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Vol. 30, No. 6d MARCH 23, 2012Two Wall Street, New York, New York 10005 www.grantspub.com

The Federal Reserve Bank of New Yorkhas invited some of its public critics to visit the

bank to unburden themselves of their criti-cisms. On March 12, it was your editors turn.The text of his remarks follows.

My friends and neighbors, I thankyou for this opportunity. You know, wearefriends and neighbors. Grants makesits offices on Wall Street, overlookingBroadway, a 10-minute stroll from yourimposing headquarters. For a spectacularvantage point on the next ticker-tape pa-rade up Broadway, please drop by. Wellhave the windows washed.

You say you would like to hear my com-plaints, and, on the one hand, I do have afew, while on the other, I cant help butfeel slightly hypocritical in dressing youdown. What passes for sound doctrinein 21st-century central bankingso-called financial repression, interest-ratemanipulation, stock-price levitation andmoney printing under the frosted-glassterm quantitative easingpresents usat Grants with a nearly endless supplyof good copy. Our symbiotic relationshipwith the Fed resembles that of Fox Newswith the Obama administration, orinan earlier erathat of the Chicago Tribunewith the Purple Gang. Grants needs theFed even if the Fed doesnt need Grants.

In the not quite 100 years since thefounding of your institution, America hasexchanged central banking for a kind ofcentral planning and the gold standardfor what I will call the Ph.D. standard. Iregret the changes and will propose re-forms, or, I suppose, re-reforms, as myprogram is very much in accord with thatof the founders of this institution. Haveyou ever read the Federal Reserve Act?The authorizing legislation projected a

much care for the Fed raising up stock

prices under the theory of the portfoliobalance channel.

It enflamed him that during congres-sional debate over the Federal ReserveAct, Elihu Root, Republican senatorfrom New York, impugned the antici-pated Federal Reserve notes as fiatcurrency. Fiat, indeed! Glass snorted.The nation was on the gold standard.It would remain on the gold standard,Glass had no reason to doubt. The pro-

jected notes of the Federal Reservewouldof coursebe convertible intogold on demand at the fixed statutoryrate of $20.67 per ounce. But more stoodbehind the notes than gold. They wouldbe collateralized, as well, by sound com-mercial assets, by the issuing member

body to provide for the establishment

of the Federal Reserve banks, to furnishan elastic currency, to afford means ofrediscounting commercial paper and toestablish a more effective supervisionof banking in the United States, and forother purposes. By now can we iden-tify the operative phrase? Of course: forother purposes.

You are lucky, if I may say so, that Imthe one whos standing here and not theghost of Sen. Carter Glass. One hesitatesto speak for the dead, but I am reasonablysure that the Virginia Democrat, who re-garded himself as the father of the Fed,would skewer you. He had an abhor-rence of paper money and governmentdebt. He didnt like Wall Street, either,and Im going to guess that he wouldnt

Piece of my mind

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U.S. current account balance as percentage of GDP (left scale)vs. gold price (right scale)

source: The Bloomberg

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Dec. 31,gold price:$1,563.70

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account balance:

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article-GRANTS/MARCH 23, 2012 2

bank anda point to which I will re-turnby the so-called double liabilityof the issuing banks stockholders.

If Glass had the stronger argument,Root had the clearer vision. One canthink of the original Federal Reservenote as a kind of derivative. It derived

its value chiefly from gold, into which itwas lawfully exchangeable. Now that theFederal Reserve note is exchangeableinto nothing except small change, it is aderivative without an underlier. Or, at astretch, one might say it is a derivativethat secures its value from the wisdom ofCongress and the foresight and judgmentof the monetary scholars at the FederalReserve. Either way, we would seem tobe in dangerous, uncharted waters.

As you prepare to mark the Feds cen-tenary, may I urge you to reflect on justhow far you have wandered from the

intentions of the founders? The institu-tion they envisioned would operate pas-sively, through the discount window. Itwould not create credit but rather liquefythe existing stock of credit by turninggood-quality commercial bills into cashtemporarily. This it would do accordingto the demands of the seasons and thecycle. The Fed would respond to thecommunity, not try to anticipate or leadit. It would not override the price mecha-nismas todays Fed seems to do at ev-ery available opportunitybut yield to it.

