Economics is the branch of social science that deals with the production and distribution and consumption of goods and services and their management. And, to a large extent, economics is a set of beliefs. Many of the beliefs cannot be proven. Nobel Prizes for economics are handed out when beliefs are more-or-less proven. In order to separate false perceptions that the immediate hype and spin induce sometimes it is necessary to go back to the beginning and re-ask basic questions. Yet another reason exists to do this. Unfortunately, historians and theoreticians rarely are in positions to see the true workings of what they choose to write about. Once I was responsible to provide input to the historical summary for the year for my organization. I found myself depicting only the best and coloring the rest to be clean and shiny. People do not want a precise and truthful depiction of events. They would much rather read history as it is depicted History of the English Speaking People by Winston Churchill. What we think we know is often just a popular story. So, we really need to ask if what we think we know really dovetails with our views of how we humans think and act. How can any historian really get a feel for the greed, that money induces? How can a historian convey the intense desire for power that some people feel or explain the mentality of Alexander the Great? How can historians explain that human nature, interwoven with time, created the present financial system?

The economic theories (Adam Smith, J. M. Keynes or whomever) are often quoted as if their theories were facts. These so called ‘facts’ then support a particular view of how the economy works. The financial system is just part of the economy, but nobody can really grasp all the intricacies of the entire financial system. So, while economics exists on a higher plain of principles, finance exists on a much lower level of interests, intrigue, and political agendas. Finance is where the rubber (money- no pun intended) meets the (economic) road.

The Financial System

By definition the financial system is the system by which money is accounted and tracked. The financial system is the plumbing through which money flows. Like plumbing with its spigots, cut-off valves, air chambers, etc. to control the water flow; the finance system controls money flow with its equivalents: interests, politics, laws, rules, definitions, institutions, accounting standards, perceptions, and emotion. But, unlike plumbing all these controls are in continuous flux. Politics has buried within the financial system; mechanisms that intentionally thwart market principles. Finance is a political battleground for fighting over the allocation of money. So while economic theory seeks to address what happens in a market, its major sub-element, finance, does not operate on the principles of a free and open market. All one can hope to do is take a thin slice of the financial system and examine it and how that slice of it interacts with the economic system.

If money did not exist, the financial system would not exist. Trading sheep for grain does not need a financial system. Perhaps the invention of numbers and the subsequent acceptance of a medium of exchange forced the development of accounting. Clay tablets dating back thousands of years show rudimentary accounting. The modern double entry system of bookkeeping is only a few hundred years old. At some point the concept of debt came about. Debt is built upon the belief that something borrowed can be used to produce three specific benefits: 

1. Repayment of what was borrowed, plus

2. Interest or benefit to the lender, plus 

3. Benefits for the borrower.

If any one of these three criteria is not met, debt is not practicable. Debt acts like a time machine. Debt is the means by which benefits in the future can be exchanged for benefits that exist today. The reverse is true for the creditor/lender: the benefits of today can be exchanged for the benefits of tomorrow. Debt is central to modern financial systems.

Underlying debt and making it work is the cultural ethic calling for integrity in the repayment of debt. That cultural ethic became part of contract law. After the state assumed responsibility for enforcement of contract law, banks really developed. We credit the Greeks with the creation of elected political leaders. But, we often fail to credit the Germanic tribes of Europe with the cultural basis for elected leaders. The crucible of the Dark Ages and Feudalism were the foundation upon which western society is built. Nascent democracy slowly gained prominence as Europe slowly unbound itself from feudalism. Feudalism used control of land to exercise power. But land is finite and power depended upon how much land was controlled. There existed no real way to expand the productive capability of land. Wealth and power became synonymous with landholding. Then from handicrafts came the guild system. Within it grew the concept of “business” without roots in land. Individual competence replaced ‘birth right’. The power of business grew in a geometric progression. The feudal aristocracy lost power to more competent operators in the ‘bourgeoisie’. The bourgeoisie preferred to elect their own political leaders. So the feudal power and its nobility that had control of the land, lost power to productive power of business and individual competence.

