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Devil in the details

By Daniel M. Ryan
web posted January 10, 2011

You can always tell a political idea that's a comer: it splits into two versions, one tailored to the Right and the other to the Left. New ideas, which propose a deep change or reform of the system, tend to be left on the fringes if there's only one version that appeals to one side. An example of an idea that only has reach on one side is drug decriminalization. Apart from stoners tired of the outlaw life, and principled libertarians, the only people who look kindly on ending the War on Drugs are civil libertarians. Except for libertarians, who aren't that numerous, the likely supporters are all liberal types – left-liberal. That one-sidedness shows in the favourite tactic of the pro-drug circuit: exposing one Drug Warrior or another as a "hypocrite." This technique is part of the standard liberal mau-mauing of the Right. In part consequently, there's a lot of support for the War on Drugs in conservative ranks. There's no conservative group of any impact has taken decriminalization under its wings. Consequently, there's no case for decriminalization that appeals to conservatives – none. Had it not been for the medical-marijuana issue, even marijuana decriminalization would have been confined to libertarian and moonbat land. Note that there's no visible support for decriminalization of LSD-25, even though "Delysid" was legal in the United States until 1966.

Because there aren't two versions of end-the-Drug-War on both side of the spectrum, that reform idea isn't a comer. In contrast, there is one that has both a liberal and conservative version; the two variants of it appeal to Right and Left. The idea is: monetary reform, or End the Fed.

The right-wing variant is championed by Rep. Ron Paul of Texas. He wants to repeal the legal tender laws, and let the chips fall where they may. Needless to say, he much prefers bank bankruptcy to bailouts. This version appeals to the conservative mindset because there's something un-conservative, something anti-cloth-coat, about special provisions for banks. Given earlier Wall Street support for Obama, it's not hard to cast the bailout beneficiaries as limousine liberals. Also, Rep Paul's stand speaks to the respect for self-reliance in conservative ranks, and to distaste for inflation.

The left-wing version is championed by Rep. Dennis Kucinich; it's the National Emergency Employment Defense Act [the NEED act] of 2010. It proposes to end the independence of the Fed by bringing it into the Treasury through a new Monetary Authority board. As Robert Wenzel noted in his criticism of it, this bill would give Congress the power to expand the money supply. If Rep. Kucinich's object was to frighten the bourgeois, he succeeded with Mr. Wenzel.

The left-wing nature of the bill is clear from the second section of it. A lot of the NEED Act's "Findings and Purposes" consist of economic-liberal talking points.

Yet therein are three goals that would normally be associated with the out-of-the-mainstream Right: paying off the national debt; restricting Treasury borrowing; ending fractional-reserve banking. These three, particularly the last, are not exactly conventional liberal goals; they're hard-core libertarian ones. How did Rep Kucinich fit these goals into a left-liberal template?

With the help of a movement called "Greenbackers." Represented nowadays by Ellen Hodgson Brown, modern Greenbackers decry what they call "private money:" banks creating money through the fractional-reserve system in the form of credit. They believe that this feature of the current monetary system is an execrable privilege of bankers, which has hung a millstone of debt around the people and government. Greenbackers want what they call "debt-free money:" fiat money created by the federal government directly. They believe that only the Treasury or Congress – the latter in Rep. Kucinich's bill – should have the privilege of adding to the money supply. Like the hard-core libertarians, Greenbackers want an end to fractional-reserve banking. Unlike the hard-core libertarians, Greenbackers have no use for a gold standard. They prefer government-created money, by a method they consider to supply accountability to the people. Like Ron Paul and his supporters, they want the Fed as central bank to be abolished. Unlike the Ron Paul crew, they want the government to have the right to issue new currency to pay for social programs, infrastructure programs, etc.

The NEED Act is carefully crafted, as is often the case with controversial bills. It does recognize the problem of inflation, and requires the Monetary Authority to set money-growth targets and monitor the economic impact of newly-created money. Section 302 (a) (5) says, quite explicitly:

The Monetary Authority shall pursue a monetary policy based on the governing principle that the supply of money in circulation should not become inflationary nor deflationary in and of itself, but will be sufficient to allow goods and services to move freely in trade in a balanced manner. The Monetary Authority shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

If the money supply grows more (or less) than 0.5% above the target range, the Treasury Secretary has to go to Congress to explain why. That stricture is enough to make critics like Mr. Wenzel look like apologists for the central bank - or people who didn't read very carefully.

I have to credit Rep. Kucinich for putting forth a carefully-crafted bill. In it, the basic mechanism of inflation is for Congress to run a deficit, or to appropriate additional funds that the Treasury would have to create and issue.

