I.O.U.S.A. (16 page)

1

Many of the homeowners were not prepared for this jump in monthly payments and found themselves falling behind on their mortgage payments. They also found that contrary to popular delusion, home prices do, in fact, decline.

As Figure 3.2 shows in dramatic fashion, home prices fell in the United States in 2007 for the fi rst time in 40 years.

Many homeowners awoke one day to fi nd that they owed more than their house was worth. Consequently, during the fi rst six months of 2008, 343,159
There are very few people in the
Americans lost their homes, up 136
world today that can afford to live
percent from 145,696 recorded during
like Americans. Too bad Americans
the same period in 2007, according
are among them.

to RealtyTrac, an online marketer of
—BILL BONNER

foreclosed properties.

1
Bloomberg News,
January 30, 2008.

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S&P/Case–Shiller Home Price Indices

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1996

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WWW.AGORAFINANCIAL.COM

Figure 3.2
S&P Case-Shiller Home Prices Indexes As home prices continue to fall, oil hits a new record high each day, and the prices for food skyrocket, American consumers will learn to tighten their belts. The days of “ buy now, pay never ” thinking are going out the window.

But is America ’ s low savings rate simply a matter of personal choice? Or are there also other forces at play here?

The Federal Reserve

In 1913, President Woodrow Wilson was successful in pushing

Fiat Money:

the Federal Reserve Act through Congress. The act allowed the
Money that has no

government to establish the third central bank in the nation ’ s
intrinsic value and

history.

is not convertible

Think of the Fed as the bank of banks, and the govern-to any commodity,

ment ’ s bank — the gatekeeper of the U.S. economy. The board,
such as gold or

silver. It is made

which is run by seven governors and presided over by a chair-legal tender by a

man and vice chairman, is charged with managing the supply
government decree.
of money and credit to the economy. By manipulating interest c03.indd 46

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Chapter 3 The Savings Defi cit
47

rates and creating money, the Fed can either stimulate or sti-fl e the economy. The Federal Reserve is the primary force in determining our nation ’ s money supply. The Fed ’ s two main goals are (1) to help stimulate economic growth and (2) to try to keep infl ation low. These goals often confl ict.

The central bank Federal Reserve System has a tremendous amount of power and a monopoly control over money and credit. The chairman of the Federal Reserve is more powerful than even the president because he has so much control over the economy. The Fed is the key to how much money and credit is in the U.S. economy in any given time. This is due to the fact that the United States currency is a
fi at money
— in other words, it is not backed by anything tangible, and therefore it can be created out of thin air.

The U.S. dollar was not always a faith - based currency.

There was a time when for every dollar in circulation, there was a coinciding amount of gold to back it up — a
gold standard.

“ In the nineteenth century, starting with the Napoleonic Era, all the major money systems of Europe were anchored by gold, ” Bill Bonner explains. “ All of these countries had gold lining their systems, so when they traded with one another they could either trade their gold, or if you traded paper money, it was certain that there was gold backing their currency.

“ And that system was very, very successful. The prosperity of the nineteenth century was amazing, ” Bonner continues.

“ But that system broke down in World War I; the governments, as they always do, spent too much money. Britain borrowed too much, the French borrowed too much, and then they couldn ’ t pay it back because they didn ’ t have enough gold to pay that kind of expense. ”

Even so, that gold - backed system lingered on throughout the twentieth century — but not perfectly — and the last stage of this system was called Bretton Woods, which lasted until 1971.

Bonner tells us:

“ Prior to 1971, we had the Johnson

administration, we had the Great Society and the Vietnam War, and those things were very, very expensive. And somebody told Johnson, ‘ Wait a minute, you can ’ t have both guns c03.indd 47

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48 The

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and butter. You can ’ t have a huge domestic spending program, the Great Society, at the same time that you have a huge war going on in Asia. That won ’ t work, we can ’ t afford that. ’ At the time the Democrats, led by Johnson, said, ‘ Oh yes we can; we ’ re a big rich country, we can afford both guns and butter. ’

Well, sure enough it wasn ’ t true, and they couldn ’ t afford that much without raising taxes, and they didn ’ t want to raise taxes because then they wouldn ’ t be reelected. So they had this big problem. And what resulted from that was a run on America ’ s money. ”

Other countries, especially the French, led by Charles de Gaulle, noticed that the dollar was weakening. So de Gaulle told then - President Nixon that he wanted to exchange the dollars France had for gold. Nixon examined the situation and realized that if France took all of that gold, the United States would not have much gold left, and in turn decided to close the gold window. That was August 15, 1971, and since then, no foreign government could trade dollars for gold.

Money Supply:

Money Supply and Infl ation

The amount of

money (coins,

Now, with the Bretton Woods System a thing of the past,
paper currency, and
when the Fed determines that the economy needs a stimu-checking accounts)

lus, interest rates are lowered, borrowing becomes easier, and
that is in circulation
more money fl ows into the economy. This is known as
openin the economy.

ing the Fed window,
and the result is an increase in the money supply. If the money supply is increasing, consumers are feeling wealthier and more money is changing hands as they buy goods and services.

