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III.
Invisible Pilferage
The
Pharaoh's Treasure
According to the ancient Greek historian Herodotus the treasure of no
Egyptian pharaoh was comparable in either size or value to the enormous hoard
of Rhampsinitos. His treasury was housed in a huge
stone building adjacent to the palace, and it was considered burglar-proof.
The door was sealed by the pharaoh's personal seal and manned around the
clock by armed guards. Rhampsinitos was present in
person every time the seal was broken and the building entered. Therefore it
was extremely disturbing when the pharaoh discovered that his treasure was
being pilfered, albeit without any sign of unauthorized entry into the
building. To find out what was going on the pharaoh caused a trap to be
placed inside to catch any would-be thief as he was approaching the
treasure-bins. To his utter amazement, on his next visit the pharaoh found
that, while the trap had done the job of catching the would-be thief, yet
this did not help him one iota to solve the mystery. More treasure was
missing, together with the head of the would-be thief. There was no sign
showing how the missing objects had been spirited out of the building. The
identity of the thieves could not be established. It appeared as if someone
had supernatural power to enter the building invisibly and pilfer the
treasure without leaving any trace.
Pilfering the Wealth of Nations
The Great Depression
seems to have presented a similar mystery. Productive enterprise came under
pressure to liquidate debt and inventory, so excruciating had the debt-burden
become. Those firms that could not liquidate fast enough were themselves
liquidated. The Wealth of Nations was decimated as scores of once flourishing
firms were going bankrupt. Nobody suspected that the loss of wealth might be
due to plunder and pilferage. For a time governments bought nostrums
prescribed by Keynesian and Friedmanite soothsayers
to prevent similar disasters from happening in the future in the belief that
the destruction of wealth was due to natural causes. But as depression struck
Japan in spite of taking the prescription, and as other countries appear also
to succumb to the Japanese disease, the peddlers of nostrums became
suspicious as being impostors. In the absence of an acceptable theory
explaining the Great Depression the danger of future depressions looms larger
than ever in the horizon.
Our revisionist view
presented here for the first time suggests that, far from being due to
natural causes, the Great Depression was unquestionably the result of plunder
and pilferage. The Wealth of Nations was being pilfered invisibly. Those
responsible couldn't be caught because the thievery involved no physical
movement of property. Whenever a dead body was found (such as that of LTCM,
or that of Enron), the head was missing and the investigation could proceed
no further. Public opinion has been lulled into the false belief by the
economists' profession and by the financial media that there was in fact no pilferage, the phenomenon must be explained by the
idiosyncrasies of the capitalist system of production.
Capital Consumption
It is a daunting task
trying to change a consensus that has been nurtured through generations. Yet
we must not shrink from exposing the crime if we know who the culprit is,
even if our evidence will be laughed out of court. Here is our analysis. The
thievery involved no physical transfer of property; it involved book-keeping
transfers from the balance sheet of the productive sector to that of the
financial sector. The root cause of the wholesale bankruptcy of productive
firms was not the falling price structure (although it certainly helped) but,
primarily, the falling interest-rate structure. As interest rates fell, bond
prices rose, and with them rose the present value of
debt. This caused the cost of servicing productive capital already deployed
to rise as well. However, no allowance for the increased costs was made in
the balance sheet. There was no recognition of the fact that falling interest
rates caused the liquidation-value of firms to snowball, materially adding to
liability. In other words, there were losses that were never realized and no
charges to income against them were made. Moreover, this was the practice
across the board. The failure to realize losses in the national economy meant
that society has been consuming capital over a period of time. In the end
productive enterprise was operating on the strength of phantom capital. Not
only was capital consumption universal affecting all firms engaged in
productive enterprise, it was going on unnoticed. The viciousness and
violence of the reaction, when it finally came, was unprecedented. Productive
firms were falling right and left, regardless of the demand for their
products. Firms that were certified as being sound one day would go bankrupt
the next. One of the lessons of the Great Depression is that capital
consumption is the most treacherous form of credit abuse that may plague
society, chiefly because it can go on unnoticed for so long before anyone can
recognize it. Corrective action, when it comes, is too late. This highlights
the importance of maintaining the highest accounting standards. Any attempt
at compromise is a crime not only against the shareholders, but against
society as a whole.
