The Tapestry of Monetary Collapse
Central Banks have been collapsing for centuries. Pop Quiz: which country witnessed the world’s first central bank meltdown? Ancient Greece, The Romans, China, England…or none of the above?
The view here at Capital & Crisis is that the patterns of economic boom and bust emerge from an unstable loam, too saturated with the oils of monetary intervention. Interest rates and money no longer manifest the natural underlying demand of consumers, nor do they provide accurate signals regarding the core supply of capital. What emerges is a distorted pattern of production, a mishmash of mis-priced capital, too soft to harden into a sound and sturdy foundation. The beacon, which the market uses to allocate capital, has become errant and is leading the market onto the rocks.
The threads of this story form a grand tapestry that will one day tell a sorry tale of monetary collapse. For the time being, we can explore the tapestry in bits and pieces, as one might examine the shards left in the trail of a twister, wondering how it came to be and where it will strike next. Today, we start at the very beginning…
The Granddaddy of central banks was probably the Swedish Riksbank. Originally chartered as a private bank in 1656, it would collapse eight years later due to bad loans, at least some of which were due from the government. After no buyers could be found for the decrepit floundering institution, the Bank was reorganized in 1668 under the authority of Parliament.
As the only bank in Sweden, it enjoyed special privileges as the only issuer of paper money, but it was still required to redeem those notes in gold. It paid for its charter, though, with an agreement to lend money to the government.
After decades of practicing its leechcraft upon the people of Sweden, it ran into grave trouble again in 1720. The government of Sweden had once again failed to make good on its obligation to the bank and the Riksbank was unable to meet its requirements for redemption from a nervous citizenry.
This time Parliament came to the rescue, with what would be a key and defining characteristic of central banks – it granted the Riksbank’s notes the status of legal tender. This meant that the Swedes had to accept its notes to satisfy any claims of payment at par value, even though in the market the notes traded at heavy discounts to face value since it was rather well known that the bank’s treasury was light on gold.
The Riksbank was an early creaky prototype for what would become, in countries all over the world, ‘the modern central bank.’ It resembles the Federal Reserve in that it was created by an act of the legislature and that it enjoyed legal tender status on all its notes.
Monopoly and privilege would define central banks from the very beginning, as various steely-eyed historians and clear-seeing economists have pointed out.
The scholar Vera Smith was one of these, as well as being a sharp critic of central banking dogma in general. She wrote her doctoral dissertation under the supervision of Friedrich von Hayek at the London School of Economics. This work was published in 1936 as ‘The Rational of Central Banking.’ Despite the fact that the book is now nearly seventy years old, it remains an interesting and critical account of the formative years of central banking. As Smith surveys the development of central banking in a number of western countries, she convincingly makes the point that central banks emerged from "a combination of political motives and historical accident" as opposed to emerging from any sound economic principles or theoretical foundations. As she puts it, "A central bank is not a natural product of banking development…[it] comes into being as a result of government favours."
Central banking has always been tied to, enmeshed with, and a part of, the exigencies of state finance. Its power emanates from its status as a legal and protected monopoly issuer of legal tender notes, which as Smith points out, was a very welcome weapon in the armory of the state.
It was for later generations to adorn it with the tinsel of necessity, and adorn it they did. The arguments for central banking have grown more sophisticated over time, as the central banks themselves have become tightly woven in the fabric of accepted, and even desirable, social institutions. As Smith noted in 1936, (and it still holds today), "in the present century centralized banking systems have come to be regarded as the usual concomitant, if not one of the conditions of the attainment of economic development."
The central bank of today enjoys a prominent place in world finance that would have shocked even the early advocates of central banking.
Smith notes, too, the irony that when laissez-faire thinking was at its apogee in other industries, banking was still carved out as a special business, even by otherwise ardent free-traders and thinkers. It was from the beginning given an exempt status, which the principles of free trade seemed unable to penetrate from a public policy point of view.
This was one of the unfortunate turns of history, where one can only imagine what might have been had banking been able to develop along more natural lines.
For example, as Smith notes, the accumulation of privilege by favored proto-central banks had the effect of squeezing out competitive banks. In England, the Bank of England enjoyed such a special position that private note issue was abandoned by about 1780. Moreover, smaller banks began keeping balances at the Bank of England, thereby giving it even more the characteristic look of a central bank. Though Bank of England notes were not declared legal tender until 1812, its notes were, for practical purposes, accepted as such for many years prior.
