By John Mauldin
Outside the Box
Forbes Editor-in-Chief and longtime friend Steve Forbes leads off this week’s Outside the Box with a sweeping historical summary — and damning indictment — of the “cheap money” policies of the US executive branch and Federal Reserve. Four decades of fiat money (since Richard Nixon and his Treasury Secretary, John Connally, axed the gold standard in 1971) and six years of Fed funny business have led us, in Steve’s words, to an era of “declining mobility, great inequality, and the destruction of personal wealth.”
And of course the damage has not been limited to the US; it is global. Steve reminds us that “The bursting of the subprime bubble put in motion a collapse of dominoes that started with the U.S. financial sector and European banks and led to the sovereign debt crisis in Europe, the Greek bankruptcy crisis, and the banking disasters in Iceland and Cyprus.” To make matters worse, the fundamentally weak dollar (and fiat currencies worldwide) have contributed a great deal to record-high food and energy prices that are spurring serious social instability.
As I showed in Code Red and as Steve notes here, we now face the looming specter of a global currency war. Steve reminds us that the real bottom line is that
Money is simply a tool that measures value, like a ruler measures length and a clock measures time. Just as changing the number of inches in a foot will not increase the building of houses or anything else, lowering the value of money will not create more wealth. The only way we will ever get a real recovery is through a return to trustworthy, sound money. And the best way to achieve that is with a gold standard: a dollar linked to gold.
Today’s Outside the Box is from Steve’s latest book, which is simply called Money.
I think it’s Steve’s best book in years. Get it for your summer reading. While there is more than one solution to reining in the current abuses by the major global central banks, Steve highlights the problems as well as anyone. This situation really has the potential to end badly. Just this morning the Wall Street Journal noted that “Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.” Rajan is one of the more highly respected economists in the world.
I am back in Dallas for an extended period of time (at least extended by my standards), where my new apartment is paying off in a less hectic lifestyle – people seem to be coming to me for the next few weeks. Tomorrow my good friend Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business, will drop by for a day. We’re going to talk about the future of work, what kind of jobs will be there for our kids (and increasingly our fellow Boomers), what policies should be developed to encourage more jobs, and a host of other issues.
I’m still trying to absorb what I learned in Maine. We enjoyed the most beautiful weather we’ve had in the last eight years, and the conversations seemed to take it up a notch. I fished more than usual, too, which gave me more time to think. On Sunday, however, my thought process was not disturbed by so much as a nibble on my hook. That was after the previous two days, when the fish were practically jumping into the boat.
We had a discussion on complexity theory and why complexity actually had a hand in bringing down more than 20 civilizations. I understand the argument but think there is more to it than that. Something can be complex but continue to work smoothly if information is allowed to run “noise-free.” I began to ponder whether our government has become so complex that it has begun to stifle the flow of information. Dodd–Frank. The Affordable Care Act. Energy policy. The list goes on and on and on. Are we taking all of the profit out of the system in order to comply with complex rules and regulations? Not for large companies, necessarily, but for small ones? When we are losing companies faster than new ones are being created, that should be a huge warning flag that something is wrong in the system. The data in this chart ends in 2011, but the pictures is not getting better.
It will be good to see my old friend Dunk, and perhaps he can shed some light on my continually confused state. Enjoy your August.
John Mauldin, Editor
Outside the Box firstname.lastname@example.org
The following book excerpt is adapted from Chapter One of Money: How The Destruction of the Dollar Threatens The Global Economy – and What We Can Do About It, by Steve Forbes and Elizabeth Ames
The failure to understand money is shared by all nations and transcends politics and parties. The destructive monetary expansion undertaken during the Democratic administration of Barack Obama by then Federal Reserve chairman Ben Bernanke began in a Republican administration under Bernanke’s predecessor, Alan Greenspan. Republican Richard Nixon’s historic ending of the gold standard was a response to forces set in motion by the weak dollar policy of Democrat Lyndon Johnson.
For more than 40 years, one policy mistake has followed the next. Each one has made things worse. The most glaring recent example is the early 2000s, when the Fed’s loose money policies led to the momentous worldwide panic and global recession that began in 2008. The remedy for that disaster? Quantitative easing — the large monetary expansion in history.
One of the reasons that QE has been such a failure was a distortionary bond-buying strategy that was part of QE known as “Operation Twist.” The Fed traditionally expands the monetary base by buying short-term Treasuries from financial institutions. Banks then turn around and make short-term loans to those businesses that are the economy’s main job creators. But QE’s Operation Twist focused on buying long-term Treasuries and mortgage-backed securities. This meant that instead of going to the entrepreneurial job creators, loans went primarily to large corporations and to the government itself.
