The Fed’s Bubbles Destroy Capital

In ancient times, people hoarded whatever they could. Salt, and later silver, worked well because they are nonperishable, widely accepted in trade, and easy to store. People accumulated stockpiles, buying a little at a time. Then in retirement, they sold some each week to pay for food and other expenses.

Hoarding works, though there is a major drawback. You can never be sure that you have enough. You can outlive your savings. To try to avoid this disaster, you have to spend as little as possible. Neither the worry, nor the austerity, make for much fun in your golden years.

People eventually discovered a better way. Lending is a win-win deal that makes life a whole lot better. A business needs capital to increase production. It borrows money, and in exchange offers to share some of its new profit with the lender. The lender is a saver or retiree who is glad to put his money to work. He is earning money on his money—interest. Interest greatly accelerates wealth accumulation during his working years. Interest allows him to live in retirement, without literally eating his capital.

It is impossible to overstate the importance of interest. It literally built our civilization. From the voyages that discovered and colonized the New World to the industrial revolution to the large manufacturers in the 20th century, there is one thing in common. They would have been impossible without raising capital. This capital was invested to obtain a return.

Unfortunately, the Fed has been waging a war on interest for decades, pushing it down. Now the interest rate is nearly zero. The Fed’s economists tell us that this somehow helps employment. It doesn’t, but it does inflict collateral damage.

For instance, it harms the saver. Zero interest drags down his rate of capital accumulation. At least the saver is still working, but those who can no longer work are even more vulnerable. Economist John Maynard Keynes called for the “euthanasia”—his term—of those who depend on fixed income, like retirees.

Having one’s income cut off can feel like being strangled. Most people won’t sit there passively. If they can’t earn interest, then they turn to an alternative. They’re forced to speculate. This creates bubbles—rising asset prices—like real estate in the 2000’s. There’s always a good bubble inflating somewhere, and people pile in.

Bubbles

Bubbles (Photo credit: pedrosek)

Bubbles pop and speculators take big losses. However, there’s an even more important, but subtler, point. An entire generation can’t pay for retirement by speculating their way to wealth. Let’s look at why not.

Bubbles do not produce new goods and services. They don’t create new wealth. For example, there was a copper bubble from 2009 to 2011. The price of copper more than tripled from $1.40 a pound to $4.60. Lots of people bet on it.

Consider the fictional case of Joe, who bought $100,000 worth of copper. A few months later, he sold some. He took a profit, yet he still has $100,000 worth of metal.

There is an old saying that you can’t have your cake and eat it too. And yet here’s Joe, who still has his money and he bought a motorcycle also.

It’s not possible to consume without producing. Yet, while Joe’s copper wager produced nothing new, he consumed the bike. Logically, if Joe did not consume new production then he must be consuming old production.

Joe consumed part of his savings.

Joe doesn’t see the loss, because he is only thinking in dollars. Instead of looking at the trade in terms of paper, let’s focus on the loss of metal. Joe starts out with 15 tonnes of metal. He sells four to buy that new Harley, and has 11 left. Joe spent a big chunk of his copper, and now he has less.

Most people don’t want to eat their capital. However, in a bubble they’re tricked. They think copper went up, but it’s just a mirage. In reality, the copper only went out—out the door. Now it’s gone.

Speculating may seem similar to earning interest, but it achieves the opposite result. Interest creates new income by financing new production. Speculative gains come from paying out existing capital as income, and consuming it. We are all harmed by this destruction.

Interest rate suppression undermines our civilization. It destroys the capital on which it depends.

