Avoiding the Inevitable - Consequences of government intervention, and delaying and manipulating economic cycles

THE CURRENT FINANCIAL CRISIS

Avoiding the Inevitable - Consequences of government intervention, and delaying and manipulating economic cycles

Causes, Conditions, and Possible Remedies


INTRODUCTION

I have been reading about business, finance, and economics regularly as a hobby since late 2006. During this time I had read and heard the warnings of many different economists and financial experts prophesying the lurking danger of another great depression. During this time I was living in New York City and befriended many people who worked on Wall Street. Being exposed to the warnings of these prescient doomsdayers and then convening with eternally optimistic Wall Streeter’s who believed the market’s would always go up, one could experience a dichotomy of sorts. The July 17th 2007 high of 14,021 points on the Dow Jones industrial average did little to dissuade my convictions although would have probably served as ammunition to sink the ark of ideas concerning the future condition of the economy I had held for the previous several months. However, I had done enough reading to have drawn some of my own conclusions irrespective of the impressive numbers on the Dow Jones Industrial Average.
Still wondering if I had accidently yet consistently encountered “lunatic fringe” economists and financial experts, I did even more research, and was only somewhat relieved when the first effects of the subprime mess really began to hit the markets in late summer of 2007, and when former Fed Chairman Alan Greenspan’s book “The Age of Turbulence” was released a few months later citing the former Fed’s warning that we would enter a financial “age of turbulence” beginning around 2010. The phrase “somewhat relieved” is rather apropos as I realized that while I wasn’t serendipitously encountering faulty conclusions derived from various financial experts and economists, and I was also simultaneously worried that their predictions looked like they were going to materialize. The July 2007 issue of Bloomberg Markets magazine, which was released in June 2007, covered subprime lending and the formation of various CDO’s and MBS’s and derivatives that were floating around in the investment ecosphere. This made me wonder if something could happen sooner than later with the respect to the markets. A month and a half later something did indeed happen.
The first initial blip felt in the markets during August of 2007 made it clear to me that something was indeed wrong – Jim Cramer’s famous meltdown on CNBC on August 3rd didn’t concern as much as it should have. It conveyed not only that something was wrong but also that things could get worse very quickly. One by one, institutions started falling apart and multiple cracks started to appear in the financial system. The Dow Jones crossing over the 14,000 to a high of 14,021 points the month before had really been the tipping point, the crescendo of the flight of an ill-fated rocket no longer moving heavenward and now hanging in mid air as its engines sputtered, right before a free fall earthward. The Dow’s rocketship would sputter up again to it’s all time high of 14,164 in October; truly the final crescendo before a cacophonous fall into four digit terrain.
I started to suspect something was really wrong when I examined the silver charts that August. In a few days the price of silver dropped over 9.5%. The spot price of silver went from $13 on August 9th 2007 to below $11.75 by August 17th. After conferring my findings with an acquaintance of mine, he alluded that “the hedge funds are getting liquid by selling their silver in massive amounts, and they’re doing it fast.” I don’t know what his reference or source was or how accurate his statement was, but I did realize we had just seen the tip of the iceberg and were going to be futilely steering the ship for sometime; damage was inevitable but now the question was “what can we do” to make the situation less of a nightmare than some of us were suspecting it could turn out to be.
After reading about economics, business and finance for the past few years, I have decided to write this paper. Many in the media today are focusing on the proximal causes of the current financial crisis. Most journalists and pundits seem to look at the lighter that the created the flame, that lit the fuse, but few mention or even know there was a fuse, and even fewer know of or even mention the bomb, and the bomb makers who played a role.
This paper talks about the bomb maker, the panoply of material that went into making the bomb, the fuse, the lighter used to light the fuse, and ties together how these different elements all made an impact in creating current financial events. The sad truth is, while underlying different elements are discussed, some elements could have stood out on their own and have triggered a financial crisis. What we are witnessing now is a perfect storm of events. The current financial system may have been checkmated from all sides and policy makers are tasked with the awesome responsibility of constructing creative and innovative solutions to solve this mess.

Antonio Goicochea, Washington, D.C. 2009


PREMISE

Excessive government involvement and intervention has led to a domino effect of events that has triggered the current financial crisis and may continue to wreak havoc on the economy even after more pressing problems are resolved.
In this paper we will examine several key forms of government intervention / involvement that have contributed to this current crisis.
First we will examine the Federal Reserve System also known as “The Fed.” We will see how the institution of the Federal Reserve System in the United States creates boom and bust cycles through the manipulation of interest rates. Central banks manipulation of interest rates create boom and bust cycles as proven by FA Hayek who won the Nobel Prize for publishing this discovery. Since the institution of the Federal Reserve, it’s manipulation of interest rates, and the adoption of a fiat money system, a level of inflation has ensued that has disproportionately raised asset prices as well as the cost of living relative to wages and salaries. As a result of the cost of living and asset prices having risen significantly disproportionately to incomes and easier access to credit spawning the rise of a “credit consuming culture”, the general populace, from average citizens to large multinational firms, had been incentivized to use debt. For average Americans many have employed debt to keep pace with the standard of living.

