Currency Wars: The Making of the Next Global Crisis (26 page)

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Authors: James Rickards

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BOOK: Currency Wars: The Making of the Next Global Crisis
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CHAPTER 9
 
The Misuse of Economics
 
“Human decisions affecting the future . . . cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; . . . it is our innate urge to activity which makes the wheels go round, our rational selves choosing . . . but often falling back for our motive on whim or sentiment or chance.”
John Maynard Keynes, 1935
 
 
 
 
I
n the late 1940s, economics divorced itself from its former allies in political science, philosophy and law and sought a new alliance with the hard sciences of applied mathematics and physics. It is ironic that economics aligned with the classic physics of causality at exactly the time physicists themselves were embracing uncertainty and complexity. The creation of the Nobel Memorial Prize in Economic Sciences in 1969, seventy-four years after the original Nobel Prize in physics, confirmed this academic metamorphosis. Economists were the new high priests of a large part of human activity—wealth creation, jobs, savings and investment—and came well equipped with the equations, models and computers needed to perform their priestly functions.
There has never been a time since the rise of laissez-faire capitalism when economic systems were entirely free of turmoil. Bubbles, panics, crashes and depressions have come and gone with the regularity of floods and hurricanes. This is not surprising, because the underlying dynamics of economics, rooted in human nature, are always at work. Yet the new scientific economics promised better. Economists promised that through fine tuning fiscal and monetary policy, rebalancing terms of trade and spreading risk through derivatives, market fluctuations would be smoothed and the arc of growth extended beyond what had been possible in the past. Economists also promised that by casting off the gold standard they could provide money as needed to sustain growth, and that derivatives would put risk in the hands of those best able to bear it.
However, the Panic of 2008 revealed that the economic emperors wore no clothes. Only massive government interventions involving bank capital, interbank lending, money market guarantees, mortgage guarantees, deposit insurance and many other expedients prevented the wholesale collapse of capital markets and the economy. With few exceptions, the leading macroeconomists, policy makers and risk managers failed to foresee the collapse and were powerless to stop it except with the blunt object of unlimited free money.
To explain why, it is illuminating to take 1947, the year of publication of Paul Samuelson’s
Foundations of Economic Analysis,
as an arbitrary dividing line between the age of economics as social science and the new age of economics as natural science. That dividing line reveals similarities in market behavior before and after. The collapse of Long-Term Capital Management in 1998 bears comparison to the collapse of the Knickerbocker Trust and the Panic of 1907 in its contagion dynamics and private resolution by bank counterparts with the most to lose. The stock market crash of October 19, 1987, when the Dow Jones Industrial Average dropped 22.61 percent in a single day, is reminiscent of the two-day drop of 23.05 percent on October 28–29, 1929. Unemployment in 2011 is comparable to the levels of the Great Depression, when consistent methodologies for the treatment of discouraged workers are used for both periods. In short, there is nothing about the post-1947 period of so-called hard economic science to suggest that it has had any success in mitigating the classic problems of boom and bust. In fact, there is much evidence to suggest that the modern practice of economics has left society worse off when one considers government deficit spending, the debt overhang, rising income inequality and the armies of long-term unemployed.
Recent failures have stripped economists of their immunity from rigorous scrutiny by average citizens. What works and what does not in economics is no longer just a matter of academic debate when forty-four million Americans are on food stamps. Claims by economic theorists about multipliers, rationality, efficiency, correlation and normally distributed risk are not mere abstractions. Such claims have become threats to the well-being of the nation. Signal failures of economics have arisen in Federal Reserve policy, Keynesianism, monetarism and financial economics. Understanding these failures will allow us to comprehend why growth has stalled and currency wars loom.
The Federal Reserve
 
