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Yet all is not as promising as it seems. Central Banks (Canada’s and the U.S.’s included),on false grounding in economics and using a monetary system based-upon an endless cycle of debt creation, have for decades maintained that the economy could be controlled by central planning and manipulating the amount of money and interest rates in the economy. This has allowed over-spending for massive government programs, unsupportable promises of future benefits to retirees, and costly military adventures all incredibly coupled with seemingly endless growth in consumers’ net worth and consumption. In a repeat of errors committed in the 1920’s, failure of central bank monetary policy led to the1990’s dot.com stock market bubble and correction in 2000 which now reveals a distorted economy saturated with unsustainable and increasing levels of debt just to continue the economy. The post-bubble response of the US Federal Reserve Bank in lowering interest rates to 1% now leads to rampant and destabilizing financial speculative bubbles in the economy including the North America-wide real estate bubble. We have a concentrated media in both Canada and the U.S, which has provided little critical analysis of economic policy choices, and a political ruling class most interested in short-term crises and solutions, which hand-off chronic but acute problems to the next elected official. The result is in that we have not had any accountability and correction of highly visible economic policy failures by our government and monetary authorities that have been visible for years. We are now on the brink of a strong economic correction likely impacting our populations for generations. Immediate and bold remedial action by government is required to mitigate the impact of the coming correction. ----------------------------------- Under
the placid surface [of the economy], there are disturbing trends: huge Paul
Volcker, Former US Federal Reserve Bank Chairman [i] ----------------------------------- If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered Thomas Jefferson The Debate Over the Recharter of the Bank Bill, 1809 ----------------------------------- The above two statements were made almost 200 years apart, however, they have a common concern – the consequent damage from the manipulation of the money stock (i.e. the money that exists in society) for economic gain. Economists and politicians have long known that increasing the money stock has the beneficial consequence of stimulating the economy. The initial short-term effect is that it increases the money available to be spent and invested which for a period increases economic activity. However, manipulation of the money supply has negative consequences which have damaged countries (including Canada and the U.S.) who travel down this road, including:
3. Inevitable internal economic distortion resulting in growing imbalances which ultimately correct with economic busts, deep recessions and depressions. It is the last item which politicians, central bankers, and economists popular in the political realm have denied is a consequence of their centrally-planned monetary control. Readers in Canada or the U.S. will likely not have a concern regarding the current economy – however, as Chairman Volcker notes, large distortions exist beneath the surface which will manifest themselves. These distortions and coming correction are visible to our political leaders, but while Volcker notes that urgent action is needed, he also notes governments tend to react after the fact – which in this case will impart great damage to the both the U.S. and Canada. The coming economic fall-out now militates that the damaging, anachronistic centrally-planned attempts by central banks and politicians to steer the economy using the monetary system must be curtailed. Jefferson’s Insight If we read Jefferson’s comments with today’s definition of inflation and deflation, it makes little apparent sense. However, the meaning of the words “inflation” and “deflation” have changed over time so that they now mean, respectively, an increase or decrease in consumer goods prices. In their more classic economic sense, inflation refers to an in increase in the money stock (cash and debt) outstanding in the society. Deflation refers to a decrease in the money stock. Jefferson’s warning now becomes a little clearer. History is riddled with monetary inflation accompanied by uneconomic activity, speculative booms, and investment mania, all resulting from the excess inflation of the money stock, followed by crashes. There is nothing surprising or even unreasonable about market speculation – so long as one realizes the dynamic causing the speculation and limits exposure be it real estate, equities, bonds, interest rate derivatives, and other financial instruments. However, few retail investors do understand when a bubble is underway and the top usually occurs after the flow of new credit or increases in the money stock starts to slow – a visible signal within the financial system but not to the average investor. Extraordinary Popular Delusions and the Madness of Crowds[3] was initially published in 1841 and documented excess credit and money creation inducing trading bubbles and collapses such as the Dutch Tulip Mania (Holland - 1630’s), John Law’s Mississippi Scheme (France – 1720 : a stock market bubble engulfing France induced by massive inflation (or debasement) of France’s money stock), The South Sea Bubble (England – 1720 : investment mania where even Sir Isaac Newton lost his family fortune), etc. In a more recent work[4], Edward Chancellor documents more than a dozen historical and contemporary monetary and credit booms that drove speculative mania including the 1920’s stock boom, the late 1980’s Nikkei stock market and real estate boom in Japan, and the 1990s dot.com stock market bubble in the US. The excess which can be attained during an investment bubble are well illustrated by the following words from an investment prospectus to raise money during the South-Sea Bubble of 1720: “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” [5] Creation of investment bubbles and their subsequent crashes are directly and obviously negative as they simply result in the transfer of wealth from the public to those promoting investments (such as through Initial Public Offerings (IPO’s) of a stock ) during an investment bubble. Thus, the phenomenon of speculative boom and bust acts as a “wealth ratchet”. The financial industry, speculators, stock industry promoters and traders make enormous profits on the ascent stage and, if savvy, can roll-out of investments with gains into cash or other stable asset positions before a correction, then buy assets at prices of pennies to the dollar in the subsequent bust when investors must liquidate assets to settle losses. Key bankers, politicians, and Wall Street traders wanted the creation of the U.S.’s central bank in 1913 and worked through a White House insider Edward Mandell “Colonel” House to see the Federal Reserve Act developed and passed. ( Colonel House was a wealthy Texas patrician who had never served in the military and whose family fortune was acquired by his father in the South during the American Civil War. ) Although called the Glass-Owen Bill (after Congressman Carter Glass and Senator Robert Owen), the Federal Reserve Act was the creation of President Wilson’s point-man on banking matters, Colonel House. The immediate effect of the creation of the new central bank (The U.S. Federal Reserve Bank) to control the money supply was the price inflation of 1914 to 1920, then the 1920’s stock market mania and crash of 1929 which revealed that average citizens who were skeptical of the wisdom of creating a central bank were correct. That the Fed caused the stock market bubble resulting in the crash of 1929 and the Great Depression is not argued by today’s supporters of the Fed. In 2002, at the 90th birthday party for famed economist and monetarist Milton Friedman, then Fed Governor Ben Bernanke commented “You were right, we did it. But thanks to you we won’t do it again.” [6] Whether the Fed and other central banks can prevent another financial rupture is a question on which the jury is still very much out. Our “Stable” Economy – Stable or a Redux to Another Apparently Stable Time? So what is former Chairman Volcker’s concern today? The economy is healthy: inflation is apparently low, the stock market has corrected to lower stock price to company earnings (p/e) ratios, the housing market is booming, we are looking forward to further growth: what’s the problem? First, The US (and in fact the World’s) economy is still very much in recovery from the dot.com stock market crash of March 2000. As we will see, Mr. Greenspan’s declared victory when stating “we were very much correct in our decision to address the after-effects of the bubble rather than the bubble itself” may have been a little premature. The stock market bubble of the late 1990’s was a textbook recreation of the 1929 bubble and the late 1980’s Japanese Nikkei stock market and real estate bubble. They all relied upon the creation of excess credit in turn brought about by excessive monetary policy of central banks (note that money enters the economy as loans from banks to borrowers. Increasing the money stock therefore means increasing the debt level in the economy). The origin of the 1920s stock market bubble, notes Economist Murray Rothbard was that, in order to “assist” Britain in artificially maintaining the strength of its currency while it was in economic decline, America increased its money stock by an average of 7.7% annually over an 8 year period from 1921 to 1929. In his words, it was “a very sizable degree of (monetary) inflation” [7] and “the entire monetary expansion took place in money substitutes which are products of credit creation… The prime factor in generating the (monetary) inflation of the 1920’s was the increase in the total bank reserves.” [8]. Yet, like today, while the 1920’s economy roared ahead, consumer price inflation was apparently tame while the stock market appeared “reasonably” priced. Rothbard notes “The fact that general prices were more or less stable during the 1920’s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.”