Discount Punch at the Never-Ending Party

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Four decades
ago, the Chairman of the Federal Reserve System who held onto
his job longer than any other Chairman, William McChesney Martin,
described the FED’s job: to take away the punchbowl just when
the party gets rolling. It is clear that his successor, Alan Greenspan,
does not see the FED’s job in the same way. He sees it as supplying
the punch at discount prices.

This report
is on the price of punch, the supply of punch, and hangovers.

To understand
this report, you need to be a good economist. To be a good economist,
you need two imaginary parrots. One sits on your left shoulder
and says, "supply and demand." The other sits on your
right shoulder and shouts, "high bid wins." If you listen
to both parrots and apply these truths to the problem you are
dealing with, you are unlikely to make a major mistake.

You can spot
a waffling free market economist when he ceases to listen to either
of these parrots. A Communist economist never listens to either
one. There are not many Communist economists these days. Most
of them are named Kim. They are hoping to defect.


There is
no area of economic theory in which ignorance is more widespread
than monetary theory and money’s relation to debt. This has always
been true. If you read Aristotle, you find that he was hostile
toward money-lending. Money should not bear interest, he said,
because money is sterile.

are no free lunches," free market economists assure the public,
but then they assure us that the economy requires a government-created
monopoly called a central bank. Why? Because a central bank can
regulate the supply of money to "facilitate business"
and "smooth out the business cycle." In other words,
the free market is a failure. It needs a little help from the
State. Not too much, though. We wouldn’t want Congress to interfere
in such matters. Then, in order to square the circle, the free
market economist assures us that this monopoly, unlike all other
monopolies, should not be regulated by the government that has
created it. A central bank should be "independent of politics."
In short, the free market economist sounds just like a Washington
lobbyist for some special interest group.

a handful of populists who are not economists, and who also do
not understand monetary theory, call for the abolition of the
Federal Reserve System. They also call for Congress to take over
monetary affairs. They want politics to set monetary policy, not
some protected special interest group. In the next breath, they
assure us that Congress is incompetent, a tool of the special
interests — something that I am prepared to believe. But in the
area of "honest money," populists assure us, we should
allow Congress to do reliably what the Federal Reserve System
somehow can’t do reliably: regulate money.

Only Austrian
School economists are in favor of market-created money. Even here,
there are divisions between the free banking (no regulation) Austrians
(Mises) and the 100% reserve banking Austrians (Rothbard).

isn’t it?


What we find
in every society is a widespread mistrust of lenders. In every
society, creditors are distrusted, yet they are universally appealed
to when people’s personal money supply runs short.

lenders who lend to people who are known to be bad risks — people
who do not consistently repay their debts — are called "usurers"
or "loan sharks," as if they, rather than their beneficiaries,
the known contract-breakers, are the culprits. To be a money-lender
is to be distrusted or even hated.

This is a
universal phenomenon. In every society, money-lenders are regarded
as moral failures. In economically backward societies, social
outcasts and foreigners tend to go into this occupation. Good,
self-respecting citizens refuse. They don’t want the stigma. Jews
in medieval Europe, Chinese in Indonesia, and lower castes in
India have been the money lenders. "Money is dirty,"
people think. Then they try to borrow some of it.

In the modern
world, we are all money lenders. The union member with his retirement
plan (ready to be looted by union executives), the grandmother
with her savings account (ready to be looted by the Federal Reserve
System’s inflation), the worker with faith in the Social Security
trust fund (long since looted by the government), the child with
his savings bond (ready to be looted by the Federal Reserve System’s
inflation) — all are money lenders. Every trusting soul who turns
over his money to financial brokers of one variety or other has
put his faith in the honesty of debtors. They will repay him,
he believes.

Sure they
will. That’s because they deeply believe in the sanctity of contracts.
They believe that a man’s word is his bond. They believe that
the lender is society’s chief beneficiary, the bedrock foundation
of capitalism. And where did they learn these truths? In the government-funded
school system. On MTV. On PBS. In Oliver Stone’s latest movie.

Western society
is schizophrenic. We tell our children to be thrifty. This means,
in most cases, to become money lenders. We get them to open a
bank account, to establish a personal budget, to "save for
a rainy day." Then we complain whenever interest rates are
higher than we want to pay. "Those bloodsuckers!"

