Reality Check: 20120727

Here is Gary’s article,  The Monetization of Everything. For more by Gary, visit his website at http://www.garynorth.com/.

This essay is about what the Fed can do in terms of monetization and what it likely will not do. As he observes:

The Federal Reserve System can monetize anything. It can create digital money and buy any asset it chooses to buy. There are no legal restrictions on what it is allowed to monetize. If it were to do this, and it continued to do this, the dollar would fall to zero value. This would produce hyperinflation.

Other points he makes are:

  • the Federal Open Market Committee will have to …  decide: mass inflation (20%) or hyperinflation (QEx). They will have to decide: recession or hyperinflation.
  • The FED [actively intervened in the market and] inflated the monetary base in order to prevent this, contrary to the account by Friedman and Schwartz in their famous book, “A Monetary History of the United States” (1963). Depositors thwarted the FED, 1931-33 [by withdrawing their deposits, bankrupting banks and deflating the money supply].
  • The system overcame the collapse of Lehman Brothers. They will assume that credit liquidation will be orderly. If it isn’t, they can intervene one more time. [It won’t because there are trillions of unused liquidity in the system globally. Adding more will achieve nothing.]
  • These effects [of hyperinflation] cause losses in production. They disrupt the banks, especially the large banks. Banks lend money; then they are repaid in money of vastly depreciated value.
  • Central bankers … resist hyperinflation.
  • The price movements within the capital markets are not the same as price movements in the consumer goods markets.
  • central banks have their choice of catastrophes: deflation/depression vs. hyperinflation/depression.

Gary’s essay follows.

Issue 1190 July 27, 2012

THE MONETIZATION OF EVERYTHING

What the Federal Reserve System can do and what it
will do are two different things.

The Federal Reserve System can monetize anything. It
can create digital money and buy any asset it chooses to
buy. There are no legal restrictions on what it is allowed
to monetize.

If it were to do this, and it continued to do this,
the dollar would fall to zero value. This would produce
hyperinflation. The result would be the destruction of all
dollar-based creditors. Debtors could pay off their loans
with the sale of an egg or a pack of cigarettes. This is
what farmers did in 1923 in Germany and Austria.

The economists who advise the Federal Reserve System
know this. The bankers who run the banks that own the
shares of the 12 regional FED banks know this. Bernanke
knows this.

The day will come when the decision-makers on the
Federal Open Market Committee will have to fish or cut
bait. They will have to decide: mass inflation (20%) or
hyperinflation (QEx). They will have to decide: recession
or hyperinflation.

Will they see that it’s really Great Depression 2 vs.
hyperinflation? I don’t think so. They have been able to
manipulate the economy for over 90 years between recessions
and booms. Only once did it become a depression: 1930-40.
That depression became deflationary, 1931-34, because the
Federal Deposit Insurance Corporation (1934) did not exist.
Depositors took their money out and did not redeposit it.
That created monetary deflation through the bankruptcy of
banks. The fractional reserve process imploded.

The FED inflated the monetary base in order to prevent
this, contrary to the account by Friedman and Schwartz in
their famous book, “A Monetary History of the United
States” (1963). Depositors thwarted the FED, 1931-33. A
chart produced by a senior official at the St. Louis FED
should forever silence those economists who think that
Friedman and Schwartz proved the case of FED “complacency.”
It won’t, of course. The Friedman/Schwartz story is just
too convenient for pressuring the FED to inflate. Friedman
and Schwartz wrote the single most important book favoring
FED inflation ever written, because it is universally
believed in academia. The only section of the book ever
cited by mainstream economists is the section on the FED in
the early 1930s. That story is analytical and historical
bunk. Here are the facts:

http://clicks.dailyreckoning.com//t/AQ/AAu8FQ/AAvP5Q/AAcpcw/AQ/AaAj7w/YmO1

Today, depositors could do it again. If the FDIC were
not backed up by a $600 billion line of credit from
Congress, we might see it happen again. But there is a line
of credit. That calms depositors.

The creditor — Congress — is the world’s biggest
debtor. Congress is running a $1.2 trillion deficit each
year. But it has central banks to cover the debt: Japan’s,
China’s, America’s. So, the depositors believe that
Congress can save the FDIC, which will save the banks. They
leave their money in banks. If they pull money out of bank
A, they deposit it in bank B. The system does not lose
deposits. There is no deflation. The fractional reserve
system survives.

