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Economics

Money and Oil

By from the December 2012 - January 2013 issue

One hundred years of monetary disorder.

“The problems that exist in the world today cannot be solved by the level of thinking that created them.”
– Albert Einstein

EVERY DAY WE WAKE UP hoping for good economic news: lower unemployment numbers, more jobs created, stronger growth. But we miss the forest for the trees. Our markets, for the past 100 years, have been engulfed in perennial financial crises.

Many of these crises have been associated with major Federal Reserve credit expansions and contractions. Upon examination, these volatile market episodes almost always lead to major moves in non-durable commodities, primarily oil and food.

But first, some historical background.

How do we mark the onset of the age of financial disorder, or, if you will, the Age of Inflation? The starting point was the volcanic eruption in 1914 at the epicenter of the Western world. World War I brought to an end the preeminence of the classical European states system; it decimated the flower of European youth; it destroyed the European continent’s industrial primacy, making Europe a debtor and America a creditor. The classical gold standard was suspended everywhere by the belligerents. The monetary gyroscope of the Industrial Revolution collapsed along with the world trading system into the anarchy of total war.

To interpret the financial events associated with the Great War —and their effect on the ensuing hundred years—let us highlight two crucial occasions of 1913: the establishment of the Federal Reserve system and the publication by the young John Maynard Keynes of his book Indian Currency and Finance. Neither event by itself would probably have created a barrier to resumption of the long period of monetary stability and economic growth under the prewar classical gold standard. But the inauguration of the Federal Reserve and the monetary ideas of Keynes, taken together, created the perfect storm.

As originally conceived, the Federal Reserve system, a government-dominated central bank, was designed to strengthen American participation in the classical international gold standard, even while making the U.S. currency and banking system more “elastic,” so it would be able to deal with crises like the panic of 1907. As the lender of last resort, the Fed was also tasked with issuing Federal Reserve notes and commercial bank deposits against collateral convertible on demand into gold. (By collateral here, we mean things such as the liquid, short-term, high-quality commercial paper of solvent firms used to finance goods in the process of production.)

In Indian Currency and Finance, Keynes had argued that whether a central bank holds its reserves in gold or in foreign exchange “is a matter of comparative indifference…India, in her [use of an informal] Gold-Exchange Standard…far from being anomalous, is in the forefront of monetary progress” heading toward “the ideal currency of the future.” Keynes foresaw the coming interwar official reserve currency roles of sterling and the dollar, which he and other British monetary experts convinced the European great powers to adopt at Genoa in 1922. Keynes hoped thereby to forestall repayment of sterling debt, held by other countries in the form of sterling foreign exchange reserves.

In 1932, months after Britain abandoned gold, Jacques Rueff, the famous French central banker and economist, summarized the basic fact contradicting Keynes’ theory and went on to describe its role in causing the 1930 financial crisis and the Great Depression. Rueff pointed out that when a monetary authority accepts dollar debt for its official reserves, instead of settling balance of payments deficits in gold, purchasing power “has simply been duplicated, and thus [e.g.] the American market is in a position to buy in Europe, and in the United States, at the same time,” which tends to cause inflation. Conversely, the liquidation of those dollar reserves causes deflation. Under the reserve currency system, Rueff argued, total demand is, in fact, divorced from total supply. Thus, disequilibrium in the general price level is inevitable.

The Genoa gold-exchange standard, based as it was on sterling and dollar reserves, was a primary cause of the financial disruptions of the 1920s and 1930s: namely, floating currencies, perennial budget and balance of payments deficits, and central bank money printing, not to mention the trade and currency wars they engendered. A generation later, after World War II, the reserve currency role of the dollar was reestablished in 1944 at the heart of the Bretton Woods gold-exchange system. Though an improvement on the interwar monetary system, Rueff correctly predicted (and tried to prevent) the collapse of Bretton Woods, which, after perennial foreign exchange crises, took place in 1971.

