Saturday, February 20, 2010

The Irresistible Sirens' Song of Inflation

In The Odyssey, Homer’s second epic poem of the Trojan War (The Iliad was the first), Greek hero Odysseus, sacker of Troy, must endure many challenges before he can return to his homeland. Some challenges were new and unexpected, but, as an experienced sailor, Odysseus was aware of the terrible Sirens. The Sirens were beautiful young women who sang irresistible songs that lured sailors to their deaths on rocky shoals. Odysseus wanted to hear the Sirens’ songs, yet he knew the danger. So he ordered his men to fill their ears with wax, to prevent them from hearing the Sirens, and then to tie him to the ship’s mast and not release him under any circumstances. As the ship approached the danger area, Odysseus heard the Sirens’ songs and begged his crew to untie him so that he could follow the Sirens. But, his crew ignored Odysseus and the ship passed the danger. Odysseus had heard the irresistible songs and understood that no man, not even a heroic and disciplined warrior, could refuse the temptation of the Sirens.

Homer’s epics can be understood at many levels, and I choose to interpret the story of the Sirens’ songs as a warning of man’s inherent weakness. There are some temptations so compelling that man must not allow himself to be placed in circumstances where he may succumb. Even when the temptations are known and understood, he must scrupulously avoid coming into contact with them. Powerful men are especially prone to these temptations, feeling superior to other men and certain that they can avoid the penalties involved. As such, they behave recklessly, only to discover that they are as human and as weak as anyone. The fall from grace of Tiger Woods comes to mind.

The temptation of inflation is inherent in our fractional reserve, central banking system in which fiat money is forced upon the populace by legal tender laws. This system creates a central bank lender of last resort—our Federal Reserve Bank—that manufactures money out of thin air, just as would any counterfeiter. But our Federal Reserve has even more power than a counterfeiter, because it operates not in the shadows and outside the law but in full daylight and with all the instruments of compulsion of the modern nation-state. No one may refuse to use its money and no one may use any other. Its only restraint is that imposed by the conscience of the men who are temporarily in charge of its machinery. This is indeed a powerful Siren song to inflate; that is, to print money.

The first temptation is so shower the banking system with money so as to ignite an unsustainable boom. Few chairmen of the Federal Reserve have been able to withstand this temptation. Even Allen Greenspan, who considered himself a “hard money man”, chose to bask in the adulation of the nation during the short-lived Boom years; therefore, he printed money to ignite one Boom after another. His successor, Ben Bernanke, has proven to be just as weak. But the Sirens’ songs are more compelling than merely desiring the limelight, as Ben Bernanke will attest, for he has given us an example of the ultimate irresistible temptation to destruction. Even when it is clear that inflation of the money supply has caused the Boom to turn, inevitably, to Bust, the Fed chairman is compelled to inflate even more. Here is why.

The essence of our fractional reserve banking system is the Fed’s ability to ignite a Boom through an increase in bank reserves. The Fed uses its power to buy assets, usually treasury bonds, to give the banking system additional reserves. The money that the Fed uses to buy these assets is created out of thin air. But that is just the tip of the pyramid, so to speak. As the banks lend money they create money out of thin air—the proceeds of bank loans become checking account money. This money was also created out of thin air, but in many multiples of the reserves that the Fed created out of thin air. Therefore, and this is crucial, this new money is backed by nothing more than debt—the debt of the banks’ borrowers.

As the Boom turns to Bust, due to the lack of real capital made available from real savings rather than money creation, the loans become worthless and, more importantly, the money supported by those loans vanishes. Now the central bank, the lender of last resort, hears the irresistible Sirens’ songs for even more money creation. All segments of society call upon the Fed to bail out the banks’ depositors, most of who are innocent bystanders of this Boom/Bust drive-by shooting. Who can resist the demands of the bankers, their shareholders, and their customers to create even more money so that the banks can honor their depositors’ checks? Everyone, from the president of the United States to the most modest widowed retiree, will ask if this entity called the central bank, formed with the ability to manufacture as much money as it itself deems necessary for the smooth functioning of the economy, is to stand idly by and watch innocent depositors lose everything. Everyone will question the justice of such an act.

Does there exist any person who, as chairman of the Federal Reserve, would be able to live peacefully among his fellow Americans who believed that their plight could be alleviated by his order? Grandma’s checking account must be made secure, at least in nominal dollar terms, from whatever size loan is required from the Fed to Grandma’s bank, regardless of the bank’s ability to repay the loan. Even though we know that the money for this loan is manufactured out of thin air, exactly the same as the money that kicked off the unsustainable Boom, we do not care. The consequences of another irresponsible act must be ignored, just as the original irresponsible act—the printing of money out of thin air—was ignored. Only now the Sirens’ song is even greater.

So, we sail toward the rocky shoals of national bankruptcy in full knowledge that we do so out of an irresistible compulsion. Better to have never heard the Sirens’ song of inflation in the first place. Better to never have given up sound money—gold and silver—in the first place. Better to never have given up responsible banking—one hundred percent reserves--in the first place. Better to never have trusted the weakness of man to withstand the irresistible Sirens’ song of inflation that appears destined to destroy modern economies everywhere in the world.

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