This week has seen a bumper crop of articles about the declining dollar. The Free Trade apologists are spinning it already, but at least one AP writer sees what is relevant:
... the European Central Bank reiterated the likelihood of a June interest rate hike. .... Historic levels of healthier European growth, continuing interest rate increases by the ECB and concern over the strength of the U.S. economy have boosted the euro.
While the loyal Bushies have been fiddling, Europe has been getting their act together, and the Euro is now more popular as international cash, and it is slowly gaining ground as a world reserve currency. A Euro-denominated oil market is now plausible, and BushCo has risked our nation's future to keep it from happening.
Lots of talking points about inflation and the finance industry, and more about blood for oil, after the bump.
We are all familiar with "inflation" as referring to a general rise in prices. But we are much less clear on what causes it. It could be demand exceeding supply; it could be higher costs passed on to customers; it could also be price manipulation. But what causes general price inflation? It could be a case of passing on higher costs for something pervasive (like gasoline), or perhaps something more fundamental:
.... Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down.
Many people mistakenly believe that prices rise because businesses are "greedy". This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can't just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else.
But if each dollar is worth less because the supply of dollars has increased, all businesses are forced to raise prices just to get the same value for their products. (Emphasis mine)
When there is monetary inflation of the dollar, it is the responsibility of the Federal Reserve System ("the Fed"). Created in 1913, the Fed is actually the third central bank in the long and controversial history of central banking in America. The very concept of central banking has many critics, including the Founding Fathers:
During the period after the Revolution, our Founding Fathers were approached by representatives of wealthy European banking families who proposed the establishment of a bank for use by America. This bank would provide the money that our young nation would need to grow into a world power. However, the Founding Fathers refused their proposal. The United States, being a sovereign nation, was fully capable of creating its own money supply. This power "to coin money and regulate the value thereof" was given to our Congress in the Constitution.
Aside from knowing that the United States had the power to create its own currency, the Founding Fathers were well aware of the motives of the European bankers... namely, to siphon off the wealth and natural resources of the people through various methods of currency manipulation, just as they had done throughout history in every major country of Europe. Thomas Jefferson expressed the prevailing attitude toward these men when he warned: "If the American People ever allow private banks to control the issue of their currency... the banks and the corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered." (Emphasis mine)
In more recent times, The Cato Institute in 1982 criticized the Fed's motives and behavior during the battle against stagflation:
That the illusory boom comes first, and the painful readjustment period of the recession comes later, helps explain why a shortsighted monetary authority is tempted by easy money policy. The temporary dip in output and employment associated with the monetary restraint necessary to cool inflation unfortunately comes before any permanent gain. A temporary bulge in unemployment appears well before price stability and productive reintegration can be established. Past expansionary impulses continue to snake their way through the economy, pushing up prices. Restraint reveals the distortions and dislocations due to the previous inflation, and popular analysis mistakenly attributes these troubles to the restraint rather than to the previous inflation. Since the Fed (as Mr. Dooley once said of another political body, the Supreme Court) follows the election returns, shortsightedness is just what we should expect of our monetary authority.
Lack of past restraint has built inflationary expectations that today make the rate of price explosion even harder to decelerate. As traditional tight money policies have worked with less and less speed at stemming inflation, the Fed has abandoned restraint before inflation could be ended, thus reinforcing expectations that prices will continue their climb. Our monetary authority must show much more resolve if it genuinely wants to break the stagflationary cycle and bring an end to rising prices.
That the Fed has reasons not to decelerate inflation should be evident from our discussion of the ways in which the federal government gains from inflation. Put simply, the transmission of inflation entails a redistribution of wealth to the recipients of the newly-injected money, namely the federal government and its beneficiaries. Those outside the favored sector, who find prices rising or accelerating faster than their incomes, are the losers. (Emphasis mine)
A year before that was written, in 1981 as Reagan took office, the total supply of dollars (graphed here in billions) was 2 Trillion, just over one sixth of what it is now. (That graph is from a site with lots of other hidden statistics in case you're curious.) This M3 "broad money" supply figure has gotten so embarrassing that in March 2006 the Fed stopped reporting it:
It is no coincidence that the M3 went up an annualized 9.4% in the last three months and an annualized 17.2% in December alone and now the FED wants to stop tracking it!
Why bother tackling a problem of this magnitude when you can just bury the evidence? Who wants to leave a "smoking gun" laying around? A 9.4% increase in money supply should translate into a 9.4% inflation rate (if GDP produces exactly enough to counteract obsolescence).
Even if there is a 1% increase in the supply of goods, that still means that we really have 8.4% inflation rather than the 3.6% the BLS is telling us.
Since real GDP has historically averaged almost 3-4% a year, in 25 years real GDP should be around 2 or 2.5 times bigger, not 6. There should have been 4-5 Trillion dollars in circulation in early 2006, not 10.
Since the 10 Trillion mark was hit and the Fed stopped reporting it (presumably after changing their underwear), the dollar money supply has risen 15% in just one year!
