Are Central Banks Killing The Golden Goose?

Are central banks a good thing, or a bad thing? The truth is both!

Let’s go back in history to see the truth about this matter.

The Industrial Revolution was clearly led by Great Britain from the late 1700s. That country industrialized faster and urbanized first before all other nations.

It was a highly innovative island country (centuries later, Japan would follow in their footsteps) and it had high resources of coal and iron ore — the key raw material for the up-and-coming industrial revolution that was accelerated by the steam engine.

But it also saw major innovations in agriculture. That forward movement freed up its workforce and made it possible to expand into the industry due to the higher productivity in farming. It was the advent of things like the four-crop system of rotation; radically better seeding development and techniques, as well as major improvements in animal breeding.

But there was more to Britain’s early success that made them the greatest and most powerful nation going into World War I… they developed the financial infrastructures needed for massive investment and urbanization.

In 1601, England established maritime insurance (later evolving into Lloyd’s of London) and not a century later, they created the London Stock Exchange in 1698. Limited liability corporations emerged to make investment less risky. But there was something else…

The Bank of England was chartered in 1694. It was to be the banker’s banker, like the Federal Reserve of today.

It became the byword for safety and stability in Europe. This allowed for a great market for its bonds so that capital was easier and more efficient to raise at lower rates. It was yet, another advantage for the capitalistic and industrial revolution that was just ahead.

During the same time frame, John Law brought the first central bank to France. But this major advantage soon turned into a secret flaw.

Both central banks not only used their power to lower short-term volatility in interest rates and economic cycles – as the Fed does today – but they created greater volatility down the road by manipulating their economies and not allowing shorter-term resets in the boom and bust and inflation/deflation cycles.

Even worse, France and England had massive debts from decades of war between the two countries. The Bank of England chose to market the South Sea Company to investors to raise money to pay off those debts.

John Law in France chose to market some newly acquired swamp land in the Mississippi territory to investors in order to raise money… both at attractive prices and low government-guaranteed interest rates to finance.

These first central banks financed speculation at low government-backed interest rates loans from money created out of thin air! Does that sound familiar?

What was the result? It was the first great stock crash in modern history from 1720 to 1722 in the chart below from the South Sea Bubble in England.

southsea bubble

 

Since this was the first major stock bubble, it was most extreme, as investors had never experienced such a thing! Not since the great tulip bubble that came about in a narrower scheme in the mid-1600s.

Stocks didn’t recover from this bubble and didn’t begin climbing up again until the late 1780s – a 67-year bear market – and it happened just as the first efficient steam engine hit and the great Industrial Revolution took off, led by Great Britain, followed by France and the rest of Western Europe.

The Fed was chartered in 1913 in order to combat the volatility in the economy and in the interest rates. This move led to a lessening in volatility until the early 1920s and 1930s when two great deflationary bubbles burst and the subsequent crashes occurred.

The lessons here can be brought up in two points:

  1. Central banks almost always increase longer-term volatility, as they tend to stimulate so they can counter downturns. This move prevents the natural rebalancing in the short-term picture. This only creates greater imbalances from the debt and financial asset bubbles that lead to even greater depressions and financial crises when things finally go wrong… i.e., the 1720s, 1930s and the one on our horizon.
  2. Central banks are necessary to provide credibility for any nation and its currency. It allows for the necessary short-term liquidity in financial crises and brings much-needed confidence and… an even greater stability, just as Great Britain first demonstrated.

The key to all of this is central bank policy that promotes point No. 2 above and not No. 1.

Today, central banks are, more than any time in history, preventing the natural cycles and rebalancing of the free market system, while simultaneously eroding the confidence that they’re supposed to provide for stability and short-term liquidity.

When a crisis first sets in, it’s OK to flood the economy with free money for a short period of time… it keeps it under control. And you don’t get the kind of crisis that makes a mountain out of a molehill, right?

On the other hand, it’s not OK to have an endless policy of printing such a colossal amount of free money that it only creates profitable and irresponsible speculation versus productive investment. It also prevents the restructuring of debt and financial asset prices for future prosperity again – and a much needed and necessary great reset!

This is what I call “killing the golden goose” and David Stockman calls it “the corruption of capitalism.”

There is no way that six years of unprecedented money printing will work out well. In fact, it can only end in an even greater depression and financial crisis… so be forewarned!

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Harry

P.S. Follow me on Twitter @harrydentjr.

Categories: Banking

About Author

Harry studied economics in college in the ’70s, but found it vague and inconclusive. He became so disillusioned by the state of the profession that he turned his back on it. Instead, he threw himself into the burgeoning New Science of Finance, which married economic research and market research and encompassed identifying and studying demographic trends, business cycles, consumers’ purchasing power and many, many other trends that empowered him to forecast economic and market changes.