Hereís what the repeal of Depression-era financial regulations--the passage of the Financial Services Modernization Act--means for the economy and the growing bubble on Wall Street.

On November 12, in an elaborate signing ceremony, President Clinton affixed his signature to the Financial Services Modernization Act. It has been described as the most significant piece of banking legislation since the Great Depression, and has been fought over--and lobbied hard for--over two decades. The landmark bill, according to one financial historian, "is the last nail in a coffin that has been under construction for quite a number of years."

In the coffin is the Glass-Steagall Act, a law that was passed in the immediate aftermath of the mass banking failures, stock market crash and economic crunch of the 1930's. At the time, a great many people believed that runaway speculation in financial markets, and among disparate financial institutions, created an artificial bubble--the breaking of which started a chain of events that kept the U.S. economy mired in the doldrums until Americaís entry into World War 2. Glass-Steagall was born of the recognition of the inherent dangers of too great a concentration of financial power in too few hands as well. The law barred common ownership of banks, brokerages and insurers, erecting a "wall of separation" between banks and non-financial companies. The legislation championed by Sen. Carter Glass (D-VA)--who had actually helped create the Federal reserve after the 1907 financial panic and later served as President Wilsonís Treasury Secretary--and Rep. Henry Steagall (D-AL) endured for several decades.

In recent years, however, financial institutions have pushed the limits to exploit what loopholes existed in this law, as well as in the federal Bank Holding Company Act. Indeed, many viewed the passing of the new Financial Services Modernization Act as rather anti-climactic, with the increasing wave of mergers and deals that have occurred recently between various financial concerns. Most noteworthy among these was the announcement many months ago of the marriage of Citigroup and Travelers. Technically, this merger violated both Glass-Steagall and the Bank Holding Company Act; but when one considers that Wall Street and Washington are more often than not "two branches of the same firm," as a recent piece in The Nation quipped, few were surprised when the deal was approved.

And, let us not forget that Wall Street has spent several hundred million dollars in recent years lobbying for the new bill.


As with so many issues today, there were two major camps fighting, respectively, for and against the repeal of Glass-Steagall. Virtually everyone who took a side fell in with the scripted arguments of their chosen camp; but, sadly, the most important issues--and the real reasons why this bill had to pass--were barely mentioned.

Proponents of the recently passed bill have long held out the utopia of highly competitive, consumer (and investor)-friendly "financial supermarkets." As the financial services industry has blossomed since the last major bottom in the stock market in 1982, increasing numbers of Americans have become larger players in the markets. Consumption has also boomed, aided by the long-term decline in interest rates that began at the same time. Together, these trends have been fed--and have indeed been fed by--ever more sophisticated offerings from financial services companies of every stripe.

It is only natural, the proponents held, that Glass-Steagall be repealed so that "competitive forces" would no longer be held back in the quest to provide American consumers and investors with more, cheaper, and faster means of joyfully taking part in this new financial Golden Age. As President Clinton stated in signing the Financial Services Modernization Act, " (It) will help the American financial services system play a leading role in propelling our economy into the 21st century, continuing the longest peacetime economic expansion in our history."

Those who opposed the bill used arguments centered chiefly around two issues: financial privacy and credit availability to minority communities. Highlighting the former, Rep. Ed Markey (D-MA), in the House debate, held up a big sign reading, "YOU HAVE NO PRIVACY RIGHTS." He and others--including consumer groups opposed to the bill--warn of these financial supermarketsí increased ability to acquire financial information and profiles on their customers. Rep. David Obey (D-WI) labeled the bill as "consumer fraud masquerading as financial reform."

Trying to deflect this concern, Clinton remarked, "I want to make sure every family has meaningful choices about how their personal information will be shared within corporate conglomerates. . .We cannot allow new opportunities to erode old and fundamental rights."

He promised those opposed to the bill that he would examine the bill in more detail later, and propose some "fine-tuning" on this point as separate legislation next year.

The other key issue of the opponents was the Community Reinvestment Act, a law--which even conservatives such as former New York Republican Congressman and 1996 vice presidential candidate Jack Kemp championed when he promoted his idea of "enterprise zones"--requiring that banks provide credit to people in low-to-moderate income areas. Sen. Phil Gramm (R-TX)--who together with Rep. Jim Leach (R-IA) were the main architects of the recent bill--had long opposed keeping the CRA as part of any new legislation. In the end, while the CRA was technically kept alive, its accompanying enforcement provisions were greatly reduced.


On the surface, the financial communityís motivation in lobbying hard for passage of the Financial Services Modernization Act seems obvious. At stake are trillions of dollars of Americansí savings, investment and insurance business--and an estimated $350 billion a year that Americans spend on the associated fees and commissions. Proponents claimed the legislation will ultimately save consumers some $15 billion of this figure annually, offering them greater choice and convenience, and spurring competition.

