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Mon, 17 December 2018 04:23:16
Why Sri Lanka and the world need monetary reform: fuss-budget
22 Dec, 2008 16:11:20
By Fuss-Budget
Dec 22, 2008 (LBO) - Oil is falling, food prices are falling, and stocks are falling, both in Sri Lanka and abroad. The world economy is not only going exactly on the path long predicted by classical economists, but also as indicated in this column last year.
This is what fuss-budget said just over a year in August 2007 in Thrift Column - Currency Crisiswhich dealt with an earlier currency crisis triggered by Sri Lanka's central bank, while the sub-prime bubble was just bursting.

Deflationary Collapse

"One silver lining is that there is a chance that the headlong climb in oil prices will ease, with the collapse in global markets," fuss-budget said in August 2007.

According to John Exter's 'inverse pyramid' a flight to quality should push up dollars and gold and cause a relative price collapse in practically everything else. It would be interesting to see if everything would fall in nominal terms under a 'deflationary collapse' scenario, as so long predicted by the likes of Exter.

Well, the dollar did go up, and commodities collapsed. The Fed failed to pull off an Exter-style 'inflationary blow-off' as it had in earlier episodes.

Of course, very few probably believed this would happen, or that the oil bubble was living on borrowed time. Least of all, Ceylon Petroleum Corporation, unfortunately.

By March 2008, when gold peaked, the outcome was more certain, because it signaled the dollar's ascent. Lanka Business Online and the International Monetary Fund as well as classical monetary economists warned that the bubble was about to burst.

As each commodity collapsed, when the year wore on, LBO repeated, "wheat prices collapsed in February, gold and precious metals in March," and later, "rice collapsed after April."

Howard Nicholas, an economist who is now working in The Netherlands, who visited Sri Lanka in March also said oil was a bubble, and that it would burst.

In April LBO warned that Sri Lanka's tea and rubber prices may also suffer the same fate when the IMF said that the entire commodity bubble would collapse soon, as credit markets unwound rapidly.

LBO even re-published IMF graphs which traced the history of bubbles and later those that predicted the end of the bubble.

"From early this year the IMF has been predicting an end to the current commodity bubble this year itself, as credit markets unwound rapidly," the LBO shouted in the wilderness in July as politicians were screaming that oil would go to 200 US dollars a barrel by year-end and most of the petroleum derivatives were bought.


A question that needs to be asked is where are the cost-push (con) artists - the flag bearers of neo-Mercantilism - who said 'supply shortfalls' caused inflation? And more to the point, are they still wearing clothes?

May be they are not, that could be why our apparel exporters are running out of orders. There sure were a lot of them around just a few months ago.

In the past year, politicians who did not know any better, and economists who should have, were screaming that there was an 'energy crisis' or a 'food crisis'.

This column in particular and Lanka Business Online in general, steadfastly refused to conform to the general 'consensus' that there was a 'shortage' of one commodity or the other.

One story pointed out the futility of the 'Colombo declaration on food' and others said time again, that there was no 'shortage' of food, but that prices were rising due to a bubble caused by a monetary shock from paper money central banking.

"Panic claims that there is a food 'shortage' have not only come from South Asian leaders but also from developed country leaders, despite many countries including India and China - the most populous countries in the world - having surplus grain stocks," LBO said in a story on plans to set up a 'food bank' as part of a South Asian initiative.

Other statistics also contrast sharply with claims of 'food shortages'.

Australia is expected to have a wheat harvest of 23.7 million tonnes this year, up from a drought hit 13 million tonnes last year. Both rice and wheat production in 2008 is expected to be the highest in global recorded history.

India's wheat production this year is expected to hit 77 million tonnes, up 4 percent over last year, the head of the Food Corporation of India, Alok Sinha, told a conference in London in June.

Wheat prices have been falling from February 2008, and rice prices from April.


But, make no mistake, cost-push artists who said bio-fuel caused food prices to go up without explaining how it did not cause oil to go down will emerge from the woodwork, knickers intact, when the central banks start re-flating the world again.

And they will re-flate, make no mistake. It is easy enough.

Whether it was Roman emperor Diocletian who debased silver coinage with copper and brought in an edict on maximum prices in 301AD when food prices exploded, or Bandula Gunewardene who brought price controls for rice in 2008, the cause is the same – a monetary shock from expanding money supply.

