Life after death for asset inflation: this is what happens when “speculative fever” remains high even after monetary inflation has paused.
This may well have been the situation in global markets during 2019 so far. But history and principle suggest that life after death in this monetary sense is short.
Readers may find it odd to be talking about a pause in monetary inflation at a time when the Fed has cancelled programmed rate rises and the ECB has embarked (March 7) on yet further “radical” policy moves. Moreover, the “core” US inflation rate (as measured by PCE) is still at virtually 2 per cent year-on-year.
Yet we know from past cycles that in the early stages of recession many market participants — and, crucially, central banks — mistakenly view a stall in rate rises or actual rate cuts as stimulatory. Later with the benefit of hindsight these policy moves turn out to be insufficient to prevent a tightening of monetary conditions already in process but unrecognized.
Even had monetary conditions been easing rather than tightening, it is highly dubious whether this difference would have meant the powerful momentum behind the business cycle moving into its recession phase would have lessened substantially.
(As a footnote here: under a gold standard regime there is no claim that monetary conditions will evolve perfectly in line with contracyclical fine-tuning. Both in principle and fact monetary conditions could tighten there at first as recessionary forces gathered. Under sound money, however, contracyclical forces would emerge strongly into the recession as directed by the invisible hand.)
Under a fiat money regime, monetary tightening can occur in the transition of a business cycle into recession, despite the opposite intention of the central bank policy-makers, due to endogenous factors such as an undetected increase in demand for money or a fall in the underlying “money multipliers.” Quite possibly, what the markets first celebrated as a seeming Fed put eventually turns out to be a sick joke.
Like the policy of the central bank, the reported trend of officially measured inflation in goods and services market is a notoriously poor indicator of turning points in monetary inflation.
Fluctuations up and down in goods prices sometimes have nothing to do with monetary inflation. Students of Austrian school economics know that under sound money, prices would fluctuate in both directions for sustained periods. For example, there could have been a sustained period of falling prices under the influence of accelerated digitalization and globalization.
In the late stage of a business cycle expansion an upward drift of prices can form under the hypothesized sound money conditions and this may be happening in the present even as monetary inflation has waned.
Labor market normalization (return to balance) goes along with some pick-up of wages and productivity growth may coincidentally slow (perhaps related to a breather in the hectic pace of new technology application. In this cycle we could argue that the pace of globalization has slowed somewhat (of especially as the US confronts Chinese abuse of free market order in international economy). Maybe also the pace of digitalization has slackened (the “online” revolution surely does not proceed forever at the same hectic pace).
In sum, a late cycle rise of prices could be a false positive test of monetary inflation.
Moreover, just as official inflation data can be a lagging indicator of monetary inflation, so it is with the continuing symptoms of monetary inflation in the asset markets. Indeed, a Fed put may have inflamed those symptoms.
In searching for the presence (or not) of asset inflation we look for evidence of irrational forces under such banners as “search for yield” or “positive feedback loops.” A key focus is the carry trade, especially in currencies and credit. Alongside, we focus on the spread speculative narratives about which investors would be highly skeptical in sober rational mood (but monetary inflation erodes such skepticism). These characteristics can all outlive for some time monetary inflation, especially if the Fed has sought to exercise a put.
Even so, in this late stage the discerning monetary analysts can detect some tiredness about the narrative-telling. The chickens are coming home to roost from growing cumulative mal-investment – translating into pre-tax earnings peaking or going into reverse. Some disturbing counter narratives have emerged concerning the one-time hot speculations.
In many past business cycles, analysts in search of when the expansion and asset inflation are set to wane look for areas of unsustainable rises for key economic aggregates. In the last cycle, one example was residential construction in the USA. In other cycles it has been business spending overall — which would be broadly in line with Austrian School literature on the business cycle focusing on how monetary inflation distorts the relative price of capital goods in terms of consumer goods.
In this cycle though there has been no obvious such overall unsustainability at the level of broad economic aggregate in the US economy. In the emerging market economies by contrast, including China, that would be an easier case to make. In Europe or Japan, we could talk of the unsustainability of export sector growth based on emerging market bubble and their own manipulated cheap currencies.
