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Medicine Worse Than the Illness?
(Dec 25, 2008)
James Grant (WSJ - Dec 20, 2008)
A better question would
be the statement: "The Medicine IS the Illness."
-- FM Duck
world ran out of trust in 2008 -- but there is no shortage of money because
the Fed is printing like mad. It's the wrong approach, with
potentially dire consequences."
-- James Grant, author of
Mr. Market Miscalculates
DC – It is a sorry place at which we Americans find ourselves this none-too
festive holiday season. The biggest names on Wall Street have gone to
their rewards or into partnership with the U.S. Treasury. Foreigners
stare wide-eyed from across the waters. A $50 billion Ponzi scheme
(baited with, of all things in this age of excess, the promise of low,
spuriously predictable returns)? Interest rates over which tiny
Japanese rates fairly tower? Regulatory policy seemingly set by a
weather vane? A Federal Reserve that can't make up its mind: Is
it in the business of central banking or of central planning? And to
think -- our disappointed foreign friends mutter -- all of these enormities
taking place under a Republican administration.
entered a bear market in 2008, complementing and perhaps surpassing the
sell-offs in stocks, mortgages and commodities. Never to be confused
with angels, we humans seem to outdo ourselves when money is on the line.
So it is that Bernard Madoff, supposed pillar of the community, stands
accused of perpetrating one of the greatest hoaxes since John Law discovered
the inflationary possibilities of paper money in the early 18th century.
Barely nudging Mr.
Madoff out of the top of the news was the Federal Reserve's announcement last
Tuesday that it intends to debase its own paper money. The year just
ending has been a time of confusion as much as it has been of loss.
But here, at least, was the bright beam of clarity. Specifically, the
Fed pledged to print dollars in unlimited volume and to trim its funds rate,
if necessary, all the way to zero. Nor would it rest on its laurels
even at an interest rate low enough to drive the creditor class back to
work. It would, on the contrary, "continue to consider ways of using
its balance sheet to further support credit markets and economic activity.
Wall Street that
day did handsprings. Even government securities prices raced higher,
as if, somehow, Treasury bonds were not denominated in the currency with
which the Fed had announced its intention to paper the face of the earth.
Economic commentators praised the central bank's determination to fight
deflation -- that is, to reinstate inflation. All hands, including
President-elect Obama, seemed to agree that wholesale money-printing was the
answer to the nation's prayers.
One market, only,
registered a protest. The Fed's declaration of inflationary intent
knocked the dollar for a loop against gold and foreign currencies. In
many different languages and from many time zones came the question, "Tell
me, again, now that the dollar yields so little, why do we own it?"
It was on Oct 6,
1979, that the then-Fed Chairman Paul A. Volcker vowed to print less money to
bring down inflation. So doing, he closed one monetary era and opened
another. With Tuesday's promise to print much more money, the Federal
Reserve of Ben S. Bernanke has opened its own new era. Whether Mr.
Bernanke's policy of debasement will lead to as happy an outcome as that
which crowned the Volcker anti-inflation initiative is, however, doubtful.
Whatever the road to riches might be paved with, it isn't little green
pieces of paper stamped, "legal tender."
Our troubles, over
which we will certainly prevail, stem from a basic contradiction. The
dollar is the world's currency, yet the Fed is America's central bank.
Mr. Bernanke's remit is to promote low inflation, high employment and
solvent finance -- in the 50 states. He wishes the Chinese well, of
course, and the French and the Singaporeans and all the rest besides, but
they don't pay his salary.
They do, however,
buy the U.S. Treasury's bonds, which frames the emerging American dilemma.
If the Fed is going to create boatloads of depreciating, non-yielding dollar
bills, who will absorb them? Who will finance the Obama
administration's looming titanic fiscal deficits? Who will finance
America's annual surplus of consumption over production (after 25 more or
less continuous years, almost a national trait)? Inflation is a kind
of governmentally sanctioned white-collar crime. Every crime needs a
dupe. Now that the Fed has announced its plan to deceive, where will
it find its victims?
Mr. Bernanke has
good reason to worry about the economy. We all do. In the boom,
a superabundance of mis-priced debt led countless people down innumerable
blind investment alleys. E-Z credit financed bubbles in real estate,
commodities, mortgage-backed securities and a myriad of other assets.
It punished saving and encouraged speculation. Imagine a man at the
top of a stepladder. He is up on his toes reaching for something.
