Warnings From the Past

On August 10, 2010, the Federal Reserve declared that it would prevent its multi-trillion dollar balance sheet from shrinking, in a continuing effort to spur the American economy.  The officials explained that they would take the proceeds from the maturing mortgage backed securities that they hold, and reinvest the proceeds into longer-term U.S. Treasury bonds.

It is important to understand that the monetization of debt, known as quantitative easing, is a subtle form of money printing.  The Fed assures us that it will “sterilize” the printed money in the future by selling securities back into the market, essentially soaking up cash.  They seem to be forgetting that many of the securities that they originally purchased at par are of dubious quality, and will command much lower prices when sold back into the market.  The price differential between the purchase and sale price of these bonds will eventually be the inflationary increase in the money supply.   As Government debt continues to build at unprecedented rates, the urge to print will more than likely become heightened.  The authorities will likely tell us that we have to print money and buy debt to keep rates low.  Our economy will not be able to handle high interest rates.   Can it handle large amounts of freshly printed money?

Most financial crises have been a function of debt accumulation that can’t be serviced by underlying cash flows.   Printing money has been promoted by academics and politician for centuries as a cure all for these crises.  If one reads history books, one quickly sees that money printing, in all of its various forms, has created more problems than it has solved.  It typically starts slowly, and increases as the desired results are never obtained.  As the printing continues, the value of the currency drops.  Nothing in this world escapes the law of supply and demand.  The larger the supply of money, the less the money is worth.  Purchasing power is reduced.   This loss of purchasing power is the root cause of inflation.  As inflation ramps up, the blame is laid on “greedy speculators” and “greedy businesses”.  The true cause of the inflation, money printing, is never mentioned.  The story is always the same.  Rather then add more to the discussion, I’ll let historical figures tell the tale.  I have taken it upon myself to highlight what we feel are the particularly important points in each piece.  Remember dear reader, you have been warned.

“Pamphlets continue to be issued, among them one so pungent that it is brought into the Assembly and read there.  The truth which it brings out with great clearness is that doubling the quantity of money or substitutes for money in a nation simply increases prices, disturbs values, alarms capital, diminishes legitimate enterprise, and so decreases the demand both for products and for labor; that the only persons to be helped by it are the rich who have large debts to pay. This pamphlet was signed “A Friend of the People.”   It was received with great applause by the thoughtful part of the Assembly.  Dupont, who had stood by Necker in the debate on the first issue of assignats, arises, avows the pamphlets to be his, and says sturdily that he has always voted against the emission of irredeemable paper and always will.” (Fiat Money Inflation In France, Andrew Dickson White, 1896, pg. 22)

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, and important part of the wealth of their citizens.  By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.  The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,”, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.  As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth getting degenerates into a gamble and a lottery.

Lenin was certainly right.  There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” (The Economic Consequences of the Peace, John Maynard Keynes, 1920, pgs. 235-236)

And as the Federal Reserve uses proceeds from printed money to re-invest in ever growing quantities of Treasury Bonds, it is important to remember the words of the former Fed Chairman, Sir Alan Greenspan.

“The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods.” (Gold and Economic Freedom, Alan Greenspan, 1966)

We got into our current mess by getting into too much debt.  Instead of slowly paying our debt off and accepting reality, we going to try and print our way out of debt.  Current Fed Chairman Ben Bernanke, in his 2002 speech to the National Economist club, stated that “Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Money printing, historically, has never been effective in bailing out debt ridden countries.  The symptoms of heavy printing have been highly disruptive, and often cataclysmic to societies.  Still, we keep on trying, perpetuating the definition of insanity.  I’ll leave you all with a few more quotes that are appropriate to this discussion.

“History repeats itself, first as tragedy, second as farce.“ – Karl Marx

“It is absolutely impossible to transcend the laws of nature. What can change in historically different circumstances is only the form in which these laws expose themselves.” -Karl Marx

“The only thing we learn from history is that we learn nothing from history.” -Friedrich Hegel

The economy is currently slowing down, and widespread deflation may still set in.  Many people are purchasing risky, long term securities in order to provide income in today’s low return world.  Others are betting on reaping capital gains if long term rates decline.  Investors must remember that Bernanke appears to be committed to stopping deflation at all costs.  Also, confidence is a fickle creature.  When change comes to financial markets, it often comes swiftly and unannounced.  It may be wise to hedge deflationary bets with some kind of inflation hedge.

Matt Marcewicz

Ancora West Advisors

August, 10 2010