But is much moral hazard created by aborting fire sales? To be sure, investors wiped out in a fire sale will clearly be less risk prone than if their mistakes were unwound in a more orderly fashion. But is the broader market well served if the resulting fear and other irrational judgments govern the degree of risk participants are subsequently willing to incur? Risk taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales.

What is a fire sale? The FED apparently has a new operational definition: "Anything that leads Jim Cramer to throw a tantrum on CNBC."

Central banking has been a moral hazard ever since Parliament gave a monopoly to the privately owned Bank of England in 1694. Central banking exists primarily to protect large fractional reserve commercial banks from bank runs, and therefore to preserve the fractional reserve banking system nationally. Of all modern institutions, none has been more committed to subsidizing moral hazards than central banking.

Along the way, central banks preserve stock markets from sell-offs that might produce runs on commercial banks, or what is the same today, cascading cross-defaults when overextended banks cannot pay off each other at the end of the business day, which today is international.

INDIVIDUALS ARE TRAPPED BY THE SYSTEM

Jesus told His disciples to be in the world, not of the world. This has been the message of most major religious reformers throughout history. It is good advice.

We live in a world that we have inherited. It is not mainly of our making. We are forced to make choices in a world that has structured and limited the choices we make. This is always true.

Consider the FED's choices regarding monetary policy. There is this inescapable choice: stable money leading to a recession and maybe a depression, given the prevailing level of debt, vs. monetary inflation, which keeps the debt structure alive and encourages additional debt to "pay off in cheap money." This policy subsidizes the market for new moral hazards. "When the price falls, more is demanded."

At the top of the visible hierarchy of control, politicians and central bankers say they want to avoid making this choice between stable money and inflation, but one or the other policy cannot be avoided in the long run. This makes short-run decision-makers out of politicians and central bankers.

A few of us prefer this choice: a money system that is not tied to credit and debt in any way. That would mean a monetary system tied to gold and silver, as it was in 1914. This is not available as a choice, nor is it likely to be, short of a complete financial collapse, which unfortunately would kill most of my readers – a breakdown in the division of labor.

So, we must make second-best or third-best choices with our money because generations of politicians made very bad choices.

As investors and decision-makers, most people tend to go with the flow. The flow is established by central bank policy: in the United States, in Japan, in Europe, and in China. Going with the flow is bad when you are floating toward Niagara Falls.

We are trapped in an international credit system which has relied on monetary inflation to pump up the capital markets. This has led to a huge expansion of debt. To keep this debt from imploding in a wave of defaults – "cascading cross defaults," Greenspan called this – central banks inflate even more.

This is a vicious circle. Ever since 1914 – World War I and the first year of the Federal Reserve System – the West has been unable to escape from this circle. As a result, the dollar buys 5% of what it bought in 1914. (See the Inflation Calculator at www.bls.gov: the Bureau of Labor Statistics.)

None of this is new. Leaders always face choices. These choices will affect those under their authority. Sometimes the effects are catastrophic.

I believe we are trapped in a vicious monetary circle. We cannot get out at anything like zero price.

Americans have been in this sort of situation before. As background, let us consider a similar vicious circle. Let us go back 230 years to the Constitutional Convention of 1787.

GEORGE MASON'S DILEMMA

I am in the process of editing and revising an amazing manuscript on conspiracies in American history. It was written as a series of newsletters over 40 years ago. The author is dead, as far as I know. Some of the chapters hold up well. I am not sure. No one has seen these articles in over 40 years, and very few saw them then. A decade ago, I paid to have them scanned in. I have added footnotes where I can. I have been editing the final copy this week.

In one of the newsletters, the author cited a statement by George Mason. Mason is rightly called the father of the Bill of Rights. He was a participant at the Constitutional Convention in 1787. Here is the passage cited:

As nations can not be rewarded or punished in the next world they must be in this. By an inevitable chain of causes & effects providence punishes national sins, by national calamities.

What caught my attention was its context. Here is the full citation.

Slavery discourages arts & manufactures. The poor despise labor when performed by slaves. They prevent the immigration of Whites, who really enrich & strengthen a Country. They produce the most pernicious effect on manners. Every master of slaves is born a petty tyrant. They bring the judgment of heaven on a Country. As nations can not be rewarded or punished in the next world they must be in this. By an inevitable chain of causes & effects providence punishes national sins, by national calamities.

Mason was arguably the most eloquent political opponent of American chattel slavery in his generation. Yet he owned 36 slaves. He did not set them free in his will, unlike George Washington. Neither did Jefferson, who also opposed slavery.

More than anyone among the framers of the Constitution, Mason saw what was coming: a great national division over slavery. He recognized a looming confrontation between moral principle and property rights. At the Virginia ratifying convention in 1788, he made an assessment of the situation. This was in reference to the Constitution's 20-year extension of the importation of slaves from Africa: the international slave trade. This was abolished by Great Britain in 1807, in the final year of legality of slave imports into the United States. Mason offered a two-part critique. The parts were in complete opposition to each other: one moral and the other legal. First, the moral and political:

The augmentation of slaves weakens the states; and such a trade is diabolical in itself, and disgraceful to mankind. Yet by this constitution it is continued for twenty years. As much as I value an union of all the states, I would not admit the southern states into the union, unless they agreed to the discontinuance of this disgraceful trade, because it would bring weakness and not strength to the union.

