What Does This Crisis Mean for the Economy's Future?

Recently, someone asked me three questions:

• Who is going to pay for the government's handouts once this virus episode and economic standstill have passed?
• What kind of price inflation might we be looking at over the coming months?
• What should a person be doing today?

It inspired me to write an article that Seeking Alpha decided to publish. It is here.

I hope you will find it of interest.

Theft By The Federal Reserve

I am thoroughly disgusted at the "legalized embezzlement" that is going on through repressed interest rates.  ["Legalized embezzlement":  A phrase originally used by E.C. Harwood, founder of the American Institute for Economic Research.]

Take a look at the following figures:

By way of illustration, let's say you are someone who has $100,000 to put aside at age 20.  Here are your savings after 40 years with 4% interest compounded daily:

$495,259.82, i.e. five times as much.

Here are your savings at today's savings rate at your local bank, about 0.01%:

$100,400.80, i.e. pretty much the same amount as you started with, in fact below the probable rate of price inflation.  (Keep in mind that $100,000 forty years ago had the same purchasing power as $350,427 today, according to AIER's Cost-Of-Living Calculator.  This means you will have LOST purchasing power even with interest on your savings.)

[Data from CalculatorSoup.com and Wells Fargo]

The formerly common 4% versus Wells Fargo's current 0.01% represents a loss of $394,859.02, stolen directly from your pocket by the U.S. Federal Reserve.  Counter-intuitively, it's not really the bank's fault, because the Fed is the one fiddling with interest rates and paying interest on bank reserves, making Wells Fargo less hungry for your money.

'Nuff said.

Disgusting.  Why do we say nothing and let this go on?  We really are a bunch of useless, blind, mindless lemmings.

[Image from Britannica.com]

Wealth Gap Statistics: Mostly Nonsense, but Maybe a Grain of Truth

I am running into more and more information from influential people about the wealth gap.  Here’s an example by Ray Dalio, an influential financier in whom people have great confidence.  

To me, at least at first, it seems like just more gasoline on the fire of leftist hysteria about income and wealth inequality.

By U.S. Department of Agriculture - Flickr: 20130817-FS-UNK-0004, Public Domain, https://commons.wikimedia.org/w/index.php?curid=27895421

Yes, I know the author is giving us statistical nonsense instead of true facts as do others, and as still others have countered.  However, in spite of its statistical errors, this article may have touched on a truly genuine and perhaps justified sentiment of injustice. 

Of course it is full of fake news, i.e. bad science that deserves to be countered.  Of course I have read Philip Magness’s marvelous pieces on income inequality, and I understand that much of what we read is poorly researched (Piketty et al.).  But in my opinion the most important point Dalio’s article makes is that there is truly an injustice that needs to be addressed today, and it has more to do with a slanted playing field that it does with wealth or income per se.

Here is an extract of Dalio’s article, in contrast to his other bad stats, that I think pinpoints the origin of the injustice:

"Central banks’ printing of money and buying of financial assets (which were necessary to deal with the 2008 debt crisis and to stimulate economic growth) drove up the prices of financial assets, which helped make people who own financial assets richer relative to those who don’t own them. When the Federal Reserve (and most other central banks) buys financial assets to put money in the economy in order to stimulate the economy, the sellers of those financial assets (who are rich enough to have financial assets) a) get richer because the financial asset prices rise and b) are more likely to buy financial assets than to buy goods and services, which makes the rich richer and flush with money and credit…."

Personally, this hits a cord.  I can definitely say that I am very miffed–indeed indignant and horrified–that my savings are so little remunerated today.  This is theft pure and simple, perpetrated indirectly by individuals in whom the public has placed its blind trust, i.e. the Federal Reserve.  

Dalio gets it wrong:  This is not capitalism; this is captivation of politicians by bankers.  (You can tell I’ve read Calomiris’s Fragile by Design, a fabulously enlightening book.)  

Also, it is entirely possible that not only are the wealthy buying financial assets more than usual but that, due to economic and political precarity, businesses have chosen to play in the speculative financial sector rather than risk their capital on producing useful things and services, and/or than invest in a trained workforce through higher wages.  

Does this notion not deserve more research?  I think so.  Yes, it’s true that Piketty and Dalio and others get the facts wrong, and I’m ecstatic to see that research institutes such as AIER and others are doing something about this.  But the anti-capitalists do get something right here.  In my words:  

Today’s politicians and their minions are acting in ways that come dangerously close to being criminal.  And perhaps even more significantly, it is precisely from this unjust state of affairs that all the hullabaloo about income and wealth inequality gets its power and influence, even as the rabble-rousers get the details wrong and miss the mark.

The troublemakers may be ineffective at inculpating the wealthy, but they have hit a sensitive nerve of the general public, and this is having an effect.  Free-market supporters need to up their argument.  Countering bad statistics is one thing; finding the underlying problem and convincing the voting public of ways to solve it are quite another.

This is just a thought on a Sunday afternoon.  I wish someone would do something to inform all of us ordinary people, modest savers such as myself who are truly the victims of government's “legalized embezzlement” as Edward C. Harwood used to call it, so that we can make changes through the ballot box.  

("Legalized embezzlement" is Harwood's term for government meddling with the money and credit supply in ways that cause harm to the economy and to the general public, usually through price distortion, sometimes with price inflation (but sometimes not), and through exaggerated stock market, real estate and other market bubbles and subsequent crashes.)

It is the ordinary public that is most devastated by violent economic events caused by diddling with money supply in a fiat-monetary environment.  Someone should explain this underlying monetary injustice to voters.  It surely helps enflame the income-inequality hysteria.  

What might the solution be?  A return to a monetary standard that will ensure that money and credit act not as gasoline on an out-of-control fire, but rather as the water that puts the flames out and allows economic life to thrive.

