The coming depression?

National Review, April 21, 1997 by Lawrence M. Parks

Leveraging by the banking system, sometimes coupled with the creation of irredeemable paper ticket money, has been responsible for every recession/depression over the past two hundred years. One of the clearest explanations of the process is that of Fed Chairman Greenspan in his essay "Gold and Economic Freedom." He wrote:

The excess credit which the Fed pumped into the economy spilled over into the stock market -- triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed.

As Michael Belkin of the Foundation for the Advancement of Monetary Education (FAME) wrote in a recent study:

Isn't this exactly what has happened in our time? The so-called real Fed Funds rate (Fed Funds minus CPI) averaged - 0.12 per cent from November 1992 to May 1993. That was the only instance in the past 16 years of negative real short-term interest rates. For the full two-year period 1992 - 93, the real Fed Funds rate averaged only 0.28 per cent, versus a 16-year average of 3.5 per cent and its current level of 2.25 per cent. In this way, excessively low interest rates in 1992 - 93 penalized savers and induced them to transfer money out of stable par-value bank deposits into much riskier stock mutual funds that promised double-digit annual returns.

Fed-manipulated lower interest rates increased the profits of highly leveraged companies. Higher profits increased valuations. But more significantly, decreasing interest rates caused profits to be capitalized at even higher levels, thereby driving equity valuations higher still -- a double whammy.

Even more troubling than the Fed's manipulating the low end of the yield curve is the monetization of U.S. debt by foreign central banks, mostly the Bank of Japan. Since the end of 1992, they have purchased almost $450 billion in U.S. Government securities. Were it not for these ongoing purchases, now routinely $2 to $5 billion per week or more, the dollar would be weaker, foreign imports would be more expensive, U.S. manufacturers would have pricing power, the CPI would be higher, and so would interest rates.

There is also the issue of irredeemable paper ticket money (dollar) creation. Lost is the fax of "balanced budget" nonsense in the fact that the U.S. budget is a cash budget, as opposed to an accrual budget, which almost every business uses. According to Peter Peterson (former secretary of commerce, former chairman of the Council on Foreign Relations, former chairman of Lehman Brothers, now head of the Concord Coalition) the U.S. budget deficit on an accrual basis is $1.5 trillion per year. Not being able to tax such large amounts, governments have always reverted to the printing press to provide the benefits with which they buy notes.

This is not all. There is also the safety net/subsidy that the Fed (really the taxpayer) provides to the banking system, enabling it to over-leverage and profit at taxpayer expense. But why should ordinary taxpayers guarantee the profits of bankers?

Finally, what are Mr. Greenspan's views about the prospects of a complete financial collapse? He says:

With leveraging there will always exist a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked . . . Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive.

What people should be asking is: How high is a "high probability?" How much of the dollar's purchasing power would be lost if the Fed were to exercise its "unlimited power to create money" to ensure the profits of the banking system?

But the most important question is: Why should we be at risk of another Great Depression? Why shouldn't we have a monetary system --the gold standard -- that, in Mr. Greenspan's view, virtually eliminates this risk?

Since the demise of the Evil Empire, there is general agreement that central planning doesn't work. Why should the Fed, a central planner par excellence, have any more success than any other central planner? It doesn't sound to me as if Mr. Greenspan thinks it will.