The financial crisis and “recession” since 2007 have led to much discussion and speculation about the nature of and causes of our economic woes. There are literally dozens of books on the economic crisis (called, variously, the “subprime crisis”, the “housing crisis”, the “credit crisis”, etc). While each perspective has its own unique “narrative” on the crisis, the dominant themes typically proffered are :
- An “epidemic of greed” by the big banks
- Regulatory failure (of the big banks and other financial institutions)
- Regulatory “capture” by the banking interests
- “Easy money policy” by the Greenspan Fed in the wake of the 2000/2001 market crash and recession
- An epidemic of mortgage fraud and greed by the homebuying public
- CRA, loose lending policies and poor underwriting by the GSEs (Fannie and Freddie) and HUD/FHA
Of course all of these are to some significant extent true, and they aren’t mutually-exclusive (though folks who advance one or more in their own narrative of the economic crisis tend to disproportionately prefer their chosen explanations and reject most of the others). But the most serious flaw in an analysis based on any one or subset or even ALL of these “explanations” is the failure to correctly see them as the outcome of a single fundamental factor: the Federal Reserve and its permanent and perpetual policy of inflation.
Our Inflationary System
I’ll be relatively brief here because there is plenty of in-depth treatment available of the Federal Reserve and the ills of its inflationary policy elsewhere (see for example G. Edward Griffin’s “The Creature from Jekyll Island” or Murray Rothbard’s “The Case Against The Fed”). I highly recommend those works for a complete basic non-establishment introduction to inflation.
But in sum, the reader should recognize that the Federal Reserve and its fiat (backed by nothing) version of the dollar are a “policy choice”. They were set up intentionally, sweeping away what we had before — which was a monetary system with a gold and silver backing. Indeed, our coinage was silver until 1964. This form of money held its value over the long term… hundreds of years (if not thousands).
The mandarins of policy argued that the new system (introduced in 1913 with the creation of the Federal Reserve) would give us a more “flexible” currency — and it has. “Flexible” to them means the ability to perform lending in times of crisis, supposedly ameliorating or even preventing banking panics and depressions.
What they neglected to mention was that there was no practical way to lend “evenly” to everyone in society, and indeed, it is unlikely they ever intended to do so. Instead, in times of crisis, it is the federal government and powerful banking institutions that get the lion’s share of the benefit of the “elastic” dollar.
That is one problem, and it is a biggie, as it blatantly violates the equal protection mandate of the law and basic notions of fairness. But it may not be the biggest problem with this queer system. That honor likely goes to another aspect of any fiat currency: that its quantity will always be increasing, gradually, causing a gradual, insidious inflation.
What makes a currency “elastic” is the ability to create more currency units (“printing” money, or its digital equivalent). This is called inflation of the money supply. But because there is more money and the same quantity of goods and services, this ultimately causes inflation in prices. It is this outcome that is typically called “consumer price inflation” or just “inflation”. Government likes to use this definition because it focuses attention on street prices and “evil merchants and businessmen”, an away from their own responsibiltiy for those prices.
In principle, the Fed could reduce the supply of money at any time, particularly after a crisis, to try to bring down prices. But that is more politically difficult than giving new money out to favored institutions and lobbies, and even less practical to carry out.
Plus, the Fed and its legions of (directly or indirectly) on-the-payroll economists believe that gradual inflation is good for the economy for a few reasons. One is that people will expect prices to go up — nowadays everyone just “assumes” inflation will happen, almost as if it were a natural phenomenon — and then as a result, hurredly make more purchases before prices rise more. This is seen to be stimulating commerce.
Another big reason (sometimes mentioned by the economists) is that inflation is seen to reduce the real value of debt, providing a continuous “debt relief” to society. In theory, if inflation is 3% a year, that $10,000 credit card balance you carry will be like $9,700 a year later. However, this rationale is pretty bogus, as it is obvious that the banks charge more than enough to make up for any background inflation (as I write, credit card rates are in the 15-30% range, while the Fed is handing out money to large banks at less than .25%. The Fed claims inflation is below 3%).