The system has worked for a long time. The day of
ultimate reckoning has been delayed. I think this has given
central bankers a sense of confidence. They will think that
one more refusal to go to hyperinflation will succeed. They
will not believe that the refusal to pump new digital money
into the system will bring on Great Depression 2. They will
believe in their ability to manipulate the system one more
time.

The system overcame the collapse of Lehman Brothers.
They will assume that credit liquidation will be orderly.
If it isn’t, they can intervene one more time.

DEFERRING THE DAY OF RECKONING

The leader of Europe’s central bank has for months
verbally played the deferral game, while inflating wildly.
Mario Draghi has kept saying that the ECB will not monetize
PIIGS’s debts, but it has done so indirectly by allowing
national central banks and commercial banks to buy PIIGS’s
bonds, and then use these bonds as collateral for ECB
loans. It has been a version of Angela Merkel’s verbal
assurances that she will not sell out her nation to the
Eurocrats, and then selling out her nation to the Eurocrats
every time. “Her lips say no-no, but her eyes say yes-yes.”

On July 26, Draghi gave a speech in London. He finally
let his rhetoric catch up with the ECB’s actual practices.
He said the following. “Within our mandate, the ECB is
ready to do whatever it takes to preserve the euro. And
believe me, it will be enough. To the extent that the size
of the sovereign premia [borrowing costs] hamper the
functioning of the monetary policy transmission channels,
they come within our mandate.”

World stock markets rose by at least 1% within
minutes. Spain’s stock market rose a huge 6% in hours.

What he said was in fact a cry of desperation. He does
not know what to do, other than to inflate. He knows he
must break the Maastricht treaty that created the EU, but
he does not have any choice. He has defined out of
existence the treaty’s limits on the ECB. He defines his
mandate broadly. He knows that Spain is close to default.
The ECB must buy Spain’s bonds, or else provide funds for
some other agencies to buy Spain’s bonds. The weekend
summit meeting less than a month ago has already broken
down. Spain’s ten-year bond rate went above the failsafe 7%
figure.

The European banking system is being propped up by
monetary inflation. There are signs that this cannot go on
much longer, but the central bankers have enormous self-
confidence. They believe that fiat money can delay any
major crisis. They believe that fiat money is the ultimate
ace in the hole. So do Keynesians. So do politicians. They
really do believe that the exclusive government monopoly
authority to supervise the creation of digits is the basis
of prosperity.

Investors invest digits called money. They are
convinced that the ability of central banks to create
digits has created a failsafe for investors’ digits. They
believe that a prudent mixture of digit-generating
investments will gain them a positive rate of return, as
measured in digits, just so long as the total number of
digits is always increasing. This is the key to every
investment strategy that is tied to “digits invested now,
more digits to invest later”: an ever-increasing supply of
digits.

You might think that investors would judge their
success in investing by increased real income: stuff, not
digits. But the vast majority of investors assume that
stuff will inevitably take care of itself, if only the
supply of digits is increasing. Here is the mantra of this
generation: “The system of stuff production depends on a
steady increase in the supply of digits.”

This is why there is no resistance to central bank
monetization. On the contrary, there is cheering. The
journalists follow the economists. The economists have
adopted the mantra of digits with the zealous commitment of
any priesthood. Milton Friedman is their high priest.

FRIEDMAN, NOT KEYNES

Keynes argued for government spending to save the
system. This is universally believed by academic
economists. But there is a problem with this scenario:
interest rates. Governments must borrow. From whom? At what
rates?

Keynes had little to say analytically about central
banks, yet central banking is at the heart of government
debt. Economists can intone the mantra, “government
spending,” but this does not answer the economist’s
universal question: “At what price?”

That is where Friedman enters the picture. Keynes was
the prophet of government spending. Friedman was the guy
with the green eyeshade in the back room. He ran the books.
Without Friedman, Keynes & Company would have folded during
World War II.

Keynes was the academic prophet of big government.
Friedman was the high priest of big central banking. The
high priest raises the money. Every prophet needs a high
priest, or else the religion disappears.

Friedman argued for decades that the banking system
need only create money at a rate of 3% to 5% per annum for
the economy to prosper.

