Jan. 15, 2008
Crank Up The Printing Presses!
After several years of ominous but murky financial conditions, the last couple months have served to make the writing on the wall much clearer. With the US real estate market in freefall, large banks facing enormous losses which will force them into bankruptcy or restructuring, a rapidly depreciating currency, and debt, debt, debt as far as the eye can see, something has to give. Basically, the financial authorities are faced with two undesirable alternatives. The first is to let things take their natural course and tolerate a painful recession. The other option is to crank up the printing presses and flood the market with dollars.
In ordinary times, it is usually the case that tolerating a recession is the more prudent (but less politically popular) option. However, the current crisis is not a typical one, as more and more people are coming to realize. Given the extraordinary amount of leverage and debt that resulted from Alan Greenspan’s ruinous policies of the early part of this decade, the prudent course of “taking our medicine” may simply not be a viable option. In past business cycles, it was possible to allow a recession to run its course, punishing the most imprudent market participants without threatening the foundations of the “blue chip” institutional players. However, this time around the blue chips themselves are in danger of collapse. The incredibly complex web of indebtedness is such that once the process of reckoning begins, there may be no effective “fire-wall” to prevent the decimation of the entire financial system. That being the case, the other alternative may be the only real option, and recent policy moves seem to indicate that the government and the Fed realize this.
A big part of the problem lies in our collective lack of understanding of the nature of money itself. The relative stability of the US dollar over the past 60 years has served to obscure the fact that few people really understand what money is. We use phrases such as “medium of exchange” or “store of value”, but do we really understand what we mean by such terms? If money is a “store of value”, how much value is stored in one dollar? The US government decrees that its currency is “legal tender for all debts public or private”, but it doesn’t tell us how much a unit of currency is actually worth. And, since money has had no “intrinsic value”, why are we all willing to give goods and services in exchange for these worthless pieces of paper? The best answer I am aware of is that we do so because everyone else does. Money, therefore, essentially boils down to a collective leap-of-faith that we all subscribe to because it benefits us to do so. However, it is important to keep all of this in mind and to never allow force of habit to prevent us from being aware of the true nature of money.
The ability of paper currency to serve its purpose is therefore predicated upon two basic requirements. First of all, everyone has to agree to use the officially designated currency as the primary medium of exchange. Secondly, whoever has the task of regulating the quantity of currency must do so in a way that keeps the purchasing power of money relatively stable. The first of these requirements is straightforward and comprehensible to virtually everyone. The second, however, is incredibly complex, and it is debatable whether anyone completely understands it. As a result, the realm of monetary policy presents endless possibilities for manipulation and deception. We are currently witnessing the consequences of decades of abuse on the part of the authorities and ignorance on the part of the general public.
The magnitude of the monetary system is so far beyond the comprehension of the average citizen that the authorities are free to tell us anything they think we’re likely to believe, regardless of whether or not it makes real sense. As John Maynard Keynes observed during the financial devastation following World War I, “the vast expenditures of the war, the inflation of prices, and the depreciation of currency, leading up to a complete instability of the unit of value, have made us lose all sense of number and magnitude in matters of finance. What we believed to be the limits of possibility have been so enormously exceeded, and those who founded their expectations on the past have been so often wrong, that the man in the street is now prepared to believe anything which is told him with some show of authority, and the larger the figure the more readily he swallows it.”
These episodes of collective delusion, however, cannot last forever. Even if we don’t understand what we’re doing, financial realities are inexorable. For example, it was possible for many people to believe that by using subprime mortgages they could “save” thousands of dollars and that they could thereby “afford” to buy houses that cost twice as much as what they could afford using standard mortgages. Their belief was the reason why so many people were willing to agree to such perilous financial terms. However, their belief does nothing to change the fact that they are indebted beyond any possibility of repayment. And, the same applies to matters of government finance, although the magnitude and duration of the episodes of delusion can greatly exceed those of individuals.
Does anyone really understand what it means that our national debt is $9 trillion? Does anyone understand the financial consequences of spending over $1 trillion on an unproductive war? Probably not, but that does nothing to change the inevitable financial consequences of such unbridled profligacy.
So, where do we go from here? If my initial analysis was correct, we may already be beyond the point at which “taking our medicine” (in the form of a traditional recession) is even an option. The other alternative is to allow the currency to completely collapse. Inflation of the currency is a windfall for anyone who owes money, since the money they use to repay the loan is worth far less than the money they borrowed. And, since the whole world has been willing to lend money indiscriminately to American government, corporations, and individuals, we are now in a position where the only course available to us (given that we can never hope to repay what we owe) is to deliberately destroy the value of the unit in which our debts are denominated. Of course, this approach doesn’t come without significant costs. For starters, anyone who has acted responsibly and foregone current consumption in order to save will see their hard-earned savings rendered worthless. Additionally, our ability to access credit in the future will be greatly diminished. Nevertheless, if the only other alternative is a complete collapse of our economy, this course may indeed prove to be the lesser evil.
As for what might come after a dollar collapse, it is beyond my ability to say with any certainty. For one thing, I believe it is possible that within the next decade the US dollar may cease to exist and be replaced with a new currency (a la Germany in the 1920s). While this may seem far-fetched to people who have lived their whole lives convinced of the absolute solidity of the dollar, historical precedent argues otherwise. To return to Keynes, a man who understood monetary issues as well as anyone in history, “there is no record of a prolonged war or a great social upheaval which has not been accompanied by a change in the legal tender, but an almost unbroken chronicle in every country which has a history, back to the earliest dawn of economic record, of a progressive deterioration in the real value of the successive legal tenders which have represented money… The creation of legal tender has been and is a Government’s ultimate reserve, and no State or Government is likely to decree its own bankruptcy or its own downfall so long as this instrument lies at hand unused.”