A wise and frugal government which leaves men free to regulate their own pursuits of industry and improvement. This is the sum of good government. - Thomas Jefferson
Introductory Chapter - The Evil Princes of Martin Place
Sat, 26/03/2011 - 12:23pm
Sat, 26/03/2011 - 12:23pm
A Liberty Australia exclusive: the introductory chapter of Chris Leithner's new book "The Evil Princes of Martin Place: The Reserve Bank of Australia, The Global Financial Crisis and the Threat to Australians' Liberty and Prosperity", placed online for free. Buy the full book at Amazon.com.
A panic exposes the essence of banking as no lecture, book or diagram can do. The essential truth about the [fractional reserve] bank is that it is no ordinary safe-deposit box. Every dollar of the depositors’ money is not in storage on the premises all the time. Some of it is, indeed, stacked in the safe, but rare is the bank … that could meet a demand for cash from all its depositors at once. The art of banking is always to balance the risk of a run with the reward of a profit.
James Grant Money of the Mind (1992)
A review of my book, The Intelligent Australian Investor: Timeless Principles and Fresh Applications (John Wiley & Sons, 2005), which appeared in the Law Institute Journal in May 2006, paid me a great and probably unintentional compliment. Its author “found the [book’s] introduction most disconcerting.” The reviewer “resent[ed] sweeping statements such as ‘… in addition to their innate immorality, politicians are inherently incompetent and their interventionist policies necessarily fail.’” He neither assessed the argument nor contested the evidence that justified this conclusion; he simply didn’t like what had been placed before him, and so declined to consider it. Yet “despite the sometimes off-putting generalisations,” the reviewer concluded that he “would recommend the text for investors.” Five years ago I aspired to ruffle a few feathers, and am pleased that, at least in one instance, I apparently did. Today I’m more ambitious: I intend that this book cause deep and abiding offence within what it calls the Australian welfare state of credit. In particular, I hope that it outrages central bankers, commercial bankers, mainstream economists, journalists, lawyers, politicians and the legions of other enthusiasts of the monetary distemper of our times. Far more importantly, I also hope that it shocks ordinary Australians into a greater interest in the utterly fraudulent foundations of modern banking and finance. Only by grabbing their attention and directing it towards a mountain of logic and evidence (none of which is mine, most of which is hundreds and some of it thousands of years old) can I provoke them to think; and only by thinking for themselves and from first principles might they conclude, as I did long ago, that today’s monetary institutions and policies are as deeply immoral as they are severely damaging. Two Simple Questions This book answers two simple questions. What caused the “Global Financial Crisis” (GFC) that erupted in mid-2007 (and whose associated worldwide economic recession, I believe, is still in its early innings)? What will be the consequences of the actions undertaken by governments to combat it? I show that the more things change, the more they stay the same: the GFC is merely the latest in a long series of economic and financial crises that have punctuated the history of the past 250 or so years. Like its predecessors, three of which we will analyse in detail, poor policies – in particular, the existence of legal tender laws, fractional reserve bank-
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ing and central banking – are the GFC’s ultimate causes. The intervention of government, in other words – and not the free market – causes financial and economic crises. Accordingly, the disappearance of crises necessitates the repeal of pernicious laws and the abolition of damaging practices. Why Are Central Banks Revered Rather Than Reviled? The central bank is the most visible and powerful manifestation of these pernicious laws and damaging practices. Unfortunately, for far too long central bankers have been revered as architects of financial stability rather than reviled as agents of monetary chaos. According to its web site (dated 6 November 2009), the Federal Reserve System
is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. Today, the Federal Reserve’s duties fall into four general areas: conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates …
Similarly, the Reserve Bank Act 1959 states
It is the duty of the Reserve Bank Board … to ensure … that the powers of the Bank … are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to: the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia.
It’s high time that somebody finally blew the whistle and pointed an accusing finger: the Federal Reserve System (“Fed”) and the Reserve Bank of Australia (RBA) – like all other central banks – have failed utterly, completely and miserably to achieve these objectives. (Indeed, Chapter 8 will demonstrate that their achievement is, as a practical matter, simply impossible.) As an example, consider “stable prices” and “the stability of the currency.” Figure 1 plots the purchasing power (PP) of the $A and $US since the formation of the Fed and RBA in 1913. 1 Within
“Purchasing power” means the quantity of goods and services that a unit of currency can purchase at a given point in time. The greater the quantity, the greater the currency’s purchasing power. The origin of the RBA is difficult to specify. One candidate of its genesis is the Commonwealth Bank Act 1911; others are Commonwealth Bank Acts of 1924 and 1945. (Before the passage of the Reserve Bank Act 1959, the Commonwealth Bank undertook many of the actions which came to be associated with central banks.) In 1960, Sir John Phillips, the RBA’s inaugural Deputy Governor and its second governor, remarked “the Reserve Bank, though a new institution … really has its roots spread back over the last forty-seven years or so …” For convenience, I’ll date the RBA’s birth to coincide with that of the Fed in 1913. For a short history of the RBA’s origins and evolution, see Selwyn Cornish, The Evolution of Central Banking in Australia (Reserve Bank of Australia, 2009), Chaps. 1-2.