The Theft Is Now Official Policy

The Federal Reserve has just published a report stating that it will continue to use new policy tools to control interest rates.

As stated in the Wall Street Journal, "The Federal Reserve defended having the flexibility to set interest rates by using relatively new tools that include paying interest to banks, in its semiannual report to Congress on Friday."

For those of you who are subscribed, see the whole article here.

Creating money and inviting the banks to park it at the Fed, with interest, is theft, in my opinion.

[Thanks to gionalepop.it]

Have you any savings at all?  (Hopefully.). Have you noticed the rate of interest you are earning?  (Probably less than 1 percent unless it's in a CD.)  Have you also noted the official (never mind the unofficial) rate of price inflation currently?  (It's creeping towards 3 percent on an annual basis.)

That's a minimum of 2 percent loss of purchasing power per year, when the banks should be competing for our savings.

So who wins in this new Fed game?  The bankers and speculators.  Who loses?  Those who can least afford it, the forgotten men and women of the Western world.

What an embarrassment.

Fed Dots - Tea Leaves By Another Name? or alternatively, The Dot Plot Thickens

My previous post mentions tea leaves as a way for the Fed to determine policy.  I bet you thought I was kidding.  Well, watch this video to see what Fed-watchers are watching.  And just in case you're wondering, it's not a comedy sketch.

[Screen capture from Bloomberg]

[Thanks to J.B. for the neat alternate headline.]

The Fed's Game of Monetary Inflating and How to Put an End to It

[Thanks to Dancendancen.com for the image.]

History has shown unequivocally that you don't want to monkey with money and credit.

This is the cogent warning recently issued by Doug Noland at Prudent Bear. He is referring to the monetary shenanigans of the central banks around the world, the most egregious of which is our very own central bank, the Federal Reserve.

After more than 15 years of almost continuous and increasingly profligate money-credit creation, the Fed is now approaching the moment of truth. In the next few months it will have to put its actions where its mouth is regarding the interest rates under its control.

Up to now, Fed Chairman Janet Yellen has been very good at what we could call the Open-Market Charade. While sounding profoundly straightforward and direct, she actually has bested Alan Greenspan at the art of Fedspeak: talking in soothingly erudite phrases, all the while saying nothing in particular.

But no matter what she says now, the Fed's predicament is clear: It must soon choose between allowing the target rate to climb, which will squeeze the necks of already precarious emerging markets, or keeping the rate low and in the process risking re-devaluation of the dollar and/or blowing even more bubbles in stocks, junk bonds, global derivatives, emerging market currencies, and selected real estate.

The inflated bubbles are right in front of our noses. For example, some condos in the West Los Angeles area have now re-attained their all time highs of 2007, and bankrupt ski resort developments have pulled the shovels out of the trash heap and are at it again. And by the way, that price inflation you're looking for? It's already in the high cost of meat, sugar, poultry and eggs, which have climbed 8.3 percent this year, and in dairy that has climbed 5.6 percent. [Source] Butter has doubled since mid-2013. [Source]

The moment the Fed governors choose the former, i.e. increasing the rates, the music will stop and everyone will head for a chair. Usually in this game there is only one empty chair and hence only one loser, but this time there are far fewer chairs and far too many players. If the music stops watch carefully what will happen to countries like Argentina and Russia. Then watch what will happen to the derivatives and other more speculative markets as investors scramble for seats.

For more on the possibilities under this scenario, see this Investopedia.com article about the carry trade, also heavily involved in the derivatives market; see also this David Wessel article about a possible global financial crisis due to a rising dollar.

On the other hand, if the Fed chooses the latter route and delays rate normalization, it may succeed in holding off the moment of truth for a few more months while the music continues and stock market speculators continue their merry dance. At the same time, America's fixed-income recipients will have no choice but to reach for their handkerchiefs again to mourn a further loss of purchasing power. (Already in 2012, the SeniorsLeague.org reported that seniors have lost 34 percent of their purchasing power since 2000.)

The old and the weak are always the first losers during the exaggerated business cycles caused by fiat-money monetary interference, and Oh My, what enormous and distorted cycles they have become. (See this study from the American Institute for Economic Research on the changing nature of business cycles.) Who are the winners? Debtors, and speculators most of whom are debtors. The biggest debtors of all are governments and financial institutions-who just happen to be co-appointers of their accomplice Fed governors.

What artifice makes this game possible? It is the fiat nature of global currencies. (Read Steve Forbes's latest book for more on this.) What is the solution? We must elect politicians who will free gold from its tax shackles. What shackles?

An act of Congress in 1974 and a legal decision in 1977 already permit the holding of and transacting in gold. (See the text of the 1974 law here and a discussion of the court case permitting gold clauses in contracts.) The only thing preventing gold from playing its traditional role as money is the fact that all gold transactions are taxed, whether it be through sales taxes or capital gains taxes.

Why are they taxed? Because back in the 1970's Congress classified gold as a commodity, kind of like copper or wheat. Why did Congress do this? Because the crafty politicians knew that by doing so the commodity-taxation protocol would immediately take the gold-as-money option off the table. This is what forces us all to accept unsafe fiat "money" instead of the real thing.

Without that handicap, we would not accept it unilaterally. Remove the taxation and gold would become money again. It would find its true exchange rate relative to all currencies (which today would probably be higher than its current $1,200 an ounce). Soon enough, someone would set up a system of international exchange based on gold. The metal would find itself at the center of a new worldwide system of exchange and value storage. Such a system would be much more solid and much more widely accepted than Bitcoin or other alternatives. Call it Bitgold, maybe? And by the way, reinstatement of a proper gold standard is probably not even necessary. Let the markets work out the particulars.

