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The Rude Awakening
Submitted by Don Stacey
Nov. 3, 2005

Last week, James Grant, publisher of Grant's Interest Rate Observer, held a conference in New York. His comments are worth careful thought. Isn't it time to get rid of the Federal Reserve?

Don Stacey

James Grant, the conference host and keynote speaker, presented a talk entitled "Man's Inner Bubble," which, he pointed out, had nothing to do with gastrointestinal functions.

In the span of forty very entertaining and amusing minutes, Grant argued that easy credit fuels EVERY U.S. asset bubble, and that the Federal Reserve is the original source of all easy credit. Therefore, the world might be much better off without the Federal Reserve...or a Federal Reserve Chairman.

Grant pointed out that before the creation of the Federal Reserve in 1913, prices "sometimes sagged." Throughout the 19th century, therefore, prices tended to drift lower as productivity gains and innovation drove the cost of living down. Post-1913, however, the Federal Reserve has presided over the continuous depreciation of the U.S. dollar.

The appointment of Ben "Helicopter-drop" Bernanke as the new Fed Chief will likely accelerate this trend. In fact, any Fed Chief who thinks that the Federal Reserve is an inflation-fighter ought to be lashed to a mast and forced to stare at the following chart until his eyeballs burn with memory of it.

The key difference between the pre-Federal Reserve American economy of the 19th century and the post-1913 variety is that the pre-fed dollar derived its value from a strict connection to gold. Indeed, many dollars were actually minted in gold itself. Such a tether limited the production of new dollars and served to contain inflation...But the last remaining tether to monetary responsibility snapped in 1971, when President Nixon eliminated any connection whatsoever between dollars and gold.

To help the audience appreciate the dubious benefit of the Federal Reserve's stewardship, Grant presented a snapshot of life circa 1890, compared to today. First, there were some stark differences. Inflation was a negative 1.2% in 1890. The population of the country was 62 million. The Federal Government was in surplus. There were 25 professional baseball teams, spread over 3 leagues. Railroad stocks dominated the Dow Jones Industrial Average (with 10 of the 12 stocks).

But, there were also some remarkable, and ominous, similarities.

Interest rates were low. High-grade bonds yielded only 3.68% and the savings rate was 4%. Investors, groping for yield, took bigger risks causing a boom in speculative Western securities.

Grant shared some quotes from Hallie Farmer (published in 1924), in a report published in the Mississippi Valley Historical Review. Credit was easy and lending standards were loose. "Competition existed not between borrowers but between lenders," Farmer notes.

This created a boon for debtors. An example from Farmer: "All the rail roads offered lands at low prices and one easy terms...The Union Pacific offered eleven years' credit. One-tenth of the purchase price was to be paid at the time of sale; deferred payments bore interest charges at 6%, but for the first three years the purchaser was required to pay interest only."

Sound familiar? It's not so far removed from the unconventional mortgages we see in our mortgage bubble today. There was a boom in housing then as well, with the total mortgages outstanding nearly tripling from 1880 to 1890.

In the 1890s, too, they had their share of securities fraud. Grant related how the bonds of Capitola township in Dakota were sold to Eastern investors and changed hands many times before it was discovered that no such township existed.

Farmer's diagnosis of 1890 applies today. "The prosperity of the period was a prosperity based upon credit," he wrote.

Today's prosperity is no different, says Grant. Easy credit fueled the stock market bubble, the housing bubble and every other bubble great and small that the Greenspan Fed has nurtured. And presumably, as America's bubble economy deflates, the dollar's value will suffer...despite the very best efforts of the Federal Reserve and its new "inflation-fighting" chairman.

But let's not forget that bad news for the buck is gold news for the gold price and the oil price and for the price of every other hard asset. Make way for the "new reserve currencies."


From The Rude Awakening, an investment advisory service

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