The Monetization of Hope

by Gary North
by Gary North

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Now faith is the substance of things hoped for, the evidence of things not seen (Hebrews 11:1).

Hope makes the world go around. It is the essence of entrepreneurship: pursuing profits by meeting future consumer demand. Samuel Johnson over two centuries ago said that a second marriage is the triumph of hope over experience. There are lots of second marriages. There is lots of hope.

Hope sells. In 1992, Bill Clinton's campaign biography was titled, The Man from Hope. In 2008, Barack Obama's campaign autobiography was titled, The Audacity of Hope. Appealing to disgruntled voters' hope in change is a time-honored tactic of political challengers, because there are always lots of disgruntled voters. (Show me a gruntled voter, and I'll show you a successful lobbyist.) No matter who gets elected, insufficient change occurs, which creates an opportunity for another political challenger to offer hope.

As far as the broad mass of voters is concerned, there is only hope deferred.

Hope deferred maketh the heart sick: but when the desire cometh, it is a tree of life (Proverbs 13:12).

PROMISES, PROMISES!

From the first year of operation of the Federal Reserve System in November 1914 until today, the official statistics of the Federal government indicate that the dollar has declined in purchasing power by 95%. You can verify this with the inflation calculator, posted by the Bureau of Labor Statistics. It's here.

Officially, the Federal Reserve System was established to attain two goals: (1) to provide monetary stability; (2) to avoid recessions – financial panics, as they were called back then. How successful was the FED? In World War I, there was price inflation. In 1921, there was a recession. In 1929–41, there was a depression. Then came World War II, when there would have been mass inflation, due to Federal Reserve policy of buying Treasury debt at a fixed, low rate, except that the government imposed price and wage controls, thereby producing a rationed economy marked by shortages of consumer goods. In short:

Hope deferred maketh the heart sick: but when the desire cometh, it is a tree of life (Proverbs 13:12).

We do not get the tree of life. Instead, we get the tree that money grows on. The money is worth progressively less.

If a nation's central bank could provide stable money, we would have slowly falling prices: more goods chasing a fixed quantity of money. If the central bank could provide stable prices, with a slightly rising money supply – Milton Friedman's hope deferred – the dollar would not have declined by 95%. The central bank cannot and has not supplied either stable money or stable prices. It has provided price inflation, except during the Great Depression and 1955.

This has been true in every nation that has a central bank, which means every nation except Andorra and Monte Carlo. The voters are unaware of any of this. All they know is that prices always go up. Whenever it appears that prices might stabilize, there is a new wave of price inflation, as if by magic.

It is not by magic. It is by design. It is by central bank design. The bank has to inflate the money supply because of promises. These promises have been made by politicians: pensions and health care. Other promises have been made by employers to workers: pensions and health care.

Still more promises have been made by large multinational banks, which are the constituents of the central banks. These promises can be boiled down to two: (1) you can get your money back at any time; (2) you can also get a positive rate of return on your money, which you turn over to us, which we will exchange for borrowers' promises to pay.

Stable money produces falling prices. Some of the borrowers cannot repay. So, the central bank creates new money, which it uses to purchase IOUs (promises): from the government, from employers, and from banks.

Until late 2007, the Federal Reserve bought only the IOUs of the U.S. government. But then large banks began to face the need to default. They could not meet all of their promises to repay: not promises to depositors but rather to each other. The Federal Reserve intervened by swapping Treasury debt to banks in exchange for promises made to banks by debtors who clearly could not fulfill their promises. This process has continued.

On Sunday, September 7, the Secretary of the Treasury announced the take-over (nationalization) of the mortgage market. The government will put its credit on the line to cover the bad mortgages made by Fannie Mae and Freddie Mac to borrowers who cannot replay. This was an unpublicized subsidy to the central bank of China, which had lent Fannie and Freddie hundreds of billions of dollars that it had earned by printing Chinese yuan and buying dollar-denominated IOUs from Fannie and Freddie.

And so it has gone. The U.S. government and the Federal Reserve System have put their credit on the line for something in the range of $8 trillion in promises.

What credit? What line?

