven months.
But last year’s rally, however ephemeral its impact either as a prop to asset prices or as a fillip to the real economy, was at least based on something tangible. The Fed was actively monetizing a sizeable fraction of the US budget deficit through its QE-II programme; Chinese real money supply growth—while undoubtedly slowing—was still swirling along in the high teens, in contrast to today’s sluggishly low single digits; the RBI was only a third of the way through its (unfinished?) tightening phase; likewise, the Banco do Brasil had seemingly paused, half way through its eventual schedule of higher rates; and the European debt crisis was still only a cloud on the horizon — and a cloud which lowered only over the periphery, at that.
In other words, however futile the attempt to print the world back to prosperity, something tangible was afoot and the newly-created monies were flooding into their most immediately accessible outlets in financial markets, en route to effecting their more malign consequence of raising the price of necessaries for the common man.
This time around, the rally was built more on hope and fear than on anything more concrete: hope that the Fed’s Operation Twist would actually mean something other than just the latest act of vandalism committed upon the price mechanism; hope that Europe would issue itself a large blank cheque and have it delivered in wheel barrows to finance ministries and banking headquarters all across the Zone; and the fear of being caught short of benchmark and mired in the slough of negative returns if the year somehow ended in a sustainable relief rally.
Two weeks of that may have been enough to goose the DAX by almost 20% and the S&P and Emerging Markets by close to 15%; it may have jolted base metals 10% and Brent Crude 17% higher; it may have reversed 140bps of the prior steep rise in junk credit spreads, but it does not look like it changed either the fundamental backdrop or the fact that new sources of central bank jungle juice are so far proving very hard to identify.
So, with a nod to the fact that everyone underwater is currently desperate to locate some last remaining, no-brain trade onto which to bandwagon, in order to dress up another year of lacklustre performance and to avoid one more career-endangering embarrassment of charging fees as a reward for losing clients’ money, we must start from the assumption that the rally has run its course, having achieved what all bear market rallies do — to magnify the pain while recharging the powder magazine — and that there is a risk that the current probe lower is met with a further, irresistible wave of panicky liquidation.
By Toby Baxendale, on 14 October 11
American Principles Project:
Washington, D.C.–Republican presidential candidate and former House Speaker Newt Gingrich called for “hard money with a very limited Federal Reserve” at the Republican presidential debate in New Hampshire on Tuesday. Gingrich is the third candidate to take this position. Herman Cain endorsed the gold standard at the American Principles Project Palmetto Freedom Forum in South Carolina last month and Ron Paul, who has been steadily advocating it for much of his career, raised it at last night’s debate.
If one of them disposes of Obama, this will be at the heart of any Republican agenda.
When will our senior politicians start to entertain a move to honest money?
By Sean Corrigan, on 10 October 11
Since the Great Financial Crisis started (in truth, since well before), we have unwaveringly maintained three main tenets in relation to how one should deal with the aftermath of a credit-driven, mass misallocation of resources.
Firstly, we have said that, even if we did accept, arguendo, the trite macroeconomic mumbo-jumbo of over-aggregation, that tired old, maintenance-of-spending-at-any-cost, Keynesian game of trying to compensate for the overstretch of one particular ‘sector’ of the economy by passing ‘the bad, or depreciating, half crown to the other fellow’ is most likely to tangle us in an inextricable knot of surindebtedness if the ‘fellow’ is a governmental body. We say this, since the specious initial advantage of the state’s temporary ability to ignore the imperatives of accounting logic is doomed to be overwhelmed by the legal intractability associated with that same entity’s eventual financial exhaustion. Furthermore, this mere procedural failing is always horribly compounded by the dilution of the sense of direct responsibility which accompanies its involvement in any plight in which the relevant country lands itself.
Secondly, we have stood foursquare behind the idea that all the losses are actually incurred during the heady euphoria of the Boom, that the Bust is nothing more than the overdue recognition of those mistakes, and that to procrastinate thereafter in their acknowledgement is not to avoid the pain, but to exacerbate it in much the same way as a sufferer from a cancer can do himself nothing but harm by trying to delay the awfulness of the therapy which sadly must await him.
Thirdly, it has been our avowed belief that, contrary to the accepted wisdom, there are very few useful macro solutions to such a condition, but only micro ones; that recovery is built one job, one company at a time, from the bottom up.
Therefore, the most beneficial role for Leviathan is not some crazed, Frankenstein process of pulling levers and administering potions in some swivel-eyed, Gene Wilder fashion, but is one of expediting the renegotiation of now-unfulfillable contracts; of impartially overseeing a just transfer of assets from the failed to the well-founded; and of ensuring as few scarce resources as possible—in this time of unexpected penury—are pre-empted by the dead hand of the bureaucracy and, hence, are made available to the putative builders of a new, more prosperous tomorrow.
In all of this, we have been generally cynical of the ability of politicians to deny themselves the chance to carve their effigy on an imaginary Mt Rushmore of interventionists. We have been even more deprecatory of the nomenklatura of would-be Plato’s who advise them, those ’socialists of the chair’ who blindly fill their pink column inches with the ludicrous argument that the only remedy for the failure of government interference is more interference. We have been vehemently opposed to the machinations of central bankers—the ultimate succourers, when not the original seeders, of the Boom—who continue to frame every response in terms of the provision of liquidity to their precious cartel of institutionally parasitic, fractional reserve banks.
Despite this, it has been hard to suppress the faint fluttering of a hope lately freed from its hard chrysalis of doubt by the integrity of some members of the northern European political class and their nominees within the Heart of Darkness of the central bank itself.
