We have a helpful example of this in The Wall Street Journal (06/06, "Ahead of the Tape" by Justin Lahart): "After a long hiatus, the Fed began raising rates in February of 1994. The increases that followed were steeper than most investors had expected and created more market havoc as well. By February of 1995, the fed had brought its federal funds target rate to 6% from 3% a year before and financial crisis had irrupted in Mexico and Orange County, Calif."
The argument here is simply "grin and bear what the Fed hands out," and don't try to understand it. But the actual facts that eventually cleared the way for the big boom that led to the big bust just don't fit into that bag. In fact policy was changed drastically but covertly, because the one that had been imposed decades earlier had collapsed the international monetary system. So frightening was the prospect, and so incompatible were the different policies rushed in to bail out the banks from their huge gambling losses, that those in charge did not even dare let the public know why they were changing their earlier certainties so completely and so abruptly.
It all goes back to the big crash of 1929, brought on largely because the banks had been allowed to expand into other financial sectors – real estate, the stock market, mortgage lending. Each of these "financial pillars" had its own pool of liquid capital essential for its own business. But these pools of liquidity exert a fatal attraction on bankers. If they could only get control of them, they could create many times their value in chequing account credits, and then move on to apply the same banking multiplier to the next liquidity pool, the banks would end up with a skyscraper conforming, if to anything, to an inverted pyramid. The market value of such a deregulated bank is embodied in the current price of the bank's stock. The trouble is that it is a deal with the devil. For at the first failure of the deregulated bank's stock to live up to this sustained growth rate already incorporated into the market price of its shares, the whole house of cards collapses. That was a major factor in the depression of the 1930s that brought on the Second World War.
That is why the Roosevelt banking legislation of 1935 confined the banks strictly to banking. However, by the end of the war, this severe regime had made the banks sound once more, with bankers feeling again the swelling libido to gamble with other people's money. And with unusually thorough planning they hit the comeback trail. Their goal was to recapture the economic preeminence they had lost with the bursting of the bubble of the late 1920s. For that they had to present a picture of the economy in danger of hyperinflation unless monopoly powers were vested in the banks – independence and power in monetary matters over the government itself.
Towards this end the universities and the press were purged of any dissenting views. It was summed up by Alexandre Lamfalussy. General manager of the Bank for International Settlements (BIS) in his annual report issued on May 23, 1991: "It has been argued that inflation in the range of 1-2% may be considered price stability for all practical purposes. Nonetheless the movement from an environment of low or moderate inflation to one of no inflation implies an important psychological shift. It has proved very difficult in recent decades to achieve merely low inflation and to move to actual price stability, even in those countries with the best price performance."
Yet technological revolutions, urbanization, mass migrations with all the infrastructures these called for, brought a mounting degree of public investment. But this resulted in a deepening layer of taxation that could only find its way into the price level. It had nothing to do with an excess of demand over supply, and hence ought not to be confused with the traditional definition of "inflation."
Moreover, our governments were at the same time treating their investments that would last for decades as current spending, rather than depreciating and amortizing them over their useful lives. When that is done even the unsuccessful effort to balance a budget is likely to raise more taxes than necessary – and thus push up prices higher. A series of Auditors General of the Canadian government had made the point, but COMER were pioneers in publicizing the issue, and relating it to the "inflation" problem.
Intent on its goal, the Bank for International Settlements warned that unless the slightest price rise were nipped in the bud it would bring on the sort of hyperinflation that ruined Germany in 1923. But that hyperinflation had resulted when Germany suspended its reparation payments from its loss of WWI, because it could not raise the strong currency that France insisted on receiving them in. As a result the French and Belgian armies occupied the industrial heartland of Germany, a national strike in response rallied the entire spectrum of Germans, virtual civil war broke out. To claim that any price climb, unless suppressed would lead to such hyperinflation is to imply that if interest rates had been pushed high enough – the BIS's formula for imposing "zero inflation" – there would retroactively have been no world war lost by Germany, no occupation of the Ruhr basin by the French, no general strike, no virtual civil war in Germany. Nevertheless this nonsense was repeated countless times in the world media. Professors and editors bit their tongues to keep their jobs. The morality of public officials became a sub-department of the bankers' drive to control the economy once again.
