And the greatest trick that central bankers ever pulled was convincing the world they were necessary. From our 2016 book, ‘Investing Through the Looking Glass’:
“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
– James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014.
“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
– Jens O. Parsson, ‘Dying of money: Lessons of the great German and American inflations’.
“I had this nightmare that the economy was run by micromanaging Econ professors, who worked for the big banks & had no real-world experience.”
– Tweet by Rudolph E. Havenstein (@RudyHavenstein).
The delusion:
Central banks are required to fight inflation and protect against financial instability.
The reality:
Central banks themselves are the primary cause of both inflation and financial instability.
Central banks have historically been born of a need to raise finance for the governments they serve. Although the Bank of England, for example, claims that its “mission is to promote the good of the people of the United Kingdom by maintaining monetary and financial stability”, it was not set up to “promote the good of the people”. When it was established in 1694 – the same year that the Scots set in progress the first slow motion train wreck of RBS – the Bank of England was created explicitly to fund the government of the day, and that remains its primary role. The same holds for the Swedish National Bank, the Sveriges Riksbank, which was established in 1668 and which is the world’s oldest central bank. Over time, each central bank has typically been given control over the management of its State’s currency, money supply and interest rates. In many cases they have gone on to take a supervisory and regulatory role over the commercial banking system and acted, in times of crisis, as lender of last resort to troubled banks. Both the Bank of England and the Swedish National Bank have, over the passage of time, ceded primacy in international monetary affairs to the US Federal Reserve, ‘the Fed’. Yet the Fed’s conflicted origins are murkier than either of them.
G. Edward Griffin in his book ‘The Creature from Jekyll Island’ explains how the US Federal Reserve was conceived.
On a cold November night in 1910, a handful of financiers boarded a private railway car in conditions of extreme secrecy at the New Jersey railway station. The passengers included the Republican “whip” in the Senate and a business associate of the banker J.P. Morgan; the Assistant Secretary of the US Treasury; the president of the National City Bank of New York, the most powerful bank of the time; a senior partner of the J.P. Morgan Company; the head of J.P. Morgan’s Bankers Trust Company; and a representative of the Rothschild banking dynasty in England and France. In other words, of the six passengers, five of them were representatives of private banks.
Those financiers would go on to meet in secret at a hideaway owned by J.P. Morgan and several of his business associates, where visitors would gather in the winter to hunt ducks or deer. The name of this remote retreat: Jekyll Island.
This group met in order to tackle five pressing issues:
1. How to reverse the growing influence of small commercial banking rivals and concentrate financial power amongst themselves;
2. How to allow the money supply to expand so that they could retake control of the industrial loan market;
3. How to consolidate the modest reserves of the country’s banks into one large reserve and standardize each bank’s loan-to-deposit ratios, thus protecting themselves from the possibility of bank runs;
4. How to shift any ultimate losses incurred by the banks onto the taxpayers instead;
5. How to convince the US government that the scheme was established to protect the public – as opposed to protecting the interests of a private banking cartel.
Perhaps most cynically of all, to address this fifth problem, the group decided to adopt the structure of a central bank and furthermore, ditch the use of the word bank altogether, in favour of a coinage that would evoke the image of the federal government instead. Three years later, after the passing of the resultant bill in Congress on December 23, 1913, the US Federal Reserve was born.
“The Federal Reserve System,” it today proudly tells us, “is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.”
Few could deny the latter point. Rather than maintain a narrow focus on managing the money supply, the Fed is now figuratively all over the shop, its fingerprints evident everywhere across the economy. Financial author and analyst James Grant:
“The Fed insists on saving us from ‘everyday low prices’ – they call it deflation. I submit that in a world of technological wonder, prices ought to be weakening: it costs less to buy things because it costs less to make them. This benign tendency the Fed resists at every turn. It wants the price level (as it defines it) to rise by two percent a year, plus or minus. In so doing, it creates redundant credit that finds its way into other things. These excess dollars do mischief. On Wall Street we call this mischief a bull market and we’re generally all in favour of it.. The Fed, in substance if not in name, is [still] engaged in a massive experiment in price control. (They don’t call it that.) But they fix the Fed Funds rate, they manipulate the yield curve.. they talk up the stock market. They have their fingers and their thumbs on the scale of finance. To change the metaphor, we all live to a degree in a valuation ‘hall of mirrors’. Who knows what value is when the Fed fixes the determining interest rate at zero ? So I said “experiment in price control” but there is no real suspense about how price control turns out. It turns out, invariably, badly.”
..In the words of Detlev Schlichter, “The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.”
Since President Nixon took the US dollar off gold in 1971, we have had five decades of unbacked, state money, globally. (There may yet not be a complete sixth.) Governments have reacted to this new-found monetary freedom precisely as you would expect. We have had limitless money creation, limitless bank credit creation, limitless deficit spending. Until now.
