A Run on Central Banks?

When I see what commodity prices are doing, I don't think "low interest rates" or "skyrocketing demand." I think about a loss of confidence.

There is that old saw about gold, that it is the only money that is no one's liability. Wheat is no one's liability, and neither is corn. Oil is no one's liability.

It is common to invest in commodities as an "inflation hedge." If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much as I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-McGyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be all right, when you've got some Spanish mortgages to pawn.

Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns (BS), Citigroup (C), or Lehman (LEH), the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates.

I can't tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra's suggestion that they step up their margin requirements, ASAP.

None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging".

People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.

Comments

[Robespierre:]

For some reason Americans have convinced themselves that there is a way to create real wealth by financial wizardry and not by producing and saving etc. It seems that the time to pay is here and we will pay either via taxes, high prices, unemployment or all of the above

2008 May 22 09:19 AM

[Jason Rines...:]

This article is dead on. I wrote exactly this theme in part of a total economic solution to the Administration back in March. When guys like me seeing proposed $300 B mortgage bailout for the irresponsible, house flippers and gamblers I get more then nervous!

Institutional Investors flocked to commodities simply because of the loss of confidence in our entire U.S. financial system. Higher margin calls and eliminating loopholes, leverage etc certainly need to be considered as part of the fix in commodities and easing inflation, but this is only part of the over-all economic solution back to American prosperity and economic might.

A big part of my plan was a $200 B Treasury backed subsidize into energy independence backed by Treasury. This would move money back into America instead of offshoring it, or hoarding through commodities. My philosophy is give the global consumer what it wants, more affordable energy, agriculture and metals. Energy is the key driver to becoming a massive exporter again of the other two. It would fix the investment bank balance sheets but more importantly create millions of sustainable jobs and long-term wealth.

2008 May 22 11:19 AM

[icandoitdon:]

to quote from the article:

"People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen."

this lies directly at the doorstep of the federal reserve. it is their job...first and foremost...to provide stability in pricing. it is not to provide cheap and easy credit.

people complain about congress "doing nothing." at least they do nothing. the federal reserve does real harm.

2008 May 22 01:42 PM

[Daniel K:]

Powerful article, cleverly written.

2008 May 22 01:49 PM

[Gold Standard:]

The financial crisis is only a symptom of a larger disease, that disease being the central bank. The Marxist idea of central planning has utterly failed everywhere that it has been tried, and yet the Federal Reserve stands as just another icon to that grand failure.

If you want to cure a disease you have to kill it at the source, and not put a bandaid on a symptom.

2008 May 22 03:41 PM

[johngonole:]

I agree with all the commentors here. And while I agree with I think most of the points in the article the combination of all the points presents quite a catch 22. On one hand Steve Waldman says the Federal Reserve is the cause of the crisis, they are lowing interest rates....BUT NOT printing money. Hoarding of commodities is sacrificing the future for a present scarcity. I disagree with this statement on two counts
1) How does it sacrifice the future. Yes that capital is not invested but do we really need more investment. We've already overbuilt capacity of most things.....EXCEPT oil.
2) The money flooding into commodities is what was dollars saved and intended for a future purpose not present day spending anyway.
3) The speculation money will come back out of commodities shortly because after all they are speculators.

So I don't think the switch from dollars to other stores of value hurts the economy. It certainly drives up prices and hurts the dollars but what other rationale action can people make other than to simply spend the money as fast as they can. This is exactly what many people have done due to the inflationary policies of the Federal Reserve. Whey save when the govt will bail you out with treasury note backed money. Why save if it cost you money to just let is sit in a bank. Whey invest if the stewarts are simply gonna buy IPO's of money losing internet companies and AIRLINES. Why do any mutual funds invest in airlines...ask youself that and you will see the corruption of the cycle. Either the Fed gets you, The Fed and the banks, or the Fed and the investment houses.

If I summarize this article it seems to suggest that the central banks are mucking things up. Taking sensible precautions to guard against the Fed's policies is just as bad. So we should trust the central banks and put our faith in them again. Besides if they can't steal from you through inflation and other forms of usery they have the power through government to simply take it from you (confiscation). If you can't fight them join them. They have to have a real plan. That is the solution lets get a real central bank plan.

I'm sorry but the notion that they are going to have a real plan basically translates to

1) Central banks can and do work if managed right
2) All knowing, all omnipotent, all trustworth, incorruptable management can be obtained.
3) This will be possible because see Jesus Christ is going to return to earth anyday.

For central banks to work it would take a Jesus Christ. I'm pretty sure he is not interested in the job. So we are going to have to bury are heads in the sand and wait for the train to run us over. Because the machinery of Fascism is here to stay. My fear is that the current constructs of our political system, big corporation controled media in league with the Fasicst profitable policies of the government, etc......will lead to only one possible cure. The cure unfortuneately can only be bloody revolution. It will probably take another 1000 years of revolution.