Once we have identified
capital consumption as the cause of the Great Depression, the focus must be
shifted to the question why the rate of interest was falling as long and as
much as it did, making capital consumption possible. To be sure, without such
a prolonged and pronounced fall in interest rates there would have been no
universal mistake in accounting. Here we have to refer to chronology in order
to establish the direct responsibility of politicians, in particular, the
responsibility of one person, F.D. Roosevelt. The banks in the United States
lay prostrate between Election Day, November 1932, and Inauguration Day,
March 1933. As a consequence of the economic boom of the "roaring
twenties" interest rates were steadily increasing, and bank capital was
greatly weakened by the proliferation of non-performing loans. Rumors had it that Roosevelt, the Democratic candidate
for the presidency would, in spite of his repeated pledges during the
campaign to the contrary, "go off" the gold standard and devalue
the dollar. There was a run on the banks. People wanted to withdraw their
savings before the monetary mischief was sprung upon the nation. They trusted
neither the integrity of the banks nor that of the politicians - not entirely
without reasons as one might add in retrospect. Some revisionist historians
even go as far as suggesting that rumors of
devaluation were deliberately planted by Roosevelt himself. He did want the
banks to fail so that upon inauguration he could declare a state of emergency
and assume dictatorial powers. (Note that these allegations of revisionist
historians have no bearing on my argument. Be that as it may, it is a fact
that Roosevelt made himself unavailable during the
interregnum, and refused to deny the rumors of an
imminent devaluation, in spite of repeated appeals from Hoover.)
Wiping out Negative Net Worth
In the event, shortly
after inauguration Roosevelt closed the banks. Later most of the banks were
reopened and given a clean bill of health but, in reality, they were in a
very sorry state rather similar to that of the Japanese banks today. They had
a negative net worth. There were huge holes in their balance sheets. They
could open for business only by virtue of the government's connivance
allowing bank inspectors not to enforce the accounting rule that assets be
carried at market value in the balance sheet. The banks had a strategy to
wipe out negative net worth by mending the holes in their balance sheet - a
Herculean task. On the assumption that interest rates would fall further,
they could keep buying government bonds to let capital gains in the bond
portfolio take care of capital insufficiency.
There was just one
problem with that strategy. It was the risk that interest rates may turn
around and start rising This would not only hurt the
banks, it would turn the bond market into a "killing field". Field
where the banks would be slaughtered. There were plenty of reasons, too, why
interest rates could indeed turn around and start rising again. There was the
continuing threat of devaluation of the dollar. There was the added threat of
a huge inflation. (In the fullness of times, both threats became a reality.)
There was a flight of capital from the country. The banks could not have concocted
a riskier strategy to save their skin. But there was a godsend, turning the
risky bet into a safe one. The risk threatening the banks' strategy was
removed by a Presidential Proclamation.
Save the Banks, Ban Gold
Roosevelt called in gold
coinage. He made trading in and owning gold (in forms other than jewelry) a crime. What has all this got to do with the
banks' strategy for survival? Here is the connection, which has never been
adequately explained by scholarship. The risk that interest rates might turn
around frustrating the banks' strategy to wipe out negative net worth was
eliminated by Roosevelt's ban on gold hoarding. Predictably, the ban had a
deflationary effect on the economy as it started a downward spiral in the
rate of interest. Before the ban those who wanted to manage their liquid
wealth most conservatively would park it in gold. After the ban they were
forced to park it in government bonds. The captive clientele for government
bonds guaranteed that bond prices would keep rising, and interest rates would
keep falling, for several years to come. The banks were given the green light
to go ahead with their massive bond-speculation scheme. An orgy of
speculation in the bond market followed.
Everybody knows about the
bull market in stocks in the 1920's. Reams of books have been written on that
subject. But nobody has ever heard about the bull market in bonds in the
1930's. Yet it is a fact that the volume of the latter surpassed that of the
former by a factor of ten. The banks made obscene profits in the form of
capital gains in the bond portfolio. For the next six years, while interest
rates continued to fall, the banks and other firms in the financial sector
got fabulously rich, while firms in the productive sector were being put
through the wringer. The banks' profits were more than enough to wipe out
negative net worth. Banks that had been technically bankrupt at the beginning
of the decade were in ultra-strong financial position by the end of the
decade.
