Hera : Euro, British pound

Value Subjectivism and Monetary Instability

Ron Hera — Sun, 01 Jul 2012 20:09:00 GMT

Subjectivism is the philosophy that reality is what we perceive to be real and that no underlying, true reality exists independent of human perception. In other words, the nature of reality for an individual person is dependent on that individual's own consciousness. It follows that each person experiences their own reality that is not shared with others. What is true and what seems moral to one person may not be true or moral for another person, i.e., truth and morality are relative. In contrast, objectivism is the philosophy that reality exists independent of human consciousness; that human beings have direct contact with reality through sense perception; and that objective knowledge of reality can be obtained through perception, evidence and logic, e.g., through scientific methods.

A subjectivist might view the stock market as a perpetual bubble floating on the hopes and dreams of entrepreneurs and investors who invest in stocks in the same way that gamblers place chips on a craps table in a casino, without any concept of an objective economic reality outside of the game. A subjectivist might view technical analysis, which is based purely on trading activity in the stock market, as the ideal tool to understand financial markets, despite the fact that is has no direct connection to the objective economic realities of the companies that stocks represent. In contrast, an objectivist might view the stock market as a venue for participation in business ownership where stocks have value as a function of the particular businesses that they represent and because of the goods and services that the businesses provide in the objective world. A subjectivist might say that "everything is relative" (although the statement is self contradictory), while an objectivist might say that they "...believe in justification, not by faith, but by verification" (Thomas H. Huxley 1825-1895). Although they may not know it, Keynesian economists, bankers and day traders are often philosophical subjectivists while Austrian economists, advocates of the gold standard and value investors are often philosophical objectivists.

An objectivist interpretation of morality is that morality flows naturally from people pursuing their own interests and that immorality results from coercion. For the vast majority of individuals, "self interest" includes supporting their own family and community, simply because human beings are social animals. Parents naturally care for their own children, for example. Morality is a natural phenomenon, not a product of coercion. Human beings naturally live peacefully together in communities and the vast majority of individuals experience empathy. Both charity and resistance to coercion occur naturally and voluntarily in human communities. Those who do not experience empathy (sociopaths) and who disregard the interests of their fellow human beings or act in ways that harm the community are extremely rare. Philosopher Ayn Rand wrote "Force and mind are opposites; morality ends where a gun begins." Human beings do not act morally because they are being watched by police or because a gun is held to their heads. In all cultures and at all times and places throughout recorded history, and certainly before, what is immoral is initiating violent force or coercion without cause, most especially when it harms the community. Although particular rules vary from one culture to another, morality is neither subjective nor relative.

Ironically, the objectivist view of morality has been widely misconstrued as a sanction for selfishness. Selfishness typically results in the deprivation or coercion of others. In contrast, pursuing their own self interest is what human beings naturally and voluntarily do in the absence of coercion. In fact, the idea that what is moral arises in a natural way based on the freedom to pursue one's own self interest, i.e., freedom from coercion, is precisely the moral doctrine of the 1776 American Declaration of Independence:

"We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness."

Where money is concerned, there are two fundamentally different concepts of "value", one rooted in subjectivism and one rooted in objectivism. In a monetary context, value subjectivism means that money has value simply because people believe that it does and that whatever people can be persuaded or coerced into using as money, such as a piece of paper bearing a government stamp, therefore has "value". In other words, value subjectivism is the view that the only "value" that exists resides in the minds of human beings as a concept or belief and that, therefore, "value" can be created ex nihilo by persuasion or coercion, i.e., by influencing or controlling (through coercion or fear of coercion) the minds of human beings. Value objectivism means that money has value because it contains the resources and labor required to produce it in the same way that clothing or shelter have value for the survival requirements of human life.

Of course, subjective value, e.g., the value of a Picasso painting to an art lover, does indeed exist but it is different in kind compared to value linked to biological survival (literally, life and death). The former refers to subjective mental states, while the latter refers to an objective biological reality that exists independent of human consciousness. Residents of the Warsaw Ghetto in 1943, for example, didn't value guns in the same way they valued Picasso paintings. Generally, a product of human labor that has real-world utility, such as a physical tool, will be recognized by human beings as having value relative to the material needs and survival requirements of human life. This "survival value" is absolutely pragmatic and is rooted in the natural understanding that human beings have about their biological needs and their physical relationship to the objective world.

