I’ve blogged before on how central banks and fiat currency allow states to silently fund large scale war machines. This idea was reinforced to me today when I ran across this quote in the book War and the Rise of the State:

The wars with Spain depleted the French treasury and forced Francis I (1515-1547) to undertake administrative reforms. Yet his reforms never resolved the fiscal dilemma, since other contenders were also boosting their military spending. France was caught in a cycle of escalating violence, which its own efforts at taxation and military spending only served to propel upward; hence a fresh military crisis loomed every few years. This unremitting fiscal pressure forced centralizing reforms on a government whose inclinations were still largely medieval, but whose aspirations required the organizational accoutrements of a modern state.

Bruce Porter, War and the Rise of the State

This is what you would expect. The French were bankrupting themselves in the so-called “Italian Wars” that seemed to go on and on. War is very, very expensive. So, what did they do about it? They created a central bank:

Two reforms in particular arose from France’s involvement in the wars. In 1523, as it was mobilizing troops for a fresh campaign in Italy, Antoine Duprat, the king’s chancellor, established the first central treasury of the realm, the Trésor de l’Épargne or Treasury of Savings.

Bruce Porter, War and the Rise of the State

This is what states do when the burden of war becomes too high. They look for ways to hide the cost from the public, who would rapidly grow disenchanted with funding endless war if they had to do so up front at face value. This is precisely the reason that nobody younger than 50 knows what a “war bond” is. The direct connection between the citizen and the funding of war has been broken. Instead, the Federal Reserve now prints the money which ends up back in the treasury, through the purchasing of Treasury Bonds, where it can be used to pay for more war. The only effect we see is price inflation on a lag. Basically, our endless wars are funded with debt created and sold by the Fed, and paid for in the form of higher market prices.

This is why I call the Federal Reserve the “silent” killer of millions of people all over the world. It’s the great enabler of vice and moral hazard. The next time a drone strike takes out a wedding party in Afghanistan, you’ll know that the extra .03 cents per gallon you’ll pay for milk in a few weeks helped pay for it.

Lewis Lehrman:

http://www.youtube.com/watch?v=yDU2p7oUk6g

James Grant:

http://www.youtube.com/watch?v=Qwj5fx1di1I

Joseph Salerno:

http://www.youtube.com/watch?v=pl566vtfLC0

Federal Reserve Bank of Kansas City President Thomas Hoenig said soaring farmland prices may be the result of an unsustainable bubble that could damage the U.S. economy when it bursts.

“My nagging concern remains that current distortions in financial markets are increasing the risk that imbalances in asset markets will catch agriculture — and the U.S. economy more generally — by surprise once again,” Hoenig told the Senate Agriculture Committee today, according to his prepared testimony.

“This run-up in farmland values has occurred, however, amid financial markets characterized by high levels of liquidity and unusually low interest rates,” he said. “It is nearly impossible to determine how much of the farmland boom may be an unsustainable bubble driven by financial markets and how much results from fundamental changes in demand and supply conditions.”

–Joshua Zumbrun, Bloomberg

Maybe I should go light on Hoenig here since he appears to be the only semi-rational person employed by the Fed at times. But he’s wrong about a farm land bubble. Guys like Jim Rogers and George Soros predicted a surge in farm land and agricultural products as far back as late 2008. Their rational was like this:

“We’re still going to eat, probably; we’re still going to wear clothes, probably. Farmers cannot get loans for fertilizers right now. So the supplies of everything are going to continue to be under pressure,” Rogers said.

He is the director of two funds which are buying greenfield land in Brazil and existing farms in Canada and starting to farm it. The funds are clearing the land, fertilizing it, irrigating it and hiring farmers and, Rogers said, some day will probably sell the land but that is a remote prospect.

“If I’m right, agriculture is going to be one of the greatest industries in the next 20 years, 30 years.”

Food inventories are at their lowest in 50 years, Rogers said, while the oil and mining sectors are also good bets.

“Even if demand goes flat or down, as it did in the 30s, as it did in the 70s, you can still have a nice market,” he told CNBC.

–Jim Rogers, CNBC Interview (Mar. 2009)

To say that the rise in agricultural prices is a speculative bubble at a time when the world is literally tossing dictators out the window because of soaring food
prices shows the depth of misunderstanding at the Fed. When there actually was a real estate bubble they told us there wasn’t one. I give you Bernanke from 2005:

Ben S. Bernanke does not think the national housing boom is a bubble that is about to burst, he indicated to Congress last week, just a few days before President Bush nominated him to become the next chairman of the Federal Reserve.

