Ahead of the Herd Blog

by Peter Schiff

There is an old adage on Wall Street that no one rings a bell at major market tops or bottoms. That may be true in normal times, but as many have noticed, we are now completely through the looking glass. In this parallel reality, Ben Bernanke has just rung the loudest bell ever heard in the foreign exchange and government debt markets. Investors who ignore the clanging do so at their own peril. The bell’s reverberations will be felt by everyday Americans, whose lives are about to change in ways few can imagine. While nearly every facet of America’s economy has been devastated over the past six months, our national currency has thus far skipped through the carnage with nary a scratch. Ironically, the U.S. dollar has been the beneficiary of the global economic crises which the United States set in motion. As a result, our economy has thus far been spared the full force of the storm.

This week the Federal Reserve finally made clear what should have been obvious for some time – the only weapon that the Fed is willing to use to fight the economic downturn is a continuing torrent of pure, undiluted, inflation. The announcement should be seen as a game changer that redirects the fury of the financial storm directly onto our shores.

In its statement, the Fed announced its intention to purchase an additional $1 trillion worth of U.S. treasury and agency debt. The purchases, of course, will be made with money created out of thin air through the Fed’s printing presses. Few can doubt that they will persist with these operations until the economy returns to its former health. Whether or not this can ever be accomplished with a printing press alone has never been seriously considered. Bernanke himself admits that we are in uncharted waters, with no map or compass, just simply a hope that more dollars are the answer.

Rather than solving our problems, more inflation will only add to the crisis. Falling asset prices, the credit crunch, declining consumer spending, bankruptcies, foreclosures, and layoffs are all part of the necessary rebalancing of our economy. These wrenching movements, however painful, are the market’s attempts to resolve the serious problems at the root of our bubble economy. Attempts to literally paper-over these problems will lead to disaster.

Now that the Fed has recklessly shown its hand, the mad dash to get out of Treasuries and dollars should not be far off. The more the Fed prints to buy bonds the less the dollar is worth. Holders of our debt (read China and Japan) understand this dynamic. We must expect that they will not only refuse to buy new bonds, but they will look to unload those bonds they already own.

Under normal circumstances, if creditors grew concerned that inflation was eating into their returns, the Fed would raise interest rates to entice them to buy. However, the Fed will avoid this course of action as it fears higher rates are too heavy a burden for our debt-laden economy to bear. To maintain artificially low rates, the Fed will be forced to purchase trillions more debt then it expects as it becomes the only buyer in a seller’s market.

Just last week, Chinese premier Wen Jiabao voiced concern about his country’s massive investments in U.S. government debt. In the most unequivocal statement yet by the Chinese leadership on this issue, Wen made it plain that he was concerned with depreciation, not default. With his fears now officially confirmed by the Fed statement, we must wonder when the Chinese will finally change course.

There is a growing consensus that if China no longer wants to buy our bonds, we can simply print the money and buy them ourselves. This naïve view fails to consider the consequences implicit in such a change. When the Treasury sells bonds to China, no new dollars are printed. Instead, China prints yuan which it then uses to buy treasuries. This effectively allows America to export its inflation to China. However, now that we will be printing the money ourselves, the full inflationary impact will fall directly on us.

With such a policy in place, America has now become a banana republic. It won’t be too long before our living standards reflect our new status. Got Gold?

Peter Schiff is president of Euro Pacific Capital and author of The Little Book of Bull Moves in Bear Markets and Crash Proof: How to Profit from the Coming Economic Collapse.

http://creativecommons.org/licenses/by/3.0/us/

Is Gold Money?
by William Rees-Mogg
www.lewrockwell.com

As someone who has been interested in gold for the last forty years, I have always been interested in the definitions which can be applied to gold. Is gold money? It often has been, but it is not at present. I suspect it may become money again. Is gold a commodity? I think the answer to that question is “yes”. Gold used in chemical reactions, or in jewellery, is plainly a commodity which can sometimes be replaced by another commodity.

However, the question I find most interesting is whether gold is a real asset. One of the problems of investment is that there are two variables, reality and liquidity. Land or property are relatively illiquid, but are also real, in that they have a use which does not depend on their value in exchange. Gold is highly liquid, indeed it is more liquid than paper money. In extreme circumstances, paper money can lose all its value, when gold is still acceptable as payment. In 1940, when the French Army was defeated, many French people took to their automobiles to escape the advancing Germans. They found that petrol stations would not accept paper francs, but would sell their petrol in exchange for gold coins.

Gold also remains an acceptable currency in periods of high inflation, when paper money can lose all its value.

What does “reality” mean, when applied to an investment? Obviously we talk about “real estate” to describe the legal possession of property. I think that means property with a permanent character and at least a potential use. In the same way, the traditional theorists of the gold standard would say that gold was a real currency, because it has permanence and a potential non-monetary use.

I accept that reality in an asset is a relative factor. In an ideal world, we would all like to hold our financial needs in a currency with a high degree of permanence, strong alternative uses and high liquidity. We have to make do with currencies which fall short of perfect “reality”, and fall short of perfect liquidity as well. We make do with imperfect currencies because we have no choice.

Gold makes one think about these issues, but it makes one even more uneasy about electronic money. In book publishing, I am well aware of the library demand for archival books which can reasonably be expected to last for centuries, like the printed works of earlier centuries. We need also to have permanent money, which can be relied upon to survive, even though its value may decline over time. The historic value of gold has been astonishingly stable over centuries.

In an extreme example, one could be worried about the issue of money and about its preservation. Mr. Madoff has shown that fraud can reach the unbelievable level of $50 billion. Might there not be still larger frauds, so large as to achieve what the wartime German operation attempted, a complete takeover of a targeted currency?

Cybercrime is already operating on a huge scale. Suppose that Al Qaeda, instead of attacking the twin towers, had attacked the electronic systems which record all the monetary holdings of New York. No lives might have been lost, but an electronic pulse might have erased one of the central counting houses of world finance. The world might have been ruined.

Is there not some element of this cybercatastrophe in the present world crisis? Reality may be a variable concept, with nothing 100 per cent real and hardly anything zero per cent. When I was born, in 1928, gold was money, and gold was over 90 per cent real. In 1970, when I was in my forties, money was paper, and even the convertibility into gold of the Bretton Woods Agreement was breaking up. Now money is a largely unidentifiable electronic pulse, itself vulnerable to attack by electronic means. Virtual money has very low reality, much lower than paper.

Surely this is a system which could be blown away because there is nothing in it to gain confidence. Even a return to paper money would raise the level of reality attached to world currencies. There is a problem of raising the reality level of all currencies – a problem which nineteenth century economists solved by convertibility to gold.

by William Rees-Mogg
www.lewrockwell.com

March 10, 2009

William Rees-Mogg is former editor-in-chief for The Times and a member of the House of Lords. He has been credited with accurately forecasting glasnost and the fall of the Berlin Wall – as well as the 1987 crash. His political commentary appears in The Times every Monday. His financial insights can only be found in the Fleet Street Letter, the UK's longest-running investment newsletter.

