After 100 years of the US central bank, does it deserve another try…?

SO IT WILL be 100 years on December 23rd since the Federal Reserve was born.

The purpose in 1913 was to form a regulatory body to help stem the tide of bank failures in the United States of America. The Fed’s proponents, Senator Nelson Aldrich, Senator Owens, Congressman Glass and others, believed that if an agency controlled the flow of money and the banking institutions, it could prevent many of the economic collapses that plagued the early years of the US.

Whatever its faults 100 years on, has the Fed at least performed its charter well in actuality?

The establishment of such a power was in no way a unanimous decision. There were many in the government who opposed it, as G.Edward Griffin details in his history of the Fed, The Creature from Jekyll Island. The name itself, the Federal Reserve, was in part intented to address their concerns. Washington avoided calling it a “central bank”, because many of the congress were also opposed to the centralization of power, especially monetary control to one agency in the government. So those supporting the central bank concept had to devise a similar method of control, but avoiding the appearance of direct control. That idea gave birth to the Federal Reserve.

The institution created to obfuscate the appearance of a central bank has 12 Reserve Banks across the country, which report up to the higher authorities within the system. This higher authority is the nine member board of directors, of which six are appointed by the 12 district banks themselves and the remaining three are appointed by the Board of Governors. 

This of course is a centralization of power. It is apparent that the Board of Governors is the controlling arm of the Federal Reserve. Where do they come from? The Board consists of seven members, appointed by the president of the United States and confirmed by the senate. Each member may hold this position for fourteen years (though the renewable terms are every two years).  From among this board, the president also chooses the chairman and vice-chairman which are ultimately the final decision makers.

Voilà! We do have a central bank, yet it has only been recently that our government has openly admitted that the Federal Reserve is the “central bank” of the United States of America. This agency literally controls the entire banking system. They have the ability to turn on and off the spigot of cash that flows through the banking network.

Is that control a good or bad thing?  Any benefits of the Federal Reserve System have as yet not been proven. Because if we take a look at the economic history of the United States of America over the last 100 years the picture “ain’t pretty” as Tony Soprano would say.

Since the inception of the Federal Reserve System 100 years ago we have been in contraction or prolonged slowdown 38% of the time. Some may say this is a good track record. But in almost half of those 38 years the US had negative growth in gross domestic product.

Thanks to Isaac Newton it is generally believed that what goes up must come down. This is a law of gravity, not economics. As the population grows the economy should grow as well, as these same new people need to eat but also produce. So why should they suffer such frequent economic decline? Greed and stupidity often are the real cause of most crises. But these two proclivities do not exist only in the purview of the private sector

Washington Mutual was the largest bank failure ever in the US, collapsing in 2008 with assets of over $300 billion. That represented a little over 2% of that year’s GDP. This and other notable failures such as Lehman Brothers would help drive the country into a deep recession that we have yet to climb out of. Where was the Federal Reserve before this occurred? The Fed got a lot of credit for rescuing the banking system after the fact. But why didn’t they see this coming? If it is their job to mop up during and after a crisis, is it not their job to prevent these calamities too? 

This experiment we call our central bank is also now playing a game it never had before, and the Board of Governors knows it. The unbridled creation of numbers that represent money characterizes a new attempt at economic manipulation that had never been tried before. Many believe that quantitative easing is working. But others, such as Jim Rogers, believe this artificial growth will collapse around us.

The Federal Reserve System’s birthday is December 23rd, when it will be 100 years old. Yet it is still an experiment. Counterfactual history can’t bear such a length of time, but there is no real proof that the Fed’s existence has had any more positive effect than alternative outcomes. In fact, many such as the Cato Instituteblame Federal Reserve policies and government banking deregulation, on which the Fed was often consulted, for our current economic crisis. Contrary to the Fed’s charter, this not only affects millions of people in the USA but has caused a domino effect around the world.

But accepting the Fed and its power as status quo, the question for the individual becomes how does this system affect your investments or income moving forward? In a world where money is controlled by centralized agencies with ultimate power to create, and thus to destroy value, one might want to seek hard assets beyond their control. This year’s drop in gold and silver prices doesn’t undo their many thousands of years’ use as stores of value, far longer than the US Fed’s fiat Dollar. And with the odds basis historical data that there will be another economic crisis inside the next 10 years, many of us today should expect to live through a fresh recession despite the best intentions of the Federal Reserve System’s creators 100 years ago.