Politicians blamed rice traders, while the real culprits - central bankers - got away Scot free, like Diocletian did so many centuries ago.

One of the earliest price control laws were passed in revolutionary France when unrestrained printing of a new paper currency called the assignat drove inflation to very high levels.

At first French producers and shopkeepers who broke price control laws were put to death.

But when everyone realized the real cause of the price explosion, people who were responsible for money printing were then guillotined and the assignat printing presses burnt in public. France returned to gold, as did Rome under Constantine after Diocletian's excesses.

Now politicians are saying that banks should be regulated, that rating agencies should be regulated, or someone else should be regulated. Very few are saying that the Fed should be regulated.

But unless the Federal Reserve and other central banks are reformed, and their discretion to inflate the world is taken away, new and bigger bubbles will come up.

A little history

The roots of the latest bubble lay in 1971-73 when the US dollar went off the gold standard and became a pure paper currency, like the infamous assignat or the US Continental dollar, or indeed John Law's Mississippi Corporation.

Though present day people had not seen anything other than central banking, and think it is the greatest thing since sliced bread, the world did not drag itself out of poverty with central banking.

Great scientific advances and the industrial revolution happened under the stability brought by alternative monetary systems, such as free banking or gold-standard-central banking and private enterprise. The first aircraft flew before the Fed was created.

Free banking had been practised not only in the US but in many parts of the world including Britain, Sweden and elsewhere. It is relatively easy to understand. A bank which took deposits in gold (gold was money at that time) could issue 'notes' or lend the money as loans.

If it lent too much, it lost deposits and had to cut down its lending. Each bank could compete with its money. Competition in money forced the banks to have prudent lending. Different types of money created no problem. It was just like dollars and Euros.

As private banks they had to be prudent. Otherwise they were eliminated. No regulation was needed. Given time a few good banks would emerge.

The bank of England was also a private corporation until it was nationalised in the middle of the last century. Essentially, it operated like a free gold bank but with a government granted monopoly. If it printed too much money (created loans to government) an inflationary bubble formed and gold was withdrawn or exported.

Then money supply was curtailed, policy rates rose and prices fell because the bank was forced to conserve gold.

So inflation, or a bubble, could not be persistent. A bout of inflation was followed by deflation.

As a private corporation, the Bank of England could go only so far. Through several centuries it kept the global economy fairly stable, until after World War I (see below).

The Fed on the other hand created the great depression, just over a decade after its creation. Then came the 1971-73 debacle, compounded by the Vietnam War, leading to the creation of fully fiat paper money, when the major central banks moved to floating rates.

And it has now created the 2007/2008 collapse.

Fed was set up to prevent banking panics after JP Morgan was forced to lead a rescue of a collapsing bank in 1907, with private money.

The US banking families then secretly engineered the setting up of the Fed (Read Thrift Column-Occupation Currency) which came into being in 1913.

Because a central bank had been abolished earlier in the US by President Andrew Jackson after it caused economic chaos – The Second Bank of the United States - the new entity was named the Federal Reserve to deceive the public.

The Fed, though nominally privately owned, was state-controlled. As a result, it inflated with impunity, without the suspicion that a private central bank like Bank of England would have normally attracted.

The great depression was created by the Fed, in collusion with the Bank of England. The 1973 oil shock was created solely by the Fed. So was the current crisis.

First Shots

The first shots of the current collapse was fired during the crash of the dot com bubble. When the bubble broke, Greenspan cut rates and kept markets going, through an 'inflationary blow-off' as John Exter once said (Read Interview)

Even in 2007, when the sub-prime bubble collapsed, Fed gambled on an inflationary blow-off and cut rates. But the banking system was too damaged to respond.

It simply created a commodity bubble and which collapsed when banks built up liquidity, as they were too scared to lend.

Even as Fed cut rates, risk premiums rose, making Fed action useless. Central Bank impotence set in. Then prices collapsed. This is an odd situation where people still have confidence in the currency (causing deflation) as opposed to hyperinflation where people dump a central bank and go for an alternative one or gold.

But the real deflation cannot be seen now because inflation indices are manipulated through various means.