This puts a chain of events into motion. Businesses see increased sales and therefore order more materials and increase production. This, in turn, increases the demand for labor and goods. What happens after that, in a buoyant economy, is that prices of stocks rise and fi rms issue equity and debt. If the money supply continues to expand, the c03.indd 48

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Chapter 3 The Savings Defi cit
49

prices for these goods and services begin to rise, especially if output growth reaches capacity limits — in other words, a bubble is formed. As the public begins to expect infl ation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

When infl ation is rising, the dollar is quickly losing value, and the Fed raises interest rates, which means borrowing becomes more expensive and money eventually fl ows out of the economy.

When the supply of money falls, or when its rate of growth declines, economic activity declines and either disinfl ation (reduced infl ation) or defl ation (falling prices) results.

Closing the Fed window
decreases the money supply.

In a worst - case scenario, the economy can become stagnant and infl ation can rise simultaneously, a situation called
stagfl ation.
The Fed is then faced with an extremely diffi cult choice, because it can ’ t raise interest rates and lower them at the same time. It must choose either to stimulate the economy or to fi ght infl ation. This last happened in the United States in the late 1970s, and it proved to be a very diffi cult time for the country.

The forces of infl ation had been picking up steam throughout the 1970s, and the prices of just about everything were hitting record highs. Pete Peterson, then secretary of Commerce under the Nixon Administration, remembers this period in U.S. history clearly. “ I was in the Nixon White House, ” Peterson recalls,

“ fi rst as an economic adviser to

President Nixon and then as secretary of Commerce. History will record that the Federal Reserve was part of the problem.

They let money supply get out of control. When Paul Volcker took over he realized he had to take truly courageous action.

And he did. ”

Dr. Volcker

’ s offi ce in New York City is adorned with poster - size caricatures depicting the former Fed chairman as a warrior, battling runaway infl ation. And these cartoons are hardly exaggerating. Over the din of the ice skaters enjoying c03.indd 49

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50 The

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themselves at Rockefeller Center, 20

- odd stories below,

Dr. Volcker told us of the tough medicine he had to spoon -

feed the United States when he took the helm of the Federal Reserve in 1979. Infl ation had reached a “ crisis point, ” he said, and in less than a year, the Fed ’ s key rate rose from 10 to 19 percent.

“ Infl ation, ” explained Dr. Volcker, “ gets built into expectations, and when people think it ’ s going to happen it affects their wage demands, it affects pricing policies, and it has a certain built - in momentum, which clearly happened during the 1970s. ”

While his raising rates to an all - time high certainly caused some controversy, Dr. Volcker did what was necessary to achieve and sustain stability in the U.S. economy — and found that, overall, the country was ready for him to step in.

“ I think the mood of the country was willing to accept action, which ten years earlier they wouldn ’ t have been willing to accept, ” he told us. “ And once the country got caught up in an anti - infl ationary effort, while they were diffi cult years, I think there was a certain acceptance of a willingness to take, among other things, very high interest rates and eventually a rather severe recession, [because]

One of the lessons of the early

there was this underlying core that

1980s is don’t let infl ation get

the country had not been on the

started because once it gets

right path economically and that it

momentum it’s very diffi cult to deal

with, but it’s also destructive for

needed to be shaken up, in a sense,

economic growth and prosperity.

to restore stability. And that faith not

If that happens—and right now it

only sustained me, it sustained the

seems like there is a little fl avor of

country.

it—we will all fi nd ourselves back

“ One of the lessons of the early

in the days of stagfl ation and unac-

1980s is don ’ t let infl ation get started

ceptable economic performance.

because once it gets momentum it ’ s

—PAUL VOLCKER

very diffi cult to deal with, but it ’ s also destructive for economic growth and prosperity. If that happens — and right now it seems like there is a little fl avor of it — we will all fi nd ourselves back in the days of stagfl ation and unacceptable economic performance. ”

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Chapter 3 The Savings Defi cit
51

As Dr. Volcker suggested, current economic indicators show we ’ re entering a similar cycle in the economy. In the second half of 2008, American

’ s infl ation expectations

have jumped to their highest level since 1981, according to the Reuters/University of Michigan Surveys of Consumers. Not only that, but growing concerns over the country ’ s two largest buyers of U.S. home loans, Fannie Mae and Freddie Mac, drag down the already hurting U.S. stocks; the price of crude oil hits a new high every day; and consumers are seeing their grocery and energy bills grow by leaps and bounds.

“ With respect to the fi scal crisis looming out there in the future, ” says Paul Volcker, “ We ’ ll see whether a democracy can deal with an obvious problem that ’ s going to be present in not too many years. The earlier we take action to deal with it, the better. ”