To be fair to our bloated government, even they cannot waste this much money in a year. The 1.5 Trillion of new money, less real GDP during the period, is a direct result of loan activity drawing new credit out of the banking system. Let me box this next point, because it is the link between debt and inflation:
This new credit, like quantum foam, will be automatically destroyed when the debt is paid back -- plus fees and interest to the bank (ka-ching!). But we've created far more of this money than we've destroyed -- this is the "excess liquidity" you hear about in the financial press. As long as these extra dollars are still floating around -- like greenhouse gases trapping heat -- the effect on supply and demand is the same as if the Fed actually printed excess money and flew around dropping it out of helicopters.
So who is taking out all these loans? The sad truth is, we all are -- government, investors, hedge funds, and normal people with home equity lines of credit, plain mortgages, credit card debt or other loans -- but the financial industry carries half of the total outstanding debt. This is a relatively recent development.
Under Reagan and Clinton, the banking industry pushed through deregulation that effectively repealed the reforms of the Great Depression:
The separation of banking and the stock exchange was ordered in response to revelations of the gross corruption and manipulation of the market by giant banking houses, above all the House of Morgan, which organized huge corporate mergers for its own profit and awarded preferential access to share issues to favored politicians and businessmen. Such insider trading played a major role in the speculative boom which preceded the 1929 crash.
....
And there is a much more recent experience than 1929 to serve as a cautionary tale. A financial deregulation bill was passed in the early 1980s under the Reagan administration, lifting many restrictions on the activities of savings and loan associations, which had previously been limited primarily to the home-loan market. The result was an orgy of speculation, profiteering and outright plundering of assets, culminating in collapse and the biggest financial bailout in US history, costing the federal government more than 500 billion. The repetition of such events in the much larger banking and securities markets would be beyond the scope of any federal bailout.
Now, take a look at this stock chart of the three major indexes from 1950 to present. The log plot of price, and the linear plot of volume, both show considerable exponential growth starting in the early 1980's. Coincidence? You decide.
The next barrier to massively leveraged financial activity was the Fed's Fractional Reserve Requirements. But during the 1990's, the banks kept finding sneaky ways to get around the restrictions, and the Fed went along with it:
The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or "broad money" with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe....
.... imagine that this change in banks' ability to create loans coincided with new and exotic forms of money being invented via the securitization of debt and extended to entirely new asset classes and made available to a far larger range of people that previously did not qualify for loans. This essentially describes our system today....
When banks wanted to expand their lending, they found a technical workaround using "retail sweep programs." How innovative! Apparently, the Fed approved of all of this, too, apparently losing sight of the reason we have reserve ratios in the first place.
What was the result of these two changes, the creation of classes of zero and near zero reserve ratio accounts and the ability of banks to move money from accounts with high reserve requirements to accounts with low or now reserve requirement?
A flood of free money.
There was then almost no limit to the promissary notes, in the form of various securities, that could be created by banks -- with fees of various sorts -- interest, originating fees, maintenance fees, penalties, and so on -- collected all along the way and booked as profits. This transformation of banking practices seems to have started small, but really picked up steam by 1996 and 1997, likely due to competitive pressures among banks; those banks that used these methods could easily out-compete those that did not. Even if some banks avoided these practices for a while because they thought them too risky, eventually they were forced to play along or risk losing business to banks competing for the same borrowers. (Emphasis mine)
That whole article is a pretty good read. Before we move on, note the graph from The Economist showing money growth and consumer-price inflation occurring together in many countries.
Quite bluntly, the Fed abandoned their post so the finance industry could borrow insane amounts of cash and pour it into stocks (tech bubble), hedge funds (LTCM was merely the first of hundreds), and housing (everyone). Now the Fed has its hands tied by politics:
Why is it that the Fed doesn’t intervene and try to stem excesses in the credit industry? We find the answer by circling back to the consumer: if the Fed were to do something about the spiraling credit expansion in the derivatives markets, the imposed tightening would quite likely hurt the consumer. Typically, a recession would not scare the Fed, but globalization has put the fear of deflation on Fed chairman Bernanke’s table. Tight credit could cause a collapse in the housing market and in consumer spending; what has been a great boom would turn into a great bust.
The fear also spills over to the U.S. dollar: as a result of the current account deficit foreigners must purchase in excess of over 2 billion U.S. dollar denominated assets every single day, just to keep the dollar from falling. As the U.S. economy slows, foreigners may be more inclined to invest some of their money elsewhere. The rising price of gold reflects that many investors believe that the Fed rather see a continuation of monetary expansion than allowing a severe contraction. Fed chairman Bernanke has also made it clear in his publications that he favors monetary stimulus at the expense of the dollar to mitigate hardship on the population at large. (Emphasis mine)
But there is another, scarier reason why the Fed cannot lower interest rates. As long as Euro interest rates keep nipping at the dollar's heels, we cannot reinvigorate the housing market with easy credit. If we did, then safe Euro debt would start paying better than safe dollar debt -- many investors currently parking their cash in safe dollar debt would switch to Euros, accelerating the dollar's decline and risking an outright panic in the currency markets. For the same reason, if the Euro interest rates rise as threatened, the Fed must raise dollar rates or risk the same catastrophe! So to all you homeowners praying for low interest rates to rescue you from your neg-am mortgage... make other plans. Seriously.