Financial Vampirism
However, the banks' newly
found wealth did not come out of nothing. It was not newly created wealth. It
was existing wealth that was siphoned off the balance sheet of productive
enterprise forcing it into bankruptcy in consequence of this financial
vampirism. We may do well to remember that the banks' pilfering the Wealth of
Nations was possible because of the falling interest-rate structure which, in
turn, was engineered by the crudest form of government intervention in the
market: the unconstitutional confiscation of the people's gold without due
process.
This is not to suggest
that Roosevelt was an accomplice or a stooge of the banks, or that he
declared his ban on gold hoarding for the purpose of bailing out the banks.
It is possible that there was a fortuitous coincidence. We may never know,
and it does not matter. The fact remains that tampering with gold is
tantamount to tampering with interest rates. It is a most dangerous expedient
as it may have many unforeseen and untoward consequences.
This, then, is the
revisionist view of the Great Depression. Without the gold ban the recession
that started with the 1929 stock market crash would have been over by 1932.
With the gold ban, the recession was turned into the greatest depression of
all times. The man who was celebrated as savior
ridding the nation of the curse of depression was in fact the one who had
brought the disaster about. He pulled the gold trigger that released the
murderous forces of bond speculation to prey upon the productive sector. It
heralded the continuing fall of the rate of interest. Bond speculators, first
and foremost the banks among them, were listening and got ready to move in
for the killing. The vultures picked the bones of productive enterprise
clean. And all this was done under the veil of anonymity. Nobody guessed that
the Great Depression was a happy time for some. Well, for the bankers it was
time for popping corks. Not only was their skin saved, but they became so
strong financially that they could thereafter dictate government policy.
Don't Entrust Your Money to Desperadoes
Thus the chief culprit
and the only beneficiary of the Great Depression was the banking fraternity.
They profited from the disaster devastating the world economy. I now pick up
the thread I left off in part two, and continue my discourse on the
consequences of relaxing accounting standards. It was a colossal mistake to
reclassify insolvent banks as merely "illiquid" and letting them
open their doors for business. An illiquid bank, by definition, is one that
can be considered solvent only by virtue of relaxing accounting standards,
allowing the bank to carry an asset (usually a government bond) at
acquisition price, regardless how low the current market price of that asset
may have fallen. Why is this a mistake? Well,
illiquid banks are desperadoes ready to take unreasonable risks with the
people's money entrusted to their care. Illiquid banks have nothing to lose
but their stigma of being insolvent. They should be closed down by bank
inspectors without hesitation. Any compromise in relaxing accounting
standards is foolish in the extreme. It invites great dangers affecting not
only shareholders and depositors, but society as a whole. It is hard to
imagine a dictum more insane than the one: "Bank X is too big to
fail".
Cui bono?
We have argued that the
Great Depression of the 1930's was caused by illiquid banks in the United
States as they became the engine of an unprecedented speculative orgy in the
bond market to drive down interest rates. We could also argue that the
depression in Japan today is caused by illiquid Japanese banks as they have
become the engine of another huge bull market in bonds to drive the rate of
interest to zero.
There is more to this
story than revisionist history. Our insight may help explaining the passing
scene of our day. For the time being, there is no ban on gold hoarding today.
But it is apparent that the gold market is being manipulated, possibly with
government connivance. In trying to understand an unexpected or puzzling
historical event, historians used to ask the key question: cui bono? (who is the
possible beneficiary?)
