The US Federal Reserve’s Interest Rate Mess

Your Weekend Markets and Money of late has been exploring the work of forecaster Phil Anderson. But no introduction to Phil’s ideas could be complete without a thorough look at the modern banking system. Because two factors underpin Phil’s real estate cycle theory: the capitalised economic rent and the credit creation of modern banks.

If you caught last weekend’s edition of the WDR you’ll know we began by pointing out this: the banking system creates its own deposits, via their lending. This credit creation brings new money into existence.

Now Phil is not, as they say, a ‘hard money’ man. He doesn’t advocate a return to the gold standard. In fact, he sees credit creation as a necessary and fundamentally positive process for the general economy — with a caveat (or two). The main flaw in the process, he says, is whether the credit is created for productive purposes (say building a bridge) or speculation in what he calls ‘government-granted licenses and privileges’.

We’ll follow up on that point for you when we interview him next week for the series of videos we’re producing on his work. You can access those already made here for free. But one crucial aspect of Phil’s work is how the modern structure of our economy makes banks ridiculously larger and more powerful than they should ever be. Effectively, he says, society works for the banks, instead of the other way around.

One consequence of this is that they cannot be permitted to fail when they overreach. If your business goes bankrupt, dear reader, nobody gives a damn. But a bank? The government will allow money printing to high heaven to get them out of trouble.

As Phil pointed out this week, this is why the Federal Reserve Bank has done everything in its power to recapitalise the US banking system and return it to profitably after the collapse of 2008. Savers be damned. Driving down the interest rate means US banks can borrow from the Federal Reserve at under 1% and buy long term government bonds paying just under 3%. They then cream profits off the spread, all for doing sweet you know what. Beats going to work, doesn’t it?

The member banks own the Fed. The Fed IS the banks. Of course it will act for their benefit, not the average American or anyone else.

There will come a time however, Phil argues, when the Federal Reserve will raise interest rates and the spread the banks earn will narrow. That is to say, it will become less profitable for them to simply borrow from the Fed and buy governments bonds. That’s when they’ll go looking for credit growth by lending to consumers and business. Once again there will be times of ‘easy credit’. This sows the seed of another credit boom, and by then, according to Phil, we’re well into another real estate cycle.

You might be inclined to think we’re in times of easy credit right now. Not so, according to
Professor Steve Hanke at John Hopkins University. He argues that the US Federal Reserve Bank has actually adopted a contradictory monetary policy. How so?

Here’s the Professor:

‘The problem is that central banks only produce what Lord John Maynard Keynes referred to in 1930 as “state money”. And state money (also known as base or high-powered money) is a rather small portion of the total “money” in an economy. The commercial banking system produces most of the money in the economy by creating bank deposits, or what Keynes called “bank money”.

‘Since August 2008, the month before Lehman Brothers collapsed, the supply of state money has more than quadrupled, while bank money has shrunk by 12.1 percent – resulting in an anemic increase of only 4.5 percent in the total money supply (M4)… The public is confused – as it should be. After all, the US Federal Reserve has embraced contradictory monetary policies. On the one hand, when it comes to state money, the Fed has been ultra-loose. But, on the other hand, when it comes to the largest component of the money supply, bank money, a tight monetary stance has been embraced.’

The commercial banks have had to adjust to higher capital ratios under Basel III rules that govern banking, plus new regulations brought in by the Bank of International Settlements. This has restrained their lending. Hopkins calls it Bernanke’s Monetary Mess. But the history of banks says it won’t be long before the credit machine cranks again because credit growth drives bank profitability.

We’ll get a sense of where Phil sees all this going at his presentation at the World War D conference next week. Stay tuned to the DR as we turn correspondent for you and cover the big themes and speeches. You can get a 25% discount off the DVD here until Tuesday too, we should add.

We know Phil’s going on the record to talk about a coming boom over the next decade or so. That’ll make an interesting contrast with Richard Duncan, who will be talking about the coming depression. This will be no theoretical exercise, either. Where you put your money will depend on which you see coming. We have a feeling the crowd will favour the Duncan angle. But we’re sure Phil won’t mind. It is lonely on the other side of the crowd. But often, in the end, that’s where you want to be.


Callum Newman
for The Markets and Money Australia

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Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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