Ron Paul: Lessons to Be Learned from Failed Central Bank Policies

The great Ron Paul tackles on the failure of central banking in the lens of the US Federal Reserve.

Mr. Paul’s article is entitled “Two Percent Inflation and the Fed’s Current Mandate” is published at his website the Ron Paul Institute

 

(bold mine)

Over the last 100 years the Fed has had many mandates and policy changes in its pursuit of becoming the chief central economic planner for the United States. Not only has it pursued this utopian dream of planning the US economy and financing every boondoggle conceivable in the welfare/warfare state, it has become the manipulator of the premier world reserve currency.

As Fed Chairman Ben Bernanke explained to me, the once profoundly successful world currency – gold – was no longer money. This meant that he believed, and the world has accepted, the fiat dollar as the most important currency of the world, and the US has the privilege and responsibility for managing it. He might even believe, along with his Fed colleagues, both past and present, that the fiat dollar will replace gold for millennia to come. I remain unconvinced.

At its inception the Fed got its marching orders: to become the ultimate lender of last resort to banks and business interests. And to do that it needed an “elastic” currency.  The supporters of the new central bank in 1913 were well aware that commodity money did not “stretch” enough to satisfy the politician’s appetite for welfare and war spending. A printing press and computer, along with the removal of the gold standard, would eventually provide the tools for a worldwide fiat currency. We’ve been there since 1971 and the results are not good.

Many modifications of policy mandates occurred between 1913 and 1971, and the Fed continues today in a desperate effort to prevent the total unwinding and collapse of a monetary system built on sand. A storm is brewing and when it hits, it will reveal the fragility of the entire world financial system. 

The Fed and its friends in the financial industry are frantically hoping their next mandate or strategy for managing the system will continue to bail them out of each new crisis.

The seeds were sown with the passage of the Federal Reserve Act in December 1913. The lender of last resort would target special beneficiaries with its ability to create unlimited credit. It was granted power to channel credit in a special way. Average citizens, struggling with a mortgage or a small business about to go under, were not the Fed’s concern. Commercial, agricultural, and industrial paper was to be bought when the Fed's friends were in trouble and the economy needed to be propped up. At its inception the Fed was given no permission to buy speculative financial debt or U.S. Treasury debt.

It didn’t take long for Congress to amend the Federal Reserve Act to allow the purchase of US debt to finance World War I and subsequently all the many wars to follow. These changes eventually led to trillions of dollars being used in the current crisis to bail out banks and mortgage companies in over their heads with derivative speculations and worthless mortgage-backed securities.

It took a while to go from a gold standard in 1913 to the unbelievable paper bailouts that occurred during the crash of 2008 and 2009.

In 1979 the dual mandate was proposed by Congress to solve the problem of high inflation and high unemployment, which defied the conventional wisdom of the Phillips curve that supported the idea that inflation could be a trade-off for decreasing unemployment. The stagflation of the 1970s was an eye-opener for all the establishment and government economists. None of them had anticipated the serious financial and banking problems in the 1970s that concluded with very high interest rates.

That’s when the Congress instructed the Fed to follow a “dual mandate” to achieve, through monetary manipulation, a policy of “stable prices” and “maximum employment.” The goal was to have Congress wave a wand and presto the problem would be solved, without the Fed giving up power to create money out of thin air that allows it to guarantee a bailout for its Wall Street friends and the financial markets when needed. 

The dual mandate was really a triple mandate. The Fed was also instructed to maintain “moderate long-term interest rates.” “Moderate” was not defined. I now have personally witnessed nominal interest rates as high as 21% and rates below 1%. Real interest rates today are actually below zero.

The dual, or the triple mandate, has only compounded the problems we face today. Temporary relief was achieved in the 1980s and confidence in the dollar was restored after Volcker raised interest rates up to 21%, but structural problems remained.

Nevertheless, the stock market crashed in 1987 and the Fed needed more help. President Reagan’s Executive Order 12631 created the President’s Working Group on Financial Markets, also known as the Plunge Protection Team. This Executive Order gave more power to the Federal Reserve, Treasury, Commodity Futures Trading Commission, and the Securities and Exchange Commission to come to the rescue of Wall Street if market declines got out of hand. Though their friends on Wall Street were bailed out in the 2000 and 2008 panics, this new power obviously did not create a sound economy. Secrecy was of the utmost importance to prevent the public from seeing just how this “mandate” operated and exactly who was benefiting. 

Since 2008 real economic growth has not returned. From the viewpoint of the central economic planners, wages aren’t going up fast enough, which is like saying the currency is not being debased rapidly enough. That’s the same explanation they give for prices not rising fast enough as measured by the government-rigged Consumer Price Index. In essence it seems like they believe that making the cost of living go up for average people is a solution to the economic crisis. Rather bizarre!

The obsession now is to get price inflation up to at least a 2% level per year. The assumption is that if the Fed can get prices to rise, the economy will rebound. This too is monetary policy nonsense.

If the result of a congressional mandate placed on the Fed for moderate and stable interest rates results in interest rates ranging from 0% to 21%, then believing the Fed can achieve a healthy economy by getting consumer prices to increase by 2% per year is a pie-in-the-sky dream. Money managers CAN’T do it and if they could it would achieve nothing except compounding the errors that have been driving monetary policy for a hundred years.

A mandate for 2% price inflation is not only a goal for the  central planners in the United States but for most central bankers worldwide. 

