by Federico Fernandez and Raoul Kirschbichler
On October 9th, 2013, John Charalambakis spoke on the art of central banking at the Hayek Saal, in a lecture organized by the Austrian Economics Center.
Dr. Charalambakis has worked as a consultant for government agencies, corporations, and non-profit groups in several countries, including providing recent support to the newly established Congressional Financial Crisis Inquiry Commission. He was Professor of Economics at Asbury College for twenty years. He earned his BA from the Athens School of Economics and Business, his MBA from Roosevelt University, and his Ph.D. from the University of East London. Charalambakis is the author of “The Fed, The Markets, and the Metamorphosis of the Business Cycle”. One of his principal areas of interest is identifying the factors that lead to the creation and sustainment of a middle class in different societies.
We detailed some of the most relevant aspects of his presentation during his visit to the Austrian Economics Center in Vienna.
The mere existence of central banks raises two very important questions:
1) Do we need a central bank? Why should a central authority dictate the price of money? Can’t the market solve this problem as it does with many other prices?
2) What is the relationship between the bubbles from the past twenty or thirty years and central banks? Are the Fed, the ECB, the Bank of England and the Bank of Japan to blame for them?
The overextension of money supply and the overextension of credit create bubbles. Bubbles, we know, inevitably burst. So, do central banks create artificial booms which in turn cause busts?
Furthermore, both the ECB and the Fed are playing the game of quantitative easing (QE). I call this “financial repression” because they are penalizing savers by keeping the interest rates artificially low. The current close to 0% interest rates create an artificial stimulus will eventually become a bubble.
Assuming that we have to have a central bank, the art of central banking consists in keeping a balance using an anchor that allows the vessel –the economy– to sail in international waters.
Let’s go back to 1971
when the gold standard was abandoned by the Fed. In a short period of just four years, from 1967 to 1971, the Fed printed as much money as it had printed since 1776. Just two years later, in 1973, we had the oil crisis.
What happened? The Arabs, realizing they were receiving inflated money, raised the oil prices. What was the Fed’s reaction? Printing more money which, in turn, made the Arabs raise the oil prices even more. Consequently, the 70s witnessed two oil crisis and period of stagflation. Instead of bringing balance the Fed brought disequilibrium and lost control.
Since we have lost the anchor, how many crises did we have? Two oil crises, the so-called “lost decade” in Latin America during the 80s, the Louvre and the Plaza Accords –both due to currency crises–, in 1987 a stock market crash, in 1989 a savings and loans crisis in the US, in 1995 Mexico declared bankruptcy –causing the “Tequila effect” in Latin America–, in 1998 Russia went bankrupted and Brazil had huge problems, in 2001 Argentina defaulted its sovereign debt and nationalize bank savings, and the boom of the “dotcoms” in the beginning of our century. Last but not least, we had a boom in the real estate sector in the US which created a big bubble and produced an apocalyptic bust in 2008.
So, what is the cause of all of these? I believe it is that we have lost the art of keeping balance using an anchor. Until 1971 there was a rule of sorts that guided the Fed and did not allow it to misbehave –and by this I mean printing more money than it was supposed to. But this anchor, gold, was abandoned. Moreover, whenever a national central authority has been given power to print money using gold as the anchor they have cheated. First the English cheated, then the Americans cheated. That is why gold standard had to be abandoned.
And what happened in 2008?
The biggest bubble burst and that was the bubble of rehypothecation. In a nutshell, rehypothecation means that people could get different loans from different banks using the same house as collateral. With bonds rehypothecation means that someone issues a loan based on a bond. Then, based on that collateral another loan is issued. This chain of loans used to get to nine levels –all based on the same and only collateral. This is cheating! It is an inverted pyramid.
Besides, in 2000 derivatives made their appearance. Derivatives are financial instruments, mathematical formulas which are believed to have some value. They have no hard asset behind them. Warren Buffet himself calls them “weapons of mass destruction”. However, institutions such as Lehman Brothers were able to issue loans against derivatives. Whoever bought the derivative instrument could go to a bank and ask for a line of credit. Later, the bank which holds the derivative issues several loans against it using it as collateral. But this “collateral” has no value.
In 2000 derivatives were worth 50 trillion dollars. Nowadays, they are worth 700 trillion dollars. Have we created 700 trillion dollars wealth between 2000 and 2008? Let’s keep in mind that the global GDP is only 60 trillion dollars. So, we have a multiplier of 10. Such a multiplier does not exist in the real market place. This is lethal.