a decade of the Fed’s birth, the purchasing power of the American currency halved: the basket of consumer goods and services that cost $US1 in December 1913 cost exactly twice as much in March 1920. PP subsequently rose from $US0.50 to $US0.78 by the nadir of the Great Depression in 1933. Since then, however, its slide has been unrelenting – to a derisory $US0.0454 in July 2010. The consumer goods and services that cost $US1.00 at the beginning of 1913 thus cost $US22.02 in mid-2010. That’s a total rise of consumer prices of no less than 2,102% during the past 97 years. Who in his right mind calls that success? The U.S. has enjoyed many things since 1913, but a stable (in terms of its PP) currency simply hasn’t been among them. Figure 1: Only a Crazed Partisan of the State Could Call This “Success” The Federal Reserve, RBA and the Currency’s Purchasing Power, 19132010 2
1.20 1.00 0.80 0.60 0.40 0.20 0.00
1913 1937 1961 1985 2009
The RBA has trashed the $A’s purchasing power even more thoroughly. The basket of consumer goods and services that cost the equivalent of $1.00 in 1913 cost more than three times as much ($3.49) in 1920; as a result, the PP of the $A plummeted to $A0.29. As in America, so too in Australia: PP subsequently rose – indeed, doubled – to $A0.41 in 1933. Since then, however, and as in the U.S., its slide has been unremitting – to a derisory $A0.0097 in 2010. In other words, the consumer goods and services that cost $A1.00 at the beginning of 1913 cost $A102.98 in mid-2010. That’s a total rise of consumer prices of almost 5,000%! The Federal Reserve took 68 years – from 1913 to 1981 – to crush the PP of the $US from $1.00 to $US0.10. The RBA needed only 55 years. What about the era of allegedly “low inflation” since the early 1990s? The $A has lost half of its PP since 1988; and it has lost one-fifth since 2004. Since the Great Depression, Australia has enjoyed many things; but at no time since then has it enjoyed anything
Sources of data: U.S. Bureau of Labor Statistics (http://www.bls.gov/cpi/) and Reserve Bank of Australia (http://www.rba.gov.au/calculator/annualPreDecimal.html).
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that by any reasonable standard could be called “stable prices.” As we’ll see in subsequent chapters, most of the conventional wisdom and mainstream propaganda about central banks and monetary affairs is at best misleading and at worst flatly incorrect. Figure 2: The Free Market Begets Stability and Central Banks Produce Chaos; the PP of the $US and £, 1800-2010 3
2.50 2.00 1.50 1.00 0.50 0.00 1800 1815 1830 1845 1860 1875 1890 1905 1920 1935 1950 1965 1980 1995 2010
It’s vital to understand that there’s more than correlation at work here: this book will demonstrate that central banks such as the Fed and RBA have caused the destruction of their respective currencies’ purchasing power. (This fact is closely related to another, which we will also describe and substantiate: far from smoothing the ups and downs of the business cycle, as the mainstream relentlessly asserts, central banks have exacerbated them.) As an initial point of corroboration, Figure 2 plots the PP of the U.S. dollar and British pound since 1800 – that is, during the approximately 100 years before and the approximately 100 years after the advent of modern central banking in these two countries. It shows that before (a) the abandonment of the classical gold standard during the First World War and (b) the creation of central banks with interventionist mandates (such as the Fed in 1913 and the Bank of England’s policy since the First World War), the purchasing power of the $US and £ remained relatively stable. The American Civil War – during which the U.S. abandoned the gold standard – provides the major exception to this stability. Since the Great Depression, however, these currencies’ PP has inexorably fallen and cumulatively collapsed. In other words, under the relatively “free market” situation – namely the classical gold standard – that prevailed before the rise of modern
Source of data: American figures before 1971 come from U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Bicentennial Edition (Washington, DC: Government Printing Office, 1975), series E135; figures since 1970 come from U.S. Bureau of Labor Statistics; and British figures come from the Bank of England’s “inflation calculator” (http://www.bankofengland.co.uk/education/inflation/calculator/flash/index.htm). See also Jim O’Donoghue, et al., “Consumer Price Inflation since 1750” (Office for National Statistics, Economic Trends, March 2004).
central banks and their interventionist monetary policies, currencies didn’t just retain their purchasing power over long periods of time: it rose appreciably. What cost $1 in the U.S. in 1800, for example, cost just $0.58 in 1913 (and $0.49 as recently as 1901). During this interval, the prices of goods and services fell at a compound rate of 0.5% per year. If you bought the same goods and services in 1800 and 1913, they would have cost $1.70 and $1 respectively. Clearly, the dollar bought much more in 1913 than it did in 1800; at the same time, people’s wages rose by a cumulatively very significant amount during these years; as a result, and thanks partly to the gently falling prices of goods and services, standards of living rose dramatically. In sharp contrast, goods and services that cost $1 in 1913 cost $22.02 in 2010 ($1/$22.02 = $0.045). In other words, if you bought exactly the same products in 2010 and 1913, they would cost you $1 and $0.05 respectively. Clearly, the dollar buys much less today than it did in 1913. Under the watch of the Federal Reserve System, then, the PP of the dollar has plunged 95%. Other central banks have, to greater (like the Bank of England) or lesser extents, also presided over the destruction of their respective currencies’ purchasing power. More specifically, Figure 2 shows • In 1800-1807, the PP of the dollar rose by 16% (i.e., from $1.00 to $1.16). This period almost perfectly coincided with the presidency (1801-1809) of Thomas Jefferson and his policy of “hard money,” continuous cuts to taxation and expenditure, and resolute reduction of the national debt. • In 1808-1819, PP decreased by 30% (i.e., from $1.16 to $0.81). During these years, the U.S. fought the War of 1812 – and incurred much inflation, taxation and government expenditure, and added greatly to the national debt. The inflation culminated in the Crisis of 1819. • In 1820-1833, PP increased 88% (i.e., from $0.91 to $1.75). During this period, “hard money” presidents governed; hence taxes and government expenditures fell. Andrew Jackson, who abolished the Second Bank of the United States (a forerunner of the Fed) and repaid all but $38,000 of the national debt, was most notable in this regard. • In 1834-1837, PP fell 22% (i.e., from $1.69 to $1.32). This period coincided with the inflationary distortions of state-chartered banks. The liquidation of these distortions (and many of these banks) culminated in the Crisis of 1837. • In 1838-1861, PP increased 43% (i.e., from $1.32 to $1.89). The national debt stood at $15m when James K. Polk took office in 1845. Fortunately, he was a hard-money and a low-tariff man; alas, and like Jefferson and Jackson, he was also a continental expansionist. He coveted California and Mexico’s other northern provinces; and to obtain them he resorted to war. The Mexican War (1846–47) increased America’s national debt four-5-
