“First they ignore you, then they laugh at you, then they fight you, then you win.”
-Mohandas Karamchand Gandhi
As gold holders with fairly comprehensive views of global monetary policies and central banking we were asked to comment about the first of four installations of Ben Bernanke’s lecture series at George Washington University, entitled “The Federal Reserve and the Financial Crisis”. Despite thinking the lecture was woefully incomplete, diversionary and oftentimes quite disingenuous, our initial reaction was to let it go. We think our anticipated macroeconomic outcome will be ignored and denied by public policy makers up until the time they are forced to adopt it and take ownership of it. The math and political expediency behind future inflation and hyperinflation are too compelling to ignore.
However, while our business is not to debate publicly, especially the Fed Chairman who must navigate multiple constituencies with various dissenting social, economic and political views, we take seriously false claims that serve to undermine our business. In our opinion the consensus view of the forces behind the general price level, borne from misconceptions about money and banking, is fundamentally wrong. Mr. Bernanke went out of his way last Monday to perpetuate that myth. (That the myth happens to be self-serving for central banks, including the Fed, and for the global banking system should not be dismissed.)
Mr. Bernanke’s lecture series is being delivered under the guise of reaching out to the public to explain better how central banks work and, we presume, promote the public good. This is an assertion we think is diametrically and obviously contrary to the facts. We have no idea whether or not Mr. Bernanke actually believes this yet determining that is not important. Most of the public believe central banks take the rough edges off unadulterated capitalism where greed, fear and inequitable resource distribution would dominate. We presume such must be the rationale behind very smart political economists saying very dumb things in public.
Chairman Bernanke promoted central banking, implied it is more powerful than natural economic functions, and spent quite a bit of time implying gold is a barbarous relic when compared to the nuances sophisticated monetary policies offer. Our business, as fiduciaries, is allocating capital based on relative value within the macroeconomic environment we see as likely. In our opinion Mr. Bernanke’s lecture last Monday perpetuated bad or unimportant data, implied impossible outcomes, and was quite self-serving in its conclusions. His description of history was incomplete, his extrapolations were baseless, and his arguments were quite weak. (Ultimately we believe Fed policy will migrate — or be suddenly reversed — to meet the consequences of its current policies.)
As we pointed out only a few weeks ago following Warren Buffett’s unsolicited gold comments, (“Golden Boy”), and in December 2009 following Nouriel Roubini’s assertion that a gold bubble was about to pop (“Roubini Rebuttal”), gold is simply money – a savings (not investment) vehicle, a means of storing purchasing power in a time of paper money dilution. That’s it. Central banks compete directly with gold ownership because they manufacture competing savings vehicles in the form of baseless paper money. For the past twelve years global wealth holders have been converting their savings from paper media of exchange (or financial assets denominated in them) to gold because central banks must dilute the purchasing power of their currencies to de-lever the global banking system. Has anyone asked why so many powerful people are going out of their way to discredit an inert rock? We think it comes down to maintaining power and control over commercial economies.
After professionally watching Fed chairmen cajole, threaten, persuade and manage sentiment in the markets since 1982, we argue this latest permutation is understandable, predictable and, for those willing to bet on the Fed’s ultimate success in saving the banking system (as we are), quite exciting. Gandhi’s quote above rings true. Gold is no longer being ignored and gold holders are no longer being laughed at. “The Powers That Be” have been fighting quietly in the markets for almost four years and they now seem to have begun a frontal campaign against gold. By our reckoning, the current and future shape of the global monetary system is at stake. Ben Bernanke stands at the highest bully pulpit defending the current regime.
Below, we address specific points the Chairman raised in his lecture last Monday. It was a…
Tour de Farce
Chairman Bernanke’s first lecture in the series included a long discussion of gold. This is as it should be because up until forty years ago global money was always backed in some way, shape or form with precious metals. Since 1971 the Fed and other central banks have been the monopoly issuers of their economies’ currencies which have not been exchangeable into gold. We will not spend time here recounting what we have already taken 150,000 words over the last five years to discuss; suffice to say US dollars and all the world’s currencies are backed by the full faith and credit of their treasury ministries and central banks, specifically backed only by their ability to print more of them. In this we truly trust.
