Greenspan: Role Of Central Bankers Is to Try to Replicate the Stability of the Gold Standard

Greenspan said on any number of occasions that his model was that a 'fiat currency' works when it emulates the rigor of the gold standard.

I am using this post as a placemarker to gather a few citations along these lines. Sometimes people doubt these things, and it is not always easy to go back and find the actual idea in print.

I will place other example here as I find them but it is not a high priority because Alan Greenspan has never deviated from this point of view. One of the most poignant examples I have was when Ron Paul asked him if he still believed in what he wrote in his famous essay on Gold and Economic Freedom.

And Greenspan answered that he would not change a word.

I think the squaring up of what Greenspan believed, and what he did as Fed Chairman, is one of the more interesting conundrums that I hope that time will explicate. 

The other of course is why the flaming liberal and 'socialist' Obama is really closer to Richard Nixon in his performance and outlook than most would care to admit, on either the right or the left. 

This is from a 2007 Interview by National Public Radio with Alan Greenspan on Turbulence and Exuberance

Greenspan: Well actually, we were not fundamentally regulators [at the Fed]. The vast portion of our efforts were not involved in bank regulation.

NPR: No, but you were regulating interest rates, which have a profound effect on world economies.

Greenspan: You're raising really a very interesting question. I have always argued that the gold standard of the 19th century was a very effective stabilizer. It kept inflation essentially at zero, and I felt it was critical for the tremendous growth that occurred for the American economy in the latter part of the 19th century. When we went off the gold standard essentially in 1933, we then had to have what we call "fiat money" which is essentially money that is - it's printed paper money. Which unless we restrict the volume of, can be highly inflationary.

The type of interest rate regulation that I and indeed most central banks in the last 20 years have been involved in...has been to try to replicate the laws and rules that were governing the gold standard.

And so it is an odd situation where all the central bankers -- while none of them are advocating a return to the gold standard -- nonetheless try to replicate the various types of interest rate policies that the gold standard would have created. And it is an interesting question whether you call that regulation, or basically functioning of a central bank in stabilizing the economy."

I remember all such statements of Greenspan's vividly because they were one of the few times in which I felt that he was telling the truth, at least as he sees it.

I think that a fiat currency can 'work' if it emulates the rigor of an external standard. And exceptions that can be made to this rigor during times of exogenous shocks could be a quite useful tool for monetary policy.

The problem is that it NEVER seems to work out that way in the real world. It does not take long for financiers and politicians to discover the heady power and easy money to be had in manipulating the markets and the fiat currencies to their own advantage, the public and the real economy be damned. And then a pigfest ensues, and a nation's savings and civic virtue are consumed.

"And, indeed, since the late '70s, central bankers generally have behaved as though we were on the gold standard. And, indeed, the extent of liquidity contraction that has occurred as a consequence of the various different efforts on the part of monetary authorities is a clear indication that we recognize that excessive creation of liquidity creates inflation, which, in turn, undermines economic growth.

So that the question is: Would there be any advantage, at this particular stage, in going back to the gold standard? And the answer is: I don't think so, because we're acting as though we were there. So I think central banking, I believe, has learned the dangers of fiat money, and I think, as a consequence of that, we've behaved as though there are, indeed, real reserves underneath the system."

Greenspan, A., Hearing on Monetary Policy Report, US House Committee on Financial Services, 20 July 2005, Washington D.C.

From: Jude Wanniski < jwanniski@polyconomics.com
To: Ben.S.Bernanke@ * * * * *.GOV
Subject: Fwd: Re: Savings glut
5:44 pm, 7/21/2005

I thought you should see this. Greenspan was plain awful in his testimony this week. But members of Congress don't know any better, so they slobber all over him. He again said we don't need a gold standard, because he has demonstrated since he came to the Fed in 1987 that the central bank could "replicate" the gold standard.

Take a look at the dollar/gold price from 1987 until today and you will see how terrific he has been in replicating the gold standard. I can't wait for him to leave, Ben, because he now has so much invested in his Fed legacy as a Maestro that he could never admit he screwed up almost all along the way.

Famous 2005 Exchange Between Ron Paul and Alan Greenspan about the Gold Standard


Related: Why There Is Fear and Resentment of Gold's Ability to Reveal the True Value of Financial Assets

Fiat Monetary Theory: The Gamblers

'The Gamblers'

"The historical behavior of interest rates and growth rates in U.S. data suggests that the government can, with a high probability, run temporary budget deficits and then roll over the resulting government debt forever.

The purpose of this paper is to document this finding and to examine its implications. Using a standard overlapping-generations model of capital accumulation, we show that whenever a perpetual rollover of debt succeeds, policy can make every generation better off.

