Some people never learn; and some governments are equally stubborn in their ignorance.
This is especially true of money and inflation, as the following case studies vividly illustrate …
PHILADELPHIA – MAY 1775
The occasion is the Second Continental Congress.
The debate: Precisely how to pay for the coming war with England.
A minority of delegates argue that to avoid inflation, they must levy taxes, pay mostly in hard currency, and encourage free enterprise to supply the army, the navy, and the militias.
But they’re ignored, even ridiculed.
Instead, Congress issues orders to crank up the printing presses at full speed, and within months, the states do the same.
In the next five years, paper money floods the economy – $241 million in continental dollars … $209 million in state notes … plus countless millions in currency counterfeited by individuals, enterprises, and even the British.
As a result, wholesale prices surge from an index of 108 in 1776 to 10,554 by 1780.
Food shortages are endemic.
Soldiers are ill-clothed and ill-fed.
The citizenry is panicked, plundered, or both.
In June of 1775, the Massachusetts Provincial Congress declares that anyone who refuses to accept state notes or demands a premium for them is an “enemy of the country.” Other states follow suit, punishing violators with public humiliation, fines, imprisonment, and the forfeiture of their goods and property.
At the end of 1776, New England states impose wage-and-price ceilings in a desperate attempt to hold down the cost of military recruitment; and in March of 1777, the Middle Atlantic states follow their lead.
Farmers and entrepreneurs balk. They hoard large stocks of food and goods, refusing to sell them at official prices.
In response, the states pass laws forbidding these practices – crimes called “forestalling” and “engrossing.”
Farmers are forced to hand over their harvests for a pittance. Many are wiped out. Others just quit planting. Supplies dry up, and prices surge even higher.
The Revolutionary War is won. But it’s a miracle – a testament to the sheer bravery and zeal of Americans, DESPITE the financial blunders of their young government.
WASHINGTON – MAY 2004
This time, the occasion is the meeting of the Federal Open Market Committee (FOMC); and again, the debate is about the inflationary consequences of their actions.
Needless to say, compared with those of 229 years prior, the decisions to be made are far more routine; and the consequences, more mundane.
But in another sense, the stakes are equally great – the present well-being of millions of Americans and the future fate of coming generations.
The committee members talk about the inflation data that is beginning to pour in. Based on the first five months of the year, the consumer price index is rising at an annual rate of 5.1%. Based on the last three months, it’s even worse.
A rise in core inflation (excluding the more volatile energy and food prices) is also beginning to gain traction as higher energy and food price begin to flow through the economy to other goods and services.
According to the notes of the meeting, data on consumer and producer prices “is generally on the high side of expectations, following considerable increases in commodity prices.”
The members also talk about information from their contacts. They say that businesses are now more able to pass on cost increases to their customers and to boost prices more generally. They cite earlier price discounts that have been canceled. They mention surcharges for higher energy and steel prices that are being added to base prices for certain goods.
But then, despite all this data and anecdotal evidence, surprisingly, the majority argues that there’s little to be concerned about. Why? They reference slack and excess capacity in the economy.
The minority questions the soundness of this line of reasoning. They counter argue that such analysis is subject to “considerable error.” Apparently, they express serious concerns that inflation could be heating up much more than previously believed.
But they’re largely ignored, perhaps even subtly ridiculed; and the majority again prevails.
Much like was done centuries earlier, orders are issued to crank up the modern-day printing presses. On top of an astounding $281 billion-dollar increase in M3 money supply in 2003, $180 billion more is added in the first quarter of 2004, and yet ANOTHER $108 billion in May, according to the Fed’s own estimates.
As a result, inflationary fires are being lit globally.
WASHINGTON – JUNE 29-30, 2004
The FOMC meets again. Some still favor a go-slow approach to combating the nascent inflation. Some do not. All are probably anxious to put the meeting behind them and celebrate the coming holiday weekend, made possible by America’s first war.
Again, data on rising inflation pour in. But again, the majority overrides any concerns that the data may imply.