Modern central banks fear deflation, not because it is bad for people, but because it is not good for highly leveraged entities, meaning banks and governments. If there is no inflation, banks and governments cannot scam grandmother's savings.

Who cares if stock prices (and profits) fall by half if the price of tea and sugar are also half and petrol prices a quarter? Granny will have enough money to drive over to her friend's house and have tea, even if she owned some stocks.

If the government or banks are forced to pay fair interest rates to grandma (remember old people have savings, young people have borrowings) they can collapse and even sovereign default will happen.

At all costs then, a positive rate of inflation must be kept, by manipulating interest rates and creating money through the purchase of treasury bills. Welcome to modern central banking.

The Greatest Fear

The greatest fear of the paper money central banker then is deflation. Inflation targeting makes sure that this does not happen.

The dollar, which is backed by treasury bills and no longer by gold, would be destroyed by a US sovereign default. The US dollar is probably the greatest Ponzi-scam ever devised.

From January 2001 Fed began to cut interest rates when policy rates were high at 6.5 percent. By December 2001 rates were 1.75 percent. Throughout 2002 rates were kept at just 1.25 percent. A freaking full year.

In March 2003 an invasion of Iran was on. A war in Afghanistan was already raging. In June rates were cut to 1.0 percent.

A central bank, remember, can print enough and manipulate rates against rising credit demand, though in a 'capitalist' free market system rising credit demand should increase rates. Central banks resist this. That is not capitalism, its state intervention or socialism, at its very worst. Neo-mercantilism if you will.

(Now of course cutting rates looks okay, because credit demand is low. and in any case demand for cash is high, which is essentially private sector sterilization.)

But the problem with gauging inflation by conventional indices is that, unlike commodities and asset prices which readily respond to money printing, services and manufactured goods don't. Through productivity improvements their price constantly falls.


Both the China factor (outsourced manufacturing) as well as off-shoring (outsourced services), which was a newer force, was pushing costs and prices down, especially in the US. Maybe even genetically modified foods.

By cutting rates and printing more money and targeting positive inflation by an index which was anyway flawed through hedonics, Fed worsened the real inflationary forces, which are bubbles and mal-investment that comes from unrealistic rates. Feds focus on core inflation made the problem worse, because when oil prices rose its effect was ignored. Brent crude was 23 dollars when the rate cuts began.

One of the key people who favoured rate cuts, despite a looming war, was Ben Bernanke, who was then one of the Fed governors under Alan Greenspan. A depression-era scholar, he wanted to avoid deflation.

His sentiments can be gauged in a revealing speech made before the National Economists Club on November 21, 2002 - Deflation: Making Sure "It" Doesn't Happen Here

Bernanke assured his listeners that there would be no deflation. First, because of "the resilience and structural stability of the U.S. economy."

"The second bulwark against deflation in the United States,…is the Federal Reserve System itself," he said.

"I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief."

The Fed was banking on an 'inflationary blow-off' which had worked fine in the 1970s and to some degree after the dot com bubble.

"…as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more pre-emptively and more aggressively than usual in cutting rates," Bernanke added.

"By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails."

Rates were not raised until June of 2003. Even then, it was only to 1.25 percent.

By 2004 a housing bubble was raging, the oil bubble was well and truly on, but Fed thought it had the lid on the problem. A speech by Fed Governor Donald L. Kohn, in April 2004 is revealing.

He was responding to critics who said the Fed was feeding the bubble, much too fast.

"I am not disputing the argument that current policy has contributed to higher asset prices, more household indebtedness, and strong activity in interest-sensitive sectors such as housing," Kohn said.

"But I am questioning the apparently firm conclusion of some that these developments represent distortions or imbalances that are likely to correct in an abrupt and harmful manner. At the very minimum, one cannot reach this conclusion with a great deal of confidence.

"The distortions in the markets I have reviewed do not appear all that large, given the stance of monetary policy, and should we experience much higher interest rates and softer asset prices our resilient markets and flexible economy probably could absorb such a shock."

Famous last words indeed!

Bernanke Prescription

Back to Bernanke. What Bernanke is doing now, was spelled out in excruciating detail in his famous 2002 speech. Even at zero interest rates, he said, a central bank will not "run out of ammunition." I can print this way… and that…and another… he said.

"It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory," said Bernanke.

"Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."

