Bankers: Their Gains, Our Risks

~ Ludwig von Mises

~ Adam Smith

Central banks are tools of the very rich to protect their capital. The central banks’ primary function is to protect large commercial banks. This reduces risk for the owners of those banks and their senior managers. But the cost of this risk reduction is transferred to the general public.

The public is told otherwise. We are told that the Federal Reserve Bank and FDIC deposit insurance protect our wealth. What these government-imposed systems do is to protect the public from one kind of loss – closed banks – at the expense of another kind of loss: depreciating money. The second form of loss gets little attention. It doesn’t hurt much. It’s more like a low-intensity headache – a headache that is caused by a malignant brain tumor.

The system reminds me of New York City, as well it should, since the heart of the system is in New York City, not Washington.

Below the streets of New York are the water pipes.

The system was built around the time of the Civil War. Maybe the city could replace them, if it had any money, but it doesn’t. Maybe the city could get the money somehow, but unfortunately, there is no map available which shows the pipe system, subway system, and electrical system in an overlay. So the pipes burst and short out the subway from time to time. The capital base of the city is literally disintegrating under their feet. The twin towers got a lot of publicity, but the water system is the accident waiting to happen.

Every once in a while, part of the water system breaks. The water leaks into the subway system, which has to be shut down on that line. This is like big bankruptcies, such as Long Term Capital Management. They can be covered up. The problem is the system of debt that undergirds the financial system.

There is no map.

THE IMMIGRANTS

Immigrants are everywhere in New York City, the very rich and the very poor. There are Indian diplomats in full dress, African diplomats in full dress, and Arabs in full dress. To cater to their demands (and lots of other people’s demands), there are lots of odd-looking ladies who are barely dressed at all.

The city is being sustained by hundreds of thousands of people who don’t speak much English, some of whom come to buy $10 million townhouses, and others who come to sell their services as cooks and janitors, or sell hot dogs. Most of the poor ones come here to work. The Puerto Ricans don’t; they’ve been corrupted by the welfare system (and forced out of Puerto Rico by U.S. minimum wage laws), but the others are here to work, and work hard. The Puerto Ricans are here legally; I suspect that most of the others aren’t. The illegals are the productive ones.

The non-Puerto Rican immigrants are all in New York for the same reason: freedom. Some are here because the level of envy is less in our nation than elsewhere. All are here because the opportunities are greater, both for private good and private evil.

It is this mix that astounds me.

You and I don’t rub shoulders with troglodytes, just as Council on Foreign Relations members don’t rub shoulders with us. What I’m trying to get at is this: there are several layers of New York City: the below-ground, the ground floor, and the upper story. These groups are totally separate culturally from each other. Only the free market fits them together productively.

The problem is, an alien ideology opposed to the free market is eroding the potential zones of co-operation among the groups. What keeps peace in such a society are window bars, alarm systems, and guards who walk up and down in front of the fortresses. It is not the illegal aliens who are the threat; it is the alien ideology which is dominant in the lands from which they have fled.

It is this same ideology which dominates the thinking of the upper-story people of New York City. And in the eyes of those who hold it and use it to their own benefit, you and I are not much different from those illegal aliens, or even much different from the troglodytes.

THE ULTIMATE "PROTECTION" RACKET

In 1907 there was a depression, sometimes called the Panic of 1907, and also called the "bankers’ panic." It created the conditions for a highly orchestrated hue and cry for government protection from recessions. The response of the bankers – the very biggest of the banks – was the preliminary designing of what was to become the Federal Reserve System. Nelson Rockefeller’s grandfather, Senator Nelson Aldrich (after whom Rockefeller was named), was its prime political promoter. Its designer was European banker Paul Warburg, whose two-volume history of the FED, The Federal Reserve System (Macmillan, 1930), conceals more than it reveals. Its dedication, however, is very revealing:

TO THE GUARDIANS
of the
FEDERAL RESERVE SYSTEM
PAST, PRESENT, AND FUTURE

The FED has done its work well. Yes, thousands of small banks went bankrupt in the 1930’s. But why should we imagine that this implies that the FED didn’t do its work well? Milton Friedman has argued endlessly that the FED made a mistake. Why not conclude that the FED did what was necessary to consolidate its own power? The FED was not entirely to blame for the magnitude of the depression; the politicians who passed high tariffs in 1930 are also blameworthy. But the FED’s loose money policies of 1924–29 created the boom, and its tight money policies led to the depression’s early stages. (See Murray Rothbard’s book, America’s Great Depression).

