Fooled Again!

This has been an unbelievable week in the markets. Just when it began to look like the European Union was on the verge of breakup (or at least a significant restructuring), six major central banks pledged – in unison – to provide whatever liquidity banks need to remain solvent. Central banks essentially told the markets that they would do whatever was necessary to keep the global financial system inflated. Of course, stock markets around the world jubilantly rocketed higher. The bears among us got bloodied once again. Now that the markets have calmed down a little it’s time to put the central bank actions in context. Can their plant work? An recent article from the Dollar Collapse blog provides a good summary and analysis.

Fooled Again!


The pattern is by now so familiar that it deserves a place beside other technical indicators like moving averages and Fibonacci retracements.

The patternbegins with part or all of the global economy appearing to implode under its five-decade accumulation of debt. The public sector/central bank nexus responds with a liquidity injection, leading the markets to rally explosively and the pundits to declare the problem fixed. Then the markets gradually remember that liquidity and solvency are two different things, and that the mortgage lenders/money center banks/PIIGS countries/hedge funds/State and local governments, etc., are insolvent, not illiquid. And the cycle begins again.

But what to call it? “Sucker rally” seems a little too benign and prosaic for a process that looks more like fraud perpetrated on a learning-disabled, desperately-credulous victim.

“Death throes of a decadent system” is accurate but too pretentious and doesn’t convey the cyclical (and cynical) nature of the process.

“Financial terrorism” is better, since the regularity of the cycle — and the fact that central banks have absolute control over the timing — seems to imply that there’s massive insider trading going on, possibly as part of a scheme by the (name your favorite elite conspiracy group) to suck as much wealth out of the system as possible before finally letting it collapse. Still, the term doesn’t convey the comic aspect of rich, supposedly-astute players getting suckered over and over. Incompetent money managers are funny.

In the end, what it’s called is less important that the fact that it’s a great trading indicator. Starting in 2007, if you’d gone long risk when the markets were falling apart — on the assumption that panicked governments would quickly intervene — and then taken profits and gone short a few weeks after the intervention, you’d have made a fortune from all the volatility.

This looks like another perfect set-up: A week ago, Europe was collapsing, China was slowing down and the US budgeting process was paralyzed. Stocks around the world had fallen hard, and a Euro-zone breakup was being actively planned for by governments and trading exchanges. Armageddon, in other words. So the central banks inject another hit of liquidity and Germany and the ECB appear to embrace the commingling of the continent’s balance sheets. And voila, the bulls are back in charge.

Now, trading strategies work until they don’t, and there’s always the risk that this latest bailout will actually fix the world’s problems and usher in a new era of consumer-led growth with soaring corporate profits, low inflation, and rising share prices. But…nah, why even give this possibility serious consideration? Nothing that was promised this week will make much of a near-term difference. Lower reserve requirements in China and cheaper dollar-denominated loans in Europe are just tweaks to already existing programs. More fiscal integration in Europe is inevitable if the common currency is to function as promised. But think for a moment about what this implies — Germany and France getting to micromanage Italy’s pension and tax system — and it clearly isn’t happening this month. Getting from here to a German-run Europe will take maybe five more near-death experiences, and in any event won’t address the fact that even Germany’s balance sheet (when you include its unfunded liabilities) really isn’t AAA.

So, the pattern should hold: “Risk-on” trades work this week, then things get choppy for a while. Then the markets grow cautious and finally terrified. The most likely catalyst for the panic stage is the massive, front-loaded refinancing schedule that Italy and Spain have unwisely set up for early 2012. But it could be anything. The point is to be short risk when it hits but not to marry the position, because more liquidity is on the way. The con will keep working as long as the world continues to see fiat currencies as valuable.

Death of the Dollar

“When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which the check is drawn. When the Federal Reserve writes a check it is creating money.”

-The Federal Reserve, Putting It Simply, 1977

I disagree and believe it’s important to draw a distinction. The Federal Reserve does not create money, it creates currency.

