Rational Conduct

Mike Shedlock points to more central banking idiocy displayed this time by the Swedish Central Bank, Riksbank.  By cutting the deposit rate by a NEGATIVE .25% the bank is essentially charging people for depositing money into their bank.  During a time when our economic woes, which Mike rightly points out, were due to our lack fo savings and the loose monetary policy of central banks we should rather encourage savings.

However, it’s that old Keynesian “paradox of thrift” fallacy all over again.  It never occurs to our central planners that the reason people are holding back and saving is because this is correcting the overconsumption, mis-allocations of capital, malinvestment of the past.  Instead the same old snake oil continues to be what is on the menu.

Will there be a run on deposits? If so, what then will Sweden do? It certainly will be interesting to see if there will be any runs on these banks or if there are any other immediate and long-term consequences which arise from this ill thought policy. Will Bernanke and other central bankers around the world follow? I certainly hope not, but I wouldn’t bet against it.

In his 1966 essay “Gold and Economic Freedom” a young Alan Greenspan quipped, “gold and economic freedom are inseparable,” to later in his essay recognize the fact that the Federal Reserve and fiat currencies have always allowed governments to spend its way into deficits, confiscate wealth, abate property rights, and diminishes the value of the money. He recognized the value of gold as money and, like Milton Friedman, Ludwig von Mises, and F.A. Hayek, realized that the Federal Reserve was the culprit that caused the Great Depression of the 1930s.

However, once he was appointed by Ronald Reagan to head the Federal Reserve he set out to prove himself as one of the “masters of the universe” with the power and knowledge to manage the entire economy’s money and credit. Yet he fell prey to the very problems which he pointed out in his essay when he observed, “the excess credit which the Fed pumped into the economy spilled into the stock market triggering a fantastic speculative boom,” but not only did the current crisis which former Fed chairman Greenspan help facilitate spill into the stock market but to the housing market, credit cards, student loans, financial derivative markets, ad nauseum.

In today’s Wall Street Journal Judy Shelton points out that about a year and a half ago Mr. Greenspan said on the FOX Business News network, “there are a number of us that, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard”. I tend to agree and would extend that further, to say that we were doing pretty well from the founding of this country to 1914 on a gold standard of some sort, with the obvious exceptions such as the Civil War when we temporarily went  off the gold standard and on a fiat money standard so Lincoln could fund his war efforts to prevent the South from obtaining independence. But, Mrs. Shelton asks a far more interesting question:

Why do we need a central bank?

If history shows us anything it’s that the consequences of a fiat money system have always been devastating: Wiemar Germany, Yugoslavia, Bolivia, Zimbabwe, Argentina, even the great empire of history Ancient Rome suffered from currency devaluation which many historians believe aided to the fall of its empire. So that begs even more questions.  Should we trust a central manager to set the price and value of our currency?  Would this not be any different than the Russian commissars that were appointed to manage Soviet Russia’s economy which, of course, failed? The answers to both of these questions is a resounding no.

The main problem with fiat money is that it holds no store of actual value but rather whatever government claims can be created with the creation of the money.  After all, what intrinsic value does a piece of paper with some ink slapped on it carry?  Very little, if any, value at all.  This is the reason why as goes the faith in the currency so goes the value, all the way down to the cost of producing that piece of paper and ink.

Fiat money also perverts price signals using artificial interest rates not set by markets, but rather these central planners.  Rather than sending a natural rational price signal that the market determines the price signal sent is whatever is politically expedient, often times artificially low because the Fed chairman doesn’t have the cohones to allow a much needed recession or correction on his watch until the bubble gets so big it has no choice but to burst.

The third problem is it allows for governments to be “flexible” with their deficit spending.  Some may consider this to be a good thing, but large government with the power to borrow as much as it needs by a mere transfer of wealth from future generations to current ones to fund their new entitlement program or new government power seems to me to be a dishonest and immoral way to get reelected.

Fortunately there is a way out of this debacle, but unfortunately politicians are unwilling to consider it.  This idea is not new.  Hayek introduced the idea several years ago.  That of a free market money in which the people choose what money they trust and not one which is monopolized with the authorization of our government.  This would allow the market to decide what constitutes money and what interest rates should be set to rather than some “master of the universe” such as Alan Greenspan or Ben Bernanke. It would rid us of the damaging legal tender laws and allow us to use whatever commodity the market demands without barrier. This will restore value to money, restore price signals, and limit government spending which will in turn restore our confidence in real money and would potentially restore confidence in our economy once again.

The U.S. dollar has reigned supreme in the world’s market for the last several decades and has long been considered one of the most stable investments.  However, the financial crisis facilitated by the Federal Reserve and the federal government has put into question the stability of those investments over the past several months or so.  One of the things that have long scared me is when the Asian countries, specifically China, get sick and tired of holding the U.S. dollar.  Talk has been buzzing that China’s many investment firms and central bank officials have been weary of continuing investments in the U.S. dollar, and even getting out of it entirely.

It appears my fears are not unfounded according to the Financial Times:

China’s central bank on Monday proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund.

In an essay posted on the People’s Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, said the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

Analysts said the proposal was an indication of Beijing’s fears that actions being taken to save the domestic US economy would have a negative impact on China.

“This is a clear sign that China, as the largest holder of US dollar financial assets, is concerned about the potential inflationary risk of the US Federal Reserve printing money,” said Qu Hongbin, chief China economist for HSBC.

