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A Quick History: Reaching Stable Disequilibrium

In my previous article, I indicated that higher food prices and unemployment were an important catalyst for the recent political unrest in parts of Africa and the Middle East, and that I believe we are likely to witness in other parts of the world as well. I then asserted that higher food prices and unemployment have been driven, in part, by deeper currents whose relevance may not be obvious.


Clearly, rapid growth in highly populated countries such as China and India will exert upward pressure on global prices for resources. What may be less clear is the extent to which increased market intervention by governments and central banks around the world is exacerbating these pressures. Let’s take a step back to put this into better perspective.


To really do this topic justice, it would help to go back to the origins of money, as Niall Ferguson does in his book, “The Ascent of Money: The Financial History of the World,” or to analyze financial crises over a period of many centuries as do Carmen Reinhart and Kenneth Rogoff in, “This Time is Different: Eight Centuries of Financial Folly.”  For now I will take you back only to the nineteenth century, when the US economy was primarily agrarian and subject to strong seasonal trends in the supply and demand for money, which consisted of thousands of different currencies created by an equal number of banks chartered at both the federal and state levels.


This was a confusing state of affairs, and waves of bank failures and/or scandals only made matters worse. The U.S. clearly needed a single currency, increased regulation, and a lender of last resort to help banks cope with the seasonal demand for bank loans and deposits.  However, the creation of such a central bank was controversial for two important reasons:


  1. Americans feared that our founding principles of liberty and justice would be jeopardized if too much power was consolidated in a centralized organization; and


  1. Our Constitution provided the government, not private bankers, with the right to coin money but was silent as to the right to print money – or, more importantly as it turned out, to create money. So, if a central bank was created, it was not clear whether it would be controlled by the government or by private bankers.


Amidst this controversy, the Federal Reserve was created in 1913. It is not a government agency, but rather is owned by private sector banks.  It was organized to consist of twelve Regional Federal Reserve Banks subject to the governance of a Federal Reserve Board in Washington, DC, in order to give it the appearance of both decentralization and a balance of power between the government and private sectors. The Federal Reserve Act also gave the government the power to print money, but the power to create money was vested with the Federal Reserve.  To conform to our Constitution, the money that the Federal Reserve decides to create is, in fact, printed by the government through the Bureau of Printing and Engraving.


Putting aside these long-forgotten controversies for the moment, the creation of the Federal Reserve did, initially, allow banks to more readily adapt to fluctuations in market demand for loans by borrowing additional funds from the Federal Reserve using as collateral the same commercial paper that had been pledged to them by their borrowers.


However, WWI broke out shortly after the Federal Reserve was created, and after the war the government found itself in debt. Although modest relative to the mountains of debt that have been accumulated since that time, the government was anxious to keep the interest rate on that debt as low as possible. Therefore, in 1918 it modified the Federal Reserve Act of 1913 to allow banks to also pledge government securities as collateral for the loans that they sought from the Federal Reserve.  In addition, the banks would be permitted to borrow from the Federal Reserve at a lower rate if they pledged such government securities as collateral rather than commercial paper.


Since banks back then were still in the business of making loans, and they could generate larger profits from these loans if amounts available for lending could be borrowed from the Federal Reserve at a lower interest rate, demand by banks for government securities quickly soared.  Almost as quickly, the Federal Reserve learned that the terms at which government securities were made available to banks could influence their lending behavior by even more than fluctuations in the demand for loans by private sector borrowers based upon natural market forces.  In other words, a relatively small group of individuals could now exercise tremendous control over the economy simply by manipulating the supply and demand for government securities rather than acting merely as a “lender of last resort” responding to fluctuations in private sector demand for loans and deposits.  This was the genesis for what are now known as “Open Market Operations,” which we take for granted as being an important and necessary monetary policy tool available to the Federal Reserve.


Putting this newly acquired power to work, primarily under the influence of a single member, namely Benjamin Strong, the head of the New York Regional Federal Reserve Bank, the Federal Reserve coordinated its activities with central banks in England, France, and Germany to restore the gold purchasing power of the British Pound to its pre-World War I level. This was achieved by causing interest rates in the United States to remain artificially low, so that cash available from other parts of the world would flow to England rather than the US in order to earn higher interest rates, thus bidding up the value of the British Pound in the process. These policy decisions obviously had little to do with the natural forces of market supply and demand, but it was hoped that this return to the status quo would somehow stabilize the world financial system.  The low interest rates and easy money policies being pursued in the US did, in fact, lead to a robust period of economic growth known as “the Roaring Twenties.”  But, the price to be paid for resisting natural market forces was excessive debt and a stock market bubble.


