The Power of Fiat Money

Tuesday, October 14, 2008

Once again, all I need do is head to the main page of the New York Times to find a headline that reads like the punchline of a bad joke. This time it's, "U.S. Investing $250 Billion in Banks". Unfortunately, this is no joke, this is where it starts, and things quickly go even further downhill from there.

Before we take a look at this travesty, let's briefly consider how loans and investments are supposed to work. Jim has what he thinks is a great idea. It could be that he feels financially secure enough to buy a house. It could be that he has an invention he'd like to mass produce and sell. Whatever. Jim's problem is that in order to put this plan into action, he needs more money now than he actually has.

Ned, on the other hand, has lots of extra money sitting around that he has no immediate need for. Ideally, Jim and Ned are free men. Jim can dream and invent to his heart's delight, and Ned can wallow in his pile of money all he wants, so long as neither threatens, robs, or harms the other. Jim can't just take Ned's money, and Ned can't compel Jim to come up with something useful to do with his capital, the extra cash.

But they can trade to mutual benefit. Jim can offer to pay Ned a portion of his later profits in exchange for borrowing his capital now and paying it back later. That's interest. If Ned lends Jim the money, both will be richer at the end of the day because Jim will now own something he did not have the means to obtain on his own and Ned will have even more money sitting around.

But remember: Both men are free. Ned can decide that Jim isn't yet financially secure enough to own a house -- or that his idea for a new whirligig won't sell very well. Ned can turn him down, causing him to seek another lender or delay or abandon his plan. Or Ned can agree with Jim that he's ready for that house, or that there is a vast, untapped demand out there for whirligigs. If both are wrong, Ned loses his money.

That last sentence encapsulates the visible downside to lending, and it is this easily graspable fact that, like Frederic Bastiat's broken window, is getting all the attention. The invisible upside that is being ignored is that the only person losing his shirt here is Ned. Tom, Dick, and Harry all saw what Ned didn't, turned Jim down, and still have their cash. And that's the way it should be. In a free society, that's also the way it is. Whether they decide to lend Ned a hand after he makes a mistake is their decision to make.

In a free society, the consequences for one man's failure are his, and his alone to bear. That's not the way it is now.

Now, we have Slow George and Payola Hank who -- after encouraging countless Neds to make loans for houses to countless Jims and predictably causing more bad loans to be made than there would have otherwise -- coming onto the scene promising to bail everyone out!

This money will ultimately either be taken from Tom, Dick, and Harry through taxation or inflation. And all the Neds and Jims out there who made bad decisions will have learned nothing but that they have a "backstop". Now, when someone makes a bad investment decision, everyone loses! That's bad enough.

Now, let's look at the story. It's worse.

"The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it," Mr. Paulson said, who offered some details of the plan along with the Federal Reserve chairman, Ben S. Bernanke, and the chairman of the Federal Deposit Insurance Corporation, Sheila C. Bair.[links dropped]
This is bad, but nothing new yet.

But the power of fiat currency to remove rational judgement from the economy is apparently boundless. Look at what happens when all the nations in a global economy can screw around with monetary units!

After ticking off a list of new government measures to "stabilize" the economy, the article informs us that the government is going to start buying shares of major banks who will, naturally, accept greater government control as part of the "bargain" and that we are in a race with Europe to see whose government will start attempting to manage the whole financial sector first!
On Monday, big banks agreed to take investments totaling about $125 billion. Citigroup and JPMorgan Chase will receive $25 billion each. Bank of America, which is acquiring Merrill Lynch, and Wells Fargo, which is acquiring the Wachovia Corporation, will receive $25 billion. Goldman Sachs and Morgan Stanley will receive $10 billion each. And Bank of New York Mellon and State Street will get $2 billion to $3 billion.

Another $125 billion is allocated for thousands of small and midsize banks. They will be eligible for government investments reflecting a similar proportion of their assets.

On Tuesday, Mr. Paulson said that in return for the investment, the government would receive preferred shares and warrants for common stock. In addition, he said, the government would expect a reasonable return.

And he said, "Institutions that sell shares to the government will accept restrictions on executive compensation, including a clawback provision and a ban on golden parachutes during the period that Treasury holds equity issued through this program." [links droped, bold added]
How paying top executives less will attract or keep good personnel Paulson never explains. Later on, Paulson admits that he will tell banks to stay away from "exotic" financial activities. Great: We'll have less private brainpower and more central planning in our banking system!