By 1951 the banking counter-revolution had been well enough prepared for its first coup to take place. In his memoirs President Harry Truman recounts his betrayal by his Treasury Secretary assigned the task of adjusting the peg of interest rates to the upward movement of prices brought on by the lifting of price controls at the very outbreak of the Korean War. Instead of adjusting the peg to prices, it was abolished altogether. That set the moral tone of the bank comeback over the following decades.
Under the legislation brought in under Roosevelt there were two tools for reining in "inflation." There were the "statutory reserves" that banks had to redeposit with the central bank as a small proportion of the deposits they received from the public. And there was the benchmark interest rate set by the central bank for overnight loans between commercial banks to enable them to meet emergencies. Few loans were made between banks at such overnight rates, and their relatively low level could only mislead the public about the largesse of the nation's money lenders. An increase in the statutory reserve, for its part, reduced the volume of loans that banks could make on a given cash base, rather than raising interest rates. However, between 1991 and 1993 in Canada the statutory reserve requirement was phased out completely. And though such provisions remained in force in the UK and the US, their use there was reduced to insignificance.
This left the central bank essentially with a "single blunt tool" for fighting inflation – raising interest rates. At the same time a vast campaign was initiated for declaring central banks independent of their governments – whatever their charters might say.
With few exceptions the governments that came out of the Second World War were oriented toward social-reform. The bankers' campaign had therefore to be based outside their governments, and often directed against them. There was thus need for a semi-underground bunker to direct the project. The vehicle for that was miraculously at hand in the Bank for International Settlements (BIS) in Basel, Switzerland. Originally set up as a purely technical body to handle the syndication of the German reparation payments arising from World War I, which Germany could pay only in its own currency but which had to be converted into a strong currency. That was the reason for BIS's founding. The Wall St. collapse of October 1929 made impossible this original purpose of BIS, but it lingered on to do some ill-considered services to Adolf Hitler. When his army marched into Prague, BIS practically tripped over itself in surrendering to him the treasure that the Prague government had stored with it. As a result at Bretton Woods in 1943, Resolution Five passed on the initiative of several governments-in-exile called for the liquidation of BIS at the earliest moment. This led to BIS cultivating a low profile – some of its offices in Basel were housed not in the standard fake Greek temple, but over a pastry shop. That low profile, however, commended it to the conspiring bankers for their underground bunker. Government officials other than central bankers are still not allowed at BIS's council meetings.
The second measure for the Big Bank Bailout was its Risk-Based Bank Capital Requirements Guidelines drawn up in 1988. It shifted the criteria for a bank's solvency from its cash to its capital. These are very different things. For the first principle of banking is to keep cash reserves to the lowest possible figure for meeting their obligations, since cash is to them "lazy money" earning no interest.
The purpose of the Risk-Based Capital Requirements that declared debt of the developed countries "risk-free" was to bail out the banks from their crippling speculative losses in gas and oil, North American real estate, and in euro dollar loans. The BIS-sponsored guidelines enabled the banks to acquire immense quantities of government debt without putting up any money of their own. To make that possible governments did less of their financing with their own central bank where its borrowing was virtually interest-free since the interest on the bonds held by the central bank came back to the federal governments. In Canada this took the form of dividends; since 1938 the Bank of Canada has had a single shareholder – the government. Now it paid through the nose by borrowing directly or indirectly through the private banking system. This latter was at rates pushed sky-high under pressure from BIS to "lick inflation."
However, in its rush to prevent a chain of bank bankruptcies, BIS had overlooked a detail – when interest rates are pushed up, the market-value of pre-existent bonds with lower coupons drop violently. This caused massive capital losses for the banks that were just bailed out by being allowed to acquire unlimited amounts of government bonds entirely on credit.
