The Moral Hazard of Central Banking

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Let me present
a syllogism. 1. Theft is immoral. 2. Inflation is theft. 3. Fractional
reserve banking is inflationary. 4. Central banking is government-guaranteed
fractional reserve banking. 5. Immorality leads to judgment.

we should expect. . . ?

other than Murray Rothbard’s disciples, never associate the concept
of theft with monetary inflation. They speak of theft in terms of
reduced efficiency and increased transactions costs, not morality.

When it comes
to avoiding morality, they are worse than lawyers. A lawyer might
appeal to morality if he had a really weak case. This appeal might
persuade a jury. An economist would rather lose the argument than
appeal to morality. He regards the shame of invoking morality as
personally more inefficient than winning the argument by an appeal
to morality. Once you appeal to morality, academic economic theory
collapses. Economics was the first science to be self-consciously
designed to avoid moral questions.

So, when stock
market bulls attack Federal Reserve monetary policy, they do not
invoke morality. They invoke the falling return on investment. Having
invested their money or other people’s money on the assumption that
the central bank’s monetary policy will always hold down “interest
rates” — we are never told which ones — they loudly decry
as unnecessary the widespread and accelerating losses that are being
sustained because the central bank has slowed down the rate of monetary
inflation. Why unnecessary? Because the central bank can create
liquidity by buying Treasury bills.

This will
lower the interest rate on T-bills. But how does this lower all
interest rates? How does it lower bond rates and mortgage rates,
which always have an inflation-defense premium in them? It doesn’t.
It raises them.

The critics
say that this forced reduction of the FedFunds rate is only temporary.
They are not calling for sustained inflation. Oh, no. They just
want a little loosening of monetary restraint, just this once. Just
get overnight money rates down.

This is what
Japan has been doing ever since 1990. It gets overnight money rates
down. It keeps it down, year after year. So, international traders
grew bold. They borrowed yen at less than 1% to buy other currencies.
Then they used these to invest in bonds at 4% or more. It’s like
money in the bank.

Yes, it is.
But what happens if there is ever a bank run?


The “run”
has begun. The Japanese yen is now rising against foreign currencies.
Those who borrowed short and lent long are facing a serious crisis:
their debt is in yen, and it is rising fast. So, they sell longer-term
debt and buy yen with the money. This forces up long-term rates.

Which raises
mortgage rates.

Which undermines
the housing bubble.

Which undermines
consumer confidence.

Which leads
to more saving and less spending on consumer goods.

Which produces
a recession.

In anticipation
of the recession, the stock market falls. This
produces a televised tantrum by Jim “Mad Money” Cramer.

Which catches
the FED’s attention.

Which then
lowers a symbolic interest rate (discount window).

Which creates
brief euphoria among fund managers.

Which leads
Cramer to tell people to buy, buy, buy.

Which is called
a bull trap.

The FED must
now make a decision: inflate slowly (2% a year) or inflate faster
(5% a year). I don’t think the FED would consider 10%. Economists
believe in change at the margin. So, 4% or 5% will probably do it.

Do what?

Restore confidence
in the gigantic confidence game that all modern finance is based
on. This game rests on this slogan: “Too big to fail.” It is more
than a slogan. It is a mantra, a confession of faith. It is the
shema Mammon.

The FED will
act to increase liquidity sufficiently to prevent disaster in the
stock market. This will calm the markets. This will once again persuade
investors that there is a safety net for them. Ironically, this
perception is designated a “moral hazard.” This is the only time
the word “moral” is seriously used in modern finance. A moral hazard
— correctly named — occurs when central banks intervene
to save specific industries, i.e., too-big-to-fail industries.