Still some remnants of feudalism remained. One such remnant was control of the medium of exchange. The control of coinage eventually passed from a king to an elected body. But, the bourgeoisie insisted that the medium of exchange be real, not promises. Gold and silver remained as money. The next step in this evolution was the replacement of actual precious metal by a promise of repayment in those metals. It responded to the practical need to get away from the cumbersome weight of gold and silver. Gold and sliver had little practical use. They could not be eaten or used for much beyond jewelry. But our culture kept them as valuable and desirable possessions. Today, money has become a promise is to pay with another promise. In part, this is in response to the need to reduce the weight and volume of paper money. Humanity needs more than a single layer of promises in order to believe what someone claims. The belief in money is no different. It also requires layers of justification as well. So instead of rarity and historical significance, we use modern ideas like supply and demand, etc to fulfill the human need for justification of link between money and value.

Political office conveys a form of status. For some, political office is immensely desirable. Money is always needed to reward supporting interest groups. The financial system, offered a bountiful opportunities for political abuse... for the sake of the country, of course. So, it should not seem strange that political power has a close relationship with money and is absolutely captivated by the concept of debt. As pointed out earlier, debt has the unique ability to increase current revenues by taking from future revenues. Those in political office were able to see that encumbering future tax revenues with promises could make more money available for immediate use. Debt could be used as a vehicle to morph future tax revenues into the present. The trick was making lenders believe that future tax revenues are a sure thing and would be actually be used for debt repayment. There is one major fly in the ointment. The three criteria mentioned earlier must be met. Debt is a three-part equation. The relationship between public debt and the third criteria is an interesting one to contemplate.

The Politics of Debt

Over time, the concept of debt became divided into rights and obligations. As it did, the parties no longer consisted exclusively of borrower and lender. At the same time, the concept of ownership also became divided into a ‘bundle of rights’. This splitting of obligations of a debtor and responsibilities of an ‘owner’ became ambiguous and focus on the three before mentioned debt criteria could easily be lost. Perhaps the biggest change of all was with the cultural ethic calling for repayment of debt. Today, debt is viewed as nothing more than a promise to pay stream money. Collateral can be any right in the ‘bundle of rights’. All of these changes wrought huge changes in the financial system. For politicians, the instrument of public debt, unbound a seated congress from the constitutional bonds that prohibited committing a future congress to a course of action. Despite these changes, we retain in our being the remnants of cultural belief that debt means something borrowed must be returned. But, various laws such as bankruptcy and corporate law have served to shred the reality of this belief. Debt can be walked away from with no more discomfort than partial loss borrowing power, if that.

The measurement of potential benefits from lending and debt is found in the time-value of money. That concept says that those future cash flows have a value in the present that can be calculated. This concept means that future tax revenues possess a specific value in the present. Commitment of those revenue flows can mean more spending money for the present political incumbents. However, future cash flows have an absolute physical limit on how much present value they can produce. One such limit is fixed by a hard backing to the currency. Creating public debt meant that the government was committed to expanding the backing of the currency (debt must increase future benefits (monetary). But, the dollar was denominated in terms of a specific weight of gold and silver. This situation meant that in order to take on public debt, the Congress had to increase the amount of gold and silver in the treasury as backing for the dollar. Increasing the velocity of circulating money could ameliorate the problem somewhat but it, too, had its physical limits as well. This problem was one heck of an inconvenience. In order to borrow from the future ran into the reality of actually having to acquire gold and silver to accommodate the needed increase in money supply.

The necessary expansion of the money supply became increasingly uncomfortable to the office holders and aspirant politicians. The obvious fix was to declare such an obligation, barbarous, a relic, etc. and free the will of American government from the golden chains. The US Government simply changed the denomination of the debt from payment in work done to payment in a promise to do work. Where gold and silver represented work done, the new form for money the politicians wanted was a promise to do work (debt). With that, money morphed from work-done to work-to-be-done. Debt became a promise to repay with a claim on work to be done.

This change necessitated modification of the way in which the financial system managed money flows. Money would not possess a fixed value. In fact it would have no value at all and be just an idea in the human mind that would act as an arbiter between things of value. In order to make the pieces fit, the Federal Reserve Board was added to the then existent financial system. The stated purpose was to ensure the banking system against failure, but the real purpose was to change the financial system. It also added the appearance augustness and came with the promises that it would not suffer from political interference.

This served the political process well until debt bumped up against the ceiling of interest rates. So the third limit the politicians needed to get rid of was the limit current interest rates imposed on how much present value future tax revenues (cash flow) could generate. Low interest rates generate high value for future cash flows. The lower the interest rate, the more value can be mined out of future cash flows. The homebuyer knows that low interest rates allow their income to qualify them for a bigger mortgage. So, to accommodate the political establishment, the Federal Reserve Board module to the financial system initiated manipulation of the interest rates for political purposes.