What I think the BIG reason for continuous inflation is, which is virtually NEVER mentioned by the establishment economists (but we know they are thinking it, as they talk about the “wealth effect”), is that it creates the appearance of rising investment and asset values (such as home prices), even when there is no “real” gain (factoring out inflation). Indeed, Case and Shiller recently built their own inflation-adjusted home price index, going back over 100 years, and discovered that since World War II there has been no real increase in home prices. So in that entire era, the conventional wisdom that “your home is a good way to grow your wealth” and “should be the bulk of a middle class investment portfolio” is totally wrong-minded.
The same analysis goes for stocks and bonds — more investment classes of assets that aren’t really limited (homes are somewhat limited as they are real property, but we built such an oversupply that the “marginal value” of housing is zero. This is proven by the fact that some new developments have had to be bulldozed).
This leaves us with “stimulating commerce” as the only motivation for perpetual inflation that even passes the sniff test. I won’t go into a full disproof here, but suffice it to say, there is no substantial argument for inflation, leaving us with just the politically-contenious “elastic” emergency-lending as the only concrete “benefit”. But since the Fed and the establishment economists say inflation is good, and the politicians are either complicit (as beneficiaries) or too clueless to argue otherwise, that is the system we’ve got.
I’ll bet you thought I already explained why inflation was bad. But I haven’t even gotten started yet. You see, I’ve only explained why the Fed’s arguments for inflation are bad.
There are three big fundamental reasons why a policy of inflation is bad:
- Regressive redistribution
- The “margin squeeze” and “yield-chasing”
The first is a direct consequence of inflating the money supply, yet it escapes the notice of most regular people and, for some reason, most “progressive” commentators on the economy and advocates of “social justice”.
What I mean by “regressive redistribution” is that inflation (of the money supply) inherently takes away real value from the dollars held in your and my pocket, out of our accounts and investment funds, and out of our salaries. This is easy to see: if the quantity of dollars doubles, then, eventually, the buying power of every dollar you have will be half what it was before.
This is where the cronyist and top-heavy doling-out of new money comes in handy: the favored institutions of the Fed not only get the vast majority of this new money, but they get it before its creation has shown up in street prices. For them, not only is it a “helicopter-drop” of money they didn’t deserve, but they get the full buying power of that money. Nice deal!
Back to the flip-side: what poor saps like us get is gradual erosion of our investments, of our cash buying power, and our wages. If inflation is about 3% a year, then you can expect to see a 3% decline in your salary, a 3% decline in buying power of the cash in your wallet (or a 3% more expensive latte, pair of jeans, and utility bill), and a 3% decline in your investments.
While a 3% nominal gain in the value of your investments an in your salary will of course cancel this out, nothing has changed in real terms. Plus, all your cash expenses will still be going up, no matter what!
So obviously this is a redistribution because this is the same as money being plucked out of your pocket and given to others — with no debate, due process, appropriation, legislation, or even acknowledgement by the authorities. And it is regressive because the benefits overwhelmingly tend to go to the already-rich and powerful (both institutions and the individuals that primarily control them).
Over time this tends to make both the poor and middle class more poor. Even at 3% inflation — a figure universally accepted by mainstream economists as “good” — an investment portfolio will tend to fall in value by 26% in 10 years (and it will fall to some extent unless it makes on average more than 3% in nominal gains every year!) For a $50,000 retirement fund, that would mean it shrinks to about $36,800 in real value in 10 years.
In 20 years it loses about half its value (this also goes for salaries and wages).
In 30 years it loses 60% of its value, leaving you with 40 cents on the dollar.
And that’s all if we get ONLY 3% inflation.
See why it is fantastically difficult for regular folks to get ahead in this kind of system?
