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     Jan 30, 2008
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A failure of central banking

By Henry C K Liu

(See also PART 1: Fed helpless in its own crisis)

It has been forgotten by many that before 1913, there was no central bank in the United States to bail out troubled commercial and associated financial institutions or to keep inflation in check by trading employment for price stability. Few want inflation but fewer still would trade their jobs for price stability.

For the first 137 years of its history, the US did not have a central bank. The nation then was plagued with recurring business cycles of boom and bust. For the past 94 years the Federal Reserve, the

US central bank, has assumed the role of monetary guardian for the nation, yet recurring business cycles of boom and bust have continued, often with the accommodating participation of the Fed. Central banking has failed in its fundamental functions of stabilizing financial markets with monetary policy, succeeding neither in preventing inflation nor sustaining growth nor achieving full employment.

Since the Fed was founded in 1913, US inflation has registered 1,923%, meaning prices have gone up 20 times on average despite a sharp rise in productivity.

For the 18 years (August 11, 1987 to January 31, 2006) of his tenure as chairman of the Fed, Alan Greenspan repeatedly bought off the collapse of one debt bubble with a bigger debt bubble. During that time, inflation was under 2% in only two years, 1998 and 2002, both times not caused by Fed policy. Paul Volcker, who served as Fed chairman from August 1979 to August 1987, had to raise both the fed funds rate and the discount to 20% to fight hyperinflation of 18% in 1980 back down to 3.66% in 1987, the year Greenspan took over the Fed just before the October 1987 crash, when inflation rose to 4.53%.

Under Greenspan's market accommodating monetary policy, US inflation reached 4.42% in 1988, 5.36% in 1989 and 6.29% in 1990. The inflation rate was moderated to 1.55% by the 1997 Asian financial crisis, when Asian exporting economies devalued their currencies to lower their export prices, but Greenspan allowed US inflation rate to rise back to 3.76% by 2000. The fed funds rate hit a low of 1.75% in 2001 when inflation hit 3.76%; it hit 1% when inflation was 3.52% in 2004; and it hit 2.5% when inflation rose to 4.69% in 2005.

For those years, US real interest rate was mostly negative after inflation. Factoring in the falling exchange value of the dollar, the Fed was in effect paying US transnational corporate borrowers to invest in non-dollar markets, and paying US financial institution to profit from dollar carry trade, ie borrowing dollars at negative rates to speculate in assets denominated in other currencies with high yields.

In recent years, the US has been allowing the dollar to fall in exchange value to moderate the adverse effect of high indebtedness and using depressed wages, both domestic and foreign, to moderate US inflationary pressure. This trend is not sustainable because other governments will intervene in the foreign exchange market to keep their own currencies from appreciating against the dollar to remain competitive in global trade. The net result will be a moderating of drastic changes in the exchange rate regime but not a halt of dollar depreciation.

What has happened is a global devaluation of all currencies with the dollar as the lead sinking anchor in terms of purchasing power. The sharp rise of prices for assets and commodities around the world has been caused by the sinking of the purchasing power of all currencies. This is a trend that will end in hyperinflation while the exchange rate regime remains operational, particularly if central banks continue to follow a coordinated policy of holding up inflated asset and commodities prices globally with loose monetary policies, ie releasing more liquidity every time markets face imminent corrections.

Politics of central banking
The circumstances that created the political climate in the United States for the adoption of a central bank came ironically from internecine war on Wall Street that spread economic devastation across the nation during the recession of 1907-08, the direct result of one dominant money trust trying to cannibalize its competition.

In 1906, the powerful Rockefeller interests in Amalgamated Copper executed a plan to destroy the Heinze combination, which owned Union Copper Co. By manipulating the stock market, the Rockefeller faction drove down Heinze stock in Union Copper from US$60 to $10. The rumor was then spread that not only Heinze Copper but also the Heinze banks were folding under Rockefeller pressure. J P Morgan joined the Rockefeller enclave to announce that he thought the Knickerbocker Trust Co would be the first Heinze bank to fail. Panicked depositors stormed the teller cages of Knickerbocker to withdraw their money. Within a few days the bank was forced to close its doors. Similar fear spread to other Heinze banks and then to the whole banking world. The crash of 1907 was on.

Millions of depositors were sold out penniless, their savings wiped out by bank failures and homeowners rendered homeless by bank foreclosure of their mortgages. The destitute, the hungry and the homeless were let to fend for themselves as best they could, which was not very well. Money still in circulation was hoarded by those who happened to still have some, so before long a viable medium of exchange became practically non-existent in a dire liquidity crisis. The 1907 depression was much more severe for the average family than the one in 1930.