It’s interesting to note that the idea of a 2% inflation rate was conceived 25 years ago in New Zealand to curtail double-digit price inflation. The claim was made that since conditions improved in New Zealand after they lowered their inflation rate to 2% that there was something magical about it. And from this they assumed that anything lower than 2% must be a detriment and the inflation rate must be raised. Of course, the only tool central bankers have to achieve this rate is to print money and hope it flows in the direction of raising the particular prices that the Fed wants to raise.

One problem is that although newly created money by central banks does inflate prices, the central planners can’t control which prices will increase or when it will happen. Instead of consumer prices rising, the price inflation may go into other areas, as determined by millions of individuals making their own choices. Today we can find very high prices for stocks, bonds, educational costs, medical care and food, yet the CPI stays under 2%.

The CPI, though the Fed currently wants it to be even higher, is misreported on the low side. The Fed’s real goal is to make sure there is no opposition to the money printing press they need to run at full speed to keep the financial markets afloat. This is for the purpose of propping up in particular stock prices, debt derivatives, and bonds in order to take care of their friends on Wall Street.

This “mandate” that the Fed follows, unlike others, is of their own creation. No questions are asked by the legislators, who are always in need of monetary inflation to paper over the debt run up by welfare/warfare spending. There will be a day when the obsession with the goal of zero interest rates and 2% price inflation will be laughed at by future economic historians. It will be seen as just as silly as John Law’s inflationary scheme in the 18th century for perpetual wealth for France by creating the Mississippi bubble – which ended in disaster. After a mere two years, 1719 to 1720, of runaway inflation Law was forced to leave France in disgrace. The current scenario will not be precisely the same as with this giant bubble but the consequences will very likely be much greater than that which occurred with the bursting of the Mississippi bubble.

The fiat dollar standard is worldwide and nothing similar to this has ever existed before. The Fed and all the world central banks now endorse the monetary principles that motivated John Law in his goal of a new paradigm for French prosperity. His thesis was simple: first increase paper notes in order to increase the money supply in circulation. This he claimed would revitalize the finances of the French government and the French economy. His theory was no more complicated than that. 

This is exactly what the Federal Reserve has been attempting to do for the past six years. It has created $4 trillion of new money, and used it to buy government Treasury bills and $1.7 trillion of worthless home mortgages. Real growth and a high standard of living for a large majority of Americans have not occurred, whereas the Wall Street elite have done quite well. This has resulted in aggravating the persistent class warfare that has been going on for quite some time.

The Fed has failed at following its many mandates, whether legislatively directed or spontaneously decided upon by the Fed itself – like the 2% price inflation rate. But in addition, to compound the mischief caused by distorting the much-needed market rate of interest, the Fed is much more involved than just running the printing presses. It regulates and manages the inflation tax. The Fed was the chief architect of the bailouts in 2008. It facilitates the accumulation of government debt, whether it’s to finance wars or the welfare transfer programs directed at both rich and poor. The Fed provides a backstop for the speculative derivatives dealings of the banks considered too big to fail. Together with the FDIC's insurance for bank accounts, these programs generate a huge moral hazard while the Fed obfuscates monetary and economic reality.

The Federal Reserve reports that it has over 300 PhD’s on its payroll. There are hundreds more in the Federal Reserve’s District Banks and many more associated scholars under contract at many universities. The exact cost to get all this wonderful advice is unknown. The Federal Reserve on its website assures the American public that these economists “represent an exceptional diverse range of interest in specific area of expertise.” Of course this is with the exception that gold is of no interest to them in their hundreds and thousands of papers written for the Fed.

This academic effort by subsidized learned professors ensures that our college graduates are well-indoctrinated in the ways of inflation and economic planning. As a consequence too, essentially all members of Congress have learned these same lessons.

Fed policy is a hodgepodge of monetary mismanagement and economic interference in the marketplace. Sadly, little effort is being made to seriously consider real monetary reform, which is what we need. That will only come after a major currency crisis.

I have quite frequently made the point about the error of central banks assuming that they know exactly what interest rates best serve the economy and at what rate price inflation should be. Currently the obsession with a 2% increase in the CPI per year and a zero rate of interest is rather silly. 

In spite of all the mandates, flip-flopping on policy, and irrational regulatory exuberance, there’s an overwhelming fear that is shared by all central bankers, on which they dwell day and night. That is the dreaded possibility of DEFLATION. 

A major problem is that of defining the terms commonly used. It’s hard to explain a policy dealing with deflation when Keynesians claim a falling average price level – something hard to measure – is deflation, when the Austrian free-market school describes deflation as a decrease in the money supply. 

The hysterical fear of deflation is because deflation is equated with the 1930s Great Depression and all central banks now are doing everything conceivable to prevent that from happening again through massive monetary inflation. Though the money supply is rapidly rising and some prices like oil are falling, we are NOT experiencing deflation.

Under today’s conditions, fighting the deflation phantom only prevents the needed correction and liquidation from decades of an inflationary/mal-investment bubble economy.

It is true that even though there is lots of monetary inflation being generated, much of it is not going where the planners would like it to go. Economic growth is stagnant and lots of bubbles are being formed, like in stocks, student debt, oil drilling, and others. Our economic planners don’t realize it but they are having trouble with centrally controlling individual “human action.” 