My favorite exposition of the sound,original doctrines is a book entitled, TheTheory and Practice of Central Bank-ing, by H. Parker Willis, first secretaryof the Federal Reserve Board and Glasssright-hand man in the House of Repre-sentatives. Writing in the mid-1930s, Wil-lis pointed out that the Fed fell into sinalmost immediately after it opened forbusiness in 1914. In 1917, after the UnitedStates entered the Great War, the Fedset about monetizing the Treasurys debtand suppressing the Treasurys borrowingcosts. In the 1920s, after the recovery fromthe short but ugly depression of 1920-21,the Fed started to implement open-mar-ket operations to sterilize gold flows andsteer a desired macroeconomic course.

Central banks, wrote Willis, glaringat the innovators, will do wisely tolay aside their inexpert ventures in half-baked monetary theory, meretriciousstatistical measures of trade, and hastygrinding of the axes of speculative inter-ests with their suggestion that by doingso they are achieving some sort of vaguestabilization that will, in the long run, befor the greater good.

Willis, who died in 1937, perhaps of abroken heart, would be no happier withyou today than Glass would beor Iam. The search for some sort of vaguestabilization in the 1930s has become aFederal Reserve obsession at the millen-nium. Ladies and gentlemen, such sta-bility as might be imposed on a dynamiccapitalist economy is the kind that even-tually comes around to bite the stabilizer.

Price stability is a case in point. It isyour mandate, or half of your mandate,I realize, but it does grievous harm, asdefined. For reasons you never exactlyspell out, you pledge to resist deflation.You wont put up with it, you keep onsayingsomething about Japans lostdecade or the Great Depression. Butyou never say what deflation really is.Let me attempt a definition. Deflationis a derangement of debt, a symptom ofwhich is falling prices. In a credit crisis,when inventories become unfinanceable,merchandise is thrown on the market andprices fall. Thats deflation.

What deflation is not is a drop in pricescaused by a technology-enhanced de-cline in the costs of production. Thatscalled progress. Between 1875 and 1896,according to Milton Friedman and AnnaSchwartz, the American price level sub-sided at the average rate of 1.7% a year.And why not? As technology was advanc-ing, costs were tumbling. Long before

Joseph Schumpeter coined the phrasecreative destruction, the Americaneconomist David A. Wells, writing in1889, was explaining the consequencesof disruptive innovation.

In the last analysis, Wells proposes,it will appear that there is no such thingas fixed capital; there is nothing usefulthat is very old except the precious met-als, and life consists in the conversion offorces. The only capital which is of per-manent value is immaterialthe experi-ence of generations and the developmentof science.

Much the same sentiments, and muchthe same circumstances, apply today,but with a difference. Digital technologyand a globalized labor force have broughtdown production costs. But, the centralbankers declare, prices must not fall. Onthe contrary, they must rise by 2% a year.To engineer this up-creep, the Bernan-kes, the Kings, the Draghisand yes,sadly, even the Dudleysof the worldmonetize assets and push down interestrates. They do this to conquer deflation.

But note, please, that the suppressionof interest rates and the conjuring of li-quidity set in motion waves of specula-tive lending and borrowing. This artifi-cially induced activity serves to lift theprices of a favored class of assethouses,for instance, or Mitt Romneys portfolioof leveraged companies. And when thecentral bank-financed bubble bursts,credit contracts, leveraged businessesteeter, inventories are liquidated andprices weaken. In short, a process is set inmotion resembling a real deflation, whichthen calls forth a new bout of monetaryintervention. By trying to forestall animagined deflation, the Federal Reservecomes perilously close to instigating thereal thing.