used the phrase. His words are worth considering. In testimony before
the House Banking Committee (Oct. 1, 1998), in the wake of the near-meltdown
of the financial futures market the previous August as a result
of the Long-Term Capital (Ha!) Management, Ltd. collapse, he said:

course, any time that there is public involvement that softens the
blow of private-sector losses — even as obliquely as in this
episode — the issue of moral hazard arises. Any action by the
government that prevents some of the negative consequences to the
private sector of the mistakes it makes raises the threshold of
risks market participants will presumably subsequently choose to
take. Over time, economic efficiency will be impaired as some uneconomic
investments are undertaken under the implicit assumption that possible
losses may be borne by the government.
That sounded good.
It sounded almost as if he had reverted to his free market youth as
a follower of Ayn Rand. But he was in front of Congress to justify
the Federal Reserve Bank of New York’s intervention, calling the lending
banks together over the weekend and recommending that they inject
another $3 billion into LTCM, Ltd. So,
he added this:

is much moral hazard created by aborting fire sales? To be sure,
investors wiped out in a fire sale will clearly be less risk prone
than if their mistakes were unwound in a more orderly fashion. But
is the broader market well served if the resulting fear and other
irrational judgments govern the degree of risk participants are
subsequently willing to incur? Risk taking is a necessary condition
for wealth creation. The optimum degree of risk aversion should
be governed by rational judgments about the market place, not the
fear flowing from fire sales.

What is a
fire sale? The FED apparently has a new operational definition:
“Anything that leads Jim Cramer to throw a tantrum on CNBC.”

Central banking
has been a moral hazard ever since Parliament gave a monopoly to
the privately owned Bank of England in 1694. Central banking exists
primarily to protect large fractional reserve commercial banks from
bank runs, and therefore to preserve the fractional reserve banking
system nationally. Of all modern institutions, none has been more
committed to subsidizing moral hazards than central banking.

Along the
way, central banks preserve stock markets from sell-offs that might
produce runs on commercial banks, or what is the same today, cascading
cross-defaults when overextended banks cannot pay off each other
at the end of the business day, which today is international.


Jesus told
His disciples to be in the world, not of the world. This has been
the message of most major religious reformers throughout history.
It is good advice.

We live in
a world that we have inherited. It is not mainly of our making.
We are forced to make choices in a world that has structured and
limited the choices we make. This is always true.

Consider the
FED’s choices regarding monetary policy. There is this inescapable
choice: stable money leading to a recession and maybe a depression,
given the prevailing level of debt, vs. monetary inflation, which
keeps the debt structure alive and encourages additional debt to
“pay off in cheap money.” This policy subsidizes the market for
new moral hazards. “When the price falls, more is demanded.”

At the top
of the visible hierarchy of control, politicians and central bankers
say they want to avoid making this choice between stable money and
inflation, but one or the other policy cannot be avoided in the
long run. This makes short-run decision-makers out of politicians
and central bankers.

A few of us
prefer this choice: a money system that is not tied to credit and
debt in any way. That would mean a monetary system tied to gold
and silver, as it was in 1914. This is not available as a choice,
nor is it likely to be, short of a complete financial collapse,
which unfortunately would kill most of my readers — a breakdown
in the division of labor.

So, we must
make second-best or third-best choices with our money because generations
of politicians made very bad choices.

As investors
and decision-makers, most people tend to go with the flow. The flow
is established by central bank policy: in the United States, in
Japan, in Europe, and in China. Going with the flow is bad when
you are floating toward Niagara Falls.

We are trapped
in an international credit system which has relied on monetary inflation
to pump up the capital markets. This has led to a huge expansion
of debt. To keep this debt from imploding in a wave of defaults
— “cascading cross defaults,” Greenspan called this —
central banks inflate even more.

This is a
vicious circle. Ever since 1914 — World War I and the first
year of the Federal Reserve System — the West has been unable
to escape from this circle. As a result, the dollar buys 5% of what
it bought in 1914. (See the Inflation Calculator at
the Bureau of Labor Statistics.)

None of this
is new. Leaders always face choices. These choices will affect those
under their authority. Sometimes the effects are catastrophic.