Commodity money comes about in a natural and voluntary way and does not depend on governments or banks. Natural money develops wherever and whenever human beings obtain things that they do not strictly need purely for the purpose of exchanging them for something else. The good most commonly used as a tool of exchange is de facto money. The Greek philosopher Aristotle first defined the characteristics of a commodity that can be used as money as (1) divisibility, (2) durability, (3) portability and (4) scarcity, i.e., rare and valuable. More recently, money has been described as a medium of exchange, a unit of account, e.g., a standard weight of gold or silver, and a store of value. Of course, money must also be widely accepted, which can be accomplished either through natural forces or through coercion.

The supply of commodity money naturally remains constrained in proportion to the production of other goods. The resources and labor required to produce natural commodity money exist in relation to other economic resources needed for the survival requirements of human life. Production of commodity money subtracts resources that have direct survival value from other economic activities. Therefore, the law that regulates the production of commodity money is the law of survival. The law of survival is not a proscriptive law (declared by a human authority) but a descriptive law based on observation. The production of commodity money is regulated automatically according to the biological needs of human beings. Thus, commodity money is tightly coupled or "tethered" to physical economic activity in the objective world in the same way as building shelter. Human beings very rarely build more shelter than they need because the economic inputs required to do so are better spent elsewhere once sufficient shelter exists. The price mechanism in modern economics is a reflection of this underlying reality.

While it is commonly believed that any token can be used as money, this refers only to the medium of exchange, i.e., currency. Currency is precisely a "money substitute", which is a convenience, but is not, strictly speaking, money. Land deeds, for example, can circulate as a currency but they are not the land itself. Creating more currency units in a vacuum, in this case un-backed "land deeds" with no land attached, does not create more land or any other form of wealth in the objective world even if it increases the number of transactions and the size of the economy measured in "land deeds".

Throughout history, schemes have been attempted whereby currencies that cost virtually nothing to produce, and that have no survival value, have been substituted for commodity money. Artificial money, known as 'fiat currency' has putative "value" simply because it is declared to have a value by a government or central bank. Fiat currency schemes replace the survival value of commodity money with subjective value and substitute a mere medium of exchange for natural commodity money. Modern currencies, including the U.S. dollar, the British pound, the euro and the Japanese yen, are all fiat currency schemes. As a practical matter, a fiat currency unit is worth whatever it can purchase but it is not a standard by which value can be measured because its purchasing power is unstable. In fact, there are several fundamental problems with fiat currencies.

1. There Is No Spoon - In the popular 1999 film The Matrix, written by Lana and Andy Wachowski ("The Wachowski Brothers"), the protagonist, Neo, has the following conversation with a gifted child who can bend spoons with his mind:

Child: Do not try and bend the spoon. That's impossible. Instead... only try to realize the truth.

Neo: What truth?

Child: There is no spoon.

Neo: There is no spoon?

Child: Then you'll see, that it is not the spoon that bends, it is only yourself.

There is a difference between an abstraction and an abstract concept. "Money" is an abstraction in the same way that "container" encompasses both a bottle and a jar. Abstractions are artifacts of language that generally describe the world. In contrast, an abstract concept is the mental representation of an idea, such as liberty. Abstract concepts are literally ideas that exist in the human mind. Law, for example, expresses the concept of justice but an arbitrary law is not just merely because it is law. Unjust laws certainly exist. Declaring that a stone is a seafaring vessel does not imbue it with the ability to float on water, even if it can skip on the surface if it has enough spin. Such a declaration would be an illogical misuse of language masking an obvious absurdity. Nonetheless, the same obvious absurdity underlies fiat currencies. The erroneous conflation of "money", which is an abstraction, and "value", which is an abstract concept, is an example of sophistry; a trick of words played on unsophisticated minds. In fact, fiat currencies which exist today, not principally as notes or coins, but as electronic digits in computers, have no value.

2. Coercion - Coercion characterizes fiat currencies because most people would not accept them unless forced to do so against their will. In the United States, for example, the replacement of gold-backed money in 1933 required the use of legal force (criminal penalties of $10,000, ten years in prison, or both) to compel U.S. citizens to accept irredeemable Federal Reserve Notes in place of gold certificates.

3. Rent Seeking - Fiat currency schemes extract economic rents by forcing commerce to take place in the fiat currency system. Since human beings trade with one another to survive, the ability to freely exchange value for value is a natural right having the same moral foundation as the right to life, liberty and the pursuit of happiness. In a marketplace based on voluntary arrangements, there is no middleman extracting an economic rent in exchange for permission to participate in commerce.