Real economic growth is being hindered by a rational and justified loss of confidence in planning business expansions. This is a consequence of the chaos caused by the Fed’s encouragement of over-taxation, excessive regulations, and diverting wealth away from domestic investments and instead using it in wealth-consuming and dangerous unnecessary wars overseas. Without the Fed monetizing debt, these excesses would not occur.

Lessons yet to be learned:

1. Increasing money and credit by the Fed is not the same as increasing wealth. It in fact does the opposite.

2. More government spending is not equivalent to increasing wealth.

3. Liquidation of debt and correction in wages, salaries, and consumer prices is not the monster that many fear. 

4. Corrections, allowed to run their course, are beneficial and should not be prolonged by bailouts with massive monetary inflation.

5. The people spending their own money is far superior to the government spending it for them.

6. Propping up stock and bond prices, the current Fed goal, is not a road to economic recovery.

7. Though bailouts help the insiders and the elite 1%, they hinder the economic recovery.

8. Production and savings should be the source of capital needed for economic growth.

9. Monetary expansion can never substitute for savings but guarantees mal–investment.

10. Market rates of interest are required to provide for the economic calculation necessary for growth and reversing an economic downturn.

11. Wars provide no solution to a recession/depression. Wars only make a country poorer while war profiteers benefit.

12. Bits of paper with ink on them or computer entries are not money – gold is.

13. Higher consumer prices per se have nothing to do with a healthy economy.

14. Lower consumer prices should be expected in a healthy economy as we experienced with computers, TVs, and cell phones. 

All this effort by thousands of planners in the Federal Reserve, Congress, and the bureaucracy to achieve a stable financial system and healthy economic growth has failed. 

It must be the case that it has all been misdirected. And just maybe a free market and a limited government philosophy are the answers for sorting it all out without the economic planners setting interest and CPI rate increases.

A simpler solution to achieving a healthy economy would be to concentrate on providing a “SOUND DOLLAR” as the Founders of the country suggested. A gold dollar will always outperform a paper dollar in duration and economic performance while holding government growth in check. This is the only monetary system that protects liberty while enhancing the opportunity for peace and prosperity.

Quote of the Day: Financial markets do not work like real markets

The first thing we need to keep in mind is that the euro and the US dollar are currencies subject to monetary central planning. They are monopoly monies controlled and issued by central banks. Their quantity is determined by the decisions of the monetary central planners who oversee them; they influence the amount of "reserves" banks have for lending purposes, and through this control over the supply of money in the banking system can manipulate a variety of interest rates, especially in the short run.

As a consequence, financial markets do not work like real markets. We cannot be sure what the amount of real savings may be in the society to support real and sustainable investment and capital formation. We cannot know what the "real cost" of borrowing should be, since interest rates are not determined by actual, private sector savings and investment decisions. And, therefore, there is no guarantee that the amount of investments undertaken and their time horizons are compatible with the available resources not also being demanded and used for more immediate consumer goods production in the society.

This is why countries around the world periodically experience booms and busts, inflations and recessions − not because of some inherent instabilities or "irrationalities" in financial markets, but because of monetary central planning through central banking that does not allow market-based financial intermediation to develop and work as it could and would in a real free-market setting.

This is from former FEE President, author and professor Richard Ebeling in an interview with Anthony Wile at the Daily Bell

When the crisis comes don't blame the markets for what is truly a product of monetary central planning

Central Bank Fractional Banking System: Bank Runs or Inflation

The incumbent central bank fractional banking system means a choice between bank runs and price inflation.

The great dean of Austrian school of economics Murray N. Rothbard explained. (bold mine)

1. Why fractional reserve banks are uninsurable

The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding. For commercial banks, the reserve fraction is now about 10 percent; for the thrifts it is far less.

This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.

We now see why private enterprise works so badly in the deposit insurance business. For private enterprise only works in a business that is legitimate and useful, where needs are being fulfilled. It is impossible to "insure" a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable.

2. Money Printing as camouflage. The political choice of inflation over bank runs.

What, then, is the magic potion of the federal government? Why does everyone trust the FDIC and FSLIC even though their reserve ratios are lower than private agencies, and though they too have only a very small fraction of total insured deposits in cash to stem any bank run? The answer is really quite simple: because everyone realizes, and realizes correctly, that only the federal government--and not the states or private firms--can print legal tender dollars. Everyone knows that, in case of a bank run, the U.S. Treasury would simply order the Fed to print enough cash to bail out any depositors who want it. The Fed has the unlimited power to print dollars, and it is this unlimited power to inflate that stands behind the current fractional reserve banking system.

Yes, the FDIC and FSLIC "work," but only because the unlimited monopoly power to print money can "work" to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.

But now bank runs--at least for the overwhelming majority of banks under federal deposit insurance--are over, and we have been paying and will continue to pay the horrendous price of saving the banks: chronic and unlimited inflation.

The political choice of inflation over bank runs can be seen via the loss of US dollar’s purchasing power.

Since the establishment of the US Federal Reserve in 1913, one US dollar in 1913 has an equivalent of buying power of $23.45 today according to the BLS inflation calculator. This means the US dollar have lost nearly 96% of their purchasing power. Chronic and unlimited inflation indeed.

The other implication is that the choice of inflation over bankruns means a subsidy to banks at society's expense.

 

3. Abolish the central banking system and ancillary regulators. Restore sound money

Putting an end to inflation requires not only the abolition of the Fed but also the abolition of the FDIC and FSLIC. At long last, banks would be treated like any firm in any other industry. In short, if they can't meet their contractual obligations they will be required to go under and liquidate. It would be instructive to see how many banks would survive if the massive governmental props were finally taken away.