I believe
we are trapped in a vicious monetary circle. We cannot get out at
anything like zero price.

have been in this sort of situation before. As background, let us
consider a similar vicious circle. Let us go back 230 years to the
Constitutional Convention of 1787.


I am in the
process of editing and revising an amazing manuscript on conspiracies
in American history. It was written as a series of newsletters over
40 years ago. The author is dead, as far as I know. I am not sure.
Some of the chapters hold up well. No one has seen these articles
in over 40 years, and very few saw them then. A decade ago, I paid
to have them scanned in. I have added footnotes where I can. I have
been editing the final copy this week.

In one of
the newsletters, the author cited a statement by George Mason. Mason
is rightly called the father of the Bill of Rights. He was a participant
at the Constitutional Convention in 1787. Here is the passage cited:

nations can not be rewarded or punished in the next world they must
be in this. By an inevitable chain of causes & effects providence
punishes national sins, by national calamities.
I wanted to cite
the source in a footnote. Google lets us locate sources more easily
than ever before in man’s history. I tracked it down late in the evening
on August 22. Mason made this statement on August 22, 1787 —
220 years to the day prior to my search.

What caught
my attention was its context. Here
is the full citation.

discourages arts & manufactures. The poor despise labor when performed
by slaves. They prevent the immigration of Whites, who really
enrich & strengthen a Country. They produce the most pernicious
effect on manners. Every master of slaves is born a petty tyrant.
They bring the judgment of heaven on a Country. As nations can
not be rewarded or punished in the next world they must be in
this. By an inevitable chain of causes & effects providence punishes
national sins, by national calamities.

Mason was
arguably the most eloquent political opponent of American chattel
slavery in his generation. Yet he owned 36 slaves. He did not set
them free in his will, unlike George Washington. Neither did Jefferson,
who also opposed slavery.

More than
anyone among the framers of the Constitution, Mason saw what was
coming: a great national division over slavery. He recognized a
looming confrontation between moral principle and property rights.
At the Virginia ratifying convention in 1788, he made an assessment
of the situation. This was in reference to the Constitution’s 20-year
extension of the importation of slaves from Africa: the international
slave trade. This was abolished by Great Britain in 1807, in the
final year of legality of slave imports into the United States.
Mason offered a two-part critique. The
parts were in complete opposition to each other: one moral and the
other legal.
First, the moral and political:
augmentation of slaves weakens the states; and such a trade is diabolical
in itself, and disgraceful to mankind. Yet by this constitution
it is continued for twenty years. As much as I value an union of
all the states, I would not admit the southern states into the union,
unless they agreed to the discontinuance of this disgraceful trade,
because it would bring weakness and not strength to the union.
Second, the legal
and economic:
though this infamous traffic be continued, we have no security for
the property of that kind which we have already. There is no clause
in this constitution to secure it; for they may lay such a tax as
will amount to manumission. And should the government be amended,
still this detestable kind of commerce cannot be discontinued till
after the expiration of twenty years. I have ever looked upon [slavery]
as a most disgraceful thing to America. I cannot express my detestation
of it. Yet they have not secured us the property of the slaves we
have already. So that “they have done what they ought not to have
done, [allowed importation of slaves for at least 20 years] and
have left undone what they ought to have done.” [protected slaves
as property]

Slavery was
not the cause of the Civil War. Southern secession was. The South
seceded because of two men: John Brown, whose murderous attempt
to launch a slave revolt in 1859 sent waves of fear throughout the
South, and Abraham Lincoln, whose party was pledged to restrict
the extension of slavery into the territories. This policy would
increase the political power of abolitionism in the Senate. Slavery
could then be eliminated by law, exactly as Mason had warned in
1788. The fact that America’s geography precluded the extension
of slavery as a social system after 1850 did not stop the secessionists
in 1860—61. The political deadlock that had prevailed until
1849’s 30 to 30 tie in the Senate was broken with the admission
of California as a free state in 1850: the Compromise of 1850. All
new states would probably be free states. That should have been
clear in 1850 to anyone who had seen the soil west of Dallas: no
water. That meant no cotton, no rice, and no tobacco. It meant cattle
ranching. It meant slaves on horseback. It meant few slaves except
household servants — consumer goods, not commercial goods.