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fold (to $65m). The next presidents, Taylor and Tyler, were Whigs; the Whigs were predecessors of the mercantilist Republican Party; as such, they were indifferent to government expenditure and debt. Under their administrations (Taylor died shortly after taking office), debt ballooned to $80m by 1851. Fortunately, his successor was a Jeffersonian Democrat – and therefore a staunch practitioner of free trade, hard money and frugal government. The last of the Jeffersonians, Franklin Pierce, retired twothirds of the national debt, such that it fell to $30m (an amount less than 5% of GDP) when he left office in 1857. Neither in absolute amount nor as a percentage of GDP would the national debt ever again fall so low. • In 1862-1865, PP plummeted 41% (i.e., from $1.89 to $1.11). These years coincide almost perfectly with the War to Prevent Southern Independence (1861-1865), during which the U.S. Government abandoned the gold standard and undertook a hitherto unprecedented program of inflation, taxation, expenditure and borrowing. • In 1866-1901, PP increased 83% (i.e., from $1.11 to $2.04). During these years, America returned to the gold standard and Grover Cleveland, its greatest president since Jackson (and thus staunch defender of hard money), held office (1885-1889 and 1893-1897). Cleveland doughtily opposed inflation, imperialism, high tariffs and subsidies to business, farmers and veterans. He also vetoed legislation more frequently than any president up to that time. The Crisis of 1893 occurred between Cleveland’s two terms of office. • In 1902-1913, PP decreased 16% (i.e., from $2.04 to $1.72). During these years, called the “Progressive Era” in the U.S., the government’s expenditure and taxation rose, as did its regulation of the economy. • In 1914-1920, PP plummeted 51% (i.e., from $1.72 to $0.85). In 1913 the Federal Reserve System commenced operations and in 1917 the U.S. Government intervened in the First World War. As a result, there occurred a hitherto unprecedented (that is, bigger than the Civil War) program of inflation, taxation, expenditure and borrowing. • In 1921-1932, PP increased 55% (i.e., from $0.85 to $1.32). The Harding and Coolidge administrations (we will see that Harding was by far America’s greatest president of the 20th century) slashed taxation and expenditure and repaid a significant portion of the national debt. • Since 1933, PP has decreased 94% (i.e., from $1.32 to $0.08). During these years, in order to finance the New Deal’s endlessly rising welfare at home and almost continuous warfare abroad, both the U.S. Government and Fed have followed a policy of incessant high inflation (greatly facilitated by the abandonment of the currency’s link to gold), high and rising taxation and
exponentially growing government expenditure and borrowing. As a result, in mid-2010 America’s national debt reached $13 trillion (“on balance sheet”) and up to $100 trillion (“off balance sheet”) – which means that the U.S. Government is effectively bankrupt. 4 America’s bankruptcy is the New Deal’s legacy; as such (and next only to Abraham Lincoln and Woodrow Wilson) it makes Franklin Roosevelt the worst president in U.S. history. The British figures show remarkably similar trends. Between 1803 and 1815, Britain fought major wars in Europe and North America, incurred much inflation, taxation and government expenditure, and added greatly to its national debt. As a result, the pound’s PP fell. It subsequently recovered all of its losses and more: by 1822, its PP stood 22% higher than it did in 1800. During the next 90 years – which was a time of free trade, the “hard money” of the classical gold standard, low taxation, small and balanced budgets and therefore of a government small enough to fit inside the constitution – the pound’s PP remained astonishingly stable. As in America and Australia, so too in Britain: the First World War was a turning point for the significantly worse. During the War, when the Bank of England assumed its modern guise as the state’s financier and manager of the economy rather than a mere custodian of sound money, the PP of the pound plummeted 62% (i.e., from £1.39 in 1914 to £0.53 in 1920). As in America and Australia, so too in Britain: PP then rose by 60% (i.e., to £0.85) in 1936. Finally, in Britain as well as Oz and the U.S., the Great Depression provided a seemingly permanent turn for the dramatically worse: since 1936 the pound’s PP’s has virtually disappeared – to £0.02 (just one fiftieth of its PP in 1800!) in 2010. There’s a pattern here, which subsequent chapters will corroborate. So – ironically – does research conducted under the Fed’s imprimatur! A study by two economists at the Federal Reserve Bank of Minneapolis concluded that “commodity money” standards (namely a classical gold standard, which subsequent chapters
See Chris Leithner, “Avoid the Rush: Prepare Now for America’s Bankruptcy” (LewRockell.com, 13 February 2007). Lawrence Kotlikoff (“U.S. Is Bankrupt and We Don't Even Know It,” Bloomberg News, 11 August 2010) says “let’s get real. The U.S. is bankrupt. Neither spending more nor taxing less will help the country pay its bills.” The President of the Federal Reserve Bank of Dallas seems to agree. See also Richard Fisher, “Storms on the Horizon” (Remarks before the Commonwealth Club of California, San Francisco, 28 May 2008). Kotlikoff adds (“Is Uncle Sam Bankrupt?” National Center for Policy Analysis, January 2010), “when it comes to nondisclosure, the U.S. Government is the father of all financial malfeasants. Indeed, Uncle Sam has been misrepresenting the nation’s finances for decades. In the process, he has run up an undisclosed bill that makes the financial bailout and economic stimulus spending look paltry … Given the magnitude of the fiscal gap, the country is broke. The United States is currently short more than $77 trillion and this figure will only increase. In fact, it is estimated that the total gap will amount to nearly $80 trillion in 2010. The United States Government, through its various financial agencies, is assuming away the country’s fiscal problems rather than confronting and correcting them. Without dramatic and immediate changes in policy, future generations are likely to face lifetime net tax rates that are twice those imposed now.” See also Kotlikoff’s “Is the United States Bankrupt?” Federal Reserve Bank of St. Louis Review, Vol. 88, No. 4 (July-August 2006), pp. 235-49.