[9] Economists who support manipulation of the economy by varying the money stock and interest rates are dubbed “monetarists”. The father of modern monetarism and the Quantity Theory of Money, which is the basis of central bankers’ expansion of the money supply, is Irving Fisher, who was himself so enthused about future prospects that in October 1929, one week before the markets crashed, he made his famous (mis)statement: “Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months” [10] Irving Fisher The DOW would decline 89% from its 1929 peak value of 381 bottoming 3 years later in 1932 at 40. Fisher who had a net personal wealth of $10 million from designing and patenting the Rolodex, lost his entire fortune in the crash and ultimately died penniless. But his Quantity Theory of Money still built favor with economists, politicians and central bankers of the future. What Fisher missed, and one of the reasons there are so few billionaire economists, was their fundamental misunderstanding of the economy and the distortions engendered by their monetarist economic theory. Like today, after administering the wrong thing (excess money (debt) creation), they were measuring the wrong things (goods inflation) and had a crucial misunderstanding regarding the apparently limitless suspension of the 1920’s economy distorted by more than a decade of excess monetary and credit expansion. To this day, monetarist economists suggest that there was nothing wrong with the stock market in 1929. The National Bureau of Economic Research (NBER) issued a working paper in December 2001 titled “The Stock Market Crash of 1929 – Irving Fisher was Right” (McGrattan and Prescott) in which they stated “We find that the stock market in 1929 did not crash because the market was overvalued. In fact, the evidence strongly suggests that stocks were undervalued, even at their peak.” The Federal Reserve agrees. In March 1999, the Federal Reserve Bank of San Francisco issued an Economic Letter that stated that with stock prices at 30 times dividend yields, the market was not overvalued [11]. (For a clear-eyed comparison of today’s and the 1920’s economy, see the article “ How Could Irving Fisher Have Been So Wrong? ” by Doug Noland - available on the internet [12]) The standard response by economists of today’s Milton Friedman / Irving Fisher monetarist school is that the depression of the 1930’s was caused by Fed incompetence in not increasing the money stock adequately in response to the crash starting in 1929. In fact between January 1930 and December 1933, the Fed did intervene by increasing their purchases of bonds from Banks by 98% per annum thereby injecting dollars into the banking system[13]. This added $2 Billion to bank reserves which should have resulted in further loans and an attendant increase in economic activity. However, bank credit contracted 30% during this period as the initial contraction had revealed the non-productive nature of many enterprises and speculative investments and their dependence upon repeated rounds of financing used to sustain the boom. The excess credit financing of speculative and unproductive activities dried-up as did consumer stomach for debt – a form of credit revulsion took hold and the economy slowed (ultimately declining almost 50% by the mid 1930’s) shaking-out the unproductive enterprises that had grown in the economy after a decade of loose credit. That economists like Milton Friedman and Fed Chairman Greenspan could today advocate that a stock market bubble and crash caused by excess credit accompanied by resultant economic distortions could and should be addressed by even more excess credit, raises serious questions. And yet, that has been Chairman Greenspan and the Fed’s response to the correction of the 1990’s dot.com stock market bubble the Fed and Treasury Secretary Robert Rubin started in 1995 with their “strong dollar” policy (we will see it was anything but). The U.S. and Canada now find themselves in an economic corner. There is a need to continue raising interest rates to combat rising inflation yet we are surrounded by investment bubbles and a housing bubble which will strongly correct if the required action is taken by our central banks. Origins of the dot.com Bubble and Post-Bubble Federal Reserve Action In 1993 and 1994, the Fed increased the broad money stock (called M3) by roughly $80 Billion each year. In 1995 the Fed suddenly reversed policy and started growing the money stock in the U.S. by larger amounts each year thereafter ( up $267 Billion in 1995 and rising until it was increased $597 Billion in 1998) – the stock markets immediately responded with the Dow Industrials Index growing 34% in 1995 vs. an historical annual average of 10%. In December 1996 when the Dow was at 6,500 (up 71% from it level of 3,861 in January 1995, 2 years earlier ) Greenspan warned of “irrational exuberance”. Instead of cutting the annual growth of the money stock, The Fed accelerated its growth and all US stock markets grew tremendously until the bubble pop in March 2000. From 1998 on, Greenspan lost his concern about irrational exuberance lauding the “new economy” and technologically driven “productivity” as justifying the elevated stock market levels. The Dow closed 1999 at 10,970 having increased more than 7,000 points (gaining more than 200%) in just 5 years and the NASDAQ gained more than 500% from a starting value of 752 points in January 1995 to an ultimate peak of over 5,000.
The creation and crash of the dot.com stock market bubble represented a complete failure of the Federal Reserve central bank – yet no accountability or consequences have stemmed from this failure either at the Fed, in the financial industry or in the media which all cheered on and justified the wildly inflated market as it grew [14]. Unchastened, Greenspan went on in 2001to encourage the massive Bush administration tax cuts despite the fact that the Congressional Budget Office warned that capital gains and other taxes received by the Government would drop along with the declining stock market craze and corporate profits were projected to grow modestly until 2010 [15]. Given the Fed’s money (debt) creation combined with further government deficits, the U.S. economy is now more financially indebted than at any other time in history – exceeding even the debt vs. GDP levels of 1934 which were only attained after the U.S. economy GDP declined almost 50% during the great depression.
In the aftermath of the crash in 2000 of the dot.com stock market bubble, the Fed and U.S. Treasury Department (now under the auspices of President Bush’s Treasury Secretary Paul O’Neill) stood ready to make sure that everyone could continue to access credit to rescue the economy and the markets. In January 2001 interest rates were first lowered from an initial 6.5 % Fed Funds Rate to an ultimate 1% (the Fed Funds determines short term interest rates in the credit system).
Before the Fed’s low interest rate response to the dot.com market crash, there were clear warnings made to the Fed about an already developing real estate bubble. The Fed insisted that a real estate bubble was not possible as the U.S. real estate market was composed of many small markets. The Fed now says it has heard “anecdotal” evidence that some real estate markets may be “somewhat frothy”. Single family homes in the entire state of California, representing 20% of the U.S. real estate stock, have increased 35% in price in the last 2 years where single family dwellings are currently 290% of their 1997 price level. The California market has now hit the silly stage where home purchases are financed risky financing methods such as increasing principal loans where the borrower does not pay the full monthly interest on a mortgage (and hopes the house increases in value at a faster rate than the increase in the loan principal). Home prices in North America increased by double digit rates in 2004.
