This was clearly a public relations stunt. Why would the head of the world’s most powerful central bank lecture to 30 undergraduates? This was not quite the equivalent of George W. Bush reading “My Pet Goat” to third graders, but it was close. Think of it as “My Pet Peeve.” His first speech was an overview of central banking. He used PowerPoint to create slides. The presentation had 49 slides.

Any experienced lecture listener, had he known of this in advance, would have headed toward the exit. Here is the man whose verbal skills produce narcolepsy in normal people who have slept at least 10 hours. To this he added 49 slides. This violated Guy Kawasaki’s 10-20-30 rule: 10 slides, 20 minutes, 30-point font. The slides are here.

UNDERGROUND GOLD

In his speech, he introduced some of the classic arguments of the fiat money advocates. Warren Buffett has invoked it:

Gold gets dug out of the ground in Africa, or someplace. “Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

This was Buffett’s reply to his father’s policy of defending the gold standard in Congress in the late 1940s. His father had far greater understanding of the gold standard than he does.

The thought of all those itching Martian heads apparently bothers Bernanke, too. So, he repeated the argument.

“Now, unfortunately, gold standards are far from perfect monetary systems. One small problem which is not on the slides but I’ll just mention is that there’s an awful big waste of resources. I mean, what you have to do to have a gold standard is you have to go to South Africa or some place and dig up tons of gold and move it to New York and put it in the basement of the Federal Reserve Bank in New York, and, that’s a lot of effort and work and it’s a, you know, it’s a – Milton Friedman used to emphasize that that was a very serious cost of a gold standard that all this gold was being dug up and then put back into another hole. So there is some cost to having a gold standard.”

There is “some cost” to having a gold standard. This means that we must pay for services rendered. Will wonders never cease! There are costs in this life! I’m telling you, this fellow Bernanke is on the cutting edge of economic science.

It’s a shame that he did not have a slide for this, even though that would have meant 50 slides.
Back in 1969, I dealt with this argument. Bernanke was 15 at the time. He must have missed it.

I begin with his first statement: “Now, unfortunately, gold standards are far from perfect monetary systems.” So, let me assure you, is central banking.

****

We live in an imperfect universe. We are not perfect creatures, possessing omniscience, omnipotence, and perfect moral natures. We therefore find ourselves in a world in which some people will choose actions which will benefit them in the short run, but which may harm others in the long run. The gold miner, by diluting the purchasing power of the monetary unit, achieves short-run benefits. Those on fixed incomes are faced with a restricted supply of goods available for purchase at the older, less inflated, price levels. This is a fact of life.

Nevertheless, Professor Mises has defended gold as the great foundation of our liberties precisely because it is so difficult to mine. It is not a perfect mechanism, but its effects are far less deleterious than the power of a monopolistic state or licensed banking system to create money by fiat. The effects of gold are far more predictable, because they are more regular; geology acts as a greater barrier to inflation than can any man-made institutional arrangement. The booms will be smaller, the busts will be less devastating, and the redistribution involved in all inflation (or deflation, for that matter) can be more easily planned for.

Nature is niggardly; that is a blessing for us in the area of monetary policy, assuming we limit ourselves to a monetary system tied to specie metals. We would not need gold if, and only if, we could be guaranteed that the government or banks would not tamper with the supply of money in order to gain their own short-run benefits. So long as that temptation exists, gold (or silver, or platinum) will alone serve as a protection against policies of mass inflation. . . .

Money, it will be recalled, is useful only for exchange, and this is especially true of paper money (gold, at least, can be made into wedding rings, earrings, nose rings, and so forth). If there is no reason to mistrust the American government, the paper bills will probably be used by professional importers and exporters to facilitate the exchange of goods. The paper will circulate, and no one bothers with the gold. It just sits around in the vaults, gathering dust. So long as the governments of the world refuse to print more paper bills than they have gold to redeem them, their gold stays put. It would be wrong to say that gold has no economic function, however. It does, and the fact that we must forfeit storage space and payment for security systems testifies to that valuable function. It keeps governments from tampering with their domestic monetary systems.

****

I used paper money as my example. Of course, digital money is what we have today. Still, a major function of gold in the vault is that it tells us if the monetary authorities are cheating.
Once the gold standard is renounced, we know the monetary authorities are cheating.

IN DEFENSE OF CHEATING

Bernanke was forthright about this. He defended cheating.

“But there are some other more serious financial and economic concerns that practical experience showed were part of a gold standard. One of them was the effect of a gold standard on the money supply. Since the gold standard determines the money supply, there’s not much scope for the central bank to use monetary policy just to stabilize the economy.”

As the Head Cheater in Charge, the Prince of Greenness himself, he proclaimed the wisdom of legalized counterfeiting. Why? Because the gold standard produces high interest rates.
And in particular, under a gold standard, typically the money supply goes up and interest rates go down in periods of strong economic activity. So that’s the reverse of what a central bank would normally do today.

Excuse me? The money supply goes up under a gold standard? When did that happen, and for how long? When did this happen when it was not followed by a run on the nation’s gold supply? That is what the gold standard does. It gives holders of fiat money the power to force the central bank or treasury to cease inflating. The run on gold forces the monetary authorities to stop inflating.

FIXED EXCHANGE RATES

Then he offered this reason for not establishing a gold standard.

“There are other concerns also with the gold standard. Now, one of the things that a gold standard does is it creates a system of fixed exchange rates between the currencies of countries that are on the gold standard. So for example, in 1900, the value of a dollar was about 20 dollars per ounce of gold. At the same time, the British set their gold standard in saying, roughly, roughly 4 pounds, 4 British pounds per ounce of gold. So 20 dollars equals 1 ounce of gold, 4 pounds equals 1 ounce of gold, so 20 dollars equals 4 pounds. So what that’s saying is basically that a pound is 5 dollars. So essentially, if both countries are on the gold standard, the ratio of prices between the two exchange rates is fixed. There’s no variability as we see today when the Euro can go up and the Euro can go down. Now, again, some people would argue that’s beneficial, but there is at least one problem which is that if there are shocks or changes in the money supply in one country and perhaps even a bad set of policies, other countries that are tied to the currency of that country will also experience some of the effects of that.”

He argued that a bad policy in one nation forces the other nation to mimic the bad policy. This is Bernanke’s version of Gresham’s Law: bad policies drive out good policies.
How is it that a bad policy on a free market is so successful in spreading to other free markets? The traditional defense of free markets is that good policies prevail. Wise monetary policies triumph. But Bernanke does not believe this. Under a gold standard, such benign results turn malign. How, he did not say.

