The Moral Hazard of Central Banking!

[Shooterman]

The Moral Hazard of Central Banking by Gary North

snip

Let me present a syllogism. 1. Theft is immoral. 2. Inflation is theft. 3. Fractional reserve banking is inflationary. 4. Central banking is government-guaranteed fractional reserve banking. 5. Immorality leads to judgment.

Therefore, we should expect. . . ?

Economists, other than Murray Rothbard's disciples, never associate the concept of theft with monetary inflation. They speak of theft in terms of reduced efficiency and increased transactions costs, not morality.

When it comes to avoiding morality, they are worse than lawyers. A lawyer might appeal to morality if he had a really weak case. This appeal might persuade a jury. An economist would rather lose the argument than appeal to morality. He regards the shame of invoking morality as personally more inefficient than winning the argument by an appeal to morality. Once you appeal to morality, academic economic theory collapses. Economics was the first science to be self-consciously designed to avoid moral questions.

So, when stock market bulls attack Federal Reserve monetary policy, they do not invoke morality. They invoke the falling return on investment. Having invested their money or other people's money on the assumption that the central bank's monetary policy will always hold down "interest rates" – we are never told which ones – they loudly decry as unnecessary the widespread and accelerating losses that are being sustained because the central bank has slowed down the rate of monetary inflation. Why unnecessary? Because the central bank can create liquidity by buying Treasury bills.

This will lower the interest rate on T-bills. But how does this lower all interest rates? How does it lower bond rates and mortgage rates, which always have an inflation-defense premium in them? It doesn't. It raises them.

The critics say that this forced reduction of the FedFunds rate is only temporary. They are not calling for sustained inflation. Oh, no. They just want a little loosening of monetary restraint, just this once. Just get overnight money rates down.

This is what Japan has been doing ever since 1990. It gets overnight money rates down. It keeps it down, year after year. So, international traders grew bold. They borrowed yen at less than 1% to buy other currencies. Then they used these to invest in bonds at 4% or more. It's like money in the bank.

Yes, it is. But what happens if there is ever a bank run?

A MODERN BANK RUN

The "run" has begun. The Japanese yen is now rising against foreign currencies. Those who borrowed short and lent long are facing a serious crisis: their debt is in yen, and it is rising fast. So, they sell longer-term debt and buy yen with the money. This forces up long-term rates.

Which raises mortgage rates.

Which undermines the housing bubble.

Which undermines consumer confidence.

Which leads to more saving and less spending on consumer goods.

Which produces a recession.

In anticipation of the recession, the stock market falls. This produces a televised tantrum by Jim "Mad Money" Cramer.

Which catches the FED's attention.

Which then lowers a symbolic interest rate (discount window).

Which creates brief euphoria among fund managers.

Which leads Cramer to tell people to buy, buy, buy.

Which is called a bull trap.

The FED must now make a decision: inflate slowly (2% a year) or inflate faster (5% a year). I don't think the FED would consider 10%. Economists believe in change at the margin. So, 4% or 5% will probably do it.

Do what?

Restore confidence in the gigantic confidence game that all modern finance is based on. This game rests on this slogan: "Too big to fail." It is more than a slogan. It is a mantra, a confession of faith. It is the shema Mammon.

The FED will act to increase liquidity sufficiently to prevent disaster in the stock market. This will calm the markets. This will once again persuade investors that there is a safety net for them. Ironically, this perception is designated a "moral hazard." This is the only time the word "moral" is seriously used in modern finance. A moral hazard – correctly named – occurs when central banks intervene to save specific industries, i.e., too-big-to-fail industries.

MORAL HAZARD

Greenspan used the phrase. His words are worth considering. In testimony before the House Banking Committee (Oct. 1, 1998), in the wake of the near-meltdown of the financial futures market the previous August as a result of the Long-Term Capital (Ha!) Management, Ltd. collapse, he said:

Of course, any time that there is public involvement that softens the blow of private-sector losses – even as obliquely as in this episode – the issue of moral hazard arises. Any action by the government that prevents some of the negative consequences to the private sector of the mistakes it makes raises the threshold of risks market participants will presumably subsequently choose to take. Over time, economic efficiency will be impaired as some uneconomic investments are undertaken under the implicit assumption that possible losses may be borne by the government.