Call that something "yield." Call the stepladder "leverage." Now
kick the ladder away. The man falls, pieces of debt crashing to the
floor around him. The Fed, watching this preventable accident unfold,
rushes to the scene too late. Not only did Bernanke et al. not see it
coming, but they actually egged the man higher. You will recall the
ultra-low interest rates of the early 2000s. The Fed imposed them to
speed recovery from an earlier accident, this one involving a man up on a
stepladder reaching for technology stocks.
cause of these mishaps is the dollar and the central bank that manipulates
it [Emphasis added]. In ages past, it was so simple. A central banker had one job
only and that was to assure that the currency under his care was
exchangeable into gold at the lawfully stipulated rate. It was his
office to make the public indifferent between currency or gold. In a
crisis, the banker's job description expanded to permit emergency lending
against good collateral at a high rate of interest. But no
self-respecting central banker did much more. Certainly, none
arrogated to himself the job of steering the economy by fixing an interest
rate. None, I believe, had an economist on the payroll. None
facilitated deficit spending by buying up his government's bonds. None
cared about the average level of prices, which rose in wartime and sank in
peacetime. It sank in peacetime because technological progress and the
opening of new regions to agricultural production made merchandise and
commodities cheaper and more abundant.
Not everyone agreed
that these arrangements were heaven-sent. In comparison to the rigor
of the gold standard, paper money seemed, to many, an intelligent and
forgiving alternative. In 1878, a committee of the House of
Representatives was formed to investigate the causes of the suffering of
working people in the depression that was five years old and counting.
Not a few witnesses pleaded for the creation of more greenbacks. They
asked that the government not go through with its plan to return to the gold
standard in 1879. But the nation did return to gold -- it had financed
the Civil War with paper money -- and the depression ended in the very same
Gold is a hard
master, and a capricious one, too, insofar as growth in the world's monetary
base depends on the enterprise of mining engineers. But, as we have
seen lately, there is no caprice like the caprice of sleep-deprived
Mandarins improvising a monetary solution to a credit crisis (or, for that
matter, of fully rested Mandarins setting interest rates by the lights of
their economic models).
The times were hard
in the 1890s, but Americans repeatedly spurned the Populist cries for a
dollar you didn't have to dig out of the ground but could rather print up by
the job lot. "If the Government can create money," as a hard-money
propagandist put it in an 1892 broadside entitled "Cheap Money," why should
not it create all that everybody wants? Why should anybody work for a
living? And -- in a most prescient rhetorical question -- he went on
to ask, "Why should we have any limit put to the volume of our currency?"
A couple of panics
later, the Federal Reserve came along -- the year was 1913. Promoters
of the legislation to establish America's new central bank protested that
they wanted no soft currency. The dollar would continue to be
exchangeable into gold at the customary rate of $20.67 an ounce. But,
they added, under the Fed's enlightened stewardship, the currency would
become "expansive." Accordian-fashion, the number of dollars in
circulation would expand according to the needs of commerce and agriculture.
Republican senator from New York, thought he smelled a rat.
Anticipating the credit inflations of the future and recalling the
disturbances of the past, Mr. Root attacked the bill in this fashion:
"Little by little, business is enlarged with easy money. With the
exhaustless reservoir of the Government of the United States furnishing easy
money, the sales increase, the businesses enlarge, more new enterprises are
started, the spirit of optimism pervades the community.
"Bankers are not
free from it," Mr. Root went on. "They are human. The members of
the Federal Reserve board will not be free of it. They are
human...Everyone is making money. Everyone is growing rich. It
goes up and up, the margin between costs and sales continually growing
smaller as a result of the operation of inevitable laws, until finally
someone whose judgment was bad, someone whose capacity for business was
small, breaks; and as he falls he hits the next brick in the row, and then
another, and then another, and down comes the whole structure."
"That, sir," Mr.
Root concluded, "is no dream. that is the history of every movement of
inflation since the world's business began, and it is the history of many a
period in our own country. That is what happened to greater or less
degree before the panic of 1837, of 1857, of 1873, of 1893 and of 1907.
The precise formula which the students of economic movements have evolved to
describe the reason for the crash following the universal process is that
when credit exceeds the legitimate demands of the country the currency
becomes suspected and gold leaves the country."