What is wrong with his argument? This. A bad economic policy in one nation produces inflows or outflows of gold. If a nation inflates, holders of its currency demand payment in gold. The gold flows out of the central bank or treasury. Soon, the authorities must change the policy.

Then there might be a policy of monetary deflation. The nation’s goods become cheaper. Residents in other nations turn in gold at the fixed rate and buy the deflationary nation’s currency. Why? To buy the nation’s cheaper goods. This raises the monetary base (gold) and reverses the monetary deflation.

Bernanke mistakes cause and effect. The fixed currency exchange rate system is not fixed by law under a gold standard. The currency exchange rates fluctuate in terms of domestic monetary policies and the currency speculators’ expectations. What is fixed is the price of gold as denominated in each domestic currency.

Currency exchange rates can and does fluctuate. But if one nation’s policies deviate from another nation’s policies, gold flows in or flows out. Good policies drive out bad policies, as is true under a free market. This is because Bernanke has this backwards. He is a Keynesian. He has economic cause and effect backwards across the board, not just in monetary theory.

The fixed exchange rate system was not a factor in the era of the international gold standard, 1815-1914. There were no exchange rate agreements. Fixed exchange rates set by governments began in 1922 at the Genoa Conference, where governments agreed to the phony gold standard known as the gold exchange standard. Here, fixed currency exchange rates by government agreement were substituted for gold coin redemption on demand, which had prevailed prior to World War I.

Fixed exchange rates among currencies have never existed. What existed from 1815 to 1914 was a system of fixed exchange rates between a national currency and the price of gold in that currency. The moderately fluctuating currency rates were an effect of the legally fixed exchange rate between gold and each national currency.

Bernanke does not understand the difference between legally fixed exchange rates among currencies and fixed exchange rates between a specific currency and gold, That is to say, he does not understand the 19th-century gold standard.

This seems inconceivable. But Keynesians do not understand prices and markets, so I suppose it should not be surprising that Bernanke does not understand the traditional gold standard that he adamantly rejects.

POWER TO THE PEOPLE – NOT!

Central bankers do not like their judgments called into question by the rabble – “rabble” being defined as people who hold a nation’s currency. These people may decide that central bankers are following policies that put their money at risk. So, they demand gold. This is an outrage. It must be stopped.

“Yet another issue with the gold standard has to do with speculative attack. Now normally, a central bank with a gold standard only keeps a fraction of the gold necessary to back the entire money supply. Indeed, the Bank of England was famous for keeping, as Keynes called it, a thin film of gold. The British Central Bank only kept a small amount of gold, and they relied on their credibility to stand by the gold standard under all circumstances to – so that nobody ever challenged them about that issue. But if for whatever reason, if markets lose confidence in your willingness and your commitment to maintaining that gold standard relationship, you can get a speculative attack. This is what happened in 1931 to the British. In 1931, for a lot of good reasons, speculators lost confidence that the British pound would stand gold, so just like a run on the bank, they all brought their pounds to the Bank of England and said, “Give me gold.” And it didn’t take very long before the Bank of England was out of gold cause they didn’t have all the gold they needed to support the money supply and then, there was essentially – they’ve essentially had to leave the gold standard, so there was a lot of financial volatility created by this attack on the gold standard.”

He did not mention that George Soros did this to the British pound and Malaysia’s currency, and this was long after the gold standard was scrapped. Currency speculators “pays their money and takes their chances.” They can break government monetary policies when central bankers tell really big lies. They can make fortunes, Soros has.

So, the complaint against the gold standard in this regard is a smoke screen.

STABLE PRICES

Then he conceded to gold’s defenders what they have always said.

“And finally, just one last word on the gold standard, one of the strengths that people cite for the gold standard is that it creates a stable value for the currency. It creates a stable inflation, and that’s true over very long periods. But over shorter periods, maybe up to 5 or 10 years, you can actually have a lot of inflation, rising prices, or deflation, falling prices, in a gold standard. And the reason is that in a gold standard, the amount of money in the economy varies according to things like gold strikes. So for example, if United States, if gold was discovered in California and the amount of gold in the economy goes up, that will cause an inflation, whereas if the economy is growing faster and there’s a shortage of gold, that will cause a deflation. So over shorter periods of time, you frequently had both inflations and deflations. Over very long periods of time, decades, prices were quite stable.”

The only case he offered was California, 1848-52. This has not happened since then.

In fact, a gold standard, when accompanied by rising output, produces falling prices: “More goods chasing a fixed quantity of money.” That is what happened in late 19th-century America.

CONCLUSION

Ben Bernanke has a pet peeve. It has to do with power – specifically, his. He does not like it when common people have the power to tell him and his Ph.D.-holding peers that they don’t know what they are doing. The common man can veto Bernanke and his peers by cashing in dollars for gold. He resents this.

The money supply should be supplied by the free market, under the laws of contract. The government should not be in the money business.

End the FED.

Regards,

Gary North

Bernanke’s Pet Peeve: The Gold Standard was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Sharp falls in the gold price have prompted some bears or pessimists to predict it will plunge below $1,000 (£625) an ounce.”

…

“Goldcore priced bullion at $1,721 or £1,079 per ounce this morning, compared to yesterday’s fix of $1,788 or £1,121 per ounce. A spokesman said: ‘The massacre is attributed to a host of different reasons — from month end book squaring to Bernanke’s suggestion that ultra loose monetary policies may soon come to an end.’“

…

“Brian Dennehy of independent financial advisers (IFAs) Dennehy Weller commented: “Yet again the ‘safe haven’ myth of gold has exploded. It went down during intraday trading by about $100.

“‘This doesn’t mean the bull market has ended. It just means that when you buy gold you must do so with your eyes open — it is a highly volatile fringe asset.

“‘Our technical analysis suggests one of two possibilities. That the bull run is over and the price will eventually work its way down into the $700 to $1,000 range — or one final high lies just ahead before that large correction towards $1,000 will begin.’”

Source: Telegraph

The only serious reason given for this recent volatility and rapid drop in the price of gold is that Fed Chairman Ben Bernanke promised he wouldn’t engage in more money printing. However, as is generally the case when discussing capital flows of hundreds of billions of dollars, things are just a bit more complicated than that.

It’s no secret that the gold markets are completely manipulated by large financial institutions and interested parties within our government that are intent on keeping the price as low and/or volatile as possible.

What better way to scare the masses away from true value than to create such extreme price swings in both directions that the misperception of risk and constant attacks by mainstream media experts diverts capital from one of the few true safe havens into the fabricated safety of, say, US dollar backed Treasury bonds? After all, unlike the US dollar which is backed by the full faith and credit of the United States, gold is backed by nothing!