This is not just fanciful thinking. States such as Arizona, Texas, and Utah are discussing the use of gold as legal tender. Highly stable gold would eventually replace highly unstable fiat money, and trillions of dollars and yen and euros, currently wasted on chasing a quick profit and fulfilling the dreams of politicians (and causing worldwide recessions), would be turned back to their rightful purposes: fomenting enterprise, creating jobs, and raising standards of living across the globe. And most important, this new gold-based monetary system would deprive our central money manipulators of the world's most corrupting, devastating, unconstitutional, and destructive monopoly power.

Time to Put the QE Genie Back In Its Bottle

Price inflation seems to be right around the corner, if it isn't already here, which means that the Federal Reserve may soon have to put their QE genie back in its bottle.  At least that's my hope, for the sake of our children's future.

[Thanks to DinoRentosStudios.com for the image.]

The only problem is:  The economy isn't cooperating.  Employment figures, never mind the full-time work force, are stubbornly refusing to increase.  Jobs are not appearing as hoped.  And GDP is not up to expectations.

Hence, the Fed will be faced with a quandary.  And I can't wait to see what happens.  Please click on this link for some further thoughts on the subject.

Bubbles or No Bubbles?

I have vented my unscientific opinion about the existence of asset bubbles in our economy.  If you are interested in this subject, please be so kind as to click on the following link:

Asset Bubbles, How Do I Love Thee?

I need Relief from the Fed

I was reeling with annoyance after reading this presidential statement about the dual mandate of the Federal Reserve:

"The challenge is not inflation, the challenge is we've still got too many people out of work."  (Read more here.)

Now, just what does the Fed have to do with unemployment?


Admittedly, the Fed has two goals mandated by Congress.  First, it should stabilize prices.  Second, it should do whatever possible to bring about full employment.

I have to believe that Congress wasn't thinking straight when they gave the Fed these two jobs.  Neither can be done without unintended consequences, and the second is quasi-impossible.  The Fed is not in the business of making anything or creating businesses that employ people, and it can't force companies to do so.  It has no influence on Congress, the debt, the President, or any particular market players except the banks.  All it can do is pander to Wall Street and keep it solvent a bit longer.

After frothing at my mental mouth and issuing epithets against what I'm certain is pure abject stupidity on the part of those in power, I fell upon this soothing article at Casey Research.  The introduction is what really calmed my frazzled nerves.  If you need refreshment like me, a quick read may do you some good.

Take a look at the main article by Alasdair MacLeod, too.  I like his style.  I do tend to stop nodding my head in agreement, however, where MacLeod affirms that the planets are lining up for price inflation.  He asserts: "Next, expect raw materials and commodities prices to rise as foreign exchanges try to recycle excess currency."

I need more information to buy into this one.  Too many possibilities exist.  Why commodities?  You might ask, why not commodities.  But we might get just more stagnation, more debt, more printing, more "concrete wings," more bank subsidies (low interest rates), more stock market euphoria, and more flapping of the jaws ad nauseum, all keeping this going for months or even years.  (Until it stops, of course.)

Fed Policy and Asset Bubbles

I am convinced that our Federal Reserve Bank's current monetary policy is hurting our economy in a number of ways.  One of these is its effect on the business sector.

I have no proof, being the gadfly that I am; but I have an argument.  I have laid out the tenets of my hypothesis in my latest Seeking Alpha article.  (Please click on the link.)

The Dollar: Biggest Moral Hazard of Them All

Please click here to see this article.

The Biggest Show On Earth Is Coming to Town

Got your agenda marked? The Federal Reserve Board meets this week, and for the first time Chairman Ben Bernanke has decided to face the public immediately afterward in an effort to increase transparency.


[Thanks to Circus Contraption, at SeattleTwist.com for the photo.]

Bernanke will be giving his first real press conference on Wednesday, April 27, 2011, at 2:15 p.m. EDT.

This particular Fed meeting is crucial, because on June 30, 2011, the Fed is planning to end its second round of quantitative easing (Fed purchases of treasury bonds). Through this program they are currently purchasing up to 85 percent of the bonds issued by the U.S. Treasury since November 2010. What will the Fed do next, stop altogether or phase the program out? Future Fed actions are based on current statistics, and the Board might do either, or they might just decide to continue easing a bit longer if the numbers so indicate.

The consensus seems to be that the Fed will stop their purchases but continue trying to hold down interest rates in other ways. However, a consensus does not a crystal ball make.

Bernanke is probably hoping he doesn't gaff and send the world's markets into fits of dyspepsia. The slightest misplaced word, sudden bead of sweat, or uncontrolled twitch of Ben's brow could add an unknown dimension of insecurity to his studied words. Will the end of QE2 cause bonds to fall into a tail spin? Will it turn the recent stock market recovery into a bursting bubble? Will it cause a flight from the dollar? Will a misplaced comma or tremble of the voice start World Recession III?

The other possibility is that the markets see the end of QE2 as they did QE1, i.e. as business as usual. The slight retraction of liquidity could simply displace a sum of money from the stock market to the assumed security of the bond market, without necessarily causing significant disruption in either. Two very prominent U.S. bond dealers are debating this very issue as I write. (See Gross versus Rieder at this Wall Street Journal article.)

My slow-motion movie on "The Economic Crisis of 2008" is unfolding even slower than I thought it would. We've had to wait three years for the denouement even to approach the horizon, but I think it's finally coming.

The next months will be fascinating. Not only do we have the QE2 situation, but we also have much to learn about the upcoming federal budget and debt ceiling, about the candidates for the 2012 election, about the future of the U.S. dollar's hegemony over other fiat currencies, and about the world's opinion of the safety of U.S. treasury instruments as a secure store of value. Any unexpected disruptions in the latter could throw a hard ball to all the Modern Portfolio Theorists, as real life tends to do.