Germany—with both tacit and expressed support from among the Dutch, the Finns, the Slovaks, and others—has wrestled itself close enough to doing the right thing—to writing off much of the debt; to making the imprudent private owners and creditors face their responsibilities; and to insisting on guarantees of future good housekeeping from the incontinent debtors—to merit our applause, even if its courage eventually does fail it, or the temptation to take the road to hell along which everyone else is frantically pointing finally does prove too hard to resist.
However, any sense of the victory we entertain in this critical war of ideas—albeit four years late and several trillion dollars short—has to be tempered greatly by the awful truth that two of the major central banks have already succumbed, once more, to their liquidity fetish, while a third is patently ravening for the chance to overcome the present domestic impediments to further action.
One of them, the ECB, is slowly transforming itself into a Fed—over the careers of ex-Bundesbankers perhaps, but nonetheless inexorably so.
Believe, if you will, that all such measures as those announced this week are ‘temporary’—only to be countenanced for the duration of the emergency—and, as our New York friends say, I have a bridge to sell you in Brooklyn.
Yes, it is true that interbank lending has frozen, that the vast apparatus of sovereign finance is creaking alarmingly, and that real money supply growth in the Zone is hovering just above the zero bound. Of these, however, only the third is a potentially justifiable field for central bank intervention in extremis.
The first is a consequence of the long-suppressed mistrust of one another’s balance sheets being expressed by the banks themselves; a fear which could be dispelled overnight if they would each do no more than is required of any public corporation, namely, to produce an honest set of accounts, even if this would be to undertake an exercise in triage—of the merciless sorting of the weak from the strong. To recognise its origin is already to point to where the cure may be found—extended repo operations and expanded bond purchases do not lie along that way.
The second handicap is the legacy of long years of populist vote-buying whereby venal politicians have far too liberally dispensed a morally corrupting patronage, not by having to undertake the invidious task of clearly identifying the winning net recipients of tax monies from the losing net payers standing beside them at the hustings, but by recourse to the seemingly painless expedient of borrowing funds which are never intended to be repaid and which are, in great part, the result of inflationary credit creation on the part of the same central and commercial banks who are now so threatened by the fall of all these democratic Bourbons. Again, to make this diagnosis is to indicate what form the remedy must take and to show that the prostitution of the central bank, so as to maintain the status quo ante, will prove futile, if not fatal, to the patient
As for the Bank of England—well, yes again, real money supply has been running at a negative rate in the UK for some good few months past, dragging activity lower as it has. Yet a very good part of this real contraction is because the Bank has also managed to ignite a nasty rise in prices in violation of its rather open-ended mandate to moderate these over a self-determined and highly elastic ‘medium-term’.
As we have said before, the fact that the UK still manages to run a near-record trade deficit amid a severe recession and during an ostensible private sector credit crunch, despite a 25% drop in sterling’s real effective exchange rate such as to take it to a level only matched during the IMF crisis of the mid-70s Labour administration, is testimony both to the fact that the overall squeeze is not so intense as it seems and to the failure of all this macro-meddling to restore a semblance of competitiveness to a hollowed-out nation.
Where the leakage occurs, of course, is in the realm of the state where, for all the gnashing of teeth and tearing of hair about the ‘austerity’ programme, spending continues to rise, with the change in the state component of expenditures in Q2 outstripping that of households for the fifth quarter out of the last six. Total state outlays are still making new record highs, both outright and as a proportion of non-state GDP—that latter ratio now bumping up against the 60% mark, no less.
So it is all very well for Mervyn King to bleat about facing the most severe financial crisis since the 1930s, or to casually dismiss the cries of the thrifty that their livelihoods are being crushed in the vice of rising prices and falling returns to capital, but it is he and his predecessors, together with the political masters they serve, who have led us into these straits, by dint of their unshrinking embrace of a perverted orthodoxy of inflationary entitlement—of the entitlement of welfare recipients to their doles, of office-seekers to their votes, and of inveterate financial gamblers to their place at the tables of the state-sponsored, state-regulated, and state-underwritten casino.
Mr. King’s response to all this? Why, again to make it easy for the state to spend more and difficult for many of the most vulnerable elements of the nation to spend as much. Bravo, indeed!
So, while Chairman Bernanke can, for now, only threaten to increase the disruption he causes to the market’s pricing signals and to its ability to allocate resources optimally over time, his peers are already at work doing much the same mischief.
Caught up with the demands of their real dual mandate—that of keeping the ruling class happy while looking after the interests of their cabal of big bankers—few of them will stop to listen to what businessmen are telling them, though the message is being broadcast in the most clarion of tones.
Take the most recent Duke University/CFO Magazine quarterly survey of senior US executives as a case in point.
Asked to list external concerns in order of importance, the perennial question of sufficient demand for the firm’s products came top, but a clear second place was secured by the category ‘Federal Government agenda/policies’ – aka, REGIME UNCERTAINTY!
As for internal worries, the ability to maintain margins was top, the cost of health care, second, and the ability to forecast, third—over to you, Mssrs Bernanke and Obama, once more, for creating and fostering such extreme REGIME and MARKET UNCERTAINTY!
And the result of all this? Exactly what we showed in graphical form and briefly discussed in our last edition:-
A third of CFOs say they will not deploy excess cash this year, because they want to retain it should credit markets tighten. Twenty-nine percent say they are hoarding cash due to economic uncertainty, and 31% say they don’t have any excess cash to spend.
