Ron Paul on Greenspan's Fed

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Dr. Ron Paul,
an obstetrician, has sat on the House Banking Committee throughout
his political career. (He was first elected to Congress in 1976.)
This is not a popular committee to sit on. The committee hands
out no money to constituents. It creates no projects that provide
employment for the folks back home. It monitors what the banking
system is doing to hand out money. Most voters don’t care.

Dr. Paul
understands monetary theory. That’s because he has read Ludwig
von Mises and Murray Rothbard. I doubt that any other member of
the committee has — at least not since Congressman Phil Crane sat
on it, even before Dr. Paul did. But Dr. Crane decided that it
wasn’t worth the effort. He resigned from it 30 years ago.

So, when
Alan Greenspan comes to testify, Dr. Paul grills him. No other
elected politician has grilled him more systematically.

Back in 1976,
I was his research assistant. Even then, when he was the newest
Congressman in Congress — he had been elected in an intra-term election,
because the incumbent Congressman had resigned — he was on the attack.
In 1976, Arthur Burns was chairman of the FED. Burns had been
chairman when Nixon closed the gold window in August, 1971. He
had endorsed Nixon’s unilateral imposition that day of price and
wage controls. (Ironically, Rothbard had earned his Ph.D. under
Burns at Columbia. Rothbard’s view of money was very different
from Burns’ view.)

Dr. Paul
has watched FED chairmen come and go. He has also watched the
dollar depreciate. No one in Congress has served as a louder watchdog
of the decline of the dollar.

he wrote a report on the state of the financial union. It deserved
a lot more attention than it received.


The expansion
of the money supply has been accompanied by a rise of household
debt. This is the Achilles’ heel of the financial system, Paul

In testimony
before the House Financial Services Committee last week, Federal
Reserve Chairman Alan Greenspan painted a rosy picture of the
U.S. economy. In his eyes, the Fed’s aggressive expansion of
the money supply and suppression of interest rates have strengthened
the financial condition of American households and industries.
If this is true, however, our nation’s "prosperity"
is merely a temporary illusion based on smoke and mirrors. True
wealth cannot be created simply by printing money; families
and businesses cannot prosper by getting deeper in debt.

In fact,
Frank Shostak of the Ludwig von Mises Institute
throws cold
water on Chairman Greenspan’s assertions in an article entitled
"Running on Empty." Mr. Shostak cites statistics showing
that American families have never been deeper in debt, never
saved so little, and never consumed so much more than they produce.
By any objective standard, U.S. families are treading on very
shaky economic ground.

Shostak has
provided a series of graphs of these developments. I recommend
that you click through and print out his article. Pay attention
to these graphs. They make it easier to see where the economy
is headed.

Dr. Paul
asks some compelling questions.

Never mind,
says Mr. Greenspan. Mortgage refinancing, made wildly popular
by artificially low interest rates established by the Fed, will
be the saving grace of American households. They can simply
borrow against their homes to finance living beyond their means,
a practice encouraged by Fed policies. But what happens when
home prices stop going up? What happens when families reach
a point where they cannot make payments on two, three, or even
more mortgages? How can the Fed chairman equate mortgage credit
with real economic growth?

The mortgage
re-financing boom has been in full swing throughout the recession
and the recovery. Analysts commonly explain the mildness of
the recession by an appeal to mortgage re-financing and the
growth in housing. But this has been a consumer goods boom,
not an increase in productive capital resources. That boom will
cease when interest rates return to normal.

Mr. Shostak
also demonstrates that American businesses aren’t doing much
better. As consumers exhaust their ability to borrow, they necessarily
buy fewer goods and services. The ratio of business liabilities
to assets is very high, price to earning ratios are still unrealistic,
and investment capital remains scarce. Business may be better
than it was two years ago, but the fundamentals are far less
healthy than Mr. Greenspan would have us believe.