4. Immorality - Fiat currency schemes are immoral because the primary thing that makes them acceptable is coercion. Forcing people to accept artificial money that has no objective value against their will and self interest is an immoral act. Additionally, fiat currency schemes allow those who control the currency to redistribute wealth by altering the availability, quantity and distribution of the currency, which is little more than legalized theft.

5. Central Planning - Since fiat currencies are based on coercive, rather than voluntary market relationships, a central authority is required that has the power to eliminate competing currencies, i.e., to establish a monopoly. Central economic planning is not only anti-democratic and the antithesis of a free market, but also inevitably fails. Human society is not blessed with the omniscient and infallible individuals required to make financial and economic decisions in place of the decisions of millions of individuals, households, entrepreneurs and businesses. The record of history, e.g., the USSR, is absolutely clear. Central planning of an economy produces a never ending stream of unintended consequences that lead to never ending interventions and that ultimately destroy economic activity.

6. Price Instability - Fiat currencies, because they require relatively insignificant physical economic inputs, have no direct relationship to the survival requirements of human life. Since it is decided by central planners, the quantity of currency in a fiat currency scheme is always and inevitably incorrect. This causes price instability and artificially stimulates or depresses economic activity as a function of how much currency is produced and of how it is distributed. As a practical matter, price stability can never be achieved in a fiat currency scheme.

7. Economic Volatility - Since fiat currencies are loosely coupled to physical economic activity in the objective world, they tend to become increasingly de-coupled and eventually "un-tethered" over time. An economy is the aggregate of millions of independent, individual human actors and there is no way that those responsible for a fiat currency can guess the correct quantity, although they can recognize incorrect quantities after the fact by their consequences, e.g., credit booms, recessions, large-scale price bubbles and economic collapses, such as the Great Depression, which began only sixteen years after the U.S. Federal Reserve was established. Of course, economies can be volatile for many reasons. The effect of fiat currencies, however, is to greatly magnify economic volatility.

8. Currency Debasement - Voltaire famously wrote that "Paper money eventually returns to its intrinsic value-zero." Fiat currencies issued by governments or central banks represent intangible, subjective concepts of value like "full faith and credit" but the currency itself has no lasting value. Specifically, fiat currencies have a built-in tendency to decline in purchasing power over time as more currency is produced, particularly in fractional reserve and debt-based fiat currency schemes. In debt-based fiat currency schemes, the currency must be constantly inflated or a deflationary vicious circle (a collapse of debt) will set in. Those responsible for the currency predictably produce more than is necessary to maintain stable prices or to sustain stable economic activity, e.g., to diminish the risk of deflation, for political promises and favors, to wage war, etc. Price instability and economic volatility are the result. Currency debasement eventually undermines the basic economic structure of society. In The Economic Consequences of the Peace (1919), John Maynard Keynes wrote:

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

9. Wealth Redistribution - Arbitrarily increasing the quantity of currency in an economy distorts the distribution of money and, therefore, redistributes purchasing power, effectively stealing wealth from the majority, e.g., savers and wage workers, to serve the interests of a privileged minority. Redistribution of wealth, as opposed to production of wealth, causes a net loss of wealth to society. Government deficit spending, although it may be motivated by good intentions, changes the quantity of currency and results in currency debasement. Thus, government deficit spending operates as a dishonest, hidden tax on savers and wage workers. In his well known 1966 essay, Gold and Economic Freedom, former Federal Reserve Chairman Alan Greenspan, wrote:

"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."

10. Concentration of Wealth - Over time, fiat currency schemes cause wealth and property to accrue to those who enjoy the extraordinary privilege of creating the currency, thus increasing the concentration of wealth in society. Extreme concentration of wealth is economically and ultimately politically destabilizing. An individual with a one million dollar income, for example, will not buy as many consumer products, cars or appliances as ten households with incomes of one hundred thousand dollars. In his remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming (August 28, 1998), then Federal Reserve Chairman Alan Greenspan pointed out that:

"Ultimately, we are interested in the question of relative standards of living and economic well-being. Thus, we need also to examine trends in the distribution of wealth, which, more fundamentally than earnings or income, represents a measure of the ability of households to consume..."

11. Moral Hazard - Baron Acton observed in 1887 that "Power tends to corrupt, and absolute power corrupts absolutely." Since fiat currencies are created by monetary monopolies ex nihilo, e.g., through loan contracts, they provide a legal means of obtaining something for virtually nothing. As a result, those responsible for fiat currencies enjoy almost unlimited influence over economic and, therefore, political life. Sadly, human beings can never be good stewards of a currency system that provides one group in society with the means to obtain something for nothing. In fact, societies dominated by immoral fiat currency schemes eventually develop a something-for-nothing culture; a culture of entitlement in which, rather than producing wealth, everyone endeavors to live at the expense of everyone else.