Sorry I'm so cynical. Things really aren't that bad right now but long term its hard to see a peaceful, economically painful, purification of the political machine, intellectual awakening, ask not what your govt can do for you minded society, and all the other things that will need to happen to reverse the course we are on. Even talk radio seems to have a vested interest in being statist. Those in power will always find enough sell outs to keep them in power. In may not be a coheret conspiracy, or an in your face dictator, but when millions of people act only in their own self interest with comlete disregard of their neighbors this is what we get. Instead of being ruled by a ruthless dictator we are losing our liberty to the statist who profit from the current system and are backed up by a mob of selfish self interest only people who will sell out for their small piece of the pie.

Perhaps I'm completely wrong about everything but I keep drawing these same conclusions over and over. And I'm pretty sure lack of oil will be the catalyst for how the country charts its course over the next 100 years. Perhaps those who store their purchasing power in oil are the smart ones. I can't afford it.

2008 May 23 01:27 AM

[elwind45:]

When W.J. BRYANT ran for president 4 times, he ran on a bi-metal backing of our curriency. At this time the central bank is moving further away from hard asset dollar backing. The special lending is the future fall guy for money inflation. We need to back the dollar against a basket of hard assets, which can make the transfer as painless as possible. It is funny how the new lending facility has made the published interest rates meaningless. Now there are three classes of rates. Fed funds, discount, and special investment bank bailout rate. There is slim chance that production will rise to meet this excess liquidity, and I do not think fed will drain any of it out. Prices will raise to meet the reserves and we will experience a new level of prices. Just add another zero to overall prices. 10$ will be 100$. Bryant lost everytime, and the central bank was created instead! The huge amount of worry about the fed's "problems" is focused on the reemergence of P. VOLCKER. The world is worried about the U.S. federal reserve. Painted into a corner between rock and hard place! We will feel the pain of being robbed by washington!

2008 May 23 03:26 AM

[30000ftview:]

i feel the need to point out one thing to johngonole, when was the last time you saw a gas station with a no gas sign? the oil shortage is not really a shortage, it is part of the run-up on commodities that the article is pointing out.

2008 May 23 05:28 AM

[suep:]

I applaud "Elwind45" with his message. I will add that President Grover Cleveland was an advocate of hard money, especially for gold as a strong alternative for silver, since Nevada's huge quantities of silver was inflationary and was dangerously close to replacing gold as the backing for the dollar in the 1890s. (I add this as germane to a very few people that understand how gold backing insured a stable dollar for 160 years.)

As esoteric as this sounds, the lack of sound money since 1933 remains as the core reason why our economy is in the fix it is in today. How can any person, company, or government plan for the future if the dollar, or the pound, or the peso, etc., is no more stable than a stretched rubber band is a measure of its actual length?

Here is a message that I sent to my senators yesterday which forebodes the ultimate outcome of using a fiat currency.

.........................

The following is the solution to this nation's money worries.

Ignore this advice at our peril. Since I don't believe you and the rest of our government will heed my warning, I am taking steps to protect me and my family in accordance with the advice I give at the conclusion.

The problem as I see it has not changed, regardless of a variety of economic dislocations I have learned about and lived through in the most recent 75 years, to be exact. The problem has continued unabated, regardless of short term fixing attempts, since President Roosevelt eliminated the gold standard. Before you double over in laughter, consider that from date of the nation's inception in 1776 until 1933, which is the date that President Roosevelt decoupled the dollar from gold, there was no inflation. If you don't believe these words, I urge you to pull up any inflation adjuster from Google and test my hypothesis. You will find what I say to be a fact. Until 1933, a politician was constrained by the people from inflating the currency. For if the word got out that too much money was being created by politicians, citizens could simply walk, trot, or canter to the Treasury and demand gold for their dollars. And it worked. In 1776, an ounce of gold bought a man's good suit of clothes. Today, it still does. Here is the way it worked when the country was on the gold standard. If the then-President wanted to give, say, to Peter, he first needed to take it away from Paul. So no politician could easily buy his way into power by giving to both. That was before the fateful year of 1933 when FDR outlawed the private ownership of gold. Since that time, politicians were under no such restraints. They peppered everyone with gifts in the form of the Ponzi Scheme of Social Security, Medicaid, Medicare, outright grants, etc., knowing that there would be no near-term repercussions. Little did they know what monstrous inflation would envelop us and culminate in a financial Armageddon. And it is almost upon us now.

I give it no more than ten years from today for the financial crisis to descend.

Did you happen to read in "USA Today" recently that an esteemed and conservative economics house argued that this year's Federal deficit was not the still-tremendous deficit of some $160 billion that The White House projected, but is rather $2.5 trillion. That disparity exists because the Federal government is singularly under no obligation to account for the present value of out-year debts as private and state governments are forced to be.

Note that when he outlawed private ownership of gold, FDR had bought it for dollars at $20.43 an ounce. When he was satisfied that he had acquired essentially all of the citizens' gold, he unilaterally raised the price to $35 an ounce. Some nice guy!

