Gary North

May 5, 2009

Imagine a national highway system. On any stretch of highway, the speed may be different. The national speed limit is changed on a regular basis by a national committee. The committee is made up of government appointees and representatives of the auto industry.

The committee decides to change the speed limit by reviewing traffic flows that are reported and analyzed weeks later.

The formula used by the committee does not affect every speed sign by the same percentage. Every speed sign along the roads is digital, allowing moment-by-moment revisions.

The signs' posted limits can and do change randomly every time the committee changes the national speed limit. They can also change randomly in between meetings, depending on traffic flow and speed, which is fed into local computers that can adjust the posted speed.

The committee assigns to a subcommittee the task of adjusting the national speed limit on a day-by-day basis within a narrow range. This speed limit affects only those stretches of highway that connect the two coasts. It does not predictably affect the side roads and intrastate highways.

The subcommittee assesses what needs to be done by means of data fed back to it from dozens of regions. The subcommittee cannot determine what individual speed signs will say. It aggregates the data by means of a proprietary formula known only to the subcommittee.

The national committee tells drivers to plan all of their trips in terms of the national speed limit.

Every trucking firm must write contracts stretching out for an unspecified number of months, based on the target national speed limit announced by the main committee every two months, which reserves the right to raise or lower the target rate.

Would you invest heavily in trucking firms on this basis?

PRICES AND INFORMATION

Prices are signals in the same way that posted speed limits are signals. When not tampered with by the government or a government-licensed private cartel agency, prices reflect the best estimations of buyers and sellers regarding supply and demand, both in the present and in the future.

The pricing system in a free market economy is the greatest single supplier of accurate information in society. Those people who forecast prices incorrectly again and again go out of business. The information system polices itself through profit and loss.

If you think of an economy run in terms of a gold coin standard, with no legal issuing of receipts for gold coins or bullion that are not backed up by gold in reserve, you have a functional idea of an economic speed limit. The free market allows pricing in much the same way as a local speed sign would, if the sign got digital feedback from traffic, thereby allowing increases or decreases in speed. There would be changes, but not dramatic and not for long.

The government can intervene directly into price-setting through laws establishing ceilings or floors on prices, including wages. The most widespread use of this power in the United States is the minimum wage law.

There are other ways of tampering with pricing. The government may grant to an association representing an industry the right to restrict entry. The organization may also be allowed to set minimum prices. Any participant that defies the cartel is threatened with sanctions. The government enforces the rules set by the cartel.

Anything that interferes with the pricing system distorts the accuracy of the information. When there are deliberate government restrictions on entry into a field, we see the formation of cartels.

Cartels are associations of producers that allow producers to reap above-market rates of return.

Every cartel suffers from the threat of dissolution through "cheating," meaning price competition, especially from newcomers that operate more efficiently.

The cartel fights back in two ways. First, it gets the government to restrict entry into the industry. Second, it gets the government to enforce the rules of the cartel against cartel members who compete in ways that would lower the profitability of the largest members of the cartel.

The cartel prospers for a while. But then it finds that it cannot respond to new conditions of supply and demand. A crisis engulfs the cartel. At this point, the cartel faces destruction.

By far the most important system of tampering with prices is the fractional reserve banking system. The government licenses banks to issue more receipts for money than they have in reserve. Depositors are led to believe that they can withdraw money at any time. Then, when they do -- such as when a recession begins -- the banks are faced with bankruptcy.

To prevent this, governments license monopolistic institutions called central banks. They are cartels.

