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QBAMCO - Our Monetary Illness - Diagnosis

QBAMCO - Our Monetary Illness - Diagnosis

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Published by Mark Gilbert

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Published by: Mark Gilbert on Jun 08, 2011
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Asset Management Company
July 26, 2010 Our Monetary Illness: Diagnosis & Treatment

The economic problems confounding Western policy makers currently are the product of a major systemic flaw in the global monetary system, one that created asset bubbles, impacted the factors of global production and ultimately led to system-wide disequilibrium. The structural flaw is the allowance and abundance of net systemic leverage. Abundant net leverage is possible only in monetary systems lacking natural discipline, where the supply of money and credit is freely manufactured by policy makers and banking systems. Over the past forty years we have come to accept banks as fractionally-reserved net suppliers of credit and shadow-bank intermediaries as net demanders and gross suppliers of credit. The result: in the US, dollar-denominated debt now exceeds the monetary base by almost 30:1 ($70 trillion/$2.5 trillion). The creation and perpetuation of net leverage is the root cause of current macroeconomic imbalances among advanced economies. It has distorted fundamental supply/demand incentives for workers, goods and services. Workers have not had to compete over wages with workers in emerging, less levered economies. At the same time, leverage allowed Western businesses to increase nominal revenues and employment. Why would US businesses build factories in an economy with synthetically high wages when workers/customers were willing to borrow to consume? Of course, credit is not evil. It is a necessary function of commerce. However, while it is reasonable for capital to flow to unlevered creditors that worked for the capital they are lending, why do we tolerate capital to flow to fractionally-reserved banking systems or to governments that repeatedly abuse their abilities to create credit from thin air or to print notional money? This is patently unfair to the factors of commercial production. And why is it commonly accepted that deflation in an economy must be avoided at all costs? To unlevered creditors, deflation is a positive transfer of wealth and to debtors it is the opposite. This is a zero sum game. Prices, per se, have nothing to do with employment levels or consumer affordability. Relative prices should simply guide consumer preference and resource allocation. Innovation, immigration and economies-of-scale would drive price lower in a purer economy. Cash would earn a positive real return, signaling when producers should slow down. Price deflation signals abundance, which raises affordability and allows individuals at all levels to pursue activities based on desire rather than necessity. Why do we expect economies to operate as though synthesizing scarcity is noble? Could the generally accepted fear of deflation be perpetuated by the two beneficiaries of systemic leverage -- over-levered banks and public sector deficit spenders?

The unchecked growth in unreserved credit has led to widespread asset inflation, which has negatively impacted employment sustainability. Past credit inflation has made shops on Main Street fundamentally overvalued, in turn requiring artificially high rents to service debts. The average shop owner can now choose to pay his inflated lease or pay his workers – but not both. Thus, asset inflation due to excessive credit creation is not wealth enhancing but, rather, productivity destroying. When the cost of capital begins to dwarf the value attributed to labor, production becomes unsustainable. When a producer can no longer afford to service his capital costs and wage obligations, employment suffers. When employment suffers, income distribution suffers. When income distribution suffers, demand suffers. The wealthy few can only consume so many eggs per day. Production naturally migrates to economies where labor demographics, regulatory apparatuses and asset pricing are more balanced. In the end, credit inflation leads to asset inflation while base money inflation leads to wage and basic goods/consumables inflation. The Austrians modeled this and predicted it. Keynesians tried to avoid it, failed, and are now unsuccessfully trying to manage it. We shouldn’t remain beholden to this ad hoc economic model. The pendulum must swing back towards hard or harder money. A currency devaluation and peg to gold at a defensible exchange rate would curtail future unreserved credit extension. Banks would become credit intermediaries, not credit creators. With $1 million in deposits, something less than that could be lent. Real interest rates would be determined by the market and so they would forever remain positive. Capital would then flow to efficient and prudent investments, and not be broadly channeled toward non-sustainable spending behavior or speculative outlets. * The yawning gap separating outstanding global debts and base money cannot be closed by issuing new debt to debtors. It must be treated with the hair of the dog – a massive coordinated monetary devaluation. A major expansion of the global stock of base money should be administered and then be capped in a credible fashion. It would work in two steps: 1) A coordinated global currency devaluation. The Fed tenders for private gold holdings at $5000/oz and maintains that bid/offer. As the Fed purchases gold, the gold flows to the asset side of its balance sheet. The Fed funds these gold purchases with newly-digitized money, which flows to banks in the form of net new deposits. This would be a discrete monetary inflation event (devaluation) and a simultaneous deleveraging. Once the Fed acquires enough gold from the markets, a gold price peg for the US dollar is established. Would this be a gold standard? Yes, if that nominal exchange value is maintained in the open market by the Fed. No, if the Fed decides to periodically adjust that $5000/oz. level following the original exchange. (In fact, tinkering with the official gold price would be a pure example of a monetary agent conducting monetary policy.)

2) A major policy-mandated contraction in unreserved bank lending. Bank reserve requirements should be increased substantially. These steps would mark a new and sustainable global monetary system. (The reason gold standards “failed” in the past is that they allowed for continued net systemic leverage; not because the basic mechanics of a gold standard are “too restrictive”.) The economic benefits would be immediate and profound. Financial assets would appreciate in nominal terms making balance sheets solvent. The loan books of global banking systems would be secured again. Debtors would welcome this devaluation and debt covenants would remain intact. Nominal wages and asset prices would rise while debt balances would remain constant. The burden of repaying debt would be greatly diminished, not the principal amount of the debt itself. Bondholders, dollar reserve holders and retirees would suffer losses in purchasing power; however, inflating away the burden of debt would likely act as a massive economic stimulant, which would, in turn, give policy makers room for fiscal maneuvering. Global wage rates in established and emerging economies would track towards equilibrium. Affordability would rise. Prices for goods and services could fall without having a deleterious impact on employment. Workers would naturally migrate where opportunity lay and would again be able to save their wages for future consumption. Is there a good reason this plan is not being discussed by serious-minded policy makers? Lee Quaintance & Paul Brodsky

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