Masterful Masters on Our Masters

by Becky Akers

Meet Tim Masters, an American of superior insight. After DNA evidence forced the State of Colorado to overturn his conviction for murder and free him from its cage, Mr. Masters knew precisely whom to blame for his ruined, stunted life. When CNN asked, "Any hard feelings toward the Fort Collins Police Department or the prosecutors in the case?", Mr. Masters responded, "Oh, absolutely. They locked me up for a decade for something I didn't do."

Yeah, take a moment to recover from such stunning brilliance. I, too, sat thunderstruck as I thought, Wow, someone finally gets it! But the perspicacious Mr. Masters wasn’t done: he holds government accountable not only for the years it stole but also for depriving him of basic human relationships ("I think they're very much responsible for me not having a family right now, a wife and kids"), of employment ("The first thing that comes up on a background check is ‘charges dismissed – first-degree murder’"), and of his youth ("…my high school days when they labeled me a murder suspect among all my peers and my teachers and everything"). He even blames the State for tormenting the murdered woman’s family ("It's a damned shame that [the police] did this to them, too, telling them they got the guy when they didn't have the right person").

Contrast that with the pass Leviathan’s other victims almost always grant the beast. The economy’s tanking thanks to Wall Street’s greed and your spendthrift neighbors rather than politicians who print money willy-nilly while taxing everybody and everything – including the air. Three thousand Americans died on 9/11 because Muslims are crazy Islamofascists; the Feds’ unconstitutional, unconscionable meddling in the Middle East had nothing to do with it. Government’s minions incinerated families at Waco, not out of psychopathic brutality but to save abused children. Public schools graduate illiterates because selfish homeowners refuse to fork over enough taxes for decent classrooms and teachers.

Et cetera, ad nauseam. However laborious or far-fetched, the sheeple prefer to excuse rather than indict their god, the State.

Not Tim Masters. He was a boy of 15 in Fort Collins, Colorado, when someone murdered vivacious, redheaded, 37-year-old Peggy Hettrick on February 11, 1987. The killer knifed her from behind with such force that it "splintered" one of her ribs, then mutilated her corpse with a "partial vulvectomy." Dr. Warren James, an obstetrician-gynecologist from Fort Collins, would later describe this desecration as "requir[ing] ‘a high degree of surgical skill and high-grade surgical instrument. … I find it highly unlikely that a 15-year-old could perform this precise surgical procedure.’" Ms. Hettrick’s butcher also "carefully removed" her "left nipple and areola" before sponging the blood from her body and dragging its 115 pounds into a field near the trailer where Tim lived with his widowed father.

Neither you nor I would figure a 110-pound teen-ager for a suspect in a crime calling for extensive knowledge of anatomy, surgical skills, expensive equipment, and Samson’s strength. That’s one reason we don’t leech off taxpayers at the Fort Collins Police Department. The whiz-bang sleuths who do fixated on Tim largely because he passed the corpse as he cut through the field on his usual route to school that morning. He even paused to look at the body. But the lady’s naturally pale coloring combined with her loss of blood had rendered her so white Tim thought she was a mannequin someone had dumped there as a prank. So did the bicyclist who saw her from the road about 30 yards away a few minutes later – until he noticed a puddle of gore at the curb. Then 38-year-old Linwood Hodgdon called 911.

Tim didn’t. He continued on to school. He was a quiet boy who "was known to keep to himself" – perhaps because his redheaded mother had died four years earlier almost to the day. Yet Fort Collins’ Finest let neither sympathy nor common sense impede them. They wondered why Tim hadn’t reacted as did the older Hodgdon, who glimpsed the body from a different angle and immediately reported it.

Worse, another older man who should have protected the boy didn’t, thanks to his faith in government. Tim’s father, Clyde, had been in the Navy for 22 years "’and felt you should obey authority,’" as Tim explained in an interview with CNN. Clyde "thought police were there to help." So he "initially told [his son] to cooperate with police, a decision that ultimately would be his undoing. … ‘We'll cooperate with them and give them anything they want and then they'll see that you didn't have anything to do with this and they'll move on,’ Masters recalled his father telling him in 1987. ‘It turns out that by cooperating with them it just encouraged them, because I was the easiest suspect to go after. … It's just a shame Dad didn't know how the system was.’"

Clyde so worshipped the State that he allowed cops to search his home. They found the sort of stuff in Tim’s room that typically fascinates teen-aged boys: six survival knives as well as "violent" sketches Tim had drawn and stories he’d written. His "artwork," including depictions "of dinosaurs with arrows through them, gruesome war scenes described by his Vietnam veteran dad and horror flicks such as ‘Nightmare on Elm Street’ that father and son watched together," had so "disturbed" a teacher that Tim wound up in a "special-ed class …. The younger Masters loved to write, and his goal was to be another Stephen King. Judith Challes, the special-ed teacher who knew him best, told his reading teacher, ‘You know, I'm not at all concerned about them (his writings and drawings).’ Most of her kids scrawled horrific images."

But Tim’s creativity and his knives had the cops off and running. "It's just unbelievable," Tim says, "because here's all these stories and drawings that have no nexus with the crime. There's no one being stabbed in the back. There's no one being sexually mutilated. The only thing they had in common with this crime is there was violence."

Clyde left his son alone with the cops and their videotaped interrogation for ten hours. If that isn’t child abuse, it’s tragically close. And it demonstrates that those who blind themselves to the State’s evil unleash catastrophe, not only on themselves but on the innocents around them. Meanwhile, Tim’s dignified, heroic silence as the cops badger, insinuate, accuse, and threaten him earns this boy my nomination for "Man of the Year." He simply, searingly shows them for the bullies they are.

And I’ll bet the cops knew it. Perhaps that’s why Tim remained their chief suspect for twelve years. Their obsession kept them from investigating other leads and far likelier killers.

In 1999, after Lt. Jim Broderick unearthed "a forensic psychiatrist who testified that Masters’ boyhood doodles were evidence of a ‘fantasy rehearsal’ for the murder," Tim finally stood trial. Supposedly, he had "single-handedly murdered Hettrick in an ambush while she was walking past Masters’ house after a night of drinking. He killed her at the curb on Landings Drive, then dragged her into an adjacent field where he mutilated her genitals and breast by the light of a military flashlight. He managed this without leaving a trace of evidence behind, or bringing back into his house any evidence from the scene. Police never found any blood, body parts, hair or fibers that could connect Masters to the crime." Instead, they relied on "circumstantial evidence to paint a picture of an anti-social youngster so wracked by abandonment from the untimely death of his mother that he took sadistic revenge on a passing woman who resembled her." That was enough to convict Tim and sentence him to life in prison.

"They won their case by assassinating my character," Tim says. Once again seeing officials as they are rather than as they want us to, he added, "My opinion is that Jim Broderick, the guy in charge of [the investigation of the murder], has a very big ego and would not allow anything or anyone to convince him that he was wrong. He made up his mind in the beginning, from day one when he walked into my bedroom and saw my horror drawings and war stories, that I was guilty. Nothing would change his mind."

From his cell, Tim filed appeals. Courts either affirmed his conviction or refused to hear his case. But when new DNA evidence exonerated him in 2007, a judge vacated his sentence – as Tim did prison in early 2008.