The U.S. Federal Reserve System is the most powerful central bank in history and the dominant force in the U.S. economy today. The Fed is often described as possessing a dual mandate to provide price stability and to reduce unemployment. The Fed is also expected to act as a lender of last resort in a financial panic and is required to regulate banks, especially those deemed “too big to fail.” In addition, the Fed represents the United States at multilateral central-bank meeting venues such as the G20 and the Bank for International Settlements, and conducts transactions using the Treasury’s gold hoard. The Fed has been given new mandates under the Dodd-Frank reform legislation of 2010 as well. The “dual” mandate is more like a hydra-headed monster.
From its creation in 1913, the most important Fed mandate has been to maintain the purchasing power of the dollar; however, since 1913 the dollar has lost over 95 percent of its value. Put differently, it takes twenty dollars today to buy what one dollar would buy in 1913. Imagine an investment manager losing 95 percent of a client’s money to get a sense of how effectively the Fed has performed its primary task.
The Fed’s track record on dollar price stability should be compared to that of the Roman Republic, whose silver denarius maintained 100 percent of its original purchasing power for over two hundred years, until it began to be debased by the Emperor Augustus in the late first century BC. The gold solidus of the Byzantine Empire had an even more impressive track record, maintaining its purchasing power essentially unchanged for over five hundred years, from the monetary reform of AD 498 until another debasement began in 1030.
Fed defenders point out that while the dollar may have lost 95 percent of its purchasing power, wages have increased by a factor of over twenty, so that increased wages offset the decreased purchasing power. The idea that prices and wages move together without harm is known as money neutrality. This theory, however, ignores the fact that while wages and prices have gone up together, the impact has not been uniform across all sectors. The process produces undeserving winners and losers. Losers are typically those Americans who are prudent savers and those living on pensions whose fixed returns are devalued by inflation. Winners are typically those using leverage as well as those with a better understanding of inflation and the resources to hedge against it with hard assets such as gold, land and fine art. The effect of creating undeserving winners and losers is to distort investment decision making, cause misallocation of capital, create asset bubbles and increase income inequality. Inefficiency and unfairness are the real costs of failing to maintain price stability.
Another mandate of the Fed is to function as a lender of last resort. In the classic formulation of nineteenth-century economic writer Walter Bagehot, this means that in a financial panic, when all bank depositors want their money at once, a central bank should lend money freely to solvent banks against good collateral at a high rate of interest to allow banks to meet their obligations to depositors. This type of lending is typically not construed as a bailout, but rather as a way to convert good assets to cash when there is no other ready market for the assets. Once the panic subsides and confidence is restored, the loans can be repaid to the central bank and the collateral returned to the private banks.
In the depths of the Great Depression, when this lender of last resort function was most needed, the Fed failed utterly. More than ten thousand banks in the United States were either closed or taken over and assets in the banking system dropped almost 30 percent. Money was in such short supply that many Americans resorted to barter, in some cases trading eggs for sugar or coffee. This was the age of the wooden nickel, a homemade token currency that could be used by a local merchant to make change for a customer and then accepted later by other merchants in the vicinity in exchange for goods and services.
The next time the lender of last resort function became as critical as it had been in the Great Depression was the Panic of 2008. The Fed acted in 2008 as if a liquidity crisis had begun, when it was actually a solvency and credit crisis. Short-term lending can help ease a liquidity crisis by acting as a bridge loan, but it cannot cure a solvency crisis, when the collateral is permanently impaired. The solution for a solvency crisis is to shut down or nationalize the insolvent banks using existing emergency powers, move bad assets to government control and reprivatize the new solvent bank in a public stock offering to new shareholders. The new bank is then in a position to make new loans. The benefit of putting the bad assets under government control is that they can be funded at low cost with no capital and no mark-to-market accounting for losses. The stockholders and bondholders of the insolvent bank and the FDIC insurance fund would bear the losses on the bad assets, and the taxpayers would be responsible only for any excess losses.
Once again, the Fed misread the situation. Instead of shutting down insolvent banks, the Fed and the Treasury bailed them out with TARP funds and other gimmicks so that bondholders and bank management could continue to collect interest, profits and bonuses at taxpayer expense. This was consistent with the Fed’s actual mandate dating back to Jekyll Island—to save bankers from themselves. The Fed almost completely ignored Bagehot’s core principles. It did lend freely, as Bagehot recommended, but it took weak collateral, much of which is still lodged on the Fed’s books. The Fed charged almost no interest instead of the high rates typically demanded from borrowers in distress. The Fed also lent to insolvent banks rather than just the solvent ones worth saving. The result for the economy even now is that the bad assets are still in the system, bank lending is highly constrained due to a need to rebuild capital and the economy continues to have great difficulty returning to self-sustaining growth.
When most urgently called upon to perform its lender of last resort functions, the Fed has bungled both times. First in 1929–1933, when it should have provided liquidity and did not. Then again in 2007–2009, when it should have closed insolvent banks but instead provided liquidity. The upshot of these two episodes, curiously, is that the Fed has revealed it knows relatively little about the classic arts of banking.
In 1978, the Humphrey-Hawkins Full Employment Act, signed by President Jimmy Carter, added management of unemployment to the Fed’s mandate. The act was an explicit embrace of Keynesian economics and mandated the Fed and the executive branch to work together in order to achieve full employment, growth, price stability and a balanced budget. The act set a specific numeric goal of 3 percent unemployment by 1983, which was to be maintained thereafter. In fact, unemployment subsequently reached cyclical peaks of 10.4 percent in 1983, 7.8 percent in 1992, 6.3 percent in 2003 and 10.1 percent in 2009. It was unrealistic to expect the Fed to achieve the combined goals of Humphrey-Hawkins all at once, although Fed officials still pay lip service to the idea in congressional testimony. In fact, the Fed has not delivered on its mandate to achieve full employment. As of 2011, full employment as it is conventionally defined is still five years away, according to the Fed’s own estimates.
To these failures of price stability, lender of last resort and unemployment must be added the greatest failure of all: bank regulation. The Financial Crisis Inquiry Commission created by Congress in 2009 to examine the causes of the current financial and economic crisis in the United States heard from more than seven hundred witnesses, examined millions of pages of documents and held extensive hearings in order to reach conclusions about responsibility for the financial crisis that began in 2007. The commission concluded that regulatory failure was a primary cause of the crisis and it laid that failure squarely at the feet of the Fed. The official report reads:
We conclude this crisis was avoidable. The crisis was the result of human action and inaction.... The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.... We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts.... Yet we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it.... The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not.... In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles.
 
The report goes on for more than five hundred pages to detail the Fed’s regulatory failures in minute detail. As noted in the excerpt above, all of the Fed’s failures were avoidable.
One last test of Fed competence involves the Fed’s handling of its own balance sheet. The Fed may be a central bank, but it is still a bank with a balance sheet and net worth. A balance sheet has two sides: assets, which are the things owned, and liabilities, which are the things owed to others. Net worth, also called capital, equals the assets minus the liabilities. The Fed’s assets are mostly government securities it buys, and its liabilities are mostly the money it prints to buy them.

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