Supporters insisted that Operation Twist’s lowering of long-term rates would stimulate the economy by encouraging people to buy homes and make business investments. In reality this credit allocating is cronyism, an all-too-frequent consequence of fiat money. Fed-created inflation results in underserved windfalls to some while others struggle.
Unstable Money: Odorless and Colorless
Unstable money is a little bit like carbon monoxide: it’s odorless and colorless. Most people don’t realize the damage it’s doing until it’s very nearly too late. A fundamental principle is that when money is weakened, people seek to preserve their wealth by investing in commodities and hard assets. Prices of things like housing, food, and fuel start to rise, and we are often slow to realize what’s happening. For example, few connected the housing bubble of the mid-2000s with the Fed’s weak dollar. All they knew was that loans were cheap. Many rushed to buy homes in a housing market in which it seemed prices could only go up. When the Fed finally raised rates, the market collapsed.
The weak dollar was not the only factor, but there would have been no bubble without the Fed’s flooding of the subprime mortgage market with cheap dollars. Yet to this day the housing meltdown and the events that followed are misconstrued as the products of regulatory failure and of greed. Or they are blamed on affordable housing laws and the role of government-created mortgage enterprises Fannie Mae and Freddie Mac. The latter two factors definitely played a role. Yet the push for affordable housing existed in the 1990s, and we didn’t get such a housing mania. Why did it happen in the 2000s and not in the previous decade?
The answer is that the 1990s was not a period of loose money. The housing bubble inflated after Alan Greenspan lowered interest rates to stimulate the economy after the 2001 – 2002 recession. Greenspan kept rates too low for too long. The bursting of the subprime bubble put in motion a collapse of dominoes that started with the U.S. financial sector and European banks and led to the sovereign debt crisis in Europe, the Greek bankruptcy crisis, and the banking disasters in Iceland and Cyprus.
Other Problems Caused by the Weak Dollar
Many may not realize it, but the weakening of the dollar is at the heart of many other problems today:
High Food and Fuel Prices
As with the subprime bubble, the oil price rises of the mid-2000s (as well as the 1970s) were widely blamed on greed. Yet here, too, no one bothers to ask why oil companies suddenly became greedier starting in the 2000s. Oil prices averaged a little over $21 a barrel from the mid-1980s until the early part of the last decade when there was a stronger dollar, compared with around $95 a barrel these days. Rising commodity prices spurred by the declining dollar have also driven up the cost of food. Many shoppers have noticed that the prices of beef and chicken have reached record highs. This is especially devastating to developing countries where food takes up a greater portion of people’s incomes. Since the Fed and other central banks began their monetary expansion in the mid-2000s, high food prices wrongly blamed on climate shocks and rising demand have caused riots in countries from Haiti to Bangladesh to Egypt.
Declining Mobility, Great Inequality, and the Destruction of Personal Wealth
The destruction of the dollar is a key reason that two incomes are now necessary for a middle-class family that lived on one income in the 1950s and 1960s. To see why, one need only look at the numbers from the U.S. Bureau of Labor Statistics. What a dollar could buy in 1971 costs $5.78 in 2014. In other words, you need almost six times more money today than you did 40 years ago to buy the equivalent goods and services. Say you had a 2014 dollar and traveled back in time to 1971. That dollar would be worth, according to the CPI calculator, a mere 17 cents. What has this meant for salaries? According to statistics from the U.S. Census Bureau, a man in his thirties or forties who earned $54,163 in 1972 today earns around $45,224 in inflation adjusted dollars –a 17% cut in pay. Women have entered the workforce in much larger numbers since then, and women’s incomes have made up the difference for families. As Mark Gimein of Bloomberg.com points out, “The bottom line is that as two-income families have replaced single-earner ones, the median family has barely moved forward. And the single-earner family has fallen behind.”
Increased Volatility and Currency Crises
The 2014 currency turmoil in emerging countries is just the latest in a succession of needless crises that have occurred over the past several decades as a consequence of unstable money. Today’s huge and often-violent global markets, in which a nation’s currency can come under attack, did not exist before the dollar was taken off the gold standard. They are a direct response to the risks created by floating exchange rates. The crises for most of the Bretton Woods era were mild and infrequent. It was the refusal of the United States to abide by the restrictions of the system that brought it down.
The weak dollar has also been the cause of banking crises that have been blamed on the U.S. system of fractional reserve banking. Traditionally, banks have made their money by lending out deposits while keeping reserves to cover normal withdrawals and loan losses. The rule of thumb is that banks have $1 of reserves for every $10 of deposits. In the past, fractional reserve banking has been criticized for making these institutions unnecessarily fragile and jeopardizing the entire economy. Indeed, history is replete with examples of banks that made bad loans and went bust. Historically, the real problems have been bad banking regulations. In the post-Bretton Woods era, however, the cause has most often been unstable money. Misdirected lending is characteristic of the asset bubbles that result when prices are distorted by inflation. This has been true of past booms in oil, housing, agriculture, and other traditional havens for weak money.