More worrying still for all those executives and traders who keep telling us that while business in the Old World may be slow, Asia will keep firing away and so save their bacon, the separate respondents from that particular region also manifested an uncharacteristically subdued tenor. We quote as follows:-
Optimism about the regional economy in Asia (not counting China) fell, with optimists and pessimists now evenly balanced. Last quarter, optimists outnumbered pessimists by two to one. In China, 69 percent of firms have grown more pessimistic about the economic outlook.
The top internal concern among Asian CFOs is difficulty in planning due to extreme uncertainty, working capital management and employee morale. The top external concerns in Asia are global financial instability, intense pricing pressure and weak consumer demand. Chinese CFOs also worry about government policies.
QED
But, carry on regardless! The present approach has been so successful that while one in ten Americans with a full-time job lost it in the slump, barely one in six of those unfortunates has found similar work since, leaving the total at 2000 levels and its fraction of the population at 1975 and 1983 recessionary depths, despite the intervening incorporation of women into the workforce. As for manufacturing—supposedly doing well on the cheapest dollar of the modern era—almost one quarter of the hours worked here were lost from the local maximum of 2006, of which, again, less than a sixth have since been replaced, leaving total hours fully a third below the stationary average of 1984-2001, and still stuck where they were in St. Roosevelt’s bleak 1940s!
Meanwhile, the 3mma of US NAPM new orders has dipped below the 50 watershed for the first time since the crisis, an event which has historically signalled a further deterioration over the succeeding six months in 70% of cases, and an ill omen we must interpret in light of the fact that the magnitude of the last few months’ fall in this component has only been exceeded three times in the past century—in 1974/5, 1980, and in 2009 itself.
Even in Germany, 2009-10’s impressive growth in factory orders has begun to peter out to the point that there has been little further sustained growth so far this year. Meanwhile, at the other end of the world, a PMI of Korean orders languishes at a 2-year low, while exports of capital goods from Taiwan have not been this weak since early 2010.
It may be too much to say that the wheels are coming off the recovery, but they are certainly beginning to wobble.
By Mark Goodhand, on 2 September 11
In his latest article for ConservativeHome, Steve Baker considers the viability of America’s central bank:
A review of the US Federal Reserve’s own document: “FEDERAL RESERVE statistical release, H.4.1: Factors Affecting Reserve Balances of Depository Institutions and
Condition Statement of Federal Reserve Banks”, issued on August 23rd 2011, reveals some interesting information about the state of the Federal Reserve, the US central bank: it’s very nearly bust. As it is indirectly the lynchpin of the global financial system, that matters to the UK.
The size of the Fed’s balance sheet is now about $2,843 billion, up from about $800 billion three years ago. The huge increase in the Fed’s balance sheet stems from bailouts, quantitative easing, and other central bank “liquidity” operations.
…
The Fed’s capital base is $71 billion. That represents about 2.5% of its assets, or a leverage ratio of 40 times its capital. This ratio would have been considered unthinkable prior to the crisis: it is about four times greater than that permitted by the new Basel proposed rules for commercial banks and simply demonstrates that the bailout format and quantitative easing do not make these problems go away. If the patient has been incorrectly diagnosed, taking the wrong medicine will not cure him.
This capital to asset ratio means that a loss on its assets of 2.5% would be enough to make the Fed, by any normal standard, insolvent – unable to pay its debts.
Read the entire article to find out just how likely this is.
By Toby Baxendale, on 1 September 11
Phase 1: Greenspan, the arch money crank
The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history.
This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange.
Now to a money crank. He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy.
One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere. Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are.
Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy). For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy. At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on. Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich!
Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers. Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process.
After the dot-com bubble, it was property prices that went up and up. Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing.
Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.
Phase 2: Bush & Brown – private debt nationalised by the Sovereign
This flood of new money brought more marginal lending possibilities onto the horizon of the bankers.
They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs!
In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other. As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry.
Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries!
Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon!
Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy.
Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they.
But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window.
But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.
Phase 3: King Canute, sovereign default
Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms.
S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in.
Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.
Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt.
However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?
“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.
So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature.
King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people.
Let better business people buy the good assets of the bust banks, and let them provide essential banking services.
Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss.
Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever.
I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s?
A process of wipe out for all will be a hell of a lot harder than sensible action now. It is still not too late.
By John Phelan, on 26 July 11
With his history in the transfer market there is no guarantee that Carlos Tevez won’t still end up at Brazilian side Corinthians. But even if he doesn’t, some are saying that the bid itself represents a shift in power away from the European clubs, which have traditionally benefited from the players produced in Brazil, and towards Brazilian clubs themselves.
Brazil’s new found wealth is being flaunted elsewhere. Last month Bloomberg reported on a growing number of Brazilians buying property in Florida. According to the report:
“As many as half of the downtown Miami condos that have been sold to foreigners for more than $500,000 since January were purchased by Brazilians, said Craig Studnicky, president of International Sales Group LLC, an Aventura, Florida, property-marketing firm. Buyers from Brazil also accounted for about half of sales of more than $1 million in Miami Beach”.
The reason for this, according to Bloomberg, is “The Brazilian real’s 45 percent increase against the dollar from the end of 2008”
This has come about despite an increasingly difficult situation for the Brazilian central bank. Without reinstating the hard peg to the dollar which shattered amid devaluation in 1999, the Banco Central has tried to maintain an exchange rate with the dollar of about 2:1. However, to maintain this the inflationary policy of the Federal Reserve’s quantitative easing programs has had to be mirrored in Brazil. But, without the reserve currency status of the dollar to tempt a China or United Arab Emirates to stack up Brazilian currency claims, the Brazilians, like any country following the dollar, have had headline inflation.
