Wednesday, April 4, 2012

Jim Grant Educates The Fed

Recently Jim Grant gave a speech to the Federal Reserve Bank of New York. Apparently the bank has invited some of its critics to come by and share their criticisms. Excerpted comments from the speech are taken from a posting at Zero Hedge:

In the not quite 100 years since the founding of your institution, America has exchanged central banking for a kind of central planning and the gold standard for what I will call the Ph.D. standard.

This introductory comment I find worth the price of admission. It is quite true that central banking is, in fact, central planning. As Ron Paul and others have noted, money is one side of every transaction in a modern economy. Yet the price and quantity of money is determined by a central committee. In other words, every transaction is directly affected by the decisions made by a small handful of central planners.

Further, instead of gold (or any other market-based commodity) acting as the standard or benchmark for money, we now have Ph.D. economists making such decisions. The wisdom of the market (in a relatively free condition), will always provide superior results to the wisdom of a chosen-few gatekeepers. This has been true in the past and would certainly be true in the future as regards money and credit.

Grant goes on to describe that the current Fed is not the one that was introduced via the infamous 1913 legislation:

I regret the changes and will propose reforms, or, I suppose, re-reforms, as my program is very much in accord with that of the founders of this institution. Have you ever read the Federal Reserve Act? The authorizing legislation projected a body “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States, and for other purposes.” By now can we identify the operative phrase? Of course: “for other purposes.”

In the original act, the role for the central bank was quite limited and defined (of course, one cannot ignore the term “for other purposes,” and this should not be ignored in the original act). Almost immediately, the Fed began violating its charter.

Writing in the mid-1930s, [H. Parker] Willis pointed out that the Fed fell into sin almost immediately after it opened for business in 1914. In 1917, after the United States entered the Great War, the Fed set about monetizing the Treasury’s debt and suppressing the Treasury’s borrowing costs. In the 1920s, after the recovery from the short but ugly depression of 1920-21, the Fed started to implement open-market operations to sterilize gold flows and steer a desired macroeconomic course.

These violations became “legal” with legislation in the 1930s, in other words after the horse left the barn.

I am not moved by such distinctions: while I accept that the Pre-1935 Fed charter was meaningfully different than the post 1935 charter, I find this irrelevant. It is occasionally argued that the Fed would be a beneficial institution if it would just return to its original purpose, as legislated in 1913 and as Mr. Grant seems to be suggesting here. This is nonsense. Once an institution is set up via government dictate, with the full force of the state behind it, said institution can ONLY migrate toward more control and centralization. Therefore, I find myself in some disagreement here with Mr. Grant.

Would I object if a group of banks formed a private cartel similar to the Fed? No. As long as the cartel had no backing or guarantee from the state, it would be subject to all the laws of economics and the marketplace. Such cartels (or monopolies) cannot last long in a free market.

It enflamed [Sen. Carter Glass] that during congressional debate over the Federal Reserve Act, Elihu Root, Republican senator from New York, impugned the anticipated Federal Reserve notes as “fiat” currency. Fiat, indeed! Glass snorted. The nation was on the gold standard. It would remain on the gold standard, Glass had no reason to doubt. The projected notes of the Federal Reserve would—of course—be convertible into gold on demand at the fixed statutory rate of $20.67 per ounce.

That it was not obvious to Senators such as Mr. Glass that such power, once granted, would be abused, speaks volumes. I am just not sure which volumes: was he naïve, or was he deceptive? I can think of no third possibility. Monopoly or privileged authority and power, when backed by the state (with a monopoly of legalized force behind it), will always result in abuse. It speaks poorly of the character of individuals who believe otherwise.

Mr. Grant goes on to describe the workings of the Fed as anticipated in the 1913 bill. This was supposed to be a very passive Fed:

The institution they envisioned would operate passively, through the discount window. It would not create credit but rather liquefy the existing stock of credit by turning good-quality commercial bills into cash— temporarily. This it would do according to the demands of the seasons and the cycle. The Fed would respond to the community, not try to anticipate or lead it.

It is difficult to imagine anyone believing, in 1913, that this institution would be satisfied by being used in such a limited manner. To the advocates of a central bank, getting the nose under the tent proved quite sufficient.

As mentioned earlier, there were critics even at the time, for example Sen. Root, and later H. Parker Willis:

“Central banks,” wrote Willis, glaring at the innovators, “…will do wisely to lay aside their inexpert ventures in halfbaked monetary theory, meretriciousstatistical measures of trade, and hasty grinding of the axes of speculative interests with their suggestion that by doing so they are achieving some sort of vague ‘stabilization’ that will, in the long run, be for the greater good.”