And it is disconcerting the way the Federal Reserve creates that currency:

  • It makes loans to the government or banking system by writing a bad check.
  • It buys something with the bad check.
    And once those newly created dollars are deposited in the banks, the banks get to employ the miracle practice of fractional reserve banking, further debasing our currency – the dollar.
    Here is the definition of fractional reserve banking in a nutshell. All banks have a reserve requirement, meaning the must keep a certain amount of dollars available for withdrawals and other day-to-day requirements. If the reserve requirement set by the Fed is 10 percent (and it currently is) the bank must keep 10 percent of the currency deposited on hand in case someone wants to make a withdrawal. They are allowed to loan out the remaining 90 percent of those deposits.But the bank doesn’t actually loan out the currency that is in their depositor accounts. It creates brand new fiat dollars out of nothing and loans them out, which means that they too were “borrowed” into existence. In other words. when you deposit $1,000 dollars, the bank can create 900 brand new dollars with nothing but a book entry, and then loan them out with interest. This process repeats over and over again. If those 900 brand new dollars are deposited in a checking account, that bank is allowed to create another 90 percent of the value of that deposit, and then another 90 percent until that original $1,000 deposit becomes $10,000 freshly minted (actually electronically created) dollars. Is it any wonder why our nation’s money supply has exploded over the past few decades.
    Coincidentally, the same year the Federal Reserve Act was passed, 1913, the 16th amendment to the Constitution was approved, which created the dreaded income tax. And guess who championed the 16th amendment? None other than Senator Nelson Aldrich, one of the driving forces behind the formation of the Federal Reserve.

The Beginning of the End

By far the most secret and least accountable operation of the federal government is not, as one might expect, the CIA, DIA, or some other super-secret intelligence agency. The CIA and other intelligence operations are under the control of Congress. They are accountable: a Congressional committee supervises these operations, controls their budgets, and is informed of their covert activities.

The Federal Reserve however, is accountable to no one; it has no budget; it is subject to no audit; and no Congressional committee knows of, or can truly supervise, its operations. The Federal Reserve, virtually in total control of the nation’s monetary system, is accountable to nobody.

-Murray N. Rothbard in The Case Against the Fed, 1994

Here’s how it began.

In 1907 there was a banking and stock market panic in the United States, aptly called the Panic of 1907. In was believed that the big New York banks, know as the Money Trust, had been causing stock market crashes and then profiting from them by buying up stocks from panicked investors and selling them for big profits days or weeks later. The Panic of 1907 was especially devastating for the U.S. economy. There was an outcry by the public for the government to do something. The federal government did something, however as we have learned in last decade – be careful what you ask for.

In 1908 Congress created the National Monetary Commission to recommend banking reforms that would prevent such panics, as well as to investigate the Money Trust. Senator Nelson Aldrich, a powerful and influential Republican, was appointed chairman. He immediately went to Europe where he spent the next two years and $300,000 – $6 million adjusted for inflation – consulting with the central bankers of England, France and Germany.

Upon his return to the states, Aldrich called a secret meeting of the top U.S. economic power brokers, many of whom, coincidentally, were bankers. It is estimated that the men invited to the conference on Jekyll Island, Georgia represented one-quarter of the world’s wealth. Aldrich and his guests spent nine days writing legislation – the Aldrich Plan – that eventually became the Federal Reserve.

Here is what two of the attendees had to say about the meeting:

“Picture a party of the nation’s greatest bankers stealing out of New York on a private railroad car under cover of darkness, stealthily hieing hundreds of miles South, embarking on a mysterious launch, sneaking to an island deserted by all but a few servants, living there a full week under such rigid secrecy that the names of not one of them was once mentioned lest the servants learn the identity and disclose to the world this strangest, most secret expedition in the history of American finance.

I am not romancing. I am giving to the world, for the first time, the real story of how the famous Aldrich currency report, the foundation of our new currency system, was written.”

-B.C. Forbes, Forbes magazine, 1916

“The results of the conference were entirely confidential. Even the fact there had had been a meeting was not permitted to become public. Though eighteen years have since gone by, I do not feel free to give a description of the most interesting conference concerning which Senator Aldrich pledged all participants to secrecy.”