As a result Brazil has been a noisy participant in the ‘currency wars’ triggered by US devaluation. Brazil’s finance minister Guido Mantega recently said that “struggles between countries” were “absolutely not over”.
But Brazil hasn’t just relied on words. In the face of rising inflation imported from the US via the soft currency peg, the Banco Central has moved aggressively to raise interest rates. This has pushed the real to a near 12 year high and made it possible for Brazilians to go shopping for assets abroad.
But what does this mean for the rest of us? In defending quantitative easing Ben Bernanke says “the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability”. In fact, for all the Fed’s money printing, unemployment remains stubbornly stuck at 9.2% and even the Fed’s diddled measure of ‘core’ inflation which doesn’t include food and energy prices (which have been skyrocketing) is beginning to tick up.
The inflationist policies of the Federal Reserve aren’t doing much for the US economy and they aren’t helping the average American. But Brazilians are benefitting from this shift in wealth and with the Fed preparing the ground for another round of quantitative easing Brazilians will be in the market for more assets, be they condos or centre forwards. When Miami hosts its first carnival for wealthy Brazilian expats Ben Bernanke should be the guest of honour.
By Detlev Schlichter, on 22 July 11
The world financial system is skating on thin ice, and that ice can crack at any moment.
The instabilities of the global paper money economy are evident everywhere. In Europe, the debt crisis is picking off one euro-member after another like the protagonists of a teenage horror movie, leaving us in no doubt what the final destination for the core is going to be. Yet – bizarrely and inexplicably – German Bundesanleihen still play the role of safe haven. In the U.S. of A., years of near-zero interest rates and two rounds of unprecedented “quantitative easing” have engineered a suspicious-looking rebound in equity markets and other financial assets, yet the victory of the interventionists over market forces looks hollow. Three years into the recovery, the economy is still sick. Manipulating financial markets seems one thing, generating prosperity quite another – only on Wall Street are the two the same. But according to the central bank’s chairman, if a policy fails it means you simply have to do more of it.
Only the intellectual and institutional inertia of the bloated financial industry, overfed on a rich forty-year diet of cheap money and ever-rising asset prices, is – for now at least – preventing a widespread rush for the exit. The industry is sitting on such a massive pile of inflated paper assets that there seem to be few alternatives to further feeding gluttonous governments and their clueless politicians. Additionally, things have gone from pretty bad to mind-blowingly worse too fast for most portfolio managers to comprehend – leading many to cling to the straws of time-worn investment routines and established asset allocation patterns. Did they not all learn back in money-manger school that government bonds were “safe assets”?
Smart ‘private money’ – nimbler, less consensus-oriented and, importantly, eager to sustain real spending power for the long run rather than beat some nominal index over the short run– is already running for the exit. Just look at the gold price and the prices of certain other real assets.
The tunnel vision of macroeconomics
My prediction is that things will get much worse very rapidly, and one of the reasons why I think this is inevitable is the inability of large sections of the political and financial establishment to even grasp what is going on. Of course, the reason for this is not any lack of intelligence. These are smart people. The reason is the oppressive dominance of an economic belief system that only provides a very narrow perspective on the full effects of an expanding supply of money.
And you want to know what really scares me? That the money-printer-in-chief, the man in charge of the printing press for the world’s dominant paper currency, the chairman of the U.S. Fed, not only shares this limited view of the effects of easy money, he is so completely beholden to the mainstream macro consensus that he is entirely incapable of even comprehending that his policy could do more harm than good.
Just look at this video of last week’s congressional hearings. The exchange between Congressman Ron Paul from Texas – the libertarian, Austrian-schooled Republican who is the only politician who ‘gets it’ – and the Fed chairman has been making the rounds on the web, and provoked already a lot of commentary. But what strikes me is not so much Bernanke’s struggle with explaining the monetary function of gold but something else. Something that indeed scares the living bejeesus out of me whenever I hear a Bernanke testimony.
Before I tell you what it is, let me stress that I don’t much like the widespread demonization of the Fed chairman. I have never met him but I cannot say that he comes across as an unpleasant individual. To the contrary, he seems to be a smart and decent person. Call me naïve, but I do not think that he is part of some conspiracy or any backroom dealing, or that he is in the pockets of the big Wall Street banks. I think he was sincere when he said that he never particularly cared about the management or the shareholders of the Wall Street firms he invariably bailed out and is still generously subsidizing with super-low funding rates and periodic debt monetization. He really believes that what he is doing is helping the U.S. economy and the U.S. people.
The problem is not that he is evil or dumb – I think he is neither – the problem is much bigger. Evil and dumb people can be dealt with. The deeply-convinced do-gooders in positions of almost unchecked power, those are the ones we should worry about, those who are full of good intentions but suffer from tunnel-vision, incurably in awe of their own theories and incapable of even beginning to grasp how what they are doing could make things worse. For keeping rates artificially low and bank reserves generously expanding is a form of constant market manipulation, and it is creating momentous dislocations and vast problems with as yet incalculable consequences – even if it does not presently generate instant hyperinflation or an intolerable expansion of the wider monetary aggregates, and thus looks deceptively harmless through Mr. Bernanke’s narrow prism of national account statistics.
Mr. Bernanke suffers from a blind side – there is an area of monetary phenomena, real and powerful phenomena, that are simply outside of his vision. It is the monetary blind side that all modern macroeconomists suffer from. For them two effects of an expanding money supply are visible, and only two:
1) The growth effect. Injecting more money lowers interest rates (temporarily) thus stimulates lending and borrowing, and leads to a (temporary) growth spurt. This effect is deemed unquestionably positive.