The South
could have seceded in August, 1850, and gotten away with it. Millard
Fillmore was not the late Zachary Taylor, who in February had told
one group of Southern Senators threatening to secede that he would
personally lead the Army into the South and hang every secessionist,
just as he had hanged deserters and spies in the Mexican-American
War in 1847. Taylor died in July. Fillmore became President. But
the South’s politicians agreed to the Compromise of 1850 in September,
and that decision sealed the region’s fate, politically and militarily,
a decade later. Lincoln was the symbol. The reality was the soil.

Yet the leading
politicians of the South did not speak of Lincoln as a symbol or
the West as a desert. They proclaimed a legal argument: the right
to a specific form of property. Politicians tend to be former lawyers.
When the facts of the case are against them, they argue the law.
As for morality, both sides do their best to ignore it.

The results
of the war were horrifying: the deaths of 620,000 Americans in 10,400
battles. This was paid for in the North by an expansion of national
debt from almost nothing in 1860 to over two billion dollars in
1865. It was paid for in the South by mass inflation and the destruction
of the South’s economy. The South did not begin to match the North’s
economy for a century.

“By an inevitable
chain of causes & effects providence punishes national sins, by
national calamities.”

Mason did
not sell his slaves. His example, not his words, was imitated by
his social peers in the South. The calamity came in 1861—65.


We cannot
opt out of the debt money economy. To use a checking account, to
use a credit card, to spend a Federal Reserve Note, we subsidize
the system. We preserve the profits of the government-protected
fractional reserve banking system.

What is our
version of selling our slaves in order to opt out of the system?
This encompasses far more than this short list. But I offer this
list of five.

  1. Avoid
    consumer debt. The mantra is Max Blumert’s law: “Buy the best,
    pay cash, take delivery.”

  2. Pay off
    all credit card debt before buying T-bills or bonds. Here is
    my law: “Escape from the trap before setting any of your own.”

  3. Pay a
    tithe. This is your personal declaration of dependence on God
    rather than dependence on Bernanke.

  4. Don’t
    take on any debt that is not collateralized 100% by an asset
    in your possession. This applies to mortgages. Your house should
    collateralize your mortgage.

  5. Emergency
    debt is for emergencies. Regard both as disasters. Save for

If you have other
rules along these lines, send
them to me here


The debt economy
makes us all vulnerable to unforeseen crises: illiquidity, insolvency,
low credibility. All three are institutionally visible today. They
are threatening Cramer’s world.

All three
are the result of the moral hazard of central banking. This is why
Cramer screamed against the Federal Reserve System. He was correct:
the FED is responsible. Earlier.

The FED should
have done nothing in 1914. It should have done nothing thereafter.
If it had done nothing as a matter of policy, there would be no
debt crisis facing the U.S. economy. There would be no advocacy
of the creation of yet more moral hazards in the financial community.

There is now
a looming immoral hazard. Eventually, the FED will imitate the People’s
Bank of China in order to re-liquify the financial system. It will
inflate at double-digit rates. The difference is, Americans do not
save 40% of their income, nor are they rebounding from Marxist tyranny
and incomparable poverty. The division of labor is being extended
by China’s monetary inflation. This extension has produced China’s
many bubbles. Our division of labor is already highly developed.
It can increase only slowly at the margin. American productivity
will therefore not rise fast enough to match the FED’s double-digit
inflation, as it has in China, thereby concealing the true rate
of inflation.

then and now, Cramer will have lots of opportunities to scream on
national TV.

27, 2007

North [send him mail]
is the author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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