The question before us today is: how many new paper currency units are necessary to secure banking systems and protect against deflation? To which we answer: probably somewhere around 15 trillion new dollars and about 75 trillion new dollar-equivalent currencies across the world. Within that context we can proceed with deconstructing the lecture.
The quotes below were taken from Ben Bernanke’s slide presentation. We take issue with the following:
BB: (Slide 6) “A central bank is not an ordinary bank, but a government agency.”
QB: As we understand it, a central bank is neither an ordinary bank nor a government agency. It is a privately-held for-profit bank (owned by its member banks, not funded with tax revenues) that has the exclusive power to print unlimited quantities of currency and take unlimited amounts of assets onto its balance sheet.
BB: (Slide 7) “All central banks strive for low and stable inflation; most try to promote stable growth in output and employment….Central banks try to ensure that the nation’s financial system functions properly; importantly, they try to prevent or mitigate financial panics or crises.”
QB: In the current baseless monetary system central banks actually create inflation and there is no other entity or economic dynamic that can create systemic inflation. (Increasing aggregate demand relative to supply does not create a sustainable increase in the general price level. Only an increase in the stock of money does.) That central banks may “strive for low and stable inflation” implies central banks strive for low and stable money printing.
Fair enough, but their consistent performance shows they do not abide by their objectives. In fact, they have been quite negligent. By maintaining easy credit within the banking system for decades, central banks promoted bank asset accumulation (and economy-wide debt accumulation) that would someday have to be serviced and paid-down with money that did not yet exist. Central banks would have to manufacture it. A cynic could argue central banks exist to help banks cover their naked currency shorts embedded in their assets (i.e. loan books).
As for financial panics, they can only arise from systemic credit deterioration. Systemic credit deterioration can only occur following a great systemic credit build-up. A great systemic credit build-up can only occur through the banking system, which the central bank regulates. Thus, trying “to prevent or mitigate financial panics or crises” implies central banks try to prevent their own contemporaneous negligence and then try to mitigate the consequences of that negligence through…money printing, which is necessary to offset credit deterioration.
BB: (Slide 8) “”In normal times, central banks adjust the level of short-term interest rates to influence spending, production, employment, and inflation… Central banks provide liquidity (short-term loans) to financial institutions or markets to help calm financial panics, serving as the lender of last resort.””
QB: By “normal times” BB is referring to a credit build-up in which the banking system creates and promotes its own assets in the form of credit, which is also systemic debt. The tertiary consequences of this process are the credit build-up’s impact on the commercial economy, including the levels of consumption, production and employment (and the general price level). Central banks provide systemic liquidity to financial institutions or markets but not directly to the commercial economy. Finally, yes, central banks are lenders of last resort; however, central banks do not advertise that they are also buyers of last resort. As we are witnessing today, the Fed is buying dubiously-marked assets from banks.
BB: (Slide 11) “Financial panics are sparked by a sudden loss of confidence in one or more financial institutions, leading the public to stop funding those institutions, for example, through deposits….Panics can cause:
• Widespread bank runs
• Restrictions on depositors’ access to their funds
• Bank failures
• Stock market crashes
• Economic contractions”
QB: Well, we would argue financial panics are caused by the realization by a quorum of the population that there is not enough money in existence to back outstanding credit. (What “sparks” the panic is of secondary concern.) BB’s implication is that financial panics and sudden losses of confidence are always unwarranted. We disagree. As for the consequences of financial panics that BB sites, please note access to depositor “funds” – not money. Over 80% of bank deposits in the US are not money but electronic credits. Money (bank reserves) would have to be created if all depositors wanted to withdraw their funds.
Further, by being the source of financial panics (through promoting easy credit conditions), and by listing economic contractions as a negative consequence of financial panics, BB is (properly) indicting central banks as the source of the “economic cycle” (in reality the credit cycle). So then, rather than titling his presentation “The Federal Reserve and the Financial Crisis” we think BB should have considered a more apt title: “How the Federal Reserve Caused the Financial Crisis.”
