Engineered Inflation Bailouts Cannot Beat the Markets

By: Michael_S_Rozeff

Once again the leaders of the western world have engineered a bailout Who pays for it? We hicks and dupes and taxpayers. Once again the politicians, central bankers, and IMFers have patched together a paper dike, in an attempt to hold up the prices of the euro and junk debts, and to prevent the liquidation of banks that hold the bad paper. Once again, they have kept banks and lenders from realizing losses. Once again they have jacked up the moral hazard in the system. Once again they have saved, if only temporarily, the fiat money-fractional-reserve system that works hand-in-hand with big government.

Inflation, bailouts, credits piled upon credits, and phony accounting are the necessary logic of the political economics of the fiat money system. The perpetuation of the political economy of big government requires all of this, and the leaders of that system know it. This has been known for a long, long time. I quote Walter A. Morton, British Finance 1930-1940 (1943):

"Since 1857 it has been the policy of the Bank of England to discount freely at high rates in times of crisis. Any other course would mean that the responsibility for maintaining liquidity would rest on the joint-stock banks themselves and thus, unless they radically altered their investments by refusing to buy government bonds and other such illiquid securities, make them vulnerable to any internal or external run. Regardless of the quality of their assets they would then be subject to failure, not because their assets were not good (in the sense that British government bonds are good for a British bank), but because they were not liquid. It has, therefore, been generally concluded that it is preferable for the central bank to unfreeze the commercial banks if they have 'good' assets rather than force the entire system to go into liquidation.

In the latter event, the total value of all assets would depreciate to the price at which those who had gold or Bank of England credits were willing to pay. Such a deflation would have been extremely destructive in 1931. If the City had gone into liquidation because the Bank had refused to discount its paper, great confusion would have resulted. Prices of domestic goods and capital values would have declined drastically, unemployment would have increased, production would have diminished, corporations and individuals would have defaulted. Under existing legal institutions, the actual process of liquidation by the transfer of titles would have continued for several years. The expenses of government would have increased because of unemployment; and because revenues would have declined, budgetary deficits would have grown. These deficits could not have been met by borrowing from the Bank of England, inasmuch as hypothetically it was bent upon reducing its liabilities. The combined opposition of bankers, bank stockholders, bank depositors, businessmen, trade unions, and shopkeepers might soon have interfered with this 'natural' process of liquidation."

Morton goes on to mention that Nassau Senior a century earlier "set forth the economic theory applicable to a complete deflation."

Morton leads off with a succinct truth: The joint-stock banks are vulnerable to runs on the bank because they take on illiquid loans, including government securities. This is the built-in flaw to fractional-reserve banking. It is the flaw that governments and central banks constantly are patching up. Morton says that "it has been concluded that it is preferable" for central banks to print credits whenever needed to keep this system going. Who concluded that? To whom is it preferable? Obviously to the bankers and to the governments that want them to finance their borrowing.

All of this quote from Morton is not applicable to today's situation, but much of it is. The EU, the ECB, and the IMF, with the assistance of the Fed, are taking the role of the Bank of England. This group includes states and financial institutions with supposedly stronger finances than those to whom they are lending, or whose debt they are guaranteeing. The "City" consists of western banks and other holders of the sovereign credits of Greece, Portugal, Spain, etc., including the credits of the states with supposedly stronger finances.

The political interests to which politicians cater still include "bankers, bank stockholders, bank depositors, businessmen, trade unions, and shopkeepers." To it may now be added government employees, bureaucrats, and all those protesting government budget cuts. Broad swaths of society cannot countenance a liquidation and a reorganization of banking.

Big government, fiat money, and fractional-reserve banking are united into a corporative state, with the sympathy of many interest groups in society. Their interest is whatever inflation and bailouts it takes to keep the system going. Their interest is to transfer wealth from a more diffuse body of people in society who pay the hard-to-identify burdens and costs of the inflation and the bailouts. The simple idea I am expressing is that there is one system at work, a big government-fiat money-central banking-fractional reserve banking system, and that system is necessarily inflationary.

The price of band-aids for the system has risen steeply in the last few years. It is up to one trillion per band-aid. Simple ideas can guide us in complex situations. Simplicity has its virtues. Another simple idea is this: The bigger they are, the harder they fall. The sheer size of the newly-created credits, guarantees, and money creation in order to save the fractional-reserve banking system is itself a large warning bell. It seems to be the death knell. It is well to regard the probability of that death knell as nontrivial.

The ECB, as predicted, has behaved its fiat-money self by agreeing to do its share to hold together the system. Like the Fed, it will turn itself into a junk bond fund. This too is a signal that a serious alteration has occurred in the last few years that goes beyond discounting good assets of member banks.

Extending finance without having some sorts of controls and collateral is a futile gesture. Just how strong will be the financial controls that EU countries will have over their newfound nation-state wards and borrowers?

My third and last simple idea is that markets win. Markets are more powerful than any person, group, institution, nation-state, or combination of nation-states. That is because they are large. If Soros can bet and win against the pound, don't you think that the hot capital in this world can bet and win against attempts to support the euro at artificially high levels? The knee-jerk reaction to the proposed EU-ECB intervention (exchange stabilization fund) in the euro was quite large in stocks and minimal in the euro itself, at least so far. No matter what rally does or does not transpire, the markets will win. Nixon's price controls produced a short-lived rally in late 1971 that led into an important 1972 top. Intervention may change the market dynamics for awhile, but it can't do so permanently. Value will out.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

© 2010 Copyright Michael S. Rozeff - All Rights Reserved
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