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will define and describe) consistently outperform “fiat” standards. Analysing data over many decades and from a large number of countries, Arthur Rolnick and Warren Weber found that “every country in our sample experienced a higher rate of inflation in the period during which it was operating under a fiat standard than in the period during which it was operating under a commodity [i.e., gold] standard.” 5 Other members of the establishment are more forthright. According to Benn Steil and Manuel Hinds of the Council of Foreign Relations, “the imposition of national [fiat] monies remains one of the most potent tools available to governments to extract wealth from their populations and to exercise political control over them.” 6 Mainstream economists have long recognised – and some have overtly celebrated – this brute fact. In The Economic Consequences of the Peace (Harcourt, Brace & Howe, 1919, p. 236), for example, John Maynard Keynes gloated
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.
More specifically, we will see that welfare and warfare – and the vast amounts of inflation required to finance them – inevitably weaken and eventually destroy the currency’s purchasing power. The inflation that necessarily underpins what we will call the welfare-warfare state enriches the privileged few; it also foments the financial crisis on Wall Street that becomes the economic crisis on Main Street. Conversely, soundly-based money, low and falling government expenditure, as well as the reductions of taxation and inflation, augment the currency’s purchasing power – and also encourage peace at home and abroad, soundly-based growth and prosperity. Today, the Australian and American dollars, British pound, etc., buy vastly fewer goods and services than they once did; at the same time, wages in these and most other Western countries have risen – but at a relatively sluggish pace since the 1970s. The result is that – subject to a critical caveat – standards of living rose at a rather robust pace in the three decades after the Second World War, but at a significantly slower pace since the 1970s. What’s the caveat? In recent times families have been obliged to take drastic action to protect their standards of living. During the 19th century, women (whether single or married) undertook paid work because economic necessity obliged them to do so. By the 1950s, however, relatively few married women worked outside the home. Prosperity had advanced to a point where a single income often sufficed to provide a family with a middle class standard of living. That reality didn’t last long. The campaign waged since the 1970s to convince women that they are economically equal to men – and have, therefore,
Arthur Rolnick and Warren Weber, “Money, Inflation, and Output Under Fiat and Commodity Standards,” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 22, No. 2 (Spring 1998), pp. 11– 17; see also Journal of Political Economy, Vol. 105, No. 6 (December 1997), pp. 1308-1314. Money, Markets, and Sovereignty (Yale University Press, 2009), p. 67.
every right to join their husbands in the workplace, thereby creating a society in which, by the 1980s, most middle-class homes earned two paycheques – has served as a cover with which to mask the eroding standard of living over the last 50 years. Today’s middle-class Americans, Australians, Britons, etc., live much better than their parents or grandparents did because they enjoy the benefits of myriad and momentous technological advances and because both partners must work. Most families could not service the mortgage, periodically buy a new car and regularly take holidays, etc., on one income. In the 1950s, membership of the middle class often required only one salary; today, it usually requires two. Why hasn’t this de facto erosion of living standards angered people? They’ve maintained a material standard of living that exceeds their forebears’ because technological advances, a more advanced division of labour and a vastly heavier load of debt play such important roles in their lives. They know something that academics and politicians apparently don’t: the re-entry of women into the paid workforce is usually not some advanced and noble achievement of equality; as it was before the 1950s, it’s once again a brute economic necessity. It’s an essential feature of modern society because it’s an inevitable consequence of the central bank’s gradual destruction of the dollar’s purchasing power. The middle class, in short, has been fleeced. Many of its members know it, but don’t quite know how. If a woman wishes to work outside the home, bless her and more power to her (see in particular Proverbs 31: 11-25), but let’s not pretend that it’s a moral breakthrough. And let’s reject outright the nonsense that it’s a consequence of allegedly enlightened attitudes and a benefit of the modern welfare state. Instead, let’s identify it for what it is: a consequence of misguided monetary institutions and poor monetary policies. In this book we will reason to the conclusion that there’s only one sensible thing to do with central banks such as the Reserve Bank of Australia: abolish them and consign them to the dustbin of history. The mainstream will shriek in horror at this “radical” conclusion. The real question (which, of course, they refuse to ask) is: why not rid ourselves of an institution that has almost completely destroyed the currency’s purchasing power and has exacerbated the cycle of boom and bust – particularly when free market arrangements have shown that money need not lose its purchasing power, and that they can actually increase it significantly over long stretches of time? We’re Radical, But They’re Extremist – and Their Banks Are Rotten to the Core “A central bank … must grow like a living organism within the environment provided by the financial and economic system in which it exists; its practices and structure must evolve in response to the needs and demands of that system.” So wrote H.C. “Nugget” Coombs, the first Governor of the RBA, in 1951. 7 I don’t think he appreciated either the significance or the true meaning of those words.
See Coombs’s Foreword to L.F. Giblin, The Growth of a Central Bank: The Development of the Commonwealth Bank of Australia, 1924-1945 (Melbourne University Press, 1951), p. v.
