• 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 www.bls.gov:
    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 http://www.garynorth.com.
    He is also the author of a free 19-volume series, An
    Economic Commentary on the Bible

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