In the June 23 article in the Financial Times on quantitative easing of the United States, there is a gigantic fact here that few really understand. It is the 2.9 trillion dollars of Federal Reserve Credit. At the time of the fall of Lehman there was only 900 billion of this credit built up from 1914, and in the three months following the Lehman catastrophe the Fed created one trillion in new credit, or a hundred years worth, to save the system, and another trillion over the past few years to keep the United States from falling back into crisis and to try to grow it out of its problems. Would Germany want to pull the plug on Greece or Portugal to face another Lehman as they could not be sure how much effect a Greecian collapse could have on the derivative structure? I might add in passing that these quadrillion of derivatives described by Warren Buffett as a potential financial weapon of mass destruction, and whose description was confirmed by the historical events of October, 2008, have not served as a deterrent for their continued utilization as the derivative aggregates continue to mushroom into larger proportions.
A way of analyzing how useful this additional two trillion has been is to divide this base in 2008 of 900 billion into the GDP then of 14.4 trillion, which was a turnover figure of 16. But in 2010 the 2.9 trillion or thereabouts divided into 15 trillion or a turnover ratio of 5. The money is just not being used effectively which is largely reflected by the excess reserves of 1.3 trillion.
The Federal Reserve credit figure is a vitally important figure for it is used by the banks as its base for fractionalizing or expanding loans as a form of money supply. If you use a 1% reserve requirement, the mathematical expansion is over 100 times which is why Milton Friedman calls this reserve base high powered money as it expands at a huge multiple in the banking system. It is also important to realize that the credit system of these banks is a closed loop and no money leaks from it except when it is converted to cash, and no money leaks overseas unless it is converted to cash and carried overseas. The latter is not easy to do with western nations watching like hawks these cash transfers via the terrorist laws, or really enemy of the people statutes a la Soviet Russia. Essentially, this credit dollar based on deposits at banks floats against the credit Yuan or credit Yen in a similar manner.
The problem with this floating system is that it is not clean. There are dirty floats all over. And instead of the dollar floating by supply and demand against the Yuan, the Chinese erect a currency tariff against our goods by buying our currency to raise its value so they can dump their goods on us. If currencies truly float, the deficit countries based on excess say dollar credits would fall making it harder for them to buy imports, and it would serve as a self-correcting mechanism. This mechanism is interfered with by these dirty floats.
When we talk about hot money in the United States of about 11.7 trillion we refer to deposits or Treasury instruments that can be immediately sold and converted to foreign credits. If this hot money were to be converted all at once into foreign credits, the currency would crash as it would constitute a dollar exposure and not a dollar turnover as the 4 trillion that turns over on the foreign exchange market each day. The only reserves the United States has against this potential run on the dollar is about 300 billion plus of gold at market and currencies at market. This is far too small to tackle the problem and if the gold were sold on the spot it would crash its price causing it to yield much less an amount than the nominal reserve value. A high Federal Reserve official told me if any of the Arabian Gulf States were to try to remove overnight many trillions of their foreign investment from the United States, it would be regarded as an act of war and the assets frozen. Even less can provoke the United States as in the case of their friend and ally, Mubarek.
The issue of turnover against exposure discussed above can be easily explained by the following comparison. If you have a billion dollars to trade with which is hypothetically all my net worth, and I buy and sell bonds all day to the tune of 300 billion dollars, then it would be foolhardy to say that what is my billion of reserves against my trading prowess of 300 billion dollars a day in bonds. But the exposure I have is a billion, and against that exposure the turnover means nothing except as to whether I lose or gain money each day. If I lose two billion dollars, I am broke, and minus one billion dollars. That demonstrates that when the president of the New York Federal Reserve, William McDonough, told me at a gathering what is 11.7 trillion (it was less then but I am using the current figure to avoid confusion) in hot money exposure when less than half that amount trades each day, either he did not know himself or he was purposely trying to mislead me as to the significance of this exposure that can be ruinous.
The three trillion exposure to China due to their surpluses is therefore potentially very dangerous for the United States and other deficit countries as if they converted these dollar credits into Yuan credits as the Middle Eastern countries could, the dollar credit system would also collapse on the foreign exchange markets. It is not likely to lead to a short-term catastrophe as China is not prepared to cease exporting to us and others, and nor would benefit from a world depression as it would deter their march into becoming the dominant world power. In any event, China’s dollar credits would also be frozen if the effort were initiated as those of the Gulf States of Arabia.
Martin Feldstein thinks that China has adopted a two prong effort to eliminate these surpluses by vigorously encouraging the reduction of savings by a massive increase in domestic consumption and a gradual but significant rise in the Yuan. But in the event Feldstein is wrong, nationalist forces are growing in the deficit countries who are watching their internal industries being destroyed, and while we don’t see convulsions in the near future due to these misalignments of currency, we do see it in the more distant future.