BB: (Slide 13) “Short-term loans from the central bank replace losses of deposits or other private-sector loans, preventing the failure of solvent but illiquid firms.”
QB: Short-term loans made by central banks to depository institutions may be rolled over, in perpetuity, by central banks because in aggregate they have no balance sheet constraints (and their balance sheets are not audited). If BB’s use of the phrase “short term” was used to imply “temporary funding”, logic and evidence shows this to be not true. Central banks continue rolling overnight loans and the possibility that they will be able to extinguish them, which would hit bank reserve ratios (not to mention bank earnings, share re-purchase plans and dividend policies) seems remote.
It would also be inconsistent with the Fed’s treatment of its member banks to impose restrictive policies. Overnight repurchase agreements increased consistently over 12% per year from 1994 to 1996. (The economy-wide debt accumulation and bank system funding mismatch this promoted would be soon felt.) Finally, bank illiquidity is the same as bank insolvency. There is no asset illiquidity at the market clearing prices of “illiquid” bank assets (there is always a price for everything). Thus, central banks promote term-credit creation by targeting accommodative overnight funding rates, then provide perpetual funding for over-valued bank assets resulting from that mismatch and, in a pinch, provide a balance sheet for member banking institutions on which those member banks may sell their over-valued assets.
BB: (Slide 16) “If financial firms can borrow freely from the central bank, using their assets as collateral, they can pay off depositors, avert “fire sales” of their assets, and restore the confidence of their depositors.”
QB: In a fractionally reserved banking system maintaining depositor and bank shareholder confidence is necessary at all times, whether or not the assets and future income of banking institutions warrant such confidence. A reasonable person should conclude that executives of banking institutions, central bank representatives like Chairman Bernanke, and politicians charged with overseeing financial and economic matters will unite in trying to promote public confidence and funding for financial institutions in times of great stress (including at times just prior to sudden systemic credit de-levering).
Thus, it makes complete sense that The Powers That Be would become less concerned with intermediate and long term consequences of monetary policy and more concerned with perpetuating short-term public confidence. (The question becomes; “can they succeed even if commercial and consumer incentives do not warrant such confidence?”)
BB: (Slide 20) “Financial panics in 1873, 1884, 1890, 1893, and 1907 led to bank closings, losses by depositors and investors, and often to broader economic slowdowns… The 1907 financial panic led Congress to consider the creation of a central bank.”
QB: The repeated financial panics from 1873 to 1907 were discrete and contained within the banking system. They did not lead to broad or lingering economic contractions. Banks that leant too much over their reserves or that made poor loan judgments failed. In 1907, credit deteriorated and banks stopped lending. The broader economy was threatened with less credit, but that would have been resolved quickly once bad banks failed, new banks offered new credit collateralized by the very same assets marked down from the values at which they were held by the bad banks. Quickly finding market clearing prices would have solved the problem. (Instead, J.P. Morgan – the man — led a syndicate that injected new money into the banking system, which calmed public fears and avoided a run.)
As for bank depositors, they used to care about the creditworthiness of bank balance sheets and they sought to save at banks they thought had adequate reserves. This, and the fact that bank failures tended to bankrupt its owners, served as a discipline on bank balance sheet leverage.
Most people today do not understand that a central bank still cannot insure the purchasing power of bank deposits. (Depositor insurance, such as the FDIC is unfunded and so the Fed would have to manufacture currency that the FDIC would then credit to bank balances). Central banks can only backstop the nominal balances of depositors. Thus, in the US, most of the $9.7 trillion of bank deposits supported by $1.6 trillion in bank reserves are nominally safe; however, these figures imply the purchasing power guaranteed to depositors could be as low as 16.5% of what it is today ($1.6 / $9.7).
A reasonable person would conclude that a system where a saver could diversify her savings among deposits in a few solidly-reserved banks would be far safer in real terms than holding one’s savings in one banking system that is insolvent in real terms.