With low interest rates and sharply rising real estate values, consumers were quick to spend their new found “wealth” through cash-out home mortgage refinancing and home equity loans. However, this only represents an increase in indebtedness relying on artificially inflated assets as collateral, not a creation of new or sustainable wealth in the U.S. economy (Noland). The low cost of borrowed money fed speculative finance activity not only in real estate, but also in bonds, derivatives, and the stock markets. Although the stock markets have corrected from historically high valuations, they continue to be over-valued on historical terms. US stock market performance has tracked the Nikkei post 1989 crash profile while, with the lowering of interest rates, yet speculation has returned to the stock markets along with increasing overvaluation of stocks. Excess has returned – the market value of the internet stock Google is now over $76 billion with a p/e ratio of 109.
In aggregate, stocks are still over-valued compared to historical norms:
A Distorted Economy Item: The U.S. has a total debt (Government, Corporate, and Household combined) of $38 Trillion. In addition, in 2002 Treasury Secretary Paul O’Neill commissioned a report identifying that the U.S. had future unfunded entitlement liabilities (Medicare, Medicaid, and Social Security) with a present value of $43 Trillion[16] which in 2002 would have required an immediate and perpetual income tax of 69% if they were to be met. The U.S.’s net annual economic production (Gross Domestic Product or GDP) is $11.75 Trillion with a current budget deficit of $500 Billion per year (includes Iraq War costs). It is clear from these numbers that, even if the economy was healthy, these debts and liabilities cannot be paid. Item: According to the Fed, In 2004 U.S. debt (government, corporate and household combined) increased by $2.72 Trillion dollars[17] (23% of GDP) yet this debt spending in the U.S. Economy can only produce economic growth this year of 3.4% of GDP. Thus $6.50 of debt increase is producing $1 of growth in the economy. Item: The U.S. requires an injection of $2 Billion in foreign investment each day to sustain its economy absorbing more than 80% of the World’s annual savings. Something is amiss. After decades of monetary and debt injections to provide a fix for the economy, the U.S. economy now stands saturated and severely distorted by its credit excess. From a vitally productive and inventive society to one where financial speculation reigns supreme, the US economy has been transformed to a financial betting parlor. Where, historically, manufacturing had accounted for 45% of business profits and financial services accounted for 15%, this relationship has been turned on its ear in the new economy with less than 15% of profits now generated by the manufacturing sector and 45% of profits generated by shuffling paper in the financial sector (stocks, bonds, derivatives, mortgage financing, etc.) . According to the U.S. Bureau of Labor Statistics, the Financial Services Industry accounts for 6% of current U.S. employment giving a sense of outsize profits being generated by the Financial Services sector.
“Globalization” was one of the critical component of the Greenspan / Rubin “strong dollar” policy talk which was initiated in 1995 – it was actually a gross, inflationary dilution of the US dollar (the “strong dollar” policy position is today amusingly repeated by the Bush Administration Treasury Secretary John Snow – despite U.S. Federal Reserve policy, deficit spending and trade policy which is flooding the world with US dollar debt and money). The service industry jobs which were supposed to be generated by globalization have been muted. Instead, the “internet driven global arbitrage in labor”, as identified by Morgan Stanley’s Chief Economist Stephen Roach, has led to a transfer of high skills job out of the U.S. service industry. Operations in China and India using highly educated and skilled workers can provide overnight legal, accounting, engineering and business services over the internet at a fraction of the price of North American service providers. Instead of gradually transitioning to a free trade environment, the U.S. market’s door has been swung wide-open. While this has gutted the production base of the U.S., the pressure of Chinese worker salaries of $0.50 per hour and lax Chinese environmental laws on the U.S. factory worker wages until recently kept consumer goods price inflation at bay. Cheap imports have effectively served as a substitute for prudent stewardship of the money stock by obscuring central bank monetary inflation. This allowed the Fed and Treasury under the Bush Administration to lower interest rates to 1% resulting in a further injection of debt into the economy thereby delaying the consequences of the popping of the dot.com stock market bubble. The correction we face with a housing bubble added to the fray will now be much worse. The depressing impact of cheap imported goods in the manufacturing industry, in combination with the distorting economic impact of the Fed’s decades of credit creation on the U.S. economy, have resulted in the economic “recovery” since the 2001 post-bubble recession posting no net private sector job growth despite claims the economy is healthy. According to Morgan Stanley, the U.S. now has 10 million fewer jobs post the dot.com economic decline than it would in an average previous recovery[18].
While the official unemployment rate has declined from 6.3% in 2003 to 5.2% in 2005, the actual percentage of the workforce that is employed has declined from over 67% of the population in 2000 to 65.5% of the population in 2005 – this despite an increase in the number of elderly forced back into the workforce after the 2000 stock market correction[19]. These contradictory figures arise because the U.S. and Canada both define those unemployed only in terms of individuals actually looking for work. If jobs are not available and an unemployed person is discouraged and in recent weeks has not actively searched for a job, they are no longer counted as unemployed and the government can ignore them in the “unemployment” survey. The Chinese economic “miracle” with unheard of 15+ % per year economic growth is itself the product not only of the U.S. export market but also of central bank monetary distortion within the Chinese economy. In the headlong rush to develop Chinese infrastructure and import technology in the shortest term possible, rather than grow at a measured pace that can be maintained over the long-term, loose Chinese central bank policy has resulted in Chinese banks now sitting on $US 800 billion of bad (or in banking parlance “non-performing”) loans equating to 50% of GDP. Also like the U.S., China maintains interest rates below the inflation rate. Chinese goods are thus subsidized by their own expandable elastic money system and with prices that do not reflect the true cost of production within China. With a declining U.S. economy and rising inflation, it will be increasingly difficult for foreign investors to continue to finance the U.S. deficits at 4% interest on a 10-year bond and sustain the real estate and speculative investment booms in the U.S. Not covered well in the media, is that in September 2004 and November 2004, the Japanese and Chinese, who had been the major purchasers of U.S. Treasury debt, veritably stopped their purchases. How long “Caribbean Banking Centers” [20], who initially filled the gap as foreign purchasers of U.S. bonds, can sustain the U.S.’s debt addiction is open to question. All the while, both Canadian and US household debt is increasing each year by more than 10% per annum. This path is unsustainable, yet U.S. and Canadian leaders have chosen the path of cheerleading the economy along with an obeisant media. And each day consumers are led on by rising and unsustainable housing market prices and a sense that the economy is healthy, to walk deeper and deeper into the quicksand of debt.