On the face of it, given that the Treasury Secretary has notify Congress about any over-the-target monetary expansion, this bill isn't inherently hyperinflationary. If a too-high inflation rate gets average voters angry, they'll holler at their Representatives and Senators to get Congress to cool it. If the holler is strong enough, then Congress will cool it down eventually. One of the reasons why Ronald Reagan came from behind in 1980 was public anger over double-digit inflation: it was part of his "Misery Index."

Given those controls, anyone who looks at it and yells "Hyperinflation!" has a burden of proof to shoulder, else (s)he'll look like a fuddy-duddy or central-bank apologist.

Unfortunately for Rep. Kucinich and his supporters, that burden can be met. There will be hollering, but in the opposite direction. That's because of one wallflowerish section of the bill that contains the enabling mechanism for a real hyperinflation.

"Cheaper Dollars."

It's not grants to the States in and of themselves that are the trouble; those are capped at no more than 25% of the amount of United States Dollars created in the prior year. The States are required to spend it on "broadly designated areas of public infrastructure, education, health care and rehabilitation, pensions, and paying for unfunded Federal mandates." They don't get to do what they like with it.

No, the seed of hyperinflation is in wallflowerish Section 502.

(a) Limit on Amount of Financing Fees- The total amount of interest charged by a financial institution on any extension of loans (other than a mortgage) to any individual borrower through amortization, including all fees and service charges, shall not exceed the total amount of the loan extended.
(b) Limit on Rate- The annual percentage rate applicable to any loan of money may not exceed 8 percent on unpaid balances, inclusive of all charges

Apart from obliging credit card issuers to turn credit cards into term loans, so as not to breach 502 (a), this provision bans lending at above an 8% annual rate – a nominal rate of 8%.

Which brings up the obvious question: what if inflation goes up above 8%, and Congress doesn't mind?

There's only one way for the loan market not to be shut down in consequence: the banks lending at 8% have to borrow at less than 8%. If inflation reaches double digits, there's next to no chance the banks can get that rate from the general public. Market forces, not to mention savers' anger at being eaten away by inflation, mean that the Treasury has to step in and loan to the banks. Section 402 (e) (2) authorizes the Treasury, through the Monetary Authority, to grant loans at interest to banks. If the Monetary Authority wants the credit markets to stay alive should high inflation militate against lending to banks even at 7%, it will have to get the Treasury to loan the funds. If the Revolving Fund is empty, such funds would have to be authorized by Congress. If Congress goes for it, then the banks can lend at negative real interest rates without them worrying about how they'll stay alive.

And therein lies the diabolic detail. That interest-rate control will make high inflation popular.

Why? Because every Joey with a job and a COLA, or any other source of income with a COLA, or with pricing power that matches a COLA, can win by borrowing if CPI inflation is above 8%. It's called paying back with cheaper dollars. And the higher inflation is, the more the borrower wins by doing so.

Consider this example. Joey X makes $40,000 per year after taxes. If inflation goes up 10% each year, and Joey's income keeps pace, Joey makes $44,000 next year, $48,400 the year after, and so on. If Joey loads up with a $200,000 25-year mortgage with a fixed rate of 8%, the monthly payment comes to $1,526. That's a yearly burden of $18,312, which is pretty onerous in year one. [For simplicity’s sake, I’m assuming that mortgage interest is no longer tax-deductible, and student loans aren't onerous. I'm also assuming mortgages with next-to-nothing down payments are available. Calculations courtesy of this mortgage calculator.] But what about three years in the future, when Joey's salary is $53,240? Granted that average expenses would have gone up more than 31% in the same timeframe, but the huge mortgage expense will not have. In the first year, Joey X has only $21,688 left over for everything else. In the fourth year, after three years of 10% inflation and assuming no bracket creep, Joey will have $34,928 left over assuming no bracket creep. That's a 61% increase in post-mortgage take-home pay, which is more than enough to meet a CPI increase of 33.1% in the same time.

So, thanks to that interest-rate cap, Joey gains from inflation by borrowing and paying back with cheaper dollars. All the Joeys will either know it in advance or be told of it.

Look at the numbers for 20% inflation. Joey Y earns $50,000 after taxes, and has a full COLA. More daringly than Joey X, Joey Y loads up with a $400,000 25-year fixed-rate mortgage that requires a monthly payment of $3,053 or $36,636.  This leaves Joey Y with only $13,364 in the first year to live on. For the first year or two, Joey Y's stuck with riding a bike and eating ramen. But look what happens after three years: Joey Y's income is now $86,400. Assuming no bracket creep, Joey Y's after-tax post-mortgage income has shot up to $49,764 and grown by 372%. That's more than enough to keep pace with a CPI increase of 72.8% in the same timeframe. By year four, Joey Y will have enough wherewithal to buy a nice car – perhaps two – and make a second home out of Whole Foods. Not to mention upgrading to new furniture.  