This subtle but telling change could not happen without changes in the political system and the way the voters think. The public became compartmentalized into interest groups. The responsibility of governance to do what is best for the whole nation became lost in the blizzard of interest groups. America became a stew or separate interest groups. Education may also have played a role. Competence in the three R’s as a basis for promotion changed to social/psychological needs. Social promotion became an accepted reason for promotion to the next grade. As a result, graduates had few tools to comprehend economics. Stimulation of the economy sounded very appealing. Stimulation of the economy, not fixing the economy, became the reason. So, the Federal Reserve manipulated interest rates downward to provide additional value to the future tax revenues and anyone with an income stream could command huge sums of money to buy houses, cars, vacations, etc. Money just came down from the sky. Everyone seemed to win with low interest rates. Nobody talked about the reverse side: The FED created a way for Congress to avoid the necessity of decreasing appropriations to match revenues. But this is the political story. There is a more technical story about the financial system as well.

Concepts of Money and The US Dollar

As the financial system changed so did the concept of money. Gold and silver cannot be stuffed through a fiber optic cable or a computer. Nor can paper money. Technology and the constant nibbling away of costs by an economic system in search of zero overhead cost per transaction created the need for something other than physical coins. These kinds of circumstance are reality. There is no sense pretending otherwise or bemoaning the fact.

A US dollar has no intrinsic value… unless the inherent ability of government to misuse the medium of exchange fiat to expropriate private assets can be considered ‘value.’ Instead, the dollar has been and continues to be a very secure medium of exchange. Without exception, it can be used for every transaction. Use of the dollar in the United States is unimpeded by caveats or restrictions. The goods or services that it purchases can move freely. It is also a convenient way for our mind to grasp the relative exchange weights between two items. Some people want the dollar to have qualities that it does not possess. It is not a store of value. It does not store the price of a loaf of bread or an ounce of gold. It acts only as an arbiter between the bread and gold. If the economic system is stable, then the price of bread relative to gold will remain the same in dollar terms. So, swings in relative prices are not the result of the dollar but, instead, they represent the instability (or simply flux) within the economic system. Because the US economic system has been very stable, dollars have become falsely thought of as a store of value. With all these attributes, it is broadly accepted. Its importance lies in the dollar’s unfettered utility and the stability of the American economy. The dollar has no intrinsic value. It is only a yardstick to measure value.

Within the economy, the American financial system exists as a counting, accounting, and allocation operation to handle layers of collateral within layers of financial instruments issued by various parties with various obligations payable in a promise of variable value. But the bottom line is that the financial system has become nearly entirely a debt-based and, therefore, a collateral-based system. Despite being a promise of variable value, the dollar is still the arbiter between collateral and most acceptable definition of value of an asset. The direct interaction with the rest of the economy affects prices of everything.

The Quality of Collateral

Inflating the value of assets that can be used as collateral to secure debt created the appearance of wealth even if the assets were no more productive than before. I use collateral and “debt security” interchangeably even though collateral is a real item and debt security can be anything that assures the payment of debt. I am using them interchangeably with the full realization that security is a much broader term than collateral. I do so, because collateral is something specific and real where as security can be nothing more than a promise.

Many methods are used to value the quality of the collateral (meaning the ability to service the debt and pay the principal.) But even after using such methods to test the quality of the collateral, the result is still just a perception, nothing more. Perception forms the basis for faith that permits lending. Perceptions combine facts with human emotions and therefore can and do change with incredible speed. Perception of the quality of the collateral can be a Trojan horse within the financial system.

Lending involves two major risks. The first is that the pledged collateral will be of lower quality than perceived. The second is that the buying power of the medium of exchange used for payment will be less than expected (note: with gold and silver based money this was not a risk). The first risk comes in two “flavors”. One risk ‘flavor’ is the possibility that the amount due on the loan (or the principal) will not be repaid. The second risk ‘flavor’ is that the interest on the loan will not be paid. Then of course the Second major risk is that lender will not receive a ‘real return’ (inflation will erode the buying power of the medium of exchange that is used) on the loan. I ask the gentle reader to keep these in mind along with the debt criteria. The real estate market offers some help in this complexity with fairly straightforward examples of how these risks are managed. These techniques are less convoluted than financial asset-based loans and much easier to grasp.

