November 1, 2011
The Death of Money
How America's cheap money addiction is inflating the next bubble and undermining faith in government.
Time magazine starred Alan Greenspan on its cover in 1998 for cutting interest rates, naming him one as of three people comprising a “Committee to Save the World.” Eleven years later, the same magazine indicted him as one of three people most culpable for the great economic collapse of 2008–09. Then, in 2009, Time named Greenspan’s successor, Ben Bernanke, as “Man of the Year” for cutting interest rates as part of “an effort to save the world economy.” Guess what comes next in this sequence of praise and blame, relief and recrimination. You have to work hard not to see it on the horizon, and the reason is clear: When money is too cheap for too long, it inevitably creates a problem.
In those bygone days known as the 20th century, the problem cheap money created was consumer price inflation. In the past 25 years or so, it isn’t consumer prices but asset prices that have run away. Cheap money gushed into real estate in the 1980s, into tech stocks in the late 1990s and into housing in the early 2000s; now it is gushing into food and commodity prices. When interest rates are low and money flows freely, all seems good and getting better. But each inrush of cheap money merely sets up high asset prices for the collapse to come. And when collapse comes, it’s nearly always bigger than the one before. And to recover from that collapse, the Federal Reserve makes money cheaper still, for even longer than it did the time before.
It has to escalate the dosage because, like that next hit of heroin, each gush of cheap money is less effective in restoring growth to the economy than the one before. When real estate prices turned down in 1989, contributing to the mild recession that started the next year, the Fed cut interest rates to 3 percent and kept them there for a year and a half. When the stock market bubble of 2000 burst and led to the “tech wreck” recession of 2001, the Fed cut interest rates to 1 percent and held them there for a year. When the housing bubble of 2007 burst and led to the Great Recession of 2009–10, the Fed cut interest rates to zero and has held them there for almost three years so far, with the promise of another two years to come.
This money is not just cheap. Indeed, even calling it free would understate just how cheap it is. If you consider that U.S. inflation is expected to be about 2 percent per year over the next decade, the Fed’s real interest rate is actually negative 2 percent. That is, the Fed is subsidizing banks to borrow money. The consumer analogy would be like someone not only giving you a free product, but actually paying you to take it—much as some banks used to give out free toasters to anyone who opened a new account.
Even that extreme measure has not been enough this time around. Implicitly conceding that it had exhausted “normal” monetary policy, the Fed announced a new approach. With its “quantitative easing”, part one in November 2008 and the bigger part two in November 2010, it forced money into the hands of investors. By buying up vast quantities of Treasuries, mortgage-backed and other securities, it has pumped $1.8 trillion into the financial system since the onset of the crisis.
This used to be called “printing money”, conveying the sense that it’s a fabrication of something from nothing, which is pretty accurate. In truth, however, the Fed doesn’t even need to go to the trouble of printing it anymore. Now the money is conjured electronically: A number appears on a bank account balance sheet because the Fed puts it there. The first and second waves of quantitative easing were abbreviated to QE1 and QE2, which also happen to be the abbreviation for certain celebrated British cruise ships. In a darkly humorous mood, international economist and former Vice Chairman for Goldman Sachs (Asia) Ken Courtis suggested that “QE2 should be renamed Titanic 2.”
Experts generally agree that the “neutral” rate of interest—that is, the rate that neither stimulates the economy nor restrains it—for the key Fed funds rate is about 4–5 percent. Can you guess how much time the rate has spent above the 5 percent level in the last ten years? The answer is all of 15 months, between June 29, 2006 and September 18, 2007, peaking at 5.25 percent. For a decade, in other words, the Fed has been pricing money at either neutral or cheap rates. If the Fed’s job is to “take away the punch bowl just when the party gets going”, as a former Fed Chairman William McChesney Martin memorably remarked, then the Greenspan-Bernanke Fed has kept the punch bowl out on the table, amply filled, for so long that the American economy has been perpetually intoxicated. As 2012 begins, that economy is an alcoholic wreck.