In America, a series of crises – Smith lists 1873, 1884, 1890, 1893, and 1907 – fueled debate about America’s haphazard banking network, which involved a two-tiered system of national and state banks. The serial crises put the spotlight on the nation’s banking system, which was criticized for being inflexible and slow to issue notes in times of need. As Smith notes, "Its failings were summarized under the term ‘inelasticity.’ This is a term which has frequently had a dangerous connotation, being more often than not a cloak for the advocacy of inflation."
The problems of course stemmed not from the banks being too slow or inflexible, as Smith alludes to, but from the fact that they were loose and liberal to begin with. Fractional-reserve banking assures that, at times, some banks will be over-extended and unable to make good on their specie requirements. In the panic of 1907, suspensions of payments lasted over two months in some cases, which led to, as one might imagine, some angry depositors.
Smith also points out that the role of providing relief in times of crisis was often taken up by the Treasury, a principle that had been established as early as 1846. Smith documents the Treasury’s actions in 1873, 1884, and again in 1907, which largely consisted of the Treasury providing funds to national banks either by purchasing bonds or prepaying interest on the national debt. So you see here the very beginnings of today’s open market operations, which are carried out by the Fed.
The point here is to show that by 1913, the birth year of the Federal Reserve, central banking was not a novel idea. It was a very old idea, borrowed from Europe, without logical or well thought out principles guiding its creation, but political ambition, expediency and exigency at the helm. Central banks allow concerted inflating of bank reserves and credit, which is a source of great profits for banks as well as terrific fertilizer for the growth of future crises. Central banks also allow the banking system to enjoy the unwritten rule that the government will cover its backside during times of crisis.
The modern sheathing of central banking in fine-spun theoretical regalia occurred after the fact by self-important bureaucrats and ambitious courtesans. Today, the central bank has put itself at the center of every discussion regarding the economy. Widely held as the key steward of the nation’s interest rates and economic health, the Fed Chairman enjoys fame near the level of the President of the United States, with his every whisper subject to endless interpretation by pundits and others.
And yet, despite its position of power, prestige and privilege, the economy lies still beyond the grasp of the central bank. The bank can influence, but it cannot control. It can turn on the hose, but it can’t aim it. The real danger arises when it thinks it can.
for The Daily Reckoning
June 2, 2004
The latest money supply figures show yet another bubble expanding; M3 is increasing at a breathtaking 20% annual rate. In the last 4 weeks, M3 has gone up $155 billion. If this were to keep up, the nation’s total money supply would rise by $2 trillion in a year’s time – an amount equal, roughly, to a fifth of national output.
But how long can it continue?
You will recall, dear reader, that Alan Greenspan has made a pact with the devil…and George W. Bush has made a pact with Alan Greenspan. They will both do all they can to keep the bubble expanding – at least until after the election. And now, with the war in Iraq going about as well as you might have expected, the economy has become more important than ever. If by ballot day, things seem to be going badly on both bubble fronts, things will also go badly for America’s bubble president on Election Day.
But we are getting a little tired of bubbles. They seem to expand…and expand…and expand some more. Every time we expect them to deflate, they merely get bigger.
"You won’t believe what is happening to real estate – even here in Baltimore," said a friend yesterday. "In your old neighborhood, they sold a house recently for over $300,000. It’s unbelievable."
Unbelievable it is. A few years ago, they couldn’t even give houses away in many parts of Baltimore. Seriously. The mayor tried it. He condemned hundreds of abandoned houses and tried to give them away for $1 each. Many of them found no takers.
The catch was you had to agree to live in them.
But now even Baltimore, which, until recently, was in a real estate bear market that began in the 1920s, is enjoying the bubbly world of the early 21st century. People not only want to live in inner-city houses, they want to pay a lot for them.
"In Hampden, [a run-down area of tiny houses built for mill workers in the last century], they’re selling houses for $150,000," our friend continued.
Bubbles to the left of us, bubbles to the right of us, bubbles in front of us… How long will it be before one of them blows up?