Few took the time to ponder, however, the coming concentration of the remaining $335 billion in fewer and fewer hands. With the passage of the new law, it is universally expected that the existing trend of larger financial institutions gobbling up smaller ones will go into overdrive, leading to the extinction of the majority of small to mid-sized banks in particular in the coming years.

More fundamentally, though, it must be recognized that the current over-extended financial environment requires the changes that the Financial Services Modernization Act brings, in order to keep both Wall Street and Main Street going. It is more important than ever--in order to keep our asset (and debt) bubbles from bursting sooner rather than later--that the financial services industry be largely unfettered in its activities.

Those who understand our fractional reserve monetary system know that, in order to keep the stock market and economy chugging along, the creation of credit and paper wealth must continue to expand geometrically. This is why recent years have seen the proliferation not only of merger activity (which leverages the valuation of existing companies, creating more wealth) but the birth of newer--and more risky--financial and monetary creations such as derivatives. The values of these hot new financial assets and the generally increased availability of credit have served to keep debt levels--and stock valuations--climbing far higher than anyone would have thought possible not many years ago. In fact, as Iíll discuss in the December issue, these new types of credit instruments and proxies for what is perceived as real wealth in underlying assets have in a very real way become part of the nationís overextended "money supply."

Particularly for those newer subscribers to The National Investor--and as a refresher for you "old timers" out there--it behooves me to explain the monetary systemís need for the Financial Services Modernization Act by once again going into my description of "The Game."


"All the perplexities, confusion and distress in America arise, not from defects in the Constitution or confederation, not from want of honor or virtue, so much as from downright

ignorance of the nature of coin, credit and circulation."

--President John Adams

Many of you reading this are familiar with the above quote. Itís been my observation that the larger context and meaning of Adamsí statement--and its particular application to todayís economy and monetary system--has not been fully understood, even by some students of monetary matters. Most observers, serious though they may be, often lose sight of the nature of money, the process of its "creation" today and the methods by which it is controlled.

There is nothing magical about the craft of what the Fed itself calls fractional reserve banking. Money creation is a deliberate, definable process; its volume and "price" fairly identifiable. Few have been able to put all of the pieces together, though and identify--and understand-- "The Game," and how it works. As the British economist John Maynard Keynes wrote in his 1920 book entitled, The Economic Consequences of the Peace, "not one man in a million" is able to diagnose the intricacies of central banking, its inflationary component, and how over time it robs the masses of wealth.

Weíre about to increase those odds.

When we do--once you understand what follows--you will immediately have more insight into what makes this whole mechanism called the U.S. economy work than does your local banker. Youíll have a much better idea of which way the financial markets and interest rates are going than does your most tenured local stock broker (who, if he or she is like most, is nothing more than a glorified salesman anyway.) Youíll be in a better position than most to generate profits in your investments and, just as importantly, to know how to preserve them as well.

And, youíll know why all the doom and gloomers failed to see the long bull market in stocks which--in part--was actually made possible by the explosion in debt levels in recent years, as Iíve previously written.

To understand it all, we must first understand what we use as money; what it is, where it

comes from, how it comes into being, etc... For the purposes of this discussion, at least, it makes no difference whether what we use AS money is gold, silver, paper, bookkeeping entries, or numbers on a computer screen. If gold were used AS money today, with all other things being equal, our lot as consumers, workers, investors and Americans would be no different (with the exception being that some would need tighter belts to keep their pants from falling down!)


In doing seminars, radio, writing my newsletter and in otherwise sharing this critical understanding over the years, my favorite prop has been an ordinary deck of playing cards. When possible, Iíll take four people and place them at a table. I am the "banker"; thus, I have the ownership and ultimate control of the deck.

To show how what we use as money today (essentially, bank credit) comes into being, and how it works, I deal each of the four people at the table five cards. I inform them that they have until this evening to play one or a number of games among themselves with those cards, provided they play by some general rules that I establish.

I also inform them that when I return each player will be obligated to repay me; not five cards, which was the amount of the "principal" I loaned, but six cards. After all, the cards are mine; I am entitled to a profit, or interest, for loaning them to each of the players. Thinking that they each might have a reasonable chance--since theyíre all experienced card players--they agree.

Oh, and one final condition. If any of the four is unable to pay me six cards when I return, I will be the new owner of their home.

More often than I care to tell you, itís taken quite a while for anyone in the audience to tell me what is fatally wrong with this scenario. Of course, you all know already...I did not put enough cards on the table! I donít care how good these four card players are, nor does it matter that their very lives might even be forfeited if they are unable to repay the debt. Simple mathematics dooms at least one of these sorry individuals to losing his or her home. There simply are not enough cards in the game to allow each to be able to repay me both principal and interest.

