Saturday, June 4, 2011

The US Dollar: Past and Future

In 1906, the New York Stock Exchange began an ugly slide downwards. By the autumn of 1907, the stock market's value had fallen by over 50%, causing a recession. It was then that a group of investors, financed by loans from banks and trust holding companies, attempted to corner the stock of a company called the United Copper Company. In 1980's, they termed such things "hostile takeover bids". Unfortunately for these investors, their bid to corner United Copper failed miserably, leaving these banks and trusts who loaned this scheme money insolvent, most importantly the gigantic Knickerbocker Trust Company. Their insolvency then spread to other institutions who in their turn had loaned them money. A general panic had begun, now known as the Panic of 1907. Financier J.P Morgan and a few other titans of finance came to the rescue of several large banks. Several other large companies affected by this had what is now known as "shotgun marriages", much like the Bear Stearns - JP Morgan marriage in 2008. Coincidentally, one of the biggest of the 1907 shotgun marriages was between JP Morgan's US Steel Corp and essentially insolvent Tennessee Coal Iron and Railroad Co. JP Morgan himself had plenty of experience in these affairs; during the Panic of 1893, JP Morgan had rescued the US Treasury itself. President Teddy Roosevelt, tiring of these constant panics, pushed through the Aldric-Vreeland Act of 1908, which did nothing but create the National Monetary Commission (1909-1912). Their goal was to create a better banking and currency system that would avoid and better deal with these endless panics. The NMC wrote what is now called the Federal Reserve Act of 1913, which was signed by newly elected US President Woodrow Wilson. At the heart of this new currency system was the idea of "Fractional Reserve Lending". In this type of system, it was seen as important to have a way to provide currency liquidity and so in this system, a bank would be able to loan out ten dollars for every dollar they had in their vault-- Fractional Reserve Lending. The 10-1 rule was the Law of the Land from 1913 to the early 1980s, which along with the Depression's Glass-Steagal Act, provided forty years of relative prosperity. But it is in truth a dangerous system by design: if more than a tenth of your loans went under, your bank was toast. 

Also in this system, all currency would be introduced into the system as debt: your local bank borrows from the Federal Reserve, and then your bank loans it out to businessmen and consumers. It is a top-down system built on debt. In the 1980s, Fed Chairman Alan Greenspan got rid of the core 10-1 rule for big banks, famously saying that these bankers are adults and can be trusted not to be foolish with the money. Big banks then loaned out vast sums of money; the Reagan, Clinton and Bush boom decades were built upon a mountain of debt. Some US financial institutions found themselves leveraged 40-1 loans/cash. People with no documented incomes were given mortgages; my ex-wife among them. This madness resulted in the Lehman Meltdown of 2008. Given the rate at which new dollars are being printed, there is at this junction little doubt that our currency system and the value of the currency itself is in serious doubt. Peter Schiff, a former US Senate candidate and investor who very publicly called the housing bubble and the stock market meltdown years before it happened, has said that a currency crisis is coming within the next couple of years. This is echoed by Canada's Eric Sprott, who runs Canada's largest and most successful investment fund. 

Currently there is only one US politician who consistently and endlessly calls for the repeal of the Federal Reserve Act and the creation of a new currency system.. Texas Rep Ron Paul. I fully believe a new system is in order. But what will replace the Federal Reserve Fractional Lending System ? Many, Paul included, believe that the answer lies in handcuffing the amount of currency in the system to the value of Gold or Silver. Paul also calls for a credit based system instead of the current top-down debt based system. No such system has ever really existed, although gold and silver based currencies have.

As I see it, part of the problem with a gold or silver based currency is that the value of these metals (and thus the value of the currency) can be manipulated. In late 1978, the Hunt brothers from Texas began accumulating vast quantities of silver. Between September 1979 and January of 1980, the value of silver went from $11/oz to over $50/oz.. in four months. Sadly for Nelson Bunker Hunt, his attempt to corner the market failed. Shortly thereafter, silver collapsed down back below the original $11/oz. If a couple of Texas billionaires can do this, imagine what a large sized nation or group of nations can do. This could result in complete havoc for any currency based in silver. The US did in fact have a gold standard as late as the 1970's-- but herein lies another problem. US President Richard Nixon and his Fed Chairman began to print US dollars well in excess of the nation's gold reserves to fund the war in Vietnam and the accompanying deficits. As there was no higher authority, there was nobody watching-- or so they thought. The Arab nations noticed. They began to exchange dollars for gold in titanic amounts. On August 15th 1971, Nixon took several steps to combat inflation caused by money printing-- the biggest one being his decision to end the convertibility of Dollars into Gold. The whole premise of tying the currency to a metal in order to prevent overprinting had just come crashing down.

So.. if Schiff and Sprott are correct and there is a currency crisis, what would replace it ? Since this is my blog and I believe I'm the Fountain of All Wisdom, I'm going to take a stab at this. Lets take a look at what we need: 1. There needs to be a viable way to prevent the printing of too many of them. 2. There needs to be a way to introduce currency into the system other than as debt (the top-down model). 3. If you are going to handcuff the currency to something physical, take care to make it something which would be immensely difficult to manipulate.4. Have a means to temporarily inject currency in the case of another panic and/or crash-- it was the lack of currency in the system which really caused the hardships of the Depression, something Bernanke is keenly aware of.