Additionally, local government intervention in metropolitan housing markets created unsustainable housing prices compared to the rest of the United States or other metropolitan housing markets that lacked government regulation and intervention.
At the level of the Federal government, politicians pushed for and intervened to achieve policy objectives of affordable housing for all which, while well intentioned, also incentivized many, both those with worthy and questionable credit, to purchase homes which drove up overall housing prices and thus creating a bubble.
In addition to government intervention increasing asset prices as well as the creation of the Federal Reserve which uses an inflationary currency system, and thus has increased the cost of living disproportionately, other forms of government intervention ranging from the enactment of ERISA in 1974, to Medicare, and Medicaid, Prescription Drug Benefits, and Social Security programs lie in wait to create a “perfect storm” of events.


“Credit delinquencies hit record highs”
CNN July 7th 2009



Hypothesized Causes, and Conditions


In this paper we will examine only a handful of postulated causes as to the current financial crisis. We will examine different economic factors. We will begin with hypothesized contributory causes and then the proximal causes which are well publicized today in the mainstream media outlets.

We will also examine other perilous factors as well that are causing or will cause a cataclysmic perfect storm of events that harbor potentially lethal consequences to economies worldwide.

First let’s examine one of the hypothesized contributory causes. I will explain how these particular causes tie into the proximal cause. In many instances the financial crisis is so severe because of these underlying causes.


PART 1: DISTAL AND UNDERLYING CAUSES
ORIGINAL OUTLINE
• Central Bank’s Control of Interest Rates and of the Money Supply
• Unsustainable Trade Imbalances: Excess credit creation and the abandonment of auto-adjusting mechanisms – The death of the Gold / Hard Money Standard and the death of the Bretton Wood’s Standard.
• The Adoption of Fiat Currency: Pro’s and Con’s
• Depressions as Cyclical Phenomena?
• Inflation
• Inflation, Control of the Money Supply, Manipulation of Interest Rates, and the Creation of Credit Culture.
NEW PROPOSED OUTLINE
1. Part 1 Distal and Underlying Causes
o Section 1: Government Intervention in the Banking Sector and It’s Effects
ß Central Bank’s Control of Interest Rates and of the Money Supply
ß The Adoption of Fiat Currency: Pro’s and Con’s
ß Unsustainable Trade Imbalances: Excess credit creation and the abandonment of auto-adjusting mechanisms – The death of the Gold / Hard Money Standard and the death of the Bretton Wood’s Standard.
ß Inflation
o Section 2 – Adding insult to injury and other miscellaneous phenomena
ß Social Security, Medicare, ERISA,
ß Depressions as Cyclical Phenomena?
ß Inflation, Control of the Money Supply, Manipulation of Interest Rates, and the Creation of Credit Culture.

Chapter 1
Central Bank’s Control of Interest Rates and of the Money Supply

In December 1974, F.A. Hayek was awarded a Nobel Memorial Prize in Economic Sciences for a paper that he co-authored with Swedish social economist Gunnar Myrdal.

In the paper he proved that the control of the money supply and of interest rates by central banks created boom and bust cycles.

The history of central banking in this country is very interesting. The founding father’s for the most part were not interested in central banking. In fact they were very much opposed to a central bank such that England’s attempts to place the “colonies under the control of the Bank of England was seen by many as the ‘last straw’” that eventually gave way to the Revolution (wiki History of central banking in the United States)

However, towards the end of revolution and before the creation of the Federal Reserve there were other attempts to create a central bank. The second attempt took place under Alexander Hamilton. He wanted to create a central bank and for a while we did have a central bank although ultimately Thomas Jefferson pulled the plug on his efforts. The next attempt at central banking took place under Andrew Jackson’s presidency. However he swiftly put an end to the creation of a central bank as he claimed it was becoming more of “competing power center beyond his control” and thus a vehicle of corruption (Meacham 212).

(Why did the founding father’s not like the idea of a central bank?)



Eventually in 1913 the Federal Reserve Act passed and the Federal Reserve was created. This was the first time the United States had ever successfully implemented a centralized type of bank long-term. Like many other central banks the Federal Reserve is a quasi-private central bank where “numerous other private U.S. member banks” are obligated to “subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks.” (wiki Federal Reserve; Lewis 20)

Critics of the Federal Reserve claim argue that the US dollar has lost over 96% of it’s purchasing power since the creation of the Fed and it’s manipulation of the money supply and interest rates.

Today centralized banking systems exist in most countries, and the major currencies of the world are fiat currencies (Lewis 20).


“Why is this important?”


While F.A. Hayek’s work proved that the manipulation of the money supply and interest rates created boom and bust cycles was important, another important factor to examine is the history of fiat currency. Currently the Federal Reserve, which determines monetary policy for the United States uses a fiat currency system. There are some advantages and disadvantages to a fiat currency system. Unfortunately, the negative characteristics of fiat currency are also the same characteristics that have contributed to the underlying back drop behind the recent financial crisis here in the states.

Chapter 2
The Adoption of Fiat Currency: Pro’s and Con’s

The use of fiat currency is still debated today. Many contend that fiat currency is more appropriate for today’s interconnected and more global economies. However this currency system has not been en vogue until more recent times. Many detested it’s use throughout the ages and the adoption of paper currency had been met with skepticism among various circles of power. Today the United States uses a fiat currency system that is deemed to be the reserve currency of choice (Bernanke). However the United States did not start out

President Andrew Jackson along with many other die-hard “hard money” proponents theorized that paper currency encouraged speculation which led to banks to lend more money than was necessary, especially in the form of risky loans, which in turn created bank panics, and depressions (Samuelson 86). Today we are witnessing the verification of this hypothesis.