Some even think there's the possibility that America's heyday is coming to an end, just as England's did at the turn of the last century. (See the article at Marketwatch.) I don't believe this quite yet, and I refuse to until I see the results of the latest silent-majority push towards smaller government. If it fails in 2012, i.e. if Obama passes again and both Congress and the Senate weaken in resolve and/or shift towards the left (whether it be Republicans or Democrats), then maybe we should start to worry.

While all this is going on, what can one do with one's money? I'm not an investment advisor, and I'm just as frustrated as the next person with 0.05 percent interest. When people remark that I have been right about gold until now and then ask whether they should get into it at this point, I still must respond that I just can't predict what gold will do in the next year. I do permit myself to say that it looks like we're headed for one of two scenarios:

1. 1970s-style price inflation with a significant rise in gold, and then the subsequent obligatory tightening a-la-Volcker with its healthy contractionary forces (not so much a recession as a readjustment of the previous misalignments of money flows), accompanied by a subsiding of the gold price to a more stable level; or

2. A Japanese-style twenty years or more of stagnation, with prices and GDP remaining relatively tame, held in check by the squeezing of the ordinary wage earner through a bad employment market, caused in turn by political dithering of the kind we saw in the 1990s when Gingrich and the Republicans lost their mojo.

I'll be heating up the popcorn come Wednesday.

The Treasury, the Fed, and Gold

Last week, two experts on the Treasury and the Fed gave a very interesting talk about the two entities' balance sheets. This is especially timely as the President is talking about applying the "leftover" TARP money to a new stimulus venture, and the Treasury is about to vote federal employees an unconscionable pay raise.

This conference was sponsored by the Cleveland-Marshall Libertarians and the Cleveland-Marshall Federalist Society and was called "U.S. Monetary and Fiscal Policy: Going Exponential."


[Thanks to Mathwarehouse.com for the image.]

Just to give you a taste, the following are excerpts from a good review by Kevin Lovach, the Co-Editor in Chief of The Gavel, CSU Ohio:

"[Walker] Todd is a former C-M professor who served as an officer of the Federal Reserve Banks of Cleveland and New York. He joined Case Western Reserve University Professor Emeritus William Pierce in analyzing the Federal Reserve’s monetary policies and federal deficit spending. Pierce served previously as Chair of the Case Economics Department and is a former Libertarian Party gubernatorial candidate.

"Stressing his view that the problems stem from Washington, D.C. and the banking-heavy northeast, Todd said 'the existing Federal Reserve leadership needs to be booted out.' He quipped, 'I’d like to see the Board of Governors hanged first, the New York Fed hanged second, Boston hanged third.'

"Pierce put federal deficit spending for the 2009 fiscal year at 9.9-percent, a figure topped only by spending during and immediately after World War II. He argued that while the economy can handle deficits of three-percent of gross domestic product 'forever,' anything substantially higher 'becomes real money.'"

For the whole review, see Page 9 of The Gavel for December 2009, which you can download at this Cleveland State University page:

The Gavel

To see the conference in its entirety, go to the following page and click on the links. They are around nine minutes each and well worth your time if you want to understand the problems and implications surrounding our exploding national debt and the current precarious Fed balance sheet. They also mention gold as a safe haven and discuss the few other options around.

U.S. Monetary and Fiscal Policy: Going Exponential

The Stress Test: Inspecting the Stable After the Horses Have Gone

[Thanks to Americaswildhorses.com for the photo.]

Even if it's too late, it's good to know that the US Treasury, other Government agencies, and the Federal Reserve are able to do what they were supposed to do all along, i.e. monitor the health of the US banking system. This Federal Reserve white paper amply demonstrates their know-how by detailing the accounting verification procedures they applied in their infamous "stress test" of 19 major US banks, the results of which they now hesitate to divulge to the public for fear of instigating another wave of panic.

This fear harks back to my growing list of examples of government running amuck through inappropriate intervention. Instead of intervening too late, they should have been minding the barn back when it might have turned up some loose beams and posts and kept the horses inside.

What makes this tragic situation worse is that since 2001 the BIS (Bank of International Settlements) has been discussing what to do about what central bank representatives had clearly identified as imbalances in international bank leveraging (e.g. assets vs. capital ratios) and as excessive fiat credit creation.

So where have our central bankers been? Why did it take so long?

Unfortunately, I have no answer to this question.

"[T]he Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the System, bank holding companies, international banking facilities in the United States, Edge Act and agreement corporations, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Board also sets margin requirements, which limit the use of credit for purchasing or carrying securities." [Source. See also this and this.]

Looks like the Fed has spent the last nine years sleeping on the job. Maybe we should start a class action suit for negligence? (Just joking, I think.)

What Went Wrong with Commercial Banking?

Part III

In Tuesday's post, Part I of this series, I told you about economist Edward C. Harwood's 1928 prediction of the 1929 Great Depression in published and unpublished articles. He saw imbalances in the banking sector that were leading us into a breakdown of the economy through a misuse of the banking system.

In Part II of the series, I gave Harwood's description of sound commercial banking, as read in an unpublished article entitled "A Sharp Distinction Should be Made Between Capital Funds and Commercial Credit." He uses the metaphor of characters in a play. Let me remind you of their names: The Earners, the Investor, the Manufacturer, the Retailer, and the Bank. I recommend that you read Parts I and II first, so that you can make better sense of what follows.


[Thanks to Dreamstime.com for the photo.]

I had described his understanding of the relationships among the players and how the Bank's main purpose is to facilitate the distribution of production into the hands of all who contributed to it and therefore deserve a share.

In Act I, the Bank's power to create credit is limited to an amount representing actual products or services coming to market. This is one of the essential characteristics of sound commercial banking, the foundation of any economy.