This conclusion does not imply that deficits are good policy, for an attempt to roll over debt forever might fail. But the adverse effects of deficits, rather than being inevitable, occur with only a small probability."

Ball, Elmendorf, Mankiw, The Deficit Gamble

As with most Ponzi schemes, modern fiat currencies are a matter of degree, belief, and tipping points.

There are always limitations in any system, and in paper money systems the debt must be balanced by real growth and investment, an organic growth that makes the rolling debt burden, which is really the basis of the money itself, sustainable and productive.    That growth must be broadly based in order to support consumption from within the system itself, and this implies income commensurate with increasing productivity.

The failure of every fiat currency has been tied to the abuse of power, in the non-organic use of created money not to increase the productive growth of the economy, but to establish monopolies, cartels, speculation, and of course, aggressive war, all in pursuit of the outsized enrichment of a relative few who define themselves as an elite.

And human nature being what it is, all paper money systems have failed within a few hundred years.

There is a variation of  Fiat Monetary Theory, also known as fiat money, which seeks to distinguish itself by its name in addition to its penchant for sophistry, called Modern Monetary Theory.

This variant eliminates the debt problem by switching from a debt based currency to a pure fiat currency issued directly by the government. The longer term problem of currency revulsion, or the rejection by the people of the stated value of the currency, is resolved by greater use of government force.

The resort to force is a tell tale marker of all ideological cults which are unable to achieve a natural stability and an informed, willing acceptance.  That force may include psychological persuasion including propaganda and ridicule.

We are seeing something like this today in Europe, with the compulsion to enforce austerity as the technocrats and careerists refuse to admit that, that by its very design, the Eurozone is inherently unstable. 

And the reforms required to avert disaster are unthinkable, because they will diminish their wealth and power.   And so they become increasingly desperate and self-destructive.

Since the leaders are naturally superior, it is the people that have failed them, because they did not believe enough, work hard enough, sacrifice enough. And so they must be punished.

Why There is Fear and Resentment of Gold's Ability to Reveal the True Value of Financial Assets

There were a few questions raised about the note on the long term chart of the SP 500 deflated by gold which was posted last night, and which is reproduced here on the right, which read "This is why the financial engineers like Bernanke hate and fear gold; it defies their plans and powers."

The chart shows something that most investors have suspected. There has been no genuine recovery in the price of stocks since the decline that cannot be fully explained by the monetary inflation of the dollar, as can be discovered by the ultimate store of value, which is gold.

I thought that this was a fairly straightforward observation, but it apparently jarred a few people and their thinking. So perhaps we have some new readers who are not familiar with the long standing animosity towards gold that is uniformly expressed by all those who promote centralized command and control economies, from both the left and the right.

Can any astute observer doubt the Fed's desire to act in secret and privacy? Their obsession with this is almost unbelievable and beyond comprehension, unless one understands that they are in a 'confidence game,' and use persuasion and even illusion to shape perceptions, especially at the extremes of their financial and monetary engineering of the real economy.

This animosity and desire for secrecy was described by Alan Greenspan in his famous essay, Gold and Economic Freedom, first published in 1966. In a fairly amusing exchange between Congressman Ron Paul and the former Chairman a couple of years ago, Mr. Paul asked Sir Alan about this essay, and if he had any corrections or misgivings about it after so many years. Would he change anything?

"Not one word." replied Greenspan, in one of his few candidly honest and straightforward statements.

It helps to understand the dynamics of the money world, which appear so mysterious to those who do not specialize in it, even economists, although some may feign ignorance to promote their cause or avoid unpleasant disclosures.

Money is power. Ownership of the means of production may provide for the control of groups of disorganized labor.  But the power of the issuance of money allows for the control of whole peoples and governments, through the distribution and transference of wealth, by the most subtle of means. And this is why the US Constitution relegated this power to the Congress and by their explicit appropriation, and denied it to the States and private parties except in the form of specie, that is, gold and silver which have intrinsic value.

It might be useful to review a prior post in reaction to the self-named maverick economist Willem Buiter, who wrote a few attacks on gold, prior to his leaving academia and the Financial Times to take a senior position with Citibank. Willem Buiter Apparently Does Not Like Gold

It may seem a bit perverse, but I do not favor a return to a gold, or a bi-metallic gold and silver standard at this time.   Each nation can be free to devalue or deflate their own money supply as their needs require, with the consent and knowledge of the people and their representatives.

What I do promote is for gold and silver to trade freely without restraint or manipulation as a refuge from monetary manipulation, and a secure store of value for private wealth. When nations adopt the gold standard, they invariably seek to 'fix' and manipulate its price, and reserve the ownership to themselves, with the tendency to seize the wealth of their citizen under the rationale of such an ownership, or dominant privilege.