The advantages of fiat currency, is that because it is a currency not backed by anything of intrinsic a nation can easily switch over to fiat currency and cease to redeem bank notes for gold or silver which was usually the case when most nations employed a representative money system. This is needed when countries need to pay off their debts are having difficulty paying off their debts. Debts are usually incurred due to increased military spending as a result of significant and usually drawn out military campaigns, and also excessive spending by the government often incurred with the commission of public works of sizeable magnitude.
To sum it up in layman’s terms, nations switching over to a fiat currency system can now pay back debts with instruments not worth anything in value. The market’s initially react to the initially printed currency as high powered currency units. However the markets eventually adjust and the new currency loses purchasing power. Many critics chide that fiat currency is a form of government sanctioned legal counterfeiting. (Schroeder p, Kiyosaki, Maloney)

For clarification, a representative money system is a monetary system where gold and silver are represented by bank notes or bills. Instead of carrying gold and silver coins, commodity money, bank notes are a much more convenient to physically carry instead of having to pay in weights of gold or silver coin. Imagine having to buy something of significant of significant value with gold and silver coins.

Today, the major currencies of the world are fiat currencies (Kiyosaki, Duncan, etc)

The disadvantages of fiat currency.

The long-term downside to fiat currencies are unfortunately rather disastrous. Since fiat currency was first implemented each and every single fiat currency has failed, with usually ominous consequences. Let’s look at some brief examples in history.

The Ancient Greeks

Fiat currency was first thought to have been invented and used by the ancient Greeks (Maloney 7). The ancient Greeks implemented fiat currency to finance an over-extended militaristic campaign. Instead of using commodity money as they used to, they started using fiat currency (debasing the precious metals content in their coins until the face value was worth far more than the intrinsic value of the debased metal) to pay for their war expenses. At the height of their empire, a far-reaching foreign military policy and the implementation of fiat currency crushed the Greek empire and successfully accomplished what their enemies could not do on the battlefield. (Maloney 7 – 8 ). In fact, in only took Greece only a handful of years for their new monetary system to be considered worthless.

Rome under the rule of Diocletian

Similar to the Greeks, the Roman Empire started mixing various metals into their coins. Eventually their coins no longer contained a gold or silver mixture and became “nothing more than tin-plated copper or bronze” and as a result inflation soared (Maloney 8).

With inflation raging, the famous Roman Emperor Diocletian issued his Edict of Prices in 301 A.D. This document mandated a “death penalty on anyone selling goods for more than the government mandated price and it also froze wages” (Maloney 9). Unfortunately, this attempt to stem inflation backfired as prices continued to rise. The Roman economy became more and more of a centralized planned economy with the invention of welfare, and ample government funded public work projects. Deficit spending was taken to extremes. In 301 when the famous Edict of Prices was issued, 50,000 denari could purchase a single pound of gold. Halfway through the 4th century it took 2.12 billion denari to purchase a pound of gold. This was first known case of hyperinflation to occur in history. This level of inflation eventually destroyed the Roman Empire.

France and John Law

John Law was considered something of a financial genius in his time and lead a life that was at times rather joyful and at other times rather turbulent. Without getting into his background, John Law eventually moved to France after a few legal scrapes in England where it was determined that he best leave the country or at least for an extended period of time. When he arrived in France Louis XIV, the well loved “Sun King” was irresponsibly running France into significant debt by funding his military campaigns and his ever lavish lifestyle vis the creation of Versailles. Around this time John Law had created some treatises discussing the benefits of paper currency. When Louis XIV passed away, Le Duc of d’Orleans, who was a gambling buddy of John Law, was made regent until Louis XV was old enough to rule France. Unfortunately Le Duc d’Orleans much to his horror discovered that tax revenue would never be able to pay off the staggering debts France had amassed under Louis XIV. John Law seized his opportunity and shared with Le Duc d’Orlean’s his economic treatises expounding the benefits of paper currency. John Law was promptly gifted a bank at the behest of the Duke, which was called Banque Générale, and was also awarded the right to print paper currency (Malone 13). This occurred on May 15, 1716.

True to form the French economy did experience an economic boom, which initially tends to happen when a nation’s monetary system switches over to a paper currency based system. John Law became something of celebrity as a result of this economic boom. In 1718 Le Banque Générale became Le Banque Royale, signifying that the regent would guarantee all bank notes (http://en.wikipedia.org/wiki/John_Law_(economist) Unfortunately, after the creation of the central bank and the conversion to a paper currency system, inflation eventually began to soar, and French citizens attempted to redeem their bank notes for various precious metals, primarily gold and silver, until the French banks had exhausted their supply. Those redeeming their banks notes were now being paid in copper. In a short amount of time, John Law’s paper currency system had collapsed. The country was on the brink of severe social unrest and on May 10th 1720 John Law was fired from his position as Controller General of Finances. In four years John Law’s paper currency system embroiled France and most of Europe into a depression that lasted decades and which “set the stage” for the French Revolution (http://homepage.newschool.edu/het//profiles/law.htm; Malone 13 - 15)

The Continental
To finance the Revolutionary War, the founding father’s of the United States switched over to a fiat based currency called “the continental.” The continental quickly lost all value. Fortunately, the United States government put in a great deal of effort to expediently pay off accrued war time debts. As common sense would dictate, excessive debt can be dangerous when mis-used as we can see is the case with governments, myriad firms, and individuals over time. (I.O.U.S.A.)





“Rule number #1 Never go into debt”
-Warren Buffett (Schroeder, “Warren Buffett Way”)

Crippling debt’s can lead the way to enormous economic catastrophes. More on this in a bit.