Even the poor can play. Joey Z has an after-tax income of $20,000 and has a COLA too. Inflation is 15% per year. Joey Z sees the way the wind is blowing, and applies for a twelve-year credit loan at 8%. Rent, ramen-level food and other necessary expenses set Joey back $1,000 per month, or $12,000 per year. This figure doesn't represent Joey Z's normal expenditures, but the rock-bottom minimum. No movies, no eating out, no clubbing, basic phone, dial-up internet, basic cable and a old TV. Minimal cell phone use, which puts a real crimp in the old social life. Used DVDs and used games for alternate entertainment. Perhaps Joey Z will discover the retro world of VCR and VHS tapes to save even more on entertainment.

Since $20,000 doesn't go far and a credit loan in unsecured, Joey Z gets only $10,000 authorized at first. The monthly payment for amortization over twelve years at 8% is $108 per month, or $1,296 per year. Joey Z begs and begs, showing how he could live at $1,000 a month, and the loan officer take pity and ups the loan to $25,000. It doesn't matter to the bank, because the funds will come from the feds at (say) 7%. The 1% margin means that the bank needs all the loan volume it can get. All that matters is if Joey can pay it back.

$25,000 over 12 years at 8% means a monthly payment of $269, or $3228 per year. Joey Z doesn't have to tighten his belt by all that much after all. With the money, he goes to the Internet (keeping his light DSL service after all) and buys $25,000 worth of silver. His after-tax post-loan income is $16,772.

In the first year, it's a struggle; Joey Z even cuts back on his cell phone for that year. By the fourth year, he's got his life back. His income is now $30,417.50. The payments are still $3228, which is a drag, but his after-tax post-loan income has gone up to $27,189.50 or 62% higher than in the first year. The CPI has gone up 52% in the same timeframe. Joey Z isn't much better off, but he has gained. He also has a hoard of silver that'll be worth considerably more than $25,000.

What should be evident from these three examples are the big gainers: the salaried middle and upper-middle classes. In order for them to play Borrow-And-Win, there has to be double-digit inflation and an accommodating Congress. All the Joeys using United States Money will move heaven and earth to make sure that Congress is accommodating.

Yes, there would be a real estate bubble – and a tangible-goods bubble, and a monster bubble in precious metals. What every beneficiary of then knows is, they all have a vested interest in double-digit inflation once they load up with loans. Given that fixed-interest loophole, what do you think "The People" will be demanding?

Actually, every Joey has an even bigger vested interest in triple-digit inflation, and even more in quadruple-digit inflation. In order for Congress to clamp down, the elected representatives and Senators will have to clamp down on "the people." Unlike with Social Security, adults of all age groups will have a vested interest in seeing the inflation engine rev up. It would make for a formidable third rail.

The combination of maximum-rate loans and Congressional control, and the consequent middle-class subsidy through borrowing once inflation hits double digits, will make higher inflation all-but impossible to control once the double-digit threshold is reached. There's no brake to the system. The only means of restraint will be Congress, because market forces will be ablated by law. There won't be any federal debt to speak of, because it will have all been paid down with newly-created United States Dollars. (Sec's 106, 107.) A hard interest-rate ceiling will be in effect, and Congress will have to keep voting additional appropriations to lend to the banks. Doing otherwise will make "Sorry, No Credit" a national slogan. There'll be a huge constituency in favour of keeping the inflation machine rolling once the word gets out. The banks will be part of that constituency, because they won't get paid back if the inflation bubble bursts.

There's no other way this experiment can end except through hyperinflation. The reason is the borrower-beneficiaries, the gleeful beneficiaries of the bubbles, can successfully petition Congress to keep the bubble going. In the now-burst real estate bubble of last decade, they couldn't.   

"For want of a nail…the kingdom was lost." Sect. 502 of Rep. Kuchnich's bill is that nail. Once the double-digit-inflation threshold is reached, there's no turning back from all-out destruction of United States Money. There's no inevitable procession to double-digit inflation if the NEED act become law, but once that line is crossed there's no going back.

And I haven't even mentioned the earmark crew in Congress, who would become quite used to running up deficits that "don't matter" because they'll be paid for by "free money." Even the provision to create enough money to retire all U.S. Federal debt might be enough to get the inflation avalanche rolling…to turn the NEED Act's United States Money into "USD-25." ESR

Daniel M. Ryan is currently watching the gold market. He can be reached at danielmryan@primus.ca.

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