Implications for Fiat Money
“No complaint”, wrote Adam Smith, “is more common than that of a scarcity of money.” Today’s America is a universe away from that particular complaint. It also happens to host history’s longest-running experiment with a system of paper money. We call it a fiat money system because in it the value of money is set by government fiat, as distinct from a system whose money’s value is derived from a link to gold or some other underlying commodity. The fiat money system in use today in America and everywhere else in the global economy has only been in place for a bit more than forty years: since the August 15,1971 collapse of the last vestige of the postwar Bretton Woods system, in which the dollar was set in reference to gold. No other fiat money system has survived so long. This raises an important question: If value derives from scarcity, then what is the value of a commodity heavily subsidized or supplied for free and thrust upon the market, these days in a barrage of electrons?
America may have a greater percentage of its people living in poverty than at any time since 1973, but, perversely, money has never been so freely available in the financial system. Three Republican presidential hopefuls have lashed out at the Fed for debauching the dollar: Rick Perry, Ron Paul and Michele Bachmann. Perry, whose presidential fortunes have lately been fading fast, expressed himself using the most intemperate terms by far:
If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous—or treasonous in my opinion.
The threat, of course, is preposterous, and the accusation that Bernanke is playing politics is unfair. He is responding in exactly the way the Fed, the markets and the political system have been conditioned to expect after two decades of Alan Greenspan, otherwise known as “Easy Al” for his readiness to resort to cheap money at almost any opportunity. The nickname bestowed by Bob Woodward’s hagiography of Greenspan, “The Maestro”, is only ever used ironically these days. However, if Perry’s central concerns were that the dollar has lost value and that the United States is on the way to losing its unique privilege as the world’s reserve currency, then he is indisputably correct.
In early 2011, a number of dramatic global events tested the world’s dollar reflexes. The “Arab Spring” and revolution in Libya sent brief frissons of panic through the markets that some oil supplies might be in danger. The Tokyo earthquake and tsunami also created global economic fears. At any other time in the past four decades, the U.S. dollar would have gained in response to events like these as investors moved into the greenback as a safe haven. But this year the old reflex simply didn’t kick in. News of the Tokyo earthquake drove up the value of other safe haven assets—gold and the Swiss franc, for instance. The dollar actually lost a fraction of its value against other major currencies, and that shift came before the disastrous debt ceiling debate and Standard & Poor’s credit downgrade in August.
Nor is it just the global market that took this view. A survey of more than eighty reserve managers for central banks around the world predicted in June that the U.S. dollar would lose its reserve currency status over the next quarter century. Most of the officials polled by the Swiss bank UBS said that they expected the dollar to be replaced by a basket of currencies. A decades-long fadeout would be consistent with historical precedent: That’s how long it took for the British pound to be replaced by the dollar.
The biggest single buyer of U.S. dollar assets, the People’s Republic of China, decided not to wait decades. In recent years, China had been investing about half its foreign exchange reserves in U.S. Treasuries and other dollar-denominated debt, but in the first four months of 2011 it put three-quarters of its newly accumulated $200 billion into non-dollar assets, according to an estimate by the British bank Standard Chartered.
Later in 2011, some investors returned to the dollar as a safe haven as the European sovereign debt crisis worsened, judging the United States to be less risky than the even shakier European states. These investors also turned to the Japanese yen and the Swiss franc. But in a time of rising anxiety about governments and their monetary promises, investors began to take shelter in the ultimate safe haven: commodities—and not just “hard” ones like minerals and energy but also “soft” ones like food. Capturing the contrast between a shaky U.S. dollar and runaway commodity prices, a recent Australian newspaper cartoon depicted a White House aide briefing President Obama on the debt negotiations as follows: “The debt ceiling is 14.3 trillion U.S. dollars. In hard currency, that’s 12 about Australian bananas.”