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I never saw anyone make this observation: 5% is 66%
more than 3%, so Friedman was not recommending anything
like stable money. Nevertheless, the monetarists adopted
his mantra. So, the free markets’ best-known academic
defenders universally accepted the legitimacy of a
government monopoly, central banking, as well as a
government-licensed cartel, fractional reserve commercial
banking. Only the Austrian School economists rejected this
legal arrangement, and there were few of them. None had any
influence.

Keynes gets the credit as the supreme economist of the
era, but Friedman was more important operationally. Keynes
promoted government spending, but said little about central
banking. In contrast, Friedman provided the theoretical
justification for the funding of government deficits by
central bank purchases of government debt.

The trouble was this: the deficits during major
recessions were so large that a steady 3% to 5% increase in
the money supply did not suffice. More was needed. The
central bankers then took their monopoly and put it to
immediate use: unlimited expansion of money. That was what
the FED did in 2008.

The predictability of steady monetary inflation never
was honored. Friedman’s defense of central banking was
well-received by the Keynesian economists. His limit of 3%
to 5% was of course ignored. The central banks did not
adhere to the limit, any more than the Internal Revenue
Service adhered to the 1943 withholding tax law as a
temporary wartime measure. Friedman provided the
intellectual support for that law, too.

Once you consecrate the priesthood, you will find that
the limitations which you specified are no longer taken
seriously by the priesthood. Call this the Nadab and Abihu
factor. Call it the sons of Eli factor. It always appears.

Friedman gave repeated theoretical justifications for
the actions of the federal government, based on an official
position of limited government. In the two most important
areas of economic policy, income taxation and central bank
legitimacy, he stood squarely behind the federal
government.

Once consecrated, the government agencies paid no
attention to his practical restrictions on the exercise of
power. This is the curse of everyone who recommends a
government policy to make government more efficient. This
merely furthers the expansion the power of government into
new areas of the economy. Then the politicians and central
bankers ignore the recommended practical limits that were
supposed to guarantee liberty and its blessings. The
camel’s supposedly efficient nose becomes its entry point
into the tent.

LIMITS TO HYPERINFLATION

The main limit is a currency unit of zero value. The
idea behind hyperinflation is for the government to be able
to buy goods and services without raising visible taxes.
This policy ceases to function when the monetary unit falls
to zero value. At that point, the currency unit has only
one practical economic function: to pay off debt.

Once the state overcomes its debts through
hyperinflation, the benefits to the state of further
inflation cease to exist. It can no longer buy anything of
value.

The economy goes to barter before hyperinflation
reaches its theoretical limit of zero purchasing power. The
tax authorities cannot easily assess taxes in barter
transactions. Most barter transactions are not recorded. If
a business must report these transactions, it pays its
taxes at the end of the tax period. By then, the purchasing
power of the monetary unit has fallen. A tax bill is a
debt. Hyperinflated money is excellent for paying debts.

So, the government starts over. It kills the old
currency. It knocks off lots of zeroes. Then the process
begins anew. But, in the meantime, the middle class was
wiped out. Pension funds are gone. Bonds are worthless. The
political system has had a major defeat. The government
promised security and justice, and it delivered insecurity
and injustice.

Western Europe experienced hyperinflation in only two
nations in peacetime: Germany and Austria, 1921 through
1923. Hungary had the worst inflation ever recorded
immediately after World War II. But it was not an
industrial economy. Israel had hyperinflation in the mid-
1980s, but pulled back short of the destruction of the
shekel. Argentina had hyperinflation in the late 1980s.

My point is this: central bankers are aware of the
short-term effects of hyperinflation. These effects cause
losses in production. They disrupt the banks, especially
the large banks. Banks lend money; then they are repaid in
money of vastly depreciated value.

The capital base of the nation is undermined. The
lenders of long-term money are wiped out. They have no
money to lend after the period of hyperinflation is over.
If they saw it coming and bought hard assets such as real
estate, as few do, then in the recessionary period after
hyperinflation they have illiquid assets. If they bought
foreign currencies, they are sitting pretty, but few
investors buy foreign currencies.

Central bankers are trained in the basics of banking.
They recognize the threat that hyperinflation poses to the
banking system. The social order is threatened. Their
pensions are threatened. They resist hyperinflation.

IS HYPERINFLATION POSSIBLE?