If you'll forgive me:
In soviet America... House owns you.
Before I get back to the subject of oil... a couple more points about inflation. First, what about the common adage that inflation helps debtors? Well, unless you are the one who controls where the fresh money goes, then it only helps in certain circumstances. This is my personal response on that subject:
People say inflation helps debtors because you can pay off your loans with cheaper dollars. But this is only a net benefit if you acquire purchasing power faster than the interest on the loan lays claim to it.
For inflation to help you, you must invest present money at a rate that beats the interest on your debt and then use it to pay the debt, or you must receive pay raises that beat the interest and use future wages to pay the debt. Otherwise, inflation always hurts you because it leaves you with less total purchasing power than you had before.
Every investment whose after-tax return is less than general price inflation is actually losing purchasing power. This is why rich people are so desperate to have low dividend and capital-gains taxes -- and it's why taxing bank interest as normal income punishes the middle class for not tithing to Wall Street by investing "for real".
Second, hyperinflation is not something that only happens to incompetent governments. It's a vicious cycle that traps whole economies in its wake. And we are very far down the Path to the Dark Side.
The danger of borrowing to survive cannot be overstated. Living on unbounded debt is financial global warming, and it too has a tipping point beyond which lies hyperinflation.
Finally... back to Oil. Most of this is connecting dots you've already heard, and this piece is insanely long already, so I will skip quotations from here on out. I can put some of them back if comments warrant.
The dollar's decline is being helped along by our extravagant oil consumption. From 2001-2003, OPEC raised oil prices to match the Euro exchange rate for a price of about 24 Euros a barrel. Now the Euro is clearly on top of the dollar again and oil has doubled to 48 Euros a barrel, so it's forcing an ever-bigger wedge into our trade deficit. This is partly a silent protest against the dollar's decline by OPEC, and partly the early warning signs of Global Peak Oil. It's no wonder foreign banks are cashing out their dollars while they can.
But now, we actually have a plausible reason why Bush is so stubbornly determined to stay in Iraq, where we have 14 shiny new permanent bases to keep the middle east under our thumb while we help ourselves to Iraqi oil and lower gas prices by breaking the cartel pricing of OPEC, thus cutting off a major source of funds to terrorist groups and buying our economy a new lease on life at the same time. If things had gone as planned, we'd have avoided financial disaster but would probably be living in a Christian Theocracy by now. Instead, we are ensnared in a military quagmire that is slowly grinding our economy down, somewhat like the USSR in Afghanistan. Obviously bin Laden learned something from his time there, because in November 2004, he told everyone it was how he was going to defeat us. Bush and the neocons obviously didn't learn anything, and fell for it hook, line, and sinker.
Which brings us to Iran, whose nuclear program was originated in the 1970's with our help. They are working on a Euro-denominated oil bourse but are also having problems producing enough oil for their own people, which gives them a perfectly understandable reason for wanting nuclear energy but doesn't indicate whether or not they are lying about nuclear weapons. It does indicate that we should wait them out rather than invading, but the Iranian oil bourse is making slow progress towards being able to directly challenge the petrodollar. Bush and the neocons are facing a choice between two of their worst nightmares and they are running out of time.
And so are we. BushCo's massive con game on the American public is unraveling before our eyes, much like the housing market. To fully discredit the Neocons, the economy has to tank on Bush's watch without the public blaming the Democrats for it. The WSJ has already begun writing op-eds to lay a paper trail and claim that any regulations enacted by the Democratic congress, no matter how patently sensible, will have killed our prosperity because they blasphemed against the Church of Free Trade. Ironically, the dollar appears to be unraveling much faster than any of them planned.
Bush could have predicted the weight on the dollar from the cost of his massive bribe package to buy off every power bloc in the country -- tax cuts for the rich, pork for congress and the states, cold-war era project restarts for the military-industrial complex, medicare drug bill for Big Pharma, bankruptcy law for credit card industry, deregulation for polluters and countless industries, corporate welfare splattered all around... the list goes on and on and on. It really is the biggest criminal syndicate in history. And it explains why the loyalty of the Bushies was so paramount.
But what Bush could not have predicted, was just how much of a Caligula-class financial orgy there would be in the hedge-fund industry. For years now the stock market has been in an endless masturbation session of inflation-induced nominal price rises. The dow adjusted for inflation isn't doing nearly as well, and the dow in Euros has moved sideways since the tech crash officially bottomed. The economic bloggers are chasing leads of blatant manipulation, but frankly all you need to know is that hedge funds account for 1/3 of the daily money flow in the markets. They can't help but influence prices if that's true.
Sooner or later the hedge funds are going to tear each other to pieces, and more of them appear to be cashing out by going public, so I think it may be close to happening. They depend heavily on borrowing Yen and dollars, so swings in either currency are the most likely events for triggering a hedge fund implosion and market crash. And, if you want more proof that Wall Street has lost it... they are planning a stock exchange based on the net worth of sports celebrities.
I plan to write more on economic topics. If you have juicy leads to leave in comments, by all means do. And, thanks for reading.