And though this infamous traffic be continued, we have no security for the property of that kind which we have already. There is no clause in this constitution to secure it; for they may lay such a tax as will amount to manumission. And should the government be amended, still this detestable kind of commerce cannot be discontinued till after the expiration of twenty years. I have ever looked upon [slavery] as a most disgraceful thing to America. I cannot express my detestation of it. Yet they have not secured us the property of the slaves we have already. So that "they have done what they ought not to have done, [allowed importation of slaves for at least 20 years] and have left undone what they ought to have done." [protected slaves as property]

Slavery was not the cause of the Civil War. Southern secession was. The South seceded because of two men: John Brown, whose murderous attempt to launch a slave revolt in 1859 sent waves of fear throughout the South, and Abraham Lincoln, whose party was pledged to restrict the extension of slavery into the territories. This policy would increase the political power of abolitionism in the Senate. Slavery could then be eliminated by law, exactly as Mason had warned in 1788. The fact that America's geography precluded the extension of slavery as a social system after 1850 did not stop the secessionists in 1860–61. The political deadlock that had prevailed until 1849's 30 to 30 tie in the Senate was broken with the admission of California as a free state in 1850: the Compromise of 1850. All new states would probably be free states. That should have been clear in 1850 to anyone who had seen the soil west of Dallas: no water. That meant no cotton, no rice, and no tobacco. It meant cattle ranching. It meant slaves on horseback. It meant few slaves except household servants – consumer goods, not commercial goods.

The South could have seceded in August, 1850, and gotten away with it. Millard Fillmore was not the late Zachary Taylor, who in February had told one group of Southern Senators threatening to secede that he would personally lead the Army into the South and hang every secessionist, just as he had hanged deserters and spies in the Mexican-American War in 1847. Taylor died in July. Fillmore became President. But the South's politicians agreed to the Compromise of 1850 in September, and that decision sealed the region's fate, politically and militarily, a decade later. Lincoln was the symbol. The reality was the soil.

Yet the leading politicians of the South did not speak of Lincoln as a symbol or the West as a desert. They proclaimed a legal argument: the right to a specific form of property. Politicians tend to be former lawyers. When the facts of the case are against them, they argue the law. As for morality, both sides do their best to ignore it.

The results of the war were horrifying: the deaths of 620,000 Americans in 10,400 battles. This was paid for in the North by an expansion of national debt from almost nothing in 1860 to over two billion dollars in 1865. It was paid for in the South by mass inflation and the destruction of the South's economy. The South did not begin to match the North's economy for a century.

"By an inevitable chain of causes & effects providence punishes national sins, by national calamities."

Mason did not sell his slaves. His example, not his words, was imitated by his social peers in the South. The calamity came in 1861–65.

CLEAN HANDS, DIRTY MONEY

We cannot opt out of the debt money economy. To use a checking account, to use a credit card, to spend a Federal Reserve Note, we subsidize the system. We preserve the profits of the government-protected fractional reserve banking system.

What is our version of selling our slaves in order to opt out of the system? This encompasses far more than this short list. But I offer this list of five.

1. Avoid consumer debt. The mantra is Max Blumert's law: "Buy the best, pay cash, take delivery."

2. Pay off all credit card debt before buying T-bills or bonds. Here is my law: "Escape from the trap before setting any of your own."

3. Pay a tithe. This is your personal declaration of dependence on God rather than dependence on Bernanke.

4. Don't take on any debt that is not collateralized 100% by an asset in your possession. This applies to mortgages. Your house should collateralize your mortgage.

5. Emergency debt is for emergencies. Regard both as disasters. Save for emergencies.

CONCLUSION

The debt economy makes us all vulnerable to unforeseen crises: illiquidity, insolvency, low credibility. All three are institutionally visible today. They are threatening Cramer's world.

All three are the result of the moral hazard of central banking. This is why Cramer screamed against the Federal Reserve System. He was correct: the FED is responsible. Earlier.

The FED should have done nothing in 1914. It should have done nothing thereafter. If it had done nothing as a matter of policy, there would be no debt crisis facing the U.S. economy. There would be no advocacy of the creation of yet more moral hazards in the financial community.

There is now a looming immoral hazard. Eventually, the FED will imitate the Bank of China in order to re-liquify the financial system. It will inflate at double-digit rates. The difference is, Americans do not save 40% of their income, nor are they rebounding from Marxist tyranny and incomparable poverty. The division of labor is being extended by China's monetary inflation. This extension has produced China's many bubbles. Our division of labor is already highly developed. It can increase only slowly at the margin. American productivity will therefore not rise fast enough to match the FED's double-digit inflation, as it has in China, thereby concealing the true rate of inflation.

Between then and now, Cramer will have lots of opportunities to scream on national TV.

August 27, 2007

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

-- Posted Monday, 27 August 2007 | Digg This Article