This Blog Has Moved!

My blog has moved. Check out my new blog at

Your Ad Here

Wednesday, June 20, 2007

The True Purpose of the Federal Reserve

Before the Federal Reserve was founded, banks were fiercely competing with each other. Each tried to offer the highest rate to attract deposits and tried to offer the lowest rate on loans. Interest rates were determined by the market. At that time, money and gold were equivalent, so there was a fixed supply of actual money. When a bank failed, customers lost their deposits.

There was a problem that concerned the large international banks. Large pools of private capital were forming, outside the control of the international banks. These private capital pools meant that it was possible to start a business that the international banks could not control. It was necessary to corrupt the financial system to destroy these private equity pools.

The banks got together and decided to fix prices. However, rather than doing it informally, where there would be a temptation to cheat, they decided to get their price-fixing mechanism coded into law. The Federal Reserve keeps interest rates artificially low compared to where they would be in a free market, where interest rates are allowed to float. The Federal Reserve has access to an unlimited amount of dollars and bonds, so it can manipulate the market at will.

By getting the price fixing mechanism coded into law, small banks who weren't in on the scam would be forced to follow the cartel-fixed rate, rather than the market rate. Most of the small banks who weren't in on the scam were forced into bankruptcy during the Great Depression.

Artificially low interest rates inflate the demand for loans. If a business has a choice between financing growth from earnings or financing growth from a loan, the loan is the more attractive option. Because loans are priced artificially low, many extra loans are issued, which is good for the financial industry. Artificially low interest rates destroyed the private equity pools, because financing via debt was now guaranteed to be better than financing via equity.

The Federal Reserve's practice of fixing interest rates at an artificially low level is the primary reason for the Discounted Cashflow Paradox.

Government-subsidized artificially low interest rates are great for the financial industry. Similarly, government-subsidized $10/barrel oil prices would be great for the oil industry. Either way, the average person would be paying for them through taxes or inflation. A government-subsidized $10/barrel oil price would encourage people to consume all the oil they could. Similarly, artificially low interest rates encourage people and businesses to take out all the loans they can.

The government ceded its money printing authority to the Federal Reserve. This was functionally equivalent to ceding sovereignty. The government no longer directly issues new money. It just borrows it from the Federal Reserve. In theory, the government still could directly print money without going through the Federal Reserve, but the last President who tried that was JFK and we know what happened to him. The reason it was necessary to strip the government of its money issuing authority was that otherwise the government could frustrate the Federal Reserve's interest-fixing attempts by issuing money.

Due to fractional reserve banking, any new money directly printed by the government would get amplified by the reserve ratio, such as 10x. In other words, if the government directly printed and spent $1 trillion, this would lead to an increase of $10 trillion in the money supply, due to the effect of fractional reserve banking. Under a fractional reserve banking system, government bonds don't count as reserves. When the government has deficit spending via a bond, it doesn't have the multiplicative money effect. That's why the government has to issue bonds rather than directly printing and spending money.

Normally, the Federal Reserve prints money, buys government bonds, and sells them back to the government at maturity, canceling out the money it just printed. Doing this, the Federal Reserve makes a guaranteed riskless profit. If the government directly printed and spent its own money, the Federal Reserve would have to sell bonds to soak up the extra money, to contain inflation. The Federal Reserve can't make a guaranteed riskless profit this way. Actually, it would lose money. That's why the government has to be barred from directly printing and spending money.

If the government issued its own money independently of the Federal Reserve, it would be like stepping on the accelerator and the gas pedal at the same time. The Federal Reserve would be acting to keep interest rates artificially low, while the government would be driving up interest rates when it was printing and spending new money.

Another goal of the Federal Reserve system was to artificially restrict the supply of money, which the Federal Reserve had a monopoly on generating. Due to the Compound Interest Paradox, each of the Federal Reserve's actions have a net effect of decreasing the total amount of money in circulation. The Federal Reserve can temporarily increase the money supply by offering more loans (i.e. lowering interest rates), but all that new money has to come back eventually, plus more, as loans are repaid. This naturally leads to boom/bust cycles. There's a boom as rates are lowered to increase the money supply, followed by a bust as the money supply naturally contracts as the loans are repaid. During the bust cycle, money is tight. Banks are able to foreclose on real assets, confiscating real assets that they only "earned" because of money they created artificially through debt. The insiders of the Federal Reserve system know in advance when credit is going to be tightened and the bust cycle will occur. They stop making loans before their competitors, increasing their cash holdings so they have an advantage during the upcoming credit crunch. The first bust cycle was the Great Depression. Nowadays, the Federal Reserve is careful to make sure the busts aren't so bad that people start questioning the fundamental nature of the system.

During the Great Depression, the Federal Reserve insiders made a killing. Knowing that credit was going to be tightened, the banks who controlled the Federal Reserve converted all their holdings to cash. They stopped issuing loans, knowing that credit would be tightened. Then, after the crash, they bought assets at a discount. They intentionally kept credit tight until Roosevelt became President so he could take credit for the economic recovery.

The Federal Reserve is also the reason most Americans are struggling under debt. Due to the Compound Interest Paradox, there are more debts than actual cash in circulation. Due to this circumstance, most Americans must be net debtors. People subconsciously act as if the market is a zero-sum game; another person's wealth necessarily came at the expense of others. On the face of it, this seems silly; why should someone else's wealth detract from me? It's not so silly when you see the structural flaw in the system. Due to the Compound Interest Paradox, one person can have great wealth only if a lot of other people are in debt by a greater amount. The Compound Interest Paradox makes the market worse than a zero-sum game. It's a negative sum game, because each new debt decreases the total score. In reality, the market should be a positive-sum game, because new goods are being produced and business processes are always being streamlined. However, new goods can't be created faster than the Compound Interest Paradox sucks the money away.