Grant noted, “Ladies and gentlemen, such stability as might be imposed on a dynamic capitalist economy is the kind that eventually comes around to bite the stabilizer.” Grant goes on to debunk the focus of central bankers on the idea of “deflation,” first offering his definition:

Deflation is a derangement of debt, a symptom of which is falling prices. In a credit crisis, when inventories become unfinanceable, merchandise is thrown on the market and prices fall. That’s deflation.

What deflation is not is a drop in prices caused by a technology-enhanced decline in the costs of production. That’s called progress. Between 1875 and 1896, according to Milton Friedman and Anna Schwartz, the American price level subsided at the average rate of 1.7% a year. And why not? As technology was advancing, costs were tumbling.

Much the same sentiments, and much the same circumstances, apply today, but with a difference. Digital technology and a globalized labor force have brought down production costs. But, the central bankers declare, prices must not fall. On the contrary, they must rise by 2% a year. To engineer this up-creep, the Bernankes, the Kings, the Draghis—and yes, sadly, even the Dudleys—of the world monetize assets and push down interest rates. They do this to conquer deflation.

I have often considered the significant increase in productivity via technology tools we have witnessed in the last forty years. In an economic revolution every bit as significant as previous revolutions in transportation and agriculture, this technology and communications revolution has vastly increased the value of applied skilled labor.

Yet, where has this value gone? Who has received the benefits of this increased productivity? Certainly not the average middle-class household. There are numerous statistics confirming, for example, that after-tax disposable income has been stagnant for decades; that inflation-adjusted private sector incomes have remained stagnant or declined over the last forty years. Anecdotally, we can recall that the lifestyle previously achieved via the earnings of one bread-winner in a family now requires two.

At the same time, government employees now make twice the salary as that of private-sector employees in comparable positions. Bankers make seven and eight figure salaries for trading paper with each other- they need not interact with the real economy of people producing real goods to achieve this kind of wealth. Pensions in the government sector dwarf the retirement benefits to those outside of the system.

The significant productivity increases of the last forty years, instead of resulting in a generally decreasing price level (thus increasing the wealth of ALL productive members in the economy), has instead gone to feed the parasite class. The productive are held to break-even – as if to say “this far and no farther, you are as well-off as you will ever be allowed – for the benefit of those who are not willing or able to produce goods desired in the free market.

Grant goes on to describe the benefits of a do-nothing Fed and government, while wondering why Bernanke remains so focused on only one episode of economic history, the Great Depressions:

If Chairman Bernanke were in the room, I would respectfully ask him why this persistent harking back to the Great Depression? It is one cyclical episode, but there are many others. I myself draw more instruction from the depression of 1920-21, a slump as ugly and steep in its way as that of 1929-33, but with the simple and interesting difference that it ended. Top to bottom, spring 1920 to summer 1921, nominal GDP fell by 23.9%, wholesale prices by 40.8% and the CPI by 8.3%. Unemployment, as it was inexactly measured, topped out at about 14% from a pre-bust low of as little as 2%. And how did the administration of Warren G. Harding meet this macroeconomic calamity? Why, it balanced the budget, the president declaring in 1921, as the economy seemed to be falling apart, “There is not a menace in the world today like that of growing public indebtedness and mounting public expenditures.” And the fledgling Fed, face to face with its first big slump, what did it do? Why, it tightened, pushing up short rates in mid-depression to as high as 8.13% from a business cycle peak of 6%. It was the one and only time in the history of this institution that money rates at the trough of a cycle were higher than rates at the peak, according to Allan Meltzer.

But then something wonderful happened: Markets cleared, and a vibrant recovery began. There were plenty of bankruptcies and no few brickbats launched in the direction of the governor of the New York Fed, Benjamin Strong, for the deflation that cut an especially wide and devastating swath through the American farm economy. But in 1922, the first full year of recovery, the Fed’s index of industrial production leapt by 27.3%. By 1923, the unemployment rate was back to 3.2%. The 1920s began to roar.