Ever the sore loser, Leviathan begrudged its prey his freedom. "Though out of prison, Masters still carries the label ‘suspect.’ District Attorney Larry Abrahamson made that clear in his order to dismiss charges against Masters. The new DNA doesn't vindicate Masters, Abrahamson wrote, but it ‘clearly warrants a complete re-examination of the evidence related to the murder of Peggy Hettrick.’" Tim mentioned his "[relief that] the charges were dismissed" while also noting, "I didn't care too much for the language of [Abrahamson’s] motion." CNN reported that Tim’s "attorneys voiced a stronger reaction. ‘They're still trying to keep him on a leash,’ said attorney Maria Liu. ‘They know there's not one single shred of evidence against Tim Masters and they don't have the backbone or integrity to acknowledge it.’"

Tim recently sued his local Leviathan for "unfair, malicious prosecution." While private citizens showered money and other gifts on this wronged man, the City of Fort Collins asked a federal judge to dismiss the claim – and, for good measure, also requested that the court force Tim to pay the city's legal costs. That doesn’t faze the victim. At this point, he understands the devil so well he can quip about his horns and pitchfork: "Right now, it looks like [the City]’ll spend millions to not give me one." Gitmo’s prisoners have received no compensation for the crimes committed against them, and Tim probably won’t either, though he estimates he lost half a million dollars in wages as well as his house, a ’46 Harley, and other property.

No, the best the State can do is investigate – and clear – Lt. Broderick, though he "illegally taped a conversation between Masters, then 15, and his dad, Clyde Masters, at police headquarters 20 years ago." (Which skullduggery backfired since "Masters repeatedly tells his dad he's innocent." No problem: Broderick never divulged his recording’s results to Tim’s attorneys.) Leviathan iced this foul cake when it "censured" two of the prosecutors who secured Tim’s wrongful conviction. David Wymore, the attorney in charge of Tim’s victorious appeal, dismissed that as "a slap on the wrist. … This man spent 10 years in prison, and the prosecutors who put him there aren't even being sentenced to an ethics class?"

Leviathan’s mauling of this motherless boy offers many lessons. First, it exposes the monster’s satanic ugliness. We should study it well despite the stench so we understand what we’re fighting.

The second lesson is for parents. When you teach your kids that poison, fire, playing in traffic, and strangers will hurt them, tell them the State will, too. Warn them that anyone on its payroll is the strangest of all strangers, a dire and often lethal enemy. Sure, government boasts a good guy now and then; some of them worked to clear Tim and win his release. But mixing sugar with cyanide only masks the fatal flavor, making it even more dangerous.

Then there’s the reminder that hundreds of thousands of Tims languish in prison, whether Leviathan frames them as it did him or whether they’re genuinely "guilty" of non-crimes. Barie Goetz, an investigator who helped prove Tim’s innocence, says, "Look, the system took his life and, in a way, his future. We all want him to make it. But … he's got this stigma. The truth is that I've asked people, 'Would you hire him?' 'Would you let him date your daughter?' The answer's always the same. You get this pause. . . ." Let those of us who have thus far escaped the fiend’s clutches employ and embrace, nourish and nurture those who haven’t.

Looking back at his dad’s veneration of Leviathan, at the years and grief it cost him, Tim advises, "You shouldn't always submit to authority. Our country wouldn't exist if everyone submitted to authority."

Sheer genius.

Becky Akers
libertatem@netzero.com

March 9, 2009

Becky Akers writes primarily about the American Revolution.

James Howard Kunstler

Isn’t that a question, though…

The Peak Oil story was never about running out of oil. It was about the collapse of complex systems in a world economy faced by the prospect of no further oil-fueled growth. It was something of a shock to many that the first complex system to fail would be banking, but the process is obvious: no more growth means no more ability to pay interest on credit… end of story, as Tony Soprano used to say.

There was a popular theory among Peak Oilers the last decade that the world would enter a “bumpy plateau” period when the global economy would get beaten down by Peak Oil, would then revive as “demand destruction” drove down oil prices, and would be beaten down again as oil prices shot up in response - with serial repetitions of the cycle, each beat-down taking economies lower - the only imaginable outcome being some sort of quiet homeostasis. This scenario did not play out as expected. It was predicated on a mistaken assumption that all systems would retain some kind of operational resilience while ratcheting down. Anyway, the banking system was mortally wounded in the first go-round and the behemoth is dying hard.

The last desperate act of the banking system in the face of Peak Oil’s no-more-growth equation was to engineer species of tradable securities that could produce wealth out of thin air rather than productive activity. This was the alphabet soup of algorithm-derived frauds with vague and confounding names such as credit default swaps (CDSs), collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and, of course, the basic filler, mortgage backed securities. The banking system is now choking to death on these delicacies.

The trouble is that the EMT squad brought in to rescue the banking system - that is, governments - can’t remove these obstructions from the patient’s craw. They don’t want to drown in a mighty upchuck of the alphabet soup.

The collapse of complex systems is actually predicated on the idea that the systems would mutually reinforce each other’s failures. This is now plain to see as the collapse of banking (that is, of both lending and debt service), has led to the collapse of commerce and manufacturing. The next systems to go will probably be farming, transportation, and the oil markets themselves (which constitute the system for allocating and distributing world energy resources). As these things seize up, the final system to go will be governance, at least at the highest levels.

If we’re really lucky, human affairs will eventually reorganize at a lower scale of activity, governance, civility, and economy. Every week, the failure to recognize the nature of our predicament thrusts us further into the uncharted territory of hardship. The task of government right now is not to prop up doomed systems at their current scales of failure, but to prepare the public to rebuild our systems at smaller scales.

The net effect of the failures in banking is that a lot of people have less money than they expected they would have a year ago. This is bad enough, given our habits and practices of modern life. But what happens when farming collapses? The prospect for that is closer than most of us might realize. The way we produce our food has been organized at a scale that has ruinous consequences, not least its addiction to capital. Now that banking is in collapse, capital will be extremely scarce. Nobody in the cities reads farm news, or listens to farm reports on the radio. Guess what, though: we are entering the planting season. It will be interesting to learn how many farmers “out there” in the Cheez Doodle belt are not able to secure loans for this year’s crop.

My guess is that the disorder in agriculture will be pretty severe this year, especially since some of the world’s most productive places - California, northern China, Argentina, the Australian grain belt - are caught in extremes of drought on top of capital shortages. If the U.S. government is going to try to make remedial policy for anything, it better start with agriculture, to promote local, smaller-scaled farming using methods that are much less dependent on oil byproducts and capital injections.

This will, of course, require a re-allocation of lands suitable for growing food. Our real estate market mechanisms could conceivably enable this to happen, but not without a coherent consensus that it is imperative to do so. If agribusiness as currently practiced doesn’t founder on capital shortages, it will surely collapse on disruptions in the oil markets. President Obama at least made a start in the right direction by proposing to eliminate further subsidies to farmers above the $250,000 level. But the situation is really more acute. Surely the US Department of Agriculture already knows about it, but the public may not be interested until the shelves in the Piggly-Wiggly are bare - and then, of course, they’ll go crazy.