 

Keith Weiner is president of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of the precious metals fund manager Monetary Metals. He created DiamondWare, a technology company that he sold to Nortel Networks in 2008. He has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona. In March 2015 he moved his Gold Standard column from Forbes to SNBCHF.com.
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  1. Dana Carlton Robinson

    How Negative Real Interest Rates Are Destroying America’s Economy and Crushing the American Middle Class

    Gather ten of your Keynesian friends around a dinner table and ask them to raise their hands if they are willing to spend more than they currently spend if you give $1 million dollars of newly printed money, or $1 million of newly available free credit to each participant. All 10 hands would be raised, as most humans have a propensity to consume far in excess of that which their effort in life permits. Then ask all ten how many are willing to produce more … you know, work longer hours, learn how to work more productively, perhaps by gaining access to better capital goods. Likely no hands will be raised, as most people believe they already work too hard, and have too little leisure time. The few exceptions to that outcome would be those hardworking folks who the current system has left behind with its misguided monetary and fiscal policies, and if we don’t see the destruction these policies are producing the numbers of those left behind will do nothing but increase on a secular basis.

    Production of goods or services, which improves standard of living, is difficult. Consumption of goods and services using “money”, credit, or debt conjured out of nothing is effortless.

    Keynesian economists’ focus on consumer demand is the chief error. There is no such thing as deficient demand … though there is such a thing as deficient demand at the current price structure. Our refusal to allow prices to correct to equilibrium levels … a price level determined by the pool of real savings in the world … not the level of bubble “financial savings” created by central banks … and not a price level determined by incremental accumulation of unpayable debt at negative real interest rates … is the reason for the current financial chaos we see everywhere.

    Humans have limitless demand, as is evidenced by the white-hot demand for $20 million apartments in New York City and elsewhere. It is the ability to produce them that is the difficult part. Otherwise we’d all live in them, or someplace similarly spectacular. The price structure of everything has been distorted to Frankenstein proportions by the world’s central bankers. Businessmen around the globe are increasingly reluctant to deploy real capital, or at least non-borrowed capital, in an environment where future costs and future revenues are wildly uncertain. This bodes ill for near-term real economic activity.

    The Federal Reserve’s imposition of negative real interest rates on the American economy, designed ostensibly to aid it, is in actuality destroying it. As human beings, we all have a propensity to live for the moment, consume whatever is available to us in the present, and leave the future to “fate”. We have to be taught by our learned elders that to improve one’s destiny in life requires deferring consumption today, enabling the resources not consumed today to be deployed into capital investment. Capital investment increases humans’ productivity, enabling more output with fewer inputs, and thus a better standard of living. But if all resources are devoted to satisfying immediate consumption desires there are no resources available for investments whose benefits will be accrued in the future. Sure, in the near-term it feels good as all resources are shifted to satisfy immediate consumption, as short-term consumption is lifted. However, soon the existing plants, machinery, and other capital goods which are key to the production of many things we consume wears out or suffers from obsolescence, and when not replaced our standard of living declines until the incentives to look out for the future are reinstated.

    A positive real interest rate is the bedrock reward for deferring immediate consumption. It says to those willing to forego immediate gratification that you will be better off in the future as a result of sacrificing in the present. In other words, your ability to consume in the future will be greater as a result of your willingness to deploy resources towards capital and away from consumption in the present. Negative real interest rates state emphatically that the exact opposite will befall those “foolish” enough to produce more than they consume. Every year part of your deferred consumption, otherwise known as your savings, will be confiscated from you, in that the amount of your future consumption possible from your savings declines annually. From December of 2008, when the Federal Reserve lowered the target Fed Funds Rate to 0.0-0.25%, until June 2015 the U.S. CPI has increased 12.5%. Under the assumption that the U.S. CPI is accurate, despite the fact all governments with debt outstanding have incentives to understate true inflation, one eighth of savers’ deferred consumption has been confiscated by the Federal Reserve with its zero percent interest rate policies.

    The negative incentives to savers from this experience alone would be bad enough for the economy and our future standards of living, but there is a far more pernicious effect of negative real interest rates. That is the incentives it provides for those with a propensity to consume far in excess of what they produce to borrow at a negative real cost to them, and consume everything which printed money or free credit can provide, transferring more and more of the economic output of America to a narrow slice of the population with access to negative real cost credit. We see this literally everywhere today, as access to money or credit at a negative real cost has caused the prices of every financial instrument and every tangible item traditionally bought with credit to soar far above equilibrium, market-based levels. If you own or control a significant amount of these “assets’, the economic pie is shifted to you, without any additional effort or savings on your part. But if your savings are confined to bank accounts, or your future pension is backed by fixed income instruments yielding a negative real interest rate, or you have no savings as you’re struggling to keep your head above water, or your children have poor job prospects after exiting from debt-financed higher education, you and your family are losing ground every year. And the pernicious incentives have gotten so bad, both your share of, and the total economic pie itself, are likely now shrinking.