The boom is politically desirable. It gets people to go into debt and buy. It gets businessmen to go into debt and expand their businesses. The fiat money artificially reduces short-term interest rates and lures people to the loan windows of the banks. In short, the boom creates a demand for personal and corporate indebtedness. The bust creates the bargain sales for those with cash to pick up.

From 1965 until late 1979, the FED was expansionist. Not in a straight line, of course; there were three major booms (1967–69, 1971–74, 1977–79) and two busts (1969–70, 1975–76). The third bust, 1980–82, was engineered by the FED’s tight money policies beginning in October of 1979. In mid-1982, the FED started expanding again.

When the FED is expansionist, people go deeper into debt. They try to take advantage of the "buy now, pay later – in cheap money." This is the familiar strategy of "get rich quick." It is the strategy of using other people’s money while it is valuable and paying off with your own money when it isn’t.

It is an exceedingly dangerous strategy. It is dangerous because it lures people into markets that they never seem to be able to leave voluntarily because of the psychological thrill of making quick and easy money at the tail end of the panic boom. This is why I am not a promoter of debt, even in mass inflations.

From time to time I receive letters from people who ask me, "If you believe that inflation is coming, why don’t you recommend debt?" Because of 1969–70, 1975–76, and 1980–82. Price inflation has never left. We are still in the age of price inflation. Central banks are still expanding money. Prices are still rising, although slowly. Price inflation will continue.

The debt whipsaw is a killer. It creates too many pitfalls for the unsuspecting. Thus, people get lured into debt positions when real interest rates are low during the boom (that is, when they are just barely above, or even below, the rate of price inflation), and they go bankrupt when real interest rates turn positive in the recession phase (like today). The risk is too great. The best rule is cash and carry of the item that is likely to go up later.

HOW SMART ARE THE INSIDERS?

The major form of "insiding" is high-level fractional reserve banking. It always has been. At first the insiders win, but they eventually lose. In 1494, the mighty Medici bank went under. Why? Because it had made too many loans to princes. It was in the 15^th and 16^th centuries that the German banking family, the Fuggers, dominated Europe. They were the Rothschilds of their day. But they also made the mistake that large-scale bankers always seem to make: they loaned huge sums to kings. In 1525, it was the wealthiest firm in Europe. In 1557, France and Spain defaulted. They couldn’t get the loans repaid. They went bankrupt in 1607.

Why do the bankers do it? Because governments grant them their fractional reserve monopoly, and then demand loans. Because the banks assemble (create) such large sums of lendable money that their loan officers can’t decide what to do with all of it. Because governments guarantee easy profits. Because the huge loans to governments offer "economies of scale." It’s cheaper to get a single billion-dollar loan placed than a thousand million-dollar loans. But who can borrow a billion dollars? More to the point, who can offer comparable security for such a loan?

Actually, this security is really a lot of smoke. The bankers have been making bad loans to Latin America for over 190 years. Nations default, and then bankers make more loans. Howard Ruff’s law of government is: "Government is dumb." My corollary is: "So are its bankers."

But they are only intermittently dumb. For a long time, they look very, very smart. The Fuggers looked like geniuses in 1525. The Medicis looked like geniuses in 1400.

The banks have buried themselves in government debt certificates. They have bought government bonds. They have bought what economist Franz Pick called "certificates of guaranteed confiscation." Eventually, the debt will be repudiated. There is a universal long-run law of all government debt: creditors eventually get skinned.

CONCLUSION

All of your long-run financial strategies should be based on the assumption that the world’s bankers will eventually make a mistake. A Big Mistake. They aren’t supermen. The system is vulnerable.

The trouble is, we have to invest for both worlds: the one in which multinational banks are doing fine, and the one in which they will make the Big Mistake. My view is that the mistake will take place over time. It will not be a one-shot shock. We will have warnings. But in the meantime, we should not assume that the dollar will always stay high in relation to everything.

In recent months, investors have begun to sense this. Foreign investors who bought dollar-denominated assets have suffered substantial losses. American investors don’t feel the pain, because they were not tempted to buy foreign currencies in 2002. But they could have. So, in terms of opportunities foregone, they have suffered losses. Maybe they made money in stocks, but if they did, they’re basically even with the market, compared to what an investment in the euro would have produced.

The dollar is doomed in the long run, because U.S. government debt, including unfunded Social Security and Medicare debt, cannot be repaid except with fiat money. Default will come, but it will be disguised by monetary inflation.

In order to transfer commercial bankers’ risks to the victims – depositors and voters – central banks must inflate. Otherwise, commercial bankers would suffer. The present system was set up to prevent this.

February 4, 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.