2) The inflation effect. More money means – all else being equal – that the purchasing power of the monetary unit drops. Prices tend to rise. Is this good or bad? Well, according to Bernanke and the mainstream consensus that he belongs to, the answer is, it depends. If there is a risk of that dreadful and debilitating deflation taking hold in the U.S. economy that seems to keep the chairman awake at night, then rising inflation is a good thing. But too much of it can be a bad thing.
So the two effects of the Fed’s money printing are higher growth and higher inflation. But here is the problem. This view is too narrow. It leaves out a very important, maybe the most important and potentially most damaging effect of money printing: the distortion of relative prices and the disruption of resource allocation and capital formation.
The Fed makes things worse
As I explain in detail in my upcoming book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, ‘elastic’ money is always destabilizing. Any expansion of the money supply (including bank reserves) must distort relative prices. Always and everywhere. Even if some fortuitous rise in money demand helps cushion the inflationary impact of expanding money and if inflation measures therefore remain contained. Even if the economy is weak and money printing is supposed to be a ‘stimulus’.
Specifically, every money injection must disrupt the market’s setting of interest rates and thus disorient the process of coordination between true savings and investment and capital formation.
Interest rates are market prices, and you interfere with them at your peril!
Continue reading at Paper Money Collapse
By Dr Richard M. Ebeling, on 18 May 11
The following testimony was delivered before the House of Representatives Subcommittee on Domestic Monetary Policy and Technology, chaired by Congressman Ron Paul (R-Texas), on “Monetary Policy and the Debt Ceiling: Examining the Relationship between the Federal Reserve and Government Debt,” in Washington, D.C. on May 11, 2011. It was previously published on Northwood University’s blog In Defense of Capitalism & Human Progress
“I place economy among the first and most important virtues, and public debt as the greatest of dangers to be feared . . . To preserve our independence, we must not let our rulers load us with public debt . . . we must make our choice between economy and liberty or confusion and servitude . . . If we run into such debts, we must be taxed in our meat and drink, in our necessities and comforts, in our labor and in our amusements . . . If we can prevent the government from wasting the labor of the people, under the pretense of caring for them, they will be happy.”
Thomas Jefferson
Government Debt and Deficits
The current economic crisis through which the United States is passing has given a heightened awareness to the country’s national debt. After a declining trend in the 1990s, the national debt has dramatically increased from $5.7 trillion in January 2001 to $10.7 trillion at the end of 2008, to over $14.3 trillion through April of 2011. The debt has reached 98 percent of 2010 U.S. Gross Domestic Product.
The approximately $3.6 trillion that has been added to the national debt since the end of 2008 is more than double the market value of all private sector manufacturing in 2009 ($1.56 trillion), more than three times the market value of spending on professional, scientific, and technical services in 2009 ($1.07 trillion), and nearly five times the amount spent on non-durable goods in 2009 ($722 billion). Just the interest paid on the government’s debt over the first six months of the current fiscal (October 2010-April 2011), nearly $245 billion, is equal to more than 40 percent of the total market value of all private sector construction spending in 2009 ($578 billion)[1]
This highlights the social cost of deficit spending, and the resulting addition to the national debt. Every dollar borrowed by the United States government, and the real resources that dollar represents in the market place, is a dollar of real resources not available for use in private sector investment, capital formation, consumer spending, and therefore increases and improvements in the quality and standard of living of the American people.
In this sense, the government’s deficit spending that cumulatively has been increasing the national debt has made the United States that much poorer than it otherwise could have and would have been, if the dollar value of these real resources had not been siphoned off and out of use in the productive private sectors of the American economy.
What has made this less visible and less obvious to the American citizenry is precisely because it has been financed through government borrowing rather than government taxation. Deficit spending easily creates the illusion that something can be had for nothing. The government borrows “today” and can provide “benefits” to various groups in the society in the present with the appearance of no immediate “cost” or “burden” upon the citizenry.
Yet, whether acquired by taxing or borrowing, the resulting total government expenditures represent the real resources and the private sector consumption or investment spending those resources could have financed that must be foregone. There are no “free lunches,” as it has often been pointed out, and that applies to both what government borrows as much as what it more directly taxes to cover its outlays.
What makes deficit spending an attractive “path of least resistance” in the political process is precisely the fact that it enables deferring the decision of telling voter constituents by how much taxes would otherwise have to be increased, and upon whom they would fall, in the “here and now” to generate the additional revenue to pay for the spending that is financed through borrowing.[2]
But as the recent fiscal problems in a number of member nations of the European Union have highlighted, eventually there are limits to how far a government can try to hide or defer the real costs of all that it is providing or promising through its total expenditures to various voter constituent groups. Standard & Poor’s recent decision to downgrade the U.S. government’s prospective credit rating to “negative” shows clearly that what is happening in parts of Europe can happen here.
And given current projections by the Congressional Budget Office, the deficits are projected to continue indefinitely into future years and decade, with the cumulative national debt nearly doubling from its present level.[3] In addition, whether covered by taxes or deficit financing, these debt estimates do not include the federal government’s unfunded liabilities for Social Security and Medicare through most of the 21st century. In 2009, the Social Security and Medicare trust funds were estimated to have legal commitments under existing law for expenditures equal to at least $43 trillion over the next seventy-five years.[4] Others have projected this unfunded liability of the United States government to be much higher – possibly over $100 trillion.[5]
The Federal Reserve and the Economic Crisis
The responsibility for a good part of the current economic crisis must be put at the doorstep of America’s central bank, the Federal Reserve. By some measures of the money supply, the monetary aggregates (MZM or M-2) grew by fifty percent or more between 2003 and 2007. This massive flooding of the financial markets with huge amounts of liquidity provided the funds that fed the mortgage, investment, and consumer debt bubbles in the first decade of this century. Interest rates were pushed far below any historical levels.