Let those who have a mind to it have the means of securing their labor and efforts, and let the state do as it will, with the open knowledge and consent of the world.

"Gold is not necessary. I have no interest in gold. We will build a solid state, without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off to a concentration camp. That's the bastion of money."

Adolf Hitler

A draconian approach no doubt. It is much more common for the ruling parties to debase the coinage secretively while advantaging their friends and supporters, thereby manipulating the value of gold and silver covertly.

 In modern times of non-specie currency one might choose to select a few cooperative banks and the central money authority to manipulate the price using paper and markets, and hope that this scheme will remain undiscovered. But it always comes out, the truth is always known in the end.

"With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people."

F. A. Von Hayek

There are any number of amateur economists and investing pundits around these days who betray an almost irrational opposition to gold, becoming jubilant in every decline, and despondent at every rally. And some of them even take the label of 'Austrianism' in their thoughts which is quite odd given that it is one of their schools strongest bulwarks.

Most often this can simply explained as the envy of those who have not prepared for a crisis, and wish ill upon those who have, regretting and hoping for another chance to provide for their own security. And yet they will fail to take advantage of every opportunity to do so, as they are creatures betrayed alternatively by their own fear and greed.

One of the best indications of quack advice on the question of investing in precious metals is when one of the reasons against it includes the scurrilous non sequitur, 'You can't eat it,' as if nutritional content is a valid measure of the durability of wealth. It betrays a lowness of argument and intellectual integrity that should promptly urge one to run in the other direction.

And regrettably, there are always those who will say almost anything for money, and the profession of economist seems to be particularly infested with that sort, given the stochastic nature of the discipline, and its lack of scientific rigor, being based on principles which do not easily lend themselves to objectification with serious damage to the data being made by the assumptions in their equations and proofs.

But most of all, the financial engineers, politicians, and Wall Street Banks fear gold because it is the antidote to their frauds, and the informant to their confiscation of wealth.

Do not expect them to capitulate once and for all, but only slowly and grudgingly as it becomes more difficult for them to sustain their illusions and persuasion. Protecting wealth against official adventurism is never easy.

Here is Alan Greenspan's famous essay on Gold and Economic Freedom. I suggest your read it, because it will help you to understand much of what is said and done as the global reserve currency system changes and evolves.

Gold and Economic Freedom
by Alan Greenspan

Published in Ayn Rand's "Objectivist" newsletter in 1966, and reprinted in her book, Capitalism: The Unknown Ideal, in 1967.

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense - perhaps more clearly and subtly than many consistent defenders of laissez-faire - that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.

In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.

Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.

The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.

What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible. More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term "luxury good" implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.

In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.

Whether the single medium is gold, silver, seashells, cattle, or tobacco is optional, depending on the context and development of a given economy. In fact, all have been employed, at various times, as media of exchange. Even in the present century, two major commodities, gold and silver, have been used as international media of exchange, with gold becoming the predominant one. Gold, having both artistic and functional uses and being relatively scarce, has significant advantages over all other media of exchange. Since the beginning of World War I, it has been virtually the sole international standard of exchange. If all goods and services were to be paid for in gold, large payments would be difficult to execute and this would tend to limit the extent of a society's divisions of labor and specialization. Thus a logical extension of the creation of a medium of exchange is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold.

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security of his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments.

When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion. Thus, under the gold standard, a free banking system stands as the protector of an economy's stability and balanced growth. When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one — so long as there are no restraints on trade or on the movement of capital. Credit, interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the "easy money" country, inducing tighter credit standards and a return to competitively higher interest rates again.

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline — argued economic interventionists — why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely — it was claimed — there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks ("paper reserves") could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates. The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's.

With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression. If the gold standard had not existed, they argued, Britain's abandonment of gold payments in 1931 would not have caused the failure of banks all over the world. (The irony was that since 1913, we had been, not on a gold standard, but on what may be termed "a mixed gold standard"; yet it is gold that took the blame.) But the opposition to the gold standard in any form — from a growing number of welfare-state advocates — was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale.

Under a gold standard, the amount of credit that an economy can support is determined by the economy's tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government's promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which — through a complex series of steps — the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy's books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Given his Randian audience and the mood at the time, it is interesting that Greenspan defines the culprits in the scheme of fiat monetization as 'welfare statists.' How ironic, that over a period of time there is indeed a group of welfare statists behind the latest debasement of the currency, the US dollar, but the recipients of this welfare are the Banks and the financial elite, who through transfer payments, financial fraud, and federally sanctioned subsidies are systematically stripping the middle class of their wealth. Perhaps they decided that if you cannot beat them, beat them to the trough and take the best for themselves until the system collapses through their abuse.

