Time to re-think the way we run our monetary system
by Richard Cluver
We humans are an odd lot who compartmentalise our lives into blocks of years and then measure each one as if they can be put away in a drawer and forgotten while we take out a shiny new one that is full of promise. We conveniently forget that the events of this year are simply a continuation of the events of previous ones.
So, we have lived too long now with a world economy that has been in a phase of stagnation that has been labelled The Great Recession and with weary hope we dream that the new year might bring better times, ignoring the fact that only fundamental change to the way we run the world economy can bring about that change. For over a century we have allowed politicians to set the economic agenda and at their behest central bankers have tinkered with the system to try and force it to deliver what the politicians want. Repeatedly they have achieved short-term gains at the price of long-term growth which is in keeping with the desires of politicians whose major preoccupation is to be re-elected a few years hence.
The consequence of it all, as we were forcibly reminded by Oxfam ahead of the World Economic Forum, is that despite a century of politicians’ efforts to uplift the poor, just eight men now own the same wealth as the 3.6 billion people who make up the poorest half of humanity. Seven out of 10 people live in a country that has seen a rise in inequality in the last 30 years. Between 1988 and 2011 the incomes of the poorest 10 percent increased by just $65 per person, while the incomes of the richest one percent grew by $11,800 per person – 182 times as much.
And to bring it home to South Africa where the gap between rich and poor is the world’s widest, the wealth of three South African billionaires is equal to that of the bottom half of the country’s population. Oxfam’s head of South Africa research and policy, Ronald Wesso, said that the top three billionaires were retail tycoon Christo Wiese, Glencore CEO Ivan Glasenberg and Aspen Pharmacare chief executive Stephen Saad. The information is based on data made available by the JSE in December 2016, and is based on share holdings.
Much more sobering, however, is the fact that in order to be included in the group of 63 000 South Africans who make up the country’s richest one percent you need an annual income greater than R570 000 after tax; that is a take home sum of R47 500 a month. More to the point, over 51% – some 29,733,210 of South Africans – live on less than R1,036.07 per month
Even more sobering is the fact, according to South African economist, Mike Schussler, that someone making R8,500 per month (R102,000 p.a.) would likely be in the top 5% of the world’s wealthiest. Or put another way, if you own assets greater than R2.4-million you are in the world’s top five percent and if you own assets greater than R9.25-million you are in the world’s top one percent.
Summing it all up is Oxfam’s executive director Winnie Byanyima who was quoted last week at Davos as saying’ “It is obscene for so much wealth to be held in the hands of so few when 1 in 10 people survive on less than $2 a day.”
Well why have we got it so wrong and is there a way to fix it? In my second article in this issue I have dealt in detail with the history of the global monetary system since the world went off the gold standard led by the United States in 2013 and, as has been repeatedly illustrated since then, successive governments have always found compelling political arguments to abandon their promise that their currency will always be backed by bullion or other acceptable reserves. It has been demonstrated over and over again that our political leaders are quite unable to resist the temptation to print more money than their reserves allow. And the result has always been the same, an economy initially on steroids which makes the leadership of the day very popular with its electorate.
But then, just as inevitably there has followed a share market crash and in its wake years of recession during which the poor have suffered excessive hardship which has usually led to social upheavals, war and the discrediting of the political party in power at the time. Now, while the massive disparities of wealth and poverty are clearly politically explosive, it is not the accumulation of wealth that is the problem. It is these stop-start economic issues that have kept so many of the world’s population in penury. In an ideal world, everyone would be gainfully employed throughout their effective working lives earning sufficient to meet their immediate living costs and a little more besides in order that they might accumulate sufficient to be able to retire in reasonable comfort when they are too old to work. But when world monetary gyrations slow the wheels of industry and workers are forced into short-time or the loss of employment, neither the economy nor the needs of the individual can be met.
We can end the boom/bust cycles by rooting out the fundamental cause of monetary indiscipline (i.e. by taking away the ability of governments to manipulate their currencies) by a return to the gold standard or its modern counterpart, the Bitcoin but allowing for an element of annual inflation which would satisfactorily answer the arguments that economists like John Maynard Keynes used against the gold standard. Where previous Gold Standard economists got it wrong was the decision to value gold in terms of a currency. Thus in the post Bretton Woods world gold was valued at 32 dollars an ounce when the reverse argument should have applied; rather than setting the dollar as the standard the unit should have been a fine ounce of gold at its current market value expressed in whatever currency you like. This week, for example, a ounce of gold was worth 1199 US Dollars or 16 353 Rands and were we to so use the metal as a standard it would easily accommodate our problems of currency sufficiency to meet global trade requirements. My graph composite below thus illustrates how the real value of the Rand has shrunk pretty constantly at 10.9 percent compound over the past 30 years. This then is the true rate of South African monetary inflation. And below it I have traced the real value of the US Dollar which has similarly inflated at 4 percent compound.
Meanwhile, it needs to be recognised that one of the biggest problems bedevilling modern governments has been the need to support the poor, the unemployed and the unemployable with social grants, medicare and the like. Though this exercise is couched in altruism, the reality is that it is a means to buy a modicum of social peace. But the ability to fund such aid is likely to come under ever increasing pressure as leading governments are forced into tax competition in order to retain their corporates in a globalised world where the existence of the Internet means that head offices can be located anywhere where tax rates are favourable. Following the initial popularity of the tax havens, major nations began getting in on the act. Ireland and Holland led the way and have been so successful that the Donald Trump administration has opted to join them. And then this month British Prime Minister Teresa May signalled that Britain might also join the corporate tax competition.
Like it or not, world governments are beginning to see the probability of this formerly major source of revenue dwindling away. And most are already taxing their working citizens close to their limits. Proposals to introduce punitive taxes upon the wealthy cannot work because the rich will always find a way to move their wealth beyond the reach of governments. And such taxation would be merely a public relations exercise anyway because the sum of the wealth of the top one percent once redistributed would barely uplift the poor while simultaneously destroying the entrepreneurs upon whose leadership the world depends for innovation and job-creation.
