The Limits of Central Banking

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Every system
has limits. No one knows exactly where these limits are. All systems
are complex, and no theory deals successfully with all of this

My favorite
example of this was provided decades ago by Dr. Ibn Browning,
a maverick climatologist. He described the following system: a
pressure cooker filled with water, which is sitting on top of
a stove’s burner, which is lit. At some point, he said, there
will be a rapid shift in the system’s conditions. No one can predict
exactly when. But he said that if you hit the pressure cooker
sharply with a hammer, you can speed up the predicted shift in
conditions. He recommended against doing this.

Most people
ignore most systems most of the time. We live in a complex physical
world which is made even more complex by mankind’s many social,
economic, political, and other systems. No one can fully understand
even one of these systems, let alone the interconnections of all
of them. We therefore are forced to trust these systems.

But we don’t
fully trust them, which is why there are always political pressure
groups that are calling on politicians to change the rules governing
thousands of mini-systems. Some of these pressure groups want
to "level the playing field," which they think will
help them. Others want to tip the playing field in their direction,
so the system will help them. All of them do this in the name
of The People, who are said to deserve help. Help from what? The
existing system.

There is
a saying, "you can’t change just one thing." It is accurate.
Over time, all systems change, but they don’t change very much
most of the time. These changes produce ripple effects throughout
the connected systems. But changes are usually slow, so we barely
notice them. When we do notice them, we get used to them. They
become background noise for us.

Prior to
World War I, taxes in all nations were under 10% of income. After
World War I, no nation enjoyed this degree of liberty. We get
used to the demons we know, including the tax collectors. History
textbooks do not remind us of the low-tax world we have lost,
because textbooks are written for use in tax-supported public
schools, which do not call into question the prevailing tax level,
except to suggest higher taxes on the rich.

in election years sometimes call for tax reform, but the public
really doesn’t expect much change. The public is wise in this
regard. The tax code is kept so complex by the politicians that
no one can understand it. This is deliberate. This complexity
allows special interest groups to persuade their politicians to
slip goodies through the cracks of the code.

The ecomomy
still bumps along. This is because the free market, with its extensive
division of labor, is resourceful. Some people find ways to beat
every system, while others find ways to milk the system. There
is a constant quest for legal loopholes. There is also a constant
quest for ways to cheat. We are told that cheaters never prosper,
but the sales of My Life seem to refute this theory. (When
Hank Williams wrote "Your Cheatin’ Heart," he did not
have in mind book royalties. Silly Hank.)

The fact
is, the quest for profit in a free market economy favors consumers.
Consumers hold the hammer: money. They determine which producers
win and which ones lose.

The law enforcement
system is flexible, which is another way of saying "arbitrary."
Politicians pass complex laws that are the products of compromise.
Bureaucrats then enforce some of these laws, ignore other laws,
modify all laws, and generally feather their own nests by increasing
the complexity of law enforcement. This gives them greater arbitrary
power over others, and it provides them with greater job security.

Round and
round it goes, and where it stops, nobody knows.


In the 1930s,
the economic system stopped working. Economists still debate over
why it stopped working. John Maynard Keynes had an answer in 1936:
not enough government spending. Milton Friedman had an answer
in 1963: not enough money creation by the Federal Reserve System,
1929—1932. Murray Rothbard had an answer in 1963: too much
money creation by the Federal Reserve, 1924—1929, and too
much economic regulation by the Hoover Administration, 1929—1932.
Keynes won the debate in academia for forty years, and in politics
still has won it. Friedman has won the debate in academia, but
not in politics, since about 1975. Rothbard’s answer is acceptable
only to those few people who trust neither the politicians nor
the central bankers to fix the system. I’m with Rothbard. I’m
therefore with Frank

The Great
Depression has cast a long shadow over the voters and the politicians
ever since. No one wants that to happen again. Keynesians say
it will not happen again because politicians will always run deficits
large enough to prevent one. Friedman says it will not happen
again because central bankers learned their lesson. They will
not again allow the banking system to run short of monetary reserves.

think that it will happen again. They debate over whether central
bankers will first destroy the monetary units by inflation before
the next Great Depression arrives. Meanwhile, they predict, central
bank money creation will lead to a series of asset bubbles, all
of which will eventually pop, and any one of which may trigger
the next depression. For a Rothbardian or a follower of Ludwig
von Mises, the economy resembles this astronomical phenomenon,
which they refer to as the Greenspan

But the economy
keeps rolling along. Most Americans are getting by. Most Asians
are getting by. Most everyone is getting by. The system holds.
The free market system seems to be able to beat the many government-imposed
systems that seek to thwart men’s ability to buy and sell with
each other.

So far, so


Things usually
change at the margin. At the edge of any system, trouble begins.
The question is: Will trouble spread to the system as a whole?
Will it force a transformation of the system, just as the hammer
may transform the pressure cooker’s system?

On June 4,
Warren Pollock published a disturbing report in his Macroeconomic
Newsletter. He reported on a statistic that I had been completely
unaware of: "settlement fails." I was well aware of
what it deals with: bank settlements. Banks must settle accounts
with each other daily. Bank A owes Bank B, which owes Bank C,
which owes Bank D, which owes Bank A. The system is enormously
complex. It is interconnected.