U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke, currently chairman of the president’s Council of Economic Advisers, in testimony to Congress’s Joint Economic Committee. But these increases, he said, “largely reflect strong economic fundamentals”…

Many economists argue that house prices have risen too far too fast in many markets, forming a bubble that could rapidly collapse and trigger an economic downturn, as overinflated stock prices did at the turn of the century. Some analysts have warned that even a flattening of house prices might cause a slump — posing the first serious challenge to whoever succeeds Fed Chairman Alan Greenspan after he steps down Jan. 31.

Bernanke’s testimony suggests that he does not share such concerns, and that he believes the economy could weather a housing slowdown.

–Nell Henderson, WaPo (2005)

Now, when there’s actual demand backing the rise in farm prices they tell us it is a bubble. There are food shortages everywhere, but somehow people buying farm land is a speculative bubble. Oh lord. It’s terrifying to see how clueless these people are who run our entire economy. We’re doomed.

The Federal Reserve launched a controversial new policy on Wednesday, committing to buy $600 billion more in government bonds by the middle of next year in an attempt to breathe new life into a struggling U.S. economy.

The decision, which takes the Fed into largely uncharted waters, is aimed at further lowering borrowing costs for consumers and businesses still suffering in the aftermath of the worst recession since the Great Depression.

The U.S. central bank said it would buy about $75 billion in longer-term Treasury bonds per month. It said it would regularly review the pace and size of the program and adjust it as needed depending on the path of the recovery.

–Reuters w/CNBC

And, the Fed shows that they don’t understand, or are unwilling to acknowledge that this is inflation. They continue to talk in terms of “measuring” inflation:

In its post-meeting statement, the Fed … said measures of inflation were “somewhat low.”

–Reuters w/CNBC

But, inflation isn’t just something that happens after you increase the money supply. Inflation IS the increase of the money supply. Let’s look at an example. Say that you have a tiny economy with only 2 people. Person A has $100 and Person B has $100. Every product in the market of this tiny economy is valued in terms of a total money supply of $200. So, let’s say that in this scenario a pack of gum costs .02 cents. Now, out of the blue Person’s A and B wake up one morning and find that a miracle has happened and they both have $200. The money supply has exactly doubled, and they both know this. You can expect that pack of gum is going to cost .04 cents now. Nothing has changed with supply and demand or product quality or anything else. The only thing that has changed is the amount of available money in the system. The price increase of the pack of gum is the result of inflation. It’s not the inflation itself. The inflation was the increase in the money supply.

The illustration becomes a little clearer if you stop thinking about money, and think of it in terms of real goods. For instance, think about trading baseball cards with your buddy. If you and your buddy both have a Mark McGuire rookie card, it might take 10 other cards to get him to trade you that one card. But, if you both have two McGuire rookies, it might only require 5 or so regular cards to get him to trade it. In other words, the McGuire card is being devalued in some proportion to it’s supply. The more of that card you have, the less valuable it is, in terms of it’s relation to other cards. That means that a McGuire rookie “buys” fewer cards than it did when there were fewer of them. In economic terms this is called marginal utility(we’ve talked about this before). And it applies to money just like everything else. Money isn’t some special thing that doesn’t have to obey the fundamental economic laws. The marginal utility of money goes down in proportion to how much is available.

Obviously, a real economy is infinitely more complex than our little examples here, but the fundamentals are exactly the same. The only difference in a real economy is all the different mechanisms that, in effect, “hide” the money supply from the market. It takes longer to see the results of inflation. But, no matter how much you hear about inflation being low, look at the money supply. As long as it continues to go up, inflation is happening.

At it’s core, interest is the cost of renting money. Since money acts conjointly as a medium of exchange and as a commodity, we rent capital(i.e. money for investment or spending) in the same way we rent any other good or service. If you rent a car, you expect to pay it’s owner a fee for it’s use. In the same way, if you rent money by taking a loan, you will pay an interest charge to the money’s owner. This may seem straightforward, but in the past, this practice has been challenged on a regular basis. Especially by those in the church. They called the practice of charging interest on loans “usury,” and it was hotly debated.