That's why people and politicians are always complaining about "not enough money". It's not "There's a shortage of productive capacity." or "Productivity is too low." The complaint is "There's not enough money." There literally isn't enough money. The amount of outstanding debts is far greater than the money in circulation. There never can be enough money under the current financial system.

I don't think that the original creators of the system really understood the effect of the Compound Interest Paradox over time. They realized that the Compound Interest Paradox enabled them to make huge profits. I don't think they planned well enough to see 50-100 years into the future, when the sum total of outstanding debts would be far far greater than the money supply. The current state of affairs is starting to get ridiculous. Debt is always going to increase exponentially faster than the total amount of money. Typically, a system like this starts to get unstable and may collapse in hyperinflation. In a period of hyperinflation, the Federal Reserve may lose its ability to regulate the economy, especially if inflation is so high that people are forced to return to a barter system. Similarly, in a deflationary depression people would be forced to return to a barter system. In a depression, anyone who was unleveraged and holding concrete assets would benefit; anyone who's in debt is stuck. In a hyperinflation scenario, someone holding gold or silver would benefit, because it would represent real value rather than worthless paper. In a deflationary depression scenario, someone holding gold or silver would benefit, because they could sell it and buy other things at a bargain.

The income tax was passed the same time as the Federal Reserve Act. That is no coincidence. Without an income tax, people would be able to effectively boycott the Federal Reserve's money, and instead perform barter transactions. However, if you perform a barter transaction, you still have to pay taxes on the equivalent value of the transaction in dollars. That means it's impossible to live solely performing barter, because you'd have to somehow acquire dollars to pay taxes. The income tax guarantees that everyone needs to use dollars to a certain extent. The tax system creates a certain guaranteed demand for dollars. However, hyperinflation would cause the whole system to fail, because the dollar value at the time of a barter transaction would be far less than the dollar value when it was actually time to pay the taxes. In a hyperinflation scenario, a return to a barter system would be necessary for survival.

Even though the banking cartel benefits greatly under the current system, a total collapse of the dollar cannot be their goal. I don't think the insiders who support the Federal Reserve system want to see total worldwide economic collapse. In such an event, a lot of their wealth and power might be lost.

That is an interesting question. Can a period of hyperinflation and collapse be postponed indefinitely under the current system? Or, will it be possible to stabilize inflation at the current level of 8-10% per year? If inflation starts to get out of control, it could happen. In particular, China has a huge economic bomb it could use against the US. If China decided to simultaneously dump all its dollars (such as buying up a large amount of commodities), other countries would follow suit and there might be hyperinflation that would break the system. Nobody would be willing to buy long-term US government debt anymore, and the high interest rates the government would have to pay on 10-year and 30-year bonds would still be causing inflation as they are retired.

On the other hand, the US has one benefit that other countries with a hyperinflation problem did not have. All of the US government debt is denominated in dollars, a currency the US controls. Other countries have had trouble because their debt was in dollars but their income was in local currency, which they could not effectively convert back to dollars. They took out dollar-denominated loans, and the Compound Interest Paradox made it hard for them to raise dollars to make the interest payments. This benefit alone might be enough to prevent the US from having hyperinflation. Having all your debts denominated in a currency you control makes it impossible for you to default. A partial default via inflation is certain, but not a complete default.

The hedge fund and leveraged buyout industry has, to a large extent, evolved to take advantage of the Federal Reserve's policy of artificially low interest rates. Hedge funds are allowed to use leverage of about 7x-10x. With interest rates fixed at a level that is 3-5% below where they naturally would be, that leads to a profit rate of 21% to 50% for the hedge funds, just from the use of leverage.

Leveraged buyouts usually target a company with a clean balance sheet (i.e. no debt). A company that is prudent and minimizes debt is effectively punished with a takeover. The takeover can be financed primarily by loading the acquired company with debt. This is made possible because money can be borrowed at an artificially low rate. It's a no-win situation for the prudently managed company. If you have no debt, you are a takeover target. If you have debt, you are subject to foreclosure by your creditors during the next bust cycle. The only companies that can effectively carry a lot of cash on their books are companies that are so big that they couldn't be a takeover target, companies such as Microsoft and Berkshire Hathaway. The average person senses that there is something unjust about hedge funds and leveraged buyouts. They are right. Hedge funds and Leveraged buyouts are made possible by the price-fixing practices of the Federal Reserve.

In summary, the Federal Reserve is bad because it's a price fixing cartel that fixes interest rates at an artificially low level. This policy has created a tremendous amount of economic distortions. I haven't mentioned all of them here.

The official CPI is 3%, but I suspect the true inflation rate is in the range of 6-10%. That means that the Federal Reserve has to have inflation-adjusted interest rates of -1% to -5%, just to encourage enough borrowing to keep enough money in circulation. The spread is only going to grow over time. All economic scams must come to an end eventually. The market cannot be tricked forever.


Anonymous said...

Thanks for your enlightening explanation of our predicament.

Do you know which banking families control the Federal reserve? I assume that the wealth thay has been accumulated has served as the basis of banking dynasties.

Also why is our media silent? Not one paper or TV news show discusses the Reserve, fractional banking,..etc. in any sort of critical light.

Anonymous said...

Good points. Mitt Romney did exactly what you mentioned while at Bain. Leveraged buy out of decent companies, load them up with debt and then fire employees and then sell assets etc. with a huge profit for a few people while destroying business, lives and communities. Free market indeed!

This Blog Has Moved!

My blog has moved. Check out my new blog at