The simple solution here is to opt for a low universal tax rate that few would fight against. A flat rate of around 15 percent with no special concessions or allowances has been shown to work extremely well in the past and if governments universally agreed to such a rate it is likely the benefits to them, particularly in saving the massive costs of enforcement, would outweigh any short-term problems. Finally, there is one tax which is easy to collect and police; VAT. The argument that the poor are disproportionally afflicted by VAT can be simply addressed by removing the tax from items that are sensitive to the poor such as basic foodstuffs, education and transport.
Ministers of Finance have repeatedly argued against such a regime as being too difficult to implement but the probable truth is that the tax enforcement industry and its counterpart, the specialists who at very high cost assist the wealthy to avoid taxes, have between them a massive political lobby. But finance ministers are likely to have to bite on this bullet in the fast approaching future because, as I have explained, the tide of history is against them.
I hope Pravin Gordhan is listening!
Why the world’s monetary system has failed us!
by Richard Cluver
I apologise for the exceptional length of this article which represents the justification for the argument I have made in the story above. It is worth the effort of reading, however for anyone seriously concerned about the outlook for world finance!
The Great Recession that currently holds the world in its grip began with the collapse of Wall Street values in April 2007 following a major boom which might be likened to a drug high, in this instance induced by a massive increase in money. The increase was caused by a commercial bank credit explosion caused by speculative loans advanced against the security of parcelled-up mortgages whose size and spread, it was believed, would insulate the lenders against the risk of borrower default.
Ironically, the ratings agencies were subsequently blamed for failing to alert everyone to the risk and Moodys was this month fined a massive $1.5-billion for its failure when the truth is that the ultimate authority in this case was the US Federal Reserve which admitted at the time that it did not have a means of evaluating the value of the sub-prime mortgage parcels that were the source of the problem.
Now the blame game is a useful means of confusing everyone about the realities of our monetary system and the hardship that messing with it brings to every one of us ordinary citizens and so let us start by recognising that there is only one monetary system that neither politicians nor bankers can mess with and that is gold bullion and its modern equivalent, the Bitcoin. If all contracts between men and businesses were written it these, we would no longer have to worry about exchange rates, exchange controls, inflation and all the hazards that afflict the modern investor. So it is difficult to appreciate that these things have only been with us for the past century.
Though wars and political ideologies like socialism, communism and nazism are nothing new, we have only been fighting over them since politicians and bankers began fiddling with the monetary system barely more than a century ago. But if you would like to fully understand it all you need to come with me on a lengthy journey to the cause of the Great Depression that began in 1913 with the passage of the US Federal Reserve Act which, in a single sweep, changed both the scope and the magnitude of government intervention in the banking and monetary systems. It had the power to regulate the size and growth of the money supply, thereby causing inflation or deflation in the economy. Through manipulation of credit, the Federal Reserve System fuelled a credit expansion the likes of which was previously thought impossible. When the steadily-expanding credit bubble finally burst with the crash of the over-inflated stock market it had created, the consequent credit contraction was infiniteoly more severe than any before.
The Federal Reserve System enacted by the US Congress in 1913 was an attempt to smooth out the then little-understood business cycles that plagued the world economy and were especially troubling to the banking system. The “Fed” was charged with ensuring the appropriate reserves of its member banks, lending to shaky financial institutions to prevent their closure, selling government securities, and regulating the banking industry. Throughout its subsequent history the American currency and monetary system has undergone many changes, going from a relatively pure gold standard at its inception to an adulterated standard in the 1940s and finally a total elimination of any gilded ties in the 1970s.
The Fed has assumed many more responsibilities than the drafters of the original legislation envisioned. Even so, its operations have changed very little over time. The most important of its roles, for our purposes, are: as setter of reserve requirements, lender of last resort, and regulator of the money supply. It is through these three functions that the US Government manipulates the economy most fundamentally. Let’s examine each function in greater detail:
Individuals lend banks money in the form of deposits. The banks issue the depositors something conveying a promise to pay on demand. Since the bank now owns this money, it can lend it to others to earn a return. In case the depositor wants his money back, the bank needs to hold some money back from its lending activities. These deposits held back are called reserves. The higher the bank’s reserves, the less it has to fear a fluctuation in its daily needs. However, if the reserves are kept too high, the loan portfolio is not productive and profitable enough. Therefore, a balance must be struck.
Prior to the Federal Reserve Act each bank had to be responsible for the maintenance of its own reserves although there was an established legal floor. If a bank misjudged its needs, it either had to call in its loans or cease transacting business. Poor judgment led to what is known as a “run” — which occurs when depositors lose confidence in the bank’s ability to meet its obligations and seek to withdraw their money before the bank goes under. If this happens with any prevalence, this can shake the stability of the banking system.
The central bank theorists presume that the bankers, if left to their own judgment, will stay fully loaned up to the legal reserve requirement floor rather than maintaining a equalising balance between loans and reserves. For this reason, the Federal Reserve system was granted the authority to centrally alter the reserve requirements of every bank but, far more important than this is its power to determine what constitutes reserves. Previously, individual banks kept reserves in their vaults and, depending on the era the reserves were simply gold or silver specie. With the advent of the Federal Reserve System, banks were compelled to maintain their reserves at the regional Federal Reserve Bank.
In so doing, the Fed also altered the nature of such reserves. Previously, reserves had taken the form of specie deposits withheld from lending operations. Shortly after its inception, the Fed allowed reserves to be kept in either gold or Federal Reserve Notes (ostensibly representing a corresponding amount of gold) as well as government securities at a ratio fixed by the Board of Governors of the Federal Reserve. After the banks had accepted the use of Federal Reserve Notes, the Fed compelled the acceptance of these Notes as legal tender. This alteration accomplished two objectives: banks could purchase various vehicles for use as reserves and still be able to lend their deposits and the government had a ready buyer for any new issues of securities.
