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.

MONETARY THEORY

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.

“There 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.

Meanwhile, 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).

Confusing, isn’t it?

OUR FRIEND, THE MONEY LENDER

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.

Specialized 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!

SOMETHING FOR NOTHING

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.

Everyone 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, 1929—33.

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. . . .

ROCK BOTTOM RATES

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 consumers.

Whenever 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.

Next 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.

WHEN MONEY IS ON THE LINE

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.

Corporations 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 counter-offer.

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 borrowers.

CHINA AND JAPAN

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.

American 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.

CONCLUSION

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.

April 17, 2004

Gary North [send him mail] is the author of Mises on Money. Visit http://www.freebooks.com. For a free subscription to Gary North’s newsletter on gold, click here.