The Weak Recovery
This bears repeating: the Federal Reserve’s quantitative easing, the biggest monetary stimulus ever, has produced the weakest recovery from a major downturn in American history. QE’s Operation Twist has not been the only constraint on loans to small and new businesses. Regulators have also compounded the problem by pressuring banks to reduce lending to riskier customers, which by definition are smaller enterprises.
In 2014 the Wall Street Journal reported that this credit drought had caused many small businesses, from restaurants to nail salons, to turn in desperation to nonbank lenders — from short-term capital firms to hedge funds — that provide loans at breathtakingly high rates of interest. Interest rates for short-term loans can exceed 50%. Little wonder there are still so many empty storefronts during this period of supposed recovery. Monetary instability encourages a vicious cycle of stagnation: the damage it causes is usually blamed on financial sector greed. The scapegoating and finger-pointing bring regulatory constraints that strangle growth and capital creation. That has long been the case in countries with chronic monetary instability, such as Argentina. Increased regulation is now hobbling capital creation in the United States as well as in Europe, where there is growing regulatory emphasis on preventing “systemic risk.” Regulators, the Wall Street Journal noted, “are increasingly telling banks which lines of business they can operate in and cautioning them to steer clear of certain areas or face potential supervisory or enforcement action.”
In Europe, this disturbing trend toward “macroprudential regulation” is turning central banks into financial regulators with sweeping arbitrary powers. The problem is that entrepreneurial success stories like Apple, Google, and Home Depot — fast-growing companies that provide the lion’s share of growth and job creation — all began as “risky” investments. Not surprisingly, we’re now seeing growing public discomfort with this increasing control by central banks. A 2013 Rasmussen poll found that an astounding 74% of American adults are in favor of auditing the Federal Reserve, and a substantial number think the chairman of the Fed has too much power.
Slower Long-Term Growth and Higher Unemployment
Even taking into account the economic boom during the relatively stable money years of the mid-1980s to late 1990s, overall the U.S. economy has grown more slowly during the last 40 years than in previous decades. From the end of World War II to the late 1960s, when the U.S. dollar had a fixed standard of value, the economy grew at an average annual rate of nearly 4%. Since that time it has grown at an average rate of around 3%. Forbes.com contributor Louis Woodhill explains that this 1% drop means a lot. Had the economy continued to grow at pre-1971 levels, gross domestic product (GDP) in the late 2000s would have been 56% higher than it actually was. What does that mean? Woodhill writes: “Our economy would have been more than three times as big as China’s, rather than just over twice as large. And, at the same level of spending, the federal government would have run a $0.5 trillion budget surplus, instead of a $1.3 trillion deficit.” And what if the United States had never had a stable dollar? If America had grown for all of its history at the lowest post-Bretton Woods rate, its economy would be about one-quarter of the size of China’s. The United States would have ended up much smaller, less affluent, and less powerful.
Unemployment has also been higher as a consequence of the declining dollar. During the World War II gold standard era, from 1947 to 1970, unemployment averaged less than 5%. Even with the economy’s ups and downs, it never rose above 7%. Since Nixon gave us the fiat dollar it has averaged over 6%: it averaged 8.5% in 1975, almost 10% in 1982, and around 8% since 2008. The rate would have been higher had millions not left the workforce. The rest of the world has also suffered from slower growth, in addition to higher inflation, since the end of the Bretton Woods system. After the 1970s, world economic growth has been a full percentage point lower; inflation, 1.5% higher.
Larger Government with Higher Debt
By enabling endless monetary expansion, the post-Bretton Woods system of fiat money has helped propel the unchecked growth of government. In 1971 the total U.S. federal debt stood at $436 billion. Today it is more than $17 trillion. It’s no coincidence that the federal debt has doubled since 2008, the same year that the Fed started implementing QE.
The Keynesian and monetarist bureaucrats who today set the monetary policies of the Fed and other central banks are like pre-Copernican astronomers who subscribed to the notion that the sun revolved around the earth. They are convinced that government can successfully direct the economy by raising and lowering the value of money. Yet, over and over again, history, and recent events, has shown that they are wrong.
What they don’t understand is that money does not “create” economic activity. Money is simply a tool that measures value, like a ruler measures length and a clock measures time. Just as changing the number of inches in a foot will not increase the building of houses or anything else, lowering the value of money will not create more wealth. The only way we will ever get a real recovery is through a return to trustworthy, sound money. And the best way to achieve that is with a gold standard: a dollar linked to gold.
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