Batten the hatches and blame the banks

The recent collapse of a major US investment bank, Bear Stearns, is evidence that the world economy may be sailing into a gale. Earlier this week the head of the International Monetary Fund, Dominique Strauss-Kahn, told a conference that "The financial crisis which started in the United States is more serious and more global than it was a few weeks ago. The risks and dangers are very high. The economic environment is still worsening."

If a storm lies ahead, it will certainly test the seaworthiness of competing theories of economic thought. Here we feature an analysis by Finnish economist Oskari Juurikkala, who presents a radical perspective. (The views are those of the author,
not MercatorNet, which is open to a range of interpretations.)

The global financial crisis is rapidly moving ahead. Be not surprised, this was foreseen by many a long time ago. What is also going to happen is quite certain, as the Ben Bernanke-led US Federal Reserve has been open about its strategy: use all means possible to save the banks, regardless of what happens to the dollar.

I am not sure if this is a viable remedy, given the magnitude of the problem. If the dollar is dumped, its declining exchange rate will exacerbate price inflation in the US and cause a downward spiral of crisis and deep depression.

But more importantly: Is the Fed’s strategy even basically just?

It may seem as if it is the exclusive business of politicians and central bank wizards to determine the right monetary policy. Monetary policy is, after all, a complex science that is far beyond the comprehension of us ordinary people.

Nothing could be further from the truth. For one thing, it is not their money -- it is ours. It is ordinary people who suffer when governments and central banks bail out failing banks (which, by the way, made big bucks taking all those risks). Secondly, monetary policy is really not all that complicated.

Printing-presses and counterfeit money

When a central bank lowers interest rates, it engages in an activity that is not morally neutral. News reports often fail to convey what is going on. Lower interest rates are achieved, effectively, by increasing the money supply. In other words, it is achieved by printing money "out of thin air" and selling it inexpensively to banks.

If it still doesn’t sound morally dubious, consider doing it yourself. Go on, be a tiger: buy a printing press, and print a couple of US dollars, a handful of Euros, a pile of Swiss Francs, and finally a bag of Yen. That’s called fraud.

What does counterfeit money do? Clearly, it enriches the counterfeiter, who can purchase real goods and services with the newly acquired dosh. Does it increase the amount of real goods and services? The answer is simple: No. By creating new money, no economic resources are generated in the process.

But someone has to pay for the profit of the fraudster, and this is the rest of the people. The purchasing power of their money balances is eroded, often without them ever realizing why it happened. Thus monetary inflation redistributes wealth. By how much, depends on how much inflation. In Mugabe’s Zimbabwe, annual price inflation hit 1000% a while ago -– I doubt they are counting any longer.

Public goods, private goods

If monetary policy is so simple, why is there so much fuss about it? For one thing, it is complicated, too. Moreover, there are usually some who benefit from the arrangement. Often, as in the case of Zimbabwe, it seems to be the government that benefits. This was also the case in ancient Rome, which tried to cover its deepening financial difficulties by clipping coins and debasing the metal. Over time, this led to hyperinflation, which according to some commentators was the main factor that destroyed the empire. By year 270 AD, a silver denarius only contained 0.02% silver. Soldiers rebelled and no longer accepted payment in Caesar’s money.

Other times, the government is more of a minority partner in the deal. It is news to many an economics student that, historically, most central banks were private entities serving the private interests of the financial sector. Historically, most central banks were once private corporations. The Bank of England was founded as such in 1694, and was only nationalized in 1946. The US Federal Reserve System was founded in 1913 as a legal hybrid, which however is considered by many as a private corporation. It is formally owned by its member banks, about whose owners little is known. As a special privilege, the Fed has never undergone a complete independent audit, and it is claimed that it keeps some of its records secret.

Causing bubbles

Monetary policy claimed to serve worthy goals, such as high employment, price stability, and economic growth. That may be so. But it is doubtful. It is now widely accepted that price inflation is predominantly caused by the expansion of the money supply, which is caused by the central bank. As more money enters the market through private hands, the value of each unit is diluted.

As to economic growth, it is true that inflationary monetary policy can stimulate economic activity -– but only for the short term. This is the argument of supporters of the Austrian school of economics such as Ludwig von Mises and the Nobel Prize-winning F. A. Hayek. By intervening in financial markets, monetary policy artificially lowers interest rates below their market rates. This encourages investment and consumption bubbles, such as the bubble of late 1990s and the real estate and overconsumption bubble in recent years.

We know that all bubbles must come to an end. What is more, the effects are destructive both economically and socially. Workers must be laid off, investments liquidated at low prices, and houses sold. Yet there are some who benefit: those who know what is going on and are able to ride the wave in both directions -– up and down.

Lessons from banking history

Debasement of money has been a temptation throughout the history of money. On top of that, there is so-called fractional-reserve banking, which refers to the use of demand deposit money in the bank’s lending business. Banks borrow funds from their depositors and lend those funds to the banks’ borrowers. They make their money by charging borrowers a higher interest rate than they pay depositors for use of their money. Many economists, including Milton Friedman and others at the University of Chicago in the 1950s have identified it as the source of banking instability throughout modern times.

Fractional-reserve banking was censured already by Roman jurists, who thought it dishonest and legally unsound. Yet modern scholarship shows that it was precisely this instability that provided the justification for inflationary central banking.

Interestingly, the struggle for sound monetary practices is anything but new. The Romans knew all about it. It was constant in Medieval Europe. The French especially experienced the bitterness of unsound banking in the 19th century. It was also present in the United States from the very beginning, as the letters of Jefferson reveal. For example, Jefferson noted the consequences of paper money in a letter to Josephus B. Stuart: "That paper money has some advantages is admitted. But that its abuses also are inevitable and, by breaking up the measure of value, makes a lottery of all private property, cannot be denied" (1817).

In another letter, to John Taylor, he identified the problem with unsound banking: "I sincerely believe... that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale" (1816).

They were courageous words then, and they are so today, as we watch the dramatic consequences of unsound financial practices reveal themselves in slow motion.

Trained in economics and law, Oskari Juurikkala works in mining and finance. He is also consultant with Ansgar Economics and founding editor of, the leading precious metals website in Finland.


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