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The American Empire is Another Bubble

September 12, 2008

Tags The FedFree MarketsInterventionism

If Ludwig von Mises were to peruse today's newspapers, he would recognize the symptoms of a worldwide central-bank-generated credit bubble and its oncoming collapse.

What increasingly characterizes the global financial order, Mises would say, is an arrangement where regulators encourage a "heads I win, tails everyone else loses" mentality, backstopped by the willingness of quasi-governmental entities to print and borrow money without bound.

A gentle man by all accounts, Mises would resist the temptation to say, "I told you so," and focus on how to avoid a full-blown global economic and political catastrophe.

The announcement by the FDIC that it might have to "temporarily" borrow money from the Treasury, i.e., the taxpayers, is the latest squawking canary that the dollar-centric global-fiat-money and regulatory era in place since WWII is approaching a final ugly dénouement.

The FDIC now fails to meet its required statutory minimum of 1.15% of capital per insured dollar in deposits due to the ongoing mortgage and credit market carnage; hence the hint for the life preserver thrown out by the FDIC to the Treasury Department the last week of August 2008.

The FDIC, like Fannie and Freddie, says, "Of course we will pay this loan back when everything returns to normal." The accounting "profession" and "civil servants" at the CBO et al. are likely to give their seal of approval to an FDIC bailout with the assurance that "all is well" in the short run. In fact, the bailouts of Fannie, Freddie, and the FDIC in the long run by themselves are likely to be as effective as the Niedermeyer character from the movie Animal House was in attempting to stop the John Belushi–triggered stampeding crowd at the end, pitifully screaming, "Remain calm, all is well."

As in the case of Fannie and Freddie, the FDIC promise to repay the taxpayers when things return to normal is worthless, because there was nothing normal about the real estate and associated credit bubble in the first place. The FDIC, Fannie and Freddie will assure everyone that "the public will receive its money back when the assets of failed banks, etc. … are sold." That is unhelpful nonsense.

By definition, a bubble is an economic disequilibrium caused by the excessive creation of money in relation to the intrinsic value of the asset class to which the money is drawn. In long-run equilibrium, therefore, the money stock (and therefore asset prices) must return to their productively useful value in relation to the size of economic output, or the general price level must rise to restore the fundamental relationships between the marginal utilities of goods and their prices: Mises 101.

In other words, in the case of the fallout from the real-estate and associated credit bubbles, either housing and bond prices must fall dramatically, or there must be a dramatic increase in inflation, or a (convex if you will) combination of the two. This is not rocket science, whatever the sophists of the political class would have us believe.

Without wishing to cause a panic, the situation is actually significantly worse than the mere bailout of Fannie, Freddie, and the FDIC would suggest, once one places the bailouts in their proper historical and political contexts.

For the last sixty years, the United States has provided military protection for the European and Asian capitalist powers, all possessing economies governed by regulatory apparatuses analogous in character to the apparatuses of the American postwar New Deal. These apparatuses, especially when coupled to fiat money, have in common the fundamental flaw that they create economic instability via moral hazard.

This provision of American military protection has been supported by the imperial tribute of the acceptance of paper dollars — dollars at first theoretically backed by gold. Of course, this charade, described by Robert Triffin in 1960, ended in 1971 with the collapse of the Breton Woods system, exposing holders of dollars to massive losses and causing the Great Inflation of the 1970s.

Through the 1970s and 1980s, the United States did not abandon the course of empire, or statist regulation, but instead expanded, especially the imperial side of the interventionist mentality and especially in the wake of the collapse of the Soviet Union. Whatever the deregulation of other sectors of the economy, the financial sector — due to its role in imperial finance — retained its peculiar regulatory privilege through its ability to generate unlimited losses at taxpayer or dollar-holder expense.

This expanded American empire was, for a time, bizarrely aided by the People's Republic of China as part of an industrialization policy in which the Chinese sterilized the purchase of dollars by massive domestic security sales to soak up excess liquidity. This is a strategy that is rapidly running out of steam and has created a dangerous inflation in Chinese real-estate and stock prices that is unlikely to end well.

Japan, capitalist-oriented East Asian and to a lesser degree Western central banks, the oil states, and Russia (yes, Russia) also purchased huge quantities of dollar-denominated assets from the 1990s onwards, with the effect of subsidizing the Pax Americana — probably because alternative security arrangements seemed more expensive.