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This is because “a central bank,” as Vera C. Smith wrote in her classic The Rationale of Central Banking and the Free Banking Alternative (1936), “is not a natural product of banking development. It is imposed from outside or comes into being as the result of Government favours. This factor is responsible for marked effects on the whole currency and credit structure which brings it into sharp contrast with what would happen under a system of free banking from which Government protection was absent.” In light of Smith’s insight, Coombs unintentionally affirmed one of this book’s principal findings – namely that central banks exist not in order to cater the needs of the general population, but rather to serve (i.e., finance) the state that creates them. As a result, and as we shall see, a small number of “insiders” gains handsomely and the mass of “outsiders” loses heavily. We will also demonstrate from first principles and in simple language that 1. For centuries, fractional reserve banks – which we’ll define and describe in detail, and which comprise virtually all contemporary banks – have misappropriated depositors’ funds and counterfeited money. Contemporary monetary institutions, practices and policies, in other words, are built upon a foundation of “legalised” fraud. 2. For this reason, and also as a consequence of their inherent illiquidity, fractional reserve banks are at all times, and not just during financial and economic crises, bankrupt. Without the constant and active intervention of the state in general and its central bank in particular, their bankruptcy would be plain for all to see. 3. Central banks don’t fight inflation: they manufacture and maintain it. These days, only the actions of commercial and central banks can create inflation. The legislation and regulations that underlie the banking system inflate the boom that inevitably busts. 4. The state has embedded its protections of commercial banks so deeply within legislation and regulations – in other words, it has extended such enormous privileges to banks for such a long time – that virtually nobody now recognises bankers for what they have always been: massively featherbedded white-collar wharfies. 5. When examined in the light of Christian theology (particularly of St Augustine of Hippo, St Thomas Aquinas, Bishop Nicolas Oresme and Popes Pius XI and John Paul II), central and fractional reserve banking is certainly deeply immoral and likely anti-Christian. This book’s premises and conclusions are radical in the proper sense of the term – they dig to the roots and sources of the monetary sickness that pervades Western societies. We will start from first principles and justify our logic and evidence every step of the way. But our approach and results are emphatically not extremist: by highlighting current arrangements’ pervasive violations of traditional legal prin-
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ciples and rights to private property, we will see that today’s defenders of the status quo are the real extremists. Interestingly, a pillar of the Australian establishment has anticipated one of our results. Surely Professor Ross Garnaut is as respected a mainstream academic economist, policymaker and business leader as is possible to imagine? 8 On 12 October 2009, during an interview on ABC TV’s The 7:30 Report, came this revealing exchange:
Kerry O’Brien: You have said in the book [The Great Crash of 2008, Melbourne University Press, 2009, p. 140] that, in fact, the big Australian banks were essentially insolvent at the time of the crash – in what way? Professor Ross Garnaut: They were starting to have great difficulty in rolling over their huge external debt, and without the Government guarantee on wholesale borrowing, they may not have been able to fund their liabilities, and you can go – you can be insolvent for two types of reasons, one: you get yourself into trouble with the way you’ve managed your debt and you can’t roll over your debt as it becomes due, or you run into trouble with the value of your assets. The rest of the world’s problems, Europe and American’s [sic] problems were problems with their bad assets, our problems were the problems of excessive reliance on a source of debt that turned out not to be reliable … 9
John Laker, the chairman of the Australian Prudential Regulation Authority, has expressed similar sentiments. He has recounted (“How APRA Handled the Crisis,” The Weekend Australian, 1-2 May 2010) that the weekend of 11-12 October 2008 was perhaps the darkest moment of the GFC for the Australian banking system and its regulators. On Friday 10 October, the Australian Securities Exchange recorded its worst one-day slide – 8% – since 1987. A rumour quickly spread that on Monday the 13th one of Australia’s mid-tier banks would suffer a “run.” According to Laker,
It could have been any of the mid-tier banks on that Monday. Whether it was St George, Suncorp, Bendigo, Adelaide, you name it, people were taking money out. We think it [the possibility of a run] was real. We think that if we [the Commonwealth Government] hadn’t put the guarantee on [bank deposits], it would have happened. I don’t think most people realise just how close we came.
In 1983-1985, Prof Garnaut was a senior economic adviser to Prime Minister Bob Hawke, and from 1985-1988 was Australia’s Ambassador to China. During 1989-1994, he chaired the Primary Industry Bank of Australia Ltd; from 1988-1995 he chaired the Bank of Western Australia Ltd (BankWest); and since 1995 he has chaired Lihir Gold Ltd. On 30 April 2007, the State and Territory Governments, at the request of Kevin Rudd (then the Leader of the Opposition), appointed him to examine the claimed impacts of climate change on the Australian economy, and to recommend medium to long-term policies and policy frameworks in response to it. David Llewellyn-Smith (“The Invisible Bailout,” Business Spectator, 16 June 2010) added: “It is a historical fact that leading up to the weekend the [bank deposit] guarantee was announced, multiple banks informed the government that without it they would need immediately to begin withdrawing credit from the Australian economy and that they would be insolvent sooner rather than later.”