The U.S. Treasury has a line of credit to the Federal Reserve System. The Federal Reserve System also has a line. It has three lines: inflation, debt-swapping, and blarney.

Inflation is tied to blarney: "We can keep the credit markets alive."

Debt-swapping is tied to Treasury debt. The FED issues this offer: "Bring in your crushed beer cans, and we will trade you our silverware." Put more precisely: "Bring in your non-marketable debt, and we will swap our AAA-rated U.S. government debt at face value."

This promise ends whenever: (1) the FED runs out of U.S. Treasury IOUs, or (2) the U.S. Treasury loses its AAA-rating.

Who rates the Treasury's debt? The same credit-rating firms that rated toxic-waste IOUs AAA until August of 2007. Today, there are no markets for this debt at anything near face value, except at the FED.

Will the U.S. Treasury ever lose its AAA-rating? Yes, according to the former CEO of Goldman Sachs, John Whitehead. On November 12, he offered his assessment. The United States faces a slump deeper than the Great Depression. Unlike the Great Depression, however, this will be accompanied by the downgrading of Treasury debt.

We're talking about reducing the credit of the United States of America, which is the backbone of the economic system. I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America. . . .

The public is not prepared to increase taxes. Both parties were for reducing taxes, reducing income to government, and both parties favored a number of new programs – all very costly and all done by the government.

The voters are unaware of any of this. They still retain hope: in Social Security, in Medicare, in government spending as a way to keep the economy's doors open, in cheap imported goods, in Wal-Mart, and in their credit cards' lines of credit.

Hope deferred maketh the heart sick: but when the desire cometh, it is a tree of life (Proverbs 13:12).

A TRANSFER OF BAD PROMISES

Over the past year, the balance sheet of the Federal Reserve System has increased by well over a trillion dollars: from about $900 billion to $2.1 trillion. Retired finance professor Michael Rozeff has reported these figures. He has also assessed their implications.

The bad loans remain hidden and submerged within banks and other institutions. This paralyzes lending. The weak companies and poor managements that should be quickly cleaned out instead are given taxpayer money.

On the other hand, when these bad loans are transferred to the Federal Reserve System and the U.S. Treasury, they threaten to make the recession worse. How? By raising Treasury debt rates.

With public debt rising, the interest costs of the national debt rise. Capital that should be going to healthy enterprises is diverted to government and to zombie enterprises. Inefficient enterprises are subsidized.

This is the famous crowding-out effect. Government absorbs the savings of the public. Private capital (e.g., mortgages) becomes dependent on the Treasury and the Federal Reserve.

The capital markets become dependent on Fed loans, and it is not clear how that dependence can be ended.

But what about commercial banks? They still exist. True, but they are no longer independent, Rozeff says.

The government takes ownership interests in the most major banks, inducing further inefficiency in these semi-nationalized firms and threatening control of the allocation of capital.

Step by step, the ownership of non-marketable promises to pay shifts from the private sector to the government sector. To get a loan, you must now promise to repay the government.

But where does the government get the money to buy more promises? From investors, meaning (1) foreign central banks, (2) investment funds seeking a safe (AAA-rated) haven from the falling stock market, and (3) the Federal Reserve System.

Why do foreign central banks and investment fund managers believe the promises of the U.S. Treasury? Because the U.S. Treasury has a team of agents acting on its behalf. They are called IRS agents. The Treasury also has a guaranteed line of credit with the Federal Reserve. What does the Federal Reserve have? A government-chartered license to issue digits called money.

From shore to shore, from top to bottom, from east to west, our world depends on promises to repay digits. If this system of promises were to break down – if most people ever lost faith in it – half the population in Europe, Japan, and the United States would be dead in a year, and maybe sooner. The division of labor would collapse. The division of labor keeps us alive. But the public does not lose faith.

Now faith is the substance of things hoped for, the evidence of things not seen (Hebrews 11:1).

The secret of maintaining faith in what are obviously broken promises that cannot be repaid is to break the promises a little at a time. This process of breaking promises is called monetary inflation. It occurs when the central bank monetizes IOUs – promises. Day by day, week by week, the world's central banks monetize promises. They are doing this at an ever-increasing rate.