In a later paragraph the article implicated that China would have to continue to hold it’s two trillion dollars as reserves, but I don’t see why they would have to do anything.  They can trade for other currencies, but who would want to do that?  No one I know of.  Instead what they may do if they wanted to get out of the dollar is buy U.S. assets and companies.  I’m not a protectionist nor a fervent nationalist, so foreign countries owning U.S. based assets wouldn’t bother me.

What does bother me however, is the fact that this action would flood the domestic market with potentially two trillion U.S. dollars driving down the value of the dollar and driving up prices.  If other countries followed suit, like Japan who holds nearly as much as China in U.S. Reserve, that could only magnify the effect of the weakening dollar and could set us on the course for hyperinflation.

If we combine this with the policies in effect, and the Fed’s plan for “quantitative easing” by pumping billions, possibly trillions, more dollars into the market we are probably in for a bumpy ride.

This weekend’s edition of the Wall Street Journal has a short interesting article on the Federal Reserve titled “Fed Doesn’t Need a Press To Print Its New Money“.  In the article the author mentions how the Fed creates money with a virtual keystroke and not much else.

The Federal Reserve has been able to inflate its reserves 259% over the last seven months from $3 billion to $776 billion with very little need for the printing press. Considering the notes themselves only have risen 8% how is it possible for the Federal Reserve to do this? According to the article the Fed “purchases securities or other assets from security dealers in exchange for electronic credits that amount to cash and are deposited in banks”.

Also, the Fed also plans to purchase as much as $1.25 trillion of mortgage backed securities backed by the government owned Fannie Mae, Freddie Mac, and Ginnie Mae. Along with this it also plans to make purchases of debt issued by Fannie, Freddie, and Ginnie, along with $300 billion in long term debt issued by the federal government to the tune of $200 billion and $300 billion respectively.

It is pursuing this course in hopes to drive long-term interest rates down making mortgages cheaper. At the same time this plan will also, in theory, drive the pricing of houses and other assets up due to the cheap money altering people’s time preferences  which will create a higher demand for housing and push these asset prices up.  Higher demand is not the only force driving the prices up.  After inflating the money supply for so long there must come an eventual weakening of the dollar. 

The plan may succeed in creating a potential, but most likely, effect of higher consumer and producer prices (overall asset prices) and making our paper dollars essentially worthless while at the same time creating the moral hazards of putting people into loans with rates they can afford now but may not be able to afford when interest rates go back up and their loan terms reset.  Thus setting us on a course that can only deepen and prolong  our economic woes further.

But not to worry. Chairman Bernanke is on the case! When we start coming out of this depression the Fed will start pulling the money out of the market at that exact perfect moment before inflation does any harm. Give me a break. I’m beginning to think the Chairman is taking his market cues from Dr. Gideon Gono, the current Governor of the Reserve Bank of Zimbabwe.  Refer to the wonderful Marc Faber below.

Yesterday Federal Reserve Chairman Ben Bernanke gave a speech to The Council of Foreign Relations trying to explain the current economic crisis and how we can try and “prevent similar crises from developing in the future” by developing strategies that “regulates the financial system as a whole, in a holistic way, not just at its individual components”.  Our banking and financial industries have become entrenched into the system and became so big that they have forced the government to intervene, which he rightfully pointed out would cause moral hazards.

Essentially what Bernanke wants to do is completely overhaul the current financial system so that there are more regulations and that banking and financial industries are even more entrenched within the system.  But, he argues, if we do it right we will be able to “help make crises less frequent and less virulent”.

To me this seems completely ignorant and arrogant.  He’s so confident that if we further tinker with and overhaul the rules we can create a near-perfect system which will have less chance to fail than if we left the market to its own devices.  The idea that we can tinker with rules, regulations, interest rates, take more stakes in the financial system we can keep ourselves from creating the problems we see today just seems presumptuous.

Everything the Federal Reserve has done to undermine the markets has not saved us from this so-called crisis.  In fact, many economists will say the Federal Reserve played an important part in creating this correction from Greenspan holding interest rates at one percent inflating the bubble to Bernanke lowering the rates trying to keep prices high while trying to patch and re-inflate the bubble.  By creating this easy money policy we have the boom and bust cycle along with the threat of the side effects of inflating the money supply, namely that of rising prices.

But of course Bernanke won’t recognize this theory as the cause.  In fact it was countries in Eastern Asia, namely China, which saved their money rather than spent it consuming things they didn’t need.  Instead the Asians want to use this money for future use which caused an imbalance that has lead to this crisis according to Bernanke.  Forget capital accumulation and time preference.  The only thing that matters is the Keynesian idea of “the paradox of thrift”.  Not surprisingly, Paul Krugman and The Economist are sending the same message.  It seems the “blame it on the Asians” crew is out in full force.

It apparently has never occurred to Bernanke and the rest of the crew that it is beneficial to the Chinese that savings is important when you are attempting to properly develop and advance an economy, something we stopped recognizing the last couple decades. It has also never occurred to him that the governments involvement of government has created malinvestments that would never occurred to the extent they have in the past several decades. Without the intervention of government economic signals would have been properly delivered to entrepreneurs, producers, and consumers that allowed them to make appropriate decisions rather than guessing what rule some bureaucrat would make, or some legislators creating barriers of entry and exit that interfere with rational economic decision making, or Federal Reserve governors setting interest rates to rates that are unable to be forecast.

So Ben Bernanke wants to further undermine markets, which will further hamper with the ability for economic calculation by market players.  Why these so-called economic geniuses don’t have the intelligence to realize that everything they’ve ever done has not had the effects they had hoped but has been responsible for our boom and bust cycle is beyond me.  One day it may dawn on them.  Until then we can only hope they come to their senses sooner than later.