The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They created paper reserves in the form of government bonds which through a complex series of steps the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.
One cannot understate the importance of this fundamental change in the American system. Government expenditures could soar high above revenues and the Federal Reserve would aggressively market the deficit spending to an avaricious banking system eager to expand its ability to extend credit. Or, put another way, the government could create fiat money out of thin air: effectively an edict by expenditure. Previously, the only means by which government expenditures could increase were by a politically-inexpedient tax hike. Now, it had the Federal Reserve as its overdraft protection and the Fed could draw from the productivity and wealth of the entire American banking system.
By manipulating the nature of bank reserves, however, the Federal Reserve also contributed to a lack of soundness in the banking system. The last thing a bank needs is an aura of insolvency, yet that is precisely what the Federal Reserve System engenders. The Fed issues its Notes at an arbitrary ratio to its gold holdings; the banks then use these Federal Reserve Notes as reserves in another arbitrary ratio to their deposit base. Or, the banks use government securities–created out of thin air–as reserves and lend against them at a large multiple.
The problem in this activity is that the underlying value of the reserves has gone from significant (in the case of actual money stored in a bank’s vault) to insignificant (in the case of gold-based Notes) to none (in the case of fiat government securities). In the banking industry, this is called lower quality of liquidity. Not only that, but the Fed also sets the reserve requirements in a vacuum of information. Bankers, by virtue of their daily contact and intimate knowledge of the local business community, are better able to assess the bank’s balance sheet and respond accordingly. That is the way it attracts depositors and customers, by a reputation for fiscal soundness.
When a bank is free to fail, it has an interest in maintaining liquidity. Its management must balance the assets and liabilities carefully and prudently. But the Fed acts in the aggregate in setting reserve requirements, thereby punishing the most able bankers (by setting their reserve requirement above what they would have) and rewarding the incompetent (by allowing them to keep lower reserves than necessary).
The Fed, in its original legislation, was charged with operating as “the lender of last resort.” This meant that, if a bank found itself in an illiquid position, it could borrow from the Fed to see it through the situation. Initially, the bank had to pledge some valuable asset — such as commercial paper — as collateral to the Fed, but that requirement was soon dropped and now anything is eligible. Under this guise, the Federal Reserve sought to prevent the bank runs and systemic bank failures of past times. In effect, the Fed would prop up the banking system using its monopoly on money creation.
This, again, ties in with the above discussion on reserve requirements, since the lender of last resort function kicks in when a bank is in a jam. Each of these seeks to correct a supposed “failure” of the nineteenth century’s free-banking system; the former to forestall bank insolvency and the latter to avert bank panics. As with reserve requirements, there are considerable unforeseen consequences to the lender of last resort function. The first–and most obvious–problem is that it makes no distinction between illiquid banks and insolvent banks. The former are in a bind; the latter are in dire straits. The Federal Reserve qua lender of last resort would come to the rescue of each equally. The effect, then, is to further destabilise an already problematic situation.
The enactment of the Federal Reserve brought almost immediate changes to the American banking system. Prior to the Federal Reserve Act when banks kept their own reserves in their own vaults, the reserve ratio hovered around 21.1 percent. By 1917, the Act had legislated the reserve requirement to a mere 10 percent. Furthermore, the gold standard was devalued, since the Federal Reserve was only required to keep gold reserves of 40 percent against the Federal Reserve Notes and 35 percent against its members’ deposits. This all occurred within five years of the System’s inception. These two actions enabled a tremendous credit expansion.
The expansion amounted to $5.8 billion in deposits and $7 billion in loans and investments. This accommodated the financing of World War I in lieu of increased taxation and, at least, had some justification due to the war effort. What happened next is best summarized by US economist Dr. Benjamin Anderson: “We watched bank credit with fear and trembling as it expanded during World War I, because we knew then what we seem since to have forgotten, the dangers of over-expanded bank credit. We held it down all we could. But a great expansion was needed and we made it. It was enough. An expansion of $5.8 billion in deposits, with $7 billion in loans and investments, was enough.
“But between the middle of 1922 and April 1928, without need, without justification, lightheartedly, irresponsibly, we expanded bank credit by more than twice as much, and in the years which followed we paid a terrible price for this.”
The episode he spoke of — the 1922-28 credit expansion — began in 1922 with the first large open-market purchase of government securities, increasing the holdings of government securities by the Federal Reserve from $250 million to approximately $650 million–an increase of 260 percent! This first large-scale operation was instigated, not for credit expansion or interest rate suppression — since rediscounting had slackened after the war and Federal Reserve reserves were faltering — but simply because it could be done. The heady, unintended credit expansion was too profitable to make it a one-time deal. Consequently, two more major open-market purchases of government securities occurred in 1924 and 1927, each amounting to hundreds of millions of dollars–a scale unprecedented in the history of the United States. Plus, due to the multiplying effect of securities qua reserves, billions of dollars became available for lending–again, out of thin air. These purchases were motivated solely by credit expansion, without any thought to the “dangers of over-expanded bank credit.”
By these open-market operations and reserve fiddling, bank credit had expanded $11.5 billion in only five years. If it had reflected a genuine need by businesses, it would have been welcome and salutary. Since, however, commerce had no use for the available credit, banks sought other venues in which to channel the funds. The three primary vehicles were mortgages, financial instruments, and foreign loans. Each of these represented a deviation from traditional banking practices, viz., the financing of short-term commercial requests; short-term, because it helped to maintain the liquid position of the bank; commercial, because these tended to be the borrowers best able to repay. Mortgages and financial instruments–like bonds and securities–are particularly susceptible to fluctuations in value. Loans made to foreign governments–predominantly Latin American ones– were risky, since revolution and instability were prevalent.
Moreover, each of these types of loans is ineligible for rediscounting. Since rediscounting was the secondary reserve of the whole system, this meant that a significant portion of the bank’s assets were constrained. As of June 30, 1926, the Federal Reserve released the following statement, “Of the total loans and investments of all member banks on June 30, 1926, sixteen percent was eligible for rediscount at the reserve banks….”