THE FEDERAL RESERVE SYSTEM

The Federal Reserve System is the enforcement arm of the American banking system's cartel. A good account of this was written by the Austrian School economist, Murray Rothbard: "The Federal Reserve as a Cartelization Device." It is free:

http://mises.org/books/cartelization.pdf

The fundamental task of the Federal Reserve System is to keep the largest banks solvent. This has been its primary purpose ever since its founding, which is why the largest banks cooperated in its creation. A good account of this is found in Rothbard's book, "The Case Against the Fed." It is free:

http://mises.org/books/fed.pdf The FED has the power to control entry into the banking system. Through its control over the monetary base, which is its balance sheet, the FED can set the short-term interest rate at which commercial banks lend to each other overnight. This is called the federal funds rate. This has been the FED's primary tool of control over the economy. It remains its primary tool, but with the rate close to zero percent, the tool no longer serves as a tool of market manipulation. The FED now finds that it must purchase assets that no longer can be sold at anything like the price that banks, insurance companies, and investors paid for them. It buys these assets with newly created money or with swaps of its remaining Treasury assets.

The FED fears a write-down of the balance sheets of commercial banks. If the balance sheets contract, the banks will have to demand payment of outstanding loans to offset the contraction of the balance sheets. So, the FED is buying these assets with newly created money, or swapping liquid Treasury debt for illiquid assets, which are called toxic.

A contraction of credit by the banks would make the recession much worse. So, a bank's balance sheets must be kept from falling.

The FED is engaged in a gigantic system of misrepresentation. It is misrepresenting the solvency of large banks and financial firms in debt to banks. It is misrepresenting the supply of invested capital. It is substituting inaccurate prices for accurate prices. These are the most important prices of all: the price of capital. These prices inform investors and entrepreneurs of the condition of the capital markets.

The FED is doing its best to conceal the degree of risk and uncertainty in the capital markets. Central banks around the world are cooperating with the FED. This is an international effort by central bankers to deceive the public.

To the extent that this deception is working, investor confidence will increase.

On April 15, 2008, the FED held $866 billion in assets, which served as the monetary base for the nation. On April 15, 2009, it held $2.2 trillion.

On April 15, 2008, $549 billion of the FED's holdings were Treasury assets. That means 63% if the FED's holdings were Treasury debt. On April 15, 2009, the FED held $526 billion in Treasury debt -- less than a year earlier. That was 24% of the FED's balance sheet. (My thanks to ContraryInvestor.com for this summary.)

The FED has intervened into the private capital markets as never before in history. It did so in order to keep the reality of the high risk of the American capital market from generating prices that reflected the true conditions of supply and demand. In short, the FED regarded its primary task as keeping the investing public misinformed about the severity of the crisis in the capital markets.

The FED's economists are doing their best to protect the biggest banks. The smaller banks are going under, one by one or two by two every Friday afternoon, after the stock market closes. The reality of toppling banks simmers over the weekend. No one pays much attention. The FDIC intervenes, arranges a transfer of the failed banks' assets to large banks, and pays off the depositors by selling more Treasury debt.

The consolidation of the big banks continues, unnoticed and unchallenged. The FED stands as the lender of last resort to the big banks. They will not be allowed to fail.

The FED has conducted a stress test of the 19 largest banks. The results of this test are supposed to be issued on May 7. The tests's full details will not be revealed. The FED will say that banks need new infusions of capital in the form of the sale of shares. Where this money will come from is not clear. This will water down the shares owned by existing investors.

The share price of Citigroup was at $1 in early March. It is now at $3. In mid-2007, just before the capital crisis began, it was $55. The investing public apparently does not believe that Citi will go under, but people are not ready to imagine that Citi will ever again see $55.

Bank of America, at $52 in late 2007, fell to $4 in early March, and is now around $9. The public thinks the bank will survive, but not recover.

These are our largest banks. The FED kept them from going under, but it did not restore public confidence. Their share prices indicate the power of the market to reveal the true costs of capital, despite the intervention of the FED into the loan market. The FED has the ability to keep a bank's doors open and its ATMs delivering pieces of green paper. But it cannot overcome the fundamental fact that the capital markets have removed most of the wealth of these two behemoths.

The directors of commercial banks try to put a good face on these enormous losses, but the stock market barely listens. Bank investors trust the FED; they do not trust the bankers.