    And the topper of all the bad effects of negative real interest rates is the incentive to speculate wildly with borrowed money. As long as real interest rates stay negative, and speculators deploy the borrowed funds in areas which those with greatest access to negative real interest rate money are chasing, they win while risking none of their own excess production over consumption, i.e. their own savings. The hyperinflation which conventional economists fail to see is readily visible in securities prices, and this hyperinflation’s distributional effects are no less pernicious than a more “typical” consumer price hyperinflation, as it transfers all wealth to owners of the inflating entity while impoverishing those devoid of such “assets”. However, all who have observed centuries of financial history know this game must end, as much of society revolts long before 100% of the economic pie is transferred to the 0.1% with unlimited access to negative real interest cost money. Iceland, Ireland, Greece, Ukraine, Venezuela, Japan, Spain, and Portugal are just some of the nations who have thought that negative real interest rate borrowing was the road to prosperity, and all are suffering mightily today as a result. In many of these nations unemployment rates are at depression-era levels, hopeless youth populations abound, and middle class incomes have collapsed, all while the money-printers and their associates in the finance/banking realm grab more of a shrinking economic pie. If that doesn’t get the masses riled up, not much else likely will.

    The U.S. experience with negative real rates from 2001-2006, and the subsequent collapse of financial and real estate markets in 2008, should have been a wakeup call for the dangers of negative real interest rates. However, the solution to the recession was mistakenly believed to be greater negative real rates for a much longer duration. We have now entered a roach motel from which there is no easy exit, but certain demise if we stay where we are.

    The Federal Reserve orchestrates negative real rates by purchasing U.S. Treasury securities and government-guaranteed mortgage-backed securities, paying for them with newly created Fed funds, otherwise known as base money, and driving those securities prices higher. Fed funds currently yield 25 basis points per annum, and the banks’ subsequent attempts to get rid of these low-yielding financial “assets” by purchasing other higher-yielding securities with the Fed funds spirals securities prices even higher. The new Fed funds are never extinguished until the Federal Reserve allows its balance sheet to shrink, and the current members of the Federal Reserve Open Market Committee are petrified of the financial fallout from such a move. And thus we are on a perpetual ride of soaring securities prices and declining real economic activity.

    A huge fraction of current borrowing is not deployed in either capital assets, or in substantive education to increase the productivity of labor assets. The borrowing supports only consumption beyond the production of the borrower, or rank speculation in asset prices, primarily financial “assets”, producing zero incremental capacity to support the incremental debt taken on in either case. This is why the Federal Reserve is panicked to perpetually keep real interest rates at negative real levels, penalizing saving and real investment. However, the more they follow this path, the further we get from equilibrium, and the less real savers and capital providers will invest in real capital formation. This is the road to economic ruin.

    With negative real interest rates, and the resulting wildly elevated securities prices, corporations have every incentive not to invest cash flows in new plant and equipment, but rather take those cash flows and supplement them with additional borrowings at negative real rates, buying back equity shares with the total. This results in an even higher disequilibrium share price, executive options further in the money, more of the economic pie to the 0.1%, and an overall economic pie that will shrink going forward due to insane incentives to borrow and speculate rather than save and invest in capital. As capital wears out or becomes obsolete, cash flows will dwindle, and more jobs will be destroyed, but few will understand why, as securities prices soar ever higher.