12. Corruption and Cronyism - As a consequence of moral hazard, fiat currencies tend to encourage cronyism and corruption and ultimately produce a culture of corruption. The Roman poet Juvenal wrote "Quis custodiet ipsos custodes?" ("Who will guard the guards themselves?"). History is replete with the horrors of absolute power and with monetary abuses resulting in economic collapse. Just as democide has been a leading cause of death in the last one hundred years, fiat currencies have been a leading cause of poverty. Fiat currency schemes redistribute and concentrate wealth, resulting in a tiny and exceedingly wealthy minority, but they do not produce wealth. Francisco d'Anconia, one of the central characters in the novel Atlas Shrugged by Ayn Rand, explains the following in his famous "money speech":

"...Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or the looters who take it from you by force. Money is made possible only by the men who produce... Not an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into bread you need to survive tomorrow... Whenever destroyers appear among men, they start by destroying money, for money is men's protection and the base of a moral existence. Destroyers seize gold and leave its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values... Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims..."

13. Confidence Failure - Since the value of fiat currencies is essentially subjective, maintaining the perception of "value" in the face of economic decline and despite rising prices can be challenging. Fiat currencies are ultimately dependent on confidence and trust in those responsible for the currency. When fiat currencies are abused, confidence fails and they revert to their intrinsic value (zero). Thus, monetary policy in a fiat currency scheme focuses directly on maintaining confidence. Behavioral economics, for example, has become a primary tool of monetary and economic policy implementation. As a consequence, economic reporting by governments and central banks, and by the news media, does not reflect an objective viewpoint. Management of perception has the effect of influencing the subjective mental states of those who use a particular fiat currency so as to maintain the perception of "value". However, in the best case, perception management is one-sided "spin", and, in the worst case, it is propaganda that is contrary to fact and that simply prevents ordinary people from recognizing the steps they need to take in order to protect their financial interests against currency debasement and other risks associated with fiat currencies. Nonetheless, cognitive dissonance (a psychological tension between conflicting cognitions) can result in the sudden collapse of fiat currencies when economic conditions deteriorate sufficiently or when prices rise too quickly, i.e., the spell of value subjectivism is broken.

14. Counterparty Risk - The "value" of fiat currencies requires trust in counterparties, but trust, like confidence, is an ephemeral, subjective mental state. In the objective world, agreements between governments and central banks and those who rely on their fiat currency schemes can be arbitrarily modified or broken. In fact, they are implicitly broken whenever a currency is debased. The promises of deposed governments and failed banks become instantly worthless.

15. Transaction Settlement - A transaction in commodity money is a direct exchange of value for value. When a fiat currency transaction is performed, one party holds fiat currency and the other is the recipient of goods or services, but, like a retroactive breach of contract, the value of the fiat currency can be changed and may even become zero. Since there is always a residual third party to the transaction, i.e., a government or central bank, transactions remain unsettled.

Fiat currency schemes are philosophically misguided, fundamentally immoral and ultimately unstable. Fiat currencies are premised on value subjectivism and erroneously conflate money and value. They represent a mere medium of exchange and rely on unstable subjective mental states such as confidence and trust. As a result, they are ultimately fragile and prone to fail suddenly when those using them wake from the dream of value subjectivism.

Fiat currencies are immoral because they are forced on people against their will and contrary to their self interest and because they are a mechanism for legalized theft through currency debasement. Monetary monopolies extract economic rents by holding hostage the rights of individuals to freely exchange value for value. Central economic planning, redistribution of wealth and concentration of wealth undermine economic activity and encourage a culture of entitlement. Since fiat currency schemes are the source of exorbitant power, they engender extreme moral hazard, produce cronyism and corruption and foster a culture of corruption.

Fiat currencies are subject to the decisions of central planners and are invariably debased producing price instability and increasing economic volatility. Governments and central banks that promulgate fiat currency schemes remain as perpetual counterparties to transactions posing a constant and unlimited risk. Resulting transactions are not fully settled because the value of the currency can be arbitrarily altered after the fact.

History has shown that fiat currencies are always debased and that confidence in them eventually fails causing vast economic disruptions, losses of wealth, social and political chaos and even loss of life. The inevitable disasters caused by fiat currency schemes are usually followed by a return to commodity money but, once stability is achieved, a new fiat currency scheme is put in place repeating an unnecessary and destructive cycle that benefits few and harms many. Ironically, while commodity money is denigrated by those who benefit from fiat currency schemes, former Federal Reserve Chairman Alan Greenspan noted as recently as 1999 that "Gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody. Gold is always accepted."