Many otherwise healthy businesses began printing private IOUs and exchanging them for raw materials as well as giving them to their remaining workers for wages. These "tokens" were passed around as a temporary medium of exchange to keep the economy functioning minimally. At this critical juncture, J P Morgan offered to salvage the last operating Heinze bank (Trust Co of America) on condition of a fire sale of the valuable Tennessee Coal and Iron Co in Birmingham to add to the monopolistic US Steel Co, which he had earlier purchased from Andrew Carnegie.

This arrangement violated then existing anti-trust laws, but in the prevailing climate of depression crisis the proposed transaction was quickly approved by a thankful Washington. Morgan was also intrigued by the paper IOUs that various business houses were being allowed to circulate as temporary media of exchange. Using the argument of the need to create order out of monetary chaos, the same argument that Rockefeller used to build the Standard Oil Trust, Morgan persuaded Congress to let him put out $200 million in such "tokens" issued by one of the Morgan financial entities, claiming this flow of Morgan "certificates" would revive the stalled economy. The nominal GDP fell from $34 billion in 1907 to $30 billion in 1908 and did not recover to $34 billion until 1911, even with an average annual inflation rate of over 7%.

Getting rich from making money
As these new forms of Morgan "money" began circulating, the public regained its "confidence" and hoarded money began to circulate again as well in anticipation of inflation. Morgan circulated $200 million in "certificates" created out of nothing more than his "corporate credit" with formal government approval. This is the equivalent of $100 billion in today's money. It was a superb device to get fabulously rich by literally making money.

Eight decades later, GE Capital, the finance unit of the world’s largest conglomerate that incidentally also manufactures hard goods, did the same thing in the 1990s with commercial paper and derivatives to create hundreds of billions in profits. Soon, every corporation and financial entities followed suit and the commercial paper market became a critical component of the financial system. This was the market that seized in August 2007, starting the current credit crisis.

"The commercial paper market, in terms of the asset-backed commercial paper market, is basically history," said William H Gross, chief investment officer of the bond management firm Pacific Investment Management Company, known as Pimco.

The commercial paper market historically was best known as an alternative market funding source for non-financial corporations at times when bank loans were seen as too expensive or possibly not available due to tight monetary policy. Finance companies, especially those affiliated with major auto companies and well-known consumer-credit lenders, have also issued paper tied to non-financial industrial entities. In the mid-1990s, non-financial corporate issues were still nearly 30% of total paper outstanding. This share began to drop precipitously just before the recession of 2001 and has stabilized but not recovered. By March 2006, the non-financial segment constituted a mere 7.8% of the total, the lowest in the 37-year history of the data.

Financial companies have also altered their approach to the market. Some paper is still backed by companies' general financial resources, but other commercial paper is backed by specific loans, including automobile and credit card debt and home mortgages. Most ominously, commercial paper is used to finance securitized credit instruments that move debt liabilities off the balance sheets of the borrowers.

Some conspiracy theorists assert that the seeds for the Federal Reserve system had been sown with the Morgan certificates. On the surface, J P Morgan seemed to have saved the economy - like first throwing a child into the river and then being lionized for saving him with a rope that only he was allowed to own, as some of his critics said. On the other hand, Woodrow Wilson wrote: "All this trouble [the 1907 depression] could be averted if we appointed a committee of six or seven public-spirited men like J P Morgan to handle the affairs of our country." Both Morgan and Wilson were elite internationalists.

The House of Morgan then held the power of deciding which banks should survive and which ones should fail and, by extension, deciding which sector of the economy should prosper and which should shrink. The same power today belongs to the Fed, whose policies have favored the financial sector at the expense of the industrial sector. At least the House of Morgan then used private money for its predatory schemes of controlling the money supply for its own narrow benefit. The Fed now uses public money to bail out the private banks that own the central bank in the name of preventing market failure.

Continued 1 2 3 4 5 

The Complete Henry C K Liu 

1. A China base in Iran?

2. US, Britain stung by an
Afghan temper

3. Obama bin lottery

4. Going bankrupt: The US's greatest threat

5. Fed helpless in its own crisis

6. India's vision blurs over China

7. Neo-cons shaken, but not deterred

8. More than 20 years in
the making

9. If it's broke, fix it - with stock tips

10. A bitter taste to Iraqi reality

(24 hours to 11:59 pm ET, Jan 28, 2008)



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