Little did Mr. Root
suspect that the dollar would lose its gold backing altogether -- that,
starting in 1971, there would be nothing behind it more than the good
intentions of the U.S. government and (somewhat more substantively) the
demonstrated strength of the U.S. economy. Still less could he have
guessed that the world would nonetheless fall in love with that
uncollateralized piece of paper or -- even more astoundingly -- that the
United States would enjoy so great a reservoir of good will that it would be
allowed to borrow its way to a net international investment position of
minus $2.44 trillion ($17.64 trillion of foreign assets held by Americans
vs. $20.00 trillion of American assets held by foreigners). "It goes
up and up," Mr. Root said of the inflationary cycle, but just how high he
could not have dreamt.
Knowledge of the precepts
of classical central banking prepared no one to understand, much less to
anticipate, the Fed's conduct in this credit crackup. The central bank
is lending freely, all right, but not at the stipulated "high" interest
rate. As a matter of fact, it is starting to lend at a rate below
which there is no positive rate. The gold standard was objective.
Modern monetary management is subjective (under Alan Greenspan, it was
intuitive). The gold standard was rules-based. The 21st century
Fed goes with what works -- or seems to work. What it hopes is going
to work for the fellow who fell off the stepladder is more debt and more
dollars. Just how much of each can be found every Thursday evening on
the Fed's own Web site. Open up form H4.1 and prepare to be amazed.
Since Labor Day, the Fed's assets have zoomed to $2.31 trillion from $905.7
billion. And what is the significance of this stunning rate of asset
growth? Simply this: The Fed pays for its assets with freshly
made dollars. It conjures them into existence on a computer;
"printing" is a figure of speech.
In this crisis, the
Fed's assets have grown much faster than its capital. The truth is
that the Federal Reserve is itself a highly leveraged financial institution.
The flagship branch of the 12-bank system, the Federal Reserve Bank of New
York, shows assets of $1.3 trillion and capital of just $12.2 billion.
Its leverage ratio, a mere 0.9%, is less than one-third of that prescribed
for banks in the private sector. Such a thin film of protection would
present no special risk if the bank managed by Timothy F. Geithner, the
Treasury secretary-designate, owned only short-dated Treasurys.
However, the mystery meat acquired from Bear Stearns and AIG foots to $66.6
billion. A write-down of just 18.3% in the value of those risky
portfolios would erase the New York Fed's capital account. In
congressional testimony eight years ago, Laurence Meyer, then a Fed
governor, tried to allay any such concerns (which then must have seemed
remote, indeed). "Creditors of central banks...are at no risk of a
loss because the central bank can always create additional currency to meet
any obligations denominated in that currency," he soothingly reminded his
Yes, today's policy
makers allow, there are risks to "creating" a trillion or so of new currency
every few months, but that is tomorrow's worry. On today's agenda is a
deflationary abyss. Frostbite victims tend not to dwell on the
summertime perils of heatstroke.
But the seasons of
finance are unpredictable. Prescience is rare enough in the private
sector. It is almost unheard of in Washington. The credit
troubles took the Fed unawares. So, likely, will the outbreak of the
next inflation. Already the stars are aligned for a doozy. Not
only the Fed, but also the other leading central banks are frantically
ramping up money production. Simultaneously, miners are ramping down
commodity production -- as if, for instance, is Rio Tinto, the heavily
encumbered mining giant, which the other day disclosed 14,000 layoffs and a
$5 billion cutback in capital expenditure. Come the economic recovery,
resource producers will certainly increase output. But it is far less
certain that, once the cycle turns, the central banks will punctually
The public has been
slow to anger in this costliest and scariest of post World War II financial
crises. Wall Street and the debt ratings agencies have come in for
well-deserved castigation. But pointing fingers rarely find the
Federal Reserve, whose low, low interest rates helped to set house prices
levitating in the first place.
After Mr. Bernanke
gets a good night's sleep, he should be called to account for once again
cutting interest rates at the expense of the long-suffering (and possibly
hungry) savers. He should be asked to explain how the central-banking
methods of the paper dollar era represent any improvement, either in
practice or theory, over the rigor, elegance, simplicity and predictability
of the gold standard. He should be directed to read aloud the text of
critique by Elihu Root and explain where, if at all, the old gentleman went
wrong. Finally, he should be directed to put himself into the shoes of
a foreign holder of U.S. dollars. "Tell us, Mr. Bernanke," a
congressman might consider asking him, "if you had the choice, would you
hold dollars? And may I remind you, Mr. Chairman, that you are under
oath?" -- FM Duck
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