Nobody at
the Federal Reserve gets criticized by Congress or The Wall
Street Journal for lowering interest rates. In 2001, America’s
lowest interest rates were in the 6% range. Then the FED, represented
in everyone’s mind by Alan Greenspan, pumped in new money by buying
government debt, and thereby forced short-term rates down to the
1% range. Did anyone in Congress, other than Ron Paul, complain
about this interference with free market forces? Of course not.
Greenspan was "providing needed liquidity." He was "keeping
businesses’ doors open." He was "restoring confidence
in the banking system." He was, in the final analysis, "saving
capitalism from itself."

He was also
hammering money-lenders. Retired people saw the return on their
savings accounts cut by 80% or more. "Sorry, granny, but
your sacrifice was necessary to save the economy. By the way,
I just re-financed my house. Man, I’ll save a bundle. I can even
put a down payment on an SUV!"

Now we read
that the re-fi boom is slowing. Worries abound. Will this stop
the economic recovery? Will interest rates soon rise? Will this
retard the American consumer in his relentless pursuit of wealth
through greater debt? Will granny finally get back her income?
Oh, no!


Here is the
debtor’s preferred world. First, interest at low rates, preferably
under 5%. Second, depreciating money, which will enable him to
pay off his lenders more easily. Third, a booming economy, which
will let him get raises. Fourth, low taxes, which will let him
spend more on consumer goods. Fifth, a good credit rating, so
he can go more deeply into debt.

Here is the
creditor’s preferred world. First, interest at high rates, preferably
over 10%. Second, appreciating money, which will get him an extra
added return above the contract’s stated rate of interest. Third,
a booming economy, which will enable borrowers to repay him. Fourth,
low taxes, which will let him keep more money to lend out. Fifth,
a good credit rating, so that if he ever needs a loan to lend
out even more money, he can get one.

wants a booming economy and lower taxes, at least lower for him.
Everyone wants a good credit rating. But when government comes
in to "save capitalism from itself," what do we get?
Interest rates that go from too high to too low — meaning added
risk for both borrowers and lenders. We almost always get depreciating
money, but not at predictable rates. We get the business cycle:
booms and busts. We get higher taxes, which are disguised as economic
regulation and inflation. The government gets the highest credit
rating, until the day it goes bust, leaving everyone who trusted
it, and therefore lent it money, much worse off.

The government
intervenes in the name of the debtors, promising something (cheap
loans) for nothing (no inflation), and the voters then get a spastic
economy that lurches from boom to bust. Example: in the aftermath
of the brief depression of 1907, Congress gave us the Federal
Reserve System in 1913, which gave us the depression of 1921 and
the Great Depression of the 1930s. The FED also debased the dollar
by about 97%. Yet you cannot find a college-level textbook in
history, government, or economics that says that the Federal Reserve
is a liability. The FED is described as the one institution created
by the government which legitimately is "above politics."
The FED’s only major error — Milton Friedman’s thesis —
was to be overly restrictive in not creating enough fiat money,

We are today
living in one of those brief periods in which most voters think
they are getting something (cheap loans, rising asset values)
for nothing (stable money). These periods never last long — a few
years, maximum.

Debtors today
think they are pulling a fast one on lenders. They think they
can borrow at low rates, spend without risk, and buy a nicer home,
which will appreciate. They forget that with rising home values
come rising property tax assessments. They also forget that lenders
can buy homes. They expect lenders to give away money to them,
for old times’ sake.

The bad news
comes when interest rates rise as a result of new monetary policies
or new lending patterns. Then the party ends. The economic boom
ends. The bills come due. The worm turns. "Those bloodsuckers!"

Today, Americans
find what appears to be the best of all possible worlds: the lenders
are mostly foreigners. These foreigners sell their currencies,
buy dollars, and lend these dollars to Americans. They even agree
to accept repayment in dollars, which the Federal Reserve can
depreciate at any time, thereby bailing out a nation of debtors.
This, Americans believe, is the true nature of things, where the
whole world exists to provide Americans with discount punch at
a never-ending party. They do not see that parties eventually
end, and party-goers will have incomparable hangovers.

The immediate
cause of the end of the party is rising interest rates. Lenders
finally decide not to become the suppliers of discount punch for
the debtors’ party.

The prelude
to rising interest rates is rising price inflation.

This leads
me to the rest of the story. . . .


