Tuesday, 18 November 2008

Interest Rates and Capital

“Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed.”
Mahatma Gandhi

“The highest use of capital is not to make more money, but to make money do more for the betterment of life.”
Henry Ford

"This weak republic throws its pieces of paper about wildly in order to enable its main party functionaries ... to feed at the trough"
Adolf Hitler


The use of paper money has become ubiquitous in modern times and with the introduction of computers in the past few decades, society has become accustomed to the further abstraction of money in the form of pixels, a series of 0's and 1's to represent money. We all use our nations currency either the paper or electronic form, and have complete trust and faith in what it represents and it's intrinsic value. Is this blind faith in pieces of paper justified? As we have only grown up in a society whose main medium of exchange is the use of government currency, should we place an almost religious belief that it will always retain its value? We have recently had a meeting between the G20 countries, to co-ordinate agreements towards a global fiscal stimulus package. The Bank of England cut rates by 1.5% with the base rate now at 3%. The Federal Reserve is down to 1%, with other nations Central Banks following the trend. However if we go back 6 years, weren't the low interest rates the main cause of the monetary problems we are now facing? Why do politicians always seek lower interest rates and why do we have central banks that try and impose a broad monetary policy on all financial institutions in our economy? We have become accustomed to Central Banks, almost conditioned, into the fact that their very presence is essential for a functioning modern economy. Contrary to what Central Bank are supposed to do, that is fight inflation, they are actually a huge inflationary mechanism that create the moral hazard we are now seeing and continually told about.

Central Banks are the Moral Hazard

When Mervin King the Governor of the Bank of England makes statements regarding moral hazards towards banks, its like a drug dealer giving a lecture on drug abuse to a drug addict. Central Banks amplify the effects of the boom, by flooding private banks with cheep money at the beginning of the boom. When the boom turns to bust, Central Banks begin a program of propping up private banks as the private banks always know they can turn to the Central Bank when the bust materialises. If you can't picture a modern economy without a Central Bank, then America had no central bank from the 1830's right up until 1913, just as it was becoming the industrial power of the world. The current central bank is the third America has had in its short history as a nation and is owned and controlled primarily by private banks. It was set up with the intention not in ensuring financial stability but for the purpose of increased profits for the banks, so they could load up even more with peoples debts with less need for capital. In a true free market there wouldn't be need for a Central Bank. Private banks would obtain capital and lend on their own accords. The setting of interest rates is just the supply and demand mechanism banks use in order to encourage people to either save with them, or borrow from them. If a bank has a lot of money in reserve then it lowers interest rates to increase demand for loans. If they have low reserves then they raise interest rates in order to encourage people to save and increase their capital base.

These aggressive cuts that we are witnessing bear no relation to the above supply demand dynamics detailed above. Many countries, in particular western nations, have pitiful low capital levels and huge levels of debts. What needs to be done is at least a stabilisation in interest rates, however an increase is required in order to incentivize people to save thus allowing banks to re-capitalise, capital based on human labour that has already been done. Debt is the modern Political-Monetary illusion of wealth, however its all a magic act with the money being taken from future human labour. Having a Central bank trying to set interest rates for the whole financial system is an crude instrument for influencing private institutions monetary policy, similar to the communist state planned centralised economy. It will always be inefficient.

Marx on Capitalism

Karl Marx, the most famous anti-Capitalist symbol in history, stated that sooner or later Capitalism would drown its markets in goods. It could only survive by continually cutting prices and real wages of the workers to below the point of subsistence. With markets ever expanding the Europeans would eventually branch into Asia, with ever more goods being produced but eventually the people of the world would revolt under these conditions and the global socialist system would emerge. So why has this not happened yet? One of the main flaws of a centralised state planned economy is its neglect of a suitable pricing mechanism.

The Capitalist Pricing Mechanism

Free market economics uses the basic premise of supply and demand to drive markets. This creates a pricing mechanism that is used to divert capital and labour to the required sectors of the economy in order to obtain economic efficiency. I'm not saying that capitalism is a fine tuned, super efficient economic model, far from it, I'm sure there is some economic model that has yet to be invented that is far more socially responsible. However for this reason a free market, operating under the direction of individuals and capital obtained from labour that has already been performed, induces a system of great productivity and material gains. This whole system relies on no monopoly and no centralised institution controlling a specific sector. Central Banks are a monopoly that prevent these very market forces. They prevent capital being used wisely and labour being re-deployed and used efficiently. Interest rates should always be driven by private institutions all in competition with one another, all responsible for their business actions, with no inflationary engine waiting in the background to bail them out or other businesses for their irresponsible decisions. Accountability has all but been ignored within finance recently as the bonuses were rewarded for short term decisions that were never beneficial to the bank and society.