Dr. Paul
then comments on a factor that the bulls ignore and the bears
believe is crucial: the debt/GDP ratio. It takes more and more
debt in the economy to produce a dollar’s increase in the Gross
Domestic Product. At the center of this increase in debt are the
Federal Reserve System and the U.S. debt. When recession hits,
the first line of defense is the FED, which then creates lots
of new money, just as it did in 2001.

As financial
analyst Jay Taylor explains, the disturbing increase in the
debt to GDP ratio illustrates that printing more money is the
only solution federal policy makers know. Federal debt naturally
grows faster than income — while there are no limits to how fast
the printing presses can run, there are natural limits to economic

He then raises
the question that economists who specialize in international currencies
have been raising. What happens when Asia’s central banks decide
to stop increasing their money supply in order to keep the dollar
from falling in value in relation to their currencies?

The end
may come when foreign central banks realize the dollars they
receive are worthless, or when they find other places to turn
for income. When that day comes, interest rates will rise, perhaps
dramatically. At that point not even Mr. Greenspan will be able
to save the economy from the painful correction necessitated
by his easy credit, easy money policies.


The FED has
been a factor in lowering rates. A price is the product of supply
and demand. The FED provides the supply. But in 2002—4, the
FED has not been creating lots of new money. The increase has
been under 6% — and negative since mid-2003. The FED can
add to the adjusted monetary base, but this does not determine
the money supply directly. The money supply has been increasing,
but not at anything like the rates in Japan and China.

Then what
else has forced down rates? Two things. First, businesses have
been hesitant to borrow until recently. Second, lenders have been
willing to lend at low rates. The fall of the stock market scared
investors. They began moving into bonds and even CDs. The upward
move of the stock market in 2003 did not persuade most of them
to sell their bonds and mortgages in order to move back into stocks.
They are still scared of equities. If they weren’t, we would see
a sell-off of bonds and rising long-term interest rates. This
has not happened.

The consumer
has been the big borrower, not the businessman.

We have seen
consumers take on more debt as rates have fallen. This is what
bothers Shostak. Consumers are not paying attention to their overall
burden of debt. They are looking only at their monthly payments.
This is determined mainly by interest rates. As the price of borrowed
money — interest — has fallen, more of it has been demanded by consumers.
The monthly debt burden seems low because of lower interest rates.

The businessman
looks at the level of debt that his business can safely sustain.
He knows that rates can rise. He knows that if his business’s
revenues don’t keep pace with the rise in rates, he can get caught
in a cash-flow squeeze. He therefore prefers long-term debt to
short-term debt, i.e., bonds rather than bank loans. Big businesses
have been doing this. Small businesses don’t have the credit rating
to do this — no access to the bond market. But they have stayed
away from bank credit, with loan renewals every five years, and
maybe as often as three. This indicates that they fear rising
rates. They don’t want to get trapped when banks call the loans.

don’t care about these negative factors. They think today’s rates
are permanent. For a 30-year mortgage, they are correct. The rate
is fixed. But taxes aren’t fixed, and fire insurance premiums
aren’t, either. Operating expenses generally aren’t. But American
consumers are optimists. They look at the interest rate today,
borrow, and buy. They risk getting trapped.

The only
thing that will keep rates from rising is price deflation. The
economy has yet to produce price deflation, but it’s getting close
this year. Prices are rising, but just barely. Under such circumstances,
buyers will not be able to pay off their debts with depreciating
dollars. The housing boom will therefore come under downward pressure.
The rate of increase in housing prices will slow or even reverse,
especially for middle-class and upper-class housing.

As debt rises,
the threat of rising rates and price inflation becomes greater
than debtors had expected. On the other hand, if rates stay low,
this can be only because the price level is close to stable or
even falling. That would thwart the dreams of "buy now, pay
off with cheap money." In either case, the level of debt
is too high. Debtors’ optimism is greater than the economy warrants.