Alas, that willingness to subsidize the United States would seem to be rapidly waning. Russia's recent assertiveness is a hint of things to come, as more and more foreigners are taking a hard look at their subsidization of an America living beyond its means. The stocktaking economic signal globally is the increasingly punishing foreign-credit-related losses caused by the Fed's last imperial bubble, a credit bubble that has infected the entire planet.

It was fun for the United States in the short and medium run, since, at least in the 1980s, the United States got to have its imperial cake and shopping-mart icing too. The United States thereby avoided having to deal with the fundamental disequilibrium between both the federal government's promised expenses versus expected revenues, as well as the associated disequilibrium between American living standards and economic productivity.

That era is coming to a close, with the increasing amplitude in the financial oscillations of the world economy at lower frequencies, demonstrating systemic instability dating, at the latest, to the Asian financial crisis of 1998.

In response to that crisis and to concerns over Y2K, and with especially intense initiation at the time of the LTCM fiasco (an event itself of course made possible by the intrinsic moral hazard of Greenspan and the postwar regulatory mentality), the Fed lowered rates, thereby pushing the tech-stock bubble into a final frenzy. Raising rates in 1999 to combat Fed-fiat-money generated inflation, the creature from Jekyll Island succeeded in crushing the NASDAQ et al., and, in the process, generating a global economic downturn.

In 2002, now concerned about deflation, the Fed took rates to absurdly low levels, thereby generating the housing bubble. Worried about inflation in 2006, in which the housing bubble was the inevitable consequence of trying to maintain American asset prices and output valuation at nonequilibrium levels, Greenspan's fall guy Bernanke took rates up, killing the housing bubble, and then took rates down while revving up the printing presses to stave off a credit-market collapse. This leads us to the current juncture with Fannie, Freddie, and the FDIC, and what Mises would clearly identify as the "policy" trap.

Viewed in isolation, the Fed can take rates neither substantially up nor down. If it fights its own inflation by taking rates up, it sends the economy into a depression. If it fights a credit-contraction-generated recession with lower rates, it risks a hyperinflation and a run on the dollar. If the federal government were to try to use any more fiscal stimulus on the tax or spending side, the Ricardian equivalence theorem would apply to an entity with a present discounted budget deficit/solvency problem of $30 trillion dollars. That is, there will be minimal effect. A bump in second-quarter GDP changes nothing about the long-run picture, and in equilibrium actually means merely a shift of output from the future to the present; it is, however, popular with politicians under the electoral gun and Wall Street types looking for suckers.

In other words, Mises would point to the bailouts of Fannie, Freddie, and the FDIC as the hint that a general system event had arrived, in which we need a new policy mentality. Mises would clearly see the solution to the fiat-money-generated world disequilibrium as a global return to a commodity-money standard with 100% reserve banking as the only monetary policy rule and a banking order that avoids the disequilibria generated by the politically motivated manipulation of the money supply.

Although the author was trained in a very different mentality, he now sees an irreducible truth in the argument that, under the current discretionary monetary policy arrangements, we keep observing the same cycles in under and overextension of credit, because the political temptation to do so is overwhelming. In the long run, when monetary authorities around the globe play the same game — and especially when the use of that credit is so often indirectly used to finance war — the results of central-bank activities are likely to be so poor in terms of system risk that the seemingly radical step of a return to commodity-based money and a new reserve order for the banking system might well be the most responsible step to take, provided that the move is done in an orderly fashion.

Given the need to avoid an implosion of the world political order, such a transition would probably have be created in conjunction with negotiations with our foreign creditors for a new gold-based monetary order to avoid a panicked run on the dollar, amid attempts to attack a grossly overextended American imperial position. In the regulatory field, what is needed at a minimum is the effective creation of an adults-only area where losses are credibly understood as not subject to a Greenspan-like put in order to permanently rid ourselves of the "heads I win tails you lose" financial-system externality that is getting increasingly expensive and disruptive.

Although this analysis of the meaning of the FDIC bailout in its broader consequences cannot be regarded as cheery — and, to some, may seem radical — human beings do poorly when imitating ostriches, and any of the alternatives available to policy makers are likely to be gratuitously destructive in character.


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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