Defenders of fiat currency schemes claim that they promote stable prices and moderate economic volatility. In fact, the opposite is true. Fiat currencies not only destabilize economies but undermine the moral basis of society. Without exception, in every historical case when a currency has been de-coupled from the objective world, i.e., from commodity money, the result has been disaster. Fiat currency schemes guarantee unending monetary and resulting economic, social and political chaos marked by brief periods of calm between inevitable abuses, bubbles and collapses.

Martin Armstrong on the Sovereign Debt Crisis

Ron Hera — Sun, 01 Jul 2012 20:06:00 GMT

The Hera Research Newsletter is pleased to present a fascinating interview with Martin A. Armstrong, founder and former Head of Princeton Economics, Ltd. In the 1980s, Princeton Economics became the leading multinational corporate advisor with offices in Paris, London, Tokyo, Hong Kong and Sydney and in 1983 Armstrong was named by the Wall Street Journal as the highest paid advisor in the world.

As a top currency analyst and frequent contributor to academic journals, Armstrong's views on financial markets remain in high demand. Armstrong was requested by the Presidential Task Force (Brady Commission) investigating the 1987 U.S. stock market crash and, in 1997, Armstrong was invited to advise the People's Bank of China during the Asian Currency Crisis.

Based on a study of historical gold prices and financial panics, Armstrong developed a cyclical theory of commodity prices, which lead to the pi-cycle economic confidence model (ECM), used to make long term forecasts. Using the ECM, Armstrong predicted both the high-water mark of the Nikkei in 1989, months ahead of time, and the July 20, 1998 high in the U.S. equities market, as well as a major top in financial markets on February 27, 2007. The ECM was called "The Secret Cycle" by the New Yorker Magazine and Justin Fox wrote in Time Magazine that Armstrong's model "made several eerily on-the-mark calls using a formula based on the mathematical constant pi." (Pg 30; Nov. 30, 2009).

Hera Research Newsletter (HRN): Thank you for joining us today. Considering the Federal Reserve swap lines and the European Central Bank's (ECB) Long Term Refinancing Operation (LTRO), what's the outlook for the Euro?

Martin Armstrong: The structure of the Euro is fundamentally flawed. To put it in American terms, it would be as if all fifty states were able to issue federal bonds. It would be total, absolute chaos. What they did, to be politically correct, was to say that, since every member issues its own federal type bonds, they all have to be reserves and the large banks have to fairly allocate among them all. It's completely crazy. As countries like Greece and Spain and Italy crumble under the debt, it feeds back into the banking system. In the United States, we had the Long Term Capital Management (LTCM) collapse and we saw the government bail out a hedge fund so that they wouldn't be seen bailing out the New York banks. They have the same problem in Europe. Basically, the ECB bailing out European banks is really going through the back door to support European sovereign bonds.

HRN: Would it be fair to say that the bailouts of Greece have really been bank bailouts while the LTRO is a sovereign debt bailout?

Martin Armstrong: Sure. The two words "political" and "economy" should have been divorced when they first met. Politicians always do this. In the U.S. Savings and Loan (S&L) crisis, the politicians encouraged lending into local real estate markets by allowing thrifts to be federally chartered in 1980 and insuring them with public dollars. So the S&Ls concentrated their portfolios in real estate. Then the politicians needed money so they reduced the schedule for write-offs in real estate. And they didn't think that would change the market? They basically expanded credit for real estate, incentivized S&Ls to invest in real estate, then passed the Tax Reform Act of 1986. So then about a quarter of S&Ls went bankrupt and they had an S&L bailout and wanted to lock everybody up when they had created the problem in the first place. It's the same type of thing in Europe.

HRN: European politicians created the European sovereign debt crisis by rating all European sovereign bonds as reserves?

Martin Armstrong: Yes. By making all European sovereign bonds reserves and requiring banks to hold reserves, they made European banks hold the debt of countries like Greece and Spain. Greece, for example, was able to borrow at substantially lower rates than they would have normally. This year, €600 billion in debt has to be rolled forward only for Spain and Italy. All these bonds were issued at a very low rate. Now they have to be rolled forward and the new rates are around six or seven percent. The government budgets are going to grow dramatically and this is going to cause the real economic crisis.

HRN: Will the European Financial Stabilization Mechanism (EFSM) help to solve that problem?