In the early 1970s, a debate broke out in the hard-
money camp between deflationists, who argued that
hyperinflation is no longer possible, and the
inflationists, who said it was inevitable. Both positions
have yet to be proven. Both positions still have their
defenders.

In the 1970s, the positions were best represented by
John Exter (deflationist) and Franz Pick (inflationist).
Pick was the first person I ever heard refer to government
bonds as certificates of guaranteed confiscation.

Exter argued that the financial structure is leveraged
to such a degree that central bank inflation could not save
it from massive de-leveraging in a panic. So, despite the
attempts of central banks to re-liquify the economy, the
collapsing financial structure would produce price
deflation.

I do not recall that he brought up the issue of excess
reserves. This may be a problem with my memory rather than
Exter’s analysis. But what we have seen since 2008 seems to
confirm one part of his thesis, namely, the lack of effect
on consumer prices of Federal Reserve monetary base
inflation. But there has not been a collapse of financial
asset prices. So far, his case is not proven.

He said there would be a massive run on gold in this
deflation. Why? Because gold is the ultimate liquid asset.
He came up with a pyramid of increasing liquidity. Gold was
at the bottom. We still see this pyramid in economic
analysis. You can see it here.

http://clicks.dailyreckoning.com//t/AQ/AAu8FQ/AAvP5Q/AAcpdQ/AQ/AaAj7w/6GiC

Yet gold fell by 25% in 2008, contrary to his prediction.
This calls into question his theory of over-leveraged
financial markets as the cause of deflation.

What he never showed was this: how the total money
supply could contract in a world in which banks are
protected from collapse by central banks. If the money
supply does not fall, then there is no reason for consumer
prices to fall. Asset prices could fall, but that has
nothing directly to do with consumer prices.

Those of us who were anti-deflationists kept coming
back to this argument. The price movements within the
capital markets are not the same as price movements in the
consumer goods markets.

Then there is this. The Federal Reserve is legally
allowed to monetize anything. It can monetize stocks,
bonds, commodities — anything.

The FED can buy the S&P 500. It can buy S&P futures.
It can buy individual shares. If there were ever a collapse
of share prices as a result of fears over Federal Reserve
deflation, the FED could monetize the entire stock market.

The FED can enter markets in a panic sell-off and buy
any asset class that it chooses. It can head off the panic
by serving as the buyer of last resort, not simply the
lender of last resort.

There is no seller of an asset who would not take the
FED’s money. There is no lack of trust in the FED so great
that a frightened seller of an asset will say, “Sorry, but
your money’s no good here.” The sellers will sell for
dollars.

CONCLUSION

I do not believe that hyperinflation is inevitable. I
think it is unlikely. I do think that a Great Default is
inevitable. Governments will default when the workers who
are paying into Social Security and Medicare finally figure
out that (1) this is not in their self-interest and (2)
they outnumber the geezers.

Central bankers are arrogant. They really do think
they have the upper hand. They really do think fiat money
creation by central planners (themselves) is more powerful
than free market forces (investors). They really do believe
that they can find a suitable middle/muddle road between
deflationary collapse and hyperinflation. So, they will not
pull out all the stops. They will not hyperinflate unless
Congress compels this.

Paul Volcker is the model. He reversed the policies of
the ill-equipped G. William Miller, who was persuaded to
resign by Carter after only 18 months in office. Volcker
stuck to his guns from the fall of 1979 until August 13,
1982. By then, the public had lost its fear of inflation.
It had gone through back-to-back recessions.

Volcker saved the dollar and the bond market. He let
the politicians pay the price: first Carter, then Reagan.
Reagan weathered the storm because the economy had turned
back up by 1984. He smashed Walter Mondale.

The leverage is much greater today. The leverage of
the big banks is much greater. The public still trusts
Bernanke and Draghi. The investors think the central banks
can save the system from a catastrophe. I don’t. But I
think the central banks have their choice of catastrophes:
deflation/depression vs. hyperinflation/depression. I think
they will try to navigate a middle ground, but when push
comes to shove, they will risk a controlled deflation, with
selective bailouts for the largest banks.

The central banks are not there to save the
governments, which come and go. They are there to save
their clients: the largest banks. They know where their
bread is buttered.

But if Congress ever nationalizes the FED, then
hyperinflation is a real possibility.

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