The Weimar Republic
In order to finance their war expenditures, Germany went off the gold standard at the beginning of World War I. However by the end of WWI, Germany was obligated to make reparations particularly to France. They failed to make their second round of payments to the French and began printing even more paper currency. Hyperinflation ensued. To give you an idea as to how much the currency had devalued itself the currency supply of marks, which was the German currency in that era, in 1919 totaled 29.2 billion marks. By November 15th 1923 Germany’s currency supply had exploded to 497 quintillion marks.

In cases of significant inflation, the middle class tends to be destroyed. Some of the rich become poor, too but the sagacious and financially adept members of the wealthy class survived and become even wealthier.

“ benefits some”
Maynard Keynes quote

“Lenin is said to have said “The best way to destroy the capitalist system is to debauch the currency.”
- John Maynard Keynes on Lenin
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
- John Maynard Keynes paraphrasing Lenin (They never said it
By Paul F. Boller, John H. George) (The Economic Consequences of the Peace 1920)


As previously stated earlier in this paper, the United States went off the Gold Standard and adopted a fiat currency standard in 1971.

I am going to make a bold statement in this paper and is it this: Fiat currency in the United States is designed to fail. The U.S. Treasury and banks pay back interest to the Federal Reserve via fractional reserve banking where they can loan up to 10 times the amount of deposits. By loaning up to 10 times the amount they hold in deposits (which means banks only have a 10% reserve requirement), banks create dollars out of thin air, and thus inflate the money supply. Thus fiat currency has to be inflationary. If fiat currency has to be inflationary we will see continue to see asset prices rise higher and faster than average wages which means the cost of living has increased even though wages have not kept pace. We will also see that people will may earn a higher income numerically speaking and thus be placed in a higher tax bracket but the purchasing of that income will be much less than a lower income a couple decades before hand. Essentially, someone is being taxed more when they really earn much less in terms of value than someone making the same income (numerically speaking) several years ago. In this manner inflation acts as a double stealth tax.


Chapter 3
Unsustainable Trade Imbalances: Excess credit creation and the abandonment of auto-adjusting mechanisms – The death of the Gold / Hard Money Standard and the death of the Bretton Wood’s Standard.

The classical gold standard has been in existence throughout history for quite sometime. For centuries the populace seems to have some sort of magical interest in gold. In times currency crisis’ many in the populace attempt to convert their currencies into something that will hold it’s value much longer than the plummeting value of their currency. In many instances the citizens of a populace will convert their failing currencies into precious metals such as silver or gold. (Maloney, , ,)

Although many economists and policymakers debate about the drawbacks of working under a classical gold standard, one of the desired characteristics about a gold standard is that because it is finite in quantity it forces countries to be much more monetarily and fiscally responsible, and also enforces a balance of trade between different countries.

For those with little exposure to macroeconomics I will explain further. Due to gold being finite in nature, a country that exports more than it imports will have a trade surplus. Let’s use the following example assuming the trading partners in this scenario are using a gold standard. A small country exports $1 billion worth of goods each year but only imports $100 million worth of goods. As a result of importing more than they export this country experiences a trade surplus. In other words they are receiving more money by selling than they are giving away by buying. As a result, more gold flows into their country. As a result of more gold flowing into their country due a trade surplus, the currency of this country becomes stronger, and as a result the purchasing power of the money of this nation increases. Assuming the country runs at a trade surplus for sometime, and it’s money appreciates in value, it will eventually begin to import more than exports. It will begin import more than it exports because the purchasing power of their monetary unit has increased significantly due to several years of trade surplus. It will export less if it’s monetary unit is strong because less nations will want to import their goods since the monetary unit commands a higher price with respect to exchange rates. As a result of it’s strong monetary unit, this nation imports more goods which means it will eventually pay more in gold to buy those imports, than it will receive in gold from sales to foreign countries. Eventually the monetary unit will decrease in value and it’s trading partners will begin to do business with them again. (Duncan)

Because precious metals are finite, currencies backed by these commodities force governments to be more responsible with their economic management, as well as enforce a balance of trade. Also

Unfortunately, today we have abandoned such monetary systems that allow for balances of trade across several countries.

With adoption of fiat currency we have created unsustainable trade imbalances. Before

Napoleon insisted France revert to the hard money standard when he took power against the wishes of his advisors.



(Duncan)



(Maloney 7)



Chapter 4
Depressions as Cyclical Phenomena?

Many economic experts state that modern day markets tend to move in a cyclical fashion. Equities tend to be in favor for an average of twenty years and then commodities are in favor for 10 to 20 years.

Recessions happen every 10? 20? Years. Statistically speaking financial depressions begin on average once every 75 years. (Kiyosaki, Maloney).

The last depression began in 1929. If statistics proves anything we were due to begin our next depression in late 2004. We spared another 3 years.



Chapter 5
Inflation

“Inflation is the one form of taxation that can be imposed without legislation”
- Milton Friedman

As we have now seen, inflation is par for the course with fiat based currencies. We will now examine the effects of inflation after we abandoned a commodities backed currency system in 1971.

In 1975 the median annual individual income equaled $5,664 and the average annual individual income was $7,704 (http://www.census.gov/hhes/www/income/histinc/p04.html)

In 1975 the median annual household income was $11,800 (priced in 1975 dollars) and the average annual house income was $13,779 (http://www.census.gov/hhes/www/income/histinc/h06ar.html)

According to one source, the average cost of a new home in 1975 was $39,300. (http://www.thepeoplehistory.com/1975.html). According to other sources, the median price for a new home in 1975 was $39,242 and the existing price of an existing home $35,250 according to Census Bureau and NAR data respectively (http://wiki.answers.com/Q/What_was_the_Average_price_of_US_home_in_1975).