Without a sufficient pricing mechanism Eastern Europe's Communist block collapsed as the planned state economy could not allocate resources efficiently. After the early illusionary productive gains obtained under the Stalinist Regime with the use of forced labour (the infamous Gulag camps) the economy began to collapse. The 1980's saw Mikhail Gorbachev introduce Perestroika, a policy to try and introduce a more efficient pricing mechanism, however it was too late as inflation and product shortages had become widespread.

The Capital of Asia

The IMF have recently begun to show the strain and how little capital they have. A world body that is supposed to ensure stability and provide capital for nations in need of it has now begun turning to the Japanese for money. They are increasingly seeking funds not from Western nations, but from Asian Nation states. The reality of the current situation in the global economy is the G7 and the IMF have very little capital. The real countries that hold the capital are now in Asia. An assumption that the West are the rich is simply not true the way things stand. Asian countries with savings rates of anything between 20% and 40% are now the people with capital, the west with negative savings rates are the ones who are now in poverty, relying on the external capital flows from Asia. It's only our high levels of debt, our old infrastructure that gives the illusion of wealth. Why do you think people were given 125% mortgages? Why do you think everything was on credit with no one saving? Why did you think people could buy a whole street of houses, with no money down, just the supposed capital gains of previous acquisitions? It wasn't because we had entered a new frontier of Western superiority. Asians were giving us their Capital. Capital that they obtained by expending human effort to produce goods for us to consume. They gave us more capital so that we could continue loading up with more debt and buy more goods from them and they further increased their capital reserves, buying bigger stakes in our economies. Now the global downturn has come, Asian economies are being hit more and more, and this 'agreement' above is beginning to break down. Capital, instead of going West is now in retreat back to China or Japan. This is what happens when you rely too much on foreign capital to fund your consumption. This is why in particular the US and the UK need savings. Tomorrow always comes and with it real problems.

Sterling Collapse?

One such country who was greatly reliant on external capital was Britain. It tapped foreigners for their capital and used London as the driver for this financial utopia. Britain has the second largest external liabilities behind the US. Recently the Shadow Chancellor George Osbourne has come out and said a future sterling collapse could occur due to the unfunded borrowing of the Labour government. What became interesting was the reaction his comments evoked. Rather than dismiss it, opposition politicians have labelled it as "irresponsible" or "dangerous". I thought our politicians were supposed to challenge and offer conflicting views. If there is a run on the pound, there will be a run on the pound not because of what one man said, but because of fundamentals relating to the UK economy. If they continue with inflationary policies, deficits continue rising with little internal savings as foreigners sell their pounds then a run seems likely.

Helicopter Ben

Ben Bernanke the current Chairman of Americas Central Bank has dedicated an academic life to the study on the causes of the Great Depression. Two of his economic heroes are Milton Friedman and the latters wife, Anna Schwartz, who some four decades ago co-authored a landmark book entitled "A Monetary History of the United States", on which he based a lot of his ideas regarding the Great Depression. In a recent interview that Anna Schwartz gave she said Ben Bernanke was getting Fed policy wrong and the problem does not lie with liquidity or money supply. It lies with the toxic securities that Wall Street has created. Her comments regarding these were,

"Because you cannot sell them, you don't know what they're worth, your balance sheet is not credible, and the whole market seizes up."

She went on and said that Paulson and Bernanke have now prolonged the crisis,

"They should not be recapitalizing firms that should be shut down ... Firms that made wrong decisions should fail."

Central Banks are just a monopoly, and just like any other monopoly are desperately inefficient. They create huge distortions during the boom and prolong the bust, punishing the prudent among us and propping up institutions that should be liquidated to create a more efficient economy. Capitalism's "Creative Destruction" has been replaced with "Monetary Creation". He still believes we had the Great Depression because the Central Bank didn't print enough money. The reason we had the Great Depression are the reasons given in the quotes above.

Weimar Germany

"I do not believe a word of the silly stories that the German Government could be so bold or so mad as to engineer on purpose what will in the end be a great catastrophe for their own people."