For a good part of those five years, according to the St. Louis Federal Reserve Bank, the federal funds rate (the rate of interest at which banks lend to each other), when adjusted for inflation – the “real rate” – was either negative or well below two percent. In other words, the Federal Reserve supplied so much money to the banking sector that banks were lending money to each other for free for a good part of this time. It is no wonder that related market interest rates were also pushed way down during this period.[6]
Market interest rates are supposed to tell the truth. Like any other price on the market, interest rates are suppose to balance the decision of income earners to save a portion of their income with the desire of others to borrow that savings for various investment and other purposes. In addition, the rates of interest, through the present value factor, are meant to limit investment time horizons undertaken within the available savings to successfully bring the investments to completion and sustainability in the longer-term.
Due to the Fed’s policy, interest rates were not allowed to do their “job” in the market place. Indeed, Fed policy made interest rates tell “lies.” The Federal Reserve’s “easy money” policy made it appear, in terms of the cost of borrowing, that there was more than enough real resources in the economy for spending and borrowing to meet everyone’s consumer, investment and government deficit needs far in excess of the economy’s actual productive capacity.[7]
The housing bubble was indicative of this. To attract people to take out loans, banks not only lowered interest rates (and therefore the cost of borrowing), they also lowered their standards for credit worthiness. To get the money, somehow, out the door, financial institutions found “creative” ways to bundle together mortgage loans into tradable packages that they could then pass on to other investors. It seemed to minimize the risk from issuing all those sub-prime home loans, which we now see were really the housing market’s version of high-risk junk bonds. The fears were soothed by the fact that housing prices kept climbing as home buyers pushed them higher and higher with all of that newly created Federal Reserve money.
At the same time, government-created home-insurance agencies like Fannie Mae and Freddie Mac were guaranteeing a growing number of these wobbly mortgages, with the assurance that the “full faith and credit” of Uncle Same stood behind them. By the time the Federal government formally had to take over complete control of Fannie and Freddie in 2008, they were holding the guarantees for half of the $10 trillion American housing market.[8]
Low interest rates and reduced credit standards were also feeding a huge consumer-spending boom that resulted in a 25 percent increase in consumer debt between 2003 and 2008, from $2 trillion to over $2.5 trillion. With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow and consume today. But, according to the U.S. Census Bureau, during this five-year period average real income only increased by at the most 2 percent. Peoples’ debt burdens, therefore, rose dramatically.[9]
The easy money and government-guaranteed house of cards all started to come tumbling down in the second half of 2008. The Federal Reserve’s response was to open wide the monetary spigots even more than before the bubbles burst.
The Federal Reserve has dramatically increased its balance sheet by expanding its holding of U.S. government securities and private-sector mortgage-back securities to the tune of around $2.3 trillion. Traditional Open Market Operations plus its aggressive “quantitative easing” policy have increased bank reserves from $94.1 billion in 2007 to $1.3 trillion by April 2011, for a near fourteen-fold increase, and the monetary basis in general has expanded from $850.5 billion in 2007 to $2,242.9 billion in April of 2011, a 260 percent increase. The monetary aggregates, MZM and M-2, respectively, have grown by 28 percent and 21.6 percent over this same period.[10]
In the name of supposedly preventing a possible price deflation in the aftermath of the economic boom, Fed policy has delayed and retarded the economy from effectively readjusting and re-coordinating the sectoral imbalances and distortions that had been generated during the bubble years.[11] Once again interest rates have been kept artificially low. In real terms, the federal funds rate and the 1-year Treasury yield have been in the negative range since the last quarter of 2009, and at the current time is estimated to be below minus two percent.
This has prevented interest rates from informing market transactors what the real savings conditions are in the economy. So, once again, the availability of savings and the real cost of borrowing is difficult to discern so as to make reasonable and rational investment decisions, and not to foster a new wave of misdirected and unsustainable private sector investment and financial decisions.
The housing market has not been allowed to fully adjust, either. With so much of the mortgage-backed securities being held off the market in the portfolio of the Federal Reserve, there is little way to determine any real market-based pricing to determine their worth or their total availability so the housing market can finally bottom out with clearer information of supply and demand conditions for a sustainable recovery.
This misguided Fed policy has been, in my view, a primary factor behind the slow and sluggish recovery of the United States economy out of the current recession.
Federal Reserve Policy and Monetizing the Debt
Many times in history, governments have used their power over the monetary printing press to create the funds needed to cover their expenses in excess of taxes collected. Sometimes this has lead to social and economic catastrophes.[12]
Monetizing the debt refers to the creation of new money to finance all or a portion of the government’s borrowing. Since the early 2008 to the present, Federal Reserve holdings of U.S. Treasuries have increased by about 240 percent, from $591 billion in March 2008 to $1.4 trillion in early May 2011, or a nearly $1 trillion increase. In the face of an additional $3.6 trillion in accumulated debt during the last three fiscal years, it might seem that Fed policy has “monetized” less than one-third of government borrowing during this period.
However, the Fed’s purchase of mortgage-backed securities, no less than its purchase of U.S. Treasuries, potentially increases the amount of reserves in the banking system available for lending. And since 2008, the Federal Reserve had bought an amount of mortgaged-backed securities that it prices on its balance sheet as being equal about $928 billion.