The average cost of a new home in 2007 peaked at $329,400 (uspricemon pdf from Census Bureau). The median annual household income and average annual household income in 2007 were $48,201 and $66,570 respectively. The average cost of a new home was now a multiple of 4.94 times, nearly five times more, the annual average household salary in the United States. The average home price to average household income multiple had increased, almost doubled since 1975.

For individuals the statistics are much worse. The median annual individual income in 2007 was $26,625 while the average annual individual income was $38,174. The annual income to new home price multiple is abysmal. Instead of explaining all of this in text form I have included the table below for your viewing pleasure.


Individual Income Household Income New Home Prices
Year Median Average Median Average Median Average
1975 $5,664.00 $7,704.00 $11,800.00 $13,779.00 $39,241.67 $42,525.00
2007 $26,625.00 $38,174.00 $48,201.00 $66,570.00 $243,741.67 $308,775.00


Multiple - Individual
Increase In Incomes
(2007 Income divided by 1975 Income)
Median:Median Average:Average
4.70074153 4.95508827


Multiple - Household
Increase In Incomes
(2007 Income divided by 1975 Income)
Median:Median Average:Average
4.08483051 4.83126497



Multiple - New Home Prices
Increase In New Home Prices
(2007 New Home Prices : 1975 New Home Prices)
Median:Median Average:Average
6.21129707 7.26102293


Multiple - Individual
(New Home Price divided by Individual Annual Income)
Year Median:Median Average:Average
1975 6.93855932 5.51985981
2007 9.15461671 8.08862053


Multiple - Household
(New Home Price divided by Household Annual Income)
Year Median:Median Average:Average
1975 3.32556525 3.08621816
2007 5.05677621 4.63835061



As we can see the multiple of annual income to new home prices has grown since 1975.

In the above tables we can see that the numerical value of the average annual individual income has increased 4.96 times since 1975. We can also see that the average annual household income has increased 4.83 times. However the average cost a new home has increased 7.26 times since 1975.


In addition to housing costs increasing disproportionately to increases in wages, the overall cost of living has increased due to inflation. (Ludwig Von Mises Institute “Money, Banking, and The Federal Reserve”).



Now let’s look at it the increase in the retail value of frozen foods in aggregate. From 1975 to 2005 the multiple is 6.3 It took 22 years for the income multiples to equal 4 through 4.9 with respect to individual and household wages. As we can see the prices for frozen foods, which includes “frozen fruits, vegetables, concentrates,
poultry, meats, seafood and prepared foods” have risen disproportionately to incomes (http://goliath.ecnext.com/coms2/gi_0199-5902179/Frozen-food-market-still-rising.html; Quick Frozen Foods International).

Let’s all look specifically at the price of steak and other and compare it versus incomes

http://www.infoplease.com/ipa/A0873707.html
http://www.census.gov/hhes/www/income/histinc/h05.html


As noted above, the average household income in 1975 was $13,779 according to the US Census Bureau. According to the BLS and their use of the Consumer Price Index (CPI), $13,779 is the equivalent of $55,389.51 today, which is well below the new average listed above. This number actually looks impressive; this number looks as if the purchasing power of the average US household has improved. If so, why is that it appears that the cost of living has increased significantly and that two sources income are now required from most households?

The answer to this question lies within the CPI itself. The basket of goods has changed significantly in the CPI since the late 1980’s and early 1990’s. As a result there has been extensive substitution bias and critics believe that this modification to the basket of goods has occurred due to political motives.

Economist John Williams has constructed a new alternate CPI that he believes accurately reflects what the true CPI should look like.

According to his website, the 1975 average annual household income of $13,779 (citing May as the reference month) is not worth $55,389.51 in May 2009 dollars as stated by BLS statistics using the modified CPI. According to John William’s alternate CPI, the 1975 purchasing power of $13,779 is worth $164,855.89 as of May 2009.

If this is the case this means that the purchasing power of the dollar has dropped by well over 66.4% (this percentage is derived by using the formula 1 – BLS stated worth / Alternate CPI worth x 100 or [1-(55,389.51/164,855.89) x 100]) of it’s value since 1975.

We can measure the debasement of the dollar by dividing the average annual household salary in 1975 $13,779 by the estimated worth of that salary in May 2009 dollars, which is estimated to be 164,855.89. Thus this means the dollar has lost
In value 91.65% of it’s value (Percentage derived using formula [1 – (13,779 / 164,855.89) x 100] )

Another way to measure the change of the purchasing power of the dollar is to view the dollar is as such; When the United States switched to a fiat currency standard from the gold standard in 1971, the price of gold was $35 per ounce of gold. As of today July 4th 2009 the price of gold is $931.80. The dollar has dropped 96.24% in value in comparison to gold since 1971.

Although the initial numbers seems staggering, given the increase in numerical value, the purchase price for most items has increased significantly since the 1970’s henceforth showing a significant decline in the value of the dollar.

Thus, when a country uses a fiat currency system, wages will not keep pace with asset prices (Ludwig Von Mises Institute “Money, Banking, and The Federal Reserve”)

True to form since 2003 “nearly every asset class [has] appreciated in value” with the exception of the US Dollar (Duncan vii).

Thus the eroded purchasing power in the dollar has created an even more serious problem which will illustrate later on in this text. (Which is??? What????)