Only the rich are well-enough connected to stay ahead of this treadmill. Keep in mind that because the money is doled out based on political connections, ours is a political monetary system; it cannot even remotely be called a “free market” and I would argue not even “capitalist”, since there is no stable definition of monetary capital! Again, what makes more sense to talk about is “political” capital — if you’ve got the political connections, you’ll probably always have money, regardless of the mistakes you make or the severity of the economic conditions.
Genesis of Crisis: The Margin Squeeze and Yield Chasing
That still leaves two reasons inflation is outright bad.
The second reason mentioned above was “malinvestment”. By this I (and the Austrian economists who coined the term) mean that those who receive cheap/free money from the Fed (either directly or indirectly through interest rates and whatnot) tend to deploy it poorly, causing greater investment losses down the road. I won’t go into too much detail on this item because one could easily write a whole book about it, but it suffices to say that if one is rapidly giving out money, and intentionally making it “easy money”, the lending process is inherently not well-policed. There also may be a tacit understanding that the borrower can (again, if politically well-connected) “do whatever they want with it”. There may even be an implicit or explicit failure guarantee (the Fed, Federal government, FDIC, FHA, aand Fannie and Freddie have ALL done this in the current crisis).
In sum, malinvestment tends to worsen the economic funamentals such that the seeds are sown for greater crisis down the road.
That leaves the final item, one related to malinvestment: the “margin squeeze” and “yield-chasing”.
As money becomes “easier”, interest rates tend to become lower. This can be a direct consequence of lending by the Fed and its various proxies (like the mortgage GSEs) at low rates, and it can be an indirect consequence in the form of a knock-on, lower general sense of risk in the economy. Interest rates essentially measure risk — they are compensation for an investment of money given that something might go wrong and the lender might lose some or all of what was lent (the principle). So when the government lowers its policy rates and bails out loss-making entities, it is essentially signalling to the rest of the economy that risk is low.
Here’s where a great irony comes into play: while banks love the “elastic currency” and bail-out aspect of our fiat money central banking system, they hate the gradual suppression of interest rates. At least, they used to. This is because it becomes harder and harder to squeeze out a reasonable return as interest rates globally go down.
Think of the example of mortgage lending: with mortgage rates around 4% after relentless bailouts and prop-ups by the Fed and the GSEs and the federal government (all ultimately resting on the Fed’s money-printing), banks are really only making a 1-2% spread over inflation. That’s a crappy return — any real estate owner will tell you that anything less than a 6% annual return on capital isn’t even worth entering into. And all this is assuming that actual inflation is really just the 2-3% admitted by the Fed — if it is even 2% more, banks earn nothing on mortgages and they may even be loss-making.
This relentless squeeze to bank margins has been going on since the founding of the Fed, and distinctly more pronounced since 1980 and the Volcker Fed era of inflation-fighting through high interest rates. Ever since then, rates have been trending down, as the Fed has continually printed money and fostered the illusion of less and less risk in the market.
So what’s a banker to do?
Well, chase yield, that’s what.
“Yield” is the term for return on investment (typically in annual percentage terms). Anyone who aggressively seeks yield with little regard to fundamentals of the investment is colloquially said to be “chasing yield”. It is universally considered to be a bad investment practice — but almost everyone does it! Why? Because the Fed forces them to!
It was not long after the Volcker Fed began its scorched-earth campaign to slay inflation (which it had caused by printing the money necessary to fund the Vietnam War and LBJ’s “Great Society) that yield-chasing resulted in our first significant banking crisis — and the most significant one since the Great Depression. In some respects, it was moreso.
I refer to the S&L crisis, which came to a head around 1990. What happened was that Savings and Loans banks, which had been limited by regulation to low single-digit rates of interest, became deregulated in response to the Fed’s much higher rates of interest at the time (to slay price inflation which was running wild in the streets — not monetary inflation, of course). Essentially, they wanted to chase yield, but could not because of arbitrary interest rate limits. They also had limits on what kinds of investments they could hold.
