In the book of which this blog is a part, Capitalism: The Liberal Revolution (CTLR), the discussion of freedom would be incomplete without a discussion of money, for which a full chapter would be appropriate. Such a chapter is planned.
The discussion in this blog post is of the experience in the United States of America since the start of the Great Depression of the 1930s, and especially the experience of the last decade of the 20th century through the first two plus years of the second decade of the 21st century. However, much of what is described here has also transpired similarly in many of the countries of the world over the same time.
For much of recorded history an entity known as “the state” has imposed a monopoly power over the creation of money. State power to create money is not the basis of the value of money. The value of money is based on the productive capacity of society. The value of money is virtually nil in a country that is desperately poor due to the coercive rule of a political elite that controls such a country. Early 21st century examples include the state monies of North Korea, Zimbabwe, Cuba, and other extremely poor countries.
All states, everywhere and in all times, have abused their money monopoly to extract wealth from the people who produce new property and set some aside to reinvest it in the production of more wealth. The people who are the victims of that extraction of wealth include anybody and everybody who works to sustain life and to use the product of their work to pursue material prosperity as one form of happiness and security.
There is significance for investors, and all Americans, in the bizarre phenomena now existing in the United States of America—that is extremely low interest rates on bank deposits, “safe” bonds of both the state and well-established businesses, and residential real estate loans. Mortgage interest rates for home loans are the lowest in the history of America.
The Federal Reserve Board (the Fed) deliberately engineered these extremely low interest rates to stimulate economic activity and bolster the sagging real estate market. This is not an opinion. Fed Chairman Ben Bernanke said this is what the Fed was aiming to do, as noted below.
The residential and commercial real estate markets fell sharply in 2007-2008 when the real estate boom of 2000-2006 came to an end. The most pronounced collapse was in residential real estate prices. The Fed induced the preceding real estate boom of 2000-2006. That rise in prices was caused by prior Fed actions in several episodes of money creation: following the stock market crash of 1987; after the real estate crash of the late 1980s and the subsequent economic recession of 1990-1991; in late 1999; and following the economic recession and stock market crash that were punctuated by the terrorist attacks of September 11, 2001.
The first episode of low interest stimulus was in the early 1990s when the Fed kept interest rates at around 1% for several years. Those low rates including low rates on home loans revived the residential real estate market, but the market was still relatively depressed through 1999. It must be said here that the U.S. real estate market is not monolithic. The national real estate market is the aggregation of all the local markets, each of which may act differently than others due to primarily local factors.
As the year 2000 approached the Fed flooded the financial system (that is big banks) with massive amounts of dollars in an attempt to prevent a feared financial crisis due to computer problems associated with what was called Y2K, the abbreviation for year 2000. The supposed Y2K problem was due to prior practice of abbreviating a year to two digits in computer software programs, e.g. 93 for 1993. Y2K turned out to be not a problem at all.
By the beginning of 2000 the American stock market was at the end of a 17-year rise that had taken the market averages to a level twice as high as at any prior bull market peak in relation to the fundamental values provided by earnings, assets and definite future prospects. The Fed’s policies played a major rôle in creating what experienced investors could see was a stock market “bubble.” That rôle was “the Greenspan put.”
The “Greenspan Put” refers to the monetary policy of the Federal Reserve under Fed Chairman Alan Greenspan from 1987 to 2006. The term “Put” refers to an option in which the buyer of the put acquires the right to sell an asset at a particular price to a counterparty over a specified period of time; thus the option offers downside protection against market prices falling below the put option price. During Greenspan’s chairmanship, when the stock market fell more than about 20%, the Fed would lower the Fed Funds rate to the point of a negative real, inflation-adjusted, yield. By this policy the Fed encouraged risk taking in the financial markets with the hope and expectation of averting further market decline. In financial circles the Fed policy was called the Greenspan Put because stock market participants could always count on the Fed to do its utmost to stop the stock market from suffering a sustained downturn or crash.
In response to the financial crisis of 2008 the Fed’s monetary stimulus under Ben Bernanke, Greenspan’s successor as Fed Chairman, vastly exceeded that under prior Fed Chairman Alan Greenspan or any prior Fed chairman. Fed policy has pushed the stock market up by around 100%, reversing the 50% plus drop of 2007-2009. The stock market again appears way over-priced in terms of the risk/reward ratio in owning company shares compared to other real and financial assets. Such over-pricing in the stock market has always led, eventually, to another large market decline.
The U.S. federal state now guarantees 90% of all residential real estate mortgages. The Fed has pushed mortgage interest rates so low that a real, inflation-adjusted, loss appears to be built into every fixed rate mortgage originated since the Fed began its program of suppressing interest rates under Chairman Bernanke. Unless a deflationary economic depression overwhelms the Fed’s inflationary efforts, monetary inflation seems virtually certain to exceed the interest rate on low interest, fixed-rate mortgages; that same inflation will devalue the principal of the mortgage. Therefore, loss to mortgage creditors seems inevitable on such low-interest, fixed rate mortgages.
