Market Watch - November 7, 2008

How Did We Get Into This Mess?

People continue to wonder what happened to leave us in this current financial mess. The current problem emanates solely from our getting away from the strong economic requirements of the Constitution.

Understanding the Constitution

The Constitution states that “all public debt will be settled in gold and silver species” (Section 10.). That’s been ignored for decades. The reason the founding fathers wanted debts settled in gold and silver species was because that very rule prevents government from getting out of hand financially. When a public debt could not be satisfied, services would cease, or be cut down to a point where the services could be paid for. This was one of the checks and balances placed in the Constitution. Now, we borrow money to cover deficits because people are “entitled” to money from their government. And Congress can’t vote on the 2/3rds of the federal budget, which is entitlements.

The Constitution states that the “Congress shall have the power to coin money” (Section 8.). That power was given away by President Wilson to the Federal Reserve System when it was founded in 1913. The founding fathers knew if Congress abused this privilege, every two years the citizens would have an opportunity to replace their representative in Congress. Congress now lays the blame, conveniently, upon the Fed.

The Constitution provides for a balanced budget “except in time of national emergency” (Section 8.). We haven’t had a balanced budget in more than 40 years. What an unbalanced budget means, over a protracted period of time, is huge debt build up. The public debt has reached $9.3 trillion, and at least another $1 trillion will probably be added for this years bailouts, deficits and wars. Debt is a killer. Every panic, recession, depression and business downturn emanates from too much debt, which is precisely what has happened the last 100 years.

The Constitution specifically prohibits “direct taxes on income” (Section 9.). In 1913, Amendment 16 providing for “direct taxes on income” nullified the clause prohibiting direct taxes. The Founding Fathers put the clause in the Constitution in the first place because they knew that direct taxes led to concentrated power in the taxing authority (in our case the Federal Government). They argued that concentrated pools of money created concentrated power. Concentrated power in the federal government would lead to war and debt, which then leads to loss of individual liberty, which is precisely what has happened the last 100 years.

Step by Step, How we got here

When the mass production era of the Industrial Revolution began in the early 1900s, gobs of money had already been made by the railroad barons who helped settle the great cities of the west as well as create banks all over the country. As industries grew these banks enjoyed huge deposit growth. Coupled with the gold rush of the previous 60 years, America’s deposit growth had increased substantially. In that setting, the chain of modern bank disasters began with the panic of 1907.

The panic of 1907 was ignited by the Heinz Brothers attempt to corner the copper market. They borrowed large amounts of money from Wall Street brokers to acquire a majority stock interest in United Copper Company. When prices of United Copper stock dropped below an amount needed to service the debt acquired to purchase the Heinz Brother’s stock, it set off bankruptcies galore bringing the stock market and Wall Street to its knees in October 1907. Wall Street bankers, in concert with the U. S. government, provided enough funds to bail out certain productive assets left by bankrupt companies so those productive assets could be re-employed as soon as possible. That’s the same thing that has happened today.

In 1913 the Federal Reserve System was created providing it with the power to create money thereby abrogating one of Congresses most important powers. In that year the income tax amendment to the Constitution was enacted and the Federal Government began to collect “direct taxes” (income taxes) as provided for in Amendment 16.

A stock market crash occurred in 1929 from another outsized build-up of debt. Brokers were borrowing $95 out every $100 to purchase stocks. With so little equity involved, a serious short-term downturn in stock market values could wipe out the equity invested, which is what happened. Banks called their loans immediately, and when the loans could not be satisfied, the value of all assets was reduced by the need for each indebted asset holder to satisfy their indebtedness. The Federal Reserve System, who had allowed the debt in the first place by encouraging excess borrowing, stepped in and “saved the day” by printing money out of nowhere. Predictably, this lead to inflation and upward pressure on the price of gold. Gold had been stable at $20 an ounce for more than 125 years. Printing money with no asset behind it other than the paper it is written upon inflated the money supply because a greater number of dollars were now available to essentially pay for the same number of goods and services that existed before that money was made. Therefore the price of goods and services increased to meet the value of the new money supply. This led to the next significant change in modern American monetary history.

In 1933, President Roosevelt made it mandatory for all citizens to turn their gold into designated banks in exchange for a similar amount of money in dollars that included an additional 67¢ worth of paper money for every $20 of gold turned in. Every single ounce of gold in the government’s storage vaults at that time was owned by the “bearer of dollars”. Your $20 bill, for example, could be redeemed at the local bank for a 1oz. gold piece. No longer after 1933. This represented the greatest transfer in wealth from the private sector to the public sector in history. It further concentrated wealth, and hence power, in the hands of the central government.

By 1944 the U. S. owned most of the world’s monetary gold supply. The transfer of wealth from Europeans for our arms in WWII had made America very rich. It also increased the power of the U. S. government. So much power, in fact, that we were able to negotiate with the rest of the world so that the world’s commerce would be carried on in dollars. That was the first step to making the dollar the world’s currency.

In 1971, President Nixon refused to settle our debts with France in gold. That represented the suspension of the gold standard for settlement of international debts. It further expanded our power, and concentration of that power. The U. S. Federal Government no longer settled debts with gold—they now used dollars. And the printing presses were owned by the U. S. Government.

From 1972 forward the dollar has lost 80% of its purchasing power. From 1913 the dollar has lost an astounding 97% of its purchasing power. The reason was debt. Our government has continued to create debt by printing money out of nothing and placing it in the spending stream with no asset to balance the increase in the monetary supply. The cost of U. S. goods and services has continuously increased to meet additional supplies of money in the economy.

Where are we today?

It’s been 95 years that the United States has enjoyed printing itself to prosperity. Even Goliath falls, though, when his burden becomes too heavy. Debt did it again. The Federal Government passed laws requiring lending institutions to make a certain percentage of their assets available to people who were not otherwise credit worthy. The Federal Reserve drove interest rates down to almost nothing, so everybody was happily borrowing “cheap money”. Enter the brokers and we have newly packaged high risk securities that include batches of “questionable” mortgage loans. The Federal Reserve continued to allow Wall Street more margin buying (borrowing money with small amounts of equity), just like in 1929, and the minute a sharp sell-off occurred, investors went through their equity, and the banks called their loans.

This time the government stepped in and added at least another $1 trillion to our $9.4 trillion national debt. This will create more problems for us in the future, and we will continue to have these problems until America returns to the monetary disciplines set forth in the Constitution.

Conclusion

Here is a quote from Cicero in 55BC whose writings influenced our Founding Fathers.

“The budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt. People must again learn to work, instead of living on public assistance.”

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