This week’s Outside the Box is unusual, even for a letter that is noted for its unusual offerings. It is a speech from last week by Charles I. Plosser, President of the Federal Reserve Bank of Philadelphia at (surprisingly to me) the Cato Institute’s 31st Annual Monetary Conference, Washington, DC.

I suppose that if Dallas Fed President Richard Fisher had delivered this speech I would not be terribly surprised. I suspect there are some other Federal Reserve officials here and there whoare in sympathy with this view Plosser presents here, but for quite some time no serious Fed official has outlined the need for a limited Federal Reserve in the way Plosser does today. He essentially proposes four limits on the US Federal Reserve:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

“These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”

Some of you will want to read this deeply, but everyone should read the beginning and ending. I find this one of the most hopeful documents I have read in a long time. Think about the position of the person who delivered the speech. You are not alone in your desire to rein in the Fed.

Two points before we turn to the speech. Both Fisher and Plosser will be voting members of the FOMC this coming year. Look at the lineup and the philosophical monetary view of each of the members of the FOMC. Next year we could actually see three dissenting votes if things are not moving in a positive direction, although another serious proponent of monetary easing is being added to the Committee, so it may be that nothing will really change.

I am not seriously suggesting that the reigning economic theory that directs the action of the Fed is going to change anytime soon, but you will see assorted academics espousing a different viewpoint here and there. I think there may come a time in the not-too-distant future when the current Keynesian viewpoint is going to be somewhat discredited and people will be open to a new way to run things. This will not happen due to some great shift in philosophical views but because the current system has the potential to create some rather serious problems in the future. This is part of the message in my latest book, Code Red.

A lot of education and change in the system is needed. I want to applaud Alan Howard and his team at Brevan Howard for making one of the largest donations in business education history to Imperial College to establish the new Brevan Howard Centre for Financial Analysis to study exactly these topics and counter what is a particularly bad direction in academia. The two leaders at the new center, Professors Franklin Allen and Douglas Gale, are renowned for their pioneering research into financial crises and market contagion – that is, when relatively small shocks in financial institutions spread and grow, severely damaging the wider economy. This new center will help offer a better perspective. What we teach our kids matters. I hope other major fund managers will join this effort!

And speaking of Code Red, let me pass on a few quick reviews from Amazon:

“Excellent review of our current economic circumstances and what we can do about it to protect our assets. Even better, it is written with the non-economist in mind.”

“I read this book from cover to cover in 24 hours and was glued to every page. Do I know how to protect my saving exactly? No. But I have the critical information necessary to make informed decisions about my investments. My husband recommended this book to me after reading a brief article, and I’m so glad I impulsively bought it. It will definitely change my investment decisions moving forward and perhaps even provide me with more restful nights of sleep.”

You can order your own copy at the Mauldin Economics website or at Amazon, and it is likely at your local book store.

It is getting down to crunch time here in Dallas as far as the move to the new apartment is concerned. Work is coming along and most of it is done, although some things will need to be finished after I move in. Furniture is being delivered and moved in as I write, and today an the new kitchen is being entirely stocked, courtesy of Williams-Sonoma – they’ll be showing up in a few minutes. I am fulfilling a long-held dream (maybe even a fantasy or fetish) of throwing everything out of the kitchen and starting over from scratch. Between my kids and a returning missionary couple, all the old stuff will find a new home, and I will renew my role as chief chef with new relish next week.

I have always maintained that I think I am a pretty good writer but I a brilliant cook. With a new kitchen from top to bottom, I intend to spend more time developing my true talent. Between the new media room and my cooking, I hope I can persuade the kids (and their kids!) to come around more often. Yes, there are a few bumps and issues here and there, but in general life is going well. I just need to get into the gym more. Which we should all probably do!

Your feeling like a kid in a candy store analyst,

John Mauldin, Editor
Outside the Box

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Era of low interest rates coming to an end says OECD report, thanks to more stable global economies and predictable growth.

Last month, Americans were transfixed by the amateur theatrics undertaken by the Washington political establishment in connection with the debt ceiling crisis. The bad faith, poor tactics and wholesale avoidance of reality were offered by all players in very large doses. When the Republican leadership finally capitulated (thereby bringing down the curtain on the tawdry production), it soon became apparent that sound and fury had signified nothing except another exercise in can kicking. Public approval of Congress sank to the lowest level on record, and has only dissipated due to the unmitigated disaster of the Obamacare launch. But as bad as domestic approval has become, the behavior of the U.S. government has played far worse internationally.

A year before, European politicians faced what looked like the same situation of national default.But after fraught negotiations, they at least achieved the illusion of a political compromise. The narrative that emerged is that Europe was better able and more willing to compromise. Although this shallow conclusion overlooks key fundamental differences between the political structure of theU.S and the European Union (EU), it nevertheless has created the perception of lost American leadership. Since America owes its continued economic strength to its perceived political might, such changes could be dangerous in the extreme.  However, the reality is that the European political machine is just as dysfunctional and completely insulated from the interests of its citizens.

In order to force political union and the creation of a European super state, often against democratic wishes, several EU nations created the Eurozone and issued their own single currency. However, unlike the United States, the EU is not yet a unified federal state, with a single treasury. Furthermore, many important EU nations, such as the UK, are not members of the Eurozone. Therefore, while the European Central Bank (ECB) may exert moral suasion, it has no executive power over non-Eurozone members of the somewhat politically disparate EU.

In the United States, Fannie Mae and Freddie Mac were rumored by Wall Street to have an implicit federal government guarantee. As such, they were enabled to over borrow at extremely low rates. A similar dynamic existed with smaller, so-called ‘peripheral’ nations within the Eurozone, including Greece, Portugal and Spain. These overly indebted, economically questionable nations were able to over borrow at low rates under the implicit guarantee of far stronger members of the Eurozone, such as Germany and the Netherlands.

When the over borrowing of the Eurozone periphery nations reached levels that caused concern within the bond markets, the gap in bond yields between the southern and northern tier of the Eurozone threatened extreme instability. To narrow the gap, Eurozone banks were ‘persuaded’ politically by Brussels to load up on the bonds of failing southern banks and national governments. In return the ECB treated these suspect holdings as prime deposits.

This mirage worked well until the recession of 2007/8. Bad loans then placed banks under strain that threatened survival. It exposed the inherent lack of explicit EU national support for Eurozone banks and even nations. It even threatened the existence of the euro, by then the world’s second currency.

The ECB can and does create trillions of dollars of fiat euros. Also, it borrows hundreds of billions of dollars from the Fed by means of currency swaps. But unlike the U.S. dollar, the euro is not the international reserve currency. In addition, unlike the U.S. with its single Treasury, the EU has separate national treasuries. Therefore, international lenders have shown a far higher willingness to loan to the U.S. (There likely will be a limit for the U.S. Treasury as well, but that threshold has yet to be identified.)

But it is important to realize that it was the real and present danger of a bond collapse that finally spurred coordinated political actions in Europe, not any forward-thinking preemptive policy moves. Such a crisis has not hit the United States. Should it, the U.S. will be forced into action as well. The big difference of course is that the solvent Germans have been able to bail out the insolvent Greeks and Spaniards.Who will be there for the United States? It is unlikely that Canada has the resources.

The current U.S. political practices of irresponsible spending, a massive creation of fiat money and the covert debasement of the dollar may never succeed in eventually spurring real political action and meaningful policy changes. Instead the bond market will call the tune. When bond investors finally head for the exits, hard choices will have to be made that will likely include deep and politically agonizing spending curbs, similar and possibly worse than those exerted now in Europe.

John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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