Krugman Declares "Mission Accomplished," Maginot Line Completed

The triumph of financial engineering based on an analysis of the past.

Conscience of a Liberal
The story so far, in one picture
By Paul Krugman
November 3, 2009

World industrial production in the Great Depression and now:

Jesse here. This chart is a bit deceptive because it compares two periods of time based on the start of the crisis. It would be interesting to compare the two crises from the start of the Fed's expansion of the monetary base. As I recall, the early 20th century Fed did not react this way until 1931 and did so in two stages. Ok, Ben was quick out of the starting gate with a massive quantitative easing. Score one for the Fed. They are quick on the draw when it comes to monetization.

And there is little hazard that Ben will tighten prematurely out of fear of inflationary forces, having learned at least that lesson from what might prove to be a simplistic historical comparison.

It would be unjust not to note that the 1930's Fed struggled a bit with the difficulties of an entirely different type of commercial banking structure and regulatory structure, and the restraints of a gold standard.

But at the heart of it, the comparison may be irrelevant. The genuine challenge in this era of fiat currency will be to avoid the 'zombification' of the economy, the appearance of vitality with none of the self-sustaining growth.

It may be discovered that the key to coming out of a crisis permanently is not how quickly and dramatically one inflates the money supply, or even how long one maintains it, and how many stimulus programs one can create, but rather how quickly and capably a country can reform, can change the underlying structures that caused the problem in the first place.

Japan has been doing it slowly because of its embedded kereitsu structure and government bureaucracy supported by a de facto one party system under the LDP. In the 1930's the impetus for reform was overturned by a strict constructionist Supreme Court and an obstructionist Republican Congress. The story of our time might be the perils of regulatory and political capture.
Before this Administration declares "Mission Accomplished" and high fives its victorious recovery, they may wish to consider that they have done the obvious quickly in one dimension, but have done very little to change the dynamics which created the crisis in the first place, choosing instead to support the status quo to a fault, partly out of ignorance and to some extent because of a pervasive and endemic corruption of the political process.

There are three traits that make a nominal bounce in production fueled by a record expansion in the monetary base a success: sustainable growth without subsidy, sustainable growth without subsidy, and sustainable growth without subsidy. And this can only be achieved by changing the game, reforming what was wrong with the system in the first place, if this is what caused the crisis.

Our forecast is that Ben and Team Obama are failing badly because they are fighting the last war, in the almost classic style of incompetent generals who lost the early stages of the Second World War because they were using the game plan from the First. And plans for a Vichy-style government establishing l'état financière seem to be well underway, in a general surrender of the goverance of the nation to the econorati.

For all its flaws, at least the Clinton Administration used to conduct polls to see which way the public was leaning, and took its cues from that. The Obama Administration blatantly ignores public outrage, and takes its calls from Wall Street, literally, and forms its policy and laws around what they want, or at most, will grudgingly accept.

Price, Demand, and Money Supply as They Relate to Inflation and Deflation

There are three basic inputs to the market price of something:

1. Level of Aggregate Supply
2. Level of Aggregate Demand
3. Relative Value (purchasing power) of the Medium of Exchange

Let's consider supply and demand first, since they are the most intuitively obvious.

The market presents an overall demand, and within that demand for individual products in particular.



Supply is the second key component to price. We are not going to go into more detail on it since what we are facing now is a decrease in Aggregate Demand.


It can seem a little confusing perhaps. Just keep in mind that if the aggregate demand decreases for goods and services for whatever reasons, such as severe unemployment, and supply remains available then prices will drop overall, with some variance across products because of their differing elasticity to price changes.

This is known as the Law of Supply and Demand.

How we do know when aggregate Demand is decreasing?

Gross Domestic Product = Consumption + Investment + Government spending + (exports − imports),
or the famous economic equation GDP = C + I + G + (X − M).

Consumption, or Aggregate Demand, is a measurable and key component of our GDP figures.

Given the huge slump in GDP, it should be obvious that we are in a demand driven price deflation on many goods and services. People are saving more and consuming less.

Now, that covers supply and demand as components of price, but what about money?

Money

Notice in the above examples we talk about Price as a value without a label.

Money is a medium of exchange. It is the label which we apply to give a meaning to our economic transactions.

If you are in England, or France, or Argentina, or China, the value label you apply to Price is going to be different according to local laws and customs.

Money is the predominant medium of exchange that a group of people have agreed to use when engaging in economic transactions that are not based on pure trading of goods, known as barter.

The source and store of wealth are the 'credits' within the system which one uses to exchange for products. The money is the medium of exchange.