Back to the US, the lack of obvious non-sustainability in a broad spending aggregate does not mean there is no recession danger — just the searchers for this must dig deeper. In particular, the overall mal-investment might be even greater than usual but concentrated in a few sectors where the speculative narratives have been intense — whether Silicon Valley or shale oil and gas. Mal-investment only shows up in many cases once the asset inflation and cycle expansion have come to an end.
In talking about main economic aggregates, the case can be made across the advanced economies that consumer spending might be in for a big fall once households realize that all was fantasy. Specifically, the high returns during the asset inflation from risk-assets including booming carry trades while they lasted made them tolerant of the manipulated low and widely negative returns on safe assets. Once gone, alarm sets in.
Even so there is a paradox to address about the present cycle. How has it been that such monetary wildness has gone along with apparent real economic moderation (no obvious unsustainable rise of broad economic aggregates)?
Fearing the Long Term
A plausible part-answer is that everyone and their dog know what the Federal Reserve and other central banks have been up to and all along have feared the eventual crash and great recession. Hence there has been a tendency for business owners to eschew long-gestation investments and focus on generating high returns via financial engineering instead (camouflaged leverage, momentum trading, carry trades).
Another part answer is the growth of monopoly power across the US economy as described by the star firm literature or more specifically in accounts of Big Tech. Specifically, the star firm theorists tell us that there is something about present technological advance — most likely its high specificity of investment much of which is intangible to the given firm with little scope for selling in a secondary market — which retards the percolation of progress beyond.
Monopolists respond often more sluggishly in their capital spending plans to manipulations down in the cost of capital than would firms in a competitive setting. Limiting supply is the name of their game.
Whatever the causes for subdued business capital investment overall in this cycle and more broadly for “real economic moderation” there is every reason to expect the real economic moderation which has coexisted with a wild monetary environment to end in immoderation. The illusion of economic moderation has fanned the carry trade into high yield credit and more broadly equity market valuations – and so the fall will be all the greater.
Watch: The Alex Jones Show
Total consumer debt broke another record in January, according to the latest report by the Federal Reserve.
Borrowing increased by $17.05 billion in the first month of 2019. The increase pushed overall consumer borrowing to a new $4.03 trillion record. That compares with $3.84 trillion in January 2018. That represents a 5.1% annual increase.
The consumer debt figures include credit card debt, student loans and auto loans, but do not factor in mortgage debt.
Revolving credit, which is primarily made up of credit card debt, rose $2.57 billion in January, pushing total American credit card balances to $1.06 trillion.
Nonrevolving credit, including borrowing for auto loans and student loans, was up by $14.47 billion in January. That comes on the heels of a $14.42 billion increase in December.
Alex Jones breaks down how globalist banking forces are conspiring to create the illusion that the policies of populists and nationalists come with financial ruin and collapse.
This piles on top of total US household debt (including mortgages) that climbed to a record $13.54 trillion in the fourth quarter of 2018. That figure was $869 billion higher than the previous peak of $12.68 trillion in the third quarter of 2008 (right before the crash) and 21.4% above the post-financial-crisis trough reached in the second quarter of 2013.
Mainstream financial analysts spun this as good news. As Bloomberg put it, the data suggests consumers are still willing to borrow, “with activity propelled by the strong labor market, higher wages and tax cuts.”
But this raises a question. If Americans are working, earning more and enjoying the benefits of tax cuts, why are they running up the credit cards? It seems just as likely they are charging it because they can’t make ends meet. And what happens to the US economy when the credit cards get maxed out? At some point, Americans have to pay back all of this debt.
Bloomberg also noted that “the Fed’s patience on raising interest rates may encourage lending.”
Of course, that’s the whole point of loose monetary policy and it helps explain the “Powell Pause.” The Fed simply can’t raise interest rates to anything resembling normal with Americans making payment on over $4 trillion in debt.
The Fed’s monthly consumer credit report does not include data on delinquencies, but the quarterly report revealed Americans are having an increasingly hard time making payments. For instance, the Q4 report said flows into serious delinquency for credit cards rose 5% in Q4, up from 4.8% in the third quarter. Meanwhile, performance in the auto loan sector is “slowly worsening.”
“Growing delinquencies among subprime borrowers are responsible for this deteriorating performance, and younger borrowers are struggling most acutely to afford their auto loans.”
