America's Road to Financial Ruin

Douglas French
Issue CCLXIX - December 14, 2010
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So you thought that troubles were over for the banking system. Now, the Financial Times reports that the 35 largest US banks will come up $100 to $150 billion short of capital after the Basel III global banking regulations kick in, "with 90 per cent of the shortfall concentrated in the biggest six banks, according to Barclays Capital." To comply with the liquidity requirements of Basel, these banks will also need to come up with half a trillion in cash or "easy-to-sell" assets.

Another hit for $100 billion might come when Fannie, Freddie, and other mortgage investors start putting back mortgages for faulty paperwork (reps and warranties) to the major banks according to Barron's.

Irish central-bank chief Patrick Honohan says that country's banks are for sale after the Emerald Isle had to go hat in hand to the EU for a bailout: and now it's considered unlawful to be informed beyond throwing darts and reading charts prior to trading stocks.

Fiat money, central banks, and fractional reserves lead to excessive debt and the monetary and financial instability that goes with it. The bubbles and crises never end — it's as American as apple pie and baseball. The debt-and-bubble culture didn't spring forth with Richard Nixon closing the gold window in 1971 while declaring "we're all Keynesians now" — although that accelerated the process.

No, as bank analyst Christopher Whalen points out in his new book Inflated: How Money and Debt Built the American Dream, America's road to financial ruin — the same road traveled by Great Britain and the Romans — began more than a couple centuries ago.

Before Whalen weaves his fascinating, far-reaching financial history, complete with the skullduggery from politicians of all stripes, none other than Nouriel Roubini provides a Keynesian-moment introduction. It's unusual for the introducer not to agree with the author, but Roubini, known as Dr. Doom in some quarters, after pointing out that Whalen takes the Austrian view, claims the Great Depression's abundant Schumpeterian "creative destruction" led to "uncreative destruction."

Roubini writes that markets do fail, and

they do fail regularly in irrationally exuberant market economies; that is the source of the role of central banks and governments in preventing self-fulfilling and destructive bank runs and collapses of economic activity via Keynesian fiscal stimulus in response to collapse in private demand.

So while Whalen puts the blame for our precarious financial state on the tools of the state, central bankers, and politicians, Roubini writes that financial crises come and go as a matter of course. What keeps him up at night is income inequality, and he concludes his intro "in thoughtful Marxist spirit" by posing the idea that booms and busts are created by "powerful economic, financial, and, thus, political forces."

I suppose having "Introduction by Nouriel Roubini" on the cover helps sell books, but readers shouldn't be fooled: Roubini's hero, Keynes, is central to all that is wrong with modern monetary matters in Whalen's eyes and is prominent throughout the book. Keynes's prescribed interventions "opened the door to the enlargement of the corporate state."

Whalen cites a curious Keynes quote that is counter to the legend that the author of the General Theory was an investment genius. On the Investment U website, Dr. Mark Skousen writes,

When it comes to the best strategy to use during a treacherous bear market, I turn to advice from my favorite guru. The British economist, John Maynard Keynes (1883–1946), made a ton of money during the Great Depression.

However, Keynes must have taken a beating along with everyone else in the 1929 stock-market crash. He said investors shouldn't "cut and run" when the market falls.

I should say that it is from time to time the duty of the serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself.

Keynes then says something about investors being judged on their long-term results, which is funny coming from a guy who said in the long run we're all dead.

Whalen starts his story with the free banking and private money of the colonial period. Barter was a dominant means of exchange, along with foreign coins and colonial paper money, and what credit was available for individuals was provided by pawnbrokers. Colonial Americans naturally distrusted bankers and were suspicious of paper money.

As soon as there was government, there was government borrowing, and soon government defaults. "By 1840 many American states had gained a well-deserved reputation in Europe for not repaying loans," writes Whalen, "although the U.S. government managed to service the federal debt in good order." Here we are in 2010, with California, Illinois, and New York thought to be teetering on the edge of default.

Whalen spends considerable time on the period between the Civil War and the creation of the Federal Reserve in 1913, describing it as "arguably as 'pure' a private national banking model as ever existed in the United States." Despite what is commonly written about this period there was tremendous growth during this time, and, without a powerful central bank and big-government apparatus in place to bail out banks and other upside-down firms, the panics of 1873, 1884, 1890, 1893, and 1907 passed quickly.

The author leans on Murray Rothbard's work about this era to flesh out his story, especially History of Money and Banking in the United States. The strength of Whalen's book is that his monetary history, like Rothbard's, is about people, not policies. While Keynesians talk about unknowable constructs like aggregate demand, Whalen's story turns on the actions of people like William Jennings Bryan, who didn't represent the people, as conventional wisdom claims, but led a coalition of ideologues who embraced religion, inflation, prohibition, and public schools.

Bryan's "Cross of Gold" speech, delivered at the 1896 Chicago convention may have been the last time monetary issues were a part of serious political discourse. With the current uproar over QE2 and with the role of the Fed being questioned, it's possible we could see a "Thou shall not drown America in a Sea of Paper" speech in 2012.

Whalen combed through Herbert Hoover's extensive memoirs to find an apt description for FDR's economic policies — fascism:

Much of what FDR did during these dark years was borrowed from the strong men of Europe — Mussolini in Italy, Hitler in Germany, and Stalin in Russia.

The current administration is doing its best FDR impression, only instead of calling it the f-word, it's change we can believe in.

Richard Nixon gets especially harsh treatment from the author, who calls Nixon's economic plan "Soviet-style New Economic Policy." Whalen sees Nixon in the same big-government league as FDR, explaining that "Nixon delighted in a growing federal budget as he felt, just as [Lyndon] Johnson did, that more spending would insulate him politically."

The interplay between Nixon, Fed chair Arthur Burns, and Treasury Undersecretary Paul Volcker is especially interesting and poignant in light of the monetary geyser the unshackling of the dollar from gold has ultimately led to. Volcker, who has reemerged as an advisor to the Obama administration, said at the time, "We have to come up with a proposal to demonstrate gold is not that important. Maybe we should sell some."

While Volcker is revered as being the Fed chair who had the courage to tame inflation, Whalen calls him "the father of too big to fail," which in fact is a big-bank-bailout legacy that compounds America's reliance on inflation and debt. Whalen's telling of the Nixon-era story is an especially strong part of the book, as if the author had been provided with a first-hand account of the Washington sausage-making over the dinner table each evening.

Ninety percent of Inflated is complete when Volcker leaves his post as Fed chair. For a blow-by-blow account of the Greenspan Fed, readers will have to look elsewhere. Whalen only speaks to Greenspan's legacy, which he says will be borne out over the next few decades. Greenspan's failure to address America's fiscal and monetary problems puts the United States "on a trajectory for economic stagnation, hyperinflation, and the attendant political and social costs of such policies."

Whalen sounds a hopeful note at the end, writing that American policymakers will act proactively instead of waiting for the next crisis or the one after to force change. Hope springs eternal for the author who grew up in the belly of the beast — Washington, DC. However, the evidence presented in his first 344 pages of Inflated is too compelling to trust that will happen.

Instead, Whalen gives away the answer with a quote from Hayek's Denationalisation of Money at the very front of the book:

I do not think it is an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order.

Democracy and central banking equal monetary chaos. The dollar's end will not be pretty.

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