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THE EVIL PRINCES OF MARTIN PLACE
Came to what? Like Toto’s opening of the curtains which revealed that the Wizard of Oz was really a lost man from Kansas, Prof Garnaut and Mr Laker affirmed (albeit in an overly limited way) one of this book’s conclusions: without the intervention of the state, fractional reserve banks are inherently bankrupt. These days, people tend almost without exception to regard bankruptcy as a negative event. From the point of view of a business’s owners and employees, that’s understandable. Yet from creditors’ and a broader social point of view, bankruptcy fulfils a critical function: whether it results from fraud, insolvency or illiquidity, it helps to preserve the stock of capital. The purpose of a fraudulent company is deliberately to channel funds from beguiled investors into the pockets of its promoters, owners or managers. The harm it causes to investors is obvious, but less evident is the social damage it wreaks. By consuming capital rather than fructifying it, fraud diminishes overall wealth. In contrast to the fraudulent company, the insolvent firm unintentionally consumes more resources than it produces. Although it benefits certain “stakeholders” (such as employees) in the short-term, it can operate for any length of time only by consuming the capital of another entity. As a result, in the long term the continued operation of insolvent companies also impoverishes society. Finally, unlike an insolvent firm an illiquid company does not suffer from a fundamental disparity of income from sales and outgoings from purchases; instead, there’s a mismatch between the timing of sales and receipts. Never mind its contractual obligations: if its creditors would only grant it more time (whether days, weeks, months, etc.), the illiquid entity could sell sufficient assets for cash and thereby honour the promises it made to others. Bankruptcy, then, can stem from fraud, insolvency or illiquidity. Garnaut’s comment on The 7:30 Report, although prompted by a question about banks’ insolvency, addressed their illiquidity. It prompted a press release (“Australian Bankers’ Association Disagrees with Professor Garnaut’s Comments on Banks,” 13 October 2009). 10 According to the ABA, “the evidence is that the Australian banks were not insolvent and the wholesale funding guarantee was introduced as a means of ensuring banks could maintain lending growth, not restore the solvency of banks.” Further, “the ABA has not yet examined the evidence put forward by Professor Garnaut in his book investigating the global financial crisis, but the claim that the Australian banking system was insolvent at the time of the crisis is contradicted by a lot of evidence.” Although they’re beside the point, ABA’s first two points of evidence are correct. Its third point, however, belies its conceptual confusion. It correctly stated “even
See also “[Australian Bankers Association] Disputes Garnaut Claim of Insolvency” (The Australian, 14 October 2008). According to Ted Evans, ex-head of the Commonwealth Treasury and presently the Chairman of Westpac (“Westpac Tips Five Years of Rate Rises,” The Australian Financial Review, 23 March 2010), Garnaut’s claim is “not well informed.” Evans offers no evidence to support his position. In Chapters 3-7 we’ll supply plenty of logic and evidence which demonstrate that Mr Evans and the ABA, and not Prof Garnaut, are poorly informed. The implication is stark: the chairman of one of Australia’s Big Four banks and the banks’ lobby group either have no idea or refuse to confess the fundamental truth about banking in this country – and in Britain, the U.S., etc.
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if the banks were constrained in rolling over overseas-sourced funding, this is not evidence of insolvency.” Quite right: the inability to “roll” debt is evidence of illiquidity, which is a form of bankruptcy. On the basis of this confusion, the ABA proceeded to make a series of erroneous assertions. “Banks have many methods to manage this cash flow situation. For example: (a) They can liquidate certain assets, such as those with high liquidity characteristics; (b) They can seek additional sources of funding (e.g., retail deposits and/or capital raisings); (c) They can secure liquidity from the central bank by pledging high quality assets as collateral; (d) They can simply constrain lending to business and household customers; (e) They can reduce their dividends to shareholders; and (f) They can introduce longer-term changes such as reductions in operating costs.” The ABA’s press release is oblivious to the fact that, during a crisis of illiquidity (usually known as a “run,” and to which fractional reserve banks are inherently prone), banks can pursue none of these options except (c). During a panic, there simply isn’t time for the others. Hence our second conclusion above: “Without the constant and active intervention of the state in general and its central bank in particular [banks’] illiquidity and hence bankruptcy would be plain for all to see.” A “run” occurs when a large number of a bank’s customers seek to withdraw their deposits – usually because they (belatedly but correctly) believe that it’s bankrupt. As a run progresses, more depositors withdraw their funds; and the greater the magnitude of withdrawals, the greater is the likelihood that the bank will default on its obligation to its remaining depositors. In a vicious circle, this realisation encourages further withdrawals. 11 According to the mainstream, several techniques can help to prevent runs. These include the “temporary suspension” of withdrawals, the creation of a central bank that acts as a “lender of last resort,” deposit insurance schemes such as the Federal Deposit Insurance Corp. (FDIC) in the U.S., and the government’s regulation of banks. Let’s limit ourselves to one observation about these techniques (apart from the obvious point that they corroborate our conclusion that fractional reserve banks cannot survive without the active intervention of the state). “Suspension of payments” is a euphemism for yet another of the state’s lavish protection of banks. In plain English, it means that the government (a) no longer enforces banks’ payments to their creditors, but (b) does continue to enforce the payments that banks receive from debtors! Moreover, even the mainstream acknowledges that these techniques don’t always work. For example, even where deposit insurance exists, depositors may still be motivated by the belief that they may lack immediate access to their deposits during a bank’s reorganisation. 12
Douglas W. Diamond, “Banks and Liquidity Creation: A Simple Exposition of the DiamondDybvig Model,” Federal Reserve Bank of Richmond Economic Quarterly, Vol. 93, No. 2 (Spring 2007), pp. 189–200. See also D.W. Diamond and P.H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity,” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 24, No. 1 (Winter 2000), pp. 14-23. See, for example, Scott Reckard and Tiffany Hsu, “U.S. Engineers Sale of WaMu to JPMorgan” (The Los Angeles Times, 26 September 2008).