The Central Bankers’ Delusion : The Root of Our Economic Malaise In his book “ Debt and Delusion: Central Bank Follies that Threaten Economic Disaster ” [21], Peter Warburton identifies that deregulation of the world’s financial markets since the 1970’s allowed Central Banks to embark on a trajectory of inflating the money stock thereby also inflating by multiples the world’s stock, bond and real estate markets - this all while apparently containing price inflation (for an good summary of Warburton’s book, see the paper Debt and Delusion commentary by Robert Blumen at www.mises.org/fullstory.aspx?control=1579&id=71). The containment of “inflation” depends upon one’s definition of inflation. With the monetary injection into the economies of the West, investment values in almost all financial asset classes have ballooned with the stimulus of the money injected. The world’s equity (stock) markets are now valued at more than $26 Trillion; the bond market has grown from less than $1 trillion in 1970, to $23 trillion in 1997, and $43 trillion in 2002[22]. Real estate is in a bubble. And the derivatives[i] markets have grown to total invested values of $9.1 Trillion and using financial leverage to multiply the opportunity for gain (but also loss), the levered exposure value of these derivatives (what the Bank of International Settlement optimistically calls “notional value”) has grown from $47 Trillion in 1995 to now exceeding more than $200 Trillion – more than 500% of the world’s entire annual economic output[23]. Inflation, while very much around us, has until recently been constrained to financial investments while central bankers have claimed that their inflation of the money supply has not produced classic consumer goods price inflation.
Interest rate related derivative instruments (70% of outstanding derivatives), in particular, are sensitive to sharp interest rate moves. [ii] Fed intervention to buffer investment losses are a previous pattern of Chairman Greenspan as the Fed has invariably turned to liquidity injections and bail-outs of destabilized market participants in times of crisis ( 1987 stock market crash, 1997 Asian currency crisis, 1998 LTCM bail-out, etc.). Lulled by past Fed Intervention and soothing words during Greenspan’s tenure, spiking interest rates are something the bond and derivatives speculators are betting won’t happen. The financial system risk which derivatives represent have long been known (derivatives have been labeled “weapons of mass destruction”), yet Greenspan has for years argued against regulation of the derivatives market. If there is a sufficient interest rate acceleration, this market can quickly lock-up as the levered nature of derivatives which multiplies losses means that, without regulated derivatives exchanges, large amounts of money can quickly be lost and derivatives holders on the wrong side of a trend can be quickly financially bankrupted. Given the level of unstable and levered risk in this market which exceed greatly exceed the assets of all financial trading institutions combined and entering a period where inflation has started to rise, the financial system is particularly vulnerable. Past Fed monetary policy and intervention has combined to form this lethal mixture: excess liquidity and low interest rates combined with the creation of moral hazard as market speculators believe that any crisis brought on by speculative excess will be buffered by a Federal Reserve bailout. In this vein, Warburton notes the danger in central banks serving as the interventional saviors or “lenders of last resort” (LLR’s) to bail-out with public money not just banks but private sector entities which are designated as “too big to fail”. In Warburton’s words “Central banks’ unquestioned roles as LLR’s to the commercial banks and guardians of the financial system maintain an ambiguity over the ultimate responsibility for catastrophic loss, however and wherever it occurs. This ambiguity has promoted excessive risk-taking in the private sector and has fostered the very circumstances in which financial disasters have occurred before.” [24] Until recently, consumer goods inflation were restrained in their price rises because (1) “Globalization” providing cheap imports have until now capped consumer goods prices, (2) our governments have defined inflation measures in a way that understates true price rises (see discussion below), and (3) financial investment vehicles have absorbed the lion’s share of the profligate money creation bloating all investment classes during this period. This is the failure of the Fed and the all the world’s central banks: they have viewed inflation in terms of prices of goods in society as opposed to an increase in the money stock and have increased money and debt in society believing they were free to do so without understanding distortion this engenders in the operating structure of the economy. While the inflationary monetary liquidity is locked in the financial markets, our notion is that consumer price inflation remains apparently stable – however, if speculation in commodities and then goods inflation occurs or if investors seek stability by investing in commodities and traditional safe havens such as precious metals, then even a relatively small portion leaking from the multi-trillion dollar financial investment silos can drive commodities prices skyward thereby resulting in an explosive appearance of consumer price inflation, forcing up interest rates to contain the inflation. The kimono so cleverly hiding central bank fiat monetary inflation for decades will suddenly be dropped. In a perverse replay of the 1970s, we may potentially see loose monetary policy followed by weak economic growth and rising commodity prices (or stagflation) – except in this version we will have twice the debt-to-GDP ratio and investment bubbles as the inflation starts to manifest itself. Speculation in commodities has already started. Driven both by international demand as well as a hedging against currency declines, the past 4 years have seen a 65% increase in the price of commodities shown in the CRB Commodities Index chart below. Inflation has now also reared its head in the U.S. consumer price index which is rising at an annualized 6.2% in the first quarter of 2005 and 3.5% in the 12 months through the first quarter. And these price rises are in spite of cheap import compressing price rises in the economy.
The manifestation of strong goods price inflation can result in one of two responses by the Fed and the World’s Central Banks: · With an aim to maintaining foreign investor confidence, defend the dollar and ultimately other fiat currencies by strongly raising interest rates. This would eventually control inflation but pop the debt-dependent investment and asset bubbles (including the real estate bubble) with severe economic fall-out. This would leave heavily indebted consumers in a form of indebted servitude unable to pay-down debt incurred in a low interest rate, real estate bubble environment. · Abandon defense of the dollar injecting massive amounts of liquidity (money) into the banking system resulting in a hyper inflationary spiral and ultimate collapse of existing paper currencies. There is third scenario which is unlikely. However, the loss of personal privacy and freedoms in the US and Canada since the 9/11 “War on Terror” was initiated makes what would have seemed absolutely impossible a decade ago now at least a considered, although remote, possibility. That would be to declare the free market too “dangerous” and the imposition of tighter government control over the economy and individuals (a scenario suggested by Jim Sinclair “Mr. Gold” of www.jsmineset.com ). It would be an irony indeed that an economic emergency caused by the failed paradigm of central planning in turn applied by central banks to a mal-designed monetary system should be deemed a failure of the free market. The game now remains one of confident statements by central bankers and politicians worldwide to continue the debt, investment and speculation cycle in financial markets. “Inflation is contained; commodities price surges are temporary; the world foresees steady growth.” It is essential that the silos of investment capital, that have temporarily enabled their policies, be maintained and constrain capital from flowing into commodities and precious metals. Former Federal Reserve Governor Ben Bernanke’s 2002 statement that the Fed stood ready to drop money from helicopters if deflation becomes a threat, perhaps becomes clearer. What sounded like an irresponsible boast made some look the wrong way (away from speculation in commodities) by giving the impression the Fed was fighting deflation, an environment where commodities lose value, not the explosive inflation that lies in the wings. The irony in Bernanke’s statement is that the Fed and central banks have been figuratively dropping money from helicopters for decades. A U.S. national savings rate being below 1% of GDP ( a record low vs. an historical norm of approximately 6% of GDP) has been driven by the Fed interest rate being lowered to its low of 1% (and at 3% today, still below the rate of inflation). This has made the U.S. dependent upon foreign