If you work for a living, you are exchanging your time and your talent, which is your source of wealth, for products. The way in which this is labeled and facilitated in the United States is through the US dollar. I n Russia and China is it something else completely.

The Value of Money

How do we know what some unit of money is worth? Try not to think about your domestic currency. Since we use it so often every day, we tend to think of it with a set of assumptions and biases. Most Americans have little practical exposure to foreign exchange, and tend to think of themselves as living in a dollar-centric world.

Let's use the Chinese yuan. What is the yuan worth? What if I offered you a roll of yuan in exchange for a day's work? How would you know if it was a 'fair trade?"

Since there is no fixed standard for money in our world, you would most likely inquire in the markets what you could obtain for those yuan I offered to you in an accessible market.

But what sets the rate at which yuan are exchanged for a given product?

In a free market system, it is a very dynamic system of barter. When you offer something for money, I know how much of my source or store of wealth I must exchange for the yuan to provide for the product offered.

Money is just a placeholder. We hold it because we expect to be able to trade it for something else which we really desire. You don't eat or wear money; you exchange it for things which you wish to eat or wear.

If the value of money changes, the price of all the things to which you have been applying that label changes. This is why it is important to distinguish between price changes because of changes in demand, and changes because of money supply. They are different, and require very different responses.

Money supply

In a very real sense, there is a relationship between how many goods and services are available, and how much money exists.

Let's say we are in China. I give you 100 yuan. Tomorrow the Chinese government triples the amount of yuan in the economy by giving each of its citizens ten thousand yuan for essentially doing nothing, for not producing anything more or less.

Do you think the 100 yuan will be worth as much as they were the day before? No, obviously not.

In real economies these changes tend to happen with a time lag, or gradually, between the action and the reaction. This is necessary because people can only adjust their daily habits, their economic transactions, gradually. Otherwise it becomes too stressful, since our daily routines and decisions are based so heavily on habits and assumptions of value and consequences.

But in general, if the supply of money is increasing faster than real per capita GDP over a longer term average the money supply is inflating, that is, losing real purchasing power.

Seems simple? Well its a bit more complicated than that unfortunately since these things relate to free markets, and if there is any other thing you need to remember, we do not have free markets, only free to varying degrees.

The logical question at this point is to ask, "What is the money supply?" That is, what is money and what is not?

We dealt with this at some length, and suggest you look at this Money Supply: A Primer in order to gain more knowledge of what is money and money supply.

We would like to note here though, that there is a difference between money supply and credit, between real money and potential money.

If I have 100 Yuan in my pocket, there is a real difference between that money, and my ability to work at some job tomorrow and be paid 100 yuan, or have you repay 100 yuan to me which I gave to you yesterday, or my hopes that I can borrow 100 yuan from some third party.

If you do not understand this, you will not understand money. It is one of the great charades of our time that risk has been so badly distorted out of our calculations. We cannot help but think that some future generation will look at us as though we had all gone barking mad.

The subject becomes even more complicated these days because we are in what is called a fiat regime. Fiat means 'let it be done' as we will it, and we are if anything in a very relativistic age in which we think we can will just about anything.

The major nations of the world get together and attempt to manage the value of their currencies relative to one another, primarily through their finance ministries and central banks.

Countries will interfere in the markets, much more than they will admit, to attempt to maintain certain relationships among currencies of importance to them. Sometimes they are overt about it, as when nations 'peg' one currency to another, and at other times they are more subtle and merely influence other currencies through mass purchases of debt and other forms of persuasion and the molding of perception.

I hope this helps. I don't intend to answer loads of questions on this, particularly from those who immediately start inventing complex examples to try and disprove this. Most of the time the examples betray a bias that person has that defies patience and a stubborn belief that everything is relative. In the longer term it is most assuredly not.

Each will learn at their own pace what is real and what is not. But they will not be able to say that they have not been warned that sometimes appearance is different than reality.

Here are some examples of money supply growth in the US. If you read our Primer you will know that MZM is by far the most important now that M3 is no longer reliably available.



Is money supply growing faster than real per capita GDP? Yes, decidedly so. And unless this trend changes significantly we will face a whopping monetary inflation.





Here is a chart that shows the buying of US debt that other countries have been doing through the NY Fed Custodial Accounts for a variety of motivations. Without this absorption of US money supply the value of the dollar would be greatly diminished relative to several other currencies. This is probably not a sustainable relationship but it has had a good long run because it is supported by the US as the world's superpower.

Other countries are essentially exchanging their productivity, their per capita GDP, for our excess money supply. This is why a US monetary inflation has remained manageable. Other countries are providing an artificial Demand for US debt at non-market prices.