Of course, it would be cruel and heartless of me to foreclose on any of these people; after all, the "luck of the draw" doesnít always go your way. Therefore, if one is short (and at least one of the players is guaranteed to be short) Iíll make him a deal--and such a deal at that!

He now owes me six cards (the other three wiped him right out.) Iíll loan him the six cards with which to "roll over" his debt--but now, heíll owe me eight in the end. "No problem," he says to himself, "I need only come up with two more. My luck is bound to change!"

And so, the game goes on, and on, and on...but it cannot--and will not--go on forever.

Now, letís relate that analogy to "real" banking itself. In an old Newsweek magazine story on the Federal Reserve System, that publication stumbled upon but then dropped a critical truth of "fractional reserve banking." In its February 24, 1986 issue, in a piece entitled "Making Money Out Of Thin Air--The Fed Is The Economic Equivalent of The Kremlin" their reporter Bill Powell reported, "The Fed controls the supply of money banks have to make loans...With the stroke of a few computer keys, the Fed creates money out of thin air, adding funds, known as reserves, to the (local) bank. The bank is able to lend out those reserves several times over, creating even more money."

So, in part through what is known as its "open market operations," the Fed generally sets the amount of money that commercial banks can loan--money created literally "out of thin air."

It is these funds--multiplied several times over--that local banks loan into being each day in the form of business, personal, mortgage, credit card and assorted other loans. That is how what we use as money--bank credit created out of thin air--comes into existence.

Letís roll over our card game analogy directly to financial matters.

Letís suppose that you and nine other people go to the bank and take one-year loans of $10,000.00 each. The banker puts a total of $100,000.00 in circulation, correct? If he requires 10 per cent interest over the course of the year, you must each pay him back $11,000.00, for a total of $110,000.00, right? Do we not have the same problem as our card players? Where will the additional $10,000 come from in this context? When asking this question of people in seminars, one or more invariably will respond that these people can go out and work, compete, etc. for money already in the economy. But even the existing money and credit in circulation only got there from previous loans of principal amounts made to other people. In those instances as well, the banks did not additionally put into circulation the dollars that would be required over time to repay them the various amounts of interest.

Hopefully you see the situation, but now pay especially close attention...

As time marches on, the banker (actually, the entire system, up to and including the Federal Reserve) must continue to make loans--to increasing numbers of people, and in increasing amounts--to keep the whole game going. As you hopefully see already, principal amounts previously loaned are all that is out there for everyone to use to make payments of both principal and interest. NOTHING has ever been put into circulation to make interest payments on all our public and private debts--do you see that, my friend? We all, public and private sectors alike, compete for money that has been "created" previously as principal amounts of loans. And, as the total debt bubble grows ever larger, the portion attributable to interest grows geometrically, eventually dwarfing the original amounts of everyoneís borrowings--a point we have now reached. Talk of occasional Federal Reserve "tightening" aside, this makes it critical that the rate of growth of the nationís "money supply" continue to rise--just so everyone can keep up with their payments!!


This, of course, is the reason for the ever-more-rapidly accelerating levels of debt. The "hyperinflation" long predicted by many has already occurred; however, instead of being evidenced in rising prices for most goods and services (which due to cheaper production costs, increasing productivity and global competition have in many cases actually declined in recent years) the hyperinflation has been evident in debt levels and equity prices. What many have more recently dubbed "The Wealth Effect" is a phenomenon that I have discussed for several years. Rising values particularly in real estate and the stock market have made Americans wealthier, and able to take on more debt; the latter, as Iíve described, is critical to keep "The Game" of fractional reserve banking going. In turn, this increased spending--based on American businesses and consumers taking on more debt--fuels corporate profits, driving the market higher.

Itís been a great "vicious circle"--and can only be kept going, at least for a while, in an environment of even greater new creation of wealth, credit instruments and the like, which will now be helped along even further by passage of the Financial Services Modernization Act.

Now, all of this does not mean that The Game will last indefinitely, at least as it is made up now. Among other things, it is mathematically impossible in the end. We have already seen from the upright spikes forming in both the levels of debt and in the stock market that the ultimately unsustainable vertical spike is at hand. In the case of the stock market, the longer we go without a pullback or "correction" of this spike, the more dramatic the eventual fall might be. In his various musings on the current valuation of stocks, Fed Chairman Alan Greenspan has warned as much.

The passage of the Financial Services Modernization Act--all things being equal--could very well keep another great crash that its critics predict at bay longer still. The resulting increase in credit and wealth creation, merger activity and more is, as Iíve described, quite necessary to keep the financial house of cards growing even higher; there can be no turning back. At the same time, though, it promises that an eventual downturn in the economy or stock market just might end up as badly as that of the Great Depression after all, in spite of the various safeguards in place.

Iíll go more into the reasons for this in Decemberís issue, where Iíll also give you some notes from an interesting--and revealing--Cato Institute meeting I attended recently in Washington on "The Search for Global Monetary Order."

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