Quote of the Day: Fed is Like the Arsonist Disguised as a Firefighter

Remember: the Fed is like the arsonist disguised as a firefighter who claims only he can put out the fires he started. Yeah, maybe the firefighter can’t rescue people from the building if he doesn’t have an axe to break down the door, but giving him a way to break in makes it far more likely that he’ll set fires in the first place.

Claiming that a gold standard ties the Fed’s hands is exactly the reason to favor it, not oppose it. The Fed was primarily, though not solely, responsible for getting us in this mess in the first place precisely because its hands were free to flood the market with artificially cheap credit.

The discretion of Big Players like the Fed is the problem, and the solution is not somehow hoping that next time they will use that discretion only for good and not evil. Tying Federal Reserve Notes to gold would take away some of that discretion, and eliminating the central bank completely in favor of a competitive monetary system with commodity backing of any sort would take it all away.

When the arsonist can’t set fires, we don’t need to worry about whether or not he has the tools to put them out. That is the fundamental argument for constraining both central banks and competitive ones by making the money they create redeemable in gold.

This is from Professor Steve Horwitz’s refutation of Ezra Klein’s critique of the Gold Standard.

Prediction Record of the US Federal Reserve: The Sun Will Come Out Tomorrow

The US Federal Reserve’s supposed transparency has only been exposing their string of serial forecasting blemishes.

Evan Solitas has been tracking the Fed’s performance and observed, (bold emphasis mine)

The Bernanke Fed has made a significant effort since June 2009, when the NBER judges the recession to have ended, to increase transparency by providing guidance about future policy and macroeconomic forecasts. What is striking, however, is how this transparency has not prevented in the slightest the intellectual dishonesty in ignoring its failure to meet its own goals.

A disparaging but not unfair comparison would be to little orphan Annie. "The sun'll come out tomorrow," Annie sang. "Bet your bottom dollar that tomorrow there'll be sun." The 3-to-4 percent recovery growth we've been long promising will come out tomorrow, the FOMC basically says every quarterly meeting. Bet your bottom dollar that tomorrow there'll be lower unemployment.

The Fed must love tomorrow. Because, as they say, it's always a day away.

What I mean by this is the Fed makes projections, misses them by miles and consistently in the wrong direction, and then doesn't own up to it. They just push back their forecast. The forecasts are not inappropriately optimistic, either -- it's just that the Fed's actions have fallen short, and that there is zero accountability to target the forecast.

Their transparency, however, allows us to demonstrate thoroughly the extent of this failure.

Their fundamental error: the haughty assumptions that human action can be aggregated into mathematical expressions similar to natural sciences or positivism.

The late economist Percy Greaves lucidly explained of the mainstream’s basic shortcomings (bold emphasis mine)

Reason and experience show us that there are two separate realms: the external world of physical, chemical, and physiological phenomena, and the internal world, in our minds, of our thoughts, feelings, valuations, and purposes in life. There is no bridge connecting these two spheres. They are not connected automatically. We always have the right to choose our actions. Identical external events often produce different human reactions, and different external events sometimes produce identical human actions. We do not know why.

So, the science of human action is different from the physical sciences. We cannot experiment with human beings except in a physiological, medical, or biological sense. In the realm of ideas, we cannot experiment as we can in the physical sciences. We cannot duplicate situations in which all things are maintained the same as before. We cannot change one condition and always get the same consequences. We cannot experiment with human actions, because the world, its population, its knowledge, its resources are all constantly changing and cannot be held still.

In economics we must use our minds to deduce our conclusions. We have to say, Other things being equal, other things being the same, this change will produce such and such an effect. We have to trace in our minds the inevitable results of contemplated changes. We are dealing with changeable human beings. We cannot perform actual experiments, because the human conditions cannot be duplicated, controlled, or completely manipulated in real life like chemical experiments in a laboratory. Therefore, there are great differences between economics and the physical sciences. We cannot experiment and we cannot measure. There are no constants with which to measure the actions and the forces which determine the actions and the choices of men. In order to measure you must have a constant standard, and there is no constant standard for measuring the minds, the values, or the ideas of men.

More, Federal Reserve (central bank) 'experts' are unlikely to produce unorthodox or radical or ‘out of the box’ thinking as they are supposed to uphold the institutions that employ them, thus the “zero accountability”. It's not about being right or wrong but what needs to broached by such institutions.

Bluntly put, their studies are basically designed to rationalize or justify the existence of their institutions. You may call this biased analysis. Also the conflict of interests between politicized money and the citizenry highlights the agency problem or the principal agent dilemma.

And such outlook applies to almost all political and politically affiliated institutions.

Why is this important? Because the Fed or central bank policies or centrally planned monetary actions have essentially been derived from their analysis or outlook.

And analysis with consistently large deviance from economic reality would only translate to high probability that their accompanying actions would have negative implications or consequences than the intended or expected goals or objectives.

Policy errors, thus, are likely to be the rule than the exception.

In short, we shouldn’t trust central bankers. We don’t even need them.

Thus, prudent investors need to anticipate of such centrally planned monetary misdiagnosis-malpractice, and take appropriate action to protect or insure themselves from their adverse effects.

Don’t forget half of every transactions we make has been coursed through political (fiat legal tender based) money. And distortions of the economics of money through interventions only extrapolates to parallel disruptions in the production or economic structure. This is why boom bust cycles and hyperinflation exists.