Now, it cannot be overemphasized that the official reserve currency role of the dollar, the so-called exorbitant privilege, continues to this day and is a primary cause of world financial instability. Among legions of recent examples, I shall briefly cite two before we discuss the related issue of money and oil.

First, the recent “Arab Spring” of 2010 and 2011, a revolutionary upheaval of the suppressed Islamic poor and middle class (and celebrated by many Americans as hope and change) was triggered, we were told, by the self-immolation of a heroic Tunisian. But for those who saw beyond New York Times headlines, the systemic fundamental trigger of the North African upheaval was the eruption of vast food and fuel inflation in the Middle East.

The shabby truth is that the inflation of food and fuel prices had been transmitted to the dollarized world commodity markets mostly by the hyper-expansive Federal Reserve monetary policy of 2008–2011—an unprecedented money-printing exercise. The Fed and Treasury’s ostensible purpose was to bail out our reckless, insolvent, cartelized banking system and to rescue the banks by issuing them virtually free money. The authorities were inspired by the conceit, perhaps the sham, that the banker class would then restart the engine of rapid economic growth by lending the free money to small businesses and individuals. But instead, the immense expansion of the Fed balance sheet—that is, the issue of new money unassociated with the production of new goods and services—initiated exchange rate and commodity arbitrage throughout the dollarized world.

This flood of new dollars could not be absorbed by the U.S. economy in recession, but it did ignite huge price increases of basic necessities—especially world-traded food and fuel, about 75 percent of which is bought and paid for in dollars. These price hikes penetrated like a sword into the heart of all subsistence economies—in this particular case, North Africa. In such economies, where food and fuel can consume as much as half of a family’s budget, a doubling of the price of necessities can bring people to desperation, indeed, to the edge of starvation.

In the second example, here at home in the United States, the same rising prices of food and fuel, combined with near-zero interest rates, reduced the real earnings of the middle class and those on fixed incomes—sowing the anger, envy, and bitter political warfare we witness today. For policymakers and investors, it is crucial to understand the subtle market mechanism set in motion by hyperactive Fed monetary policy, joined as it is to the exchange rate and price effects caused by the expansion and contraction of official foreign dollar reserves. Of course, we read everywhere that the absolute dominance of the dollar has gradually diminished since World War II, given the rise of Asia and Europe. Still, the world dollar standard persists because of the scale and liquidity of the dollar markets, despite predictions of its collapse in every bear market I can remember since 1962. There is in fact no equivalent alternative.

Page: 1 2  

About the Author

Lewis E. Lehrman is a senior partner at L. E. Lehrman & Co. and chairman of the Lehrman Institute.

Letter to the Editor View all comments (32) |

Von Mises Jr| 12.3.12 @ 7:53AM

Our government and government economist always talks of inflation as the rise in price of goods. This is the same reason the Europeans love the VAT tax. As the prices rise, government can blame capitalism, speculators or greedy businessmen.
But the real metric is that as Lew Lehrman points out is the expansion of the money supply devalues the dollar. So when you are holding dollars or cash equivalents, as the Fed prints more dollars, the real purchasing power of your dollars craps the bed. If you are still being paid the same or a few dollars more per year, and your 401K still looks about the same, it is more difficult for the non-economist or non-finance professional to grasp that their real purchasing power has been crushed due to the Federal Government and the Federal Reserve, not capitalism, markets or greedy private sector businesses.
This is so insidious since it is the redistribution of wealth on steroids in disguise. At 3% inflation, your value of your money declines by half every 24 years (Rule of 72). So if your parents left you $100K and you do the same for your child; he only has about $50K worth of today's purchasing power.
People are starting to figure this out as evidenced by today's headline at Drudge, or they are just panicking: http://www.zerohedge.com/news/.....anke-night

Jack in Wi| 12.3.12 @ 8:02AM

This is a brilliant essay. It explans so much of what happened in the lst 100 years in a very short form. It is too bad Mr Lehrman was not elected governor of New York when he ran against Mario Cuomo in a close race. He would of been a far better successor to Reagan the G. H. W. Bush.