Therefore-- I would establish a National Currency Board, with each state electing a new member every four years, who's job it is to determine the amount of currency needed in the system based on growth (or contraction) of the economy. For example, if the Currency Board determines that the US economy grew by 1.1% in the first quarter, the nation would need to increase the monetary base by the same amount. If it contracts, no additional currency. Secondly, the currency would be introduced into the system by simply mailing checks (or electronic credits now a days) to all of the nation's citizens.. the first bottom-up system ever tried. Banks, stocks and bonds would compete for the investment capital from the citizenry instead of Central Bank lending, thus achieving Paul's dream.Thirdly I would handcuff the value of the currency to a certain value of a whole group of agricultural commodities such as corn, wheat, lumber, oats etc. So under my scenario, twenty dollars would be able to purchase four bushels of corn, two bushels of wheat, five bushels of oats, etc.. with the party expected to cough up the commodity having the choice in which commodity he wishes to pay the presenter. The idea here is to have some sort of constraining influence on the printing of money, but make it so that the commodity is not easily manipulated. Also, if a 7/8ths majority of the Currency Board agrees, a mechanism to loan cash to savings banks (not investment houses) and/or the Federal Government will exist; the limit of these loans will not exceed 1/20th of the nation's GDP. 5. Glass-Steagal will be reinstated.. verbatim.

Will this happen ? Not while the bankers and politicians have the power to prevent it. Only by revolution will we ever have a bottom-up currency system, and I don't see that happening. If Schiff's Day of Reckoning does arrive, the new system will very likely be much the same as the old one, condemning yet more generations to indentured servitude. Wash, Rinse, Repeat.

PS 4pm: In the Greek bailout, one of the major parts of "The Plan" is to ask creditors to voluntarily accept new, longer dated bonds as a way of easing the short term demands on the Greek Treasury. My question is.. if you are holding a credit default swap and were watching this, how comfortable would you be that your CDS was worth anything when it appears Greece deftly scooted around it's obligations without anybody benefitting from the insurance policy they took out against precisely this outcome ? Jamie Dimon will be fielding some interesting phone calls from those he's insuring come monday morn.


  1. If you're going to take a stab at this, pickup the right knife! ;) You already mentioned that even 10:1 leverage is too much. Why not end fractional reserve lending? It is, after all, a license to conjure money... why should any private institution have the right to do that with currency that is owned by the public? Its forgery for self enrichment.
    A completely separate thought on the knife you chose; how about currency based on population alone? Constant Dollars/Citizen? Just a thought. kimo ps obviously, i enjoy your work. thanks.

  2. This DOES end fractional reserve lending-- currency would be added into the system by a Currency Board evaluating the growth (or lack thereof) and appropriately printing currency and giving it to the citizens, who may-- if they choose-- stick it into a bank. The Bank will not be able to loan any more money than they have in the vault.

  3. There is nothing wrong with 10:1 reserve to lending ratio, if that is accurate and enforced. For the economy to function that ration has to be greater than 1:1. The problem we have now is that those limits were wildly exceeded by Banksters everywhere.

    A 1:1 reserve:lending ration means for practical purposes there would be no credit available at all, for anyone, except the most credit-worthy who don't need it anyway.

    While some might think that is a great idea. in today's economy, it would lead to economic implosion. Making some survivalists etc happy, but bad news for 99% of the population. Small businesses, which will drive any recovery in employment, would mostly cease to exist, except on the smallest level, when credit is that tight. Be careful what you wish for.

    The key words are excessive and regulation, we had the former without the latter. There is a happy medium, like in most things, not too much nor too little.

    1. Credit is just free money. It doesn't exist and by saying you owe person X real money for money you didn't have in the first place leads to global debt.

      Lost you?

      Try this: If every country in the world is in debt, where did the money go?

  4. typo: ratio not ration

  5. GAW: Yes credit in such a system would be very hard to come by; the average citizen would never get a credit card or a loan for anything except a house, and even then would have to come up with a substantial down payment. I have no problem letting the people go without credit for the most part. But lack of capital for businesses is what made the Depression much worse than it had to be. Perhaps some sort of small (say 20%) government guarantees of certain financial vehicles (The American Agriculture and Infrastructure Investment Bank ?) would bring in foreign investors into important industries. Also if the returns were promising enough, I dare say Americans would become investors instead of just consumers. But overall I dislike the entire top-down system that makes indentured servants of us all and makes banking far more profitable that it need be and hope some sort of bottom-up system can be created. I doubt my golden day will ever arrive, but it's my blog and I can dream, right ?

  6. "in today's economy, it would lead to economic implosion."

    take a number. fractional reserve lending is ahead of you.

    "This DOES end fractional reserve lending"
    Bravo! Thanks for the clarification.

    The pessimist in me says, "no matter what is adopted, in eighty years some otherwise knowledgeable people will be saying,'what went wrong?'".

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