For those paying attention, there is a distinct effort by high level public officials and influential financial leaders to marginalize the value of gold as a safe haven asset. Ben Bernanke, for example, in testimony before Congress last year, made it clear that he does not believe gold is money.

Yet, any time that US dollar hegemony is threatened anywhere in the world, be it because of gold or oil, the response by financial institutions and government alike is unmistakable and severe. Sadaam Hussein’s demise is a direct result of his unwillingness to cooperate. Bernard Von NotHaus was labeled a domestic terrorist and imprisoned by the Department of Justice for his attempts to introduce a purely precious metals based system of exchange in the US. And most recently the Pan Asian Gold Exchange, which promised to level the playing field and allow for fair global price discovery of precious metals, was curtailed before it ever had a chance to get off the ground because, as SGT Report details, it “posed an enormous threat to the existing fractional reserve bullion banks.”

We advised our readers to expect exactly these manipulations:

“It will be an extremely volatile ride going forward, perhaps to the point where you’ll hate your gold so much you’ll want to spit on it. But don’t sell unless you’re sure that global crisis has turned to recovery and growth.

“Gold will eventually become the ultimate bubble — you can bet on it!”

Via: You’ll Hate Your Gold So Much You’ll Want to Spit On It [July 2010]

So, while we will hear that the gold bubble has burst, and that gold is a relic of the past, and that the economies of the world are recovering, remember that we have been told nothing but lies for decades. Ben Bernanke’s promises to limit monetary intervention mean absolutely nothing. Remember when he told us that there was no risk of a bubble in real estate? Or when he said that the collapse of sub-prime mortgages was contained? Keep that in mind as you take in all of the expert opinions from or benevolent leaders.

Trillions of dollars are being stolen as we speak. Governments around the world are collapsing. Instability, not recovery, is the order of the day. Thus, when the experts make a promise about something, you can fully expect exactly the opposite.

Yes, there will be volatility in gold, especially if we see a collapse in Europe, or if the government is able to maintain the perception of recovery among the masses. But be assured that if gold collapses, it won’t be alone. Asset price volatility is one of the few predictions we can make as the global economic, financial and political systems seize up.

However, unlike most assets, gold and silver have stood the test of time, especially during economic and political climates such as that in which we find ourselves today.

Given that we’ve been forced by a debilitated and collapse-prone global environment to make the choice of where to invest our time-energy yield (i.e. money), we feel much more confident investing in commodities that carry no counter-party risk, as opposed to assets denominated in paper receipts and derivatives of those receipts.

Investments like precious metals, food, personal energy production, and individual skills development, are the few assets we’re willing to consider.

Yes, there’s always the possibility of ‘losing’ value in our investment, but at least those assets will NEVER go to zero.

Regards,

Mac Slavo

SHTFPlan

Analysts Predict Gold Will Plunge Below $1000 was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

They all ask some version of the same question, in any case. It’s the cocktail-hour question asked of every economist: What does the future hold and what should be done about it? The problem is that Bernanke doesn’t know more about the future than the markets know. Actually, looking at the transcripts of the 2006 FOMC meetings, the Fed knows much less than the markets know.

But at least we now know what Bernanke thinks he knows. A short summary of the flurry of news from the Fed yesterday: The economy is still in the tank, it will stay that way for years, interest rates will be held at zero and savers can go to hell.

That last part we can glean from the most-interesting question posed to Bernanke yesterday. Greg Robb of MarketWatch pointed out to him that he has some severe Republican critics. The Fed has been a major issue in the debates and on the campaign trail. Mr. Robb had a theory about why: Many Republican voters lived on fixed incomes that depend on some return on their money. For this crowd, zero interest rates are a disaster. Robbery, really.

Bernanke’s first response was to say that he was not going to involve himself in politics because he “has a job to do.” It is a credit to the press corp that they did not double over in laughter at the ridiculous claim that the Fed’s job has nothing whatever to do with politics! After 100 years of Fed service, it is pretty obvious that the Fed serves two clients: the big banks and the government. The Fed certainly doesn’t serve the class of people who save and invest.

So how did Bernanke deal with the second part of the question? This was interesting. He said that he was very sorry for savers and those who depend on interest income, but they need to understand that they too have a long-term interest in a healthy economy. If investment and productivity are rising, they create the conditions for growth down the line, and surely this is good for everyone.

That’s some crazy kind of circuitous reasoning going on there. It’s a bit like the thief who steals the silverware and then explains to the former owners that a wider distribution of beautiful tableware is surely good for everyone in the long run. Even if you buy the argument, it would be nicer if the owner had some choice in the matter.

And there’s another problem that is so incredibly obvious that no one at the press conference even dared point it out. The problem is that the zero-interest-rate policy has not worked to boost economic growth. What possible basis is there for thinking that two more years of this extermination of the saving class is going to do what the last three years have not done?

Of course, it depends on what you mean by “worked.”

Let’s say that the Fed wants to drive all investors away from government bonds and into riskier instruments in an attempt to artificially boost financial markets. Check.

Let’s say that the Fed wants to punish anyone who wants to sock away money for a rainy day and, instead, prod them into buying more plasma TVs, digital gizmos and summer homes. Check.

And let’s say that the Fed wants to artificially suppress the government’s own costs of borrowing in order to reduce pressure on the political class. Check.

In all these ways, abolishing interest rates works for the Fed and the political elites. But there are at least three downsides.

First, banks depend on interest payments for profitability, and low interest removes the financial incentive for banks to lend money in a normal way. This is why commercial bank loans remain low, with the latest data showing the volume at mid-2007 levels. One might suppose that this is contrary to the Fed’s aims, but it is a price that it is willing to pay.

Second, a low interest rate agenda requires that the Fed try to control not just the short-term rates over which it has the most influence, but also rates across the entire yield curve. This means removing risk premiums on longer-term loans by implicitly guaranteeing bailouts, just like those of 2008-10. This entrenches more moral hazard and drives a wedge between risk and result.

Third, this policy of low rates is similar to — but even worse than — the very policies that created the bubble of the 2000s that burst in 2008 and prompted the worst financial and economic calamity of many generations. The Fed has learned absolutely nothing from even its own most-recent history. If people can’t earn money through interest, financiers will find some other way to market risk, leading to crazy investments schemes and misallocated capital.

As David Malpass writes in The Wall Street Journal:

Near-zero interest rates penalize savers and channel artificially cheap capital to government, big corporations and foreign countries. One of the most fundamental principles of economics is that holding prices artificially low causes shortages. When something of value is free, it runs out fast and only the well-connected get any. Interest rates are the price for credit and shouldn’t be controlled at zero. It causes cheap credit for those with special access but shortages for those without — primarily new and small businesses and those seeking private-sector mortgages.