But, if interest is just the cost of renting money, then how is the interest rate determined. Is it just a random figure? No, it arises as a market price, the same way the price of any other good is determined. If there are five lenders on the street and 2 of them lower their rates, the other three will have to follow suit or lose business. Likewise, if the current market conditions become very risky, lenders will raise their rates to cover the new risk. Those that don’t risk serious defaults on their loans. This is the same way that any other price is determined. But, there is another factor about interest rates that is often overlooked by non-austrians, and that’s the effect of “time preference.”

Time preference is the idea that people almost always prefer having a good now to having a good later. The strength of this preference per individual is said to either be high or low. A person with a high time preference is somebody that strongly wants a certain good right now. Conversely, someone with a low time preference is less concerned with the immediate acquisition of a good. Time preference is a major influence on interest rates since a low time preference would drive rates down in order to entice borrowers. Likewise, a high time preference will raise rates since more pressure is being placed on the supply of lendable funds.

So, with those ideas in place, we can now look at the Fed and it’s manipulation of interest rates for what it really is: price controls. Just like Nixon putting price controls on things like meat, having a central bank “set” the interest rate to a certain level is a price control on the loan market. And we all know what happens when price controls are enforced. First, market players will come up with loopholes to get around the price controls. We saw this en’ masse during the housing boom with the popularity of so-called “exotic” financial instruments. And secondly, when price controls are applied to a sector of the economy, you always see a “black market” pop up. Again, we see this right now with the derivatives market. All the politicians are screaming about how bad the derivatives market is since it’s unregulated. It’s a black market. Which is to say, it’s the real market trying to work.

And, hopefully, now you can see pretty easily why the Fed setting the interest rate to 0% is so hazardous. The Fed’s rate setting places an artificial cap on the market price of borrowing money. It’s equivalent to passing a price control law that sets the wholesale cost of beef to zero. That means that the local grocery store would be getting it’s beef stock for free and selling it at 100% profit for an artificially low price. Of course, this would never work with beef since producers wouldn’t raise cattle for free, but it does work with banking since the central bank is creating money out of thin air at zero cost. Obviously, the ramifications of this type of price control are bad.

Given our beef scenario, what do you think will happen if all of the sudden steaks were .10 cents per pound? That’s right, people would be buying beef like mad. In the same way, artificially low interest rates entice people to borrow money when they otherwise wouldn’t in a free market. Just like increasing the price for any other good is a check on the overconsumption of that good, increases in the market interest rate are a check on the overconsumption of borrowed money. As more and more people are borrowing money, the interest rate would naturally rise and detract more borrowers. But, when the central bank sets the rate at some arbitrary amount, it negates this natural market check and balance system and creates the boom and bust cycle.

We can’t know what exact effect a zero percent interest rate will have in the short term(although Japan offers up some decent examples), but in the long term the effect is clear. There will be another huge boom. Let’s just hope it isn’t the so-called crackup boom. We’ll talk about that next time.

The boom that preceded the 1837 panic and subsequent deep recession took on a little different form than the one that led up to 1819, but the fundamentals were basically the same. We might want to praise Andrew Jackson for ending the second Bank of the United States in 1836, but his own mistakes on monetary policy would just compound what the federal and state banks had begun:

Temin completely ignores the expansion in banking after President Jackson hinted in his first annual message (December 1829) that he would oppose a renewal of the charter for the second Bank of the United States. From January 1830 to December 1833, the number of banks increased from 330 to 506, a 53% increase. Then, from 1833 to 1837, the number of banks increased from 506 to 788, a 56% increase. The chartering of so many new banks meant that the banking system as a whole could inflate the money supply significantly even while maintaining the same proportion of reserves. Contemporary political economists (Gallatin, Gouge, and Raguet) all cited Jackson’s campaign against the federal bank as spurring a bank mania in the states. Bank projectors and state legislators rushed to organize and charter new banks in the hope not only of getting a share of the public deposits but a share in the bank business being forfeited by the Bank of the United States’ loss of prestige, circulation, and deposits resulting from the loss of its privileged federal status.

–Scott Trask, The Panic of 1837

I bet that sounds familiar doesn’t it. Did you notice how many new banks popped up during the 2000′s? Lots and lots. Entrepeneurs aren’t stupid. If there’s a good investment to be made they will find it. Banking was just such an investment in the leadup to our most current bust, and it was a great investment in the 1830′s too. After all, with reserve rates low, low interest rates and plenty of government money to use as capital reserves who wouldn’t want a piece of that action. That’s easy banking right there.