Through Jack Biddell, then a member of the COMER Board, we contacted Michael Mackenzie, former head of the Office for the Superintendence of Financial Institutions (OSFI) and warned of the time-bomb the combination of the BIS Risk-Based Capital Requirements and the phasing out of the statutory reserves, and his shocked reaction to Biddell was, "My God at the Basel meeting we overlooked the connection!"
This oversight becomes perfectly logical when you realize that the purpose of BIS was less the prudent management of banking than regaining the power position that bankers had lost in 1929. These are not only two different things, but two incompatible ones.
And in December 1994 the first of a resulting series of national banking disasters we were warning about began in Mexico. Investors fled the country. The prosperity of Mexico under the new Globalization and Deregulation and the North American Free Trade Treaty had depended largely on the influx of foreign money.
When the smoke finally cleared, Mexico's endemic corruption had risen to historic records, informed capital, native and foreign, had fled the land, banks had been replaced by the new stock market moguls. Government borrowing took the form of auctioning on the stock market to reflect this. So severe was the shift of power, that it brought on the break up of the coalition of parties and the trade unions that had put an end of the long bloody history of civil wars and the not infrequent assassination of political leaders. Civil war broke out in the impoverished states of Chiapas and Guerrero, and candidates for the Presidency came to be assassinated again.
The Value Added Tax on consumers rose 50% from 10% to 15%. Gasoline prices rose by 35% and retail electricity rates by 20%. The peso dropped by 18% in March, 1995.
So serious was the outlook, that Washington feared that the entire international monetary system might be brought down. Without the backing of Congress President Clinton arranged for a standby fund in excess of $50 billion to be organized with the help of the International Monetary Fund and the Canadian government, that did not have to be drawn on. But even so the Mexican crisis echoed through much of Eastern Asia in 1998, and then in Russia. When the smoke finally settled 85% of Mexico's banking system had been taken over by foreign banks.
In the words of an American observer: "For the men and women in the street in Mexico, the experience of the meltdown was a tragedy. Incomes declined, unemployment rose, poverty increased, and lawlessness in large cities took on new intensity. Nothing will ever be quite the same for the Mexican people; distrust of what the government says, and speculation about what it is keeping secret, has now become part of the national character."1
Robert Rubin, Clinton's Secretary of the Treasury, an alumnus of Wall St. knowledgeable about capital movements, drew another even more important conclusion from these happenings. Grasping the incompatibility of high interest as a means of avoiding "inflation," with contemporary banking and the economy as a whole, he found a healthier way of alleviating the upward pressure on prices. He introduced the distinction between current and capital expenditures in the government accounts – something that had been recognized in the private sector for centuries. By depreciating government investment in physical infrastructures over the useful life of the asset and recognizing its depreciated book value as assets, and applying the adjustment to some earlier years, he was able to retrieve some 1.3 trillion dollars of ignored government assets on the government's books.
This was without extending the treatment to human investment such as education, health, and social services. In studying the unexpectedly rapid recovery of Germany and Japan from the physical devastation of World War II, economists like Theodore Schultz of the University of Chicago even concluded that investment in human capital – i.e., education, health, and social services – was the most productive investment a government could make. But respecting Clinton's preoccupation with holding the political center, these increased assets were booked as "savings" in the statistics of the Department of Commerce beginning with January 1996. But they definitely were not savings – they had long been invested in bricks, mortar and equipment. Though this deprived the public from a knowledge of what was happening in their economy, it was enough with the usual wink and nod to convince the bond rating companies to improve the ratings on government debt, and bring down interest rates enough to give Clinton a second term and the nation the high-tech boom and bust that closed the millennium.
Such are the unmentioned and unmentionable factors behind the Delphic utterances of Chairman Greenspan. The reinstatement of the bankers as virtual rulers of the world has gone far toward depriving society of even a language through which it can learn the lessons of its own recent history. In an epoch devoted to technological communication magic, economists and governments have lost the means of articulating an experience that is tightening like a noose around our necks.
1. Weintraub, Sidney (2000). Financial Decision-Making in Mexico. To Bet a Nation. University of Pittsburgh Press, pp. 151 and 160.