Many types of real estate loan/mortgage insurance can be purchased to insure against the occurrence of each of the above risks. Syndication of mortgages and syndication of other debts is completely dependent upon insurance that removes risk. For debt backed by real estate, combining several types of simple mortgage insurance removes most of the risk to the lender posed by the collateral. The biggest insurer is the US Government. Through FHA, other governmental agencies, and quaisi-governmental institutions, the U. S. Government takes on almost all the risk for the lender. This leaves banks able to create packages of mortgages and sell them within the capital markets. The syndicated mortgages become a secure source of future cash flows for paying retirement benefits etc. The mortgage backed security holders have the perception that the risk to such cash flows is virtually zero. The inflation indices published by the government form the basis for faith in the medium of exchange. Again, all of this is only a perception.

FED activities have reduced the short-term interest rates to something below the rate of inflation. One perspective is to conclude that the FED has engineered an artificial increase in the value of collateral. Of course, by doing this it has imposed a risk that dollar denominated debt instruments will not provide a ‘real return’ to investors. The rates are below inflation and therefore, with regard to being able to provide real returns, the debt instruments start in deficit (One has to wonder what is implied when the financial system does not demand that debt be discounted.) The FED module to the financial system has passed this artificial interest rate through to both intermediate and long-term rates. This feat was and is still being accomplished through the internal operation of the capital markets using the power of substitution of one form of debt for another, to force down longer-term interest rates. Tax codes that subsidize/reduce taxes and regulation establish the incentives and systems for a pass-through system. The combined influence of the tax code, FED, and Treasury, can and do modify the yield curve.

The problem facing the FED has been to make people believe that the enhancement of asset value is not simply depreciation of the currency. After all, the assets are no more productive and no more valuable relative to foreign assets of the same types. So the Fed resorted to enhancing certain perceptions and minimizing others (jawboning) and Federal Agencies helped through manipulation of statistics they issue. Another means by which longer-term interest rates are manipulated is through money management institutions in which compensation to money managers does not bear any relationship to the performance of the investments over the term of the investment. Almost no risk managers’ or money managers’ salaries or bonuses are contingent upon the long-term results of the securities under their management. A clear example of this operating is that rewards in the carry trade come from short term trading gain, not long-term earning capacity of the financial instruments. One way of looking at all this is to see what happened as a temporary devaluation of the dollar. More on that later.

Through a decades long iterative process involving subtly shifting definitions and obligations, and amendment of laws; the risk of substantial loss of collateral value and the ability to service debt has been transferred from the free market lenders to the government where it becomes the people’s debt. Fannie Mae and Freddie Mac and FHA have taken over from the banks, a huge chunk of risk of loss in the real estate business. The size is so large, and the insurance premium so low, that the market has difficulty adding risk premiums to lending in general. Indeed, the debt held by banks compared to insurance funds, retirement funds, and mutual funds; is minuscule. Banking profits stem less from interest on portfolios than from fees for passing through debt to the capital markets. The potential payout on the insurance will not cause government to reduce expenditures. Instead the payouts would pass through to the people as public debt. It will become public debt as such actions have done in the past. An example of this is the S&L crisis. The savings and loan crisis added some $350 billion to the public debt. It caused no pain to the government or even the taxpayer because that $350 simply went into the public debt and was lost. Congress never had to come up with a net savings of that amount from the annual appropriations. The government has trillions of dollars of insurance in effect and virtually no capability to pay it should the need arise. Government risk-removal insurance payouts are a cost waiting to be tallied. The Pied Piper will appear to demand payout when there is a deflationary economy.

The Taxpayer Bears The Burden

Not only is the taxpayer loaded with personal debt, but the taxpayer must also the bear the weigh of paying for public debt. Looking to the future; clearly, taxes cannot support planned government expenditures, so adding even a small part of the trillions in exposure held by Fannie, Freddie and FHA would just add to the already unsupportable load.