What begs the question: how do we solve this?
What sort of measures do we need to solve this predicament. I think that we should take both defensive and proactive measures and that these have to be taken in the short, medium and long terms. I strongly believe that the next three years are pivotal. Unless these measures are taken, we are going to see the “crisis of all crises”.
Sort-term (12-18 months) defensive measures:
- Setting higher standards for acceptable paper in collateralization chain.
- Gradually reduce the length of the chain of rehypothecation.
- Start regulating derivatives.
Sort-term (12-18 months) proactive measures:
- The Fed should start reducing its balance sheet. This is being done by the use of Repurchase Agreements (Repos)
Medium-term (18-36 months) defensive measures:
- The Required Reserve Ratio (RRR) that banks cannot lend out has to be increased up to 30 or 40 %. This will slow down the credit creation that produces booms.
- Reduce further the collateralization chain and implement higher standards of acceptable paper in chain.
- Tight the standards of what is used as collateral.
- Continue limiting the scope of derivatives because they are the problem.
Medium-term (18-36 months) proactive measures:
- Cover the M1 money supply with gold and start introducing a basket of precious metals and other commodities as anchor for money. This will boost confidence.
- Partial transfer on central banks’ Treasuries to the Treasury Department.
- Identification of hard assets to be used in the collateralization base.
- Allow limited well-capitalized banks with sufficient hard asset collateral to issue their own notes. In other words, starting a free banking system.
Long-term (> 36 months) defensive measures:
- Adjust Required Reserve Ratio (RRR) as needed.
- Instead of donating its profits, the Fed should transfer its assets to the Treasury.
Long-term (> 36 months) proactive measures:
- Credit creation based on hard assets.
- Money issuance backed by the established anchor.
- Expand the number of banks that are allowed to issue their own notes. Let private and public money compete. There is no need to “end the Fed”. If we had good banks that issue sound money, the need for a central bank would be obsolete.
Finally, some remarks about Europe.
I think that is the Fed the one who have saved the Euro. Why? Because 50% of the money printed since 2009 has ended in the ECB to support the Euro. This is because the fall of the Euro would result in the disintegration of the European Union which, in turn, would have significant consequences to the American market. In a way, it is like trying to put down the fire in your neighbour’s house to avoid your own to be caught by the flames.
Nevertheless, the Euro is the most dysfunctional currency in the world. The Euro has to die. You cannot have a central bank that issues a currency without a treasury that issues the bonds. There is no federal treasury in the EU that issues bonds. Without mutualization of debt you cannot have a common currency. Eventually, the Euro zone is going to break apart.
The role of Greece is complex. Greece citizens are victims of a political elite and strog unions that spouse big government and regulations. Lack of competitiveness and corruption are always the result of big government. The Greek government and the unions behaved as if money grew in trees…
But Greece also was imposed with the role of “scape goat”. It is true that Greek economy was in dire straits. However, in 2009, at the height of the financial crisis, the Greek crisis was used as a diversion. Exactly at the same time that big banks in Europe were at the edge of bankruptcy. Most, if not all, of the big European banks received trillions of dollars in bailouts. It was indeed the Fed who saved Deutsche Bank… Had we known that Deutsche Bank had a liquidity problem in 2009, what would have happened? My guess: the European Union would have collapsed within six months. Even Germany could have been bankrupted. But then entered Greece: a good candidate to divert attention.
By the way, Greece has not been bailout. Trillions of dollars went to save not people, not countries but the banks. Consequently, the money went to save those who created the crisis with their irrational lending policies.
Let’s face it: we should have left the banks die. We would have come out stronger. We would have understood that we cannot have fiat money. We would have realized that we need sound, honest, real money. And sound, honest, real money is money that is based on, not in the word of any government, but on a good collateral, like gold or silver.
In this context:
“Der Shutdown ist eine große Kinderei“ (“Salzburger Nachrichten Oct. 15, Mag. Helmut Kretzl interviewed Dr. Charalambakis at the Hayek-Saal in Vienna)
“In drei Jahren droht die Mutter aller Finanzkrisen, wenn sich nichts ändert” (Kurier vom 11.10. 2013: Vortrag von John Charalambakis im Hayek-Saal in Vienna)
eigentümlich frei – Veranstaltungsbericht: Die „Kunst“ der Zentralbanken (von Andreas Tögel; Vortrag von John E. Charalambakis beim Wiener Hayek-Institut)