And do you know that the biggest nationally chartered bank to fail during this deflationary collapse was the First National Bank of Cleburne, Texas, with not quite $2.8 million of deposits? Even the forerunner to today’s Citigroup remained solvent (though for Citi, even then it was a close-run thing, on account of an oversize exposure to deflating Cuban sugar values). No TARP, no starving the savers with zero-percent interest rates, no QE, no jimmying up the stock market, no federal “stimulus” of any kind. Yet—I repeat—the depression ended. To those today who demand ever more intervention to cure what ails us, I ask: Why did the depression of 1920-21 ever end? Given the policies with which the authorities treated it, why are we still not ensnared?

If there was an ounce of honesty in the economics profession and the business media, these observations and facts would be known far and wide given today’s market turmoil. Let me know when you find that ounce.

Instead of trying to cure the problems caused by too much debt and too much intervention with yet more debt and intervention, an alternative was tried in 1920-1921, and this alternative was successful.

If you object to using the template of 1920-21 as a guide to 21st-century policy because, well, 1920 was a long time ago, I reply that 1929 was a long time ago, too. And if you persist in objecting because the lessons to be derived from the Harding depression are unthinkably at odds with the lessons so familiarly mined from the Hoover and Roosevelt depression, I reply that Harding’s approach worked. The price mechanism is truer and enterprise hardier than the promoters of radical 21st-century intervention seem prepared to acknowledge.

There is no greater communication mechanism devised by man than the pricing mechanism (and no better tool to conserve scarce resources than the profit-and-loss system). This language cuts across all borders and all industries. The more freedom it is allowed, the wealthier the society.

Today, there is no market mechanism for pricing. The prices for all assets and goods are directly or indirectly affected by actions of central bankers and other state actors. Profit and loss is not allowed to play its role in conserving resources. Man is destroying wealth, because man has circumvented two of the best tools ever devised to increased wealth and prosperity (the other being contract).

Grant goes on to state that the best course would be a return to a gold-standard:

There isn’t time, in these brief remarks, to persuade you of the necessity of a return to the classical gold standard. I would need another 10 minutes, at least. But I anticipate some skepticism. Very well then, consider this fact: On March 27, 1973, not quite 39 years ago, the forerunner to today’s G-20 solemnly agreed that the special drawing right, a.k.a. SDR, “will become the principal reserve asset and the role of gold and reserve currencies will be reduced.” That was the establishment— i.e., you—talking. If a worldwide accord on the efficacy of the SDR is possible, all things are possible, including a return to the least imperfect international monetary standard that has ever worked.

Notice, I do not say the perfect monetary system or best monetary system ever dreamt up by a theoretical economist. The classical gold standard, 1879-1914, “with all its anomalies and exceptions . . . ‘worked.’” The quoted words I draw from a book entitled, “The Rules of the Game: Reform and Evolution in the International Monetary System,” by Kenneth W. Dam, a law professor and former provost of the University of Chicago. Dam’s was a grudging admiration, a little like that of the New York Fed’s own Arthur Bloomfield, whose 1959 monograph, “Monetary Policy under the International Gold Standard,” was published by yourselves.

Of course, the best system for money a credit would be one derived and maintained solely in the free market. The idea of a government managed gold standard would return us to a state of the fox guarding the hen house. Free markets have delivered the best things that we enjoy in life (yes, even so-called non-economic goods – fortunately we do not have the state choosing marriage partners for us. That market is still relatively free). This will be true also in the realm of money, credit and banking.

Grant concludes his remarks referencing Ron Paul’s recent statement that he would, if elected President, appoint Jim Grant as Chairman of the Federal Reserve. Finally, a little humor:

Let me thank you once more for the honor that your invitation does me. Concerning little Grant’s and the big Fed, I will quote in parting the opening sentences of an editorial that appeared in a provincial Irish newspaper in the fateful year 1914. It read: “We give this solemn warning to Kaiser Wilhelm: The Skibbereen Eagle has its eye on you.”

I will add, the primary reason "The Skibbereen Eagle" has decided the story is newsworthy is due to Ron Paul.

1 comment:

  1. Elasticity was not meat to become a 4.5 trillion balance sheet It as become a transfer mechanism. Middle class ends up losing a larger part of the benefit of their production in order to compensate the constant devaluation of their manipulated medium of exchange. If not for the transfer of trillions into the non producing sectors we would actually not even have to produce that much more on a non aggregate basis. Technological progress would positively take prices even lower and give us more time to live better life instead of compensating for parasites. Unfortunately the fact that the benefactors of this system for the most part not coming from real production (In fact in precedes production) continues to give them tremendous political power and it's likely not going to change anytime soon.