Mechanical Economists and the Gold Standard

Bill Bonner writes well in the Daily Reckoning Australia about the difference between the humanistic viewpoints of classical economists and the technical viewpoints of modern day economists.

The first economists - the two Adams, Adam Smith and Adam Ferguson - called themselves "moral philosophers." They were studying the human economy as though it were an anthill -- to see how it worked. They figured it must follow rules - just like all other things under Heaven - and tended to see mistakes people made, such as spending too much money, as moral failings.

Modern economists are more like auto mechanics. They think they can control the economy with a screwdriver. And to some extent they're right. Which is why the world economy is in such a mess; they turned the wrong screws. But it's why we moral philosophers are having such a good time; finally, we get to laugh and say "I told you so."

Economic activity is inherently a human process, and economists would need a lot more understanding of psychology (especially mass psychology) and philosophy. Instead, they tend to treat economics like it was a branch of engineering. This is most strongly evident in the modern field of "financial engineering".

But Bill Bonner has a strange fixation on the gold standard, which is actually not so relevant in this issue. He writes:

Since then, the U.S. government could print almost as many dollars as it wanted. Arguably, it printed too many. For something - perhaps it was too much cash and credit in circulation - led American homeowners to think house prices would rise forever.

In this case it is mostly too much credit. Growth of cash has been relatively sluggish (except in the far east and the Euro zone). The reality is that the credit decisions of commercial banks are not tied to the amount of cash anymore. Reserve requirements have been taken to practically zero. And this has happened in a regulatory environment that has the near equivalence of cash and credit as a base assumption.

In earlier times, before the deregulatory wave of the last 30 years, banks were forced to acquire a certain amount of cash for each accepted promissory note. But this is not so anymore. The last major relaxation in the US was in 1995 when retail sweeps were taken into use. There is almost nothing in these regulations to relax anymore. Banks have been able to magic deposits from thin air by accepting huge amounts of promissory notes at a negligible opportunity cost.

This relaxation has been a main cause in the growth of speculative flows as well. When banks can accept a promissory note at zero cost to cash reserves, it is very easy for them to lend huge amounts to speculators that make leveraged short term bets on price fluctuations.

In earlier times banks had to find actual depositors for a fraction of each dollar that they lent out. But now they have almost no opportunity cost at all.

Without cash reserve requirements, the only thing that is left to limit the growth of credit is solvency, either regulatory solvency in the form of capital requirements, or actual solvency. It is only natural that any lower limits of a self-enforcing process will eventually be reached, so here we are, exactly where the deregulators put us, either willfully or unwittingly.

More importantly, the lack of reserve requirements has essentially decoupled the financial economy from any actual monetary policy. When no cash reserves are needed for the growth of credit, a gold standard would not have necessarily saved the banks from this kind of a "race to the bottom".

In a certain sense, a gold standard would have been a fear factor for the bank owners. It would have made many of the ongoing bailout efforts much more difficult, thus raising the impact of the current crisis. This would have encouraged more strident risk controls from bank equity investors, but not in any binding way.

Bill Bonner's orthodox take on the gold standard creates a strange contrast with the philosophical and practical outlook of the classical economists that he so admires. A strict attachment to a crude and inflexible tool like the gold standard is more like a mechanistic view of the economy.

After all, gold has no practical inherent value at all. It is durable and its quantity is hard to manipulate. But it has been responsible for some of the most useless undertakings in human history, like gold rushes, military adventures, occupations and wars.

Money can also retain its value too well in some situations. In a deflationary spiral, money is seen to have a rising value. But cash should only have value as a medium of exchange. It should not be infinitely storeable. Value is only in what goods or services people can provide to each other, not in some heavy and soft (if quite pretty) metal in a safe.

The purpose of monetary policy should be aimed at keeping people from excessive hoarding or excessive consumption, either of actual goods or of the medium of exchange. The only way to create actual savings is to invest in capital goods (no, commodities are not capital goods) that have a value in being able to produce goods and (increasingly) services.

Dictatorial Powers for the US President

Andy Worthington (author of "The Guantánamo Files"), has written a good review of the recent US 4th Circuit Court decision against Ali Al-Marri, a Qatari national and legal resident in the US.

This decision has upheld an indefinite military detention, as an "enemy combatant", of a person that has never raised arms against the US. It gives the US president the authority to designate just about anybody as an "enemy combatant" on the basis of hearsay "evidence" of assumed intentions.

Mr. Worthington finishes with a strong quote from the verdict's minority opinion:

I leave the final words to Judge Motz, and her clear-eyed awareness of the injustice of the al-Marri verdict. “To sanction such presidential authority to order the military to seize and indefinitely detain civilians, even if the President call them ‘enemy combatants,’ would have disastrous consequences for the Constitution –- and the country,” Judge Motz wrote. “For a court to uphold a claim to such extraordinary power would do more than render lifeless the Suspension Clause, the Due Process Clause, and the rights to criminal process in the Fourth, Fifth, Sixth and Eighth Amendments; it would effectively undermine all of the freedoms guaranteed by the Constitution. It is that power — were a court to recognize it — that could lead all our laws ‘to go unexecuted, and the government itself to go to pieces.’ We refuse to recognize a claim to power that would so alter the constitutional foundations of our Republic.”

Unless Ali al-Marri is allowed a meaningful review of his status as an “enemy combatant,” Judge Motz’s fears have already come true.

The Onion: Recession-Plagued Nation Demands New Bubble To Invest In

The Onion hits the nail on the head with a piece of satire on the state of the US economy.

A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.

"What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future," said Thomas Jenkins, CFO of the Boston-area Jenkins Financial Group, a bubble-based investment firm. "We are in a crisis, and that crisis demands an unviable short-term solution."

Go ahead and read the whole piece. It would be quite hilarious if it wasn't so accurate.

Investors Worrying about Cheap Stocks?

Carter Dougherty writes in the New York Times under headline "Falling Prices Grip Major Stock Markets Around the World":

As the United States markets edge toward bear territory, losing nearly 20 percent of their value from last fall’s peak, investors might wonder where they can turn for relief.

The gloomy answer: nowhere.

This is a pretty typical viewpoint in the financial world. But there are two sides in every transaction: The buyer and the seller. There are a lot of people, predominantly young, that are currently accumulating their savings. They are looking for a place to park their surplus earnings.

These are the people that fit mostly under the headline of "investors". For these people, a stock market that goes cheaper is a very positive thing. Of course the situation would be better, if the price declines would not be preceded by even higher profit declines. But a lower price level is always preferable to a higher one if one wants to make long time investments.

The same situation was clearly visible in the real estate market. One person's unearned equity was another person being priced out of the market or going into crushing debt. There are a lot of young couples that are breathing a sigh of relief in the face of plummeting house prices. But there are also a lot of young couples in serious negative equity.

Then who are the people that are losing in a bear market? Naturally most damaging it is to people who are drawing from their savings, such as the baby boomers who are at the start of retirement. But they are not "investors" any more. They are more accurately referred to as "divestors".

So why are the baby boomers losing out on their savings? Simply, they have already eaten those savings, by letting the businesses that they have invested in take on huge debts to create premature earnings, dividends and market valuations. A huge part of future income has been already paid out, just like in the housing market. Many companies, like GM, are like squeezed oranges. Completely devoid of any significant equity. And this is at a time when those savings would really be needed.

Baby boomers have also taken out a significant portion of future taxes, which will be paid by the younger generations. Now that there is a day of reckoning, many divestors that are losing out on their investments are going to cry to high heavens. But one can't eat one's cake and save it too.