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THE EVIL PRINCES OF MARTIN PLACE
The ABA’s press release of 13 October made three more points that indicate both its ignorance of recent events and its tenuous grasp of the “soundness” of contemporary banking: 1. “Throughout the global financial crisis, most banks had their credit ratings maintained, including the four major banks which have maintained their AA credit rating. 2. Profit levels of the banks held up well and dividends continued to be paid. 3. Banks were able to maintain credit growth, including lending to small business.” Each of these points is true (I wonder about the third one, but will concede it to the ABA), yet none provides what the ABA thinks it does – namely evidence of Australian banks’ soundness. Why not? Because these points and more besides also applied to Washington Mutual, Inc. “WaMu” was a holding company and the owner of Washington Mutual Bank. As such, it was the largest savings and loan association in the U.S. – until it suddenly became the largest federally-insured bank failure in American history. On 25 September 2008, the Office of Thrift Supervision (OTS) seized Washington Mutual Bank and placed it in the receivership of the FDIC. The OTS took this action in response to the withdrawal of $16.4 billion of deposits (an amount equal to 9% of its deposits on 30 June 2008) during a 10-day “run.” The FDIC sold the banking subsidiaries (minus unsecured debt) to JPMorgan Chase for $1.9 billion, which reopened them on 26 September as branches of JPMorgan Chase. Also on that day Washington Mutual, Inc. filed for voluntary protection under Chapter 11 of the U.S. Bankruptcy Code. Figure 3: It Was Great Whilst It Lasted Washington Mutual’s Payments of Dividends
$0.30 $0.25 $0.20 $0.15 $0.10 $0.05 $0.00 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Dividend (CPS)
Source of Data: WaMu corporate filings 1998-2008
Figure 3 shows that in the decade preceding its demise WaMu continuously paid dividends. From 1998 until 2003, it did so annually and at the rate of $0.01 per share. (Since the early 1990s, WaMu had expanded its retail banking and lending operations organically and through a series of acquisitions of retail banks and mortgage companies. Most of its growth resulted from acquisitions between 1996
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and 2002.) From 2004, it paid dividends quarterly. It also paid them at a rapidlyincreasing pace: from February 2004 until its demise, its dividends increased by 44%, from an annualised $0.752 per share to an annualised $1.08 per share. Clearly, the reliable payment of a rising stream of dividends is no impediment to bankruptcy; as such, it is neither a necessary nor a sufficient condition of financial soundness. To appreciate the suddenness of WaMu’s collapse, consider this abbreviated time line of its final fortnight of life: • On 11 September 2008 it issued an “Update on Expectations for Third Quarter Performance.” Its provisions for bad loans would be approximately $1.4 billion less than in the second quarter; liquidity remained stable at approximately $50 billion; and capital remained “significantly above “well-capitalized” levels. • On 12 September a banking analyst at Goldman Sachs upgraded his recommendation of the stock to “Neutral” from “Sell.” “Capital and reserves seem to be stable in the quarter, thus, even though losses continue to deliver body blows to the bank, the equity base is absorbing the pain and another capital raise might be avoidable.” Also on 12 September, Standard & Poor’s Ratings Services confirmed WaMu’s investment-grade ratings. • On 15 September, S&P downgraded WaMu. Yet it affirmed that the “overall liquidity profile at the bank and the holding company is positioned to withstand this weak credit cycle through the end of 2010. During the past year, WAMU has conservatively and prudently managed its holding company liquidity position. It faces minimal debt maturities through the end of 2009.” In response, WaMu issued a statement:
“The change in Standard & Poor’s ratings for Washington Mutual announced today brings S&P’s ratings in line with those announced last week by Moody’s. However, it’s important to note that S&P attributed its action to worsening market conditions, and not to any material change in the evaluation of Washington Mutual’s financial condition. S&P’s ratings for Washington Mutual Bank remain investment grade. None of Washington Mutual, Inc.’s or Washington Mutual Bank’s unsecured debt is subject to ratingsbased financial covenants that would result in acceleration or early maturity events or defaults. The company does not expect the impact of S&P’s actions on borrowings, collateral or margin requirements to be material. WaMu’s capital levels at quarter end are expected to remain significantly above the levels required of ‘well capitalized’ institutions. The company’s outlook for expected credit losses is unchanged.”
• On 17 September, the Associated Press reported that WaMu repeated that it possessed enough capital to operate. “A spokeswoman for Washington Mutual says the company is standing by last week’s statement that it has enough capital to operate while it returns to profitability. Spokeswoman Olivia Riley says the company has been pretty transparent.
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THE EVIL PRINCES OF MARTIN PLACE
• Washington Mutual said it expects provisions for bad loans in the third quarter to be $4.5 billion. It lost $3 billion in the second quarter and set aside $8 billion for bad loans.” • On 18 September, OTS designated WaMu a “problem” institution. The Wall Street Journal reported that OTS’s reluctance to take this action came despite heavy pressure from the FDIC, which was charged with backing a huge portion of the bank’s $188 billion in deposits. “Tensions between the two regulators [had been dragging on] for weeks.” • Also on 18 September, WaMu’s CEO, Alan Fishman, sent an open letter to customers, employees and shareholders:
“All financial institutions have been affected by the turmoil in the mortgage and financial markets, but WaMu is very different from the investment banks, such as Bear Stearns, Lehman Brothers and Merrill Lynch, that you may have read about. Those firms have very different and less stable sources of funding than we do. WaMu’s business is funded largely through the deposits that customers like you put with us. We also borrow billions of dollars from the Federal Home Loan Banks system. Most importantly, your deposits are insured to the limits established by the Federal Deposit Insurance Corporation (FDIC). “Capital ratios describe the financial strength of a bank. Our ratios continue to be well in excess of the levels that government regulators require of ‘well capitalized’ institutions. We also have an ample supply of funds on hand to meet your needs and the needs of … our day-to-day operations. The entire leadership team wants to make sure you know that WaMu has the liquidity and capital strength it needs to manage through this period.”
• On 19 September, WaMu stated that it was “encouraged” by the Bush Administration’s bank bailout plan:
“We’re encouraged by the direction of the plan proposed by the President, Treasury and the Federal Reserve to support the troubled financial markets. We look forward to seeing the details as the plan is further developed by Congress. [It] should assist in providing stability to our financial markets and should provide a mechanism for an orderly transition of troubled illiquid assets.”
