Picking the Market’s Pocket Again

July 12, 2005 – Alan Greenspan gets blamed for many things. You know the usual drill – interest rates are too high, inflation is getting worse, the economy is not creating enough jobs, etc. Whether this blame is appropriate or not, who really knows.

Frankly, I think focusing on what Alan Greenspan should or should not be doing is hopelessly misguided because it misses the big picture that should be worrying to all of us. Namely, the US is relentlessly becoming a command economy that increasingly is being forced to respond to the various strings being pulled by our monetary politburo, the Federal Reserve. As the man in charge, I hold Commissar Greenspan responsible for this sad state of affairs.

What’s worse, a pernicious doctrine has been introduced during his watch. Whether he is the creator of this doctrine, I don’t know. But because it appeared on his watch and he has used it to accomplish his politburo’s goals, I hold Commissar Greenspan responsible. It is the harmful doctrine that allows governments to intervene in markets in order to pick the market’s pocket. Before explaining how it works, here’s some background information.

Shortly after Greenspan was appointed to head up the Federal Reserve in August 1987, the stock market crashed. The crash created uncertainty, which slowed the economy and in turn worsened the ‘savings & loan’ crisis that had been brewing for a few years. The collapse of countless S&L’s had softened the real estate market because many of the loans the S&Ls had made to build houses and office buildings turned out to be bad and uncollectible. These buildings had no immediate use, so they were sold for whatever price they could fetch – normally at bargain basement prices.

Given this glut of inventory and the volume of distressed selling, real estate prices nationwide then pretty much went into a bear market, and the knock-on effect was eventually felt by commercial banks. By 1990, giants like Citibank were essentially insolvent, and it looked like they in turn were going to need a taxpayer bailout like the one the S&Ls had received only a few years before.

However, taxpayer bailouts are never popular, and another one seemed politically impossible – the cost of the S&L fiasco was becoming all too apparent, and the public had become sickened by the management corruption and incompetence that led to the collapse of so many S&Ls.

So Greenspan was faced with a dilemma. How do you save Citibank and other big banks from collapsing when a taxpayer bailout was not possible? It was here when the Federal Reserve started to pick taxpayers’ pockets.

The Fed dropped short-term interest rates to artificially low levels, but it kept medium term rates relatively high. To take advantage of this widening spread, Citibank and other banks borrowed huge amounts of short-term funds at relatively low interest rates, and then invested this money in relatively high interest rate US government notes and bonds, earning the huge profits available from the spread between these assets and liabilities.

In time all the banks strapped on this feedbag, and within a few years their capital positions were replenished, even after allowing for all of the bad real estate loans they had to write off. In effect, the banks were bailed out in a hidden way. Taxpayers paid for the bailout, but not one in a million Americans realized that they had their pocket picked by having their taxes used to pay excessively high interest rates on US government notes and bonds. What’s worse, this form of pocket picking has led to another equally pernicious form of theft, where the feds are now picking the market’s pocket.

I have written before at length about the gold cartel. This group consists of a handful of bullion banks that work together with governments to try keeping a lid on the gold price. These bullion banks execute the trades requested by governments and their captive central banks, and the problem for these bullion banks and their government handlers is that they are facing huge losses on the short positions they carry. So how do these banks get bailed out?

The Federal Reserve cannot ask for a politically impossible taxpayer bailout, and the Federal Reserve is not going to manipulate interest rate spreads again like it did fifteen years ago because only a few bullion banks are in trouble, and not the majority of the banking industry. So the bailout must be focused exclusively on bullion so that the bullion banks will benefit from it without adversely affecting other banks.

The scheme that the Federal Reserve is using takes advantage of ‘black-box’ traders. These traders manage vast amounts of money using supposedly proprietary mathematical formulas. The key point though is that these formulas are all very much alike, which is logical. They all try to track gold’s change in trend, so when the trend changes, these traders tend to all jump on board at pretty much the same time. So under this scheme, if the gold cartel can force these traders to buy and sell at disadvantageous moments, and the gold cartel is on the winning side of the trade, the profits generated from the winning trades can be used to bailout the bullion banks participating in this scheme.

We have seen this scheme in practice over the past several years, and the way the market traded over the last couple of months provides a particularly good example of it. When gold was trading in the $430’s and $440’s in March and April, the gold cartel was selling everything the black-box traders were buying. Eventually the weight of gold cartel selling outstripped this buying and in time forced gold down into the $420 area, helped of course by incessant anti-gold propaganda (for example, Gordon Brown talking about IMF gold sales) and the huge build-up in gold derivatives.

As a result, the black-box traders went from long to short, taking huge losses by selling in the 420’s or lower what they had bought from the gold cartel in the $430’s and $440’s. At the same time, the gold cartel was making huge profits by buying back in the $420’s or lower the short positions that had been put on in the $440’s and $430’s. See how the scheme works? It’s absolutely diabolical, but it will come to an end.

The reason is that governments do not possess enough physical gold to keep gold as cheap as it is today. People are increasingly fleeing national currencies and seeking the safety and security of gold, just like they did in the 1960’s and early 1970’s when the US government dishoarded 10,000 tonnes of gold from Ft. Knox in a vain and hopeless attempt to keep gold at $35 per ounce. They failed then, and they are failing again today. Gold will keep climbing, even though governments will continue trying to disrupt the gold market and its message.

The greatest economist of the 20^th century, Ludwig von Mises, warned us about governments and the havoc they can wreak on markets and the economy. In fact, we should take Mises’s warning to heart, that governments will destroy free markets long before they ever understand how they work. The longer we have a Federal Reserve intervening willy-nilly in various markets, the sooner Mises will be proven right.