But this is what really grabs me:
The Treasury's plan would help the United States catch up to Europe in what has become a footrace between countries to reassure investors that their banks will not default or that other countries will not one-up their rescue plans and, in so doing, siphon off bank deposits or investment capital. [bold added]
Note the irony. Fiat currency was originally adopted because governments wanted to be able to evade the fact that that you can neither make something out of nothing nor avoid redistributing wealth in order to have loot -- like apparent guarantees for bank deposits -- to pass around. So instead of dealing effectively with knowable, predictable, metaphysical facts, we get to flounder about in a sea of unpredictable man-made crises and their unforeseeable consequences.

Words cannot trump reality. Our government's attempt to repeal reality has deprived it of power to such an extent that we're now aping socialist Europe, and not because we feel like it.

-- CAV


Anonymous said...

Here is something scary I read from an AP article on the bank stock "purchase"

"Executives of the country's biggest banks were summoned to a remarkable meeting at the Treasury Department on Monday to be briefed on the plan. Paulson basically told the bank CEOs that they had to accept the government stock purchases for the good of the U.S. economy.

If this is true, then this "purchase" is nothing more than a forced, compensated nationalization of major banks.

I am seriously considering moving my savings out of Bank of America to a local credit union. I have read that credit unions are in much better shape than the banks and very few of them participated in sub prime loans. I am not sure if this makes them a better safe haven or not. But having my money in a government owned banks sounds pretty scary to me. Of course, wherever I put my money, I am at huge risk of its purchasing power being looted away by inflation. So that is something else I am having to look into in terms of what I can do to minimize the impact of the horrible assault our economy is going to be subjected to.

If Obama wins and the Dems get a veto proof senate - well, we are REALLY going to be screwed as they will use this "emergency" as a pretext for one of the biggest power grabs seen to date. That is their nature and what they have been wanting to do for years. And the precedent for it will have already been established by the "emergency" measures already being enacted by the Bush Administration. If that happens - well, there will be very little that we can do via the political process to stop it as I am sure they will shut down whatever recourse is left through that and clamp down on media outlets via the reintroduction of the Fairness Doctrine. I am more frightened of Democratic gains in the House and Senate than I am of Obama winning the presidency.

Gus Van Horn said...

That "forced nationalization" you describe is about the only thing that could have made this picture uglier. Who would have imagined a bunch of bad loans to dead-beats as a precipitating factor to such a huge lurch towards dictatorship? Under capitalism, the vast majority of the loans being now used as an excuse for more government control of the economy would never have even been made!

God help us if the Democrats win as big as some say they might, and for exactly the reason you say.

Anonymous said...

Dismuke writes:

"Of course, wherever I put my money, I am at huge risk of its purchasing power being looted away by inflation."

Do you have any gold, or other such hedges against inflation? Gold carries its own risks, of course -- it must be stored securely, and there is the precedent of government confiscation -- but then again, they didn't do that when people were hedging against inflation in the 70's.

The nasty thing about fiat currency here, is that in order to preserve your wealth, you are forced to put it into illiquid forms. Gold, having not been seen as money by the mainstream for decades, could be money, but everyone would have to gain the same sense of "priced in gold" that they have for dollars now. Until that happens, you could keep your wealth in gold or another commodity, but you have to turn it into dollars first before using it to by food, pay bills etc.... if you offer to trade gold, everyone has to recalibrate on the fly to get a sense of what a good price is -- and today, that is usually done by converting to dollars first.

And rest assured, if that adjustment process started happening, the confiscation risk becomes very, very likely -- because gold is a shield against the inflation tax.

Gus Van Horn said...

I am completely at a loss. The scope and pace of events over the past few weeks are both so rapid that there is almost no basis for making a decision as to what to do. I am already developing a far better understanding of how government force can negate the value of one's own mind than I'd ever really hoped to have.

On a lighter note, you could say that not having much money to confiscate has a silver lining, but don't: Hank Paulson will hear you and try to confiscate it.

Anonymous said...

I found this particularly disturbing:

Some of the big banks had to be pressured to participate in the program by Paulson, who wanted healthy institutions that did not necessarily need capital from the government to go first as a way of removing any stigma that might be associated with banks getting bailouts.


Gus Van Horn said...


The more I learn about this, the more it sounds like the de facto socialization of the banking sector.

This is something a Democratic President could have never accomplished in his wildest dreams.