No surprise eh? If Gideon Gono can do it in Zimbabwe, with a busted banking system; why not the great US of A, with a soon-to-be-restored one? It will be done with much more finesse.

Now read this.

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

So who said this? Some gold bug? Steve Hanke? Robert Barro? Oh dear me, no! It was great Bernanke himself.

In that speech he went to great lengths to specify what the Fed could do. The Fed must expand the "scale of asset purchase", "expand the menu of assets", "making low-interest-loans to banks" or by "cooperating with the fiscal authorities."

"If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation," he said.

It may be sickening, but at least it is honest. Now that Fed target rate is 0 to 0.25 percent read the rest at this link if anyone wants to know what the great Gono, sorry Bernanke, will do next.

All this will be done very elegantly with a banking system that will be fixed soon at the cost of the taxpayer and printed money.

They are paying to get the Fed's inflationary apparatus back to working order and reverse or at least halt the slide in house prices, halt the slide in commodities, and halt the slide in financial assets. And of course weaken the dollar, which is what it really means.

To quote Bernanke again "the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services." Okay?

If the Fed doesn't, the great Ponzi-scam that we call central banking and modern government will collapse. Madoff, a child of Fed's loose monetary policy, just like all those hedge funds, was just the tip of the iceberg.

Goldman Sachs is just as much of a Ponzi as Madoff, only now it has a license to 'rob' tax payers (and inflation payers) to pay Paul, instead of Peter.

Shabby Secret

In the 1930s it was not fiscal action and the 'New Deal' that took USA out of the depression (though Roosevelt's action on banks helped). It was simply changing the gold standard to 35 dollars an ounce. Printing press, in other words.

During the depression people were taking money out of banks and burying them in their backyards and earning 10 percent a year through deflation. Talk about private sector sterilization.

The depression itself was caused by printing, basically a massive deviation from the gold standard. But after World War I, Britain was losing gold to the US.

So the Fed and the Bank of England cooked up a brilliant scheme. If the Fed printed faster (cut rates), or as fast as the Bank of England, it would halt the flow of gold from UK to USA. Right?

Maybe. Unfortunately it had a side effect. The Fed fired a bubble in the US. Most of the new printing went to margin trading on stocks. Then Fed had to raise rates to cure the bubble. Then everything collapsed. Read this analysis.

"When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable).

The 'Fed' succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed."

What happened was that Britain, after printing (or counterfeiting) during the war, came back to the gold standard at a rate that was not consistent with the resulting inflation (Inflation during the War period was supposed to be in excess of 200 percent).

At the new rate, the Sterling was estimated to have been about 30 percent overvalued. After the resumption of gold convertibility, the Bank of England was losing gold to US, but the Old Lady was reluctant to raise rates due to a weak domestic economy. A devaluation, would have also done the same trick.

This is the same as foreign reserves being lost by the Central Bank of Sri Lanka, which shows that central bankers have not learnt much from 1920 to 2008.

And there is more:

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly re-established a sound basis to resume expansion.

Who said this? Lawrence White? Freidrich Hayek? Ludwig von Misses? Guess again. This was the greatest conjuror, Ponzi artist par excellence, Alan Greenspan himself, in 1966.

At the time he was not part of the Ponzi scam that we call government, or welfare state, which fleeces the old and the helpless and working class people in productive sectors by counterfeiting money. He was a hotshot consultant with Townsend-Greenspan & Company in the productive sector.

"With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression," he continued.

"But the opposition to the gold standard in any form-from a growing number of welfare-state advocates, was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes."

This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.

Fuss-budget did not say this. Greenspan said this. So you better believe it.

But returning to the gold standard, even at 800 dollars an ounce seems like a pipe dream.

In a world peopled by Bernanke, Paul Krugman, Robert Mugabe, Joseph Stiglize, Mahinda Rajapaksa (and even Barrack Obama if he is not careful); the poor and the hardworking: the factory workers, street sweepers, tea pluckers, everybody's grandmothers and grandfathers who have saved up a little nest egg, and pension fund beneficiaries who hold the bulk of state debt; will pay the price of big government.

They grab the headlines. They drive policy.

But while there may be no return to the gold standard, there is a great deal that can be done to make governments less predatory.