The big take-away from the Fed’s day in the news is its new policy benchmark of keeping inflation at 2%. This is sheer silliness. There is no such thing as a price level, as even recent CPI releases illustrate. Some prices went up (food, education, health), and some prices went down (oil, software, services). Mash them together and you get a single number that applies to absolutely nothing in particular.

In any case, the Fed can’t control prices in this way. It is always driving while looking in the rearview mirror. When the crash comes, there is nothing the Fed can do about it, despite Bernanke’s repeated promises to rescue the world from any bad effects of his policies.

As Bloomberg’s Caroline Baum says, it’s almost as if the Fed itself has completely forgotten the existence of the “long and variable lag” that separates its policies from their effects. She recalls Milton Friedman’s own analogy of the “fool in the shower” who keeps turning the water from all hot to all cold and wonders why he is either scalded or frozen.

Baum concludes that under Bernanke’s own plan, we would have “eight years of 0% interest rates. There will be a revolution in this country before then if the economy is lousy enough to warrant 0% interest rates for that long.”

Really? One would hope.

Regards,

Jeffrey Tucker

Zero Percent Uber Alles was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

All they can offer is a description of symptoms, such as with their favorite phrase: lack of “aggregate demand.” Which, if you think about it, doesn’t really explain anything. How come demand dropped? Why did it drop now and not at any other time? Whose demand dropped? (Hint: Mine didn’t.)

Sigmund Freud Meets Dr. Ruth

But hey, when faced with a lack of proper economic explanations, you can always fall back on some amateur psychology. Everything must be down to what goes on in people’s heads, right? People just get all mixed up. Too pessimistic. (Animal spirits, anybody?)

That’s why it is always up to those coolheaded guys and gals in government to use their policy tools to change expectations, change the psychology of people, cajole everybody into some elevated state of positive thinking and, hence, more economic activity. Save the masses from their own silly notions in their tiny heads, like saving and getting rid of debt. They all just clam up and save? Pitiful. But most importantly, why even worry about explaining the recession if you are confident, if you simply know, deep down in your heart, how to get out of it?

Most politicians don’t know any better. They certainly don’t know any economics. So the same toxic policy mix of Keynesian deficit spending and monetarist money printing has been implemented around the world since this crisis started four years ago. Just as in any other recession of the past 40 years, ever since Nixon cut the last link to gold and fulfilled every interventionist’s wildest fantasy: unlimited paper money under full control of the state! Yeah, baby, no more recessions!

Alas, it is not working, is it?

Rates were cut, and the state not only spent money it didn’t have…as usual, it spent much more money it didn’t have. But the economy did not recover. So more of this policy was implemented. And then, more again. In fact, by any standard, never before in modern times has the economy been “stimulated” more through Keynesian and monetarist government intervention than over the past four years.

Balance sheets of major central banks have tripled. Banks have been receiving limitless funds for free and will continue to do so forever, and governments are running deficits the likes of which mankind has only ever seen at the height of major wars, and which are increasingly funded by the printing press.

It is still not working.

You would probably guess that the interventionists of Keynesian and other ilk would be a bit more humble by now. Maybe check a few of those premises in their models? Or maybe start thinking again about those elusive explanations for what’s wrong with the economy in the first place? Are we really suffering from a lack of paper money and government spending? Maybe it is not simply down to all of us being too depressed, morose and in need of some policy Prozac. Maybe something else is broken.

Alas, no. The academically trained Keynesian economist is too committed to his or her beliefs to let the facts get in the way. Why has policy not worked? Because we have been too timid. We need the same policy. We just need more of it. A lot more.

More monetary madness

In her recent op-ed piece in The New York Times, High Priestess of Keynesianism Christina Romer suggests a radical policy “change” at the Federal Reserve: toward more money printing.

Rather astutely, she calls for Helicopter-Ben to embrace a Volcker-moment. Maybe by quoting the poster boy of the Reaganites and the hard-money crowd, she hoped to reach a new audience for her tiring and dreary, old policy recipe of more and bolder interventionism. She almost had me fooled.

Wait a minute, I thought. Volcker? He is the guy who abruptly stopped the printing press and allowed high real market rates to cleanse the system of the dislocations of previous booms, and to squeeze inflation out of the system, thus, giving the paper dollar another lease of life — albeit one that is quickly running out.

I thought, has Christina finally seen the light? Has she begun to realize how massively disruptive a constantly expanding supply of fiat money is for an economy? Is she calling, as I do, for an end to this monetary madness of zero policy rates and quantitative easing?

Well, no, she isn’t. She wants the Fed to print more money, much more. She wants the Fed to adopt a nominal GDP target. This will allow the Fed to become even more aggressive in its monetary policy and to communicate this aggressiveness better. Make people trust in that aggressiveness. And this communication is important for Romer.

As we have seen, for the good Keynesian, the policy was never wrong. The policy was just not ambitious enough. All it needs is a more-ambitious goal and better communication. People just have these bad thoughts and wrong expectations. The public is just not playing ball, not going along with this enlightened economic program. Well, says the Keynesian, we’ll teach them.

The Volcker analogy works like this for Romer: In 1979, inflation was too high, and small rate hikes didn’t work. So Volcker implemented a much tighter policy and crushed inflation. And it worked, because people believed him. Today, unemployment is too high. Gradual policy easing (not sure what planet Christina is on, but from where she is sitting, monetary policy in the U.S. must have appeared to be gradual) is not working, either.

So Bernanke needs to become more aggressive, and publicly so. Because people believe that if you stick to your policy, which — please remember — was, of course, the right policy to begin with, then the policy will really begin to work. You just need to drill it into those blockheads.

Every first-semester economics student, not only those at Berkeley — where Romer is economics professor — should be able to tear this apart with ease. The analogy with Volcker is silly. Volcker used monetary policy to fix a monetary problem: inflation. Stopping inflation by not printing money anymore is pretty straightforward. The link is kind of direct.

To be honest, it doesn’t even matter what the public believes or not. If you stop printing money, inflation will drop. Period. The link is that direct. You don’t need the accompanying belief system.

Was there full employment in Weimar Germany?

However, unemployment or the level of ‘aggregate demand’ is decidedly not a monetary phenomenon. Only in the airy-fairy dreamland of macroeconomic models is there a direct link.

To assume that we can simply and straightforwardly establish whatever nominal growth rate and level of employment we desire by means of the printing press is precisely the type of naive “building block economics” that got us into this mess in the first place. According to this worldview, the economy is just a machine, and all we need to do is to pull the right levers. Or it is like a cooking recipe, in which we need to simply change the ingredients a bit and — voila! The souffle will rise!