I have no idea of the extent of the ultimate cost of all this risk being assumed by the government. FHA premium for multifamily residential real estate is about 5 tenths of one percent of the loan…same premium regardless of the real estate risk. That money paid as a premium does not just stay with FHA as money in the bank. It is spent on affordable housing programs and made available to the government to ‘borrow’. What is in the FHA float is not money but treasury debt instruments. No oversight of FHA exists beyond that specified to the Congress under the US Constitution. So FHA is a savings and loan-style crisis just waiting to happen. Should FHA not be able to pay on its insurance, the response will simply be another “OOPS!.” The perspective of Congress is that the cost can become part of the public debt. So, the Congress has no real fear of an FHA failure. This total lack of fear has a sound basis. Despite the savings and loan crisis/scandals, the Enron and WorldCom scandals, scandals from applying improper pressure on the SEC on behalf of favored clients, not a single one of these travesties resulted in a change in any committee leadership. The Congress is confident that the taxpayer will not feel a thing because the costs will get rolled into the Treasury debt outstanding and get lost. Congress will feel no pain because there exists no evidence that such events would force a reduction in Congressional appropriations.

It is a fact that no discipline remains in the system by which government acquires debt, and risk. No way to stem the tide of debt exists. At best, only the perception of its magnitude can be managed. Mr. Greenspan’s position on the risk acquired by Fannie Mae and Freddie Mac shows that he is well aware of this. With the fine tuning of perceptions of risk and future inflation, the thought of having an sick ox pulling one of the most important carts in the financial systems wagon train, became too much to ignore. If that cart overturned and the true extent of the obligations suddenly came to light, it would severely damage the perceptions of the American financial system. Overnight the critical perception of risk to those ‘risk free’ investments in United States would change. The ripple effect of suddenly changing perceptions of the ability of the United States to service its debt would become apparent. Suddenly debt holders would face the reality that the sheer size would force payment from current appropriations. That would reduce funds for essential services with the follow-on political uncertainty with unknowable repercussions. The bottom line would be to substantially change the fortunes of the debt holders.

To summarize briefly, the management of the perception of risk to holders of American debt is a critical role for both the Federal Reserve Board and the U. S. Treasury. Since perception is influenced by the emotions of greed and fear, it can turn on very quickly. History shows that the United States has an unfortunate tendency to continue on course until it hits a wall of some sort. So one can expect that the political incumbents to ignore the danger of debt until the Trojan horse within bursts open. This dovetails with operation of the American political system. The prevailing political beneficiaries represent vested interests that operate to prevent political change. When America encounters the proverbial ‘wall’, the public gets stuck with the consequences as the Congress just lets the interest groups just walk away. The view of the political character of governance shows itself as willing to ride a good horse into the ground. The system that is in place cannot be reined in. The Trojan horse is within the gates of the financial system. When the Trojan horse is no longer seen as merely and inconsequential idol of pessimists, its lethal cargo will burst out.

Two Opposing Scenarios

If loss of faith in the containment of risk occurs, one of two opposing scenarios could develop. One scenario would involve a massive return of debt instruments to the market. Current holders would want to get out. The result would be rapid ramp up of long-term rates as bonds were dumped into the market. The problem with this scenario is that it makes totally invalid assumptions about how the system would operate. Currently, the vast bulk of the money goes through a system that takes freely lent money and passes that money through to borrowers who in turn send back debt service payments. Banks, insurance, mutual funds, serve only as intermediaries lending money from one set of individuals and collecting debt service to return to the original lenders of money into this system. This includes foreign governments that acquire Treasury paper in order to keep their own currency down and their people employed. Those important interests will remain in place. The scenario relies heavily on this system working in reverse as it did going forward. This is not just doubtful; it is impossible without massive operational changes. Imagine the specter of banks offering back to mortgagees their real estate loans discounted to the higher interest rates. It cannot happen. Of course a small proportion of the holders exists that could cause much disruption. But most money will stay put because providing a specified cash flow locks it in. Said another way, for holders of most debt, the value of the debt instruments is inconsequential as only the cash flow matters. What has been obligated is the cash flow. (This creates the obvious derivative market where asset value and cash flow are separated and the benefits can be ‘owned’ by different parties.)

The second scenario is that within the overall economy, the cash flow to service the debt obligations would drop. In this situation, the value of the collateral would decline in tandem with the declining ability to service the debt. This would initiate a deflationary spiral in which lending cannot take place because declining collateral value would make loans infeasible. The before mentioned criteria for lending can not be met in a deflationary situation. More and more collateral from more and more parts of the economy would be drawn in on this downward spiral. That is known as a liquidity crisis. The government has an intense and immediate interest in preventing such a crisis. It’s means for doing so is by creating the conditions for collateral value to rise. Since value is based upon perceived ability to service the loan, the easiest way is to increase value is to reduce the cost of borrowing (Basically, profit is what is left over after operations, and interest payments, etc. have been made).

