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Business Observer Friday, Sep. 7, 2012 10 years ago

Government destroyed the economy. Here's how we can revive it.

The war on gold, and the urge of politicians to get rid of it to settle a country's accounts, has led us to an undisciplined Congress, and president.
by: George Rauch Staff Writer

In the early 1970s, the Nixon administration refused to transfer gold from our Federal Reserve System to France, in settlement for a pool of dollars that existed in French banks that President Charles DeGalle wanted redeemed for gold. Such redemption followed the age-old standard of settling accounts by countries, affirmed by the Bretton Woods Agreement of 1944, to which the U.S. was host and primary sponsor.

The use of gold and silver by banks and government, historically, was to provide real value (gold) when settling accounts. The war on gold, and the urge of politicians to get rid of it to settle a country's accounts, has led us to an undisciplined Congress, and president, who are devoted to protecting themselves, rather than upholding the Constitution, which states clearly:  “No state shall ... make anything but gold and silver coin a tender in payment of debts ...” (Article 1, Section 10).

Prior thereto, throughout the history of the United States, economic growth was driven by capital accumulation (savings), and then investments. Since then, government credit creation (loans), followed by Congress forcing banks to make loans to those unworthy of credit and the subsequent spending of those loans has fueled recent economic growth.

Furthermore, total U.S. debt has increased 50 times to more than $50 trillion since the Gold Reserve Requirement Elimination Act of 1968. The rapid expansion of credit creation through government mandated high-risk loans, rather than savings, created a bulge of debt that, by 2008, could not be repaid. The trail of fatal errors explaining this is as follows:
1. The Federal Reserve Act of 1913 required the Fed to hold 40% of every U.S. dollar issued in gold or silver, so that for every U.S. dollar issued, 40 cents was held back by the Fed in gold or silver. That was a mathematical restraint on the amount of money that could be created. In 1945, Congress reduced that ratio to 25%. Such reduction meant that $1 issued by the Fed would now be backed by only 25 cents instead of 40 cents. The result of such math was an expansion of loans. 
2. After the Federal Reserve Act of 1913, commercial banks were required to hold at least 12% of their deposits in cash reserves, so that depositors could be assured of being able to redeem their cash, at all times. 
3. In 1968, Congress removed any restraints upon the Fed to hold gold in reserve, with the Gold Reserve Requirement Elimination Act of 1968. In other words, Congress just handed the banking system, now controlled through Congress and the president, carte blanche to create money and lend it with no gold and silver backing.
Let's concentrate on this: The government was now allowed to make as much money as it wanted (needed) because there was absolutely no restraint to hold it back from creating unlimited amounts of money. U.S. dollars were no longer a currency whose worth was derived from intrinsic value such as gold. We changed from a commodity-money system to a fiat (fake) money system.
Without restraint by the government, yet under the control of Congress, the consequence was that the amount of fiat money outstanding exploded over the next 40 years.
4. Bankers and politicians took advantage of this quickly. Bankers soon lobbied to have their own reserves reduced so they could have less cash on hand to meet deposit withdrawals, which meant more cash was available to loan at interest-bearing rates. The government's part was the creation of new credit entities with no mandatory requirements for reserves, whatsoever.
In 1945, cash reserves required were 12% of each bank's total assets. By 2007, reserves were essentially less than 1%. This is equal to a family owning houses and assets equal to $100,000 of fair market value and having loans against that $100,000 of assets equal to almost $10 million.
5. In 1945, traditional credit-type institutions, such as banks, issued 52% of the loans in this country. By 2007, these traditional institutions made only 27% of loans in this country. The rest of the loans were created by GSEs (Government-Sponsored Entities) such as Fannie Mae, Freddie Mac, and so forth, all of which had no limit on expenditures other than what Congress would require. Congress required nothing. This was done to make “housing more affordable,” but in the long run all it did was create votes for politicians, income for bankers, growth for government and enormous debt obligations for the rest of us. It did not help the top 50% of earners in this country who pay 100% of the income taxes. But, it did help the 50% of citizens who are required to file tax returns, yet who pay no income taxes at all. In the long run, the latter 50% will not have to pay for any of this catastrophe because they have no money and no substantial assets.
6. These clever government acronyms-GSEs, ABS (Asset-Backed Securities), SPV (Special Purpose Vehicles) were all designed for one purpose: to avoid requirements of having solid bank reserves in the event economic catastrophe occurs. The idea is that the government is smarter, better managed and more able to evaluate risk than we are in the private sector. We are currently suffering from the results. 
7. As recently pointed out by Market Watch, from 2006 to 2011, individuals and corporations reduced their debt while the federal government more than doubled its debt from $4.9 trillion to $11.6 trillion. Additionally, the U.S. government pressured third world countries, primarily in Asia, to fund our government budget deficit by buying U.S. government debt. In return, they received favorable export and import laws that gave special advantages to foreign producers, who in turn purchased our debt. 
What is the solution?
In 1945, the banking system in this country was straightforward and understandable. It has become complex, all because the government and the bankers have made it that way. It has been responsible for an explosion of debt that can no longer be serviced. Interestingly, the solution is simple:
1. Phase out the Federal Reserve System, but, in the meantime, require the Fed to maintain 20% of its loans to member banks backed by gold. This will require a marking of the U.S. gold supply to market value; not the phony values the government currently uses to value gold. It will also require a thorough audit of the Fed's books and a verification of the U.S. gold supply. If implemented, Congress could not create more debt than the reserve ratio of gold allows: It's mathematical. It removes the urge to defy the laws by politicians. Congress could no longer create more debt than the reserve ratio of gold allows. Inflation would stop.
2. Five banks hold 56% of deposits in this country. Break up the banks so that all banks can become competitive again. Those five banks also hold the bulk of the private banks' stock in the New York Federal Reserve System, which is a problem all by itself. The Federal Reserve System of New York sets interest rates, and those bankers sit on the Federal Reserve Committee that sets the rates. That is like letting the fox into the hen house. The five banks derive a huge competitive advantage from being in on the setting of interest rates between banks. Here's one additional terrific competitive advantage:  “TOO BIG TO FAIL!”