TLP| 12.3.12 @ 10:15AM

I find it very Apropo that Mr. Lehman chose his High School Yearbook Picture at the bottom. That's about how Old his line of thinking is concerning what we're facing Right Now.

It's not The Fed. It's not Monetary Systems or Exchange Rates or Currency Flunctuations and Manipulations. It's something else.

It's Cloward and Piven.

It's Alinksy and it's Marx and Engels and Lenin and Chavez. It's Barack Hussein Obama. And, it's ON PURPOSE.

Who thinks that anything he does, is Good for Job Creation? Nobody IN THE HISTORY OF THIS COUNTRY, has Spent the People's Money, like he has.

If Churchill were alive today, he would say that: Never before in Human Conflict, has So Much been Owed to the Chinese, by So Few, for So Little.

He is Intentionally running this Country into the Ground. Intentionally, making it Impossible for Employers to add jobs. Intentionally, Bankrupting everything that he gets his hands on. Be it - Banks, Businesses, Coal Mines, Coal Fire Electrical Plants, Hospitals, Small Oil Companies, or the U.S. Treasury with "a Credit Card from The Bank of China, and putting the Burden on our Children".

WHY would he do this? WHY are his Czars so Far Left Radical? WHO thinks that Thousands upon Thousands of New Business Killing Regulations is a Good Idea?

Occam's Razor, for God sakes.

There are none so Blind, as those who Refuse to see.

And, I'm thinking that all of these Brainiacs, need a New Pair of Glasses.

I don't even have a Riding Mower, and I know this Sh*t.

FBX1999| 12.3.12 @ 3:31PM

You are absolutely right, sir. Obama's destruction is deliberate. The goal of all of it is a total collapse of the world economy, I mean a real collapse, and from the ashes will arise a global oligarchy with Soros, Buffet, Gates, et al in charge. One world electronic currency. Total control of all.

TLP| 12.3.12 @ 4:41PM

I'm giving you an A.

FBX1999| 12.4.12 @ 3:30PM

Thank you sir, from one Catholic to another.

aware| 12.3.12 @ 6:06PM

Yeah, keep concentrating on the puppets and pay no attention to the puppetmasters. And FBX, none of your supposed list of suspects has the name of Rothschild or Rockefeller, so these are just puppets too.

This is how the Shadow Rulers stay in the shadows, by giving you easy targets to blame.

SUBVET| 12.4.12 @ 10:25AM

shhhhhhhhhhhhh......aware don't confuse him.

FBX1999| 12.4.12 @ 3:30PM

It's the JOOOOZ! (not)

C. Vernon Crisler | 12.3.12 @ 11:29AM

Keynes knew this would happen. He believed inflation was a way to fool labor into accepting real wage cuts. Labor wouldn't recognize them as real wage cuts because their nominal wages would remain the same or even increase.

Keynes was naive to the point of imbecility or perhaps even perverseness. He apparently thought labor unions were stupid and couldn't hire their own economists to see through the Keynesian subterfuge. Hello, can you say COLAs?

Anyone who doesn't receive the new money is hurt, especially old people who don't know anything about economics but who have their retirement money lose its purchasing power. Inflationists are simply redistributionists who make themselves feel good by spending the money of the old and infirm. Inflationists will face a harsher judgment one day, much harsher than the inevitable crash after the inflationary boom.

Bob K| 12.3.12 @ 7:21PM

That's what Keynes really meant when he said: "In the long run we are all dead!" Roll over in the clover now and when you die let the living pay for it!

And so on until the Kiplings "Gods of the Copybook Headings" return to explain it once more.

"The dog returns to his vomit, the sow returns to her mire and the burnt fool's damaged finger goes wobbling back to the Fire! And after all this is accomplished and the brave new world begins, when all men are paid for existing and no man must pay for his sins; as surely as water will wet us, as surely as fire will burn, the Gods of the Copybook headings with terror and slaughter return."

SUBVET| 12.3.12 @ 12:06PM

Read the nuts & bolts of the Federal Reserve in "The Creature from Jekyll Island" by G. Edward Griffin.