The most recent example in modern Western history of a nation experiencing serious inflation and its destructive effects was Weimar Germany just after the First World War. After incurring substantial debts during the war and the imposition of further debts by the victor nations, the Reichbank pursued inflationary policies through persistent trade and budget deficits and the increase of government spending. All the European countries incurred substantial debts during the First World War, Britain had debts amounting to 136% of GDP but Britain avoided hyperinflation. Inflation was high, running at around 22% but nothing like Germany which witnessed people wheelbarrowing worthless Marks to burn as a source of fuel. The currency was destroyed by irresponsible fiscal and monetary policies, Britain chose debt service, while Germany ramped up the printing presses. Just before hyperinflation became evident Germany experienced deflation, with inflation dropping to 2% with the Mark rallying, just before its spectacular collapse. I warned in one of my previous posts that the media and institutions would begin warning about the misconceived notion of the dangers of deflation, and we are beginning to hear more about it with Gordon Brown now mentioning it. Deflation is a natural function of a free market. We are not going to get a true deflationary bust that would happen in a truly free market as governments and Central Banks are now pursuing inflationist policies similar to the above, with economies that ill equipped to weather the storm.

One of the main causes for the rise of National Socialism and Adolf Hitler was the hyperinflation caused by Weimar Republic contrary to the conventional emphasis placed towards anti-semitism and First World War grievances. It destroyed peoples savings, capital that people had laboured for their whole life vanished in a matter of months. Whether any Western nation will experience hyperinflation remains to be seen and one hopes not, but as economies shrink, debt increases, trade collapses, deficits rise and more people claim benefits, we have the conditions for at best, mild inflation.

The quote given above is a comment made by economist John Maynard Keynes in November 1921, who was an advisor and influential figure towards German economic policy during those fateful post war years. A person whose inflationary economic theories have become biblical in recent decades.

The Last Bubble?

Western Government Bonds are shaping up to be the next bubble in a very long line of bubbles, from the Dot Com Stock Market bubble, to the Real Estate bubble now government debt is beginning its exponential climb upwards. However if this does become a bubble and bursts, its effects will be felt very quickly and violently in the nations it occurs in. If there are no buyers for government debt, then interest rate will have to rise in order to attract capital, how high it all depends on if investors think the government is solvent. For years the US has abused the Dollars status of world reserve currency, building up many enemies throughout the world through its Imperialist policies. From the teachings of Sun Tzu in China, to the chess culture of Russia, they are all waiting for their opponent to self destruct or make continued mistakes.

A Sound Currency

Money is not a new concept, it has been around for millennium used as a means of exchange between people, a store of human labour or something people value. Empires have come and gone along with currencies too, but there is one that has withstood the test of time. Gold. In our modern western culture it has been associated with extravagance with no intrinsic value, however when we step outside our conditioned frame of mind that has been shaped by the environment we have grown up in it becomes something different. If you took an ounce of gold a thousand years ago, to an ounce of gold now its purchasing power would be more or less the same. Gold is a rare metal that can't be printed out of thin air like banknotes can. That's why it has always held its value throughout time, throughout the world. Older generations always remark that a penny today isn't worth what it was 50 years ago, however people don't seem to realise that this is due to the inflationist policies of the people who regulate our currencies. The reason why we have more money then we did at any other time in history, is not due to the fact that everyone has become richer, its because more of it has been printed. This is why we always experience inflationary periods throughout life, market forces are always deflationary as economic efficiencies are made from capital that is re-invested. Its politically popular to increase the money supply, to give a short term illusion of wealth or to try and pay off excessive debts. People make statements asking why value is placed in an archaic metal such as Gold or Silver, but never ask the right question, why a set value is placed in a piece of paper with pictures on it. History has always shown precious metals to uphold their value as a store of human labour. All modern fiat currencies have shown persistent devaluation over time, especially when debt is as high as now.

Will it Work?

The favourite phrase in the media over the past year has been "Will it Work?". New policies are implemented with the same question repeated over and over again, now with interest rates falling we are told this is the latest silver bullet. The real question should be what are we trying to solve? The Credit Crunch isn't the problem, its the cure. Its brought about an end to reckless lending, a recapitalisation of banks, a break on consumption, the re-balancing of the economy, yet "remedies" to the credit crunch are formulated as though it is the problem. The patient is sick and just as the doctor was about to administer the medicine the "I know better" parent with no medical training stepped in to provide the "real cure". By delaying the treatment the patient becomes worse, until eventually the patient is no longer ill but becomes terminally ill, beyond help. The pricing mechanism for capital has been distorted by the Central Banks and Governments. The end result could be disaster for nations with little or no capital.

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