China’s Sovereign Wealth Fund in the Red

Many think that government (central banking) surpluses should be ‘invested’ through loans or through financial markets as sovereign wealth funds. They solely look at the benefits of the supposed ‘investments’ while ignoring both the hidden and the visible costs.

The recent losses of China’s sovereign wealth fund should be an example.

From CNN,

China's sovereign wealth fund suffered its worst year ever in 2011, losing 4.3 per cent on its global investment portfolio.

In an annual report that has become the focal point of its efforts to portray itself as a transparent institution, China Investment Corp also confirmed that it had received a $30bn capital injection from the government at the end of last year, boosting its investment firepower.

CIC was established in 2007 with money carved out from China's foreign exchange reserves and given a mandate to make investments that would generate higher returns. However, it quickly ran into concerns about its government background and so has been at pains to demonstrate that it is a long-term investor focused on profits, not politics.

In its annual report CIC emphasised that point, noting that its board decided in 2011 to make rolling 10-year annualised returns a key measure of performance.

"As a long-term investor, we are well positioned to withstand short-term volatility in markets, to pursue contrarian investments and to build long-term positions that can capture the premium for less liquidity," it said.

There is no guarantee that government ‘investments’ will produce positive returns.

After all, government and central bank bureaucrats are human and suffer from the same knowledge problem, as well as, other human frailties (heuristics, biases, etc..) as with the rest.

The difference is that government actions has externality effects which unduly exposes taxpayers. Yes, central banks as government institutions are underwritten by taxpayers.

The other difference is that actions by government agents or bureaucrats are driven by legal technicalities and political priorities than from the profit and loss incentives.

Besides given the huge distortions of the marketplace financial assets are subject to immense volatility and boom bust cycles, which makes sovereign wealth funds highly susceptible to market risks.

Do We Need Central Banks?

Tim Price at the Sovereign Man asks why the need for a central bank? (bold emphasis original)

A typical if feeble answer is that we need a lender of last resort. To which the answer is… Why? Why do we need a government-appointed entity to support banks that get in over their heads?

A typical answer is that if our banks start failing, our society starts going down the toilet. (It already has, but never mind.)

So now we have the worst of all possible worlds. Our banks are already failing, in the sense of no longer functioning according to the principles of offering an economic rate to depositors and offering economic funding to borrowers.

Plus, now we have ended up with a handful of quasi-nationalised banking group zombies that appear to be being run for the sole purpose of being granted dollops of money that they are free to hoard whenever the central bank deems it appropriate to depreciate our currencies some more.

If our banks were free to fail, a) we would have no need of a central bank, and b) we would have no need for banking guarantees.

Banking deposit agreements would simply come with a giant ‘Caveat Emptor’ on them, and depositors might be able to start earning a positive real interest rate on their savings again.

Abolishing central banks and their core functions would have the happy and non-trivial side effect of reintroducing something akin to sound money into the world economy, rather than live with permanent inflation and have the entire economy held hostage by banking interests.

In reality central banks exists as backstop financiers to the welfare-warfare state. For instance, wars has been facilitated and enabled by the existence of central banks.

Professor Gary North explains

The sinews of war are strengthened by central banking. This is why textbooks praise the Bank of England. It let the British fight longer wars and more destructive wars. The message: get a central bank for your nation, so that your politicians can declare war more readily and stay in that war far longer.

Central banks signify as central planning and the politicization of money. They are part of the 10 planks of Karl Marx’s Communist Manifesto.

Centralization of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly.

Yes it's a delusion to equate capitalism with 'communist' central banking.

Central banks also promote the interests of the banking and political class at the expense of society through inflationism which not only causes boom bust cycles, but importantly has been diminishing the purchasing power of our currencies. This why a huge amount of the public’s resources have been funneled to insolvent “zombie” banks and bankrupt states.

And this is why once zombie institutions become desperate they resort to other measures of financial repression and take the political route towards despotism. And this is also why the private sector will always become the scapegoat for policy errors. That's until people don't understand the essence of central banking.

Yes, I agree Mr. Price, we need the de-politicization of money or the return to sound money through the free markets.

End the Fed. End all central banking.

Video: Milton Friedman: Abolish the Fed! (2)

In the following 1994 interview (17:17), the preeminent free market Nobel laureate economist Milton Friedman said that he favored the abolishment of the US Federal Reserve primarily due to its blatant string of policy failures. His position then seems consistent even with his 2006 interview which I earlier posted.

Unfortunately, as David Kramer points out at the Lew Rockwell Blog, while Mr. Friedman desired the elimination of the FED, he maintained a pro-central banking stance, which seemed a bizarre paradox.

Cartoon of the Day: Have You Thanked Your Central Banker Today?

Well, have ya? (hat tip Bob Wenzel)

Thank them for this…

Central banking balance sheets at levels never seen in history!

Video: Lawrence White On Free Banking, Gold Standard and Central Banking

GMU Professor Dr. Lawrence White speaking at a monetary conference at the Cato Institute deals with free banking, the Gold Standard Banking and Central Banking. (hat tip: Tom Palmer)

The Middle Of The Road Policy Of A Local Free Market Group

I was delighted to learn about the existence of a “free market” group in the country, especially that it seemed to have several prominent members.

But when I read further and saw that the same group acclaimed or endorsed the leadership of the local central bank for “steering” the economy and for producing “low inflation”—my enthusiasm faded. I got turned off and dismayed.