Martin Armstrong: No. I told them in 1997 or 1998, when they were creating the Euro, that they couldn't do this and they had to have a single debt. They felt that it would be perceived as a bailout of members that had more debt at the time. The EFSM, which is part of the European Financial Stability Fund (EFSF), is moving in that direction but it's more of a bailout mechanism, not a consolidation. It's a half measure. They need to convert the existing debt into federal bonds and whatever new debt is issued by European Union member countries would be the equivalent of U.S. state debt and not acceptable for reserves.

HRN: Can the Euro survive?

Martin Armstrong: I don't think it will go off the boards. I think they will do everything in their power to keep it there. Politicians never want to admit a mistake. If they have to inflate they will inflate. Germany has capitulated.

HRN: Will this cause another financial crisis?

Martin Armstrong: The next crisis we're going to see will be from 2015 on. It doesn't take more than a three year old with a pocket calculator to see the long term trends.

HRN: Do you mean the European sovereign debt crisis?

Martin Armstrong: It's not just the Euro zone. The entire idea that you can borrow perpetually year after year and never pay anything back and that, somehow, that's less inflationary than if you just print money is absolutely insane. In the U.S., if we had just printed the money, the national debt would only be 40% as much as it is today. We're both creating currency and also paying interest on it.

HRN: Do you see Japan as having the same problem as well?

Martin Armstrong: Japan's debt is slightly below 300% of GDP. The only reason the yen has remained strong is because money is being drawn back into Japan. I think we're approaching a bottom in Japan that will be followed by inflation and that will probably be the last straw.

HRN: How would you compare the U.S. dollar to the Euro and the yen?

Martin Armstrong: The U.S. dollar is the best looking of the three ugly sisters. Europe is a basket case because of its structure. They'd have to federalize Europe and I don't think there's a political will to do that. Japan is totally hopeless at this stage.

HRN: Does this call into question the whole concept of central banking?

Martin Armstrong: Central banks can step up and add cash to the system when necessary, taking in the longer term assets. That was basically the original idea of the Federal Reserve.

HRN: Isn't the Federal Reserve System the main reason why the U.S. national debt is so high compared to what would have happened if the U.S. government issued its own currency?

Martin Armstrong: When the Federal Reserve was created there really wasn't any national debt. The U.S. national debt began with World War I and then World War II. When the Federal Reserve wanted to stimulate the economy it bought corporate paper not federal bonds and that really did stimulate the economy. The politicians have completely distorted what the Federal Reserve was supposed to be. In order to issue all the debt for the wars, the politicians instructed the Federal Reserve not to buy corporate paper but to buy federal paper. Throughout World War II they also instructed that the Federal Reserve maintain the par value of those bonds.

HRN: Politicians altered the role of the Federal Reserve?

Martin Armstrong: When the Federal Reserve was created, in 1913, it really was a kind of an insurance mechanism to help manage the banks and it was owned by them. It wasn't as sinister as many people have portrayed it. It was closer to something like the Securities Investor Protection Corporation (SIPC) or the Federal Deposit Insurance Corporation (FDIC). It was World War I that changed the role of the Federal Reserve. They came up with this theory that inflation was an increase in the money supply and, since the Federal Reserve was in charge of the money supply, the politicians basically said to the Federal Reserve that inflation was their problem. The vast majority of the members of Congress don't think they have any responsibility for the economy. They throw their hands up in the air and say "well, that's the Fed's job."

HRN: Fractional reserve banking systems are inherently inflationary.

Martin Armstrong: Well, it's really a leveraging system. You're increasing the money supply by taking the same money and lending it out several times, so if I deposit $100 and the bank lends you $100 we both think we have $100 but there's only one $100 deposit. Take the mortgage market where the Federal Reserve created trillions by buying mortgage backed securities (MBS). The mortgage market contracted by maybe $5 trillion from the top. So, you have deleveraging at the same time. If the Federal Reserve created $3 trillion when there was no deflation then that would be inflationary, but, in this type of system, every time you get a decline in the economy it's deflation and deleveraging. In a deflation, everyone wants cash so asset values fall. The cash is only a small fraction of the total asset value at the peak. If Bill Gates sold all his Microsoft stock at once it wouldn't be worth as much as it is on paper. It's a yin and yang between leverage and deflation.

HRN: What's the difference between leveraging deposits to loan out $10 for every $1 on deposit and creating money out of thin air?