The big run-up in commodity prices lampooned in this cartoon began in 2000. And even after adjusting for inflation, it has been dramatic. According to the IMF’s index, average prices trebled over eight years, halved when the global financial crisis struck and then zoomed back to levels surpassing even their 2008 peaks by mid-2011. They have tapered off somewhat in the months since but remain at levels, in real terms, not seen since the great inflationary crisis partly caused by the oil shocks of the 1970s.
We can glimpse the future by looking to Argentina, which exports, among other things, 55 million metric tons of soybeans a year. The boom in world food prices has farmers rolling in money, says Dr. Courtis:
You ask the farmers, where do you keep your money? They don’t trust the government, and they don’t trust the banks. But you know what I learned? Soybeans keep for up to four years. These guys store their wealth in soybeans. So when they need a new tractor, they just sell a few soybeans.
So they have already, effectively, monetarized soybeans. Courtis foresees that, in a world wary of government debt and paper currencies, investors will put ever more faith in physical assets: “The only things people will want to buy will be ones that hurt when you drop them on your foot.”
One possible objection to this analysis is that this behavior might be explained not by cheap U.S. money and distrust of the greenback, but by the great industrial revolutions now under way in China in particular, as well as in India, Indonesia, Brazil, Russia and South Africa—a grouping of countries that is home to most of the world’s population. We know that once a nation’s income moves past about U.S. $3,000 or so per capita, but before it reaches somewhere between $18,000 and $25,000, that nation moves into a resource-intensive development phase, building roads, rail, bridges, housing and telecoms on a large scale. Countries in this group accounted for three-quarters of all growth in the world economy over the past five years. Indonesia and India have just entered that middle-income realm. China is a bit further along at $5,000 per capita. Brazil and Russia are at around $10,000. In other words, they all have some ways to run yet.
For instance, China’s steel consumption has risen at an extraordinarily rapid clip—15 percent per year on average over the past decade—and now accounts for 45 percent of the world total. Yet its demand for steel is still expected to grow by an average of 8 percent per year for another five years. By then, China will be consuming 52 percent of all steel produced in the world, according to the Australian Government’s Bureau of Agricultural and Resource Economics. So yes, underlying demand for commodities is a powerful driving force behind their zooming prices.
However, there’s more to it than that. In 2009, Professor Jayati Ghosh of the Centre for Economic Studies and Planning at Jawaharlal Nehru University in Delhi compared food staples traded on futures markets with ones that are not. Guess what? Foods that were not open to futures trading rose by only a fraction as much as those that were. The effect of liquidity flows and investment activities on food prices is known as “the financialization of food.” In other words, this is not purely a supply-and-demand story. The amount of liquidity in financial markets matter, and the price of foods traded on financial markets has become intimately connected with energy prices.1 “Over the past ten years we have seen a much closer linkage with energy prices”, says World Bank President Robert Zoellick, whose career highlights include work at the U.S. Treasury and Department of State as well as Goldman Sachs.
It’s partly biofuels but it’s not only biofuels. It’s partly the energy used in fertilizer and in bringing products to market. And it also reflects this fact that both energy and food are commodities. . . .
Commodities have become an alternative investment class.
There is a monetary plotline on top of the underlying supply-and-demand story, and this monetary plot can have a major effect on prices.
Just as the U.S. government will not admit that its ethanol policies destabilize world food prices, so the Fed won’t admit that its policies have any effect either. But this is economically impossible. The Fed is the world’s biggest source of liquidity, and we know that asset prices worldwide rise and fall on the tide of cheap money that Ben Bernanke directs from his austere, white marble boardroom on Constitution Avenue in Washington, DC. The Chairman himself has said that his monetary tide affects the U.S. stock market. Asked in January 2011 how successful quantitative easing had been, Bernanke replied, in part:
Our policies have contributed to a stronger stock market, just as they did in March of 2009, when we did the last iteration (of quantitative easing). The S&P 500 is up about 20 percent plus and the Russell 2000 is up 30 percent plus.
