WEEKLY COMMENTARY

January 6, 2004

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FUNNY MONEY

By James R. Cook

"How do I know that hard times are coming? I know it because America and the dollar are slip-sliding into an ocean of debt and deficits. The banner of the U.S.’s economic system, the gauge of our success has been our currency, the dollar. Now the dollar is on a downward course. We’ve spent it. We’re drowning in a sea of debt. We’ve forgotten how to save. We’ve passively allowed our politicians to sell us out. We’ve allowed our currency to become irredeemable and intrinsically worthless.

"We’re living today on the kindness of our foreign creditors. They provide merchandise and services, and we pay for them with our junk currency. Then our creditors turn around and buy pieces of America with the junk dollars that they receive from us. It’s the dance of economic death. It’s a game played by a mad-nation, and it will end in a collapse of the dollar and hard times in America."

Inflating has never been more popular. In fact, inflating has become a desirable policy. After decades of censure, inflation is suddenly good. It’s hard not to like inflation. The expansion of money and credit seems to make all of our assets more valuable. At my fortieth class reunion a speaker told us that, since leaving school, we had lived through a "golden age." This "golden age" has also been the age of inflation. Not only have our homes jumped in value, but land, buildings, stocks, antiques, collectibles and art have all appreciated nicely and continue to climb. Furthermore, the banks will give us money for whatever we want to buy. It’s been a great life and the economic recovery we hear about only promises more prosperity. Who would argue against the Fed policies of low interest rates and easy money? Who doesn’t like a little inflation?

Today, the average Joe hears about the economic recovery and the benefits of low interest rates. The dollar’s fall has no noticeable impact. The daily newspaper is filled with optimistic economic reports and positive projections about the future. Who can doubt the wisdom of Mr. Greenspan and his associate, Mr. Bernanke, with their aggressively loose monetary policies? Inflating has gone mainstream, championed by Kudlow and Cramer, Wall Street and Washington. If there are dangers associated with it, who’s going to look that far? Who’s going to believe any negatives when stocks are going up? Hey, if it makes the stock market go up, it’s got to be good; end of story!

Nobody knows the future. Perhaps we can go on for decades more without tarnishing our "golden age." A few voices are heard that say we can’t. They argue that the game is over. If, by chance, they are right, then you should hear their case. Simply by knowing this counter-argument puts you among a tiny minority of Americans who understand that government economic policies have both short-term effects and long-term effects and everything is not always as it seems.

The great Austrian economist, Ludwig von Mises was the world’s greatest opponent of inflating. He argued that inflation was a policy that could not last. It must evolve into hyperinflation or a depression. "No inflation can go on forever," he said. "It must result in the total devaluation of the currency system if it is not stopped in time." He elaborated further, "Credit can easily be expanded and rates of interest temporarily lowered. However, the boom thus created cannot last. It must sooner or later result in a slump and depression with all their disastrous consequences."

Another Austrian economist of note, Hans Sennholz, had this to say. "It is not money, as is sometimes said, but the depreciation of money – the cruel and crafty destruction of money – that is the root of many evils. Inflation destroys individual thrift and self-reliance as it gradually erodes personal savings. It benefits debtors at the expense of creditors as it silently transfers wealth and income from the latter to the former. It generates the business cycles, the stop-and-go, boom-and-bust movements of business that inflict incalculable harm on millions of people. For money is not only the medium for virtually all economic exchanges, but also the very denominator of economic calculation. When money suffers depreciations and devaluations it invites government price and wage controls….. and many other governmental restrictions on individual activities. Monetary destruction breeds not only poverty and chaos, but also government tyranny. Few policies are more calculated to destroy the existing basis of a free society than the debauching of its currency. And few tasks, if any, are more important to the champion of freedom than creation of a sound monetary system."

Since 1997, the Greenspan Fed has pursued a policy of shocking monetary looseness. Our thirty-two trillion dollars of credit and debt now amounts to three times the size of the entire economy. Recently there’s been ten dollars of debt growth for every dollar of economic growth. Over the past five years, consumers have added $3.00 of debt for every $2.00 of income. In 2002, credit grew $2.3 trillion and the economy $375 billion. Outrageously large injections of money and credit verify that the size and scope of inflating exceeds anything in our history. Furthermore, this monetary prescription has lost its pizzazz. We need more and more credit to get less and less economic growth.

All this new money and credit translates into higher prices for homes and other assets. The rise in asset prices means there’s fresh collateral that can be financed and refinanced. This unleashes a fresh round of borrowing and spending. Inflation of asset values has morphed into an epic asset bubble, unprecedented leverage and dangerous financial instability.

Since the end of WW II, easy money and low interest rates have been responsible for periodically overheating the economy. When this boom caused prices to rise, interest rates were pushed up to cool off the economy and a recession began. Once the downturn started to hurt, the monetary authorities lowered rates and began inflating again. However, in the 2001 recession money and credit were looser than ever, and the slowdown still occurred. This forced the Fed to unleash even greater degrees of monetary ease via artificially low interest rates. Today it takes unprecedented levels of new money and credit to keep the economy from collapsing.

Where will it all end? Mises warned, "The longer inflation goes on the more detrimental becomes its inextricable evils, and the more difficult it is to stop it spontaneously." He added, "There is no means to make permanent a boom created by credit expansion and inflation."

"It is true," he said, "the banks (or the governments) are in a position to prolong the boom for some time by injecting progressively increasing quantities of bank notes and deposits into the market. But the artificially created prosperity cannot last forever. Sooner or later it must come to an end. There are only two alternatives:

1. The banks do not stop, and go on expanding credit at a progressively accelerated pace. But the spell of inflation breaks once the public has the conviction that the banks and the authorities are resolved not to stop. If no limit of the inflation and, consequently, of the general rise of prices can be foreseen, a general flight into real values [tangible assets] starts. Everybody becomes aware of the fact that to hold cash and deposit balances with the banks involves loss, and that he does better to buy and store goods. Everybody is anxious to get rid of money and to exchange it for some other commodities, no matter how much he must pay for them. Prices are running away, and the purchasing power of the monetary unit drops to zero. The national currency system cracks up.
2. As a rule, the banks do not let things go so far. They stop sooner by restricting credit. Then the day of reckoning dawns. The illusions disappear, people begin again to see reality as it is. The blunders committed in the boom become visible."

Unfortunately, the blunders and excesses of the monetary authorities today far exceed what Mises could have imagined. (He died in 1973.) He warned of a future crisis. "Only the acceptance of a rigid principle will prevent an unprecedented credit expansion and its unavoidable outcome, a slump more terrible than that of 1929." Unfortunately, to stop the credit expansion now would lead to economic anarchy as one failure led to another and cascading cross-defaults obliterated the dollar, feeding a panic, paralyzing the economy and engendering colossal finger-pointing.

Not that we don’t already have more than enough problems. Excessive monetary looseness, soaring indebtedness, paltry national savings, overconsumption, a runaway budget deficit, a soaring trade deficit (flooding the world with too many dollars) and anemic levels of production, business investments and profits, point to great dangers ahead. A falling dollar, with no room to raise interest rates and provide a decent return to dollar holders, spells more trouble for the buck. Already foreign capital inflows are falling sharply and the huge size of the currency markets makes government support more difficult.