• On 24 September, following the announcement of Moody’s earlier in the week, Standard & Poor’s cut its ratings of WaMu into “junk” territory. S&P said that it was concerned that a mooted breakup of the bank holding company would adversely affect creditors. • On 25 September, the OTC announced that WaMu did not have enough liquidity to pay its debts, and was in an “unsafe and unsound condition to transact business.” Yet OTC affirmed that WaMu remained wellcapitalised: “WMB met the well capitalized standards through the date of receivership.” Clearly, Washington Mutual was not broke because it was insolvent: it was bankrupt because it was illiquid. Once the “run” commenced its illiquidity took just days to
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metastasise from chronic to acute to fatal. Perhaps for that reason, virtually until the day it entered bankruptcy practically nobody seemed to realise that – like all fractional reserve banks – WaMu was inherently bankrupt. A hefty dose of scepticism therefore needs to accompany the penultimate paragraph of the Australian Bankers’ Association’s press release of 13 October 2009:
There has never been any commentary or report from the Reserve Bank of Australia, the Australian Prudential Regulation Authority, the Treasury, senior economic Ministers, banking analysts, the International Monetary Fund, the World Economic Forum or other reputable commentators that Australian banks were insolvent.
Every word of that paragraph is true. And that truth utterly condemns the RBA, APRA, Treasury, etc. That’s because none of these agencies foresaw the Global Financial Crisis. None saw it when it appeared on the horizon. “Objectively, it is extremely unlikely that the subprime mortgage exposures [in the U.S.] could significantly damage the core banking system in any significant country,” the RBA’s Governor, Glenn Stevens, assured the House of Representatives economics committee on 17 August 2007. Indeed, the RBA didn’t even recognise the GFC after it had arrived. In its Financial Stability Review (September 2007), it stated that “the outlook for the world economy remains positive, notwithstanding prospects for slower growth in the United States.” “My own view,” added Ric Battellino, its Deputy Governor, in a spectacularly poorly timed speech on 12 December 2007, “is that Australian households are in very good shape. They are not in any way exposed or vulnerable – the structure of assets and liabilities is quite sound. There would obviously be examples of people getting themselves into financial difficulty. But fundamentally, the household sector as a whole is in very good financial shape… and there’s no hint the share market is grossly overvalued [italics added].” In December 2007, the All Ordinaries Index averaged 6,492. Twelve months later, it averaged 3,529. The Australian crowd didn’t infer from these figures that the All Ords was overvalued in December 2007; instead, it concluded that it was undervalued in December 2008. After a brief hesitation early in the final quarter of 2008 and the first quarter of 2009, the Australian crowd has resumed the economic and financial bacchanalia that the RBA hosted during the 1990s and 2000s. Yet it’s imperative that investors keep one point uppermost in mind: those who didn’t see the Global Financial Crisis coming are now relatively upbeat about the future; in sharp contrast, the doughty few who anticipated trouble remain downcast. It’s demonstrably false to say, as the mainstream now does, that “nobody saw it coming;” what’s certainly true, though, is that the few who “saw it coming” were and are, from a mainstream point of view, “nobodies.” The Financial Meltdown and the Intellectual Meltdown These days, Australian and other Western politicians promise to “deliver” (that is, to redistribute from producers to consumers) as much prosperity as possible to as many people as possible. As we will show, this promise (which is impossible to honour) itself triggers financial and economic instability. Behind it lies the mis- 17 -
THE EVIL PRINCES OF MARTIN PLACE
guided presumption that economic and financial knowledge has developed to such a high and reliable level that governments, ably guided by economists, can competently manage the financial system and overall economy. This presumption has spawned a corollary: voters can legitimately hold governments to account for the results of their economic policies. Neither politicians nor economists show any sign that they will repudiate their hubris; nor do voters show any sign that the scales will fall from their eyes. The superficial result is that a ramshackle collection of buffoons, carpetbaggers, dodgers, grafters, shifters and morons govern Australia. Much more seriously, the central precept of the governing class – namely that The Government Knows Best – is utterly bankrupt. Hence the GFC has revealed longstanding crises of economics and democracy. The financial meltdown, in other words, has triggered a necessary, salutary and long overdue intellectual meltdown. The GFC caught the mainstream completely unawares, and prompted them to panic and to resurrect defective policies that most economists had rightly repudiated decades ago. 13 These policies are now doing no good and considerable harm. By using principles that are hundreds and in a few instances thousands of years old to demonstrate that today’s monetary status quo is rotten to the core, this book shows that the distant past is the way to a better future. In particular, by rededicating ourselves to traditional legal principles and an uncompromising respect for rights to private property, I hope to recommend and reassure as well as to denounce and disconcert.
On 19 October 2001, The Wall Street Journal concluded that “it’s pretty much impossible to find an introductory macroeconomics textbook that recommends … fiscal stimulus. If [John Maynard] Keynes appeared in any of the heavy-duty academic centres around the world, he would find his idea referred to as a ‘classic fallacy.’ Most economists have moved on to other models”. Christina Romer, who chairs President Obama’s Council of Economic Advisors, has devoted much of her academic career to the analysis of policy responses to post-war recessions. She has found little evidence that fiscal stimulus has helped to end them (a readable review of her research appeared in The New York Times on 2 December 2008). John Cochrane, a professor at the University of Chicago Business School, concluded on his blog (3 February 2009): “I’ve been looking through graduate course outlines and textbooks, and I can find nowhere in the last 50 years that anybody in economics has said that [deficit spending as a] fiscal stimulus is a good idea. What are we doing giving [such] advice … [when] there’s nothing [in what] … we teach our graduate students that says fiscal stimulus works?”
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