That sounded good. It sounded almost as if he had reverted to his free market youth as a follower of Ayn Rand. But he was in front of Congress to justify the Federal Reserve Bank of New York's intervention, calling the lending banks together over the weekend and recommending that they inject another $3 billion into LTCM, Ltd. So, he added this:

But is much moral hazard created by aborting fire sales? To be sure, investors wiped out in a fire sale will clearly be less risk prone than if their mistakes were unwound in a more orderly fashion. But is the broader market well served if the resulting fear and other irrational judgments govern the degree of risk participants are subsequently willing to incur? Risk taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales.

What is a fire sale? The FED apparently has a new operational definition: "Anything that leads Jim Cramer to throw a tantrum on CNBC."

Central banking has been a moral hazard ever since Parliament gave a monopoly to the privately owned Bank of England in 1694. Central banking exists primarily to protect large fractional reserve commercial banks from bank runs, and therefore to preserve the fractional reserve banking system nationally. Of all modern institutions, none has been more committed to subsidizing moral hazards than central banking.

Along the way, central banks preserve stock markets from sell-offs that might produce runs on commercial banks, or what is the same today, cascading cross-defaults when overextended banks cannot pay off each other at the end of the business day, which today is international.

INDIVIDUALS ARE TRAPPED BY THE SYSTEM

Jesus told His disciples to be in the world, not of the world. This has been the message of most major religious reformers throughout history. It is good advice.

We live in a world that we have inherited. It is not mainly of our making. We are forced to make choices in a world that has structured and limited the choices we make. This is always true.

Consider the FED's choices regarding monetary policy. There is this inescapable choice: stable money leading to a recession and maybe a depression, given the prevailing level of debt, vs. monetary inflation, which keeps the debt structure alive and encourages additional debt to "pay off in cheap money." This policy subsidizes the market for new moral hazards. "When the price falls, more is demanded."

At the top of the visible hierarchy of control, politicians and central bankers say they want to avoid making this choice between stable money and inflation, but one or the other policy cannot be avoided in the long run. This makes short-run decision-makers out of politicians and central bankers.

A few of us prefer this choice: a money system that is not tied to credit and debt in any way. That would mean a monetary system tied to gold and silver, as it was in 1914. This is not available as a choice, nor is it likely to be, short of a complete financial collapse, which unfortunately would kill most of my readers – a breakdown in the division of labor.

So, we must make second-best or third-best choices with our money because generations of politicians made very bad choices.

As investors and decision-makers, most people tend to go with the flow. The flow is established by central bank policy: in the United States, in Japan, in Europe, and in China. Going with the flow is bad when you are floating toward Niagara Falls.

We are trapped in an international credit system which has relied on monetary inflation to pump up the capital markets. This has led to a huge expansion of debt. To keep this debt from imploding in a wave of defaults – "cascading cross defaults," Greenspan called this – central banks inflate even more.

This is a vicious circle. Ever since 1914 – World War I and the first year of the Federal Reserve System – the West has been unable to escape from this circle. As a result, the dollar buys 5% of what it bought in 1914. (See the Inflation Calculator at Bureau of Labor Statistics Home Page the Bureau of Labor Statistics.)

None of this is new. Leaders always face choices. These choices will affect those under their authority. Sometimes the effects are catastrophic.

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CLEAN HANDS, DIRTY MONEY

We cannot opt out of the debt money economy. To use a checking account, to use a credit card, to spend a Federal Reserve Note, we subsidize the system. We preserve the profits of the government-protected fractional reserve banking system.

What is our version of selling our slaves in order to opt out of the system? This encompasses far more than this short list. But I offer this list of five.

1. Avoid consumer debt. The mantra is Max Blumert's law: "Buy the best, pay cash, take delivery."

2. Pay off all credit card debt before buying T-bills or bonds. Here is my law: "Escape from the trap before setting any of your own."

3. Pay a tithe. This is your personal declaration of dependence on God rather than dependence on Bernanke.

4. Don't take on any debt that is not collateralized 100% by an asset in your possession. This applies to mortgages. Your house should collateralize your mortgage.

5. Emergency debt is for emergencies. Regard both as disasters. Save for emergencies.

CONCLUSION

The debt economy makes us all vulnerable to unforeseen crises: illiquidity, insolvency, low credibility. All three are institutionally visible today. They are threatening Cramer's world.