We have grown weary of waiting. Budget deficits, trade deficits, consumer borrowing – the trends we thought would barely last another day now appear almost eternal. A kind of ‘bubble fatigue’ has set in. Like a crowd on the slopes of Vesuvius, we have all given up watching. Ignoring the smoke and ash, we go about our business…forgetting that the volcano could erupt at any minute.
"There are three rules for bubbles," writes Jim Jubak.
Rule #1 is that they continue much longer than you expect.
Rule #2 is that they expand faster near the end of the cycle…so just when you think they should have ended long ago, they seem more robust than ever.
Rule #3 is that no one wants to admit when it’s over.
Like us, Jubak is not sure when the bubble period will finally end, but he thinks we must be getting near. Countrywide Financial reports a huge surge in adjustable rate mortgages – up 130% over last year. The credit bubble is expanding so fast, it must be nearing its pin.
Likewise, General Motors has seen a big increase in its finance division. Making and selling cars is hard work, but financing cars, houses and insurance contracts is a piece of cake. GMAC now contributes 2 out of every 3 dollars of GM’s profits…with more than half of the financing profits completely unrelated to the auto business.
"One of the most frustrating things about this market and about the interlocking relationships so characteristic of our financial system is that it is so hard to figure out who will get left holding the bag," writes Jubak. "I am certain, however, that this isn’t the time for investors to let their guard down. This bubble is unlikely to break with the kind of pop that took down the entire stock market in 2000. But it is even less likely to deflate gently and without any pain."
Over to Addison for more news:
Addison Wiggin, from Baltimore, the greatest city in America…
– Like a pair of snarling hyenas, fighting for the last scraps of flesh from a rotting carcass, the U.S. and China are desperately competing for scarce resources. Who will win this battle of the mangy dogs? The story begins down south, in the sunshine state…
– In Florida, construction projects have been put on hold, contractors are panicking and cement is nowhere to be found. It’s all being sucked up by China. The reason is simple: An economy the size of France or Italy is growing at rates usually reserved for small island economies; China grew at a 9.8% annual growth rate in the first three months of the year.
– China has 4,813 cement plants, more than the rest of the world combined, and they still don’t have enough. Projects like the Three Gorges Dam and Beijing Olympics forced China to gobble up 55% of the world’s supply of cement, 40% of its steel, and 25% of its aluminum. Yesterday we learned that, in Shanghai, real estate prices rose by 28.3% in the first quarter, according to the Detroit Free Press, causing the local bureaucrats to ban developers from selling apartments before they have been built…these are more than mere details for our Pao Mo file…they’re affecting markets all over the world.
– Of course, to the astute reader of the Daily Reckoning, none of these statistics will come as any surprise. You know as well as anyone that this story is not a new one. Stories of cargo ships waiting to dock and chronic power outages have been flogged to death by the media.
– But over on the other side of the globe, the U.S. is also expanding rapidly. The good numbers just keep on rolling in…yesterday another strong reading from the ISM Index was released. The reported number came out at 62.8, the seventh straight reading above 60, and further proof of a robust turnaround in the manufacturing sector.
– And what about this just out – global chip sales grew by 4.1% in April – the strongest growth since late 2000…
– Or this from the Dismalscientist.com, released yesterday, "Construction spending soared 1.3% in April, blowing away consensus calls for a modest 0.4% rise in building activity, and setting the stage for a strong start to the second quarter. March’s already strong preliminary estimate was also revised up sharply."
– The good news didn’t have much impact on the markets, but then again, it never does these days…still, stocks staged a strong late-day rally. The Nasdaq turned in the warmest performance, gaining 4 points, up 0.2% to 1,991. The Dow and the S&P, for all intents and purposes, finished flat despite the initial sell off in the morning. At session close, they stood at 10,203 and 1,121 respectively.
– As flippantly as ever, market sentiment towards China has also changed from positive to negative. "Some analysts fear that, if unchecked, the investment boom could collapse, similar to the collapse of the high-tech bubble in 2000," warns the Detroit Free Press article by Ken Moritsugu and Tim Johnson.
– Their fears are not unfounded; authorities in Beijing have been making some noises of their own…unlike their counterparts in the U.S., they recognize the bubble potential and are taking steps to restrain it. Officials have already moved to restrict some of the more aggressive lending practices in use by state-owned banks, which, according to reports, maybe hold bad loans equivalent to 40% of their asset base.
