One of the most puzzling questions from history is why smart people do such moronic things. Bonaparte was warned; it seemed obvious to anyone who knew the lay of the land that the Russian campaign was foolhardy. In WWI, both sides should have called it quits by 1917. And what was Rudolf von Havenstein thinking? The president of the Reichsbank printed up billion-mark notes; surely he must have known they would cause trouble.
But people come to think what they must think when they must think it. One decision leads to another one. Each one is rational, as far as it goes. But put them together and you are on your way to hell. Von Havenstein was just trying to keep the economy from collapsing. In the pageant of unwelcome possibilities, he judged inflation less ugly than a Bolshevik uprising.
The US central bank had its Havenstein moment last year, in March, when it began buying private sector securities – effectively adding billions to the world’s money supply. A worldwide bull market followed. Equities rose about 70%. At the end of March a year later, the “quantitative easing” program came to an end. After spending $1.2 trillion, the feds withdrew and the bull market ended. Since then, the S&P has lost 8% of its value. The Shanghai stock market has just hit a 12-month low and is now down 60% below its January 2008 high.
Now we see both how our modern monetary system began…and how it will end. In the sunny days of August, 1971, Richard Nixon was merely solving another problem caused by another solution. The solution to the world’s problems in the ’60s was to spend money on the war in Vietnam and the War on Poverty. The spending of the ’60s created the debts that Nixon had to reckon with – particularly to the French. Rather than pay the foreigners in gold, as had been customary for hundreds of years, the Nixon team defaulted. They changed the world’s monetary system, beginning the monetary equivalent of Napoleon’s march on Moscow.
They thought they were doing the world a favor. A more ‘flexible’ currency system would give financial authorities another powerful weapon with which to fight downturns. Instead of holding gold as their main monetary reserve, nations switched to holding each other’s paper. Henceforth, one’s reserve assets were another’s liabilities – all netting out to zero.
With this new weapon in their hands the feds won every battle – from the Latin American debt crisis of the ’80s to the mini recession of 2001. But the trouble with money that grows on trees is that you are soon raking it off your lawn. The pile of international reserves, other than gold, grew from under $300 billion in 1971 to more than $8.5 trillion today. Prices rose too. As measured in Britain, consumer prices rose as much in the last 40 years as in the entire preceding 700.
According to Alan Newman, daily trading volume has ballooned more than 25 times since the 1970s. The financial industry has gone from a minor activity representing only 3% of GDP in the ’70s, to a substantial 7.5% of GDP today…and its single major source of profits.
This financial dervish produced plenty of dust but less and less forward motion. Net private investment in the US hit a high in 1978 at about 8% of GDP. It has been declining ever since, recently hitting zero. After WWII, wages and real GDP increased steadily. But without investment in new plants and equipment, hourly wage gains stopped in the 1970s, while real GDP gains declined. People kept up appearances by borrowing heavily. But that only caused another problem.
The private sector is now solving the problem of too much debt by cutting back. Consumer credit is falling. Commercial and industrial loans are falling. The money supply, as measured by M3, is deflating at the fastest rate since the Great Depression – more than 9% annually. And prices – as measured by the US core CPI – are going up at the slowest paces since 1966.
This correction is natural and normal. But the feds want to stop it anyway. What can they do? ECB council member Patrick Honohan, from Ireland, has the answer. He applauds an “important new weapon,” referring to the very same hot cannon that blew up in Rudolf von Havenstein’s face 9 decades ago. The ECB has begun its own program of quantitative easing. It bought 35 billion euros of bonds in the first 3 weeks of the program.
“Restoring market confidence in the solidity of governments’ finances is absolutely crucial,” Honohan said.
Mr. Honohan is neither evil nor stupid. He is merely putting one foot in front of the other. He judges the need for confidence greater than the risk of inflation. Reasonable…as far as it goes. But where does it lead? The Rhine, the Niemen, and the Volga have all been breached. Sooner or later, he will be on the banks of the Berezina.
for Markets and Money