The recent huge drop in oil prices has left the public once again convinced that the world is drowning in oil - if only the scoundrelly oil companies were forced to deliver it at reasonable prices. The public has been consistently deluded about this for decades. What’s missing so far is for the president of the United States to lay out the reality of the situation in a dedicated TV address. I know a lot of you think that Jimmy Carter already tried this and failed to make an impression (and ruined his presidency in the process). I guarantee you that Mr. Obama will have to do this sometime in the next few years whether he likes or not, and he’d be well-advised to get it done sooner rather than later. And by this I don’t mean just vague allusions to “energy independence” or “renewables” in speeches devoted to many other issues. I mean telling the public the plain truth that we’ll never offset oil depletion and the intelligent response is to do everything possible to transition to walkable towns and public transit, not to sustain the unsustainable.

The alternatives - i.e. what we’re trying now - is to further delude ourselves into thinking that we can run Wal-Mart and the suburbs by some other means than oil. Despite all our investments in these things, we won’t be able to run them by other means, and the news about this had better get out before enormous disappointment turns into titanic rage. If Americans think they’ve been grifted by Goldman Sachs and Bernie Madoff, wait until they find out what a swindle the so-called “American Dream” of suburban life turns out to be.

This week, in the power centers of America, attention is fixed on the never-ending fiasco of AIG - a company whose main product turned out to be credit default swaps, and is now choking on them. Kibitzers on the sidelines of finance are forecasting a king-hell bear market suckers’ rally in the stock markets followed by a belly flop to Dow 4000 or lower. I myself called for Dow 4000 two years ago - and was obviously a bit off on my timing. All this is surely trouble enough. But while your attention is focused on Rick Santelli in the Chicago trader’s pit, or Larry Kudlow desperately seeking “mustard seeds” of new growth in financials, try to let one eye stray to the horizon where these other complex systems are working out their next moves. Farming. The oil markets. These are the coming theaters of alarm and distress.

http://www.kunstler.com/

They Done Us Wrong: Spending Our Way Into Greater Depression

by Michael S. Rozeff

If you like economic depression, Obama is your man. The stock market is shouting this message loudly and clearly. The S & P 500 (measured by the security SPY) made a little high at 100.41 on November 4, 2008. The election was the next day. It has been downhill ever since. The close on March 2, 2009 was 70.60. This 30 percent decline qualifies as what used to be an ordinary bear market!

Congress and the President could not construct better measures, proposed and enacted, to deepen this depression if they tried. Congressional Democrats intend to ensconce Democrats as the majority party for the next 25 years or so. Their chosen method is wasteful pork sold as rational investment. But by gilding the nests of their chosen constituencies and supporters with huge taxpayer-funded giveaways, they will deepen and lengthen the depression.

The stock market tells us this, but it is easy for stimulus supporters to explain away the stock market’s drop in other ways. Obama supporters are likely to extol the good things that his program is doing to revive spending in the economy, and to regard the stock market as an aberrant den of gamblers and thieves who deserve their Bush-induced fate.

Very few men on the street, including my doctor, understand that spending, whether private or government, does not get rid of economic depression; and the lack of spending does not cause it. They do not fathom that government spending, borrowing, and taxing will further gash the sinking economy below the water line and send it to its watery grave. They are more inclined to believe, along with prominent economists, that government spending should be increased by trillions more. There cannot be too much of a good thing.

People automatically think that if everyone does not spend, then how can businesses keep going and hire people? How can the economy work? Then they think, if people only have money, then they can spend. If the government spending will only put that money into their hands, this will cause people to spend. It will jump start the economy, restore business confidence, and all will be well.

This story has a firm hold on the public imagination, but things don’t work that way. People in the aggregate can only earn money to spend by working productively. Money still doesn’t grow on trees.

The government doesn’t have a money tree either. Without resorting to inflation, it can only shift money around. America’s federal government is a group of Americans who are empowered to tax the rest of us and borrow from anyone in the world. This money is collected from you, me, and others. We then have less to spend. Shifting money from the left pocket to the right pocket doesn’t enhance the total amount.

Americans are not unwise enough to accept government money that is rolled off a printing press with absolutely nothing to back it up. Our government does not do things so crudely. Its money is printed up for it only after it issues government bonds that promise to pay interest. For all practical purposes, these bonds are perpetuities on which the promise is made to pay interest forever. There is no government money tree in this process because the government taxes Americans to pay the interest. If the government borrows from us and spends more now, we have less to spend now. The money goes from one pocket to another with no aggregate gain.

The government has another way to borrow. The central bank (the FED) can take the bonds and credit the government’s bank account. This exchanges one credit for another credit. The taxpayer must still pay interest. The credit created for the government has not directly diminished the taxpayer’s wealth on his personal account. There has been no money transferred from taxpayer to government. The taxpayers have a new liability, nonetheless. They will be made to pay the present value of the interest payments, which is the value of the bonds. This may or may not crimp their spending. It probably will not. They are unlikely at first to realize that they owe this money. As time goes on and they have to pay higher taxes, they might realize it. When the government relieves many people of direct taxes, it hides this burden of the debt for as long as it can.

So what do we have? The government can get money from the FED and spend it. It will seem to many people like money that grows on trees because they do not see the eventual taxes or the current hidden taxes. The government can spend this money. It will stimulate people into working at various government-selected projects. There is, however, no such thing as a free lunch. If people do not value these projects (which is usually the case) or the projects lose money (which they usually do), the welfare of people does not go up. It goes down, for they are paying for useless work. Furthermore, the government spending raises costs and prices by bidding labor and materials away from others. And this prevents those prices from adjusting to levels that make it profitable for businesses to employ people in making stuff that people really want.

There are those who contest the notion that government spending is largely waste. They imagine brand new bridges, newly-paved roads, and intercity rail transport. Even if these projects paid off, they are a tiny fraction of all government spending. And most of these do not pay off. Government spending only creates wealth if it spends money on things whose return exceeds the cost of the capital used. The government’s own operating costs are so high that, viewed as a business, it gets a return on its investments that fall far short of its capital costs. In other words, the government is like a gigantic money-losing business. One reason for this is that interest groups get the money. The image of public-minded officials dispersing the money efficiently is unreal.

Everyone who has spent any time at all looking into the matter of government spending, all regular readers of LRC, all readers of Ideas in Liberty, all readers of the publications of the Independent Institute, etc., and all those who have not looked into it, but have merely had experience with government, take it for granted that every $1 spent by government costs the taxpayer $1.25 or more. Governments routinely destroy wealth. The case is so overwhelming that anyone who believes otherwise can only be willfully ignorant or blinding himself. One scholar (Martin J. Bailey), who was far from a radical anti-government person, but who spent many years studying government and trying to write an improved Constitution to mitigate problems with representative government, wrote as follows:

"The leader, if truly well-informed, will know about several barriers to sound government. We may summarize these as follows. In existing nations the clash of interests often has powerfully wasteful and detrimental effects, among other reasons because elected professional politicians with almost unlimited authority to enact and administer laws are subject to enormous rent-seeking pressures. Indeed, they seek out groups that have been unable to solve their own organizational free rider problems and solve them through legislation – e.g., for labor in the 1930s through the National Labor Relations Act and more recently for the poor and the ‘homeless.’ Political discourse in all venues is routinely filled with fraudulent claims, slander and other misrepresentations. Even if they might wish to enact perfectly constructive, statesmanlike legislation, politicians have no reliable conduit with which to collect valid information about the preferences and values of their constituents. A fundamental reason for these symptoms is that citizens have no incentive to seek out the truth on public issues, but instead choose rational ignorance and, often, rational non-participation. See Downs (1957: 238–274). From this core problem emanate others that permeate government. Finding a corrective mechanism for this core problem is a necessary condition for overall improvement."