And speaking of low reserve requirements, by 1837 reserves had fallen to 13.7% (that’s specie by the way, not paper. And the Fed reserve limit is 10% today). It’s at this point that the stage was set for some good ol’ fashion bank runs:

Furthermore, there is evidence that the state-bank depositories did lend out at least part of the public deposits with which they were entrusted. Treasury Secretary Taney informed them that they were expected to increase their discounts after receiving the government funds; and when the government in 1837 called on the banks to pay out the remainder of the surplus fund s deposited with them in previous years, the banks replied that the money was gone. Thus, it seems clear that by depositing the government’s funds in the state banks, President Jackson did contribute to the inflation of the mid-1830s.

–Scott Trask, The Panic of 1837

But all of that isn’t even the best part. What makes the 1830′s boom so intriguing is that it had a major real estate/land bubble just like our most current crisis of 2008/09. And it was fueled by worthless bank note printing by state banks, similar to what happened in the run up to 1819:

Finally, Temin’s contention that the land boom of the 1830s had a deflationary effect upon the economy is simply insane. The government accepted state bank paper in payment for the purchase of public lands. When the Bank of the United States was the fiscal agent of the federal government (from 1817 through mid-1833), this money was deposited in the federal bank or one of its branches. As the B.U.S. was a specie-paying bank, and as merchants and the public felt less compunction about withdrawing specie from it compared to their local bank, the federal bank had to keep a large stock of specie. If state bank notes began to accumulate due to an increase in land sales, the managers would have to return at least some of them for payment. This acted to check or restrain the state banks from inflating. However, after mid-1833, the B.U.S. was no longer the fiscal agent of the federal government, so state-bank paper used to purchase public lands now ended up in a state bank. The state banks then lent it out again. The same money could now be used to purchase more land, or for other purposes. It could be lent out a third and fourth time. Federal land sales simply exploded after 1833. They went from $4.2 million in 1833 to $6.1 million in 1834, $16.2 million in 1835, and $24.9 million in 1836, and $6.9 million the first few months of 1837 before the panic. While the price of public land was fixed by law, its price could, and did, rise after it was sold to the first purchaser (often a land speculator who bought up large amounts only to sell it at a profit).

–Scott Trask, The Panic of 1837

But a fiat printing bank is a fiat printing bank, whether it’s at the national or state level. Giving any institution the power to print money that isn’t backed by a commodity that has real value like gold, silver, etc. is going to guarantee a boom/bust will ensue. And that’s exactly why the Federal Reserve needs to be ended. It’s the most monstrous inflationary fiat money machine that the world has ever seen.

To understand the Panic of 1819 properly, it must be viewed in it’s proper context as being inextricably linked to the war of 1812. War’s are among the most powerful inflationary forces that exist and the war of 1812 was no exception. Governments love to wage war, and to wage a proper war it’s almost always necessary to fire up the printing press and inflate the currency. This is exactly what happened starting in 1811. Banks outside of New England were buying government bonds like mad to finance the war. When it became obvious in 1814 that the outstanding bank notes could not be covered by gold reserves, the Federal government issued a declaration for the suspension of specie payment. This simply meant that, by law, the banks weren’t required to redeem their notes in gold.

CJ Maloney lays it out like this:

Now freed from having to actually raise money (gold) prior to issuing paper promises for it, the banking system’s highly inflationary printing binge went into overdrive. During the war’s three years, domestic prices rose by 25% and import prices by 70%.

From 1811 to 1815, banks multiplied like mushrooms on a dung heap, lending out credit they didn’t have as if it were manna from heaven. Where actual money in bank vaults had decreased by 9.4% during that period, paper bank notes and deposits, all with claims on that money, had increased by 87.2%. Keynes himself would have been proud (Rothbard 2002, p. 73).

–Maloney, Mises.org

All of this led to a, now classic, easy credit consumption binge(sound familiar?) where imports severely outpaced exports. Trade imbalances are a classic symptom of currency debasement. As a country inflates it’s currency, it’s citizens begin to import goods from other countries who haven’t inflated because prices in the non-inflated country are cheaper(again, sound familiar?). People in 1815 were buying everything they could get their hands on, fueled by the moral hazard that the government injected into the system by buying paper debt and suspending gold redemption. There was no central bank yet, but all of the classic checks and balances on free banking that the market imposes had been legislatively removed by Washington. What we got next would just add more fuel to the fire: the second Bank of the United States.

