In the March 2, 2009 edition of Fortune magazine, Katie Benner provides a vivid description of the activities of Pimco (a subsidiary of the German company Allianz), “the world’s largest and most influential bond investment house.” It has total assets of $747 billion under management, its own assets are valued at $132 billion, and it manages about 1.5% of all bonds outstanding worldwide. 

“Thanks to enormous bets on mortgage bonds backed by Fannie Mae and Freddie Mac, Pimco had an outstanding year”, Benner reports. Pimco’s main mutual fund earned a return of 4.8% while “the typical intermediate-term bond fund lost 4.7%”. 

Significantly, Pimco was guided by a view that the US economy was “being fuelled by an unsustainable borrowing binge” that would end in an “economic storm” and that “ultimately the government would have to step in to ease the pain”. Based on the view that the US government would not allow government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac to fail, Pimco in 2008 invested a substantial part of its managed funds into GSEs. In other dealings, such as an investment in GMAC, the General Motors financial company, Pimco also successfully bet on the government coming to the aid of selected ailing financial companies. 

The main difference between Pimco and the investors that have lost billions of dollars on sub-prime mortgages is that it holds the mortgage bonds directly and not through derivatives. If any of the borrowers fail to pay, it is Fannie Mae, Freddie Mac and now, ultimately the US taxpayers who will lose, not Pimco and its managed funds. Pimco has the added advantage that the US government has a sensitive political reason for not allowing its main GSEs to fail: the Chinese government, “a huge holder of Fannie and Freddie debt” and foreign central banks would suffer substantial losses. 

During an interview with Fortune magazine, the founder and co-chief investment officer of Pimco, Bill Gross said, “We efficiently allocate capital around the US and the world. We are in the business of capitalism.” He could not be more wrong. The opportunity to trade on government failure would not be a phenomenon of a free market or truly capitalist world in which economic freedom predominates. Pimco is in the business of rent-seeking, a business which trades on government favours and government failures. True economic freedom would eliminate such possibilities. 

The ultimate source of the government failures that are rippling around the world is the monopoly over the provision of money that governments have appropriated to themselves. The credit boom and its subsequent crash are direct consequences of excessive fiat money creation and manipulation of interest rates. The US Federal Reserve created the credit binge by being prepared to lend money to banks at interest rates that were, for example, 1.82%, 1.24% and 0.98% in December 2001, 2002 and 2003, respectively (down from 6.40% in December 2000), causing the prime lending rates of the banks to vary between 4.00% and 5.15% during that period. Increasing the money supply is the only way that a central bank can induce and maintain such artificially low interest rates. 

Consider the plight of an American homebuyer, who borrowed $250,000 (about R2.6M) to purchase a house in December 2003 at the prime bank interest rate of 4%. The annual interest would have amounted to $10,000 (R104,000). By December 2006 the prime interest rate had increased to 8.25% and the annual interest rate payable by the home owner to $20,625 (R214,500), more than double the amount of the original interest.

With the benefit of hindsight, commentators are now suggesting that it was unwise of homebuyers to borrow at low interest rates, especially at variable rather than fixed rates, and pay the high prices that resulted from the availability of low interest rates. However, those rates had already been around for about 3 ½ years and had been declining during that time. Borrowers were not to know that the Federal Reserve would jump their rate from 0.98% in 2003, to 5.24% in 2006, only to slash it back again to 0.16% in December 2008. By then they had lost their houses and were blaming the banks for ill-treating them. Politicians, meanwhile, yelled from the wings that the whole mess resulted from the greed of banks, insufficient regulation, rampant capitalism, and anything else they could think of to direct attention away from their own ill-conceived policies and the manipulation of the currency and interest rates by the Federal Reserve Board they had appointed.

British Prime Minister Gordon Brown, who appears to relish the prospect of nationalising British banks and increasing the power of his government over the citizens, during his visit to the US, took the opportunity in his joint press conference with President Barack Obama to describe how his government was taking control and would be revising regulations that had become outdated. He left no doubt that he meant an even greater role for government. President Obama was much more restrained in his remarks, saying that the US supported free markets and that any steps taken by the American government would be temporary measures intended to restore stability to the economy. He also stressed the importance of maintaining free trade policies. 

The current crisis is a monetary crisis. Money worldwide is monopolised by governments and all responsibility for monetary crises can therefore be laid squarely at the door of governments. Citizens should stop this form of behaviour and impose controls on those governments and central banks that, by excessive printing of money and unwise manipulation of interest rates, have behaved irresponsibly.  

Citizens should insist that mechanisms be introduced to prevent future monetary manipulation for political or any other purpose. They should also insist that legislation be changed to open the way for the introduction of private currencies to compete with national currencies on a basis of equality before the law. This would prevent the kind of mayhem that has resulted from government failure in the management of money. It would also reduce the opportunities of rent-seekers to make fortunes from government failures and government favouritism that are ultimately paid for by taxpayers and citizens in general. 

By Eustace Davie, 

Free Market Foundation.