sources for financing of budget deficits and trade deficit requiring the daily injection of $ 2 billion of foreign capital. With the Japanese and Chinese pause in US Treasuries purchases, a sustainable source of foreign financing for the US has not yet appeared. Foreign investors already hold more than $5 Trillion in U.S. Treasuries, currency and stocks alone. A decline in foreign appetite for U.S. investments can send investment paper washing back to the U.S. Just a slowdown of US debt purchase by foreigners, not a full stoppage or dumping of U.S. dollars, is all that is required to cause a further fall in the US dollar and interest rates to rise steeply disrupting markets and precipitating a further decline of US investments held by foreigners. Compounding the tenuous nature of the current situation is that 60% of the outstanding $4.5 trillion U.S. Treasury bonds (net $2.7 Trillion) in the hands of the foreign and domestic public will mature within the next 3 years. Thus in addition to the $500 billion in treasuries that need to be floated each year to finance the budget deficit and the Iraq war, another $900 billion on average must be rolled-over into new bonds to continue the U.S. debt at the current low interest rates [25]. In total, $1.4 trillion of U.S. Treasuries need to be purchased each year by foreign and domestic investors – unless the Fed wishes to print more money and purchase the bonds itself. This is perfectly possible but will be attended by much higher interest rates as even the lethargic “bond vigilantes” recognize the aggressive dollar dilution this signals. How did we ever get to this point? That the money stock can today be manipulated at will by central banks is a consequence of our current unbacked (or “fiat”) monetary system. In years past, the world’s industrial economies were limited in their ability to manipulate the money stock as most currencies were on a strict “gold standard”. Gold backed a country’s money at a fixed ratio and currency was freely redeemable for gold from a country’s treasury and banks at that fixed ratio. Because the gold standard monetary system prevents limitless creation of money, it has been noted: “Gold is an unimaginative taskmaster. It demands that men, banks, and government be honest. It demands that they create no debt without seeing clearly how these debts can be paid… … But when a country creates debt light-heartedly,… …then gold grow nervous. There comes a flight of capital (gold) out of the country. ” [26] Benjamin M. Anderson Much to the bane of politicians and central banks, currency backed at a fixed gold ratio and freely redeemable for gold coin from a country’s banks and Treasury allows that currency’s citizen holders to convert that currency to gold coin and to either hold it in hand or safety deposit boxes within a country. Foreign holders could also remove the gold from a country that exercises economic policy that cannot be supported by reasonable taxation and fiscal policy. By removing the backing mechanism (gold) from banks and the Treasury, such action essentially removes money from circulation within that country forcing-up interest rates and forcing a change in policy by the offending government (Fekete). This disciplinary “problem” was addressed gradually over the 20th Century by governments’ transition to today’s monetary system where no currency redeemable in gold thus allowing central banks to control the money supply by central bank edict or “fiat” - a privilege that all have abused. With the elastic, fiat monetary system where the money stock is freely expandable, Governments are able to generate large debts by issuing government bonds then dissipating the debt at a later date by printing[iii] currency to consume that debt by inflationary dilution and devaluation. Creation of money to stimulate an economy is nothing new. The Romans secretly diluted their silver coins and the Chinese (the first to use paper money) experienced monetary inflations in the 1300s During the 20th Century the world witnessed Weimar Germany undergoing hyperinflation (defined as more than 50% per month) in 1922 – 1923 which consumed its WW I reparations debt. Serbia issued 500 billion dinar notes as recently as 1993 with daily rates of inflation of 100%. Hyperinflationary periods result in currency crashes so the helicopter money scenario discussed by Ben Bernanke is not an attractive scenario. In the U.S., the United States Revolutionary War in 1775 was financed by the Continental Congress issuing notes (“Continentals”) which were unbacked by gold or silver and were predictably printed and inflated to worthlessness leading to the saying “not worth a Continental” and George Washington to comment “A wagonload of currency will hardly purchase a wagonload of provisions.” [27] This as well as other bank currency schemes in the 1800s left a deep and abiding distrust for irredeemable paper currency in the American people. ---------------------------------------------------------------- How is money created and the money stock controlled? “This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system…” Robert H. Hamphill, Formerly of the Atlanta Federal Reserve Bank Three concepts are key to understanding the creation of money,
Money is lent from the Central Bank to chartered banks which in turn lend out multiples (typically 10 times the amount received ) thus creating money in the economy. This is referred to as “fractional reserve banking”. If interest rates are held constant and central banks lend money beyond demand in the banking system, banks lower credit quality requirements for borrowers to stimulate demand and “deploy” their assets. Central banks lower interest rates thus stimulating demand for loans which are then offered by banks, again as multiples of their cash deposits, to create money by simply crediting accounts. Contrary to popular belief, a loan does not necessarily come from someone else’s savings. It is merely created as an account entry as a response to the issuance of a loan. The flip side of this consideration is that if all loans were paid-off, the money stock disappears - thus Mr. Hamphill’s comment that our system exists without a permanent money stock and the need for increasing debt levels. By the broad monetary measure called M3, all the money in existence (Canada roughly $930 billion and in the U.S. $ 9.6 Trillion) reflects institutional loans that require the payment of interest.
Our central banks, the US Federal Reserve and Canada’s Bank of Canada are relatively new creations – they are not the inevitable result of using currency whether or not that currency is backed by gold. There is an alternative to this monetary system and that is one where the Treasury of Canada or the U.S. would issue money which is permanent (whether backed or unbacked by gold is another discussion). In such a system, the Treasury would issue money, typically through government spending, without money being created through bank loans. Such money would be permanent and exist without being originated as a loan – however this would remove a major profit generating mechanism from our financial institutions as it would greatly slow the growth of debt. ---------------------------------------------------------------- The Fiat Cat Keeps Coming Back In America, the failed “Continentals” were followed in 1861 by another attempt at issuing a central currency because, as noted by the Federal Reserve itself, “once again the need to finance a war provided the impetus for a change to the monetary system.” [28] That war was the Civil War. Thus, in 1861 Congress authorized “Demand Notes” (called greenbacks due to their green ink) which were unbacked by gold and then in 1862 also began issuing “United States Notes” which, during the Civil War and until 1879, were also made irredeemable in gold and silver coin. Both the North’s Notes and the South’s Confederate Notes were printed (and counterfeited) en masse during the Civil War deepening the mistrust of U.S. citizens (North and South) for irredeemable paper currency. (It should be noted that the Federal Reserve on its website states the fact that paper currency U.S. Notes issued by the North starting 1861 (Confederate notes were in the end worthless) are still redeemable for modern monetary notes at face value is important for “the record or currency stability which this represents” [29]. That this currency only has a fraction of its original buying power seems to escape the Fed.) The US Federal Reserve Bank was created in 1913 when the American people were reticent to have a central bank – a sentiment arising both because of numerous upheavals from previous failed currency manipulation[iv] in the U.S. and in other countries. The reticence also existed because of a fear of concentration of power which many believed would be abused by “Money Trusts” in the Eastern financial banking centers. Reflecting this mistrust, the Wizard of Oz was written as an allegory about the dangers of central bank wizards; where the Wizard of Oz represented central bankers who promised ceaseless wealth by magical means; Oz was short for the gold ounce, Dorothy represented the average rural American citizen, the Cowardly Lion represented the weak William