Von Mises Jr| 12.3.12 @ 7:53AM

Either way, if you have a 401K rollover or Brokerage Account that you haven't liquidated, I think Lew just told you to buy gold and oil stocks.

Peter Schiff advises the same, and in his book "The Real Crash" thinks one should own physical gold when possible and buy metals and miners, oil and commodities and dividend paying stocks that reside overseas or do much of their business in foreign countries especially with foreign currencies.

Pecos Pete| 12.3.12 @ 8:18AM

The Plan: King O nationalizes oil and mineral companies. King O issues an Executive Order that criminalizes ownership of gold.

Von Mises Jr| 12.3.12 @ 8:39AM

Forget TLP's contest this Friday. Pete just won the "brass ring." This is another reason why oil is off limits. It and gold have value. The Ruling Class wants it to bribe the hoi polloi with "bread and circus."

Our dollars will be worthless, but the commodities and real money (gold and silver coinage) will belong to Barry and Moochelle. They will treat Nancy to another face lift before she kicks off.

TLP| 12.3.12 @ 10:56AM

So. You admit that everything is becoming Worthless, and whatever does retain its Worth, will be gobbled up by the Bourgeoisie. Yet you still Trash The Contest.

Have you forgotten all of The Imaginaray Prizes?!!!!!!

Apparently.

Unfreakinbelievable.

Von Mises Jr| 12.3.12 @ 11:12AM

I did not call for a boycott of your contest. I just simply stated no one can hope to outpace Pete with his succinct and prescient observation on Monday.

TLP| 12.3.12 @ 1:05PM

I don't have any Brass Rings, so I'm sending Pesco Pete an Imaginary Cck Ring, instead.

2Anglico| 12.3.12 @ 9:13AM

To paraphrase Voltaire, "Paper money always reverts to its intrinsic value, zero." Now we don't even have paper money, we rely on "digital" dollars.

Drunken Sailor| 12.3.12 @ 2:35PM

bullets hold their value well and may become precious at this rate.

BackToBasics| 12.3.12 @ 9:31AM

from the article - "....in America...reduced the real earnings of the middle class and those on fixed incomes—sowing the anger, envy, and bitter political warfare we witness today"

I enjoy reading Lehrman's articles. Interesting that the negative effects he speaks of did not translate into defeat for Obama as it was expected as too many looked to government to meet their needs, angry or not. If Romney had won by enough of a margin to overcome the voter fraud by the democrats, oil may well have begun a decline in price as our output would have risen significantly.

Lehrman always makes sense but poor political decisions in social and fiscal areas have had as much negative effect as bad monetary policy and I don't think the former was simply a cause-and-effect outcome of the latter. When we were on the gold standard in the 19th century, prescient thinkers warned of the government corrupting our republic through the "buying of votes."

BackToBasics| 12.3.12 @ 4:42PM

I will add that I think Lehrman is right in speaking about the problems of going off the gold standard and using fiat currency. My point wasn't to contend with this but rather to say that the same problems we have now may have eventually ensued even if we had stayed on the gold standard. I would better have mentioned that it would most likely have taken longer to reach the large numbers of problems we face now. I just think that even good monetary policy, although much preferred, is no guarantee against the bad effects of greed among the general populace and thirst for power by leadership that have been evident throughout history.

Cobalt| 12.3.12 @ 9:39AM

"The abandonment of the gold standard made it possible for the welfare
statists to use the banking system as a means to an unlimited expansion of
credit. They have created paper reserves in the form of government bonds
which- through a complex series of steps- the banks accept in place of tangible
assets and treat as if they were an actual deposit, i.e., as the equivalent of what
was formerly a deposit of gold. The holder of a government bond or of a bank
deposit created by paper reserves believes that he has a valid claim on a real
asset. But the fact is that there are now more claims
outstanding than real assets."