-Paul Warburg, The Federal Reserve System: Its Origin and Growth,bodytext>

Secrecy was so important to the attendees of this summit because Aldrich, as a U.S. Senator and chairman of the National Monetary Commission, was charged with investigating the banking practices of the very people he conspired with on Jekyll Island. Aldrich and the bankers plotted at a secret meeting on an isolated island to draft a bill – the Aldrich Plan – for a private central bank (the Federal Reserve) that the bankers under investigation would own.

Congressional debate raged when the bill was introduced. Congressman Charles Lindberg was quoted as saying, “Our financial system is a false one and a huge burden on the people. I have alleged that there is a Money Trust. Why does the Money Trust press so hard for the Aldrich Plan now, before the people know what the Money Trust has been doing?”

Ultimately the Aldrich Plan never became law for partisan reasons. However, the bankers did not give up. In 1913 a nearly identical bill, called the Federal Reserve Act, was presented to Congress. And on December 22, 1913, three days before Christmas when the populace wasn’t looking, Congress relinquished its Constitutional right to coin money and regulate the value of that money, and passed it to a private corporation – the Federal Reserve.

Dread The Fed

The beginning of the end for the United States economy started with the inception of the Federal Reserve, the United States Central Bank, some 98 years ago. The Fed as it’s called, is a private bank, separate from (and presumably not under the control of) the federal government. The Federal Reserve has the power to dictate the country’s fiscal policy. The Federal Reserve chairman, not the President, is arguably the most powerful bureaucrat in the nation.

From about 1871 to 1914, when World War I began, most of the developed world operated under the classical gold standard. Most of the world’s currencies were pegged to gold. This meant they were also pegged to each other. This made business planning and investment far more reliable than today. Business people could make plans and  projections far into the future and trade with foreign countries knowing exactly what the currency exchange rate would be.

During this period, on average, there was no inflation – none. Yes, there were the inevitable booms and busts – inflations and deflations, but from the beginning of this period until World War I inflation averaged out to zero. Gold, and the gold standard, was the equalizer.

Here’s how it worked: When a country experienced an economic boom it imported more goods. These goods were paid for with (currency backed by) gold, so gold flowed out of the country. As gold flowed out of the country the currency supply contracted (i.e. deflated). This caused the economy to slow and demand for imports to fall. As the economy slowed, prices fell, making the country’s goods more attractive to foreign buyers. As exports rose to meet foreign demand, gold flowed back into the country. Then the process started all over again. The value of a countries currency (again based on gold) continuously moved up and down in a narrow range.

During this period currency, paper money, was just a receipt for actual money – gold. The gold standard stabilized currencies worldwide and acted as a constraint on the growth (inflation) of the currency supply.

Central banking is a controversial subject. Governments have embraced the concept, while sound money advocates increasingly decry the economic destruction caused by central banks the world over.

Central banking offers no benefits to society and contributes, mostly through the process of inflation, to serious problems. The following are just a few of the issues engendered by central banking and inflation:

  • It causes capital consumption and misallocation of capital
  • It taxes fixed income earners (savers and fixed wage laborers)
  • It discourages saving or forces savers to take more risk
  • It encourages consumption and debt
  • It benefits debtors (especially government), speculators, politicians, lobbyists, and fractional reserve banks
  • It produces the business boom/bust cycle
  • It rewards corruption and leads to morals hazards
  • It accelerates the growth of government
  • And if not abandoned it can result in a currency crisis, impoverishment, and economic and social chaos

By manipulating interest rates away from their natural free-market level central banks distort the pricing mechanisms by which entrepreneurs, businesses and consumers make decisions. This distortion results in massive amounts of wasted resources as capital gets invested in unsustainable areas. Row after row of empty houses in Florida, Nevada and Arizona are excellent such examples of capital that was put to work in the wrong area because people were fooled by artificially low interest rates into believing there was a need for new housing in these areas.

This boom and bust process has been recurring over and over for decades and the boom/bust cycle is now accelerating as the system nears collapse. This continual boom/bust cycle and massive amount of misallocation of capital has destroyed trillions of dollars in wealth and is the real reason why the US is in such terrible shape today.
Yet, despite decades of wealth destruction caused by the Federal Reserve, who does the American public look to in order to fix the problems? Unbelievably, they look to Ben Bernanke and the Fed.