November 22, 2011

Philosophy moves the world. We sometimes forget that it is people’s ideas that give form to public policy and policy in turn shapes the very society we live in. The ideas rattling around the Euro-Zone right now are all about austerity and recapitalizing banks. People are looking to austerity as a way to reign in all the overspending these countries have done and to mitigate the promises their governments have made but can’t keep. Recapitalization is required for the banks that hold bonds on their books of questionable value. For these banks to be seen as solvent they need to either write down or sell assets, such as their suspect bonds at a loss, or raise additional capital through stock offerings or borrowed money. Each course poses problems and this deleveraging coupled with austerity measures is introducing a deflationary/recessionary bias into Europe’s economies.

The United States decided to deal with this problem by injecting capital directly into the banking system through both the Treasury and the Federal Reserve. During the crisis here, the investment banks which were outside of the Federal Reserve System were brought back into the system for protection. The US government is now trying to persuade the Europeans to follow the same model, which for us worked quickly to stop a fast and growing contagion threat to our entire banking system.

When Europe constructed the Euro-Zone and went to a single unified currency they opted not to give the European Central Bank the power to create money. The idea was that any money coming from governments had to either be borrowed or come from taxes. This might work fine if governments fiscally behaved. But in a world filled with fraud, too many promises, and overleveraging, the actual result has been bond interest rates rising as fast as Euro-Zone growth is falling. Not to mention the unrelenting threat of financial contagion and the possible complete failure of their financial system. By not allowing the ECB to create money they’ve handcuffed themselves. They have no way to prevent deflation.

Lacking a method or channel for creating an anti-deflationary monetary policy, Europe is facing a deflationary recession similar to Japans. The Fed staved off deflation here, and despite all of the inflationary fears, so far the most obvious result of the Fed’s actions has been the absence of deflation.  Quantitative easing was not inflationary but anti-deflationary. This is something most conservative economists around the world have yet to understand.

I favored the TARP plan and I think a similar plan would stop the contagion in Europe. But Europe, especially Germany, is so deathly afraid of inflation that they’ve refused to create money in order to recapitalize their banks as a solution to their problem. Many conservatives here agree with that decision. But the massive inflation so many feared would result from TARP never happened. And the loans to the banks made by the Treasury were all but paid back in full. Our banking system now holds more capital than at any time since its inception. TARP worked.

And whatever you may argue the price was for the Fed’s intervention, at least it wasn’t a Japanese style deflationary depression like the one threatening to break apart the Euro-Zone. A breakdown of that kind would lead to great and unnecessary pain being inflicted on millions of innocent victims. The refusal of conservatives in Europe to yield because of "principle" is just another example of sticking to what is “right” while refusing to look at reality in full context.

How can it be “right” if it comes at everyone else’s expense? As a hard money guy I completely understand their dilemma. But the choice they are faced with isn’t hard money versus inflation—they are choosing between the economic destruction of the Euro Zone versus the equivalent of a bridge loan from the government to save it. These monumental decisions must be made taking context into account. Collapsing Europe’s and perhaps the world’s economy because leaders insist they must “do the right thing” is an ironic contradiction no one can afford.

For example, I am philosophically for a gold standard, but the institution of a gold standard in today's economic reality would lead to disaster. A standard of discipline won’t work in an undisciplined society. I’m also against government having the power to raise taxes or print money arbitrarily, but sometimes the price of their not doing so, at least temporarily, is too high. Difficult choices have to be made and I think America made the right calls during the 2008 credit crisis.

To date America is one of the only developed countries during this worldwide crisis whose growth has progressively increased and whose inflation rates have stayed low. All other countries including China, have decelerating growth rates and accelerating inflation. It needs to be acknowledged that the Fed has not allowed the kind of injury afflicting other nations to happen here.

Still, there is a third alternative available to Europe that no one has mentioned and that needs to be explored. I think we may be confronted with the possible move toward the nationalization of the banking system there. And it wouldn’t surprise me to see that possibility being discussed for the US as well. A case can be made that the banks should have their leverage reduced, and like utilities, be strictly regulated under a government system such as the Federal Reserve System. I am not advocating this, but let’s consider the argument and its appeal given today’s crisis mentality.

Under such a system there could be no run on banks and money would always be available to depositors, no questions asked. If the government guaranteed and backed all bank deposits and had the power to either tax or print the money at any time, no shortage of money, therefore no liquidity crisis could ever exist. Risk taking and speculation would be curtailed together with huge financial profits, and many of the markets, products, and services that now exist would be diminished. Derivatives would dwindle and many hedge instruments and investment vehicles would disappear entirely. Venture capital would also be reduced as speculation lessened considerably.

But guaranteeing deposits wouldn’t cause inflation as long as the money supply was held fairly constant. Remember the money supplied by government would simply be money already created and listed on the books. It would be money made tangible and supplied to depositors on demand. The total amount of money in the banking system would stay the same as long as the government followed a consistent policy of increasing the money supply at a fixed rate. But that’s a separate discussion.

The main reason people will start throwing around the idea of nationalizing banks is because doing so would eliminate the possibility of bank runs and liquidity crises. This is the main perceived threat today. The few banks that have been “run” and that failed under our Federal Reserve System have done so orderly with no depositor having ever lost a cent. And it was all financed not by the taxpayer, but with bank dues.

Nationalized banks can fail just like private ones. Poorly run banks would be liquidated and absorbed by the strong banks at a discount. Managers would lose their jobs and reputations. Stock in individual banks and loans by banks would lose value, but only at the investor’s expense. However, there would be no contagion threat to the world economy. The FDIC is a perfect example of this. Every week banks fail in this country and they are absorbed into the system without inconvenience to anyone except the shareholders and management.

That’s how utilities work too and that is why these giant companies have never suffered a financial crisis in their entire history. They are regulated, boring companies, whose stocks pay a consistent dividend—and that’s about it. A nationalized banking system wouldn’t mean the end of inflation or recessions or trouble from our fiscal follies, but again, that’s not the crux of this. The question is will the world turn to the safety of nationalization? Will we trade the economic booms which can only result from greater risk taking for the elimination of banking crises and resulting systemic damage? Will we trade profit for decreased risk and speculation for lower but predictable growth?

Expect this subject to be broached in the near future. Our founding fathers debated and decided against it, but there may not be as much resistance this time. This is not about gold versus fiat money nor is it a money supply debate. It’s about how banks should operate in our society and what government’s role is in banking.

There is a growing school of thought that the financial system is an unfair system and that the big banks benefit unfairly from their privileged status. The income gap has also become an issue many are angrily talking about. Huge profits were made on Wall Street and by the financial industry in spite of the financial crisis, and some believe because of it. During the same period innocent victims suffered collateral damage that changed their lives.

Financial experts and politicians are taking notice of the “inequality issue” and it isn’t a large leap to envision support for the nationalization of banks worldwide. If no broad agreement can be reached in Europe, and austerity’s bite is too hard, and interest rates move higher while there is less and less growth—don’t be surprised if you wake up one morning and troubled banks are now in the hands of government. The governments have the power to take over banks if they choose to.

Again, I bring up the subject of nationalized banks not as an advocate, but as an observer. While I understand the case for nationalization, I personally reject it in my book The New Gold Standard (See the chapter titled The Banking System of a Free Society). But as an investor I acknowledge current reality and am always on the lookout for any major turn of events. I believe this is one in the making.

How would this affect stock and gold prices? I look forward to covering that in detail for my subscribers as warranted in my Market Updates.


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