Martin Armstrong: The current banking system that we have in the world today is really a fraud. You used to pay the bank as a storage facility to store your money but they began lending it out to make more money. They figured out a long time ago that they only needed to keep 6% or 10% of deposits. When the economy goes down it's a kind of a run on the bank. But the real problem is that they borrow short term on demand deposits and lend long term to make the spreads. When a crisis comes, their assets are tied up for ten or twenty or thirty years but they've got short term demand saying 'give me my money now'. So the system doesn't really work on a perpetual basis.

HRN: Let's talk about the gold standard. Would it have prevented the European sovereign debt crisis?

Martin Armstrong: No. In the U.S., they could have kept the gold standard but they had to raise the price of gold. They kept the official price at $35 and went to a two tier system in 1968 where the free market also had a price. They continually issued more paper but didn't change the ratio. They didn't think, at some point, it was going to go bust? Politicians always spend more than they have. We had a gold standard and they blew it up. It's "vote for me and I'll give you a chicken in every pot." Nothing is funded. In the U.S., there has been no planning for Social Security. It's just politicians standing up and saying "vote for me and I'll give you this and that" but nobody pays for it.

HRN: Do you favor returning to a gold standard?

Martin Armstrong: We have to deal directly with the government spending. Eliminate the ability to borrow. That's more important than what you are going to call money. In theory, what are they trying to do with the gold standard? They are trying to say, if we put the gold standard in then you can't create money beyond what you have in gold, but they did that the last time. I don't see where that is some sort of magic bean that's going to stop them from doing it again. It gets to a stage where it doesn't matter if you use conch shells for money or gold. There is no fiscal responsibility in government. We have to eliminate the core problem and eliminate government borrowing except in time of war.

HRN: Is that an argument for smaller government?

Martin Armstrong: Absolutely. During the Great Depression, unemployment had only gotten up to where it is now but then we had the Dust Bowl. It was what Schumpeter called creative destruction. It started the American workforce on a path to skilled labor. Before the Great Depression nearly half of the workforce was in agriculture. By 1980 only 3% was in agriculture. We are facing the same problem now only 40% of the workforce is in government. They produce nothing and don't contribute anything at all to the gross domestic product (GDP). Of course, the government statistics include both the government's spending and also the wages of government employees, so, if the government hires someone, the GDP goes up twice as fast.

HRN: That would suggest that the debt to GDP situation is worse than it appears.

Martin Armstrong: Yes. The government basically finagles every number under the sun. We're looking at a very, very serious situation. The only country that has funded its pension plan is Australia. The U.S. has $60 trillion in unfunded liabilities. At the peak, in 2007, the total of U.S. mortgages was $15 trillion. We are facing dire circumstances ahead. This is why the government is going after what they call the rich, etc. The rich now include anyone with household income of $250,000 or more. If you and your wife both have a job that pays $125,000 per year you're part of the rich. Since young people are staying with their parents longer, their income may be a part of household income too.

HRN: Isn't that what's left of the middle class?

Martin Armstrong: They always bring out people like Warren Buffett or Bill Gates but there aren't that many of those people and if the government took everything they had it wouldn't even balance the budget for a year. This is effectively a war against the American middle class. The ceiling will start to cave in when they can't sell bonds anymore. At that point, the bond market will be absolutely devastated.

HRN: Do you expect the Federal Reserve to continue monetizing U.S. Treasuries: QE3, for example?

Martin Armstrong: They are forced into monetization but it won't stimulate the economy. It isn't only Americans that own 30 year bonds. Maybe the Chinese sell their bonds to the Federal Reserve and then say thanks and take the money back to China. You can't stimulate just a domestic economy. The theories the Federal Reserve has are antiquated. They're based on the domestic economy and even on the old gold standard. These are theories based on things that don't even exist anymore. Look at the universities. They don't even teach hedging at the London School of Economics. It's amazing.

HRN: Do you think we'll see U.S. dollar hyperinflation?

Martin Armstrong: No, because the economy would not survive long enough to reach the stage of hyperinflation. Everything would collapse before that happens. What's important to understand is that Americans tend to focus on American numbers but Europe is in far more serious trouble. A lot of the European banks are still owned by the governments.

HRN: What can the U.S. government do to get the economy back on track?

Martin Armstrong: It's hard to get them to do anything that's actually going to be beneficial to the economy. They don't get it. There are also record highs in terms of corporate cash in the U.S. because the politics are so bad.

HRN: What is it that members of Congress don't understand?