Miguel Perez-Santalla

BullionVault

Miguel Perez-Santalla is vice president of business development for BullionVault, the physical gold and silver exchange founded a decade ago and now the world’s #1 provider of physical bullion ownership online. A fierce advocate for retail investors, and a regular speaker at industry and media events, Miguel has over 30 years’ experience in the precious metals business, previously working at the United States’ top coin dealerships, as well as international refining group Heraeus.

(c) BullionVault 2013

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

These days a lot of macro discussions are focusing on rising interest rates. Will the Fed taper? When will they taper (seemingly next week)? And what will happen to markets when they do, in particular what will happen to equities?

Conventional wisdom says that rising rates are bad for equities. There are lots of justifications of this claim the main one (that we like and think makes sense) is that rising rates mean a higher “risk-free” rate which means higher interest rates on fixed income products from savings accounts to 30-year bonds (yield curve assumptions aside). Ultimately, the qualitative thought behind this argument is that as rates rise the average Joe will see higher yields in fixed income products and will opt to put more of his money into some kind of interest bearing account (savings, money market, CDs, notes, bonds, etc.). When that excess capital goes into the various interest bearing vehicles, the money will have to come out of whatever vehicles it was parked in. Conventionally, the thought is the money will come out of equities thus lowering stock market returns. This, of course, makes logical sense, if I can get a high yield with “no risk” why risk the volatility inherent in the stock market, especially against the often frightening macro backdrop offered these days. At the same time, higher yields will incentivize Joe to save not spend thus impacting the economy in a negative way.

However, despite this completely logical argument, we can make a counter claim, which is equally logical and convincing. The claim would be that if the Fed does taper and rates rise that means things are on the mend in the economy and that means companies are doing better and things are otherwise getting better. So if things are getting better we should probably expect equity markets to keep marching up indefinitely-better economy means better things for the companies which make up said economy means better sales>earnings>valuations.

While each of these arguments is compelling and could be used to justify action, we prefer to find out what lessons history tells, in particular what historical data tell us about the relationship and what we might expect going forward based on historical outcomes.

We examined monthly data on 2 and 10-year yields and the S&P 500 (SPY). We calculated simple percentage change returns, comparing this month’s S&P 500 return to last month’s 2 and 10-year yield change. We did this because we were trying to determine what happens to stock returns after rates rise. In order to determine what happened “after” rate changes historically, we would have to see what happened to the S&P 500 the month after the various rate changes. Below are two charts, which show the scatter diagram relationship including a simple linear regression line.

(click to enlarge)

….continue reading HERE

Market Buzz – Pay Down Your Debt Canada 

The S&P/TSX Composite Index closed down 1.17% on the week and is up just over 5.5% in 2013 so far. Gains on Toronto’s main index year-to-date continue to pale in comparison to U.S. indexes where the S&P 500 is up just under 25% on the year.

A story that is receiving a good deal of attention North of the border involved the latest data from StatsCanada. The government number cruncher reported Friday that the level of household credit market debt to disposable income in Canada increased to 163.7% in the third quarter from 163.1% in the second quarter.

That means Canadians owe nearly $1.64 for every $1 in disposable income they earn in a year.

Policymakers and many international investors are fixated on the debt ratio in part because it was at above 160% that households in the United States and Britain ran into trouble about five years ago, contributing to defaults and the financial crisis that triggered the 2008-09 recession.

Before you start to assume that we are extrapolating a Canadian debt crisis, we will stop you right there. But as debt adverse investors, we do not believe the country is headed in the right direction and believe that many in this country should “give their heads a shake” and stop living beyond their means. It is not sustainable and often leads to a scenario where the responsible pay for and suffer for the irrational and selfish behaviour of the irresponsible.

Growing debt levels are a worrying trend and should truly be the focus of the report, but the collective media (both financial and not) is telling us there is some great news in this report. The sunshine comes from the fact that household net worth hit a record high of $7.5 trillion. That’s an increase of almost 2% quarter-over-quarter, thanks mostly to rising housing and equity prices. We immediately question if both the former and the latter are sustainable, but that is for another column.