Quite apart from the fascinating revelation here that the Fed has been targeting stock prices (something it has long denied but which turns out to be its secret third mandate) is Bernanke’s frank admission that the Fed’s monetary policy is an important influence on stock prices. Yet when an interlocutor blamed the Fed for rising global commodity prices and the world food crisis, Bernanke denied any connection.2
This denial fails the test of common sense. If easy money helps lift stock prices, then it should logically have the same influence on all assets whose prices are connected through the same financial system, shouldn’t it? President of the Dallas Fed Richard Fisher confirmed exactly this train of logic this past June, accepting that U.S. monetary policy was a factor in rising commodity prices. Hong Kong Chief Executive Donald Tsang expressed his fear that cheap Fed money was also having a dangerous effect on yet another asset class: “I’m scared and leaders should look out”, said Tsang, who was formerly Hong Kong’s financial secretary. “America is doing exactly what Japan did last time. . . . We have a U.S. dollar carry trade”, Tsang said in 2009, referring to the widespread practice in which big investors borrow money in the country where it’s cheapest and use it to buy assets in countries where money is more expensive.
Where is the money going? It’s where the problem’s going to be—Asia. You can see asset prices going up, not only in Korea, in Taiwan, in Singapore, and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals.
The excess supply of money from the Fed is cheapening the value of the U.S. dollar, inflating bubbles in the prices of food, energy and mineral commodities, and helping pump up the price of foreign real estate. And the Fed has declared that it will keep its free-money-plus-subsidy policy intact for another two years as these bubbles swell, blister and boil away in markets around the world.
All That Glitters
The consummate evidence of all these expanding bubbles is surely the price of gold. The precious metal has not been precious enough for gold investors over the past thirty years. After spiking at $711 an ounce in 1980, gold spent twenty years languishing between about $300 and $500, ending at $272 in the year 2000. Even the terrorist attacks of 9/11, and the Fed’s following big monetary cheapening, did nothing for gold, which was trading for less than $290 an ounce a month after the attacks. Gold, in short, had been a lousy investment. It doesn’t pay a dividend. It doesn’t pay a yield. It just sits there and shines.
Even as its price ran up dramatically, hitting $1,400 an ounce in March 2011, it was still a lousy investment. Adjusting for inflation, gold had lost 40 percent of its value since the 1980 spike. Warren Buffett pointed out its uselessness in the same month that gold bugs rejoiced at its March highpoint. If you had collected all the gold in the world at that time, it would have formed a cube 67 feet on each side worth $7 trillion, Buffett observed. With that, you could have bought every acre of American farmland plus seven companies the size of Exxon-Mobil and still had $1 trillion left in your pocket. As the Sage of Omaha said,
If you offered me the choice of looking at some 67-foot cube of gold and looking at it all day, you know, I mean touching it and fondling it occasionally, you know, and then saying, you know, ‘Do something for me,’ and it says, ‘I don’t do anything. I just stand here and look pretty.’
He is, of course, correct. But since then, the price of gold has shot up by almost a third and flirted with $1,900 an ounce. Why?
“The gold price is not so hard to deconstruct”, writes James Grant in his newsletter, Grant’s Interest Rate Observer. “The price may be expressed as one divided by the world’s trust in the institution of managed currencies. As the trust factor in the denominator shrinks, so does the gold price rise.” Thus it isn’t gold’s inherent attractiveness but the deepening mistrust of paper currencies that explains the boom in price. Says Grant, “With the Fed at wit’s end and the euro on the ropes, we rate trust in managed currencies a candidate for continued shrinkage, the gold price a candidate for continued appreciation.”