All three are the result of the moral hazard of central banking. This is why Cramer screamed against the Federal Reserve System. He was correct: the FED is responsible. Earlier.

The FED should have done nothing in 1914. It should have done nothing thereafter. If it had done nothing as a matter of policy, there would be no debt crisis facing the U.S. economy. There would be no advocacy of the creation of yet more moral hazards in the financial community.

There is now a looming immoral hazard. Eventually, the FED will imitate the People's Bank of China in order to re-liquify the financial system. It will inflate at double-digit rates. The difference is, Americans do not save 40% of their income, nor are they rebounding from Marxist tyranny and incomparable poverty. The division of labor is being extended by China's monetary inflation. This extension has produced China's many bubbles. Our division of labor is already highly developed. It can increase only slowly at the margin. American productivity will therefore not rise fast enough to match the FED's double-digit inflation, as it has in China, thereby concealing the true rate of inflation.

Between then and now, Cramer will have lots of opportunities to scream on national TV.

August 27, 2007

Gary North iis the author of Mises on Money. He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

The Moral Hazard of Central Banking by Gary North

[sabadgeman]

This is scarey stuff I am just about to buy a house for our retirement and I am not so sure this is the right way to go as i will have to mortgage again.

[Shooterman]

Originally Posted by sabadgeman

This is scarey stuff I am just about to buy a house for our retirement and I am not so sure this is the right way to go as i will have to mortgage again.

I don't believe Mr North is telling anyone not to buy, especially a long term investment. I believe he is just saying to be careful and not bite off more than you can chew.

With the prices of houses to come down, the near future may be a good time to buy.

Of course, if the bottom falls out of the FIAT Money system, there will not be a good time to buy.

[sabadgeman]

Lol Yes the bottom dropping out is a bit scary!

[Shooterman]

Originally Posted by sabadgeman

Lol Yes the bottom dropping out is a bit scary!

I try to read a lot of things by people that have and are making a good living within the financial world. I try, most days, to tune in the afternoon financial news shows that mostly, here of late, are either crying for the FED to save the World, or beaming from ear to ear when the Market has a booming day. ( the volatility has been amazing ) There are those that that shill for the Market, or those that tell us there is a big correction coming. ( not known exactly when ) but our houses must be in order )

The shills, naturally, make a lot of money, telling us exactly how wonderful the FED is, how marvelous that central bankers have discovered Playdough, FIAT Money, Counterfeit Money, Monopoly Money, or whatever one cares to call it.

Most Austrian Economists ( I'm certainly not an economist ) will show that a specie currency ( authorized by the Constitution with a known weight and size ) is the only way to go, and many ( not the shills ) remind us of how closely conditions are mirroring those of '29.

I hope it never happens. I am far too old to have to do manual labor again to put food on my table.

[sabadgeman]

Yes abandoning the gold standard was another World War I casualty. Lord Grey and his cronies who engineered WWI have much to answer for. It is really the only way forward as liking the currency to a tangible asset with an agreed rate to asset value ie gold. that stops credit explosions and the hyperinflation that so bedevils economies.

[Shooterman]

Originally Posted by sabadgeman

Yes abandoning the gold standard was another World War I casualty. Lord Grey and his cronies who engineered WWI have much to answer for. It is really the only way forward as liking the currency to a tangible asset with an agreed rate to asset value ie gold. that stops credit explosions and the hyperinflation that so bedevils economies.

Let's lay the blame where it is deserved; at Wilson's feet. The Federal Reserve Act was passed in 1913 and took effect in 1914. Wilson then used the cover of an expanded FIAT currency to get us into WWI.

FDR stole American's gold in 1934, the arch criminal Nixon, killed Bretton Woods and we've been on the downhill side ever since.

Remember the slogan "Not worth a Continental", the means of financing the Revolutionary War with paper money, driving the value to zero, hence the establishment later of the Silver Standard by the early Congress.

The arch criminal Lincoln financed his war with 'Greenbacks' which eventually approached zero in value.

The dollar today is worth about one nickel compared to the dollar of 1913. Since 2000, the purchasing power of the dollar has dropped 40%. The FED, our CongressCritters, and children in the White House, ( regardless whether DIM or PUB ) are doing a bang up job, eh?

All paper money eventually becomes worthless if enough is printed and circulated.