Gerald Celente explains what’s ahead as the Federal Reserve is crashing the debt & real estate bubble it created worldwide.
The February jobs report came in significantly below expectations. First quarter GDP estimates are way down. And we’re seeing other numbers that indicate a rotting economic foundation.
But nobody is worried.
In fact, most of the attention continues to be focused on the trade deal as if it is going to push the economy to new heights. In his most recent podcast, Peter dug into some of the numbers and came to the conclusion that most of the analysts and pundits are utterly clueless about what’s really going on.
Last week, the Dow Transports wrapped up 11 straight days of declines. That hasn’t happened since 1971. And the last time the transports fell 10 straight days was in 2009 – during the great recession. Of course, we also got a bad February jobs report with just 20,000 jobs added. And Q1 GDP estimates remain below 1%. But by-and-large, pundits looked passed all of this bad news and continued to focus on the trade deal. As Peter pointed out, the trade deal seems to have become the economy’s white knight.
“Everybody is just ignoring these numbers because they are just blindly optimistic either they think it’s going to be this great trade deal or just because they’re so convinced. Everybody, Republicans, in particular, have convinced themselves that this is a great economy, this is a booming economy, and it’s their fault. It’s more wishful thinking.”
Peter said they are not looking at reality.
Speaking of reality, the February jobs report came in way below expectation. The estimate was for about 181,000 new jobs. It was the fewest job gains since September 2017 when major hurricanes temporarily curtailed employment.
Wage rates are up, but as Peter noted, there are two sides to that coin. From the employer’s perspective, this isn’t good news because it’s just another added cost. He pointed out that Whole Foods committed to paying all of its employees $15 per hour, but the company recently announced it was cutting hours. So, employees could actually end up taking home less pay despite the increase in their hourly wage.
Peter said he thinks the next step will be layoffs.
“Because as it becomes more expensive to keep your workers, well, then you fire your workers. I mean, employers will look for ways to reduce their overhead.”
Peter said this is a hint of stagflation. This is how it looks.
“Wages could be going up, but that doesn’t mean employment is going up. Employment can be going down as wages are going up, and so what good is a higher wage if you’re not earning it?”
Peter also talked about gold. The yellow metal has rallied after its recent correction. Peter said that it is going to go a lot higher.
“The reason it hasn’t already gone higher is because people still don’t understand the situation that we are in. In fact, I don’t think I’ve ever seen people more clueless, more oblivious to a problem than they are now.”
Just because we haven’t had a crisis yet doesn’t mean one isn’t on the horizon. Sometimes you can underestimate how long it’s going to take. Peter used a dam as an analogy. What if you think it’s going to break so you don’t want to build your house under it. People may make fun of you and say, “It’s fine. Stop worrying.” And then they start building there. The community grows. Years go by and nothing happens. Then, 15, 20 years later, the dam breaks and the community gets wiped out.
“It turns out I was right. I was just early. But if I built my house someplace else, I didn’t get wiped out. Maybe it seemed like I was wrong because for a while what I was warning about didn’t happen because I underestimated how long it would take the dam to break. But the fact of the matter is it broke.”
We need to look beneath the surface. We have to take into account sound economic theory.
“We had an orgy on debt. We have destroyed the economic foundations of this country. We have hollowed out our industrial base. There have been real problems that have been growing beneath the surface as a result of these budget deficits and trade deficits that everybody have been ignoring because they are focusing on the wrong thing.”
Paul Joseph Watson reveals that the Basilica of Saint-Denis was heavily damaged in Paris by vandals in one of the city’s suburban “no-go” zones where primarily Muslim migrants are held by the government.
Context is key.
During last week’s Friday Gold Wrap podcast, Mike Maharrey emphasized the importance of understanding sound economic theory.
Without a firm grasp of basic economic principles, it becomes impossible to properly evaluate any observations you make and to properly interpret economic data.
As economist Frank Shostak put it in a recent article published at the Mises Wire, “In order to really make sense of the data one must have a theory, which stands on its own feet, and did not originate from the data. By means of a theory, one could scrutinize the data and could then try to make sense out of it.”