It is precisely because (a certain type of) economists have been telling us…that we can have more growth and high employment by constantly debasing money. This is how we created this highly levered economy over the past four decades. One that is so thoroughly addicted to ever larger fixes of cheap credit and that is now choking on excessive debt and weak banks.

By printing money and artificially lowering interest rates we have, again and again, bought near-term economic growth at the expense of long-term economic imbalances. That this was bad economics everybody is now learning the hard way. Everybody, that is, except Christina Romer. Her simple worldview is unshaken.

It is this weird combination of childlike belief in the simplicity of the problem (aggregate demand, lack of optimism) and the striking arrogance of the notion that the government can and should control the economy by simply pulling at the right strings hard enough that makes Romer’s article such an illustrative example of the intellectual dead end that is mainstream economics today.

Romer has apparently no notion of relative prices and of the importance, in particular, of interest rates for coordinating saving with investment. She cannot see that lowering interest rates administratively and injecting new money into the financial system will have many additional effects, other than lifting some statistical measure of aggregate economic activity. Easy money will always change resource use and capital allocation. Cheap credit encourages borrowing and debt accumulation, and will cause additional problems for the economy later.

Romer cannot perceive of these complexities. In her ivory tower, the world is one of simple statistical aggregates and large wholes that you can direct and mend to your liking. You just add the desired real growth rate (2.5%) and the acceptable inflation rate (2%) and stir it nicely to come up with the nominal growth rate (4.5%). How hard can it be?

We have some indication that Bernanke is not very sympathetic to this proposal at present. It doesn’t look like this will become official policy anytime soon. But who knows? A lot of what is now accepted monetary and fiscal policy in major countries and debated dispassionately by financial market economists would only a few years ago have been the mark of the economic crank, or the populist policy program of some economic backwater just before it was put under IMF surveillance.

But what is striking is this: Such rubbish emanates from the highest echelons of academic economics in America. Christina Romer is economics professor in Berkeley, Calif., and I fear that a lot of very bright young people burden themselves and their families with student loans and waste valuable time absorbing such drivel. If Romer is all that economics in Berkeley has to offer, why not emulate the late Steve Jobs and drop out?

Regards,

Detlev Schlichter

Christina Romer’s Toxic Cookbook was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Case in point: The July 13, 2011 exchange between the Austrian-schooled Republican who “gets it” Whiskey bar favorite Congressman Ron Paul and the Fed chairman.

What strikes me is not Bernanke’s struggle to explain the monetary function of gold, but something else. It’s something that scares the living bejesus out of me whenever I hear Bernanke testify.

Before I say what it is, let me stress that I don’t much like the widespread demonization of the Fed chairman. I think he was sincere when he said that he never cared about the management or the shareholders of the Wall Street firms he invariably bailed out and is generously subsidizing. He really believes that what he is doing is helping the U.S. economy and the U.S. people.

The problem is not that he is evil or dumb – I think he is neither – the problem is much bigger. You can deal with people who are evil and dumb. Deeply-convinced do-gooders in positions of almost unchecked power, those are the ones we should worry about. The good intentioned can suffer from tunnel-vision, incurably in awe of their own theories and are incapable of even grasping how what they are doing could make things worse.

Market manipulations — keeping rates artificially low and bank reserves expanding – are creating momentous dislocations, vast problems with as-yet incalculable consequences – even if they do not generate instant hyperinflation or intolerable expansion in the wider monetary aggregates.  This only looks deceptively harmless through Bernanke’s narrow prism of national account statistics.

Mr. Bernanke suffers from a blind side: He can’t see that ‘elastic’ money is always destabilizing. In my forthcoming book, Paper Money Collapse, I show how any expansion in the money supply (including bank reserves) distorts relative prices, always and everywhere. Even if some fortuitous rise in money demand cushions some inflationary impact and if inflation measures therefore remain contained.

Every money injection disrupts the market’s setting of interest rates, thus disorienting the process of coordination between true savings and investment and capital formation.

Bottom line: Interest rates are market prices, Mr. Bernanke, and you interfere with them at your peril!

I didn’t discover this, of course. I owe much to Ludwig von Mises and the young F.A. von Hayek. Ron Paul understands them, Bernanke doesn’t.

Bernanke: Man on a Mission – To the Wrong End

Bernanke upholds the original mission of the Federal Reserve: to avert credit contraction and debt deflation at all costs. During the Q&A, he reminded the laissez-faire Congressman Paul of the bank runs of the 19th century. Instability in banking — and in the wider economy as a result of banking — should come as no surprise to anybody who understands the practice of fractional-reserve banking.

Today, banks are money-producers. But here’s the problem: whenever the economy slows, the nervous public ditches deposit money for ‘real’ money. In fact, we want money that is not somebody else’s liability, such as gold or, even, state paper tickets. The banks then have to contract the supply of deposit money — shrinking the supply of what is used as money in the economy — thus exacerbating the recessionary forces in the economy.

The Fed Reserve wanted to avoid recessions — or shorten them –and avoid credit contraction. What they thought was needed is some form of elastic money so that in economically challenging times the banks do not have to contract the supply of credit.

It is almost comical how Mr. Bernanke seems to say, why are you criticizing me? I am spending all this money, but it doesn’t add to the federal deficit. I am printing this myself. I just press a button. Money printing is costless. And I can help the economy.

The Austrians know that such a powerful threat to the banks is brought about by the banks themselves! The lowering of reserve ratios and the creation of deposit money leads to a credit boom which always creates imbalances — in the saving-investment equation — and thus must end in bust.

What the Fed is trying to do is destined to fail. It cannot solve the problem. It must exacerbate the problem. Bernanke believes that with his all-powerful printing press he can always buy another recovery. For him his job appears to require an astute balancing act between the two things his macro-tunnel vision allows him to see: the trade-off between growth and inflation, both — so he believes — neatly observable with macro-statistics (the fetish of the economics profession). He cannot grasp the distortions in prices he creates, the misallocations in capital he furthers, and the accumulation of debt he encourages. None of them register on his statistical radar.

The debt-ceiling debate in the U.S. is trivial. What matters is this: as long as there is a Federal Reserve and as long as it is run by men like Mr. Bernanke — dedicated, smart but hopelessly committed to a flawed belief system — the economy will not be a capitalist one, benefiting fully from saving, entrepreneurship and true capital accumulation but will always be addicted to easy money, cheap credit and propped up asset markets.

What Will Happen Next?

Like a little hamster in his hamster wheel, Mr. Bernanke will only run faster and faster. Next, the interest rates that banks get on their deposits at the Fed will be cut to encourage more lending. The Fed will conduct QE3, and then QE4, and so forth. Maybe they will not call it that, but in effect that is what the Fed chairman’s own belief system will force him to do.