In response, rather than allowing the economy and financial markets to achieve a true state of equilibrium, additional market-distorting government and central bank interventions were introduced instead. These shifting, sometimes contradictory policy decisions and interventions created confusion and uncertainty, which wreaked further havoc on the economy and markets for over a decade. In effect, the growth and stability of our economy became increasingly subject to the policy decisions of the federal government and the Federal Reserve, rather than the direct market forces of supply and demand operating within the private sector.  However, a more “stable disequilibrium” was eventually achieved, subject to the “mere” expense of growing mountains of debt, and increased reliance upon the centralized policy decisions taken by an increasingly powerful federal government and “Federal” Reserve.


These growing debt levels could not even be kept in check by using American workers’ social security retirement plan contributions to temporarily reduce outstanding US Treasury obligations that had been issued to the public. This is explained, in part, by the eagerness of export-oriented countries such as Japan and the East Asian Tigers (Taiwan, Hong Kong, South Korea, and Singapore), to acquire our debt along with many OPEC-member countries. So, in effect, the growth and stability of our economy became increasingly subject not only to the policy decisions of “our” federal government and “our” Federal Reserve, but also to the policy decisions of foreign governments and foreign central banks.


Nonetheless, for decades, most Americans seem to have been lulled into the belief that these growing debt levels “didn’t matter” as long as our GDP grew faster. Unfortunately, little attention was given to the composition of our GDP, in particular the erosion of our manufacturing base and the growing percentage of GDP attributable to consumer spending.  More importantly, little attention seems to have been given to the possibility that economic growth, in percentage terms, may not persist at the same levels as it had before, when our economy was smaller, less fully developed, and less subject to more serious competition from other countries. If the growth rate of our economy falls below the growth rate of our debt, the burden of this debt would increase. As many individuals with excessive credit card debt at rates high above their initial teaser rates can now attest, these liabilities can spin further out of control when rates rise.


Faced “suddenly” with the realization that new debt would soon have to be issued to raise the funds needed to return social security retirement plan contributions to aging baby boomers, and that decreased spending by these aging baby boomers could simultaneously serve to slow economic growth, it gradually became clearer to more and more people that something would need to be done to ward off soaring debt-to-GDP ratios. The two primary choices are:


  1. Reduce the debt; and
  2. Increase economic growth.


Austerity measures have proven themselves to be unattractive ever since the federal government and Federal Reserve were initially faced with this conundrum in 1929, and less spending means a smaller government. So, predictably, the latter alternative has been given priority.


Unfortunately, no other age group spends as much as 45-year-olds in their peak earning years. Furthermore, some of the more astute policy makers have observed that it could take as long as 45 years to make new 45-year-olds. Some have even speculated that the disproportionately large segment of the US population known as the Baby Boom generation might even reduce their spending in order to save for their retirement, or “worse” yet, to actually begin to tap their retirement nest eggs.  That could put downward pressure on the value of investment assets, which is of particular concern because many leveraged banks rely on the value of these assets to collateralize their loans, as well as the leveraged investments held by their proprietary trading departments.  So, without jeopardizing their popularity among voters, at least not within their terms of office, policy makers have finally conceded that something must be done about these inherited problems.  It just isn’t clear what that something should be, and who should be held accountable.


Tragically, in the midst of these deliberations, the US suffered terrorist attacks on the Pentagon and the World Trade Center on 9/11/2001.  The impact that further terrorist threats could have on our already slowing economy at the time was not at the top of the list of priorities to be addressed, but it was not completely overlooked either.  This risk of further terrorism was thought to be magnified by the existence of poverty, and a lack of opportunity particularly among youth populations in countries most subject to the influence of terrorist groups.  So, increased emphasis was placed on providing aid to impoverished countries, and the US obviously stepped up its presence in the Middle East, among much controversy.


However, another event that took place at that time is often overlooked.  When reference is made to the eleventh day of a month in 2001 that marked a turning point in history, few people are likely to think of 12/11/2001, which was the day that China was admitted to the World Trade Organization. Yet, that event has profoundly changed the world, and has much to do with the unrest that we are now witnessing in a number of poor countries, including, but not limited to, those in the Middle East.  That will be the topic covered in my next article.