BB: (Slide 22) “The gold standard sets the money supply and price level generally with limited central bank intervention.”
QB: More accurately, in the gold standard BB is referencing, the government sets a fixed exchange rate of its economy’s media of exchange to an ounce of gold. This fixed exchange rate forces banking systems to be more careful about issuing unreserved credit denominated in the media of exchange. It also makes governments less able to deficit-spend. Extreme unreserved credit issuance or deficit spending would give incentive to holders of the paper media to exchange it for gold, which would not be diluted.
[It is important to understand that BB’s definition of the gold standard, while an accurate portrayal of past gold standards, is not market-based because the government is setting the fixed exchange rate. A true gold standard would treat gold as the collateral for all media of exchange, which in turn would be exchangeable at an exchange rate set by the markets. This would differ from today’s regime in that physical gold would be considered “money”, not subject to taxes of any kind, and there would not be a gold futures market in which issuers of the competing baseless currencies could potentially suppress the “floating” exchange rate (i.e. gold price) without limit.]
BB: (Slide 23) “The strength of the gold standard is also its weakness too: Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions.”
QB: Frankly, this is a straw man argument the Chairman seems to be using to mislead. It is true that the supply of money could not be adjusted in response to changing economic conditions. However, in a gold standard system with a floating gold exchange rate the price of money would adjust in response to changing economic conditions. In other words, the value of money – determined by both its quantity and price (exchange rate to media) – would accommodate any economic environment. BB chose to pick on a government-priced and managed gold standard.
BB: (Slide 24) “All countries on the gold standard are forced to maintain fixed exchange rates. As a result, the effects of bad policies in one country can be transmitted to other countries if both are on the gold standard.”
QB: Who would force countries to maintain fixed exchange rates? Governments. In a gold standard with floating gold exchange rates, governments would compete for money with the private sector. They would not be able to create money and so they would have to tax citizens to pay for government projects, wars, and any debts they may accrue. This inherent discipline would likely give great incentive to politicians to solicit the will of taxpayers more earnestly, which implies governments would be loathe to cede power over spending to the private economy.
(This is probably the reason gold advocates have developed a reputation as “strict constructionists” or even “anarchists”. Framing money in political terms is no doubt accurate. After all, it would be naïve to think that governments in liberal democracies would allow the private sector to control the terms of commercial and financial exchange. However, as we will show shortly, it seems obvious that government control over private sector exchange has begun to be quite regressive, not in the best interest of the vast majority of populations.)
BB: (Slide 25) “If not perfectly credible, a gold standard is subject to speculative attack and ultimate collapse as people try to exchange paper money for gold. The gold standard did not prevent frequent financial panics.”
QB: BB offered a gold standard that is not credible, and so as he suggests, it was (and would be) subject to speculative attack. This is no different than the current baseless monetary system, which is not credible and is, as we are seeing today, also subject to speculative attacks. The only reason today’s baseless currencies did not collapse in 2008 (or before) is because central banks can manufacture money, which delays reconciliation between the amount of debt denominated in that currency and the amount of base money in that currency (delays de-leveraging). This is the benefit (?) and justification for a system of central banks that may create unlimited quantities of currency when deemed necessary.
It is true that fixed-exchange rate gold standards did not prevent frequent financial panics; however, they did repair them far more quickly and with far less damage to broader commercial economies. Wage earners and savers benefitted. Creditors suffered.
BB: (Slide 26) “Although the gold standard promoted price stability over the long run, over the medium run it sometimes caused periods of inflation and deflation.”
QB: Really? This implies BB thinks the raison d’être of central banks is to avoid periods of inflation and deflation in the “medium run” that might occur “sometimes”? This is certainly inconsistent with past and current policies, which show an overwhelming emphasis on solving for short-term crisis management. And please recall that the general price level is purely a function of the supply and demand for goods and services, ONLY UNLESS THE STOCK OF MONEY OR CREDIT RISES OR FALLS (inflates or deflates) MORE, in which case the supply of money determines the GPL. Blaming gold for inflation and deflation is, well, either sloppy or a pre-meditated deception.