Paper money—or fiat money—is worth only as much as people are willing to believe it is worth. Preserving a shared myth that pieces of colored paper are stores of value requires what the poet Samuel Taylor Coleridge once called “the willing suspension of disbelief.” (It is no coincidence that the word “credit” stems from the Latin “credere”—to believe.) But a silent conspiracy of make-believe about colored pieces of paper is fragile. It is particularly vulnerable to a supply shock. There is a finite supply of gold in the world. The supply grows as more is mined each year, but it is added in steady, small and predictable quantities. Paper money lately has been either issued in such vast numbers of sheets or electronically conjured so indiscriminately that the Fed’s mortgage-backed securities-buying sorties, dubbed its “pawnbroker of last resort” function, has lost scarcity value.
There is something else going on, too, however. Courtis believes that gold and other commodities have hit a short-term peak and will stagnate in the months ahead as new fears about sluggish global growth unsettle investors. However, the “Himalayas” of debt, public and private, in the United States, Japan and Western Europe trouble him. The total debt burden in these countries ranges from 350 percent of national GDP to 500 percent. “Only people who believe in the tooth fairy should believe this will be repaid”, he jibes. One result of this unsustainable debt burden, he predicts, is that governments and central banks will try to inflate their way out of their debt problems even more than they are doing now. “We will look back and say to ourselves, ‘Why didn’t we buy gold when it was only $1,900 an ounce?’” says Courtis.
Most of us have probably noticed the booths in shopping malls with big “We Buy Gold” signs out front. They offer to pay cash to shoppers who bring jewelery, coins or watches in to trade. These boutiques are evidence that “the public hasn’t cottoned on yet”, Courtis suggests. “When you see people queuing around the block to buy gold coins, you’ll know they’ve worked it out.”
For most of the past forty years, only the obsessive and the eccentric kept the faith in gold as an investment. This contrasts with the 1890s, a time when the gold bugs were the respectable mainstream and the advocates of paper “fiat” currencies were the ones on the political and intellectual fringe. Today, the gold bugs are back. For the first time in two decades, private banks are opening vaults for customers to hold bullion. Europe’s central banks in 2011 became net buyers of the precious metal for the first time in a quarter-century. “Mexico, Russia, South Korea and Thailand have all made large purchases this year, in a move to reduce their exposure to the dollar”, reports the Financial Times. “Globally, central banks are set to buy more gold this year than at any time since the collapse of the Bretton Woods system 40 years ago—the last time the value of the dollar was linked to gold.” As Jonathan Spall, a precious metals salesman at Britain’s Barclay’s Capital, says, “We’re going back to a time when gold is seen very much as money. It’s been a complete reversal of the attitudes we saw during the 1990s.”
Even the governments of the G-20 are actively discussing the idea of spreading the risk, creating a new reserve system comprising the currencies of multiple countries. This was unthinkable just a few years ago. The World Bank’s Zoellick has suggested that any new system should not only comprise a basket of currencies but also include gold as a component. It is implausible that the world could return to a classical gold standard, if only because the very slow growth in the gold supply would be rapidly outstripped by global economic growth. Any attempt to require a country to hold a set amount of gold for each new dollar issued would be horrendously restrictive and economically ruinous. Zoellick’s suggestion, then, is a way of trying to restore confidence in the current system by creating a hybrid of fiat money and a gold standard.
It’s quite extraordinary that a responsible and experienced official of the global financial system should be proposing that trust and value should be restored through the use, in part, of gold. “There is a system change under way”, suggests the head of Sydney-based Platinum Asset Management, billionaire investor Kerr Nielsen. “You can see it in the price of gold.” Gold, in this view, is playing a part as a transitional store of value between one system and the next. The problem is that this next system is still nowhere in sight.
The anxiety coursing through global markets and financial systems today is not just about confidence in the U.S. government and its currency. Nor is it just about the United States and the other leading powers of the developed world, Japan and Western Europe. While confidence in the reigning superpower might be sinking, there is no corresponding rise in confidence in the potential successor, China.