The promises that sustain hope today are government promises to repay. Yet the great irony here is that no one in authority believes they will ever be repaid. They will always be deferred. Economists believe this. Politicians believe this. Those few voters who understand that the trust funds of Social Security and Medicare are accounting devices within the Federal government believe this.

One man has put this faith in print – or digits – more forthrightly than anyone else. He calls himself and his blog site The Skeptical Optimist. This is perhaps the most misnamed site and persona on the Web. He is not skeptical. He has enormous faith . . . in government. He shares this faith with the vast majority of economists, who affirm his statement of faith. He has posted his statement of faith.

Keep in mind that (1) we'll never, ever have to pay back any of the principal on the debt if we just keep rolling it over (see this article); (2) the interest is the "debt service" we must never, ever, ever, ever default on; and (3) maintaining our status as the large, reliable, predictable borrower supporting the large, liquid, worldwide market for US Treasury securities should always be one of our top financial priorities. To maintain the bond-buying public's confidence that we'll always be able to afford to pay them their interest in stable-value dollars, and to roll the debt over into a large market full of willing buyers, the proceeds from the taxing power of the federal government must comfortably cover our interest obligations.

This statement of faith undergirds the modern system of world finance. Everything that is familiar to Americans and to central bankers around the world hinges on widespread acceptance of this statement of faith.

Everything in this religion of hope hinges on this: the revenue-collecting ability of the U.S. government. "The taxing power of the federal government must comfortably cover our interest obligations."

Chairman Mao wrote: "All power grows out of the barrel of a gun." The entire system of international finance today grows out of the barrel of a gun: an IRS gun.

This gun has power only because people believe that most other people will pay their taxes, so that if anyone refuses to pay, there will be an agent with a gun available to be sent to visit him if he refuses to deal with an agent without a gun.

The Skeptical Optimist now faces a conceptual problem. There is a worldwide recession in progress, and any increase in taxation might turn it into a depression. Government policymakers at every level fear this. Economists of all persuasions fear this. This is why Obama is promising a public works spending program that may increase the Federal debt by a trillion dollars. He is also promising tax cuts.

To lure lenders into continuing to lend after the recovery begins, the Treasury will have to offer higher interest rates. So, the following will increasingly not be the case: "The taxing power of the federal government must comfortably cover our interest obligations." To hold down Treasury rates, the Treasury will have to find a willing lender. That lender exists. The Federal Reserve System will buy Treasury bonds. The Treasury will make an offer that the FED cannot refuse. It is already making this offer. So are banks and financial institutions. The FED has complied so far. It will continue to do so. The FED will create money, meaning monetary base money, meaning high-powered money.

The Skeptical Optimist will soon face a waning of faith in one of his premises: "To maintain the bond-buying public's confidence that we'll always be able to afford to pay them their interest in stable-value dollars."

Then what will sustain the system? What will restore the voters' faith in promises that have been broken, must be broken, and will be broken.

How will these promises be broken? By monetization. In short, by the monetization of hope.

CONCLUSION

You must make a choice. You must decide whether I am correct or the Skeptical Optimist – the most trusting of souls – is correct. He trusts the Federal government. I trust the free market. He thinks that government promises will never be fulfilled – "we'll never, ever have to pay back any of the principal on the debt if we just keep rolling it over" – yet never be broken, either: "the interest is the 'debt service' we must never, ever, ever, ever default on." I agree with his initial affirmation. I believe that the promises of repayment by the U.S. government will never be fulfilled. This is because I reject his third premise: "We'll always be able to afford to pay them their interest in stable-value dollars, and to roll the debt over into a large market full of willing buyers."

I believe this: "The wicked borroweth, and payeth not again: but the righteous sheweth mercy, and giveth" (Psalm 37:21). In contrast, most Americans have trusted the wicked, who will not repay. They have trusted the wicked to show mercy and give. So has the Skeptical Optimist.

You must choose your statement of faith. You should then act in terms of this statement of faith, or else be a hypocrite.

December 13, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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