BB: (Slide 27) “In the second half of the 19th century, a global shortage of gold reduced the U.S. money supply and caused deflation (falling prices).”
QB: There cannot be a global shortage of gold because everything is relative. There can only be a shortage of gold at a certain exchange rate to government-issued media. If the gold price were to have risen then the U.S. money supply would have risen too, not have been reduced. (The elegance and obviousness of this logic makes one question the institutionalized intelligence of, or motivations behind, contemporary economics.) Demand for food and other inelastic items remained relatively constant. Falling prices were caused by consumers starved of money and credit and suppliers starved of working capital. (We can understand why banking systems and governments do not like fixed exchange rate gold standards. We cannot understand why wage earners at all levels do not demand floating rate gold standards.)
BB: (Slide 28) “William Jennings Bryan ran for President on a platform of modifying the gold standard.”
“You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.”
-William Jennings Bryan, July 9, 1896
QB: We agree that the gold standard, as practiced, was a political construct, as is the current monetary system. (We would also agree that politicians tend towards drama and populism, if that was BB’s point in including this frame.) However, if Mr. Bryan were alive today we are quite sure he would argue the following:
“You shall not press down upon the brow of labor this yolk of debt, you shall not shackle mankind to serve the banks.”
-The Ghost of William Jennings Bryan, 2012
Bryan was a populist and we would argue that the vast majority of populations in developed economies are not being served well by the current debt-based global monetary system. In today’s baseless monetary system labor cannot save its wages because banks may issue infinite credit that raises the general price level (GPL) above where it would naturally gravitate. If left to its own devices, prices would naturally fall, not rise, due to population growth, innovation, economies-of-scale, and productivity improvements. This would benefit all wage earners because a lower GPL would make wages more competitive vis-à-vis the goods, services and assets available for purchase. Affordability would rise for all economic participants, and would be especially beneficial to those at the lower end of the wage scale.
Obviously this is not the monetary system we have, which is premised on continually rising prices and policies that seek to ensure that. The current monetary regime issues credit and creates systemic debt. In this system asset price growth can outpace wage growth for long stretches of time. Asset prices, however, may be driven higher by the availability of credit, not rising demand or productivity. The debt build up that goes hand-in-hand with the credit build up creates a drag on demand and productivity. Unemployment rises. Debt cannot be serviced or repaid easily through wages.
Central banks must ultimately dilute the purchasing power of their currencies by manufacturing more currency with which debtors can repay their debts or with which creditors can extend new credit to debtors so they can roll over their debts. Any saved wages lose their purchasing power if held in that currency. This gives incentive to laborers not to save in the currency in which they are paid. Rather, they are forced to speculate in financial asset markets (directly or indirectly).
Clearly, today’s global monetary system is built for the global banking system. We think Mr. Jennings Bryan would argue it is a system of financial servitude and we are quite certain he would be as passionate about ending it as he was about ending the government-controlled fixed exchange rate gold standard.
BB: (Slide 32) “The 1920s-the “Roaring Twenties”- was a period of great prosperity in the United States. Elsewhere many countries struggled to recover from World War I.”
QB: The U.S. entered WWI late and as a result it did not deplete its gold stock. As a victor, the U.S. also did not have to pay reparations. This introduces a very big topic beyond the scope of this paper, but the U.S. remained a creditor with much of the world’s gold at a time when other developed economies were debtors with empty purses. Off-the-charts central bank generated inflation occurred in the Weimar Republic in 1922, causing the baseless currency to fail.
BB: (Slide 33) “In 1929, however, the world was hit by a Great Depression. The U.S. stock market crashed in October 1929, and the largest bank in Austria failed in 1931. Output and prices fell in many countries, and many experienced political turmoil. The Depression continued until the United States entered World War II in 1941.”
QB: BB frames these events as though they are beyond the influence of monetary policies. They are not, in fact central bank monetary policies in the twenties contributed greatly to them.