At the end of the last post, Earners had placed a small portion of their claims to production (otherwise known as purchasing power, or money) in savings accounts at the Bank. They did this for safety and convenience, and also to derive a little income from the Bank's judicial placement of these savings into the hands of proven wise investors like Investor, who is asking for some of these claims (money) to buy more stock from Manufacturer.

Manufacturer has seen that his products sell well and that he could profitably expand by issuing more stock. The savings department of the Bank agrees and offers a loan to Investor, holding Investor's stock as collateral. Note that the Bank's savings department does not create any credit here; quite the contrary. They extend claims already in existence (Earners' savings), taking only a conservative calculated risk on their return with interest.

So far, this Act I scenario represents the correct use of commercial credit and of capital funds. All's well that begins well in our sound commercial banking system.

Act II

Here the situation starts to go awry. We are 1913. Congress thinks it wise and useful to create a national entity that would have two functions: to apply modern technology to grease the wheels of check clearance, and to serve as a back-up reserve of funds to avoid the destructive effects of irrational, panicky bank runs.

Simultaneously, a war is brewing abroad and some in government foresee a need for a source of emergency financing for the military industrial sector should the US get involved.

They hit upon the formula of establishing a master bank that would have the two first functions, and a third function as well: to create credit--temporarily of course--by "monetizing debt," or "buying" US bonds with credit created out of thin air--claimless "money," if you will. (See how real money is actually claims on production in Wednesday's post.)

This extra claimless "money" would circulate throughout the economy and become indistinguishable from real money as it flowed first through those industries that would receive government checks to arm the military machine, and then on into the rest of the economy. Our master bank is named the Federal Reserve, Fed for short.

The formula works well. The war is won, thanks in part to this stimulus scheme. The Fed must now withdraw all that excess credit; but this causes a recession and pain, like withdrawal symptoms. Instead of taking his medicine and cleaning the toxic credit from the banking system, our Fed decides to relax his standards and allow the credit to remain in circulation.

In doing so, he loses control of the amount of credit he has created and finds himself in need of a less painstaking measuring stick. He settles on the price level. This, he thinks, will be just as good a measure of the supply of money, because it is well known that excess money creates general price inflation. This is not always true; but the Fed has good intentions and lots of faith in his knowledge of things monetary. (But we know what the road to hell is paved with, don't we?)

This illusion of wealth and the apparent stability of prices deceive all of our players. The Manufacturer converts his arms factory back into peacetime production. The Investor puts all his savings, plus as much as he can borrow from the now credit-stuffed Bank, into buying the Manufacturer's stock for further expansion. Optimism reigns.

Seeing the success of the Investor and plush with cheap "cash" (really only claimless credit) issued by the Fed, the commercial department of the Bank starts to think of new ways to make money. They begin to create credit accounts for Investor's investments, instead of letting the savings department lend real savings. This credit is not collateralized by sales documents as normal commercial credit would be, but is based only on a mutual appetite for risk-taking--not the commercial Bank's proper function. Leveraging creates more claimless "money" and makes the situation even worse.

(Note that there is a place for speculative investment, but it is not within a healthy commercial banking system. True speculators are fully informed of the risks involved and must be forced to withstand the full consequences of their actions, down to the last penny.)

A few Earners, seeing Investor becoming increasingly wealthy through his stock investments, begin to do likewise. They take their money out of the conservative savings account that now offers only a paltry interest, given that the Bank is flush with Fed "credit" and doesn't need Earners' savings anymore. Earners also start requesting loans from the Bank, and the Bank, now having lost itself in this adventure, begins to provide even more claimless credit "money," based on nothing but Earners' stocks, the Bank's optimistic and foolhardy assessment of risk, and also on the Fed's own example. Remember too that the Fed's mere existence has now "guaranteed" the banking system's equilibrium. (Economists call this "moral hazard.")

Times are good. Even Manufacturer and Retailer put a little of their profit aside to speculate in the stock market, sending stock prices sky high, even though general prices are stable. What's the first thing you think of when you get your first extra income? Buying a home, of course. Money (or this claimless credit hybrid it has become) turns towards the real estate market. A housing boom ensues.

More conservative Earners note that their wages seem to be stagnating, and that a good number of individuals around them are becoming extraordinarily rich. Manufacturers and Retailers are not expanding jobs like they used to, engrossed as they are in making it rich through speculation.

Once again, let's stop the carousel. This is starting to look like a game of musical chairs. When the drugged music of easy credit wears off, as it inevitably will (there being nothing but speculative and ephemeral gains to be claimed with all this claimless money), many Earners will be left chairless, and/or some will be sharing useless pieces of a chair when a rise in general price inflation sucks the value out of their real wealth.

Here we are in 1928, at the brink of the Great Depression.

"Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

Harwood's phrases. "Inflation" as he uses it here refers to the inherently risky "claimless" credit expansion, to be contrasted with healthy expansion spurred by sound commercial credit creation as described in Part I.

Act III takes place one year later in 1929 with the collapse of a stock market bubble and a bursting real estate boom, much like the ones we find ourselves in today.

What makes today's situation worse than 1928 is that back then, the country observed the gold standard, which guaranteed the value of the dollar and limited the amount of risk-credit expansion that could occur. It was indeed the scarsity of gold that forced the Fed to retract credit in 1929. But both gold and the Fed were only doing their job, something the academic community dismisses today as primitive misguided meddling in free markets, which it was not. On the contrary, it was playing by the rules on a gentleman's playing field. Today, it's a game of Scoundrel Takes All, at least until the public wises up--not through more government intervention, but through a reestablishment of basic rules.

Standardization of the monetary unit referent to something of generally perceived and constant value is the second characteristic of sound commercial banking, whether it be gold or something better. (I know of nothing better.)