The $1.4 trillion increase in the monetary base since the end of 2007, from $850.5 billion to $2.2 trillion, has increased MZM measurement of the money supply by $2,161.1, or an additional $769 billion dollars in the economy above the increase in the monetary base. This is an amount that is 83 percent of the dollar value of the $927 billions in mortgage-backed securities.
Due to the “money multiplier” effect – that under fractional reserves, total new bank loans are potentially a multiple of the additional reserves injected into the banking system – it is not necessary for the Fed to purchase, dollar-for-dollar, every additional dollar of government borrowing to generate a total increase in the money supply that may be equal to the government’s deficit.
Thus, it can be argued that Fed monetary policy has succeeded, in fact, in generating an increase in the amount of money in the banking system that is equal to two-thirds of the government’s $3.6 trillion of new accumulated debt.
That the money multiplier effect has not been as great as it might have been, so far, is because the Federal Reserve has been paying interest to member banks to not lend their excess reserves. This sluggishness in potential lending has also been affected by the general “regime uncertainty” that continues to pervade the economy. This uncertainty concerns the future direction of government monetary and fiscal policy. In an economic climate in which it difficult to anticipate the future tax structure, the likely magnitude of future government borrowing, and the impact of new government programs, hesitancy exists on the part of both borrowers and lenders to take on new commitments.
But the monetary expansion has most certainly been the factor behind the worsening problem of rising prices in the U.S. economy and the significant fall in the value of the dollar on the foreign exchange markets.
The National Debt and Monetary Policy
It is hard for Americans to think of their own country experiencing the same type of fiscal crisis that has periodically occurred in “third world” countries. That type of government financial mismanagement is supposed to only happen in what used to be called “banana republics.”
But the fact is, the U.S. is following a course of fiscal irresponsibility that may lead to highly undesirable consequences. The bottom line truth is that over the decades the government – under both Republican and Democratic leadership – has promised the American people, through a wide range of redistributive and transfer programs and other on-going budgetary commitments, more than the U.S. economy can successfully deliver without seriously damaging the country’s capacity to produce and grow through the rest of this century.
To try to continue to borrow our way out of this dilemma would be just more of the same on the road to ruin. The real resources to pay for all the governmental largess that has been promised would have to come out of either significantly higher taxes or crowding out more and more private sector access to investment funds to cover continuing budget deficits. Whether from domestic or foreign lenders, the cost of borrowing will eventually and inescapably rise. There is only so much savings in the world to fund private investment and government borrowing, particularly in a world in which developing countries are intensely trying to catch up with the industrialized nations.
Interest rates on government borrowing will rise, both because of the scarcity of the savings to go around and lenders’ concerns about America’s ability to tax enough in the future to pay back what has been borrowed. Default risk premiums need not only apply to countries like Greece.
Reliance on the Federal Reserve to “print our way” out of the dilemma through more monetary expansion is not and cannot be an answer, either. Printing paper money or creating it on computer screens at the Federal Reserve does not produce real resources. It does not increase the supply of labor or capital – the machines, tools, and equipment – out of which desired goods and services can be manufactured and provided. That only comes from work, savings and investment. Not from more green pieces of paper with presidents’ faces on them.
However, what inflation can do is:
- Accelerate the devaluation of the dollar on the foreign exchange markets, and thereby disrupting trading patterns and investment flows between the U.S. and the rest of the world;
- Reduce the value, or purchasing power, of every dollar in people’s pockets throughout the economy as prices start to rise higher and higher;
- Undermine the effectiveness of the price system to assist people as consumers and producers in making rational market decisions, due to the uneven manner in which inflation impacts of some prices first and affects others only later;
- Potentially slow down capital formation or even generate capital consumption, as inflation’s uneven effects on prices makes it difficult to calculate profit from loss;
- Distort interest rates in financial markets, creating an imbalance between savings and investment that sets in motion the boom and bust of the business cycle;
- Create incentives for people to waste their time and resources trying to find ways to hedge against inflation, rather than devote their efforts in more productive ways that improve standards of living over time;
- Bring about social tensions as people look for scapegoats to blame for the disruptive and damaging effects of inflation, rather than see its source in Federal Reserve monetary policy;
- Run the risk of political pressures to introduce distorting price and wage controls or foreign exchange regulations to fight the symptom of rising prices, rather than the source of the problem – monetary expansion.
What is To Be Done?
The bottom line is, government is too big. It spends too much, taxes too heavily, and borrows too much. For a long time, the country has been trending more and more in the direction of increasing political paternalism. Some people argue, when it is proposed to reduce the size and scope of government in our society, that this is breaking some supposed “social contract” between government and “the people.”
The only workable “social contract” for a free society is the one outlined by the American Founding Fathers in the Declaration of Independence and formalized in the Constitution of the United States. This is a social contract that recognizes that all men are created equal, with governmental privileges and favors for none, and which expects government to respect and secure each individual’s right to his life, liberty, and honestly acquired property.
The reform agenda for deficit and debt reduction, therefore, must start from that premise and have as its target a radical “downsizing” of government. That policy should plan to reduce government spending across the board in every line item of the federal budget by 10 to 15 percent each year until government has been reduced in size and scope to a level and a degree that resembles, once again, the Founding Father’s conception of a free and limited government.[13]
A first step in this fiscal reform is to not increase the national debt limit. The government should begin, now, living within its means – that is, the taxes currently collected by the Treasury. In spite of some of the rhetoric in the media, the U.S. need not run the risk of defaulting or losing its international financial credit rating. Any and all interest payments or maturing debt can be paid for out of tax receipts. What will have to be reduced are other expenditures of the government.