One of the great errors of our generation has been the gradual and erroneous mispricing of risk through a variety of bad assumptions and convenient fallacies. Without the appropriate allowance for risk, there is no ability to discover valid pricing and allocation of capital.

The consequences of this abuse of reason are going to be enormous.

I do not see this improving quickly because the manipulation of risk for the benefit of the few, and the transfer of that risk to the public and the rest of the world, has tremendous value to the powerful status quo.

But the day of reckoning and settlement of accounts is coming, and as it approaches it will accelerate and come with a vengeance. For after all,

"Life is a school of probability." Walter Bagehot

School is almost out.

The Decline of Monetarism: Our Next Financial Crisis

"Throughout the world financial interests have taken control of government and used neoliberal policies to promote their own gain-seeking – financial gains without industrialization or agricultural self-sufficiency. Betting against one’s own currency is more remunerative than making the effort to invest in capital equipment and develop markets for new output. So unemployment and domestic budget deficits are soaring. The neoliberal failure to distinguish between productive and merely extractive or speculative forms of gain seeking has created a travesty of the kind of wealth creation that Adam Smith described in The Wealth of Nations. The financialization of economies has been decoupled from tangible capital investment to expand employment and productive powers.

Central to any discussion of financialization is the fact that credit creation has been monopolized in the United States and Britain for their own national gain."

This is an interesting essay from Michael Hudson, because it helps to illuminate some of the less frequently discussed implications of the rise of fiat currencies since the 1970's and the growth of financial engineering amongst an elite group of multinational corporations.

This subject has preoccupied the thoughts of this forecaster since the late 1990's and the Asian currency crisis.

How the evolution of monetarism and international trade plays out will shape the political and societal landscape of the first half of this century, and perhaps beyond.

This looks to be a classic showdown between those who issue and control the reserve currencies of the world, and those who make real products and write their nation's laws.

The Collapse of the Neoliberal Model
Where Russia Went Wrong
By Michael Hudson

Last week Izvestiya published an interview with former Premier Yevgeny Primakov, now president of the Chamber of Commerce and Industry. (Johnson’s Russia List published a translation on May 8). The discussion centered on a universal problem – what China and other Asian countries, as well as OPEC and Europe should do with the export surpluses and proceeds mounting up in their central banks from mortgaging or selling off their real estate and industry. Or to put matters in retrospect, what should they have done to avoid the neoliberal monetarist ideology that governments should do nothing at all with these surpluses, not even use them to fuel economic growth.

If U.S. diplomats had their way, countries would simply let their foreign exchange reserves accumulate in the form of loans to the United States, in the form of Treasury bonds and other securities. Mr. Primakov has long opposed what his interviewer called “the fetishization of the Stabilization Fund – our beloved ‘piggy bank.’” Urging that it be spent on “primary needs,” to buy tangible capital goods, undertake infrastructure investment and finance imports to rebuild Russia’s dismantled manufacturing sector, he explained, “I was always opposed to having the Stabilization Fund considered something saved for an emergency. Money needs to be spent inside the country. Naturally not all of it. Some part should certainly be kept as a reserve.” But it was Vladimir Putin’s own “initiative to divide the Stabilization Fund into the Reserve Fund and the Fund for Well-Being. The latter was to be used to develop the economy and for social needs. It is too bad that they did not get to it in time.”

Ever since the Asian financial crisis of 1997, countries that have built up foreign exchange reserves have found themselves targets of global raiders. The tactic has been to sell a currency short, that is, to promise to deliver a few hundred million (or nowadays a few billion dollars) of it to a buyer (usually the central bank) near the current price, and then drive down the exchange rate by selling. The central bank tries in vain to absorb the selling wave, until finally its reserves are exhausted and the currency depreciates. This is how George Soros broke the Bank of England – and what he denies having done in Malaysia during the 1997 crisis.

Under Prime Minister Dr. Mahathir Mohammed, Malaysia protected itself by not making its currency available for foreign speculators to buy and cover their short-sale position. But most other countries have passively built up reserves in an attempt to outspend potential raiders. Today, however, underlying trends are using up these reserves. The global financial crisis has ended the real estate bubble that enabled many countries to cover their trade deficits by selling off their real estate or simply taking out foreign-currency mortgages against it. The Baltics and other post-Soviet countries in particular have been financing their trade deficits by fostering a property bubble that has led real estate owners to borrow mortgage credit from Western banks. In the absence of putting in place a viable domestic banking system, Scandinavian, Austrian and other Western banks are the only institutions able to create credit. Now that the global real estate bubble has burst, this foreign exchange credit is no longer forthcoming. The financial End Time has arrived. Rather than facing the new state of affairs – chronic trade deficits are now over-layered with heavy foreign-debt service. Countries that have built up foreign reserves are running them down.