Engineering interest rates to drop accomplishes this objective. Lets look at the numbers. Lets use the example of a real estate property worth $1.25 million, with an interest-only loan rate of 8% for 30years, a loan to value ratio of 0.80 and an expense ratio of 30% and is producing an operating net of $6,000. A drop in interest from 8% to 5% increases the money left over (or net) from $6,000 to $45,000. The next step can be to capitalize that added annual income of $39,000 at 5%. This provides for an added value of $780,000. That new equity can be spent invested… or used for speculation. The FED thus engineered an increase in collateral value of nearly 62% just by engineering a drop in interest rates. In short, the FED can add (or deduct) money going to the profit line and increase collateral value simply by manipulating interest rates.

The deflationary spiral can be cured, so the theory goes. All that is needed is to ramp up lending. To do that the Fed must create the conditions that allow borrowing. The FED accomplishes this increased borrowing by inflating collateral value by engineering interest rates below what the market would dictate. At the very minimum the result of FED action must be to stop the decline in the ability of collateral to underwrite debt. As we have seen, the FED has reduced the rates for lending to institutions that, in turn, lend directly to the public and, this forced a drop in the interest rates. Banks did not object as their profit source has switched from interest payments to fees. The need to re-inflate collateral value is so critical that, as FED Governor Bernanke has said, the FED would resort to all means possible to counter the decline, even to the point of giving money away. So, scenario number two is not only possible it is on going.

The FED operations are designed to artificially inflate collateral to the point at which it would re-ignite the upward spiral of value. As dollar value of an asset increases, the new equity can be used as collateral to borrow and the borrowed money can be invested or it can be spent. Theory says that finally it reaches the point where leveraging cash flows re-circulate the money into the economy. At that point, and the FED could again allow interest rates to reassume normal levels of a real return of 2.5% on risk free securities with zero inflation. This scenario is what the FED wants to accomplish (unfortunately, that upward spiral requires increased productivity of the assets, so we will see how this plays out.) In attempting to predict the long-term outcome of such action, the gentle reader should consider the assumptions upon which this second scenario is based. Assumptions are those conditions that must exist in order for the desired result to occur. Another thing to consider is that the second scenario faces one of the laws of money: bad money chases good money out of circulation. Since this second scenario is the course we are on today, the final outcome will be interesting.

What The FED Has Done

Let’s be clear about what the FED has done. The Federal Reserve Banking module to the financial system has intentionally disrupted the market-pricing mechanism within the capital markets and done so on a huge scale.

This action has also induced an artificial sub-economy to take advantage of the government manipulation of asset values. Any profit from such operations must be categorized as a wealth transfer, not earned income. Will such market intervention return the US to a thriving economic condition or will the result be simply competitive devaluation of the dollar?

Here is an effect to consider. The intrinsic value of collateral does not change simply because the FED engineered interest rates to inflate its value. So, if real value does not change, then what must have changed is the value of the dollar (medium of exchange) relative to other currencies (other mediums of exchange). In short the action of the FED to reduce interest rates serves to depreciate the currency relative to other currencies. It is not immediately understood as a devaluation of the dollar because it takes about three years for the effects of collateral manipulation (inflation) appear. If the depreciation of the currency is temporary then deflation will occur in that segment of the market inflated by the FED. The unsuspecting new owners who thought that the market priced the collateral take the losses. Another way of viewing the FED price manipulation is that the immediate benefits from inflated collateral are used today, but the long-term effects are a burden passed on to the future. The delay between action of the FED and response by the currency markets is something like three to four years. So, if the FED can allow rates to return to normal levels in less than three years, the damage cannot be attributed to the FED. Today, that time window is rapidly closing for the FED.

Pumping up of collateral does not appear to be working quite as the theoreticians predicted. It has created its own pump and dump operation to which I referred two paragraphs above. Pump up collateral using artificial interest rates and dump on the innocent and unwise who rally around the U. S. flag thinking that interest rates are market driven and collateral pricing is real. This is the same as pump and dump of stocks (financial assets). The economy has not responded quite as expected or hoped. It appears increasingly that wealth transfers created by FED interest rate manipulation does not create permanent demand and supply. It appears that stoking the economy with the equivalent of sugar for the human body produces about the same result… fat and very little muscle.