But the required reductions and cuts in various existing programs should be considered as the necessary “wake-up call” for everyone in America that we have been living far beyond our means. And as we begin living within those means, priorities will have to be made and trade-offs will have to be accepted as part of the transition to a smaller and more constitutionally limited government.
In addition, the power of monetary discretion must be taken out of the hands of the Federal Reserve. The fact is, central banking is a form of monetary central planning under which it is left in the hands of the members of the Board of Governors of the Federal Reserve to “plan” the quantity of money in the economy, influence the value or purchasing power of the monetary unit, and manipulate interest rates in the loan markets.
The monetary central planners who run the Federal Reserve have no more or greater knowledge, wisdom or ability that those central planners in the old Soviet Union. The periodic recurrence of the boom and bust of the business cycle demonstrates that there is no way for them to get it right – in spite of them saying, again and again, that “next time” they will get it right.
It is what the Nobel Prize-winning, Austrian economist, Friedrich A. Hayek, once called a highly misplaced “pretense of knowledge.” That is why in a wide agenda for reform, the goal should be to move towards a market-based monetary system, the first step in such an institutional change being a commodity-backed monetary order such as a gold standard.[14]
And in the longer-run serious consideration must be given the possibilities of a monetary system completely privatized and competitive, without government control, management, or supervision.[15]
The budgetary and fiscal crisis right now has made many political issues far clearer in people’s minds. The debt dilemma is a challenge and an opportunity to set America on a freer and potentially more prosperous track, if the reality of the situation is looked at foursquare in the eye.
Otherwise, dangerous, destabilizing, and damaging monetary and fiscal times may be ahead.
[1] The 2011 Statistical Abstract: The National Data Book (Washington, D.C., U.S. Census Bureau, 2011), Table 669.
http://www.census.gov.compendia/statab/2011/tables/11s0669.pdf.
[2] Richard M. Ebeling, Why Government Grow: The Modern Democratic Dilemma,” AIER Research Reports, Vol. LXXV, No. 14 (Great Barrington, MA: American Institute for Economic Research, August 4-18, 2008); James M. Buchanan and Richard E. Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes (New York: Academic Press, 1977); and earlier, Henry Fawcett and Millicent Garrett Fawcett, Essays and Lectures on Social and Political Subjects (Honolulu, Hawaii: University Press of the Pacific, [1872] 2004), Ch. 6: “National Debts and National Prosperity,” pp. 125-153.
[3] The Budget and Economic Outlook: Fiscal Years 2011 to 2021 (Washington, D.C.: Congressional Budget Office, January 27, 2011)
[4] Richard M. Ebeling, “Brother, Can You Spare $43 Trillion? America’s Unfunded Liabilities,” AIER Research Reports, Vol. LXXVI, No. 3 (Great Barrington, MA: American Institute for Economic Research, March 2, 2009), pp. 1-3.
[5] Michael D. Tanner, “The Coming Entitlement Tsunami.” April 6, 2010. http://www.cato.org/pub_display.php?pub_id=11666 (accessed May 5, 2011).
[6] For more details, see, Richard M. Ebeling, “The Financial Bubble was Created by Central Bank Policy,” American Institute for Economic Research, November 5, 2008, http://www.aier.org/research/briefs/667-the-financial-bubble-was-created-by-central-bank-policy (accessed on May 5, 2011).
[7] See, Richard M. Ebeling, “Market Interest Rates Need to Tell the Truth, or Why Federal Reserve Policy Tells Lies,” in Richard M. Ebeling, Timothy G. Nash, and Keith A. Pretty, eds., In Defense of Capitalism (Midland, MI: Northwood University Press, 2010) pp. 57-60; http://defenseofcapitalism.blogspot.com/2009/12/market-interest-rates-need-to-tell.html
[8] Thomas Sowell, The Housing Boom and Bust (New York: Basic Books, 2010); Johan Norberg, Financial Fiasco (Washington, D.C.: Cato Institute, 2009).
[9] Richard M. Ebeling, “Is Consumer Credit the Next Bomb in the Economic Crisis?” American Institute for Economic Research, October 22, 2008, http://www.aier.org/research/briefs/599-consumer-credit-the-next-qbombq-in-the-economic-crisis (accessed May 5, 2011).
[10] Monetary Trends (St. Louis, MO: St. Louis Federal Reserve, May 2011)
[11] See, Richard M. Ebeling, “The Hubris of Central Bankers and the Ghosts of Deflation Past” July 5, 2010, http://defenseofcapitalism.blogspot.com/2010/07/hubris-of-central-bankers-and-ghosts-of.html (accessed May 5, 2011)
[12] See, Richard M. Ebeling, “The Lasting Legacies of World War I: Big Government, Paper Money, and Inflation,” Economic Education Bulletin, Vol. XLVIII, No. 11 (Great Barrington, MA: American Institute for Economic Research, November 2008), for a detailed example of the German and Austrian instances of monetary-financed inflationary destruction following the First World War.
[13] See, Richard M. Ebeling, “The Cost of the Federal Government in a Freer America,” The Freeman: Ideas on Liberty (March 2007), pp. 2-3; http://www.thefreemanonline.org/from-the-president/the-cost-of-the-federal-government-in-a-freer-america/ (accessed May 5, 2011).
[14] See, Richard M. Ebeling, “The Gold Standard and Monetary Freedom,” March 30, 2011, http://defenseofcapitalism.blogspot.com/2011/03/gold-standard-and-monetary-freedom-by.html
[15] See, Richard M. Ebeling, “Real Banking Reform? End the Federal Reserve,” January 22, 2010, http://defenseofcapitalism.blogspot.com/2010/01/real-banking-reform-end-federal-reserve.html
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