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