There is
productive debt, of course. Higher education is usually productive,
although paying $50,000 to $150,000 for a college degree when
you can get one for $8,000 doesn’t seem sensible. At least 99.9%
of college attendees overpay. I have written a report on this.
Click in this link,
and then click SEND

Buying the
tools of your trade (preferably used but in good condition), subscribing
to magazines and newsletters in the field, attending hands-on
seminars, and spending time in the library (which few people do)
all require money, either out of pocket or in forfeited income.
Yet this is the road to wealth. If you invest as little as an
hour a day for one year in reading about some field, you can become
an expert, or close to it. If you have to go into debt, do it.

Start a small
business. Sign a lease or a bank note, but only after you have
invested at least 300 hours in researching the field. The debt
enables you to gain a high pay-off from the time that you invested
in gaining entry to a field. The debt leverages your information.
But get that information early, as cheaply as you can. And if
you can start a business without debt, I recommend it. But remember:
a lease is a debt.


There are
people who say, "Never go into debt." These people have
one thing in common: they don’t have enough investment capital
to live on. If they should lose their jobs, they would be in trouble.
They operate on the assumption that they won’t get sick or get
fired. Most people make this assumption.

Now, if it’s
a question of living on your salary without debt or with debt,
the former is preferable. It reduces your risk. But without capital,
you will remain dependent on the debt decisions of your employer.
You have not escaped debt in your life. You have merely transferred
to your employer the responsibility of deciding how much debt
to bear. If he guesses wrong, you could lose your job.

How many
salaried people are aware of the financial condition of their
companies? Very few. They trust their employers. They assume that
their employers have looked at the company’s debt/income and debt/capital
ratio, and that their employers have made wise decisions. Even
employees who work for companies that must submit reports to the
Securities & Exchange Commission rarely read these reports,
even though they are posted on-line (EDGAR).
They don’t know how to interpret them. They don’t invest time
and a little money to find out how to interpret them.

It never
ceases to amaze me that people who are meticulous about their
own financial condition are uninformed about the financial condition
of their employers. They are dependent on other people’s decisions,
yet they prefer to remain uninformed about the solvency of the
organizations that supply them with their jobs, their pensions,
and their future.

Debt can
be productive. It can also be a liability. My recommendation is
that you know the debt condition of your employer. You should
also know something about the market your employer competes in
and the strength of his competitors. If you do this, you will
be in a position to jump ship early, if required. You will also
become a more valuable employee. You will be much more likely
to move up in the corporate hierarchy.


The debt
condition of the United States is an important factor in the success
of the economy and therefore of your employer. Yet most voters
pay no attention to government debt. They assume that Congress
knows what it is doing. This is not a safe assumption.

Because of
the extreme division of labor today, we can’t second-guess everyone
on whom we are dependent. But we can and should spend time and
money in finding out more about the debt level of those on whom
we depend directly.

The debt
structure is like a row of dominoes. If a key one topples, it
could topple the system. We assume that there are safety switches
and fuses in the system that will keep this from happening. There
are, but the question is: Will they work? Usually, they do. But
when most people rely on these fuses to protect them in all situations,
they are playing with statistical fire. No system is protected
from all eventualities.

Dr. Paul
is correct: the debt structure is the interconnected domino that
offers the greatest risk for the economy. Congress spends more
than it takes in. It issues IOUs on a massive scale every month.
The Federal Reserve supposedly is the lender of last resort, the
switch that will keep everything running smoothly. But today,
the Bank of Japan and the Bank of China have more to do with the
international value of the dollar than the FED does. Foreigners
have become major players in our markets. Above all, salaried
central bankers in Asian countries hold the hammer.

How much
do you trust their judgment? The less you trust them, the more
time you should spend on establishing alternative sources of income
that will not run dry when interest rates rise, the value of the
dollar falls, and unemployment increases. You do not want to spend
your golden years saying, "Welcome to Wal-Mart." It’s
better to shop there than work there.

28, 2004

North [send him mail]
is the author of Mises
on Money
. Visit
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