Another example of exposure versus turnover is the high frequency turnover in the stock and Forex markets. The average holding or turnover of stock in the United States is twenty seconds. In the Forex markets, which is 70% electronically based on preset algorithmic trading, the roundtrip trades or turnover are completed in under a second on average, and the Big Five players are in and out in under 1/10 of a second. This is truly an unproductive use of capital as it produces nothing of value to the society, as well as most of the quadrillion of derivatives. The Tobin transactional tax to discourage this wasteful expenditure of national resources is one way to redirect bank credit. As John D. Rockefeller laid out for his Standard Oil combine that is best reflected in one of its former components, EXXON, whose Rockefeller principles they still follow, derivatives for decreasing risk are an authentic business purpose but not to gain speculative profit. As John D. wrote in his “Random Reminiscences”, “Standard Oil is not concerned in speculative interests as the oil business itself is speculative enough, and its successful administration requires a firm hand and a cool head.” And this principle was carried forward in a recent Annual Report of EXXON that stipulated that derivatives are only used to protect investment but not speculation. An example would be farmers selling their futures in corn to Kellogg to pay for seed, and supplies, so that Kellogg can be able to plan on a stable price for their corn flakes but not otherwise for the purpose of gambling using bank credit. Or in the case of EXXON, their selling in the future their refinery production of products to be sure they reaped the money necessary to pay for the building of the refinery while it gives the buyer an assured supply of product at a fixed price they can plan on.
There is a misconception that the creation of bank credit, or the M-3 money supply, is solely the concern of the banks and should remain within the confines of the free market. But the creation of money out of nothing in our fractionally reserved banking system is essentially a conversion of the wealth of one part of the population to another, and at the very least should be guided by the government as Dr. Hjalmar Horace Greely Schacht did as Reichbank President in 1933 where no bank credit was allowed to be used for unproductive purposes such as speculation and where he turned around the catastrophic unemployment situation relatively quickly which should be an inspiration to our Euro friends John Maynard Keynes in his introduction to the 1938 German edition of his “General Theory of Employment, Interest and Money” declared that Dr. Schacht was the greatest exemplar of this theories. (This approach was replicated after World War Two by the Schacht Reichbank protege, Dr. Wilhelm Vocke, who created the German postwar economic miracle, and my friend, George Champion, who was then head of Chase Manhattan Bank, invited him over in the 1950s to explain this to the American Banking Association). It was Schacht in 1923 who stopped the German hyperinflation by ceasing to supply credit to the currency speculators who were shorting the Mark, and this created a surge in the Mark ending the hyperinflation. The speculators could no longer go to the central bank for credit to cover their short but had to buy it in on the open market. Similarly, the Chinese authorities blocked the speculators and insulated their economy from the so-called Asian currency contagion of 1997 by buying both the Hang Sang Index and their own currency which the speculators had shorted thereby creating a bloodbath among the speculators–who promptly called in Milton Friedman to call foul as government intervention against manipulation was not regarded by him a part of the functioning of a free market. Creation of money was always historically under the rule of the sovereign whether it was a monarchy or Congress and not to be held in private hands for their use according to their sole discretion.
This does not even cover the lender of last resort role. Even Goldman Sachs had to flee to for cover in the Lehman debacle under the Federal Reserve tent despite almost all of their positions being in the right direction, as well as General Electric, who could not turn over their commercial paper liabilities created under the so-called genius of management, Jack Welsh, to save interest expenses against the higher interest expenses for the more conservative long-term bond issuances, which is another reason for the right of the government to exercise control over this sector that they have to bail out or face the destruction of their economy. The thought of this Jack Welsh must cause the great Thomas Edison to turn over in his grave.
We can look at total central bank gold reserves of 30,562.5 tons or 977,984,000 ounces, and divide these ounces into the world M-3 estimated to be 60 trillion, and come out $63,000.00 per ounce. This relates to the earlier value of the dollar as $20.00 an ounce in 1920. This expansion validates Aristotle’s contention in Politica 1:3:23 that the interest rate system is contrary to nature in that the gold, paper or credit cannot produce its own children, or the liquidity to cover the interest without either hypothecating the gold or issuing more paper money or credit. What this means in ordinary lingo is that if I own a house, and it is worth ten million dollars, and I sell ten five million first mortgages on it, then I have hypothecated the asset gaining fifty million in credit on a ten million dollar asset. Doesn’t that sound familiar in the various alphabet soup derivatives involved in the last Lehman crisis? So when England in 1900 had a 3% gold base against its Pound credits, it had hypothecated its gold over 33 times with similar Pound issuances. It was an untenable gold interest rate system as the dwindling ratio of gold ounces could not sustain a run on the central bank because of the inverse credit pyramid, and the Pound failed in 1931 with the English going off the gold standard.
There is the question of whether gold is in sufficient quantities to allow for expansion of an economy but the liquidity for the economy can be achieved by the gold rising in value if there is a proliferation of other commodities far in excess of the gold base, and in that sense gold should float as a money in the form of a commodity against other commodities. Therefore, in a system under Sharia law gold savings would be rewarded as the production of the system expanded, and it would create a much more valuable gold and a certainly honest currency. The rising value of gold in such a situation would also furnish the additional liquidity for the financing of the growth of the economy.
Even a currency separated from gold, whose value constitutes a form of secular transubstantiation, follows the same laws of the interest rate system as it must continuously create the credit or liquidity to pay the interest until it starts to disintegrate in currency crises based on the aggregates becoming unmanageable. This is why historically all currencies so divorced from a metallic metal, and based on the interest rate system, die. The British economist Alfred Marshall was the last one to struggle with this paradox and could not solve it. He could not figure out how to circumvent the fact that the interest rate system cannot create its own liquidity except through diluting the currency, credti or gold until it expires.