The size of the accumulated dislocations is already too gigantic today to allow any politically acceptable correction. Nobody had the stomach for it during Lehman. Nobody has the stomach for it today. In the monetary environment the Fed maintains, deleveraging will never be accomplished. Mr. Bernanke digs himself deeper into a hole that he won’t get out of when the market demands higher interest rates to maintain confidence in the paper dollar.

Paper money systems collapse — and they have all collapsed, throughout history and without exception — not because the money printers don’t understand inflation. They simply always reach a point when they fear the immediate impact of turning off the monetary tab more than the further printing of money. Of course, the disaster in the end is only bigger.

Bernanke is no James Bond villain out for world domination or even a big Wall Street payout. He is more the mad  professor in some sci-fi B-movie, unwittingly in cahoots with the forces of destruction not out of mean-spiritedness but out of intellectual hubris and infatuation with his own theories and technical wizardry.

Utterly convinced that he has worked out all the effects of his manipulation of the money supply and of interest rates, Bernanke can’t see why anybody would not want him to go on manipulating. In the meantime, debasement of paper money continues…

Regards,

Detlev Schlichter

The Bernanke Blind Side was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Bernanke spooked investors in New York when he fronted a group of empty headed Senators in Washington and told them that the future of the U.S. economy was “unusually uncertain.” But in a real boon to those of us looking forward to the inflationary effects of trillions of dollars more in quantitative easing, Bernanke assured the Senators that, “We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability.”

Can this sort of nonsense really be taken seriously? Unfortunately, we have to take it seriously because it has serious investment consequences.

But how long will it be before most people understand that the Fed, the regulators, and the monetary authorities have no credibility when it comes to: a) understanding what is going on, b) fixing it, c) confessing to their culpability in causing the misallocation of capital and the zombification of large chunks of the global banking sector and generally forcing all of us contemplate their moronic and opaque pablum?

These people really are vandals and thieves. We are encouraged to take them seriously and cede micromanagement of the economy and public life to people who don’t have an entrepreneurial bone in their body. What a big con.

In any event, don’t be fooled by the results of the stress test. Those so-called stress tests for European banks are just as much a whitewash of the real capital inadequacy issues as were the American stress tests. In fact, the whole exercise is perfect pretext for another round of central bank quantitative easing/outright support of asset prices.

After all, American and European banks are stuffed full of housing-backed securities and sovereign debt. The credit boom manifested itself in many assets. Much of the fiscal and monetary policy since 2000 has been designed to keep those assets from deflating. It can’t work.

We reckon this latest and largest round of quantitative easing will come sooner than most people are expecting and be a lot less effective than some people are hoping. It’s time to get ready for it now. Crank up the fan…here comes the merde.

Meanwhile, a minor merde storm is brewing between Australian banks. Nothing sexier than watching the banks go at it over lending practices. Commonwealth Bank of Australia hard man Ralph Norris delivered a rhetorical smash to the nose of NAB’s Mark Joiner. According to the Australian, Joiner said last month that some banks in Australia were making “super profits” by expanding their mortgage lending to the detriment of small business lending.

“Kapow!” says Mr. Norris. Well, not literally. Rather, he said, “I think the real issue is that we have a bank (NAB) that has performed poorly for many years and missed out on an opportunity when the mortgage market opened up… The market [for small business lending] grew by 0.5 per cent and we grew by 9 per cent…I don’t know where that rubbish is coming from, because the facts certainly don’t support it.”

Never having been a banker, we are inclined to sit back and watch the slap fight. But the stakes are high. CBA’s loan book is 60% in residential mortgages. Under Basel II, the bank has to hold less capital against a home loan than it does against a ‘riskier’ business loan. So, you could argue that expansion of the mortgage lending book, even at the expense of business lending, is a safer move for the bank and delivers bigger profits to shareholders. It also keeps the rivers of credit flowing into Australian property.

You could argue that. But it’s not the argument we would make. We would instead make a high-handed, ivory tower, abstract kind of comment that the people of a nation can’t all get rich by buying and selling houses from one another. For one, it’s a singularly unambitious national goal. But that’s not the biggest argument against it.

Creating a profit is hard. In some ways, it’s unnatural. Profit is surplus value. Human beings improve their living standards by increasing productivity and efficiency through innovation and constant adaptation. The free market is a great mechanism for producing surplus, as long as risk taker and small businesspeople and crack pot inventors and dreamers and builders have access to capital. Of course the banks are under no obligation to take bad risks (unless you’re talking about U.S. banks compelled to make loans to bad credit risks during the American housing boom.)

As for the aforementioned impending (we believe) quantitative easing round two, how should you prepare? Well, in the fashion that you find most fit naturally. But we’d suggest that asset markets are going to cop it good and hard in the second half of this year. We’re expecting a one-two combination of big falls in stock markets and then wild, irresponsible, unprecedented and unconventional attempts to reflate by central banks.

Regards,

Dan Denning,
The Daily Reckoning Australia

P.S. In the meantime don’t forget: the people backing an emissions trading scheme the most usually have a vested interest in the exchanges that will be set up to trade said emissions. It’s like a potential casino owner telling you we should all be compelled to gamble. The government’s interest in the matter is self-evident: mo’ money. And the bureaucrats who are backing it presumably thrive, in some small-minded and mean-spirited but satisfying way, on simply telling people what to do.

Resist them all! And as the great thinker, champion of liberty, and emancipated American slave Frederick Douglass advised, “Agitate! Agitate! Agitate!”

Fed Up with the Fed and the Welfare State was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“The reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention…”

So said Henry Paulson, U.S. Treasury secretary and ex-Goldman Sachs chief, in Shanghai on March 7, 2007. Hank was lecturing Chinese officials (who this week allowed short-selling on their domestic equity markets for the first time) at the so-called China-U.S. Strategic Dialogue summit.

Of course, Paulson bent their ear before Bear Stearns “Enhanced Leverage” mortgage-bond hedge funds blew up in June ‘07. The following month, Ben Bernanke, chairman of the Fed, made his first guesstimate of total bank losses — “in the order of between $50 billion and $100 billion” — to come from the subprime collapse.

Now the terrified trio of Bush, Bernanke and Hank want $700 billion just to refinance the U.S. investment banks and their foreign landfill sites, let alone home-buyers, mortgage lenders and house builders.

Yet five U.K. banks alone hold $175 billion of qualifying junk — fully one quarter of the sum requested. So no wonder Bill Gross — boss of Pimco, the world’s biggest bond fund, and a cheerleader for governmental intervention ever since Bear Stearns’ hedge funds went “hiccup!” — says the “troubled auction recovery program” will need another $500 billion on top, just for starters.