Today, we have no such disciplinary tools in place, and "claimless" credit expansion has been allowed to expand to a degree never before seen in history. What remains to be seen is whether the very people who allowed this expansion to take place can now persuade it to retract in an orderly manner.

(The public is not blameless. It is we who elected the 1913 Congress in the first place.)

The Origin of This Whole Mess: 1913

Part I

Economists disagree on the identity of the true culprit behind our current crisis. Some blame Wall Street; some blame the progressive politics that pushed Freddie Mac and Fannie Mae beyond their capacity; some blame the profiteering loan brokers, the foxy house flippers, and the naive subprime home buyers in their rush for quick profits. Some blame the Federal Reserve, including me from time to time.


[Thanks to James Montgomery Flagg, the artist, and Wikimedia.org. The image is in the public domain.]

In reality, all of the above had their role, but they are just players in a game, the rules of which are defined by politicians. The origin of the problem lies in the rule changes that caused the demise of sound commercial banking back in 1913.

Before then, good commercial banking had been functioning well, both in England and and the US, for about a century. Business cycle fluctuations, although sometimes painful, managed to keep the profession on the right track. The invention of the Fed in 1913 was supposed to allow banks to weather business cycle downturns without going completely bust because of irrational panic withdrawals that had no justification in the real data.

Morphing onto a national stage out of private banking functions already in development, the Fed's check clearing services and temporary commercial loan facilities were indeed a clever and useful idea. But the politicians discovered that, once the Fed found it could take over the centralized monopoly of legal tender issuance and then credit creation, it could be used for other things than just stabilizing the banking system. And everyone believed the Fed could control this new-found usage and that it would not do any harm.

In preparation for WWI, the government turned to the Fed credit-creation facilities to finance the war. It was a great success. The Fed managed to wrest most of the genie back into the bottle after the war by early 1920; but the temptation was too great and the discipline and privations too onerous, so they allowed over-issuance of credit to continue, ostensibly to help the country out of the recession the war disruption had caused.

The downturn ended in 1921; but the credit issuance continued. The result was 1929. As Doug Noland says in this week's article at Prudent Bear:

"It was understood at the time [during the Great Depression] that our fledgling central bank had played an activist role in fueling and prolonging the twenties boom - that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone."

How true. Very few economists today remember the Fed's role in inflating credit previous to the Depression. On the contrary, everyone, from Keynes to Friedman to Bernanke, believed and continue to believe to this day that the problem lay in too little credit.

Many base their hypothesis that the Fed did not over-expand credit in the 1920s on the fact that the price level was relatively stable. Economist Edward C. Harwood pointed out in published articles that an economy can present over-expansion of the money supply even in a climate of stable prices; and furthermore, that this held true in the 1920s. Outside factors can cause real prices to fall, while an excess of money supply camouflages these factors by keeping prices at the higher level, with no one the wiser.

Furthermore, what these theorists ignore entirely is that the Fed's newly assumed power to unleash the credit genie destroyed sound commercial banking in pretty short order. ("Power tends to corrupt; absolute power corrupts absolutely." Lord Acton)

In an unpublished article written around May of 1928, Harwood described the process by which the art of commercial banking became tainted and was eventually lost. He compared it to a play in three acts. After describing the players and the events of the first two acts, he wrote:

"To date [May 1928], recent business history has paralleled acts one and two of this drama of commerce. Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

He correctly predicted the depression that came one year later. He is one of the few, unfortunately forgotten today.

In the next parts of this blog post, I will go into the details of sound commercial banking, how it was allowed to self-destruct by the creation of the Federal Reserve, and how its destruction led to today's crisis.

Fed Credit: The Latest And Perhaps Next-To-Last Bubble

I can't claim to be the origin of the Fed Credit Bubble idea, because it occurred to me as I read a fantastic piece by one of my favorite analysts, Doug Noland of Prudent Bear.

We've just come out of a huge bubble that consisted of inflated real estate investment and speculative finance credit. The bubble burst and the market began to correct itself, menacing to take a lot of nations' economies with it.

The reaction of our economic leaders was and continues to be to try to maintain a minimum of stability by propping up the various players on the world financial stage as they began to totter, one by one: first the real estate sector with aid to Freddie Mac and Fannie Mae, then the banking sector by saving Bear Stearns and loans to other institutions, then the insurance sector by bailing out AIG, then the automobile sector with handouts to GM and Chrysler, more money and loans to the banking and real estate sectors, more to AIG, recently some more to auto supply companies, more to AIG, and now the credit card and other large ticket item credit sector--an endless list, it would seem.

The central banks of the world, to a varying degree, are performing their propping-up role as the ultimate insurance company, the lender of last resort; and the US Fed, given the universal role of the US dollar as reserve currency, is the one that will be the buck-stops-here Last Lender of All Last Resorts.

As Noland points out, however:

"Our federal government has set a course to issue Trillions of Treasury securities and guarantee multi-Trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires Trillions of securities. After witnessing the disastrous financial and economic distortions wrought from Trillions of Wall Street Credit inflation (securities issuance), [it is possible that] the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness - just as Wall Street finance destroyed theirs."

He's saying that the Fed is going to create the Bubble of All Bubbles, right there in its own house.


[Thanks to Bouncehousesnow.com for the picture]

But just how much air can the US Fed balance sheet withstand, without bursting its own skin? The inflationist central banks are acting on the assumption that they can right the "market failure" (see PS below) through this "temporary" remedy, that the market cannot right itself alone, or at least not without disastrous consequences. But aren't they trying to add air to an already burst bubble?

Instead of curing the problem, they are acting contrary to the market's instinctive corrective hiatus and will end up distorting events even further. How can arbitrarily selective bailouts and the forced financing of government projects--projects that otherwise most likely would not have been financed--do anything except further distort the admittedly slow and cumbersome but essential market reevaluation process?