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Federal Reserves total assets (left scale) vs. S&P 500 (right scale)

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The economist Hyman Minsky laiddown the paradox that stability is itselfdestabilizing. I say that the pledge of astable funds rate through the fourth quar-ter of 2014 is hugely destabilizing. Inter-est rates are prices. They convey informa-tion, or ought to. But the only information

conveyed in a manipulated yield curve iswhat the Fed wants. Opportunists donthave to be told twice how to respond.They buy oil or gold or foreign exchange,not incidentally pushing the price of a gal-lon of gasoline at the pump to $4 and be-yond. Another set of opportunists borrowshort and lend long in the credit markets.Not especially caring about the risk of in-flation over the long run, this speculativecohort will fund mortgages, junk bonds,Treasurys, what-have-you at zero per-cent in the short run. The opportunists,a.k.a. the 1 percent, will do fine. But what

about the uncomprehending others?I commend to the Federal Reserve

Bank of New York Financial HistoryBook Club (if it doesnt exist, please or-ganize it at once) a volume by the Brit-ish scholar and central banker, CharlesGoodhart. Its title is The New YorkMoney Market and the Finance ofTrade, 1900-1913. In the pre-Fed dayswith which the history deals, the callmoney rate dove and soared. There wasno stabilityand a good thing, Goodhartreasons. In a society predisposed to spec-ulate, as America was and is, he writes,unpredictable spikes in borrowing rateskept the players more or less honest. Onthe basis of its record, he writes of theSecond Federal Reserve District beforethere was a Federal Reserve, the finan-cial system as constituted in the years1900-1913 must be considered successfulto an extent rarely equaled in the UnitedStates. And that not withstanding thePanic of 1907.

My reading of history accords withGoodharts, though not with that of theFeds front office. If Chairman Bernan-ke were in the room, I would respect-fully ask him why this persistent harkingback to the Great Depression? It is onecyclical episode, but there are many oth-ers. I myself draw more instruction fromthe depression of 1920-21, a slump asugly and steep in its way as that of 1929-33, but with the simple and interestingdifference that it ended. Top to bottom,spring 1920 to summer 1921, nominalGDP fell by 23.9%, wholesale pricesby 40.8% and the CPI by 8.3%. Unem-ployment, as it was inexactly measured,topped out at about 14% from a pre-bust

low of as little as 2%. And how did the ad-ministration of Warren G. Harding meetthis macroeconomic calamity? Why, itbalanced the budget, the president de-claring in 1921, as the economy seemedto be falling apart, There is not a men-ace in the world today like that of grow-

ing public indebtedness and mountingpublic expenditures. And the fledglingFed, face to face with its first big slump,what did it do? Why, it tightened, push-ing up short rates in mid-depression toas high as 8.13% from a business cyclepeak of 6%. It was the one and onlytime in the history of this institution thatmoney rates at the trough of a cycle werehigher than rates at the peak, accordingto Allan Meltzer.

But then something wonderful hap-pened: Markets cleared, and a vibrantrecovery began. There were plenty

of bankruptcies and no few brickbatslaunched in the direction of the gov-ernor of the New York Fed, BenjaminStrong, for the deflation that cut anespecially wide and devastating swaththrough the American farm economy.But in 1922, the first full year of recov-ery, the Feds index of industrial pro-duction leapt by 27.3%. By 1923, theunemployment rate was back to 3.2%.The 1920s began to roar.

And do you know that the biggest na-tionally chartered bank to fail during thisdeflationary collapse was the First Na-tional Bank of Cleburne, Texas, with notquite $2.8 million of deposits? Even theforerunner to todays Citigroup remainedsolvent (though for Citi, even then it wasa close-run thing, on account of an over-size exposure to deflating Cuban sugarvalues). No TARP, no starving the sav-ers with zero-percent interest rates, noQE, no jimmying up the stock market,no federal stimulus of any kind. YetIrepeatthe depression ended. To thosetoday who demand ever more interven-tion to cure what ails us, I ask: Why didthe depression of 1920-21 ever end? Giv-en the policies with which the authoritiestreated it, why are we still not ensnared?

If you object to using the template of1920-21 as a guide to 21st-century policybecause, well, 1920 was a long time ago,I reply that 1929 was a long time ago, too.And if you persist in objecting becausethe lessons to be derived from the Hard-ing depression are unthinkably at oddswith the lessons so familiarly mined fromthe Hoover and Roosevelt depression, Ireply that Hardings approach worked.The price mechanism is truer and enter-

prise hardier than the promoters of radical21st-century intervention seem preparedto acknowledge.