With increased long-term holdings and decreased potential for rediscounting, the banks were in a pretty precarious position by the end of the twenties. All that was needed was a scaling-down of the expansion–maybe even a contraction–thereby allowing banks to liquidate imprudent investments gradually. This could be accomplished by setting the rediscount rate above the market rate and strictly limiting the use of open-market operations. However the Federal Reserve Board did precisely the opposite. In 1927, the Federal Reserve Board, under the Chairmanship of Benjamin Strong, inaugurated a new policy of cheap money to help the farmer. The Fed lowered the buying rate on acceptances–essentially future loan drafts–in the summer of 1927; sharply increased–by $320 million–its purchase of government securities through November; and lowered its system-wide rediscount rate to 3.5 percent by September of that year. This time, the credit expansion was funnelled almost exclusively into stocks. While further comment will be reserved for later, it bears mention that this growth in stock market investment that started in 1927 continued right up until the Crash.
Towards the end the Federal Reserve authorities desperately tried to reverse their mistake, increasing the rediscount rate to five percent by July 1928 and selling over $400 million worth of government securities by June 1928. This divestiture reduced bank reserves, necessitating over $600 million in rediscounting–though not enough to fully account for the reduction in reserves. In the week following the stock market crash, the Fed doubled its holdings of government securities. The Fed was trying desperately to increase its reserve situation but could barely keep its head above water due to the counteracting influence of a continuous outflow of gold to other nations. Throughout the crisis period–1929 to 1933–the Federal Reserve continued its inflationary policies in a futile attempt to initiate another boom akin to that of the twenties.
By the end of 1930, however, the fundamental instability of the Federal Reserve System became apparent. The number of commercial banks in the United States stood at 29,087 on June 30, 1920 and at 15,353 on June 30, 1934. In the period 1930-33 alone, a total of 9,106 banks failed. Bank failures had always been endemic to the Federal Reserve System, though, averaging 166 per year between 1913-1922 and 692 per year between 1923-1929. The reason for this should by now be clear. In creating money from nothing for banks to lend, the government distorts the market processes that regulate the economy. Credit arises from production. It cannot be overextended by private institutions, since they do not possess the power to counterfeit and debase. The creation of credit by banks is a productive enterprise in which all participating parties hope to benefit, and in which non-participating parties are not directly affected. Banks, in selecting where to extend credit, must necessarily be choosy. They must maintain liquidity at all costs, while maximizing the return on their investments.
Under the Federal Reserve, however, the banks found themselves awash in credit, regardless of the financial needs of their customers. They felt pressure to lend, without the assistance of a customer seeking a loan. Thus, they sought out anyone willing to take the credit off their hands. In the competitive world of banking, quality and creditworthiness were luxuries they could not afford to consider. As one banking historian put it, “numerous examiner reports cited bank failures as due to `generosity to borrowers’…with insufficient attention paid to discipline, the result of which is detrimental to both borrowers and lenders in the long run.” The banks ended up carrying a portfolio of speculative stock and real estate loans, long-term mortgages, and loans to impoverished countries. When the public loses confidence in the financial establishment, the banking industry bleeds to death until wholesale liquidation ensues. That is, unless the government frees the banking industry from meeting its obligations–through a banking holiday–or unless the government sets the money supply adrift–through the abandonment of the gold standard. Both of these things happened in 1933. These two events, then, were the culmination and the pinnacle of intervention in the banking system.
Another part of the economy that is deeply affected by Federal Reserve policies, albeit indirectly, is the private business sector. When we think of businesses in the Great Depression, we think of joblessness and overproduction. Not unemployment or large inventories on an individual, localized level, but on a nationwide scale. One must ask the question: how is it that problems can occur so? How can so many individual businessmen make erroneous judgments at the same time? This points to a more fundamental reason, one that can uniformly lead to miscalculation.
Once again, we find that the source of dislocation is expansion of bank credit divorced from any real source of expansion. In the boom–or inflationary–period, the businessman engages in a process of predicting the future return or value of present projects. One of the factors entering into his calculations is the interest rate–a measure of the cost of future goods versus present consumption. The drop in interest rates inherent in an inflationary environment interferes with the businessman’s planning. It implies an increase in the rate of thrift–traditionally the source of available capital–by individuals and corporations. This causes a shift by the businessman from investment in consumer goods to investment in higher-order capital goods, in expectation of soaring future demand. “An expansion in the production facilities and the production of the heavy industries, and in the production of durable producers’ goods, is the most conspicuous mark of the boom.”
As the bubble fills, productive capacity is expanded. Capital goods are acquired and implemented. Money flows into the capital goods industry. This money, remember, is not the result of increased savings, but money artificially created by the government in the form of credit expansion. So this boom is illusory. For, once workers in the higher-order industries receive income in the form of wages and salaries, `they would immediately attempt to expand consumption to the usual proportions.’ This sudden surge in consumption demand undercuts the demand for the still incomplete projects involving higher-order producer goods far removed from consumption, resulting in a slump in the capital-goods industries.
In other words, because the savings qua capital is not genuine, the money sunk into higher-order goods is spent according to existing consumption/thrift ratios. Or: the money spent by the misinformed entrepreneur is ultimately transferred to the consumer goods industries, shifting demand for the capital good. That is, unless the borrowing firm returns to the bank for more credit and temporary salvation. The greater the credit expansion, the longer it will last. When the expansion ceases, the boom complies. As Rothbard puts it, “the longer the boom goes on the more wasteful the errors committed, the longer and more severe will be the necessary depression readjustment.”
If we look to the historical record, we see that the facts bear this analysis out. Productivity per person-hour increased 63 percent from 1920 to 1929. Stock prices quadrupled during the twenties–stock being the primary source of capital. Durable goods, as well as steel production, increased approximately 160 percent. Non-durables, largely consumer goods, increased only 60 percent. Moreover, wages in the capital goods industries were higher than wages in the consumer goods industries. According to the Conference Board Index, hourly wages in manufacturing industries–such as meat packing, hardware, and clothing–increased an average of 12 percent while those in the capital goods industries rose even higher–12 percent in machine tools, 19 percent in lumber, 22 percent in chemicals, and 25 percent in steel.