It is really as simple as that.  As the Bible says, “the love of money is the root of all evil” (1 Timothy 6:10).  That is why the Founding Fathers wrote into our Constitution all sorts of restraints on money and credit.  They knew that human beings could not handle unlimited responsibilities to create and spend money.  The Founders saw what happened in Europe when kings were allowed to create money out of nowhere with a printing press.  And when those countries defaulted, Kings confiscated lenders assets when obligations could no longer be met.  The Constitution required commodity money to settle all debts to avoid exactly what has happened today.  It's amazing foresight that the authors of our Constitution were capable of understanding this concept more than 200 years ago.
Anticipated reaction
The stock market is a discounting machine. Millions and millions of bits of information go into creating the values that price stocks. One of the greatest discounts on value is risk. The riskiest thing we have in our economy is government debt, so, if government debt becomes confined by a set of criteria that people can understand, there is likely to be a huge favorable impact upon the stock market. This is not only because it is “the right thing to do economically,” but, rather, because such an action would free up huge amounts of capital for the private sector that would create jobs.

Remember that while public sector jobs sound good, they are counter-productive at this point in growing the economy. People who work in the private sector who are paying taxes must pay every government salary.

At some economic point, dependency upon government overwhelms an economy because it uses all capital created in one year, and then some, by borrowing. We are there, and, in fact, we have been for years. It's simple, economically: The smaller the government, the greater the opportunity for the private sector to succeed, and for individual success to be achieved.
Markets outlook
The markets are as dysfunctional now as they ever have been. Limit stock exposure to only the most highly rated dividend payers with a record of increasing dividends and earnings annually.

Caveat Emptor.

George Rauch, Longboat Key, is chief executive officer of Bradenton-based General Propeller and a former Wall Street investment banker.

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