It helps the cause of liberty when polite and well-mannered experts, people who have studied the matter for years and speak in restrained tones, inform us that politicians cater to interest groups and not the public welfare, that they routinely lie, that they organize interest groups and shake them down, that even if they wanted to, they could not serve the public interest, and that our representative government is wildly dysfunctional.

The image of government restoring confidence by raising and spending money could not be more mistaken. This is the fantasy of Keynes. It is the rhetoric of FDR ("the only thing we have to fear is fear itself"). If business confidence depended on government spending, there would not have occurred any of the last 5 recessions in the U.S., for government spending rose both before and during these recessions. And there would have been a recession during the Clinton years when government spending moderated. The confidence of a businessman depends on the anticipated demand for his goods and services. He does not invest in plant and hire labor on the basis that the government is spending money on its favorite interest groups.

There are unemployed resources in a depression. Doesn’t the government improve matters by putting these to work? There is a large vacant building for lease in a nearby commercial strip. It used to be a shoe store. At the same time, there are unemployed men and women in the area. So far, no business has seen fit to rent the building. Does the government have a viable business in view? This is highly doubtful. It is not how the government operates. If it directly hires the building, the chances are that it will hire people to do make-work. The operation will run a loss, paid for by taxpayers. Why should they be taxed to pay the unemployed and lose money in the process? Nothing is accomplished but a transfer of wealth from taxpayers to the unemployed and an additional loss. Meanwhile, when business recovers and seeks to satisfy needs of consumers, it finds that its costs are higher because the government has rented the building and hired labor. The government’s actions inhibit recovery. Why should wealth be taken from taxpayers? If they would have spent the money on goods, they no longer can. If they would have invested it, that too is no longer possible.

Meanwhile, there is another effect of government borrowing from the FED. When the FED credits the government, it creates bank reserves. This typically sets off a multiple credit expansion among banks. This stimulates business, but it is a process of credit inflation that leads to a recession or worse. Ordinarily, business demand for labor and materials is constrained and rationed by the supply of savings. The FED’s credit creation, however, causes a lowering of the interest rate. That relaxes the constraint. The stimulation causes economic distortions and imbalances and eventual recession.

Imagine that IBM is induced to borrow and to produce a new supercomputer because it thinks that its cost of capital is lower. It hires people, builds a new production line, and starts churning out new supercomputers. Other businesses do the same. But their planned selling prices and costs are predicated on spending, saving, and hiring patterns that no longer exist – the credit inflation changes all of that. The business activity that comes into the economy affects particular people first and not others, and their spending and saving behavior is not what would have occurred had they not been employed and paid in this new activity. Furthermore, people change their economic behavior when they observe the activities of others and experience price changes.

The result is that somewhere along the way, some businesses find that their costs are rising beyond what they planned and expected. Some businesses also find that people are not buying the newly-produced items in the anticipated volume. The costs are rising because IBM is competing with Apple and many others to hire factors of production. Some products are not selling because the stimulus is uneven or not neutral in its effects. To sell their products, some firms have to lower their prices. Since they still have to pay their debts, they find themselves caught in a squeeze. This leads to cutbacks. This affects other firms. A recession or depression starts.

Government credit inflation is not a free lunch. The Obamaniacs are not overtly promising more depression via increased government spending, but that is inherent in their program. If they borrow from the public, it has no net stimulating effect. If they borrow from the FED, it produces temporary stimulation and inflation and then further depression. Credit creation through the central bank ultimately sends the economy on a downward course.

The stimulus story is that if people only can get money, they can spend and the economy will rise. People only can earn money by working. They earn money by providing something of value to others, like their labor or a good or service. The money they get entitles them to cash in on the value of their service by choosing to buy the goods or assets that others make available.

The image of money making the wheels of commerce turn is misleading. The money is a counter, a ticket that allows one to buy an array of goods. Money is a chit or a voucher. Money is a credit that can be cashed in against society’s goods and services; it is a credit that you can use up as you choose. When you make money, that money measures something else that is more basic, which is that you have supplied a valuable service or good. The money is an option to get goods in return at a later time and place of your choosing.

Money is not the problem. We do not have a depression for lack of money. The official M1 money supply at this time is almost $1.6 trillion. It was $1.4 trillion when the depression began. The problem is much more subtle. It has to do with prices and the price system. It has to do with overcoming problems caused by bad credits that arose when the price system was distorted by inflation. We have a depression because of the distortions and imbalances in the economy that arose over many years when too many people were induced by the FED to borrow too many credits and use them to buy and produce goods and services.

The image of government spending putting money into people’s hands is misleading. When the federal government spends money on windmills, it has to get that money from taxes or borrowing. When it borrows from the public, it has to raise taxes to pay the costs of the debt. So we may as well say that all the federal spending is paid for with taxes. This takes money out of the hands of those who might otherwise spend it or invest it. The government isn’t jump-starting anything.

If people want to trade goods and do not have enough money to carry out their exchanges, they can always create more. Money itself is not the problem, as the spending and stimulus story suggests. What you spend is what you produce. You can only spend what you produce. (If you borrow and spend, you must eventually pay that back with your production.) If Iowa corn farmers want to buy Chinese pots and pans, they have to produce corn. If the Chinese want to buy Iowa corn, they have to produce pots and pans. They don’t want our dollars to eat anymore than we want their yuan to cook with; these currencies are only media of exchange. We can always arrange means of paying each other. The real problem is that the production of goods has been dis-arranged and that many firms have to restructure. Many will go bankrupt and liquidate. Many will lay off workers. The adjustments take time. This is not now a problem of money and credit, although it was brought about by central banking’s excessive money and credit. It is now a problem of real production being interrupted because it is not geared to producing what people want to and can buy at current prices. When a lot of us do not have the means to spend, it is because we are not producing enough product that others want at prices they are willing to pay. That happens because inflation has distorted the price system and production.

In this situation, government spending does not restore the production system to one that caters to people’s wants and demands. Government spending does the opposite. It induces men and materials into work that is not in demand. This lengthens the period of adjustment back to normal production. It causes even more distortion by bidding labor and materials away from businesses and into lines of work promoted by government. It creates a new inflation and price distortions that must cause more depression. Furthermore, as we know, the government spending itself is on wasteful activities.

The government spending under Bush and Obama is piling up immense new liabilities and debts. Americans are trying to save more. The data on their private account show this clearly. The personal savings rate in January of this year is 5 percent. From 2005 to April of 2008, it averaged just under 0.5 percent. Meanwhile their government is frustrating their actions by incurring immense new debts.

Sadly, spending is not the end of the story of the Obama administration. Its tax and regulatory policies are equally destructive. It is certain that higher capital gains taxes, estate taxes, income taxes, and carbon taxes will provide new depressing effects on the American economy. The federal government’s projects now include a growing array of wealth-destroying investments that include AIG, Citigroup, Fannie Mae, Freddie Mac, the auto industry, and other major banks.