The period after the boom also corroborates Mises’ and Rothbard’s cycle theory. Industrial production was 114 in August 1929 and 54 in March 1933. Business construction totalled $8.7 billion in 1929 and $1.4 billion in 1933. There also occurred a 77 percent decline in durable goods manufacturing in the same four-year period. Unemployment rose from 3.2 percent in 1929 to 24.9 percent in 1933. Furthermore, from 1929 to 1932, the money supply was contracting, “and since wages are less elastic than prices, real wages were rising (unbeknown to most workers), making it extremely difficult for business to employ people.”
Our last sector of concern is the investment sector, the stock market, its brokerage houses, and individual investors. The image that comes to mind immediately is the Crash of 1929. It occurred because the general price-to-earnings ratios–a common estimate of value in a security–had soared far above any representation in reality. The reason for this inordinate rise was due to speculative fever within the general public. Everyone wanted a piece of the action and were largely able to buy into it. Further probing finds the spectre of the Fed artificially propping the market.
The Fed’s purchase of government securities in 1924 was the first instance when the additional bank credit was almost exclusively channelled into securities–partly into direct bond purchases by banks and partly into stock/bond collateral loans. “This immense expansion of bank credit, added to the ordinary sources of capital, created the illusion of unlimited capital and made it easy for markets to absorb gigantic quantities of foreign securities as well as a greatly increased volume of American security issues.” Although the 1924 issue was the first instance of influence in the stock market, it was most definitely not the last.
The 1927 cheap money policy of the Fed was the final turn that opened the floodgates of giddy speculation. By lowering the rediscount rates, the Fed allowed the member banks to lower their own interest rates on stock and bond collateral loans as well as brokers’ loans. When the Fed reversed its policy late in 1927, it was too late. The psychological intoxication of the boom had taken hold of the American public. Eager speculators ignored increasing interest rates and took greater volumes of brokers’ loans. Even as member banks dried up the speculative security loans, new sources were utilized, viz., brokers’ loans `for account of others.’ Previously, brokers’ loans would be made for the bank’s account or an out-of-town bank’s account, with an occasional brokers’ loan for other customers. At the beginning of 1926, such loans accounted for $564 million of a total of $3.141 billion in brokers’ loans. By the summer of 1929, these loans totalled $3.372 billion of the total $6.085 billion in brokers’ loans. Furthermore, call loan rates rarely exceeded 10 percent, except just prior to the Crash, when they finally were raised to 20 percent. This also served as a fresh source of speculation money.
The effects of such ubiquitous investment were astounding. On November 15, 1922, the Dow-Jones Industrial Average closed at $95.11. By August 29, 1929, the Average had risen to $376.18. The Standard & Poor’s Common Stocks Indices showed similar fantastic gains: industrials, rails, and public utilities indices had risen from 44.4, 156.0, and 66.6, respectively, in 1921 to 172.5, 384.1, and 272.2 just six years later.
When the bubble finally burst–in October of 1929–it shattered confidence in the economy. The intoxication of seven years of giddy inflationary credit expansion had resulted in an economic hangover of heretofore unseen proportions. The following year, 1930, marked a watershed. The government’s response to the failings of the Federal Reserve would determine the severity of the necessary liquidation and recession. If the government allowed the market to correct itself, through interest rate hikes and bankruptcy, the consequent recession would be severe but brief. If, however, the government interfered with the market, the country would be in for a slow, arduous bloodletting and, ultimately, a future littered with cyclical depressions.
These three areas of the economy are the most important sectors and the ones most influenced by the arbitrary credit expansion of the Federal Reserve. In each one, government monetary intervention led to dislocations, distortions, and disequilibria. However, it would be foolish to imply that the Federal Reserve System was the sole factor in the playing out of the Great Depression. For our purposes, though, I will specifically omit the sometimes drastic effects of the Hawley-Smoot Tariff of 1930, Britain’s abandonment of the gold standard, reparations from defeated Germany, and other international elements that contributed to the extent and severity of the Depression of 1929-1940.
As I stated in the Introduction, if we can understand the ideas and underlying philosophy of the Great Depression, we can seek to eradicate those ideas from our midst and stave off a repetition of their actualization. The fundamental idea behind the Federal Reserve System is statism. It is the subjugation of individual freedoms and choices to the will and interests of the state, as representative of the “public good.”
In the case of the Federal Reserve, we can see that the Federal Reserve essentially dictates to the banking system what it can and cannot do. Consequently, individual depositors experience a reduction in choice among financial institutions, since they all are treated uniformly and it becomes impossible to determine the reserve quality and sufficiency of an individual bank. Furthermore, bankers are denied the possibility of issuing banknotes against real reserves and the element of control this encompasses. Businessmen are given mixed–and sometimes false–signals regarding the future cost of activities, leading to malinvestment and wasted capital. Finally, individuals are unable to assess the underlying value of the stock market, due to the dislocations produced by credit expansion on the part of the Fed. And volatility is officially sanctioned through the inflationary mechanism.
The lesson of the Great Depression is that statism leads to unintended consequences and undesirable effects and that this is inherent in the system. It illustrates the fact that the government has no business interfering in the private dealings of individuals. If the government had adopted the laissez-faire program it is alleged to have adopted, the economy would have certainly contracted, but its result would have been a strengthened and sounder economy. By the correction’s end, banks would have found appropriate reserve ratios and liquidated imprudent loans; businesses would have converted misguided endeavours into productive uses and shaken off inefficiencies; and investors would be left with more accurately valued stockholdings and a renewed confidence in the financial status of the nation. In short, the economy would have righted itself.