In notable contrast to the Hardingmethod, todays policies seem not to beworking. We legislate and regulate andintervene, but still the patient languishes.

Its a worldwide failure of the institutionsof money and credit. I see in the papersthat Banca Monte dei Paschi di Siena is inthe toils of a debt crisis. For the first timein over 500 years, the foundation thatcontrols this ancient Italian institutionmay be forced to sell shares. Weve allheard of hundred-year floods. We seemto be in a kind of 500-year debt flood.

Many now call for more regulationmore such institutions as the Treasurysbrand-new Office of Financial Research,for instance. In the March 8 FinancialTimes, the columnist Gillian Tett ap-

pealed for more resources for the over-whelmed regulators. Inundated withinformation, she lamented, they cantkeep up with the institutions they aresupposed to be safeguarding. To me,the trouble is not that the regulators areignorant. Its rather that the owners andmanagers are unaccountable.

Once upon a timespecifically, be-tween the National Banking Act of 1863and the Banking Act of 1935the im-pairment or bankruptcy of a nationallychartered bank triggered a capital call.Not on the taxpayers, but on the stock-holders. It was their bank, after all. Indi-vidual accountability in banking was therule in the advanced economies. HartleyWithers, the editor of The Economist inthe early 20th century, shook his headat the micromanagement of Americanbanks by the Office of the Comptrol-ler of the Currency25% of their de-posits had to be kept in cash, i.e., goldor money lawfully convertible into gold.The rules held. Yet New York had pan-ics, London had none. Adjured Withers:Good banking is produced not by goodlaws but by good bankers.

Well said, Withers! And what makes agood banker is more than skill. It is alsothe fear of God, or, more specifically, ac-countability for the solvency of the insti-tution that he or she owns or manages. Tostay out of trouble, the general partners ofBrown Brothers Harriman, Wall Streetsoldest surviving general partnership, needno regulatory pep talk. Each partner is li-able for the debts of the firm to the full ex-tent of his or her net worth. My colleaguePaul Isaac, who is with me todayhedoubles as my food and beverage taster


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has an intriguing suggestion for instillingthe credit culture more deeply in oursemi-socialized banking institutions.

We cant turn limited liability corpora-tions into general partnerships. Nor couldwe easily reinstate the so-called doubleliability law on bank stockholders. But

what we could and should do, Paul urges,is to claw back that portion of the com-pensation paid out by a failed bank inexcess of 10 times the average wage inmanufacturing for the seven full calendaryears before the ruined bank hit the wall.Such a clawback would not be subject toaveraging or offset one year to the next.And it would be payable in cash.

The idea, Paul explains, is twofold.First, to remove the government from thebusiness of determining what is, or is not,riskyreally, the government doesntknow. Second, to increase the personal

risk of failure for senior management, butstopping short of the sword of Damoclesof unlimited personal liability. If bankersare venal, why not harness that venalityin the public interest? For the better partof 100 years, and especially in the pastfive, we have socialized the risks of highfinance. All too often, the bankers whotake risks dont themselves bear them.By all means, let the capitalists keep theupside. But let them bear their full shareof the downside.

In March 2009, the Financial Timespublished a letter to the editor concern-ing the then novel subject of QE. I cannow understand the term quantitativeeasing, wrote Gerald B. Hill of Stour-bridge, West Midlands, but . . . realize Ican no longer understand the meaning ofthe word money.

There isnt time, in these brief re-marks, to persuade you of the necessityof a return to the classical gold standard. Iwould need another 10 minutes, at least.But I anticipate some skepticism. Verywell then, consider this fact: On March 27,1973, not quite 39 years ago, the forerun-ner to todays G-20 solemnly agreed thatthe special drawing right, a.k.a. SDR, willbecome the principal reserve asset and therole of gold and reserve currencies will bereduced. That was the establishmenti.e., youtalking. If a worldwide accordon the efficacy of the SDR is possible, allthings are possible, including a return tothe least imperfect international monetarystandard that has ever worked.

