The Federal Reserve Goes ‘Full Retard’ Part II

Dear Diary,

When we left off yesterday, we were explaining how the feds had unlearned the three critical lessons of more than 2,000 years of market history:

1) Make sure the money is backed by gold (otherwise it loses its buying power).
2) Don’t let the government spend too much money it doesn’t have (otherwise it will cause havoc).
3) Don’t try to centrally plan an economy… especially not with fixed prices (or you’ll soon have a wealth-destroying mess on your hands).

The US took gold out of the global monetary system through two closely related measures: the first, taken by President Johnson, in 1968, when he removed the requirement of the dollar to be backed by physical gold; the second, taken by President Nixon, in 1971, when he ended the direct convertibility of the dollar to gold.

The US federal budget was last balanced (not counting Social Security contributions) under President Carter. It hasn’t been balanced since.

And after 1980, when the Republican Party became the Party of Big Spenders, there was no hope of controlling federal deficits.

Since then, the only two electable political parties were in favour of spending more than the government collected in taxes. Republicans wanted to spend on an activist agenda overseas. Democrats wanted to spend on an activist agenda at home.

In the resulting compromise, they agreed to overspend on both.

Manipulating prices

The government, meanwhile, manipulated prices lightly before…then heavily after…the Black Monday crash in 1987.

Nixon had tried general price controls in 1971. Those were quietly abandoned and quickly forgotten.

But after the October 1987 crash, the new Federal Reserve chairman, Alan Greenspan, began to closely manage and grossly distort the single most important price in capitalism: the price of credit.

As political appointees with a mandate to make life as easy as possible for their masters in Washington, naturally, Greenspan and his successors had a bias to fix the price of credit ever lower…until it finally hit zero in 2009.

That’s where the Federal Reserve funds rate — the rate at which banks lend money on deposit with the Fed to each other overnight and the base rate for all other credit — has been for the last five and a half years.

As the price of credit went down, the price of assets went up. Dot-com stocks in the 1990s. Real estate in the 2000s. Now just about everything is inflating — fast. Even consumer prices are starting to show signs of bloating.

This inflation was more or less what the Feds were looking for. They wanted to mislead entrepreneurs into believing there was more demand than there really was. They also wanted investors to believe they were richer than they really were.

On this last objective they were rewarded with rampant speculation, risk taking, complacency and grotesque distortions.

When capital is free…

Putting so much money in the hands of the moneyed classes led them to feel cavalier about it.

The fix was in…and they knew it. They quickly realized that speculating on further distortions would deliver more immediate profits than investing in capital stock and new ventures…even though only these types of long-term investments would create more genuine demand.

This was the most retarded part of the Federal Reserve’s program. By making it appear that real capital had no value (wasn’t the price of it near zero?) they gave investors little incentive to create more of it.

Instead, speculators took their EZ credit and used it for various forms of gambling and financial engineering.

Buybacks, buyouts, LBOs, M&As — corporate debt rose as corporate managers figured out ways to get more cheap money into their pockets.

One of the classics was to buy a corporation…have the corporation borrow heavily (which even the junkiest business could do)…then pay out huge fees to managers and manipulators.

Lending standards are so lax…and lenders so forgiving…the sharpies can get away with almost anything. Reagan’s former budget director David Stockman elaborates:

[I]t is plainly evident that most of the massive expansion of business credit since the last peak has gone into…stock buybacks, LBOs and cash M&A deals — not expansion of productive business assets.

Indeed, total non-financial business credit outstanding has risen from $11 trillion in December 2007 to $13.8 trillion at present, or by 25%, yet real business investment in plants and equipment is still $70 billion or 5% below its pre-crisis peak.

None of this should be surprising. It’s what you get when you artificially set the price of credit too low for too long. It’s like selling diamonds too cheaply; pretty soon customers will be gluing them to the backs of their blue jeans.

The result is less genuine demand.

Remember Say’s Law of Markets (named after French economist Jean-Baptiste Say): ‘Products are paid for with products.’ In other words, production is the source of demand.

Demand comes from output, not from printing money. If you could boost real demand simply by printing money, we’d all be rich already.


Bill Bonner,
for Markets and Money

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Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America’s most respected authorities. Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind Markets and Money.

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