Martin Armstrong: I testified before the House Committee on Ways and Means in 1996 and they wanted to know why no American companies had gotten any of the contracts to build the Yellow River dam. I said that the U.S. and Japan are the only countries in the world that tax worldwide income. We hear about companies paying their fair share, but if they're not in the United States, what is a fair share? As far as the U.S. government is concerned, you're an economic slave. If you're born in the United States, you owe taxes in the U.S. even if you're not in the U.S. and don't receive any benefits. Other countries don't do that. A German company, for example, bidding on the same contract in China is automatically cheaper than an American company.

HRN: Are you saying that the U.S. federal government's tax policies have driven companies offshore?

Martin Armstrong: In order to compete internationally, American companies have to leave the United States. It isn't just because of the labor costs because you have to have a skilled labor force. I helped take a lot of companies into Europe. You have to balance the type of labor force versus tax advantages. You can't just put an automaker in Zimbabwe. It's much more of a delicate balance than what politicians tend to say.

HRN: Is there anything that policymakers can do to bring companies back to the U.S.?

Martin Armstrong: One of the primary things is that the tax rate should be cast in stone and it should not change for every election. That is why corporate cash is at record highs. Why should a company start to hire people when all you hear is "we're going to get the rich", "we're going to get the corporations" and they're going to have to pay more. This is why corporate cash is at an all time high. Why should you start hiring people now and then next year you might have to pay 20% more? You can't do things that way. No one, on a personal level, would go sign a lease on an apartment where the lease said the landlord can change your rent at any time he wants if he spent too much money for himself. A contract is a contract and you're not going to have stability until you have something set in stone. A lot of countries have attracted capital by doing precisely this. If you go there and set up a plant, they guarantee not to increase taxes for 20, 30, 40 years. If you're going to do a business plan then you need to know what your costs are. It can't be maybe $1 mill this year and next year it's 25% more. Business plans don't work like that. The politicians need to just cast it in stone and that's it; take it off the table. Stop the rhetoric. They're not going to create jobs without that. Why should anyone build a plant in the U.S. if the government can change everything in 6 months? That's not the way to build an economy.

HRN: So, uncertainty is one of the main problems with the U.S. economy?

Martin Armstrong: The major problem is the whole debt structure. Uncertainty is why cash is at record levels and it's been that way for at least 2 years now. Lack of stability dampens confidence. In order for somebody to invest, there has to be confidence. This is why interest rates can go to 0%, but if you don't think you can make 1% then you're not going to borrow at 0%. Interest rates always go down dramatically during a depression because no one is willing to borrow. There is a lack of confidence in the future, so you're not going to have somebody opening a new restaurant or hiring a bunch of people. Small companies, in particular, are not hiring because they can't get a loan from a bank. They're cut off more than a large company. A large company, if it's public, has shares and banks will lend more against them then they will against a small business owner. Small businesses create the most jobs but they get bashed the most by the banks and they are less likely to hire because they can't borrow to do so.

HRN: What else should the U.S. government do to get the economy back on track?

Martin Armstrong: The government has to stop the perpetual borrowing and we have to really deal with the national debt. It would have to change the tax policies and they would have to cast it in stone that it can't change. It can't flip back and forth for every election because when you do that then you are undermining confidence. Why should somebody build a plant or hire more people until after the next election?

HRN: How can monetary policy help?

Martin Armstrong: As soon as something happens the politicians throw their hands up in the air and say it's the Federal Reserve's fault. It's not the Fed's fault. The politicians are the ones actually doing the spending. The Federal Reserve can't control Congressional spending. There's not much it can do to change the dynamics of the problem. The Fed can seize any company it thinks is too big to fail, so now we're outside the scope of banking. They can seize Ford Motor Company if they want to. We are so far from what the Federal Reserve was supposed to be, it's just insane. It wasn't supposed to be in charge of the money supply. It wasn't supposed to be in charge of inflation or bailing out companies that are too big to fail. It was never designed to do this, it was simply there as an insurance fund for banks, period. The Congress assumes they have no responsibility. Nobody takes responsibility. It's just one big party down in D.C.

HRN: Thank you for your time.

Martin Armstrong: It's my pleasure.

After Words

Martin Armstrong, founder of Princeton Economics, Ltd. is one of the most sought after experts in the world on financial markets, global capital flows and currencies. His frank assessment of the monetary and economic problems facing the U.S., the EU and Japan today points to government spending, tax policies and meddling in the banking system by politicians as the root causes. The solution starts with cutting government spending, instituting consistent, long term tax rates and tackling the real reasons why American companies have moved offshore. Without fundamental changes, out of control spending, failure to take responsibility, lack of accountability and crippling uncertainty will prolong poor economic conditions and high unemployment indefinitely.