Suggesting that central banks can “steer” the economy essentially destroys the free market principle. Doing so suggests that socialism is superior to the free markets. If central banks can steer the economy, then why the heck bloviate about free markets at all?

There are many aspects to quibble with central bank operations, but the most important facet is the manipulation of interest rates.

Tinkering with interest rates represents a form of price control that causes price distortions which subsequently produces bubble cycles. In addition, maneuvering interest rates impels for indirect redistribution: from savers and creditors to debtors.

So essentially a central bank that dabbles with interest rates does this to promote the local banking cartel, (banks are financial intermediaries so lowering of interest rates attracts borrowers or clients for the industry) at the expense of the other industries and the consumers.

So what’s the essence of free market here? What you have instead is a banking cartel buttressed by state capitalism that essentially privatizes profits and socializes losses. (You will see this when a crisis surfaces)

As for low inflation, policies have intertemporal effects. Previous low interest regime was not due to central bank policies but due to many factors as globalization and technology aided productivity gains. Today’s rampaging food and energy prices are an offshoot to manipulated artificially suppressed interest rates, which promotes simulated unnatural demand, that will cause another global, if not, domestic crisis.

Thus, crediting central banks for current policies represents a naive and very narrow time oriented viewpoint.

It is of no wonder why free markets precepts in the Philippines have been denigrated.

They are founded on tenuous framework, which frequently gets obfuscated with the social democratic platforms.

In short, the free market principle is severely compromised and selectively and conveniently applied. This also means that the accommodation of the middle of the road policies such as the endorsement of central banking is a misguided way to promote free markets. It would seem like the devil who uses the Bible in order to mislead Christian devotees.

As the great Ludwig von Mises wrote,

The middle-of-the-road policy is not an economic system that can last. It is a method for the realization of socialism by installments.

Paper Money Is Political Money

Populist blogger John Mauldin writes,

The euro never was an economic currency. It is a political currency, and for it to remain a currency or at some point in the future become an economic currency, it will take massive political resolve on the part of the members of the EU.

Unless the US dollar operates on a genuine gold standard or a monetary system based on free banking, then this statement or implied comparison or categorization is patently false.

Although to give credit to Mr. Mauldin for admitting that he has been a “Euro skeptic”, his opinions has apparently been shaped by biases rather than from facts.

So why is the above statement false? Because paper money has always been political money.

ALL paper money, whether the US dollar, Euro, the Yen, the Yuan or the Peso, operates on a platform which is not determined by the market forces but by the judgments of unelected bureaucracy whom are appointed by their respective governments.

Thus, from the organizational structure to the operating “technical” procedures to the underlying incentives of the bureaucracy in conducting administration of these instituted statutes or policies, which are all outside the profit and loss dimensions and whose operations are underwritten by taxpayers, all these represent the political nature of the system.

Importantly, the paper money system is founded from legal tender laws, which according to Wikipedia.org, is “a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation”.

In other words, a monetary system imposed by the government (by fiat or decree), which has largely been operated by central banks, has always been political.

Yet to speak of an “economic currency” extrapolates to a market based currency from which the legal tender-paper money system is not required.

According to the great Friedrich August von Hayek,

We owe it to governments that within given national territories today in general only one kind of money is universally accepted. But whether this is desirable, or whether people could not, if they understood the advantage, get a much better kind of money without all the to-do about legal tender, is an open question. Moreover, a "legal means of payment" (gesetzliches Zahlungsmittel) need not be specifically designated by a law. It is sufficient if the law enables the judge to decide in what sort of money a particular debt can be discharged.”

Thus, to besmirch a currency without the appropriate consideration of the overall framework of the system would seem misguided if not a flimflam.

Caveat Emptor.

Banking System And Global Imbalances

This is an interesting observation from the Economist,


``The finances of banks are a mirror of the economies where they are based. In emerging markets, the surplus of customer deposits over loans (ie, excess savings) at listed banks was about $1.6 trillion in 2008, compared with a deficit of about $1.9 trillion at rich-world banks. Banks in emerging markets, which have vast branch networks to suck in deposits from thrifty families and companies, park their surplus with the state, by buying government bonds or keeping it in central banks. The state in turn acts as the international recycling agent for those excess savings: it lends them to Western countries through its foreign reserves or through a sovereign-wealth fund. Meanwhile, overextended Western banks do the exact opposite: they borrow from capital markets to plug the hole created by having more loans than deposits. In 2009, the funding gap was smaller, reflecting the slow rebalancing of Western banks' finances." (all bold highlights mine)

My comment:

The above shows the following:

-trade imbalances are offset by capital account transfers [see US-China Trade Imbalance? Where?]

-governments are shown here to be very inefficient intermediaries in the allocation of resources (finance or real). Allocations are fundamentally politically motivated, e.g. in the US, the homeownership bias in the 1990s to 2007 (ergo the bubble bust of 2008); today, the focus is on deficit spending.

-moral hazard from sustained subsidies to government (as recycling mechanism) has partly caused bubbles and will likely continue to do so.

-the overall problem basically seems due to the architecture of our monetary system, which have been premised on a cartelized banking system that revolves around central banking.

Inflationism And The Bailout Of Greece

``The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”- Leo Tolstoy

Speaking of economic reality, the unsustainable state of welfare system in Greece and the PIIGS in the Eurozone today seems like a good example of government wastrel, that needs to be rebalanced or ‘revert to the mean’.