Before we do that let’s examine look more at housing prices in the US. While the average and median prices of homes did increase faster than average and median salaries of individuals and households, it is very likely that the prices of homes that drove up the national statistics actually occurred in area situated within or near major metropolitan cities.


“If we stay as we are, with no coordination [to stop the decline of the dollar], one can imagine a catastrophic economic situation at the global level.”
- French Finance Minister Herve Gaymard, 2004 (Duncan p274)

Government Intervention In Housing

For many home ownership was still affordable. However, zoning restrictions, height restrictions, open space laws, and other myriad forms of regulation in the real estate and property markets, while well intended, effectively increased the prices of homes tremendously within many metropolitan areas.

This is how

Chapter 6
Inflation, Control of the Money Supply, Manipulation of Interest Rates, and the Creation of Credit Culture.



The concept of credit is not new. The Babylonians are the first documented users of credit with its use being traced to several centuries before the birth of Christ. (http://www.didyouknow.org/creditcards.htm).


However, prior to 1913 credit was typically issued in the form of commercial loans. Consumer loans as well as loans to purchase things such as homes or cars were not common and interest rates were very high for these types of non-commercial loans (Maloney 31).

Now, the rise of consumer credit culture came about due to easy credit created by central banks, and inflation. Inflation encouraged the use of easily available credit. This easily available credit to both consumers and businesses was made possible due to artificially low interest rates determined by the Federal Reserve and not the market. (Maloney ).

The first multi-merchant credit card came into existence in 1950. The idea was pioneered by New York City businessman Frank X. McNamara. He invented the Diner’s Club card, and originally issued the card to 200 people and was accepted at only a few different restaurants. By the end of 1950, over 20,000 people had signed up to use the Diner’s Club card. (http://history1900s.about.com/od/1950s/a/firstcreditcard.htm). American Express soon followed suit and by the 1980’s credit cards were a part of the fabric of our lives.

By 1987 American Express became the first credit card to allow it’s users to pay off debts accrued over time as opposed to settling their account at the end of each month.

Today this easy access to credit fueled by low interest rates and subsequently credit cards, along with the widespread use of fractional reserve banking has created a significant credit bubble. This is only possible wherever fiat currency and fractional reserve banking are in use.

Unfortunately, fiat currency, easy credit creation and resulting unsustainable trade imbalances threaten the US dollar. (Duncan)

“But I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful.”
- Tim Giethner, on the Charlie Rose show March 10th 2009



Chapter 7
ERISA

In 1974


PART 2: PROXIMAL CAUSES

http://cashmoneylife.com/2008/09/29/economic-financial-crisis-2008-causes/

Outline
Section 1 Government Intervention in Housing
Community Reinvestment Act
Government involvement in more recent times / Barney Frank / Christopher
Dodd
Mortgages
Fannie Mae
Freddie Mac
Section 2 Wall Street
Derivatives
CDOs
MBS
Credit Default Swaps


“…The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions… like all artificially created bubbles, the boom in housing prices can not last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.”

Ron Paul, Address to House Financial Services Committee, September 10th 2009 http://www.youtube.com/watch?v=MQ3JNcMDWwg




Affects of the Derivatives

“Derivatives are financial weapons of mass destruction”
- Warren Buffett, 2002 Letter to Shareholders


The market for derivatives was relatively small for sometime. The market for derivatives grew substantially in the 90’s and by 2001 the market value for credit default swaps (CDS) skyrocketed and backed over “$900 billion worth of credit by [the end of the year]” (Portfolio). The credit derivatives designed by JP Morgan, the same firm which also help create the derivatives market, were originally thought to strengthen markets by dividing risk from one party to another (Portfolio ). It was in this manner that derivatives were structured that allowed and justified many different institutions to take on loans of different sizes.

Since it was thought that risk would be divided using different exotic derivative contracts, it was justifiable that different financial institutions could package these securities and sell them to the market.

The July 2007 issue of Bloomberg Markets discusses the effects of “toxic debt” This issue, which came out in early June 2007, raised serious concerns about what could happen if the house of cards of derivatives, in which several parties were really tied together as a result of these transactions, were affected. A shock to the system could be disastrous, especially considering that debt or leverage, was being used to buy securitized debt in the form mortgage backed securities and collateralized debt obligations (Dartmouth youtube clip).

The world had seen the possibility of a financial pandemic before. In 1998, the highly leveraged hedge fund Long Term Capital Management with 4 billion dollars of cash and a 100 billion dollars of assets under management had leveraged their positions an average of thirty five to one primarily on various derivative contracts with underlying assets being worth the notional value of over one trillion dollars (). Unfortunately, while debt can bolster returns, it can also easily sink a fund that when the market slides against their positions ( ). Unfortunately, every single one of LTCM’s positions went against them for several months (with the exception of one single day in August), in a true twist of “statistical freakery.”. In the end the President of the Federal Reserve Bank of New York, Bill McDonough, orchestrated for the heads of several different investment banks to meet at the New York Fed office and discuss possibilities of helping out the distressed fund. Considering the size of their positions, and the amount of leverage they had employeed, McDonough feared that if LTCM failed the entire financial system could collapse. The world nearly faced a melt down through one single hedge fund irresponsibly employing massive amounts of debt, and exotic derivative contracts. As we can see today, the lesson was not learned.
(Lowenstein )

Too big to fail MIT Tom Malone (Wired Magazine)

Mention credit rating agencies from Bloomberg Markets July 2007



The housing market, inflation, and derivatives.

