Central Problem: The Central Bank

By Robert Klein and George Reisman
Barron's
Saturday, December 26, 2009

http://online.barrons.com/article_email/SB126167814839704681-lMyQjAxMDI5NjIxNjYyNzY4Wj.html

The Federal Reserve's easy-money madness must end.

President Barack Obama heads the list of Americans who believe that the continuing financial crisis should be blamed on excessive risk-taking by bankers who had an unbridled desire to make money in mortgages. These would-be reformers want stronger government regulation of the bankers to make sure that nothing like this ever happens again.

In a recent 60 Minutes interview, Obama blamed "fat cat bankers" for causing the crisis, putting America through its "worst economic year...in decades." He went on to chide Wall Street banks for "fighting tooth and nail" the new regulations he believes would be vital in preventing future crises.

A deeper examination, however, reveals that this is neither a housing crisis nor a Wall Street banking crisis. This is a monetary crisis, rooted in the lending of money created out of thin air. This is what leads to economic booms and busts.

The current crisis goes back to the Asian Contagion of 1997 and the meltdown of the Long Term Capital Management hedge fund in 1998. In response to each of these situations, the Federal Reserve cut interest rates and rapidly expanded the money supply. This excess liquidity helped push stocks, especially tech issues, to unsustainably high levels. The excess money created by the Fed and the banking system spilled into the rest of the economy, pushing up consumer prices.

To combat the rise in prices that it had caused, the Fed tightened monetary policy, which precipitated a massive plunge in stocks. Then, to bail out investors and stimulate the slowing economy once again, the central bank expanded the money supply rapidly to force rates lower. It ultimately jammed down the overnight fed-funds rate to 1%.

Unhappy with the correspondingly low returns on money-market funds, recently burned by the stock market, and spurred on by Washington policies intended to encourage homeownership, investors turned to real estate, largely housing, seeking higher returns. In time, in the hands of frenzied investors, the new money created by the Fed and banking system boosted home prices sharply.

In our present crisis, excess money created by the Fed also pushed up consumer prices. Once again, concerned about this, the Fed raised interest rates, thus raising mortgage rates. Subprime borrowers were the first casualties of these higher rates. Unable to afford their interest payments, they kept refinancing their loans by taking out new ones. When the easy money and credit stopped flowing, the loans became harder to refinance, and these borrowers began to default; the higher interest rates and reduced availability of easy mortgage credit also hurt more highly rated borrowers looking for homes. And, of course, the speculators, or flippers, who had feasted on the easy-money loans, saw their schemes disintegrate without easy credit flowing from Washington.

When the Fed tries to induce business activity in this manner, it never lasts. This is because the central bank always has to cut off the flow of easy money, in fear of causing further damage in the form of rising consumer prices. When the Fed removes this artificial stimulus, business activity dependent on it grinds to a halt, asset prices plunge, and recession sets in. In some ways, the process is analogous to a doctor administering adrenalin to a patient. Remove the stimulus and the patient collapses.

Healthy economic growth is supported by savings, rather than newly created money. People and businesses save and invest the money they don't need to consume right away. They make loans and investments that create computer equipment, copper mines, retail stores, and new homes. These loans and investments need not be cut off suddenly by a Fed worried about rising prices, as is the case when the Fed induces business activity by simply creating money.

In the most recent boom, total debt rose to a record 375% of gross domestic product. (By comparison, debt was 150% of total GDP in the inflationary boom of the 1970s.) Thus, the Fed has had to resort to desperate measures to bail out the economy. Along with its gargantuan loan programs, it has injected over $1.2 trillion in new bank reserves into the system -- building upon a base of about $800 billion -- in an effort to hold overnight interest rates near zero. This has propelled stock and commodity prices upward, while credit spreads have tightened. In time, borrowing and lending should accelerate, and economic activity should increase. This should continue until the inflationary consequences of the easy-money policy become evident. Consumer prices should rise, as should long-term interest rates. Then, confronted with the inflationary effects, the Fed once again will have to reverse its easy-money scheme and raise short-term interest rates, or allow the inflationary effects to accelerate.

How many more crises must we endure until we realize the common denominator is the creation of money and credit by the Fed? Wall Street bankers and speculators, who try to game the system and make profits during each boom, are mere bit players in these crises. By fostering the booms and triggering the busts, the real villain is the institution of central banking itself. Thus, instead of providing stability to the economy, central banking has created great instability. Until this is understood, we will make little progress in preventing future crises or easing the current one.

Lurching from crisis to crisis in boom-bust fashion is unacceptable and unnecessary. The Federal Reserve must stop juicing the economy with massive amounts of newly created money and move to a monetary system free of government-caused booms and busts. The only effective way to do this would be to remove control of our money supply from politicians and their appointees. We need to move to a money that is 100% backed by a commodity, such as gold. Only then can we rid the economy of the devastating effects of the creation of money and credit out of thin air.

Robert Klein is a financial advisor in Newport Beach, California and George Reisman is author of "Capitalism: A Treatise on Economics".

For further reading:
"America's Forgotten War Against the Central Banks", Mike Hewitt, October 19, 2007