But this outcome while necessary may not likely be a preferred path for policymakers.

Mainstream’s Penchant For Currency Devaluation

Figure 4: Danske Bank[1]: The Euro Crisis

Yet the problems of the PIIGs (see figure 4) is not mostly because of the recent bursting of the US housing bubble but from previous government profligacy which arose from the incentives brought about by the prevailing monetary platform...the fractional reserve system operated by central banking.

Economists Peter Boone and former chief of the IMF, Simon Johnson formerly chief of the IMF writes[2], (bold highlights mine)

``The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

``This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.” (all bold highlights mine)

While Messrs. Boone and Johnson prescribe a whopping $1 trillion backstop for Portugal, Italy and Greece, they also call for the end of the current “repo window” to be substituted by “eurozone bonds”.

And like most of the Euro doomsayers, the common denominator to blame for the Greece or the PIIGS crisis has been the rigid monetary system from the Union or that these crisis-affected-countries can’t devalue its way out of the mess.

However, contra such generalizations, devaluing a currency would have some merit if the debts had been priced in local currency. But if they are priced in foreign currency then devaluation raises the cost of real debts. Hence, devaluations will not resolve the problems that require massive adjustments or reversion to the mean in economic sphere.

Central Banking Means Inflationism, ECB Included

For the mainstream economists, as always, money printing appears to be the only feasible solution to the mess surrounding the government’s spendthrift ways for so-and-so noble reasons.

Whether it is the ECB or the Fed, the political incentives for the central banks remain the same, to re-quote Murray N. Rothbard[3] anew,

``The Central Bank has always had two major roles: (1) to help finance the government's deficit; and (2) to cartelize the private commercial banks in the country, so as to help remove the two great market limits on their expansion of credit, on their propensity to counterfeit: a possible loss of confidence leading to bank runs; and the loss of reserves should any one bank expand its own credit. For cartels on the market, even if they are to each firm's advantage, are very difficult to sustain unless government enforces the cartel. In the area of fractional-reserve banking, the Central Bank can assist cartelization by removing or alleviating these two basic free-market limits on banks' inflationary expansion credit.”

In other words, governments are not likely to radically alter the framework of the banking system because of the following reasons:

One, it defeats the purpose of having a central bank, i.e. finance government deficit, cartelize private banks and circumvent market’s restriction to expand credit,

As for the government banks financing of government debt, Germany’s government banks had been recently reported to have sizeable holdings of Greek debt. According to the New York Times[4], (bold highlights mine)

``Germany’s financial institutions hold some €28 billion, or $37 billion, in Greek bonds, Barclays Capital estimates, extrapolating from International Monetary Fund data.

``A quick survey of Germany’s largest banks Wednesday indicates that probably half of that debt — rated “junk” by Standard & Poor’s since Tuesday — sits on the balance sheets of institutions that are owned or controlled by the government. The percentage could be much higher, but outsiders have no way of knowing for sure because bank regulators and many of the banks refuse to disclose precise numbers.”

So this only serves as proof of how central banks and the banking cartel system work hand in hand.

Second, the most conspicuous path dependency for the authorities of the ECB and the US Fed (or even with Bank of Japan) would be to inflate the system (as we previously discussed[5]), given the du jour mainstream ideology triumphalism of present policies and the addiction to the printing press,

Third, except for some tweaks (via financial reforms) in the banking regulation, the path towards banking regulation is to maintain the status quo but with more control over the cartelized system (one just needs to ask why has governments steadfastly refrained from the nationalizing the system?) and

Importantly, as long as the private sector continues to use government’s “legal tender” as the preferred medium of exchange then some semblance of political control over the economy is assured.

In essence, central banks are means to a political end. This only extrapolates that politics and central banking have been tightly enmeshed. And to argue that politics only emerged recently is unalloyed hogwash.

So it would be quite naive to suggest that for instance, Germany can simply walk away given the current problems, as this view ignores the main function of central banks.

Understanding The Euro’s Political Foundation, The Bailout Of Greece

One major reason why the Eurozone forged a union through a common currency had been to avoid from having to get immersed into repeated military conflicts, given its vulnerable geographic location.

As Marko Papic and Peter Zeihan of Stratfor[6] writes, (bold emphasis mine)

``Germany’s exposure and vulnerability thus make it an extremely active power. It is always under the gun, and so its policies reflect a certain desperate hyperactivity. In times of peace, Germany is competing with everyone economically, while in times of war it is fighting everyone. Its only hope for survival lies in brutal efficiencies, which it achieves in industry and warfare.”

``Pre-1945, Germany’s national goals were simple: Use diplomacy and economic heft to prevent multifront wars, and when those wars seem unavoidable, initiate them at a time and place of Berlin’s choosing.”

So I guess Frederic Bastiat’s “when goods don’t cross borders, then armies will” serves as the foundation behind Euro’s emergence.

From a moral point of view (which I subscribe to), the EU should have kicked Greece’s wazoo for fudging or falsifying her data, just to be included in the elite membership. But that would be overly simplistic reasoning.