Recent experience shows that federal regulatory authorities and Congress have a “too big to fail” policy, under which the U.S. bails out banks and other lenders whose failure is considered to create “systemic” risk, that is risk the entire financial system could cease functioning. The ultimate cost of large loan losses is passed on to taxpayers in order to save the lenders from going out of business. Since the U.S. is now guaranteeing 90% of mortgage originations, the taxpayers must bear the loss of improvident mortgage lending that is being encouraged and subsidized by the U.S. federal state. The U.S. federal state is using its money monopoly and the power of the Fed to create money at will and to suppress interest rates in order to protect big banks at the expense of America’s savers.
The Fed creates booms and busts, although it was established to prevent them. To get out of each bust it creates the next and larger boom. In the early years of the second decade of the 21st century there has been a new boom in home prices going on in some parts of the country–engendered, where it occurs, by a low supply of homes for sale together with ultra-low mortgage interest rates; there is even a renaissance of the boom in condominiums in Miami, Florida where there was tremendous overbuilding in the last boom and a subsequent bust of monumental proportions.
The rise in the American stock market and in residential real estate prices in certain areas is an artificial prosperity based on the Fed’s manipulation of interest rates, and creation of dollars out of thin air to buy Treasury securities. I.e., one arm of the United States of America, the Treasury, borrows (with Congressional authorization) and another arm of the state (the Fed) buys the Treasury debt with money of its own creation. This practice is called “monetization of the debt.” The term is pejorative, not complimentary, due to its ultimate adverse consequences on the wealth of citizens whose savings are committed to U.S. dollars via the banking industry or the securities market for bonds and money market instruments.
The one thing that seems to be virtually certain is that the purchasing power of the U.S. dollar will go down substantially over time, and that precious metals will have a corresponding rise in value.
In terms of the U.S. dollar, the price of real assets, such as precious metals, petroleum, and shares of companies have fluctuated widely over time. However, the continuous debasement of the U.S. dollar propels a long-term upward movement of the dollar price of real assets–that is assets that are called “real” in contradistinction to paper money created by the state.
According to the U.S. itself, the purchasing power of a dollar in 2013 is the same as six cents ($0.06) in 1933. 1
Over that same 80-year period the price of gold is up from $20 an ounce to $1,600 an ounce (as of late March 2013) and the price per barrel of crude oil is up from $1 to $93. Gold is no scarcer in 2013 than in 1933. Since 1933 global crude oil reserves have increased due to advances in the technology of extracting petroleum from the earth. The standard definition of crude oil reserves is petroleum that could be extracted under existing technological capabilities.
Shares of public companies are also real assets as they represent the underlying earning power of the companies. Since 1933 the U.S. stock market, including dividends paid along the way, is up even more than gold and petroleum. 1933 was a false reference point in a way, because the market was then down over 80% from its 1929 high. However, even measuring from the 1929 peak in the stock market, the market (including dividends) is up even more in percentage terms than gold and petroleum.
Imagine a child’s teeter-totter, with the dollar on one end and precious metals, commodities priced in dollars, real estate and the shares of companies on the other. As the dollar goes down in purchasing power the precious metals and other “real” assets will go up.
These relative changes in purchasing power of the dollar vis-à-vis real assets are due to the operation of the supply and demand as Fed Chairman Bernanke himself said in a speech on November 21, 2002:
“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” 2
There we have it, from one of the sources of monetary debasement. Of course, the U.S. Congress, and ultimately the use of political democracy by politicians, is the fundamental source of monetary debasement.
Historically, the Fed stimulated economic activity by lowering interest rates through purchases of Treasury securities from commercial banks. That has the effect of injecting money into the banks which then usually lend the money out to businesses and consumers. The idea of this monetary injection is to spur economic activity by making money more easily available, called “easing” for short. Easing usually does stimulate economic activity, but it also causes rising prices of goods and services. Rising prices are considered “inflation” in common parlance, but the inflation actually occurs first by increases in the money supply which in turn cheapens money, bringing about a corresponding rise in the price of goods and services.
When the Fed had already reduced interest rates to near zero by the beginning of 2009, it could not stimulate the economy by “easing” the usual way—lowering interest rates. Therefore, the Fed inaugurated a policy of “quantitative easing”—which as stated by Fed Chairman Ben Bernanke is accomplished through “a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” However, there is a cost to Americans in the form of cheapening the purchasing power of the dollar.