    Negative real interest rates lead to unsupportable amounts of borrowing and leverage amongst all those with access to the subsidized borrowing. Central banks and commercial banks today facilitate the creation of new debt to allow governments to spend in excess of their willingness to tax, allow speculators to gamble on assets they cannot afford through their own savings, and allow bankers to skim off large swaths of the total production pie before these bad loans they made have their “emperor has no clothes” moment. Many nations have followed this path all the way to bankrupting themselves, and are now attempting to transfer the burden of all that bad debt onto the backs of middle class citizens, many of whom had nothing to do with and did not benefit from the creation of the bad debt. This is the primary reason for today’s political earthquakes throughout Europe, and we in the U.S. are not that far behind them in having to pay the Piper for our foolishness.

    In our modern financial system, banks have the ability to create financial assets (i.e. loans or mortgages, which are assets of the bank), as well as money (another financial claim, and a liability of the bank which grants the loan or mortgage), out of nothing at all. There are no real savings in the economy, or production in excess of consumption, required whatsoever! The financial claims on both limited real assets and real annual production spiral ever higher, and the central banks of the world cut interest rates to more negative real levels and print additional financial claims, known as QE or quantitative easing, to keep the ever-increasing bad/unserviceable claims on limited actual real assets and production from defaulting. As in all of mankind’s historical efforts to print its way to prosperity, it will end in an epic collapse of the “real” value of the financial claims, though the nominal value may go asymptotically higher as currencies collapse versus real assets. The apparent current “value” of the financial claims, denoted by their current government-subsidized prices, is a fiction. If even a small fraction of the holders of such financial claims attempts to trade them for real assets or production, the prices of real assets soar. Certain real assets, such as real estate in many areas around our country and the globe, are soaring in price currently. And the middle class, and the young, fall further and further behind.

    Here, from the Bank of England, is one of the best pieces I have encountered describing the process through which banks create financial claims independent of any real savings:

    http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf

    Ever since Federal Reserve Chairman Greenspan gutted bank reserve requirements in 1994 by enabling overnight sweep accounts, U.S. banks have been virtually unconstrained in creating limitless, and therefore increasingly bad/unserviceable financial claims. These three pieces provide the history surrounding this monetary development:

    http://research.stlouisfed.org/publications/review/01/0101ra.pdf

    http://www.philadelphiafed.org/research-and-data/publications/business-review/1998/november-december/brnd98jw.pdf

    http://www.federalreserve.gov/monetarypolicy/0693lead.pdf

    After six years of virtually unconstrained credit growth, the tech bubble fostered by this credit growth collapsed in 2000, and with the workout of bad financial claims necessitating a severe restructuring/recession, Greenspan and the Fed panicked. They slashed interest rates to negative real levels, producing a greater and more destructive wave of bad financial claims. This culminated with the 2008 global financial crisis. Once again, this time under Federal Reserve Chairman Bernanke, the Federal Reserve panicked, and interest rates were slashed to negative real levels for seven years and counting. This has produced a virtual tsunami of bad financial claims, which is currently being masked through ultra-low interest rate servicing levels. That does not make the claims any more “real” in terms of actual tangible assets and production standing behind the claims, but it does make the eventual adjustment/restructuring/recession that much more difficult to overcome. As a result, if unchecked the Federal Reserve will likely follow the path almost all governments have followed throughout history. They will print money and bail out favored constituents, eventually destroying any utility whatsoever for the current U.S. fiat dollar, and they will decimate the middle class.

    We can and must do better in America. The transition to market-determined, positive real interest rates is laden with landmines. But the alternative of staying on our current path will be materially more destructive and painful for the American populace in the end. With a new free market-based fiscal policy emphasizing limited government, fairer and flatter taxation to support only those areas government is best suited to provide to the citizenry due to an inherent collective nature (e.g. national defense, certain aspects of interstate commerce and travel, our shared environment), and emphasis on personal responsibility, hopefully much of the pain of adjustment can be mitigated by a renewed economic vigor on the part of individuals and businesses currently trapped in a host of misguided incentives. While many net debtors and speculators will collapse as real interest rates move higher, and should under no circumstances be bailed out again by the productive agents in the economy, that is a necessary hurdle we must surmount to get back on the correct path for a better future. The alternative is a path all, including the 0.1%, will regret taking.

    Dana Carlton Robinson

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