Many countries are trying to delay the Day of Judgment by borrowing from the IMF, dissipating the proceeds by subsidizing capital flight by investors and speculators who can see that exchange rates for chronic trade-deficit countries are about to plunge steeply. Russia has joined in expending its foreign-exchange reserves to stabilize the ruble in the face of capital flight and foreign speculative selling.

In retrospect this appears to have been inevitable, and indeed was widely foreseen by critics of the neoliberal Washington Consensus. The reserves built up during the oil-price run-up last year and the recent boom in minerals prices are being spent without having used the proceeds to develop its industry so as to replace imports and develop export markets for what used to be a high-technology economy prior to the Yeltsin “reforms” (that is, dismantling of industry). Russia continued to rely almost exclusively on raw materials and oil exports. “In our country,” explained Mr. Primakov, “40% of GDP was created and is created through raw material exports. The share of industrial enterprises engaged in development and introduction of new technologies barely comes to 10%.” The problem is that having given away its mineral resources and other public enterprises to insiders and their cronies, Russia has relied on what they choose to leave in the country from their exports and sale of shares in their companies. “The prolonged refusal to inject the capital being built up into the real economy and its direct investment in American treasury securities instead of its use inside the country to diversify the economy. … As a result, Russia will most likely come out of the recession in the second echelon – after the developed countries.”

The alternative, Mr. Primakov said, would have been to use the Stabilization Fund “to switch the economy to the innovation track and for its restructuring. ‘Patching the holes does not help for long.’” But he the then-minister of economics, German Gref, fought off attempts “to cannibalize the Stabilization Fund.” Under the kleptocracy the money was left to be stolen.

The problem is where to go from here. Neoliberal “monetarist” ideology conjures up the threat of inflation to deter public spending. This IMF and World Bank propaganda blocked Russia from investing in industry during the Yeltsin disaster of the mid-1990s. “Fear of inflation,” Mr. Primakov explained, “was named as the main reason that huge amounts of money lay idle. They said that inflation would soar if what had been built up began to be spent. At one of the representative conferences, I asked: ‘What kind of inflation can there be in building roads? The work would just spur on production of concrete, cement, and metal ...’ But our financial experts have a monetarist view of inflation. They are afraid of releasing an additional money supply into circulation. But in reality inflation rises much more strongly from that fact that we have colossal monopolization.” Trade dependency leads the ruble’s exchange rate to weaken, raising the price of imports and thus aggravating the inflation – precisely the opposite of what Washington Consensus orthodoxy insists.

I myself have heard Scandinavian and other European officials make this argument in almost the same words, and it has persuaded many Third World governments to do nothing with their raw-materials export proceeds but “save for a rainy day,” not promote domestic self-sufficiency in food and consumer goods. The argument seems maddeningly stupid, because it pretends that all government spending is inherently inflationary, adding to the spending stream without producing any production to absorb it. The practical effect is to block countries from growing in the way that the United States and other developed nations have done – by investing in infrastructure and other capital formation, with the government providing basic infrastructure at cost or even freely (as in the case of roads) so as to minimize the cost of living and doing business. Instead of having investment in place to show for the foreign exchange earned by exporting raw materials (and selling off ownership of national assets), countries that follow this policy are now seeing their reserves drained rapidly. And as far as government spending is concerned, the economic collapse is increasing public budget deficits after all!

Contrast this behavior with Pres. Obama’s February 17 economic stimulus plan for the United States. When the Izvestiya interviewer asked Mr. Primakov what he thought about it, he noted that: “In America investments in ‘intellect’ have been increased – in science, progressive technologies, and education, and expenditures for medicine are rising. ... Doesn’t it seem to you that our package of anti-crisis measures is less ambitious? … This law should be considered a plan of investment related to the American economy and society entering the 21st century and a new technological platform of competitiveness. That is why expenditures for science have been increased. The same thing, undoubtedly, with human capital.”

But that is not the Russian strategy today, Mr. Primakov complained. Russia has been living in the short run. “The TPP (Chamber of Commerce and Industry) conducted a poll in 720 firms. Only a third of the managers said that they associate getting out of the crisis with producing new output. The rest are counting on staff cutbacks. If the ministries are given the assignment of reducing expenditures at their discretion, the first thing they sacrifice is scientific research and experimental design development. However, research and development should be classified as protected articles of any budget.”

So much for the free-market policy of automatic stabilizers and do-nothing government policy, leaving choice in the hands of the nation’s financial oligarchs. The situation calls for structural change, coordinated by the government. “If a plane is having trouble, the autopilot cannot handle an unusual situation. Only the personal skills of the pilot can save the ship. It is similar with the economy. Autopilot does not work in extreme conditions. … Self-regulation of the economy disappears as a factor.”