Jennings Bryan who, although a leading Democrat populist supporter of full gold and silver backing of the dollar, caved to the interests proposing the Federal Reserve Act, the Tin Woodman representing the American factory worker, and so on. [30] To address the concern of American citizens about a Central Banking System, the Federal Reserve Act of 1913 created a system of 12 regional banks now overseen by 7 governors appointed by the President. In theory, this was a system of regional banks. In reality, these reserve banks formed the U.S.’s Central Bank overseen by the Board of Governors and its principal policy making body, the Federal Open Market Committee (FOMC). The creation of the Federal Reserve was on the eve of World War I which began in 1914 and the Federal Reserve Act was passed on December 22, 1913 by the U.S. Senate by a vote of 43 to 25, at a time when 28 Senators were away for Christmas vacation, and signed by President Wilson on December 23. With the creation of the Fed, money was backed by gold but could be created in greater quantities than held in gold by Treasury. After running on an election platform promising to retain the gold standard, President Franklin D. Roosevelt (FDR) reneged in 1933, confiscated gold held by U.S. citizens in their Bank deposit boxes and suspended the right of citizens to own gold or redeem U.S. notes and Federal Reserve notes for gold (although foreign holders could). Finally in 1971, after having run an exceptionally loose monetary policy and creating money at multiples of the official gold reserves of the US to finance the Vietnam War, after France (initially) then other countries redeemed massive amounts of U.S. currency for gold. To prevent such further delivery of national assets for outstanding debt, ending all pretenses, President Nixon officially defaulted and made all U.S. currency and debt instruments held by foreigners also irredeemable for gold. The U.S. public was once again able to own gold by law. The dollar has lost 92% of its buying power since the Fed’s initiation of operation in 1914 while during the 1800’s, despite bouts of currency manipulation, the buying power of the gold-backed dollar was ultimately steady when the interventionist schemes subsided. Central Banks and Their “Elastic” Currency The founding fathers, being aware of the withering effect of monetary inflation which had occurred with the unbacked “Continentals” during the revolution forbade the use of a currency that was not gold or silver backed. Specifically Article 1, Section 10 of the Constitution stipulates : “No State shall… …coin Money, emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; …”. Despite clear and express opposition of those who wrote the Constitution to un-redeemable fiat money as Legal Tender, through a series of hand-wringing decisions, U.S. courts in 1878 finally ruled paper money constitutional allowing the future removal of gold and silver from any disciplinary role in the issuance of US currency [31] There are many who have voiced concerns about the creation of the Federal Reserve and the elastic money it created including Warren Buffett’s father [32] (Congressman 1943-49, 1951-53) as well as Alan Greenspan himself in a previous manifestation [33]. From 1914 and on in the U.S. and in Canada we have the current age of Central Bank fiat currency, where the Central Bank in each country modulated the amount (stock) of money and its cost (the interest rate) in an effort to control the economy. Freed by the suspension of the fixed convertibility of money into gold, Canada and the U.S. were able to finance their war activities with an “elastic” (expandable) money stock. Since the creation of the Federal Reserve, the U.S. has had three major price inflations corresponding with an increase in the money supply: 1914 to 1920, 1939 to 1948, and 1967 to 1980 [34] – coincidentally corresponding to WW I, WW II and the Vietnam War, respectively. The Federal Reserve Bank, while permitted to operate U.S. monetary policy by the U.S. government, are not Federal at all and they have no hard reserve backing the Federal Reserve notes. Instead, the Fed’s shares are fully owned by a combination of national banks (who must own shares in the Fed) and state banks (who may own shares in the Fed). Thus the U.S. monetary system (interest rates, money stock growth, etc.) is controlled by an institution (the Federal Reserve), that, while approved to operate by the Federal Government, is a private institution owned by banks operating in the U.S. In conjunction with the Fed, the U.S. Treasury prints Federal Reserve Notes (today’s paper dollar currency) at the directive of the Federal Reserve. The Secretary of the Treasury is the principle economic advisor to the President and thus works with the Fed although he does not have authority over the US money stock – only the Fed Board of Governors and the Fed’s FOMC has that control and operates independently. The interest rate setting FOMC is composed of the 7 Fed Governors plus the president of the New York Fed plus 4 other presidents selected from the remaining 11 Fed Regional Banks. The Fed has grown in its powers over time. Initially limited to controlling the money supply under the directive of the Secretary of the Treasury, the Fed’s powers have been increased both by Congressional action and by the Fed’s own edict. As an example of the latter, the Fed states that in order to maintain its “independence” the Fed of its own volition in 1962 began to intervene in foreign currency markets [35] that had been the strict purview of the U.S. Treasury. This raises the question how an independent, non-government body can expand its own powers giving it the ability to act in contravention to the Department of the Treasury which is overseen by the President and the executive branch of government. In Canada, monetary policy is set by the Bank of Canada. Established in 1934 as a privately held bank, the Bank of Canada was nationalized in 1938[36]. Since Confederation, Canada’s dollar had been redeemable at a fixed quantity for gold. Due initially to World War I, from 1914 to 1926, and forward from 1931 (de facto) and officially (by Cabinet Order) in 1933, Canada’s currency was removed from the fixed gold standard. The Age of Monetarism – Already Looking for a Place to Happen In 1911, the famed economist, Irving Fisher published his “quantity of money” theory in his work “The Purchasing Power of Money” where he postulated that the level of economic activity was somehow related to the amount of money in an economy. What Fisher did not show with his theory was causality – that the government could effect greater sustained and real economic activity by increasing the money stock. This was not an issue as the Central Banks in 1914 did not rely on Fisher’s economic theory as justification for their massive increases in the money stock. A war was on and money needed to be created and spent in relation to the war effort – they now had the elastic money stock needed. That there was immediately a price inflation in 1914 in both the U.S. and Canada followed by the stock market mania and crash of the 1920’s tells us the machine was not quite perfected. A tangible sigh of relief must have swept through central bank and government circles with the publishing of John Maynard Keynes’ “General Theory” in 1936 which put forth that during economic slow-downs, falling prices were evidence of “insufficient” money in the economy and not only could the money stock affect the level of economic activity, the government and central banks should intervene with government spending and Central Bank injections to the money supply to counter this “insufficiency” made evident by falling price levels – this theory is accepted even today by government and Central Bank economists. Keynes’ theory relied on humans acting neatly and predictably as aggregates who, no matter what the money stock levels, could and should be steered by government and central bank intervention using their mathematical models. Not all embraced Keynes. As noted by economist Henry Hazlitt: “I have been unable to find in [Keynes’ General Theory] a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, even much that is fallacious in the book is not original, but can be found in a score of previous writers.” [37] However, the ball was already rolling and Governments and Central Banks now had the ammunition backing the monetary and government expansionist policy they had already been using – creating money to allow activity beyond their means. “In the long run we are all dead.” - Keynes Keynes trite argument for not waiting and rather intervening to spur on the economy should give us pause for our current monetary intervention in the economy. Before monetarism and Keynes’ belated theory to justify Central Bank expansion of the money stock and government spending to boost the economy, there was what is now referred to as the Austrian School. Starting in the late 1800s the name ‘Austrian’ was applied as a derisory term by German economists to attempt to portray this group as not being part of the mainstream Prussian-German body of economists. In the Austrian school started by Carl Menger in the 1870’s and extended most famously by