August 26, 2011

 

In last week’s article I concluded: “It is time to debate and resolve whether we as a nation want a bank of last resort or not. Our decision will determine the future of the Federal Reserve and perhaps the future of the financial system and economy we live in.” The following is a continuation of that discussion.

 

The idea of a central bank has been around longer than this country. Our first bank, The Bank of North America, was chartered for five years. Sponsored by Alexander Hamilton despite Thomas Jefferson’s objections, it was in operation from 1781-1785. The Second Bank of North America (1816-1836) had no less than James Madison’s signature on its charter. Both banks eventually closed.

 

The country saw hyper-inflation as the Treasury issued fiat notes to finance the war of 1812. During this period we had bank runs, and specie payments were suspended by all banks. So this argument we are having now about the validity of our central bank is not a new one, it is an argument which has re-occurred many times throughout our history.

 

The question of whether we should have a central bank and what form it should take is as old as the Bank of England, established in 1694. Banks in general have had a spotty record of performance throughout most of history. During the gold standard there were periods where 50% of banks, which were privately owned, failed. But then so did state chartered banks, and even nationally chartered banks. Banks in general have always been a source of concern and debate.

 

In my book, The New Gold Standard, there is a chapter titled, "Are the Fiat and Gold Standards Converging?" In it I suggest we may be moving toward a hybrid system utilizing parts of both standards. If in the next few years the Fed pulls off a non-inflationary return to stability, we will be looking at a stronger Fed, not a weaker one. But what kind of Fed should that be?

 

I am for a return to the gold standard. But I am also keenly aware that a gold standard will not prevent panics, recessions, or monetary crises. The Fed has an important role as lender of last resort. It has the ability to prevent a systemic breakdown.  It can work in conjunction with the Treasury to take extraordinary action if necessary, to preserve and protect the financial system. TARP, a program initiated by the US Treasury, actually worked to save the financial system in the recent financial crisis. Most of the loans lent have been paid back by banks. Since then, banks have raised capital and cut leverage; and now their reserve ratios are among the highest in a hundred years. This is but another example of how a Federal Bank can be constructive instead of destructive.

 

The way back to limited government and a sound monetary system is by eliminating the Board of Governors of the Fed. Instead of the Fed setting interest rates and increasing or decreasing the money supply, let the market perform that function. However, until we return to a much smaller government, and eliminate much of its spending and intervention into the economy, the central bank should preserve its power as a lender of last resort.

 

Think of this last resort as the net under a tight rope walker. You don't need a safety net if you are only ten feet in the air, but you better have one if you are balancing on a thin rope 100 feet above the hard ground. Under a fiat standard, you are a hundred feet in the air. In today’s world of high leverage it is only prudent to have a safety net. But because reserve requirements are much higher under a gold standard, leverage is much less than the permissive leverage of a fiat standard. With decreased leverage comes decreased danger. With increased leverage comes increased danger.

 

It is also important to realize that some things just go together—such as fixed exchange rates under a gold standard and floating exchange rates under a fiat standard. You cannot mix and match these things. The two systems have different natures and require different institutions. The same is true of the need for a central bank. Having one, is necessary in today’s world of high leverage to protect against a fatal fall, but not needed under the low leverage typical of a gold standard. This is something Europe is beginning to rethink, as they are now considering what amounts to a European Union style Treasury and Fed.

 

 

The key to any successful Fed intervention taken to prevent systemic damage is to neither create victims nor protect victims. Any intervention should isolate the problem, neutralize it, and leave everything as it was before the operation. A bank of last resort's attempt to save the system should never amount to a bail out. The options should either be loans with collateral (with reasonable expectations they will be paid back), or an organized liquidation with all the top officers of the corporation removed whenever this kind of action is necessary. The liquidation of hundreds of banks during the eighties should be enough of a template to see how this should be done. The FDIC is an excellent example of forced liquidations where heads of banks lost their jobs, yet no taxpayer or customer monies were ever lost. FDIC is paid for by the member banks. No taxpayer money has ever been needed. Hundreds of banks have failed over the last few years, yet none have resulted in the ruin of innocent victims, nor came at the expense of citizens.