In the United States, total credit market debt has doubled five times over the course of four decades. Everything that we know about the economy’s behaviour was learned during a period when credit doubled, on average, every 30 quarters. Every dollar that circulates in the US was loaned into existence by a bank, with interest. The interest can only be paid from further loans. Every year, the money supply must expand by an amount at least equal to the interest charges on all past money borrowed into existence, or the banking system will start to display extreme stress.
Our debt-based monetary system has a fatal flaw. As debts are created through loan origination, additional obligations arise in the form of interest payments. As a result, there can never be enough money to service debt obligations unless the stock of debt is continually expanded. When the costs of interest payments exceed growth in debt, marginal debtors can no longer afford to maintain their debt payments, and must begin liquidating.
The system reaches its terminal point when new debt creation fails to match existing interest charges. As soon as that point is reached, defaults will spiral through the system. Which is why the world’s central banks are doing everything in their power to keep the debt creation bandwagon on the road.
Why is this process destined to fail? Because nothing can expand forever. Money and debt have been growing at exponential rates, but they cannot do so indefinitely. The system can only hold together with perpetual economic growth. The last four decades of debt accumulation are not the steps towards some form of equilibrium, but rather the calm before the storm; progress towards huge disequilibrium. A lot of what we think of as wealth is going to vanish. Claims upon it are too numerous and future growth is almost destined to disappoint.
—
We have no dog in the bond market fight. We have no meaningful exposure to government debt, but neither do we have any direct short exposure to the asset class, either. We would rather simply avoid the inevitable storms to come. We intend to do that by favouring tangible, real assets – notably the shares of listed companies run by principled, shareholder-friendly entrepreneurs, where we can obtain those shares cheaply, and where those companies generate significant cash flow whilst maintaining insignificant levels of debt. We seek exposure to profitable businesses contributing to the real economy – as opposed to the dead hand of debt that is strangling much of the real economy, especially in the form of the Big State.
‘The Usual Suspects’ owes its title to another film altogether, namely to Warner Brothers’ evergreen ‘Casablanca’. With one of ‘Casablanca’s more memorable lines, Captain Louis Renault (Claude Rains) responds to the shooting of the German Major Strasser by ordering his men to “round up the usual suspects”. But it is another of Captain Renault’s lines that has become arguably more iconic still. Announcing the closure of Rick’s casino, even as he pockets his winnings, Renault shamelessly announces, “I’m shocked, shocked to find that gambling is going on here !”
As participants in the capital markets, we are not so shocked. We will be less shocked still when the current central banking game comes to an entirely predictable but nonetheless chaotic end.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you, too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Get your Free
financial review
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
And the greatest trick that central bankers ever pulled was convincing the world they were necessary. From our 2016 book, ‘Investing Through the Looking Glass’:
“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
– James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014.
“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
– Jens O. Parsson, ‘Dying of money: Lessons of the great German and American inflations’.
“I had this nightmare that the economy was run by micromanaging Econ professors, who worked for the big banks & had no real-world experience.”
– Tweet by Rudolph E. Havenstein (@RudyHavenstein).
The delusion:
Central banks are required to fight inflation and protect against financial instability.
The reality:
Central banks themselves are the primary cause of both inflation and financial instability.
Central banks have historically been born of a need to raise finance for the governments they serve. Although the Bank of England, for example, claims that its “mission is to promote the good of the people of the United Kingdom by maintaining monetary and financial stability”, it was not set up to “promote the good of the people”. When it was established in 1694 – the same year that the Scots set in progress the first slow motion train wreck of RBS – the Bank of England was created explicitly to fund the government of the day, and that remains its primary role. The same holds for the Swedish National Bank, the Sveriges Riksbank, which was established in 1668 and which is the world’s oldest central bank. Over time, each central bank has typically been given control over the management of its State’s currency, money supply and interest rates. In many cases they have gone on to take a supervisory and regulatory role over the commercial banking system and acted, in times of crisis, as lender of last resort to troubled banks. Both the Bank of England and the Swedish National Bank have, over the passage of time, ceded primacy in international monetary affairs to the US Federal Reserve, ‘the Fed’. Yet the Fed’s conflicted origins are murkier than either of them.
G. Edward Griffin in his book ‘The Creature from Jekyll Island’ explains how the US Federal Reserve was conceived.
On a cold November night in 1910, a handful of financiers boarded a private railway car in conditions of extreme secrecy at the New Jersey railway station. The passengers included the Republican “whip” in the Senate and a business associate of the banker J.P. Morgan; the Assistant Secretary of the US Treasury; the president of the National City Bank of New York, the most powerful bank of the time; a senior partner of the J.P. Morgan Company; the head of J.P. Morgan’s Bankers Trust Company; and a representative of the Rothschild banking dynasty in England and France. In other words, of the six passengers, five of them were representatives of private banks.
Those financiers would go on to meet in secret at a hideaway owned by J.P. Morgan and several of his business associates, where visitors would gather in the winter to hunt ducks or deer. The name of this remote retreat: Jekyll Island.