It ought to be understood
well that gold manipulation (i.e., conspiracy to keep the price of gold
permanently in a low range) is deflationary. Just as Roosevelt's ban on gold
hoarding, the present exercise in gold manipulation also has the effect of
restricting demand for physical gold. The result is the same: interest rates
keep falling, and for the same reasons. Liquid capital all over the world is
seeking out the 'next best' alternative to gold as a conservative investment
medium. It will find it in the form of government bonds. Once more, a captive
market for government bonds has been created. As bidding for bonds continues,
interest rates keep falling. Bond speculators are invited to jump on the
bandwagon: the risk that interest rates might turn around and start rising,
thereby frustrating the speculation, has been reduced by the gold
manipulation. Before our very eyes (and not everyone has eyes to see this
sort of thing) there is an orgy of bull-market speculation in bonds that
started twenty years ago. The end may not be in sight yet. In 1980, interest
rates in the United States were around 16 percent per annum. They have come down
to around 5 percent. If the example of Japan is any guide, they still have a
long way to go. American interest rates could follow the Japanese into the
abyss. Why not? The mechanism to link the two rates is already in place. It
is called the yen-carry trade. The speculator sells the Japanese bond and
buys the American. This amounts to borrowing yens at zero percent (or
thereabouts), converting the proceeds into dollars and lending them at 5
percent. The reward? Almost 5 percent - not bad for shuffling paper. Clearly,
the effect of the yen-carry trade is to drive down the rate of interest in
America, too.
The consequences of a
falling interest-rate structure today are no different from those in the
1930's. There is capital consumption in the productive sector. There is a
stealthy transfer of wealth from the productive to the financial sector. Cui
bono? Why, for the benefit of the banks, of course. American and Japanese
banks. Banks of any stripe or color. The worst part
of it all is that the public is still in the dark about the invidious
consequences of falling interest rates. It is told a tale about free markets
deciding bond values and the value of gold. The ominous fact, however, is
that both markets are rigged. They are like a casino where the dice are
loaded for the benefit of the house.
$ 100 trillion worth of hot air
The truth is that there
is no public benefit in bond, foreign exchange, and gold speculation. None
whatsoever. The world could still go on without any of this trading, and no
one would be any worse off. The overwhelming majority of the people,
including all savers and producers, would be better off. Interest and foreign
exchange rates were so stable under the regime of the gold standard that no
speculator in his right mind would hold bonds or foreign exchange in the hope
of speculative gain. Today not only do we have speculation in bonds and
foreign exchange; since 1971 we have also allowed speculators to construct
derivatives markets on the top of the bond , foreign
exchange, and gold markets. The combined volume of these derivatives markets
has snowballed and its size has hit and surpassed the $100 trillion mark! No
misprint here. There is commitment to pay compensation for the fluctuation in
the value of $100 trillion worth of paper. (Never mind that there is isn't nearly as much paper in existence, not even if we
include the scum of the junk bond market.) For centuries before 1971, the
grand total of paper so 'insured' was exactly $ 0 (zero dollar).
In other words, in 1971 the world all of a sudden developed an insatiable
appetite for insurance. In thirty years the world came up with $ 100 trillion
worth of 'insurables' to bolster security. What
security? Maybe financial security? No, we can't very well say that, not
after the collapse of Enron, and not after the dollar having lost 90 percent
of its purchasing power during the same thirty years. Then physical security,
perhaps? No, not physical security. Not after the destruction of the twin
towers of the World Trade Center, and not in the
middle of a drama in two acts: oil war against Iraq. Then what kind of
security is it that the insuring of $ 100 trillion represents? Search as you
may, but you will find only hot air. The world was a much better and safer
place for hundreds of years with stable interest and foreign exchange rates,
and with a stable gold price, and without any insurance on hot air. Had it
kept them that way, it could have earmarked funds for the eradication of
poverty, hunger, diseases, illiteracy, or for any other noble cause.
The $ 100 trillion dollar
market in derivatives created by the big American banks serves no purpose
consonant with the interest of the national or world economy. It serves one
purpose only: the aggrandizement of the profits of the financial sector, at
the expense of the productive sector. The big American banks were as
insolvent twenty years ago as the Japanese banks are today. Then they started
their desperate bond-market gamble, trying to drive down interest rates. They
badly needed capital gains in their bond portfolio to mend the enormous holes
in their balance sheets. The gamble has paid off. Today the American banks
are in a better financial shape. However, a high price for saving the banks'
skin was paid by the productive sector. American firms producing hardware
have been put out of business. Solid jobs in the productive sector were
eliminated and replaced by soft jobs in the service sector. The plight of the
American breadwinner who is now flipping hamburgers instead of pouring molten
steel (and who may soon be out of any job) is in direct consequence of the
orgy in bond speculation. Nor is this all. The depression in Japan may not
stop at the Pacific. It may well portend to engulf America and the rest of
the world.