Ludwig von Mises (1881 – 1973) in the 20th century, the central tenet of this school was that analysis of economic phenomena and then attempted explanation by various mathematical models was not possible – humans are complex and cannot be predicted by aggregating their “average” behavior according to neat mathematician’s curves. The nub of von Mises’ theory was as follows: the complexity of human behavior required that you could only develop a rational and objective economic theory based upon fundamental logical principles (deduction) of human action as opposed to the monetarists’ and Keynesians’ selected observation followed by attempted mathematical modeling (induction). (The latter method being the source of endless frustration of those who rely on economist’s predictions as mathematical forecasting models have shown their failure. To wit: President Lyndon Johnson’s exclamation “Will someone get me a one-armed economist!” after tiring of hearing “On one-hand…. Yet on the other hand….” from his economists with their insufficient models and need to hedge their predictions.). von Mises correctly identified that all individuals are independent actors and the effect of addition of money to the money supply would see individuals using it in different ways that could not be predicted – only observed after the fact. von Mises identified that the pool of funding (loan availability from savings) in a gold standard economy is set by organic growth of the economy through productive enterprise and consequent savings. As a medium of exchange, the money stock in the economy and the associated bank interest rate of money transfers critical information about the state of the economy, self-adjusted economic activity and were thus not to be manipulated. The Austrian / von Mises model works as follows: in a system with a given money stock, the availability of money through savings in bank accounts sets interest rates according to the laws of market supply and demand. With high consumer spending, bank accounts would be drawn-down and interest rates set by market forces would increase to attract savings so that banks could still provide loans. These higher interest rates would focus industry on activities which would give short-term financial return on the loans by satisfying current consumer and industry demand. As consumer/industry needs were met, demand for goods would slow somewhat and savings would increase thereby lowering interest rates as more money was available for lending. Less costly loans at lower interest rates allow industry to undertake longer-term project which give a return over a longer period. “When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives rise to the consumption of goods, which is not preceded by production (and savings). It leads to less means of sustenance. As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downwards plunge. The most aggressive loosening of money will not reverse the plunge…” [38] Frank Shostak Under a gold standard monetary system, the availability and cost of money, as the signaling mechanism for self-adjustment of the economy, is continually adjusted by economic activity as a consequence of the decisions of consumers. Because there is no central bank intervention into interest rates and the money supply, the continual self-adjustment of the interest rate and industry and consumer response to these movements results in interest rates tending to be stable and varying little over time. As a result of this continual market driven adjustment of interest rates, economic growth and recessions also tends to be more steady under the gold standard. From 1850 to 1910, the U.S. average economic growth of 1.3% per worker[39] per annum which speaks to the relative strength of the economy during this period of industrialization and social upheaval. Compared to the contraction of GDP by nearly 50% during the Great Depression, the gold standard performed in a far superior manner compared to the Federal Reserve’s elastic money era which quite literally started with a bang (and will likely end thus). As a result of this stability, under the gold standard there is little variability between various bond maturities be they 1-year, 2-year, 5-year, or 10-year bonds; because interest rates vary little, bond market speculation over interest rates would be stopped and they would simply hold value for their intrinsic interest rate return of the bond. What economists today call the yield curve which graphs variations in bond yields based upon their maturity, simply reflects anticipation of central bank error and correction of interest rates. This guessing game and speculation over what the central bank will do with interest rates disappears under the gold standard[40] as does the opportunity for outsize trading profit, which depends upon changing sentiments as to where interest rates are headed. This would free up some of the greatest talents in our society to pursue truly productive activity – minds which today are locked-into the financial markets trying to find opportunities to make profit by clever trading of financial assets. The effect of central planning intervention by central banks in manually enlarging the money pool and manually setting the interest rate, forces interest rates down to levels far below the natural market set-point, thus mal-structuring the economy and the demand for goods and services by distorting the market pricing mechanism of money. In addition, with excess money and credit available in the economy, growth of ineffective commercial enterprises, “investment” wagering, bubbles and crashes occur that otherwise would be limited when the availability of money meets the natural productive needs of society. Artificially inflating the money supply (savings pool) to drive demand is no replacement for preceding organic growth and savings in the economy. von Mises saw the folly of central planning of the economy and the distortions and overshoot created by interfering with the natural market pricing mechanism of money by Central Banks interfering with the money supply and the natural market rate of interest. The resulting distortions in the economy caused by excess credit creation ultimately reveal themselves when the credit and interest rate policy of the central banks are normalized as they always must (if not, crippling inflation explodes within the economy as the excess money creation starts to manifest itself in higher commodity and goods prices driving the price level higher). von Mises also identified that in prolonging the expansion of credit, in addition to mal-structuring the economy, by definition dictates that continually lower credit quality borrowers must be brought into the credit pool which further destabilizes the financial system. When these distortions and uneconomic activities are revealed and shaken-out by rising interest rates, a sharp recession follows while restructuring the economy for future productive. If the credit and money supply distortions continue for a long-enough period, then this correction is strong and prolonged as was the 1930s Depression – von Mises indelicately named such a collapse and general depression a “crack-up boom”. von Mises’ noted that when rationally arguing the monetarist/Keynesian model be abandoned because of the inevitable unsustainability, economic distortion and busts it produces, he found: “It could not influence demagogues who care for nothing but success in the impending election campaign and are not in the least troubled about what will happen the day after tomorrow. But it is precisely such people who have become supreme in the political life of this age of wars and revolutions… …Nearly all governments are now committed to reckless spending and finance their deficits by issuing additional quantities of unredeemable paper money and by boundless credit expansion.” [41] On Keynes’ “new economics” he noted: “The policies he advocated were precisely those which almost all governments, including the British, had already adopted many years before his “General Theory” was published. Keynes was not an innovator and champion of new methods of managing economic affairs. His contribution consisted rather in providing an apparent justification for the policies which were popular with those in power in spite of the fact that economists viewed them as disastrous. His achievement was a rationalization of the policies already practiced. He was not a “revolutionary”, as some of his adepts called him. The “Keynesian revolution” took place long before Keynes approved of it and fabricated a pseudo-scientific justification for it. What he rally did was right an apology for the prevailing policies of governments. This explains the quick success of his book. It was greeted enthusiastically by the governments and the ruling political parties. Especially enraptured were a new type of intellectual, the “government economists”. ” [42] (One of Keynes’ great advantages was that his “theory” necessitated legions of economists analyzing data and creating mathematical equations in an attempt to model the results – and thus it was quickly embraced and promoted by economists in both government and academia. It is telling that today there is no unifying and