This, then, is the proper policy to follow in adjusting to a depression. It should be similarly obvious the method by which depressions may be averted; it is time for a separation of bank and state, akin to the separation of church and state and for the same reasons. An examination of free banking is beyond the scope of this essay, but suffice it to say that “depositors lost more money in the early phase of central banking (1913-1933) than earlier depositors had lost in the entire 75-year free banking period (1838-1913).” To paraphrase Ronald Reagan: in that time of crisis, government was not the solution to our problems–government was the problem.
What relevance have the events of the 1920s to do with modern economics and global investment? Well the overwhelming evidence is that the cause of the Great Depression was, firstly, the fact that in the years leading up to the 1928 share market crash the US monetary authorities allowed an approximately four-fold increase in the total American money supply and the direct consequence was a nearly mirror image gain in the average prices of shares on the New York Stock Exchange. The Dow Jones Industrial Index rose from 9 511 in November 1922 to 37 618 in August 1929. The money supply increase led inevitably to soaring inflation, but the actual cause of the share market crash and the subsequent economic depression was the fact that the Fed raised interest rates in order to soak up excess money and so the actual cause of the crash was this tightening of credit.
Now let us turn to current events and note in the graph above that on October 11 2002 the Dow Industrial reached a low point of 71975 and subsequently doubled reaching a peak value of 141980 on October 12 2007. That increase happened, however, against a background of a steadily declining value of the dollar which was the result of a massively adverse US balance of trade that understandably led investors to seek safer havens for their money.
A major beneficiary of these world investment flows during the same period was South Africa where the JSE All Share Index quadrupled from a low point of 77 062 on March 11 2002 to a peak value of 317 282 on October 11 2007.
So were there parallels between the money supply data of the 1920s and the first decade of the new millennium? Surprisingly at this stage of mankind’s development when we have access to data on practically everything, official global money supply statistics are extremely hard to come by. However a group of amateur US investors who, as they explain themselves “… got fed up with the lack of straight and relatively simple data on investing and economics, and put up a web site to address our various concerns….”
( http://www.nowandfutures.com ) have been collecting data from every available source in order to, among other conclusions observe that the total global money supply rose nearly five-fold between July 2004 and July 2007. Their graph overleaf tracks the annual percentage rate of change of the US “Monetary Base” together with the total change rate of reserves of the main Central Banks of the world. It basically measures how fast the central banks were adding liquidity by measuring the growth rate of their own reserves at the International Monetary Fund, then adding the Monetary Base to overweight the US Federal Reserve fund data. It is overlain with a graph tracking the annual rate of change in the dollar price of gold and what is important about this contrast is how accurately the gold price responds to increases in global money supplies albeit with an approximately two-year time lag.
So let us note in the graph below that the gold price more than trebled from a low of $252.60 on August 25 1999 to a peak of $842 on November 8 2007 ( and to $1851 in 2011). This tidal wave of new money had been engorging the world’s markets seeking a home wherever it could be found. So it should be no surprise that reports abounded at the time everywhere on the planet of credit cards arriving unsolicited in the post and of unemployed people being offered tens of thousands in shopping credits. But the process reached its pinnacle of irresponsibility with the advent of the sub-prime mortgage lending industry which had its roots in the US and whose ultimate collapse during 2007 shook the world’s financial system to its core. Here again it was a case of when the conventional lending market had become saturated, the money surplus inevitably began trickling down to would-be borrowers whose past credit record was so poor that in normal circumstances they would never have qualified for a loan. Suddenly, as if by magic, it was argued that this risk had gone away because someone had the bright idea of packaging hundreds of these mortgages together and selling them on to investment banks and pension funds who bought them on the understanding that by this process of aggregation only a moderate percentage of the loans might be expected to default and that this risk was covered by the relatively higher interest yield that the packages were offering.
Perhaps these institutions would not normally have been persuaded to take on the additional risk, but they had been under increasing pressure to obtain higher-yielding investments in order to fund the pension requirements of a society of “Baby Boomers” who had been living far longer than was anticipated by the actuaries who originally devised their pension plans. Frighteningly, however, in the aftermath of the sub-prime crisis when one after another the world’s biggest financial institutions were writing off billions in unrecoverable debts and CEOs were falling on their swords, it emerged that few had ever fully understood the risk potential of what they had been buying let alone grasped the extent of the non-performing portion of these bundled-together mortgages. The reality, of course, is that when you lend money to people who have very little ability to repay you, no amount of fancy financial engineering can cover up that fact.
Nevertheless, the whole card castle of debt might have remained hidden for far longer and assumed even more disastrous proportions had that inevitable consequence of a surging money supply, inflation, not come back to haunt the world and had central banks not, as they did in 1929, invoked their standard defence of raising their lending rates. People, who up till then had been just able to get bye meeting their mortgage repayments, could suddenly no longer do so and the process of mortgage repossessions began. In a chilling re-run of the events of the Great Depression, by the end of 2007 some two-million US citizens had lost their homes and the process was accelerating.
The graph below, courtesy again of nowandfutures.com traces US money supply over the past century (green lines) and inflation (black line) which emphasises the mirror image link between the two and, more pertinently at present, that money supply growth was at the time of writing showing no sign of abating and with it the inexorable upward march of inflation seemed endless.
Here a brief tour through a century of economic history is appropriate to an understanding of the graph. We have already documented the events of the 1920s and the Great depression which resulted from the increased money supply of that period. Then followed the huge contraction in money of the depression itself. However, as we have noted, right up to the 1940s the Fed was once again cranking up the money supply in a vain attempt to re-stimulate the US economy and resurrect the “good times” of the 1920s. The steep recession that followed the ending of World War 2 lasted until the middle 1960s although the corner was turned in the late 1950s accompanied by another expansion of the money supply and the first really significant post-war share market boom which was to end so spectacularly in South Africa with the crash of 1969 which in a matter of weeks in May 1969 knocked R5,6-billion off the value of ordinary shares listed on the Johannesburg Stock Exchange. Again it was the result of an interest rate hike following a warning in Parliament by the then Minister of Finance Nico Diederichs that excessive levels of speculation were being reached.