Homeowners for the last few decades have had an increasing incentive to buy houses using mortgages. Why? The price of real estate has been rising disproportionately in comparison to real estate due to significant inflation. Again the level of inflation we had been dealing with is characteristic of most fiat currencies which is the case here. Keep in mind the value of the dollar has dropped 98% since our current system of Central Banking came into place in 1913. Unfortunately due to inflation many families had been borrowing credit in order to finance their lifestyle albeit meager (reference needed). Then different securities were created that were thought to allow even those with terrible or unacceptable credit to purchase homes that they could not afford. (explain here, i.e. credit default swaps). (the cost of living has risen disproportionately to wages) possibly quote kiyosaki. Before we go any further let’s look at what has happened with respect to earning power and asset prices as a result of inflation. Remember the United States went off the Bretton Woods system, which was a quasi-gold standard in 1971 and adopted a fiat currency standard under then president Richard Nixon’s helm.



PART 3: HYPOTHESIZED SYNERGY OF PHENOMENA

Outline
Government Intervention creates artificial scarcity
Central Banks manipulation of interest rates create boom and bust cycles
Inflation since the 1930s
Abandoning the gold standard
Ë These 3 factors lead to inflation
Government Intervention in Fannie and Freddie and Mortgage Market

Inflation means that the cost of living increases disproportionately to wages.
The creation of credit culture (the rise of credit culture).
Since, the cost of living has increased, central banks created access to easy credit, and the subsequent rise of credit culture, more and more people use debt to finance their homes and their lifestyles. More and more people are in debt now more than ever thanks to credit card usage which is encouraged by inflation.
Encouragement of Risky Loans especially via Wall Street
Local Government intervention
Ë Zoning laws, zoning restrictions, height restrictions, open space laws (Sowell)
Government intervention
Ë Fannie Mae, Freddie Mac, Chris Dodd, Barney Frank (Sowell)



As early as the mid 1970’s many different individuals began to hypothesize that a remarkable crash would occur sometime in the future. Alan Greenspan warned of the “Age of Turbulence” in his book of the same name. Among many, a significant crash was expected to occur post the year 2010. However, as we have seen serious declines began to occur in 2007.

Specifically in August of 2007 the first effects of the subprime meltdown were felt. Numerous harbingers, such as the folks over at Bloomberg Markets Magazine, were prophesying “any day now” that the effects of too much toxic debts being found in the investor space would seen be felt.

The author first read about the securitization of risky mortgages in the July 2007 issue of Bloomberg Markets Magazine, which hit the newsstands in June 2007, and realized that the potential for serious financial turbulence could occur if these securities imploded. And they did.


(When the author first read this an article about the overabundance of risky CDO’s put into tranches of AAA of June 2007)


The Domino Effect

With the creation of central banks we have seen the creation of boom and bust cycles. FA Hayek’s has proven that this should cause us to worry. We have seen the effects of fiat currency. While they are nice to initially pay off debts using weaker currency, the long term uses of paper currency and in some cases even short term implementation are fraught with devastating consequences. Tie these two factors, a central bank controlling interests rates and issuing fiat currency, and inflation will ensue.

We have now seen how much the dollar has become devalued since the 1970’s when the United States abandoned the Bretton Wood’s system, which featured an automatic trade balance adjusting mechanisms (Duncan). Since wages did not keep in line with asset prices particularly the pricing of homes, which is usually case with fiat currencies, more and more people had to take out loans. This was all fine and well until several important events occurred.
First we had the invention or rather rampant use of derivatives that were though to spread the risk of risky home loans taken out by those with shoddy credit and subsequently sold to Wall Street. Second we had members of the government decide that everyone should own a home, thanks to people politicians such as Barney Frank, and thus these dangerous loans were sold to institutions such as Fannie Mae and Freddie Mac. We have also seen the effects of low interest rates and subsequent excessive borrowing by various Wall Street firms which was interestingly enough used to buy many of these risky loans packaged along with other investments into AAA rated bonds as they were mixed with OK and safe AAA bonds.
We also the lack of government oversight. The government turned a blind eye to firms borrowing more money than they should and being highly leveraged. In some cases we had firms such as the Carlyle group that had a 95 to 1 leverage ratio. The boys at Long Term Capital Management would certainly cringe hearing this knowing the debacle they created which the world narrowly escaped. We’ve also seen that the financial institutions selling the idea of investing in the stock market to normal everyday Americans convincing them the only way to retire is to invest in the stock market as the market always go up. We have also learned that just because the numbers go up in the stock market, the purchasing power represented by those has actually diminished. We’ve seen that as a result of many people hoping to retire from the promised and falsely prophesied consistently good performance of the stock market, we are now witnessing and will continue to observe for sometime people selling their stocks in various companies en masse in order to survive as they realize now that their 401 k, pension fund, etc, etc will not be enough for them to live off of thanks to the current economic crisis. I feel really sad for people who have settled for annuities. The M2 money supply is expanding at such a rapid pace we will have doubled the amount of currency available in less than five years, which means individuals with savings accounts, and receiving pension funds will be toast. Too bad there is no such a thing as an adjustable rate pension fund.





PART 4: POSSIBLE REMEDIES

Possible Remedies

The Fed’s policy to tackle the current dilemma of the current crisis has been to cut interest and pursue the oh-so-affectionately named “nuclear option” which entails “dropping dollars by helicopters” if need be. By printing more and more dollars at never before seen levels of output here in the United States, the Fed hopes to allow the United States to pay off its debts. However, it will only be a matter of time before the markets adjust to the devaluation of the dollar and possibly before the United States risks becoming like Zimbabwe or the Weimar Republic. Unfortunately, it is easier to cure hyperinflation than it is to cure deflation.