If the settlement
system ever fails, we will get what Greenspan has called "cascading
cross-defaults." In defending the New York FED’s decision
to call together a 1998 meeting of commercial banks to encourage
them to bail out Long Term Capital Management, Greenspan
told the House Banking Committee in October, 1998

While the
principle that fire sales undermine the effective functioning
of markets may be clear, deciding when a potential market disruption
rises to a level of seriousness warranting central bank involvement
is among the most difficult judgments that ever confronts a
central banker. In situations like this, there is no reason
for central bank involvement unless there is a substantial probability
that a fire sale would result in severe, widespread, and prolonged
disruptions to financial market activity.

It was
the judgment of officials at the Federal Reserve Bank of New
York, who were monitoring the situation on an ongoing basis,
that the act of unwinding LTCM’s portfolio in a forced liquidation
would not only have a significant distorting impact on market
prices but also in the process could produce large losses, or
worse, for a number of creditors and counterparties, and for
other market participants who were not directly involved with
LTCM. In that environment, it was the FRBNY’s judgment that
it was to the advantage of all parties — including the
creditors and other market participants — to engender if
at all possible an orderly resolution rather than let the firm
go into disorderly fire-sale liquidation following a set of
cascading cross defaults.

cross defaults are the greatest single threat to the world economy.
They could push the world’s banking system into gridlock. Then
our plastic, credit-based money would no longer buy things. This
would create a monumental crisis.

Think of
your situation at a distant gas station: a nearly empty gas tank,
far from home, little or no cash, and the message box on the gasoline
pump says "card rejected." All of your cards are rejected.
All cards everywhere are rejected. Then what?

This is the
hammer on the pressure cooker. Wham!


On two occasions,
once after 9/11 and in August, 2003, the system came close to
going into gridlock. The FED intervened both times to inject liquidity
— fiat money — into the banking system. Pollock supplies
a graph of what happened.

What is bothersome
is that something like this happened again in May, 2004, when
long-term interest rates began moving upward. Here
is Pollock’s explanation

The Federal
Reserve provides the banking system with a framework to settle
inter-bank transactions. On two occasions it is very clear that
interest rate increases severely stressed the banking system.
When the inter-bank settlement system temporarily fails to clear
transactions banks are effectively "bouncing or kiting
checks" to each other.

The 9-11
event triggered the first failure of the settlement system.
For technical reasons a statistic called "Settlement Fails"
surged to epic proportions. At the peak of the technical problem
it became impossible to settle $1.4 Trillion dollars of inter-bank
transactions. The Fed was able to smooth the failure over.



The system
failed in July and August of 2003 when an unexpected market
driven spike in long-term interest rates occurred. Rates were
managed downward and the problem was temporarily solved.











same condition of failure occurred in May of 2004. The failure
was directly related to the recent rise in interest rates. Increases
in M3 liquidity could be "a fix" to this problem.





then provides a graph of the 10-year treasury yield in comparison
to the settlement-fails spike. He

The recent
failures are timed exactly to interest rate increases. The settlement
system has a significant problem absorbing modest changes in
interest rates. The FED must have to step in periodically to
prevent a crisis from occurring. Interest rate sensitive derivatives
and interest rate arbitrage plays are putting pressure on the
continuity of the banking system.

Given this
condition, how can the FED raise interest rates to levels needed
without blowing up the entire system? The problem is that the
market will raise rates if the FED fails to do so.


The Federal
Reserve System has intervened repeatedly because entrepreneurs
always push every profit-based system to its limits. Someone will
always press against the rules of the game. The 1998 failure of
Long Term Capital Management provides an example of entrepreneurs
who went beyond their ability to fulfill their debt contracts
in the highly leveraged financial futures market.

The FED has
bailed out the system so often that it has created a sense of
abandon among entrepreneurs. These entrepreneurs have access to
enormous lines of credit through the futures market. This is what
the carry trade is all about: borrowing short to lend long, with
an inverted pyramid of interconnected debt. No one knows how large
this pyramid is. No one knows the limits of the system.

We trust
the system: the free market. What choice do we have? We live in
an era of digital money, secured by plastic cards by means of
the banking system. Almost no one has enough cash (non-digital
currency) to pay his bills for a month, let alone a year.

But the decision-makers
at the FED do not trust the free market. Not really. This is why
the FED has repeatedly intervened to keep the banking system from
going into gridlock.

No one knows
the limits of the world monetary system. The web of credit and
debt is too complex. Complex systems generally hold together,
just as spider webs hold together. But any system’s limits are
beyond anyone’s ability to comprehend. This is true of the fractional
reserve banking system, in which money is a form of debt, and
the debt is pyramided inversely.

We live in
an economic system in which arrogant but politically clever men
believe that they can use political coercion to adjust the economy
more favorably — more favorably for their constituents, whom
they equate with The People. They intervene to make the system
better. Problem: you can’t change just one thing.

We see the
FED playing the role of the sorcerer’s apprentice. To understand
Alan Greenspan and the system he represents, visualize Mickey
Mouse in "Fantasia,"
with the sorcerer’s pointed cap on his head, and the brooms hauling
water and dumping it. There is lots of liquidity!

Have you
ever noticed how much a sorcerer’s cap resembles a dunce cap?


You should
do what you can to make yourself resistant to the web of debt
that sustains the present world economy. You should have reserves
that are not part of the debt system. These reserves must be non-digital.
It’s not enough to have a money market fund. You need some currency,
some silver coins, and some gold coins.

You cannot
disconnect from the economy and still remain productive. But you
would be wise not to place all of your capital eggs in a digital
basket that is guarded by Alan Greenspan.

30, 2004

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