By the 1970s, it was a widely accepted economic doctrine by followers of British economist John Maynard Keynes that manipulating the money supply in order to create modest amounts of inflation was an acceptable price to pay as a consequence of government efforts to keep unemployment low. Keynes’ view was that runaway inflation could only occur at times of full employment, a proposition that was resoundingly discredited when the cumulative consequence of this approach by central banks led to an explosive surge of inflation which peaked at 13.5% in the United States in 1980 accompanied by a long period of high unemployment; the dreadful phenomenon which was to became known as “stagflation.”
US economist Milton Friedman provided an explanation for the onset of stagflation by arguing that once they were used to inflation as a daily fact of life, people would take it into account in their financial planning and so the long-term effect of reducing unemployment by increasing the money supply was a mirage. Eventually, ever-higher rates of inflation would be needed to stimulate hiring in order to keep unemployment low…. and the economy would collapse! This “monetarist” theory was put to the test by Paul Volker when he was Chairman of the Board of Governors of the Federal Reserve System in the late 1970s and early 1980s. He raised interest rates and reduced the money supply. The US entered a recession, unemployment went up, but inflation came down very fast. From 13.5% in 1980, it fell to a low of 1.9% in 1986. Then unemployment slowly came down and the recession ended, but high inflation did not return and had not returned by 2000 at which stage US inflation stood at 2.2%.
In the aftermath of the Milton Friedman/Paul Volcker cure, however, monetary policy was again relaxed but inflation remained low, seemingly giving the lie to the theory. We now know, however, that the reason inflation remained low during that period, notwithstanding a continued build-up of the world’s money supply, was economic globalisation: the sleeping giants of China and India were awakening their teeming millions of workers: armies who were prepared to slave long hours for less money than Western workers were accustomed to spending on lunch. The resultant flood of extremely low-priced consumer goods exerted a dampening effect upon global inflation that masked a rapidly increasing global money supply resulting in a new era of apparent prosperity in which the world’s central bankers (led by US Federal Reserve chairman Allan Greenspan as chief guru) basked in world adulation as geniuses who had finally cracked the secret of global economic fiscal management. Of course it was merely another illusion – as affirmed by Greenspan himself in his book ‘The Age of Turbulence: Adventures in a New World’ – which began unravelling, quietly at first from as early as December 1998 when a languishing oil price began creeping upwards and then quite dramatically 12 months later when Brent crude prices started an upward price acceleration rising at a compound annual rate of 37.6% until mid-2006. Then, after a brief five-month respite it returned with a vengent compound annual rate of 112.3% during 2007. Soon the oil price gains began to be matched by rises in most minerals, next by food prices and finally by wages in the beginning of another era of stagflation which promised to be even worse than that endured in the 1970s because the monetary authorities had clearly not learned the lessons of the past and were cranking up the money supply in order to stave off the pain of the sub-prime crisis.
In retrospect, other than the Great Depression, the 1970s had arguably been the worst phase of the 20th Century world economy as reflected by share markets that wallowed for over a decade after the stock market crash of 1973. And again it was clear that past lessons had not been learned for the world’s central banks had continued creating new money and inevitably inflation had soared on a global scale. With the buying power of money being steadily eroded, oil-producing nations of the Middle East had as a consequence been prompted to form the OPEC oil cartel in attempt to restore the real value of their exports. For a brief period OPEC held the world to ransom and, amid fuel shortages and soaring prices, the financial world had to adapt to a tidal wave of petrodollars seeking investment homes.
Simultaneously France, which had long been uneasy about the world’s dependency in terms of the Bretton Woods Agreement on the US Dollar as its ultimate reserve currency, had as a consequence been accumulating huge reserves of gold. Finally in 1971 French president Charles De Gaulle directly challenged America to honour its foreign debt with payments in bullion, grabbing headlines by demanding that the US prove that it did indeed hold gold bullion in the vaults of Fort Knox equal, at $35 an ounce, to the sum of its issued paper dollars. US President Richard Nixon responded by initially moving the official price of gold to $42 an ounce and finally, in a tacit admission that De Gaulle’s allegations were true, officially ended the link which thereafter allowed for a free float of the Gold price.
With the world’s monetary system again bloated, this time by petro-dollars, central banks again raised interest rates to rein in the inevitable wave of inflation and In the two years from 1972 to 1974, the American economy slowed from 7.2 percent real GDP growth to a minus 2.1 percent contraction, while inflation jumped from 3.4 percent in 1972 to 12.3 percent in 1974. The petrodollar surge had inevitably created a speculative bubble in the world’s share markets and the market crash of January 1973 was the aftermath of these events. In the 694 days between 11 January 1973 and 6 December 1974, the New York Stock Exchange’s Dow Jones Industrial Average lost over 45 percent of its value, making it the seventh-worst bear market in the history of the index.
Worse was the effect in Britain where the London Stock Exchange’s Footsie Index lost 73% of its value. From a position of 5.1 percent real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1 percent. At the time, the UK’s property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders. In Britain the market slide only ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices. Over the following year share prices rose by 150%. However, still reeling under the impact of an excessive build up of money, inflation continued to rise to a British peak of 25% in 1975 before the Paul Volcker solution ushered in a world-wide era of stagflation.
All the main share indices of the future G7 bottomed out between September and December 1974, having lost at least 34% of their value in nominal terms, and 43% in real terms. In all cases, the recovery was a slow and painful process. Although West Germany’s market was fastest to recover, returning to the original nominal level within eighteen months. However even it did not return to the same real level until June 1985. The London Stock Exchange did not return to the same market level until May 1987 when the notorious Black Monday crash happened. The United States did not see the same level in real terms until August 1993: over twenty years after the 1973 crash began.
