THE FED IS CULPABLE,
Part II
by Hans Sennholz dailyreckoning.com
The American money and credit system now resembles an inverted pyramid that rests on legal-tender Federal Reserve notes and credit. These support various forms of bank money, such as commercial bank deposits, savings accounts, large-time deposits, and other liquid assets.
The base of some $672 billion may expand rather moderately, presently at some 6% a year, or by $40 billion; the layered superstructure of $8.333 trillion in bank money (M3) may grow at a similar rate, or by $529 billion.
Commercial banks tend to 'securitize' their loans, converting them into marketable securities for sale to investors, which enables them to grant new loans in a continuing process of lending, securitizing, selling, and lending again.
Massive non-bank credit constitutes the upper layers of the money pyramid. There are Federal Home Loan Banks, thrift institutions, life insurance companies, brokerage firms, mutual funds and other credit grantors. Last but not least, offshore banks in the Bahamas, the Cayman Islands, Panama, Hong Kong, and Singapore, enjoying favorable regulatory and tax treatment, constitute the top layer of the multi-trillion dollar money pyramid. And high above the American pyramid hovers the international pyramid, which builds on the U.S. dollar standard.
The Chairman and his fellow governors are expected to balance it all with their high-powered Federal-Reserve- dollar base. They are expected not only to manage this monstrous pyramid of fiat money and fiduciary credit, but also to safeguard the stability of the American economy, to maintain asset prices, protect the value of the dollar, and avoid the business cycle. They are supposed to manage a monstrous structure which politicians have built for their own use and glory. That's too much to ask of any mortal.
"Money will not manage itself": this is the very rationale of Federal Reserve existence.
Its sponsors and managers usually refer to the days when gold and silver coins were the principal media of exchange. The supply of money, they assure us, depended more on the discovery and exhaustion of gold and silver mines than upon the needs of business. Moreover, many abuses developed, such as debasing the coinage, "clipping" and counterfeiting.
Unfortunately, the Fed sponsors and managers hate to admit that the clipping of a few coins in ages past was a negligible abuse when compared to the continuous 'clipping' of all forms of money today. Even in moments of 'stability', all U.S. dollars in the form of cash or deposits lose at least two to three percent every year. They have lost some 95% since the Federal Reserve introduced its dollar in 1914. They probably will lose more in the coming years.
Fed sponsors and managers point to the recurrence of business cycles prior to the inauguration of the Federal Reserve System. They may turn to the crisis of 1873 and the depression that followed, or to the crash of 1893 and the aftermath, or the crisis of 1907 and the "creeping depression" which lasted until the World War brought an unprecedented boom. Unfortunately, Fed supporters hate to recall the cyclical instability that has characterized the economy ever since. We count at least eight boom-and- bust cycles since 1914, in addition to the Great Depression, which held the country in its grip from 1929 to the outbreak of World War II in 1939.
Surely, no one can contend that the Federal Reserve System has brought economic stability or conquered the trade cycle. On the contrary, its critics are convinced that a politically conceived and administered money monopoly, such as the Federal Reserve System, is the worst of all money systems. It will breed business cycles as long as it lives.
Stock market cycles are the most spectacular offspring of central banking and credit creation. There are several others, less sensational, such as the cycles in precious metals and objects of art and collection. They affect only small groups of affluent clientele, which usually suffer in silence. The most ominous of all cycles, which touches millions of people, is the boom-and-bust sequence in real estate. Just as in equity markets, these bubbles are clearly visible in their price-earnings ratios or price-rental ratios greatly exceeding those of healthy markets.
Abundant credit at bargain rates of interest causes housing prices to soar, especially in growing communities, which fosters not only feverish construction activity but also enlarges the mountains of debt, even consumer debt. Fannie Mae, the publicly owned and government-sponsored Federal National Mortgage Association, reports that soaring housing prices and falling mortgage rates are allowing homeowners to refinance $1.4 trillion of mortgages in 2002, up from $1.1 trillion last year. In both years, homeowners are estimated to take out some $100 billion in equity.
The real estate bubble is bound to burst as soon as the distortions become visible to ever greater numbers of participants. Commercial construction already has fallen sharply in 2001 and 2002, with the steepest declines in the industries most afflicted by the September 11 attacks, including hotels and office space. Government- sponsored industries, such as public works and health- care facilities, are likely to expand further.
Driven by the same forces of easy credit and falling interest rates, all interest-bearing and discounted government securities have developed fever bubbles. The U.S. Treasury bubble, which few economists have as yet discovered, is still growing under the impact of avalanches of investors' money seeking shelter in Treasury safety. Tired of losing any more money in stocks, investors are piling into Treasury notes yielding barely 4%. As the federal government will be forced to raise hundreds of billions of dollars in the coming months in order to cover its growing deficits, interest rates are likely to rise. They are bound to increase substantially when the current flood of new money and credit finally aggravates the price inflation. When note rates return to just five percent, the yield of two years ago, the bubble will burst and the market value of all notes and bonds will drop drastically.
The economic maladjustments are numerous and severe, inflicting painful losses on ever more people. The number of job cuts continues to rise, making unemployment a potent economic and political problem. It is compounded by chronic trade and current-account deficits, which are causing many American jobs to move to Asia. The rising rates of unemployment, together with the staggering losses of income and wealth, cast doubt on the ability of debt-laden American consumers to support the American economy much further.
Some pessimists hold to the single notion that the length of a readjustment is determined by the length of the bubble preceding it. Because we experienced the longest and most spectacular financial bubble in history, we are condemned to suffer history's longest recession. Such notions unfortunately spring from mechanical perceptions of human action and reaction. It is the severity of the maladjustment, not its duration, together with the capacity of correction, not its length of time, that will determine the kind and quality of readjustment.
An administration walking in the footsteps of Presidents Hoover and Roosevelt - who practically closed the national borders to trade and commerce, doubled the tax burden, and imposed numerous business regulations and restrictions - undoubtedly will create another 'great depression.' An administration that lightens its burdens and releases the energy of the people will facilitate a speedy recovery.
A Federal Reserve Board which, obedient to public opinion, keeps its interest rates far below market rates and readily finances growing federal deficits will only make matters worse. The popular reduction of its rates on November 6, 2002 was just another popularity ploy, which is bound to aggravate the maladjustment and delay the recovery.
Sincerely,
Hans Sennholtz,
for The Daily Reckoning |