– Fortunately, here at the Daily Reckoning, we don’t need to base our investment decisions on hearsay – we have a fresh report from our man in Asia, Dan Denning.
– Are the fears of Pao Mo warranted? Not so, says Dan. "First, all that worry about China cooling down and a soft landing is misplaced. The real story is that the government is turning over more and more control of the economy to market forces. You can break it down into two broad categories: financial services and agriculture. And in these two areas, there is huge opportunity for investors without the risk of a bubble."
– Now that both the Chinese and American economies are running on full power – competing for cement, oil, and other resources – action in the commodity trading pits promises to be volatile for quite some time to come.
Bill Bonner, back in…Baltimore!
*** Wait, Addison is in Baltimore. And so is your editor.
"What’s it like being back in Baltimore," we asked our formerly Paris-based colleague. Americans in France become euro-snobs; returning to the U.S. they find that nothing quite measures up. Life is easier, but not as nice. People take their politics too seriously back home, and their meals not seriously enough.
"Well, the transition was easy. We used to live here, of course. But it was almost too easy coming back. It was a little like putting on an old pair of socks."
*** Can we Americans ‘hack it,’ dear reader?
Not according to Niall Ferguson, author of "Colossus: The Price of America’s Empire." Ferguson seems to like the idea of an American empire. But he just doesn’t think Americans are up to it.
"The greatest of today’s maritime-industrial powers, the United States, has projected itself right into the center of this vortex, and to a degree that would have astonished the Founding Fathers, Teddy Roosevelt, Wilson, FDR, and Eisenhower," writes Paul Kennedy in his review of Ferguson’s book. "Department of Defense reports on overseas deployments vary from month to month, but, roughly speaking, there are 130,000 American troops in Iraq, about 30,000 in Kuwait, and 15,000 in Afghanistan. The United States is using air bases and training bases in Turkey, Uzbekistan, and Kazakhstan. It has gone further into the Heartland than Lord Curzon might ever have imagined an offshore power could do."
But do Americans have what it takes to run an empire? Probably not.
First, we don’t have the money. Ferguson repeats what we have been saying in the Daily Reckoning for the last 5 years: America’s empire is built on a bubble of debt, deficits and self-delusion. Some day…it will blow up and blow away.
But Ferguson offers another interesting reason why Americans cannot hack the job of being an imperial power for very long; we don’t have the guts. Kennedy explains: "[They] do not have the social, cultural, and political strength to produce a ruling class that would benignly administer Iraq for the seventy or so years that, for example, the British administered Egypt. The sons of the British elite competed fiercely to get into the India Civil Service, the Colonial Service, the Sudan Service. Nowadays, he [Ferguson] says, Harvard and Yale graduates are going off to law school or to Wall Street. Besides, which members of the proselytizing neocon elite have ever served in the military, or have children in the military? How many members of the U.S. Senate have a child in the military? Which of our vigorous neocons are willing to send off their daughters to rule Mosul for the next thirty years? We are still under the shadow of Vietnam. And so, Ferguson teases us: we should be an imperial nation, but we haven’t the guts to be one. What’s more, if we decide to follow the path of Richard Perle and Paul Wolfowitz and become the new Western empire in the Middle East, we will be stuck there for ages. And one day, like Curzon and Cromer and the rest, we will have to go. Heads you lose, tails you don’t win. You are, Ferguson charges, an empire in denial; but you cannot properly attend your new estates."
*** America’s empire may be headed for extinction…but that doesn’t mean we Americans can’t have a good time, just not in our beloved Homeland, apparently. Alas, Tyler Brule, in the Financial Times, lists the world’s best cities to live in. Two are in Australia. Not a one is in North America: Sydney, London, Barcelona, Copenhagen, Melbourne, Stockholm, Beirut, Zurich, Sao Paulo and Paris.
*** Forget empire…worry about getting enough to eat, says MoneyWeek editor Merryn Somerset-Webb. Currently, China is competing with the West for jobs and resources. Oil, for example, rose to $42.33 a barrel yesterday. Soon, China’s billion-plus citizens will be competing for food. Food prices will rise, says Somerset-Webb. Buy farmland?