Why is hyper-inflation easier to cure than deflation? The United States is in a gargantuan amount of debt. As of this writing the United States is in debt over $11 trillion dollars according to the accounting standards they government uses for itself. If the US government were to require itself to adhere GAAP, Generally Accepted Accounting Principles, they debt owe is actually $57.8 trillion dollars. This is truly the money the US owes in unfunded liabilities ranging from debt to foreign nations to the amount of money owed to Medicare and Social Security.

As a result if deflation of the currency occurred purchasing power for the dollar would strengthen, however the 57.8 trillion debt would still be the same. In simplified terms, if someone owes a hundred dollars, and has fifteen dollars left over after expenses at the end of each month, they can apply that fifteen dollars to paying off their debts, in which case they will be able to pay off their debt in ten months, assuming their monthly minimum is also ten dollars per month. Now presuming that deflation occurs in this same scenario, all of a sudden this same person no longer has fifteen dollars left over at the end of the month. They now have eight dollars left over at the end of the month. This means they will not be able to make their minimum payments. Although the purchasing power of the dollar has increased, the numerical value of their debt has not decreased. If people can not meet their minimum payments, and are given an option between paying off their debts or paying for necessities such as food or rent, chances are they will side with choosing their necessities.

In the case of inflation let’s assume this same person lives in an economy where significant inflation ensues. They still owe a hundred dollars and the fifteen dollars they had at the end of each month balloons up to twenty dollars even though the purchasing power of each dollar has decreased. If our friend wants to he can repay back the loan in as a little as five months. Let’s assume hyper-inflation takes place. That same fifteen dollars now becomes forty dollars. Our good friend can repay the loan in as little as two and a half months albeit with weaker dollars. At some point however, the rest of the world will refuse to accept the dollar. Suspicion and distrust of the U.S. dollar is already taking place in various parts of the world.



Reinstituting the gold standard?

Federal Reserve Chairman Ben Bernanke has been receiving criticism as role as Fed Chairman for sometime. Recently he had been meeting in Europe with other central bankers but no one knows the details of those meetings. It has been hypothesized that there is a great deal of interest of creating a unified international currency between the Fed and several other central banks, many of which are based out of Europe. A congressman once asked Ben Bernanke whether or not gold would be considered to back a new unified international monetary system should such a system be implemented.

Historically speaking, there is usually one of two options that occur whenever there is a currency crisis.


Mention technical knock out and or reinstiution of commodities (as per Maloney’s book)


There have been instances when the reinstitution of the gold standard has been successful.
Mention Germany post WWII under the finance minister
Mention Napoleon reinstituting gold against the wishes of his advisors




References:

Article name confession: U.S. Treasury Secretary Timothy Geithner - It Was a Hayekian Artificial Boom, i.e. a Money Driven Misdirection of Resources Made the Bust Inevitable

U.S. Treasury Sec. & former NY Fed President Timothy Geithner on the Charlie Rose show:
Mr. Geithner: ” .. I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this [...]


October 7th 2007
Dow closed at record high of 14,164





“The media blames the free market for the current economic failures but what the media does not understand along with the rest of the country is that we do not have a free market. We have a mixed economy or regulated market. It is hard to say the free market failed when in fact it is a regulated market economy that has failed. Since we have not had a true free market system for several decades, it is hard to divine whether or not a crisis of this kind would have happened and even if it some how did occur, we can only postulate how the free market would have reacted in response to this burgeoning crisis”





Buffett, Warren. 2002 Letter to Shareholders

Duncan, Richard The Dollar Crisis

Hagstrom, Robert. The Warren Buffett Way.

Kiyosaki, Robert.

Kiyosaki, Robert.

Kiyosaki, Robert

Lewis, Nathan. Gold – The Once and Future Money.

Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long Term Capital Management

Maloney, Michael Guide to Investing in Gold and Silver

Meacham, Jon. American Lion: Andrew Jackson in the White House.


Paul, Ron. Address to House Financial Services Committee, September 10th 2009 http://www.youtube.com/watch?v=MQ3JNcMDWwg

Paul, Ron http://www.tenthamendmentcenter.com/2008/07/21/why-the-founders-rejected-a-central-bank/
Samuelson, Robert J. The Great Inflation and It’s Aftermath.

Wiki History of central banking in the United States


http://www.federalreserve.gov/generalinfo/faq/faqfrs.htm

http://en.wikipedia.org/wiki/Federal_Reserve

Bloomberg markets magazine July 2007



Portfolio Magazine



“Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.”
John Williams
http://www.shadowstats.com/article/consumer_price_index

http://goliath.ecnext.com/coms2/gi_0199-5902179/Frozen-food-market-still-rising.html

http://cashmoneylife.com/2008/09/29/economic-financial-crisis-2008-causes/

http://www.census.gov/hhes/www/income/histinc/h06ar.html

http://homepage.newschool.edu/het//profiles/law.htm

Ludwig Von Mises Institute. “Money, Banking and The Federal Reserve” http://www.youtube.com/watch?v=iYZM58dulPE

“Credit’s the lifeblood, as this president said, the lifeblood of this economy”
-Tim Geithner, Charlie Rose Show part 1 of 6 circa 5:20 to 5:30