Paulson’s ideological grandstanding in Shanghai last year preceded a few other events that may have forced his Damascene conversion.

All this while, of course, the developed world’s central banks were pouring cash into the credit market, trying to fix the first big problem, the first of five “big freeze” spikes in world money market interest rates.

It just keeps coming back, however. Because the people who know best the liquidity and solvency of major banks — the other banks — refuse to lend whatever money they get, hoarding it instead for fear of a run at their own branches.

“British banks have squirreled away nearly £6 billion [$11 billion] with the Bank of England rather than lend it to each other for more than a few days,” reports the Financial Times, “using its safe but low-interest deposit standing facility is a sign of the fear gripping money markets.”

Little surprise that inter-bank lending rates are holding near an eight-month high for U.S. dollars — despite the Fed now offering more than $290 billion to foreign authorities for their own domestic money markets — while the banks’ price for borrowing euros has reached a record high for the single currency, launched in 1999.

And all this while as well, of course, the Federal Reserve has been busy slashing U.S. interest rates…finally joined by the U.K., Aussie and New Zealand authorities in making debt cheaper even as the free market — both the interbank market and the commercial market of home-loans, overdrafts and corporate lending — pushed in the other direction.

This privilege, allowing central banks to set the price of money whenever it thinks the economy needs tweaking, might seem to jar with Paulson’s tidbit from Shanghai.

But shepherding the free market is why central banks, regulators and government itself exist today. And as they’ve proven so adept at this task, guiding the lambs of Wall Street to the slaughter of Florida and California condos, it would surely make sense to extend their powers — and shepherd the free market a little more closely — from here.

Right?

“We thought Resolution was just suspended, not delisted,” said a spokeswoman for City watchdog the Financial Services Authority last Friday.

You’d think they might know. But no, Resolution, a U.K. insurer, was delisted in London after being bought out in May. Yet it still found its name on the banned list of 29 “no shorting” stocks proscribed by the FSA.

“It will be removed,” said the all-powerful watchdog. “A revised list will be up on our website later today.”

Meantime in New York — where Hank Paulson’s “open, competitive, and liberalized financial market” is also taking a break — the Securities & Exchange Commission (SEC) has banned short-selling of GLG, the giant London-based hedge fund, along with 798 other financial stocks and 100 or more stray sheep like GE, GM and Ford.

Funny, but GLG itself paid a $3.2 million fine in June ‘07 for “multiple violations” of the SEC code, after shorting some 14 public offerings in the U.S. and making $2.2m over two years in “illegal” profits.

Still, there is more rejoicing in heaven over one lost sheep found, eh?

“Markets are usually right,” says Anatole Kaletsky in the London Times, “but sometimes they are dangerously wrong — and they need to be managed with decisive and competent government intervention.”

Ignore Polly-Ana’s morality if you can; fact is, markets often get dangerous. Whether they’re right or wrong doesn’t matter much if you’re buying high and then forced to sell cheaper.

Here and now, the market — right or wrong — is pricing toxic debt and derivatives at zero or worse. U.S. subprime mortgage bonds, if marked-to-market — rather than against the apparent “final redemption value” used to help pay $66 billion to Wall Street staff in 2007 — are also worth zilch. That’s why there’s no danger of anyone buying them, no one outside Washington, that is. And there’s the true danger today.

The dangerous market has been and gone. It popped when Florida condos stopped selling to buy-and-flip wannabes without a red cent of cash but one million in debt. Only government meddling — just like Hank Paulson said — risks further danger; the danger that U.S. taxpayers will pay through the nose (and through inflation) for $700 billion of utterly worthless “investments.”

Hell, he did run Goldman Sachs, after all. What did you expect! But is there any danger of letting the free market do what needs doing?

Regards,
Adrian Ash
September 29, 2008
BullionVault

Government Regulation and Financial Bailout was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

He did that to get your attention.

Fed chairs rarely ever say that word, for reasons that Greenspan learned on his first days in office back in 1987 — the same reasons that CEOs rarely comment on their stock’s valuation.

Bernanke’s original remarks came before Friday’s unemployment report rained on Wall Street.

But just in case anyone thought the weak report might have softened his stance over the weekend, on Monday, he repeated his determination to tackle increases in long-term inflation expectations, and to fix the dollar. The rhetoric helped boost the currency and splashed cold water on gold’s recovery.

I say “helped” because the Saudis did most of the work by announcing an output hike (500,000 bpd).

Let me tell you right out of the gate that, as a rule, the Fed talks tougher than it is capable of acting, especially with a new administration around the corner. Bernanke has nothing more in mind than taking away the interest rate stimulus, as Greenspan did after 2004 — gradually and marginally…if that!

What’s more, the consensus doesn’t expect any action near term. Even more crucially, ultimately, his resolve rests on the correctness of his premise that the risks to economic growth have abated.

The Fed is not ideologically equipped to tackle the duality of rising unemployment and rising prices. Do you really think it is going to hike rates while stocks are reeling?

No. It just assumes that won’t be happening at the same time that prices are generally still rising.

But what is most important to understand is the factor that stirred the hawkish rejoinder.

For it is obvious that the Fed is reacting to market sentiments. And those sentiments are what I want to bring to your attention.

Is This the Crackup?

Back in March, oil prices were just breaking through $100, and the Fed hinted that it was probably finished cutting interest rates. Investors started looking for a big commodity and oil price correction.

It wasn’t to be.

Oil continued charging higher, egged on by bullish calls from America’s biggest investment dealers.

It is now backing off a high of about $139 in the nearest futures contract. That’s up 40 percent in three months, 100 percent in 12 months and nearly 200 percent in fewer than two years. It’s up more than 1,000 percent over the past 10 years. The moves in crude have been nothing short of spectacular.

On May 21, when the front month was breaking through $130, I got a call from a friend of mine — an oil analyst who runs his own investment service out of New Jersey. Like me, he’s been bullish since the turn of the millennium, but neither of us expected anything like this. Is this the crackup, he asked?

That’s the first time someone asked me if this was it…you know, “it.”

The crackup is a stage of the inflationary boom that occurs late in the cycle — when the market gets the idea that money grows on trees…and it finally abandons the idea that “prices will one day drop.”

Fear marks this final stage — in particular, of the erosion in monetary values.

It is born of a revelation, according to its author: “Finally, the masses wake up” to the fact that “inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears.”

However, it is the final stage of the boom. It is relatively short. It could last days, weeks, maybe even months, but the author (Mises) did not have much more in mind than that.

It is literally the death of that particular money.

Importantly, Ludwig von Mises concludes, “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds.”