As a matter of fact, FDR was the very first earmarker. Shortly after decoupling the dollar from gold, he went on a long train ride with Henry Ickes, the Treasury Secretary, father of the current Henry Ickes, Clinton confidante. What was the purpose of the trip? Answer: to win votes. Until that time, no Federal tax money was ever used for infrastructure such as building of bridges, roads, etc. FDR changed all that. Until then, it had all been provided by local and state authorities. He went with his no longer gold-backed, now-unconstrained checkbook to localities, dispensing taxpayer money for bridge building, et. al, in return for promises of votes. It worked. Historians and common people alike know that he successfully ran and won the Presidency four times. FDR saw to it that he could pay BOTH Peter and Paul once he could indiscriminately create money without the restraint of gold. And this country's ruinous flirtation with an unbacked currency began. Sadly, no nation on the face of the earth has decoupled its unit of currency from the restraints of gold and survived. The United States will be no exception.

And we already pay the price today, in spades. Recall that the price of gold in 1933, which remains a proxy for general prices of the time, was $20 an ounce. Today, the price is greater than $900 for that same ounce of gold. That is a price increase of over 40 times. It will get worse. The current price in dollars for an ounce of gold will look like chump change several years from now as Federal budget deficits continue to grow. And grow they will without any meaningful constraints. Why? We all know the reason: the Baby Boomer Generation is fast approaching 65 years of age, and all that signifies to the nation's financial "obligations" to them. Need I enumerate? Can you say, "Social Security?" Can you say "Medicare?" The unfunded liabilities for these programs approach $60 trillion.

But all is not lost.

Why not?

Social Security and Medicare are both creatures of Congress. Each can simply be changed by law. Neither program is supported by a contract. That would change the problem into a most ruinous one. But fortunately, Social Security and Medicare are creatures of Federal law. They can be amended by Congressional action. They can be abolished by Congressional action.

But there is a downside for the Congress that will be forced to face the eventual roaring tide of uncontrollable debt (as if what we have now is managable). Since each of these programs is always considered sacrosanct and untouchable by the voting public, those Third Rails of politics will incinerate the legislative careers of those who kick either one in the ... teeth. And it will happen, eventually. The country will not be able to support the budget-busting payouts when they are forced to pay trillions yearly from the Federal treasury.

Let us look at what has happened to the size of the Federal budget in the last hundred years or so.

In 1900, the entire Federal budget was $550,000,000. In words, over one-half billion dollars. Compare that to President Bush's projected 2009 budget: $3,107,000,000,000, or, again, in words, three trillion, three hundred seven billion dollars. Dividing, 2009's budget is nearly 5,700 times larger than it was in 1900. Scrubbing this ratio by inflation over that same time period, the current Federal budget is "only" 140 times larger than it was in 1900. And we wonder if the nose of the Federal government is under our own tent? Don't wonder. It is.

Under either President Obama or Clinton, that number is certain to increase. And I'm far from certain about President McCain

What about the National Debt? You may say, "Who cares about the National debt?" I say, "You should care," because you are paying interest on it with every Federal income tax payment you pay each April 15th. Not one person in a hundred is aware of what I am about to write...

Early in President Reagan's first administration, the National Debt crossed $1 trillion. A scant 25 years later, it has crossed $9 trillion, increasing a cool 900%. It is now increasing at the rate of $1 trillion every 15 months! The rate of debt increase promises to quicken, and since the slope of the curve is positive, it means that the National Debt is accelerating over time. In the next 25 years, the nation's National Debt promises to be even larger than $81 trillion. Attendant increases in the annual carrying cost measured by interest on this debt are reflected in rising Federal income taxes borne by every taxpayer. That serves to explain why the Fed is moving heaven and earth to try to keep interest rates low. Interest on the National Debt must be paid to the holders of that debt. But unstoppable Congressional spending increases constantly exacerbate the Fed's problem. The only way for the nation's citizens to be able to service the interest on the National Debt, along with rising payouts for Social Security, Medicare, Medicaid, etc., is for inflation to be the norm. No wonder why "Helicopter Ben" says he will dump dollars indiscriminately to prevent deflation.

And inflation is baked into the cake, as they say. It has been with us for a long, long time. And it will remain thus. That is, if Fedhead Bernanke has anything to say about it.

What to do? Buy gold at pace, and have a foreign bank account that you fund as best as you can.

2008 May 23 11:44 AM

[flow5:]

"The Federal Reserve, much as I might criticize it, has not gone on a printing spree"

Wrong. The evidence of inflation is represented by "actual" prices in the marketplace. The “administered” prices would not be the “actual” market prices were they not “validated” by (MVt) - (validated by the FOMC period).

(1) Be truthful, the "money supply" is unknown & unknowable.
(2) The "transactions velocity" of money is unknown & unknowable.
(3) Legal reserves are no longer binding/restrictive.
(4) Bank credit has been growing at a 10% annual clip for years.
(5) The broad, trade weighted exchange index, has fallen 26% since 2/6/2002.

The Keynesian economists that dominate the halls of academia, Congress, & the Fed's technical staff, may know a whole hell of a lot about money & central banking. The problem is - they don't know the right things.

Thirty years ago I discovered how to forecast (& forecasts are mathematically certain). But Joeseph Granville's subscribers anticipated the Sept 81 market bottom. Granville didn't get to issue an alert because he had so many followers. That's why you don't advertise the Gospel. But the real curious thing is how do you spend your entire career & not discover the market's inner workings?

2008 May 23 03:21 PM