The second Bank of the United States was chartered in 1816 under the auspices of bringing inflation under control. But, of course that’s not what they did:

Instead, the men who ran the new central bank promised not to demand redemption of any state bank paper notes until over one year later. And they bailed out the insolvent state banks with $6 million in taxpayer money. The more things change, the more they stay the same.

To add injury to insult, the men who ran the central bank “jumped on the inflationary bandwagon” themselves (Dupre 2006, p. 271). Printing paper and promises with Bernanke-like abandon, within two years of its creation they had loaned $41 million worth of gold promises and issued paper bank notes redeemable in gold worth $23 million, all on top of just $2.5 million worth of gold (Dupre 2006, p. 270), a level of leverage insane enough to make a Lehman Brothers risk manager feel right at home.

–Maloney, Mises.org

You can, of course see where all of this is heading. A bubble was forming by rampant money printing with no real money(gold) to back it. What began with an attempt to deal with war-time debt blossomed into a full blown credit expansion bubble. What were the effects of this? The same kinds we see today. Exorbitant real estate/land prices, ridiculously low interest rates, rampant speculation into all kinds of wierd business schemes. Easy credit makes people do things they would never ordinarily do. And it was as true then as it is now.

The whole thing came to a head in 1819 when foreign debtors, specifically England and France, were demanding payment in gold from the Bank of the United States. This meant the bank had to call in loans from smaller state banks in order to raise enough specie to pay these foreign debts. But, of course, the smaller banks didn’t have nearly enough gold to cover the amount of paper it had printed either. When this was publicly realized the whole thing collapsed:

When it was realized that many paper bank notes were just that, their values began to collapse, many to zero (the same amount of gold you could get for it), and the money supply contracted at a ferocious rate. From the fall of 1818 to the beginning of 1819, demand liabilities at the central bank fell from $22 million to $12 million (Dupre 2006, p. 272) and the total money supply fell about 28% (Rothbard 2007, p. 89).

Insolvent banks and overextended debtors alike collapsed, while prices, no longer pumped up by the bubble, raced downward to their equilibrium. As the money supply cleansed itself of the bad apples, time and effort had to be paid so that the flow of funds could adjust back to their best uses, following prices as their guideposts. It was a massive, countrywide downturn, and introduced a slowly industrializing America to a new experience — mass unemployment.

–Maloney, Mises.org

So, as you can see, the first true economic disaster of the 19th century was completely enabled by government intrusion into the monetary system and by central banking. Suspension of specie payment led to defacto inflation since banks no longer had to redeem what they printed. This created a scenario of basically hundreds of little federal reserves that were able to inflate like mad. And when the Bank of the United States came into the fray it just accelerated the whole process.

Next time we’ll look at the Panic of 1837.

…thwarting a bid by the second Bank of the United States to extend its charter beyond 1836. The U.S. would go without a central bank until the Federal Reserve System was established in 1913.

Like many clever politicians, Paul has a knack for mixing sound observations with Utopian promises. Without the Fed, he says, we would enjoy “all the privileges of modern economic life without the downside of business cycles, bubbles, inflation, unsustainable trade imbalances and the explosive growth of the government that the Fed has fostered.”

Hold on, though. Wasn’t America’s Fed-less 19th-century history punctuated with recurring booms, busts and banking panics? Paul dismisses such talk.

–James Pressley, Bloomberg

This is an oft used argument that wilts at the slightest bit of research. The “booms, busts and banking panics” of the 19th century were very much a product of government involvement in the economy. And, sometimes they were produced directly by the Fed’s pre-cursor: the Bank of the United States. Just because the Fed didn’t appear until 1913 doesn’t mean that our economy was a free market utopia. On the contrary, there were just as many government shenanigans going on then as there are now. The difference is that the market couldn’t tolerate, mask or absorb those government tricks as well as it can when you have an all-powerful central bank like we have today. The Fed simply inflates all those problems away now. But that just kicks the can down the road. And the can gets bigger with each kick.

But, back to the matter at hand. He mentions that the second Bank of the United States was abolished in 1836, but he can’t be implying that because of that we were free from government control over money. Has he forgotten the “greenback” laws passed by Lincoln during the war years? What about all the railroad “speculation” that was fueled directly by the Congress? And, what about the issuance of millions in municipal bonds to pay for “internal improvement” projects in the various states preceeding the war? He can’t think that none of this had any impact on these pre-fed booms and busts can he? I guess so. But we’re going to set the record straight. I’m going to go one by one through the major busts and panics of the 19th century and show what really happened in each case.

We’ll start tommorrow with the panic of 1819.