"[T]he seductive part of [the optimistic] view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming 'stabilization' will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It’s called a debt trap. The Great Hyman Minsky would view it as the ultimate 'Ponzi Finance.'”

Precisely. The ultimate Bubble, created by those who are supposed to help us avoid them altogether.

So how will the world react when this latest bubble bursts? At some point, investors looking to preserve the value of their wealth will realize that there is no investment denominated in an existing national currency that does the trick, and they'll turn to gold, always the last fat lady to sing before the curtain falls and reality sets back in. (By now, you've figured out that I'm somewhat of a gold bug.)

_______

PS: We have no market failure here. On the contrary, the market is functioning perfectly. It is waiting to discover the real price of toxic assets, if only the government and its allies would let it. Rather, it is the market players who have failed us, and more specifically those who would pretend to manage our monetary units. For more on the true source of the real estate and credit bubbles, find yourselves a copy of the March 16, 2009 Research Reports out of the American Institute for Economic Research (annual subscription), and read the piece by Walter M. Cadette entitled "Greenspan the Goat."

Why Isn't the Market Listening?

You've probably seen the Disney film, Fantasia, in the segment called The Sorcerer's Apprentice. Mickey Mouse is the apprentice, and he decides to use some of the sorcerer's magic while the boss is away. The experience is glorious, until he realizes that he can't control it any more and he finds himself drowning in a self-created flood.


[Thanks to Wikipedia.org for the illustration by S. Barth.]

Jean-Claude Trichet, the European Central Bank president, must see the market as a kind of sorcerer who is on his way home to save the day. As the Financial Times tells us (here and here), Mr. Trichet has called on financial markets to "help policymakers rebuild the levels of confidence in the banking system required to kick-start economic growth around the world." He "gave a stark warning to financial markets yesterday to stop putting pressure on banks to hold more capital."

But the market is not the sorcerer. It is the water--neither good nor bad, just flowing, or flooding, or drying up, doing what water does.

Trichet's jawboning reveals that politicians and their appointees, the quasi-government officials, are not part of the solution; they're part of the problem. They are Mickey.

It should be no surprise, then, that Mickey decided in 1913 to take over the powers of the sorcerer by turning a market-suggested financial-market-system convenience--the Federal Reserve clearing house set-up--into a powerful and politically expedient government-like macromanager of our money supply. Nor should it be a surprise when he ends up destroying our economy in the process. (See my article on the Fed, Page 1, Page 2, and Page 3 for more.) He's got the broom now, and things are getting out of hand. Mickey can call on every power he possesses, the water will never heed him.

We shouldn't be disappointed when ordinary humans fail at sorcery. It's not really their fault. Our government agents are themselves part of a bigger "market," in a sense. When we go to the polls and vote for more government intervention in our life, we are expressing our political "market" preference for government sorcery.

In our current crisis, here's an example that shows the pickle their in. This article in the FT says:

"Amid the recrimination and hand-wringing over the causes and consequences of the financial crisis, bankers and policymakers at the World Economic Forum in Davos have identified a new threat to global prosperity: the rise of financial protectionism. The huge state-backed bank bail-outs in Europe and the US, while necessary to prevent a collapse of confidence in the financial system, have forced banks to withdraw from overseas markets in order to concentrate their limited resources at home. ... The sharp reversal of capital flows appears at least partly due to political pressure on banks, especially those that have received large doses of state support, to sacrifice international operations in favour of maintaining lending to domestic consumers and companies. For governments attempting to explain their decision to commit hundreds of billions of taxpayers' money, this is an understandable response."

Likewise, when our factory workers start to hurt, the government becomes protectionist on that front as well. In 1930, Roosevelt's Congress, in response to public pressure to "do something," forced the market to "buy American" by passing the Smoot-Hawley Tariff Act. This Tariff turned out to be one of the main reasons the country didn't recover from the Great Depression until a decade later.

Here's more evidence of the public's growing protectionist spirit in the form of restrictions on purchases of steel with the stimulus package. (At press time, Obama seems to be rethinking this, but he will have to disappoint his base to do anything about it.)

Another example of forthcoming problems for the Sorcerer's Apprentice: The stimulus package won't work the way it's intended. You can't force banks to lend by throwing money at them, because as one banker put it, paraphrased by the Financial Times, "it is difficult to make loans to companies and individuals as most new lending would be loss-making and end up burdening their balance sheets with further writedowns." (FT Article.)

You can't buck the market. Nor can you force home buyers to buy when they know darn well prices will go down even more. Furthermore, when the government borrows money to spend on its own projects, it takes it away from the very people it is trying to help: capital-starved small businesses.

If we step back for a better perspective, clearly we are confronted with a culturo-political phenomenon: People have turned to government to cure a problem of government's own making. That's like asking Apprentice Mickey to solve the water problem.

There is one natural market phenomenon that will get Mickey back onto dry land in the longer run. It is a return to some form of a gold standard. This standard evolved in the marketplaces of the world over the centuries, and it would exist today if government agents had not decided to force their citizens to abandon it by declaring paper money to be our only legitimate legal tender.

Inflation Target: Getting it Right

In today's context of financial disarray, verbal clarity is vital. Many financial commentators, and even some serious economists, make grave errors that sprout from the misuse of terminology.

One of the most mangled of these terms is "inflation." This word has come to mean two different things over the last century, both in the understanding of the public and in the mind of otherwise highly erudite scientific economists. Some speakers and writers mix the two variations within the same paragraph.

Here are the two distinct meanings that they often confuse:

1. [Price] Inflation: The degree of increase in the CPI and other price indices. More and more, this is the meaning used by some of the most influential people in the world today, among them even most of the Federal Reserve Board members, legislators, and former and future presidents. It's the one we all understand when we see the word "inflation" in the news media.