Notice, I do not say the perfect mon-etary system or best monetary systemever dreamt up by a theoretical econo-mist. The classical gold standard, 1879-1914, with all its anomalies and excep-tions . . . worked. The quoted words Idraw from a book entitled, The Rules

of the Game: Reform and Evolution inthe International Monetary System, byKenneth W. Dam, a law professor andformer provost of the University of Chi-cago. Dams was a grudging admiration, alittle like that of the New York Feds ownArthur Bloomfield, whose 1959 mono-graph, Monetary Policy under the Inter-national Gold Standard, was publishedby yourselves. No, Bloomfield points out,as does Dam, the classical gold standardwas not quite automatic. But it was syn-chronous, it was self-correcting and it diddeliver both national solvency and, over

the long run, uncanny price stability. Thebanks were solvent, too, even the centralbanks, which, as Bloomfield noted, mon-etized no government debt.

The visible hallmark of the classicalgold standard was, of course, goldtoevery currency holder was given theoption of exchanging metal for paper,or paper for metal, at a fixed, statutoryrate. Exchange rates were fixed, and Imean fixed. It is quite remarkable,Dam writes, that from 1879 to 1914, ina period considerably longer than from1945 to the demise of Bretton Woodsin 1971, there were no changes of pari-ties between the United States, Britain,France, Germanynot to speak of anumber of smaller European coun-tries. The fruits of this fixedness weremany and sweet. Among them, againto quote Dam, a flow of private for-eign investment on a scale the worldhad never seen, and, relative to othereconomic aggregates, was never to seeagain. Incidentally, the source of mypurchased copy of Rules of the Gamewas the library of the Federal ReserveBank of Atlanta. Apparently, PresidentLockhart isnt preparing, as I amas,may I suggest, as you should beforthe coming of classical gold standard,Part II. By way of preparation, I com-mend to you a new book by my friendLew Lehrman, The True Gold Stan-dard: A Monetary Reform Plan withoutOfficial Reserve Currencies: How WeGet from Here to There.

Its a little rich, my extolling gold toan institution that sits on 216 million troyounces of the stuff. Valued at $42.222per ounce, the hoard in your basement isworth $9.1 billion. Incidentally, the offi-cial price was quoted in SDRs, $35 to theouncenow theres a quixotic choice for

you. In 2008, when your in-house publica-tion, The Key to the Gold Vault, waspublished, the market value was $194billion. Today, the market value is $359billion, which is encouraging only if youpersonally happen to be long gold bullion.Otherwise, it strikes me as a pretty severecondemnation of modern central banking.

And what would I do if, following theinauguration of Ron Paul, I were sittingin the chairmans office? I would do whatI could to begin the normalization of in-terest rates. I would invite the Wall StreetJournals Jon Hilsenrath to lunch to let

him know that the Fed is now well overits deflation phobia and has put asideits Atlas complex. Its capitalism forus, Jon, I would say. Next I would callPresident Dudley. Bill, I would say,pleasantly, were not exactly leadingfrom the front in the regulatory drive toreduce the ratio of assets to equity at thebig American financial institutions. Doyou have to be leveraged 89:1? Finally, Iwould redirect the efforts of the brainiacsat the Federal Reserve Board research di-vision. Ladies and gentlemen, I wouldsay, enough with Bayesian Analysis ofStochastic Volatility Models with Levy

Jumps: Application to Risk Analysis.How much better it would please me ifyou wrote to the subject, Command andControl No More: A Gold Standard forthe 21st Century. Finally, my pice dersistance, I would commission, staff andceremonially open the Feds first Officeof Unintended Consequences.

Let me thank you once more for thehonor that your invitation does me. Con-cerning little Grants and the big Fed, Iwill quote in parting the opening sen-tences of an editorial that appeared in aprovincial Irish newspaper in the fatefulyear 1914. It read: We give this solemnwarning to Kaiser Wilhelm*: The Skibber-een Eaglehas its eye on you.

*On further review, the editorial appeared inTheSkibbereen Eagles pages in 1899. TheEagle

directed its warning towards the Czar of Russia.

Copyright 2012 Grants Financial Publishing Inc. All rights reserved.

Grants and Grants Interest Rate Observer are registered trademarks of Grants Financial Publishing, Inc.

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