complete theory of monetarism and Keynesian intervention. Economics textbooks invariably state that the real world can be explained by macro-economic theory which is a patchwork of monetarism, a bit of Keynesianism, several other concepts – and a pinch of moon dust. Almost nowhere in University macro- economics texts can we find analysis of the “Austrian” school. This writer in completing his MBA heard months of monetarism and Keynesian theory. On the last day of lectures, the professor mentioned that there was another school of macro-economic thought and that they were called “fiscalists” - that was it. Fiscalists, indeed. They are also called the Austrian School.) In discussion of the Keynesian philosophy of active monetary and government intervention with economists, one typically gets the response that monetary intervention is correct “you’ve just got to know when to stop”. That government spending intervention, central bank monetary intervention and suppression of interest rates distorts the market pricing mechanism structuring the economy with unproductive enterprise and attendant speculation, and that the consumption of savings today at the cost of tomorrow’s economic growth, is beyond their ken. A final note on Keynes. Keynes well understood the damaging effect of a system of inflating elastic money. In 1919, in his book The Economic Consequences of the Peace, he made the observation about inflation: “..By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens..” von Mises’ theory did not win him many friends because they worked against the perceived interest of the political class, economists and academics, bankers and the investment industry. The tragedy of von Mises remains that, as a Jewish intellectual living in Switzerland during WW II, upon the publishing of his major work “Nationalokonomie” in 1940 which was written in German but went against the prevailing socialist winds of the National Socialist (Nazi) party in Germany (the book was later published as Human Action in 1949 by the Yale University Press), von Mises was pressured to leave Switzerland narrowly escaping through France to the United States. While almost all other socialist and communist economists who emigrated to the U.S. could find employ and despite von Mises keen and productive mind and extensive publishing of economic thought, he could find no paid economic tenure in the U.S.[43] The real testament to von Mises’ strength of character is he never capitulated. He steadily supported an economic approach that he knew was superior despite the fact that easy personal reward, which his peers so easily accessed, lay in promoting monetarist economics. --------------------------------------------------------------- Creative Numbers von Mises saw the occasional and shallower slow-downs in the economy under the gold standard as a healthy restructuring of the economy for future growth where ineffective and unproductive enterprise are weeded-out. During periods where there is higher measured unemployment, those with jobs tend to spend less until the economy strengthens. Keynes called this phenomenon the “Paradox of Thrift”[44]. According to Keynes’ theorem, citizens’ response to an economic slowdown makes slowdowns worse than need be. During these periods, Keynesians and many political leaders feel that more money needs to be injected into the economy and government spending enacted to overcome this natural economic characteristic. In the 1970s during a period of economic turmoil and high inflation, we saw the introduction of the “unemployment rate” that only included individuals actively looking for work; the unemployed who were discouraged were not counted as unemployed. In this way, citizens were presented with a better picture to prolong their spending (but deepening imbalances) and politicians, who liked to pretend they create jobs during good time yet not wanting responsibility for slow-downs and job losses, were offered an out. As noted above, today we hear from Washington that inflation is subdued, the economy is strong, and unemployment is declining. If we look at the “employment participation rate” which is the percent of the population actually employed, we find that there has been a steady decline from 67% of the U.S. population employed in 2000 to 65.5% of the population employed in 2005. This while the Bureau of Labor Statistics states the Unemployment rate has dropped from 6.3% in 2003 to 5.2% in 2005. In addition to inflation’s human toll which aggravates voters, governments are averse to acknowledging inflation because it triggers the hoarding response which creates artificial shortages worsening the price inflation condition. Price inflation also increases the cost of entitlement costs (old age pension / social security payments, welfare payments, etc.) limiting the amount of new government initiatives that can be undertaken. Yet inflation is a feature of the fiat money system. We’ve also had the introduction of the “core” consumer price index (CPI) that excluded “volatile” items such as food and energy. If a government understates inflation, pension and employment wage increases which are indexed to the “Core” CPI are diminished – Social Security payments alone constitute a $480 Billion per year expense for the U.S. government. Containing benefit increases that compound annually in the social security budget is not a trivial matter. In addition, the Consumer Price index is now calculated using a tool called “hedonics”. The term is derived from the Latin word “pleasure”. For example, if a product such as a computer were to feature a 50% greater speed for, say, the same price year-to-year, the product would be deemed to be 33% cheaper ( 100% / 150%). More than 35% of the U.S. basket of goods in the CPI is hedonically adjusted including clothing. For a summary of how government statistics are massaged to make the consumer and business leader feel better while having less money left over see links below for papers by Gillespie Research [v]. In Canada, the CPI shelter component in Canada is now broken down into two components: Rented Accommodation and Owned Accommodation that together constitute 26.8% of the total CPI basket. The Rented Accommodation component accounts for roughly 1/3 of the Shelter Component while Owned Accommodation accounts for 2/3 of the Shelter Component. The art in the Canadian CPI calculation is interesting. The Rent Paid portion accounts for approximately 6.0% of the total CPI basket while the Owned Accommodation cost is calculated using an “imputed user cost” or what “rent” for which a homeowner could rent the accommodation back to themselves. In calculating the imputed user cost, the mortgage interest composes 5.4% of the total CPI basket, building depreciation costs (excluding property value) are calculated at 2% per annum of the building value (3.3% of the total CPI basket) and property taxes (3.2% of the total basket) are utilized - it is assumed that the property is not amortized (i.e. the mortgage is never paid-off). Adding the above, the total direct Owned Accommodation housing costs (excluding insurance, hydro, water, maintenance, etc.) accounts for 18% of the CPI. When all shelter costs are included, shelter composes 26.8% of the CPI. According to the Royal Bank’s Housing Affordability Index, rent accounts for 40 to 70% of renters’ pre-tax median income while home ownership costs (including amortization of the home loan but excluding maintenance) accounts for 20 to 30% of home owners’ pre-tax median income in Canada. In total, the Royal Bank finds that shelter costs for all households in Canada (overall rental and ownership costs combined) total 25 to 40% of Canadians’ pre-tax household income. This compares to a total CPI shelter component of 26.8% of the consumer goods basket which would reflect post-tax costs and assume no amortization of mortgages. New housing purchasers in Vancouver and Victoria will be heartened by the following March 2005 CPI statistic: without adjusting for inflation, owned accommodation dollar costs in Vancouver are 95.3% of their 1992 costs and in Victoria they are 96.9% of their 1992 – adjusting for the Bank of Canada estimate of 26.6% inflation since 1992, owned accommodation costs today are 75.3% of the 1992 cost for Vancouver and 76.5% of the 1992 cost for Victoria. (for reference: The Real Estate Board or Greater Vancouver gives a current detached house average selling price of $555,000 vs. $300,000 in 1992 (and $400,000 at the beginning of 2003) for an increase of 85% and a similar 81% increase in condo housing prices over the 1992 to 2005 period) – as amortization is ignored in the index. In July of 2004 with interest rates at their bottom, it was determined that the mortgage interest cost at 8.4% of the Consumer Price Index basket was excessive and this component was reduced to 5.4% of the basket total (a 33% decrease). The total shelter component of the CPI was also decreased by 8% from its previous weighting – this at a time when real estate costs were climbing steeply across Canada and interest rates would start to climb. What the CPI reflects is not clear, however, it should not be used to inflation adjust pensioner income and cost of living increases in labor agree |