"In the absence of the gold standard, there is no way to protect savings
from confiscation through inflation. There is no safe store of value. If there were,
the government would have to make its holding illegal, as was done in the case
of gold. If everyone decided, for example, to convert all his bank deposits to silver
or copper or any other good, and thereafter declined to accept checks as
payment for goods, bank deposits would lose their purchasing power and
government-created bank credit would be worthless as a claim on goods.
The financial policy of the welfare state requires that there be no way for the
owners of wealth to protect themselves."

Cobalt| 12.3.12 @ 9:39AM

""This is the shabby secret of the welfare statists' tirades against gold.
Deficit spending is simply a scheme for the 'hidden' confiscation of wealth.
Gold stands in the way of this insidious process. It stands as a protector
of property rights. If one grasps this, one has no difficulty in
understanding the statists' antagonism toward the gold standard."
- - Alan Greenspan

Aaron Investigates | 12.3.12 @ 9:44AM

Really two way of looking at the article. The one way is accept whats coming and plan accordingly, why stand in the way of a freight train?

On the other hand, as BtB suggests, there were, (and are) ways that our illustrious leaders could have either mitigated or avoided the situation. Of course that would have meant saving main street rather than wall street and that never is much of a contest. The problem for at least "47%" of the population is that they don't have the extra dollars with which to purchase the only hedges which are available and thus the wheel continues to turn.

Abdullah| 12.3.12 @ 12:52PM

So, if you are living in Egypt and are poor, you get around $300 a year from the US Federal gov. foreign aid, mostly in food and medicine staples. But as soon as you move, or crawl over to the land of milk and honey, the Feds spend $30,000 a year to keep you fed, med and lodged. That is 100-fold instant increase. So, would somebody explain me why change of address entitles you to a life of leisure? As dollar keeps debasing, more and more poor 3-rd word folks will try to solve their problems by jumping the fence.

TLP| 12.3.12 @ 1:06PM

Have not seen you at The Contest, lately.

Abdullah| 12.3.12 @ 2:08PM

TLP, I was busy writing politically incorrect review for "Anna Karenina" the movie. BTW, it is a perfect team for the next competition. Conservative Constantine Levin vs liberal Vronski and Anna the ultimate feminist. WDYS?

elias| 12.3.12 @ 3:06PM

"Similarly, the world dollar base expansion resulting from the Treasury’s effort to sink the dollar from 1985–88 led to the commodity inflation of 1989–90, followed by recession."

Oil prices were more-or-less in the toilet from 1986 to 1995, in spite of the dollar base expansion you cite above from 1985 - 88. Where was your "18 month" oil pricing model during this period, Mr. Lehrman?

cicero| 12.3.12 @ 4:17PM

You can't eat gold, silver, or oil. Inflation , while a problem, can be the boon of the debtor class. I suggest everyone purchase about 1 - 10 acres of land, and built a dwelling on it. Learn to grow your own food. If you can, buy the land on or near water, and learn how to catch fish. For the really ambition, teach yourself, or learn, fundamental hun ting skills, or small animal husbndry.

The land never leaves. The worker will always survive, and those who put their trust in their hordes of cooin will always perish. Ask the Greeks, the Romans, the French, the Russians, etc.

mike 3/505| 12.3.12 @ 5:57PM

Yes and no. If you work and "are fortunate" enough to build a successful, productive farm, the proceeds will be stolen from you in the name of "fairness."

Theo Prinse| 12.4.12 @ 10:38AM

I disagree with the hidden axioms in this excellent article in that the level of innovation is to low and innovation on itsleves is not fully understood and or accepted as the only source of wealth ... Nixon - among many important measures - killed the Nuclear Thermal Rocket that had reached Technical Readiness Level 10 and can bring man on the Moon, Mars etc 1.000 times cheaper than conventional H-O rocketry.
2nd. Nobel Prize winner Paul Krugman is wrong saying there can be no economic interstellar trade.
Krugman is wrong because of the millions of tons of Helium-3 on the Moon. The prize of Gold = 40 USD per gram and Helium-3 300.000 USD per gram

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