Bond Speculation is No Zero-Sum Game
I am well aware that the
sum $ 100 trillion is a 'notional' amount. We are not talking about $ 100
trillion worth of bonds being traded. We are talking about the combined
stakes of bond speculators who have placed bets on the rate of interest, and
want to profit as if they have owned bonds in that amount. But the profits,
provided the speculators' bet comes off, are not 'notional'. They are payable
in cold cash. Suppose, for the sake of argument, that
most of the bets call for lower interest rates. In other words, most
speculators would buy bonds as they expect their value to rise further. (This
is a plausible assumption. No doubt this is exactly what Japanese banks
scrambling to get out of bankruptcy are likely to be doing right now.) If
interest rates did in fact go down and the price of bonds did go up, say 1
percent, then the speculators' profit would be $ 1 trillion in cash. Who is
going to pay that?
Economists will tell you
that the profit of one speculator is the loss of another. Don't buy that. It
is arrant nonsense. It would be true only if speculation were a zero-sum
game. This is the case for stabilizing speculation dealing with risks created
by nature, for example, in the futures markets for agricultural commodities.
Here speculators make money by resisting the formation of price trends. As
there is no consensus whether the formation of an uptrend or a downtrend is
more likely, speculators will be betting on either side of the market. But in
markets where risks are man-made, speculation is not a zero-sum game. This is
the case of destabilizing speculation. For example, in the market for bonds
and its derivatives speculators make money by inducing and then riding price
trends. They are on the same side of the market, which is practically always
the winning side. Remember, speculators can influence the outcome by throwing
their weight around. (Try to do that against the blind forces of nature!)
Why are risks in the bond
market man-made? Because under the gold standard interest rates were stable.
There was little risk that bond values might change. Risks were injected
artificially when politicians forcibly removed the gold standard.
But if the profit of the
speculator who bet on higher bond values and won is not paid by another
speculator on the other side of the bet, then who is paying it? This is a
crucial question and we must answer it very carefully. The other side of the
bet was probably taken by a banker for hedging rather than speculative
purposes. He sold the bond in order to hedge his exposure in lending money to
productive enterprise. His is a neutral position with regard to the bond
market. He has a straddle: the loss on one leg is cancelled out by the profit
on the other leg of the straddle. The loss is passed on to the party on the other
side of the hedging banker's bet. Therefore, ultimately, the losers paying
the $ 1 trillion profit to bond speculators are the firms in the productive
sector. They are sitting ducks in this speculative game. They have no choice.
They must carry the risk of owning productive capital, without which there
will be no consumer goods for you, for me, or for any other member of
society. The foregoing argument demonstrated conclusively that as speculators
drive down the rate of interest to zero, the value of productive capital is
surreptitiously siphoned off the balance sheets of the producers and will
show up as capital gains in the balance sheets of bond speculators. Firms in
the productive sector are condemned to bankruptcy for the benefit of
parasites. This is the essence of depressions.
Monument to Folly
The $ 100 trillion
derivatives market is a monument to the folly of man. Derivatives trading
serves no purpose other than benefiting a parasitic class, that of the bond
speculators, chief among them the banking fraternity, at the expense of the
productive sector. Producers meekly accept their role of sacrificial lamb.
They do so because they lack understanding of what is happening to them, just
as lambs herded in the slaughterhouse do.
This exposes the enormity
of the folly of having destroyed the gold standard thus allowing interest
rates to fluctuate. Thereafter bond speculators would, whenever the
opportunity presented itself, drive down the rate of interest all the way to
zero while, in the best tradition of vampires, they suck the life-blood out
of the producers. The $ 100 trillion monument ought to be our reminder that
bond speculators are hell-bent to plunge the world into a depression once
again, as they did in the 1930's.
Unless
governments can muster their brain- and will-power, demolish that monument,
stop the deadly game, and stabilize interest rates once more by opening the
Mint to gold.
March 13, 2002
Dr. Antal E. Fekete
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