When both limits were lifted, they went absolutely hog-wild. They ended up taking advantage of “unconventional” investments aggressively in order to pay out higher rates of returns expected by depositors — which depositors could easily get from a conventional bank or even Treasury bonds.
Then when it was noticed that there were unsavory practices going on the S&Ls, Congress made some regulatory changes to tighten the tax-preferred structure of S&Ls, and there almost immediately commenced a massive collapse of (what was then realized to be the) S&L “bubble”.
More banks failed than the Great Depression. An entirely new agency of the government, the Resolution Trust Corporation, was set up to receive and wind down the thousands of S&Ls that failed.
Today the sitution is slightly different — interest rates are much lower and have been for a long time, again, as the Fed has created a perception of very little risk, and when it cannot, it simply pushes rates down (to the best of its ability) with brute force. But throughout the 90s, this low-and-trending-lower interest rate environment made possible by the Fed’s easy money bred some new unsavory lending practices in the banking system — writ large.
The most glaring of these practices was mortgage loan securitization with very poor underwriting. This includes subprime, Alt-A, and any other sort of loan that would never have been given a snowball’s chance in hell of being underwritten by any legitimate bank prior to the 90s.
This problem worsened through the early 2000s, with an extra shot in the arm by the Fed’s policies at the time (as well as non-policy overtures, such as Greenspan’s vocal advocation of floating-rate ARM mortgage loans over conventional 30-year fixed-rate loans). The impetus to inflate and yield-chase was increased by the collapse of the stock market bubble, which ran the “wealth effect” in reverse and made Americans feel poorer.
In reality, stocks had just been inflated by money printing themselves, and were an earlier manifestation of banks “yield chasing” (though rather than expecting dividends, they expected to profit from IPOs, flip stocks to “greater fools” at higher prices, and make money from lending to dodgy dot-com era ventures.)
You might think the banks would, by now, be keen to the fact that yield-chasing and pursuit of other sort of poorly-controlled and poorly-thought-out investments would lead to disaster. You might even be forgiven for thinking that banks could look at the recent history of the S&L crisis and the stock market crash (and now, the housing crash and credit crisis) to exercise more caution.
But you’d be wrong, for two reasons: 1) banks are left with NO CHOICE than to get creative by the relentless margin squeeze of the Fed’s easy money, inflationary policies (remember the crappy spread on conventional mortgages right now), and 2) you’re forgetting the first role of the easy-money system: to bail out troubled institutions (“elastic” currency in times of crisis).
By and large, nowadays banks don’t care because they don’t have to: the system (demonstrably) underwrites their aggressive, unsound practices. This has become a virtual “gentleman’s agreement” that the Fed can totally up-end and distort interest rates, making it difficult to have a healthy profit margin from “normal” banking activities, and banks will nonetheless be “underwritten” by the Fed in whatever they do (this is even jokingly called the “Greenspan Put”, or now, the “Bernanke Put”).
So what’s next?
Well, it has probably already started: that’s the sovereign debt crisis. It’s already touched most “marginal” countries of the European union, and rumblings have recently begun about the trustworthiness of the US’s debt (“Treasuries”).
The end-game of all this madness is likely a currency crisis. Put simply, an “elastic currency” played out long enough, and stretched far enough, will break. Witness the chaos of the Euro in recent years (up and down radically, depending on whether it or the dollar or Euro is feared more at the moment), or the recent hyperinflationary crack-up of the Zimbabwe dollar.
So what’s the way out? Ironically, in the crackup of the worst offender in recent history lies the seed of truth for a new economic beginning: the Zimbabwe Central Bank boss, Gideon Gono, has recently admitted that a gold backing might be needed to restore monetary stability to the world — and that maybe Zimbabwe should lead the way. The US and its Federal Reserve would do well to take notes.