Since the Democrat victory in November, the stock market has been discounting these negatives. It will continue to do so as long as these negatives continue and worsen. At present, the Obama administration is still serving up a daily diet of negative shocks to the economy and the stock market. It is frustrating the recuperative powers of Americans, just as it is frustrating their attempts to save and put the American house in order. If this is not an example of the evils of our federal government and of our form of representative constitutional government, I don’t know what is.

Michael S. Rozeff
msroz@buffalo.edu

Michael S. Rozeff is a retired Professor of Finance living in East Amherst, New York.

By: Michael S. Rozeff
first posted on www.lewrockwell.com

There are many slips betwixt cup and lip, and thus this introduction before getting to the FED’s unsound theories.

Neither the federal government nor its Constitution have a moral or rightful foundation over any person residing in America who does not consent to them, for civil and political rights include the right of association. If men and women cannot associate with those whom they will in governing themselves, then they have no liberty. They are governed by others against their will. They are slaves. The existing Union is a product of force, including the American Civil War (1861–65), also known as the War Between the States and the War for Southern Independence, and including laws we are made to obey today that lack our consent. Force is not a moral or rightful foundation for government.

But even if the federal government and Constitution had moral authority, the Constitution provides that government with no legal authority and power over any of us. Lysander Spooner has argued this case persuasively and at length in No Treason. For one thing, none of us has signed the document or made a contract with the federal government. Spooner’s many arguments have never been refuted, although some, like Colin Williams, have tried and failed. Even the manner of its passage makes the Constitution lack authority. See Hologram of Liberty by Kenneth W. Royce. The present-day states of the union have little or no viable legal or moral authority either, dating, as they do, from nothing more than monarchical and territorial claims of old. But, if the states did have such rights, the Constitution, as it has been interpreted by the Supreme Court (a body within the federal government that judges the power of the federal government), would still lack authority in nearly all of its actions. A good many state legislators understand this and wish for their states to maintain these rights, as in this resolution introduced into the New Hampshire legislature.

But even if the Constitution did have legal authority, the Federal Reserve (FED) is unconstitutional. Article 1, Section 1 says "All legislative powers herein granted" vest in Congress. The powers are granted in the document. The Constitution enumerates or lists the powers of Congress and confers no others except those necessary and proper to their execution. It is not within the enumerated powers of the Constitution to establish a central bank with the FED’s powers, nor is the FED necessary and proper to achieve any of its listed powers. Indeed, the FED contradicts the articles that mention money. Section 8 gives Congress power "To coin money, regulate the value thereof,..." This does not preclude the right of any person to issue money, so that legal tender laws for private transactions are unconstitutional. And it does not allow government to do anything other than coin money, which the FED does not do. Congress may regulate the value of these coins by stating the gold or other metal content, which is why the article goes on to say "fix the standard of weights and measures."

In sum, the FED lacks any moral and legal authority.

But even if the FED were constitutional, its actions are pragmatically unsound. And because they are unsound, they damage the interests of many Americans. The rest of this article focuses on the practical failings of the FED.

It is really not up to me to prove that what the FED does is unsound in practice or that the theories that found its maneuvers are unsound and lead to damaging consequences. It is up to the FED and the FED’s supporters to prove that the FED’s theories and practices are sound. I am aware of no such proof or evidence that the FED does any good, either in achieving aims that one might attribute to it or in achieving its own aims. If someone will point me to this proof, I shall happily consider and evaluate it.

The closest thing to a defense of the central bank is that it can supply credits when the banking system needs them either seasonally or due to some crisis. Banks would, however, operate more soundly without having this backstop. They would be forced to. They’d also find ways to backstop each other. They were doing this before the FED was instituted. The supposedly limited and restrained backstop initial capabilities of the FED (to provide an elastic currency on short-term collateral) at decentralized reserve banks have long since wilted in favor of legal amendments to the 1913 act creating the FED that have given the FED almost unlimited (and centralized) power to discount almost any collateral and issue credit against it. This is a development that parallels the constitutional relaxations of the Supreme Court. In addition, it did not take the FED long to discover the power of open-market operations that it had. The foot in the door has become a ferocious tiger in the room.

I have looked at the FED’s web site for proof that it does good. At the very top of the page, the FED characterizes itself as follows: "The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system." The states met, in one way or another, and united to create a federal government governed by a Constitution. It is not clear whether the FED thinks of itself as the central bank of these 50 states (the United States) or as the central bank of that federal government (also called the United States). In either event, as noted above, the Constitution does not provide the Congress with the power to create a central bank. It does not even charge the Congress with the duty of creating a monetary and financial system, other than to coin money. And if Congress did coin money and regulate its content properly within the Constitution, the nation would be able to create a monetary and financial system that is sound, safe, flexible, and stable. And because Congress is enjoined in the Constitution from destroying contracts, the federal government could not arbitrarily alter the metal content of coins or seize the metal that goes into those coins, as the federal government did in 1933.

So, does the FED provide the nation with a monetary and financial system? If that is the FED’s claim, that claim is false. The FED provides nothing of the sort. The FED began in 1913. The nation developed its monetary and financial system long before the FED existed and has continued to develop it after the FED came into being. The evolving institutions of banking, clearing houses, correspondent banks, credit, money markets, stock markets, bond markets, foreign exchange markets, forward markets, commodity markets, futures markets, and derivatives markets pre-date and post-date the FED. The FED is one institutional development within much broader arrangements of many kinds that constitute money, credit, and capital markets. The FED is a central bank with particular powers, but it by no means provides the nation with a monetary and financial system. It has the power to alter, transform, regulate, and interfere with that system, and it has done so; but the basic system is not of its making. If there were no FED, the nation would still have a monetary and financial system.

If the FED’s claim, contrary to its expansive language, is that it makes the system safe, flexible, and stable, that claim too is false. It is up to the FED to prove that what it says is true, but it has never done so. If it has and I have missed it, which is surely possible, I will happily consider its claim. We know for a fact that the value of the paper dollar, which is the FED’s direct liability and note of issue, has experienced a long-term deterioration and that the nation has had to deal with and suffered from long-term inflation. There is hardly stability in this. We know that within that long-term downtrend, the dollar has fluctuated violently in value at times, both up and down. We know that these fluctuations have caused and/or contributed to violent fluctuations in employment, prices, and the production of goods and services. Where is the claimed stability for our economy? At times, the nation has endured severe depression under the FED, as in the 1930s, and that lengthy episode was preceded by the FED’s mismanagement of the dollar during the 1920s. The same thing is happening at present, again preceded by the FED’s inflation of bank reserves; and it is likely to occur again. Where is the safety in the FED’s monetary management? We know that inflation raged during the 1970s as a consequence of the FED’s loose monetary policies, and that the result was a series of severe recessions.

The FED makes no attempt to prove its claims, and it cannot prove them for they are false. The FED claims to be doing good for the nation. The Congress acts as if the FED is doing good for the nation. The system continues on its way with the powers-that-be acting as if the FED does good for the nation. Congress even wants the FED to have more powers. But there is no evidence that the FED has done good for the people at large who constitute the nation. The evidence, past and present, suggests the opposite.