The stock market crash in October 1929 was the precise moment when a quorum of creditors and debtors acknowledged there was not enough money in the system to service and repay systemic debt. Throughout the 1920s, the Fed, the Bank of England and many other central banks maintained very easy monetary policies for their banking systems (“credit policies” would be more accurate, even today). “The Great Depression” that followed was in reality “The Great De-leveraging”. Because money was exchangeable for gold at a fixed exchange rate of $20.66/ounce, the only way to de-lever the system was to allow credit to deteriorate (rather than manufacture more money). Obviously this bankrupted most banks, which were fractionally reserved and saw the value of their loan books decline dramatically, and bankrupted many debtors who did not have enough gold in reserve against their debts.
Output contraction and political turmoil naturally followed, as BB suggests. The “Great Depression” was only made possible because there was a “Great Deleveraging” that took place in the “Roaring Twenties”. Banking systems greatly exaggerated natural commercial processes through unreserved finance then, just as they did from 1982 to 2007 (and did so in earnest from 1994 to 2006). The only difference between then and now is that economies can now de-lever by manufacturing money. This, policy makers aver, is why gold should be thought of as a “barbarous relic”. (Larry Summers likes to say the gold standard is “the creationism of economics”, implying he thinks econometric models and smart guys and gals can supersede commercial incentives over time.) We shall see.
BB: (Slide 38) “What Caused the Great Depression?
There were many causes, including
-economic and financial repercussions of World War I, including the effects of reparations (sic) payments
-the structure of the international gold standard
-a bubble in stock prices
-financial panic and the collapse of major financial institutions”
QB: We covered most of this above but feel it is important to address BB’s inclusion of “the structure of the international gold standard” in his list of causes of the Great Depression. This is true; the discipline of the gold standard did not allow the Fed or other central banks to print money in order to de-lever the banking system, as they are doing today.
However, four critical things should also be understood:
1) Money, per se, cannot cause economic or business cycles. Neither can monetary systems, including a gold standard. Money and monetary systems that do not reflect the real value of wages, goods, services and assets can and do cause business and economic cycles. The problem in the 1930s and today is that the value of money (not money and credit) is entirely inconsistent with the value of all things money is supposed to value.
2) Fractionally-reserved banking systems can and do cause economic and business cycles (in effect, credit cycles in which unreserved bank credit is built up into the system and ultimately reconciled through the de-leveraging process). BB blamed a money system when he should have blamed the unreserved banking systems.
3) Had bank asset values been allowed to decline immediately to levels at which they could be sold to savers (gold holders), output and unemployment would likely have rebounded with great haste. There would have been a shift of wealth from creditors to savers. This was not allowed to occur.
4) The jury is not yet out about the success of de-levering the economy through money manufacturing today, though we think it is safe to assume enough money will be made to fully reserve bank assets. We are unsure whether enough new money will be manufactured and distributed directly to debtors to meaningfully reduce the burden of repaying their debts. Rather, central bank precedent suggests necessary liquidity for debtors will be executed through the soon-to-be-well-collateralized banking system in the form of abundant new credit.
Rather than falling prices, we think the likeliest outcome from this type of de-leveraging is substantially rising prices, followed by even more substantially rising prices, followed by the demise of the baseless monetary system and a reversion to a hard money system. (We doubt the political exists to do away with fractionally-reserved banking.)
BB: (Slide 41) “The Fed kept money tight in part because it wanted to preserve the gold standard. When FDR abandoned the gold standard in 1933, monetary policy became less tight and deflation stopped.”
QB: The remark above is misstated. The Fed kept money tight because if it didn’t then dollar holders would have exchanged their dollars for Treasury’s gold, to the point of complete depletion, which would have bankrupted the government. When FDR abandoned the gold standard in 1933 (and forced all US citizens to turn in their gold to the government at $20.67), monetary policy became less tight and deflation stopped because dollars could no longer be exchanged for gold. (FDR then de-valued the dollar to $35.00 per ounce.)
BB: (Slide 48) “We will want to keep these lessons in mind as we consider the Fed’s response to the crisis of 2008-2009.”
Lee Quaintance & Paul Brodsky