I pay less
attention to the consumer price index than I do to the Median
CPI, which is published by the Cleveland Federal Reserve Bank.
In its most recent posting,
the Cleveland FED reported that the Median CPI was up in March
by 0.3%.
This, if repeated monthly, would result in an annual
increase in prices of 3.3%. The regular CPI (I call it the media’s
CPI) was up 0.5% for the month. This would produce a price inflation
rate of 6% for the year.

In February,
the Median CPI was up by 0.2%. In January, it was up 0.1%. Thus,
the figure has tripled in two months. This is not good news for

I hear what prices have done recently, I immediately go to "U.S.
Financial Data
," a weekly publication of the Federal
Reserve Bank of St. Louis. I check the adjusted monetary base.
More than any other statistic, this one tells me about actual
Federal Reserve monetary policy. This is the one statistic that
the FED can control directly: the book value of the reserve assets
that it owns.

In the April
15 issue, the graph and the table underneath it reveal that not
much is happening. The increase, year to year, is a little over
4%. If anything, this is a bit on the low side.

This means
that whatever the cause of the price increases in recent weeks
may be, the FED’s policies over the last year are not the primary
source of the increase. We can look for a lag between policy and
results, and we should, but the FED is not in high gear today.

on my survey of graphs is money of zero maturity.
This is
sometimes said to be the closest surrogate statistic for what
the monetary markets are actually doing with whatever reserves
the FED is providing. I’m willing to go along with this. Everyone
is guessing, so why not this guess? MZM is up almost exactly what
the adjusted monetary base is up, year to year. It shrank in the
second half of 2003, but it is up sharply since the beginning
of the year.

As to why
MZM is gyrating all over the place despite the absence of much
change in the adjusted monetary base, I have no idea. I suppose
I could make one up. I could talk about increased optimism on
the part of borrowers and lenders regarding the pace of economic
change. I would then direct you to the FED’s graph of Bank Loans
and Commercial Credit to prove my case. Both figures began rising
last December.

The problem
with this graphic evidence is that, on
the same page
, immediately beneath the chart of Bank Loans
and Credit, there is a dual chart: Commercial and Industrial Loans.
Except for a spike in the middle of December, both indicators
have been headed downward for over a year. The pattern is systematically
depressing. It points to a complete lack of enthusiasm for non-bond
debt on the part of businessmen.

The economy
is doing better than this chart indicates. What this chart tells
me — I don’t know what it tells Greenspan — is that those businesses
that can tap into the bond market are doing so. They are selling
long-term debt to individual investors and institutions, taking
advantage of today’s historically low interest rates. They are
locking in the rate of interest on their debt.

Either the
corporation executives are stupid or else the investors who are
lending them long-term money at 6% are stupid. In the race of
the lemmings, I am betting that the investors will go over the
edge of the cliff first. I think they will be looking at enormous
capital losses before the end of the decade, as inflation drives
up long-term rates, thereby lowering the market value of existing
fixed-rate debt.

A corporation
that borrows from a bank cannot secure a low interest rate comparable
in length to what it can secure from bond investors. Bankers are
determined not to get burned by locked-in rate loans. They want
to be able to re-negotiate in three to five years — preferably three
— regarding the terms of the loans. Corporations are equally
determined to avoid any such day of accounting. So, they have
abandoned the banking system as a source of new loans. They are
not rolling over existing loans. They are using money raised by
selling bonds to investors to pay off existing bank loans.

This tells
me that bankers and corporate decision-makers think that rates
will rise. I think so, too.


The banks
and the corporations have ceased dealing with each other. Both
sides sense risk in the debt markets. Bankers see the risk in
long-term debt. Corporate executives see the risk in short-term
debt. Neither side is willing to budge. They agree with each other’s
assessment, namely, that rates are going back up.

Why would
long-term rates go up in a deflationary scenario? If prices are
actually falling, you can get a nice return on your money through
rising purchasing power. You get capital appreciation, too: when
the bond is paid off, the money will buy more. This means capital
gains without taxation. When your money buys more, yet stays the
same numerically, it’s a non-taxable event. This is why governments
hate deflation.