The reason why this institution persists, which is to the detriment of many Americans, is that it benefits certain interests within the State and the banking industry, as well as certain Americans at large. Central banks benefit the States that create them. Historian Edwin J. Perkins writes of the Bank of England: "During the eighteenth century the British national debt had risen steadily in order to finance a series of overseas military campaigns, and the Bank of England had regularly accommodated the Exchequer [the Treasury] in financing budget deficits through the direct purchase of numerous fresh issues of government bonds running into the millions of pounds. Indeed, the Bank of England had been created in the seventeenth century for the explicit purpose of assisting Parliament in floating new debt issues." (From Perkins on U.S. Financial History and Related Topics.)

One may argue that the British military ventures that created the Empire benefitted the nation. One may similarly argue that the American military ventures, which could not have occurred in their frequency and size without the FED, also have benefitted the nation. This, however, is a thesis that is extraordinarily difficult to maintain. Great numbers of persons in the nation came to understand that the Vietnam War was wrong and that the Iraq War is wrong. As time passes, greater numbers may come to understand that these wars are not exceptions but the general rule, and that other American wars have equally borne bitter fruit in the making, the executing, and the aftermath.

Ben Bernanke knows that the FED mismanaged money in the past. For example, in a 1995 article he writes: "First, exhaustive analysis of the operation of the interwar gold standard has shown that much of the worldwide monetary contraction of the early 1930s was not a passive response to declining output, but instead the largely unintended result of an interaction of poorly designed institutions, shortsighted policy-making, and unfavorable political and economic preconditions."

In referring to "poorly designed institutions," Bernanke refers to various problems of the gold exchange standard and how central banks operated in the 1920s. For example, he writes "...for a majority of the important continental European central banks, open market operations were not permitted or were severely restricted." But in the current situation, central banks have had no such restrictions. They have been merrily inflating for a very long time. Why then has the world suddenly been plunged into depression? Why have commodity and asset prices fallen so sharply? This cannot be blamed again on a lack of power of central banks to inflate.

Will the next generation of central bankers and economists like Bernanke continue to ignore the connections between prior major inflations and subsequent depressions? Will they come up with yet another set of particular circumstances and blame the depression on them? There is never any shortage of such factors. In this case, there are hedge funds, derivatives, leverage, ratings errors, low loan standards, and securitization to name a few.

"Shortsighted policy making" refers to the errors of the FED and other central banks. Bernanke proposes to do better, but will he and can he? His own research only tentatively endorses two of the three main policies that he is now using, which are a huge expansion in the FED’s balance sheet, and the large-scale open market purchases of specific securities such as mortgage-backed bonds. In 2004, he wrote:

"Despite finding evidence that alternative policy measures may prove effective, we remain cautious about relying on such approaches. We believe that our findings go some way toward refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy. However, the effects of such policies remain quantitatively quite uncertain."

Is it right that he and the FED have the power to experiment with these untried solutions on a massive scale? Should we be made to bear the risks of this enormous gamble? How can this gamble possibly be reconciled with the notion that the FED is bringing us a safe and sound monetary policy? That policy is certainly flexible, but is that good? Not if it is an ongoing and untried work-in-progress whose results may prove disastrous. If the FED still exists in a few years, another chairman will probably look back and cite the poor institutions and shortsighted policy making of the current FED and its officials. We can do that now merely by applying sound economic analysis to those policies.

Bernanke has a peculiar blindness to causation that is difficult to understand. His thinking about the Great Depression starts in the 1930s. He does not seek its roots in the FED’s actions in the 1920s and in the boom that the FED promoted that eventually came to grief. Similarly, in 2008, Bernanke has not gotten to the roots of the current depression. He acts as if depressions suddenly spring full-blown upon us and we need only deal with them at that point or before – with more inflation.

Bernanke’s answer to depression prevention and control is incredibly simple and naïve: "Thus we believe that policymakers should continue to maintain an inflation buffer and to act preemptively against emerging deflationary risks."

The simple fact is that policymakers maintained inflation at high rates for decades on end. There has been a very large inflation buffer! They have acted preemptively against deflation for decades! Bernanke has to be wrong, because after all of that, the deflation in prices has occurred anyway. The inevitable depression has arrived.

Bernanke’s erroneous ideas would be a matter of indifference to me if Bernanke had no power. I would ignore his flawed ideas; and if I did stumble across them, I would dismiss them. Unfortunately for us, we have elevated him (and others) to power whose ignorance and bias can and will harm us greatly. We need to learn that we should never allow people to have such unchecked power, no matter how capable or learned we think they are.

In his 1995 article on the macroeconomics of the Great Depression, Bernanke argues that deflation (he means price deflation) propagated the depression and that inflation (here he means monetary inflation) alleviated it. His solution to a depression is therefore the inflation of money, and this is what he is now fostering to the best of his ability. Bernanke is not interested in basic causation. He thinks that the results of basic causes can be circumvented or thwarted by subsequent actions. He thinks that deflation (in prices) is the proximate cause of depression. Even in that regard, his thinking is wrong. Deflation in prices is a phenomenon during a depression that is correcting a variety of prior imbalances that have been built up. It is a liquidation that needs to occur in order to establish a firm basis for economic growth. That basis has to be rooted in prices. Businesses cannot begin to operate again and hire people unless they have some reasonably stable expectations about future prices and demands.

Deflation in prices is not a never-ending or self-propagating mechanism as some believe. Falling prices do not cause more falling prices. This is no more true than the opposite view that rising prices cause more rising prices. Some believe that everyone who observes falling prices will expect them to fall even more and hoard money as a result rather than spend it or invest it. This cannot happen on a broad scale by itself any more than prices can rise on a broad scale by themselves because they have already risen. If prices kept on falling, someone with a given amount of money would eventually be able to buy Rembrandts for small amounts or be able to buy factories and hire labor at small amounts. And he’d be able to sell the products to other people who had also hoarded their money. In other words, for a given stock of money, there would be immense profit opportunities to use capital assets to produce products in demand if prices kept falling. The existence of that stock of money prevents prices from falling indefinitely. Furthermore, given the monetary freedom and opportunity and not restricted by federal law, people will create their own money and scrip. They will see the profit opportunities presented by unemployed labor and unemployed capital goods, and they will create their own credit and payments mechanisms in order to bring them back into employment.

Bernanke emphasizes that bank runs cause a collapse in bank reserves and the money supply, and that withdrawal of money from foreign banks with questionable currencies does the same. He mentions the failure of Austria’s largest bank, Kreditanstalt, as a trigger in May of 1931. There is no doubt that a run on American gold began after Austria failed and after England unnecessarily went off gold. That action brought all currencies into question. Confidence in paper currencies plummeted.

But Bernanke does not raise the central questions. Why were these currencies questionable? How it is that banks with questionable practices could thrive and prosper, before they collapsed? Why have central banks in the first place? What might a stable monetary system look like? How is a depression related to and caused by monetary causes that occur in the boom? Bernanke is very concerned about the monetary cause of deflation in the 1930s but relatively unconcerned with the monetary and other causes that preceded the 1930s. He has very much ignored those, having made up his mind that both central banks and inflation are good things to have around.