This group met in order to tackle five pressing issues:
1. How to reverse the growing influence of small commercial banking rivals and concentrate financial power amongst themselves;
2. How to allow the money supply to expand so that they could retake control of the industrial loan market;
3. How to consolidate the modest reserves of the country’s banks into one large reserve and standardize each bank’s loan-to-deposit ratios, thus protecting themselves from the possibility of bank runs;
4. How to shift any ultimate losses incurred by the banks onto the taxpayers instead;
5. How to convince the US government that the scheme was established to protect the public – as opposed to protecting the interests of a private banking cartel.
Perhaps most cynically of all, to address this fifth problem, the group decided to adopt the structure of a central bank and furthermore, ditch the use of the word bank altogether, in favour of a coinage that would evoke the image of the federal government instead. Three years later, after the passing of the resultant bill in Congress on December 23, 1913, the US Federal Reserve was born.
“The Federal Reserve System,” it today proudly tells us, “is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.”
Few could deny the latter point. Rather than maintain a narrow focus on managing the money supply, the Fed is now figuratively all over the shop, its fingerprints evident everywhere across the economy. Financial author and analyst James Grant:
“The Fed insists on saving us from ‘everyday low prices’ – they call it deflation. I submit that in a world of technological wonder, prices ought to be weakening: it costs less to buy things because it costs less to make them. This benign tendency the Fed resists at every turn. It wants the price level (as it defines it) to rise by two percent a year, plus or minus. In so doing, it creates redundant credit that finds its way into other things. These excess dollars do mischief. On Wall Street we call this mischief a bull market and we’re generally all in favour of it.. The Fed, in substance if not in name, is [still] engaged in a massive experiment in price control. (They don’t call it that.) But they fix the Fed Funds rate, they manipulate the yield curve.. they talk up the stock market. They have their fingers and their thumbs on the scale of finance. To change the metaphor, we all live to a degree in a valuation ‘hall of mirrors’. Who knows what value is when the Fed fixes the determining interest rate at zero ? So I said “experiment in price control” but there is no real suspense about how price control turns out. It turns out, invariably, badly.”
..In the words of Detlev Schlichter, “The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.”
Since President Nixon took the US dollar off gold in 1971, we have had five decades of unbacked, state money, globally. (There may yet not be a complete sixth.) Governments have reacted to this new-found monetary freedom precisely as you would expect. We have had limitless money creation, limitless bank credit creation, limitless deficit spending. Until now.
In the United States, total credit market debt has doubled five times over the course of four decades. Everything that we know about the economy’s behaviour was learned during a period when credit doubled, on average, every 30 quarters. Every dollar that circulates in the US was loaned into existence by a bank, with interest. The interest can only be paid from further loans. Every year, the money supply must expand by an amount at least equal to the interest charges on all past money borrowed into existence, or the banking system will start to display extreme stress.
Our debt-based monetary system has a fatal flaw. As debts are created through loan origination, additional obligations arise in the form of interest payments. As a result, there can never be enough money to service debt obligations unless the stock of debt is continually expanded. When the costs of interest payments exceed growth in debt, marginal debtors can no longer afford to maintain their debt payments, and must begin liquidating.
The system reaches its terminal point when new debt creation fails to match existing interest charges. As soon as that point is reached, defaults will spiral through the system. Which is why the world’s central banks are doing everything in their power to keep the debt creation bandwagon on the road.
Why is this process destined to fail? Because nothing can expand forever. Money and debt have been growing at exponential rates, but they cannot do so indefinitely. The system can only hold together with perpetual economic growth. The last four decades of debt accumulation are not the steps towards some form of equilibrium, but rather the calm before the storm; progress towards huge disequilibrium. A lot of what we think of as wealth is going to vanish. Claims upon it are too numerous and future growth is almost destined to disappoint.
—
We have no dog in the bond market fight. We have no meaningful exposure to government debt, but neither do we have any direct short exposure to the asset class, either. We would rather simply avoid the inevitable storms to come. We intend to do that by favouring tangible, real assets – notably the shares of listed companies run by principled, shareholder-friendly entrepreneurs, where we can obtain those shares cheaply, and where those companies generate significant cash flow whilst maintaining insignificant levels of debt. We seek exposure to profitable businesses contributing to the real economy – as opposed to the dead hand of debt that is strangling much of the real economy, especially in the form of the Big State.
‘The Usual Suspects’ owes its title to another film altogether, namely to Warner Brothers’ evergreen ‘Casablanca’. With one of ‘Casablanca’s more memorable lines, Captain Louis Renault (Claude Rains) responds to the shooting of the German Major Strasser by ordering his men to “round up the usual suspects”. But it is another of Captain Renault’s lines that has become arguably more iconic still. Announcing the closure of Rick’s casino, even as he pockets his winnings, Renault shamelessly announces, “I’m shocked, shocked to find that gambling is going on here !”
As participants in the capital markets, we are not so shocked. We will be less shocked still when the current central banking game comes to an entirely predictable but nonetheless chaotic end.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you, too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Get your Free
financial review
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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