Let me give
you an example. In 1985, I bought British pounds. I was planning
to go to England to visit used book stores. I bought travelers’
checks. (Remember those?) I bought the pound at its all-time low:
$1.10. By the time I got to England, and then Wales, the pound
had recovered to about $1.30. Had I converted my pounds to dollars,
I would have owed the IRS on the profit. No fool, I! I bought
books with my checks. I bought lots of books. I bought them all
over the British Isles: London, Oxford, Wales, Scotland. It was
the greatest spending spree I ever had in used book stores. And
it was all tax-free! (Note: buying used books did not produce
guilt because I justified every purchase by saying, "I may
never see this book again." That was pre-Internet, pre-Amazon,
pre-ABE Books.)

So, I now
ask myself, if deflation is coming, why should corporations be
happy to sell billions of dollars in bonds, but refuse to go to
banks to borrow money? Why would they become legally obligated
to pay lots of appreciating dollars to investors? Two reasons:
because (1) they plan to re-finance bonds if rates do fall, ruthlessly
paying off today’s bondholders, or (2) do the same debt substitution
with bank debt. This points to the asymmetric aspect of investing
in corporate bonds: heads (falling prices/rates), I lose; tails
(rising prices/rates), I lose.

win in either case. Bond investors lose in either case. So, corporations
prefer long-term debt to short-term debt.

This means
that banks today have to make their money by lending to consumers,
who are for the most part economic ignoramuses — almost as ignorant
as investors in commercial bonds. The banks get far higher rates
of interest from consumers. Banks can raise rates when rates in
general rise. They can keep charging high rates when rates in
general fall, because consumers are not aggressive in demanding
lower rates. They do not pay off old debt at 14% with new debt
of 5%. They can do this, if their credit is still good, but they
don’t. They don’t send letters to their credit card companies
threatening to switch to Capital One or some other aggressive
credit card company. If they did, their own card companies would

So, banks
are lending, but they are not lending to businesses. They are
lending to Joe and Sally, who were not taught to be aggressive


The central
banks of China and Japan are buying enormous quantities of dollar-denominated
assets, mainly short-term U.S. Treasury debt paying less than
1.5%. They are creating money out of nothing to make these purchases.
They are supplying discount punch to a nation of truly serious
party-goers. For as long as they are willing to do this, the party
will go on.

The FED is
not the source of today’s low interest rates. It is not pumping
in above-average supplies of money. It is not in deflationary
mode, but it surely is in disinflationary mode. Problem: price
inflation has now reappeared. In fact, if we go by the CPI, price
inflation now exceeds the monetary inflation of the adjusted monetary
base. This is a rare situation, indeed. It has usually preceded
rising interest rates.

lenders are getting nailed. They pay income taxes on interest
received. They are getting a return that is lower than the rate
of price inflation if they are in short-term assets, and they
are bearing enormous risk of loss through monetary depreciation
if they are in bonds, whose rates barely exceed the rate of CPI
price inflation (as of March). They are in the "nothing for
something" mode. As George H. W. Bush put it in 1990, "this
will not stand." American lenders will not do this forever.
They can buy bonds denominated in foreign currencies, and at least
get the prospect of capital gains through the monetary appreciation
of foreign currencies compared to the dollar. They are not legally
tied to the dollar.

At some point,
Chinese central bankers and Japanese central bankers will cease
to supply the discount punch. They will cease buying so many dollars.
At that point, the international demand for dollars will fall.
The supply of willing lenders of dollars will fall. The remaining
lenders will face reduced competition. Then they will do what
any rational supplier does when he faces reduced competition.
They will hike the price of their product. Rates will go back
up. Woe unto today’s bond holders and woe unto borrowers with
adjustable rate mortgages.


When you
think that you can get something for nothing, beware; you may
get nothing for something. Parties eventually end. When people
mistake a party for their day jobs, they do more partying. They
will have more painful hangovers as a result.

Alan Greenspan
has made it clear that he will supply the discount punch if China
and Japan and other central banks lose interest in maintaining
the Great American Party. Right now, he doesn’t have to supply
the discount punch. But something strange is happening; prices
are rising, even though the FED is not pumping in new reserves
at a high rate. This could bring an end to the party. The hangover
looks as though it is about to begin.

We will now
see if this is a temporary price blip or a reversal of fortune.
If price inflation continues, the dollar will fall, despite the
intervention of foreign central banks. Rising import prices and
rising interest rates will surely put a damper on the party. There
will be a lot of complaining about hangovers.

17, 2004

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