Again we cite Messrs. Papic and Zeihan[7], (all bold highlights mine)

``The problem with that logic is that this crisis also is about the future of Europe and Germany’s place in it. Germany knows that the geopolitical writing is on the wall: As powerful as it is, as an individual country (or even partnered with France), Germany does not approach the power of the United States or China and even that of Brazil or Russia further down the line. Berlin feels its relevance on the world stage slipping, something encapsulated by U.S. President Barack Obama’s recent refusal to meet for the traditional EU-U.S. summit. And it feels its economic weight burdened by the incoherence of the eurozone’s political unity and deepening demographic problems.

``The only way for Germany to matter is if Europe as a whole matters. If Germany does the economically prudent (and emotionally satisfying) thing and lets Greece fail, it could force some of the rest of the eurozone to shape up and maybe even make the eurozone better off economically in the long run. But this would come at a cost: It would scuttle the euro as a global currency and the European Union as a global player.”

And this appears to undergird why Germany assiduously took all the time and efforts to convince Greece on reforms, than to speedily embrace a bailout. By successfully convincing Greece to adapt fiscal austerity, Germany would be able to reduce the leash effect from the moral hazard that would influence the actions of the other “crisis affected countries” from taking on the same path.

Yet Greece has adamantly resisted reforms until last week’s panic in the CDS and bond markets (see Figure 5), which apparently posed as the proverbial straw that broke the camels’ back.

Figure 5: Danske Bank[8]: Greece Debt Meltdown - What's Next?

And this has forced the arms of both the Eurozone and Greece to come up with a package.

And as of this writing, Greece appears to have finally acceded to a €100 billion (US $133 billion) bailout[9], which appears to validate our view once again!

No Trend Goes In A Straight Line

Does the panic in the European bond markets imply the end to the inflation driven financial markets?

Hardly.

The incentives driving the authorities of central banks have been to use more inflation in the face of any crisis (throw them money at them[10]), and the Greek episode simply amplified and validated this path dependency.

Considering that much of the world has been more on the recovery phase in the current economic cycle (or at the next phase of a budding bubble cycle), we aren’t inclined to believe that a market meltdown from a contagion is likely to prosper.

Also, it doesn’t mean that because global equity markets stumbled this week translates to the end of the current cycle.

For the perma-bears that would be wishful thinking.

In the US, the Dow Jones Industrials has been up for 8 consecutive weeks prior to this correction along with the Nasdaq, while the S&P 500 had been up for 6 straight weeks prior to 2 successive weekly declines (see figure 6).

In short, markets don’t move in a straight line!

Figure 6: stockcharts.com: Greece Contagion?

Yet there is hardly any trace that the correction has been related to the contagion of the Greek crisis.

Funny how, perma bears scamper for any piece of evidence to justify a bearish outlook- a cart before the horse logic. Two weeks ago it was Goldman, now they’re back to Greece after failing last February.

If the recent correction is about a Greece sovereign spillover, then why has US treasury 10 year yields fallen or why has US treasuries bonds rallied?

We seem to be seeing some rotation away from the Euro area and into US Treasuries. The US dollar appears to likewise validate this perspective.

Most of Asia, except for China, has been less as pressured. The Philippine Phisix was up this week, while the Philippine Peso was slightly lower. Asia’s mixed performance implies that the rotation was very much a Euro-US dynamic.

The VIX or the fear index isn’t likely much of a forward looking indicator either. The current spike in the VIX index hasn’t even surpassed the February high, yet the S&P after this week’s correction is still very much higher than the when the VIX previously spiked.

Moreover we are seeing a rally in Gold and Oil.

While US treasuries haven’t chimed with these commodities to indicate general inflation, this only continues to affirm our outlook that we are currently treading in the sweet spot of the inflation cycle.

So there are hardly any vital signs to exhibit that markets are about to inflect. What we are likely seeing is just a natural pause from a persistent run-up.

China’s Next Wall Of Inflationism

Finally, today’s Keynesian world only means more money printing to fund the government sponsored shindig as insurance against any crisis.

China’s market is in an apparent doldrums following the repeated assaults by her government to stem a localized bubble. The latest government directive was reportedly the “most draconian measures in history[11]” as noted by an analyst, as China’s government ordered a total freeze in loans on acquisitions of third properties.

So aside from the government actions, China’s languid markets may also reflect on the present weakening of her domestic credit cycle.

Nevertheless China appears to be preparing for any eventuality. A Chinese daily have recently floated that the next tsunami of government spending worth 4 trillion yuan ($586 billion) for nine industries will be announced in August[12].

Apparently for policymakers there is no alternative route but to engage in rampant inflationism.

In my view, it is not worthy to fight this trend.

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[1] Danske Bank, The Euro Crisis, Can Politicians Catch Up With The Avalanche?

[2] Boone, Peter and Johnson, Simon; To Save The Eurozone: $1 trillion, European Central Bank Reform, And A New Head for the IMF

[3] Rothbard, Murray N. The Case Against The Fed p. 58

[4] New York Times, Germany Has Big Investment in Greece Even Before Bailout

[5] See Why The Greece Episode Means More Inflationism

[6] Papic, Marko and Zeihan, Peter; Germany's Choice stratfor.com

[7] Ibid

[8] Danske Bank Greece Debt Meltdown - What's Next?

[9] Bloomberg, Greece Accepts Terms of EU-Led Bailout, ‘Savage’ Budget Cuts

[10] See Mainstream’s Three “Wise” Monkey Solution To Social Problems

[11] Bloomberg.com, China’s Property Demand May Remain ‘Strong,’ HSBC’s Yorke Says

[12] Bloomberg.com, China May Announce 4 Trillion Yuan Stimulus, China Business Says