When asked about the oligarchs keeping their funds abroad rather than investing them in domestic industry, Mr. Primakov replied that Russian officials did not “take into account that banks’ interests do not coincide with the interests of the real sector of the economy. … It should have been explained that after receiving state support, in using it banks no longer [should] act as commercial structures but as agents of the state. It should have been watched to make sure that the state capital was not commingled with the banks’ other assets in common accounts but was marked off with a red line. But that was not done. Probably some people were lobbying for the banks’ interests at that point. And the bankers hurriedly began to convert the rubles into hard currency and export it abroad and build up their capitalization” instead of “extend[ing] credit to the real sector of the economy.” Oversight was done poorly, and Russia did not even use its public funds to finance capital investment. But when it comes to what to do at this late point, Mr. Primakov acknowledged, “Punishing the banks for what happened means destroying them.”

The problem is how to restructure the financial system to make it serve the objectives of industrial growth rather than merely facilitating capital flight. Throughout the world financial interests have taken control of government and used neoliberal policies to promote their own gain-seeking – financial gains without industrialization or agricultural self-sufficiency. Betting against one’s own currency is more remunerative than making the effort to invest in capital equipment and develop markets for new output. So unemployment and domestic budget deficits are soaring. The neoliberal failure to distinguish between productive and merely extractive or speculative forms of gain seeking has created a travesty of the kind of wealth creation that Adam Smith described in The Wealth of Nations. The financialization of economies has been decoupled from tangible capital investment to expand employment and productive powers.

Central to any discussion of financialization is the fact that credit creation has been monopolized in the United States and Britain for their own national gain. What makes this interview so relevant is that Mr. Primakov is speaking as head of Russia’s shrunken manufacturing sector. Russia “practically pushes big business outside our borders,” Mr. Primakov noted, “to borrow money from banks there in places where the interest rates are incomparably lower.” Just as the nation was becoming underdeveloped industrially, so it and other post-Soviet economies have failed to create domestic financial institutions to provide the credit that is needed to finance circulation between producers and consumers. As a result, these countries are simply fooling themselves to imagine “that credit can continue to be borrowed abroad ‘for the crisis.’ It is not out of the question that for the first time in 10 years, the state itself will even go begging for a loan again.” So a byproduct of today’s crisis will be to put the world outside of the creditor nations on rations, as it were.

Mr. Primakov was asked what he thought of Moscow Mayor Yuri Luzhkov’s tracing “the sources of the present Russian crisis [to] the 1990s, when the liberal government permitted the ‘stealing, squandering, and distribution of natural resources and the largest sectors of industry to those who could not support their development.’” He replied that there were many smart managers among the oligarchy’s ranks, but acknowledged that “It is a different question that in buying up enterprises (mainly raw material ones) for a song and obtaining mega-profits, many from the beginning preferred not to raise the efficiency of production, but to skim off the cream. … Why think about some processing of raw materials if they bring in big money anyway in natural form? The state should have entered that niche long ago. To have done everything to make certain that some of the petrodollars were pumped into science-intensive industry.”

Contrasting Russia’s failure to industrialize with that of China and its anticipated 8% economic growth in 2009, Mr. Primakov noted: “China exports ready-made products, while in our country a strong raw material flow was traditional.” Now that Western economies are shrinking, China is “moving a large part of the ready-made goods to the domestic market. At the same time, they are trying to raise the population's solvent demand. On this basis the plants and factories will continue to operate and the economy will work. We cannot do that. If raw materials are moved to the domestic market, consumers of such vast volumes will not be found.” Increasing domestic purchasing power will “merely step up imports.” That is the price that Russia is now paying for having failed to sponsor “structural changes in the economy.”

I have cited these long quotations because they have been made by a man who once had a chance to steer Russia along different lines than the economically suicidal death trap promoted by the Harvard Boys and their Washington Consensus. It is the trap into which the Baltics and other countries have fallen. A decade ago Mr. Primakov proposed an alternative, based on a resource-rent tax to finance Russia’s re-industrialization. The government would have collected the “free lunch” of its raw materials sales proceeds in excess of their low costs of production. Instead of retaining the revenue in the public domain from the decades of capital investment that the Soviet government had made to develop its mineral, oil and gas resources, instead of using it to finance economic modernization, Russia simply gave it away to political insiders and let them sell off shares in these resources to foreign buyers on the cheap. Anatoly Chubais and his Western “free-market” backers promised that giving property to individuals in this way would transform them into forward-looking Western-style industrialists. Instead, it turned them into Westernized finance capitalists.

Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website, mh@michael-hudson.com