KEN LEWIS LEARNS A LESSON

Last October, Ken Lewis, at the time the chairman of Bank of America, agreed for the BofA to buy Merrill Lynch. The bank would not pay money. It would swap stock. Lewis did not consult the board. It turned out to be a bad deal for BofA shareholders. The shares were at $38 when the deal was announced. They were at $10 by late November. News had begun to leak out about Merrill's losses. The deal was consummated at the lower BofA share price on January 1: $15. The owners of Merrill were outraged at the final price they received. Then the price went to $4.

It now turns out that Henry Paulson, the former Goldman Sachs CEO, and Ben Bernanke, the former university professor, ganged up on Lewis last year. They told him, he said under oath, that they would fire the bank's board, along with him, if he backed out of the deal. He had found out the enormous losses sustained by Merrill, which totaled almost $16 billion in just the 4th quarter. He capitulated to the deal, went through with it, and kept his job.

Paulson and Bernanke told a senior bank official what to do, and he did it. They have received no significant public criticism for this assertion of raw Federal power.

Recently, the board of BofA forced Lewis out as chairman, but kept him on as CEO and president. He kept his pension. The board kept their positions. The stockholders kept their losses.

The public does not care what Bernanke said to Lewis. It wants the FED in charge. The government has transferred comprehensive regulatory power to the FED. There have been no protests from Congress.

THE POWER OF THE MARKET

It takes time for the true conditions of supply and demand in the capital markets to be reflected in the stock market and bond market. These markets operate on the assumption that digits are capital. The reality is more complex. Capital value is reported in prices, and prices are reported in digits. But digits are not capital. Capital is whatever wealth investors surrender to entrepreneurs to invest in production. Investors surrender capital in the hope of gaining more capital. But they write their checks in the form of digits.

The FED controls the supply digits. It does not control the supply of capital. It buys bad assets a face value in order to keep investors investing. Investors see the result of these newly created digits: keeping up the market price of a limited number of investment assets -- the ones that banks lent too much money to hedge funds to buy at naively optimistic prices.

The legal effect of high market value is preserved, but only as book entries. The banks' balance sheets do not contract, thereby shrinking the supply of credit. The FED's balance sheet rises, but no one outside the FED exercises control over the FED.

The counting rule governing bank reserves is preserved, but at what cost? At the cost of investors' future wealth. Investors see that the prices of these assets are not falling, digitally speaking. Yet these prices should fall.

Investors then take hope. They assume that the source of more funding is still intact. They buy investment assets that ought to be lower priced. They bid up the price of these assets in digits. They transfer digits that could be used to buy productive assets -- productive in a free economy -- to sellers of ownership shares or promises to pay.

The sellers of these assets benefit. They can then use their proceeds to buy something else.

The illusion of high economic value persists. Why? Because of the illusion created by the FED. This illusion rests on the fact that the FED creates digits out of nothing and uses these digits to buy assets that would otherwise fall in price and thereby create a crisis for banks. The flow of digits from the banks would then contract. Prices would fall. Expectations based on an illusion -- the boom phase of the boom-bust cycle -- would be shown to have been misguided.

Over time, the market will assess greater value to those assets that produce above-market rates of return, a return not based on access to bank credit, but because consumers are willing to purchase the output of this capital.

Consumers will regain control of the markets at some point. If the Federal Reserve continues to fund the illusion that digits are wealth, then mass inflation will arrive. Mass inflation will reveal to millions of people that Federal Reserve digits are not wealth. They will buy less and less.

CONCLUSION

There is the real economy and there is the digital economy. The digital economy is supposed to reflect the real economy. This is what the Federal Reserve System is determined to delay. The FED cannot prevent that day of reckoning, but it can delay it.

Eventually, the day of reckoning comes. The digits are revealed to be digits rather than wealth, accounting entries rather than consumption.

Ben Bernanke will wind up like Marie Antoinette, famous for something he never will say: "Let them eat digits!" He may not say it, but his policies rest on it.