In their statement issued this past Thursday, they say:
“ALTHOUGH INCOMING INFLATION DATA ARE SOMEWHAT ELEVATED, a portion of the increase in recent months appears to have been due to transitory factors.” (Emphasis is mine).
The inflation data is becoming more blatant – so much so that they feel compelled to acknowledge it … and then make excuses to explain it away.
As you can see for yourself, if you re-read their words above, they even admit that only a PORTION of the high inflation can be explained … and that the explanation itself is based on APPEARANCES, not fact.
NEW YORK – JULY 1
It’s the morning after the Fed announcement.
Typically, whenever Fed Chairman Greenspan makes a move, it’s welcomed by most money experts with praise and enthusiasm.
Not this time! As the New York Times documents, the Fed’s meager quarter-point hike (and weak accompanying statement) have unleashed a wave of stinging criticism unlike any in recent history:
New York Times: “Fears that Mr. Greenspan has opened wide the door to inflation in the United States by keeping interest rates too low for too long prompted a sell-off in the bond market recently. That has pushed short- and long-term rates far above the federal funds rate and produced the worst quarter for bond investors in almost 25 years.”
Paul Kasriel, director of economic research, Northern Trust Company: “Everyone recognizes that holding the Fed funds rate below the inflation rate is a recipe for accelerating inflation.”
Henry Kaufman: “… the inflation rate is creeping up and will continue to creep up.”
New York Times: “The Fed policymakers thumbed their nose at inflation worries in the statement [yesterday].”
Alan W. Kral, portfolio manager at Trevor Stewart Burton & Jacobsen: “… inflation has returned. And the cause of it has been an overexpansive monetary policy for almost 10 years.”
Richard Bernestein, chief U.S. strategist, Merrill Lynch: “Every time the Fed has started raising rates, people say it doesn’t matter. But every time it has mattered.”
Their near-unanimous conclusion: Inflation is a lot worse than the Fed is letting on. And to catch up, the Fed is going to have to jack up rates a lot more quickly.
THE CONSEQUENCES
The Fed’s quarter-point interest-rate hike was widely expected. But the immediate and long-term consequences are not:
Consequence #1. DISAPPOINTMENT. The stinging criticism of the Fed – in the papers, on TV, and all over the Web – is just one of the symptoms.
Another is the action in the U.S. and Asian markets at the end of the week, shattering the quiet, plunging through key lows, raising the specter of more to come.
Consequence #2. BIG LOSSES AT MORTGAGE COMPANIES. They’re loaded with bets on low interest rates. Freddie Mac (profits down 52% in 2003) is just one of many victims. Others are bound to follow.
Consequence #3. THREAT TO BANKS THAT HAVE BEEN BETTING EVEN MORE HEAVILY ON LOW INTERST RATES. I’ve been warning about this for a long time. Now, the Office of the Comptroller of the Currency (OCC) is issuing some warnings of its own. Their own words:
“A number of banks have chased yields in their investment portfolios … In particular, we are concerned that some banks have locked in a disproportionate volume of their assets at the cyclical low in yields. … However, when rate changes cause significant asset impairment, to the point where it has a material effect on the economic value of the bank’s equity, then this does become a safety and soundness issue …
“The rise in longer-term interest rates has had, and may continue to have, a particularly damaging effect on the values of assets with embedded options. Values decline first because interest rates are rising. As the anticipated maturities of these assets with embedded options extend, values decline further because of the longer maturities.”
CONCLUSION: This is not a stable situation. Although a quarter-point hike in interest rates seems mild, the die has been cast. The era of record-low interest rates is over, and the time of nearly-free money is ending.
Don’t underestimate the significance of our government’s blunders – Congress’ unrestrained money spending … the Treasury’s full-speed-ahead money printing … and the Fed’s complacency with new inflation data.
No, they’re not as bad as the blunders made by our founding fathers in 1775. But in view of the two and a quarter centuries of financial experience we’ve supposedly gained in the interim, they’re equally inexcusable.
Brace yourself. The consequence of complacency may be catastrophe.
Good luck and God bless!
Martin
Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