My current job allows me to see what happens with subsidized housing. I see that money given away as direct payments to people does not create jobs or the work ethic. Making money free does not create a willing worker or a paying job. Instead, give-away money induces people to find ways to manipulate the give-away system and find inventive ways to use the system to provide higher net (or discretionary income) than actually working. Panhandling is one manifestation of free money encouraging continued/increased demand for free money. Instead of creating new industries and entrepreneurial wage-creators, the FED appears to have created a niche for financiers, hedge funds, and market manipulators. Just as free handouts encourage panhandling, free money encourages political demand for more free money. The straight fact is that the only value people feel in money comes from the sweat that they put into acquiring it. This is vastly different from viewpoint of the FED and the assumptions economists and financial experts.

Conclusion

So, where do we stand? The U.S. dollar is only a medium of exchange. It is an arbiter, between and among labor, capital, and land (as Adam Smith might put it.) There exists no collateral behind the dollar. If one wants one, the only direct link to collateral is that the government can print new tender that can be used to buy (expropriate) assets. That same fiat does not provide for any fixed value in exchange for goods and services. It takes about three years for the currency exchange markets and masses in the economy to realize that acquiring each dollar takes less sweat.

Pumping up collateral value by engineering below market interest rates and then issuing additional money is entirely governed by political interests.

I have a pessimistic view of the character of the political animals in whose hands these enormous powers are entrusted. I cannot imagine that they would, under all conditions ignore personal benefit and refuse, absolutely, to succumb to the siren song of self-interest or the necessity of ‘national interests’ or war. Further, this financial system exists within a system of checks and balances, so refusal of one institution, like the FED, to go along is impossible. Without a means to pull in the reins on debt, the monetary system is out of control. The FED has taken an immense risk that it can single-handedly bring money creation under control without being in a position to control debt creation.

For this business cycle the FED has corrupted the market pricing in a breathtaking manner. The financial system is rigged and has insiders who understand what the FED is doing and therefore leverage their positions to engineer massive transfer of wealth without adding a penny of value. As the FED corrupts the financial system, it corrupts the entire economy and the work ethic. FED interference with the capital market has added greatly to the portion of risk that involves assurance of real returns. Below market interest rates creates above market collateral value. This has an end point. Natural resources are sold only because profit from the sale and investment of the proceeds exceeds the rate at which the unsold resources gain value. Engineering interest rates below that necessary return creates economic incentives to stops natural resource extraction. The course chosen by the FED could eventually create economic conditions that would encourage oil companies to leave petroleum in the ground. The below market interest rates has resulted in creation of a financial constituency with welfare-like mentality that scoffs at production of goods and services and rewards short-term get-rich-quick schemes.

The FED is now faced with rising raw materials costs, a natural result of shortage from the misallocation of capital within the economy. The FED is faced with outrageous promises of medical care and social security that feed on the FED-built welfare mentality. These acts by the FED simply add more burdens upon collateral that cannot perform at real market ratios. Anemic rate of saving by the American people and business provides very limited investment capital to use as a prayer rug. This leaves the FED with little evident choice but to continue to clip the value of collateral. In FED-speak this is payment transfers into the future. As Alan Greenspan said in one of his European trip speeches: ‘…it appears to be going well, so far.”

At present, Chairman Greenspan and Secretary Snow have some economic ‘wagons’, such as the energy and raw materials markets, with economic flat tires; while others, such as the housing market, have bulging tires. The speeches that have been made would seem to be in keeping with what I see as the top priority for both Treasury and the FED. The urgency with which the interest rates are being raised in a ‘measured way’ is perhaps evidence of concern that the window to which I referred is closing rapidly. This will induce obvious economic instability and breach of the dollar-faith (what makes the dollar so acceptable.) My economic concerns are amplified by my belief that the most solemn obligations will be forgotten and that personal interest/ambition will combine with self-preservation in the mad scramble that may result in a systemic breakdown.

Put yourself in the position of Congress, the President, or the Federal Reserve Board member. What would you do if you realized your tools were not effective against the implosion?

Perhaps the Patriot Act is the first of the measures needed for the next step on this monetary adventure. Perhaps the extent to which the dollar has spread throughout the world is an indication of bad money chasing good money out of circulation. Who knows! It is all perception anyway.

© 2004 Richard K. Brawn
Editorial Archive

CONTACT INFORMATION
Richard K. Brawn, CCGA, MPA
Petaluma, CA USA
Email
California Certified General Appraiser (CCGA)
Master Public Administration (MPA)

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.