 

We need to redefine the duties of the Fed and move toward a Fed that increases reserve requirements, and limits the increase in money supply, permanently. Only then will we see stability in the value of the dollar, and market originated interest rates. This would provide a neutral monetary environment for the economy to operate within. Then the Fed’s job would be monitoring the economy for distortions or anomalies that may arise.

 

I can live with a central bank that has defined, limited, powers. Or I can live without one in a much freer society where government doesn’t intervene into the economy. But, it would be a mistake simply to outlaw the Fed while we are still on this ultra-leveraged tight rope. It makes more sense to cut back its power as we strive to cut back economic government intervention in general.

 

A lot of people out there right now believe the best way to rectify our past mistakes is for the economy to collapse.

They argue for the elimination of the Fed to “hasten the inevitable”. This is totally unnecessary, and I would argue immoral. I have never accepted the proposition that allowing a total breakdown of the monetary system is a moral obligation. On the contrary, if you can save innocent victims of government intervention, I believe you should.

 

I am all for market forces resolving problems. But government does have a role: it is to get out of the way gracefully. Gracefully means having and following a plan. The plan should be to back out of the economy the same way they moved in to it. Year by year, we must reduce the intrusive intervention of government. Only then will we return to a free society where the responsibility of living is on the shoulders of individuals, rather than the mandate of governments. The de-evolution of the Fed’s powers to a more limited and defined bank of last resort is one way to achieve this.

 

Market Update:

 

As expected there was no indication from the Fed of further easing. Market pundits have missed the point: the Fed has already made its move by fixing the fed funds rate for two years. Pundits have also taken their eye off the ball and are missing the sharp move in M2 money supply occurring as we speak. No one in the press, including CNBC, has caught this.


In the last couple of months, M2 has almost increased as much as it did during all of last year. Low interest rates and high monetary growth are on a collision course. Interest rates will have to move up eventually or the money supply will need to be drained and leveled off at a more sustainable increase. The latter is the more obvious move. Now, it is possible that the Fed could raise interest rates on reserves to banks. This would entice banks to hold more in reserves and lend less, which would retard money growth. Or, the Fed could sell paper to banks, thereby draining reserves. Either way they have to move soon.

But even more important going forward than monetary policy is fiscal policy and what Europe does. By not making a move, the Fed has put the ball squarely in Washington DC. The Fed supplied the game field by fixing interest rates, but the President and Congress will have to finish the game. How that game is played out will define the future.
 

Meanwhile, the Euro Zone is in disintegration. The European monetary authorities also need to move convincingly in order to address their problems. So far they are failing to do so and this is the main worry of markets everywhere right now. While monetary and fiscal policy are within America's control, the Euro crisis is not, and what happens there will also define the future here.


Gold corrected this week. I shorted gold via DZZ and took some profits on selected gold stocks. Gold bounced back nicely on Friday, but I did not cover my short position. I would rather sell DZZ where I bought it and keep the protection in place. Besides, I shorted gold as a hedge more than to make money. My mental stop is 4.30, which would yield a slight profit if touched.


The market is where it was last week at 11,250. The dollar is stable to lower, and so are commodities with the CRB at 335. Interest rates are stable and inflation is trending down. Aside from extreme volatility, there is no trend to invest in; except gold. I would like to see the price of gold stabilize and the market trend up. This scenario would provide the best profits possible. There is a good chance I will get my wish, since I think most people were too optimistic at the first of the year, and overly pessimistic today. A market rally and stable gold, I think would lead to a run on resource stocks, the likes of which we have not seen in some time.


Holding the same portfolio, as is, and will issue alerts to subscribers on any and all future trades as warranted.