However, there is another, in fact more precise, economic meaning of the term:

2. [Monetary] Inflation: The rise in money supply, i.e. of money and credit, over and above what the market requires, leading always to eventual price distortions. These distortions may manifest themselves in CPI increases, or they may not. They may appear instead as speculative bubbles such as the real estate bubble of 2006. Such bubbles reduce consumer purchasing power, relative to what it would be if there were no bubbles, through the siphoning off of corporate wealth to speculative activity, rather than towards increasing worker wages and funding solid new capital ventures.

This may come as a surprise to you, but this second meaning is the one in Webster's New World College Dictionary, 4th ed., as I noted in my May 2007 post. Here is the exact Webster's quote:

"inflation ... 2a) an increase in the amount of money and credit in relation to the supply of goods and services b) an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power. [emphasis added]."

How amazing to find that Webster's is more precise and on point than most economists today, including the research staff and board of the Federal Reserve, the very people harnessed with the responsibility for controlling the same phenomenon that they cannot define or use correctly in their research--with dire consequences.

In a recent article by Krishna Guha of the Financial Times, we learn that the US Federal Reserve is moving "to establish a de facto inflation target in order to shore up inflation expectations and reduce the risk of deflation." This "inflation target" would be based on a measurement of the "personal consumption expenditure deflator on average over the medium term." The "personal consumption expenditure deflator" [PCECTPI] is the measuring stick used by the Fed to calculation the "rate of inflation."


[Thanks to Joe-ks.com for the image.]

Admittedly, the Federal Reserve has an impossibly fuzzy mandate. (See my Los Angeles Business Journal article, Page 1, Page 2, and Page 3.) They are supposed to (1) maintain full employment, and (2) control "inflation." But which one? The text of the law is unclear.

My cursory study of a number of the Federal Reserve's research papers, including this one written by Ben Bernanke, allows us to draw the conclusion that the Fed believes they can best fulfill their dual mission by maintaining "price stability," and that they see a clear cause-and-effect relationship between "zero inflation" and "price stability."

It would seem, then, that the Fed does not see any other way of measuring the appropriate amount of money and credit the system needs other than by trying to interpret the effects of their monetary adjustments on general prices, as seen in their version of the CPI, the above-mentioned PCECTPI.

Is that the way to measure the efficacy of their monetary interventions? I don't think so.

For example, I can think of a number of situations that would show zero inflation on the PCECTPI statistics, i.e. perfect "price stability" according to the Fed, but where the public would be the victim of monetary theft through reduction of purchasing power (which is mentioned in the text of law, if my memory serves). Here's one:

Imagine a new technology that cuts the cost of production of all manufactured things in half. (Over a period of a few decades, such advances have done exactly that, if not more.) Imagine that the Fed, by targeting "price stability," allows the money supply to reach a point where it causes the price index to read zero, or perfect price stability. (They currently are not aiming at zero, but rather 2 percent annual increase.) Isn't it clear that, over time, at price stabilization, their actions would be forcing us all to pay at least twice as much as our products are worth?

This sounds like an exaggeration, and I realize that it doesn't take into account the increases in our wages. But this is essentially what the Federal Reserve has done. And have our wages truly kept pace with price inflation? Certainly not in the last few years.

But where has monetary excess gone if it isn't in general prices? It has gone into the hands of our more playful producers and speculators, to create the dot-com boom and the more recent real estate and Wall Street bubbles. Why work for a living when you can make more money so much more easily by playing poker?

The Fed's major booboo in economic analysis stems from--well, first of all from their lack of humility, but also from their underlying confusion of the difference between Price Inflation and Monetary Inflation.

What the Fed needs to fight is "inflation" as defined in Webster's dictionary, i.e. excessive money and credit creation; and targeting price stability will just not do the trick.

However, they are bankers, not supermen. We may have given them an impossible task. And if they can't find a modern tool to do a better job, they should reinstate one that has functioned pretty well for centuries, a monetary measuring stick (gold has worked pretty well), so that the market can find money-and-credit equilibrium itself.

Fed Comes to Debtors' Rescue

The Fed announced today that it will allow its target rate to reach zero percent.


[Click on the image for a larger version of my latest cartoon.]

Up until now, the Fed has tried to bend its legal parameters just enough to absorb some of the bad debts of our banks and financial institutions in exchange for good credit, in order to prevent what they fear would be an economic crisis. (And for the moment, these are just fears.)

Today they announced that they will proceed forward with their intention to buy Treasuries outright, in an effort to replace the credit they think we are desperate for.

From today's statement:

"As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities."

Just as debtor nations have done in the past, the USA has once again decided to turn on the printing presses to save debtors. From my understanding of this commentary by Walker Todd of the American Institute for Economic Research, or of this one, the steps the Fed is about to take are inflationary. The Fed seems to be doing what it can to fight deflation through inflating the money supply, a counterproductive measure at best.

What the Fed should be (and probably is) afraid of is not so much deflation per se, but rather a deflationary spiral that causes fragile yet economy-essential entities to collapse. The problem is that they can't act on the deflationary spiral without stopping the deflating itself.

They will end up artificially propping up already inflated bubble-prices that are trying to right themselves through the deflating process.

Something I think we all forget is that when prices go down (i.e. deflate, in the loose sense of the term), we all get richer. When gasoline, bread, meat, lettuce and rice get cheaper, our purchasing power increases.

Inflation does the opposite. It favors debtors and makes the rest of us--and even the debtors themselves--all the poorer by decreasing our purchasing power relative to our income.

When you have an inflating of the money supply in a deflationary environment, you get the equivalent of a bubble under the surface, i.e. an unstable propping up of prices concomitant with the reduction of real wages.

Inflating may save the debtors, but it will only do so through the impoverishment of all of us.