And it all starts with central bank reform. Or better still by breaking up the central bank monopoly in money and loosening legal tender laws.

And there has to be inflation index reform.

But that has to be left to be the subject of another column.

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5. Dinesh Dec 23
Workable proposals for a return to a gold standard exist. The main constraints are political opposition (Governments are the single largest beneficiary of monetary inflation), and a lack of public support for monetary reform (due to a lack of education on the impact of monetary inflation).

One such proposal (Money, Bank Credit, and Economic Cycles by Jesus Huerta De Soto) essentially goes like this:

1. A sufficient quantity of cash be printed and be given to banks so that the banks will have 100% reserves. Simultaneously, a 100% reserve requirement is imposed. Despite a large increase in the monetary base, aggregate money supply does not increase, and hence the proposal is not inflationary.

2. In return for the cash, the banks deliver their existing investments in Government Securities (De Soto's proposal had a mechanism to deal with differences in the amounts of cash given to the banks and their Govt. Sec. holdings - I can't remember what the mechanism was). The component of government debt that is now owned by the Central Bank is extinguished.

3. The Central Bank's gold holdings (in Sri Lanka's case our foreign reserves will be converted to gold) will back the currency notes in issue and the ratio of gold to currency will form the exchange rate between gold and currency.

4 The Central Bank is abolished and formed into an institution that will just exchange gold for currency and vice versa - something like a government mint. Legal tender laws are also abolished, and the establishment of private mints is allowed.

As I said, I can't remember De Soto's proposal in detail (my summarisation above is probably not entirely accurate), but it allows a return to a gold standard and 100% reserve free banking. It also enables a large reduction in Government Debt and hence significantly reduces the probability of default. De Soto's proposal is not without risk - if fractional reserve banking is re-established, the monetary base will then be so large that high inflation can re-emerge.

In addition to De Soto, many other Austrian Economists have made proposals for monetary reform - among them, Ludwig von Mises. F. A. Hayek, Murray N. Rothbard - that call for a return to a gold standard and 100% reserve banking.

The point is, I believe the current monetary system can be reformed, but Governments won't allow that reform to take place until a huge public outcry happens. It is simply not in the Government's (vs. the public's) interest to give up the inflation option. Fiat money is not new - it has been tried many times before, has failed every time, and has eventually been replaced with a commodity money (gold or silver) once the public realize what Governments do to its money.

I don't see why that can't happen again - the sooner the better.

Keep up the good work.


4. fuss Dec 23
Hi Dinesh
Can't agree with you more. To quote Franklin Saunders (a very interesting character by the way) who conducted the now famous interview with John Exter:

Fractionalised banking is the child (or is it the mother?) of politics, & sooner or later politics will demand its due. Frail human character, in the face of politics, is no substitute for gold.

But what do you think are the chances of a gold standard? There will be sovereign default all over the place if that happens. So it is not likely to happen.

3. fuss Dec 22
Dear Dumb Question
There were congressional hearings on this matter later. New York Fed governor Benjamin Strong and Montagu Norman had a relationship. Also JP Morgan was Bank of England agent in New York. Everyone knows how influential they are.

There were wheels within wheels, just as there are wheels within wheels now. The excuse given was that it was done to save the international monetary system.

It is a manifestation of the agency problem. The gold was not privately owned by anyone.

Essentially US gold reserves were sacrificed to give a stronger exchange rate to the British. But it did not work and actually backfired on British exports.

2. Dinesh Dec 22
The Central Bank is not the sole culprit in creating inflation - the fractional reserve banking is system creates most of the money supply (albeit the monetary base is expanded by the Central Bank). The economic evils of monetary inflation are far larger than just rising prices and a wealth transfer effect.

They also cause massive entrepreneurial errors (malinvestments) which need to be corrected in a subsequent recession. In short, the boom-bust business cycle is caused by monetary inflation - a process identified as early as 1912 by Ludwig Von Mises.

So, yes, the current crisis is caused by the creation of a great deal of money and credit. Sadly, the solution being offered to the problems created by excessive money and credit creation is even more money and credit.

The solution long advocated by the Austrian School: return to the gold standard, abolish the Central Bank, and re-establish 100% reserve banking.

1. Dumb Question Dec 22
Why did the Fed agree to print money to help Britain? That seems stupid