Mike Adams exposes the agenda of the private Fed as a war against the prosperity of Americans that simply want to make America great.
Shostak goes on to explain the most fundamental economic concept and how we can use the framework of “human action” to better understand economic data.
The following article by Frank Shostak was originally published on the Mises Wire. The views expressed are his own and do not necessarily reflect the views of Peter Schiff or SchiffGold.
Could historical data by itself serve as the basis for the factual assessments of the world of economics? It is believed that through the application of statistical methods on historical data, or just by gazing at the data, one could extract the facts of reality regarding the world of economics. But in order to really make sense of the data, one must have a theory, which stands on its own feet, and did not originate from the data. By means of a theory, one could scrutinize the data and could then try to make sense out of it.
The key ingredient of such a theory is that it must originate from something real that cannot be refuted. A theory that rests on the foundation that human beings are acting consciously and purposefully fulfills this.
Contrary to popular thinking, economics is not about GDP, the CPI, or other economic indicators as such, but about human activities that seek to promote people’s lives and well-being. One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.
Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals such as buying food or clothing. Dining in a restaurant could be a means to establishing business relationships. Driving a car could be a means for reaching a particular place. In other words, people operate within a framework of ends and means; they are using various means to secure ends.
Purposeful action implies that people assess or evaluate various means at their disposal against their ends.
At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated — i.e., people’s living standards is going to increase.
Another limitation on reaching various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard.
That human beings are acting consciously and purposefully cannot be refuted, for anyone that tries to do this does it consciously and purposefully i.e. he contradicts himself.
Ludwig von Mises, the founder of this approach, labeled it as praxeology. By stating that human beings act consciously and purposefully Mises was able to derive the entire body of economics.
Causes in economics originate from human beings
That man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors.
For instance, by looking at the data without a coherent framework of thinking one could fit any theory to provide an explanation of what the heart of economic growth is all about.
However, if we start from the fact that human beings are operating in the means-ends framework then one is likely to establish that without an expansion in the means of sustenance no sustainable expansion in economic growth is going to emerge.
In his framework of thinking, Mises was very precise in presenting the essence of the terms he employed. For Mises defining the terms was the key for successful analyses. For instance, his analysis of money begins by establishing the definition of money. To do that Mises started from the beginning — at the point where the world was in a state of direct exchange.
According to Mises the distinguishing characteristic of money, that it is the general medium of exchange. It has evolved from the most marketable commodity. On this, he wrote,
“There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.”
Money is the thing that all other goods and services are traded for. This fundamental characteristic of money must be contrasted with other goods.
For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that in turn will permit the production of a larger quantity of goods and services.
Once the definition of money is established, we are now ready to explore the interactions between money and various parts in an economy.
Two Kinds of Economists
In mainstream economics there are two types of economists — in one camp, there are the so-called theoreticians, or “ivory-tower economists,” who generate various imaginary models and use them to form an opinion on the world of economics.
In the other camp, we have the so-called “practical” economists, who derive their views solely from the data.
Whereas the ivory-tower economists are of the belief that the key to the secret of the economic universe is via abstract models, the “practical” economists hold that if one “tortures” the data long enough, it will ultimately confess and the truth will reveal itself.
Economic theory, however, must have only one purpose — to explain the essence of the subject matter of economics. However, statistical methods are of no help in this regard. All that various statistical methods can do is just compare the movements of various historical pieces of information. These methods cannot identify the driving forces of the world of economics.
Likewise, models that are based on economists’ imaginations are not of much help either since these theories are not ascertained from the real world.
For example, in order to explain the economic crisis in Japan, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model could be useful in offering solutions to the economic crisis in Japan.
Using Data Within the Context of Human Action
The knowledge that human actions are conscious and purposeful allows us to make sense out of historical data. According to Murray Rothbard,
One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was in looking at Grand Central Station behavior during rush hour. The “objective” or “truly scientific” behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine “scientist”.
To undertake the identification of a data, one is required to reduce it to its ultimate driving force, which is purposeful human action. For instance, during an economic slump, a general fall in the demand for goods and services is observed. Are we then to conclude that the fall in the demand is the cause of an economic recession?