The laws of supply and demand determine money’s value, as with anything else. And if the supply of something is unlimited, it’s not usually worth much. So the Fed likes to downplay the fact that it can or will print money “beyond all bounds.”

I doubt we are seeing the crackup.

But we are seeing some of the things that characterize the onset of the late stages of a long-in-the-tooth inflationary cycle — in which prices rise because people expect them to rise, and the demand for money drops as confidence in the economy and the world’s common medium of exchange erodes.

As Market Focus Shifts to Money Relation…

Bernanke senses that the market is making a dangerous transition.

If I could point to one catalyst, it would be that the commodity markets are making moves that make the situation difficult to explain in terms of regular supply-and-demand fundamentals. That is, people are finally asking questions like how could the total demand for oil have doubled in just 12 months?

As Dr. Benn Steil, an economist at the Council on Foreign Relations, on May 20 stated:

“If you want to explain this terrifying apparent shortage of food that we now have in the world, I don’t think you could possibly explain it based upon enormous growth in the world’s appetite for food over the past three quarters. It just can’t be done.”

Indeed, although it was completely unrelated to this speech, the question of crack-up came the day after Steil’s speech to the Committee on Homeland Security, in which he pinned the commodity bull market almost entirely on fiat money inflation, and drew attention to gold’s relative stability as money:

“Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold — gold having been the foundation of the world’s monetary system until 1971. It is, therefore, reasonable to conclude not that we are  experiencing a commodities bubble, but, rather, the end of what might usefully be termed a ‘currency bubble.’”

George Soros’ subsequent comments last week regarding doubts about the dollar’s reserve status were like a beacon to the Fed. Undoubtedly, they provoked Bernanke’s rebuttal. For they reflect sentiments the Fed would rather discourage, as they are difficult to “control.”

For the past eight years, the big money has explained the commodity bull market in terms of events like Sept. 11, growth in Asia and other developing frontiers, previous underinvestment or the finiteness of commodities. The Fed has succeeded in discouraging the market from pointing its invisible finger at it.

But the commodity bull market is about to take on a whole new form…

Regards,
Ed Bugos
June 18, 2008

P.S.: With gold still readying itself for another historic run, there has never been a better time to begin investing in the miners that bring this gold to market. Readers of my Gold & Options Trader service have already heard the word on a new miner that has a new take on the process of mining itself.

Inflation and Commodity Prices was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg
May 15, 2008

The Danger of Stagflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

Greenspan was vexed: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of [banks without knowledge of LTCM’s positions] is just mind-boggling.” So boggled was the man that the Greenspan (and Bernanke) Fed allowed the banks to lever as never before and write $400 trillion worth of derivatives between then and 2008 — without so much as a dollar bill of reserves: Nor a peep that maybe these off-balance-sheet liabilities might bear closer attention.

A staff member described what he had learned on his field trip to LTCM. On Aug. 31, the hedge fund had a $125 billion balance sheet. It also had $1.4 trillion of off-balance-sheet assets. On Sept. 21, when it appears (from the transcript) the Fed first saw LTCM’s balance sheet, its leverage was 55-to-1 and the “off-balance-sheet leverage was 100-to-1 or 200-to-1 — I don’t know how to calculate it.” He wasn’t alone. Greenspan’s “first line of regulatory defense” didn’t know if LTCM was trading interest rate swaps or stolen cars. The models of LTCM’s “counterparty supervision” were so “complex and sophisticated” that the hedge fund’s portfolio had been translated into a Greek salad — gammas, thetas, and epsilons.

For practical purposes, LTCM had no capital by Sept. 29. It was not able to meet margin calls. The hedge fund had not been required to post margin, but was required to post collateral worth 100 percent of the assets it borrowed. Even this looked amateurish. Greenspan, a former director of J.P. Morgan, shared his view: “If I am a bank lender and I lend $200 million to a hedge find, ordinarily, I would be overcollateralized. I would hold more than $200 billion in, say, U.S. Treasury bills.” Greenspan asked if the collateral was U.S. Treasuries. A staffer replied: “U.S. Treasuries, Danish government bonds, BBB credits — you name it.” Beanie Babies were next on the list. The value of LTCM’s collateral was falling. The balance sheets of the banks LTCM traded with were sinking.

A staffer explained the risk: “I’m going to say this in plain English. If markets keep moving away from [LTCM] in the wrong direction, their future exposure could be large and they might not have the collateral at that point in time to cover the exposure.” McDonough had described the house of cards earlier: “The firm’s position in a variety of instruments was very large. What my contacts were talking about was the effect that the failure of the firm would have on world markets if all these positions had to be dumped on the markets. People who thought they had an offsetting position with [LTCM] would suddenly find that they did not have one. They would suddenly find themselves with big open positions…” Globalization might end in a financial meltdown.

A Fed staffer thought the banks “were saying the right things in terms of the kinds of risk management processes they had in place” but “the question is how effectively the banks were actually implementing them…” The Fed staff had not taken the initiative to check. Greenspan was told the Federal Reserve had not examined the banks since December 1997. In Greenspan’s remaining decade at the helm, his bureaucrats produced masterful studies on counterparty risk, but permitted the banks’ risk models to optimize executive bonus compensation.

This is interesting, but not of great utility in 2008. The 1998 Fed weaknesses are important because the molehill grew into a mountain. Greenspan and Bernanke chaired the most egregious administrative failure in financial history. Paulson’s proposal is on a par with Caligula’s decision to name his horse consul.

In March 1999, Greenspan gave a speech on derivatives. He might have wandered onto the podium from Mars. Derivatives “are an increasingly important vehicle for unbundling risk.” He doused the post-LTCM movement toward a better form of regulation: “Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk schemes. In my view, this would be a major mistake.” The regulators’ risk models “are much less accurate than banks’ risk measurement models.” The Federal Reserve is not the institution to lead the much-needed bank regulation.

The nominal value of derivative contracts held by U.S. commercial banks (those over which the Fed has direct regulatory authority) leapt from $33 trillion at the end of 1998 to $101 trillion at the end of 2005, about the time Greenspan left office. We mustn’t ignore Greenspan’s successor: By the second quarter of 2007, 18 months later, these banks held $153 trillion in derivatives. The collapsing financial system is in the early stage of unwinding. Ben Bernanke has had time as Fed chairman to do something — anything — to slow the production of bad debt. Instead, the rate of financial claims in the economy accelerated.

The virtues of derivatives (their ability to diversify risk away from the banking system) received full approval from Greenspan and, more to the point, from his audiences. Bernanke is considered a monetary genius. Will we ever learn? Someday, we might ridicule, rather than praise, the Fed. On that day, it should be disbanded.

Regards,
Fred Sheehan
April 14, 2008

Mistakes at the Federal Reserve was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.