The 1970s were also an extremely painful time for Latin America. In the 1960s and 1970s Brazil, Argentina, and Mexico had borrowed huge sums of money from international creditors to fund industrialisation and infrastructure development and as a result their economies were booming. Creditors were thus happy to continue to providing loans with a result that between 1975 and 1982, Latin American debt to commercial banks increased at a cumulative annual rate of 20.4 percent. This heightened borrowing led Latin America to quadruple its external debt from $75 billion in 1975 to more than $315 billion in 1983, or 50 percent of the region’s gross domestic product (GDP). Debt service (interest payments and the repayment of principal) grew even faster, reaching $66 billion in 1982, up from $12 billion in 1975.
Then came the oil crisis when OPEC quadrupled oil prices in 1973. While the developed world met the challenge by printing money, the developing countries found themselves in a desperate liquidity crunch. The petroleum exporting countries were flush with cash after the oil price increases and invested their money with international banks which ‘recycled’ a major portion of it as loans to Latin American and African governments. Later, as interest rates increased in the USA and Europe in 1979, debt payments also increased making it harder for borrowing countries to pay back their debts.
Gradually the international capital markets became aware that Latin America would not be able to pay back its loans and the crunch came in August 1982 when Mexico’s Finance Minister, Jesus Silva-Herzog declared that his country would no longer be able to service its debt. In the wake of this default, most commercial banks significantly reduced or halted new lending to Latin America. Since most of Latin America’s loans had been short-term, a crisis ensued when their refinancing was refused. Billions of dollars of loans that previously would have been refinanced, were now due immediately.
As a result of the Latin America loan crisis, international banks were also growing wary of their loans to South Africa where a similar situation of constantly rolled on short-term loans was the order of the day. Thus in August 1985, US banks led by Chase Manhattan, suspended their South African lending operations. The credit crunch sent the rand into a nose dive, which was soon followed by the imposition of exchange controls and a debt “standstill.” was declared by South Africa which froze some $10 billion in payments to foreign creditors.
In both the Latin American and South African cases, repayment moratoria were put in place and the debts were gradually repaid at the expense of general recessions in all these countries and a considerable degree of sacrifice by their citizens. Not so the Asian Tigers when they got into a similar crisis a decade later. There, surprisingly, monetary authorities again forgot the lessons of the past and turned to the printing press to rescue them, thereby sowing the seeds of the next monetary crisis that would reach its conclusion in the Crash of 2008. What a pity they had so rapidly forgotten the lessons of the 1970s and 80s when such largess was untenable and austerity was the order of the day everywhere.
The market crash of 1987 was a little unusual although as ever it was again triggered by interest rate increases. A chain reaction had begun with Germany raising its interest rates which prompted the then Secretary of the US Treasury James Baker to comment that the increase was “…not a trend which we favour…” There was an immediate international panic among investors who for some months had been fearful that the market had been rising to excessive heights. At the time both Germany and Japan were running huge trade surpluses while the US was in deficit. James Baker’s remarks exacerbated fears that foreign investors might dump US investments and, to counter these, the Fed was rapidly forced to do what Baker had indicated it would not do: interest rates were increased and, as money supply shrank and recession again loomed, the inevitable happened: the market crashed.
Here in South Africa the JSE fell 40 percent between October 19 and November 4. In Britain where dividend yields had fallen to a record average low of 3%, the market fell less spectacularly but again the authorities over-reacted. Fearing that the crash would lead to a recession Chancellor Nigel Lawson cut base lending rates from 10% to 7.5% and slashed taxes. The result fuelled inflation and the Bank of England was later forced to raise rates to 15% which, inevitably, triggered Britain’s worst post-war recession.
So severe was this period of economic stagnation in the developed world that when the East Asian Financial Crisis gripped much of Asia, beginning in July 1997 raising fears of a worldwide economic meltdown, only the United States was economically strong enough to shoulder the burden of throwing money at the problem. US financial authorities at that time argued that the US economy was the sole engine of world growth and as such they were obligated to crank up money supply once more for the good of everyone on the planet.
At the time, and as a consequence of the stagnation in most western nations, Asia had been attracting as much as half of the total capital inflow to developing countries. The economies of South-east Asia in particular were maintaining high interest rates that were more attractive to foreign investors than the returns they were getting at home. As a result of this large inflow of money the Pacific “Rim of Fire” nations experienced a dramatic run-up in asset prices. The economies of Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea experienced GDP growth rates of 8 to 12% throughout the late 1980s and early 1990s and were at the time acclaimed by the IMF as the “Asian economic miracle”.
Then came the Asian Crisis that started in Thailand with the collapse of the Thai baht which in turn resulted from a decision by the Thai government to float the baht by cutting its peg to the US Dollar. Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency and the drastically-reduced import earnings that resulted from the forced revaluation rendered a quick recovery impossible without strenuous international intervention. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and asset prices, and a precipitous rise in private debt.
Although most of the governments of Asia had no national debt and seemingly sound fiscal policies, the International Monetary Fund (IMF) was forced to initiate a $40-billion aid program aimed at stabilising the currencies of South Korea, Thailand, and Indonesia, whose economies were hit particularly hard by the crisis.
Japan had already been in a state of profound recession due to a highly inefficient banking system weighed down under mountains of bad debt, much of which up to that point had been relatively invisible because of the established Japanese banking practice of hiding the losses of major customers. As part of the IMF-engineered life raft, the United States intervened to stop a precipitous slide in the value of the yen by agreeing to buy some $2 billion worth of the Japanese currency. In doing so, the United States hoped to increase the value of the yen, which had fallen to its lowest point in some eight years. In Indonesia, after 30 years in power, President Suharto was forced to step down in May 1998 in the wake of widespread rioting that followed sharp price increases caused by a drastic devaluation of the rupiah.
The seeds of the monetary crisis of 2007/8 were sown then for not only were the printing presses resorted to in an effort to re-float these Pacific economies, but Japan’s recovery plan included dramatically lowering its interest rate structure which led in turn to the development of what became known as the “Carry Trade”. Taking advantage of Japan’s low interest rates, speculators were able to borrow money a