We know that people persistently strive to improve their life and well-being. Their demands or goals are thus unlimited. The only way then for general demand to fall is via people’s inability to support their demand. In short, problems on the production side, i.e., with means, are the likely causes of an observed general fall in demand.
Data and Money Production
Alternatively, consider the situation in which the central bank announces that increasing money supply growth while price inflation is low could lift real economic growth. To make sense of this proposition we must examine the essence of money. Money is the medium of exchange. Being the medium of exchange, money can only facilitate existing real wealth. It cannot create more wealth. Money cannot be used in production. It cannot be used in consumption. Hence, we can conclude that printing money is not the right mean to promote economic growth. In other words, the goal — of lifting real economic growth — cannot be achieved by means of printing money. On the contrary, we can establish that printing money is going to set in motion an exchange of nothing for something and thus the weakening in the wealth-generating process.
The knowledge that people are pursuing purposeful actions also permits us to evaluate the popular way of thinking that holds that the “motor” of an economy is consumer spending — i.e., demand creates supply. We know, however, that without means, no goals can be met. However, means do not emerge “out of the blue” — they must be produced first. Hence, contrary to the popular thinking, the driving force is supply and not demand.
The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. Whilst it is true that people will respond to increases in their incomes, the response is not automatic. Every individual assesses the increase in income against the particular set of goals he wants to achieve. He might decide that it is more beneficial for him to raise his investment in financial assets rather than to raise consumption.
Data by itself cannot produce much information about the facts of reality without a theory that “stands on its own feet” and is not derived from the data.
Gazing at the data cannot assist an analyst in establishing causes in the world of economics. All that gazing will do is to help describe things. To ascertain the underlying causes one requires an explanation that can be made by a logically worked out theory.
The arbitrary nature of mainstream economics has given rise to the view that there is a gulf between theory and practice. There is no such thing as a good-but-not-applicable theory. A good theory is also an applicable one.
Economists and various other financial experts who derive their knowledge of the economy solely from statistical correlations of various historical data or from pure gazing at the data run the risk of misleading themselves and their audiences.
Likewise, economists who base their views on imaginary models are not in a position to say anything meaningful, and whatever they utter is just plain arbitrary.
Words have become redefined by the left over time. Owen Benjamin breaks down how that shapes reality.
Right after the last Federal Reserve Open Market Committee meeting, Peter Schiff said the “Powell Pause” won’t be enough to save the stock market and head off a recession.
He said ultimately, the central bank would have to cut interest rates and launch another round of quantitative easing.
Well, it seems the mainstream is starting to catch up with Peter’s thinking. Yesterday, Bloomberg ran an article asserting that “instead of pausing, the central bank may need to start cutting interest rates to avoid a recession.”
After the Jerome Powell indicated that the pause was on during the last FOMC meeting, Peter said it wouldn’t be long before the Fed would pivot toward rate cuts. He said it was inevitable because the economy is hooked on easy money and you can’t just take the drug away.
“I think that soon the markets are going to be demanding a lot more from the Fed than just a cessation of rate hikes and a commitment not to shrink the balance sheet. I think what the addicts are going to require is going to be more quantitative easing and a return to zero, and that is exactly what the Federal Reserve is going to provide once it realizes that’s what’s necessary.”
The Bloomberg article by Lakshman Achuthan and Anirvan Banerji makes a similar assertion, arguing that “first, the cyclical slowdown in growth that precipitated the plunge in stocks in the fourth quarter isn’t about to end. Second, everyone seems to have forgotten that monetary policy impacts economic growth and inflation with ‘long and variable lags.’”
“Removing the risk of a recession and sparking a renewed acceleration in economic growth – never mind reigniting inflation pressures – will require much more than the doctrine of primum non nocere, meaning first, do no harm. The Fed would actually need to start a rate cut cycle.”
Peter said even if the Fed does turn to rate cuts, and QE, it’s not going to work. A recession is a done deal and another infusion of easy money will unleash inflation and a dollar crisis.
The Bloomberg article also asserts that it may be too late to avert a recession, although for different reasons. Achuthan and Banerji say the Fed waited too long.
“Even if [the rate cut cycle] happened in short order, Milton Friedman’s observation that ‘monetary actions affect economic conditions only after a lag that is both long and variable’ virtually guarantees that the economy wouldn’t feel much of an impact this year. Recall that, despite the Fed rate cut cycles starting in January 2001 and September 2007, recessions began two and three months later.”
