The Fed Blinks

The Los Angeles Times reported this morning: "Anxious customers jammed the phone lines and website of Countrywide Bank and crowded its branch offices to pull out their savings because of concerns about the financial problems of the mortgage lender that owns the bank." We haven't seen a bank run of this magnitude since March 1985 when a so-called 'bank holiday' declared in Ohio and Maryland closed the savings banks in those states.

The problems at Countrywide Bank and its parent company, the largest mortgage lender in the US, are becoming headline news across the country as other papers pick up the story off the LA Times newswire. Responding to the growing crisis, the bank said: "It is very important to remember that Countrywide Bank is well capitalized, with FDIC-insured deposits, and is one of the largest banks in the United States, with assets over $107 billion." While that statement may be reassuring to depositors, I doubt if that was the reaction at the Federal Reserve.

First of all, the Fed's governors no doubt realize - in contrast to uninformed bank depositors - that the FDIC is just a fig leaf, and not a viable safety net. Its Deposit Insurance Fund only has $50 billion of assets, an amount that is less than half the size of Countrywide and that money is 'insuring' $4.2 trillion of deposits in 8,662 banks.

More importantly, a run on a bank of Countrywide's size no doubt sent shivers up the spine of the Fed governors. With visions of the Great Depression most likely rampant, the Fed blinked. It today cut the discount rate at which banks can borrow from it.

Did the Fed just re-arrange the deck chairs on the Titanic? Or was their step more meaningful? Unfortunately, the Fed did not change the Titanic's course. It is still heading for that iceberg lying in wait.

One could argue that the Fed's action is necessary because the financial system is about to implode, which can cause a lot of collateral damage to innocent people and institutions. I completely agree, but thinking like that misses the key point. Any system that has the potential to implode is a broken system.

Central banks are at the heart of that broken system, and they perpetuate it because doing so is in the vested interests of those they serve - spendthrift politicians and the big banks. Further, it is a system supported by too many Americans who have chosen to overspend, overborrow and undersave for too many years.

The great professor of the Austrian School of Economics, Murray Rothbard, got it exactly right with clear foresight when he penned these words in March 1991, as the S&L crisis was drawing to a close and a few years before his death:

"The banking system, in short, is a house of cards, the FDIC as well as the banks themselves...The only reason the FDIC is still standing...is because the people believe that, even though it technically doesn't have the money, if push came to shove, the Federal Reserve would simply print the cash and give it to the FDIC. The FDIC in turn would give it to the banks, not even burdening the taxpayer as the government has done in the recent [S&L] bailouts...But there's a hitch. If it does so, this means that all the trillion or so dollars of bank deposits would...be unbelievably inflationary, and would hurl us immediately into 1923 German-style hyper-inflation."

Is a German-style hyperinflation really our future? Central banks in the past week created 1/3rd of a trillion dollars out of thin air in the blink of an eye. Does that sit right with you?

That's fiat money, which is inflationary and destructive to the currency, and therefore in the end, the economy. Who benefits from this kind of largesse? Not the little guy and taxpayer who will end up bailing out the banks to pay for this mess (just like they did twenty years ago with the taxpayer funded Resolution Trust Co. that bailed out the S&Ls). The banks are the only ones who benefit, and they made the inferior quality subprime loans in the first place.

This subprime mess is a good example of the so-called "moral hazard". Banks don't worry about going bankrupt because they know central banks will always bail them out. Thus the banks can't lose. They make a bundle during good times and get bailed out in bad times - but they are to blame for the bad times. Their imprudent lending creates the boom, which inevitably is followed by a bust. This is the "trade cycle" so clearly documented by Austrian School economists.

So what does this mean for gold? Back in March 1985 when the S&L crisis hit, gold responded as expected. It rose 16% in five days. And this time around?

Even though gold recovered most of yesterday's $20 drop, it is still down 2% over the past five days. Clearly, the gold cartel had a hand in capping the gold price. It's just one more example of dozens in which central banks would rather shoot the messenger - gold - than allow everyone to see its message.

A rising gold price highlights monetary problems like inflation and bank crises. But gold is a messenger that just won't die, and rightly so. It is the only money that doesn't have counterparty risk, as explained in the last alert. So gold is headed higher, and yesterday's low was probably the starting point.

Both the gold and silver charts remain bullish. Admittedly, both are testing support, but I expect support to hold. This week's low has all the same earmarks seen during the two previous lows this year in early January and June, but those are not the only times we've seen action like this. Take comfort from the following words from my alert on October 5, 2003

"What is most striking about this chart [it was dated Oct 3, 2003] is that Friday's sell-off [which was 3.6%, compared to this past Thursday's 3.1% drop] is barely visible. Gold clearly remains well within its important long-term uptrend, above its 200-day moving average, and above its recent breakout point of $366. In short, there is nothing wrong with this chart, so by implication, there is nothing wrong with gold, which remains in its major long-term uptrend.

So what do we do? Simple, we stay the course. Continue to accumulate gold, as declines like the one seen on Friday enable you to get more metal for your dollars. And given the growing uncertainty about the dollar and its bleak prospects, gold is still the place to be."

Those words, written when gold was $300 lower than today, remain just as valid as they were nearly four years ago.

Published by GoldMoney
Copyright © 2007. All rights reserved.
Edited by James Turk, alert@goldmoney.com

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