Price deflation and depression in the 1930s, Bernanke fails to acknowledge, are the consequences of a severe prior central bank inflation that took place on three separate occasions when the FED, during the 1920s, stimulated the economy with the means of excessive credit. These were in 1922, 1924–25, and 1927. The third of these stimulated the stock market to an excessive degree, whereupon the FED reversed policy during 1928 and raised the rediscount rate in 3 steps from 3.5 to 5 percent. The boom went on for another 14 months. The FED could not have continued its inflation indefinitely without creating a severe inflation that would have disrupted the economy and sent stock prices lower in real (and perhaps nominal) terms. Contraction becomes a necessity at some point, the only alternative being an even worse contraction later. The 1920s money-induced boom would have come to an end anyway as it was associated with imbalances, unrealistic and uncoordinated prices, excessive leverage, attenuated balance sheets, and mal-investments. But these are common features of credit-induced booms. They were recognizable in the last 10 years, had Bernanke only looked, rather than turned a blind eye.

Bernanke has not yet addressed what it is about today’s central banking and the monetary system, with all of its powers, that has contributed to the current depression. He ignores the biggest question: why, despite the fact that central banks are not using the gold standard, has the world again been plunged into a depression? If, as he has written, it was the adherence of central banks to the gold standard that brought about the worst of the Great Depression, why is another depression in progress when central banks no longer adhere to a gold standard?

Bernanke criticizes the FED’s contractionary policy in 1928, but he is blind to his own contractionary policy. For the two years after he succeeded Greenspan, he kept the monetary base to a 1 percent growth rate. For most of that period he held the Fed Funds rate at 4.5 to 5.25 percent. This policy became something of a necessity in view of the mounting imbalances in the American economy, which included a stock price bubble and a housing and real estate bubble, both identifiable by using traditional value criteria. The imbalances included a massive credit expansion, extensive leveraging, loss of the country’s manufacturing base, a huge trade deficit and massive government debts. The FED’s easy money policy had gone on unabated, not just in 3 episodes as in the 1920s, but for decades. The monetary base increased from 70 billions to 800 billions between 1972 and 2006, when Bernanke took over. This was at a rate of over 7 percent a year, which is far in excess of what might reasonably be needed in an economy growing at 3 percent a year. The FED could not continue to pump out money without destroying the dollar or otherwise disrupting some part of the fragile system that its own actions had created. The illusion of a safe, flexible, and stable monetary system had eventually to give way to the reality that is now upon us. Eventually the imbalances had to be corrected.

Bernanke has now reinstated the FED’s inflation with a vengeance.

The FED’s policies are unsound in numerous ways, some of which I will mention.

The FED operates on the unsound theory that the economy is demand-driven. A sound economy is supply-driven, that is, production driven. Every person who produces goods and services has thereby produced the means to purchase (demand) goods from others who have also produced goods and services. Demands (wants) are always infinite. They can only be satisfied (and price-rationed) when there is supply (production.)

The FED operates on the unsound theory that it can affect demand in a sound and stable manner by influencing credit and by influencing the prices of certain assets. Typically the FED stimulates by buying short-term Treasury bills and raising their prices.

The reality is that there are no stable and sound connections between the FED’s influences and the economy at large. The FED hits buttons but the economy, not being a machine, does not respond immediately or in stable ways over time. The markets in an economy are very diverse and very complex in their interconnections, and all that happens in them arises from human actions, valuations, and expectations that cannot be contained in Bernanke’s favorite vector autoregression models. Anyone who looks at the data will find that many inexplicable things happen in the inter-market relations among wages, rents, consumer good prices, wholesale and commodity prices, exchange rates, interest rates, and the prices of capital assets. On a disaggregated basis, even more inexplicable changes occur. There are numerous frictions, costs of adjustment, shifts in demand, and lagged effects that are always occurring and shifting. There are industries that are dying and industries being born. There are industries going overseas, and there are overseas industries coming ashore. There are constant regulatory and tax and policy changes. There are wars.

The FED thinks that it can create stability by using its influence on short-term interest rates. This is a pipe dream. This is not to say that the FED’s actions will have no effects. They will. But they are unlikely to be what the FED expects and they are likely to cause more harm than good.

The FED can drive down short-term interest rates. If people expect this to continue, one effect is that the economy will shift to the cheaper short-term financing. This will move many people and businesses away from sound financing by long-term means.

Alternatively, long-term rates will come down, and this will distort the allocation of capital. There will be investment in uneconomic projects that would be rejected if the interest rates reflected real saving.

When the FED inflates, it creates uncertainty over future prices and interest rates. The FED is able to alter inflation expectations as well as the uncertainty of those expectations. It creates the instability that it claims to avoid. The FED is a large and powerful player. Its every statement causes assets to change price. Its every move can change the value of the currency we use. There is nothing more basic than the standard of value. If this is altering at the FED’s whim, where is the stability?

When the FED inflates, money is not neutral. It affects certain prices and not others in ways that lack a basis in the realities of demand and supply. This disrupts the economy by altering price relations and disturbing the coordinating effects of prices. Business firms alter their production as these effects ripple through the economy. When the inflation ceases, they find that their plans cannot be fulfilled.

The FED’s actions cause a lack of coordination with foreign economies, which have their own central banks and go their way with their own policies.

But, to a great extent, many foreign central banks are on a dollar standard. They use dollar assets as reserves. They amount to branches of the FED that create derivative currencies off of the dollar assets. The problem then becomes that the FED induces worldwide instability, worldwide bubbles, worldwide imbalances, and worldwide mal-investments.

The FED’s actions usually prevent prices from falling due to productivity increases. The benefits of production then do not feed through to the pocketbooks of those who produce and consume.

The FED’s current zero-interest rate policy will probably cause speculators to issue credit in dollars at vanishing cost by selling federal securities short or by borrowing at low bank rates. Having received dollars, they can buy other assets with them and create bubbles. This is exactly what the FED wants to happen. It will be the yen carry trade revisited. It will be a dollar carry trade. It is highly likely that the yen carry trade (having arisen from a zero-interest policy in Japan) that has gone on for years now, has contributed to the current financial market crashes and depression by having supported worldwide financial bubbles. Hedge funds, investment bankers, and many other investors and speculators have ended up buying overpriced assets using cheap borrowed funds. And they did this in part in an effort to obtain yields that could no longer be found in ordinary markets that had become overpriced. The FED is now encouraging a repeat performance.

The FED’s focus on the quantity of credit ignores the quality of credit. We have seen that a vast increase in the quantity leads to a lowering of credit standards. With credit widely available and a boom expected to continue, the quality of credit declines. We then observe the system accumulating loans that fail when the boom slows down or reverses. Again, the FED promotes instability.

Economics students are routinely taught that central banks are a good thing or that they are the highest stage to which banking has now evolved. This is a presumption offered without proof. There is no proof that I know of that central banks are a good thing. The FED offers none. This article presents a few of my reasons why the FED is a bad thing.

It may be thought that I am indirectly arguing here for 100% reserve banking. Those who do not know my position may think that is the only alternative to the FED. It is not. The alternative that I favor is known as free banking. I favor monetary freedom, and that may include fractional reserve banking without a central bank. The works of Larry Sechrest, George A. Selgin, and Kevin Dowd will provide a good idea of what free banking is about. One might start with Free Banking by Larry Sechrest.

February 28, 2009

Michael S. Rozeff msroz@buffalo.edu is a retired Professor of Finance living in East Amherst, New York.

Copyright © 2009 by LewRockwell.com. Permission to reprint in whole or in part is gladly granted, provided full credit is given.`