There’s another parallel between what Peter has been saying and this Bloomberg article. They both pinpoint the same reason for the Fed’s sudden dovish turn.
Keep in mind, as recently as September, Jerome Powell was talking about multiple rate hikes in 2019 and insisted that the balance sheet reduction plan was on “autopilot.” So, what changed in a few short months? As Peter said, nothing really changed in the economy. It was all about the stock market.
“Yes, we had a government shutdown; the government shutdown is over. Not that big a deal. I mean, there has been weak economic data, but there’s been weak economic data that the Fed has been ignoring the entire time … The only thing that’s really changed between the September meeting and today is a bear market in stocks. The bear market that happened in the fourth quarter of last year and the acceleration of the downtrend that accompanied the last rate hike the Fed delivered in December. That’s the only substantive difference between now and then. And that’s the only reason the Federal Reserve has done a complete 180 when it comes to monetary policy.”
And from Bloomberg:
“In fact, the Fed’s dovish about-face was predictable. After all, it was a reaction to the 14 percent plunge in the S&P 500 Index during the fourth quarter, triggered by the market’s belated realization that economic growth was slowing amid concern that the Fed was exacerbating the problem with its intent to keep raising rates.”
Of course, Achuthan and Banerji are drawing their conclusions from a vastly different economic point of view than Peter. They appear to support all of this Federal Reserve intervention into the economy. They seem frustrated that the central bank hasn’t been aggressive enough. And they seem to ultimately believe in the efficacy of this monetary central planning. But it’s interesting that their worldview leads them to call for exactly what Peter has been predicting all along.
And it’s also interesting to note the hint of bearishness entering into the mainstream discussion. Achuthan and Banerji, at least, seem to think it might be too late.
“If the US slowdown continues until the opening of a recessionary window of vulnerability, within which almost any negative shock would trigger recession, it will be too late for the Fed to head off a hard landing, as it was before the 2001 and 2007-09 recessions.”
The Federal Reserve’s doors have been open for “business” for one hundred years.
In explaining the creation of this money-making machine (pun intended — the Fed remits nearly $100 bn. in profits each year to Congress) most people fall into one of two camps.
Those inclined to view the Fed as a helpful institution, fostering financial stability in a world of error-prone capitalists, explain the creation of the Fed as a natural and healthy outgrowth of the troubled National Banking System. How helpful the Fed has been is questionable at best, and in a recent book edited by Joe Salerno and me — The Fed at One Hundred — various contributors outline many (though by no means all) of the Fed’s shortcomings over the past century.
Others, mostly those with a skeptical view of the Fed, treat its creation as an exercise in secretive government meddling (as in G. Edward Griffin’s The Creature from Jekyll Island) or crony capitalism run amok (as in Murray Rothbard’s The Case Against the Fed).
In my own chapter in The Fed at One Hundred I find sympathies with both groups (you can download the chapter pdf here). The actual creation of the Fed is a tragically beautiful case study in closed-door Congressional deals and big banking’s ultimate victory over the American public. Neither of these facts emerged from nowhere, however. The fateful events that transpired in 1910 on Jekyll Island were the evolutionary outcome of over fifty years of government meddling in money. As such, the Fed is a natural (though terribly unfortunate) outgrowth of an ever more flawed and repressive monetary system.
Before the Fed
Allow me to give a brief reverse biographical sketch of the events leading up to the creation of a monster in 1914.
Unlike many controversial laws and policies of the American government — such as the Affordable Care Act, the Troubled Asset Relief Program, or the War on Terror — the Federal Reserve Act passed with very little public outcry. Also strange for an industry effectively cartelized, the banking establishment welcomed the Fed with open arms. What gives?
By the early twentieth century, America’s banking system was in a shambles. Fractional-reserve banks faced with “runs” (which didn’t have to be runs with the pandemonium that usually accompanies them, but rather just banks having insufficient cash to meet daily withdrawal requests) frequently suspended cash redemptions or issued claims to “clearinghouse certificates.” These certificates were a money substitute making use of the whole banking system’s reserves held by large clearinghouses.