The old system may be faltering, but there is not yet a new system to replace it. Standard & Poor’s may have cut America’s debt rating from AAA to AA+, but it rates China’s three notches lower. In other words, no matter how much money China has, it is inherently risky because it has no independent institutions. It doesn’t even have the institutions of a normal nation-state, because what institutions do exist are inseparable from the ruling party. Chinese reformers have long talked about the need to change this, but the Chinese Communist Party’s need for absolute power has always trumped the national need for systemic stability. In China, everything turns on the whim of a small group of elites who are as unaccountable as they are invisible.
As we have seen, the price of the Fed’s cheap money policy is high. But maybe the price is worth paying if it succeeds in its avowed aim of creating jobs and restoring the U.S. economy. Will it?
Three of the 12 voting members of the Fed’s Open Market Committee (FOMC), voting to oppose the most recent episodes of quantitative easing, apparently think not. Former Fed Governor Larry Meyer wrote in his memoir that two dissenting votes was the maximum number compatible with comity on the committee. “A third”, he wrote, “would be viewed as a sign that the FOMC was in open revolt with the chairman’s leadership.” By Meyer’s indicator, then, the Fed’s topmost officers are in open revolt.
One of the rebels, Richmond Fed President Jeffrey Lacker, explained his no vote in September 2011: “My sense is that more monetary stimulus at this point would likely show up almost entirely in higher inflation with very little constructive influence on growth.” In July 2011, Dallas Fed President Richard Fisher used a car metaphor to say more or less the same thing:
We can fill the gas tank with attractively priced fuel? abundant and cheap money? needed to propel the economy forward. But we cannot trigger the impulse to step on the pedal and engage the transmission mechanism of job-creating investment by the private sector. This is the province of those who write our laws and regulations? the Congress of the United States. I firmly believe that the Federal Reserve has already pressed the limits of monetary policy. So-called QE2, to my way of thinking, was of doubtful efficacy, which is why I did not support it to begin with. But even if you believe the costs of QE2 were worth its purported benefits, you would be hard pressed to now say that still more liquidity, or more fuel, is called for given the more than $1.5 trillion in excess bank reserves and the substantial liquid holdings above the normal working capital needs of corporate businesses. . . . U.S. banks and businesses are awash in liquidity. Adding more is not the answer to our problems.
Bernanke later came around to this point of view himself and in an appearance before Congress’ Joint Economic Committee in October challenged the legislature to address the problem of growth.3
Even though some members of the Fed itself aren’t sure that hyper-liquidity will restore the U.S. economy to health, there’s one thing we can be pretty confident of: America and the rest of the world will pay a price for it. If recent history is any guide, hyper-liquidity will lead to another bust in asset prices and another downturn in the economy. All the while, the credibility and standing of the United States as the leader and standard-bearer of the global financial system will come under a serious and sustained challenge unlike any it has known since its postwar rise. In short, this is a policy of uncertain economic benefit, but of a predictable and steep cost.
It’s harder to know exactly how long it will take for sticker shock to set in this time around. Last time, it took 11 years for the Fed Chairman to go from hero to zero. How long will it take this time before the editors of Time, those experts at spotting the stunningly obvious, tell us that the Fed chief they congratulated in 2009 has now fully ripened as a villain? More importantly, when this bout of hyper-liquidity inevitably ends in a bust, rendering the monetary trick even feebler than it is now, what will the Fed do then?
Peter Hartcher is the author of Bubble Man: Alan Greenspan and the Missing Seven Trillion Dollars (2006), which predicted the collapse of the U.S. housing market and the recession that followed. He is the political editor of the Sydney Morning Herald.
1A point emphasized in Rosamond L. Naylor and Walter P. Falcon, “The Global Costs of American Ethanol”, The American Interest (November/December 2011).
2In answer to a question at the National Press Club in Washington, February 3, 2011, as reported on the Financial Times website on the same date.
3Fisher’s comments were made to the Rotary Club of Dallas on July 13, from the Federal Reserve Bank of Dallas website. Bernanke’s were made in testimony to the Joint Economic Committee of Congress, October 4, 2011, from the Federal Reserve website.