Mr. Bernanke is an intelligent man who thinks he is doing the right thing. His goal in creating inflation is to stave off a deflation like that of the Great Depression of the 1930s. That is why his speech quoted above is entitled “Deflation: Making Sure ‘It’ Doesn’t Happen.” However, suppose the Great Depression was not caused by a lack of money, but rather by a combination of well-intentioned but counter-productive political acts that suppressed the economy? That is the view of the cause of the Great Depression expressed in CTLR chapter nine, “Political Democracy in America,” under the caption The Great Depression of the 1930s and its aftermath—a fundamental change in America. 3 This view of the cause of the Great Depression is also expressed in The Great Deformation: The Corruptions of Capitalism in America (2013) by David A. Stockman, Chapter 8 entitled “New Deal Myths of Recovery.”
The U.S. Congress, the Department of the Treasury, and the Federal Reserve are pursuing a policy of debasing the U.S. dollar. Over the past 80 years that has raised the price of real assets in dollar terms. Policies now in effect seem certain to debase the U.S. dollar further. Thus, it appears inevitable that there will be a continuing consequent rise in the dollar prices of real assets.
Furthermore, it is the stated intention of the Fed to raise prices of housing and company shares to spur a “wealth effect,” by making people feel more prosperous and thus more willing to spend. Fed Chairman Bernanke said so himself, as follows:
“Lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” 4
The Fed policy of extremely low interest rates has another goal: to recapitalize banks that dissipated their capital by losing so much money on real estate loans as to jeopardize their continued existence.
According to an outstanding financial analyst specializing in the banking industry, during the financial crisis of 2008 “. . . twelve of the thirteen largest U.S. banks would have failed if not for government intervention.” 5
The Fed has established the power to lend money of its own creation to banks to facilitate normal banking operations and also to meet short-term liquidity needs or to resolve severe financial difficulties. Starting in the aftermath of the financial crisis of 2008, banks could borrow all they wanted from the Fed at ultra-low interest rates, below 1% per annum. Banks could use such cheap money to lend to customers at far higher rates, enabling the banks to collect the huge difference between what they pay the Fed and their cost of interest on customer deposits in comparison to the interest they charge on consumer and business loans. This Fed policy is rewarding banks that made bad loans while penalizing savers who get a pittance in interest, typically less than 0.5% per annum on even large deposits. That is a negative rate of interest rate compared to the embedded historical average 3% per annum increase in the Consumer Price Index.
Although the U.S. has been reporting a relatively low increase in the CPI in recent years, according to John Williams, a leading expert on the methodology used by the state to calculate changes in its Consumer Price Index (the CPI), that index understates significantly the cost of living increases borne by the American public. Mr. Williams calculates that as of the beginning of the second decade of the 21st century the CPI would be rising around 5% per year under the methodology used before 2000, and around 9% per year under the methodology used before 1980. 6
The near zero interest rates on savings is tantamount to confiscating each day, month, and year part of the principal of the property deposited in American banks and committed to safe bonds. In effect the Fed’s policy of near zero interest rates differs little from an actual tax on, or an outright confiscation of the savings of Americans, and of foreigners committed to deposits in American banks and to loans evidenced by safe bonds. 7
For individuals with sizable residential mortgages the Fed’s policy provides a virtual gift in the ability to refinance at historically low interest rates. For many such people their home is by far their largest investment, so low mortgages rates are far more beneficial than the detriment of low interest on cash savings.
However, for people who rent their residence and are saving for the future, including a possible home purchase, the Fed policy is entirely disadvantageous.
This blog post anticipates in part a more detailed discussion that will be presented in a chapter of CTLR on the subject of money, and how money with integrity—money that does not lose value—can and will be created by competition in the free market.
- See the CPI Inflation Calculator of the federal Bureau of Labor Statistics at http://www.bls.gov/data/inflation_calculator.htm ↩
- Quoted from “Remarks by Governor Ben S. Bernanke, Before the National Economists Club, Washington, D.C. November 21, 2002,” http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm At the time of this statement Mr. Bernanke was a Member of the Board of Governors of the Fed. He became chairman in 2006 when Alan Greenspan retired from the Fed. ↩
- See CTLR, chapter 9, text accompanying notes 57 through 60 ↩
- Quoted from “What the Fed did and why: supporting the recovery and sustaining price stability,” by Ben S. Bernanke, Op-Ed, The Washington Post, November 4, 2010. ↩
- Quoted from Mayo, Mike, Exile on Wall Street: One Analyst’s Fight to Save the Big Banks from Themselves (2012), page 5. ↩
- See John Williams’ Shadow Government Statistics where some information is available without charge, but full reports are available only to subscribers. http://www.shadowstats.com/ ↩
- The statements in this paragraph are based on an insightful comment of Darren C. Pollock, principal in Cheviot Value Management, LLC. ↩