Both of these “solutions” to the common bank run were illegal as they allowed a bank to redefine the terms of the original deposit contract. This fact notwithstanding, the US government turned a blind eye as the alternative (widespread bank failures) was perceived to be far worse.
The creation of the Fed, the ensuing centralization of reserves, and the creation of a more elastic money supply was welcomed by the government as a way to eliminate those pesky and illegal (yet permitted) banking activities of redemption suspensions and the issuance of clearinghouse certificates. The Fed returned legitimacy to the laws of the land. That is, it addressed the government’s fear that non-enforcement of a law would raise broader questions about the general rule of law.
The Fed provided a quick fix to depositors by reducing cases of suspensions of their accounts. And the banking industry saw the Fed as a way to serve clients better without incurring a cost (fewer bank runs) and at the same time coordinate their activities to expand credit in unison and maximize their own profits.
In short, the Federal Reserve Act had a solution for everyone.
Taking a central role in this story are the private clearinghouses which provided for many of the Fed’s roles before 1914. Indeed, America’s private clearinghouses were viewed as having as many powers as European central banks of the day, and the creation of the Fed was really just an effort to make the illegal practices of the clearinghouses legal by government institutionalization.
Why Did Clearinghouses Have So Much Power?
Throughout the late nineteenth century, clearinghouses used each new banking crisis to introduce a new type of policy, bringing them ever closer in appearance to a central bank. I wouldn’t go so far as to say these are examples of power grabs by the clearinghouses, but rather rational responses to fundamental problems in a troubled American banking system.
When bank runs occurred, the clearinghouse certificate came into use, first in 1857, but confined to the interbank market to economize on reserves. Transactions could be cleared in specie, but lacking sufficient reserves, a troubled bank could make use of the certificates. These certificates were jointly guaranteed by all banks in the clearinghouse system through their pooled reserves. This joint guarantee was welcomed by unstable banks with poor reserve positions, and imposed a cost on more prudently managed banks (as is the case today with deposit insurance). A prudent bank could complain, but if it wanted to use a clearinghouse’s services and reap the cost advantages it had to comply with the reserve-pooling policy.
As the magnitude of the banking crisis intensified, clearinghouses started permitting banks to issue the certificates directly to the public (starting with the Panic of 1873) to further stymie reserve drains. (These issues to the general public amounted to illegal money substitutes, though they were tolerated, as noted above.)
Fractional-Reserve Free Banking and Bust
The year 1857 is a somewhat strange one for these clearinghouse certificates to make their first appearance. It was, after all, a full twenty years into America’s experiment with fractional-reserve free banking. This banking system was able to function stably, especially compared to more regulated periods or central banking regimes. However, the dislocation between deposit and lending activities set in motion a credit-fueled boom that culminated in the Panic of 1857.
This boom and panic has all the makings of an Austrian business cycle. Banks overextended themselves to finance the booming industries during America’s westward advance, primarily the railways. Land speculation was rampant. As realized profits came in under expectations, investors got skittish and withdrew money from banks. Troubled banks turned to the recently established New York Clearing House to promote stability. Certain rights were voluntarily abrogated in return for a guarantee on their solvency.
The original sin of the free-banking period was its fractional-reserve foundation. Without the ability to fund lending activity with their deposit base, banks never would have financed the boom to the extent that it became a destabilizing factor. Westward expansion and investment would still have occurred, though it would have occurred in a sustainable way funded through equity investments and loans. (These types of financing were used, though as is the case today, this occurred less than would be the case given the fractional-reserve banking system’s essentially cost-free funding source: the deposit base.)
In conclusion, the Fed was not birthed from nothing in 1913. The monster was the natural outgrowth of an increasingly troubled banking system. In searching for the original problem that set in motion the events culminating in the creation of the Fed, one must draw attention to the Panic of 1857 as the spark that set in motion ever more destabilizing policies. The Panic itself is a textbook example of an Austrian business cycle, caused by the lending activities of fractional-reserve banks. This original sin of the banking system concluded with the birth of a monster in 1914: The Federal Reserve.
Stewart Rhodes and Alex Jones reveal to listeners how lawmakers in the Texas State Government are taking building the wall into their own hands.